Deloitte's Roadmap: Hedge Accounting
Preface
Preface
We are pleased to present the 2023 edition of Hedge Accounting.
This Roadmap provides an overview of the FASB’s authoritative guidance on hedge
accounting in ASC 8151 as well as our insights into and interpretations of how to apply that guidance in
practice.
Entities are exposed to operational risks, and they can mitigate some of those risks by
entering into separate contracts that may meet the definition of a derivative
instrument. For such circumstances, ASC 815 allows entities to use a specialized hedge
accounting for qualified hedging relationships. If hedge accounting is not applied,
changes in the fair values of derivative instruments are recognized in earnings in each
reporting period, which may or may not match the period in which the risks that are
being hedged affect earnings. Therefore, the objective of hedge accounting is to match
the timing of income statement recognition of the effects of the hedging instrument with
the timing of the recognition of the hedged risk.
Hedge accounting is a complex aspect of GAAP that is largely governed by
“rules-based” guidance developed over many years in response to constituents’ requests
for interpretive guidance. This Roadmap is intended to help entities navigate that
accounting and financial reporting guidance, reduce complexity, and arrive at
appropriate accounting conclusions. For a summary of substantive changes made to this
publication since the 2022 version, see Appendix
D.
This Roadmap provides guidance on the application of hedge accounting to a qualified
hedging relationship. For a comprehensive discussion of the identification,
classification, measurement, and presentation and disclosure of derivative instruments,
including embedded derivatives, see Deloitte’s Roadmap Derivatives.
Be sure to check out On the Radar (also available as a stand-alone publication), which
briefly summarizes emerging issues and trends related to the
accounting and financial reporting topics addressed in the
Roadmap.
We hope you find this Roadmap a useful resource, and we welcome your suggestions for future improvements.
If you need assistance with applying the guidance or have other questions about this
topic, we encourage you to consult our technical specialists and other professional
advisers.
Footnotes
1
For a list of abbreviations used in this publication, see
Appendix C. For
the full titles of standards, topics, and regulations used in this publication,
see Appendix B.
On the Radar
On the Radar
Some entities mitigate certain risks by entering into separate
contracts that meet the definition of a derivative instrument. For such
circumstances, ASC 815 allows entities to use a specialized hedge accounting for
qualified hedging relationships. If hedge accounting is not applied, changes in the
fair values of derivative instruments are recognized in earnings in each reporting
period, which may or may not match the period in which the risks that are being
hedged affect earnings. Therefore, the objective of hedge accounting is to match the
timing of income statement recognition of the effects of the hedging instrument with
the timing of recognition of the hedged risk. For further discussion of derivatives
not designated in qualifying hedging relationships, see Deloitte’s Roadmap Derivatives.
Financial Reporting Considerations
What Are the Different Hedge Accounting Models?
ASC 815 provides three
categories of hedge accounting, each with its own accounting and reporting
requirements:
Fair Value Hedges
For a fair value hedge to qualify for hedge accounting, the exposure to
changes in the hedged item’s fair value attributable to the hedged risk must
have the potential to affect reported earnings. Examples of eligible
exposures (i.e., hedged items) may include fixed-interest-rate assets or
liabilities, inventory on hand, foreign-currency-denominated assets or
liabilities, a portion of a closed portfolio of prepayable financial assets
(or one or more beneficial interests secured by a portfolio of prepayable
financial instruments), or a fixed-price firm commitment.
Generally speaking, an entity with a fair value hedge that meets all of the
hedging criteria in ASC 815 would record the change in the derivative’s
(i.e., hedging instrument’s) fair value in current-period earnings. It would
also adjust the hedged item’s carrying amount by the amount of the change in
the hedged item’s fair value that is attributable to the risk being hedged.
The adjustment to the hedged item’s carrying amount would also be recorded
in current-period earnings. For fair value hedges, both the change in the
hedging instrument’s fair value and the change in the hedged item’s carrying
amount are presented in the same income statement line item and should be
related to the risk being hedged. As a result of applying hedge accounting
in a qualifying fair value hedging relationship, an entity accelerates the
income statement recognition of the impact of changes on the hedged item
that are attributable to the hedged risk. Accordingly, the entity recognizes
the changes in the same period as the changes in the derivative’s fair
value.
Cash Flow Hedges
To be eligible for designation as a hedged item in a cash flow hedge, the
exposure to changes in the cash flows attributable to the hedged risk must
have the potential to affect reported earnings. Examples of eligible hedged
items may include variable-interest-rate assets or liabilities,
foreign-currency-denominated assets or liabilities, forecasted purchases and
sales, and forecasted issuances of debt. The objective of a cash flow hedge
is to use a derivative to reduce or eliminate the variability of the cash
flows related to a hedged item or transaction.
Generally speaking, an entity with a cash flow hedge that meets all of the
hedging criteria of ASC 815 would record the change in the hedging
instrument’s fair value in other comprehensive income (OCI). Amounts would
be reclassified out of accumulated other comprehensive income (AOCI) into
earnings as the hedged item affects earnings. Those amounts would also be
presented in the same income statement line item in which the earnings
effect of the hedged item is presented. As a result of applying hedge
accounting in a qualifying cash flow hedging relationship, an entity defers
the income statement recognition of changes in the derivative’s fair value.
Accordingly, the entity recognizes the changes in the same period in which
the hedged item affects earnings.
If it becomes
probable that a hedged forecasted transaction
either will not occur or will not occur without
significant delay, an entity must immediately
reclassify amounts from AOCI into
earnings.
Net Investment Hedges
A net investment hedge is a hedge of the foreign currency exposure of a net
investment in a foreign operation. Even though the translation of a net
investment in a foreign operation is recognized as part of the currency
translation adjustment in OCI, there is a potential earnings risk upon
disposition of that investment in the foreign operation. Accordingly, the
foreign currency exposure in a net investment in a foreign operation is a
hedgeable risk. Generally speaking, an entity with a net investment hedge
that meets all of the hedging criteria of ASC 815 would record the change in
the hedging instrument’s fair value in the cumulative translation adjustment
(CTA) portion of OCI.
Does the Entity Want to Apply Hedge Accounting?
Not all derivatives will be designated as hedging instruments in qualifying
hedging relationships under ASC 815. For example, an entity that owns shares of
a publicly traded stock can economically hedge price changes in that stock by
entering into financially settled options or forwards related to that stock. If
both the hedging instrument (i.e., the derivative) and the hedged item (i.e.,
the stock) are recognized on the balance sheet at fair value, with changes in
fair value recognized in earnings in each reporting period, no specialized
accounting is needed to match the recognition of gains and losses on the
derivative with the recognition of those on the stock investment.
In addition, some derivatives may be entered into as economic hedges of risk but
may not qualify for hedge accounting because they are related to an exposure
that is not a qualifying hedge accounting exposure. Further, hedge accounting is
optional, so some entities choose not to apply it to qualifying hedging
relationships because they perceive that the costs of such accounting exceed its
benefits.
Note that
derivatives that are used as economic hedges but are
not designated in qualifying hedging relationships
require special consideration for financial
reporting purposes. Finally, some derivatives are
entered into for speculative purposes and are not
part of a risk mitigation strategy.
Does the Hedging Relationship Qualify for Hedge Accounting?
ASC 815 outlines the types of items that qualify as the hedging instrument
(generally, derivatives that are not written options) and the hedged item. In
addition, the guidance permits an entity to hedge the risk of changes in the
entire fair value of the hedged item or in all the item’s cash flows, but an
entity may hedge certain other risk components of the hedged item as well. The
nature of the risks that may be hedged depends on whether the hedged item is a
financial asset or liability or a nonfinancial asset or liability. An entity is
permitted to hedge any of the risks individually or in combination with other
risks. The most common component risks that entities hedge are interest rate
risk, foreign currency risk, and the risk of changes in contractually specified
components of the forecasted purchase or sale of nonfinancial assets.
Before a hedging relationship can qualify for the application of hedge
accounting, an entity must demonstrate that the hedging instrument is “highly
effective” at offsetting the changes in the fair value or cash flows of the
hedged item. ASC 815 does not explicitly define a quantitative threshold that
would be considered highly effective; however, in practice, a hedge is
considered highly effective if the change in the hedging instrument’s fair value
provides offset of at least 80 percent and not more than 125 percent of the
change in the fair value or cash flows of the hedged item that are attributable
to the risk being hedged.
Finally, when issuing its initial accounting and reporting requirements for derivatives in FASB Statement 133 in June 1998, the FASB noted that “concurrent
designation and documentation of a hedge is critical; without it, an entity
could retroactively identify a hedged item, a hedged transaction, or a method of
measuring effectiveness to achieve a desired accounting result.” The way in
which entities comply with those requirements is commonly referred to as the
hedge designation documentation. Most aspects of the hedge designation
documentation must be completed at the inception of the hedging relationship,
including identification of the method of assessing whether the hedging
relationship is highly effective.
Changing Lanes
ASU
2017-12 added the “last-of-layer” method to ASC 815,
which enables an entity to apply fair value hedging to closed portfolios
of prepayable financial assets without having to consider prepayment
risk or credit risk when measuring those assets. In March 2022, the FASB
issued ASU
2022-01, which expands the current single-layer
model to allow multiple-layer hedges of a single closed portfolio of
financial assets under this method. The last-of-layer method is renamed
the “portfolio layer method” to reflect this change.
On the Horizon
In November 2019, the FASB issued a proposed ASU of Codification improvements to hedge accounting.
Comments were due in January 2020. The FASB is still considering comment letter
feedback on the proposed ASU.
This Roadmap provides an overview of the
FASB’s authoritative guidance on hedge accounting as well as
our insights into and interpretations of how to apply that
guidance in practice. For guidance on the identification,
classification, measurement, and presentation and disclosure
of derivative instruments, including embedded derivatives,
see Deloitte’s Roadmap Derivatives.
Contacts
Contacts
|
Jonathan Howard
Audit & Assurance
Partner
Deloitte & Touche
LLP
+1 203 761 3235
|
|
Ashley Carpenter
Audit & Assurance
Partner
Deloitte & Touche
LLP
+1 203 761 3197
|
|
Brandon Coleman
Audit & Assurance
Partner
Deloitte & Touche
LLP
+1 312 486 0259
|
|
Andrew Pidgeon
Audit & Assurance
Partner
Deloitte & Touche
LLP
+1 415 783 6426
|
For information about Deloitte’s hedge accounting
service offerings, please contact:
|
Jamie Davis
Audit & Assurance
Partner
Deloitte & Touche
LLP
+1 312 486 0303
|
Chapter 1 — Overview
Chapter 1 — Overview
1.1 Objective of Hedge Accounting
An entity is exposed to risks. The more complex its operations are,
the more risks it is exposed to. An entity that uses a commodity in its operations
is exposed to the risk that the commodity’s price will increase (i.e., commodity
price risk), which would increase its production costs. That same entity may fund
some of its operations by borrowing money under debt arrangements in which interest
rates are adjusted periodically (i.e., variable-rate debt). As a result, the entity
would also be exposed to the risk of higher interest rates on its debt (i.e.,
interest rate risk), which would increase its interest expense. If the entity has
global operations, it would also be exposed to changes in foreign currency exchange
rates.
Some entities mitigate certain risks by entering into separate contracts that may
meet the definition of a derivative instrument. For such circumstances, ASC 815
allows entities to use a specialized hedge accounting for qualified hedging
relationships. For example, assume that Reprise manufactures tweezers and uses
aluminum in its tweezer production process. To protect itself from a possible
increase in the cost of the metal, Reprise may enter into financially settled
futures contracts to purchase the aluminum. Because Reprise’s aluminum futures
contracts are derivative contracts within the scope of ASC 815, the futures
contracts are recognized on its balance sheet at fair value in each reporting
period.
If hedge accounting is not applied, changes in the fair value of derivative
instruments are recognized in earnings in each reporting period, which may or may
not match the period in which the risks that are being hedged affect earnings. In
the case of Reprise, if the price of aluminum were to increase, it would recognize
gains related to the futures contracts in each reporting period over the contracts’
life. However, the cost of the aluminum needed in production would also increase and
would be recognized as an increased cost of goods sold in the period in which the
tweezers are ultimately sold. The objective of hedge accounting is to match the
timing of the income statement recognition of the effects of the hedging instrument
with the timing of the recognition of the hedged risk.
Not all derivatives will be designated as hedging instruments in qualifying hedging
relationships under ASC 815. For example, an entity that owns shares of a publicly
traded stock can economically hedge price changes in that stock by entering into
financially settled options or forwards related to that stock. If both the hedging
instrument (i.e., the derivative) and the hedged item (i.e., the stock) are
recognized on the balance sheet at fair value, with changes in fair value recognized
in earnings in each reporting period, no specialized accounting is needed to match
the recognition of gains and losses on the derivative with the recognition of those
on the stock investment. In addition, some derivatives may be entered into as
economic hedges of risk but may not qualify for hedge accounting because they are
related to an exposure that is not a qualifying hedge accounting exposure. Further,
hedge accounting is optional, so some entities choose not to apply it to qualifying
hedging relationships because they perceive that the costs of such accounting exceed
its benefits. Derivatives that are used as economic hedges but are not designated in
qualifying hedging relationships require special consideration for financial
reporting purposes (see further discussion in Section 6.3.2).
Finally, some derivatives are entered into for speculative purposes and are not part
of a risk mitigation strategy.
Note that not all risk mitigation activities involve derivative instruments — for
example, Reprise could have locked in its production costs by purchasing large
quantities of aluminum in advance. In this case, once the aluminum inventory is
acquired, there is no need for hedge accounting because the inventory is recorded at
cost and there is no further income statement volatility associated with that
portion of the production costs.
While the term hedging is sometimes used broadly to include any of
the risk mitigation activities discussed above, this Roadmap focuses primarily on
the application of hedge accounting, including the importance of the term’s usage in
financial reporting (see Chapter
6). In most cases, hedge accounting involves the designation of a
derivative as the hedging instrument and a hedged item that is (1) a recognized
asset or liability that is not remeasured at fair value, (2) an unrecognized firm
commitment, or (3) a forecasted transaction. For a comprehensive discussion of the
identification, classification, measurement, and presentation and disclosure of
derivative instruments, including embedded derivatives, see Deloitte’s Roadmap
Derivatives.
1.2 History of Hedge Accounting Guidance
Before the FASB’s issuance of Statement 133 in June 1998, the existing guidance on derivatives and hedging activities (provided first by the AICPA and later by the FASB) applied to specific transactions or groups of transactions. FASB Statement 133 established comprehensive accounting and reporting requirements for derivatives (as defined in the standard) and qualifying hedging activities. Derivatives within the scope of FASB Statement 133 were required to be (1) recognized on the balance sheet as assets or liabilities and (2) measured at fair value in each reporting period. FASB Statement 133 indicated that the accounting for
changes in a derivative’s fair value would depend on whether that derivative was
designated and qualified as the hedging instrument in a hedging relationship that
satisfied the criteria to qualify for hedge accounting and the accounting and
reporting requirements for such accounting.
Concurrently with the issuance of Statement 133, the FASB established the Derivatives Implementation Group (DIG) to help it develop guidance on matters associated with an entity’s implementation of FASB Statement 133. The DIG
did not vote on issues or reach consensuses; rather, the FASB chairman identified
resolutions on the basis of the discussions of each issue. The FASB staff then
documented tentative conclusions and made them available for public comment. Once
those conclusions were formally cleared by the Board, they became part of a FASB
staff implementation guide composed of DIG Issues. The DIG met bimonthly from
mid-1998 through March 2001.
In addition to addressing DIG Issues, the FASB issued several amendments to Statement 133, and the EITF deliberated some issues associated with
derivatives and hedging. When the FASB Accounting Standards Codification (the
“Codification”) was released in 2009, ASC 815 became the primary home of the
collective guidance.
In August 2017, the FASB issued ASU 2017-12, which amended the hedge
accounting recognition and presentation requirements in ASC 815. The Board’s
objectives in issuing the ASU were to (1) improve the transparency and
understandability of information conveyed to financial statement users about an
entity’s risk management activities by better aligning the entity’s financial
reporting for hedging relationships with those risk management activities and (2)
reduce the complexity of hedge accounting and simplify its application by
preparers.
ASU 2017-12 is now effective for all entities; see Section 7.2 for a summary of key changes to the
hedge accounting recognition and presentation requirements in ASC 815.
Industry groups, accounting firms, standard setters, and regulators
continue to discuss issues raised related to the implementation of ASU 2017-12. On
the basis of several meetings in 2018 and 2019 regarding these implementation
issues, the FASB posted certain interpretations on its Web site. In addition, in
April 2019, the FASB issued ASU 2019-04, which included amendments to ASC 815 related to
hedge accounting. ASU 2019-04 is now effective for all entities.
As discussed further in Chapter 8, the FASB also established a
reference rate reform project to address concerns about accounting consequences that
could result from the global markets’ anticipated transition away from LIBOR and
other interbank offered rates to alternative reference rates. The first phase of the
reference rate reform project resulted in the October 2018 issuance of
ASU
2018-16, which amended ASC 815 to add the “Secured Overnight
Financing Rate (SOFR) Overnight Index Swap (OIS) Rate” as a fifth U.S. benchmark
interest rate. ASU 2018-16 is now effective for all entities.
Further, in March 2020 the FASB issued ASU 2020-04, which added a new Codification
topic, ASC 848, to provide temporary, optional expedients related to contract
modification accounting and hedge accounting. In December 2022, the FASB issued
ASU 2022-06 to defer the sunset
date of ASC 848 until December 31, 2024. ASU 2022-06 became effective upon issuance
(see Section 8.2 for
more information about the ASU).
ASU 2017-12 added the “last-of-layer” method to ASC 815 (see
Section 3.2.1.4),
which enables an entity to apply fair value hedging to closed portfolios of
prepayable financial assets without having to consider prepayment risk or credit
risk when measuring those assets. In March 2022, the FASB issued ASU 2022-01, which expands the current
single-layer model to allow multiple-layer hedges of a single closed portfolio of
financial assets under this method. The last-of-layer method is renamed the
“portfolio layer method” to reflect this change. See Chapter 9 for further discussion of ASU
2022-01.
Changing Lanes
In addition to the ASUs discussed above, in November 2019,
the FASB issued a proposed ASU of Codification improvements to hedge
accounting. The proposed ASU considered the following potential improvements
to hedge accounting guidance in ASC 815:
- Change in hedged risk in a cash flow hedge.
- Designation of contractually specified components in cash flow hedges of nonfinancial forecasted transactions.
- Use of the term prepayable under the shortcut method.
- Use of foreign-currency-denominated debt instrument as hedging instrument and hedged item.
In June 2021, the Board issued an invitation to comment to request feedback on how to
refine its broader standard-setting agenda. On the basis of feedback
received, the FASB decided to include the following issues in the project scope:
- Application of shared risk assessment in cash flow hedges of loan portfolios.
- Use of net written options as hedging instruments.
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.
See Appendix
A for a comparison of the hedge accounting guidance in U.S. GAAP with
that in IFRS Accounting Standards.
1.3 Overview of Three Hedge Accounting Models
ASC 815-20
35-1 Paragraph 815-10-35-2 states
that the accounting for subsequent changes in the fair value
(that is, gains or losses) of a derivative instrument
depends on whether it has been designated and qualifies as
part of a hedging relationship and, if so, on the reason for
holding it. Specifically, subsequent gains and losses on
derivative instruments shall be accounted for as follows:
- No hedging designation. Paragraph 815-10-35-2 requires that the gain or loss on a derivative instrument not designated as a hedging instrument be recognized currently in earnings.
- Fair value hedge. The gain or loss on a derivative instrument designated and qualifying as a fair value hedging instrument as well as the offsetting loss or gain on the hedged item attributable to the hedged risk shall be recognized currently in earnings in the same accounting period, as provided in paragraphs 815-25-35-1 through 35-6. If an entity excludes a portion of the hedging instrument from the assessment of hedge effectiveness in accordance with paragraph 815-20-25-82, the initial value of the excluded component shall be recognized in earnings using a systematic and rational method over the life of the hedging instrument with any difference between the change in fair value of the excluded component and amounts recognized in earnings under that systematic and rational method recognized in other comprehensive income in accordance with paragraph 815-20-25-83A. An entity also may elect to recognize the excluded component of the gain or loss currently in earnings in accordance with paragraph 815-20-25-83B. The gain or loss on the hedging derivative or nonderivative instrument in a hedge of a foreign-currency-denominated firm commitment and the offsetting loss or gain on the hedged firm commitment shall be recognized currently in earnings in the same accounting period. The gain or loss on the hedging derivative instrument in a hedge of an available-for-sale debt security and the offsetting loss or gain on the hedged available-for-sale debt security shall be recognized currently in earnings in the same accounting period.
- Cash flow hedge. The gain or loss on a derivative instrument designated and qualifying as a cash flow hedging instrument shall be reported as a component of other comprehensive income (outside earnings) and reclassified into earnings in the same period or periods during which the hedged forecasted transaction affects earnings, as provided in paragraphs 815-30-35-3 and 815-30-35-38 through 35-41. If an entity excludes a portion of the hedging instrument from the assessment of hedge effectiveness in accordance with paragraph 815-20-25-82, the initial value of the excluded component shall be recognized in earnings using a systematic and rational method over the life of the hedging instrument with any difference between the change in fair value of the excluded component and amounts recognized in earnings under that systematic and rational method recognized in other comprehensive income in accordance with paragraph 815-20-25-83A. An entity also may elect to recognize the excluded component of the gain or loss currently in earnings in accordance with paragraph 815-20-25-83B. The gain or loss on the hedging derivative instrument in a hedge of a forecasted foreign-currency-denominated transaction shall be reported as a component of other comprehensive income (outside earnings) and reclassified into earnings in the same period or periods during which the hedged forecasted transaction affects earnings, as provided in paragraph 815-20-25-65.
- Net investment hedge. The gain or loss on the hedging derivative or nonderivative hedging instrument in a hedge of a net investment in a foreign operation shall be reported in other comprehensive income (outside earnings) as part of the cumulative translation adjustment, as provided in paragraph 815-20-25-66. If an entity excludes a portion of the hedging instrument from the assessment of hedge effectiveness in accordance with paragraphs 815-35-35-5 through 35-5B, the initial value of the excluded component shall be recognized in earnings using a systematic and rational method over the life of the hedging instrument. Any difference between the change in fair value of the excluded component and the amounts recognized in earnings under that systematic and rational method shall be recognized in the same manner as a translation adjustment (that is, reported in the cumulative translation adjustment section of other comprehensive income) in accordance with paragraph 815-35-35-5A. An entity also may elect to recognize the excluded component of the gain or loss currently in earnings in accordance with paragraph 815-35-35-5B.
ASC 815 provides three categories of hedge accounting, each with its own accounting
and reporting requirements: (1) hedges of the exposure to changes in the fair value
of a recognized asset or liability or an unrecognized firm commitment (fair value
hedges), (2) hedges of the exposure to variable cash flows of an existing asset or
liability or a forecasted transaction (cash flow hedges), and (3) hedges of the
foreign currency exposure of a net investment in a foreign operation (net investment
hedges).
1.3.1 Fair Value Hedges
As indicated in ASC 815-35-20, a fair value hedge is a “hedge of the exposure to
changes in the fair value of a recognized asset or liability, or of an
unrecognized firm commitment, that are attributable to a particular risk.” To be
eligible for designation as a hedged item, the exposure to changes in the fair
value attributable to the hedged risk must have the potential to affect reported
earnings. Examples of eligible hedged exposures may include fixed-interest-rate
assets or liabilities, inventory on hand, foreign-currency-denominated assets or
liabilities, a portion of a closed portfolio of prepayable financial assets (or
one or more beneficial interests secured by a portfolio of prepayable financial
instruments), or a fixed-price firm commitment.
Generally speaking, an entity with a fair value hedge that meets all of the
hedging criteria in ASC 815 would record the change in the hedging instrument’s
fair value in current-period earnings. It would also adjust the hedged item’s
carrying amount by the amount of the change in the hedged item’s fair value that
is attributable to the risk being hedged. The adjustment to the hedged item’s
carrying amount would also be recorded in current-period earnings. For fair
value hedges, both the change in the hedging instrument’s fair value and the
change in the hedged item’s carrying amount are presented in the same income
statement line item and should be related to the item and risk being hedged. As
a result of applying hedge accounting in a qualifying fair value hedging
relationship, an entity accelerates the income statement recognition of the
impact of changes on the hedged item that are attributable to the hedged risk.
Accordingly, the entity recognizes the changes in the same period as the changes
in the derivative’s fair value.
Timing of Income Statement Impact — Effect of
Hedge Accounting
See Chapter 3 for a more thorough discussion of fair value
hedging.
1.3.2 Cash Flow Hedges
As indicated in ASC 815-30-20, 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.” To be
eligible for designation as a hedged item in a cash flow hedge, the exposure to
changes in the cash flows attributable to the hedged risk must have the
potential to affect reported earnings. Examples of eligible hedged exposures may
include variable-interest-rate assets or liabilities,
foreign-currency-denominated assets or liabilities, forecasted purchases and
sales, and forecasted issuances of debt. The objective of a cash flow hedge is
to use a derivative to reduce or eliminate the variability of the cash flows
related to a hedged item or transaction.
Generally speaking, an entity with a cash flow hedge that meets
all of the hedging criteria of ASC 815 would record the change in the hedging
instrument’s fair value in OCI. Amounts are reclassified out of AOCI into
earnings as the hedged item affects earnings. Those amounts are also presented
in the same income statement line item in which the earnings effect of the
hedged item is presented. As a result of applying hedge accounting in a
qualifying cash flow hedging relationship, an entity defers the income statement
recognition of changes in the derivative’s fair value. Accordingly, the entity
recognizes the changes in the same period in which the hedged item affects
earnings.
Timing of Income Statement Impact — Effect of
Hedge Accounting
See Chapter 4 for a more thorough discussion of cash flow
hedging.
1.3.3 Net Investment Hedges
A net investment hedge is a hedge of the foreign currency exposure of a net
investment in a foreign operation. Even though the translation of a net
investment in a foreign operation is recognized as part of the currency
translation adjustment in OCI, there is a potential earnings risk upon
disposition of that investment in the foreign operation. Accordingly, the
foreign currency exposure in a net investment in a foreign operation is a
hedgeable risk.
Generally speaking, an entity with a net investment hedge that meets all of the
hedging criteria of ASC 815 would record the change in the hedging instrument’s
fair value in the CTA portion of OCI.
See Chapter 5 for a more thorough
discussion of net investment hedging.
Chapter 2 — Hedge Accounting Requirements
Chapter 2 — Hedge Accounting Requirements
2.1 Overview
ASC 815-20
25-1 This Section sets forth
criteria that must be met for designated hedging instruments
and hedged items or transactions to qualify for fair value
hedge accounting, cash flow hedge accounting, and accounting
for a hedge of a net investment in a foreign operation. The
criteria are organized as follows:
- Formal designation and documentation at hedge inception
- Eligibility of hedged items and transactions
- Eligibility of hedging instruments
- Hedge effectiveness
- Hedge accounting provisions applicable to certain private companies
- Hedge accounting provisions applicable to certain not-for-profit entities.
ASC 815-20 provides the framework for determining (1) the types of
hedging relationships that qualify for hedge accounting and (2) the requirements for
applying hedge accounting in those relationships. Although ASC 815-20-25-1
establishes the order of the guidance in ASC 815-20-25, we believe that it will be
more useful to readers if the guidance is discussed in the order in which an entity
performs hedging activities in response to its risk exposure. Accordingly, the
discussion in this chapter of the Roadmap is arranged as follows:
- The types of items and transactions that qualify as hedgeable items (see Section 2.2).
- The types of risks within those items that may be hedged (see Section 2.3).
- The types of hedging instruments that may be used to achieve hedge accounting (see Section 2.4).
- What it means to have a highly effective hedge (see Section 2.5), which is necessary for the application of hedge accounting.
- The documentation of the hedging relationship and the ongoing criteria for applying and maintaining hedge accounting, including specific considerations for certain private companies and not-for-profit entities (see Section 2.6).
2.2 Qualifying Hedged Items
For an item to be designated as a hedged item in a qualifying
hedging relationship, it must have the potential to affect earnings. ASC 815-20
breaks down its discussion of hedgeable transactions and risks into the two major
types of hedges: fair value and cash flow. There is not much detailed guidance on
what sorts of items can qualify as the hedged item in a net investment hedge because
there is really only one item that qualifies — a net investment in a foreign
operation — and one type of risk to be hedged — foreign currency risk. However,
before we cover the criteria that items must satisfy to qualify for designation as
hedged items in fair value and cash flow hedges, we will discuss items that are
specifically prohibited from being designated as the hedged item in a qualifying
hedging relationship, regardless of the type of hedge an entity is seeking.
2.2.1 Items Prohibited From Being Designated as the Hedged Item
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: . . .
d. The forecasted transaction is not the
acquisition of an asset or incurrence of a
liability that will subsequently be remeasured
with changes in fair value attributable to the
hedged risk reported currently in earnings.
e. If the forecasted transaction relates to a
recognized asset or liability, the asset or
liability is not remeasured with changes in fair
value attributable to the hedged risk reported
currently in earnings. . . .
g. The forecasted transaction does not involve
a business combination subject to the provisions
of Topic 805 or a combination accounted for by an
NFP that is subject to the provisions of Subtopic
958-805.
h. The forecasted transaction is not a
transaction (such as a forecasted purchase, sale,
or dividend) involving either of the following:
1. A parent entity’s
interests in consolidated subsidiaries
2. An entity’s own equity
instruments. . . .
25-43 Besides those hedged
items and transactions that fail to meet the specified
eligibility criteria, none of the following shall be
designated as a hedged item or transaction in the
respective hedges:
- Subparagraph not used
- With respect to both fair value hedges and cash
flow hedges:
- An investment accounted for by the equity method in accordance with the requirements of Subtopic 323-10 or in accordance with the requirements of Topic 321
- A noncontrolling interest in one or more consolidated subsidiaries
- Transactions with stockholders as
stockholders, such as either of the following:
- Projected purchases of treasury stock
- Payments of dividends.
- Intra-entity transactions (except for foreign-currency-denominated forecasted intra-entity transactions) between entities included in consolidated financial statements
- The price of stock expected to be issued pursuant to a stock option plan for which recognized compensation expense is not based on changes in stock prices after the date of grant.
- With respect to fair value hedges only:
- If the entire asset or liability is an instrument with variable cash flows, an implicit fixed-to-variable swap (or similar instrument) perceived to be embedded in a host contract with fixed cash flows
- For a held-to-maturity debt security, the risk of changes in its fair value attributable to interest rate risk
- An asset or liability that is remeasured with the changes in fair value attributable to the hedged risk reported currently in earnings
- An equity investment in a consolidated subsidiary
- A firm commitment either to enter into a business combination or to acquire or dispose of a subsidiary, a noncontrolling interest, or an equity method investee
- An equity instrument issued by the entity and classified in stockholders’ equity in the statement of financial position
- A component of an embedded derivative in a hybrid instrument — for example, embedded options in a hybrid instrument that are required to be considered a single forward contract under paragraph 815-10-25-10 cannot be designated as items hedged individually in a fair value hedge in which the hedging instrument is a separate, unrelated freestanding option. . . .
As indicated in the guidance above, entities are prohibited from
designating the following items as the hedged item in a hedging relationship:
- Items that are already remeasured at fair value, with changes in fair value recognized in earnings (see Section 2.2.1.1).
- Investments in equity securities (see Section
2.2.1.2):
- Equity securities within the scope of ASC 321.
- Equity method investments.
- Equity investments in consolidated subsidiaries.
- Forecasted transactions and firm commitments that are related to business combinations, the acquisition or disposition of a subsidiary, a noncontrolling interest, or an equity method investee (see Section 2.2.1.3).
- Own-equity transactions (see Section 2.2.1.4):
- Noncontrolling interests.
- Treasury stock transactions.
- Dividends to shareholders.
- The fair value of issued shares classified in equity.
- The forecasted issuances of shares classified in equity.
- Other items that do not affect earnings (see Section 2.2.1.5):
- Implicit embedded derivatives or components of embedded derivatives (see Section 2.2.1.6).
2.2.1.1 Items That Are Already Remeasured at Fair Value, With Changes in Fair Value Recognized in Earnings
As discussed in Section 1.1, for hedges of an asset or a
liability that is already remeasured at fair value, with changes in fair
value recognized in earnings, an entity does not generally need to use
specialized hedge accounting to achieve the same accounting result as it
would in a qualifying fair value hedging relationship. If an entity chooses
to economically hedge such an asset or a liability with a derivative, the
gains and losses on the derivative will already be recognized in the same
period as the gains and losses on the hedged item. Accordingly, ASC
815-20-25-43(c)(3) prohibits an entity from designating as hedged items
assets or liabilities that are remeasured at fair value, with changes in
fair value recognized in earnings, in fair value hedges.
Similarly, ASC 815-20-25-15 lists acceptable cash flow hedging strategies and
prohibits entities from designating as the hedged item the forecasted
acquisition of an asset or incurrence of a liability that will subsequently
be remeasured at fair value, with changes in fair value attributable to the
hedged risk recognized in current earnings. The reason for this prohibition
is that those items must be recognized at fair value upon recognition.
Accordingly, there is no earnings exposure before their initial recognition.
Also, ASC 815-20-25-15(e) prohibits entities from designating as a hedged
item a forecasted transaction involving a recognized asset or liability that
is remeasured, with changes in fair value attributable to the hedged risk
reported currently in earnings.
Items that do not qualify for designation as hedged items under the above
criteria include derivatives (such as bifurcated embedded derivatives),
financial assets and financial liabilities for which the entity has elected
a fair value option, debt securities accounted for as trading securities,
and investments in equity securities within the scope of ASC 321 (see
further discussion in the next section).
2.2.1.2 Investments in Equity Securities
Investments in equity securities do not qualify as hedged
items; however, the reasons for this depend on the type of equity
investment. Before the issuance of ASU
2016-01, which added ASC 321, investments in equity
securities that did not result in consolidation or the application of the
equity method would be accounted for either at cost (if the security did not
have a readily determinable fair value) or fair value, with changes in fair
value recognized in either OCI (available-for-sale [AFS] securities) or
earnings (trading securities), depending on the classification of the
security. However, ASU 2016-01 eliminated both the cost method and the AFS
designation for investments in equity securities.
Under ASC 321, all equity securities with a readily
determinable fair value are accounted for at fair value, with changes in
fair value recognized in earnings. Accordingly, as discussed in Section 2.2.1.1, those equity securities do
not qualify for designation as the hedged item in a hedging relationship.
Investments in equity securities that do not have a readily determinable
fair value qualify for a measurement alternative under which the entity
would initially recognize the investment at cost (fair value less
transaction costs) and then subsequently remeasure the investment if (1)
there is an orderly transaction in the identical or a similar investment of
the same issuer or (2) there is an impairment. However, if remeasurement is
required, the investment is remeasured at fair value, with changes in fair
value since the last measurement recognized in current-period earnings.
Thus, investments in equity securities in which the measurement alternative
is applied do not qualify for designation as hedged items even though
remeasurement is not necessarily required in every period. ASC
815-20-25-43(b) does not make any distinction between the two measurement
methods in ASC 321; it simply says that the hedged item may not be an
investment that is accounted for “in accordance with the requirements of
Topic 321.”
In addition, since the issuance of FASB Statement 133, entities have been
prohibited from designating as hedged items investments accounted for under
the equity method (ASC 323-10). The rationale for this prohibition is stated
in the Background Information and Basis for Conclusions of FASB Statement
133.
FASB Statement 133 (Pre-Codification Guidance)
Investment Accounted for by the Equity
Method
455. The Board decided to retain the
prohibition in the Exposure Draft from designating
an investment accounted for by the equity method as
a hedged item to avoid conflicts with the existing
accounting requirements for that item. Providing
fair value hedge accounting for an equity method
investment conflicts with the notion underlying APB
Opinion No. 18, The Equity Method of Accounting
for Investments in Common Stock. Opinion 18
requires an investor in common stock and corporate
joint ventures to apply the equity method of
accounting when the investor has the ability to
exercise significant influence over the operating
and financial policies of the investee. Under the
equity method of accounting, the investor generally
records its share of the investee’s earnings or
losses from its investment. It does not account for
changes in the price of the common stock, which
would become part of the basis of an equity method
investment under fair value hedge accounting.
Changes in the earnings of an equity method investee
presumably would affect the fair value of its common
stock. Applying fair value hedge accounting to an
equity method investment thus could result in some
amount of double counting of the investor’s share of
the investee’s earnings. The Board believes that
result would be inappropriate. In addition to those
conceptual issues, the Board was concerned that it
would be difficult to develop a method of
implementing fair value hedge accounting, including
measuring hedge ineffectiveness, for equity method
investments and that the results of any method would
be difficult to understand. For similar reasons,
this Statement also prohibits fair value hedge
accounting for an unrecognized firm commitment to
acquire or dispose of an investment accounted for by
the equity method.
The FASB cited similar reasons for the prohibition against designating an
investment in the equity of a consolidated subsidiary as a hedged item.
However, an entity that has an equity investment in a consolidated
subsidiary does not actually account for the equity investment individually
since all of the assets and liabilities of the subsidiary are recognized on
the consolidated balance sheet of the investor entity.
2.2.1.3 Business Combinations and Disposals of Subsidiaries
For reasons that are similar to those for prohibiting hedges of equity method
investments, entities are also prohibited from designating as hedged items
transactions that involve the acquisition or disposition of subsidiaries.
The Board was concerned that on a conceptual basis, some aspects of
acquiring an entity through a business combination would not affect
earnings, especially if the effects of hedge accounting were recognized in
goodwill. The operational difficulties involved with hedging the acquisition
or disposition of a subsidiary probably weighed heavily on the Board’s
decision as well. For example, if an entity were allowed to hedge the
acquisition price of all of an acquired entity’s equity shares, the effects
of that hedge accounting might have to be allocated to all of the acquired
entity’s individual assets and liabilities once the business combination was completed. As a result, the entity might be required to perform a theoretical purchase price allocation both at the inception and the completion of the hedge. Paragraph 473 of the Background Information and Basis for Conclusions of FASB Statement 133 discusses these concerns by
stating:
The Board noted that the current accounting for a business
combination is based on considering the combination as a discrete event
at the consummation date. Applying cash flow hedge accounting to a
forecasted business combination would be inconsistent with that current
accounting. It would also be, at best, difficult to determine when to
reclassify the gain or loss on the hedging derivative to
earnings.
ASC 815-20-25-15(g) prohibits the hedge of a forecasted transaction involving
a business combination. In addition, ASC 815-20-25-43(c)(5) prohibits a fair
value hedge of “a firm commitment either to enter into a business
combination or to acquire or dispose of a subsidiary, a noncontrolling
interest, or an equity method investee.”
2.2.1.4 Own-Equity Transactions
One of the requirements for
hedge accounting is that the hedged transaction must be exposed to a risk
that could affect earnings. Transactions in an entity’s own equity are
recorded in equity and do not have an earnings impact. Accordingly, even
though there are economic risks that could affect cash flows, transactions
in an entity’s own equity do not qualify for designation as hedged items.
The following are examples of prohibited hedged items related to equity
transactions:
Prohibited Hedged Item
|
ASC Reference
|
---|---|
Noncontrolling interest in a consolidated
subsidiary
|
ASC 815-20-25-43(b)(2)
|
Forecasted purchases of treasury stock
|
ASC 815-20-25-43(b)(3)
|
Forecasted issuance of equity3
|
ASC 815-20-25-15(h)
|
Forecasted dividends on equity4
|
ASC 815-20-25-15(h) and ASC 815-20-25-43(b)(3)
|
Fair value of issued equity5
|
ASC 815-20-25-43(c)(6)
|
2.2.1.5 Other Items That Do Not Affect Earnings
2.2.1.5.1 Stock Price Related to Stock Option Plans
As noted above, to be eligible for hedge accounting, a hedged transaction
must be exposed to a risk that could affect earnings. Accordingly, ASC
815-20-25-43(b)(5) prohibits entities from designating as the hedged
item the price of stock that will be issued under a stock option plan if
compensation expense will not vary on the basis of changes in the
underlying stock price. This prohibition is consistent with the
principle that if a designated risk does not give rise to a potential
earnings exposure, it is not a hedgeable risk under hedge accounting.
2.2.1.5.2 Intra-Entity Transactions
Similarly, intra-entity transactions cannot be designated as hedged
transactions in the consolidated financial statements, as stated in ASC
815-20-25-43(b)(4). There is an exception for forecasted
foreign-currency-denominated intra-entity transactions that potentially
affect earnings. See Section 5.3.3.1.2 for further
discussion of this exception.
As noted in ASC 815-20-25-44, hedge accounting may be applied to the
freestanding financial statements of an entity involved in intra-entity
transactions within consolidated financial statements, but any impact of
such accounting must be removed from the consolidated financial
statements.
Example 2-1
FarmHouse Inc. has two wholly owned subsidiaries,
A and B. Subsidiary A owns and operates corn
fields; B owns and operates livestock farms. Most
of the corn produced by A is sold to third
parties. However, B acquires corn on a monthly
basis from A at the current market price and uses
the corn to feed its animals. Subsidiary A expects
to sell 1,000 bushels of corn to B in each of the
next 12 months (A sells a total of about 100,000
bushels per month) and wants to hedge its corn
price exposure related to corn sales, including
its sales of corn to B, over the next year.
Accordingly, A enters into financially settled
futures contracts on 100,000 bushels per month for
the next 12 months.
Subsidiary A’s forecasted sales of corn are as
follows:
The sales from A to B are not hedgeable
transactions in the consolidated financial
statements of FarmHouse because those sales are
eliminated in consolidation and do not present an
earnings exposure. Subsidiary A could apply hedge
accounting to those sales in its own freestanding
financial statements, provided that the conditions
for hedge accounting are met, but any effects of
hedge accounting for those sales must be removed
when FarmHouse prepares its consolidated financial
statements.
Another potential hedging strategy that FarmHouse
could employ would be to hedge its corn inventory
against changes in fair value due to changes in
corn prices; however, this strategy would only
mitigate risks related to FarmHouse’s existing
corn inventory.
Connecting the Dots
If all of the criteria for cash flow hedging are met, an entity
can hedge a forecasted transaction with an equity method
investee under the cash flow hedging model. To be eligible for
designation as a hedged transaction under ASC 815-20-25-15(c), a
forecasted transaction must meet both of the following
conditions:
- 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).
- It presents an exposure to variations in cash flows for the hedged risk that could affect reported earnings.
Although ASC 815-20-25-43(b)(4) prohibits an entity from
designating as hedged items “[i]ntra-entity transactions . . .
between entities included in consolidated financial statements,”
this prohibition applies only to transactions (or portions
thereof) that are entirely eliminated in consolidation and that
therefore create no earnings exposure in the consolidated
financial statements. If a forecasted transaction is only
partially eliminated in consolidation, the entity may hedge the
portion of the transaction that is not eliminated since it still
exposes the entity to potential variations in cash flows that
could affect reported earnings.
For example, ASC 323-10-35-7 through 35-9 require intra-entity
transactions that involve an equity method investee to be
eliminated in consolidation as though the equity method investee
was consolidated. However, ASC 323-10-35-11 indicates that only
a portion of the transaction would be eliminated; therefore, the
portion that is not eliminated may be designated as the hedged
item in a cash flow hedge (if all of the other hedge accounting
criteria are satisfied).
This matter was addressed in informal discussions with the FASB
staff, which agreed that the portion of the transaction that is
not eliminated may be designated as the hedged transaction in a
cash flow hedge as long as all of the hedge accounting criteria
are satisfied.
2.2.1.6 Implicit Embedded Derivatives or Components of Embedded Derivatives
Entities are allowed to designate specific component risks
of a hedged item in a qualifying hedging relationship. However, they are
prohibited from designating as a hedged exposure an embedded component of an
item that is already being measured at fair value, with changes in fair
value recognized in earnings. Under ASC 815, if multiple embedded
derivatives must be bifurcated from a host contract, they must be accounted
for as one compound derivative (i.e., one unit of account) in accordance
with ASC 815-15-25-7 unless the hybrid instrument is accounted for at fair
value in its entirety. In addition, if a freestanding instrument composed of
multiple derivatives meets the definition of a derivative in its entirety,
the instrument is accounted for as one compound derivative because embedded
derivatives are not bifurcated out of a host contract that is already
measured at fair value, with changes in fair value recognized in earnings.
While ASC 815-20-25-43(c)(7) specifically prohibits entities from
identifying the hedged item as a component of a bifurcated embedded
derivative, we believe that prohibition also extends to a component of a
freestanding compound derivative.
In addition, ASC 815-20-25-43(c)(1) prohibits an entity from
designating “an implicit fixed-to-variable swap (or similar instrument)” in
a recognized variable-rate asset or liability as the hedged item in a fair
value hedge. Even though the potential embedded derivative is not bifurcated
and measured at fair value, this prohibition is actually based on the fact
that a permissible hedging strategy already exists — a cash flow hedge of
the variability in interest payments on the asset or liability (see further
discussion in Section
2.3.1.1).
2.2.2 Items That May Be Designated as the Hedged Item
While the discussion in Section 2.2.1 covers items that entities
are prohibited from designating as the hedged item in a hedging relationship,
the discussion in this section focuses on those items that can be designated as
such. Section 2.3 addresses the different
types of risks related to those hedged items that may be identified as the
hedged risk in a hedging relationship.
ASC 815-20
Hedged Item Criteria Applicable to Fair Value
Hedges Only
25-11 An entity may designate
a derivative instrument as hedging the exposure to
changes in the fair value of an asset or a liability or
an identified portion thereof (hedged item) that is
attributable to a particular risk if all applicable
criteria in this Section are met.
25-12 An asset or a liability
is eligible for designation as a hedged item in a fair
value hedge if all of the following additional criteria
are met:
- The hedged item is specifically identified as either all or a specific portion of a recognized asset or liability or of an unrecognized firm commitment.
- The hedged item is a single
asset or liability (or a specific portion thereof)
or is a portfolio of similar assets or a portfolio
of similar liabilities (or a specific portion
thereof), in which circumstance:
- If similar assets or similar liabilities are aggregated and hedged as a portfolio, the individual assets or individual liabilities shall share the risk exposure for which they are designated as being hedged. The change in fair value attributable to the hedged risk for each individual item in a hedged portfolio shall be expected to respond in a generally proportionate manner to the overall change in fair value of the aggregate portfolio attributable to the hedged risk. See the discussion beginning in paragraph 815-20-55-14 for related implementation guidance. An entity may use different stratification criteria for the purposes of impairment testing and for the purposes of grouping similar assets to be designated as a hedged portfolio in a fair value hedge.
- If the hedged item is a
specific portion of an asset or liability (or of a
portfolio of similar assets or a portfolio of
similar liabilities), the hedged item is one of
the following:
- A percentage of the entire asset or liability (or of the entire portfolio). An entity shall not express the hedged item as multiple percentages of a recognized asset or liability and then retroactively determine the hedged item based on an independent matrix of those multiple percentages and the actual scenario that occurred during the period for which hedge effectiveness is being assessed.
- One or more selected contractual cash flows, including one or more individual interest payments during a selected portion of the term of a debt instrument (such as the portion of the asset or liability representing the present value of the interest payments in any consecutive two years of a four-year debt instrument). Paragraph 815-25-35-13B discusses the measurement of the change in fair value of the hedged item in partial-term hedges of interest rate risk using an assumed term.
- A put option or call option (including an interest rate cap or price cap or an interest rate floor or price floor) embedded in an existing asset or liability that is not an embedded derivative accounted for separately pursuant to paragraph 815-15-25-1.
- The residual value in a lessor’s net investment in a direct financing or sales-type lease.
- The hedged item presents an exposure to changes in fair value attributable to the hedged risk that could affect reported earnings. The reference to affecting reported earnings does not apply to an entity that does not report earnings as a separate caption in a statement of financial performance, such as a not-for-profit entity (NFP), in accordance with paragraph 815-20-15-1. . . .
25-12A For a closed portfolio
of prepayable financial assets or one or more beneficial
interests secured by a portfolio of prepayable financial
instruments, an entity may designate as the hedged item
a stated amount of the asset or assets that are not
expected to be affected by prepayments, defaults, and
other factors affecting the timing and amount of cash
flows if the designation is made in conjunction with the
partial-term hedging election in paragraph
815-20-25-12(b)(2)(ii) (this designation is referred to
throughout Topic 815 as the “last-of-layer method”).
- As part of the initial hedge documentation, an analysis shall be completed and documented to support the entity’s expectation that the hedged item (that is, the designated last of layer) is anticipated to be outstanding as of the hedged item’s assumed maturity date in accordance with the entity’s partial-term hedge election. That analysis shall incorporate the entity’s current expectations of prepayments, defaults, and other events affecting the timing and amount of cash flows associated with the closed portfolio of prepayable financial assets or beneficial interest(s) secured by a portfolio of prepayable financial instruments.
- For purposes of its analysis, the entity may assume that as prepayments, defaults, and other events affecting the timing and amount of cash flows occur, they first will be applied to the portion of the closed portfolio of prepayable financial assets or one or more beneficial interests that is not part of the hedged item (that is, the designated last of layer).
Pending Content (Transition Guidance: ASC
815-20-65-6)
25-12A [See Section 9.7.]
Hedged Transaction Criteria Applicable to Cash Flow
Hedges Only
25-13 An entity may designate
a derivative instrument as hedging the exposure to
variability in expected future cash flows that is
attributable to a particular risk. That exposure may be
associated with either of the following:
- An existing recognized asset or liability (such as all or certain future interest payments on variable-rate debt)
- A forecasted transaction (such as a forecasted purchase or sale).
Note that the glossary definition of transaction is
intended to clearly distinguish a transaction from an
internal cost allocation or an event that happens within
an entity.
25-14 For purposes of this
Subtopic and Subtopic 815-30, 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 or hedged
transaction.
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:
- A single transaction
- 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:
- 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).
- It presents an exposure to variations in cash flows for the hedged risk that could affect reported earnings. . . .
The designated hedged item in a hedging relationship can be all
or a portion of an existing asset or liability, an unrecognized firm commitment,
a forecasted transaction, or the net investment in a foreign operation.
Sometimes, an entity may designate a portfolio of existing assets, liabilities,
or forecasted transactions (see Section 2.2.2.2). In all cases, the
hedged item must present an exposure that could affect reported earnings, but it
cannot be one of the prohibited items discussed in Section 2.2.1. In a fair value hedge, the hedged item must have
an exposure to changes in market prices that can affect the fair value of an
existing asset, a liability, or an unrecognized firm commitment and thereby
potentially affect the entity’s earnings. The hedged item in a cash flow hedge
is a variable-rate financial asset or liability or a forecasted transaction that
exposes an entity to variability in cash flows that could affect earnings. See
Chapters 3 and 4 for a more thorough discussion of fair value hedging and cash
flow hedging, respectively. The hedged item in a net investment hedge is a net
investment in foreign operations (typically a foreign subsidiary). See Section 5.4 for a more thorough discussion of net investment
hedges.
The following are some examples
of hedged items that may be designated and the hedging model that would
typically apply:
Hedged Item
|
Type of Hedge
|
---|---|
Fixed-rate debt (asset or liability)
|
Fair value
|
Inventory
|
Fair value
|
Fixed-price supply contract (not a
derivative)
|
Fair value
|
Foreign-currency-denominated debt
|
Fair value or cash flow
|
Variable-rate debt (asset or
liability)
|
Cash flow
|
Forecasted issuance of debt
|
Cash flow
|
Forecasted sale of inventory
|
Cash flow
|
Forecasted purchase of commodity
|
Cash flow
|
Net investment in foreign operations
|
Net investment
|
2.2.2.1 Hedging Portions of Items
ASC 815 allows an entity to designate a portion of an item
as the hedged item in a hedging relationship. That portion can be expressed
as a percentage of the item or as specifically identified components or cash
flows of the item, depending on the type of item and type of hedge. In
addition, an entity may identify a portion of a qualifying portfolio of
items as the hedged item (see Section 2.2.2.2 for a discussion of qualifying portfolios of
hedged items).
The table below shows
portions of items (or qualifying portfolios of items) that entities can
designate as hedged items in each type of hedging relationship.
Type of Hedge
|
Eligible Portions
|
---|---|
Fair value
|
|
Cash flow
|
Any specified cash flows
|
Net investment
|
A stated amount of the beginning
balance of a net investment in foreign
operations
|
2.2.2.1.1 Fair Value Hedges — Portions
ASC 815-20
Example 2: Portions and Portfolios of
Individual Items as Hedged Item
55-81 This Example
illustrates the application of paragraph
815-20-25-12.
55-82 An entity that issues
$100 million of fixed-rate debt may wish to hedge
50 percent of its fair value exposure to interest
rate risk, as permitted by paragraph
815-20-25-12(b)(2). To accomplish that, the entity
could enter into an interest rate swap with a
notional amount of $50 million. The paragraph
815-20-25-104(a) criterion is satisfied because
the entity has designated as a fair value hedge 50
percent of the contractual principal amount as the
hedged item and has entered into an interest rate
swap with a notional amount that matches the
hedged principal amount.
55-83 If $100 million of
fixed-rate debt were issued in increments of
$1,000 individual bonds, the entity could
aggregate 50,000 of those individual bonds as a
portfolio to equal the notional amount of the
swap, as permitted by paragraph 815-20-25-12(b)(1)
(for the purposes of this Example, it is assumed
that the hedge satisfies the portfolio
requirements of that paragraph).
Of its guidance on the three types of hedges, ASC 815 provides the most
details on the identification of acceptable portions of items that may
be designated as the hedged item in a fair value hedge. ASC
815-20-25-12(b)(2) lists four acceptable portions of items, which are
discussed below.
2.2.2.1.1.1 Proportions
Under ASC 815-20-25-12(b)(2)(i), an entity may designate as the
hedged item “[a] percentage of the entire asset or liability (or of
the entire portfolio).” For example, assume that an entity owns a $1
million fixed-rate, five-year debt security. It enters into a
five-year receive-variable, pay-fixed interest rate swap with an
$800,000 notional amount, and all other terms of the interest rate
swap match the terms of the debt. The entity could designate 80
percent, or $800,000, of the debt security as the hedged item in a
fair value hedging relationship. We believe that in the hedge
designation documentation, the hedged item can be expressed either
as a percentage or as a fixed dollar amount; however, if the hedged
item is expressed only as a percentage of the item that is being
hedged, the documentation should acknowledge that fact and indicate
the total amount of the asset or liability. In this example, the
hedged item could be designated as “80% of the $1 million debt
security.”
Connecting the Dots
The examples in ASC 815-20-55-82 and 55-83 discuss hedging a
percentage of a single item as well as a portfolio of
individual bonds. We believe that if items in a portfolio
are fungible, an entity may hedge a specified dollar amount
of that portfolio, as opposed to a fixed percentage. For
example, consider the example in ASC 815-20-55-83 in which
an entity issues $100 million of fixed-rate debt in
increments of $1,000 bonds. We believe that if those bonds
all have the exact same terms and are interchangeable, the
entity could designate as the hedged item a fixed dollar
amount of the issuance (e.g., $50 million), but it does not
necessarily have to specify which individual bonds are the
hedged bonds. In that scenario, if the entity were to
repurchase some of the bonds, the hedged item would remain
intact as a fixed dollar amount as long as the designated
hedged amount was still outstanding.
ASC 815-20
Prohibition of Preset Hedge Coverage Ratios
55-63 Subtopic 860-50
requires that if an entity subsequently measures
servicing assets and servicing liabilities using
the amortization method, any impairment of
servicing assets, which is the amount by which the
carrying amount of the servicing assets for an
individual stratum exceeds their fair value, be
recognized in current earnings. However, an
increase in the fair value above the carrying
amount of servicing assets for an individual
stratum may not be recognized in current
earnings.
55-64 Entities that service
certain types of financial assets may wish to
designate as the hedged item in a fair value hedge
a prespecified percentage of the total change in
fair value of those servicing rights (attributable
to the hedged risk) that varies based on changes
in a specified independent variable. Because the
prespecified percentage for each specified
independent variable can be presented in a
rectangular array, that method of determining the
hedged item retroactively based on the actual
independent variable is sometimes referred to as
the matrix method. Under that approach, at the end
of the hedge assessment period, the entity would
determine the hedged item and assess hedge
effectiveness by determining retrospectively which
hedge coverage ratio would be applied to the
servicing right asset to identify the hedged item
for that period. That approach is in contrast to
designating the hedged item at the inception of
the hedge by specifying a single percentage of
that recognized servicing right asset as the
hedged item.
55-65 In a fair value hedge
of a portion of a recognized servicing right asset
subsequently measured using the amortization
method and its related impairment analysis, an
entity may not designate the hedged item at the
inception of the hedge by initially specifying a
series of possible percentages of the servicing
right asset (that is, preset hedge coverage
ratios) and then determining at the end of the
assessment period what specific percentage of the
servicing right asset is the actual hedged item
for that period based on the change in a specified
independent variable during that period. Such a
matrix method would not be a valid application of
the provisions of this Subtopic.
55-66 Paragraph
815-20-25-12(b)(2)(i) precludes an entity from
expressing the hedged item as multiple percentages
of a recognized asset or liability and then
retroactively determining the hedged item based on
an independent matrix of those multiple
percentages and the actual scenario that occurred
during the period for which hedge effectiveness is
being assessed.
55-67 There is a limited
exception under paragraph 815-20-25-10 in which a
collar that is comprised of one purchased option
and one written option that have different
notional amounts is designated as the hedging
instrument, and the hedged item is specified as
two different proportions of the same asset based
on the upper and lower rate or price range of the
asset referenced in those two options.
Generally speaking, only a single percentage of an entire asset or
liability (or of the entire portfolio) may be designated as the
hedged item in a fair value hedging relationship. DIG Issue F8
addressed a potential strategy for hedging an asset in which an
entity establishes a matrix of different prespecified percentages of
the asset on the basis of the performance of specified independent
variables during the hedge period. Under the proposed strategy, the
entity would refer to the table at the end of the hedge period to
determine what portion of the asset was the hedged item. This
strategy of hedging multiple potential percentages of items, which
the DIG discussed in the context of mortgage servicing rights, was
deemed to be inappropriate. That conclusion is codified in ASC
815-20-25-12(b)(2)(i), which states that “[a]n entity shall not
express the hedged item as multiple percentages of a recognized
asset or liability and then retroactively determine the hedged item
based on an independent matrix of those multiple percentages and the
actual scenario that occurred during the period for which hedge
effectiveness is being assessed.”
ASC 815-20
Different Proportions of the Same Asset as a
Hedged Item
25-10 In a hedging
relationship in which a collar that is comprised
of a purchased option and a written option that
have different notional amounts is designated as
the hedging instrument and the hedge’s
effectiveness is assessed based on changes in the
collar’s intrinsic value, the hedged item may be
specified as two different proportions of the same
asset referenced in the collar, based on the upper
and lower price ranges specified in the two
options that make up the collar. That is, the
quantities of the asset designated as being hedged
may be different based on those price ranges in
which the collar’s intrinsic value is other than
zero. This guidance shall be applied only to
collars that are a combination of a single written
option and a single purchased option for which the
underlying in both options is the same. This
guidance shall not be applied by analogy to other
derivative instruments designated as hedging
instruments. Although the quantities of the asset
designated as being hedged may be different based
on the upper and lower price ranges in the collar,
the actual assets that are the subject of the
hedging relationship may not change. The
quantities that are designated as hedged for a
specific price or rate change shall be specified
at the inception of the hedging relationship and
shall not be changed unless the hedging
relationship is dedesignated and a new hedging
relationship is redesignated. Since the hedge’s
effectiveness is based on changes in the collar’s
intrinsic value, the assessment of hedge
effectiveness shall compare the actual change in
intrinsic value of the collar to the change in
value of the prespecified quantity of the hedged
asset that occurred during the hedge period.
Example 9: Definition of Hedged Item When
Using a Zero-Cost Collar With Different Notional
Amounts
55-123 Entity B forecasts
that it will purchase inventory that will cost 100
million foreign currency (FC) units. Entity B’s
functional currency is the U.S. dollar (USD). To
limit the variability in USD-equivalent cash flows
associated with changes in the USD-FC exchange
rate, Entity B constructs a currency collar as
follows:
- A purchased call option providing Entity B the right to purchase FC 100 million at an exchange rate of USD 0.885 per FC 1.
- A written put option obligating Entity B to purchase FC 50 million at an exchange rate of USD 0.80 per FC 1.
55-124 The purchased call
option provides Entity B with protection when the
USD-FC exchange rate increases above USD 0.885 per
FC 1. The written put option partially offsets the
cost of the purchased call option and obligates
Entity B to give up some of the foreign currency
gain related to the forecasted inventory purchase
as the USD-FC exchange rate decreases below USD
0.80 per FC 1. (For both options, the underlying
is the same — the USD-FC exchange rate.) Assuming
that a net premium was not received for the
combination of options and all the other criteria
in paragraphs 815-20-25-89 through 25-90 have been
met, if Entity B chooses to use the combination of
options as a hedging instrument, it is not
required to comply with the provisions contained
in paragraph 815-20-25-94 related to written
options.
55-125 Entity B would like to
designate the combination of options as a hedge of
the variability in USD-equivalent cash flows of
its forecasted purchase of inventory denominated
in FC. Assume Entity B specifies in the hedge
effectiveness documentation that the collar’s time
value would be excluded from the assessment of
hedge effectiveness.
55-126 The hedging
relationship involving the currency collar
designated as a hedge of the effect of
fluctuations in the USD-FC exchange rate qualifies
for cash flow hedge accounting. In that example,
the hedged risk is the risk of changes in
USD-equivalent cash flows attributable to foreign
currency risk (specifically, the risk of
fluctuations in the USD-FC exchange rate). The
foreign currency collar is hedging the variability
in USD-equivalent cash flows for 100 percent of
the forecasted FC 100 million purchase price of
inventory for USD-FC exchange rate movements above
USD 0.885 per FC 1 and variability in
USD-equivalent cash flows for 50 percent of the
forecasted FC 100 million purchase price of
inventory for USD-FC exchange rate movements below
USD 0.80 per FC 1. Cash flow hedge effectiveness
will be determined based on changes in the
underlying (the USD-FC exchange rate) that cause
changes in the collar’s intrinsic value (that is,
changes below USD 0.80 per FC 1 and above USD
0.885 per FC 1). Because the hedge’s effectiveness
is based on changes in the collar’s intrinsic
value, hedge effectiveness must be assessed based
on the actual exchange rate changes by comparing
the change in intrinsic value of the collar to the
change in the specified quantity of the forecasted
transaction for those changes in the
underlying.
DIG Issue E18 (codified in ASC 815-20-25-10 and ASC 815-20-55-123
through 55-126) addressed a hedging strategy in which a zero-cost
collar with different notional amounts is designated as a hedging
instrument. Issue E18 provided examples that involved zero-cost
collars in which the notional amount of the purchased option was
greater than that of the written option. In these cases, it was
considered acceptable to designate the hedged item as two different
proportions of the same asset to match the different notional
amounts of the two components of the collar.
Connecting the Dots
The guidance in ASC 815-20-25-10 appears to conflict with
that in ASC 815-20-25-12(b)(2)(i): ASC 815-20-25-10 allows
different notional amounts of the same asset to be
designated as the hedged item, but ASC 815-20-25-12(b)(2)(i)
does not. As discussed above, these requirements resulted
from two DIG Issues that provided examples of specific
hedging strategies. The principle from DIG Issue F8 appears
to be the general rule (i.e., an entity may not designate
more than one proportion of an item as the hedged item),
while DIG Issue E18 presents a limited exception to that
rule. ASC 815-20-55-67 (derived from DIG Issue F8) states
that “[t]here is a limited exception under paragraph
815-20-25-10,” while ASC 815-20-25-10 (derived from DIG
Issue E18) states, in part, that “[t]his guidance shall be
applied only to collars that are a combination of a single
written option and a single purchased option for which the
underlying in both options is the same. This guidance shall
not be applied by analogy to other derivative instruments
designated as hedging instruments.”
2.2.2.1.1.2 One or More Selected Contractual Cash Flows
Under ASC 815-20-25-12(b)(2)(ii), an entity may also
hedge one or more selected contractual cash flows of an item (or
qualifying portfolio of items). For instance, an entity may
designate a hedge of individual interest payments in a debt
instrument, which is also known as a partial-term hedge (see further
discussion of partial-term hedges in Section 3.2.1.1). If an entity
issues five-year fixed-rate debt with semiannual interest payments
and principal due at maturity, it could enter into a pay-variable,
receive-fixed interest rate swap to hedge its interest rate risk for
any portion of that five-year period and identify the interest
payments that occur during the swap period as the hedged item.
Example 2-2
Hedging Selected Contractual Cash Flows
With a Forward-Starting Swap
Company R is replacing maturing debt with a new
$100 million 10-year fixed-rate borrowing. It
believes that interest rates will be volatile for
the next three years and will decline in years
4–10. Company R issues the new debt with a fixed
rate of 8.25 percent on January 1. Interest on the
debt is payable annually beginning December 31.
Concurrently with issuing the debt, R enters into
a forward-starting interest rate swap to convert
the last seven years of the debt from a fixed rate
to a variable rate.
The swap is designated as a hedge of selected
contractual cash flows of the 10-year debt (i.e.,
R designates the last seven contractual interest
payments and the final principal payment due at
maturity as the hedged items). The risk being
hedged is the fair value exposure related to
changes in interest rates on the payments in years
4–10. In this case, because (1) the swap’s
maturity date matches the debt’s maturity date and
(2) all of the interest payments on the debt
during the term of the swap are designated as
being hedged, changes in the swap’s fair value
will be similar to change in the fair value of the
specified cash flows being hedged.
In accordance with ASC 815-20-25-12(b)(2)(ii),
an entity can hedge any consecutive interest
payments during the term of a debt instrument.
Thus, if R only wanted to hedge interest rate risk
for years 4–7, it could enter into a
forward-starting interest rate swap to convert
years 4–7 of the debt from a fixed rate to a
variable rate and then designate the
forward-starting swap as a hedge of those
specified contractual cash flows (i.e., the
interest payments for years 4–7 of the 10-year
debt). In addition, an entity is permitted to have
more than one separately designated partial-term
hedging relationship outstanding at the same time
for the same debt instrument as long as the same
contractual cash flows are not designated in more
than one hedging relationship at a time. See
Section 3.2.1.1 for further
discussion of partial-term hedging.
2.2.2.1.1.3 Embedded Options That Are Not Bifurcated
Under ASC 815-20-25-12(b)(2)(iii), an entity may designate an option
that is embedded in an existing asset or liability as the hedged
item in a hedging relationship. Although that guidance specifically
mentions call and put options (including caps and floors), we do not
believe that eligibility is limited to those types of embedded
options. In the assessment of which items may be designated as
hedged items, the important consideration is that eligibility is
limited to options embedded in existing assets or liabilities that
are not bifurcated and accounted for separately under ASC
815-15-25-1. In addition, the component being hedged must have the
potential to affect earnings and cannot be one of the prohibited
items discussed in Section 2.2.1. For example,
the issuer of convertible debt cannot hedge the conversion option in
its debt because doing so would be hedging a transaction in the
issuer’s own equity (see Section 2.2.1.4). If
an entity chooses to hedge a prepayment option (put or call), there
are some limits on the types of risk that may be hedged (see
Section 2.3.1).
2.2.2.1.1.4 Residual Value in a Lessor’s Net Investment in a Direct Financing or Sales-Type Lease
Under ASC 815-20-25-12(b)(2)(iv), an entity may designate as the
hedged item in a hedging relationship the residual value in a
lessor’s net investment in direct financing and sales-type leases.
In both types of leases, the lessor’s net investment is composed of
the lease receivable and the present value of the unguaranteed
residual value. ASC 815-20-25-12(b)(2)(iv) allows an entity to
identify the unguaranteed residual value as a hedgeable portion of
the net investment in the lease. The lease payments can also be
separately designated as a hedged item as specified contractual cash
flows (discussed in Section 2.2.2.1.1.2).
2.2.2.1.2 Cash Flow Hedges — Portions
Less guidance exists on hedging portions of items in a cash flow hedge.
While the guidance in ASC 815-20-25-13 through 25-15 does not include
the terms “portion” or “proportion,” ASC 815-20-25-13 does address
hedging the exposure to variability in expected future cash flows
related to an existing recognized asset or liability “such as all or
certain interest payments on variable-rate debt.” Because it mentions
“certain interest payments” but not percentages of certain cash flows,
this guidance could be interpreted as explicitly allowing only
partial-term hedges of an entire asset, a liability, or a portfolio of
assets or liabilities, as opposed to a proportion of certain cash flows
of an asset or liability. However, we do not believe that the criteria
for cash flow hedging were meant to be more restrictive than those for
fair value hedging.
2.2.2.1.3 Net Investment Hedges — Portions
ASC 815-35
35-27 If an entity documents
that the effectiveness of its hedge of the net
investment in a foreign operation will be assessed
based on the beginning balance of its net
investment and the entity’s net investment changes
during the year, the entity shall consider the
need to redesignate the hedging relationship (to
indicate what the hedging instrument is and what
numerical portion of the current net investment is
the hedged portion) whenever financial statements
or earnings are reported, and at least every three
months. An entity is not required to redesignate
the hedging relationship more frequently even when
a significant transaction (for example, a
dividend) occurs during the interim period.
Example 1 (see paragraph 815-35-55-1) illustrates
the application of this guidance.
A hedge of a net investment in foreign operations is typically expressed
as a specific currency unit amount of the net investment. Frankly, it
would not be practical to designate a fixed percentage of an overall net
investment as a hedged item because of the nature of the ongoing
accounting for a foreign subsidiary. The net investment in a foreign
subsidiary typically changes in each reporting period on the basis of
net income or loss of the subsidiary and equity transactions with the
entity. Accordingly, entities generally designate a portion of the
beginning balance of a net investment in foreign operations. While ASC
815-35-35-27 addresses potential redesignations of a hedge of a net
investment in a foreign operation, it also provides some guidance on how
a net investment hedge may be designated. That guidance states that the
designation of the hedging relationship would “indicate what the hedging
instrument is and what numerical portion of the current net investment
is the hedged portion.”
2.2.2.2 Hedging Portfolios of Items
ASC 815-20
Hedged Item Criteria Applicable to Fair Value
Hedges Only
25-12(b)(1) If similar assets
or similar liabilities are aggregated and hedged as
a portfolio, the individual assets or individual
liabilities shall share the risk exposure for which
they are designated as being hedged. The change in
fair value attributable to the hedged risk for each
individual item in a hedged portfolio shall be
expected to respond in a generally proportionate
manner to the overall change in fair value of the
aggregate portfolio attributable to the hedged risk.
See the discussion beginning in paragraph
815-20-55-14 for related implementation guidance. An
entity may use different stratification criteria for
the purposes of Topic 860 impairment testing and for
the purposes of grouping similar assets to be
designated as a hedged portfolio in a fair value
hedge.
Hedged Transaction Criteria Applicable to Cash
Flow Hedges Only
25-15(a) The
forecasted transaction is specifically identified as
either of the following:
- A single transaction
- 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.
Groups of similar items may be aggregated and identified as the hedged item
in a single hedging relationship. Portfolio hedging is only available for
fair value hedges and cash flow hedges but not for net investment hedges.
The eligibility criteria are similar for both fair value and cash flow
hedges in that the items that are included in a portfolio all need to share
the same risk exposure for which they are being hedged (e.g., assets and
liabilities cannot be included in the same hedged portfolio).
2.2.2.2.1 Hedging Portfolios — Fair Value Hedging
ASC 815-20
Determining Whether Risk Exposure Is Shared
Within a Portfolio
55-14 This implementation
guidance discusses the application of the guidance
in paragraph 815-20-25-12(b)(1) that the
individual assets or individual liabilities within
a portfolio hedged in a fair value hedge shall
share the risk exposure for which they are
designated as being hedged. If the change in fair
value of a hedged portfolio attributable to the
hedged risk was 10 percent during a reporting
period, the change in the fair values attributable
to the hedged risk for each item constituting the
portfolio should be expected to be within a fairly
narrow range, such as 9 percent to 11 percent. In
contrast, an expectation that the change in fair
value attributable to the hedged risk for
individual items in the portfolio would range from
7 percent to 13 percent would be inconsistent with
the requirement in that paragraph.
55-14A If both of the
following conditions exist, the quantitative test
described in paragraph 815-20-55-14 may be
performed qualitatively and only at hedge
inception:
- The hedged item is a closed portfolio of prepayable financial assets or one or more beneficial interests designated in accordance with paragraph 815-20-25-12A.
- An entity measures the change in fair value of the hedged item based on the benchmark rate component of the contractual coupon cash flows in accordance with paragraph 815-25-35-13.
Using the benchmark rate component of the
contractual coupon cash flows when all assets have
the same assumed maturity date and prepayment risk
does not affect the measurement of the hedged item
results in all hedged items having the same
benchmark rate component coupon cash flows.
Pending Content (Transition Guidance: ASC
815-20-65-6)
55-14A [See Section 9.7.]
55-15 In aggregating loans in
a portfolio to be hedged, an entity may choose to
consider some of the following characteristics, as
appropriate:
- Loan type
- Loan size
- Nature and location of collateral
- Interest rate type (fixed or variable)
- Coupon interest rate or the benchmark rate component of the contractual coupon cash flows (if fixed)
- Scheduled maturity or the assumed maturity if the hedged item is measured in accordance with paragraph 815-25-35-13B
- Prepayment history of the loans (if seasoned)
- Expected prepayment performance in varying interest rate scenarios.
In a fair value
portfolio hedge, each portfolio item’s fair value should be expected to
respond in a proportionate manner to the overall changes in the
aggregate portfolio’s fair value that are attributable to the hedged
risk. As noted in ASC 815-20-55-14, the change in the fair value that is
attributable to the hedged risk of each item within a portfolio should
be expected to be proportional (“within a fairly narrow range”) to the
change in the fair value that is attributable to the hedged risk of the
overall portfolio. To illustrate this concept, ASC 815-20-55-14
discusses a portfolio whose fair value changes because of changes in the
designated risk. ASC 815-20-55-14 addresses the appropriateness of the
following two ranges of changes in the fair values of individual
portfolio items in proportion to the changes in the overall portfolio’s
fair value that are attributable to the hedged risk:
Range of Changes in the Fair
Value of Individual Portfolio Items Attributable
to the Hedged Risk
|
Is Portfolio Acceptable as a
Hedged Item?
|
---|---|
90–110%
|
Yes
|
70–130%
|
No
|
Connecting the Dots
On the basis of the two examples in ASC 815-20-55-14, we believe
that the changes in the fair values of individual items in a
portfolio that are attributable to the hedged risk should be
within 80 to 125 percent of the overall change in the
portfolio’s fair value that is attributable to that risk, on a
proportional basis. In the determination of whether the
instruments in the portfolio are similar (i.e., “a similarity
analysis”), comparisons to the expected change in the hedging
instrument’s fair value are not relevant. In other words, while
there is a requirement that a hedging instrument is expected to
be highly effective at offsetting the change in a hedged item’s
fair value that is attributable to the designated risk (see
Section 2.5), there is
no requirement to evaluate whether the hedging instrument would
be highly effective at offsetting the change in the fair value
of each individual item in the portfolio that is attributable to
the designated risk.
Assume that an entity is
attempting to hedge the risk of changes in the fair value of a portfolio
of three fixed-rate debt instruments. To designate the portfolio as a
hedged item in a hedging relationship, the entity must perform an
analysis to determine whether the fixed-rate debt instruments are
similar. The table below depicts a scenario in which the entity assumes
an increase in the designated benchmark interest rate (i.e., the
proposed designated hedged risk) of 200 basis points. It shows the
expected changes in the fair values of (1) each of the three fixed-rate
debt instruments and (2) the overall portfolio. Since the fair value of
the overall portfolio changed by 11.6 percent, the change in the fair
value of each item in the portfolio is expected to be within a 9.3 to
14.5 percent band. (The lower end of the acceptable range is 80 percent
of the portfolio’s overall fair value change of 11.6 percent; the upper
end of the acceptable range is 125 percent of the 11.6 percent change.)
Because the fair value of the four-year debt in the portfolio shown
below is expected to change by 20 percent, which is outside of the
computed acceptable range, the items in the portfolio would not be
considered similar, and the overall portfolio would not qualify as a
hedgeable item.
When designating a portfolio as a hedged item, an entity should consider
the characteristics of the individual items and how those
characteristics would respond to changes in the designated risk. For
example, in aggregating loans in a portfolio to be hedged, an entity may
choose to consider some of the following characteristics: loan type and
size, the nature and location of collateral, interest rate type (fixed
or variable) and the coupon interest rate (if fixed), scheduled
maturity, prepayment history of the loans (if seasoned), and expected
prepayment performance in varying interest rate scenarios.
An entity may have difficulty tracking portfolios and the individual
items in a portfolio if there are underlying differences in how those
items respond to changes in fair value or cash flows that result from
changes in the designated risk. For example, if changes in the fair
values of certain items in the portfolio are no longer expected to
respond within a range of 80 to 125 percent of the overall portfolio’s
fair value change, the entity will have to remove those items and
dedesignate a related proportion of the hedging derivative.
The analysis of whether all of the items in a portfolio are similar
should be performed at the inception of the hedging relationship, and it
should be reperformed on an ongoing basis during the life of the hedge
as frequently as hedge effectiveness assessments are performed. The
similarity analysis will generally be quantitative, but sometimes a
qualitative analysis may be sufficient. An entity’s ability to use a
qualitative analysis will depend on the items in the portfolio and the
risk being hedged. ASC 815-20-55-14A specifically addresses a
last-of-layer hedge in which an entity measures the change in fair value
of the hedged item on the basis of the benchmark component of the
contractual coupon cash flows. For such hedges, an entity may assume
that all of the items are similar on the basis of a qualitative analysis
that is only performed at the inception of the hedge. See further
discussions of last-of-layer hedging in Section
3.2.1.4).
When an entity constructs a portfolio to be hedged, it may also want to
consider how differences in the designated risk and certain fair value
hedge measurement alternatives would affect the similarity analysis. For
example, if an entity (1) designates as the hedged risk the changes in
fair value due to changes in the designated benchmark interest rate (see
Section 2.3.1.1) and (2) elects to calculate
the changes in fair value by using cash flows based on the benchmark
rate component of the contractual coupon cash flows (see
Section 3.2.1), it would assume that all
individual items with the same maturity would have the same coupon rate
for analysis purposes. If the individual items were prepayable during
the term of the hedge, the entity could also elect to consider only how
changes in the designated benchmark rate would affect each borrower’s
decision to prepay its obligation. In addition, an entity that elects to
designate a partial-term hedge could use the same assumed maturity date
for all of the items in the portfolio. Electing to apply a combination
of all of these risk designation and measurement alternatives could
eliminate many or all of the differences in how the individual items
that make up the portfolio would respond to changes in the designated
risk.
Example 2-3
Hedging Net Exposures
Entity B, a bank, has an investment in $100
million of fixed-rate debt securities and $60
million of fixed-rate debt outstanding; its net
exposure is $40 million of fixed-rate assets.
Although B would like to designate the net
exposure as the hedged item, ASC 815 requires
entities to designate and hedge risks on a gross
basis and does not permit them to macro hedge
their exposures (effectively, macro hedging is the
accumulation of risks, such as long and short
positions with a hedge of the net position).
Accordingly, B must instead identify an item (or
portfolio of items) to hedge that comprises part
of that net exposure. While B could not designate
its net exposure of $40 million as the hedged
item, it could achieve a similar outcome by
designating $40 million of its investment in
fixed-rate debt securities as the hedged item.
Example 2-4
Hedging Both the Purchase of Materials and the
Sale of Product
Entity X, a manufacturing company, hedges the
forecasted purchase of raw materials and
separately hedges the forecasted sales of the
manufactured product. Since X has exposure to two
distinct price risks, it is permitted under ASC
815 to use cash flow hedge accounting for both the
forecasted purchase of raw materials and the
forecasted sales of the manufactured product.
However, X would not be permitted to hedge
(1) inventory on hand in a fair value hedge and
(2) the forecasted sale of that inventory as a
cash flow hedge because, by doing so, it would be
hedging the same risk exposure twice.
2.2.2.2.1.1 Hedging Portfolios of Mortgage Servicing Rights
ASC 815-20
55-16 Paragraph
815-20-25-12(b)(1) provides criteria under which
similar assets or similar liabilities may be
aggregated and hedged as a portfolio under a fair
value hedge, requiring, in part, that the
individual assets or individual liabilities share
the risk exposure for which they are designated as
being hedged. Servicers of financial assets that
designate a hedged portfolio by aggregating
servicing rights within one or more risk strata
used under paragraph 860-50-35-9 would not
necessarily comply with the requirement in
paragraph 815-20-25-12(b)(1) for portfolios of
similar assets because the risk strata under
paragraph 860-50-35-9 can be based on any
predominant risk characteristic, including date of
origination or geographic location.
Under ASC 860, entities that recognize mortgage servicing rights
under the amortization method (i.e., not remeasured at fair value)
are required to perform an impairment analysis by stratifying each
class of mortgage servicing rights on the basis of one or more of
the predominant risk characteristics of the underlying financial
assets, as discussed in ASC 860-50-35-9. The criteria for
determining stratification of mortgage servicing rights are not
consistent with the criteria for determining whether items in a
portfolio would be considered similar under ASC 815; therefore,
compliance with the stratification criteria under ASC 860 would not
ensure that the items in the portfolio would be considered similar
under ASC 815. Accordingly, the entity would still need to
separately assess whether the servicing rights would be considered
similar under the criteria in ASC 815 before it could determine
whether the portfolio was eligible for designation as a hedged item
in a fair value hedge.
2.2.2.2.2 Hedging Portfolios — Cash Flow Hedging
ASC 815-20
55-22 Under the guidance in
this Subtopic, a single derivative instrument of
appropriate size could be designated as hedging a
given amount of aggregated forecasted
transactions, such as any of the following:
- Forecasted sales of a particular product to numerous customers within a specified time period, such as a month, a quarter, or a year
- Forecasted purchases of a particular product from the same or different vendors at different dates within a specified time period
- Forecasted interest payments on several variable-rate debt instruments within a specified time period.
55-23 At the time of hedge
designation only, the transactions in each group
must share the risk exposure for which they are
being hedged. For example, the interest payments
in the group in (c) in the preceding paragraph
shall vary with the same index to qualify for
hedging with a single derivative instrument.
The designated hedged item in a cash flow hedge may
be a group of items that share the same risk exposure for which they
are being hedged. As discussed in Section 2.2.2.2.1, this
concept of sharing the same risk exposure also exists when hedging a
portfolio of items in a fair value hedge. While the quantitative
similarity analysis discussed in Section
2.2.2.2.1 is not explicitly required by the guidance
on cash flow hedges of a portfolio of items, we believe that a
similar concept should be applied. Accordingly, if the items
included in the portfolio are not identical, the entity should
prepare an analysis that demonstrates that all of the individual
items in the portfolio would react similarly to changes in the
hedged risk.
Example 2-5
Hedging Loans With Different
Indexes
Bank B has a $1 billion portfolio of 10-year
variable-rate loans that are indexed to various
contractually specified interest rate indexes,
including LIBOR, prime, and the federal funds
rates. It enters into an interest rate swap to
hedge the cash flow exposure related to the future
interest receipts. The swap is a $1 billion
notional, 10-year pay-LIBOR, receive-fixed
interest rate swap. The repricing dates of the
swap match the interest receipt dates of the
loans. Although B would like to hedge the loans as
a single portfolio, it cannot do so because, at
the time of the hedge designation, the forecasted
interest receipts of the loans in the portfolio
vary with different interest rate indexes (i.e.,
LIBOR, prime, and federal funds rates) and
therefore do not share the same risk exposure.
However, B could divide its loan portfolio into
smaller groups of loans so that each loan within a
group would be indexed to the same contractually
specified rate. Each group could then qualify to
be designated as the hedged item in a separate
cash flow hedge under ASC 815-20-25-15 (as long as
all other cash flow hedging criteria are met).
Under ASC 815-20-25-15, for a group of
individual transactions to be designated as the
hedged transaction in a cash flow hedge, the
individual transactions in the portfolio must
share the same risk exposure for which they are
designated as being hedged. While ASC
815-20-55-22(c) does indicate that an entity may
designate “[f]orecasted interest payments on
several variable-rate debt instruments within a
specified time period” as the hedged item, ASC
815-20-55-23 provides the following caveat: “the
interest payments in the group in (c) in the
preceding paragraph shall vary with the same index
to qualify for hedging with a single derivative
instrument.”
Many cash flow hedging strategies involve a group of forecasted
transactions with terms that are not fixed or known at the inception
of the hedging relationship. The designation documentation should
identify the hedged forecasted transactions in a single hedging
relationship at a level of specificity that would only include
future transactions that would be similar to each other at the time
of occurrence. Hedging groups of forecasted transactions is
discussed in further detail in Chapter
4.
Footnotes
1
The words intercompany and intra-entity are
interchangeable. However, since the Codification mostly
uses the term “intra-entity,” we use that term for the
remainder of this Roadmap.
2
There is an exception for certain
foreign-currency-denominated forecasted intra-entity
transactions.
3
Equity means the instrument is classified in
the hedging entity’s stockholders’ equity.
4
See footnote 3.
5
See footnote 3.
6
ASU 2022-01
replaces the last-of-layer hedge with the
portfolio layer method hedge, under which the
closed portfolio of financial assets are not
limited to prepayable financial assets. See
further discussion of the portfolio layer method
and the effective date of ASU 2022-01 in Chapter
9.
2.3 Risks That May Be Identified as the Hedged Risk
ASC 815 permits an entity to hedge the risk of changes in the entire fair value of
the hedged item or in all the item’s cash flows, but an entity may hedge certain
other risk components of the hedged item as well. The nature of the risks that may
be hedged depends on whether the hedged item is a financial asset or liability or a
nonfinancial asset or liability. An entity is permitted to hedge any of the risks
individually or in combination with other risks.
2.3.1 Financial Instruments — Risks That May Be Hedged
ASC 815-20
Hedged Item Criteria Applicable to Fair Value
Hedges Only
25-12(f) If the hedged item
is a financial asset or liability, a recognized loan
servicing right, or a nonfinancial firm commitment with
financial components, the designated risk being hedged
is any of the following:
- The risk of changes in the overall fair value of the entire hedged item
- The risk of changes in its fair value attributable to changes in the designated benchmark interest rate (referred to as interest rate risk)
- The risk of changes in its fair value attributable to changes in the related foreign currency exchange rates (referred to as foreign exchange risk)
- The risk of changes in its fair
value attributable to both of the following
(referred to as credit risk):
- Changes in the obligor’s creditworthiness
- Changes in the spread over the benchmark interest rate with respect to the hedged item’s credit sector at inception of the hedge.
- If the risk designated as being hedged is not the risk in paragraph 815-20-25-12(f)(1), two or more of the other risks (interest rate risk, foreign currency exchange risk, and credit risk) may simultaneously be designated as being hedged.
Hedged Transaction Criteria
Applicable to Cash Flow Hedges Only
25-15(j) If the hedged
transaction is the forecasted purchase or sale of a
financial asset or liability (or the interest payments
on that financial asset or liability) or the variable
cash inflow or outflow of an existing financial asset or
liability, the designated risk being hedged is any of
the following:
- The risk of overall changes in the hedged cash flows related to the asset or liability, such as those relating to all changes in the purchase price or sales price (regardless of whether that price and the related cash flows are stated in the entity’s functional currency or a foreign currency)
- 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. See paragraphs 815-20-25-19A through 25-19B for further guidance on the designation of interest rate risk in the forecasted issuance or purchase of a debt instrument.
- The risk of changes in the functional-currency-equivalent cash flows attributable to changes in the related foreign currency exchange rates (referred to as foreign exchange risk)
- The risk of changes in its cash
flows attributable to all of the following
(referred to as credit risk):
- Default
- Changes in the obligor’s creditworthiness
- Changes in the spread over the contractually specified interest rate or benchmark interest rate with respect to the related financial asset’s or liability’s credit sector at inception of the hedge.
If the risk designated as being hedged is not the risk in
paragraph 815-20-25-15(j)(1), two or more of the other
risks (interest rate risk, foreign exchange risk, and
credit risk) simultaneously may be designated as being
hedged.
The table below illustrates the types of interest
rate, credit, and foreign currency risks that may be hedged in connection with a
financial instrument. These include the risks of changes in the forecasted
issuances, purchases, or sales of a financial instrument; recognized loan
servicing rights; and nonfinancial firm commitments with financial components.
Each risk is discussed in more detail below the table.
Fair Value Hedge
|
Cash Flow Hedge
| |
---|---|---|
Interest rate risk (see Section 2.3.1.1)
|
The risk of changes in fair value attributable to changes
in the designated benchmark interest rate.
|
Either of the following:
|
Credit risk (see Section 2.3.1.2)
|
The risk of changes in fair value attributable to changes
in the obligor’s credit and changes in the general
credit spread for the relevant credit sector.
|
The risk of changes in cash flows attributable to
(1) default, (2) changes in the obligor’s
creditworthiness, and (3) changes in the general credit
spread for the relevant credit sector. Note that items
(2) and (3) are relevant for forecasted purchases or
issuances of debt or for an existing debt instrument
whose contractual payment terms change with changes in
those factors.
|
Foreign currency risk (see Section 2.3.1.3)
|
The risk of changes in fair value attributable to changes
in the related foreign currency exchange rates.
|
The risk of changes in functional-currency-equivalent
cash flows attributable to changes in related foreign
currency exchange rates.
|
Overall risk (see Section 2.3.1.4)
|
The risk of overall changes in fair value.
|
The risk of overall changes in cash flows.
|
An entity is permitted to designate more than one of the above component risks as
the combined risks in a single hedging relationship. For example, if an entity
has issued foreign-currency-denominated variable-rate debt, it may hedge its
exposure to changes in cash flows that are attributable to both interest rate
risk and foreign currency risk in a single hedging relationship. The most common
hedging strategy to achieve that objective would involve a cross-currency
interest rate swap (see further discussion of this hedging strategy in
Section 5.3.1.2).
2.3.1.1 Interest Rate Risk
An entity is permitted to
hedge the interest rate risk in a financial instrument. There are multiple
definitions of interest rate risk, depending on whether the hedged item is
an existing fixed-rate debt instrument, an existing variable-rate debt
instrument, or the forecasted issuance or purchase of a debt instrument. The
table below illustrates how interest rate risk is defined relative to the
item being hedged.
Hedged Item
|
Type of Hedge
|
Risk
|
---|---|---|
Existing fixed-rate debt instrument
|
Fair value
|
Benchmark interest rate
|
Existing variable-rate debt instrument
|
Cash flow
|
Contractually specified interest rate
|
Forecasted issuance or purchase of fixed-rate debt
instrument
|
Cash flow
|
Benchmark interest rate
|
Forecasted issuance or purchase of variable-rate debt
instrument
|
Cash flow
|
Expected contractually specified interest rate
|
When issuing Statement 138, the FASB decided that interest rate risk and credit risk were separable components of the overall risk in a debt instrument. This decision was based on feedback received after the issuance of FASB Statement 133 indicating that (1) the separation of such risks would
be consistent with the common understanding of market participants and (2)
hedging activities that existed at the time (and still exist today) were
based on hedges of a benchmark interest rate. In addition, the feedback
indicated that it would be difficult to measure the impact of changes in
market credit sector spreads because consistent data on such spreads was not
readily available in the market.
In most interest rate
derivatives, the underlying is a benchmark interest rate. For example, most
interest rate swaps have a floating leg that is indexed to LIBOR. Other
common interest rate derivatives are options and forwards related to U.S.
Treasury obligations. However, the interest rate on debt instruments is
typically composed of two components: a benchmark or contractually specified
interest rate and a credit spread. For variable-rate debt instruments, it is
easy to observe the two components because the terms of the debt separately
identify the contractually specified interest rate and the credit spread
(which is typically fixed for the life of the debt arrangement). For
fixed-rate debt instruments, the interest rate on the debt does not
typically equal the benchmark interest rate, so the credit spread can be
determined as the difference between the overall interest rate and the
benchmark interest rate.
When it issued Statement
138, the FASB designated the LIBOR and U.S. Treasury rates as the benchmark
interest rates in the United States. In July 2013, the FASB issued
ASU
2013-10, which established the Fed Funds Effective Rate
Overnight Index Swap Rate (also referred to as the OIS Rate) as a benchmark
interest rate. In August 2017, the FASB issued ASU 2017-12,
which established the Securities Industry and Financial Markets Association
(SIFMA) Municipal Swap Rate. And in October 2018, in response to concerns
about the sustainability of LIBOR and the contemplated shift to an
alternative reference rate, the Board issued ASU 2018-16, which established
the SOFR OIS rate. As of the issuance date of this Roadmap, the acceptable
benchmark interest rates in the United States, as listed in ASC
815-20-25-6A, are as follows:
Rate
|
Origin
|
---|---|
U.S. Treasury
|
FASB Statement 138 — June 2000
|
LIBOR
|
FASB Statement 138 — June 2000
|
Fed Funds OIS
|
ASU 2013-10 — July 2013
|
SIFMA Municipal Swap
|
ASU 2017-12 — August 2017
|
SOFR OIS
|
ASU 2018-16 — October 2018
|
Changing Lanes
In April 2022, the FASB issued a proposed
ASU that would “amend the definition of the SOFR
Swap Rate so that it is no longer limited to the OIS rate based on
SOFR but would include other rates based on SOFR, such as SOFR
term.” However, in October 2022, the Board decided not to amend the
definition of the “SOFR Swap Rate.”
See Sections 3.2.1 and 4.2.1.2 for
further discussion of hedging the benchmark interest rate and how that
affects the application of hedge accounting for fair value hedges and cash
flow hedges, respectively.
ASU 2017-12 amended ASC 815 to remove the notion of a benchmark interest rate
for variable-rate debt instruments and replaced it with the concept of a
contractually specified interest rate. In many cases, this change is of
little significance because most variable-rate debt instruments have an
interest rate that only resets on the basis of one predefined interest rate
index. ASC 815 has never permitted an entity to hedge a benchmark interest
rate component of a variable-rate debt instrument that is explicitly indexed
to a rate that is not a qualifying benchmark interest rate. Since the hedge
of a variable-rate debt instrument is a hedge of potential changes in
interest cash flows, it is more relevant to hedge the variables that can
actually affect those cash flows. Accordingly, an entity that wants to hedge
the interest rate risk in a variable-rate debt instrument can hedge the risk
related to the contractually specified interest rate. If the hedged item is
the forecasted issuance of a variable-rate debt instrument, an entity can
designate as the hedged risk the changes in cash flows that are attributable
to changes in the expected contractually specified interest rate.
If a change in the benchmark interest rate is designated as the hedged risk
in either a fair value or a cash flow hedge, the evaluation of the hedge’s
effectiveness should encompass only changes in the benchmark interest rate
(i.e., changes in credit spreads over the benchmark rate should be
excluded). Similarly, if the contractually specified interest rate (or
expected contractually specified interest rate) is designated as the hedged
risk in a cash flow hedge, the evaluation of the hedge’s effectiveness
should take into account only changes in that interest rate.
2.3.1.1.1 Prohibition Against Hedging Interest Rate Risk — HTM Securities
ASC 815-20-25-43(c)(2) and (d)(2) prohibit entities from hedging interest
rate risk related to a held-to-maturity (HTM) security on the premise
that entities with the intent and ability to hold a debt security to
maturity should be indifferent to changes in market interest rates. In
fact, hedging such a security for changes in interest rates may
contradict the notion that the entity is holding it purely for the
collection of cash flows. Unless there is a default by the obligor, the
fair value of an HTM security will always equal its par amount on the
maturity date. However, such a security may be hedged for credit risk
and foreign currency risk since those risks could affect the security’s
fair value or cash flows upon maturity. In addition, an entity may hedge
the fair value of a prepayment option in an HTM security.
2.3.1.1.2 Prohibition Against Hedging Interest Rate Risk — Prepayment Option
An entity that designates the prepayment option
component of a debt instrument as the hedged item in a fair value hedge
(see Section 2.2.2.1.1.3) is prohibited from designating
interest rate risk as the hedged risk. In addition, ASC 815-20-25-6
notes that prepayment risk is also not an acceptable risk to designate:
An entity shall not simply designate prepayment
risk as the risk being hedged for a financial asset. However, it
can designate the option component of a prepayable instrument as
the hedged item in a fair value hedge of the entity’s exposure
to changes in the overall fair value of that prepayment option,
perhaps thereby achieving the objective of its desire to hedge
prepayment risk.
2.3.1.2 Credit Risk
An entity’s borrowing rate is the benchmark interest rate plus or minus the
entity’s own sector credit spread, if any. Its credit spread is the risk
premium required over the benchmark rate and is based on the difference
between (1) the credit risk that is implicit in the benchmark rate and (2)
the credit risk of the entity. The same principle applies to
interest-bearing assets. In a credit risk hedge, the relevant credit spread
to be considered is that of the issuing entity. Under ASC 815, credit risk
includes the risk of a widening or compression of a sector spread relative
to the benchmark interest rate with respect to the hedged item’s credit
sector upon inception of the hedge.
The fair value of fixed-rate debt instruments is affected by both the
obligor’s default risk and changes in credit sector spreads. Generally
speaking, variable-rate debt instruments have a fixed spread over the
contractually specified interest rate. For example, an entity may issue debt
that is repriced every three months to achieve a rate that is equal to the
three-month LIBOR plus 1.5 percent. In such a case, the only real potential
for credit risk to affect the actual cash flows is if a default occurs.
However, for the forecasted issuance or purchase of debt instruments, the
credit risk that can affect future cash flows includes all the components of
credit risk.
2.3.1.3 Foreign Currency Risk
An entity with a financial instrument denominated in a
foreign currency is exposed to changes in the exchange rate between that
foreign currency and its functional currency. Changes in foreign currency
exchange rates can actually affect both the instrument’s fair value and the
cash flows related to the instrument on a functional currency basis.
Accordingly, an entity will sometimes have a choice between designating a
hedge as a fair value hedge or a cash flow hedge. See Chapter 5 for a more thorough discussion of foreign currency
hedging under both the fair value and cash flow hedging models.
2.3.1.4 Overall Risk
An entity is not required to hedge any individual component
risks that would affect the fair value or cash flows of a financial
instrument. Instead, it may designate as the hedged risk the overall changes
in (1) the fair value or (2) the cash flows of the hedged item. In fact, in
some cases, an entity is only permitted to designate either the overall
changes in the fair value or the overall changes in the cash flows (i.e., it
is unable to designate any other type of hedged risk). For example, as noted
in Section 2.3.1.1.2, if an entity designates the prepayment
option in a debt instrument as the hedged item, it must hedge the total
changes in that option’s fair value. However, the entity is prohibited from
hedging (1) a fixed-rate HTM security for overall changes in its fair value
(in accordance with ASC 815-20-25-12(d)) and (2) a variable-rate HTM
security for total changes in cash flows (in accordance with ASC
815-20-25-15(f)).
2.3.2 Nonfinancial Items — Risks That May Be Hedged
ASC 815-20
Hedged Item Criteria Applicable to
Fair Value Hedges Only
25-12(e) If the hedged item
is a nonfinancial asset or liability (other than a
recognized loan servicing right or a nonfinancial firm
commitment with financial components), the designated
risk being hedged is the risk of changes in the fair
value of the entire hedged asset or liability
(reflecting its actual location if a physical asset).
That is, the price risk of a similar asset in a
different location or of a major ingredient shall not be
the hedged risk. Thus, in hedging the exposure to
changes in the fair value of gasoline, an entity may not
designate the risk of changes in the price of crude oil
as the risk being hedged for purposes of determining
effectiveness of the fair value hedge of gasoline.
Hedged Transaction Criteria Applicable to Cash Flow
Hedges Only
25-15(i) If the hedged
transaction is the forecasted purchase or sale of a
nonfinancial asset, the designated risk being hedged is
any of the following:
- The risk of changes in the functional-currency-equivalent cash flows attributable to changes in the related foreign currency exchange rates
- The risk of changes in the cash flows relating to all changes in the purchase price or sales price of the asset reflecting its actual location if a physical asset (regardless of whether that price and the related cash flows are stated in the entity’s functional currency or a foreign currency), not the risk of changes in the cash flows relating to the purchase or sale of a similar asset in a different location.
- The risk of variability in cash flows attributable to changes in a contractually specified component. (See additional criteria in paragraphs 815-20-25-22A through 25-22B for designating the variability in cash flows attributable to changes in a contractually specified component as the hedged risk.)
The table below illustrates the types of risks
that may be hedged relative to nonfinancial items. Each risk is discussed in
more detail after the table.
Fair Value Hedge
|
Cash Flow Hedge
| |
---|---|---|
Contractually specified component risk
(see Section 2.3.2.1)
|
N/A
|
The risk of changes in the cash flows
associated with a forecasted purchase or sale of a
nonfinancial asset that are related to changes in a
contractually specified component of the overall
price
|
Foreign currency risk (see Section
2.3.2.2)
|
N/A
|
The risk of changes in the
functional-currency-equivalent cash flows attributable
to changes in related foreign currency exchange
rates
|
Overall risk (see Section
2.3.2.3)
|
The risk of overall changes in fair
value
|
The risk of overall changes in cash
flows
|
2.3.2.1 Contractually Specified Component Risk
ASC 815-20
25-22A For
existing contracts, determining whether the
variability in cash flows attributable to changes in
a contractually specified component may be
designated as the hedged risk in a cash flow hedge
is based on the following:
- If the contract to purchase or sell a nonfinancial asset is a derivative in its entirety and an entity applies the normal purchases and normal sales scope exception in accordance with Subtopic 815-10, any contractually specified component in the contract is eligible to be designated as the hedged risk. If the entity does not apply the normal purchases and normal sales scope exception, no pricing component is eligible to be designated as the hedged risk.
- If the contract to purchase or sell a nonfinancial asset is not a derivative in its entirety, any contractually specified component remaining in the host contract (that is, the contract to purchase or sell a nonfinancial asset after any embedded derivatives have been bifurcated in accordance with Subtopic 815-15) is eligible to be designated as the hedged risk.
25-22B An
entity may designate the variability in cash flows
attributable to changes in a contractually specified
component in accordance with paragraph
815-20-25-15(i)(3) to purchase or sell a
nonfinancial asset for a period longer than the
contractual term or for a not-yet-existing contract
to purchase or sell a nonfinancial asset if the
entity expects that the requirements in paragraph
815-20-25-22A will be met when the contract is
executed. Once the contract is executed, the entity
shall apply the guidance in paragraph 815-20-25-22A
to determine whether the variability in cash flows
attributable to changes in the contractually
specified component can continue to be designated as
the hedged risk. See paragraphs 815-20-55-26A
through 55-26E for related implementation
guidance.
Before the issuance of ASU 2017-12, foreign currency risk was the only
component of the forecasted purchase or sale price of a nonfinancial asset
that was acceptable as a hedged risk. The amendments in ASU 2017-12 gave
entities the ability to hedge a contractually specified component of the
ultimate price of the forecasted purchase or sale of the nonfinancial asset.
The ASU amended ASC 815 to allow an entity to designate the “risk of
variability in cash flows attributable to changes in a contractually
specified component” as the hedged risk in a cash flow hedge of a forecasted
purchase or sale of a nonfinancial asset. ASU 2017-12 defines a
contractually specified component as “[a]n index or price explicitly
referenced in an agreement to purchase or sell a nonfinancial asset other
than an index or price calculated or measured solely by reference to an
entity’s own operations.”
Under the ASU, a contractually specified component risk may be hedged, which
allows entities to hedge purchases and sales of nonfinancial assets in
situations in which a contract has a pricing formula with one or more
variable components. For example, a purchase contract may have a base
component price for a related commodity and other variable pricing
components associated with actual transportation costs at the time of
delivery, different fixed spreads based on different grades of the
commodity, or both. In addition, entities that purchase or sell nonfinancial
assets of varying qualities or grades or at different locations can now
designate those purchases or sales in a single hedging relationship if the
price of the nonfinancial assets have a common contractually specified price
component.
2.3.2.1.1 Contractually Specified Component of Existing Contract
An entity may wish to designate as the hedged risk the variability in the
cash flows attributable to changes in a contractually specified
component in the purchase or sale of a nonfinancial asset. The ability
to make such a designation depends on the nature of the contract:
- If the contract is a derivative in its entirety and the entity applies the “normal purchases and normal sales” derivative scope exception in ASC 815-10-15-13(b), it may designate any contractually specified component in the contract as the hedged risk (failure to apply the normal purchases and normal sales scope exception precludes designation of any contractually specified component in the contract). For further discussion of the application of the normal purchases and normal sales scope exception, see Section 2.3.2 of Deloitte’s Roadmap Derivatives.
- If the contract is not a derivative in its entirety, the entity may designate any contractually specified component in the host contract as the hedged risk, other than any pricing component that is an embedded derivative that is bifurcated and accounted for separately.
According to ASC 815-20-55-26A, “[t]he definition of a
contractually specified component is considered to be met if the
component is explicitly referenced in agreements that support the price
at which a nonfinancial asset will be purchased or sold.”
Sometimes it is easy to determine whether an entity has
a contractually specified component in an existing contract to purchase
or sell a nonfinancial asset. An example would be an annual aluminum
supply contract7 in which each month’s purchases are based on the average price per
pound, as quoted on the London Metals Exchange (LME), plus the monthly
average of the Midwest Transaction Premium, as published by Platts
Metals Daily, plus $0.15 per pound. In this case, an entity could
identify any of the following as contractually specified components of
the forecasted purchases of aluminum:
- The LME aluminum price.
- The Midwest Transaction Premium.
- A combination of both of the above components (commonly referred to as the Midwest Transaction Price).
Questions have also arisen about what sorts of
agreements qualify as contracts that support the price at which a
nonfinancial asset will be purchased or sold. We believe that a legally
binding agreement between a buyer and seller that explicitly refers to a
formula with a specific index or indexes needs to exist before the
actual purchase or sale of the nonfinancial asset. However, ASC 815 also
allows an entity to hedge a contractually specified component of a
contract that does not yet exist. See Section 2.3.2.1.2 for a discussion of the criteria for
hedging a contractually specified component of a contract that does not
yet exist.
Changing Lanes
In November 2019, the FASB issued a
proposed ASU of Codification improvements
to hedge accounting. One of the proposed improvements would
allow an entity to hedge the risk related to a contractually
specified component in a contract that is accounted for as a
derivative as long as (1) it is probable that the contract will
result in the delivery of the nonfinancial asset and (2) the
pricing is based on an underlying that is clearly and closely
related to the asset that is being sold or purchased. 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.
2.3.2.1.2 Contractually Specified Component of a Contract That Does Not Yet Exist
An entity is permitted to designate a hedge of a contractually specified
component related to the forecasted purchases or sales of a nonfinancial
asset (1) for a period that extends beyond the existing contractual term
or (2) in circumstances in which a contract does not yet exist to sell
or purchase the nonfinancial asset, the criteria specified for existing
contracts will be met in a future contract, and all the other cash flow
hedging requirements are met (see ASC 815-20-25-22B).
However, an entity is generally not permitted to hedge a contractually
specified component of a forecasted purchase or sale on the spot market.
Most transactions in the spot market are simply purchases or sales of a
nonfinancial asset at the current market price without a preexisting
contract that contains a pricing formula.
ASC 815-20-55-26A illustrates how a contractually specified component of
a purchase could exist in a spot market and provides an example of an
entity that intends to buy a commodity in such a market. That guidance
states, in part, that “[i]f as part of the governing agreements of the
transaction or commodities exchange it is noted that prices are based on
a pre-defined formula that includes a specific index and a basis, those
agreements may be utilized to identify a contractually specified
component.” It is our current understanding that few, if any, spot
markets operate in a manner in which the pricing of the commodity traded
in the market is based on a predefined formula.
Changing Lanes
In November 2019, the FASB issued a
proposed ASU of Codification improvements
to hedge accounting. One of the proposed improvements would
allow documentation that was obtained either before or after the
transaction is consummated to provide evidence of a
contractually specified component of the purchase price. A spot
transaction receipt, or other documentation that supports the
price at which a nonfinancial asset is purchased or sold would
qualify as evidence, as long as the pricing formula that
includes the contractually specified component is based on how
the price is determined in the nonfinancial asset’s market.
On the basis of questions raised by stakeholders about the
proposed guidance, the Board changed the scope of the project;
contractually specified components in cash flow hedges of
nonfinancial forecasted transactions remain on the list of
issues that the project will address.
2.3.2.1.3 Contractually Specified Component Prohibited for Fair Value Hedge
ASC 815 does not permit the changes in the fair value of
a component or major ingredient of a nonfinancial asset to be the
designated risk in a fair value hedge. The only acceptable risk
designation for a fair value hedge of a nonfinancial asset is the
overall changes in fair value. However, as discussed in Section 2.3.2.1.1, an entity is allowed to hedge
components of the price of a forecasted purchase or sale of a
nonfinancial asset if that price component is contractually
specified.
Example 2-6
Reprise manufactures tweezers made from aluminum
and other alloys. It cannot designate the aluminum
component of the tweezers in inventory as the
hedged item in a fair value hedge because ASC 815
precludes fair value hedges of a component or
major ingredient of a nonfinancial asset or
liability. Reprise could, however, designate an
aluminum-based derivative as a hedge of the entire
change in the fair value of the tweezer inventory
if the derivative is expected to be highly
effective at offsetting changes in the inventory’s
fair value.
Reprise also would potentially be able to
designate a cash flow hedge of a contractually
specified component of a forecasted purchase of
raw materials or a sale of finished goods. For
example, Reprise could designate the aluminum
component of a forecasted sale of tweezers as the
hedged risk if the price of aluminum was a
contractually specified component of the sale
price of the tweezers.
2.3.2.2 Foreign Currency Risk
Purchases and sales of nonfinancial assets that occur in a currency other
than an entity’s functional currency expose the entity to changes in price
when foreign currency exchange rates change, even if the stated transaction
price of the underlying asset does not change. The entity’s real economic
risk is that the ultimate price of a foreign-currency-denominated forecasted
purchase or sale can change because of fluctuations in foreign currency
exchange rates. Also, any related receivable or payable that results from
that purchase or sale represents a financial instrument that is still
exposed to foreign currency risk until it is settled.
ASC 815 permits entities to hedge the risk of changes in
functional-currency-equivalent cash flows that are attributable to changes
in foreign currency exchange rates related to the forecasted purchases and
sales of nonfinancial assets.
The fair values of
nonfinancial assets are not exposed to the risk of changes in foreign
currency exchange rates because those assets (1) are not denominated in any
currency and (2) do not result in any contractual cash flows. Accordingly,
an entity cannot designate a fair value hedge of the foreign currency risk
exposure of its nonfinancial assets.
See further discussion of foreign currency hedges in
Chapter 5.
2.3.2.3 Overall Risk
An entity is not required to hedge any individual component
risks that would affect the fair value or cash flows associated with a
nonfinancial asset, including the forecasted purchases and sales of
nonfinancial assets. The entity is always permitted to designate as the
hedged risk the changes in the overall fair value or overall cash flows of
the hedged item that reflect its actual location if it is a physical asset.
Note, however, that the entity may exclude foreign currency risk from its
designation of the hedged risk if it is going to purchase or sell a
nonfinancial asset in a foreign currency and is only concerned about the
price risk of the underlying asset.
Example 2-7
Company M, whose functional currency
is the euro (EUR), uses crude oil in the manufacture
of certain products. In international commerce, the
price of crude oil is denominated only in USD.
Company M hedges its probable forecasted purchases
of crude oil by using derivatives indexed to crude
oil and determines that the derivatives are highly
effective at offsetting its exposure to variability
in the cash flows arising from its crude oil
purchases in USD.
In its hedge documentation, M can specify that it is
excluding the foreign currency risk associated with
making USD crude oil purchases from its designation
of the hedged risk. In other words, its objective is
to hedge variability in the cash flows that may
arise from changes in the forecasted commodity price
in USD, not changes in the price that are
attributable to changes in the exchange rate from
USD to EUR. Company M can designate as the hedged
risk the changes in cash flows related to all
changes in the purchase price of crude oil in the
currency in which the forecasted transaction will
occur (USD), while ignoring its USD to EUR currency
exposure.
The risk of changes in overall fair value is the only risk that can be
designated in a fair value hedge of a nonfinancial asset, other than a
recognized loan servicing right or nonfinancial firm commitment with
financial components.
2.3.3 Net Investment Hedges — Risk That May Be Hedged
The only risk that an entity can hedge in connection with a
net investment in foreign operations is the exposure to foreign currency
risk. See further discussion of net investment hedging in Chapter 5.
Footnotes
7
Assume that the contract is not accounted for as
a derivative because it qualifies for and is designated as a
normal purchases and normal sales contract.
2.4 Items That May Be Designated as the Hedging Instrument
ASC 815-20
25-45
Either all or a proportion of a derivative instrument
(including a compound embedded derivative that is accounted
for separately) may be designated as a hedging instrument.
Two or more derivative instruments, or proportions thereof,
may also be viewed in combination and jointly designated as
the hedging instrument. A proportion of a derivative
instrument or derivative instruments designated as the
hedging instrument shall be expressed as a percentage of the
entire derivative instrument(s) so that the profile of risk
exposures in the hedging portion of the derivative
instrument(s) is the same as that in the entire derivative
instrument(s). Subsequent references in the Derivatives and
Hedging Topic to a derivative instrument as a hedging
instrument include the use of only a proportion of a
derivative instrument as a hedging instrument. Whether a
written option may be designated as a hedging instrument
depends on the terms of both the hedging instrument and the
hedged item as discussed beginning in paragraph
815-20-25-94.
25-58
A derivative instrument or a nonderivative financial
instrument that may give rise to a foreign currency
transaction gain or loss under Topic 830 can be designated
as hedging changes in the fair value of an unrecognized firm
commitment, or a specific portion thereof, attributable to
foreign currency exchange rates. The designated hedging
relationship qualifies for the accounting specified in
Subtopic 815-25 if all the fair value hedge conditions in
this Section and the conditions in paragraph 815-20-25-30
are met.
25-66
A derivative instrument or a nonderivative financial
instrument that may give rise to a foreign currency
transaction gain or loss under Subtopic 830-20 can be
designated as hedging the foreign currency exposure of a net
investment in a foreign operation provided the conditions in
paragraph 815-20-25-30 are met. A nonderivative financial
instrument that is reported at fair value does not give rise
to a foreign currency transaction gain or loss under
Subtopic 830-20 and, thus, cannot be designated as hedging
the foreign currency exposure of a net investment in a
foreign operation.
Hedge accounting typically involves the use of a derivative instrument to hedge a
risk exposure. Much of the hedging guidance in ASC 815 applies to derivative
instruments, which can be a single derivative, a combination of derivatives, or a
proportion of derivatives. However, in a few limited circumstances,
foreign-currency-denominated debt instruments can be designated as the hedging
instrument in a foreign currency hedge (see Section
2.4.2). The discussion below addresses the “dos and don’ts” of
designating qualifying hedging instruments in more detail.
2.4.1 Hedging With Derivatives
An entity may use a derivative, a proportion of
a derivative, or a combination of derivatives (or proportions thereof) as the
hedging instrument in a hedging relationship, with some limitations. The table
below summarizes both the acceptable and the prohibited uses of derivatives as
hedging instruments. All references to freestanding derivatives also include
bifurcated embedded derivatives.
Qualifies as Hedging Instrument
|
Prohibited as Hedging Instrument
|
---|---|
|
|
2.4.1.1 Combinations of Derivatives
Sometimes, an entity with exposure to multiple risks has multiple derivatives
that it would like to designate in combination as the hedging instrument in
a single hedging relationship. For instance, in the example discussed in
Section 2.3.2.1.1, an entity
forecasts purchases that vary on the basis of changes in the Midwest
transaction price of aluminum, which is composed of two component risks —
the LME aluminum price and the Midwest Transaction Premium. Derivatives
commonly trade with an underlying that is referenced to each of the risk
components. If the entity wants to hedge the total changes in the Midwest
transaction price, it could separately enter into (1) financially settled
fixed-price forward purchase contracts based on the LME and (2) financially
settled forwards based on the Midwest Transaction Premium. The entity could
then designate a combination of the two forwards as the hedging instrument
in a cash flow hedge against the risk of changes in the cash flows of its
forecasted aluminum purchases that are attributable to changes in the
contractually specified Midwest transaction price component of the aluminum
price.
2.4.1.2 Portions Versus Proportions of Derivatives
Under ASC 815-20-25-45, an entity is permitted to designate a proportion of a
derivative (or combination of derivatives) as the hedging instrument as long
as that proportion is “expressed as a percentage of the entire derivative
instrument(s) so that the profile of risk exposures in the hedging portion
of the derivative instrument(s) is the same as that in the entire derivative
instrument(s).” We believe that this principle is satisfied if an entity
designates as the hedging instrument either (1) a percentage of the
derivative(s) or (2) a stated amount of the derivative(s), provided that it
is clear that the entity intends to use a proportion of that derivative to
offset its risk exposure.
For example, an entity may enter into an interest rate swap with a notional
amount of $100 million and want to designate $60 million of that swap as the
hedging instrument in a hedge of $60 million of outstanding debt. We believe
that the entity could designate as the hedging instrument either (1) 60
percent of the outstanding swap or (2) $60 million of the $100 million
notional swap.
In accordance with ASC 815-20-25-71(a)(2), an entity is prohibited from
designating a component of a compound derivative as the hedging instrument
in a hedging relationship. For example, assume that an entity enters into a
receive-fixed, pay-floating interest rate swap with an interest rate cap on
the variable leg. The entity would not be permitted to designate only the
interest rate cap component of the swap as the hedging instrument in a hedge
of the interest rate risk associated with the interest payments on the
variable-rate debt. Similarly, the entity could not designate only the
interest rate component (without the cap) of the swap as the hedging
instrument in a hedge of interest payments on a fixed-rate debt
liability.
2.4.1.3 Prohibited Derivatives
As discussed in the previous section, an entity is precluded from designating
a component of a compound derivative as the hedging instrument in a hedging
relationship. The discussion below addresses a few other types of
derivatives that cannot be designated as hedging instruments in hedging
relationships.
2.4.1.3.1 Intra-Entity Derivatives
Intra-entity derivatives that hedge risks other than foreign currency
risk (e.g., interest rate risk, credit risk, the risk of changes in a
contractually specified component, or the risk of changes in overall
fair value or cash flows) cannot be designated as hedging instruments in
hedging relationships recognized in an entity’s consolidated financial
statements because such derivative contracts would be eliminated in
consolidation. ASC 815 provides an exception for certain foreign
currency hedges, which is discussed further in Section
5.1.2.3. Intra-entity derivatives could, however, qualify
for designation as hedging instruments in hedging relationships
recognized in a subsidiary’s stand-alone financial statements if the
required hedging criteria are satisfied. In such cases, the entity would
be required to disclose the related-party nature of the transaction
under ASC 850-10-50.
Because ASC 815 does not require the operating unit with interest rate,
market price, or credit risk exposure to be a party to the hedging
instruments, an entity can, in its consolidated financial statements,
hedge a subsidiary’s exposure to these risks by (1) having a parent
entity’s central treasury function enter into derivatives with third
parties and (2) designating those contracts as the hedging instruments
in hedges of the subsidiary’s risk exposures (for more information, see
ASC 815-20-25-46A and 25-46B).
If an entity uses a central treasury function for all derivatives and
would like to achieve hedge accounting in both the consolidated
financial statements and the stand-alone financial statements of a
subsidiary, the central treasury function would need to enter into both
(1) a derivative with an unrelated third party and (2) a mirrored
derivative with the subsidiary that is exposed to the hedged risk. In
this case, the derivative with an unrelated third party would be
designated as the hedging instrument in the consolidated financial
statements, and the intra-entity derivative would be designated as the
hedging instrument in the subsidiary’s stand-alone financial statements.
Alternatively, the subsidiary could simply enter into a derivative with
an unrelated third party (i.e., not use the central treasury function)
and designate that derivative as the hedging instrument; in such case,
hedge accounting would be allowed at the subsidiary level and would
survive consolidation.
Note that an entity that enters into a derivative with
an equity method investee would not be permitted to use the derivative
as a hedging instrument in its consolidated financial statements unless
(1) the derivative is designated as a hedge of foreign currency exposure
and (2) the conditions in ASC 815-20-25-61 are met (see
Section 5.1.2.3).
ASC 815-20-25-52 through 25-56 address hedging with intra-entity
derivatives. Although the guidance initially mentions only derivatives
between two members of a consolidated group, it also addresses
related-party derivatives. In clarifying what type of derivative can be
used to hedge permitted risks other than foreign exchange risk
(specifically, overall cash flow or fair value, interest rate risk,
credit risk, or contractually specified component risk), ASC
815-20-25-46B states, in part, that “[o]nly a derivative instrument with
an unrelated third party can be designated as the hedging instrument in
a hedge of those risks in consolidated financial statements.” An
“unrelated party” is any entity that is not a related party. Since the
definition of a related party in ASC 850 includes an equity method
investee, a derivative entered into with an equity method investee
cannot be used as a hedging instrument in the consolidated financial
statements.
2.4.1.3.2 Written Options
Under a written option, an entity (the option writer) must perform as
stated in the option if it is exercised by the counterparty (the option
purchaser). For the option writer, the upside is limited to the option
premium received; however, the downside could be unlimited. Because
written options generally do not reduce an entity’s risk, they do not
qualify as hedging instruments for hedge accounting unless they meet
what is commonly referred to as the “written option test.”
ASC 815-20
25-94 If a
written option is designated as hedging a
recognized asset or liability or an unrecognized
firm commitment (if a fair value hedge) or the
variability in cash flows for a recognized asset
or liability or an unrecognized firm commitment
(if a cash flow hedge), the combination of the
hedged item and the written option provides either
of the following:
- At least as much potential for gains as a result of a favorable change in the fair value of the combined instruments (that is, the written option and the hedged item, such as an embedded purchased option) as exposure to losses from an unfavorable change in their combined fair value (if a fair value hedge)
- At least as much potential for favorable cash flows as exposure to unfavorable cash flows (if a cash flow hedge).
The exposure draft for FASB Statement 133 prohibited the use of written
options in a hedging relationship because of concerns that such options
increase risk for the option writer. However, on the basis of feedback
from constituents, the FASB decided to permit the use of hedge
accounting with written options on a very limited basis. The written
option test outlined in ASC 815-20-25-94 allows hedge accounting in
scenarios in which the written option and the hedged item provide
symmetrical upside and downside potential on a combined basis. The next
sections discuss:
- The criteria for determining whether a derivative is a written option (see Section 2.4.1.3.2.1).
- How to evaluate a combination of options (see Section 2.4.1.3.2.2).
- When to perform the analysis (see Section 2.4.1.3.2.3).
- When a written option can be used in a hedging relationship (i.e., the written option test) (see Section 2.4.1.3.2.4).
2.4.1.3.2.1 Definition of Written Option
As noted above, a
written option requires the option writer to perform as stated in
the option if it is exercised by the option purchaser.
Example 2-8
Cactus Co. writes an option to Fish’s Donuts
that allows the donut shop to acquire 1,000
gallons of agave syrup for $1.00 per gallon at any
time over the next three months. Fish’s Donuts
pays Cactus Co. $30 for this option to call agave
syrup. From the perspective of Cactus Co., its
upside is limited to the premium received (i.e.,
$30). However, its downside is unlimited. For each
$0.01 per gallon increase in the price of agave
syrup, Cactus Co. will lose $10 on the option
(1,000 gallons × $0.01/gallon).
The identification of a written option is fairly easy in the context
of a freestanding option such as that described above, especially
since Cactus Co. receives compensation (i.e., the $30 premium) upon
entering into the contract. However, sometimes options are combined
either with other options or with other nonoption derivatives. ASC
815 provides a framework for determining whether compound
derivatives are considered written options under the hedge
accounting requirements. Any derivative that results from combining
a written option with a nonoption derivative (e.g., a forward or
swap) is considered a written option in accordance with ASC
815-20-25-88, regardless of whether a premium is received under the
arrangement.
Example 2-9
Swap With a Cap on Variable Leg
BigBank enters into a pay-fixed,
receive-three-month LIBOR interest rate swap with
a customer. The bank agrees to cap the amount it
can receive on the LIBOR leg at 5 percent. The
swap is a combination of a traditional interest
rate swap (a nonoption derivative) and a written
cap whose strike price is based on a three-month
LIBOR of 5 percent. The combination of the written
option (the cap) and the nonoption derivative (the
swap) is considered a written option.
Example 2-10
Knock-Out Swap
BigBank enters into a knock-out swap, which is
structured as a pay-fixed, receive-three-month
LIBOR interest rate swap. However, under one of
its provisions, the swap is terminated if the
three-month LIBOR rate increases above 6 percent.
This embedded termination option is a written
option for BigBank because the swap terminates
when the three-month LIBOR rate increases above 6
percent and BigBank receives three-month LIBOR
under the terms of the swap. Therefore, the
knock-out swap is considered a written option
because the instrument combines a nonoption
derivative (the interest rate swap) with a written
option (the automatic termination provision).
Example 2-11
Swap With Termination Option
Cactus Co. issues a 10-year fixed-rate
corporate bond that it can call at any time after
five years. It then enters into a 10-year
receive-fixed, pay-three-month LIBOR interest rate
swap with BigBank that can be terminated by
BigBank at any time after five years. The swap
with a termination option is a written option for
Cactus Co. because it is the combination of a
nonoption derivative (the swap) and a written
option (the termination option held by
BigBank).
Connecting the Dots
Interest rate swaps often contain a provision that permits
one of the counterparties to terminate the swap. Such a
provision can have many different characteristics. For
example, if the option is exercised, the payoff may be at
fair value, there may be no payoff, or there may be some
calculation of the payoff amount. The option may be a
European-style option that the counterparty can only
exercise on one specific day or an American-style option
that allows the counterparty to terminate the option at any
time during its term.
If the termination option is written by the counterparty that
seeks to apply hedge accounting to the swap, the written
option embedded into the nonoption derivative (the interest
rate swap) makes the entire contract a written option.
Generally, the counterparty that can exercise the
termination option has a purchased, not a written,
option.
We believe that if the payoff upon exercise of a termination
option is the fair value of the swap, the entire contract
would not be considered a written option. A termination
option with a fair value payoff has a fair value of zero at
all times during its term; therefore, such an option would
not affect the swap’s fair value and does not have the
payoff profile of a written option (i.e., the option does
not expose the writer to unlimited risk).
2.4.1.3.2.2 Combination of Options
ASC 815-20
Determining Whether a Combination of
Options Is Net Written
25-88
This guidance addresses how an entity shall
determine whether a combination of options is
considered a net written option subject to the
requirements of paragraph 815-20-25-94. A
combination of options (for example, an interest
rate collar) entered into contemporaneously shall
be considered a written option if either at
inception or over the life of the contracts a net
premium is received in cash or as a favorable rate
or other term. Furthermore, a derivative
instrument that results from combining a written
option and any other non-option derivative
instrument shall be considered a written option.
The determination of whether a combination of
options is considered a net written option depends
in part on whether strike prices and notional
amounts of the options remain constant.
Strike Prices and Notional Amounts Remain
Constant
25-89 For
a combination of options in which the strike price
and the notional amount in both the written option
component and the purchased option component
remain constant over the life of the respective
component, that combination of options would be
considered a net purchased option or a zero cost
collar (that is, the combination shall not be
considered a net written option subject to the
requirements of paragraph 815-20-25-94) provided
all of the following conditions are met:
- No net premium is received.
- The components of the combination of options are based on the same underlying.
- The components of the combination of options have the same maturity date.
- The notional amount of the written option component is not greater than the notional amount of the purchased option component.
25-90 If
the combination of options does not meet all of
those conditions, it shall be subject to the test
in paragraph 815-20-25-94. For example, a
combination of options having different underlying
indexes, such as a collar containing a written
floor based on three-month U.S. Treasury rates and
a purchased cap based on three-month London
Interbank Offered Rate (LIBOR), shall not be
considered a net purchased option or a zero cost
collar even though those rates may be highly
correlated.
Entities need to evaluate whether specific combinations of options
meet the definition of a net written option. If any of the four
criteria in ASC 815-20-25-89 are not met, the combination is
considered a written option. All of the component options must
mature on the same date and be based on the same underlying;
otherwise, the combination of options is a net written option. The
notional amounts of the component options do not need to match, but
if the notional amount of the written option is greater than that of
the purchased option, the combination of options is a net written
option.
If an entity receives a premium as compensation for entering into the
combination of options, such a combination represents a net written
option, even if the premium is paid on a future date or over time.
Common examples of combinations of options are collars and capped
calls. By its definition, a costless collar does not involve the
payment of a premium by either party. Capped calls generally require
the purchaser to pay a premium to the writer. Both types of
combinations are described in the examples below.
Example 2-12
Costless Collar
Reprise is concerned about the rising costs of
aluminum, so it enters into the following
combination option on the LME aluminum price:
Such a combination option would be considered a
net purchased option because (1) the notional
amount and strike prices are fixed, (2) no net
premium is received because the fair values of the
component options offset, (3) the put and call are
based on the same underlying (i.e., LME aluminum
price), and (4) the maturity dates and notional
amounts of the component options match.
Example 2-13
Capped Call
Instead of entering into a costless collar,
Reprise purchases a capped call based on the LME
aluminum price. The call option has a notional of
2 million pounds and a strike price of $0.95 per
pound, but it also has a cap on the payout such
that Reprise will receive $100,000 if the price of
aluminum exceeds $1.00 per pound (2 million pounds
× $0.05 per pound). Reprise pays $4,500 for the
capped call. This combination option is a net
purchased option because (1) a premium is paid by
Reprise, (2) the purchased option (i.e., call) and
the written option (i.e., cap) are both based on
the same underlying (i.e., LME aluminum price),
(3) the components mature at the same time, and
(4) the notional amount for each component is the
same.
ASC 815-20
Strike Prices and Notional
Amounts Do Not Remain Constant
25-91 If either the written
option component or the purchased option component
for a combination of options has either strike
prices or notional amounts that do not remain
constant over the life of the respective
component, the assessment to determine whether
that combination of options can be considered not
to be a written option under paragraph
815-20-25-88 shall be evaluated with respect to
each date that either the strike prices or the
notional amounts change within the contractual
term from inception to maturity.
25-92 Even though that
assessment is made on the date that a combination
of options is designated as a hedging instrument
(to determine the applicability of paragraph
815-20-25-94), it shall consider the receipt of a
net premium (in cash or as a favorable rate or
other term) from that combination of options at
each point in time that either the strike prices
or the notional amounts change, such as either of
the following circumstances:
- If strike prices fluctuate over the life of a combination of options and no net premium is received at inception, a net premium will typically be received as a favorable term in one or more reporting periods within the contractual term from inception to maturity.
- If notional amounts fluctuate over the life of a combination of options and no net premium is received at inception, a net premium or a favorable term will typically be received in one or more periods within the contractual term from inception to maturity.
25-93 In addition, a
combination of options in which either the written
option component or the purchased option component
has either strike prices or notional amounts that
do not remain constant over the life of the
respective component shall satisfy all of the
conditions in paragraph 815-20-25-89 to be
considered not to be a written option (that is, to
be considered to be a net purchased option or zero
cost collar) under paragraph 815-20-25-88. For
example, if the notional amount of the written
option component is greater than the notional
amount of the purchased option component at any
date that the notional amount changes within the
contractual term from inception to maturity, the
combination of options shall be considered to be a
written option under paragraph 815-20-25-88 and,
thus, subject to the criteria in the following
paragraph.
If the notional amounts or the strike prices of the component options
are not constant over the options’ life, an entity must assess
whether the combination of options is a written option. Such an
assessment must be performed by analyzing the options’ terms as of
each date that either the strike prices or the notional amounts
change within the contractual term from inception to maturity. ASC
815 provides the examples below, which are based on changing strike
prices and notional amounts.
ASC 815-20
Example 20: Combinations of Options in
Which Strike Prices or Notional Amounts Do Not
Remain Constant
55-179 The following Cases
illustrate the application of paragraph
815-20-25-91 to combinations of options in which
either the strike price or the notional amount in
either the written option component or the
purchased option component can fluctuate over the
life of the respective component:
- Changes in strike prices (Case A)
- Changes in notional amounts (Case B).
55-180 Cases A and B share
the following assumptions:
- An entity wishes to hedge its forecasted sales of a commodity by entering into a five-year commodity-price collar.
- Under the collar, the entity will do both of
the following:
- Purchase commodity-price put option components (a floor)
- Write commodity-price call option components (a cap).
- Each of the alternative collars discussed
otherwise meets the criteria established in
paragraphs 815-20-25-89 through 25-90 including
all of the following:
- No net premium is received at inception of the combination of options. Paragraph 815-20-25-94 addresses, in part, whether a net premium is received at any point during the life of the combination of options that the strike price or notional amount is changed.
- The components of the combination of options are based on the same underlying (that is, the same commodity price).
- The components of the combination of options have the same maturity date.
- The notional amount of the written option component is not greater than the notional amount of the purchased option component. Paragraph 815-20-25-94 addresses, in part, whether this criterion should be applied to only the entire contractual term to maturity or to some part thereof.
Case A: Changes in Strike Prices
55-181 The following table
presents both of the following:
- Commodity prices implied by the forward price curve based on market prices
- The strike prices of two alternative collars.
The minimum prices for each collar represent
the strike prices of the purchased put options.
The maximum prices for each collar represent the
strike prices of the written call options. (Assume
that the notional amounts of the two option
components are identical and constant over the
life of the option components.)
55-182 Note that the 5-year
averages of the minimum prices (98.3 cents) and
the maximum prices (110.6 cents) of the 2 collars
are identical and are consistent with the 5-year
average implied by the forward price curve. (That
is, 104.5 cents equals the average of the
98.3-cent minimum strike price and the 110.6-cent
maximum strike price.) No net premium is received
at inception for either collar taking into
consideration the entire contractual term of the
combination of options from inception to
maturity.
55-183 For Collar 2, premiums
are received in early periods as consideration for
entering into net written options in later
periods. Specifically, the (higher-than-average)
strike prices in years 20X2 and 20X3 are received
(that is, receipt of a net premium) in return for
accepting less favorable (lower-than-average)
strike prices in years 20X4 through 20X6 (that is,
net written options). Thus, at the inception of
the hedge and over its life, Collar 2 would be
subject to the provisions of paragraph
815-20-25-94.
Case B: Changes in Notional Amounts
55-184 The following table
presents the notional amounts of two alternative
collars. (Assume that the strike prices of the two
collars are identical and constant over the life
of the collars.)
55-185 Note that both the sum
and average of the notional amounts of the written
option component for all periods are not greater
than the sum and average of the notional amounts
of the purchased option component for all
periods.
55-186 For Collar 4,
favorable terms are received in early periods (net
purchased options) as consideration for entering
into net written options in later periods.
Specifically, the (higher-than-average) notional
amounts on the purchased put option in years 20X2
through 20X4 are received in return for accepting
a less favorable notional amount in years 20X5 and
20X6. Thus, at the inception of the hedge and over
its life, Collar 4 in Case B would be subject to
the provisions of paragraph 815-20-25-94.
2.4.1.3.2.3 Timing of Evaluation
Note that an entity is required to determine whether an option (or
combination of options) is a written option only at the time of
hedge designation. If an entity plans to designate a preexisting
option or combination of options as the hedging instrument in a
hedging relationship, the option’s fair value at the inception of
the hedge is considered to be the premium. Therefore, an option with
a negative fair value at hedge inception (i.e., it is in a liability
position) would be considered a written option. If the option’s fair
value is zero or positive, the condition in ASC 815-20-25-89(a) that
no net premium is received is considered to be met and the entity
should evaluate the other conditions in ASC 815-20-25-89. An entity
would perform this analysis every time an option or combination of
options is designated as a hedging instrument in a hedging
relationship.
Consider a hedging strategy that is based on the delta of a
combination of options and is periodically designated as a hedge of
a commodity inventory. As the delta of the option position changes,
the units of inventory that are being designated as hedged items
also changes, resulting in a dedesignation and a redesignation of
the combination option position. If, on any redesignation date, the
combination of options results in an economic net liability
position, the combination does not qualify as a net purchased
option.
If a combination of options satisfies the criteria to be considered a
net purchased option on the designation date but subsequently market
conditions change and the combination is then considered a net
written option, the hedging relationship would not be affected as
long as the relationship remains in effect. Although the change in
market conditions may create a potential mismatch in the extent to
which the change in the fair value or cash flows of the hedging
instrument offsets the change in the fair value or cash flows of the
hedged item or hedged transaction, there would be no need to perform
the written option test discussed in Section 2.4.1.3.2.4. This is because (1) the
combination of options was considered a net purchased option on the
date of designation and (2) the evaluation of whether an option is a
written option is performed only at hedge inception.
For a combination of options to be designated as a hedging
instrument, the options do not necessarily have to be entered into
at the same time. The requirement for designating a combination of
options is that the tests in ASC 815-20-25-89 through 25-93 (see
examples in ASC 815-20-55-179 through 55-186, which illustrate the
application of ASC 815-20-25-91) must be performed on the date on
which the combination is designated in the hedging relationship.
Example 2-14
Cactus Co. purchases an option on January 1
and writes a new option on June 1. It would like
to combine the new written option with the option
that it purchased on January 1 and designate the
combined option as a hedging instrument. On June
1, Cactus Co. should compare the then fair value
of the purchased option with the fair value
(premium received) of the written option as a
basis for determining whether a net premium was
received and then consider the other requirements
of ASC 815-20-25-89 through 25-93.
Note that if an entity enters into an interest rate swap with an
embedded written option that does not qualify for hedge accounting
under ASC 815 but it subsequently settles the written option
component of the instrument, it can designate the stand-alone
interest rate swap as a hedging instrument without having to apply
the guidance for written options.
According to ASC 815-20-25-88, a nonoption derivative (such as an
interest rate swap) with an embedded written option is considered a
written option for hedge accounting purposes. Examples of such
instruments include an interest rate swap with an embedded option
for the counterparty to terminate (see Example
2-11) or an interest rate swap with an embedded
option in which the swap will automatically terminate if the
variable interest rate increases above a specified rate (“knock-out
swap”) (see Example 2-10). Since both of these
types of swaps are written options under ASC 815-20-25-88, they will
only qualify for hedge accounting if the written option test is
passed (see Section 2.4.1.3.2.4).
However, if the embedded option expires
out-of-the-money or, after the inception of the instrument, the
company negotiates with the counterparty to terminate the option,
the resulting stand-alone interest rate swap may be designated as a
hedging instrument without having to satisfy the hedge criteria for
a written option. Presumably, the swap will not qualify for the
shortcut method discussed in Section
2.5.2.2.1 because it is not likely to satisfy the
criterion in ASC 815-20-25-104(b), which requires a swap to have a
fair value of zero upon inception of the hedging relationship.
2.4.1.3.2.4 The Written Option Test
As previously noted, an entity’s ability to designate a written
option as a hedging instrument in a qualifying hedging relationship
is limited. A written option may be designated as a hedging
instrument in a hedge of the fair value or variability in cash flows
of a recognized asset or liability or of an unrecognized firm
commitment only if the written option test outlined in ASC
815-20-25-94 and 25-95 is passed. All of the other criteria for
hedge accounting must also be met. (Note that for the remainder of
this section, all references to a written option also include
combinations of options that are considered net written options.)
The purpose of the written option test, sometimes referred to as the
“symmetrical gain and loss test,” is to prove that the combination
of the written option and the hedged item has at least as much
potential for gains (or favorable cash flows) as it does exposure to
losses (or unfavorable cash flows). Like the evaluation of whether a
combination of options is a net written option (see Section 2.4.1.3.2.3), this test is performed only
upon the inception of a hedge.
Changing Lanes
At the October 11, 2023, FASB meeting, the Board directed the
staff to draft proposed amendments to the guidance on
applying the written option test when the designated hedging
instrument in a cash flow hedge is a compound derivative
made up of a written option and a non-option derivative. The
amendments would permit entities to assume that certain
terms of the hedged forecasted transactions match those of
the hedging instrument when applying the net written option
test.
ASC 815-20-55-45 specifically states that a covered call strategy
would not pass the written option test unless the hedged item was a
call option embedded in another instrument. As illustrated below, a
covered call strategy involves writing call options on assets that
the option writer owns.
Example 2-15
FarmHouse Inc. has 5,000 bushels of corn. The
current market value of corn is $3.81 per bushel.
FarmHouse writes an option that allows the
counterparty to call 5,000 bushels of corn at
$4.00 per bushel at any time over the next month.
It receives a $1,000 premium for writing the
option. If the price of corn increases above $4.00
per bushel, the corn will be called away from
FarmHouse and its overall gain will be capped at
$1,950 ($1,000 premium + $0.19 per bushel × 5,000
bushels). However, if the price of corn were to
drop to $0, FarmHouse would lose $18,050 ($3.81
loss per bushel multiplied by 5,000 bushels,
partially offset by the $1,000 premium on the call
option).
ASC 815-20-25-96 permits an entity to exclude the time value of a
written option (or net written option) from the test, provided that,
in its documentation of how the hedge will be assessed for
effectiveness, the entity specifies that the effectiveness tests
will be based solely on changes in the option’s intrinsic value (see
Section 2.5.2.1.2.2).
Example 2-16
InvestorPlus issued $100 million of
floating-rate debt; the interest rate is equal to
three-month LIBOR plus 300 basis points. To hedge
its exposure to variability in the expected future
cash outflows attributable to changes in
three-month LIBOR (the contractually specified
interest rate), the company enters into an
interest rate collar when three-month LIBOR is 5
percent. The collar has the following terms:
- Notional — $100 million.
- Underlying — three-month LIBOR.
- Cap strike — 7 percent per year.
- Floor strike — 4 percent per year.
The purchased cap goes into effect when
three-month LIBOR increases above 7 percent, and
the written floor goes into effect when
three-month LIBOR decreases below 4 percent. Thus,
the interest rate collar has the effect of
limiting the interest rate of the floating-rate
debt to a range between 7 and 10 percent. On the
basis of market conditions as of the collar
transaction date, InvestorPlus received a net
premium from the bank.
To determine whether the hedging relationship
between the debt and the collar qualifies for cash
flow hedge accounting, InvestorPlus must apply the
written option test in ASC 815-20-25-94 and 25-95.
To pass this test, the combination of the hedged
item and the written option must have “[a]t least
as much potential for favorable cash flows as
exposure to unfavorable cash flows” for all
possible percentage changes (from 0 to 100
percent) in three-month LIBOR.
The table below illustrates the potential
impacts on cash flows associated with the
combination of the hedged item and net written
option, provided that three-month LIBOR changes by
the same percentage in opposite directions.
As indicated in the table above, given
comparable favorable and unfavorable changes in
the three-month LIBOR, the gains (favorable cash
flows) from a favorable change would not be at
least as large as the losses (unfavorable cash
flows) from a comparable unfavorable change in
three-month LIBOR. Accordingly, the combination of
options would not be considered eligible for hedge
accounting.
Example 2-17
Reprise has $100 million of existing
floating-rate debt that is repriced semiannually
on the basis of changes in six-month LIBOR (note
that there is no credit spread in this example).
Reprise’s risk management objective is to mitigate
its exposure to variability in expected future
cash outflows that are attributable to changes in
six-month LIBOR. To achieve this goal, Reprise
purchased an interest rate corridor (also known as
a capped call) that consists of the following
interest rate caps:
Both of the interest rate caps have the same
underlying (six-month LIBOR) and notional amounts
($100 million). As a result of the market
conditions on the transaction date, Reprise paid a
premium of $2.5 million to the counterparty to the
corridor. Regardless of the premium paid, the
corridor does not meet the criteria in ASC
815-20-25-89 to be considered a net purchased
option (because of the differing maturity dates of
the options and interest rate caps); therefore,
the corridor is subject to the test in ASC
815-20-25-94 and 25-95 for cash flow hedges. Under
this test, written options that are designated as
a hedge must provide “[a]t least as much potential
for favorable cash flows as exposure to
unfavorable cash flows” for all possible
percentage changes (from 0 to 100 percent) in
six-month LIBOR.
When Reprise entered into the corridor,
six-month LIBOR was 5.0 percent. The following
table illustrates the potential impacts on the
cash flows associated with the combination of the
hedged item and the net written option if
six-month LIBOR changes by the same percentage in
opposite directions:
The calculations in the table above show
comparable favorable and unfavorable moves in
six-month LIBOR. The favorable change (a decrease
from 5.0 to 0.0 percent) would result in a 100
percent decrease in interest cash flows, while a
similar unfavorable change (an increase from 5.0
to 10.0 percent) would result in a 70 percent
increase in overall interest expense (from 5.0 to
8.5 percent). Therefore, given a 100 percent
fluctuation in rates, the interest rate corridor
provides at least as much potential for favorable
cash flows as exposure to unfavorable cash flows.
The corridor would have a similar effect for
percentage changes in six-month LIBOR that range
from 31 to 99 percent. In such scenarios, the
favorable changes in six-month LIBOR (i.e.,
percentage declines) would result in comparable
declines in the effective interest rate on
Reprise’s variable-rate debt; however, unfavorable
changes (i.e., percentage increases) would be
reduced by 1.5 percent because of the impact of
the corridor. In all cases, the favorable
percentage changes in six-month LIBOR would
produce changes in cash flows that are at least as
great as the unfavorable cash flows that would be
incurred from an unfavorable change of the same
percentage.
Finally, percentage changes in six-month LIBOR
that range from 0 to 30 percent would fall within
the corridor. In such cases, favorable changes
(i.e., percentage declines) would reduce Reprise’s
effective interest rate on its variable-rate debt,
while unfavorable changes (i.e., percentage
increases) would produce an effective rate of 5
percent (a 0 percent unfavorable change) because
of the corridor.
On the basis of this analysis of the effect of
all possible favorable percentage changes in
six-month LIBOR (the underlying) from 0 to 100
percent and the comparable unfavorable percentage
changes, the interest rate corridor satisfies the
test in ASC 815-20-25-94 and 25-95 and is eligible
to be designated as the hedging instrument in a
cash flow hedge.
Also note that the written interest rate cap
expires before the purchased interest rate cap.
Therefore, there are no additional possible
scenarios to consider in which the symmetry test
would have been failed after the written interest
rate cap expired but the purchased interest rate
cap was still in place.
2.4.1.3.3 Basis Swaps
ASC 815-20
25-50 If a hedging instrument
is used to modify the contractually specified
interest receipts or payments associated with a
recognized financial asset or liability from one
variable rate to another variable rate, the
hedging instrument shall meet both of the
following criteria:
- It is a link between both of
the following:
- An existing designated asset (or group of similar assets) with variable cash flows
- An existing designated liability (or group of similar liabilities) with variable cash flows.
- It is highly effective at achieving offsetting cash flows.
25-51 For purposes of
paragraph 815-20-25-50, a link exists if both of
the following criteria are met:
- The basis (that is, the rate index on which the interest rate is based) of one leg of an interest rate swap is the same as the basis of the contractually specified interest receipts for the designated asset.
- The basis of the other leg of the swap is the same as the basis of the contractually specified interest payments for the designated liability.
In this situation, the criterion in paragraph
815-20-25-15(a) is applied separately to the
designated asset and the designated liability.
ASC 815-20-25-50 and 25-51 address the use of interest rate basis swaps
in hedge accounting for a specific hedging strategy under which the
entity uses the basis swap as a link between existing variable-rate
assets and existing variable-rate liabilities. Although the guidance may
appear to limit the use of basis swaps, some believe that it actually
provides an exception to the general hedge accounting model by allowing
a strategy that would not otherwise be available. Without this guidance,
an entity would be prohibited from (1) including both assets and
liabilities in the same hedging relationship and (2) hedging forecasted
interest payments on variable-rate debt instruments that do not vary
with the same index (see Section 2.2.2.2.2). The guidance on hedging with basis
swaps allows an entity to link assets and liabilities with interest
payments that vary on the basis of different contractually specified
interest rates and hedge their interest rate risk exposures with a
single derivative in a single hedging relationship. It is also extremely
unlikely that a basis swap would have been highly effective at hedging a
variable-rate asset or liability for changes that are attributable to
the contractually specified rate in the asset or liability since the
basis swap would not eliminate the variability.
The guidance in ASC 815-20-25-50 and 25-51 is not meant to prohibit the
use of basis swaps in combination with other derivatives in a single
relationship. For example, if an entity issues debt that is repriced on
the basis of changes in the prime rate, it could enter into a
traditional interest rate swap with a pay-fixed leg and a receive-LIBOR
leg. It could also enter into a prime-to-LIBOR basis swap, combine that
basis swap with the interest rate swap, and hedge the variability in
interest payments that are attributable to changes in the contractually
specified interest rate (prime).
2.4.1.3.4 Net Investment Hedges With Compound Derivatives
ASC 815-20
25-67
Hedging instruments that are eligible for
designation in a net investment hedge include,
among others, both of the following:
- A receive-variable-rate, pay-variable-rate
cross-currency interest rate swap, provided both
of the following conditions are met:
- The interest rates are based on the same currencies contained in the swap.
- Both legs of the swap have the same repricing intervals and dates.
- A receive-fixed-rate, pay-fixed-rate cross-currency interest rate swap. A cross-currency interest rate swap that has two fixed legs is not a compound derivative instrument and, therefore, is not subject to the criteria in (a).
25-68 A
cross-currency interest rate swap that has either
two variable legs or two fixed legs has a fair
value that is primarily driven by changes in
foreign exchange rates rather than changes in
interest rates. Therefore, foreign exchange risk,
rather than interest rate risk, is the dominant
risk exposure in such a swap.
25-68A
Under the guidance in paragraph
815-20-25-71(d)(1), a cross-currency interest rate
swap with one fixed-rate leg and one floating-rate
leg cannot be designated as the hedging instrument
in a net investment hedge.
25-71
Besides those hedging instruments that fail to
meet the specified eligibility criteria, none of
the following shall be designated as a hedging
instrument for the respective hedges: . . .
d. With respect to net investment hedges
only:
1. A compound derivative
instrument that has multiple underlyings — one
based on foreign exchange risk and one or more not
based on foreign exchange (for example, the price
of gold or the price of an S&P 500 contract),
except as indicated in paragraph 815-20-25-67 for
certain cross-currency interest rate swaps
2. A derivative
instrument and a cash instrument in combination as
a single hedging instrument (that is, an entity
shall not consider a separate derivative
instrument and a cash instrument as a single
synthetic instrument for accounting
purposes).
The only risk that can be designated in a hedge of a net investment in
foreign operations is foreign currency risk. Accordingly, the most
plain-vanilla derivative that an entity can use to hedge its foreign
currency risk is a forward contract.
Example 2-18
Kasvot is a Swedish subsidiary of TreyCo. The
functional currency of Kasvot is the Swedish krona
(SEK), and the functional currency of TreyCo is
the USD. TreyCo could enter into a forward
contract to sell SEK and buy USD to hedge its net
investment.
TreyCo could also consider designating a cross-currency interest rate swap as the hedging instrument in its net investment hedge. Even before the issuance of FASB Statement 133, it was
common for entities to also use such swaps to
hedge their foreign currency risk for net
investments in foreign subsidiaries. For example,
assume that TreyCo enters a fixed-for-fixed
cross-currency interest rate swap to hedge its net
investment in Kasvot of SEK 50 million. At the
inception of the hedge, TreyCo pays USD 5.402
million in exchange for SEK 50 million. The
following amounts are returned on the maturity
date of the swap:
Fixed-for-Fixed Cross-Currency Interest Rate
Swap
The fair value of a cross-currency interest rate swap is based on changes
in foreign currency exchange rates, interest rates, and the
cross-currency basis spread. ASC 815-20-25-68 allows either a
fixed-for-fixed or a float-for-float cross-currency interest rate swap
to be the hedging instrument in a net investment hedge because for such
swaps, the changes in foreign currency exchange rates are the primary
sources of the changes in fair value. A float-for-float cross-currency
interest rate swap would look just like the example above, except that
the periodic interest settlements would be based on two variable-rate
legs.
Entities are prohibited from designating a fixed-for-float cross-currency
interest rate swap (i.e., with one fixed interest leg and one variable
interest leg) as the hedging instrument because the impact of interest
rate risk on the swap’s fair value is too pronounced.
In addition, entities are prohibited from designating in a net investment
hedging relationship any compound derivative that incorporates an
underlying other than foreign currency risk. The only compound
derivatives that can be designated in such hedges are the two types of
cross-currency interest rate swaps that are specifically mentioned in
ASC 815-20-25-67.
See Section 5.4 for further
discussion of net investment hedges.
2.4.2 Hedging With a Nonderivative Financial Instrument
Most hedging relationships involve a derivative that hedges a risk exposure; however, ASC 815 does provide guidance on hedging with a nonderivative foreign-currency-denominated financial instrument in certain foreign currency hedges. This guidance resulted from the FASB’s decision that Statement 133 retain the accounting previously provided in FASB Statement 52. Under ASC 815,
unrecognized firm commitments are the only item that may be hedged with a
nonderivative instrument in a foreign currency fair value hedge. Recognized
assets and liabilities (including AFS securities) are precluded from designation
in such hedges by ASC 815-20-25-71(b). ASC 815-20-25-58 states, in part, that “a
nonderivative financial instrument that may give rise to a foreign currency
transaction gain or loss under Topic 830 can be designated as hedging changes in
the fair value of an unrecognized firm commitment, or a specific portion
thereof, attributable to foreign currency exchange rates.”
In a manner similar to the exception for intra-entity
derivatives discussed in Section 2.4.1.3.1, ASC 815-20-25-60 allows an entity to
designate “an intra-entity loan or other payable as the hedging instrument in a
foreign currency fair value hedge of an unrecognized firm commitment” as long as
the counterparty to that loan or payable has entered into a mirrored loan or
payable with an external third party. We believe that although not explicitly
addressed by ASC 815, an entity may also designate intra-entity
foreign-currency-denominated debt as the hedging instrument in a hedge of a net
investment in foreign operations as long as the counterparty to that debt has
entered into a mirrored debt instrument with an external third party.
In addition, ASC 815-20-25-66 states, in part, that “a nonderivative financial
instrument that may give rise to a foreign currency transaction gain or loss
under Subtopic 830-20 can be designated as hedging the foreign currency exposure
of a net investment in a foreign operation provided the conditions in paragraph
815-20-25-30 are met.” However, an entity cannot designate a synthetic
instrument composed of a derivative and a financial instrument as a hedging
instrument in a net investment hedge. For example, an entity whose functional
currency is the USD may not hedge a net investment in a subsidiary whose
functional currency is the EUR with a synthetic EUR-denominated debt instrument
composed of Japanese yen (JPY)-denominated debt and a JPY-EUR cross-currency
interest rate swap. This was addressed by DIG Issue H10 and codified in ASC
815-20-25-71(d)(2).
A nonderivative instrument cannot be designated as the hedging instrument in a
foreign currency cash flow hedge. In addition, hybrid instruments that are
measured at fair value, with changes in fair value recognized in earnings, are
prohibited from designation as the hedging instrument in any hedging
relationship.
See Section 5.2.1.2 for further discussion of a foreign
currency fair value hedge of an unrecognized firm commitment. Also, see
Section 5.4 for a discussion of net investment hedges.
2.5 Hedge Effectiveness
ASC 815-20
25-75 To
qualify for hedge accounting, the hedging relationship, both
at inception of the hedge and on an ongoing basis, shall be
expected to be highly effective in achieving either of the
following:
- Offsetting changes in fair value attributable to the hedged risk during the period that the hedge is designated (if a fair value hedge)
- Offsetting cash flows attributable to the hedged risk during the term of the hedge (if a cash flow hedge), except as indicated in paragraph 815-20-25-50.
When the FASB issued Statement 133, one of its fundamental decisions was to require
entities to demonstrate that a hedging instrument is highly effective at offsetting
the changes in the fair value or cash flows of the hedged item before that hedging
relationship can qualify for the application of hedge accounting. Accordingly, hedge
accounting is permitted only if the changes in the fair value or cash flows of the
hedged item that are attributable to the hedged risk are expected to be offset by
the related changes in the fair value of the hedging instrument. To assess the
effectiveness of a hedging relationship, entities must compare the changes in the
fair value of the hedging instrument to the changes in the fair value or cash flows
of the hedged item that are related to the risk being hedged.
Entities may not apply hedge accounting unless the hedging
relationship is expected to be highly effective (1) at the inception of the hedging
relationship and (2) on an ongoing basis. Accordingly, for a relationship to qualify
for hedge accounting, the entity must perform an initial prospective hedge
effectiveness assessment upon hedge inception.8 Thereafter, the entity must perform prospective and retrospective assessments
of the hedging relationship’s effectiveness whenever it reports financial statements
or earnings and at least every three months. Although for most hedging relationships
the entity’s initial prospective assessment of hedge effectiveness must be a
quantitative analysis, the entity may elect to perform subsequent assessments either
quantitatively or qualitatively if certain conditions are satisfied (see ASC
815-20-35-2A).
Under ASC 815-20-25-3(b)(2)(iv), an entity is required to document,
upon a hedging relationship’s inception,9 “[t]he method that will be used to retrospectively and prospectively assess
the hedging instrument’s effectiveness in offsetting the exposure to changes in the
hedged item’s fair value (if a fair value hedge) or hedged transaction’s variability
in cash flows (if a cash flow hedge) attributable to the hedged risk.” An entity
should use the same method of assessing hedge effectiveness for all similar hedging
relationships; however, the election to perform subsequent qualitative assessments
may be made on a hedge-by-hedge basis. In some limited cases, an entity may perform
qualitative assessments of hedge effectiveness throughout the life of the hedging
relationship. See Section
2.5.2 for further discussion of the different methods of assessing
hedge effectiveness, including the criteria for determining when qualitative
assessments are appropriate.
ASC 815 does not explicitly define a quantitative threshold that would be considered
“highly effective”; however, in practice, a hedge is considered highly effective if
the change in the hedging instrument’s fair value provides offset of at least 80
percent and not more than 125 percent of the change in the fair value or cash flows
of the hedged item that are attributable to the risk being hedged.
2.5.1 Prospective Versus Retrospective Assessment
ASC 815-20
25-79 An entity shall
consider hedge effectiveness in two different ways — in
prospective considerations and in retrospective
evaluations:
- Prospective considerations. The entity’s expectation that the relationship will be highly effective over future periods in achieving offsetting changes in fair value or cash flows, which is forward looking, must be assessed on a quantitative basis at hedge inception unless one of the exceptions in paragraph 815-20-25-3(b)(2)(iv)(01) is met. Prospective assessments shall be subsequently performed whenever financial statements or earnings are reported and at least every three months. The entity shall elect at hedge inception in accordance with paragraph 815-20-25-3(b)(2)(iv)(03) whether to perform subsequent assessments on a quantitative or qualitative basis. See paragraphs 815-20-35-2A through 35-2F for additional guidance on qualitative assessments of hedge effectiveness. A quantitative assessment can be based on regression or other statistical analysis of past changes in fair values or cash flows as well as on other relevant information. The quantitative prospective assessment of hedge effectiveness shall consider all reasonably possible 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 and the hedged items for the period used to assess whether the requirement for expectation of highly effective offset is satisfied. The 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. Generally, the process of formulating an expectation regarding the effectiveness of a proposed hedging relationship involves a probability-weighted analysis of the possible 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 and the hedged items for the hedge period. Therefore, a probable future change in fair value will be more heavily weighted than a reasonably possible future change. That calculation technique is consistent with the definition of the term expected cash flow in FASB Concepts Statement No. 7, Using Cash Flow Information and Present Value in Accounting Measurements.
- Retrospective evaluations. An assessment of effectiveness may be performed on a quantitative or qualitative basis on the basis of the entity’s election at hedge inception in accordance with paragraph 815-20-25-3(b)(2)(iv)(03). That assessment shall be performed whenever financial statements or earnings are reported, and at least every three months. See paragraphs 815-20-35-2 through 35-4 for further guidance. At inception of the hedge, an entity electing a dollar-offset approach to perform retrospective evaluations on a quantitative basis may choose either a period-by-period approach or a cumulative approach in designating how effectiveness of a fair value hedge or of a cash flow hedge will be assessed retrospectively under that approach, depending on the nature of the hedge documented in accordance with paragraph 815-20-25-3. For example, an entity may decide that the cumulative approach is generally preferred, yet may wish to use the period-by-period approach in certain circumstances. See paragraphs 815-20-35-5 through 35-6 for further guidance.
ASC 815-20-25-79 requires an entity to “consider hedge effectiveness in two
different ways — in prospective considerations and in retrospective
evaluations.”
As indicated in ASC 815-20-25-79(a), prospective considerations address the
“expectation that the [hedging] relationship will be highly effective over
future periods in achieving offsetting changes in fair value or cash flows.”
Unless a hedging relationship meets one of the exceptions that permits an
assumption of perfect effectiveness (see Sections 2.5.2.2.1 through
2.5.2.2.5), the entity will need to perform an initial
quantitative prospective effectiveness assessment of the hedging relationship.
Although the entity will not have actual results from the hedging relationship
on which to base its effectiveness assessment at the inception of the
relationship, it needs to obtain evidence showing that it expects the hedge to
be highly effective at producing offsetting fair values or cash flows.
Thereafter, the entity must perform prospective effectiveness assessments
whenever financial statements or earnings are reported and at least every three
months. In accordance with ASC 815-20-25-3(b)(2)(iv)(03), at hedge inception,
the entity must indicate whether it will perform subsequent effectiveness
assessments on a quantitative or qualitative basis. See Section
2.5.2.2 for a discussion of qualitative assessments of hedge
effectiveness.
By contrast, when performing retrospective evaluations, the entity considers the
effectiveness of a hedging relationship up to the assessment date. ASC
815-20-35-2 states, in part, that “[i]f a fair value hedge or cash flow hedge
initially qualifies for hedge accounting, the entity would continue to assess
whether the hedge meets the effectiveness test on either a quantitative basis
(using either a dollar-offset test or a statistical method such as regression
analysis) or a qualitative basis. . . . At least quarterly, the hedging entity
shall determine whether the hedging relationship has been highly effective in
having achieved offsetting changes in fair value or cash flows through the date
of the periodic assessment.”
To apply hedge accounting in a reporting period, an entity needs to perform (1) a
prospective assessment at the beginning of the period that supports the
conclusion that the hedge will be highly effective and (2) a
retrospective assessment at the end of the period that supports the conclusion
that the hedge was indeed highly effective during the period. If the results of
either assessment indicate that the hedging relationship is not highly
effective, hedge accounting cannot be applied for that reporting period.
If an entity uses different methods for its prospective and retrospective hedge
effectiveness assessments and the results of the retrospective assessment
indicate that the hedging relationship was not highly effective in one period,
the entity may not automatically be precluded from applying hedge accounting in
the following period if the results of the prospective effectiveness assessment
indicate that the hedging relationship is expected to be highly effective in
future periods. An entity is not necessarily required to dedesignate a hedging
relationship upon a “failed” hedge effectiveness assessment. However, if there
are repeated failures, the entity may be required to reassess its expectations
about whether the hedging relationship will continue to be highly effective in
the future and reconsider whether the hedging instrument would be better used in
a different hedging relationship. Note that hedge accounting cannot be applied
in any period in which the results of a retrospective assessment indicated that
the hedging relationship was not highly effective.
As discussed above, at the inception of a hedging relationship, an entity must
define and document the methods it will use to assess the hedge’s effectiveness,
both prospectively and retrospectively. The method that an entity uses to
perform its prospective effectiveness assessments may differ from its method for
performing retrospective effectiveness assessments; however, for similar hedges,
an entity must use the same method for all of its prospective assessments and
the same method for all of its retrospective assessments throughout the term of
the hedging relationship. Most entities use the same method for both the
prospective and retrospective effectiveness assessments. For example, if an
entity chooses to perform a regression analysis for both its prospective and
retrospective effectiveness assessments, at the end of the reporting period, the
entity would use that regression analysis in (1) the retrospective effectiveness
assessment for the period just ended and (2) the prospective effectiveness
assessment for the following period.
As discussed in Section 2.5.4, entities cannot change their
methods of assessing hedge effectiveness from one period to the next unless the
hedge designation is terminated and a new hedge is established. For example, an
entity cannot document at hedge inception that it will assess effectiveness
retrospectively by using the period-by-period dollar-offset method and then, in
the next reporting period, change its effectiveness assessment method to the
cumulative dollar-offset method unless, at the time the change is made, the
entity terminates the original hedging relationship and redesignates a new
hedging relationship. Instead, the entity must continue to use the
period-by-period dollar-offset method for the duration of the hedging
relationship. In addition, as discussed in Section 2.5.3,
an entity should assess effectiveness for similar hedges in a similar manner;
use of different methods for similar hedges must be justified.
2.5.2 Methods of Effectiveness Assessment
2.5.2.1 Quantitative Methods of Assessment
ASC 815-20-25-79(a) states, in part, that “[a] quantitative assessment can be
based on regression or other statistical analysis of past changes in fair
values or cash flows as well as on other relevant information.” The two most
common statistical methods of assessing a hedge’s level of effectiveness are
the dollar-offset method and regression analysis. As part of addressing
considerations related to the purpose of a hedge effectiveness assessment
(i.e., to determine how effective a hedging instrument is and will be at
offsetting the hedged risk), the discussion below summarizes the types of
quantitative analyses that are generally performed and the data inputs an
entity needs to perform each type of analysis. Note that different methods
may be used, depending on the type of hedge and the nature of the hedging
instrument.
The discussion below regarding quantitative effectiveness assessment methods
focuses on hedging relationships that involve derivative instruments as the
hedging instrument. In the limited cases in which a nonderivative instrument
can be designated as the hedging instrument in a qualifying relationship,
entities often assume that (1) a hedge is perfectly effective (see
Section 2.5.2.2.4) or (2) if it is not, any
quantitative assessment is not typically complex (see Section
2.5.2.1.2.5).
2.5.2.1.1 Models for Assessment
2.5.2.1.1.1 Dollar-Offset Method
The dollar-offset method is the simplest assessment method to apply,
but it is mostly used for retrospective effectiveness assessments
that take into account data over the life of the hedging
relationship. Under the dollar-offset method, an entity compares the
change in the fair value of the derivative to the change in the fair
value or cash flows of the hedged item that is attributable to
changes in the designated risk.
Example 2-19
Entity H hedges changes in the fair value of
its investment in a fixed-rate AFS debt security
that are attributable to changes in the benchmark
interest rate. It designates a receive-floating,
pay-fixed interest rate swap as the hedging
instrument. In a given period, the security
appreciates in value by $1,000 as a result of
changes in the benchmark interest rate, while the
interest rate swap declines in value by $875.
Entity H calculates the ratio of the changes in
the values of the two instruments by dividing the
change in the fair value of the derivative by the
change in the fair value of the hedged item that
is attributable to the hedged risk — that is, 87.5
percent. Entity H concludes that the hedge has
been highly effective because the ratio falls
within the acceptable range of 80 to 125 percent.
Before the issuance of ASU 2017-12, entities had to measure and
recognize the ineffectiveness of qualifying hedging relationships,
so the use of the dollar-offset method was a bit more common than we
expect it will be after the adoption of ASU 2017-12.
When using the dollar-offset method, an entity must choose to
determine the dollar-offset on the basis of either (1) changes in
the fair values (or cash flows) for the period under evaluation (a
period-by-period approach) or (2) the cumulative changes that have
occurred since the inception of the hedging relationship. The entity
should note which approach it elects in the hedge designation
documentation it prepares at hedge inception.
If an entity elects to apply a period-by-period approach, the
evaluation period cannot exceed three months. Under such an
approach, patterns of changes in the fair values (or cash flows) of
the hedging instrument or the hedged item (or hedged transaction)
that occurred in periods before the assessment period are not
relevant.
For example, assume
that an entity uses a derivative to hedge the fair value of a debt
instrument. The table below illustrates the changes in the fair
values of a derivative and a hedged item that are attributable to
the hedged risk and the hedge effectiveness dollar-offset ratios
under both a period-by-period assessment and a cumulative
assessment. (The numbers in green indicate that the percent offset
is within the acceptable range of 80 to 125 percent and the hedge is
highly effective; the numbers in red mean that the percent offset is
outside the acceptable range and the hedge is not highly effective.)
As illustrated above, if an entity applies the dollar-offset method
to assess hedge effectiveness, its election to use the
period-by-period approach instead of the cumulative approach may
affect whether the hedging relationship is considered highly
effective and can qualify for hedge accounting for the current
assessment period. If the entity elected to use the period-by-period
approach, the hedging relationship would not be highly effective for
the quarters ended December 31, 20X0, and March 31, 20X1. If the
entity elected to use the cumulative approach, the hedging
relationship would not be highly effective only for the quarter
ended March 31, 20X1.
2.5.2.1.1.2 Regression Analysis
Regression analysis is a technique for predicting the extent to which
the change in one variable (the independent variable) will result in
a change in another variable (the dependent variable). In assessing
hedge effectiveness, an entity regresses the data related to the
derivative and the hedged item against each other and evaluates the
results of the regression analysis to determine whether the hedge is
expected to be highly effective (prospective) or has been highly
effective (retrospective), or both. For example, if an entity wants
to use forward contracts to purchase crude oil to hedge forecasted
jet fuel purchases, it might use historical price changes for jet
fuel as the dependent variable and historical price changes for
crude oil as the independent variable. In fact, some entities use
regression analysis to determine their risk mitigation strategies
regardless of whether they intend to apply hedge accounting.
As indicated in ASC 815-20-35-3, if, at the inception of a hedging
relationship, an entity elects to use the same regression analysis
approach for both prospective and retrospective effectiveness
assessments, those regression analysis calculations should generally
incorporate the same number of data points during the term of that
hedging relationship. An entity should use enough data points, but
not an inappropriately excessive number, to create a statistically
sound analysis. Use of at least 30 data points is recommended. The
entity also must periodically update its regression (or other
statistical) analysis.
For a hedging relationship to be considered highly
effective under a regression analysis, (1) R2 should be
equal to or greater than 0.8, (2) the slope should be between
negative 0.8 and negative 1.25,10 and (3) the F and t statistics should be evaluated at a 95
percent confidence level. These terms are defined below.
The formula for a linear regression is y = mx + b +
x1:
- y represents the dependent variable.
- m represents the slope of the line.
- x represents the independent variable.
- b represents the y intercept.
- x1 represents the error term.
The table below
discusses how to evaluate the validity of a linear regression.
Factors Indicating That a
Regression Analysis Is Valid
|
Confidence Level or Numerical
Requirement
|
How to Evaluate the Confidence
Level or Numerical Requirement
|
---|---|---|
R2
|
≥ 0.8
|
The R2 output
should be greater than or equal to 0.8.
R2 is the coefficient of determination,
which is the square of the coefficient of
correlation, or r. The r value indicates the
linear relationship between two variables. It can
range from –1 to +1. R2 represents the
proportion of variability in y that is
explained by x. The higher the value, the
higher the indication that y is related to
x.
|
m (slope factor)
|
Between –0.8 and –1.25
|
The slope (m) of a line is the
change in y over the change in x.
The slope should be within the range specified. An
increasing or decreasing value indicates the
positive or negative change in y for every
change in x. For example, a slope of +1
would indicate that y is increasing at a
positive rate for each change in x. In a
hedging relationship, a hedge is used to offset
changes in the value of the hedged item;
therefore, a regression equation for a hedging
relationship should have a negative slope within
the specified range if changes in the fair value
of the derivative are compared with changes in the
fair value or cash flows of the hedged item.
However, if an entity is using the
hypothetical-derivative method (see Section
2.5.2.1.2.4), the slope should be
positive.
|
t statistic
|
95 percent confidence level
|
The t statistic for the x
coefficient is used to evaluate the probability
that the slope is zero. A slope of zero indicates
that there is no relationship between the x
and y variables. A high t statistic
for the x coefficient, positive or
negative, generally is a good indicator that there
is correlation and thus a linear relationship
exists. This statistic may be further evaluated by
examining the p-value — a statistical
output of the t statistic calculation. A
low p-value associated with the t
statistic for the x variable (e.g., less
than 5 percent) indicates that there is a low
probability that the slope is zero and, thus, a
high probability that the independent variable is
useful in the prediction of the dependent
variable.
|
F statistic
|
95 percent confidence level
|
The F statistic is used to evaluate the
probability that there is no linear relationship
between the x and y variables. For a
relationship to achieve a 95 percent confidence
level, the significance of F should be less
than 5 percent. In such a case, there is a less
than 5 percent probability that no linear
relationship is present.
|
Note that statistical problems with data (e.g., serial correlation or
nonconstant variance of the error terms) may result in inaccurate
estimates of t, F, and R2. When this
occurs, consultation with statistical analysis experts is often
advisable.
Entities should challenge all statistical model assumptions to ensure
that they remain valid under current market and business conditions.
Even if an entity does not elect the dollar-offset method as one of
its methods of assessing hedge effectiveness, it still may need to
be aware of the dollar-offset results; this is because a continued
“failure” of that method (i.e., if the dollar offset indicates that
the effectiveness of the hedging relationship was not in the 80–125
percent range) would call into question the reliability of the
results produced by the statistical models. This periodic “reality
check” is necessary because a statistical analysis, such as
regression, inherently smooths historical data and may not
appropriately reflect current market or business conditions. One way
of challenging the validity of the model’s assumptions is to monitor
the results of dollar offset. Another potential alternative would be
to analyze the data points used as inputs in the regression analysis
to identify whether the relationship between the most recent data
points indicates that current market or business conditions are
inconsistent with historical trends. In that case, the entity might
then perform dollar-offset tests.
In accordance with the documentation requirements of ASC 815 and as
an appropriate risk management practice, entities should establish
policies and procedures that address the possibility that a
statistical method, such as regression, could indicate that a
hedging relationship is, or is expected to be, highly effective
while a dollar-offset analysis (i.e., the determination of the
actual offset) indicates that the relationship has not been highly
effective. Such policies may dictate that falling below a certain
level of offset, as indicated by a dollar-offset analysis, for a
specified period will trigger reassessment by an appropriate level
of management of the validity of the inputs used in the statistical
model. That reassessment would need to take into account current
market and business conditions. In some instances, consultation with
statistical analysis experts may be advisable. An entity’s process
for challenging the validity of a regression analysis should be well
documented and consistently applied.
ASC 815-20-25-79 states, in part:
The quantitative prospective
assessment of hedge effectiveness shall consider all reasonably
possible 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 and the hedged items for the period used
to assess whether the requirement for expectation of highly
effective offset is satisfied. The 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. Generally, the process of
formulating an expectation regarding the effectiveness of a
proposed hedging relationship involves a probability-weighted
analysis of the possible 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 and the hedged items for the hedge
period. Therefore, a probable future change in fair value will
be more heavily weighted than a reasonably possible future
change.
2.5.2.1.1.3 Other Statistical Methods
Generally speaking, regression analysis is the most
common type of statistical analysis used by entities to determine
the level of effectiveness of a hedging relationship. The
dollar-offset method and regression analysis are both specifically
mentioned in ASC 815, but broader reference is also made to “other
statistical analysis.” Other analyses may involve simulations (e.g.,
Monte Carlo simulation), which may be necessary in scenarios in
which there is not enough historical information available to
provide a statistically valid regression analysis. For example, a
new market may develop for a product or a derivative market may
develop in connection with a specific underlying. In these cases,
entities should consider consulting with relevant experts to develop
the proper parameters for an analysis that would validate whether a
hedging relationship is expected to be or has been highly effective.
2.5.2.1.2 Data for Models
To perform a statistical analysis, an entity must select an appropriate
mathematical model and identify the relevant inputs for the model. These
are not necessarily distinct processes; in fact, they often go hand in
hand. For example, if an entity is going to perform a dollar-offset
analysis (see Section 2.5.2.1.1.1) to assess hedge
effectiveness, the relevant inputs are changes in the fair value of the
hedging instrument and changes in the fair value or cash flows of the
hedged item that are attributable to the hedged risk. While an entity
has limited options regarding the nature of the inputs (changes in fair
value or cash flows), the actual inputs it uses will vary depending on
whether it has chosen to perform the analysis on a period-by-period or
cumulative basis. The discussion below focuses on the various elections
an entity can make that would influence the data inputs for the
statistical model the entity uses to perform its quantitative hedge
effectiveness assessment.
2.5.2.1.2.1 Derivative — Excluded Components
ASC 815-20
25-82 In
defining how hedge effectiveness will be assessed,
an entity shall specify whether it will include in
that assessment all of the gain or loss on a
hedging instrument. An entity may exclude all or a
part of the hedging instrument’s time value from
the assessment of hedge effectiveness, as follows:
- If the effectiveness of a hedge with an option is assessed based on changes in the option’s intrinsic value, the change in the time value of the option would be excluded from the assessment of hedge effectiveness.
- If the effectiveness of a hedge with an option is assessed based on changes in the option’s minimum value, that is, its intrinsic value plus the effect of discounting, the change in the volatility value of the contract shall be excluded from the assessment of hedge effectiveness.
- An entity may exclude any of
the following components of the change in an
option’s time value from the assessment of hedge
effectiveness:
- The portion of the change in time value attributable to the passage of time (theta)
- The portion of the change in time value attributable to changes due to volatility (vega)
- The portion of the change in time value attributable to changes due to interest rates (rho).
- If the effectiveness of a hedge with a forward contract or futures contract is assessed based on changes in fair value attributable to changes in spot prices, the change in the fair value of the contract related to the changes in the difference between the spot price and the forward or futures price shall be excluded from the assessment of hedge effectiveness.
- An entity may exclude the portion of the change in fair value of a currency swap attributable to a cross-currency basis spread.
Time value is a
component of the fair value of derivative instruments, and it can be
a source of ineffectiveness in a hedging relationship if there is no
corresponding time value component in the hedged item’s fair value
or expected cash flows. ASC 815 gives entities the option to exclude
components of a derivative’s fair value (and the resulting changes
in the components’ fair value) from the assessment of hedge
effectiveness. Depending on the type of derivative used, different
components of a derivative’s fair value may be excluded. The
following table illustrates, by type of derivative, the alternatives
available for excluded components:
Type of Derivative
|
Excludable Component
|
---|---|
Option
|
|
Forward/futures
|
Forward points — The change in fair
value related to the changes in the difference
between the spot price and the forward or futures
price
|
Currency swap
|
Cross-currency basis spread
|
An entity’s decision to exclude changes in the fair values of certain
components of a derivative is part of its overall method of
assessing hedge effectiveness. Since an entity should assess the
effectiveness of similar hedges in a consistent manner (see
Section 2.5.3), the entity should apply its
decision to exclude certain components (or no components) to all
similar hedging relationships.
ASC 815-20
25-83A For fair value and
cash flow hedges, the initial value of the
component excluded from the assessment of
effectiveness shall be recognized in earnings
using a systematic and rational method over the
life of the hedging instrument. Any difference
between the change in fair value of the excluded
component and amounts recognized in earnings under
that systematic and rational method shall be
recognized in other comprehensive income. Example
31 beginning in paragraph 815-20-55-235
illustrates this approach for a cash flow hedge in
which the hedging instrument is an option and the
entire time value is excluded from the assessment
of effectiveness.
25-83B For fair value and
cash flow hedges, an entity alternatively may
elect to record changes in the fair value of the
excluded component currently in earnings. This
election shall be applied consistently to similar
hedges in accordance with paragraph 815-20-25-81
and shall be disclosed in accordance with
paragraph 815-10-50-4EEEE.
When an entity excludes a component of the change in a derivative’s
fair value from its hedge effectiveness assessment, it has two
alternatives for accounting for the change in the fair value of that
excluded component:
- Recognize the initial value of the excluded component in earnings by using a systematic and rational method over the life of the hedging instrument. Any differences between the actual change in the fair value of the excluded component and the amount recognized in earnings would be recognized in OCI.
- Recognize the change in the fair value of the excluded component in earnings.
As indicated in ASC 815-20-25-83A, the default method of accounting
for an excluded component is the “systematic and rational
amortization method.” An entity that prefers to recognize changes in
the fair value of the excluded component in earnings as they occur
should document that election. Similar hedges should be accounted
for similarly.
Note that if an entity uses a purchased option that meets the
definition of a derivative under ASC 815 in a hedge, it can amortize
the time value of the option over its life by (1) designating the
option as the hedging instrument in a qualifying hedging
relationship and (2) electing to exclude the time value from the
hedge effectiveness assessment.
The fair value of an option has two components: intrinsic value and
time value. Intrinsic value is calculated by comparing the strike
price (or strike rate) of the option with the market price (or
market rate) of the underlying exposure. An option will have
intrinsic value only if its strike price is favorable compared with
the current market price. Time value is equal to the option’s fair
value minus its intrinsic value. The premium paid to enter into an
option generally represents the option’s time value since most
options are issued at-the-money or out-of-the-money.
ASC 815 requires all derivatives to be recorded at fair value. Under
ASC 815-20-25-82, when designating an option as a hedging instrument
in a qualifying hedging relationship, an entity can exclude the
option’s time value from the assessment of the hedging
relationship’s effectiveness if the entity documents that it is
using the change in the option’s intrinsic value to hedge the
exposure. In such a case, the entity recognizes the initial value of
the excluded time value component as an adjustment to earnings over
the life of the hedging instrument (i.e., the option) by using a
systematic and rational method. Any difference between the change in
the fair value of the excluded component (i.e., the time value) and
the amount recognized currently in earnings under the amortization
approach is recorded in OCI (for net investment hedges, this amount
should be in the CTA within OCI).
Alternatively, an entity may elect to record the changes in the fair
value of the excluded time value component currently in earnings
(albeit this election must be consistently applied to similar
hedges). In accordance with ASC 815-20-25-129, the time value of an
option can be an effective portion of the hedging relationship if
the “terminal value” method is applied and certain criteria are met
(see Sections 2.5.2.1.2.2 and
2.5.2.2.3).
Example 2-20
Golden Age is a premium gold watch
manufacturer. As of July 1, 20X9, Golden Age
expects to purchase 1,000 ounces of gold on
December 31, 20X9. The current price of gold is
$1,320 per ounce. To protect itself from increases
in the gold price, Golden Age purchases a call
option with the following terms:
- Notional: 1,000 ounces.
- Strike price: $1,320 per ounce.
- Expiration: December 31, 20X9.
- Premium: $60,000.
Golden Age designates the option as a hedge of
its forecasted purchase of 1,000 ounces of gold at
prices above $1,320 per ounce. The company elects
to exclude the time value of the option from the
hedge effectiveness assessment and will account
for the excluded component by using the
amortization method.
Since the term of the option is six months and
the initial time value is $60,000, the application
of a systematic and rational method of recognizing
the option’s initial time value in earnings
results in the recognition of $10,000 per month in
the cost of sales during the option’s term,
provided that the hedging relationship remains
highly effective (from July to December).
The following table shows the changes in the
price of an ounce of gold and the fair value of
the option components over the life of the hedge:
Because Golden Age excludes the option’s time
value from its assessment of the hedging
relationship’s effectiveness, it assesses
effectiveness by comparing the changes in only the
option’s intrinsic value with the change in the
forecasted cash flows related to the purchase of
gold. If Golden Age were performing a monthly
hedge effectiveness assessment, the change in the
intrinsic value of the derivative for each of
month of the hedge would be as follows:
If the hedging relationship is highly effective
throughout its term, all of the intrinsic value
changes would be recorded in OCI. The following
table illustrates the treatment of the changes in
the excluded component (time value):
The accounting for hedging relationships that
involve excluded components is discussed in more
detail in Chapters 3, 4, and 5.
2.5.2.1.2.2 Options — Unique Considerations
Hedging with options is different from hedging with forwards or swaps
because the payoff profile of an option is asymmetrical. Regardless
of whether an entity hedges with a single option or a combination of
options (like a collar), there is an unhedged element in the hedged
transaction. If an entity is seeking to eliminate a risk exposure,
it can enter into a forward contract; however, when it enters into
an option, it is hedging only the underlying risk beyond a certain
desired threshold (or thresholds). Accordingly, the hedge
effectiveness assessment should not focus solely on the risk being
hedged but also on the level of that risk.
ASC 815-20
25-76 If the hedging
instrument (such as an at-the-money option
contract) provides only one-sided offset of the
hedged risk, either of the following conditions
shall be met:
- The increases (or decreases) in the fair value of the hedging instrument are expected to be highly effective in offsetting the decreases (or increases) in the fair value of the hedged item (if a fair value hedge).
- The cash inflows (outflows) from the hedging instrument are expected to be highly effective in offsetting the corresponding change in the cash outflows or inflows of the hedged transaction (if a cash flow hedge).
For instance, in Example 2-20, Golden Age was
only concerned about its exposure to rising gold prices, so it
purchased an at-the-money option with a strike price of $1,320 per
ounce of gold. If it performed an assessment of hedge effectiveness
for scenarios in which the price of gold declined, the forecasted
cash flows related to the purchase of gold would be decreasing
(lowering the ultimate cost of sales), with no offsetting change in
ultimate cash flows from the option (it would expire unexercised).
Therefore, the hedge effectiveness assessment should actually focus
on those scenarios in which the price of an ounce of gold increases
above the option’s strike price (i.e., $1,320). Golden Age should
document that it is hedging the risk of changes in its overall cash
flows related to its purchases that are attributable to an increase
in the price of gold above $1,320 per ounce. A hedging relationship
that is documented in this manner would qualify for hedge accounting
if the option is highly effective at offsetting the increased costs
of the forecasted purchase of gold at prices above that threshold.
The type of hedge may dictate which components of the change in the
option’s fair value the entity will designate as part of its hedge
effectiveness assessment. For options that hedge a net investment in
foreign operations, ASC 815-35-35-5 describes the “spot method” of
assessing hedge effectiveness in which the only excludable component
is the change in fair value that is attributable to changes in the
difference between the forward exchange rates and the spot exchange
rate. For options in a fair value hedging relationship, all of the
time value components discussed in Section
2.5.2.1.2.1 may be excluded (i.e., time value,
volatility value, theta, vega, and rho). However, for options in
cash flow hedging relationships, there is another alternative, as
described below.
ASC 815-20
Additional Considerations for Options in Cash
Flow Hedges
25-123 When an entity has
documented that the effectiveness of a cash flow
hedge will be assessed based on changes in the
hedging option’s intrinsic value pursuant to
paragraph 815-20-25-82(a), that assessment (and
the related cash flow hedge accounting) shall be
performed for all changes in intrinsic value —
that is, for all periods of time when the option
has an intrinsic value, such as when the
underlying is above the strike price of the call
option.
25-124 When a purchased
option is designated as a hedging instrument in a
cash flow hedge, an entity shall not define only
limited parameters for the risk exposure
designated as being hedged that would include the
time value component of that option. An entity
cannot arbitrarily exclude some portion of an
option’s intrinsic value from the hedge
effectiveness assessment simply through an
articulation of the risk exposure definition. It
is inappropriate to assert that only limited risk
exposures are being hedged (for example, exposures
related only to currency-exchange-rate changes
above $1.65 per pound sterling as illustrated in
Example 26 [see paragraph 815-20-55-205]).
25-125 If an option is
designated as the hedging instrument in a cash
flow hedge, an entity may assess hedge
effectiveness based on a measure of the
difference, as of the end of the period used for
assessing hedge effectiveness, between the strike
price and forward price of the underlying,
undiscounted. Although assessment of cash flow
hedge effectiveness with respect to an option
designated as the hedging instrument in a cash
flow hedge shall be performed by comparing the
changes in present value of the expected future
cash flows of the forecasted transaction to the
change in fair value of the derivative instrument
(aside from any excluded component under paragraph
815-20-25-82), that measure of changes in the
expected future cash flows of the forecasted
transaction based on forward rates, undiscounted,
is not prohibited. With respect to an option
designated as the hedging instrument in a cash
flow hedge, assessing hedge effectiveness based on
a similar measure with respect to the hedging
instrument eliminates any difference that the
effect of discounting may have on the hedging
instrument and the hedged transaction. Pursuant to
paragraph 815-20-25-3(b)(2)(iv), entities shall
document the measure of intrinsic value that will
be used in the assessment of hedge effectiveness.
As discussed in paragraph 815-20-25-80, that
measure must be used consistently for each period
following designation of the hedging
relationship.
If an option is designated as a hedging instrument in a cash flow
hedge, an entity may calculate the intrinsic value of the option in
three different ways. Since the time value of the option is the
difference between the option’s total fair value and intrinsic
value, the intrinsic value calculation alternative selected directly
affects how the excluded time value component is calculated. An
entity may calculate intrinsic value as one of the following:
- The difference between the strike price of the option and the spot rate.
- The present value of the difference between the strike price and the forward rate.
- The undiscounted difference between the strike price and the forward rate.
In summary, the following methods of
calculating intrinsic value are available for options in hedging
relationships:
In addition, DIG Issue G20 introduced an assessment method (and a
measurement method until ASU 2017-12 eliminated it) called the
“terminal value” method for cash flow hedging strategies that
involve certain options.
ASC 815-20
Assessing Hedge Effectiveness Based on an
Option’s Terminal Value
25-126 The guidance in
paragraph 815-20-25-129 addresses a cash flow
hedge that meets all of the following conditions:
- The hedging instrument is a purchased option or a combination of only options that comprise either a net purchased option or a zero-cost collar.
- The exposure being hedged is the variability in expected future cash flows attributed to a particular rate or price beyond (or within) a specified level (or levels).
- The assessment of effectiveness is documented as being based on total changes in the option’s cash flows (that is, the assessment will include the hedging instrument’s entire change in fair value, not just changes in intrinsic value).
25-127 This guidance has no
effect on the accounting for fair value hedging
relationships. In addition, in determining the
accounting for seemingly similar cash flow hedging
relationships, it would be inappropriate to
analogize to this guidance.
25-128 For a hedging
relationship that meets all of the conditions in
paragraph 815-20-25-126, an entity may focus on
the hedging instrument’s terminal value (that is,
its expected future pay-off amount at its maturity
date) in determining whether the hedging
relationship is expected to be highly effective in
achieving offsetting cash flows attributable to
the hedged risk during the term of the hedge. An
entity’s focus on the hedging instrument’s
terminal value is not an impediment to the
entity’s subsequently deciding to dedesignate that
cash flow hedge before the occurrence of the
hedged transaction. If the hedging instrument is a
purchased cap consisting of a series of purchased
caplets that are each hedging an individual hedged
transaction in a series of hedged transactions
(such as caplets hedging a series of hedged
interest payments at different monthly or
quarterly dates), the entity may focus on the
terminal value of each caplet (that is, the
expected future pay-off amount at the maturity
date of each caplet) in determining whether each
of those hedging relationships is expected to be
highly effective in achieving offsetting cash
flows. The guidance in this paragraph applies to a
purchased option regardless of whether at the
inception of the cash flow hedging relationship it
is at the money, in the money, or out of the
money.
Under the terminal value method of assessing hedge effectiveness, an
entity compares the ultimate settlement amount of the option with
the change in the cash flows of the hedged transaction that is
attributable to the hedged risk. This approach requires the entity
to apply the hypothetical-derivative method of hedge effectiveness
assessment (see Section 2.5.2.1.2.4) and even
specifies the criteria for making a qualitative assessment (see
Section 2.5.2.2.3). Understanding the
theoretical underpinnings of DIG Issue G20 requires a bit of
intellectual flexibility. An entity that applies the terminal value
method establishes the “perfect” hypothetical derivative as an
option whose terms match the hedged transaction, which allows the
entity to essentially exclude the erosion of the initial time value
from the hedge effectiveness assessment. Because the entity is able
to focus on the option’s terminal value when assessing hedge
effectiveness, it can “account” for this excluded component
differently from other excluded components in hedging relationships.
In fact, when the entity applies the terminal value method, it does
not even acknowledge that time value is an excluded component.
Accordingly, if the hedging relationship is highly effective, the
entire change in the option’s fair value is recognized in OCI
(including all of the initial time value) and reclassified into
earnings when the hedged item affects earnings. Section
4.1.3 provides more details on the accounting for
cash flow hedges that use the terminal value method.
2.5.2.1.2.3 Hedged Item — Fair Value Hedge
In a qualifying fair value hedging relationship, an
entity will remeasure the hedged item in each reporting period for
changes in its fair value that are attributable to changes in the
designated risk. There is substantial guidance on how to measure
such changes in the context of accounting for qualifying fair value
hedges (see the discussion of measurement principles for fair value
hedges in Chapter 3). That
guidance is equally relevant for determining the inputs for the
hedged item that are used in a quantitative hedge effectiveness
assessment model because the purpose of such an assessment for a
fair value hedge is to determine whether the changes in the hedging
instrument’s fair value are highly effective at offsetting the
changes in the hedged item’s fair value that are attributable to
changes in the designated risk. Accordingly, the method that an
entity uses to calculate the changes in the hedged item’s fair value
that are attributable to the changes in the designated risk in a
quantitative effectiveness assessment should be consistent with the
method that the entity uses to calculate such changes when
remeasuring the hedged item in a qualifying fair value hedge.
Furthermore, a change in the method of measuring such changes would
also be considered a change in the method of assessing hedge
effectiveness for those fair value hedges.
2.5.2.1.2.4 Hedged Item — Cash Flow Hedge
DIG Issue G7 introduced three general methods for determining the
change in the hedged item in a cash flow hedge effectiveness
assessment.
ASC 815-30
Assessing Hedge Effectiveness in
Certain Cash Flow Hedges Involving Interest Rate
Risk When Effectiveness Is Assessed on a
Quantitative Basis
35-10 This guidance addresses
the following three methods of assessing
effectiveness of certain cash flow hedges when
hedge effectiveness is assessed on a quantitative
basis in accordance with paragraphs
815-20-25-3(b)(2)(iv)(01) and 815-20-35-2 through
35-2F:
- Change-in-variable-cash-flows method
- Hypothetical-derivative method
- Change-in-fair-value method.
35-11 Those three methods
relate to assessing the effectiveness of a cash
flow hedge that involves any of the following:
- A receive-variable, pay-fixed interest rate swap designated as a hedge of the variable interest payments on an existing floating-rate liability
- A receive-fixed, pay-variable interest rate swap designated as a hedge of the variable interest receipts on an existing variable-rate asset
- Cash flow hedges of the variability of future interest payments on interest-bearing assets to be acquired or interest-bearing liabilities to be incurred (such as the rollover of an entity’s short-term debt as described in Example 9 [see paragraph 815-30-55-52]).
35-12 The hedging
relationships covered by this guidance encompass
either of the following:
- Hedges of interest rate risk (pursuant to paragraph 815-20-25-15(j)(2)) that do not qualify for the shortcut method
- Hedges of the risk of overall changes in the hedged cash flows related to the asset or liability (pursuant to paragraph 815-20-25-15(j)(1)).
DIG Issue G7 specifically addressed how to assess and measure
ineffectiveness in an interest rate swap that hedges a variable-rate
debt instrument (including forecasted issuances of debt) for a
hedging relationship that did not qualify for the shortcut method
because (1) the terms of the swap did not perfectly match the terms
of the debt, (2) the entity wanted to hedge the total change in cash
flows (not just interest rate risk), or (3) the entity was hedging
interest rate risk related to forecasted debt.
The three models in DIG Issue G7 were:
- The change-in-variable-cash-flows method.
- The hypothetical-derivative method.
- The change-in-fair-value method.
If, at the inception of a hedge, the fair value of the swap that was
designated as the hedging instrument is zero or near zero, an entity
may apply any of the three methods listed above. By contrast, if, at
the inception of the hedge, the fair value of the swap is not at or
near zero, an entity cannot apply the change-in-variable-cash-flows
method.
ASC 815-20-25-3 and ASC 815-20-25-80 and 25-81 require an entity, at
the time it designates a hedging relationship, to define and
document the method it will use to assess a hedge’s effectiveness in
achieving offsetting cash flows. The guidance also requires the
entity to use that defined method consistently when evaluating
effectiveness in subsequent periods. In addition, an entity should
assess the effectiveness of similar hedges in a similar manner. If
an entity uses different methods for similar hedges, it should
justify such differences.
The three models are discussed in more detail later in this section,
but the discussion below begins with the hypothetical-derivative
method because it is the most broadly used, even outside of interest
rate hedging. In fact, it is required in certain situations.
ASC 815-30
Hypothetical-Derivative Method
35-25 An entity shall assess
hedge effectiveness under the
hypothetical-derivative method by comparing the
following amounts:
- The change in fair value of the actual interest rate swap designated as the hedging instrument
- The change in fair value of a
hypothetical interest rate swap having terms that
identically match the critical terms of the
floating-rate asset or liability, including all of
the following:
- The same notional amount
- The same repricing dates
- The same index (that is, the index on which the hypothetical interest rate swap’s variable rate is based matches the index on which the asset or liability’s variable rate is based)
- Mirror image caps and floors
- A zero fair value at the inception of the hedging relationship.
35-26 Essentially, the
hypothetical derivative would need to satisfy all
of the applicable conditions in paragraphs
815-20-25-104 and 815-20-25-106 necessary to
qualify for use of the shortcut method except the
criterion in paragraph 815-20-25-104(e). Thus, the
hypothetical interest rate swap would be expected
to perfectly offset the hedged cash flows. Because
the requirements of paragraph 815-20-25-104(e)
were developed with an emphasis on fair value
hedging relationships, they do not fit the more
general principle that the hypothetical derivative
in a cash flow hedging relationship should be
expected to perfectly offset the hedged cash
flows.
35-27 The change in the fair
value of the perfect hypothetical interest rate
swap can be regarded as a proxy for the present
value of the cumulative change in expected future
cash flows on the hedged transaction.
35-28 Paragraph superseded by
Accounting Standards Update No. 2017-12.
35-29 The determination of
the fair value of both the perfect hypothetical
interest rate swap and the actual interest rate
swap shall use discount rates based on the
relevant interest rate swap curves.
DIG Issue G7 extended the hypothetical derivative concept that
previously existed in net investment hedging. Under that concept, an
entity could assess effectiveness (and, until ASU 2017-12 was
issued, measure ineffectiveness) by comparing the actual derivative
in the hedging relationship with a derivative that would be deemed
“perfectly effective.” Since the shortcut method requires the terms
of an interest rate swap to perfectly match the relevant features of
a debt instrument to qualify for an assumption of perfect
effectiveness (see Section 2.5.2.2.1), the DIG
believed that using those criteria as the yardstick for comparison
when the actual swap used did not mirror the terms of the debt was
an acceptable approach for assessing the effectiveness of a hedging
relationship.
Under the hypothetical-derivative method, an entity uses the same
discount rate to compare (1) the change in the fair value of the
actual interest rate swap designated as the hedging instrument with
(2) the change in the fair value of a hypothetical swap (one that
would have qualified for the shortcut method). The hypothetical
derivative should have the same critical terms as the floating rate
asset or liability (hedged item) — including notional amount,
repricing dates, index, caps, and floors — and have a fair value of
zero at the inception of the hedging relationship. Thus, the
hypothetical swap would be expected to perfectly offset the hedged
cash flows. Under this method, the actual swap is recorded at fair
value on the balance sheet, and an offsetting entry is recorded in
OCI, as long as the hedging relationship is deemed highly effective.
Amounts are reclassified out of AOCI when hedged transactions affect
earnings.
In addition, the shortcut method criterion in ASC 815-20-25-104(e),
under which an interest rate swap must mirror any prepayment
features in the related debt, is not a required term of the
hypothetical derivative under ASC 815-30-35-26 “[b]ecause the
requirements of paragraph 815-20-25-104(e) were developed with an
emphasis on fair value hedging relationships.” However, if the
hedged debt is prepayable or is related to a future forecasted
transaction, the entity still needs to assert that it is probable
that those payments will either occur or be replaced by a sufficient
amount of interest payments with the same key characteristics.
The hypothetical-derivative method may also be applied to hedges of
interest payments for debt instruments that cannot be hedged under
the shortcut method and could potentially achieve shortcut-like
results. For example, the shortcut method cannot be applied to
rollovers of fixed-rate debt or forecasted purchases or issuances of
variable-rate debt, but the hypothetical-derivative method would be
available.
Example 2-21
On July 1, 20X0, PiperPiper issues $100
million of noncallable 10-year variable-rate debt
that (1) is indexed to six-month LIBOR and (2)
resets semiannually. At the same time, the company
enters into a 10-year pay-fixed, receive-variable
interest rate swap with a notional amount of $100
million that resets quarterly on the basis of
three-month LIBOR. The only reason the cash flow
hedging relationship does not qualify for the
shortcut method is that the interest rate on the
debt resets semiannually on the basis of six-month
LIBOR while the swap resets quarterly on the basis
of three-month LIBOR.
Under the
hypothetical-derivative method, a hedge
effectiveness assessment can be based on a
comparison of (1) the change in the fair value of
the actual swap that is designated as the hedging
instrument and (2) the change in the fair value of
a hypothetical swap. The hypothetical swap should
have terms that match the critical terms of the
hedged item and satisfy all of the applicable
conditions to qualify for the use of the shortcut
method.11 Thus, the hypothetical swap would be a $100
million notional, 10-year pay-fixed,
receive-variable interest rate swap that resets
semiannually on the basis of six-month LIBOR
(unlike the actual swap, which resets quarterly on
the basis of three-month LIBOR). To qualify for
the shortcut method, the hypothetical swap must
also have a fair value of $0 at inception (unless
the nonzero fair value is attributable solely to
differing prices within the bid-ask spread; see
ASC 815-20-25-104(b)).
PiperPiper uses discount rates that are based
on the relevant swap curves to compute the fair
values of the actual swap and the hypothetical
swap. On September 30, 20X0, the fair value of the
actual swap used by PiperPiper is $100,000 and the
fair value of the hypothetical swap is $95,000,
resulting in a hedging relationship that is 105.3
percent effective ($100,000 ÷ $95,000). Because
the hedging relationship is deemed to be highly
effective (i.e., within the 80 to 125 percent
threshold), the swap is eligible for hedge
accounting. Accordingly, PiperPiper would record
the actual swap on the balance sheet at fair value
($100,000), with an offsetting balance recorded in
OCI ($100,000).
The hypothetical-derivative method has also been applied in practice
to many cash flow hedging relationships other than those involving
interest rate swaps that hedge interest rate risk in debt
instruments. Oftentimes, it is used as a proxy for determining the
change in the hedged item’s estimated cash flows in cash flow hedges
of forecasted transactions in commodities and foreign currencies. An
entity that applies the hypothetical-derivative method by analogy to
assess the effectiveness of non-interest-related hedges would
construct the hypothetical “perfectly effective” derivative so that
it satisfies all applicable conditions in ASC 815-20-25-84 and
25-84A for designation as the hedging derivative in a
“critical-terms-match” relationship (see Section
2.5.2.2.2). This is because the conditions in ASC
815-30-35-25 and 35-26 are specific to interest rate swaps that
hedge the interest payments of a recognized interest-bearing asset
or liability, while ASC 815-20-25-84 and 25-84A describe scenarios
in which a hedge of a forecasted transaction could be deemed
perfectly effective.
ASC 815-30
Change-in-Variable-Cash-Flows Method
35-16 An entity shall assess
hedge effectiveness under the
change-in-variable-cash-flows method by comparing
the following items:
- The variable leg of the interest rate swap
- The hedged variable-rate cash flows on the asset or liability.
35-17 As noted in paragraph
815-30-35-14, the change-in-variable-cash-flows
method shall not be used in certain circumstances.
35-18 The
change-in-variable-cash-flows method is consistent
with the cash flow hedge objective of effectively
offsetting the changes in the hedged cash flows
attributable to the hedged risk. The method is
based on the premise that only the floating-rate
component of the interest rate swap provides the
cash flow hedge, and any change in the interest
rate swap’s fair value attributable to the
fixed-rate leg is not relevant to the variability
of the hedged interest payments (receipts) on the
floating-rate liability (asset).
35-19 An entity shall assess
hedge effectiveness under this method by comparing
the following amounts:
- The present value of the cumulative change in the expected future cash flows on the variable leg of the interest rate swap
- The present value of the cumulative change in the expected future interest cash flows on the variable-rate asset or liability.
35-20 Because the focus of a
cash flow hedge is on whether the hedging
relationship achieves offsetting changes in cash
flows, if the variability of the hedged cash flows
of the variable-rate asset or liability is based
solely on changes in a variable-rate index, the
present value of the cumulative changes in
expected future cash flows on both the
variable-rate leg of the interest rate swap and
the variable-rate asset or liability shall be
calculated using the discount rates applicable to
determining the fair value of the interest rate
swap.
35-21 Paragraph superseded by
Accounting Standards Update No. 2017-12.
35-22 The
change-in-variable-cash-flows method will result
in a perfectly effective hedge if all of the
following conditions are met:
- The variable-rate leg of the interest rate swap and the hedged variable cash flows of the asset or liability are based on the same interest rate index (for example, three-month London Interbank Offered Rate (LIBOR) swap rate).
- The interest rate reset dates applicable to the variable-rate leg of the interest rate swap and to the hedged variable cash flows of the asset or liability are the same.
- The hedging relationship does not contain any other basis differences (for example, if the variable leg of the interest rate swap contains a cap and the variable-rate asset or liability does not).
- The likelihood of the obligor not defaulting is assessed as being probable.
35-23 However, a hedge would
not be perfectly effective if any basis
differences existed. For example, this would be
expected to result from either of the following
conditions, among others:
- A difference in the indexes used to determine cash flows on the variable leg of the interest rate swap (for example, the three-month U.S. Treasury rate) and the hedged variable cash flows of the asset or liability (for example, three-month LIBOR)
- A mismatch between the interest rate reset dates applicable to the variable leg of the interest rate swap and the hedged variable cash flows of the hedged asset or liability.
Under the change-in-variable-cash-flows method, an entity compares
the changes in the floating-rate leg of the swap that is designated
as the hedging instrument with the changes in the floating-rate cash
flows related to the hedged item. Both items would be discounted by
using the relevant discount rate for valuing the swap. If the
hedging relationship is deemed to be highly effective, the entire
change in the swap’s fair value is recorded in OCI and will not
affect the entity’s earnings until the hedged item affects earnings
(which will trigger the reclassification out of AOCI).
Although it may seem counterintuitive, it is possible for a hedge to
be deemed perfectly effective under the guidance in ASC 815-30-35-22
on the change-in-variable-cash-flows method even if the hedging
relationship did not qualify for the application of the shortcut
method. Before the issuance of ASU 2017-12, strategies that involved
debt that was repriced on the basis of a nonbenchmark interest rate
(e.g., prime rate) would not have qualified for application of the
shortcut method even if the swap terms matched the hedged debt’s
terms.
ASU 2017-12 eliminated the requirement that to be eligible for the
shortcut method, the interest rate index of variable-rate debt and a
hedging interest rate swap must be a benchmark interest rate;
instead the ASU introduced the notion of a “contractually specified
interest rate.” As a result, this hedging strategy may now qualify
for the shortcut method.
As noted above, the change-in-variable-cash-flows method
cannot be applied if, at the inception of the hedge, the
fair value of the swap is not at or near zero.
ASC 815-30
Change-in-Fair-Value Method
35-31 An entity shall assess
hedge effectiveness under the change-in-fair-value
method by comparing the following amounts:
- The present value of the cumulative change in expected variable future interest cash flows that are designated as the hedged transactions
- The cumulative change in the fair value of the interest rate swap designated as the hedging instrument.
35-32 The discount rates
applicable to determining the fair value of the
interest rate swap designated as the hedging
instrument shall also be applied to the
computation of present values of the cumulative
changes in the hedged cash flows.
The use of the change-in-fair-value method is fairly limited. As
discussed above, most entities that cannot apply the shortcut method
elect to apply the hypothetical-derivative method. Under the
change-in-fair-value method, the entity would use the same discount
rate to compare (1) the cumulative change in the fair value of the
interest rate swap that is designated as the hedging instrument with
(2) the present value of the cumulative change in expected variable
future interest cash flows that are designated as the hedged
transactions. The discount rate used to calculate the fair value of
the interest rate swap should also be used to calculate the present
value of the cumulative change in expected variable future interest
cash flows that are designated as the hedged transactions. If the
hedging relationship is deemed to be highly effective, the entire
change in the swap’s fair value is recorded in OCI and will not
affect the entity’s earnings until the hedged item affects earnings
(which will trigger the reclassification out of AOCI).
2.5.2.1.2.5 Hedged Item — Net Investment Hedge
ASC 815-35
35-4 If a derivative
instrument is used as the hedging instrument, an
entity may assess the effectiveness of a net
investment hedge using either a method based on
changes in spot exchange rates (as specified in
paragraphs 815-35-35-5 through 35-15) or a method
based on changes in forward exchange rates (as
specified in paragraphs 815-35-35-17 through
35-26). This guidance can also be applied to
purchased options used as hedging instruments in a
net investment hedge. However, an entity shall
consistently use the same method for all its net
investment hedges in which the hedging instrument
is a derivative instrument; use of the spot method
for some net investment hedges and the forward
method for other net investment hedges is not
permitted. An entity may change the method that it
chooses to assess the effectiveness of its net
investment hedges in accordance with paragraphs
815-20-55-55 through 55-56A.
35-4A Hedge effectiveness
shall be assessed on a quantitative basis at hedge
inception in accordance with paragraph
815-20-25-3(b)(2)(iv)(01) unless one of the
exceptions in that paragraph applies. Subsequent
assessments of hedge effectiveness may be
performed either on a quantitative basis or on a
qualitative basis in accordance with paragraphs
815-20-35-2 through 35-2F.
ASC 815 provides detailed guidance on assessing the effectiveness of
net investment hedges. If the hedging instrument is a
foreign-currency-denominated nonderivative instrument, the spot
method is the only method that can be used to assess the
effectiveness of the hedging relationship. By contrast, if the
hedging instrument is a derivative instrument, the entity may choose
between the “spot method” and the “forward method.” Generally
speaking, the entity’s choice is largely based on the financial
reporting differences between the methods, which we explain in
further detail in Section 5.4.2.1. However, an
entity must use the same method of assessing effectiveness for all
of its net investment hedges that involve derivative instruments. A
change in methods can only be made if the new method is considered
an improved method of assessing hedge effectiveness (see
Section 2.5.4).
Note that regardless of whether the hedging instruments is a derivate
or nonderivative, if an entity elects to assess and measure the
results of the net investment hedge on an after-tax basis (see
Section 5.1.3), the assessment should
reflect the after-tax notional amounts of the hedging instrument.
When assessing the effectiveness of a net investment hedge, an entity
may be able to assume that the hedge is perfectly effective if
certain conditions are satisfied (see Section
2.5.2.2.4); in such a case, the entity would make a
qualitative assessment. If the conditions for a qualitative
assessment are not met for the net investment hedging relationship,
the entity should refer to the detailed quantitative assessment
guidance in ASC 815-35. The mechanics of that quantitative
assessment will vary, depending on (1) whether the hedging
instrument is a derivative or a foreign-currency-denominated
nonderivative instrument and (2) for derivatives, whether the spot
method or the forward method is applied.
ASC 815-35
Method Based on Changes in Spot
Exchange Rates
Hedging Instrument Is a Derivative Instrument
35-9 The hedging relationship
would not be considered perfectly effective, and
the guidance in paragraph 815-35-35-10 shall be
applied if any of the following conditions exist:
- The notional amount of the derivative instrument does not match the portion of the net investment designated as being hedged.
- The derivative instrument’s underlying exchange rate is not the exchange rate between the functional currency of the hedged net investment and the investor’s functional currency.
- When the hedging derivative instrument is a cross-currency interest rate swap eligible for designation in a net investment hedge in accordance with paragraph 815-20-25-67, both legs are not based on comparable interest rate curves (for example, pay foreign currency based on the three-month London Interbank Offered Rate [LIBOR], receive functional currency based on three-month commercial paper rates).
35-10 If any of the
conditions in paragraph 815-35-35-9 exist, the
change in fair value of the hypothetical
derivative instrument that does not incorporate
those differences shall be compared with the
change in fair value of the actual derivative
instrument in assessing hedge effectiveness.
35-11 The hypothetical
derivative instrument used to assess hedge
effectiveness also shall have a maturity and
repricing and payment frequencies for any interim
payments that match the maturity and repricing and
payment frequencies for any interim payments of
the actual derivative instrument designated as the
hedging instrument in the net investment
hedge.
Hedging Instrument Is Not a Derivative
Instrument
35-13 The hedging
relationship would not be perfectly effective if
either of the following conditions is met:
- The notional amount of the nonderivative instrument does not match the portion of the net investment designated as being hedged.
- The nonderivative instrument is denominated in a currency other than the functional currency of the hedged net investment.
35-14 Effectiveness shall be
assessed by comparing the following two values:
- The foreign currency transaction gain or loss based on the spot rate change (after tax effects, if appropriate) of that nonderivative instrument
- The transaction gain or loss based on the spot rate change (after tax effects, if appropriate) that would result from the appropriate hypothetical nonderivative instrument that does not incorporate those differences. The hypothetical nonderivative instrument shall also have a maturity that matches the maturity of the actual nonderivative instrument designated as the net investment hedge.
In situations in which a net investment hedge does not qualify for an
assumption of perfect hedge effectiveness, if the hedging instrument
is a derivative and the entity elects to apply the spot method, the
quantitative effectiveness assessment would involve a comparison of
(1) the changes in the fair value of the actual derivative with (2)
the changes in the fair value of a hypothetical derivative that is
deemed to be “perfectly effective.” In other words, if the hedging
relationship did not qualify for the qualitative assessment outlined
in Section 2.5.2.2.4, the changes in the fair
value of the actual derivative would be compared with those of a
derivative that would have met those conditions. The sources of
ineffectiveness would result from:
- Differing notional amounts.
- Differing underlying currencies.
- For a derivative that is a float-for-float cross-currency interest rate swap, interest rate indexes that are not comparable.
If the hedging instrument is a foreign-currency-denominated
nonderivative instrument, the spot method must be applied. If the
net investment hedge does not qualify for an assumption of perfect
effectiveness, the entity would perform a quantitative assessment to
compare (1) the foreign currency transaction gain or loss on the
actual hedging instrument with (2) the foreign currency transaction
gain or loss on a hypothetical nonderivative that would have
qualified for a “perfectly effective” hedging relationship. The
potential sources of ineffectiveness are:
- Differing notional amounts.
- Differing underlying currencies.
ASC 815-35
35-18 However, the hedging
relationship would not be considered perfectly
effective if any of the following conditions
exist:
- The notional amount of the derivative instrument does not match the portion of the net investment designated as being hedged.
- The derivative instrument’s underlying exchange rate is not the exchange rate between the functional currency of the hedged net investment and the investor’s functional currency.
- When the hedging derivative instrument is a cross-currency interest rate swap eligible for designation in a net investment hedge in accordance with paragraph 815-20-25-67, both legs are not based on comparable interest rate curves (for example, pay foreign currency based on three-month LIBOR, receive functional currency based on three-month commercial paper rates).
35-19 The assessment of hedge
effectiveness due to such differences between the
hedging derivative instrument and the hedged net
investment considers the following:
- Different notional amounts.
If the notional amount of the derivative
instrument designated as a hedge of the net
investment does not match the portion of the net
investment designated as being hedged, hedge
effectiveness shall be assessed by comparing the
following two values:
- The change in fair value of the actual derivative instrument designated as the hedging instrument
- The change in fair value of a hypothetical derivative instrument that has a notional amount that matches the portion of the net investment being hedged and a maturity that matches the maturity of the actual derivative instrument designated as the net investment hedge. See paragraph 815-35-35-26 for situations in which the hedge of a net investment in a foreign operation is hedging foreign currency risk on an after-tax basis, as permitted by paragraph 815-20-25-3(b)(2)(vi).
- Different currencies. If the
derivative instrument designated as the hedging
instrument has an underlying foreign exchange rate
that is not the exchange rate between the
functional currency of the hedged net investment
and the investor’s functional currency (a tandem
currency hedge), hedge effectiveness shall be
assessed by comparing the following two values:
- The change in fair value of the actual cross-currency hedging instrument
- The change in fair value of a hypothetical derivative instrument that has as its underlying the foreign exchange rate between the functional currency of the hedged net investment and the investor’s functional currency and a maturity and repricing and payment frequencies for any interim payments that match the maturity and repricing and payment frequencies for any interim payments of the actual derivative instrument designated as the net investment hedge.
- Multiple underlyings. In accordance with paragraph 815-20-25-67(a), the only derivative instruments with multiple underlyings permitted to be designated as a hedge of a net investment are receive-variable-rate, pay-variable-rate cross-currency interest rate swaps that meet certain criteria. Paragraph 815-20-25-67(b) also permits receive-fixed-rate, pay-fixed-rate cross-currency interest rate swaps to be designated as a hedge of a net investment.
35-20 If a
receive-variable-rate, pay-variable-rate
cross-currency interest rate swap is designated as
the hedging instrument in a net investment hedge,
hedge effectiveness shall be assessed by comparing
the following two values:
- The change in fair value of the actual cross-currency interest rate swap designated as the hedging instrument
- The change in fair value of a hypothetical receive-variable-rate, pay-variable-rate cross-currency interest rate swap in which the interest rates are based on the same currencies contained in the hypothetical swap and both legs of the hypothetical swap have the same repricing intervals and dates. The hypothetical derivative instrument also shall have a maturity that matches the maturity of the actual cross-currency interest rate swap designated as the net investment hedge.
Assessing hedge effectiveness under the forward
method is not substantially different from doing so under the spot
method. Although the entity is potentially able to perform a
qualitative assessment for a perfectly effective hedge under the
forward method (see Section
2.5.2.2.4), a quantitative assessment, if required,
would involve comparing the actual hedging instrument with a
hypothetical perfectly effective derivative. As with the spot
method, the sources of ineffectiveness that would require an entity
to perform a quantitative assessment are:
- Differing notional amounts.
- Differing underlying currencies.
- If the derivative is a float-for-float cross-currency interest rate swap, interest rate indexes that are not comparable rates.
2.5.2.1.2.6 Impact of Derivative Credit Risk
The fair value of a derivative is affected by the credit risk of both
parties to the derivative contract (i.e., the entity and the
counterparty to the derivative). The impact on fair value can be
somewhat mitigated by collateral arrangements or master netting
arrangements (for multiple derivatives between the same
counterparties), but changes in credit risk are not typically
eliminated by such arrangements. Changes in a hedging derivative’s
fair value that are attributable to changes in credit risk are not
generally offset by changes in the fair value (or cash flows) of the
hedged item, since the hedged item may not have any credit risk
(e.g., a nonfinancial asset) or it may have a different credit risk
(e.g., debt only has credit risk related to the issuer).
The impact of changes in credit risk on the hedge effectiveness
assessment depends on the type of hedging relationship and the
method of assessment chosen by the entity. The table below briefly
summarizes the impacts of credit risk changes. We divide the
discussion between default risk (i.e., whether it is no longer
probable that both parties will perform under the derivative) and
general credit risk (changes in the credit spreads of either party
to the arrangement that do not rise to the level of default risk). A
more detailed discussion follows the table.
Impact of Changes in the Credit Risk of
Derivatives on the Hedge Effectiveness
Assessment
| |
---|---|
All hedges
|
If an entity can no longer
assert that performance by both parties to the
derivative is probable (i.e., default risk), hedge
accounting must cease.
|
Fair value hedge
|
Shortcut method — No
impact. The shortcut method allows an entity to
assume that the change in the hedged item’s fair
value that is attributable to changes in the
interest rate risk is equal to the change in the
derivative’s fair value.
All other methods — Creates
ineffectiveness. Changes in credit risk that
affect the derivative’s fair value will not affect
the change in the hedged item’s fair value that is
attributable to the hedged risk in the same
manner. This mismatch will affect both the
assessment of hedge effectiveness and the hedging
relationship’s effect on earnings.
|
Cash flow hedge
|
Shortcut method — No
impact. All changes in the swap’s fair value are
recorded in OCI.
All other methods — Mostly no impact.
Under the following methods of hedge effectiveness
assessment, the same discount rate is used to
measure both the derivative and the hedged item:
Because of the mechanics of the calculation
under the change-in-fair-value method, hedging
relationships whose effectiveness is assessed by
applying this method may show some
ineffectiveness, even though the same discount
rate is used to measure both the hedging
instrument and the hedged item. Ineffectiveness
does not affect the amount recognized in OCI for a
highly effective hedging relationship.
|
Net investment hedge
|
Assessment — No impact. Under both the
spot method and the forward method, the
effectiveness assessment is based on the
application of a hypothetical-derivative
method.
Measurement — Results in imperfect
offset. The amount recognized in the CTA section
of OCI is limited to the actual changes in the
derivative’s fair value. This impact is not
mirrored in the translation of the net investment
in foreign operations.
|
2.5.2.1.2.6.1 Risk of Default
DIG Issue G10 dealt with the need to consider default risk
related to a derivative in a cash flow hedging relationship. The
guidance in DIG Issue G10 was codified in ASC 815-20-35-14
through 35-18.
ASC 815-20
Possibility of Default by the
Counterparty to Hedging Derivative
35-14 For an entity to
conclude on an ongoing basis that the hedging
relationship is expected to be highly effective in
achieving offsetting changes in cash flows, the
entity shall not ignore whether it will collect
the payments it would be owed under the
contractual provisions of the derivative
instrument. In complying with the requirements of
paragraph 815-20-25-75(b), the entity shall assess
the possibility of whether the counterparty to the
derivative instrument will default by failing to
make any contractually required payments to the
entity as scheduled in the derivative instrument.
In making that assessment, the entity shall also
consider the effect of any related
collateralization or financial guarantees. The
entity shall be aware of the counterparty’s
creditworthiness (and changes therein) in
determining the fair value of the derivative
instrument. Although a change in the
counterparty’s creditworthiness would not
necessarily indicate that the counterparty would
default on its obligations, such a change shall
warrant further evaluation.
35-15 If the likelihood that
the counterparty will not default ceases to be
probable, an entity would be unable to conclude
that the hedging relationship in a cash flow hedge
is expected to be highly effective in achieving
offsetting cash flows.
35-16 In contrast, a change
in the creditworthiness of the derivative
instrument’s counterparty in a fair value hedge
would have an immediate effect because that change
in creditworthiness would affect the change in the
derivative instrument’s fair value, which would
immediately affect both of the following:
- The assessment of whether the relationship qualifies for hedge accounting
- The amount of mismatch between the change in the fair value of the hedging instrument and the hedged item attributable to the hedged risk recognized in earnings under fair value hedge accounting.
35-17 Paragraph superseded by
Accounting Standards Update No. 2017-12.
35-18 Paragraph 815-20-25-103
states that, in applying the shortcut method, an
entity shall consider the likelihood of the
counterparty’s compliance with the contractual
terms of the hedging derivative that require the
counterparty to make payments to the entity. That
paragraph explains that implicit in the criteria
for the shortcut method is the requirement that a
basis exist for concluding on an ongoing basis
that the hedging relationship is expected to be
highly effective in achieving offsetting changes
in fair values or cash flows.
DIG Issue G10 addressed the lack of guidance on the consideration
of counterparty default risk related to derivatives in cash flow
hedging relationships as a result of the failure of many hedge
effectiveness assessment methods to pick up changes in credit
risk as a source of ineffectiveness (see Section
2.5.2.1.2.6.2). Under DIG Issue G10, if an entity
could not assert that it was probable that the counterparty
would perform under the derivative contract, it would not be
appropriate to (1) conclude that the hedging relationship is
highly effective and (2) apply hedge accounting. In other words,
even if a quantitative assessment of hedge effectiveness
indicates that a hedging relationship is highly effective, if it
is no longer probable that the counterparty to the derivative
will perform under the contract (i.e., it is no longer probable
that the counterparty will not default), the qualitative
nonperformance risk will override any quantitative analysis, and
the application of hedge accounting is inappropriate.
Example 2-22
Effect of Entity’s Own Nonperformance
Risk
Entity B designates a derivate as the hedging
instrument in a cash flow hedging relationship.
When assessing hedge effectiveness, B is required
to consider its own creditworthiness and ability
to comply with the contractual terms of the
hedging derivative. Although ASC 815-20-25-122 and
ASC 815-20-35-14 through 35-18 do not explicitly
address assessment of the possible impact of an
entity’s own default in a cash flow hedging
relationship, there is still a requirement in ASC
815 that any hedging instrument must be expected
to be highly effective at offsetting cash flows
attributable to the hedged risk. This requirement
is further clarified in ASC 815-20-35-2. Thus, if
B is unable to conclude (on the basis of a
qualitative analysis) that it is probable that it
will not default on the contractual terms of the
hedging derivative, it cannot continue to assert
that it expects the cash flow hedging relationship
to be highly effective. That is, before B can
conclude that it expects a cash flow hedging
relationship to be highly effective at achieving
offsetting changes in cash flows, it must first
conclude that it is probable that both parties to
the derivative contract (i.e., both the entity
itself and the derivative counterparty) will not
default and will perform in accordance with the
provisions of the derivative contract.
Although deterioration in B’s own
creditworthiness would not necessarily be the sole
basis for a conclusion that it would default on
its obligations, B would generally need to further
evaluate whether the likelihood remains probable
that it will not default as the result of such a
change.
The guidance in ASC 815-20-35-16 does not specifically indicate
that the likelihood of a default related to the hedging
derivative would automatically render a fair value hedging
relationship not highly effective. The reason for the lack of
specific guidance on such hedges is that an entity is unlikely
to conclude that a fair value hedging relationship that involves
a derivative with significant nonperformance risk would be
highly effective since the derivative’s nonperformance risk
would not be mirrored in the hedged item. However, ASC
815-20-35-16 does indicate that any changes in credit risk will
directly affect the hedge effectiveness assessment. Thus, we
believe that an entity should not rely on a quantitative hedge
effectiveness assessment under which a hedging relationship is
determined to be highly effective if it is no longer probable
that the parties to the derivative contract will not
default.
Similarly, there is no explicit guidance addressing
nonperformance risk for a net investment hedge. Generally
speaking, we believe that when there is no specific guidance
related to net investment hedges, it is appropriate to consider
the overall hedge qualification requirements that apply to both
fair value and cash flow hedges. In addition, since the hedge
effectiveness quantitative assessment guidance for net
investment hedges involves a hypothetical-derivative analysis,
which is similar to the guidance for cash flow hedges, we
believe that if it is no longer probable that both parties to a
derivative contract will continue to perform, any related net
investment hedging relationship should be discontinued.
2.5.2.1.2.6.2 Other Changes in Credit Risk
Even before it becomes no longer probable that both parties will
perform under a derivative, changes in credit risk can affect
the effectiveness of a hedging relationship. However, any
assessment method that uses the changes in the derivative’s fair
value as a proxy for changes in the fair value or cash flows of
the hedged item (e.g., the shortcut method or the
critical-terms-match method) will not be affected by changes in
credit risk, other than the default risk discussed above.
In addition, any assessment method that uses a hypothetical
derivative requires the derivative to be valued by using the
same discount rate as the actual derivative. Therefore, the
impact of changes in credit risk are also negated when the
hypothetical-derivative method is used. As discussed previously,
the hypothetical-derivative method is required for “imperfect”
net investment hedges and is the most widely used assessment
method for cash flow hedges. The change-in-variable-cash-flows
method also requires an entity to use the same discount rate to
determine the present value of the cumulative changes in
expected future cash flows for both the variable leg of the swap
and the variable-rate asset or liability. Accordingly, changes
in credit risk, in and of themselves, do not cause
ineffectiveness to be reflected in the assessment.
The two remaining scenarios in which changes in credit risk have
a direct impact on hedge effectiveness assessments are (1)
non-shortcut-method fair value hedges and (2) cash flow hedges
that use the change-in-fair-value method.
As noted in ASC 815-20-35-16, a change in the credit risk of the
hedging derivative in a fair value hedge would have an immediate
impact on the effectiveness of the hedging relationship because
it would affect the change in the fair value of the derivative
but not that of the hedged item. This mismatch would directly
affect the results of a quantitative assessment of hedge
effectiveness, and entities should also consider its potential
effect in any qualitative effectiveness assessment (see
Section 2.5.2.2.6 for further
discussion of the impact of credit risk on qualitative
assessments).
Because of its mechanics, the change-in-fair-value method for
cash flow hedges could generate some ineffectiveness that needs
to be evaluated in the assessment of hedge effectiveness. Under
that method, an entity must (1) calculate the change in expected
cash flows that is attributable to the change in the hedged risk
and then (2) discount those cash flows by using the
end-of-period discount rate (which incorporates the
end-of-period credit spread) that is used to measure the change
in the derivative’s fair value (which incorporates the change in
the credit spread over the period). In other words, in the
calculation of the change in the derivative’s fair value, the
starting fair value is based on the relevant discount rate (and
credit risk) as of the beginning of the measurement period,
while the ending fair value incorporates changes in the
derivative’s underlying and is then discounted by using the
relevant discount rate (and credit risk) as of the end of the
measurement period. However, the entity separately calculates
the change in expected cash flows related to the hedged item
from period to period and then determines the derivative’s
present value by applying the ending-period discount rate (and
credit risk) to that change.
2.5.2.1.2.6.3 Allocation of Portfolio-Level Credit Risk Adjustments
If an entity enters into multiple derivatives with a single
counterparty that are subject to a master netting arrangement,
the impact of credit risk on the valuation of those derivatives
is typically assessed on the basis of the entity’s net exposure;
however, hedge accounting (and the related hedge effectiveness
assessments) is applied on a hedge-by-hedge basis. To calculate
the fair value of its derivative holdings, an entity generally
determines the fair value of multiple derivatives with a single
counterparty that are subject to a master netting arrangement by
viewing those contracts as a single portfolio. In doing so, the
entity may adjust its portfolio valuation to reflect credit risk
(i.e., the entity may consider credit risk at the portfolio
level), but such valuation adjustments might not be allocated to
individual derivative contracts within the group.
For a hedging relationship to qualify for fair value hedge
accounting, the change in the hedging derivative’s fair value
must be highly effective at offsetting the changes in the hedged
item’s fair value that are attributable to the hedged risk, as
indicated by periodic assessments of hedge effectiveness. In
these assessments, each individual derivative contract covered
by a master netting arrangement is considered a separate unit of
account (i.e., the effectiveness assessment is performed at the
level of the hedging relationship). Many preparers have
questioned whether an entity that uses a “long-haul” method to
assess hedge effectiveness needs to consider valuation
adjustments for credit risk made at the master netting
arrangement/portfolio level in its determination of the fair
value of individual hedging derivatives within such a
portfolio.
The short answer to the question is yes — an entity needs to
consider such portfolio-level valuation adjustments in the hedge
effectiveness assessments of individual hedging relationships.
Discussions with the SEC staff have confirmed the view that a
reporting entity must consider the impact of credit risk on the
fair value of a designated hedging derivative when assessing the
effectiveness of a fair value hedge. However, the reporting
entity may separately determine the credit-risk effect of the
designated derivative on the effectiveness of the hedging
relationship by performing a qualitative analysis that shows
that the changes in fair value attributable to the credit risk
would not affect the highly effective nature of the fair value
hedge. This qualitative determination should take into account
(1) the magnitude of the credit valuation adjustment in relation
to the portfolio size and (2) the level of effectiveness of each
individual hedging relationship before consideration of credit
risk. For example, the qualitative assessment may include a
determination, made at both the portfolio level and the
individual-counterparty level, that the credit-risk adjustment
is insignificant.
Even if a reporting entity’s qualitative analysis supports a
conclusion that the effect of credit risk on hedge effectiveness
is not significant, the entity still must perform a separate
assessment of hedge effectiveness that excludes the effect of
the derivative’s credit risk. In other words, the reporting
entity may exclude credit risk from its periodic quantitative
fair value hedge effectiveness assessments when it determines
qualitatively that credit risk would not cause the hedging
relationship to fail that assessment. If an entity is performing
its periodic hedge effectiveness assessments qualitatively, its
analysis should also factor in the effect of credit risk (see
Section 2.5.2.2.6).
If a reporting entity cannot or does not determine qualitatively
that credit risk would not cause the hedging relationship to
fail the reporting entity’s periodic effectiveness assessment,
it must include credit risk in its periodic quantitative
assessment of the effectiveness of the fair value hedging
relationship. As noted above, ASC 815 requires reporting
entities to perform hedge effectiveness assessments at the
individual hedging relationship level (i.e., the individual
derivative level). If, in determining the fair value of its
derivatives, the reporting entity estimates the credit
adjustment at the portfolio level, the following four methods
are acceptable alternatives for allocating the portfolio-level
credit adjustment to the individual derivative contract:
- Relative fair value approach — An entity may allocate to the portfolio a portion of the portfolio-level credit adjustment made to each derivative asset and liability on the basis of the relative fair value of each derivative instrument.
- In-exchange or “full credit” approach — An entity may use the derivative’s stand-alone fair value (in-exchange premise), which would take into account the parties’ credit standing and ignore the effect of the master netting arrangement.
- Relative credit adjustment approach — An entity may allocate to the portfolio a portion of the portfolio-level credit adjustment made to each derivative asset and liability on the basis of the relative credit adjustment of each derivative instrument. This approach would require the entity to use an in-exchange premise to calculate a credit adjustment for each instrument.
- Marginal contribution approach — An entity may allocate a portion of the portfolio-level credit adjustment to each derivative asset and liability on the basis of the marginal amount that each derivative asset or liability contributes to the portfolio-level credit adjustment.
The SEC staff has indicated that it would not object to any of
these methods. Other rational methods may also be appropriate. A
reporting entity should always consistently apply the selected
method and consider whether the method is a significant
accounting policy that should be disclosed in its financial
statements.
The above guidance addresses considerations related to
creditworthiness in the context of hedge effectiveness. It does
not change the overall guidance on measuring the fair value of
hedging derivatives, which specifies that the change in a
hedging instrument’s fair value must include an adjustment for
nonperformance risk (as that term is defined in ASC 820).
2.5.2.1.3 Period of Assessment
ASC 815-20
Hedge Effectiveness During Designated Hedge
Period
25-101 It is inappropriate
under this Subtopic for an entity to designate a
derivative instrument as the hedging instrument if
the entity expects that the derivative instrument
will not be highly effective in achieving
offsetting changes in fair value or cash flows
attributable to the hedged risk during the period
that the hedge is designated, unless the entity
has documented undertaking a dynamic hedging
strategy in which it has committed itself to an
ongoing repositioning strategy for its hedging
relationship.
Hedge Effectiveness Criterion Applicable to
Fair Value Hedges Only
25-118 In documenting its
risk management strategy for a fair value hedge,
an entity may specify an intent to consider the
possible changes (that is, not limited to the
likely or expected changes) in value of the
hedging derivative instrument and the hedged item
only over a shorter period than the derivative
instrument’s remaining life in formulating its
expectation that the hedging relationship will be
highly effective in achieving offsetting changes
in fair value for the risk being hedged. The
entity does not need to contemplate the offsetting
effect for the entire term of the hedging
instrument.
ASC 815-20-25-79 requires an entity to perform assessments of hedge
effectiveness (both prospective and retrospective) “whenever financial
statements or earnings are reported, and at least every three months.”
In addition, ASC 815-20-25-101 notes that the purpose of the prospective
hedge effectiveness assessment is to determine whether the entity can
support an expectation that the hedge will be highly effective during
the period in which the hedge is designated. Finally, ASC 815-20-25-118
addresses the possibility that an entity may not intend to use a hedging
instrument in an individual fair value hedging relationship for the
entire term of the instrument.
When determining how often to perform a hedge effectiveness assessment,
an entity should consider the nature and term of the hedging
relationship. ASC 815-20-25-79 requires an entity to perform its hedge
effectiveness assessment at least every three months, or sooner if the
entity reports earnings before then. The initial prospective assessment
must be performed at the inception of the hedging relationship (see
Section 2.6 for a discussion of timing relief).
The timing of the next subsequent assessment depends on the following:
- When the reporting period ends.
- When the hedging instrument matures or expires.
- The intended term of the hedging relationship.
- How often the entity intends to reassess whether the hedge remains highly effective.
In many cases, an entity will default to performing its hedge
effectiveness assessments at the end of each quarter. For example, if an
entity is hedging interest payments on 10-year debt with an interest
rate swap that has a 10-year term, the entity is likely to perform its
hedge effectiveness assessments every quarter. However, if the entity is
only hedging a risk for one month, the hedge effectiveness assessments
need to be performed both at inception of the hedge and at the end of
the hedging relationship, which would be a period that is shorter than a
quarter. Of course, if that one-month period includes a reporting date,
the entity needs to perform an additional assessment (e.g., if a
calendar-quarter company enters into a one-month hedge on June 15, the
hedge effectiveness assessments must be performed as of June 15, June
30, and July 15).
If a hedging relationship does not have significant potential sources of
ineffectiveness, it is typically not necessary for an entity to consider
assessing the effectiveness of the hedge more frequently than it must
under the minimum requirements discussed above (i.e., before the end of
the quarterly reporting period or the maturity of the hedging
instrument, if sooner). However, for some hedging relationships, an
entity may choose to assess effectiveness more frequently, or it may
even assert that the hedging relationship is only expected to be
effective until the next assessment date but not necessarily over the
life of the hedging instrument.
For example, an entity may designate a 10-year interest rate swap as a
hedge of a 30-year mortgage-backed security because it expects that
security to have a weighted-average life of approximately 10 years as a
result of prepayments. However, the entity may indicate in its
documentation that it intends to assess hedge effectiveness on the basis
of three-month periods and thus designate the hedge for three months. To
determine whether that hedging relationship is and will continue to be
highly effective, the entity would compare the changes in the swap’s
fair value with the change in the fair value of the hedged
mortgage-backed security (MBS). The entity would need to perform this
assessment frequently enough to take into account small movements in the
yield curve.
In addition, an entity may use a dynamic hedging strategy under which it
continually adjusts the hedging instrument or the amount of the hedged
item in a hedging relationship (e.g., by making daily or weekly
adjustments). If so, the retrospective and prospective hedge
effectiveness assessments would only need to support the entity’s
expectation that the hedging relationship was or will be highly
effective over the minimum period in which the entity intends to keep
the current hedging relationship in place.
2.5.2.1.4 Off-Market Derivatives
If a nonoption derivative has off-market terms (i.e., its fair value is
other than zero) at the inception of the hedging relationship, such
terms will affect the assessment of hedge effectiveness. In fact, an
entity is not permitted to use the following methods to assess the
effectiveness of hedging relationships that involve off-market nonoption
derivatives:
- Shortcut method (see Section 2.5.2.2.1).
- Critical-terms-match method (see Section 2.5.2.2.2).
- Change-in-variable-cash-flows method for cash flow hedges (see Section 2.5.2.1.2.4).
A forward-based derivative with off-market terms has an embedded
financing component that is equal to the fair value of the derivative
asset or liability. When assessing hedge effectiveness, an entity should
take into account changes in the embedded component’s fair value, which
are a source of ineffectiveness in a hedging relationship. In addition,
the entity should consider the “principal” element of that financing
component in the financial reporting for the hedging relationship.
Before we discuss the mechanics of hedging with off-market derivatives,
it is important to highlight some common scenarios in which an entity
would designate such a derivative as the hedging instrument in a hedging
relationship:
- The derivative is initially structured as an off-market derivative — An entity may decide to enter into an off-market derivative to either (1) pay or receive cash at the inception of the derivative in exchange for changing the forward price or swap rate or (2) compensate one of the parties to the derivative for a separate transaction that occurs simultaneously with the entity’s entering into the derivative (e.g., fees for an associated debt issuance). Payment of a “normal” fee for entering into the derivative does not itself establish an off-market derivative. For example, interest rate swaps typically include the dealer fee as an adjustment to the fixed leg of the swap. However, if the entity has other transactions with the dealer, incorporating the fees and payments related to those transactions into the fixed leg of the swap would create an off-market swap (see Example 2-25).
- The existing derivative is modified or replaced — An entity may have an existing derivative whose terms become off-market. Sometimes, the terms of the derivative are renegotiated and the life of the derivative is extended (i.e., a “blend-and-extend” strategy). For example, assume that an entity has an existing receive-variable, pay-fixed interest rate swap with three years remaining and a negative fair value. In such a case, the entity may be willing to replace that derivative with one that has a lower fixed rate in exchange for a three-year extension of the term. The new fixed rate would still be considered “above market” but would be lower than the fixed rate of the existing swap. After the modification, the overall fair value of the new swap would be the same as that of the old swap (i.e., no consideration would be exchanged).
- The entity is an acquirer in a business combination — An acquirer in a business combination recognizes the assets and liabilities acquired at fair value on the acquisition date. If the acquirer wants to designate those derivatives in the same hedging relationships that the acquiree had before the combination (or even in new hedging relationships), the derivatives are likely to be off-market at the inception of the new hedging relationships.
- The entity emerges from bankruptcy — ASC 852-10-45-21 indicates that after a bankruptcy, a new reporting entity is created at the time fresh-start accounting is applied. Therefore, because the post-bankruptcy entity is considered a new entity, any hedging relationships are new to that entity and must be designated and documented anew.
- A derivative is redesignated in a new hedging relationship — An entity may have derivatives that are dedesignated from previous hedging relationships and designated in new hedging relationships. This could occur for several reasons, including (1) the hedging relationship is no longer highly effective, (2) the hedging relationship was voluntarily dedesignated, or (3) the documentation of a prior hedging relationship was insufficient.
- Hedge designation documentation is not completed on time — If an entity does not complete the hedge designation documentation in a timely manner when entering into an at-market derivative, it is likely that the terms of the derivative will no longer be at-market when the hedge designation documentation is completed (see Section 2.6 for further discussion of the hedge designation requirements).
- There is a change in the method of assessing hedge effectiveness — An entity may decide to change its method of assessing the effectiveness of a hedging relationship. As discussed in Section 2.5.4, such a change requires a hedging relationship to be dedesignated and redesignated. Common reasons for changing the method of assessing the effectiveness of a hedging relationship include (1) a change in the components (if any) that are excluded from the derivative’s fair value in the assessment of hedge effectiveness (including changing between the forward and spot methods for net investment hedges) and (2) a change from the dollar-offset method to the regression method and vice versa.
The examples below
illustrate the nature of an off-market derivative and its impact on
hedge effectiveness.
Example 2-23
Off-Market Forward
Reprise wants to hedge the cost of aluminum sales
with a forward contract to sell aluminum that
settles in one year. The market forward price is
$2,070 per metric ton (the current spot price is
$1,896 per metric ton). Reprise would prefer to
lock in a price of $2,270 per metric ton on the
forward. To “buy up” the forward price by $200 per
metric ton, Reprise must pay $192.31 at the
inception of the forward. The up-front payment of
$192.31 represents the present value of $200 one
year from now.
The off-market forward consists of the following:
The change in the fair value of the “loan” over
the life of the forward is a source of
ineffectiveness. Although the cumulative amount of
ineffectiveness that will be recognized over the
life of the hedging relationship is $7.69 (the
“interest” on the loan), the periodic changes in
the loan’s fair value will not necessarily act in
the same manner as accrued interest. By the
settlement date, the fair value of the actual
forward (off-market derivative) will be $200
greater than that of the hypothetical forward (one
that was at-market on the date the forward was
entered into). The hypothetical-derivative method
will reflect this ineffectiveness.
Assume that prices and fair values throughout the
life of the hedging relationship are as follows:
At the end of the third month of the hedging
relationship, the spot price of aluminum remains
at $1,896 per metric ton, and the nine-month
forward rate is $2,033.61 per metric ton. The
market forward points have shrunk from $174 per
metric ton to $137.61 per metric ton because of
the decrease in remaining time, which is partially
offset by a slight increase in risk-free interest
rates (which are a component of the forward points
related to aluminum). The increase in risk-free
interest rates and the decrease in remaining time
affect the fair value of the loan component of the
actual derivative in opposite ways, but the impact
of the passage of time is stronger.
Note that even the hypothetical derivative has
forward points that would erode over time. Because
Reprise is using the hypothetical-derivative
method to assess the hedge’s effectiveness, the
portion of the change in fair value that is based
on the market erosion of the forward points is no
longer a source of ineffectiveness. All that is
left is the change in the fair value of the loan
component, and that fair value is actually exposed
only to the changes in interest rates and the
passage of time.
If the entity was performing a dollar-offset
analysis, the hedge would be 103.3 percent
effective ($36.36 ÷ $35.20), which would indicate
that the hedging relationship is highly effective.
Now, assume that three more months have passed.
The spot price of aluminum has dropped to $1,700
per metric ton, and the six-month forward rate is
$1,782.26 per metric ton. The market forward
points have fallen from $137.61per metric ton to
$82.26 per metric ton solely because of the
decrease in remaining time, which affects the fair
value of the loan component of the actual
derivative. The decreases in the spot price have
resulted in even larger changes in the fair values
of both the actual and hypothetical forwards.
Under the period-by-period dollar-offset method,
the hedge is calculated to be 100.9 percent
effective ($248.34 ÷ $246.21) during the period.
Under the cumulative dollar-offset method, the
hedge is calculated to be 101.2 percent effective
($284.70 ÷ $281.41). Therefore, both methods
demonstrate that the hedging relationship is
highly effective.
After three more months pass,
the spot price of aluminum partially recovers to
$1,800 per metric ton, and the three-month forward
rate is $1,841.85 per metric ton. The market
forward points have shrunk from $82.26 to $41.85
per metric ton because of the decreases in
remaining time, risk-free interest rates, and
other costs to carry aluminum. The decreases in
both the remaining time and the risk-free interest
rates increase the fair value of the loan
component of the actual derivative. The increase
in the spot price had a slightly greater impact on
the fair values of both the actual and
hypothetical forwards than did the decrease in
forward points.
Under the period-by-period dollar-offset method,
the hedge is calculated to be 95.9 percent
effective ($53.36 ÷ $55.66) during the period.
Under the cumulative dollar-offset method, the
hedge is calculated to be 102.5 percent effective
($231.34 ÷ $225.75). Therefore, both methods
indicate that the relationship is highly
effective.
During the last three months, the spot price of
aluminum recovers more to finish at $1,850 per
metric ton. The loan component of the actual
derivative is then due (Reprise will collect $200
more per ton than it would have on an at-market
forward). The increase in the loan’s fair value is
the interest accrual in the final period of the
forward.
Under the period-by-period dollar-offset method,
the hedge is calculated to be only 63.4 percent
effective ($3.65 ÷ $5.75) during the period, which
would not be indicative of a highly effective
hedging relationship. However, under a cumulative
dollar-offset method, the hedge is calculated to
be 103.5 percent effective ($227.69 ÷ $220), which
would support a conclusion that the hedging
relationship is highly effective. This also
illustrates why most entities that employ the
dollar-offset method choose to perform that
analysis by using cumulative changes in fair value
over the hedging relationship.
Note that the example above describes a
single-settlement forward in which the loan component of an off-market
forward had no interim payments. However, if an entity uses a
multiple-delivery forward or a swap at off-market terms as the hedging
instrument, the loan component would also have a series of payments that
warrant unique consideration in the hedge effectiveness assessment and
in the determination of the gain or loss on the derivative that should
be recorded in OCI for a qualifying cash flow hedging relationship or
net investment hedging relationship (see Section 5.4.2.1.1.1.1).
Example 2-24
Off-Market Swap
Fish’s Donuts has an existing receive-variable,
pay-fixed interest-rate swap with two years
remaining that it is using to hedge $100 million
of three-month LIBOR-based debt. Interest rates
have decreased since it entered into the swap, so
the swap is currently a derivative liability with
a fair value of $2,437,887. Fish’s Donuts agrees
with the counterparty to enter into a
“blend-and-extend” modification that would reduce
the fixed rate on the pay leg of the swap but
extend the swap’s term to five years. Under the
modification, the interest rate on the fixed leg
on the swap is reduced from 3.5 to 3.126 percent,
while the market rate for the fixed leg of the
five-year swap is 2.5 percent. The terms of the
new swap and the hypothetical swap at the
inception of the hedging relationship are as
follows:
To illustrate our earlier point about the need to
consider the settlements in a hedge effectiveness
assessment, we can look at the effectiveness
assessment for this hedging relationship through
the first quarter. Assume that at the end of three
months, the relevant swap curve shows that
interest rates have decreased further, resulting
in the following fair values:
In calculating the changes in the fair values of
the actual derivative and the hypothetical
derivative, an entity should note that because the
actual derivative has off-market terms, there is a
difference between (1) the net settlements that
occur on the actual swap and (2) the net
settlements that would have occurred on the
hypothetical swap. To properly assess the
effectiveness of the hedging relationship, the
entity must measure the changes in fair value
before any settlements that occur during the
period; this is because after settlements occur,
some of the change in fair value will be
attributable to payments that were made on the
actual swap (and theoretically made on the
hypothetical swap).
In the case of the embedded loan, which can be
represented by the difference between the fixed
legs of the two swaps, a payment was made on the
loan that was not recognized in the income
statement. That payment represented a partial
settlement of the initial liability. The hedge
effectiveness assessment should actually compare
the changes in the fair values of the swaps after
the settlements are added back. The appropriate
dollar-offset ratio for the period would be 101.1
percent ($382,050 ÷ $377,847). If the entity did
not add back the net settlements during the
period, it would inappropriately calculate a
dollar-offset ratio for the period of 49.2
percent, or ($2,585,429 – $2,437,887) ÷
$299,722.
Connecting the Dots
Recent changes in U.S. interest rates (i.e., a
steep drop before 2022 and a sharp increase during 2023) have
posed challenges for some entities using interest rate swaps to
hedge variable-rate debt obligations. When interest rates
decrease significantly, many entities are interested to exit
pay-fixed interest rate swaps as they become significant balance
sheet liabilities; alternately, when interest rates increase,
many entities wish to settle pay-fixed swaps as they become
significant balance sheet assets in order to accelerate receipt
of cash payments on the contracts. In either case, early
settlement will require the party in a net-loss position to make
significant cash payments to terminate the instrument, which may
not be desirable or possible. Therefore, some lenders and
borrowers may agree to restructure borrowers’ existing
pay-fixed, receive-variable interest rate swaps by changing the
fixed leg and changing the term of the swap.
For example, for a swap in a deep liability position, a “blend
and extend” strategy may be used — under this strategy, the
lender agrees to (1) extend the maturity date of the existing
interest rate swap and (2) revise the fixed interest rate. The
new fixed interest rate is determined such that the fair value
of the new swap (with the extended maturity date) approximates
the current fair value of the existing swap. The new swap’s
fixed rate would be higher than the rate of a new at-the-market
swap but lower than the existing swap’s rate.
Similarly, we have seen entities engage in a “blend and shorten”
strategy when swaps are in a significant asset position as a
result of increasing interest rates. In this strategy, the
lender agrees to (1) shorten the maturity date of the existing
interest rate swap and (2) revise the fixed interest rate. Just
as in the blend and extend strategy, the new fixed interest rate
and shortened maturity date is determined such that the fair
value of the new swap approximates the current fair value of the
existing swap.
Practitioners have questioned whether the modified derivative
contracts should continue to be accounted for as derivatives in
their entirety or, instead, as hybrid debt instruments. We
believe that the fair value of the existing derivative contract
should be considered the entity’s initial net investment in the
new contract under ASC 815-10-15-83(b). If the fair value of the
existing swap is large enough (i.e., greater than 90 percent of
the effective notional amount of the new derivative contract),
the new derivative contract would not meet the definition of a
derivative under ASC 815-10-15-83 and should be considered a
hybrid instrument with an embedded derivative. See Section 1.4.2 of Deloitte’s
Roadmap Derivatives
for further discussion of the initial net investment
characteristic of a derivative and the concept of the effective
notional amount of an interest rate swap.
If a reporting entity determines on the basis of its specific
facts and circumstances that its off-market contract does
not meet the definition of a derivative instrument in
its entirety, the financial instrument will be accounted for as
a debt host with an embedded interest rate swap derivative. The
entity can thereafter either (1) elect the fair value option to
measure the entire hybrid instrument at fair value under either
ASC 825 or ASC 815-15-25-4 or (2) measure the debt portion of
the hybrid instrument at amortized cost while bifurcating the
embedded “at-market” swap at fair value.
If the entity elects to mark the entire hybrid instrument to
market under the fair value option, it may not designate that
hybrid instrument as a hedging instrument under ASC 815-15-35-1.
However, if the entity bifurcates the at-market swap from the
debt host contract, the swap may qualify to be designated in a
hedging relationship. Initial and subsequent measurement of the
debt and bifurcated at-market swap are as follows:
- The initial principal amount of the debt will equal the day-one fair value of the instrument. The initial day-one fair value of the bifurcated at-market interest rate swap is zero.
- Each settlement under the swap will comprise two parts: (1) settlement of the bifurcated at-market swap and (2) a principal and interest payment under the debt host.
- The interest on the debt will equal the difference between (1) the day-one fair value amount and (2) the undiscounted difference between the fixed leg payments on the derivative contract and the fixed leg payments on the bifurcated hypothetical at-market derivative with all other terms corresponding exactly to the actual derivative contract.
- If the bifurcated at-market swap is designated in a qualifying cash flow hedging relationship, changes in its fair value will be recorded in OCI.
2.5.2.2 Qualitative Methods of Assessment
Sometimes, a hedge
effectiveness assessment can be qualitative rather than quantitative. While
a quantitative assessment typically must be performed at the inception of a
hedging relationship, there are some exceptions listed in ASC
815-20-25-3(b)(2)(iv)(01) that permit an assumption of perfect
effectiveness. If an entity elects to apply these exceptions to a hedging
relationship, the entity is not required to perform an initial prospective
assessment of hedge effectiveness on a quantitative basis. The table below
summarizes the circumstances in which qualitative assessments may be used
and the timing of those assessments. Each scenario is discussed in more
detail throughout this section.
Qualitative Method
|
Timing of Method
|
Roadmap Discussion
|
---|---|---|
Shortcut method
|
At inception and subsequently
| |
Critical-terms-match method
|
At inception and subsequently
| |
Critical-terms-match method — options: terminal value
(DIG Issue G20)
|
At inception and subsequently
| |
Perfect net investment hedge
|
At inception and subsequently
| |
Simplified hedge accounting approach for private
companies
|
At inception and subsequently
| |
Certain highly effective hedges
|
Only after inception of hedge
|
2.5.2.2.1 The Shortcut Method
ASC 815-20
25-102
The conditions for the shortcut method do not
determine which hedging relationships qualify for
hedge accounting; rather, those conditions
determine which hedging relationships qualify for
a shortcut version of hedge accounting that
assumes perfect hedge effectiveness. If all of the
applicable conditions in the list in paragraph
815-20-25-104 are met, an entity may assume
perfect effectiveness in a hedging relationship of
interest rate risk involving a recognized
interest-bearing asset or liability (or a firm
commitment arising on the trade [pricing] date to
purchase or issue an interest-bearing asset or
liability) and an interest rate swap (or a
compound hedging instrument composed of an
interest rate swap and a mirror-image call or put
option as discussed in paragraph 815-20-25-104[e])
provided that, in the case of a firm commitment,
the trade date of the asset or liability differs
from its settlement date due to generally
established conventions in the marketplace in
which the transaction is executed. The shortcut
method’s application shall be limited to hedging
relationships that meet each and every applicable
condition. That is, all the conditions applicable
to fair value hedges shall be met to apply the
shortcut method to a fair value hedge, and all the
conditions applicable to cash flow hedges shall be
met to apply the shortcut method to a cash flow
hedge. A hedging relationship cannot qualify for
application of the shortcut method based on an
assumption of perfect effectiveness justified by
applying other criteria. The verb match is
used in the specified conditions in the list to
mean be exactly the same or correspond
exactly.
The shortcut method is used to account for certain hedging relationships
in which interest rate swaps hedge interest rate risk in existing debt
instruments. If a hedging relationship qualifies for the shortcut
method, it is assumed to be a “perfect” relationship, so an entity does
not need to perform any quantitative assessments during the relationship
(see discussion of credit risk in Section
2.5.2.2.1.8). Under the shortcut method, synthetic
instrument accounting is combined with the requirement to recognize
derivatives on the balance sheet at fair value in each reporting period.
The periodic net settlements on the swap are recognized in the same
income statement line item as the coupon payments on the debt (interest
income or expense), while the derivative is recorded at fair value in
each period.
Note that the shortcut method applies to both fair value
hedges and cash flow hedges. For a fair value hedge, an entity should
adjust the carrying amount of the debt in an amount that equals and,
therefore, offsets the change in the derivative’s fair value. For a cash
flow hedge, the change in the fair value of the derivative is recorded
in OCI. The accounting is discussed in more detail in Examples 3-6 and
3-8 in Section 3.2.7
(fair value hedges) and Examples 4-18 and 4-19 in Section 4.2.6
(cash flow hedges). The discussion below focuses on the criteria that
need to be met for a hedging relationship to qualify for the application
of the shortcut method.
The shortcut method may
be applied to the following hedging relationships:
Debt Instrument
|
Swap — Debt Is Asset
|
Swap — Debt Is Liability
|
---|---|---|
Fixed-rate debt
|
Receive-variable, pay-fixed
|
Receive-fixed, pay-variable
|
Variable-rate debt
|
Receive-fixed, pay-variable
|
Receive-variable, pay-fixed
|
Application of the shortcut method allows an entity to assume that it has
a perfectly effective hedging relationship; therefore, there is no need
for the entity to perform any quantitative assessments of whether the
hedge is highly effective. Accordingly, an entity’s ability to use the
shortcut method is fairly restricted. Note that all further references
to debt in this section on the shortcut method refer to a debt
instrument that could be either an asset (to the investor/lender) or a
liability (to the issuer/borrower).
Also, the guidance in ASC 815 acknowledges that although
entities are exposed to interest rate risk at the time they firmly
commit to the terms of a debt instrument (i.e., on the trade date), many
entities do not recognize the debt in their financial statements until
the settlement date. To ensure prudent risk management, those entities
may want to enter into an interest rate swap on the trade date before
the debt is recognized on the balance sheet. Under ASC 815-20-25-102, a
shortcut hedging relationship can begin when there is a “firm commitment
arising on the trade [pricing] date to purchase or issue an
interest-bearing asset or liability [if] the trade date of the asset or
liability differs from its settlement date due to generally established
conventions in the marketplace in which the transaction is
executed.”
An entity may apply the
shortcut method to hedging relationships that meet all of the conditions
in the table below. If any one condition is not met, application of the
shortcut method is not appropriate. However, failure to qualify for the
shortcut method does not mean that a hedging relationship is not highly
effective; therefore, the hedging relationship may still be eligible for
hedge accounting.
These conditions are discussed in greater detail in the next sections.
2.5.2.2.1.1 Notional Matches — Hedged Item
ASC 815-20
25-104 All of the following
conditions apply to both fair value hedges and
cash flow hedges:
- The notional amount of the interest rate swap matches the principal amount of the interest-bearing asset or liability being hedged. . . .
25-105 All of the following
incremental conditions apply to fair value hedges
only: . . .
d. For fair value hedges
of a proportion of the principal amount of the
interest-bearing asset or liability, the notional
amount of the interest rate swap designated as the
hedging instrument (see (a) in paragraph
815-20-25-104) matches the portion of the asset or
liability being hedged.
e. For fair value hedges
of portfolios (or proportions thereof) of similar
interest-bearing assets or liabilities, both of
the following criteria are met:
1. The notional amount of the interest rate
swap designated as the hedging instrument matches
the aggregate notional amount of the hedged item
(whether it is all or a proportion of the total
portfolio).
2. The remaining criteria for the shortcut
method are met with respect to the interest rate
swap and the individual assets or liabilities in
the portfolio. . . .
25-106 All of the following
incremental conditions apply to cash flow hedges
only: . . .
e. For cash flow hedges of
the interest payments on only a portion of the
principal amount of the interest-bearing asset or
liability, the notional amount of the interest
rate swap designated as the hedging instrument
(see paragraph 815-20-25-104(a)) matches the
principal amount of the portion of the asset or
liability on which the hedged interest payments
are based.
f. For a cash flow hedge
in which the hedged forecasted transaction is a
group of individual transactions (as permitted by
paragraph 815-20-25-15(a)), if both of the
following criteria are met:
1. The notional amount of the interest rate
swap designated as the hedging instrument (see
paragraph 815-20-25-104(a)) matches the notional
amount of the aggregate group of hedged
transactions.
2. The remaining criteria for the shortcut
method are met with respect to the interest rate
swap and the individual transactions that make up
the group. For example, the interest rate
repricing dates for the variable-rate assets or
liabilities whose interest payments are included
in the group of forecasted transactions shall
match (that is, be exactly the same as) the reset
dates for the interest rate swap. . . .
The first criterion that must be met for an entity to apply the
shortcut method is that the notional amount of an interest rate swap
designated as the hedging instrument must match the amount of the
debt being hedged. If a proportion of a swap is designated as the
hedging instrument in a hedging relationship, the designated
notional amount of that swap needs to match the portion of the
hedged asset or liability. If multiple swaps are designated as the
hedging instrument in a single hedging relationship, the combined
notional amount of the swaps needs to match the hedged item. Also,
if multiple swaps are used in one hedging relationship, all of the
swaps must have the same terms so that they all meet the other
conditions for application of the shortcut method (e.g., the net
settlements are calculated in the same manner and the maturity dates
match).
If the hedged item is (1) only a proportion of fixed-rate debt or (2)
interest payments related to a proportion of variable-rate debt, the
notional amount of the swap must match the amount of the hedged
debt. Also, if the hedged item is a portfolio of fixed-rate debt or
interest payments on a portfolio of variable-rate debt, the notional
amount of the swap must match the principal amount of the debt
portfolio. When such a portfolio is designated in a hedging
relationship that is eligible for the shortcut method, each of the
debt instruments in the portfolio must individually qualify to be
the hedged item. Consequently, all of the other criteria for
application of the shortcut method must be evaluated against each
individual item in the portfolio (see ASC 815-20-25-116 and 25-117
for further discussion).
2.5.2.2.1.2 Fair Value of Swap at Hedge Inception
ASC 815-20
25-104
All of the following conditions apply to both fair
value hedges and cash flow hedges: . . .
b. If the hedging instrument is solely an
interest rate swap, the fair value of that
interest rate swap at the inception of the hedging
relationship must be zero, with one exception. The
fair value of the swap may be other than zero at
the inception of the hedging relationship only if
the swap was entered into at the relationship’s
inception, the transaction price of the swap was
zero in the entity’s principal market (or most
advantageous market), and the difference between
transaction price and fair value is attributable
solely to differing prices within the bid-ask
spread between the entry transaction and a
hypothetical exit transaction. The guidance in the
preceding sentence is applicable only to
transactions considered at market (that is,
transaction price is zero exclusive of commissions
and other transaction costs, as discussed in
paragraph 820-10-35-9B). If the hedging instrument
is solely an interest rate swap that at the
inception of the hedging relationship has a
positive or negative fair value, but does not meet
the one exception specified in this paragraph, the
shortcut method shall not be used even if all the
other conditions are met.
c. If the hedging instrument is a compound
derivative composed of an interest rate swap and
mirror-image call or put option as discussed in
(e), the premium for the mirror-image call or put
option shall be paid or received in the same
manner as the premium on the call or put option
embedded in the hedged item based on the
following:
1. If the implicit
premium for the call or put option embedded in the
hedged item is being paid principally over the
life of the hedged item (through an adjustment of
the interest rate), the fair value of the hedging
instrument at the inception of the hedging
relationship shall be zero (except as discussed
previously in (b) regarding differing prices due
to the existence of a bid-ask spread).
2. If the implicit
premium for the call or put option embedded in the
hedged item was principally paid at
inception-acquisition (through an original issue
discount or premium), the fair value of the
hedging instrument at the inception of the hedging
relationship shall be equal to the fair value of
the mirror-image call or put option. . . .
As discussed in Section 2.5.2.1.4, the
designation of an off-market derivative in a hedging relationship
results in a source of ineffectiveness related to the embedded
financing component of that derivative. Thus, since the shortcut
method is based on an assumption of perfect hedge effectiveness, it
is only available for at-market swaps, with one exception for
prepayable debt in certain circumstances. That is, if the hedged
item is prepayable debt that was issued at a premium or discount on
the basis of the value of the prepayment option, the swap’s fair
value upon the inception of the hedge must be equal to and offset
the fair value of the premium or discount on the debt related to
that prepayment option. The prepayment option in most debt
instruments is paid for by adjusting the coupons on the debt. For
example, debt that may be called by the issuer carries a higher
interest rate than debt that is not prepayable. Conversely, debt
that is puttable by the investor carries a lower interest rate than
debt that is not puttable. However, if an entity issued callable
debt at a discount instead of structuring it to have a higher coupon
rate, the fair value of the hedged interest rate swap should match
that of the debt discount and that swap should be a liability for
the issuer. In other words, the combination of the fair value of the
swap and the proceeds from the debt (ignoring debt issuance costs
with third parties) should equal the par amount of the debt if the
discount or premium is solely attributable to the fair value of the
prepayment option.
A swap is considered to be at-market as long as it is entered into
for no consideration, exclusive of commissions and other transaction
costs (see ASC 820-10-35-9B). If there is an initial fair value
because there are differences in the bid-ask spread or the
transactions occurred in markets that are not the entity’s primary
market, the swap is not automatically ineligible for application of
the shortcut method.
Example 2-25
Bank B enters into a brokered certificate of
deposit (CD) arrangement and an interest rate swap
whose terms are similar to those of the CD but
offset them. Under these arrangements, the broker
introduced B to (1) the investor in the CD and (2)
an unrelated interest rate swap counterparty. Bank
B does not pay the broker’s commission; instead,
it is paid by the interest rate swap counterparty.
To reimburse the counterparty for this payment, B
increases the “pay leg” of the swap (from B’s
perspective) and then designates the swap as a
hedge of the interest rate risk in the CD.
The interest rate swap does not qualify for the
shortcut method since its fair value at inception
is not zero and the brokered CD is not prepayable;
the swap’s fair value is equal to the amount of
the broker’s commission that was effectively
financed by the swap counterparty. Note that while
brokered CDs can be liquidated by the investor
before their maturity, the method of liquidation
actually represents a sale to another investor
through the brokered CD market. The CD itself is
not prepaid.
An interest rate swap will qualify for the
shortcut method only if it meets all of the
conditions in ASC 815-20-25-102 through 25-111.
ASC 815-20-25-104 requires the fair value of a
designated interest swap to be zero at the
inception of the hedging relationship unless (1)
the nonzero fair value is attributable solely to
differing prices within the bid-ask spread or (2)
the swap’s initial fair value offsets the fair
value of a prepayment option in the debt that was
not paid principally over the life of the debt
through the coupons.
In the case of B, even though no cash
consideration was exchanged between the
counterparties at the swap’s inception, the swap’s
fair value is other than zero because of the
financing element embedded in the pay leg of the
swap (i.e., the pay leg is not at market terms as
of the swap’s inception date). Therefore, use of
the shortcut method is not permitted.
The interest rate swap could still qualify for
hedge accounting if it is a highly effective
hedging instrument; however, the financing element
creates some level of mismatch between the change
in the fair value or cash flows of the interest
rate swap and the change in the fair value or cash
flows of the CD, which results in a hedging
relationship that is not perfect. If the financing
element is too significant, the hedging
relationship may not be highly effective. In
addition, if there is an other-than-insignificant
financing component at hedge inception, all cash
inflows and outflows associated with the interest
rate swap should be reported as financing cash
flows in the statement of cash flows in accordance
with ASC 815-10-45-11 through 45-15. See further
discussion of the classification of derivative
activity on the cash flow statement in
Section 6.5.
2.5.2.2.1.3 If Debt Is Prepayable, Swap Has Mirror Terms
ASC 815-20
25-104 All of the following
conditions apply to both fair value hedges and
cash flow hedges: . . .
e. The interest-bearing
asset or liability is not prepayable, that is,
able to be settled by either party before its
scheduled maturity, or the assumed maturity date
if the hedged item is measured in accordance with
paragraph 815-25-35-13B, with the following
qualifications:
- This criterion does not apply to an interest-bearing asset or liability that is prepayable solely due to an embedded call option (put option) if the hedging instrument is a compound derivative composed of an interest rate swap and a mirror-image call option (put option).
- The call option embedded in the interest rate
swap is considered a mirror image of the call
option embedded in the hedged item if all of the
following conditions are met:
- The terms of the two call options match
exactly, including all of the following: 01. Maturities02. Strike price (that is, the actual amount for which the debt instrument could be called) and there is no termination payment equal to the deferred debt issuance costs that remain unamortized on the date the debt is called03. Related notional amounts04. Timing and frequency of payments05. Dates on which the instruments may be called.
- The entity is the writer of one call option and the holder (purchaser) of the other call option.
- Subparagraph not used. . . .
- The terms of the two call options match
exactly, including all of the following:
If the debt is prepayable during the term of the hedging
relationship, the swap must have mirrored prepayment terms, as
defined in ASC 815-20-25-104(e)(2), to qualify for application of
the shortcut method. Because this criterion is applicable to debt
that is prepayable during the hedging relationship, questions have
arisen about the types of terms that would cause a debt instrument
to be considered prepayable in the application of the shortcut
method. Consequently, that subject was addressed in DIG Issue E6,
which is codified in ASC 815-20-25-112 through 25-115 and the
examples in ASC 815-20-55-75 through 55-78.
ASC 815-20
25-112 An interest-bearing
asset or liability shall be considered prepayable
under the provisions of paragraph 815-20-25-104(e)
if one party to the contract has the right to
cause the payment of principal before the
scheduled payment dates unless either of the
following conditions is met:
- The debtor has the right to cause settlement of the entire contract before its stated maturity at an amount that is always greater than the then fair value of the contract absent that right.
- The creditor has the right to cause settlement of the entire contract before its stated maturity at an amount that is always less than the then fair value of the contract absent that right.
25-113 However, none of the
following shall be considered a prepayment
provision:
- Any term, clause, or other
provision in a debt instrument that gives the
debtor or creditor the right to cause prepayment
of the debt contingent upon the occurrence of a
specific event related to the debtor’s credit
deterioration or other change in the debtor’s
credit risk, such as any of the following:
- The debtor’s failure to make timely payment, thus making it delinquent
- The debtor’s failure to meet specific covenant ratios
- The debtor’s disposition of specific significant assets (such as a factory)
- A declaration of cross-default
- A restructuring by the debtor.
- Any term, clause, or other
provision in a debt instrument that gives the
debtor or creditor the right to cause prepayment
of the debt contingent upon the occurrence of a
specific event that meets all of the following
conditions:
- It is not probable at the time of debt issuance.
- It is unrelated to changes in benchmark interest rates, contractually specified interest rates, or any other market variable.
- It is related either to the debtor’s or creditor’s death or to regulatory actions, legislative actions, or other similar events that are beyond the control of the debtor or creditor.
- Contingent acceleration
clauses that permit the debtor to accelerate the
maturity of an outstanding note only upon the
occurrence of a specified event that meets all of
the following conditions:
- It is not probable at the time of debt issuance.
- It is unrelated to changes in benchmark interest rates, contractually specified interest rates, or any other market variable.
- It is related to regulatory actions, legislative actions, or other similar events that are beyond the control of the debtor or creditor.
25-114 Furthermore, a right
to cause a contract to be prepaid at its then fair
value would not cause the interest-bearing asset
or liability to be considered prepayable because
that right would have a fair value of zero at all
times and essentially would provide only liquidity
to the holder.
Note that in the determination of whether terms need to be mirrored
in a swap in a qualifying shortcut method hedge, the term
“prepayable” is a subset of what is considered prepayable in the
following contexts:
- The identification and evaluation of embedded derivatives.
- The application of portfolio layer method (see Section 3.2.1.4).
- The measurement of basis adjustments to the hedged item in fair value hedges (see Section 3.2.1.2).
In addition, the definition of “prepayable” in the context of the
shortcut method differs from the guidance in the ASC master
glossary, which defines prepayable as “[a]ble to be settled by
either party before its scheduled maturity.”
Changing Lanes
In November 2019, the FASB issued a
proposed ASU of Codification
improvements to hedge accounting. One of the proposed
improvements was to replace the phrase “prepayable” with
“early settlement feature” in the guidance on the
application of the shortcut method; however, at the October
11, 2023, FASB meeting, the Board decided not to affirm the
proposed amendment.
DIG Issue E6 stated that the
definition of prepayable that is used in other areas of derivative
and hedge accounting was too broad to incorporate into the criteria
for the shortcut method. This is because a requirement that interest
rate swaps mirror many typical prepayment options that may have
little to no economic substance or would only be triggered in remote
scenarios would be impractical to apply in practice. Accordingly,
DIG Issue E6 carved out prepayment options that would have no
theoretical economic value, which resulted in the guidance in ASC
815-20-25-112 and ASC 815-20-25-114. The following types of
prepayment options are excluded from the definition of prepayable:
Prepayable by Debtor (Callable)
|
Prepayable by Creditor (Puttable)
|
---|---|
At fair value
|
At fair value
|
At an amount always greater than fair value
|
At an amount always less than fair value
|
Further, since the shortcut method applies only to hedges of interest
rate risk and not to credit risk, prepayment options related to the
borrower’s credit are also carved out of the definition and are
addressed in ASC 815-20-25-113(a). That guidance establishes that a
prepayment provision in debt does not need to be mirrored in the
interest rate swap if the debt would be prepaid at either the
debtor’s or creditor’s option upon the occurrence of a specific
event related to either (1) the debtor’s credit deterioration or (2)
other changes in the debtor’s credit risk. ASC 815-20-25-113(a)
provides the following examples of events that could trigger
prepayment but would not be considered prepayment provisions:
- The debtor’s failure to make timely payment, thus making it delinquent
- The debtor’s failure to meet specific covenant ratios
- The debtor’s disposition of specific significant assets (such as a factory)
- A declaration of cross-default
- A restructuring by the debtor.
Finally, DIG Issue E6 established
that contingent acceleration clauses that could be exercised by
either the debtor or the creditor do not need to be mirrored in the
interest rate swap if those prepayment options were triggered by
events whose occurrence was not probable, depending on the nature of
the triggering event. The following table highlights different types
of triggering events that do and do not need to be mirrored in the
interest rate swap:
Prepayment Trigger Needs to Be
Mirrored
|
Prepayment Trigger May Be
Ignored
|
---|---|
|
Any of the following events whose occurrence is
not probable:
|
Example 2-26
Debt Prepayable Upon Tax Law
Change
PiperPiper issues debt that is prepayable if
there is a tax law change that causes interest on
the debt to be disqualified from being tax
deductible. To hedge the debt, PiperPiper enters
into an interest rate swap. If, at the time of
hedge designation, it is not probable that such a
tax law change will occur during the term of the
hedge, the prepayment option does not need to be
mirrored in the swap for the hedging relationship
to qualify for the shortcut method. ASC
815-20-25-113(b) states, in part, that in the
application of the shortcut method, debt is not
considered prepayable if that prepayment provision
is triggered by “the occurrence of a specific
event that meets all of the following conditions:
- It is not probable at the time of debt issuance.
- It is unrelated to changes in benchmark interest rates, contractually specified interest rates, or any other market variable.
- It is related either to the debtor’s or creditor’s death or to regulatory actions, legislative actions, or other similar events that are beyond the control of the debtor or creditor.”
This exclusion from the definition of
prepayable also would apply to prepayment clauses
triggered by “regulatory capital events” and
“investment company events,” which are common in
trust-issued preferred securities.
Note that the guidance in ASC 815-20-25-112
through 25-115 relates to when debt instruments
would be considered prepayable is only for use in
the application of the shortcut method. If a debt
instrument is considered prepayable under this
guidance, the hedging instrument (i.e., the
interest rate swap) must contain a mirror-image
prepayment option. Note that this example
addresses only one aspect of that guidance. ASC
815-20-25-113 discusses other situations in which
the debt would not be considered prepayable in the
application of the shortcut method.
DIG Issue E6
provided examples that illustrate whether certain terms in a debt
instrument make the instrument prepayable in the assessment of
eligibility for the shortcut method. These examples are codified in
ASC 815-20-55-75 through 55-78. The table below summarizes the
examples and conclusions in ASC 815-20-55-75.
Illustrative Debt
Instrument
|
Prepayable?
|
---|---|
Debt instrument 1 — “Some fixed-rate
debt instruments include a typical call option
that permits the debt instrument to be called for
prepayment by the debtor at a fixed amount, for
example, at par or at a specified premium over
par. In some instruments, the prepayment amount
varies based on when the call option is
exercised.”
|
Yes. “Fixed-rate debt instruments that provide
the borrower with the option to prepay at a fixed
amount . . . permit settlement at an amount that
is potentially below the contract’s fair value [if
the designated benchmark interest rate
decreases].”
|
Debt instrument 2 — “Some debt
instruments include contingent acceleration
clauses that permit the lender to accelerate the
maturity of an outstanding note only if a
specified event related to the debtor’s credit
deterioration or other change in the debtor’s
credit risk occurs (for example, the debtor’s
failure to make timely payment, thus making it
delinquent; its failure to meet specific covenant
ratios; its disposition of specific significant
assets, such as a factory; a declaration of
cross-default; or a restructuring by the debtor).
A common example is a clause in a mortgage note
secured by certain property that permits the
lender to accelerate the maturity of the note if
the borrower sells the property.”
|
No. “Debt instruments that include contingent
acceleration clauses that permit the lender to
accelerate the maturity of an outstanding note
only upon the occurrence of a specified event
related to the debtor’s credit deterioration or
other changes in the debtor’s credit risk are not
considered prepayable.”
|
Debt instrument 3 — “Some fixed-rate
debt instruments include a call option that
permits the debtor to repurchase the debt
instrument from the creditor at an amount equal to
its then fair value.”
|
No. “[D]ebt instruments that provide the debtor
with the option to repurchase from the creditor
the debt at an amount equal to the then fair value
of the [debt] are not considered prepayable . . .
because that right would have a fair value of zero
at all times.”
|
Debt instrument 4 — “Some fixed-rate
debt instruments, typically issued in private
markets, include a make-whole provision. A
make-whole provision differs from a typical call
option, which enables the issuer to benefit by
prepaying the debt if market interest rates
decline. In a declining interest rate market, the
settlement amount of a typical call option is less
than what the fair value of the debt would have
been absent the call option. In contrast, a
make-whole provision involves settlement at a
variable amount typically determined by
discounting the debt’s remaining contractual cash
flows at a specified small spread over the current
Treasury rate. That calculation results in a
settlement amount significantly above the debt’s
current fair value based on the issuer’s current
spread over the current Treasury rate. The
make-whole provision contains a premium settlement
amount to penalize the debtor for prepaying the
debt and to compensate the investor (that is, to
approximately make the investor whole) for its
being forced to recognize a taxable gain on the
settlement of the debt investment. In some debt
instruments, the prepayment option under a
make-whole provision will not be exercisable
during an initial lock-out period. (For example,
Private Entity A borrows from Insurance Entity B
under a 10-year loan with fixed periodic coupon
payments. The spread over the Treasury rate for
Entity A at issuance of the debt is 275 basis
points. The loan agreement contains a make-whole
provision that if Entity A prepays the debt, it
will pay Insurance Entity B an amount equal to all
the future contractual cash flows discounted at
the current Treasury rate plus 50 basis
points.)”
|
No. “Fixed-rate debt instruments that include
this type of make-whole provision . . . are not
considered prepayable . . . because [the
provision] involves settlement of the entire
contract by the debtor before its stated maturity
at an amount greater than (rather than an amount
less than) the then fair value of the contract.”
See the Connecting the Dots discussion
below.
|
Debt instrument 5 — “Some variable-rate
debt instruments include a call option that
permits the debtor to repurchase the debt
instrument from the creditor at each interest
reset date at an amount equal to par.”
|
Yes. Generally speaking, the terms of
variable-rate debt instruments refer to a
contractually specified interest rate but have a
fixed spread to that rate that represents the
issuance-date credit spread. “Because the reset
provisions typically do not adjust the variable
interest rate for changes in credit sector spreads
and changes in the debtor’s creditworthiness, the
variable-rate debt instrument’s par amount could
seldom be expected to be equal to its fair value
at each reset date.”
|
Debt instrument 6 — “Some fixed-rate
debt instruments include both a call option as
described in . . . debt instrument 1 and a
contingent acceleration clause as described in . .
. debt instrument 2.”
|
Yes. Even though the contingent acceleration
clause described in debt instrument 2 does not
cause the instrument to be considered prepayable,
the call option described in debt instrument 1
does.
|
Debt instrument 7 — “Some debt
instruments contain an investor protection clause
(which is standard in substantially all debt
issued in Europe) that provides that, in the event
of a change in tax law that would subject the
investor to additional incremental taxation by tax
jurisdictions other than those entitled to tax the
investor at the time of debt issuance, the coupon
interest rate of the debt increases so that the
investor’s yield, net of the incremental taxation
effect, is equal to the investor’s yield before
the tax law change. The debt issuance also
contains an issuer protection clause (which is
standard in substantially all debt issued in
Europe) that provides that, in the event of a tax
law change that triggers an increase in the coupon
interest rate, the issuer has the right to call
the debt obligation at par. There would be no
market for the debt were it not for the prepayment
and interest rate adjustment clauses that protect
the issuer and investors.”
|
No, provided that, at the inception of the
debt, it is not probable that the prepayment
option will be triggered. As indicated in ASC
815-20-25-113(c), the prepayment feature in debt
instrument 7 does not make the debt prepayable
under the shortcut method criteria because:
Note that the example in DIG Issue E6 did not
include the fact that it is not probable at the
time of issuance that the prepayment option will
be triggered, but we believe it is implicit in the
example.
|
Connecting the Dots
Many corporate debt agreements contain
make-whole provisions such as those outlined in debt
instrument 4 above. The description of debt instrument 4
includes an example in which (1) upon a prepayment, the
debtor must repay an amount of cash flows equal to all the
future contractual cash flows discounted at the current
Treasury rate plus 50 basis points and (2) the entity’s
credit spread to the Treasury rate at issuance was 275 basis
points. In Issue E6, the DIG concluded that this prepayment
clause would not cause the debt to
be considered prepayable because the amount paid upon early
settlement would always exceed the debt’s fair value. While
it may be unlikely that the entity’s credit spread would
decrease to 50 basis points above the Treasury rate, it is
not impossible. Accordingly, the logic in this exception is
flawed. We have had multiple discussions with the FASB staff
regarding this issue. In our latest discussion, the staff
indicated that it would recommend that the Board address
this inconsistency by (1) removing the example in debt
instrument 4 as part of the FASB’s annual improvements and
technical correction process and (2) providing appropriate
transition for entities that had previously concluded that
their debt instrument was not prepayable on the basis of the
conclusion in debt instrument 4.
We believe that when applying the shortcut
method, an entity may conclude that a debt instrument with a
make-whole provision similar to the one in debt instrument 4
is not prepayable. This conclusion would be appropriate as
long as there is only a remote likelihood that the debtor’s
credit spread will decline below the spread in the
make-whole redemption calculation. Stay tuned for further
developments.
When an entity designates a partial-term hedge (either a fair value
or cash flow hedge), its analysis of whether the debt is prepayable
in the assessment of shortcut method eligibility should take into
account only those terms that are operable during the designated
term of the hedging relationship. For example, assume that the
entity wants to hedge a 10-year fixed-rate debt instrument that (1)
is callable by the issuer at any time after the five-year
anniversary and (2) has no other prepayment features. If the entity
designates as the hedging instrument an interest rate swap that
matures in five years and identifies the hedged item as the first
five years of interest payments (see Section
2.2.2.1.1.2), the debt would not be considered
prepayable in the analysis of shortcut method eligibility. This is
because the call option cannot be exercised during the designated
term of the hedge. The analysis of prepayment features in the debt
should cover the entire period represented by the hedged interest
payments.
Now that we have
discussed how to determine when a prepayment feature in a debt
instrument needs to be mirrored in the interest rate swap to qualify
for the shortcut method, we will explain how to mirror the terms in
the swap. As indicated in ASC 815-20-25-104(e)(2), the prepayment
features are considered to be mirrored if there is an exact match of
the terms of the prepayment options. including all of the following
features:
- Maturities.
- Strike price. If the amount for which the debt could be called is at a premium or discount to the face amount of the debt, the swap must have a termination payment that is equal to that premium or discount.
- Related notional amounts.
- Timing and frequency of payments.
- Dates on which the instruments may be prepaid.
In addition, the entity must be the writer of one option and the
holder (purchaser) of the other option.
Example 2-27
Shortcut Method With a Balance Guarantee
Swap
Insurance Company X owns a fixed-rate MBS that
it classifies as AFS. It enters into a
receive-variable, pay-fixed interest rate swap
whose notional amount declines in proportion to
the declines in the contractual principal of the
MBS.
Such a swap is considered a balance guarantee
swap because its notional amount is tied to a
reference asset (or pool of assets). Since the
referenced asset (or assets) and the designated
hedged item are the same, the balance guarantee
swap satisfies the mirrored call option criterion
of the shortcut method. In accordance with ASC
815-20-25-104, the balance guarantee is a mirror
purchased call option that offsets the mirror
written call option that is embedded in a typical
MBS.
There are typically not any other features in
an MBS that would otherwise prevent a hedging
relationship from qualifying for the shortcut
method; however, each security should be evaluated
separately. We do not believe that this would
violate the condition that all settlements must be
calculated in the same manner (see
Section 2.5.2.2.1.4) because
ASC 815-25-104(d) only requires the rates used for
each leg in every settlement to be consistent.
2.5.2.2.1.4 All Settlements Are Calculated the Same Way
ASC 815-20
25-104 All of
the following conditions apply to both fair value
hedges and cash flow hedges: . . .
d. The
formula for computing net settlements under the
interest rate swap is the same for each net
settlement. That is, both of the following
conditions are met:
- The fixed rate is the same throughout the term.
- The variable rate is based on the same index and includes the same constant adjustment or no adjustment. The existence of a stub period and stub rate is not a violation of the criterion in (d) that would preclude application of the shortcut method if the stub rate is the variable rate that corresponds to the length of the stub period. . . .
The shortcut method was developed to reduce the complexity of
applying the hedge accounting model when entities want to use
plain-vanilla interest rate swaps to hedge typical debt instruments
for interest rate risk. In a typical interest rate swap, the
settlement formula does not change during the life of the swap. In
other words, the swap has the same indexed rate with a fixed (or no)
basis adjustment on its variable leg and the same fixed rate on its
fixed leg throughout its life. However, if the swap agreement calls
for a change in the payment terms from one period to the next, the
change in terms (i.e., moving partial payments from one period to
the other) would essentially represent an embedded financing
component in the swap, which would be inconsistent with the notion
that a hedging relationship is perfectly effective and that no hedge
effectiveness assessments are required. Therefore, a hedging
relationship with a swap whose payment terms change during the swap
term would not qualify for application of the shortcut method.
The existence of a stub period and a stub rate would not violate the
criterion in ASC 815-20-25-104(d) as long as the stub rate is the
variable rate that corresponds to the length of the stub period. For
example, assume that (1) an entity issues fixed-rate debt with a
term of 10 years and three months, (2) interest is due semiannually
through the first 10 years, and (3) at maturity, the issuer must pay
three months of interest and the principal amount. If the entity
wants to hedge its interest rate risk for the entire term of the
debt and apply the shortcut method, it should use a swap that is
repriced and settled on each payment date. In such a case, all of
the semiannual periods covered by the swap would be repriced on the
basis of six-month benchmark rates; however, the repricing for the
final stub period should be based on the three-month benchmark rates
(the variable rate that corresponds to the length of the final stub
period).
Example 2-28
Shortcut Method Not Appropriate for
Hedging Choose-Your-Rate Debt
Entity C issues variable-rate debt that gives
it the option of performing interest rate
repricings on the basis of several different
interest rate tenors or indexes — one- or
three-month LIBOR, the three-month U.S. Treasury
rate, or the prime rate. Debt with this feature is
commonly referred to as either “you-pick-‘em” or
“choose-your-rate” debt. To hedge the interest
payments on the debt, C enters into a swap that
mirrors the rate options provided by the debt.
Even though the rate optionality is mirrored in
the swap, C cannot apply the shortcut method to
its hedge of interest payments on the
choose-your-rate debt. A swap with a variable leg
that has more than one potential rate would not
meet the condition in ASC 815-20-25-104(d)(2) that
the “variable rate is based on the same index and
includes the same constant adjustment or no
adjustment.”
Note that a more common
hedging strategy involves entering into a
plain-vanilla interest rate swap whose variable
leg is indexed to one of the rate options in the
swap (e.g., three-month LIBOR). If the optionality
in the variable leg of the swap does not match the
optionality in the debt, the hedging relationship
would not qualify for the shortcut method under
ASC 815-20-25-104(g) because the debt contains an
optionality feature that is not mirrored in the
swap, which invalidates an assumption of perfect
effectiveness. (See the next section for further
discussion of ASC 815-20-25-104(g) and
Section 4.2.1.1.2 for a more
detailed discussion of hedging choose-your-rate
debt.)
2.5.2.2.1.5 Terms Are Typical
ASC 815-20
25-104 All of the following
conditions apply to both fair value hedges and
cash flow hedges: . . .
g. Any other terms in the
interest-bearing financial instruments or interest
rate swaps meet both of the following conditions:
- The terms are typical of those instruments.
- The terms do not invalidate the assumption of perfect effectiveness.
ASC 815-20-25-104(g) is commonly referred to as a “catch-all”
criterion that prevents any hedges from qualifying for the shortcut
method other than plain-vanilla hedging relationships in which
“typical” interest rate swaps hedge the interest rate risk of
“typical” debt. This criterion can be difficult to interpret because
what is “typical” in accordance with ASC 815-20-25-104(g)(1) can
change over time as market conventions evolve. Note that the
shortcut method (1) allows an entity to assume that a hedging
relationship is perfectly effective without having to perform any
quantitative assessments of hedge effectiveness and (2) simplifies
financial reporting. Consequently, in the evaluation of the criteria
for the shortcut method, the determination of whether the catch-all
provision has been satisfied should not be viewed as a simple
check-the-box process. If either the swap or the debt is highly
structured, the hedging relationship is not likely to meet this
condition and therefore would not qualify for the shortcut
method.
Example 2-29
Shortcut Method Not Appropriate for Debt
With Interest Deferral Option
Entity Y issues fixed-rate debt with a
provision that gives the issuer the option to
defer making interest payments if the issuer has
net income of $0 or less over a period of two
quarters. In such circumstances, the deferred
interest payments are accrued and added to the
principal of the debt.
To hedge the interest payments on its
fixed-rate debt, Y designates as the hedging
instrument a compound derivative composed of an
interest rate swap and an option that is the
mirror image of the option embedded in the
fixed-rate date (i.e., the hedged item). Entity Y
cannot apply shortcut accounting to the hedging
relationship because the hedged item contains a
provision that gives the issuer the option to
defer making interest payments on the debt.
During informal discussions, the SEC staff has
expressed its belief that only embedded options
that are explicitly discussed in ASC
815-20-25-104(e) and ASC 815-20-25-106(c) can be
mirrored in a hedged interest rate swap under the
shortcut accounting requirements of ASC 815. An
interest deferral option is not a term that is
“typical” in a debt arrangement, and it also would
not be typical in an interest rate swap. If a
hedging relationship includes other embedded
options, even if mirrored in the hedging interest
rate swap, use of the shortcut method is
precluded. Staff members from the SEC’s Division
of Corporation Finance also have taken the same
position and asserted that the shortcut method
cannot be applied to hedges of trust-preferred
securities, even if the interest deferral feature
of the security is mirrored in the hedging
interest rate swap.
However, if an interest deferral option is only
exercisable after a certain period and an entity
elects to designate partial-term hedges of
interest rate risk under ASC 815-25-35-13B, the
hedging relationship may qualify for shortcut
accounting if the assumed maturity of the hedged
item does not exceed the nonexercisable
period.
Note that securities that contain these types
of features (or provisions in which the issuer can
defer making interest payments at its discretion)
include those issued by sponsors of trust
preferred security arrangements, such as monthly
income preferred securities, quarterly income
preferred securities, and trust-originated
preferred securities and enhanced capital
advantaged preferred securities. These securities
are particularly advantageous for banks because
the Federal Reserve Board allows bank holding
companies to include qualifying issues as part of
their “tier 1 capital” for regulatory capital
purposes, subject to certain limitations.
Example 2-30
Shortcut Method for Late-Term Hedges
Entity X enters into an interest rate swap to
hedge interest rate risk in preexisting debt
(i.e., a late-term hedge). Since the debt is
fixed-rate debt, it is highly unlikely that the
benchmark interest rate at the inception of the
hedging relationship will be the same as it was on
the debt’s issuance date. Accordingly, the debt’s
fair value will not be equal to its face amount,
even if credit spreads were held constant since
issuance.
We believe that in such a
case, X could still apply the shortcut method to
the hedging relationship if the criteria for its
application are met. The application of the
shortcut method to late-term hedges was addressed
when DIG Issue E23 was being discussed in 2008. At
that time, the FASB proposed the following
clarification of paragraph 68(e) of Statement
133:12
Any other terms in the
interest-bearing financial instruments or interest
rate swaps are both typical of those instruments
and do not invalidate the assumption of no
ineffectiveness. That is, the terms of the
interest rate swap and the interest-bearing
financial instrument must both:
- Be typical for those instruments; and
- Not invalidate the assumption of no ineffectiveness
For example, in a fair value
hedging relationship the fair value of the hedged
item must equal its par value at inception of the
hedging relationship because the amortization of
the initial difference (a discount or premium)
would create ineffectiveness. However, an
exception to this principle exists, as follows: A
difference between fair value and par value of the
hedged item would not invalidate the assumption of
no ineffectiveness if the difference is a discount
or premium attributable solely to the market
convention of rounding the coupon rate of the
hedged item at issuance.
This clarification would have precluded
application of the shortcut method in a late-term
fair value hedge. However, the clarification was
not finalized when the FASB issued DIG Issue E23.
In addition, the Alternative Views section of
proposed DIG Issue E23 stated:
Three Board members dissented to the issuance of this proposed Implementation Issue. Those Board members generally support the conclusions reached in this proposed Implementation Issue but disagree with the conclusion that a condition of the shortcut method is that the fair value of the hedged item has to equal its principal amount (which disqualifies hedge transactions that are entered into after the initial issuance or purchase of the debt instrument). Those Board members believe that Statement 133 does not currently include this requirement, and they do not support amending Statement 133 to add such a
requirement.
Paragraph 68 enumerates the requirements for
the shortcut method. Paragraph 68(a) states: “The
notional amount of the swap matches the principal
amount of the interest-bearing asset or liability
being hedged.” Paragraph 68(b) imposes an
additional requirement for the swap — its fair
value must equal zero at inception. No other
condition states that the fair value of the hedged
item must equal its principal amount.
Paragraph 114 sets forth the computational
steps in the shortcut method for a fair value
hedge. Subparagraph (c) states:
Compute and
recognize interest expense using that combined
rate and the fixed-rate liability’s principal
amount. (Amortization of any purchase premium or
discount on the liability also must be considered,
although that complication is not incorporated in
this example.)
The table following that guidance also states
that the trade date of the swap and the borrowing
date of the debt “need not match for the
assumption of no ineffectiveness to be
appropriate.” Those Board members believe this
guidance explicitly permits the hedged item to
have a purchase premium or discount and still
qualify for the shortcut method. Therefore, those
Board members reject the suggestion that paragraph
68(e) implicitly requires that the fair value of
the hedged item equal its principal amount.
Those Board members also observe that [DIG
Issue E10], “Application of the Shortcut Method to
Hedges of a Portion of an Interest-Bearing Asset
or Liability (or Its Related Interest) or a
Portfolio of Similar Interest-Bearing Assets or
Liabilities,” refers to either the principal
amount or the notional amount of the hedged item.
It does not mention the fair value of the hedged
item. Likewise, [DIG Issue E15], concludes the
shortcut method would generally not be permitted
because the fair value of the swap is unlikely to
be zero at the date of the acquisition. The
guidance does not mention that the fair value of
the hedged items would not likely equal their
principal or notional amounts.
Those Board members would not amend Statement
133 to impose this new requirement. They believe
that changes in the fair value of a debt
instrument prior to the hedge transaction do not
distort the effectiveness of the hedging
relationship going forward, provided that the
terms of the swap match the remaining terms of the
debt. In that case, it is still reasonable to
assume that changes in the fair value of the swap
will be highly effective in offsetting subsequent
changes in the fair value of the debt attributable
solely to subsequent changes in the benchmark
interest rate. Other accounting standards would
govern the recognition in earnings of any premium
or discount on the hedged item prior to the
inception of the hedge. That element does not
represent ineffectiveness in the current hedging
transaction. Those Board members observe that the
same economic phenomenon exists in the issues
involving differences between the fair value of
the hedged item and the principal amount due to
differences in the trade date of the derivative
and settlement date of the debt, or due to a
rounding down of the coupon at issuance (that is,
the fair value of the hedged item might be
different from its principal amount). The Board
appropriately decided to permit the shortcut
method in those cases albeit primarily on the
basis of the expected insignificance of the
premiums and discounts and also because of
prevalent market conventions relating to the
hedged items.
We believe that the statements from the
dissenting FASB members, along with the fact that
proposed DIG Issue E23 contained transition
provisions (i.e., previous applications of the
shortcut method in late-term fair value hedges
would not have been considered errors), make it
clear that the requirements for shortcut method
eligibility do not include a condition that the
fair value of the hedged item must equal its par
amount on the date on which hedge accounting is
applied. Although the FASB had proposed such a
requirement, it was not ultimately included in DIG
Issue E23; therefore, the shortcut method can
still be applied in a fair value hedge that is
designated after the inception of the hedged item.
In other words, since the amendment to ASC 815 was
not finalized as proposed, it is reasonable to
conclude that the shortcut method is not
prohibited in a late-term fair value hedge.
Example 2-31
Shortcut
Method When Fixed Rate on Swap Does Not Match
Fixed Rate on Debt
Entity A enters into a swap to hedge the
interest payments on its fixed-rate debt. Although
the rate on the fixed leg of the swap does not
match the fixed rate on the debt, A can apply the
shortcut method to the hedging relationship as
long as all of the other criteria for its
application are met.
ASC 815-20-25-109 explicitly
allows the shortcut method to be applied in a fair
value hedging relationship in which the fixed rate
on the swap does not match that on the hedged
debt. However, the interest rate swap must have a
fair value of zero at inception (aside from the
exceptions noted in Section
2.5.2.2.1.2). If the fixed leg of the
swap is set to equal the fixed rate on the debt,
the variable leg of the swap must have a fixed
adjustment to ensure that the swap has a fair
value of zero at inception. This would result in
no change in net settlements.
In addition, the variable rate on the swap does
not need to match the interest rate on the
variable-rate debt for an entity to apply the
shortcut method in a cash flow hedging
relationship. The contractually specified interest
rate index must match; however, for the reasons
discussed above, there is no need to match up any
existing fixed credit spread on the debt.
Example 2-32
Shortcut Method Not Appropriate for
Forward-Starting Swaps
Entity Y enters into a
forward-starting swap to hedge interest rate risk
and would like to apply the shortcut method to the
hedging relationship. While hedge accounting is
not prohibited for interest rate hedging
strategies that involve forward-starting swaps,
the shortcut method is not appropriate for such
strategies, although views differ on which
shortcut method criterion would not be satisfied.
Some believe that the condition in ASC
815-20-25-104(d) would not be met because not all
of the net settlements are calculated the same way
(see Section 2.5.2.2.1.4).
Another view is that a forward-starting swap is
not a “typical” swap and that the shortcut method
is limited to plain-vanilla swaps under ASC
815-20-25-104(g) (see Section
2.5.2.2.1.5). In addition, ASC
815-20-25-102 states that “[i]f all of the
applicable conditions in the list in paragraph
815-20-25-104 are met, an entity may assume
perfect effectiveness in a hedging relationship of
interest rate risk involving a recognized
interest-bearing asset or liability (or a firm
commitment arising on the trade [pricing] date to
purchase or issue an interest-bearing asset or
liability) and an interest rate swap (or a
compound hedging instrument composed of an
interest rate swap and a mirror-image call or put
option as discussed in paragraph
815-20-25-104[e]).” A forward-starting swap is a
compound hedging instrument composed of an
interest rate swap and a forward, not a “compound
hedging instrument composed of an interest rate
swap and a mirror-image call or put option.”
We understand that in response to questions
from stakeholders, the FASB staff has indicated
that it would be inappropriate to apply the
shortcut method to a hedging relationship that
involves a forward-starting swap.
2.5.2.2.1.6 Fair Value Hedge — Requirements for Swap Terms
ASC 815-20
25-105 All of
the following incremental conditions apply to fair
value hedges only:
a. The expiration date of the interest rate
swap matches the maturity date of the
interest-bearing asset or liability or the assumed
maturity date if the hedged item is measured in
accordance with paragraph 815-25-35-13B.
b. There is no floor or cap on the variable
interest rate of the interest rate swap.
c. The interval between repricings of the
variable interest rate in the interest rate swap
is frequent enough to justify an assumption that
the variable payment or receipt is at a market
rate (generally three to six months or less). . .
.
f. The index on which the variable leg of the
interest rate swap is based matches the benchmark
interest rate designated as the interest rate risk
being hedged for that hedging relationship.
For a hedge of the interest rate risk related to fixed-rate debt to
be eligible for application of the shortcut method, the hedge must
meet all of the conditions discussed in Sections
2.5.2.2.1.1 through 2.5.2.2.1.5 as well as the
following:
- The expiration date of the swap must match either the actual maturity of the debt or, in the case of a partial-term hedge, the assumed maturity of the debt.
- The variable leg on the swap must be indexed to the designated benchmark interest rate.
- The variable leg on the swap cannot have a cap or floor.
- The swap must be repriced frequently enough to justify an assumption that the rate is at-market.
An interest rate swap and a debt instrument with different maturities
would not be expected to react to changes in interest rates
similarly, which would invalidate an assumption of perfect hedge
effectiveness. Therefore, the expiration date of a swap must match
the actual maturity date of the debt unless a partial-term hedging
strategy is employed.
Before the issuance of ASU 2017-12, an entity could not apply the
shortcut method to a partial-term fair value hedge. In fact, such a
hedge was unlikely to be eligible for hedge accounting because of
the potentially significant ineffectiveness. However, under ASC
815-25-35-13B, which was added by ASU 2017-12, if an entity hedges
selected cash flows of an existing debt instrument, it can measure
the change in fair value that is attributable to changes in interest
rates by using an assumed maturity that occurs on the date on which
the last hedged cash flow is due and payable. In addition, ASC
815-20-25-105(a) was amended to explicitly allow a partial-term fair
value hedge to qualify for the shortcut method, provided that the
other conditions for the shortcut method are also met. See further
discussion of partial-term hedges in Section
3.2.1.1. Note that partial-term cash flow hedges
already qualified for the shortcut method before the issuance of ASU
2017-12.
In addition, for an entity to assume that a hedge is perfectly
effective, the terms of the variable leg of the swap must (1) match
the designated benchmark interest rate, (2) not incorporate caps or
floors, and (3) be repriced often enough that the rate at any given
time is close to a market rate. In practice, this means that the
swap must be repriced at least every six months. Note that the
timing of the repricing and settlements of the swap does not need to
match the timing of coupon payments on the fixed-rate debt.
2.5.2.2.1.7 Cash Flow Hedge — Requirements for Swap Terms
ASC 815-20
25-106 All of
the following incremental conditions apply to cash
flow hedges only:
a. All interest receipts
or payments on the variable-rate asset or
liability during the term of the interest rate
swap are designated as hedged.
b. No interest payments
beyond the term of the interest rate swap are
designated as hedged.
c. Either of the following
conditions is met:
- There is no floor or cap on the variable interest rate of the interest rate swap.
- The variable-rate asset or liability has a floor or cap and the interest rate swap has a floor or cap on the variable interest rate that is comparable to the floor or cap on the variable-rate asset or liability. For purposes of this paragraph, comparable does not necessarily mean equal. For example, if an interest rate swap’s variable rate is based on LIBOR and an asset’s variable rate is LIBOR plus 2 percent, a 10 percent cap on the interest rate swap would be comparable to a 12 percent cap on the asset.
d. The repricing dates of
the variable-rate asset or liability and the
hedging instrument must occur on the same dates
and be calculated the same way (that is, both
shall be either prospective or retrospective). If
the repricing dates of the hedged item occur on
the same dates as the repricing dates of the
hedging instrument but the repricing calculation
for the hedged item is prospective whereas the
repricing calculation for the hedging instrument
is retrospective, those repricing dates do not
match. . . .
g. The index on which the
variable leg of the interest rate swap is based
matches the contractually specified interest rate
designated as the interest rate being hedged for
that hedging relationship.
For a hedge of the interest rate risk related to
variable-rate debt to be eligible for application of the shortcut
method, the hedge must meet all of the conditions discussed in
Sections 2.5.2.2.1.1 through
2.5.2.2.1.5 as well as the following:
- The term of the hedged interest payments
match the term of the swap, which means:
- No debt interest payments are excluded during the term of the swap.
- No debt interest payments beyond the term of the swap are identified as hedged.
- The variable leg on the swap mirrors the
interest rate reset features of the debt (ignoring fixed
credit spreads), which means:
- The designated contractually specified interest rate in the debt is the same as the interest rate index of the variable leg of the swap (e.g., three-month LIBOR).
- The repricing dates and calculation of the variable-rate debt and the swap match (frequency, prospective vs. retrospective rate).
- Any floors or caps on the variable rate are the same in both the debt and the swap.
It is not necessary for an entity to hedge all of the interest
payments on variable-rate debt to qualify for the shortcut method;
however, an entity cannot use a forward-starting swap in a
qualifying shortcut method hedge (see Example
2-32).
Example 2-33
Applicability of Shortcut Method to
Hedging Nonbenchmark Interest Payments on
Variable-Rate Debt
Entity B enters into an interest rate swap and
designates a cash flow hedge of its variable-rate
debt. Although the variable leg of the interest
rate swap is not a benchmark interest rate, the
interest rate index in the debt and the swap
match. Therefore, Entity B may apply the shortcut
method.
ASU 2017-12 eliminated the concept of benchmark
interest rates from the guidance on hedging
variable-rate debt instruments in cash flow
hedges. As a result, under ASC 815-20-25-106(g),
such a hedge would qualify for application of the
shortcut method (and a qualitative assumption of
perfect effectiveness) as long as all of the other
shortcut method criteria were met. ASC
815-20-25-106(g) requires that the “index on which
the variable leg of the interest rate swap is
based matches the contractually specified interest
rate designated as the interest rate being hedged
for that hedging relationship.”
2.5.2.2.1.8 Credit Risk — Nonperformance Risk
ASC 815-20
25-103 Implicit in the
conditions for the shortcut method is the
requirement that a basis exist for concluding on
an ongoing basis that the hedging relationship is
expected to be highly effective in achieving
offsetting changes in fair values or cash flows.
In applying the shortcut method, an entity shall
consider the likelihood of the counterparty’s
compliance with the contractual terms of the
hedging derivative that require the counterparty
to make payments to the entity.
25-111 Comparable credit risk
at inception is not a condition for assuming
perfect effectiveness even though actually
achieving perfect offset would require that the
same discount rate be used to determine the fair
value of the swap and of the hedged item or hedged
transaction. To justify using the same discount
rate, the credit risk related to both parties to
the swap as well as to the debtor on the hedged
interest-bearing asset (in a fair value hedge) or
the variable-rate asset on which the interest
payments are hedged (in a cash flow hedge) would
have to be the same. However, because that
complication is caused by the interaction of
interest rate risk and credit risk, which are not
easily separable, comparable creditworthiness is
not considered a necessary condition for assuming
perfect effectiveness in a hedge of interest rate
risk.
The shortcut method allows an entity to qualitatively assess hedge
effectiveness without recognizing ineffectiveness in the income
statement. If a cash flow hedge is highly effective, all changes in
fair value are already initially recorded in OCI. While
ineffectiveness is not separately tracked and reported for a highly
effective fair value hedge (see Chapter 3 for
further discussion), any differences between the changes in the
derivative’s fair value and changes in the hedged item’s fair value
that are attributable to changes in the designated risk will affect
the income statement. However, if the shortcut method is applied,
entities may recognize an adjustment to the basis of the hedged debt
that is equal to the changes in the derivative’s fair value. In that
sense, the shortcut method is a simplified way of measuring changes
in the debt’s fair value that are attributable to changes in the
designated benchmark interest rate.
A hedge of a debt instrument’s interest rate risk already excludes
credit risk from the hedging relationship, which means that changes
in the debt issuer’s creditworthiness are not directly considered.
However, under the cash flow hedging model, it must be probable that
the hedged transaction will occur. Accordingly, for variable-rate
debt to qualify for the application of hedge accounting, it must be
probable that the interest payments (i.e., the hedged item) will
occur; therefore, the hedging entity must be able to continually
assert that it is probable that the hedged interest payments will be
made. If the entity is hedging its own debt, it must assess its own
performance risk. If the entity is hedging an asset, it must assess
whether it is probable that the issuer or borrower will continue to
make the payments being hedged. The entity must discontinue the use
of hedge accounting, even under the shortcut method, if the entity
concludes that it is no longer probable that hedged payments will be
made on the debt instrument (see Section 4.1.5
for further discussion of discontinued cash flow hedges).
Although the creditworthiness of both parties to the derivative
contract must also be monitored when the shortcut method is applied,
the only real purpose of such monitoring is to assess the
probability of default. ASC 815-20-25-111 acknowledges that
“[c]omparable credit risk at inception is not a condition for
assuming perfect effectiveness even though actually achieving
perfect offset would require that the same discount rate be used to
determine the fair value of the swap and of the hedged item or
hedged transaction.” However, ASC 815-20-25-103 does note that “an
entity shall consider the likelihood of the counterparty’s
compliance with the contractual terms of the hedging derivative that
require the counterparty to make payments to the entity.” While an
entity is only explicitly required to consider the performance risk
of the counterparty to the derivative, if either party to the
hedging interest rate swap experiences a significant decline in its
creditworthiness, that party’s ability to comply with the
contractual provisions of the arrangement may be called into
question. Consequently, the entity may be unable to assert that the
hedging relationship is expected to be highly effective (i.e.,
because it is questionable whether either party to the arrangement
will be able to fulfill its contractual obligations under the
arrangement).
If there is a deterioration in the creditworthiness of either the
entity itself or a counterparty, the impact on a hedging
relationship that qualifies for the shortcut method depends on (1)
the severity of the deterioration and (2) the likelihood of
performance by both parties to the derivative. An expectation of
“offset” is a prerequisite for all hedging relationships, and the
effects of credit are a required element of that consideration.
ASC 815-20-35-18 notes:
Paragraph 815-20-25-103 states that, in
applying the shortcut method, an entity shall consider the
likelihood of the counterparty’s compliance with the contractual
terms of the hedging derivative that require the counterparty to
make payments to the entity. That paragraph explains that
implicit in the criteria for the shortcut method is the
requirement that a basis exist for concluding on an ongoing
basis that the hedging relationship is expected to be highly
effective in achieving offsetting changes in fair values or cash
flows.
Even if there is a deterioration in the creditworthiness of one of
the parties to the interest rate swap, an entity may still be able
to conclude that (1) it is probable that each counterparty will
perform in accordance with the contractual provisions of the
arrangement and (2) the hedging relationship continues to satisfy
all of the requirements of the shortcut method. ASC 815 is clear
that in such a case, the changes in creditworthiness that affect the
fair value of the interest rate swap will not be recognized in
income as hedge ineffectiveness.
ASC 815-20-35-18 addresses considerations of creditworthiness in the
context of hedge effectiveness. Note that it does not change the
overall guidance on measuring the fair value of the hedging
derivative, such as the requirement that the change in the hedging
instrument’s fair value include adjustments for nonperformance risk
(as the term is defined in ASC 820).
2.5.2.2.1.9 Backup Quantitative Assessment
Some entities have applied the shortcut method to ineligible hedging
relationships and subsequently needed to issue restatements, which
has been a topic of public discussion. In fact, at the 2005 AICPA
Conference on Current SEC and PCAOB Developments, an SEC staff
member shared the staff’s view on the consequences of
inappropriately applying the shortcut method:
[O]ne of the more
frequent questions that we have been asked relates to the
quantification of errors that arose from an inappropriate
application of the shortcut method. Some believe that the amount
of the error should be measured as the ineffectiveness that
would have been recognized under other hedge accounting methods.
The staff has often objected to this approach for quantification
of errors for these hedging relationships because it assumes
that the error only concerned the measurement of ineffectiveness
and that the requirements for hedge accounting were still met.
As I stated earlier, one of the general hedge accounting
requirements is prospective and retrospective testing of hedge
effectiveness. If a company has been relying on the application
of the shortcut method, these tests may very well not have been
performed. As such, the provisions to allow hedge accounting
under other methods may not have been complied with. Thus, if
the shortcut method has been applied inappropriately, it may be
that the error needs to be quantified as if hedge accounting was
not applied in those periods.
According to the SEC staff, when an entity is assessing the
materiality of an error that resulted from inappropriately applying
the shortcut method, it is not acceptable to quantify the error as
the amount of ineffectiveness that would have been recognized under
a long-haul method unless the hedging relationship also meets all of
the other criteria for long-haul hedge accounting in ASC 815 (e.g.,
prospective and retrospective testing of hedge effectiveness). If
the hedging relationship had not complied with the long-haul
criteria since the hedge’s inception, the error to be evaluated
would be the difference between (1) the recorded amounts that
resulted from applying the shortcut method and (2) the amounts that
would have been reported if hedge accounting had not been used
(i.e., if the derivative had been marked to fair value through
earnings since inception). When evaluating an error related to fair
value hedges, the entity must also consider the amount of the
reversal of the basis adjustments that were made to the hedged item.
The shortcut method provides an exception to the overriding principle
that an entity can only apply hedge accounting if it can (1)
quantitatively establish, at inception, an expectation that the
hedging relationship will be highly effective and then (2)
continuously reassess the effectiveness both prospectively and
retrospectively on an ongoing basis. If the rigorous conditions for
eligibility are met and the shortcut method is applied, the
effectiveness assessment will be qualitative and the financial
reporting will also be simplified.
Because the shortcut method is an exception to the overall principles
of hedge accounting, its application is rules-based. If any
condition for shortcut eligibility is not met exactly, application
of the shortcut method is inappropriate, and entities’ failure to
comply explicitly with all of the criteria has led to many
restatements. In fact, the SEC staff has rejected the notion that
entities could qualify for the shortcut method by complying with
“the spirt” of its criteria. When deliberating ASU 2017-12, the FASB
considered the number of restatements and noted the following in the
Background Information and Basis for Conclusions:
To address the
restatements that had resulted from the application issues
associated with the shortcut method in practice, the Board
decided to ease application in instances in which an entity
determines that the shortcut method should not have been
applied, but the hedging relationship was and remains highly
effective.
Consequently, the Board amended ASC 815 to permit entities to use a
backup method of quantitatively assessing the effectiveness of a
hedging relationship in cases in which application of the shortcut
method was not or is no longer appropriate.
ASC 815-20
25-117A In the period in
which an entity determines that use of the
shortcut method was not or no longer is
appropriate, the entity may use a quantitative
method to assess hedge effectiveness and measure
hedge results without dedesignating the hedging
relationship if both of the following criteria are
met:
- The entity documented at hedge inception in accordance with paragraph 815-20-25-3(b)(2)(iv)(04) which quantitative method it would use to assess hedge effectiveness and measure hedge results if the shortcut method was not or no longer is appropriate during the life of the hedging relationship.
- The hedging relationship was highly effective on a prospective and retrospective basis in achieving offsetting changes in fair value or cash flows attributable to the hedged risk for the periods in which the shortcut method criteria were not met.
25-117B If the criterion in
paragraph 815-20-25-117A(a) is not met, the
hedging relationship shall be considered invalid
in the period in which the criteria for the
shortcut method were not met and in all subsequent
periods. If the criterion in paragraph
815-20-25-117A(a) is met, the hedging relationship
shall be considered invalid in all periods in
which the criterion in paragraph 815-20-25-117A(b)
is not met.
25-117C If an entity cannot
identify the date on which the shortcut criteria
ceased to be met, the entity shall perform the
quantitative assessment of effectiveness
documented at hedge inception for all periods
since hedge inception.
25-117D The terms of the
hedged item and hedging instrument used to assess
effectiveness, in accordance with paragraph
815-20-25-117A(b), shall be those existing as of
the date that the shortcut criteria ceased to be
met. For cash flow hedges, if the hypothetical
derivative method is used as a proxy for the
hedged item, the value of the hypothetical
derivative shall be set to zero as of hedge
inception.
With respect to the two criteria outlined in ASC 815-20-25-117A
above, there are three possible scenarios that could arise after an
entity determines that the shortcut method was not or is no longer
appropriate:
- Scenario A — The entity (1) appropriately documents at hedge inception the backup quantitative (or long-haul) method it would use to assess hedge effectiveness if it subsequently determines that it is not appropriate to apply the shortcut method and (2) later determines that the hedging relationship is highly effective both prospectively and retrospectively for the periods in which the shortcut method criteria were not met (i.e., the criteria in both ASC 815-20-25-117A(a) and (b) are met).
- Scenario B — The entity does not appropriately document at hedge inception its backup quantitative (or long-haul) method (i.e., the criterion in ASC 815-20-25-117A(a) is not met).
- Scenario C — The entity (1) appropriately documents at hedge inception its backup quantitative (or long-haul) method but (2) later determines that the hedging relationship is not highly effective on both a prospective and retrospective basis for the periods in which the shortcut method criteria are not met (i.e., the criterion in ASC 815-20-25-117A(a) is met, but the criterion in ASC 815-20-25-117A(b) is not met).
The impact of each scenario on the hedging relationship is described
below:
-
Scenario A — The entity used a backup quantitative hedge effectiveness assessment method that was documented at hedge inception and determined that the hedging relationship was highly effective both prospectively and retrospectively. Therefore, for a cash flow hedge, there would be no difference between how the hedging relationship would be accounted for under the long-haul method and how it would have been accounted for under the shortcut method. That is, even if an entity determines that a cash flow hedging relationship is not perfectly effective, the accounting for any mismatch between the change in the fair value of the hedging instrument and the change in the fair value or cash flows of the hedged item would be the same under both the long-haul and shortcut methods because all changes in the fair value of a derivative in a highly effective cash flow hedging relationship are initially recorded in OCI. Going forward, the entity would continue to use the documented quantitative method to assess hedge effectiveness (for both the prospective and retrospective hedge effectiveness assessments).For a fair value hedge, the entity would apply the guidance in ASC 250 on error corrections. The error to be evaluated would be the difference between (1) the recorded amounts that resulted from the application of the shortcut method and (2) the amounts that would have been recorded if the shortcut method had not been applied (i.e., the amounts that would have been recorded under the long-haul method). This is because for a fair value hedge, there may be a difference between the change in fair value of the derivative and the change in the fair value of the hedged item that is attributable to the hedged risk, which must be considered in the evaluation of the error (i.e., the basis adjustments made to the hedged item may need to be adjusted). Such an error could result in a restatement of prior period results.
-
Scenario B — The entity did not appropriately document at hedge inception its backup quantitative (or long-haul) method. Thus, the hedging relationship would be invalid for the periods in which the shortcut method criteria were not satisfied and all subsequent periods through the date of the analysis. The entity would apply the guidance in ASC 250 on error corrections; the error to be evaluated would be the difference between (1) the recorded amounts that resulted from the application of the shortcut method and (2) the amounts that would have been recorded if hedge accounting had not been applied (i.e., if the derivative had been marked to fair value through earnings since inception). When evaluating an error associated with a fair value hedge, an entity would also consider the reversal of the basis adjustments made to the hedged item during periods in which hedge accounting was not appropriate, which could lead to a restatement of prior-period results.
-
Scenario C — The entity used a backup quantitative hedge effectiveness assessment method that was documented at hedge inception and determined that the hedging relationship was not highly effective for one or more periods. Thus, the hedging relationship would be invalid for the period(s) in which the shortcut criteria were not satisfied. The entity would apply the guidance in ASC 250 on error corrections; for the period(s) in which the hedging relationship was not highly effective, the error to be evaluated would be the difference between (1) the recorded amounts that resulted from the application of the shortcut method and (2) the amounts that would have been recorded if hedge accounting had not been used in those periods (i.e., if the derivative had been marked to fair value through earnings during those periods). When evaluating an error associated with a fair value hedge, an entity would also consider the reversal of the basis adjustments made to the hedged item during periods in which hedge accounting was not appropriate.In addition, for fair value hedges, for any periods in which the shortcut criteria were not satisfied but the hedge was determined to be highly effective, there may be differences between (1) the change in the fair value of the derivative and (2) the change in the fair value of the hedged item that is attributable to the hedged risk. An entity must consider these differences when evaluating such an error (i.e., the entity may need to alter the basis adjustments it made to the hedged item when applying the shortcut method). Such consideration may lead to a restatement of prior-period results.Further, in accordance with ASC 815-20-25-117C, “[i]f an entity cannot identify the date on which the shortcut criteria ceased to be met, the entity shall perform the quantitative assessment of effectiveness documented at hedge inception for all periods since hedge inception.”Under ASC 815-20-25-117D, when an entity uses a documented backup quantitative method to assess hedge effectiveness, the terms of the hedging instrument and hedged item “shall be those existing as of the date that the shortcut criteria ceased to be met.” For cash flow hedges, if an entity uses the hypothetical-derivative method as a proxy for the hedged item in the hedge effectiveness assessments, “the value of the hypothetical derivative shall be set to zero as of hedge inception.”
In light of these scenarios, it would be prudent for an entity that
applies the shortcut method to specify a backup method for
quantitatively assessing the effectiveness of the hedging
relationship as part of the hedge designation documentation it
prepares at the inception of the relationship. By providing such
documentation, an entity would avoid scenario B above, in which the
error correction guidance in ASC 250 must be applied if the entity
determines that use of the shortcut method was not or no longer is
appropriate regardless of whether the hedging relationship was
highly effective.
2.5.2.2.2 Critical-Terms-Match Method
ASC 815-20
25-84 If the critical terms
of the hedging instrument and of the hedged item
or hedged forecasted transaction are the same, the
entity could conclude that changes in fair value
or cash flows attributable to the risk being
hedged are expected to completely offset at
inception and on an ongoing basis. For example, an
entity may assume that a hedge of a forecasted
purchase of a commodity with a forward contract
will be perfectly effective if all of the
following criteria are met:
- The forward contract is for purchase of the same quantity of the same commodity at the same time and location as the hedged forecasted purchase. Location differences do not need to be considered if an entity designates the variability in cash flows attributable to changes in a contractually specified component as the hedged risk and the requirements in paragraphs 815-20-25-22A through 25-22B are met.
- The fair value of the forward contract at inception is zero.
- Either of the following
criteria is met:
- The change in the discount or premium on the forward contract is excluded from the assessment of effectiveness pursuant to paragraphs 815-20-25-81 through 25-83.
- The change in expected cash flows on the forecasted transaction is based on the forward price for the commodity.
25-84A In a cash flow hedge
of a group of forecasted transactions in
accordance with paragraph 815-20-25-15(a)(2), an
entity may assume that the timing in which the
hedged transactions are expected to occur and the
maturity date of the hedging instrument match in
accordance with paragraph 815-20-25-84(a) if those
forecasted transactions occur and the derivative
matures within the same 31-day period or fiscal
month.
25-85 If all of the criteria
in paragraphs 815-20-25-84 through 25-84A are met,
an entity shall still perform and document an
assessment of hedge effectiveness at the inception
of the hedging relationship and, as discussed
beginning in paragraph 815-20-35-9, on an ongoing
basis throughout the hedge period. No quantitative
effectiveness assessment is required at hedge
inception if the criteria in paragraphs
815-20-25-84 through 25-84A are met (see paragraph
815-20-25-3(b)(2)(iv)(01)).
35-9 If, at inception, the
critical terms of the hedging instrument and the
hedged forecasted transaction are the same (see
paragraphs 815-20-25-84 through 25-84A), the
entity can conclude that changes in cash flows
attributable to the risk being hedged are expected
to be completely offset by the hedging derivative.
Therefore, subsequent assessments can be performed
by verifying and documenting whether the critical
terms of the hedging instrument and the forecasted
transaction have changed during the period in
review.
35-10 Because the assessment
of hedge effectiveness in a cash flow hedge
involves assessing the likelihood of the
counterparty’s compliance with the contractual
terms of the derivative instrument designated as
the hedging instrument, the entity must also
assess whether there have been adverse
developments regarding the risk of counterparty
default, particularly if the entity planned to
obtain its cash flows by liquidating the
derivative instrument at its fair value.
35-11 If there are no such
changes in the critical terms or adverse
developments regarding counterparty default, the
entity may conclude that the hedging relationship
is perfectly effective. In that case, the change
in fair value of the derivative instrument can be
viewed as a proxy for the present value of the
change in cash flows attributable to the risk
being hedged.
35-12 However, the entity
must assess whether the hedging relationship is
expected to continue to be highly effective using
a quantitative assessment method (either a
dollar-offset test or a statistical method such as
regression analysis) if any of the following
conditions exist:
- The critical terms of the hedging instrument or the hedged forecasted transaction have changed.
- There have been adverse developments regarding the risk of counterparty default.
When the critical terms of the hedging instrument and
the designated risk of the hedged item match, an entity may assume that
the hedge is perfect, at least at inception, and perform a qualitative
assessment of hedge effectiveness. The critical-terms-match method can
be applied to hedging relationships with forward and futures contracts
that hedge risks other than interest rate risk as well as to certain
option hedging strategies, depending on how the risk of the hedged item
is defined. ASC 815-20-25-84 states that the critical-terms-match method
applies to situations in which an “entity could conclude that changes in
fair value or cash flows attributable to the risk being hedged are
expected to completely offset at inception and on an ongoing basis.”
However, while it would appear that entities can use the
critical-terms-match method for both fair value and cash flow hedges, in
most cases, the critical-terms-match method is applied to cash flow
hedges of forecasted transactions. It is very rare to see a fair value
hedge in which all of the critical terms of a derivative match the
hedged item since there are usually some sources of ineffectiveness
(e.g., location differences, grade differences). See Section 5.2.1.1.1 for a discussion of
the application of the critical-terms-match method to a cross-currency
interest rate swap hedging foreign-currency-denominated debt.
An entity applies the critical-terms-match method if the terms of the
hedging instrument match the designated risk of the hedged item (except
for the timing of a group of forecasted transactions, as discussed
below). ASC 815-20-25-84 provides an example of a match in which a
forward contract hedges a forecasted purchase of a commodity under the
following circumstances:
- The forward and the forecasted purchase have the same:
- Notional (quantity).
- Underlying commodity.
- Time.
- Location (or contractually specified component).
- The forward contract has a fair value of zero at hedge inception.
- The hedge effectiveness assessment will be based on either:
- Changes in forward prices.
- Changes in spot prices (the forward points are excluded from the assessment).
ASU 2017-12 added ASC 815-20-25-84A to U.S. GAAP. Accordingly, an entity
is allowed to assume that the timing of a group of hedged transactions
and the maturity date of the hedging instrument match “if those
forecasted transactions occur and the derivative matures within the same
31-day period or fiscal month.” This “exception” can also be applied to
hedges with a purchased option if the assessment is based on changes in
the option’s terminal value (see Section
2.5.2.2.3).
Under the critical-terms-match method, an entity is required to have a
formal ongoing process for assessing whether the terms still match and
to identify a quantitative method that will be applied if they no longer
match. These requirements differ from those of the shortcut method,
discussed in Section 2.5.2.2.1, which is used for
hedges of the interest rate risk of an existing debt instrument with an
interest rate swap. Since the terms of the debt and swap are, by their
nature, fixed at the inception of the hedge, the only ongoing
requirement for an entity applying the shortcut method is to assess the
default risk of the debtor and of the counterparties to the swap (see
Section 2.5.2.2.1.8).
By contrast, the critical-terms-match method often
applies to scenarios in which the derivative hedges forecasted
transactions that are exposed to potential changes in terms (except for
all-in-one hedges in which the terms are firmly committed; see Section
4.1.1.3.2). Accordingly, an entity applying this method is
required to have an ongoing process for either confirming that the
critical terms still match or performing a quantitative assessment of
hedge effectiveness. In that sense, the critical-terms-match method is
really a hybrid of qualitative and quantitative assessment methods. In
fact, some would say that it is really a quantitative assessment model
overlaid with a qualitative expedient for periods in which (1) the
critical terms match and (2) there have been no adverse developments
regarding the default risk of any of the parties to the derivative or
the hedged transaction. For example, if an entity was using the
hypothetical-derivative method (see Section 2.5.2.1.2.4) to assess
hedge effectiveness and the critical terms of the derivative matched the
terms of the hedged item, the hypothetical derivative would have the
same terms as the actual derivative; therefore, the entity would not
need to perform the same fair value calculations twice.
Connecting the Dots
Even though ASC 815-20-25-85 states that “[n]o
quantitative effectiveness assessment is required at hedge
inception if the criteria in paragraphs 815-20-25-84 through
25-84A are met (see paragraph 815-20-25-3(b)(2)(iv)(01)),” we
believe that it would be a best practice for an entity to
document a quantitative method of hedge assessment as part of
its hedge designation documentation when it plans to use the
critical-terms-match method (see Section 2.6 for further
discussion of hedge designation requirements). ASC 815-20-35-12
clearly states that an entity would need to perform a
quantitative analysis if the critical terms no longer match or
if there have been adverse developments related to default risk.
Some may argue that it is implicit in the critical-terms-match
method that the fallback effectiveness assessment method would
be the hypothetical-derivative method (see Section
2.5.2.1.2.4); however, the
hypothetical-derivative method is specifically required in
certain circumstances in which the critical terms do not match
(i.e., for the “terminal value” method discussed in Section
2.5.2.1.2.2 and the net investment hedges
discussed in Section 2.5.2.1.2.5), and there is no explicit
requirement to use it for other hedging relationships in which
the critical terms do not match. Accordingly, we believe that
entities should document the quantitative method of assessing
hedge effectiveness if the critical-terms-match method is no
longer applicable.
2.5.2.2.3 Critical-Terms-Match Method — Options: Terminal Value
ASC 815-20
25-129 A hedging relationship
that meets all of the conditions in paragraph
815-20-25-126 may be considered to be perfectly
effective if all of the following conditions are
met:
- The critical terms of the hedging instrument (such as its notional amount, underlying, maturity date, and so forth) completely match the related terms of the hedged forecasted transaction (such as the notional amount, the variable that determines the variability in cash flows, the expected date of the hedged transaction, and so forth).
- The strike price (or prices) of the hedging option (or combination of options) matches the specified level (or levels) beyond (or within) which the entity’s exposure is being hedged.
- The hedging instrument’s inflows (outflows) at its maturity date completely offset the change in the hedged transaction’s cash flows for the risk being hedged.
- The hedging instrument can be exercised only on a single date — its contractual maturity date.
The condition in (d) is consistent with the
entity’s focus on the hedging instrument’s
terminal value. If the holder of the option
chooses to pay for the ability to exercise the
option at dates before the maturity date (for
example, by acquiring an American-style option),
the hedging relationship would not be perfectly
effective.
25-129A In a hedge of a group
of forecasted transactions in accordance with
paragraph 815-20-25-15(a)(2), an entity may assume
that the timing in which the hedged transactions
are expected to occur and the maturity date of the
hedging instrument match in accordance with
paragraph 815-20-25-129(a) if those forecasted
transactions occur and the derivative matures
within the same 31-day period or fiscal month.
If an entity focuses on an option’s terminal value when assessing the
effectiveness of a hedging relationship that involves a purchased
option, the entity may assume that the hedging relationship is perfectly
effective if the terms of the option match the terms of the forecasted
transaction that are related to the hedged risk. The following
conditions would be indicators of a perfectly effective hedging
relationship:
- The terms of the option match the related terms of the
forecasted transaction(s) with respect to the:
- Notional amount.
- Underlying risk being hedged.
- Maturity date or transaction date (exception for groups of transactions).
- The option’s strike price(s) matches the levels of exposure that are designated as hedged.
- The option’s inflows (outflows) at maturity completely offset the change in cash flows of the hedged item related to the hedged risk.
- The option can only be exercised at its maturity (i.e., it is a European option). Note that this does not disqualify a series of options as long as each option is a European option.
ASU 2017-12 added ASC 815-20-25-129A, which allows an entity that is
hedging a group of forecasted transactions to assume that the timing of
the hedging option’s maturity matches the timing of the transactions as
long as the forecasted transactions occur and the derivative matures
within the same 31-day period or fiscal month.
If any of the above conditions is not met, the entity cannot assume that
the hedging relationship is perfectly effective, and any effectiveness
assessment should include a comparison of the changes in the terminal
values of (1) the actual option and (2) a hypothetical option that would
meet the criteria for perfect effectiveness to be assumed (i.e., one
that would meet the conditions in ASC 815-20-25-129).
If an entity is hedging a series of forecasted transactions with one
purchased option but is unable to assume that the hedge is perfectly
effective, it should assess the effectiveness of the hedging
relationship by comparing the change in the fair value of the actual
derivative with the change in the fair value of a hypothetical
derivative that would meet the conditions to be considered a perfectly
effective hedge (i.e., one that meets the conditions in ASC
815-20-25-129 and 25-129A). The entity should view the option as a
series of smaller options, each hedging one of those purchases
(forecasted purchases that are expected to occur on the same day may be
aggregated). Although the maturity date of each hypothetical option
should “match” the forecasted date of each purchase, as noted in ASC
815-20-25-129A, such dates are considered matched as long as the
forecasted transactions all occur in the same 31-day period or fiscal
month in which the derivative matures.
Accordingly, in constructing a hypothetical derivative, an entity may
group forecasted transactions that occur over a period that is greater
than 31 days or a fiscal month into subsets of forecasted transactions,
with each subset occurring within the same 31-day period or fiscal
month. For each group of transactions, the entity can then construct a
separate smaller option whose maturity date is within the 31-day period
or fiscal month. To assess whether the hedging relationship is expected
to be highly effective (at inception and during the term of the hedge),
the entity should compare the actual derivative to the aggregation of
the smaller hypothetical derivatives.
An entity should clearly state in its hedging policies how it determines
the terms of the hypothetical option(s), and it should apply such
policies consistently.
Example 2-34
Constructing Hypothetical Derivative for
Period Greater Than One Month
Golden Age wants to hedge its forecasted
purchases of gold for the first quarter of 20X2.
In January 20X1, it enters into an option to
purchase 1,000 ounces of gold at $275 per ounce on
February 15, 20X2. Golden Age designates the
option as a hedge of the purchase of the first
1,000 ounces of gold in the first quarter of 20X2.
Its forecasted gold purchases in the first quarter
of 20X2 are as follows:
Golden Age’s policy is to establish the maturity
date of its hypothetical derivatives as the 15th
of the month. In accordance with the guidance
discussed above, Golden Age’s hypothetical
derivative would be a combination of three
European options to purchase gold at $275 per
ounce, with the following maturities and notional
amounts:
Note that the hedged item is the first 1,000
ounces of gold purchased in the first quarter of
20X2. Therefore, the notional amount of the
hypothetical derivative with a maturity date of
March 15, 20X2, is 300 ounces, which is not the
same as the forecasted purchases for March 20X2
(350 ounces) because the total notional amount of
the hypothetical derivative should not exceed the
amount of the hedged forecasted transactions.
2.5.2.2.4 Perfect Net Investment Hedges
ASC 815-20
Formal Designation and Documentation at Hedge
Inception
25-3 Concurrent designation
and documentation of a hedge is critical; without
it, an entity could retroactively identify a
hedged item, a hedged transaction, or a method of
measuring effectiveness to achieve a desired
accounting result. To qualify for hedge
accounting, there shall be, at inception of the
hedge, formal documentation of all of the
following:
- Subparagraph not used.
-
Documentation requirement applicable to fair value hedges, cash flow hedges, and net investment hedges: . . .2. The entity’s risk management objective and strategy for undertaking the hedge, including identification of all of the following: . . .iv. The method that will be used to retrospectively and prospectively assess the hedging instrument’s effectiveness in offsetting the exposure to changes in the hedged item’s fair value (if a fair value hedge) or hedged transaction’s variability in cash flows (if a cash flow hedge) attributable to the hedged risk. There shall be a reasonable basis for how the entity plans to assess the hedging instrument’s effectiveness.01. An entity shall perform an initial prospective assessment of hedge effectiveness on a quantitative basis (using either a dollar-offset test or a statistical method such as regression analysis) unless one of the following applies: . . .G. In a net investment hedge, the entity assesses hedge effectiveness using a method based on changes in spot exchange rates, and the conditions in paragraph 815-35-35-5 (for derivative instruments) or 815-35-35-12 (for nonderivative instruments) are met.H. In a net investment hedge, the entity assesses hedge effectiveness using a method based on changes in forward exchange rates, and the conditions in paragraph 815-35-35-17A are met. . . .
ASC 815-20-25-79 does not explicitly discuss the
application of prospective considerations and retrospective evaluation
to a net investment hedge in foreign operations. ASC 815-35-35-4 states,
in part, that “[i]f a derivative instrument is used as the hedging
instrument, an entity may assess the effectiveness of a net investment
hedge using either a method based on changes in spot exchange rates (as
specified in paragraphs 815-35-35-5 through 35-15) or a method based on
changes in forward exchange rates (as specified in paragraphs
815-35-35-17 through 35-26).” In addition, ASC 815-35-35-4A states that
“[h]edge effectiveness shall be assessed on a quantitative basis at
hedge inception in accordance with paragraph 815-20-25-3(b)(2)(iv)(01)
unless one of the exceptions in that paragraph applies. Subsequent
assessments of hedge effectiveness may be performed either on a
quantitative basis or on a qualitative basis in accordance with
paragraphs 815-20-35-2 through 35-2F.”
ASC 815-20-25-3(b)(2)(iv)(01) indicates that an entity does not need to
perform an initial quantitative prospective effectiveness assessment for
certain net investment hedges that are deemed to be perfectly effective
under the criteria in ASC 815-35.
ASC 815-35
Method Based on Changes in Spot Exchange
Rates
Hedging Instrument Is a Derivative Instrument
35-5 The change in the fair
value of the derivative instrument attributable to
changes in the difference between the forward rate
and spot rate would be excluded from the
assessment of hedge effectiveness if all of the
following conditions are met:
- The notional amount of the derivative instrument designated as a hedge of a net investment in a foreign operation matches (that is, equals) the portion of the net investment designated as being hedged.
- The derivative instrument’s underlying exchange rate is the exchange rate between the functional currency of the hedged net investment and the investor’s functional currency.
- When the hedging derivative instrument is a cross-currency interest rate swap, it is eligible for designation in a net investment hedge in accordance with paragraph 815-20-25-67.
In that circumstance, the hedging relationship
would be considered perfectly effective, and no
quantitative effectiveness assessment is required
at hedge inception. (See paragraph
815-20-25-3(b)(2)(iv)(01).)
Hedging Instrument Is Not a Derivative Instrument
35-12 The translation gain or
loss determined under Subtopic 830-30 by reference
to the spot exchange rate between the transaction
currency of the debt and the functional currency
of the investor (after tax effects, if
appropriate) shall be reported in the same manner
as the translation adjustment associated with the
hedged net investment (that is, reported in the
cumulative translation adjustment section of other
comprehensive income) if both of the following
conditions are met:
- The notional amount of the nonderivative instrument matches the portion of the net investment designated as being hedged.
- The nonderivative instrument is denominated in the functional currency of the hedged net investment.
In that circumstance, the hedging relationship
would be considered perfectly effective, and no
prospective quantitative effectiveness assessment
is required at hedge inception (see paragraph
815-20-25-3(b)(2)(iv)(01)).
Method Based on Changes in Forward Exchange
Rates
Assessment of Effectiveness
35-17A If the notional amount
of the derivative instrument designated as a hedge
of a net investment in a foreign operation matches
(that is, equals) the portion of the net
investment designated as being hedged and the
derivative instrument’s underlying relates solely
to the foreign exchange rate between the
functional currency of the hedged net investment
and the investor’s functional currency, the
hedging relationship would be considered perfectly
effective, and no quantitative effectiveness
assessment is required at hedge inception (see
paragraph 815-20-25-3(b)(2)(iv)(01)).
While the guidance is split up according to whether the hedging
instrument is a derivative or a nonderivative and whether the spot
method or forward method is being applied, an entity’s ability to
perform a qualitative assessment is essentially the same in each
situation. A hedge is considered to be perfectly effective if the terms
of the hedging instrument and the portion of the net investment that is
being hedged match with respect to the following:
- They have the same notional amount.
- They have the same underlying currency.
- If the hedging instrument is a float-for-float cross-currency interest rate swap, both legs are based on comparable interest rate curves.
Because of the nature of a net investment in foreign operations, the
qualitative assessment process for a net investment hedge is less likely
to be an “autopilot” type of assessment. The balance of an entity’s net
investment in foreign operations is subject to change in each reporting
period on the basis of (1) the operating results of the investee and (2)
capital transactions between the entity and the investee
(e.g., dividends). Accordingly, the entity should continually assess the
balance of the net investment to ensure that it is not overhedged before
the start of a reporting period (i.e., when it would be performing the
prospective assessment for the upcoming period).
ASC 815-35
Redesignation
35-27 If an entity documents
that the effectiveness of its hedge of the net
investment in a foreign operation will be assessed
based on the beginning balance of its net
investment and the entity’s net investment changes
during the year, the entity shall consider the
need to redesignate the hedging relationship (to
indicate what the hedging instrument is and what
numerical portion of the current net investment is
the hedged portion) whenever financial statements
or earnings are reported, and at least every three
months. An entity is not required to redesignate
the hedging relationship more frequently even when
a significant transaction (for example, a
dividend) occurs during the interim period.
Example 1 (see paragraph 815-35-55-1) illustrates
the application of this guidance.
Fortunately, ASC 815-35-35-27 addresses some of the potential operational
difficulties associated with becoming overhedged with respect to a net
investment hedge. Accordingly, an entity is required to assess whether
redesignation of its net investment hedge is necessary only as
frequently as it would perform its hedge effectiveness assessments
(i.e., at least quarterly). If the entity determines that it is
overhedged at the beginning of a reporting period, it does not need to
determine when in the prior period the balance of the net investment
fell below the notional amount of the hedging instrument, “even when a
significant transaction (for example, a dividend) occur[ed] during the
interim period.” Although a hedging relationship may continue to be
highly effective in periods in which the entity is overhedged, the
entity may still be required to redesignate the relationship because the
designated hedged item may need to be changed (see Section
5.4.3).
In addition, as discussed in Section 2.5.2.2.7, an
entity needs to monitor the credit of both parties to the hedging
instrument; if it is no longer probable that neither party will default,
hedge accounting must be discontinued.
2.5.2.2.5 Private Companies — Simplified Hedge Accounting Approach
ASC 815-20
Hedge Accounting Provisions Applicable to
Certain Private Companies
Assuming Perfect Hedge Effectiveness in a
Cash Flow Hedge of a Variable-Rate Borrowing With
a Receive-Variable, Pay-Fixed Interest Rate Swap
Recorded Under the Simplified Hedge Accounting
Approach
25-133 Paragraphs
815-10-35-1A through 35-1C, 815-10-50-3,
815-20-25-3A, 815-20-25-119, 815-20-25-134 through
25-138, 815-20-55-79A through 55-79B, 825-10-50-3,
and 825-10-50-8 provide guidance for an entity
electing the simplified hedge accounting approach.
See paragraph 815-10-65-6 for transition guidance
on applying the simplified hedge accounting
approach.
25-134 The conditions for the
simplified hedge accounting approach determine
which cash flow hedging relationships qualify for
a simplified version of hedge accounting. If all
of the conditions in paragraphs 815-20-25-135 and
815-20-25-137 are met, an entity may assume
perfect effectiveness in a cash flow hedging
relationship involving a variable-rate borrowing
and a receive-variable, pay-fixed interest rate
swap.
25-135 Provided all of the
conditions in paragraph 815-20-25-137 are met, the
simplified hedge accounting approach may be
applied by a private company except for a
financial institution as described in paragraph
942-320-50-1. An entity may elect the simplified
hedge accounting approach for any
receive-variable, pay-fixed interest rate swap,
provided that all of the conditions for applying
the simplified hedge accounting approach specified
in paragraph 815-20-25-137 are met. Implementation
guidance on the conditions set forth in paragraph
815-20-25-137 is provided in paragraphs
815-20-55-79A through 55-79B.
25-136 In applying the
simplified hedge accounting approach, the
documentation required by paragraph 815-20-25-3 to
qualify for hedge accounting must be completed by
the date on which the first annual financial
statements are available to be issued after hedge
inception rather than concurrently at hedge
inception.
25-137 An eligible entity
under paragraph 815-20-25-135 must meet all of the
following conditions to apply the simplified hedge
accounting approach to a cash flow hedge of a
variable-rate borrowing with a receive-variable,
pay-fixed interest rate swap:
- Both the variable rate on the swap and the borrowing are based on the same index and reset period (for example, both the swap and borrowing are based on one-month London Interbank Offered Rate [LIBOR] or both the swap and borrowing are based on three-month LIBOR).
- The terms of the swap are typical (in other words, the swap is what is generally considered to be a “plain-vanilla” swap), and there is no floor or cap on the variable interest rate of the swap unless the borrowing has a comparable floor or cap.
- The repricing and settlement dates for the swap and the borrowing match or differ by no more than a few days.
- The swap’s fair value at inception (that is, at the time the derivative was executed to hedge the interest rate risk of the borrowing) is at or near zero.
- The notional amount of the swap matches the principal amount of the borrowing being hedged. In complying with this condition, the amount of the borrowing being hedged may be less than the total principal amount of the borrowing.
- All interest payments occurring on the borrowing during the term of the swap (or the effective term of the swap underlying the forward starting swap) are designated as hedged whether in total or in proportion to the principal amount of the borrowing being hedged.
25-138 A cash flow hedge
established through the use of a forward starting
receive-variable, pay-fixed interest rate swap may
be permitted in applying the simplified hedge
accounting approach only if the occurrence of
forecasted interest payments to be swapped is
probable. When forecasted interest payments are no
longer probable of occurring, a cash flow hedging
relationship will no longer qualify for the
simplified hedge accounting approach and the
General Subsections of this Topic shall apply at
the date of change and on a prospective basis.
In January 2014, the FASB issued ASU 2014-03 in response to feedback received from
the Private Company Council. Since private companies generally find it
difficult to obtain fixed-rate financing and do not want to be exposed
to rising interest rates, some enter into interest rate swaps to
effectively convert their debt to fixed-rate debt. However, because of
their limited resources and the complexities associated with hedge
accounting, many private companies lack the expertise to apply hedge
accounting. Consequently, the Board issued ASU 2014-03 to provide a
simplified approach (i.e., a practical expedient) that private companies
other than financial institutions can use to qualify for cash flow hedge
accounting under ASC 815 if certain conditions are met. The simplified
approach is not available for any of the following:
- Public business entities.
- Not-for-profit entities.
- Employee benefit plans within the scope of ASC 960 through 965 on plan accounting.
- Financial institutions.
Under the simplified hedge accounting approach, an entity may assume that
a hedge is perfectly effective when it is hedging variable-rate debt
(only the liability) with a receive-variable, pay-fixed interest rate
swap, provided that it meets all of the following conditions:
- The rate on the swap and the debt are based on the same index and reset period (e.g., three-month LIBOR). (The rate does not need to be a benchmark rate.)
- The swap is plain vanilla.
- Any cap or floor on interest rates is mirrored in the swap.
- The repricing and settlement dates for the swap and the borrowing are within a few days of each other.
- The swap’s fair value at inception is at or near zero.
- The notional amount of the swap matches the principal amount of debt being hedged.
- All interest payments related to the hedged proportion of the debt are hedged for the entire term of the swap.
All of the other requirements for cash flow hedge accounting must be met
(except the documentation requirements, which are discussed in
Section 2.6.2). Therefore, an entity that
applies the simplified hedge accounting approach still needs to (1)
assert that it is probable that the hedged interest payments will occur
and (2) monitor the creditworthiness of the counterparties to the swap
for adverse developments (i.e., it must still be probable that neither
party will default under the swap).
The simplified hedge accounting approach is discussed in
more detail in Section
4.2.1.1.5.
2.5.2.2.6 Qualitative Assessments for Imperfect Hedges
ASC 815-20
Effectiveness Assessments on a Qualitative
Basis
35-2A An entity may
qualitatively assess hedge effectiveness if both
of the following criteria are met:
- An entity performs an initial quantitative test of hedge effectiveness on a prospective basis (that is, it is not assuming that the hedging relationship is perfectly effective at hedge inception as described in paragraph 815-20-25-3(b)(2)(iv)(01)(A) through (H)), and the results of that quantitative test demonstrate highly effective offset.
- At hedge inception, an entity can reasonably support an expectation of high effectiveness on a qualitative basis in subsequent periods.
See paragraphs 815-20-55-79G through 55-79N for
implementation guidance on factors to consider
when determining whether qualitative assessments
of effectiveness can be performed after hedge
inception.
35-2B An entity may elect to
qualitatively assess hedge effectiveness in
accordance with paragraph 815-20-35-2A on a
hedge-by-hedge basis. If an entity makes this
qualitative assessment election, only the
quantitative method specified in an entity’s
initial hedge documentation must comply with
paragraph 815-20-25-81.
35-2C When an entity performs
qualitative assessments of hedge effectiveness, it
shall verify and document whenever financial
statements or earnings are reported and at least
every three months that the facts and
circumstances related to the hedging relationship
have not changed such that it can assert
qualitatively that the hedging relationship was
and continues to be highly effective. While not
all-inclusive, the following is a list of
indicators that may, individually or in the
aggregate, allow an entity to continue to assert
qualitatively that the hedging relationship is
highly effective:
- An assessment of the factors that enabled the entity to reasonably support an expectation of high effectiveness on a qualitative basis has not changed such that the entity can continue to assert qualitatively that the hedging relationship was and continues to be highly effective. This shall include an assessment of the guidance in paragraph 815-20-25-100 when applicable.
- There have been no adverse developments regarding the risk of counterparty default.
35-2D If an entity elects to
assess hedge effectiveness on a qualitative basis
and then facts and circumstances change such that
the entity no longer can assert qualitatively that
the hedging relationship was and continues to be
highly effective in achieving offsetting changes
in fair values or cash flows, the entity shall
assess effectiveness of that hedging relationship
on a quantitative basis in subsequent periods. In
addition, an entity may perform a quantitative
assessment of hedge effectiveness in any reporting
period to validate whether qualitative assessments
of hedge effectiveness remain appropriate. In both
cases, the entity shall apply the quantitative
method that it identified in its initial hedge
documentation in accordance with paragraph
815-20-25-3(b)(2)(iv)(03).
35-2E When an entity
determines that facts and circumstances have
changed and it no longer can assert qualitatively
that the hedging relationship was and continues to
be highly effective, the entity shall begin
performing subsequent quantitative assessments of
hedge effectiveness as of the period that the
facts and circumstances changed. If there is no
identifiable event that led to the change in the
facts and circumstances of the hedging
relationship, the entity may begin performing
quantitative assessments of effectiveness in the
current period.
35-2F After performing a
quantitative assessment of hedge effectiveness for
one or more reporting periods as discussed in
paragraphs 815-20-35-2D through 35-2E, an entity
may revert to qualitative assessments of hedge
effectiveness if it can reasonably support an
expectation of high effectiveness on a qualitative
basis for subsequent periods. See paragraphs
815-20-55-79G through 55-79N for implementation
guidance on factors to consider when determining
whether qualitative assessments of effectiveness
can be performed after hedge inception.
As indicated in ASC 815-20-35-2A, if an entity’s initial prospective
quantitative effectiveness assessment of a hedging relationship
demonstrates that (1) there is a highly effective offset and (2) the
entity can, at hedge inception, “reasonably support an expectation of
high effectiveness on a qualitative basis in subsequent periods,” the
entity may elect to perform subsequent retrospective and prospective
effectiveness assessments qualitatively. To do so, the entity must, in
the hedge documentation it prepares at hedge inception, specify how it
will perform the qualitative assessments and document the alternative
quantitative assessment method that it would use if it later concludes,
on the basis of a change in the hedging relationship’s facts and
circumstances, that subsequent quantitative assessments will be
necessary. The entity may make this election on a hedge-by-hedge basis.
An entity should exercise judgment when it assesses whether it can
reasonably support an expectation of high effectiveness for the hedging
relationship on a qualitative basis in subsequent periods. Factors to
consider include (1) the results of the initial prospective quantitative
assessment and (2) the entity’s assessment of whether the critical terms
of the hedging relationship are aligned. If the entity determines that
one or more critical terms of the hedging instrument and the hedged item
are not aligned, it should consider whether a change in market
conditions could reduce the extent of the offset between the changes in
the fair values or cash flows of the hedging instrument and those of the
hedged item that are attributable to the hedged risk. In other words, an
entity should consider the sources of ineffectiveness in the hedging
relationship that are identified in the hedge effectiveness assessment
and determine how volatile those sources of ineffectiveness could be.
Below are examples of
some general sources of a potential mismatch between (1) the change in
the fair value or cash flows of the hedging instrument and (2) the
change in the fair value or cash flows of the hedged item or hedged
transaction that can arise in hedging relationships:
Type of Risk
|
Example
|
---|---|
Index risk
|
British pound exposure hedged
with a euro derivative
|
Location risk
|
Commodity priced on Chicago
Board of Trade for delivery in Florida
|
Grade/quality risk
|
A purchase of wheat that is a
different grade or quality level than that
referenced in a wheat futures contract
|
Credit spread
|
A hedge of all the changes in
interest payments (not only interest rate risk)
from a forecasted issuance of fixed-rate debt and
changes in credit spreads
|
Timing
|
Interest rate swap whose reset
dates differ from interest rate reset dates on
variable-rate debt
|
Off-market derivative
|
Off-market derivatives that have
a financing element in them (see Section
2.5.2.1.4)
|
As noted above, an entity that wants to perform subsequent qualitative
assessments should consider the potential sources of ineffectiveness in
the hedging relationship and the results of the initial prospective
quantitative effectiveness assessment. For example, as indicated in ASC
815-20-55-79G, if the hedging instrument and the hedged item have
different underlyings, the entity should carefully assess both “the
extent and consistency of the correlation exhibited between the changes
in the underlyings of the hedged item and hedging instrument.” In
circumstances in which those changes have not been consistently highly
correlated and the entity determines that expected changes in market
conditions could prevent the hedging relationship from achieving highly
effective offset, the entity would not be able to reasonably support a
decision to perform qualitative effectiveness assessments in subsequent
periods. ASC 815-20-55-79H through 55-79N provide other examples of how
an entity would gauge its ability to perform subsequent assessments of
hedge effectiveness qualitatively.
In accordance with ASC
815-20-35-2C, after an entity elects to perform subsequent qualitative
assessments of hedge effectiveness, it must “verify and document
whenever financial statements or earnings are reported and at least
every three months that the facts and circumstances related to the
hedging relationship have not changed such that it can assert
qualitatively that the hedging relationship was and continues to be
highly effective.” An entity may assert qualitatively that a hedging
relationship continues to be highly effective if indicators such as the
following exist:
- There have not been any events or circumstances that were significant enough to affect the factors that originally enabled the entity to conclude that it could reasonably support, qualitatively, an expectation that the hedging relationship was and will continue to be highly effective.
- There have not been any adverse developments related to the counterparty’s risk of default.
Other indicators may exist.
Connecting the Dots
When developing the parameters for performing a qualitative hedge
effectiveness assessment, entities should understand that is it
is unlikely that such an assessment can be performed purely
qualitatively on an ongoing basis.
Example 2-35
Qualitative Assessment — Parameters
for Performing Quantitative Assessment
Reprise is hedging forecasted purchases of
aluminum in Washington for total changes in cash
flows with a derivative whose underlying is the
Midwest Transaction Price. Additional
transportation costs, which vary on the basis of
actual transportation costs, are added to the
purchase price. Reprise might perform an analysis
to identify how much the transportation costs
would have to change compared with how much the
underlying Midwest Transaction Price of aluminum
has changed and, on the basis of that analysis,
establish some thresholds for when a formal
quantitative analysis should be performed. In
addition, Reprise should consider the default risk
of the counterparties to the derivative contract
in each period.
An entity may initially elect to perform subsequent qualitative
effectiveness assessments but later determine that the hedging
relationship’s facts and circumstances have changed so that qualitative
assessments are no longer sufficient to support a conclusion that the
relationship was and continues to be highly effective. In such a case,
the entity would be required to quantitatively assess effectiveness at
the time of the change by using the method it specified in its initial
hedge documentation. However, if no identifiable event triggered the
change in the facts and circumstances of the hedging relationship, the
entity may begin performing quantitative assessments of effectiveness in
the current period. ASC 815-20-35-2F states that after an entity has
performed a quantitative assessment (because the entity was required or
elected to do so, for example, to validate that its qualitative
assessments of hedge effectiveness remain appropriate), the entity may
revert to making qualitative assessments if “it can reasonably support
an expectation of high effectiveness on a qualitative basis for
subsequent periods.”
ASC 815-20-55-79G(b)(1)(ii) amplifies this guidance by noting that a
“specific event or circumstance” may temporarily disrupt a market and
cause an entity to conclude that it must make a quantitative assessment
of hedge effectiveness. In such a circumstance, if the results of the
newly performed quantitative assessment “do not significantly diverge
from the results of the initial [quantitative] assessment of
effectiveness,” it is likely that the entity can revert to performing
qualitative assessments in future periods. However, if the results of
the new quantitative effectiveness assessment significantly differ from
those of the original assessment, the entity would need to “continually
monitor” the market and assess whether the temporary disruption has
eased before it could consider reverting to qualitative hedge
effectiveness assessments in future periods.
2.5.2.2.7 Impact of Credit Risk on Qualitative Assessments
As noted in Section 2.5.2.1.2.6 and in the
discussions of the various qualitative methods above, hedge accounting
is not appropriate if an entity cannot assert that it is probable that
both parties to the derivative will perform under the derivative
contract. Under the shortcut method and the simplified hedge accounting
approach, it is not necessary to assess changes in credit risk other
than the probability of default. However, if an entity is applying
another qualitative method, the impact of credit spread changes on the
qualitative assessment depends on the quantitative method that would be
applied if a quantitative hedge effectiveness assessment were performed.
An entity should consider the discussion in Section 2.5.2.1.2.6 and the impacts of other changes in
credit risk when evaluating whether its qualitative assessment should
take into account changes in credit risk as well as the probability of
default.
2.5.3 Similar Hedges — Similar Methods of Assessment
ASC 815-20
25-81 This
Subtopic does not specify a single method for assessing
whether a hedge is expected to be highly effective. The
method of assessing effectiveness shall be reasonable.
The appropriateness of a given method of assessing hedge
effectiveness depends on the nature of the risk being
hedged and the type of hedging instrument used.
Ordinarily, an entity shall assess effectiveness for
similar hedges in a similar manner, including whether a
component of the gain or loss on a derivative instrument
is excluded in assessing effectiveness for similar
hedges. Use of different methods for similar hedges
shall be justified. The mechanics of isolating the
change in time value of an option discussed beginning in
paragraph 815-20-25-98 also shall be applied
consistently.
35-2B An
entity may elect to qualitatively assess hedge
effectiveness in accordance with paragraph 815-20-35-2A
on a hedge-by-hedge basis. If an entity makes this
qualitative assessment election, only the quantitative
method specified in an entity’s initial hedge
documentation must comply with paragraph
815-20-25-81.
As discussed throughout this section on hedge effectiveness
assessments, ASC 815 does not prescribe a particular method for assessing the
effectiveness of a hedging relationship. However, ASC 815-20-25-81 does specify
that an entity “shall assess effectiveness for similar hedges in a similar
manner, including whether a component of the gain or loss on a derivative
instrument is excluded in assessing effectiveness for similar hedges. Use of
different methods for similar hedges shall be justified.” ASC 815-20-65-3(i)
provides an exception that allows an entity to change its method of assessing
hedge effectiveness as part of its adoption of ASU 2017-12; in such a case, the
entity does not necessarily need to change its method of assessing the
effectiveness of similar preexisting hedges (see Chapter 7). In addition, ASU 2020-04 provides a similar exception
that allows an entity to change its method of assessing hedge effectiveness on a
hedge-by-hedge basis as part of its adoption of ASC 848 (see Chapter 8).
Note that a qualitative analysis, as discussed in Section
2.5.2.2.6, is not necessarily considered a different method of
hedge effectiveness assessment in this context. Before an entity can elect to
qualitatively assess the effectiveness of a hedging relationship, it must
identify and perform an initial prospective quantitative assessment of the
hedging relationship’s effectiveness and document that it will apply that
quantitative method in circumstances in which it believes that using a
qualitative method is not sufficient to support an assertion that the hedging
relationship is highly effective. Accordingly, an entity may elect to perform
this type of qualitative assessment on a hedge-by-hedge basis, as allowed by ASC
815-20-35-2B. However, the quantitative method of effectiveness assessment
specified should be consistent for similar hedges.
2.5.4 Changing Methods of Assessment
ASC 815-20
35-19 If the
entity identifies an improved method of assessing hedge
effectiveness in accordance with the guidance in
paragraph 815-20-25-80 and wants to apply that method
prospectively, it shall do both of the following:
- Discontinue the existing hedging relationship
- Designate the relationship anew using the improved method.
35-20 The new
method of assessing hedge effectiveness shall be applied
prospectively and shall also be applied to similar
hedges unless the use of a different method for similar
hedges is justified. A change in the method of assessing
hedge effectiveness by an entity shall not be considered
a change in accounting principle as defined in Topic
250.
An entity may change its method of assessing hedge effectiveness at any time.
However, before it can do so, the entity must be able to demonstrate that the
new method it would like to apply is “an improved method of assessing hedge
effectiveness” in accordance with ASC 815-20-35-19. ASC 815-20-35-20 states that
a change in the method of assessing hedge effectiveness is not considered a
change in accounting principle; therefore, the entity’s documentation of why the
new method is an improved method is not the same as a “preferability” analysis.
However, because the new method needs to be an improved method, an entity would
not generally be able to switch back and forth between two methods.
In addition, any change in assessment methods would be prospective and could only
be achieved through a dedesignation and redesignation of the hedging
relationship. For example, if an entity performs a retrospective assessment of
hedge effectiveness that indicates that its hedging relationship was not highly
effective, it cannot change its method of assessment and still apply hedge
accounting for the period just ended. Any change in the method of assessing
hedge effectiveness is prospective (see ASC 815-20-35-20) and can only be
achieved by de-designating and redesignating the hedging relationship.
Before making a change, an entity should also consider that (1) the effectiveness
of similar hedges should be assessed in a similar manner (see Section 2.5.3) and (2) because a redesignation
represents the inception of the new hedging relationship, the hedging derivative
is likely to be an off-market derivative. Off-market derivatives do not qualify
for most types of qualitative effectiveness assessments (e.g., the shortcut
method, critical-terms-match method, simplified hedge accounting approach)
because such derivatives create a source of ineffectiveness (see
Section 2.5.2.1.4).
Footnotes
8
See Section 2.6.1 for a discussion of the required timing of the
initial hedge effectiveness assessment.
9
As discussed in Sections 2.6.2 and 2.6.3, private
companies that are not financial institutions or not-for-profit entities
(other than those that have issued, or are a conduit bond obligor for,
securities that are traded, listed, or quoted on an exchange or an
over-the-counter [OTC] market) do not have to prepare this documentation
until their next set of financial statements (including interim financial
statements, if applicable) is available to be issued.
10
The slope of the regression should be
negative in the comparison of the change in the fair value
of the derivative to the change in the fair value or cash
flows of the hedged item that are attributable to the hedged
risk. This is because the purpose of a hedge is for the
effects of the derivative to offset the hedged risk.
However, in some cases, the slope should be positive (within
the same 0.8 to 1.25 parameters). For example, if an entity
is using the hypothetical-derivative method to assess
effectiveness, the purpose of the regression is to compare
changes in the fair value of the actual derivative to the
changes in the fair value of a hypothetical derivative that
would have been a “perfect” hedging derivative.
11
The hypothetical swap does not
need to meet the conditions in ASC
815-20-25-104(e) related to mirroring prepayment
features because those were developed with an
emphasis on fair value hedging relationships.
12
Paragraph 68(e) of FASB Statement 133 is codified in ASC
815-20-25-104(g).
2.6 Hedge Designation Documentation
2.6.1 General Hedge Designation Requirements
ASC 815-20
Formal Designation
and Documentation at Hedge Inception
25-3 Concurrent designation
and documentation of a hedge is critical; without it, an
entity could retroactively identify a hedged item, a
hedged transaction, or a method of assessing
effectiveness to achieve a desired accounting result. To
qualify for hedge accounting, there shall be, at
inception of the hedge, formal documentation of all of
the following:
- Subparagraph not used.
- Documentation requirement
applicable to fair value hedges, cash flow hedges,
and net investment hedges:
- The hedging relationship
- The entity’s risk management
objective and strategy for undertaking the hedge,
including identification of all of the following:
- The hedging instrument
- The hedged item or transaction.
- The nature of the risk being hedged.
- The method that will be used
to retrospectively and prospectively assess the
hedging instrument’s effectiveness in offsetting
the exposure to changes in the hedged item’s fair
value (if a fair value hedge) or hedged
transaction’s variability in cash flows (if a cash
flow hedge) attributable to the hedged risk. There
shall be a reasonable basis for how the entity
plans to assess the hedging instrument’s
effectiveness. 01. An entity shall perform an initial prospective assessment of hedge effectiveness on a quantitative basis (using either a dollar-offset test or a statistical method such as regression analysis) unless one of the following applies:A. In a cash flow or fair value hedge, the entity applies the shortcut method in accordance with paragraphs 815-20-25-102 through 25-117.B. In a cash flow or fair value hedge, the entity determines that the critical terms of the hedging instrument and the hedged item match in accordance with paragraphs 815-20-25-84 through 25-85.C. In a cash flow hedge, the hedging instrument is an option, and the conditions in paragraphs 815-20-25-126 and 815-20-25-129 through 25-129A are met.D. In a cash flow hedge, a private company that is not a financial institution as described in paragraph 942-320-50-1 applies the simplified hedge accounting approach in paragraphs 815-20-25-133 through 25-138.E. In a cash flow hedge, the entity assesses hedge effectiveness under the change in variable cash flows method in accordance with paragraphs 815-30-35-16 through 35-24, and all of the conditions in paragraph 815-30-35-22 are met.F. In a cash flow hedge, the entity assesses hedge effectiveness under the hypothetical derivative method in accordance with paragraphs 815-30-35-25 through 35-29, and all of the critical terms of the hypothetical derivative and hedging instrument are the same.G. In a net investment hedge, the entity assesses hedge effectiveness using a method based on changes in spot exchange rates, and the conditions in paragraph 815-35-35-5 (for derivative instruments) or 815-35-35-12 (for nonderivative instruments) are met.H. In a net investment hedge, the entity assesses hedge effectiveness using a method based on changes in forward exchange rates, and the conditions in paragraph 815-35-35-17A are met.02. The initial prospective quantitative hedge effectiveness assessment using information applicable as of the date of hedge inception is considered to be performed concurrently at hedge inception if it is completed by the earliest of the following:A. The first quarterly hedge effectiveness assessment dateB. The date that financial statements that include the hedged transaction are available to be issuedC. The date that any criterion in Section 815-20-25 no longer is metD. The date of expiration, sale, termination, or exercise of the hedging instrumentE. The date of dedesignation of the hedging relationshipF. For a cash flow hedge of a forecasted transaction (in accordance with paragraph 815-20-25-13(b)), the date that the forecasted transaction occurs.03. An entity also shall document at hedge inception whether it elects to perform subsequent retrospective and prospective hedge effectiveness assessments on a qualitative basis and how it intends to carry out that qualitative assessment. See paragraphs 815-20-35-2A through 35-2F for additional guidance on qualitative assessments of effectiveness. In addition, the entity shall document which quantitative method it will use if facts and circumstances of the hedging relationship change and the entity must quantitatively assess hedge effectiveness in accordance with paragraph 815-20-35-2D. An entity must document that it will perform the same quantitative assessment method for both initial and subsequent prospective hedge effectiveness assessments. The guidance in paragraphs 815-20-55-55 through 55-56 applies if the entity wants to change its quantitative method of assessing effectiveness after the initial quantitative effectiveness assessment.04. An entity that applies the shortcut method in paragraphs 815-20-25-102 through 25-117 may elect to document at hedge inception a quantitative method to assess hedge effectiveness and measure hedge results if the entity determines at some point during the term of the hedging relationship that the use of the shortcut method was not or no longer is appropriate. See paragraphs 815-20-25-117A through 25-117D.
- Subparagraph superseded by Accounting Standards Update No. 2017-12.
- If the entity is hedging foreign currency risk on an after-tax basis, that the assessment of effectiveness will be on an after-tax basis (rather than on a pretax basis).
- Documentation requirement applicable to fair
value hedges only:
- For a fair value hedge of a firm commitment, a reasonable method for recognizing in earnings the asset or liability representing the gain or loss on the hedged firm commitment.
- For a hedging relationship designated under the last-of-layer method, an analysis to support the entity’s expectation that the hedged item is anticipated to be outstanding as of the hedged item’s assumed maturity date (see paragraph 815-20-25-12A(a) for additional guidance).
- Documentation requirement applicable to cash
flow hedges only:
- For a cash flow hedge of a forecasted
transaction, documentation shall include all
relevant details, including all of the following:
- The date on or period within which the forecasted transaction is expected to occur.
- The specific nature of asset or liability involved (if any).
- Either of the following: 01. The expected currency amount for hedges of foreign currency exchange risk; that is, specification of the exact amount of foreign currency being hedged02. The quantity of the forecasted transaction for hedges of other risks; that is, specification of the physical quantity (that is, the number of items or units of measure) encompassed by the hedged forecasted transaction.
- If a forecasted sale or purchase is being
hedged for price risk, the hedged transaction
shall not be specified in either of the following
ways: 01. Solely in terms of expected currency amounts02. As a percentage of sales or purchases during a period.
- The current price of a forecasted transaction shall be identified to satisfy the criterion in paragraph 815-20-25-75(b) for offsetting cash flows.
- 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).
- If the hedged risk is the variability in cash flows attributable to changes in a contractually specified component in a forecasted purchase or sale of a nonfinancial asset, identification of the contractually specified component.
- If the hedged risk is the variability in cash flows attributable to changes in a contractually specified interest rate for forecasted interest receipts or payments on a variable-rate financial asset or liability, identification of the contractually specified interest rate.
- For a cash flow hedge of a forecasted
transaction, documentation shall include all
relevant details, including all of the following:
Pending Content (Transition Guidance: ASC
815-20-65-6)
25-3 [See Section 9.7.]
Upon issuing Statement 133, the FASB noted in paragraph 385 of
the Background Information and Basis for Conclusions that “concurrent
designation and documentation of a hedge is critical; without it, an entity
could retroactively identify a hedged item, a hedged transaction, or a method of
measuring effectiveness to achieve a desired accounting result.” The
documentation requirements are enumerated in ASC 815-20-25-3, and the way in
which entities comply with those requirements is commonly referred to as the
hedge designation documentation. Before the adoption of ASU 2017-12, all of the
components of the hedge designation documentation had to be completed at the
inception of the hedging relationship (except for hedging relationships that
used the simplified hedge accounting approach). ASU 2017-12 provided some timing
relief related to certain aspects of the hedge designation documentation, which
we discuss in more detail below, but there is still a requirement for at least
some level of hedge designation documentation at the inception of a hedge
(unless an entity is applying the simplified hedge accounting approach).
As stated in ASC 815-20-25-3, the documentation for a hedging
relationship must describe:
- The hedging relationship
- The entity’s risk management objective and strategy
for undertaking the hedge, including identification of all of the
following:
- The hedging instrument.
- The hedged item or transaction.
- The nature of the risk being hedged.
The documentation also must describe the method an entity will
use to retrospectively and prospectively assess the hedging instrument’s
effectiveness in offsetting the exposure to changes in the hedged item’s fair
value or cash flows that are attributable to the hedged risk. If an entity
elects to perform subsequent retrospective and prospective hedge effectiveness
assessments qualitatively, it should note its election in the hedge designation
documentation and indicate (1) how it will perform such qualitative assessments
and (2) the quantitative method it will use if facts and circumstances change so
that qualitative assessments are no longer sufficient for evaluating hedge
effectiveness (see Section
2.5.2.2.6). An entity that applies the shortcut method to the
hedging relationship also may elect to document a quantitative (i.e., a
long-haul) method that it will use to assess hedge effectiveness and measure
hedge results if it determines at some point during the hedge that use of the
shortcut method was not or is no longer appropriate (see Section 2.5.2.2.1.9).
An entity also must perform the initial prospective assessment
of hedge effectiveness on a quantitative basis (see Section 2.5.2.1) at hedge inception unless
the hedging relationship qualifies for an assumption of perfect hedge
effectiveness (see Sections
2.5.2.2.1 through 2.5.2.2.5). However, because of the changes to
ASC 815-20-25-3(b)(2)(iv)(02) made by ASU 2017-12, an entity would be deemed to
have completed the initial prospective quantitative assessment concurrently with
hedge inception if it uses the information applicable at hedge inception to
complete the assessment by the earliest of:
- “The first quarterly hedge effectiveness assessment date.”
- “The date that financial statements that include the hedged transaction are available to be issued.”
- “The date that any [required hedge accounting] criterion in Section 815-20-25 no longer is met.”
- “The date of [the hedging instrument’s] expiration, sale, termination, or exercise.”
- “The date of dedesignation of the hedging relationship.”
- “For a cash flow hedge of a forecasted transaction . . . , the date that the forecasted transaction occurs.”
Certain hedge designation documentation requirements are
specific to either fair value hedges or cash flow hedges. Under those
requirements, an entity must document the following for each type of hedge:
- Fair value hedges:
- Hedge of a firm commitment — A reasonable method that the entity will use to recognize in earnings the asset or liability that represents the gain or loss on the hedged firm commitment.
- Last-of-layer hedge — An analysis that, according to ASC 815-20-25-3(c)(2)), supports “the entity’s expectation that the hedged item is anticipated to be outstanding as of the hedged item’s assumed maturity date” (see Section 3.2.1.4).13
- Cash flow hedges:
- Hedge of a 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.
- The specific nature of the asset or liability involved (if any).
- The current price of the forecasted transaction.
- Depending on the nature of the forecasted transaction, there may be other specific documentation requirements (e.g., an assertion that an entity will always pick a specific rate under “choose-your-rate” debt; see Section 4.2.1.1.2).
- If the hedged risk is the variability in the cash flows attributable to the changes in a contractually specified component in a forecasted purchase or sale of a nonfinancial asset, the entity must identify and document the hedged component.
- If the hedged risk is the variability in the cash flows attributable to changes in a contractually specified interest rate for forecasted interest receipts or payments on a variable-rate financial asset or liability, the entity must identify and document the hedged rate.
- Hedge of a forecasted transaction:
Note that even if a company has a specific risk management
policy that identifies permissible and required hedging activities, it is still
required to provide individual documentation of each hedge. A general policy
would not be specific enough to meet the formal documentation requirements
related to the individual hedging relationships. ASC 815 expressly requires an
entity, at the inception of each hedge, to formally document the hedging
relationship and the entity’s risk management objectives and strategy for
undertaking the hedge. Such documentation should include everything outlined
above and provide the basis for assessing effectiveness and determining when a
hedging relationship is terminated. An entity is not permitted to apply hedge
accounting without providing specific documentation of each hedging
relationship.
2.6.2 Certain Private Companies — Additional Timing Relief
ASC 815-20
Assuming Perfect
Hedge Effectiveness in a Cash Flow Hedge of a
Variable-Rate Borrowing With a Receive-Variable,
Pay-Fixed Interest Rate Swap Recorded Under the
Simplified Hedge Accounting Approach
25-136 In applying the
simplified hedge accounting approach, the documentation
required by paragraph 815-20-25-3 to qualify for hedge
accounting must be completed by the date on which the
first annual financial statements are available to be
issued after hedge inception rather than concurrently at
hedge inception.
Timing of Hedge
Documentation for Certain Private Companies if
Simplified Hedge Accounting Approach Is Not
Applied
Concurrent Hedge Documentation
25-139 Concurrent with hedge
inception, a private company that is not a financial
institution as described in paragraph 942-320-50-1 shall
document the following:
- The hedging relationship in accordance with paragraph 815-20-25-3(b)(1)
- The hedging instrument in accordance with paragraph 815-20-25-3(b)(2)(i)
- The hedged item in accordance with paragraph 815-20-25-3(b)(2)(ii), including (if applicable) firm commitments or the analysis supporting a last-of-layer designation in paragraph 815-20-25-3(c), or forecasted transactions in paragraph 815-20-25-3(d)
- The nature of the risk being hedged in accordance with paragraph 815-20-25-3(b)(2)(iii).
Pending Content (Transition Guidance: ASC
815-20-65-6)
25-139 [See Section 9.7.]
25-140 A private company that
is not a financial institution is not required to
perform or document the following items concurrent with
hedge inception but rather is required to perform or
document them within the time periods discussed in
paragraph 815-20-25-142:
- The method of assessing hedge effectiveness at inception and on an ongoing basis in accordance with paragraph 815-20-25-3(b)(2)(iv) and (vi)
- Initial hedge effectiveness assessments in accordance with paragraph 815-20-25-3(b)(2)(iv)(01) through (04).
25-141 Example 1A beginning
in paragraph 815-20-55-80A illustrates hedge
documentation when the critical terms of the hedging
instrument and hedged forecasted transaction match.
Although that Example illustrates the documentation of
the method of assessing hedge effectiveness, private
companies that are not financial institutions may
complete hedge documentation requirements in accordance
with paragraphs 815-20-25-139 through 25-140.
Hedge Effectiveness Assessments
25-142 For a private company
that is not a financial institution, the performance and
documentation of the items listed in paragraph
815-20-25-140, as well as required subsequent quarterly
hedge effectiveness assessments, may be completed before
the date on which the next interim (if applicable) or
annual financial statements are available to be issued.
Even though the completion of the initial and ongoing
assessments of effectiveness may be deferred to the date
on which financial statements are available to be issued
the assessments shall be completed using information
applicable as of hedge inception and each subsequent
quarterly assessment date when completing this
documentation on a deferred basis. Therefore, the
assessment should be performed to determine whether the
hedge was highly effective at achieving offsetting
changes in fair values or cash flows at inception and in
each subsequent quarterly assessment period up to the
reporting date.
Private companies that are not financial institutions may apply
the simplified hedge accounting approach to certain hedging relationships (see
Section
4.2.1.1.5 for more details). Under ASC 815-20-25-136, the
documentation required for a hedging relationship that qualifies for the
simplified hedge accounting approach “must be completed by the date on which the
first annual financial statements are available to be issued after hedge
inception rather than concurrently at hedge inception.”
ASU 2017-12 gave private companies that are not financial
institutions additional relief related to the timing of documentation for
hedging relationships that do not qualify for the simplified hedge accounting
approach. For example, under ASC 815-20-25-139, such entities need only document
the following at hedge inception:
- “The hedging relationship.”
- “The hedging instrument.”
- “The hedged item . . . , including (if applicable) firm commitments or the analysis supporting a last-of-layer designation . . . , or forecasted transactions.”
- “The nature of the risk being hedged.”
As stated in ASC 815-20-25-140, such entities do not need to (1)
document the “method of assessing hedge effectiveness at inception and on an
ongoing basis” or (2) perform the initial prospective quantitative hedge
effectiveness assessment until the date on which the next interim (if
applicable) or annual financial statements are available to be issued. The
performance of the subsequent hedge effectiveness assessments may also be
deferred until the time of the initial hedge effectiveness assessment.
Example 2-36
Page and Leo is a private piano
manufacturing company. It prepares financial statements
annually only and has a December 31 year-end. On July
15, 20X0, Page and Leo enters into an interest rate swap
to hedge interest payments on its debt and prepares
documentation of the hedging relationship, the swap, the
debt that gives rise to the interest payments, and the
fact that it is hedging for interest rate risk. Page and
Leo will perform hedge effectiveness assessments at the
end of each quarter. By the time the December 31, 20X0,
financial statements are available to be issued (assume
that date is May 15, 20X1), Page and Leo will have to
use data relevant to the following dates to complete
hedge effectiveness assessments:
- July 15, 20X0 (initial prospective quantitative assessment).
- September 30, 20X0.
- December 31, 20X0.
- March 31, 20X1.
There is no timing relief for subsequent
assessments over the remaining life of the hedging
relationship. Therefore, future assessments, starting
with the June 30, 20X1, assessment, must be performed on
a timely basis.
In addition to deferring documentation of the four items listed
in ASC 815-20-25-139 (see above), an entity may defer its preparation of all
other hedge documentation required by ASC 815-20-25-3 until the date on which
the financial statements are available to be issued.
2.6.3 Certain Not-for-Profit Entities — Additional Timing Relief
ASC 815-20
Hedge Accounting
Provisions Applicable to Certain Not-for-Profit
Entities
25-143 Not-for-profit
entities (except for not-for-profit entities that have
issued, or are a conduit bond obligor for, securities
that are traded, listed, or quoted on an exchange or an
over-the-counter market) may apply the guidance on the
timing of hedge documentation and hedge effectiveness
assessments in paragraphs 815-20-25-139 through 25-142.
Specifically, those entities shall document the items
listed in paragraph 815-20-25-139 concurrent with hedge
inception, but they may perform and document the items
listed in paragraph 815-20-25-140 and perform the
required subsequent quarterly hedge effectiveness
assessments in accordance with paragraph 815-20-25-142
within the time periods discussed in paragraph
815-20-25-142.
Not-for-profit entities may also use the timing relief for
hedging relationships unless such entities have issued, or are conduit bond
obligors for, securities that are traded, listed, or quoted on an exchange or an
OTC market.
Footnotes
13
ASU 2022-01 replaces the last-of-layer hedge with the
portfolio layer method hedge. Under the portfolio layer
method hedge, an entity still must provide an analysis
documenting its expectation that the hedged layer or
layers would be outstanding for the designated hedge
period. See further discussion of the portfolio layer
method and the effective date of ASU 2022-01 in
Chapter 9.
Chapter 3 — Fair Value Hedges
Chapter 3 — Fair Value Hedges
3.1 Overview
As indicated in the ASC master glossary and discussed briefly in
Section 1.3.1, a fair value hedge is a
“hedge of the exposure to changes in the fair value of a recognized asset or
liability, or of an unrecognized firm commitment, that are attributable to a
particular risk.” Variability in that risk has the potential to affect reported
earnings.
ASC 815-25
35-1
Gains and losses on a qualifying fair value hedge shall be
accounted for as follows:
- The gain or loss on the hedging instrument shall be recognized currently in earnings, except for amounts excluded from the assessment of effectiveness that are recognized in earnings through an amortization approach in accordance with paragraph 815-20-25-83A. All amounts recognized in earnings shall be presented in the same income statement line item as the earnings effect of the hedged item.
- The gain or loss (that is, the change in fair value) on the hedged item attributable to the hedged risk shall adjust the carrying amount of the hedged item and be recognized currently in earnings.
Pending Content (Transition Guidance: ASC
815-20-65-6)
35-1 [See Section 9.7.]
An entity with a fair value hedge that meets all of the hedging
criteria in ASC 815 (see Chapter 2) would (1)
record the change in the hedging instrument’s fair value in current-period earnings,
except for amounts that are excluded from the hedge effectiveness analysis (see
Section 3.4), and (2) adjust the hedged
item’s carrying amount for the change in the hedged item’s fair value that is
attributable to the risk being hedged. The adjustment to the carrying amount of the
hedged item would also be recognized in current-period earnings. For qualifying fair
value hedges, all amounts recognized in earnings that are related to both the
hedging instrument and the hedged item are presented in the same income statement
line item and should be related to the risk being hedged.
Common examples of fair value
hedging strategies include the following:
Hedged Item
|
Derivative
|
---|---|
Fixed-rate debt (liability)
|
A receive-fixed, pay-variable interest rate swap
|
Fixed-rate loans (assets)
|
A receive-variable, pay-fixed interest rate swap
|
Commodity inventory
|
Fixed-price forward or option to sell a commodity
|
Foreign-currency-denominated fixed-rate debt
|
Pay-variable, receive-fixed cross-currency interest rate
swap
|
Nonderivative fixed-price commitment to sell a commodity
|
Fixed-price forward to purchase a commodity
|
This chapter discusses the accounting for fair value hedges from start to finish,
including how to account for the hedged item throughout the hedging relationship and
beyond. The discussion is broken down into the two major categories of fair value
hedging relationships — hedges of financial instruments and hedges of nonfinancial
assets. Foreign currency hedges (both fair value and cash flow hedges) is discussed
separately in Chapter 5.
3.1.1 Hedging Firm Commitments
Although fair value hedging typically involves hedges of recognized assets or
liabilities, an entity is also permitted to hedge changes in the fair value of
an unrecognized firm commitment. Such a commitment to purchase or sell an asset
at a fixed price exposes an entity to fluctuations in the asset’s fair value
because the market price of the asset can change before the commitment is
fulfilled. If an entity has entered into a firm commitment to deliver a
commodity but does not already have the commodity in inventory, it may enter
into a derivative contract to purchase the commodity at a fixed price to hedge
that exposure.
The ASC master glossary defines a firm commitment, in part, as an agreement
between unrelated parties that (1) is “binding on both parties and usually
legally enforceable,” (2) “specifies all significant terms, including the
quantity to be exchanged, the fixed price, and the timing of the transaction,”
and (3) “includes a disincentive for nonperformance that is sufficiently large
to make performance probable.” (See the ASC master glossary for the complete
definition of a firm commitment.)
Disincentives include both monetary penalties and nonmonetary consequences, such
as exposure to costly litigation in the event of nonperformance (see ASC
815-25-55-84). In evaluating whether a monetary penalty is significant, an
entity should consider market volatility and the price risk of the asset
underlying the firm commitment.
Intercompany commitments do not meet the definition of a firm commitment because
they are not made with a third party. However, intercompany commitments that
have foreign currency exposure can be hedged as a forecasted transaction in a
foreign currency cash flow hedge (see Section
5.3.1.1.1).
In addition, a contract with an equity method investee does not
satisfy the criteria of a firm commitment because such a commitment must be made
with an unrelated party. Since the definition of “related parties” in ASC
850-10-20 includes an equity method investee, a contract does not qualify as a
firm commitment if it is between (1) an investor and its equity method investee
or (2) a subsidiary and an equity method investee of the subsidiary’s parent. As
discussed in Section 2.2.1.5, an entity is
permitted to hedge exposures related to forecasted transactions with an equity
method investee that are not eliminated through equity method accounting in a
cash flow hedge. However, if an entity has a fixed-price firm commitment with an
equity method investee, any transactions related to that firm commitment will no
longer have exposure to changes in cash flows related to any component of the
transaction with fixed terms.
3.2 Financial Instruments and Mortgage Servicing Rights
As discussed in Chapter 2, in a fair value hedge that involves existing financial
assets and liabilities, an entity can designate a derivative instrument to hedge one
or more specific risks of a hedged item. The table below summarizes the potential
hedged items and risks in a fair value hedge of a financial asset, mortgage
servicing right,1 or financial liability.
Underlying Asset or Liability
|
Hedgeable Portion
|
Risks That May Be Hedged
|
---|---|---|
|
|
|
Although in many fair value hedges the hedging derivative does not provide a
perfectly effective offset to the total changes in fair value that are related to
the hedged item, the ability to designate (1) select portions of the hedged item and
(2) specific hedged risks may affect both the hedge effectiveness assessment
discussed in Section 2.5 and how the hedged
item is remeasured. In fact, thoughtful designation of such items can make the
difference between a hedging relationship that qualifies for hedge accounting and a
relationship that does not, which will also affect earnings.
For example, the hedged item in a qualifying fair value hedging relationship is
remeasured for changes in its fair value that are attributable to the risk being
hedged, not necessarily for all changes in its fair value during the period. By
designating a component risk (or risks) that more closely aligns with the underlying
risk (or risks) of the hedging instrument, an entity can significantly improve the
amount of offset achieved in the income statement and, in some cases, achieve a
perfectly effective hedging relationship. Further, in the assessment of hedge
effectiveness, the change in the hedged item’s fair value that is attributable to
the designated risk is also the amount that is compared with the change in the
derivative’s fair value. Therefore, proper risk designation also increases an
entity’s chances of having a highly effective hedging relationship that would
qualify for hedge accounting.
3.2.1 Interest Rate Risk Hedging
Interest rate risk is the most common hedged risk related to
financial instruments and mortgage servicing rights. Entities often hedge
mortgage servicing rights, fixed-rate assets, or fixed-rate liabilities with
derivatives that have an underlying that is based on a benchmark interest rate
(e.g., derivatives based on U.S. Treasury rates or LIBOR). As discussed in
Section
2.3.1.1, the selection of interest rate risk as the hedged risk
removes from the hedging relationship the changes in the hedged item’s fair
value that are attributable to changes in credit spreads. As a reminder, an
entity is prohibited from hedging HTM debt securities and embedded prepayment
options in debt instruments for interest rate risk (see Sections 2.3.1.1.1 and
2.3.1.1.2).
ASC 815-25
35-13 In calculating the
change in the hedged item’s fair value attributable to
changes in the benchmark interest rate (see paragraph
815-20-25-12(f)(2)), the estimated coupon cash flows
used in calculating fair value shall be based on either
the full contractual coupon cash flows or the benchmark
rate component of the contractual coupon cash flows of
the hedged item determined at hedge inception.
If an entity selects interest rate risk as its designated risk in a fair value
hedging relationship, it has two alternatives regarding how it defines the
hedged interest cash flows when calculating the changes in the hedged item’s
fair value that are attributable to the changes in the benchmark interest rate;
the entity may look to either (1) the full contractual coupon cash flows or (2)
the benchmark rate component of those contractual coupon cash flows. The
alternative chosen will affect both the cash flows that will be the foundation
of the present value calculation and the discount rate used for that
calculation. If the entity looks to the full contractual coupon cash flows, the
discount rate used in the measurement should incorporate the credit spread at
inception. If the entity looks to the benchmark rate component of the
contractual coupon cash flows, the discount rate should not incorporate a credit
spread. In either case, the discount rate used at the end of each reporting
period should reflect the rate used at the beginning of the hedging
relationship, adjusted for changes in the benchmark interest rate. See
Section 3.2.1.5 for further discussion of how to
measure the changes in the hedged item that are attributable to changes in the
benchmark interest rate under both alternatives. One way to determine the
benchmark rate component of contractual coupons is by reference to the interest
rate on the fixed leg of an interest rate swap that has the following terms:
-
The variable leg is based on the designated benchmark rate and has no spread.
-
The term of the swap matches the term of the hedged item (i.e., matches the portion of the debt being hedged).
-
Any prepayment terms in the debt during the term of the hedge are mirrored in the swap.
-
The swap has a fair value of zero at the inception of the hedging relationship.
For example, assume that an entity is hedging a 10-year fixed-rate debt
instrument with no prepayment features for changes in the instrument’s fair
value that are attributable to changes in LIBOR. To determine the benchmark rate
component of the contractual coupons, the entity would reference the rate on the
fixed leg of an at-market interest rate swap that has (1) a variable leg that is
repriced on the basis of LIBOR with a tenor that matches how often the swap is
repriced or settled (e.g., three-month LIBOR if the swap is repriced on a
quarterly basis) and (2) a term that matches the term of the hedged item (10
years).
In most hedging relationships involving an at-market interest rate swap, we would
expect the benchmark rate component of the contractual coupons to match the rate
on the fixed leg of the actual swap used (adjusted to remove any fixed spread
that exists on the variable leg). Note that the swap does not necessarily need
to qualify for the shortcut method (e.g., it does not need to be repriced at
least every six months). However, if the hedging instrument is not a swap, an
entity may construct a hypothetical at-market interest rate swap to determine
the benchmark rate component of the contractual coupons. The example below,
which is derived from Example 16 in ASC 815-25-55-100 through 55-108,
illustrates this approach.
Example 3-1
Measurement of
Hedged Item — Full Contractual Coupon Cash Flows
Versus Benchmark Component of Contractual Coupon
Cash Flows
On July 2, 20X0, Entity XYZ issues, at
par, $100 million of A1-quality five-year fixed-rate
debt with an annual 8 percent interest coupon payable
semiannually. On that same date, XYZ also enters into a
$100 million notional five-year receive-8 percent,
pay-six-month LIBOR + 200 basis points (i.e., current
LIBOR swap rate is 6 percent) interest rate swap that
settles semiannually. Entity XYZ designates the swap as
the hedging instrument in a fair value hedge of the
interest rate risk of the $100 million liability. Assume
that the LIBOR swap rate increased by 100 basis points
to 7 percent on December 31, 20X0.
The table below highlights the reduced
impact on earnings that results from using the benchmark
interest rate component of the contractual coupon cash
flows to calculate the change in the hedged item’s fair
value that is attributable to interest rate risk.
Note that the example above contains a few important simplifying assumptions that
may affect the degree of hedge effectiveness, which in turn has an impact on the
net effect on the income statement during the hedging relationship. Those
simplifying assumptions are:
-
Fair value of derivative not impacted by changes in credit — In the example, it is assumed that there are no changes in the counterparty’s creditworthiness, credit, or funding spreads that would change the effectiveness of the hedging relationship. As noted in Section 2.5.2.1.2.6, the fair value of a derivative is affected by changes in the creditworthiness of both counterparties to the derivative. However, changes in creditworthiness that affect the derivative’s fair value during the life of the hedging relationship will not have an impact on the determination of changes in the hedged item’s fair value unless the shortcut method is applied.
-
The yield curve is flat — While, for simplicity, it is typically assumed in the examples in ASC 815 (including the example above) that there is a flat yield curve throughout the term of the hedging relationships, such a yield curve is actually quite rare. Therefore, any calculations of fair value should be consistent with the concepts in ASC 820, even though the hedged item will generally not be recognized at its full fair value because it is remeasured only (1) for changes in fair value that are attributable to the designated risk and (2) during the period in which it is in a qualifying fair value hedging relationship. If the yield curve is not flat, the actual discount rate that an entity uses in determining the fair value of each individual cash flow will depend on the timing of that specific cash flow.
An entity is permitted to designate a swap whose variable leg is an index other
than the entity’s designated benchmark rate as a hedge of the interest rate risk
related to the benchmark rate in fixed-rate debt. Accordingly, if an entity has
fixed-rate debt outstanding and it designates a benchmark rate in a hedge of
interest rate risk, the index on which the variable leg of the hedging interest
rate swap is based does not have to be the benchmark rate. However, the hedging
relationship would not qualify for the shortcut method in ASC 815-20-25-102
through 25-111 unless the index of the variable leg is the designated benchmark
rate (see ASC 815-20-25-105(f)).
For example, assume that an entity has entered into an interest rate swap whose
variable leg is based on the prime rate and, under the entity’s risk management
policy, LIBOR is the designated benchmark rate for interest rate risk. In
assessing hedge effectiveness, the entity will have to consider the basis
difference between LIBOR and the prime rate. If the results of the entity’s
assessment indicate that the hedging relationship is highly effective, hedge
accounting would be appropriate. However, when the entity is measuring the
change in the hedged item’s fair value that is due to changes in the designated
benchmark interest rate, it should consider changes in the designated benchmark
interest rate (i.e., LIBOR) and not changes in the rate referenced in the swap
(i.e., the prime rate). If it is later determined that the hedge of LIBOR
interest rate risk with a swap whose variable leg is based on the prime rate is
not highly effective, hedge accounting would be discontinued.
3.2.1.1 Partial-Term Hedging
ASC 815-25
35-13B For a fair value
hedge of interest rate risk in which the hedged item
is designated as selected contractual cash flows in
accordance with paragraph 815-20-25-12(b)(2)(ii), an
entity may measure the change in the fair value of
the hedged item attributable to interest rate risk
using an assumed term that begins when the first
hedged cash flow begins to accrue and ends when the
last hedged cash flow is due and payable. The
assumed issuance of the hedged item occurs on the
date that the first hedged cash flow begins to
accrue. The assumed maturity of the hedged item
occurs on the date in which the last hedged cash
flow is due and payable. An entity may measure the
change in fair value of the hedged item attributable
to interest rate risk in accordance with this
paragraph when the entity is designating the hedged
item in a hedge of both interest rate risk and
foreign exchange risk. In that hedging relationship,
the change in carrying value of the hedged item
attributable to foreign exchange risk shall be
measured on the basis of changes in the foreign
currency spot rate in accordance with paragraph
815-25-35-18. Additionally, an entity may have one
or more separately designated partial-term hedging
relationships outstanding at the same time for the
same debt instrument (for example, 2 outstanding
hedging relationships for consecutive interest cash
flows in Years 1–3 and consecutive interest cash
flows in Years 5–7 of a 10-year debt
instrument).
Pending Content (Transition Guidance: ASC
815-20-65-6)
35-13B [See Section 9.7.]
As discussed in Section 2.2.2.1.1.2, an
entity may hedge one or more selected contractual cash flows of an item (or
a portfolio of items) in a fair value hedging relationship. A hedge of some,
but not all, of the contractual cash flows of a debt instrument is commonly
referred to as a partial-term hedge. Before the issuance of ASU 2017-12, it was difficult for an
entity to qualify for hedge accounting when designating a partial-term
hedge, but ASU 2017-12 and ASU
2019-04 changed how an entity measures changes in a
hedged item’s fair value that are attributable to changes in the designated
risk for partial-term hedges, which in turn affects the hedge effectiveness
assessment. In addition, ASU 2017-12 amended the shortcut method criteria to
allow partial-term hedges to qualify for the shortcut method.
ASC 815-25-35-13B states that in a fair value hedge of
interest rate risk, an entity may measure the change in the hedged item’s
fair value that is attributable to changes in the benchmark interest rate by
“using an assumed term that begins when the first hedged cash flow begins to
accrue and ends when the last hedged cash flow is due and payable.”2 By using an assumed term that ends when the last hedged cash flow is
due and payable, the entity assumes that the remaining principal payment
will occur at the end of the specified partial term.
Example 3-2
Partial-Term Hedge
TreyCo issues $100 million of five-year noncallable
fixed-rate debt. It enters into an at-market
two-year receive-fixed, pay-variable (LIBOR)
interest rate swap with a notional amount of $100
million and designates the swap as a fair value
hedge of the interest rate risk for the first two
years of the debt’s term. When TreyCo calculates the
change in the debt’s fair value that is attributable
to changes in the benchmark interest rate (LIBOR),
it may assume for calculation purposes that (1) the
term of the hedged debt is two years and (2)
repayment of the outstanding debt occurs at the end
of the second year. If TreyCo also elects to measure
the changes in the debt’s fair value that are
attributable to changes in LIBOR on the basis of the
benchmark rate component of the contractual coupon
cash flows, it may assume the benchmark rate
component of the coupons would be equal to the fixed
rate on the swap.
When an entity designates a partial-term fair value hedge,
it may, in accordance with ASC 815-20-25-12(b)(2)(ii), designate any single
interest payment or any consecutive interest payments associated with the
debt instrument as the hedged partial term. The entity is not required to
designate the first scheduled contractual interest payment as the first
payment in the hedged partial term; therefore, partial-term hedging also
applies to hedging strategies that involve forward-starting swaps (see
Example
2-2). As noted above, under ASC 815-25-35-13B, the entity would
measure the change in the debt’s fair value that is attributable to interest
rate risk by “using an assumed term that begins when the first hedged cash
flow begins to accrue and ends when the last hedged cash flow is due and
payable.”3
Furthermore, for prepayable instruments, if the designated hedged partial
term ends on or before the date on which the instrument may be prepaid, the
designated hedged item is essentially not prepayable. Therefore, the entity
does not need to consider prepayment risk for such a hedging relationship
when determining hedge effectiveness or measuring changes in the hedged
item’s fair value that are attributable to interest rate risk (which aligns
with how an entity would consider prepayment risk in a partial-term cash
flow hedge of a callable instrument).
An entity should account for any basis adjustments made to the hedged item’s
carrying value in a partial-term hedging relationship in accordance with its
hedging policies. Under ASC 815, any method of amortization must result in
amortization of the basis adjustments over the life of the hedging
relationship, not the life of the debt instrument. Accordingly, if an entity
elects to amortize the basis adjustments during the hedging relationship
(see Section 3.2.5), the period of amortization would
match the term of the hedge (i.e., amortization would occur up to the
assumed maturity date). Upon an early termination of the hedging
relationship, the entity should amortize any remaining carrying amount
adjustments in a manner consistent with how it amortizes any other premiums
or discounts for the hedged item (generally over the remaining life of the
debt instrument).
3.2.1.1.1 Multiple Concurrent Partial-Term Hedges of Same Hedged Item
An entity can have multiple partial-term hedging relationships involving
the same hedged item outstanding at the same time. However, the same
hedged cash flows may not be designated as the hedged item in more than
one outstanding hedging relationship at the same time. ASU 2019-04 added
the following to ASC 815-25-35-13B:
[A]n entity may have one or more separately designated
partial-term hedging relationships outstanding at the same time
for the same debt instrument (for example, 2 outstanding hedging
relationships for consecutive interest cash flows in Years 1–3
and consecutive interest cash flows in Years 5–7 of a 10-year
debt instrument).
3.2.1.1.2 Partial-Term Hedging for Risks Other Than Interest Rate Risk
After the issuance of ASU 2017-12, questions arose about whether the
ability to measure the change in the fair value of the hedged item in a
partial-term fair value hedge by using the item’s assumed term only
applies to hedges of interest rate risk or whether the change in the
fair value of the hedged item in a partial-term fair value hedge of both
interest rate risk and foreign exchange risk also can be measured by
using the instrument’s assumed term. In response, ASU 2019-04 added the
following to ASC 815-25-35-13B:
An entity may measure the change in fair value of the hedged item
attributable to interest rate risk in accordance with this
paragraph when the entity is designating the hedged item in a
hedge of both interest rate risk and foreign exchange risk. In
that hedging relationship, the change in carrying value of the
hedged item attributable to foreign exchange risk shall be
measured on the basis of changes in the foreign currency spot
rate in accordance with paragraph 815-25-35-18.
As a result of this clarification, partial-term hedging is allowed for
interest rate risk, foreign currency risk, or a combination of those
risks, but ASC 815-25-35-18 already requires any asset or liability that
is denominated in a foreign currency to be remeasured for changes in
foreign currency exchange rates in accordance with ASC 830 (i.e., on the
basis of the spot exchange rate as of the balance sheet date). For
example, ASC 830 already requires a foreign-currency-denominated debt
instrument to be translated on the basis of the spot exchange rate as of
the balance sheet date. Accordingly, the maturity date of a debt
instrument (actual or assumed) is irrelevant when the instrument is
remeasured for changes in its fair value that are attributable to
changes in foreign currency exchange rates.
3.2.1.2 Prepayable Debt
ASC 815-20
Fair Value Hedges of Interest Rate Risk in Which
the Hedged Item Can Be Settled Before Its
Scheduled Maturity
25-6B An entity may
designate a fair value hedge of interest rate risk
in which the hedged item is a prepayable instrument
in accordance with paragraph 815-20-25-6. The entity
may consider only how changes in the benchmark
interest rate affect the decision to settle the
hedged item before its scheduled maturity (for
example, an entity may consider only how changes in
the benchmark interest rate affect an obligor’s
decision to call a debt instrument when it has the
right to do so). The entity need not consider other
factors that would affect this decision (for
example, credit risk) when assessing hedge
effectiveness. Paragraph 815-25-35-13A discusses the
measurement of the hedged item.
ASC 815-25
35-13A In a hedge of
interest rate risk in which the hedged item is a
prepayable instrument in accordance with paragraph
815-20-25-6, the factors incorporated for the
purpose of adjusting the carrying amount of the
hedged item shall be the same factors that the
entity incorporated for the purpose of assessing
hedge effectiveness in accordance with paragraph
815-20-25-6B. For example, if an entity considers
only how changes in the benchmark interest rate
affect an obligor’s decision to prepay a debt
instrument when assessing hedge effectiveness, it
shall consider only that factor when adjusting the
carrying amount of the hedged item. The election to
consider only how changes in the benchmark interest
rate affect an obligor’s decision to prepay a debt
instrument does not affect an entity’s election to
use either the full contractual coupon cash flows or
the benchmark rate component of the contractual
coupon cash flows determined at hedge inception for
purposes of measuring the change in fair value of
the hedged item in accordance with paragraph
815-25-35-13.
ASU 2017-12 also significantly changed how, under ASC 815, an entity may
evaluate the impact of prepayment features when measuring the change in the
hedged item’s fair value that is attributable to changes in the designated
benchmark interest rate. As noted in paragraph BC99 of ASU 2017-12, the FASB
was responding to concerns that “estimating the fair value of the prepayment
option to the level of precision required in the current reporting and
regulatory environment is virtually impossible because an entity is required
to incorporate credit and all other idiosyncratic factors that would affect
the prepayment option.” If we assume that entities act on the basis of
available market information and in a timely manner, an issuer of a callable
debt instrument will exercise its right to prepay the debt on the basis of
changes in its market borrowing rate, which include both changes in the
benchmark interest rate and changes in credit spreads. Even if a prepayment
option is “mirrored” in an interest rate swap, the decision to terminate an
interest rate swap would only be based on changes in the underlying rate of
the swap, which would not include changes in credit spreads. In addition, as
noted in paragraph BC99 of ASU 2017-12, borrowers do not always exercise
prepayment options when it makes sense to do so since there may be
idiosyncratic factors at play. For example, borrowers are required to prepay
residential mortgage loans upon the sale of the underlying property, which
is often driven by non-market-based factors (e.g., death, relocation).
In addition, ASU 2017-12 added ASC 815-20-25-6B, which allows an entity that
is assessing hedge effectiveness to elect to “consider only how changes in
the benchmark interest rate affect the decision to settle the hedged item
before its scheduled maturity.” This decision also affects the measurement
of the change in the hedged item’s fair value that is attributable to
changes in the designated benchmark interest rate; ASC 815-25-35-13A states
that “the factors incorporated for the purpose of adjusting the carrying
amount of the hedged item shall be the same factors that the entity
incorporated for the purpose of assessing hedge effectiveness in accordance
with paragraph 815-20-25-6B.” An entity may also elect to consider all
factors that would affect its decision to settle the hedged item before its
scheduled maturity when (1) assessing hedge effectiveness and (2) measuring
the change in the hedged item’s fair value that is attributable to changes
in the designated benchmark interest rate. However, we do not expect many
entities to do so since considering all factors would increase the sources
of ineffectiveness in most cases. In fact, the sources of ineffectiveness
might be great enough to prevent many hedging relationships from being
considered highly effective.
So, what happens when an entity only considers how changes in the benchmark
interest rate affect the decision to settle the hedged item before its
scheduled maturity? One impact is that an investor in a callable debt
instrument can consider only how changes in the benchmark interest rate will
affect an obligor’s decision to call the debt instrument. The investor is
not required to consider all factors that will affect the decision to settle
the financial instrument before its scheduled maturity when assessing hedge
effectiveness and measuring the change in the debt’s fair value that is
attributable to changes in the benchmark interest rate.
If an entity designates interest rate risk as the hedged risk in a fair value
hedge of a prepayable financial instrument and elects to consider only how
changes in the benchmark interest rate affect the decision to settle the
hedged item before its scheduled maturity, one acceptable way to determine
the change in the instrument’s fair value attributable to interest rate risk
is to assume that the credit spread of the issuer remains fixed over the
life of the hedging relationship.
Example 3-3
Determining Change in Fair Value of Prepayable
Debt Attributable to Benchmark Interest
Rate
InvestorCo holds a $1 million 10-year debt instrument
issued by DebtCo, which can call the debt at par any
time after the five-year anniversary of the debt
issuance. The debt pays interest semiannually at 6
percent per annum. Also assume that InvestorCo
enters into an at-market pay-fixed, receive-variable
interest rate swap with a notional amount of $1
million and a term of 10 years. InvestorCo will
receive six-month LIBOR and pay 4 percent per annum
semiannually. It can terminate the swap at any time
after five years. When determining the fair value of
the debt in periods after the issuance, InvestorCo
would assume that the market rate on the debt is 200
basis points (6% – 4%) above the swap rate for an
interest rate swap that (1) has a life that matches
the remaining life of the debt and (2) can be
terminated by InvestorCo at any time after the
five-year anniversary of the debt’s issuance. The
swap rate is the rate on the fixed leg of a swap
that has a fair value of zero.
Note that if the hedged item is convertible debt and the hedged risk is
interest rate risk, the analysis would not take into account any early
conversions or exercises of call options that would be triggered by the
value of the underlying equity instruments. This is because such events,
which would qualify as prepayments, do not result from changes in the
benchmark interest rate.
Also, as noted in Section 3.2.1.1, if
an entity designates a partial-term fair value hedge and the designated
partial term ends on or before the date on which the instrument may be
prepaid, the designated hedged item is essentially not prepayable.
Therefore, the entity does not need to consider prepayment risk for such
hedging relationships when it determines hedge effectiveness or measures
changes in the fair value of the hedged item. Note that all other references
to “scheduled maturity” in ASC 815-20-25-6B and in the discussion above
should be interpreted as referring to the assumed maturity in a partial-term
fair value hedging relationship.
3.2.1.2.1 Contingent Prepayment Terms
The ASC master glossary defines prepayable as “[a]ble to
be settled by either party before its scheduled maturity.” At its
February 14, 2018, meeting, the FASB staff indicated, and the Board agreed,
that in most circumstances, an entity should look to this broad
definition when determining whether an instrument is prepayable.
Therefore, an instrument with noncontingent prepayment features that are
exercisable at any time is considered prepayable. In addition, an
instrument with features that make it prepayable upon the passage of a
specified amount of time, or conversion features (with or without a call
option) that could require the issuer to convert debt into equity, would
also be prepayable if, under the contractual terms of the instrument,
those features could be triggered before its maturity date. An
instrument with a prepayment feature in which the timing of
exercisability is unknown (e.g., an event-based contingency or a
contingency that is triggered by specified interest rate movements) also
would qualify as being prepayable because the contingency could be
resolved at any time during the instrument’s life.
However, to apply the accounting guidance in ASC 815-20-25-6B and ASC
815-25-25-13A and actually designate the prepayable asset in a
last-of-layer hedging relationship (see Section 3.2.1.4), an entity must determine that the
instrument’s features could allow it to become prepayable during the
life the designated hedging relationship. For example, if an entity
holds an instrument with a conversion option that becomes exercisable
five years after its issuance, the entity would be unable to designate
the convertible instrument as a hedged item in either (1) a hedging
relationship in which it applies the guidance in ASC 815-20-25-6B and
ASC 815-25-25-13A or (2) a last-of-layer hedging relationship unless the
hedging relationship’s designated duration includes the period in which
the conversion option becomes effective (i.e., the term of the hedging
relationship extends beyond the five-year anniversary of the
instrument’s issuance). When an entity assesses whether an instrument
that contains multiple prepayment features can be the designated hedged
item in one of these hedging relationships, the entity may make its
determination on the basis of the prepayment feature that could be
triggered the soonest.
At the February 14, 2018, FASB meeting, the staff also clarified that
contingent acceleration clauses that permit an acceleration of
contractual maturity should not be considered prepayment features if the
contingent event is related to the debtor’s credit deterioration or
other changes in the debtor’s credit risk. However, if the credit
contingency is accompanied by other features that would otherwise make
the instrument eligible to be considered prepayable, the existence of
the contingent acceleration clause related to credit would not preclude
an entity from considering the instrument to be prepayable.
Changing Lanes
In November 2019, the FASB issued a
proposed ASU of Codification improvements
to hedge accounting. One of the proposed improvements was to
replace the term “prepayable” with “early settlement feature” in
the guidance on the application of the shortcut method; however,
at the October 11, 2023, FASB meeting, the Board decided not to
affirm its proposed amendment.
If an entity designates an instrument that is considered prepayable as
the hedged item in a fair value hedge of interest rate risk, it will
generally elect to only take into account how those features are
affected by changes in the benchmark interest rate when analyzing the
prepayment features for its (1) assessment of hedge effectiveness under
ASC 815-20-25-6B and (2) measurement of the change in the hedged item’s
fair value that is attributable to changes in the benchmark interest
rate under ASC 815-25-35-13A. ASC 815-20-25-6B states, in part, that an
entity “may consider only how changes in the benchmark interest rate
affect the decision to settle the hedged item before its scheduled
maturity,” and ASC 815-25-35-13A requires “the factors incorporated for
the purpose of adjusting the carrying amount of the hedged item [to] be
the same factors that the entity incorporated for the purpose of
assessing hedge effectiveness.”
Below are examples of instruments that are considered prepayable. If such
an instrument is designated as the hedged item in a fair value hedge of
interest rate risk, an entity should consider the effects of the
prepayment features as follows:
-
An instrument in which the entity’s ability to prepay is triggered by the occurrence of a specified event that is unrelated to changes in the benchmark rate — If the entity considers only how changes in the benchmark interest rate affect the decision to settle the hedged item before its maturity, its assessment of hedge effectiveness and measurement of the hedged item should ignore the contingent feature until the specified event occurs because changes in the benchmark interest rate do not affect the timing of the event. After the contingency is resolved (i.e., after the event that triggers the prepayment feature occurs), the entity would consider the effect of the prepayment feature in its assessment of hedge effectiveness and measurement of the hedged item only to the extent that changes in the benchmark interest rate would affect the entity’s decision to prepay.
-
An instrument with an interest-rate–related contingency — When the entity assesses hedge effectiveness and measures the change in hedged item’s fair value that is attributable to interest rate risk, it must consider both (1) interest rate fluctuations that could trigger the contingency and (2) “the probability of exercise given the interest rate scenario (only considering the effects of the benchmark interest rate),” as indicated in the FASB’s “Staff Interpretations of Update 2017-12 for Prepayable Financial Instruments.” However, if the contingency is related to movements in a nonbenchmark interest rate, the entity may ignore the effects of any movements in the actual referenced rate that differ from movements in the benchmark interest rate. In essence, the entity is allowed to assume that there is a fixed spread between the benchmark interest rate and the interest rate linked to the contingency.
-
A debt instrument with a conversion feature — As stated in “Staff Interpretations of Update 2017-12 for Prepayable Financial Instruments,” when an entity assesses hedge effectiveness or measures the changes in the hedged item’s fair value that are attributable to changes in the benchmark interest rate, it should “consider only how changes in benchmark interest rates affect the decision to prepay,” even though changes in equity prices and equity volatility and dividend considerations historically have been much more significant factors in such decisions. Note that the occurrence of a conversion before the instrument’s contractual maturity is considered a “prepayment” in this context since the instrument would be settled before its scheduled maturity.
3.2.1.3 Shortcut Method
As discussed in Section 2.5.2.2.1, the shortcut method
is used to account for certain hedging relationships in which interest rate
swaps hedge interest rate risk in existing debt instruments. The shortcut
method cannot be applied to hedges of mortgage servicing rights since such
rights do not meet the definition of a debt instrument because of the
performance obligation required by the servicer. If a hedging relationship
qualifies for the shortcut method, it is assumed to be a “perfect” hedging
relationship, so the entity does not need to perform quantitative
assessments at any time during the hedging relationship. Section 2.5.2.2.1 primarily focuses on the
conditions that need to be met for a hedging relationship to qualify for the
shortcut method.
When the shortcut method is applied to a fair value hedging relationship, the
hedged item is a fixed-rate debt instrument (asset or liability) and the
hedging instrument is an interest rate swap that effectively converts the
fixed cash flows on the debt instrument into a variable rate based on the
designated benchmark interest rate. The application of the shortcut method
combines synthetic instrument accounting with the recognition of derivative
instruments at fair value on the balance sheet in each reporting period. The
periodic net settlements on the swap are recognized in the same income
statement line item as the coupon payments on the debt (interest income or
expense), while the derivative is recorded at fair value in each period. In
a fair value hedge, an entity adjusts the carrying amount of the hedged debt
in an amount equal to and offsetting the change in the derivative’s fair
value. The shortcut method may be applied to either a full-term or
partial-term fair value hedging relationship, but it may not be applied to a
partial-term hedging relationship that involves a forward-starting swap (see
Example 2-32).
As noted in Section 2.5.2.2.1.8, an
entity needs to monitor the nonperformance risk of both parties to the
interest rate swap because if it is no longer probable that both parties
will perform under the swap, the continued application of the shortcut
method is no longer appropriate.
In addition, as noted in Section
2.5.2.2.1.9, if the application of the shortcut method is no
longer appropriate (for any reason) but the entity has documented a backup
quantitative hedge effectiveness assessment method, it may still be
appropriate for the entity to apply hedge accounting if the hedging
relationship is still highly effective.
Section 3.2.7 includes detailed illustrations of the
application of the shortcut method to a full-term fair value hedging
relationship (see Example 3-6) and a partial-term fair
value hedging relationship (see Example 3-8).
3.2.1.4 Last-of-Layer Method/Portfolio Layer Method
ASC 815-20
25-12A For a closed
portfolio of prepayable financial assets or one or
more beneficial interests secured by a portfolio of
prepayable financial instruments, an entity may
designate as the hedged item a stated amount of the
asset or assets that are not expected to be affected
by prepayments, defaults, and other factors
affecting the timing and amount of cash flows if the
designation is made in conjunction with the
partial-term hedging election in paragraph
815-20-25-12(b)(2)(ii) (this designation is referred
to throughout Topic 815 as the “last-of-layer
method”).
-
As part of the initial hedge documentation, an analysis shall be completed and documented to support the entity’s expectation that the hedged item (that is, the designated last of layer) is anticipated to be outstanding as of the hedged item’s assumed maturity date in accordance with the entity’s partial-term hedge election. That analysis shall incorporate the entity’s current expectations of prepayments, defaults, and other events affecting the timing and amount of cash flows associated with the closed portfolio of prepayable financial assets or beneficial interest(s) secured by a portfolio of prepayable financial instruments.
-
For purposes of its analysis, the entity may assume that as prepayments, defaults, and other events affecting the timing and amount of cash flows occur, they first will be applied to the portion of the closed portfolio of prepayable financial assets or one or more beneficial interests that is not part of the hedged item (that is, the designated last of layer).
Pending Content (Transition Guidance: ASC
815-20-65-6)
25-12A
[See Section 9.7.]
ASC 815-25
35-7A When the hedged item
is designated and accounted for under the
last-of-layer method in accordance with paragraph
815-20-25-12A, an entity shall perform and document
at each effectiveness assessment date an analysis
that supports the entity’s expectation that the
hedged item (that is, the designated last of layer)
is still anticipated to be outstanding as of the
hedged item’s assumed maturity date. That analysis
shall incorporate the entity’s current expectations
of prepayments, defaults, and other events affecting
the timing and amount of cash flows using a method
consistent with the method used to perform the
analysis in paragraph 815-20-25-12A(a).
Pending Content (Transition Guidance: ASC
815-20-65-6)
35-7A [See Section 9.7.]
ASU 2017-12 also added the “last-of-layer” method to ASC 815, which enables
an entity to apply fair value hedging to closed portfolios of prepayable
financial assets without having to consider prepayment risk or credit risk
when measuring those assets. An entity can also apply the method to one or
more beneficial interests secured by a portfolio of prepayable financial
instruments (e.g., an MBS). The last-of-layer method cannot be applied to
liabilities, so the issuer of an MBS could not hedge the issued security
under the last-of-layer method. In addition, the method is not available for
hedges of mortgage servicing rights because such rights do not meet the
definition of a financial asset. Finally, the last-of-layer method cannot be
applied to cash flow hedging relationships.
In accordance with ASC 815-20-25-12A, an entity that uses the last-of-layer
method would designate a stated amount of the asset or assets that it does
not expect “to be affected by prepayments, defaults, and other factors
affecting the timing and amount of cash flows” (the “last of layer”) as the
hedged item in a fair value hedge of interest rate risk. This designation
would occur in conjunction with the partial-term hedging election discussed
in Section 3.2.1.1.
Changing Lanes
Because the last-of-layer method was a late addition
to ASU 2017-12, it was not in the exposure draft and, therefore,
never subject to public comment. After its issuance, several
questions were raised related to the last-of-layer method. In March
2022, the FASB issued ASU 2022-01, which clarifies the guidance in
ASC 815 on fair value hedge accounting of interest rate risk for
portfolios of financial assets. ASU 2022-01 renames the
“last-of-layer” method the “portfolio layer” method and addresses
feedback from stakeholders regarding its application. See Chapter 9 for
a discussion of the main provisions, effective dates, and transition
requirements of ASU 2022-01.
To support the designation, the entity should include evidence that it
performed an analysis that reinforced its expectation that the hedged item
(i.e., the last of layer) would be outstanding as of the item’s assumed
maturity date in the initial hedge designation. That analysis should reflect
the entity’s current expectations about factors that can affect the timing
and amount of the closed portfolio’s (or, for beneficial interests, the
underlying assets’) cash flows (e.g., prepayments and defaults); however,
the entity may assume that the effects of any events, such as prepayments or
defaults, would first apply to the portion of the closed portfolio or
beneficial interest(s) that is not part of the designated hedged item (last
of layer).
As of each subsequent hedge effectiveness assessment date, the entity must
continue to update its analysis supporting the expectation that the hedged
item (i.e., the last of layer) will be outstanding on the assumed maturity
date. The updated analysis should reflect the entity’s current expectations
about the level of prepayments, defaults, or other factors that could affect
the timing and amount of cash flows. When updating its analysis, the entity
should use the same methods as those used at hedge inception.
Connecting the Dots
ASU 2017-12 did not change the requirement that a
hedged portfolio in a single fair value hedge must consist only of
“similar” assets that share the risk exposure for which they are
designated as being hedged. However, an entity that applies the
last-of-layer method may qualitatively satisfy this criterion if it
combines the partial-term fair value hedge election (see Section
3.2.1.1) and the election to measure changes in the
hedged item’s fair value by using the benchmark rate component of
the contractual coupon cash flows (see Section 3.2.1). Paragraph
BC112 of ASU 2017-12 states, in part:
Using the benchmark rate component of the
contractual coupon cash flows when (a) all assets have the
same assumed maturity and (b) prepayment risk does not
affect the measurement of the hedged item results in all
hedged items having the same benchmark rate coupon. When
those elections are made, and because the portfolio is
closed, a similar assets test needs to be performed only at
hedge inception. Additionally, all assets in the portfolio
for hedge accounting purposes are considered nonamortizing
and nonprepayable with the same maturity and coupon,
resulting in the similar assets test being performed on a
qualitative basis.
When an entity accounts for a hedging relationship that is
designated under the last-of-layer method, it may exclude prepayment risk
and credit risk when measuring the change in the hedged item’s fair value
that is attributable to changes in interest rate risk. Also, on each
reporting date, the entity should adjust the basis of the hedged item for
the gain or loss that is attributable to changes in the hedged risk (i.e.,
interest rate risk), as it would do for any other fair value hedge. However,
in a last-of-layer hedge, the hedged item is a closed portfolio of
prepayable assets, so the basis adjustment is a portfolio-level basis
adjustment. As discussed below, an entity must, by using a systematic and
rational method, allocate the basis adjustment (or portion thereof) to the
individual assets within the portfolio upon a full or partial discontinuance
of the last-of-layer hedge. The shortcut method may not be applied to a
last-of-layer hedge.
In accordance with ASC 815-25-40-8(a), an entity that concludes on any hedge
effectiveness assessment date that it no longer expects the entire hedged
last of layer to be outstanding on its assumed maturity date must, at a
minimum, discontinue hedge accounting for that portion of the hedged last of
layer that is not expected to be outstanding. Moreover, in accordance with
ASC 815-20-40-8(b), the entity must discontinue the entire hedging
relationship on any assessment date on which it determines that the hedged
last of layer currently exceeds the outstanding balance of (1) the closed
portfolio of prepayable assets or (2) one or more beneficial interests in
the prepayable assets. If an entity discontinues a full or partial hedge, it
must allocate, in a systematic and rational manner, the outstanding basis
adjustment (or portion thereof) that resulted from the previous hedge
accounting for this hedging relationship to the individual assets in the
closed portfolio. Under ASC 815-25-40-9, such allocated amounts must be
amortized over a period “that is consistent with the amortization of other
discounts or premiums associated with the respective assets.” We believe
that if an entity is required to discontinue the entire hedging relationship
because the outstanding balance of the hedged item is less than the hedged
last of layer, a proportion of the portfolio basis adjustment should be
reversed through earnings for the portion of the hedged last of layer that
no longer exists. See Section 3.5 for further
discussion of dedesignating and discontinuing fair value hedges.
Connecting the Dots
The last-of-layer method does not specifically incorporate a tainting
threshold; therefore, an entity that is required to discontinue a
last-of-layer hedging relationship is not precluded from designating
similar hedging relationships in the future. However, we believe
that an entity that needs to dedesignate a last-of-layer hedging
relationship, partially or fully, should consider the reasons for
the dedesignation when performing similar analyses for future
last-of-layer hedges.
Example 3-4
Last-of-Layer
Hedge
Weekapaug Regional Bank has a
portfolio (“Portfolio X”) of fixed-rate prepayable
residential mortgages with stated maturities of up
to 30 years. The fixed rates and maturity dates of
the mortgages vary. The current outstanding
principal balance of the pool of mortgages is $300
million.
Weekapaug wants to hedge its
exposure to changes in the fair value of the
mortgages in Portfolio X that are attributable to
changes in the benchmark interest rate over the next
five years. On the basis of its current expectations
about the level of prepayments, defaults, and other
factors that could affect the timing and amount of
cash flows in Portfolio X, Weekapaug believes that
the outstanding unpaid principal balance will not
fall below $160 million at the end of the five-year
period. With that in mind, it executes a five-year,
receive-variable (one-month LIBOR), pay-fixed
interest rate swap with a notional amount of $160
million to hedge the interest rate risk.
Last-of-Layer
Method — Application at Inception
-
Weekapaug designates as the hedged item interest receipts on the last $160 million of unpaid principal balance within Portfolio X over the next five years (i.e., a partial-term hedge election) and elects to measure the hedged item (i.e., $160 million last of layer) by using the benchmark rate component (LIBOR) of the contractual coupon cash flows.
-
In accordance with ASC 815, Weekapaug (1) performs an analysis that supports its expectation that the hedged item will be outstanding as of the item’s assumed maturity date and (2) documents its conclusion that the $300 million of mortgages in Portfolio X are similar.
-
Because the designated $160 million of unpaid principal balance (the last of layer) is expected to be outstanding at the end of the specified hedge term, Weekapaug can ignore prepayment risk and default risk when assessing whether the hedging relationship is expected to be highly effective.
Last-of-Layer
Method — Application in Subsequent Reporting
Periods
- Because of the combined effect of Weekapaug’s (1) elections related to the partial-term hedge, (2) use of the benchmark rate component of the coupon, and (3) last-of-layer designation, the hedged last of layer is essentially transformed into a homogeneous group of loans and cash flows within Portfolio X. As a result, Weekapaug can ignore contractual principal payments, prepayments, and defaults for measurement purposes and avoid having to assess after hedge inception whether the assets in Portfolio X are still similar.
- The designated hedging relationship will pass the quarterly hedge effectiveness assessment given that the key terms of the hedging relationship match (although the shortcut method may not be applied).
-
Weekapaug will account for the hedge accounting basis adjustments that arise during the hedging relationship at the Portfolio X level (i.e., the level of the designated hedged item).
-
As of each effectiveness testing date, Weekapaug will perform an analysis to support its expectation that the unpaid principal balance at the end of the hedged term will be no less than $160 million (i.e., the designated hedged exposure).
-
If Weekapaug concludes on any assessment date that it expects the outstanding balance of Portfolio X to be less than $160 million on the assumed maturity date, it would be required to (1) discontinue hedge accounting for at least the portion of the designated last of layer that it no longer expects to be outstanding on the assumed maturity date and (2) allocate the related portion of the outstanding basis adjustment to individual assets in the closed portfolio by using a systematic and rational method.
-
If the outstanding balance of loans in Portfolio X is less than $160 million on any assessment date, Weekapaug must discontinue the entire hedging relationship and allocate the portfolio-level basis adjustment to the individual assets by using a systematic and rational method. A proportion of the portfolio basis adjustment should be reversed through earnings for the portion of the hedged last of layer that no longer exists. For example, if the outstanding balance of the loans in Portfolio X is $144 million on an assessment date, Weekapaug should (1) reverse 10 percent, or ($160 million – $144 million) ÷ $160 million, of the portfolio-level basis adjustment through earnings and (2) allocate the remaining 90 percent of the basis adjustment to the remaining individual assets.
-
3.2.1.5 Methods of Measuring Changes in Fair Value That Are Due to Changes in Benchmark Interest Rates
ASC 815 does not prescribe a single method for determining the change in the
hedged item’s fair value that is attributable to changes in the benchmark
interest rate. Rather, it provides illustrative examples, such as those
shown below.
3.2.1.5.1 Example 9 Method
ASC 815-25
Example 9: Fair Value Hedge of the LIBOR
Swap Rate in a $100,000 BBB-Quality 5-Year
Fixed-Rate Noncallable Note
55-53
This Example illustrates one method that could be
used pursuant to paragraph 815-20-25-12(f)(2) in
determining the hedged item’s change in fair value
attributable to changes in the benchmark interest
rate. Other methods could be used in determining
the hedged item’s change in fair value
attributable to changes in the benchmark interest
rate as long as those methods meet the criteria in
that paragraph. For simplicity, commissions and
most other transaction costs, initial margin, and
income taxes are ignored unless otherwise stated.
Assume that there are no changes in
creditworthiness that would alter the
effectiveness of the hedging relationship.
55-54 On
January 1, 20X0, Entity GHI issues at par a
$100,000 BBB-quality 5-year fixed-rate noncallable
debt instrument with an annual 10 percent interest
coupon. On that date, Entity GHI enters into a
5-year interest rate swap based on the LIBOR swap
rate and designates it as the hedging instrument
in a fair value hedge of the $100,000 liability.
Under the terms of the interest rate swap, Entity
GHI will receive fixed interest at 7 percent and
pay variable interest at LIBOR. The variable leg
of the interest rate swap resets each year on
December 31 for the payments due the following
year. This Example has been simplified by assuming
that the interest rate applicable to a payment due
at any future date is the same as the rate for a
payment at any other date (that is, the yield
curve is flat). During the hedge period, the gain
or loss on the interest rate swap will be recorded
in earnings. The Example assumes that immediately
before the interest rate on the variable leg
resets on December 31, 20X0, the LIBOR swap rate
increased by 50 basis points to 7.50 percent, and
the change in fair value of the interest rate swap
for the period from January 1 to December 31,
20X0, is a loss in value of $1,675.
55-55
Under this method, the change in a hedged item’s
fair value attributable to changes in the
benchmark interest rate for a specific period is
determined as the difference between two present
value calculations that use the remaining cash
flows as of the end of the period and reflect in
the discount rate the effect of the changes in the
benchmark interest rate during the period.
- Subparagraph superseded by Accounting Standards Update No. 2017-12.
- Subparagraph superseded by Accounting Standards Update No. 2017-12.
55-56
Both present value calculations are computed using
the estimated future cash flows for the hedged
item, which would be either its remaining
contractual coupon cash flows or the LIBOR
benchmark rate component of the remaining
contractual coupon cash flows determined at hedge
inception as illustrated by the following
Cases:
- Using the full contractual coupon cash flows (Case A)
- Using the LIBOR benchmark rate component of the contractual coupon cash flows (Case B).
55-56A
This Example illustrates two approaches for
computing the change in fair value of the hedged
item attributable to changes in the benchmark
interest rate. This Subtopic does not specify the
discount rate that must be used to calculate the
change in fair value of the hedged item.
55-56B In
Cases A and B in this Example, Entity GHI presents
the total change in the fair value of the hedging
instrument (that is, the interest accruals and all
other changes in fair value) in the same income
statement line item (in this case, interest
expense) that is used by Entity GHI to present the
earnings effect of the hedged item before applying
hedge accounting in accordance with paragraph
815-20-45-1A.
In accordance with Example 9 in ASC 815-25-55-53 through 55-61C, the
entity calculates the change in the hedged item’s fair value that is
attributable to changes in the benchmark interest rate by using the
remaining cash flows of the hedged item as of the end of the reporting
period in the present value calculations. The Example 9 method isolates
changes in interest rates during the period but excludes changes in fair
value that are due to the passage of time. The mechanics of the
calculation depend on whether a company elects to use the full
contractual coupons or the benchmark component of the contractual
coupons, which we discuss further below.
Because the Example 9 method excludes changes in fair value that are
attributable to the passage of time, the cumulative basis adjustments to
the hedged item will not reverse themselves out. In other words, the
strict application of the Example 9 method will almost certainly result
in a cumulative adjustment to the basis of the hedged item that still
remains at the end of the hedging relationship. If the term of the
hedging relationship covers the full term of the debt instrument and the
debt is then extinguished, any remaining basis adjustment would result
in a gain or loss upon extinguishment if the entity does not elect to
amortize basis adjustments before the end of the hedging relationship
(see Section 3.2.5.1 for a
discussion on the amortization of basis adjustments).
Note that the Example 9 method includes some very important simplifying
assumptions. First, it is assumed that the yield curve is flat in all
scenarios, which makes the discounting of cash flows very simplistic
because the same discount rate is applied to every cash flow. Second, it
is assumed that the discount rates used for the swaps are also
appropriate for discounting the hedged item’s cash flows. That
assumption ignores the fact that derivatives typically use a discount
rate that (1) reflects the credit of both parties to the derivative and
(2) is influenced by credit enhancements (e.g., master netting
arrangements or collateral).
3.2.1.5.1.1 Full Contractual Coupons
ASC 815-25
Case A: Using the Full Contractual Coupon Cash
Flows
55-57 In this Case, assume
Entity GHI elected to calculate the change in the
fair value of the hedged item attributable to
interest rate risk on the basis of the full
contractual coupon cash flows of the hedged item.
Accordingly, both present value calculations in
accordance with paragraph 815-25-55-55 are
computed using the remaining contractual coupon
cash flows as of the end of the period and the
discount rate that reflects the change in the
designated benchmark interest rate during the
period. The method chosen by Entity GHI in this
Case requires that the discount rate be based on
the market interest rate for the hedged item at
the inception of the hedging relationship. The
discount rates used for those present value
calculations would be, respectively:
-
The discount rate equal to the market interest rate for that hedged item at the inception of the hedge adjusted (up or down) for changes in the benchmark rate (designated as the interest rate risk being hedged) from the inception of the hedge to the beginning date of the period for which the change in fair value is being calculated
-
The discount rate equal to the market interest rate for that hedged item at the inception of the hedge adjusted (up or down) for changes in the designated benchmark rate from the inception of the hedge to the ending date of the period for which the change in fair value is being calculated.
55-58 Entity GHI elected
to subsequently assess hedge effectiveness on a
quantitative basis. In Entity GHI’s quarterly
assessments of hedge effectiveness for each of the
first three quarters of year 20X0 in this Example,
there was zero change in the hedged item’s fair
value attributable to changes in the benchmark
interest rate because there was no change in the
LIBOR swap rate. However, in the assessment for
the fourth quarter 20X0, the discount rate for the
beginning of the period is 10 percent (the hedged
item’s original market interest rate with an
adjustment of zero), and the discount rate for the
end of the period is 10.50 percent (the hedged
item’s original market interest rate adjusted for
the change during the period in the LIBOR swap
rate [+ 0.50 percent]).
55-59 Calculate the
present value using the end-of-period discount
rate of 10.50 percent (that is, the
beginning-of-period discount rate adjusted for the
change during the period in the LIBOR swap rate of
50 basis points).
55-60 The change in fair
value of the hedged item attributable to the
change in the benchmark interest rate is $100,000
– $98,432 = $1,568 (the fair value decrease in the
liability is a gain on debt).
55-61 When the change in
fair value of the hedged item ($1,568 gain)
attributable to the risk being hedged is compared
with the change in fair value of the hedging
instrument ($1,675 loss), a mismatch of $107
results that will be reported in earnings, because
both changes in fair value are recorded in
earnings. The change in the fair value of the
hedging instrument will be presented in the same
income statement line item as the earnings effect
of the hedged item in accordance with paragraph
815-20-45-1A.
If an entity that is applying the Example 9 method elects to use the
full contractual coupon cash flows to calculate the changes in the
hedged item’s fair value that are attributable to changes in the
benchmark interest rate, it should use discount rates that are based
on the market interest rate at the inception of the hedge (including
the credit spread) adjusted for changes in the benchmark rate
(either positive or negative) since the beginning of the hedging
relationship. The change in fair value that is attributable to
changes in the benchmark interest rate should be calculated as the
difference between (1) and (2) below:
-
The remaining cash flows of the hedged item as of the end of the period, discounted at a rate equal to the market interest rate as of the beginning of the hedging relationship adjusted for changes in the benchmark rate from the inception of the hedging relationship to the beginning of the period.
-
The remaining cash flows of the hedged item as of the end of the period, discounted at a rate equal to the market interest rate as of the beginning of the hedging relationship adjusted for changes in the benchmark rate from the inception of the hedging relationship to the end of the period.
3.2.1.5.1.2 Benchmark Component of Contractual Coupons
ASC 815-25
Case B: Using the LIBOR Benchmark Rate
Component of the Contractual Coupon Cash Flows
55-61A In this Case,
assume Entity GHI elected to calculate the change
in the fair value of the hedged item attributable
to interest rate risk on the basis of the
benchmark rate component of the contractual coupon
cash flows determined at hedge inception.
Accordingly, both present value calculations in
accordance with paragraph 815-25-55-55 are
computed using the remaining benchmark rate
component of contractual coupon cash flows as of
the end period and the discount rate that reflects
the change in the designated benchmark rate during
the period. The discount rates used by Entity GHI
in this Case would be, respectively:
-
The benchmark rate (designated as the interest rate risk being hedged) as of the beginning date of the period for which the change in fair value is being calculated
-
The designated benchmark rate as of the ending date of the period for which the change in fair value is being calculated.
55-61B Entity GHI elected
to subsequently assess hedge effectiveness on a
quantitative basis. In Entity GHI’s quarterly
assessments of hedge effectiveness for each of the
first three quarters of year 20X0, there was no
change in the hedged item’s fair value
attributable to changes in the benchmark interest
rate because there was no change in the LIBOR swap
rate. However, in the assessment for the fourth
quarter 20X0, the discount rate for the beginning
of the period is 7 percent, and the discount rate
for the end of the period is 7.50 percent
reflecting the change during the period in the
LIBOR swap rate. The change in fair value of the
hedged item attributable to the change in the
benchmark interest risk for the period January 1,
20X0, to December 31, 20X0, is a gain of $1,675,
calculated as follows.
55-61C Because the change
in fair value of the hedged item ($1,675 gain)
attributable to the risk being hedged is the same
as the change in fair value of the hedging
instrument ($1,675 loss), there is perfect offset
and, therefore, a zero net earnings effect.
If an entity that is applying the Example 9 method elects to use the
benchmark component of the contractual coupon cash flows to
calculate the changes in the hedged item’s fair value that are
attributable to changes in the benchmark interest rate, it should
use discount rates that are based on the benchmark interest rate at
the beginning and end of the period. The change in fair value that
is attributable to changes in the benchmark interest rate should be
calculated as the difference between (1) and (2) below:
-
The remaining assumed (benchmark component) cash flows of the hedged item as of the end of the period, discounted at the benchmark rate at the beginning of the period.
-
The remaining assumed (benchmark component) cash flows of the hedged item as of the end of the period, discounted at the benchmark rate at the end of the period.
3.2.1.5.2 Example 11/16 Method
ASC 815-25
Example 16: Fair Value Hedge of the LIBOR
Swap Rate in a $100 Million A1-Quality 5-Year
Fixed-Rate Noncallable Debt
55-100 The following Cases
illustrate application of the guidance in Sections
815-20-25, 815-20-35, and 815-25-35 to a fair
value hedge of the LIBOR swap rate in a $100
million A1-quality 5-year fixed-rate noncallable
debt:
-
Using the full contractual coupon cash flows (Case A)
-
Using the benchmark rate component of the contractual coupon cash flows (Case B).
55-101 On July 2, 20X0,
Entity XYZ issues at par a $100 million A1-quality
5-year fixed-rate noncallable debt instrument with
an annual 8 percent interest coupon payable
semiannually. On that date, Entity XYZ enters into
a 5-year interest rate swap based on the LIBOR
swap rate and designates it as the hedging
instrument in a fair value hedge of interest rate
risk of the $100 million liability. Under the
terms of the interest rate swap, Entity XYZ will
receive a fixed interest rate at 8 percent and pay
variable interest at LIBOR plus 200 basis points
(current LIBOR 6 percent) on a notional amount of
$100 million (semiannual settlement and interest
reset dates). For simplicity, commissions and most
other transaction costs, initial margin, and
income taxes are ignored unless otherwise stated.
Assume that there are no changes in
creditworthiness that would alter the
effectiveness of the hedging relationship. The
Example also assumes that the yield curve is flat
and that the LIBOR swap rate increased 100 basis
points to 7 percent on December 31, 20X0. The
change in fair value of the interest rate swap for
the period from July 2, 20X0, to December 31,
20X0, is a loss of $3,803,843.
55-102 In both Cases A and
B in this Example, Entity XYZ presents the total
change in the fair value of the hedging instrument
(that is, the interest accruals and all other
changes in fair value) in the same income
statement line item (in this case, interest
expense) that is used by Entity XYZ to present the
earnings effect of the hedged item before applying
hedge accounting in accordance with paragraph
815-20-45-1A.
Example 11 in ASC 815-25-55-72 through 55-77 and Example 16 in ASC
815-25-55-100 through 55-108 use the same approach, which is referred to
herein as the “Example 11/16 method.” However, Example 11 only reflects
an entity that elects to use the full contractual coupon cash flows as
the basis for measuring the changes in the hedged item’s fair value that
are attributable to changes in the benchmark interest rate, while
Example 16 applies to both entities that elect to use the full
contractual coupon cash flows and entities that elect to use benchmark
component of the contractual coupon cash flows. Accordingly, we will
focus on Example 16.
In a manner similar to the Example 9 method discussed in Section 3.2.1.5.1, under the Example 11/16 method, the
entity calculates the change in the hedged item’s fair value that is
attributable to changes in the benchmark interest rate by performing two
present value calculations. However, unlike the Example 9 method, the
Example 11/16 method does not exclude changes in fair value that are due
to the passage of time. The present value calculation related to the
beginning of the period is based on the remaining cash flows as of the
beginning of the period, and the present value calculation related to
the end of the period is based on the remaining cash flows as of the end
of the period. The mechanics of the present value calculation depend on
whether a company elects to use the full contractual coupon cash flows
or the benchmark component of the contractual coupon cash flows.
Under Example 9 in ASC 815-25-55-53 through 55-61C, changes in fair value
that are attributable to the passage of time are excluded. However,
under Example 11 in ASC 815-25-55-72 through 55-77, the cumulative basis
adjustments to the hedged item will reverse themselves out unless
all the following conditions are met:
-
The entity designates a hedging relationship when the debt’s current fair value does not equal its par amount because either (1) the debt is issued at a premium or discount or (2) the designated relationship is a late-term hedge (see Example 2-30 for a discussion of the availability of the shortcut method for late-term hedges).
-
The term of the hedging relationship matches the remaining life of the hedged item (i.e., it is not a partial-term fair value hedge).
-
The entity elects to use the full contractual coupon cash flows when measuring changes in the hedged item’s fair value that are attributable to changes in the benchmark interest rate.
In other words, under the Example 11/16 method, there will generally not
be a basis adjustment to the hedged item at the end of the hedging
relationship unless the entity (1) enters into a late-term hedge and (2)
elects to use the full contractual coupon cash flows when measuring
changes in the hedged item’s fair value that are attributable to changes
in the benchmark interest rate. Accordingly, an entity would not need to
amortize basis adjustments before the end of the hedging relationship if
any of the following are true:
-
The entity designates the hedging relationship on (1) the issuance date (or the trade date) of debt that is issued without a premium or discount or (2) another date on which the debt’s fair value equals its par amount.
-
The entity elects to use the benchmark component of the contractual coupon cash flows when measuring changes in the hedged item’s fair value that are attributable to changes in the benchmark interest rate.
-
The entity enters into a partial-term fair value hedging relationship.
While an entity may not be required to amortize basis adjustments to the
hedged item during the term of the hedging relationship, it still may
elect to do so. See Section 3.2.5.1 for a
discussion of the amortization of basis adjustments.
Note that Example 11 in ASC 815-25-55-72 through 55-77 and Example 16 in
ASC 815-25-55-100 through 55-108 include some very important simplifying
assumptions. First, it is assumed that the yield curve is flat in all
scenarios, which makes the discounting of cash flows very simplistic
because the same discount rate is applied to every cash flow. Second, it
is assumed that the discount rates used for the swaps are also
appropriate for discounting the hedged item’s cash flows. That
assumption ignores the fact that derivatives typically use a discount
rate that reflects the credit of both parties to the derivative and is
also influenced by credit enhancements (e.g., master netting
arrangements or collateral).
3.2.1.5.2.1 Full Contractual Coupons
ASC 815-25
Case A: Using the Full
Contractual Coupon Cash Flows
55-103 In
this Case, assume that Entity XYZ elected to
calculate fair value changes in the hedged item
attributable to interest rate risk using the full
contractual coupon cash flows of the hedged item.
The change in fair value of the debt attributable
to changes in the benchmark interest rate for the
period July 2, 20X0, to December 31, 20X0, is a
gain of $3,634,395, calculated as follows.
55-104 As of
December 31, 20X0, the fair value of the debt
attributable to interest rate risk is calculated
by discounting the full contractual coupon cash
flows at the debt’s original market rate with a
100 basis point adjustment related to the increase
in the LIBOR swap rate (50 basis point adjustment
on a semiannual basis). The following journal
entries illustrate the interest rate swap and debt
fair value changes attributable to changes in the
LIBOR swap rate.
55-105 The
net earnings effect of the hedge is $169,448 due
to the mismatch between the changes in fair value
of the hedging instrument and the hedged item
attributable to the changes in the benchmark
interest rate.
If an entity that is applying the Example 11/16 method elects to use
the full contractual coupon cash flows to calculate the changes in
the hedged item’s fair value that are attributable to changes in the
benchmark interest rate, it should use discount rates that are based
on the market interest rate at the inception of the hedge (including
the credit spread), adjusted for the changes in the benchmark rate
(either positive or negative) since the beginning of the hedging
relationship. The change in fair value that is attributable to
changes in the benchmark interest rate should be calculated as the
difference between (1) and (2) below:
-
The remaining cash flows of the hedged item as of the beginning of the period, discounted at a rate equal to the market interest rate as of the beginning of the hedging relationship adjusted for changes in the benchmark rate from the inception of the hedging relationship to the beginning of the period.
-
The remaining cash flows of the hedged item as of the end of the period, discounted at a rate equal to the market interest rate as of the beginning of the hedging relationship adjusted for changes in the benchmark rate from the inception of the hedging relationship to the end of the period.
3.2.1.5.2.2 Benchmark Component of Contractual Coupons
ASC 815-25
Case B: Using the Benchmark Rate Component of
the Contractual Coupon Cash Flows
55-106 In this Case,
assume that Entity XYZ elected to calculate fair
value changes in the hedged item attributable to
interest rate risk using the benchmark rate
component of the contractual coupon cash flows of
the hedged item determined at hedge inception. The
change in fair value of the debt attributable to
changes in the benchmark interest rate for the
period July 2, 20X0, to December 31, 20X0, is a
gain of $3,803,843, calculated as follows.
55-107 As of December 31,
20X0, the fair value of the debt attributable to
interest rate risk is calculated by discounting
the benchmark rate component of the contractual
coupon cash flows using the benchmark interest
rate at December 31, 20X0 (7 percent annual rate;
3.5 percent for each semiannual period). The
following journal entries illustrate the interest
rate swap and debt fair value changes attributable
to changes in the LIBOR swap rate.
55-108 The net earnings
effect of the hedge is zero due to the perfect
offset in fair value changes between the hedging
instrument and the hedged item attributable to the
changes in the benchmark interest rate.
If an entity that is applying the Example 11/16 method elects to use
the benchmark component of the contractual coupon cash flows to
calculate the changes in the hedged item’s fair value that are
attributable to changes in the benchmark interest rate, it should
use discount rates that are based on the benchmark interest rate at
the beginning and end of the period. The change in fair value that
is attributable to changes in the benchmark interest rate would be
calculated as the difference between:
-
The remaining assumed (benchmark component) cash flows of the hedged item as of the beginning of the period, discounted at the benchmark rate at the beginning of the period.
-
The remaining assumed (benchmark component) cash flows of the hedged item as of the end of the period, discounted at the benchmark rate at the end of the period.
3.2.1.5.3 Comparison of Methods
The following table summarizes the Example 9 and Example 11/16 methods
for calculating the change in the hedged item’s fair value that is
attributable to changes in the designated benchmark interest rate, with
use of (1) the full contractual coupon cash flows and (2) the benchmark
component of the contractual coupon cash flows:
Method
|
Calculation of the Change in the Hedged Item’s
Fair Value That Is Attributable to Changes in the
Designated Benchmark Interest Rate
|
Will Unamortized Basis
Adjustments to Hedged Item Exist at End of Hedging
Relationship?4
|
---|---|---|
Example 9 — full contractual coupon cash flows
(see Section 3.2.1.5.1.1)
|
The difference between (1) and (2) below:
|
Yes. Because the impact of the passage of time is
excluded from the calculation, the entity will
need to make cumulative basis adjustments to the
hedged item at the end of the hedging term unless
it elects to amortize basis adjustments over the
life of the hedging relationship (see
Section 3.2.5.1).
|
Example 9 — benchmark component of contractual
coupon cash flows (see Section 3.2.1.5.1.2)
|
The difference between (1) and (2) below:
|
Yes. Because the impact of the passage of time is
excluded from the calculation, the entity will
need to make cumulative basis adjustments to the
hedged item at the end of hedging term unless it
elects to amortize basis adjustments over the life
of the hedging relationship (see Section
3.2.5.1).
|
Example 11/16 — full contractual
coupon cash flows (see Section 3.2.1.5.2.1)
|
The difference between (1) and (2) below:
|
If fair value of debt is equal to par at hedge
inception — No. The entity will make
cumulative basis adjustments that should equal
zero. An entity may still elect to amortize basis
adjustments over the life of the hedging
relationship, but there is no reason to do so.
If fair value of debt is not equal to
par at hedge inception — Yes. The entity will
make cumulative basis adjustments on the debt
instrument that will equal and offset the
difference between the debt’s fair value at hedge
inception and the par amount of the debt unless
the entity elects to amortize basis adjustments
over the life of the hedging relationship (see
Section 3.2.5.1).
|
Example 11/16 — benchmark component of
contractual coupon cash flows (see Section 3.2.1.5.2.2)
| The difference between (1) and (2) below:
|
No. The entity will make cumulative basis
adjustments that should equal zero. An entity may
still elect to amortize basis adjustments over the
life of the hedging relationship.
|
Connecting the Dots
After reviewing the differences between the methods for
calculating the change in the hedged item’s fair value that is
attributable to changes in the designated benchmark interest
rate, along with the differences that result from use of the
full contractual coupon cash flows or use of the benchmark
component of the contractual coupon cash flows, we believe that
most entities will elect to apply the Example 11/16 method and
use the benchmark component of the contractual coupon cash flows
when the shortcut method is not applied. Such a combination of
elections will allow an entity to avoid having to amortize the
basis adjustments to the hedged item during the hedging
relationship regardless of when the relationship is established
(i.e., even in the case of late-term hedges). We also expect
entities to make these elections when identifying a backup
quantitative assessment method for fair value hedging
relationships for which the shortcut method is applied (see
Section 2.5.2.2.1.9).
3.2.2 Foreign Currency Risk Hedging
ASC 815-25
35-18 Remeasurement of
hedged foreign-currency-denominated assets and
liabilities is based on the guidance in Subtopic 830-20,
which requires remeasurement based on spot exchange
rates, regardless of whether a fair value hedging
relationship exists.
Foreign currency hedging is discussed in detail in Chapter 5. As noted in ASC 815-25-35-18, if the hedged item is a
recognized foreign-currency-denominated asset or liability, hedge accounting
does not override the ASC 830 model for translating foreign-currency-denominated
assets or liabilities. Such assets and liabilities must still be remeasured on
the basis of the spot exchange rate on the balance sheet date. While this may
seem to obviate the need for hedge accounting, an entity may still achieve some
benefits from applying the fair value hedging model to a hedge of foreign
currency risk related to financial assets or liabilities. One reason for doing
so would be to exclude components of the change in the hedging instrument’s fair
value from the assessment of hedge effectiveness, which would allow the entity
to recognize the initial time value or cross-currency basis spread, or both, in
a systematic and rational basis over the life of the hedge. In addition, an
entity may want to apply fair value hedge accounting to a strategy in which it
hedges foreign currency risk in combination with interest rate risk (e.g.,
hedging a fixed-rate foreign-currency-denominated debt instrument).
3.2.3 Credit Risk Hedging
It is fairly uncommon for an entity to hedge only the credit
risk of a mortgage servicing right, a financial asset, or a financial liability,
largely because there are few derivatives that are based on the credit of one or
more specific obligors. If a derivative only pays out on the basis of the
default of a debt instrument, it is not likely to be accounted for as a
derivative under the financial guarantee scope exception in ASC 815-10-15-58
(see Section 2.3.4 of Deloitte’s Roadmap
Derivatives for further detail
on the financial guarantee scope exception). Sometimes, an entity will enter
into a credit default swap to hedge a debt instrument’s credit risk. However,
the entity’s ability to achieve a highly effective hedging relationship may
depend on the types of triggering events that would result in a payout under the
credit default swap because such events may not align with all of the factors
that would affect the issuer’s credit spread. As previously discussed, credit
risk for a fair value hedging relationship is defined in ASC 815-20-25-12(f)(4)
as:
The risk of changes in its fair value attributable to
both of the following (referred to as credit risk):
-
Changes in the obligor’s creditworthiness
-
Changes in the spread over the benchmark interest rate with respect to the hedged item’s credit sector at inception of the hedge.
If an entity enters into a derivative that is highly effective against all
changes in credit risk and the hedging relationship meets all of the other
conditions for fair value hedge accounting, the entity would remeasure the
hedged item for changes in fair value that are attributable to changes in credit
risk.
3.2.4 Overall Fair Value Hedging
If an entity elects to hedge a mortgage servicing right, a financial asset, or a
financial liability for overall changes in fair value in a qualifying fair value
hedging relationship, it will remeasure the hedged asset or liability for all
changes in fair value during the period. Note that such remeasurement does not
result in recognition of the hedged item at fair value unless the item was
recognized at fair value as of the beginning of the hedging relationship. For
example, assume that an entity is hedging debt for overall changes in fair value
and, at the inception of the hedge, the debt has an amortized cost basis of $1
million and a fair value of $1.1 million. If the debt’s fair value at the end of
the reporting period increases to $1.18 million, the debt would be remeasured to
$1.08 million since its fair value increased by $80,000 during the period.
In addition, as discussed in Section 2.3.1.1.2, an entity may hedge the prepayment option
embedded in a debt instrument, but if it does so, it may only hedge the
prepayment option for overall changes in fair value. Accordingly, the guidance
in Section 3.2.1.2 about ignoring the impact of anything other than
changes in the benchmark rate when measuring the change in the hedged item’s
fair value that is attributable to the hedged risk does not apply if the hedged
item is the prepayment option in a debt instrument that is hedged for changes in
its overall fair value.
3.2.5 Accounting for Basis Adjustments
ASC 815-25
35-8 The adjustment of the
carrying amount of a hedged asset or liability required
by paragraph 815-25-35-1(b) shall be accounted for in
the same manner as other components of the carrying
amount of that asset or liability. For example, an
adjustment of the carrying amount of a hedged asset held
for sale (such as inventory) would remain part of the
carrying amount of that asset until the asset is sold,
at which point the entire carrying amount of the hedged
asset would be recognized as the cost of the item sold
in determining earnings.
35-9 An adjustment of the
carrying amount of a hedged interest-bearing financial
instrument shall be amortized to earnings. Amortization
shall begin no later than when the hedged item ceases to
be adjusted for changes in its fair value attributable
to the risk being hedged.
Pending Content (Transition Guidance: ASC
815-20-65-6)
35-9 [See Section 9.7.]
35-9A If, as permitted by
paragraph 815-25-35-9, an entity amortizes the
adjustment to the carrying amount of the hedged item
during an outstanding partial-term hedge of an
interest-bearing financial instrument, the entity shall
fully amortize that adjustment by the hedged item’s
assumed maturity date in accordance with paragraph
815-25-35-13B. For a discontinued hedging relationship,
all remaining adjustments to the carrying amount of the
hedged item shall be amortized over a period that is
consistent with the amortization of other discounts or
premiums associated with the hedged item in accordance
with other Topics (for example, Subtopic 310-20 on
receivables — nonrefundable fees and other costs).
Pending Content (Transition Guidance: ASC
815-20-65-6)
35-9A [See Section 9.7.]
The hedged item in a qualifying fair value hedge of a financial asset or
liability is remeasured for changes in its fair value that are attributable to
changes in the designated risk. Adjustments to the carrying amount are then
treated in the same manner as any other basis adjustment that applies to the
asset or liability. For example, if a debt instrument is adjusted for an
increase in its fair value that is attributable to changes in the designated
risk, the increase creates a premium on the debt instrument.
3.2.5.1 Amortization of Basis Adjustments
As long as a hedging relationship continues to qualify for hedge accounting,
an entity has the option to either (1) immediately begin amortization of
basis adjustments to an interest-bearing hedged item or (2) wait until the
hedging relationship has been discontinued. If the entity elects to begin
amortizing a basis adjustment while the hedging relationship is still
outstanding, the period of amortization should coincide with the remaining
life of the hedging relationship in a manner consistent with the guidance in
ASC 815-25-35-9A.
For example, assume that CactusCo has 10-year fixed-rate debt that it hedges
with a five-year interest rate swap in a partial-term fair value hedging
relationship. If CactusCo begins amortizing the basis adjustments as they
occur, the amortization period should match the period of the hedging
relationship (i.e., five years) as long as that relationship qualifies for
hedge accounting and continues. When hedge accounting is discontinued, any
remaining basis adjustment should be amortized over the remaining life of
the debt (i.e., to the 10-year maturity date).
An entity’s decision about whether to amortize basis adjustments may be
driven by the method the entity is using to determine the changes in the
hedged item’s fair value that are attributable to changes in the designated
risk. For example, if an entity enters into an interest rate swap to hedge a
debt instrument for changes in fair value that are attributable to changes
in the designated benchmark interest rate and is using a method that will
result in no cumulative basis adjustments at the end of the hedging
relationship, the entity is not likely to elect to amortize the basis
adjustments before the end of the hedging relationship. This would be the
case if an entity applies any of the following methods to determine the
change in the hedged item’s fair value that is attributable to changes in
the designated benchmark interest rate:
-
The shortcut method (see Section 3.2.1.3).
-
The Example 11/16 method in combination with an election to use the benchmark component of the contractual coupon cash flows (see Section 3.2.1.5.2.2).
-
The Example 11/16 method in combination with an election to use the full contractual coupon cash flows (see Section 3.2.1.5.2.1) when the fair value of the hedged debt instrument is equal to par at hedge inception.
See Section 3.2.1.5 for a discussion of
the methods for determining the change in the hedged item’s fair value that
is attributable to changes in the designated benchmark interest rate.
Section 3.2.1.5.3 includes a table
summarizing the various methods.
3.2.5.2 Interaction With Impairment Guidance
ASC 815-25
35-10 An asset or
liability that has been designated as being hedged
and accounted for pursuant to this Section remains
subject to the applicable requirements in generally
accepted accounting principles (GAAP) for assessing
impairment or credit losses for that type of asset
or for recognizing an increased obligation for that
type of liability. Those impairment or credit loss
requirements shall be applied after hedge accounting
has been applied for the period and the carrying
amount of the hedged asset or liability has been
adjusted pursuant to paragraph 815-25-35-1(b).
Because the hedging instrument is recognized
separately as an asset or liability, its fair value
or expected cash flows shall not be considered in
applying those impairment or credit loss
requirements to the hedged asset or liability.
Pending Content (Transition Guidance: ASC
815-20-65-6)
35-10 [See Section 9.7.]
Interaction With Measurement of Credit Losses
35-11 This Subtopic
implicitly affects the measurement of credit losses
under Subtopic 326-20 on financial instruments
measured at amortized cost by requiring the present
value of expected future cash flows to be discounted
by the new effective rate based on the adjusted
amortized cost basis in a hedged loan. Paragraph
326-20-55-9 requires that, when the amortized cost
basis of a loan has been adjusted under fair value
hedge accounting, the effective rate is the discount
rate that equates the present value of the loan’s
future cash flows with that adjusted amortized cost
basis. That paragraph states that the adjustment
under fair value hedge accounting for changes in
fair value attributable to the hedged risk under
this Subtopic shall be considered to be an
adjustment of the loan’s amortized cost basis. As
discussed in that paragraph, the loan’s original
effective interest rate becomes irrelevant once the
recorded amount of the loan is adjusted for any
changes in its fair value. Because paragraph
815-25-35-10 requires that the loan’s amortized cost
basis be adjusted for hedge accounting before the
requirements of Subtopic 326-20 are applied, this
Subtopic implicitly supports using the new effective
rate and the adjusted amortized cost basis.
Pending Content (Transition Guidance: ASC
815-20-65-6)
35-11 [See Section 9.7.]
35-12 This guidance
applies to all entities applying Subtopic 326-20 to
financial assets that are hedged items in a fair
value hedge, regardless of whether those entities
have delayed amortizing to earnings the adjustments
of the loan’s amortized cost basis arising from fair
value hedge accounting until the hedging
relationship is dedesignated. The guidance on
recalculating the effective rate is not intended to
be applied to all other circumstances that result in
an adjustment of a loan’s amortized cost basis.
Pending Content (Transition Guidance: ASC
815-20-65-6)
35-12 [See Section 9.7.]
As noted in Section 3.2.5, basis
adjustments to a hedged asset or liability in a qualifying fair value
hedging relationship are accounted for in the same manner as other
components of the asset’s carrying amount. Accordingly, in the evaluation of
a financial asset or an unrecognized loan commitment for impairment or
credit losses, the relevant starting point is the carrying amount of the
asset or loan commitment after the hedge accounting adjustments. In
addition, if an entity is determining impairment on the basis of a
discounted cash flow model, the discount rate should be the relevant
effective interest rate after the basis adjustments.
Changing Lanes
As discussed in Section 3.2.1.4, basis
adjustments for a last-of-layer hedge are done at a portfolio level
unless the hedge is discontinued in part or in full. In March 2022,
the FASB issued ASU 2022-01, which addresses the interaction of the
portfolio-level basis adjustments with impairment and credit losses
standards. Under the ASU, portfolio-level basis adjustments from an
existing hedging relationship would be ignored in the evaluation of
assets for impairment. See Chapter 9 for further
discussion of ASU 2022-01.
If the hedged item is a recognized mortgage servicing right, the impairment
guidance in ASC 860-50-35-9 through 35-14 is applicable. For impairment
analysis purposes, the carrying amount of a mortgage servicing right should
be determined after any fair value hedging basis adjustments. Mortgage
servicing rights may be either an asset or a liability, and the impairment
guidance applies to both. An impairment of a mortgage servicing asset would
result in an allowance, and an impairment of a mortgage servicing liability
would result in an increased liability.
If the hedged item is an existing financial liability, no additional
considerations related to impairment apply.
3.2.6 Hedged Item Measured at Fair Value, With Changes in Fair Value Recognized in OCI
ASC 815-25
35-6 If a hedged item is
otherwise measured at fair value with changes in fair
value reported in other comprehensive income (such as an
available-for-sale debt security), the adjustment of the
hedged item’s carrying amount discussed in paragraph
815-25-35-1(b) shall be recognized in earnings rather
than in other comprehensive income to offset the gain or
loss on the hedging instrument.
Pending Content (Transition Guidance: ASC
815-20-65-6)
35-6 [See Section 9.7.]
If the hedged item in a qualifying fair value hedge has already been measured at
fair value, with changes in fair value reported in OCI, no additional
remeasurement of the hedged item is required. However, the portion of the change
in fair value that is attributable to changes in the designated risk is
recognized in earnings instead of OCI.
Example 3-5
Hedged Item Is an AFS Debt Security
SimpleBand acquires a fixed-rate AFS debt security for
$100,000. It designates an interest rate swap to hedge
the interest rate risk in the security, and the hedging
relationship qualifies for the shortcut method. At the
end of the reporting period, the security’s fair value
is $110,000 and the interest rate swap’s fair value is
negative $8,000 (it is a liability). SimpleBand
recognizes the $8,000 decrease in the swap’s fair value
in the income statement. To account for the $10,000
increase in the fair value of the debt security,
SimpleBand recognizes $8,000 in the income statement and
$2,000 in OCI.
If an AFS debt security has an unrealized loss in OCI, in a manner consistent
with the discussion in Section 3.2.5.2, an
entity should still evaluate the asset for impairment in accordance with ASC
326-30. Generally speaking, a credit-related impairment would result in a
reclassification of at least a portion of the unrealized loss out of AOCI into
earnings. If the AFS debt security was hedged for changes in its fair value that
are attributable to changes in the designated benchmark interest rate, the basis
adjustments previously recognized in earnings were not related to credit
risk.
Changing Lanes
In March 2022, the FASB issued ASU 2022-01, which
clarifies the guidance in ASC 815 on fair value hedge accounting of
interest rate risk for portfolios of financial assets. ASU 2022-01
renames the “last-of-layer” method the “portfolio layer” method and
addresses feedback from stakeholders regarding its application. In
addition, ASU 2022-01 amends ASC 815-25-35-6 to clarify that if the
hedged closed portfolio includes AFS debt securities, some or all of the
change in the hedged item’s fair value attributable to the hedged risk
should be recognized in earnings rather than in OCI to offset the gain
or loss on the hedging instrument. See Chapter 9 for a more thorough
discussion of ASU 2022-01.
3.2.7 Illustrative Examples
Example 3-6
Shortcut Method —
Interest Rate Swap Hedging Fixed-Rate Debt
(Full-Term Hedge)
On January 2, 20X4, Reprise issues $100
million of fixed-rate debt, with interest payable
quarterly at a rate of 3 percent per year. Principal is
payable at maturity, which is on December 31, 20X8, and
the debt is not prepayable. To maintain compliance with
its policy of having at least half of its outstanding
borrowings in the form of variable-rate debt (either
directly or indirectly by using swaps), Reprise enters
into an interest rate swap on January 2, 20X4, to
effectively convert the debt from fixed- to
variable-rate debt. The interest rate swap has the
following terms:
Notional
|
$100 million
|
Effective date
|
January 2, 20X4
|
Maturity date
|
December 31, 20X8
|
Fixed-leg payer
|
Counterparty
|
Fixed-leg rate
|
1.7346%
|
Variable-leg payer
|
Reprise
|
Variable rate
|
Three-month LIBOR
|
Reset/settlement frequency
|
Quarterly: March 31, June 30,
September 30, December 31
|
Reprise designates the swap as a hedge
of changes in the debt’s fair value that are
attributable to changes in benchmark interest rates. As
part of the hedge designation documentation, Reprise
notes that the hedging relationship qualifies for the
shortcut method and that the shortcut method will be
applied.
For this example, assume that neither
the creditworthiness of Reprise nor the creditworthiness
of the counterparty to the interest rate swap calls into
question whether it is probable that both parties will
perform under the interest rate swap over its life.
Reprise recognizes (1) the accruals of
the settlements of the interest rate swap directly in
the same income statement line item in which the hedged
item affects earnings (interest expense) and (2) the
change in the fair value of the swap on the basis of the
change in its “clean” fair value each period. The swap’s
clean fair value does not include any accrued
settlements.
Reprise records the following journal
entries throughout the term of the hedge:
No entry is required for entering into
the interest rate swap because the swap has a fair value
of zero at inception.
March 31,
20X4
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement) and the
end of the period, (2) the current period’s swap
settlement, (3) the swap’s fair values at the beginning
and end of the period, and (4) the change in the swap’s
fair value for the period.
June 30,
20X4
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement) and the
end of the period, (2) the current period’s swap
settlement, (3) the swap’s fair values at the beginning
and end of the period, and (4) the change in the swap’s
fair value for the period.
September 30,
20X4
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement) and the
end of the period, (2) the current period’s swap
settlement, (3) the swap’s fair values at the beginning
and end of the period, and (4) the change in the swap’s
fair value for the period.
December 31,
20X4
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement) and the
end of the period, (2) the current period’s swap
settlement, (3) the swap’s fair values at the beginning
and end of the period, and (4) the change in the swap’s
fair value for the period.
March 31,
20X5
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement) and the
end of the period, (2) the current period’s swap
settlement, (3) the swap’s fair values at the beginning
and end of the period, and (4) the change in the swap’s
fair value for the period.
June 30,
20X5
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement) and the
end of the period, (2) the current period’s swap
settlement, (3) the swap’s fair values at the beginning
and end of the period, and (4) the change in the swap’s
fair value for the period.
September 30,
20X5
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement) and the
end of the period, (2) the current period’s swap
settlement, (3) the swap’s fair values at the beginning
and end of the period, and (4) the change in the swap’s
fair value for the period.
December 31,
20X5
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement) and the
end of the period, (2) the current period’s swap
settlement, (3) the swap’s fair values at the beginning
and end of the period, and (4) the change in the swap’s
fair value for the period.
March 31,
20X6
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement) and the
end of the period, (2) the current period’s swap
settlement, (3) the swap’s fair values at the beginning
and end of the period, and (4) the change in the swap’s
fair value for the period.
June 30,
20X6
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement) and the
end of the period, (2) the current period’s swap
settlement, (3) the swap’s fair values at the beginning
and end of the period, and (4) the change in the swap’s
fair value for the period.
September 30,
20X6
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement) and the
end of the period, (2) the current period’s swap
settlement, (3) the swap’s fair values at the beginning
and end of the period, and (4) the change in the swap’s
fair value for the period.
December 31,
20X6
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement) and the
end of the period, (2) the current period’s swap
settlement, (3) the swap’s fair values at the beginning
and end of the period, and (4) the change in the swap’s
fair value for the period.
March 31,
20X7
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement) and the
end of the period, (2) the current period’s swap
settlement, (3) the swap’s fair values at the beginning
and end of the period, and (4) the change in the swap’s
fair value for the period.
June 30,
20X7
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement) and the
end of the period, (2) the current period’s swap
settlement, (3) the swap’s fair values at the beginning
and end of the period, and (4) the change in the swap’s
fair value for the period.
September 30,
20X7
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement) and the
end of the period, (2) the current period’s swap
settlement, (3) the swap’s fair values at the beginning
and end of the period, and (4) the change in the swap’s
fair value for the period.
December 31,
20X7
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement) and the
end of the period, (2) the current period’s swap
settlement, (3) the swap’s fair values at the beginning
and end of the period, and (4) the change in the swap’s
fair value for the period.
March 31,
20X8
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement) and the
end of the period, (2) the current period’s swap
settlement, (3) the swap’s fair values at the beginning
and end of the period, and (4) the change in the swap’s
fair value for the period.
June 30,
20X8
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement) and the
end of the period, (2) the current period’s swap
settlement, (3) the swap’s fair values at the beginning
and end of the period, and (4) the change in the swap’s
fair value for the period.
September 30,
20X8
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement) and the
end of the period, (2) the current period’s swap
settlement, (3) the swap’s fair values at the beginning
and end of the period, and (4) the change in the swap’s
fair value for the period.
December 31,
20X8
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement), (2) the
current period’s swap settlement, (3) the swap’s fair
values at the beginning and end of the period, and (4)
the change in the swap’s fair value for the period.
Example 3-7
Long-Haul Method —
Interest Rate Swap Hedging Fixed-Rate Debt for
Interest Rate Risk (Full-Term Hedge)
Assume the same facts as in Example
3-6, except that Reprise does not elect
to apply the shortcut method. As a result, as long as
the hedge remains highly effective and continues to meet
the conditions for applying hedge accounting, Reprise
determines (1) the changes in the debt’s fair value that
are attributable to changes in the benchmark interest
rate and (2) the fair value of the interest rate
swap.
To calculate the change in fair value
that is attributable to changes in the benchmark
interest rate, Reprise elects to apply the Example 11/16
method by using estimated cash flows based on the
benchmark interest rate component of the contractual
coupon cash flows, as allowed under ASC 815-25-35-13
(see Section
3.2.1.5.2.2). Reprise determines that the
benchmark component of the contractual coupon cash flows
is equal to the interest rate on the fixed leg of the
interest rate swap (i.e., 1.7346 percent) because:
-
The swap has a variable leg that is based on the designated benchmark rate (three-month LIBOR) and has no spread.
-
The term of the swap matches the term of the hedged item (matches the portion of debt being hedged).
-
There are no prepayment terms in the debt that need to be mirrored in the swap.
-
The swap has a fair value of zero at the inception of the hedging relationship.
Reprise recognizes (1) the accruals of
the settlements of the interest rate swap directly in
the same income statement line item in which the hedged
item affects earnings (interest expense) and (2) the
change in the fair value of the swap on the basis of the
change in its “clean” fair value each period. The swap’s
clean fair value does not include any accrued
settlements.
In addition, for each period, Reprise
determines the “fair value” of a theoretical debt
instrument that has been remeasured for changes in fair
value that are attributable to changes in the designated
benchmark interest rate. The terms of the theoretical
debt instrument are consistent with the actual debt,
except for a coupon of 1.7346 percent per year (the
benchmark component of the contractual coupons).
As in Example 3-6,
assume that neither the creditworthiness of Reprise nor
the creditworthiness of the counterparty to the interest
rate swap calls into question whether it is probable
that both parties will perform under the interest rate
swap over its life. However, their creditworthiness does
affect the swap’s fair value. Accordingly, even though
the assumed coupons on the debt are the same as those on
the fixed leg of the swap, the fair values of the swap
and the assumed debt do not react to changes in the
benchmark interest rate in the same manner.
The hedge effectiveness assessments performed throughout
the life of the hedging relationship indicate that the
hedging relationship is highly effective.
Reprise
records the following journal entries throughout the
term of the hedge:
No entry is required for entering into
the interest rate swap because the swap has a fair value
of zero at inception.
March 31,
20X4
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement) and the
end of the period, (2) the current period’s swap
settlement, (3) the fair values of the swap and the
theoretical debt at the beginning and end of the period,
and (4) the changes in the fair values of the swap and
the theoretical debt for the period.
June 30,
20X4
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement) and the
end of the period, (2) the current period’s swap
settlement, (3) the fair values of the swap and the
theoretical debt at the beginning and end of the period,
(4) the changes in the fair values of the swap and the
theoretical debt for the period.
September 30,
20X4
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement) and the
end of the period, (2) the current period’s swap
settlement, (3) the fair values of the swap and the
theoretical debt at the beginning and end of the period,
and (4) the changes in the fair values of the swap and
the theoretical debt for the period.
December 31,
20X4
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement) and the
end of the period, (2) the current period’s swap
settlement, (3) the fair values of the swap and the
theoretical debt at the beginning and end of the period,
and (4) the changes in the fair values of the swap and
the theoretical debt for the period.
March 31,
20X5
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement) and the
end of the period, (2) the current period’s swap
settlement, (3) the fair values of the swap and the
theoretical debt at the beginning and end of the period,
and (4) the changes in the fair values of the swap and
the theoretical debt for the period.
June 30,
20X5
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement) and the
end of the period, (2) the current period’s swap
settlement, (3) the fair values of the swap and the
theoretical debt at the beginning and end of the period,
and (4) the changes in the fair values of the swap and
the theoretical debt for the period.
September 30,
20X5
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement) and the
end of the period, (2) the current period’s swap
settlement, (3) the fair values of the swap and the
theoretical debt at the beginning and end of the period,
and (4) the changes in the fair values of the swap and
the theoretical debt for the period.
December 31,
20X5
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement) and the
end of the period, (2) the current period’s swap
settlement, (3) the fair values of the swap and the
theoretical debt at the beginning and end of the period,
and (4) the changes in the fair values of the swap and
the theoretical debt for the period.
March 31,
20X6
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement) and the
end of the period, (2) the current period’s swap
settlement, (3) the fair values of the swap and the
theoretical debt at the beginning and end of the period,
and (4) the changes in the fair values of the swap and
the theoretical debt for the period.
June 30,
20X6
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement) and the
end of the period, (2) the current period’s swap
settlement, (3) the fair values of the swap and the
theoretical debt at the beginning and end of the period,
and (4) the changes in the fair values of the swap and
the theoretical debt for the period.
September 30,
20X6
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement) and the
end of the period, (2) the current period’s swap
settlement, (3) the fair values of the swap and the
theoretical debt at the beginning and end of the period,
and (4) the changes in the fair values of the swap and
the theoretical debt for the period.
December 31,
20X6
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement) and the
end of the period, (2) the current period’s swap
settlement, (3) the fair values of the swap and the
theoretical debt at the beginning and end of the period,
and (4) the changes in the fair values of the swap and
the theoretical debt for the period.
March 31,
20X7
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement) and the
end of the period, (2) the current period’s swap
settlement, (3) the fair values of the swap and the
theoretical debt at the beginning and end of the period,
and (4) the changes in the fair values of the swap and
the theoretical debt for the period.
June 30,
20X7
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement) and the
end of the period, (2) the current period’s swap
settlement, (3) the fair values of the swap and the
theoretical debt at the beginning and end of the period,
and (4) the changes in the fair values of the swap and
the theoretical debt for the period.
September 30,
20X7
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement) and the
end of the period, (2) the current period’s swap
settlement, (3) the fair values of the swap and the
theoretical debt at the beginning and end of the period,
and (4) the changes in the fair values of the swap and
the theoretical debt for the period.
December 31,
20X7
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement) and the
end of the period, (2) the current period’s swap
settlement, (3) the fair values of the swap and the
theoretical debt at the beginning and end of the period,
and (4) the changes in the fair values of the swap and
the theoretical debt for the period.
March 31,
20X8
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement) and the
end of the period, (2) the current period’s swap
settlement, (3) the fair values of the swap and the
theoretical debt at the beginning and end of the period,
and (4) the changes in the fair values of the swap and
the theoretical debt for the period.
June 30,
20X8
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement) and the
end of the period, (2) the current period’s swap
settlement, (3) the fair values of the swap and the
theoretical debt at the beginning and end of the period,
and (4) the changes in the fair values of the swap and
the theoretical debt for the period.
September 30,
20X8
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement) and the
end of the period, (2) the current period’s swap
settlement, (3) the fair values of the swap and the
theoretical debt at the beginning and end of the period,
and (4) the changes in the fair values of the swap and
the theoretical debt for the period.
December 31,
20X8
The table below shows (1) the
three-month LIBOR at the beginning of the period (which
affects the current period’s swap settlement), (2) the
current period’s swap settlement, (3) the fair values of
the swap and the theoretical debt at the beginning and
end of the period, and (4) the changes in the fair
values of the swap and the theoretical debt for the
period.
Example 3-8
Shortcut Method —
Interest Rate Swap Hedging Fixed-Rate Debt
(Partial-Term Hedge)
On January 2, 20X6, Reprise issues $100
million of 10-year fixed-rate debt, with interest
payable quarterly at a rate of 3 percent per year.
Principal is payable at maturity, which is in 10 years;
the debt is not prepayable. Reprise believes that
interest rates will decline over the next three years
and only wants to hedge interest rate risk for that
period. Accordingly, it enters into an interest rate
swap on January 2, 20X6, with the following terms:
Notional
|
$100 million
|
Effective date
|
January 2, 20X6
|
Maturity date
|
December 31, 20X8
|
Fixed-leg payer
|
Counterparty
|
Fixed-leg rate
|
1.5173%
|
Variable-leg payer
|
Reprise
|
Variable rate
|
Six-month LIBOR
|
Reset/settlement frequency
|
Semiannually: June 30,
December 31
|
Reprise designates the swap as a hedge
of the changes in the debt’s fair value that are
attributable to changes in the designated benchmark
interest rate. The hedged debt’s assumed maturity is
December 31, 20X8 (the maturity date of the interest
rate swap). As part of its hedge designation
documentation, Reprise states that the hedging
relationship qualifies for the shortcut method and that
the shortcut method will be applied. Note that even
though the reset and settlement frequency of the
interest rate swap (i.e., semiannually) does not match
the frequency of interest payments on the debt (i.e.,
quarterly), the fair value hedging relationship still
qualifies for the shortcut method (see Section
2.5.2.2.1.6).
As in the previous examples, assume that
neither the creditworthiness of Reprise nor the
creditworthiness of the counterparty to the interest
rate swap call into question whether it is probable that
both parties will perform under the swap over its
life.
Reprise recognizes (1) the accruals of
the settlements of the interest rate swap directly in
the same income statement line item in which the hedged
item affects earnings (interest expense) and (2) the
change in the fair value of the swap on the basis of the
change in its “clean” fair value each period. The swap’s
clean fair value does not include any accrued
settlements.
Reprise records the following journal
entries throughout the term of the hedge:
No entry is required for entering into
the interest rate swap because the swap has a fair value
of zero at inception.
March 31, 20X6
The table below shows (1) the six-month LIBOR as of the
last reset date (which affects the current period’s
accrual of the next swap settlement), (2) the swap’s
fair values at the beginning and end of the period, and
(3) the change in the swap’s fair value for the
period.
June 30, 20X6
The table below shows (1) the six-month LIBOR as of the
last reset date (which affects the current period’s
accrual of the swap settlement) and the current
six-month LIBOR, (2) the current period’s swap
settlement, (3) the accrued interest on the swap for the
prior and current periods (both components of the
current period’s swap settlement), (4) the swap’s fair
values at the beginning and end of the period, and (5)
the change in the swap’s fair value for the period.
September 30, 20X6
The table below shows (1) the six-month LIBOR as of the
last reset date (which affects the current period’s
accrual of the next swap settlement), (2) the swap’s
fair values at the beginning and end of the period, and
(3) the change in swap’s fair value for the period.
December 31, 20X6
The table below shows (1) the six-month LIBOR as of the
last reset date (which affects the current period’s
accrual of the swap settlement) and the current
six-month LIBOR, (2) the current period’s swap
settlement, (3) the accrued interest on the swap for the
prior and current periods (both components of the
current period’s swap settlement), (4) the swap’s fair
values at the beginning and end of the period, and (5)
the change in the swap’s fair value for the period.
March 31, 20X7
The table below shows (1) the six-month LIBOR as of the
last reset date (which affects the current period’s
accrual of the next swap settlement), (2) the swap’s
fair values at the beginning and end of the period, and
(3) the change in the swap’s fair value for the
period.
June 30, 20X7
The table below shows (1) the six-month LIBOR as of the
last reset date (which affects the current period’s
accrual of the swap settlement) and the current
six-month LIBOR, (2) the current period’s swap
settlement, (3) the accrued interest on the swap for the
prior and current periods (both components of the
current period’s swap settlement), (4) the swap’s fair
values at the beginning and end of the period, and (5)
the change in the swap’s fair value for the period.
September 30, 20X7
The table below shows (1) the six-month LIBOR as of the
last reset date (which affects the current period’s
accrual of the next swap settlement), (2) the swap’s
fair values at the beginning and end of the period, and
(3) the change in the swap’s fair value for the
period.
December 31, 20X7
The table below shows (1) the six-month LIBOR as of the
last reset date (which affects the current period’s
accrual of the swap settlement) and the current
six-month LIBOR, (2) the current period’s swap
settlement, (3) the accrued interest on the swap for the
prior and current periods (both components of the
current period’s swap settlement), (4) the swap’s fair
values at the beginning and end of the period and (5)
the change in the swap’s fair value for the period.
March 31, 20X8
The table below shows (1) the six-month LIBOR as of the
last reset date (which affects the current period’s
accrual of the next swap settlement), (2) the swap’s
fair values at the beginning and end of the period, and
(3) the change in the swap’s fair value for the
period.
June 30, 20X8
The table below shows (1) the six-month LIBOR as of the
last reset date (which affects the current period’s
accrual of the swap settlement) and the current
six-month LIBOR, (2) the current period’s swap
settlement, (3) the accrued interest on the swap for the
prior and current periods (both components of the
current period’s swap settlement), (4) the swap’s fair
values at the beginning and end of the period, and (5)
the change in the swap’s fair value for the period.
September 30, 20X8
The table below shows (1) the six-month LIBOR as of the
last reset date (which affects the current period’s
accrual of the next swap settlement), (2) the swap’s
fair values at the beginning and end of the period, and
(3) the change in the swap’s fair value for the
period.
December 31, 20X8
The table below shows (1) the six-month LIBOR as of the
last reset date (which affects the current period’s
accrual of the swap settlement), (2) the current
period’s swap settlement, (3) the accrued interest on
the swap for the prior and current periods (both
components of the current period’s swap settlement), (4)
the swap’s fair values at the beginning and end of the
period, and (5) the change in the swap’s fair value for
the period.
Example 3-9
Long-Haul Method — Interest Rate Swap Hedging
Fixed-Rate Debt for Interest Rate Risk (Partial-Term
Hedge)
Assume the same facts as in Example 3-8, except that Reprise does
not elect to apply the shortcut method. As a result, as
long as the hedge remains highly effective and continues
to meet the conditions for applying hedge accounting,
Reprise determines (1) the changes in the debt’s fair
value that are attributable to changes in the benchmark
interest rate and (2) the fair value of the interest
rate swap.
To calculate the changes in the debt’s fair value that
are attributable to changes in the benchmark interest
rate, Reprise elects to apply the Example 11/16 method
by using estimated cash flows based on the benchmark
interest rate component of the contractual coupon cash
flows, as allowed under ASC 815-25-35-13 (see
Section 3.2.1.5.2.2). Reprise
determines that the benchmark rate component of the
contractual coupon cash flows is equal to the interest
rate on the fixed leg of the interest rate swap (i.e.,
1.5173) because:
-
The swap has a variable leg that is based on the designated benchmark rate (six-month LIBOR) and has no spread.
-
The term of the swap matches that of the hedged item (i.e., it is a partial-term hedge in which the swap matches the portion of the debt being hedged).
-
There are no prepayment terms in the debt that need to be mirrored in the swap.
-
The swap has a fair value of zero at the inception of the hedging relationship.
Reprise recognizes (1) the accruals of the settlements of
the interest rate swap directly in the same income
statement line item in which the hedged item affects
earnings (interest expense) and (2) the change in the
fair value of the swap on the basis of the change in its
“clean” fair value each period. The swap’s clean fair
value does not include any accrued settlements.
As in the previous examples, assume that neither the
creditworthiness of Reprise nor the creditworthiness of
the counterparty to the interest rate swap calls into
question whether it is probable that both parties will
perform under the swap over its life. However, their
creditworthiness does affect the swap’s fair value.
Accordingly, even though the assumed interest rate on
the debt is the same as that on the fixed leg of the
swap, the fair values of the swap and the assumed debt
do not react to changes in the benchmark interest rate
in the same manner. In addition, the swap only has
settlements on a semiannual basis, while the debt has
interest payments on a quarterly basis.
The hedge effectiveness assessments performed throughout
the life of the hedging relationship indicate that the
hedging relationship is highly effective.
Reprise records the following journal entries throughout
the term of the hedge:
March 31,
20X6
The table below shows (1) the six-month LIBOR as of the
last reset date (which affects the current period’s
accrual of the next swap settlement), (2) the fair
values of the swap and the theoretical debt at the
beginning and end of the period, and (3) the changes in
the fair values of the swap and the theoretical debt for
the period.
June 30, 20X6
The table below shows (1) the six-month LIBOR as of the
last reset date (which affects the current period’s
accrual of the swap settlement) and the current
six-month LIBOR, (2) the current period’s swap
settlement, (3) the accrued interest on the swap for the
prior and current periods (both components of the
current period’s swap settlement), (4) the fair values
of the swap and the theoretical debt at the beginning
and end of the period, and (5) the changes in the fair
values of the swap and the theoretical debt for the
period.
September 30, 20X6
The table below shows (1) the six-month LIBOR as of the
last reset date (which affects the current period’s
accrual of the next swap settlement), (2) the fair
values of the swap and the theoretical debt at the
beginning and end of the period, and (3) the changes in
the fair values of the swap and the theoretical debt for
the period.
December 31, 20X6
The table below shows (1) the six-month LIBOR as of the
last reset date (which affects the current period’s
accrual of the swap settlement) and the current
six-month LIBOR, (2) the current period’s swap
settlement, (3) the accrued interest on the swap for the
prior and current periods (both components of the
current period’s swap settlement), (4) the fair values
of the swap and the theoretical debt at the beginning
and end of the period, and (5) the changes in fair
values of the swap and the theoretical debt for the
period.
March 31, 20X7
The table below shows (1) the six-month LIBOR as of the
last reset date (which affects the current period’s
accrual of the next swap settlement), (2) the fair
values of the swap and the theoretical debt at the
beginning and end of the period, and (3) the changes in
the fair values of the swap and the theoretical debt for
the period.
June 30, 20X7
The table below shows (1) the six-month LIBOR as of the
last reset date (which affects the current period’s
accrual of the swap settlement) and the current
six-month LIBOR, (2) the current period’s swap
settlement, (3) the accrued interest on the swap for the
prior and current periods (both components of the
current period’s swap settlement), (4) the fair values
of the swap and the theoretical debt at the beginning
and end of the period, and (5) the changes in the fair
values of the swap and the theoretical debt for the
period.
September 30, 20X7
The table below shows (1) the six-month LIBOR as of the
last reset date (which affects the current period’s
accrual of the next swap settlement), (2) the fair
values of the swap and the theoretical debt at the
beginning and end of the period, and (3) the changes in
fair values of the swap and the theoretical debt for the
period.
December 31, 20X7
The table below shows (1) the six-month LIBOR as of the
last reset date (which affects the current period’s
accrual of the swap settlement) and the current
six-month LIBOR, (2) the current period’s swap
settlement, (3) the accrued interest on the swap for the
prior and current periods (both components of the
current period’s swap settlement), (4) the fair values
of the swap and the theoretical debt at the beginning
and end of the period, and (5) the changes in the fair
values of the swap and the theoretical debt for the
period.
March 31, 20X8
The table below shows (1) the six-month LIBOR as of the
last reset date (which affects the current period’s
accrual of the next swap settlement), (2) the fair
values of the swap and the theoretical debt at the
beginning and end of the period, and (3) the changes in
the fair values of the swap and the theoretical debt for
the period.
June 30, 20X8
The table below shows (1) the six-month LIBOR as of the
last reset date (which affects the current period’s
accrual of the swap settlement) and the current
six-month LIBOR, (2) the current period’s swap
settlement, (3) the accrued interest on the swap for the
prior and current periods (both components of the
current period’s swap settlement), (4) the fair values
of the swap and the theoretical debt at the beginning
and end of the period, and (5) the changes in fair
values of the swap and the theoretical debt for the
period.
September 30, 20X8
The table below shows (1) the six-month LIBOR as of the
last reset date (which affects the current period’s
accrual of the next swap settlement), (2) the fair
values of the swap and the theoretical debt at the
beginning and end of the period, and (3) the changes in
the fair values of the swap and the theoretical debt for
the period.
December 31, 20X8
The table below shows (1) the six-month LIBOR as of the
last reset date (which affects the current period’s
accrual of the swap settlement), (2) the current
period’s swap settlement, (3) the accrued interest on
the swap for the prior and current periods (both
components of the current period’s swap settlement), (4)
the fair values of the swap and the theoretical debt at
the beginning and end of the period, and (5) the changes
in the fair values of the swap and the theoretical debt
for the period.
Footnotes
1
Although a mortgage servicing right is not a financial asset
because the servicer is obligated to perform to receive the servicing fee,
it is included in this section because certain aspects of the model for fair
value hedges of financial assets also apply to hedges of mortgage servicing
rights (e.g., the types of risks that may be hedged and the amortization of
basis adjustments).
2
ASU 2022-01 modifies this language in ASC
815-25-35-13B to “using an assumed term that begins when the first
hedged cash flow begins to accrue and ends at
the end of the designated hedge period” (emphasis
added).
3
See footnote 2.
4
For simplicity, we assume that
the hedging relationship is not discontinued
before the end of the hedging relationship.
3.3 Nonfinancial Assets and Liabilities
As discussed in Section 2.3.2, in a fair value
hedge that involves nonfinancial assets or liabilities (including nonfinancial firm
commitments with no financial components), an entity can only designate a derivative
instrument to hedge the overall changes in fair value. Component hedging is not
available for fair value hedges of nonfinancial items. However, an entity is
permitted to hedge certain risks in cash flow hedges of the forecasted purchases and
sales of nonfinancial assets, so such hedges are much more common than fair value
hedges of existing nonfinancial assets or liabilities.
In many cases, the hedging derivative is not perfectly effective at offsetting the
total changes in fair value related to the hedged item in a fair value hedge of a
nonfinancial asset or liability. If an entity designates such a hedge, it must
remeasure the hedged item for changes in its overall fair value during the period.
Any mismatch between the derivative and the hedged item is recognized in
current-period earnings.
3.3.1 Basis Adjustments
ASC 815-25
35-8 The adjustment of the
carrying amount of a hedged asset or liability required
by paragraph 815-25-35-1(b) shall be accounted for in
the same manner as other components of the carrying
amount of that asset or liability. For example, an
adjustment of the carrying amount of a hedged asset held
for sale (such as inventory) would remain part of the
carrying amount of that asset until the asset is sold,
at which point the entire carrying amount of the hedged
asset would be recognized as the cost of the item sold
in determining earnings.
The hedged item in a qualifying fair value hedge is remeasured for changes in its
fair value that are attributable to the risk being hedged, which for
nonfinancial items can only be the overall changes in fair value. As is the case
for fair value hedges of financial assets (see discussion in Section 3.2.5), an entity treats adjustments to
the carrying amount of the hedged item in a fair value hedge involving a
nonfinancial item in the same manner as any other basis adjustment to the asset
or liability. However, unlike the treatment of interest-bearing assets and
liabilities, the basis adjustment to a nonfinancial item is not amortized at any
time. The entity recognizes the impact of hedge accounting in the income
statement when the nonfinancial item is sold, derecognized, or impaired (see
Section 3.3.1.1).
In a qualifying fair value hedging relationship, the change in the hedged item’s
fair value should be determined by using changes in the spot price, not the
forward price, of the item. For highly effective hedging relationships, ASC 815
requires the hedged item to be adjusted for changes in fair value that are
attributable to the hedged risk. As discussed previously, in a fair value hedge
of a nonfinancial asset, the only risk that may be designated is the overall
changes in fair value. Fair value is defined in the ASC master glossary as follows:
The price that would be received to sell an asset or paid to transfer a
liability in an orderly transaction between market participants at the
measurement date.
Fair value is the price of a current transaction, which is the spot price, not
the forward price.
3.3.1.1 Interaction With Impairment Guidance
ASC 815-25
35-10
An asset or liability that has been designated as
being hedged and accounted for pursuant to this
Section remains subject to the applicable
requirements in generally accepted accounting
principles (GAAP) for assessing impairment or credit
losses for that type of asset or for recognizing an
increased obligation for that type of liability.
Those impairment or credit loss requirements shall
be applied after hedge accounting has been applied
for the period and the carrying amount of the hedged
asset or liability has been adjusted pursuant to
paragraph 815-25-35-1(b). Because the hedging
instrument is recognized separately as an asset or
liability, its fair value or expected cash flows
shall not be considered in applying those impairment
or credit loss requirements to the hedged asset or
liability.
Pending Content (Transition Guidance: ASC
815-20-65-6)
35-10 [See Section 9.7.]
As noted in Section 3.3.1, basis
adjustments to a hedged item in a qualifying fair value hedging relationship
are accounted for in the same manner as other components of the item’s
carrying amount. Accordingly, when evaluating the hedged item for
impairment, an entity should use the carrying amount of the hedged item
after the hedge accounting adjustments as the starting point. ASC 815 does
not change the relevant impairment model for the hedged item.
3.3.2 Illustrative Examples
Example 3-10
Fair Value Hedge of Inventory With Futures Contract
(Excluded Forward Points)
On January 1, 20X1, FarmHouse Inc. enters into a
cash-settled futures contract to sell one million
bushels of corn at $2.16 per bushel on March 31, 20X1.
It designates the futures contract as a hedge of the
overall fair value of one million bushels of its corn
inventory, which is $2.10 per bushel as of January 1,
20X1.
FarmHouse elects to exclude the initial value of the
forward points (i.e., the excluded component) from the
assessment of effectiveness. According to ASC
815-20-25-83A, “the initial value of the [excluded
component] shall be recognized in earnings using a
systematic and rational method over the life of the
hedging instrument [with] [a]ny difference between the
change in fair value of the excluded component and
amounts recognized in earnings under that systematic and
rational method . . . recognized in other comprehensive
income.” Alternatively, FarmHouse could make an
accounting policy election under ASC 815-20-25-83B in
which it records the changes in the excluded component’s
fair value currently in earnings over the life of the
instrument (i.e., the fair value method). For
illustrative purposes, journal entries for both methods
of accounting for the excluded component are included
below.
The initial value of the forward points is $60,000, or
1,000,000 × ($2.16 – $2.10). For simplicity, assume that
no location basis differential exists for the spot rates
on the hedged item and hedging instrument.
The following table outlines the spot prices and March
31, 20X1, futures prices of corn as of January 1,
January 31, February 28, and March 31, 20X1, as well as
the cumulative losses on the futures contract as of
these respective dates.
Excluded Component — Systematic and Rational
Method
Using the default systematic and rational method,
FarmHouse records the following journal entries as of
January 1, January 31, February 28, and March 31:
Excluded Component — Recognized in Current
Earnings
Under the method in which changes in the excluded
component’s fair value are recognized in earnings, the
journal entries as of January 1, January 31, February
28, and March 31 are as follows:
Example 3-11
Fair Value Hedge of
Inventory — Discontinued Because of
Ineffectiveness
On January 1, 20X1, Maize Company
entered into a cash-settled futures contract to sell
$100 million worth of corn on December 31, 20X1. The
futures contract was designated as a hedge of the
overall fair value of its corn inventory. Maize’s policy
indicates that no components of the change in the
derivative’s fair value will be excluded from the
assessment of hedge effectiveness, which will be
performed quarterly by using regression analysis for
both the prospective and retrospective analyses.
The table below outlines the fair values
of the corn inventory and the futures contracts as well
as the results of the regression analyses on January 1,
March 31, June 30, September 30, and December 31.
Maize records the following journal
entries as of January 1, March 31, June 30, September
30, and December 31:
January 1,
20X1
No entry is required because the futures
contract was entered into at-market.
March 31,
20X1
Hedge accounting may be applied because
both the prospective assessment performed at the
beginning of the period and the retrospective assessment
performed at the end of the period support an assertion
that the hedging relationship is highly effective.
June 30,
20X1
Hedge accounting cannot be applied
because the retrospective assessment performed at the
end of the period does not support an assertion that the
hedging relationship is highly effective. Accordingly,
the inventory is not remeasured for changes in its fair
value.
September 30,
20X1
Hedge accounting cannot be applied
because the prospective assessment performed at the
beginning of the period did not support an assertion
that the hedging relationship is highly effective.
Accordingly, the inventory is not remeasured for changes
in its fair value.
December 31,
20X1
Hedge accounting may be applied because
both the prospective assessment performed at the
beginning of the period and the retrospective assessment
performed at the end of the period support an assertion
that the hedging relationship is highly effective.
Example 3-12
Fair Value Hedge of
Firm Commitment to Purchase Inventory
On January 1, 20X0, Reprise enters into
a firm commitment to buy 10,000 units of titanium at the
current forward price of $310 per unit on June 30, 20X0.
The titanium will be used in the production of goods
that Reprise will ultimately sell. The contract meets
the requirements for the normal purchases and normal
sales scope exception and is not accounted for as a
derivative (see Section 2.3.2 of
Deloitte’s Roadmap Derivatives).
On January 1, 20X0, Reprise also enters
into a net-settled forward contract to sell 10,000 units
of titanium at the current forward price of $310 per
unit on June 30, 20X0. It designates the forward
contract as a hedge of the changes in the fair value of
the firm commitment. Reprise measures hedge
effectiveness on the basis of the changes in the June
30, 20X0, forward price of titanium. Note that (1) any
gain or loss on the hedging instrument and (2) the gains
or losses on changes in the hedged item’s fair value
that are attributable to the risk being hedged are
recognized in earnings in the same income statement line
item as the earnings effect of the hedged item. In this
case, the titanium being purchased under the firm
commitment will be used in the production of goods and,
therefore, the gains and losses on both the derivative
and the hedged item (the firm commitment) will be
recognized in cost of goods sold.
The table below outlines the spot prices
and forward prices of titanium, as well as the fair
values of the firm commitment and forward contract, as
of March 31 and June 30:
Reprise records the following journal
entries as of January 1, March 31, and June 30:
January 1,
20X0
No entry is required because the futures
contract was entered into at-market.
March 31,
20X0
June 30, 20X0
3.4 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 its assessment of hedge
effectiveness. An entity’s decision to either include or exclude components of fair
value from the assessment of hedge effectiveness does not affect the basis
adjustments to the hedged item in a qualifying fair value hedging relationship
because such adjustments are determined independently from the changes in the fair
values of the different components of the hedging instrument.
If an entity excludes components of the derivative’s fair value from the assessment
of hedge effectiveness and elects to recognize those amounts in earnings by using a
systematic and rational method over the life of the hedging instrument, any
difference between the change in fair value of those components and the amount
recognized in earnings should be recognized in OCI, even for a fair value hedging
relationship.
Example 3-13
Hedging Inventory — Excluding Time Value
MineAllMine owns and operates gold mines. As of July 1, 20X9,
MineAllMine has one ton of gold inventory and is concerned
about falling gold prices. The price of gold in the local
market is $1,400 per ounce, while the Chicago Mercantile
Exchange (CME) spot price is $1,320 per ounce. MineAllMine
purchases a financially settled put option on the CME with
the following terms:
Notional
|
32,000 ounces
|
Strike price
|
$1,320 per ounce
|
Expires
|
December 31, 20X9
|
Premium
|
$1,760,000
|
MineAllMine designates the put option as a fair value hedge
of its gold inventory for prices below $1,400 per ounce and
elects to exclude the option’s time value from its hedge
effectiveness assessment. Since this is a fair value hedging
relationship, MineAllMine must hedge the total change in the
inventory’s fair value, which is based on prices in the
gold’s current location (i.e., MineAllMine cannot hedge
solely for changes in the CME price).
MineAllMine will recognize the initial time value in a
systematic and rational basis over the life of the hedge.
Since the term of the put option is six months, use of the
systematic and rational method will result in the
recognition of $880,000 per quarter in cost of sales
provided that the hedging relationship is highly
effective.
The table below shows the CME spot prices of gold and the
fair values of the option components over the life of the
hedge.
The table below shows the local prices of gold and the fair
values of the inventory over the life of the hedge.
MineAllMine records the following journal entries over the
term of the hedging relationship:
July 1, 20X9
September 30, 20X9
December 31, 20X9
3.5 Discontinuing a Fair Value Hedge
In certain circumstances, an entity may be required to discontinue
hedge accounting because of a change in circumstances. In other cases, an entity may
elect to do so. Section 3.5.1 discusses
possible reasons why hedge accounting might be discontinued for a fair value hedging
relationship, and Section 3.5.2 walks through
the accounting for the hedged item after such a discontinuation, including a
discussion of amounts in AOCI related to components that were excluded from the
hedge effectiveness assessment.
3.5.1 Reasons for Discontinuing a Fair Value Hedge
ASC 815-25
40-1 An entity shall
discontinue prospectively the accounting specified in
paragraphs 815-25-35-1 through 35-6 for an existing
hedge if any one of the following occurs:
-
Any criterion in Section 815-20-25 is no longer met.
-
The derivative instrument expires or is sold, terminated, or exercised.
-
The entity removes the designation of the fair value hedge.
3.5.1.1 Derivative or Hedged Item No Longer Held
ASC 815-25-40-1(b) requires an entity to discontinue hedge accounting for a
fair value hedging relationship if the hedging derivative “expires or is
sold, terminated, or exercised.” In such a case, hedge accounting should be
applied through the date of the of expiration, sale, termination, or
exercise if the hedging relationship met the criteria to qualify for hedge
accounting until then. After that date, there will no longer be a derivative
measured at fair value on the balance sheet, so the hedged item should no
longer be remeasured for changes in its fair value that are attributable to
the hedged risk unless it is designated as the hedged item in a new
qualifying fair value hedging relationship.
ASC 815-20-40-1 does not specifically mention the sale, termination, or
exercise of the hedged item. However, if the item is no longer recognized on
the balance sheet, there is no longer a hedged item with exposure to changes
in fair value that are attributable to the hedged risk that could affect
earnings. Therefore, the hedging relationship would no longer meet the
general hedging requirements of ASC 815-20-25 because there would not be an
eligible hedged item. Accordingly, the entity would need to discontinue
hedge accounting for the hedging relationship in accordance with ASC
815-20-40-1(a).
3.5.1.1.1 Derivative Modifications
ASC 815 does not contain explicit guidance on how to determine whether
the modification of an existing derivative instrument results in the
“termination” of the original derivative and replacement with a new one.
If the premodified derivative was a hedging instrument in a qualified
hedging relationship and the modification is considered a termination of
the derivative, the hedging relationship would be discontinued under ASC
815-25-40-1(b) (for a fair value hedge) or ASC 815-30-40-1(b) (for a
cash flow hedge). In addition, ASC 815-20-55-56 states, in part, that
“[i]f an entity wishes to change any of the critical terms of the
hedging relationship (including the method designated for use in
assessing hedge effectiveness), as documented at inception, the
mechanism provided in this Subtopic to accomplish that change is the
dedesignation of the original hedging relationship and the designation
of a new hedging relationship that incorporates the desired changes.” As
discussed in Sections 3.5.1.3,
4.1.5.1.3, and 5.4.3, a
hedging relationship must be discontinued upon its dedesignation
regardless of the type of hedging relationship (i.e., fair value hedge,
cash flow hedge, or net investment hedge).
As noted above, ASC 815 does not provide specific guidance on determining
whether a modification of a derivative’s terms is significant enough to
be viewed as the termination of the original derivative and replacement
with a new one. One reason for this lack of guidance could be that there
is no need for such a distinction. A derivative within the scope of ASC
815 must be recognized on the balance sheet at fair value. If the
modification of a derivative’s terms results in a change in its fair
value and the counterparties do not exchange consideration for that
change, the entity would generally recognize the change in earnings. If
the derivative is not in a qualifying hedging relationship, all changes
in fair value must be recognized in earnings. If the derivative is in a
qualifying hedging relationship and the change is viewed as a change in
a critical term of the derivative, the entity is required to dedesignate
the hedging relationship under ASC 815-20-55-56. Accordingly, any change
in the derivative’s value that results from the modification of terms
would (1) not be attributed to the preexisting hedging relationship and
(2) then be recognized in earnings.
The guidance does not explicitly address a modification of terms that is
not deemed to be a change in a critical term of the derivative or
hedging relationship. If the derivative is designated in a qualifying
fair value hedging relationship, the hedged item would not have a
corresponding change in fair value (or payment, if a payment was
required to execute the modification), so the mechanics of fair value
hedging would result in no offset for any change in the derivative’s
fair value that must be recognized in earnings. If the derivative is
designated in a qualifying cash flow hedge or net investment hedge and
the entity determines that the hedging relationship was still highly
effective (by considering the change in the derivative’s fair value or
cash flows that is not offset by any change in the hedged cash flows or
net investment in foreign operations), any change in fair value that was
not offset by a payment for the modification would be recognized in
OCI.
Connecting the Dots
Some believe that any modification of a
derivative’s terms that affects its fair value is a change of a
critical term of the derivative, which would result in the
automatic dedesignation of any hedging relationship. Others
believe that modifications that would affect the fair value of
the derivative but do not result in changes in any of its
settlement terms are not changes in the critical terms of the
derivative or the hedging relationship; therefore, such
modifications would not result in an automatic hedge
dedesignation event. Examples of such modifications could be
changes in collateral requirements or novations.
ASU 2016-05 added ASC
815-20-55-56A to clarify that derivative novations would not be
considered a change in the critical terms of a hedging
relationship (see the next section). We believe that an entity
should carefully evaluate any other modifications (e.g., changes
in collateral requirements) that would affect the fair value of
the derivative but do not result in changes in any of its
settlement terms before concluding that a change in the critical
terms of the hedging relationship has not occurred. For example,
if the modification resulted in a significant change in the
derivative’s fair value, it would be difficult for the entity to
conclude that the critical terms of the hedging relationship
were not changed.
In addition, the FASB issued ASU
2021-01 in January 2021 to address the
accounting for changes in interest rates used for discounting
and for variation margin settlements and price alignment
interest (PAI). See Section 8.3 for further
discussion of ASU 2021-01.
3.5.1.1.2 Derivative Novations
ASC 815-20
55-56A For the purposes of
applying the guidance in paragraph 815-20-55-56, a
change in the counterparty to a derivative
instrument that has been designated as the hedging
instrument in an existing hedging relationship
would not, in and of itself, be considered a
change in a critical term of the hedging
relationship.
ASC 815-25
40-1A For the purposes of
applying the guidance in paragraph 815-25-40-1, a
change in the counterparty to a derivative
instrument that has been designated as the hedging
instrument in an existing hedging relationship
would not, in and of itself, be considered a
termination of the derivative instrument.
ASC 815-30
40-1A For the purposes of
applying the guidance in paragraph 815-30-40-1, a
change in the counterparty to a derivative
instrument that has been designated as the hedging
instrument in an existing hedging relationship
would not, in and of itself, be considered a
termination of the derivative instrument.
A novation of a derivative occurs when one of the counterparties to the
derivative is replaced with another counterparty.
Example 3-14
TreyCo has an outstanding interest rate swap with
Weekapaug Regional Bank, which assigns its rights
and obligations under the swap to Makisupa
Regional Bank. In this case, the interest rate
swap was novated. Weekapaug would no longer
recognize the interest rate swap on its balance
sheet; the swap would instead be recognized on
Makisupa’s balance sheet. However, TreyCo would
continue to recognize the swap on its balance
sheet.
Novations were not very common until the enactment of
Dodd-Frank,5 which includes certain provisions that require entities to novate
derivatives. If a novated derivative had previously been designated in a
hedging relationship, it was not clear whether such a change in
counterparties to the derivative would be deemed a change in the
critical terms of the hedging relationship that would give rise to a
requirement to dedesignate the relationship in accordance with ASC
815-20-55-56. As a result, the International Swaps and Derivatives
Association (ISDA) consulted with the SEC’s Office of the Chief
Accountant (OCA) about whether novations made in response to Dodd-Frank
would result in a requirement to dedesignate hedging relationships that
involve novated derivatives. In response, in a May 2012 letter to the
ISDA, the OCA indicated that a required novation of a bilateral OTC
derivative contract on the same financial terms would not have to be
deemed a termination of the old derivative or a change in the critical
terms of the hedging relationship. As long as other terms of the
derivative were not changed, the existing hedging relationships could be
continued.
Even after the OCA addressed novations resulting from the Dodd-Frank Act,
it continued to receive questions related to the novation of a
derivative in the following scenarios:
-
The reporting entity’s derivative counterparty merges with and into a surviving entity that assumes the same rights and obligations that existed under a preexisting derivative instrument of the merged entities.
-
The reporting entity’s derivative counterparty novates a derivative instrument to an entity under common control with the derivative counterparty.
-
At the inception of the hedging relationship, the reporting entity knows and contemporaneously documents that all or part of the derivative will be novated to a new counterparty during the hedging relationship.
At the 2014 AICPA Conference on Current SEC and PCAOB Developments, the
OCA indicated that in any of the circumstances described above, it would
not object if an entity continues its existing hedging relationship
despite the derivative instrument’s novation provided that (1) no other
critical terms of the derivative are changed and (2) the hedging
relationship continues to be highly effective.
As a result of discussions by the EITF in 2015, the FASB issued ASU
2016-05 in March 2016. The ASU added ASC 815-20-55-56A, ASC
815-25-40-1A, and ASC 815-30-40-1A, which indicate that a change in the
counterparty to a derivative instrument that has been designated in an
existing hedging relationship would not, in and of itself, be considered
either a termination of the derivative instrument or a change in a
critical term of the hedging relationship.
3.5.1.2 Relationship No Longer Qualifies for Hedge Accounting
3.5.1.2.1 Hedging Relationship Not Highly Effective
ASC 815-25
Noncompliance With Effectiveness
Criterion
40-3 In general, if a
periodic assessment indicates noncompliance with
the effectiveness criterion in paragraphs
815-20-25-75 through 25-80, an entity shall not
recognize the adjustment of the carrying amount of
the hedged item described in paragraphs
815-25-35-1 through 35-6 after the last date on
which compliance with the effectiveness criterion
was established.
40-4 However, if the event
or change in circumstances that caused the hedging
relationship to fail the effectiveness criterion
can be identified, the entity shall recognize in
earnings the changes in the hedged item’s fair
value attributable to the risk being hedged that
occurred before that event or change in
circumstances.
As noted in ASC 815-25-40-1(a), hedge accounting should be discontinued
for a fair value hedging relationship if any of the qualifying criteria
for a fair value hedge are no longer met. The most common reason for
needing to discontinue such a relationship under ASC 815-25-40-1(a) is
that the hedge effectiveness assessment no longer supports an assertion
that the hedging relationship is or is expected to be highly effective.
However, while ASC 815-25-40-1(a) requires hedge accounting to be
discontinued, as discussed in Section
2.5.1, we do not believe that a hedging relationship must
be dedesignated upon a failed hedge effectiveness assessment because the
effect of discontinuing hedge accounting is that it is not applied
during the period in which the hedging relationship does not qualify for
it. ASC 815-25-40-3 states, in part, that “an entity shall not recognize
the adjustment of the carrying amount of the hedged item [in a fair
value hedging relationship] after the last date on which compliance with
the effectiveness criterion was established.”
If an entity’s retrospective hedge effectiveness assessment shows that a
hedging relationship was not highly effective in the period just
completed, the entity should consider whether there was a specific event
or change in circumstances that caused the relationship to fail the
effectiveness assessment. ASC 815-25-40-4 states, in part, that “if the
event or change in circumstances that caused the hedging relationship to
fail the effectiveness criterion can be identified, the entity shall
recognize in earnings the changes in the hedged item’s fair value
attributable to the risk being hedged that occurred before that event or
change in circumstances.” In other words, if the hedging relationship
was highly effective for a portion of the period before the specific
event or change in circumstances occurred, it would be appropriate to
apply hedge accounting to that portion.
If the hedging relationship is not dedesignated, hedge accounting may be
applied in any subsequent period in which the entity can show that (1)
it expects the hedging relationship to be highly effective at the
beginning of the period (the prospective hedge effectiveness assessment)
and (2) the hedge was highly effective during the period (the
retrospective hedge effectiveness assessment). However, as noted in
Section 2.5.1, if there are
repeated failed hedge effectiveness assessments, the entity may want to
consider whether a different hedging strategy would qualify for hedge
accounting. Example 3-11
illustrates a fair value hedge of inventory that is discontinued but not
dedesignated.
3.5.1.2.2 Hedged Item No Longer Meets Definition of Firm Commitment
ASC 815-25
Hedged Item No Longer Meets Definition of
Firm Commitment
40-5 If a fair value hedge
of a firm commitment is discontinued because the
hedged item no longer meets the definition of a
firm commitment, the entity shall do both of the
following:
-
Derecognize any asset or liability previously recognized pursuant to paragraph 815-25-35-1(b) (because of an adjustment to the carrying amount for the firm commitment)
-
Recognize a corresponding loss or gain currently in earnings.
40-6 A pattern of
discontinuing hedge accounting and derecognizing
firm commitments would call into question the
firmness of future hedged firm commitments and the
entity’s accounting for future hedges of firm
commitments.
The guidance in ASC 815-25-40-1(a) would also apply if the hedged item in
a fair value hedge no longer qualifies to be the hedged item. This would
be the case if the hedged item is an unrecognized firm commitment that
no longer meets the definition of a firm commitment. In that case, as
indicated by ASC 815-25-40-5, an entity must not only discontinue the
application of hedge accounting but also derecognize in earnings the
asset or liability that was recognized as an adjustment to the carrying
amount of a previously qualifying fair value hedging relationship. In
addition, a pattern of hedged firm commitments that no longer meet the
definition of a firm commitment would call into question whether an
entity could assert that the commitments it wanted to hedge would meet
the definition of a firm commitment. Note that a commitment that was
settled according to its terms is not considered a firm commitment that
no longer meets the definition of a firm commitment.
3.5.1.2.3 Last-of-Layer Breach
ASC 815-25
40-8 For a hedging
relationship designated under the last-of-layer
method in accordance with paragraph 815-20-25-12A,
an entity shall discontinue (or partially
discontinue) hedge accounting in either of the
following circumstances:
-
If the entity cannot support on a subsequent testing date that the hedged item (that is, the designated last of layer) is anticipated to be outstanding in accordance with paragraph 815-25-35-7A, it shall at a minimum discontinue hedge accounting for the portion of the hedged item no longer expected to be outstanding at the hedged item’s assumed maturity date.b. If on a subsequent testing date the outstanding amount of the closed portfolio of prepayable financial assets or one or more beneficial interests is less than the hedged item, the entity shall discontinue hedge accounting.
Pending Content (Transition Guidance: ASC
815-20-65-6)
40-8 [See Section 9.7.]
40-9 If a last-of-layer
method hedging relationship is discontinued (or
partially discontinued), the outstanding basis
adjustment (or portion thereof) as of the
discontinuation date shall be allocated to the
individual assets in the closed portfolio using a
systematic and rational method. An entity shall
amortize those amounts over a period that is
consistent with the amortization of other
discounts or premiums associated with the
respective assets in accordance with other Topics
(for example, Subtopic 310-20 on
receivables–nonrefundable fees and other
costs).
Pending Content (Transition Guidance: ASC
815-20-65-6)
40-9 [See Section 9.7.]
Last-of-layer hedging involves a partial-term fair value
hedge of a portfolio of prepayable financial assets for changes in fair
value that are attributable to changes in the designated benchmark
interest rate, as discussed in Section 3.2.1.4. At each hedge
effectiveness assessment date throughout the life of a last-of-layer
hedge, an entity is required to support the expectation that the
designated last of layer will be outstanding on the assumed maturity
date. If the entity cannot support that assertion, in accordance with
ASC 815-25-40-8(a), it is required to dedesignate the proportion of the
hedge related to the portion of the last of layer that is not expected
to be outstanding on the assumed maturity date. Proportional
dedesignations are discussed in Section
3.5.1.3.1.
However, if, on an assessment date, the outstanding amount of the closed
portfolio of a last-of-layer hedge is less than the designated last of
layer (commonly referred to as a “breach” of the last of layer), the
entity must dedesignate and discontinue the entire last-of-layer hedging
relationship in accordance with ASC 815-25-40-8(b).
According to ASC 815-25-40-9, at the time of a partial or full
discontinuance of a last-of-layer hedge, the outstanding portfolio-level
basis adjustment “shall be allocated to the individual assets in the
closed portfolio using a systematic and rational method.” As noted in
Example 3-4, we believe that
in the case of a breach of the last of layer, the portion of the basis
adjustment related to the breached portion should be reversed through
earnings since it is related to assets that no longer exist (e.g.,
sales, prepayments, or defaults). The basis adjustment that is allocated
to the assets that still remain in the pool on the date of
discontinuance would be amortized over “a period that is consistent with
the amortization of other discounts or premiums associated with the
respective assets.”
Changing Lanes
In March 2022, the FASB issued ASU 2022-01,
which clarifies the guidance in ASC 815 on fair value hedge
accounting of interest rate risk for portfolios of financial
assets. ASU 2022-01 renames the “last-of-layer” method the
“portfolio layer” method and addresses feedback from
stakeholders regarding its application. ASU 2022-01 amends ASC
815-25-35-6 to clarify that in the event of an anticipated or
actual breach of a hedged layer, an entity should discontinue
hedge accounting for all or part of one or more hedging
relationships related to the portfolio layer method hedge. In
addition, in the event a breach has occurred, the portion of the
basis adjustment related to the breached portion of the
portfolio should be reclassified into interest income. See
Chapter
9 for a more thorough discussion of ASU
2022-01.
3.5.1.3 Dedesignations
ASC 815-25-40-1(c) notes that fair value hedge accounting should be
discontinued if an entity “removes the designation of the fair value hedge.”
An entity may discontinue a hedging relationship at any time, even if the
hedging instrument and the hedged item remain unchanged and are not sold,
terminated, expired, or exercised. In some cases, an entity may dedesignate
a hedging relationship to change its method of assessing hedge effectiveness
(see Section 2.5.4), but in other
cases, it may want to change the hedging relationship itself, such as in a
dynamic hedging strategy (see Section
2.5.2.1.3). For example, the entity may want to deploy the
hedging instrument in a different hedging relationship or simply may no
longer want to apply hedge accounting to the relationship. The voluntary
discontinuance of a hedging relationship is accomplished by (1) formally
documenting the dedesignation of the relationship and then (2) discontinuing
the application of hedge accounting to the dedesignated relationship on the
date of the documentation.
Connecting the Dots
The concept of voluntarily dedesignating an existing
hedging relationship has been a topic of deliberation by both the
FASB and the International Accounting Standards Board
(IASB®). While we further examine some of the
differences between U.S. GAAP and IFRS Accounting Standards in
Appendix
A, this is one subject in which the standards are not
converged. Under IFRS 9, an entity is not allowed to dedesignate a
hedging relationship without either terminating the hedging
derivative or entering into an offsetting derivative. When the FASB
issued its June 2008 and May 2010 exposure drafts to amend hedge
accounting, it proposed a model similar to IFRS 9. However, on the
basis of comments received and further deliberations, the Board did
not include such a requirement in its September 2016 exposure draft
on targeted improvements to accounting for hedging activities, which
was ultimately issued as ASU 2017-12. Instead, the ASU maintains an
entity’s ability to voluntarily dedesignate a hedging relationship
through documentation.
3.5.1.3.1 Proportional Dedesignations
If an entity wants to dedesignate part of a hedging relationship, rather
than the entire relationship, it must make a proportional dedesignation
in which it dedesignates the same proportion of both the hedging
instrument and the hedged item. For example, if an entity is using a
forward contract to sell 100 ounces of gold to hedge 100 ounces of gold
inventory and decides to dedesignate 10 percent of the hedging
relationship, it would dedesignate 10 percent of the forward contract
(the notional amount related to 10 ounces) and 10 percent of the gold
inventory (10 ounces) from the hedging relationship. After the
dedesignation, the remaining hedging relationship would involve 90
percent of the outstanding forward contract hedging 90 ounces of gold
inventory.
ASC 815-30-55-67 through 55-76 provide an example of a hedge of foreign
currency risk related to forecasted royalty payments. In the example,
the overall foreign currency exposure is related to the ultimate
settlement of a quarterly payable that results from three different
monthly royalty expenses. When each monthly royalty is incurred and the
forecasted transaction becomes a recognized payable, the entity
dedesignates a proportion of the derivative from the existing overall
cash flow hedge and then can redesignate that proportion in a fair value
hedge of the recognized payable. In Section
5.3.1.1.2, we discuss a foreign currency hedging strategy
in which a forecasted transaction (e.g., the royalty expense) is hedged
through the settlement date (e.g., the settlement of the payable) as a
combination of a cash flow hedge (i.e., the forecasted transaction)
followed by a fair value hedge (i.e., the recognized payable).
Another example of a required proportional dedesignation event is when an
entity has an existing last-of-layer hedging relationship (see Section 3.2.1.4) and it no longer
believes that the outstanding balance of the closed portfolio of assets
will equal or exceed the designated last of layer through the assumed
maturity date. Accordingly, under ASC 815-25-40-8(a), the entity should
“at a minimum discontinue hedge accounting for the portion of the hedged
item no longer expected to be outstanding at the hedged item’s assumed
maturity date.”
An entity may not dedesignate a proportion of a derivative from the
hedging relationship without also dedesignating the same proportion of
the hedged item. In addition, an entity may not dedesignate a portion of
a derivative and hedged item that is not expressed as a proportion of
the original hedging relationship without a full dedesignation of the
original hedging relationship and redesignation of a new hedging
relationship. For example, if an entity wants to dedesignate the last
two years of a hedging relationship that involves a five-year interest
rate swap hedging a five-year fixed-rate debt instrument, it must
dedesignate the entire five-year relationship and redesignate the new
three-year relationship. Note that a portion of a derivative does not
qualify as the hedging instrument in a hedging relationship, as
discussed in Section 2.4.1.2.
Any dedesignation should be accomplished through contemporaneous
documentation. A proportional dedesignation maintains the remaining
proportion of the original hedging relationship (i.e., the proportion
that has not been dedesignated) for the remainder of its term. If the
hedging relationship met the conditions to apply hedge accounting up to
the date of proportional dedesignation, hedge accounting would be
applied to the entire hedging relationship up until that date.
After a dedesignation, an entity would only assess the remaining
proportion of the hedging relationship to determine whether it qualifies
for hedge accounting. In other words, the entity would compare only (1)
the proportion of the changes in the derivative’s fair value that are
related to the proportion that is still designated as the hedging
instrument and included in the assessment of hedge effectiveness with
(2) the changes in the fair value of the newly designated proportion of
the hedged item that are attributable to changes in the designated risk.
The proportion of the derivative that was dedesignated from the hedging
relationship may be used as the designated hedging instrument in another
qualifying hedging relationship.
The table below summarizes the treatment of the derivative and hedged
item both before and after a proportional dedesignation of a fair value
hedging relationship. It is assumed that the proportion of the
derivative that was dedesignated is not designated in a new qualifying
hedging relationship.
Before Date of Dedesignation
|
After Date of Dedesignation
| |||
---|---|---|---|---|
Hedge Is Highly Effective
|
Hedge Is Not Highly Effective
|
Hedge Is Highly Effective
|
Hedge Is Not Highly Effective
| |
Derivative
|
Remeasured
at fair value through earnings6
| |||
Proportion of hedged item still designated
|
Carrying amount adjusted for changes in fair
value attributable to hedged risk.
|
Carrying amount not adjusted.
|
Carrying amount adjusted for changes in fair
value attributable to hedged risk.
|
Carrying amount not adjusted. See Sections 3.2.5
(financial) and 3.3.1 (nonfinancial) for treatment of
basis adjustments.
|
Proportion of hedged item dedesignated
|
Carrying amount not adjusted. See Sections 3.2.5
(financial) and 3.3.1 (nonfinancial) for treatment of
prior basis adjustments.
|
An entity could accomplish the same objective of a proportional
dedesignation by dedesignating the entire hedging relationship and
redesignating the portion of the hedging relationship that it intends to
apply hedge accounting to; however, redesignating an existing derivative
into a new hedging relationship would most likely involve an off-market
derivative, which would affect the assessment of hedge effectiveness
(see Section 2.5.2.1.4).
3.5.2 Accounting for a Discontinued Fair Value Hedge
Upon the discontinuation of hedge accounting for a fair value hedging
relationship, the treatment of any remaining basis adjustments to the hedged
item from the application of fair value hedge accounting until its
discontinuation depends on the hedged item’s nature. If the hedged item is an
interest-bearing financial instrument, cumulative adjustments to the carrying
amount should be amortized to earnings “over a period that is consistent with
the amortization of other discounts or premiums associated with the hedged item”
in accordance with ASC 815-25-35-9A (see Section
3.2.5). If the hedged item is a nonfinancial asset or liability,
the entity should account for the basis adjustments in the same manner as other
components of the carrying amount of that asset or liability (see Section 3.3.1).
ASC 815-25
40-7 When applying the
guidance in paragraph 815-20-25-83A, any amounts
remaining in accumulated other comprehensive income
associated with amounts excluded from the assessment of
effectiveness shall be recorded in earnings in the
current period if the hedged item is derecognized. For
all other discontinued fair value hedges, any amounts
associated with the excluded component remaining in
accumulated other comprehensive income shall be recorded
in earnings in the same manner as other components of
the carrying amount of the hedged asset or liability in
accordance with paragraphs 815-25-35-8 through
35-9A.
If a fair value hedge is discontinued early, any amounts associated with
remaining components in AOCI that were excluded from the hedge effectiveness
assessment should be reclassified into earnings in the same manner as other
components of the hedged item’s carrying amount. For example, if an entity had
designated a purchased put option in a fair value hedge of inventory for changes
in overall price risk and had been excluding the option’s time value from the
assessment of hedge effectiveness, any amounts in AOCI related to changes in the
fair value of the time value that had not already been recognized in earnings
would remain in AOCI until the inventory affected earnings (i.e., those amounts
in AOCI would be reclassified into cost of sales when the inventory was sold or
reclassified into impairment expense if the inventory was subsequently
impaired).
Footnotes
5
Title VII of the Dodd-Frank Wall Street Reform
and Consumer Protection Act of 2010.
6
If any component of the
derivative is excluded from the assessment of
hedge effectiveness and the difference between the
changes in that component’s in fair value and the
amount recognized in earnings under a systematic
and rational method are recorded in OCI as
permitted by ASC 815-20-25-83A, only the
proportion of the derivative that is still in a
hedging relationship qualifies for this treatment
after the date of the proportional dedesignation.
Amounts related to the proportion of the
derivative that was dedesignated should remain in
AOCI and be reclassified in earnings in a manner
similar to the related basis adjustments on the
hedged item, as discussed in this table (see
Section 3.5.2).
Chapter 4 — Cash Flow Hedges
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:
-
A single transaction
-
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:
-
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).
-
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:
| |
---|---|---|
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 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
1
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.
2
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
|
---|---|---|
|
Any specified cash flows
|
|
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:
-
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.
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.
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 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 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:
December 31,
20X4
The table below shows (1)
the three-month LIBOR at the beginning of the period
(which affects the current period’s swap settlement and
the 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:
March 31,
20X5
The table below shows (1)
the three-month LIBOR at the beginning of the period
(which affects the current period’s swap settlement and
the 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,
20X5
The table below shows (1)
the three-month LIBOR at the beginning of the period
(which affects the current period’s swap settlement and
the 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:
September 30,
20X5
The table below shows (1)
the three-month LIBOR at the beginning of the period
(which affects the current period’s swap settlement and
the 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:
December 31,
20X5
The
table below shows (1) the three-month LIBOR at the
beginning of the period (which affects the current
period’s swap settlement and the 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:
March 31,
20X6
The table below shows (1)
the three-month LIBOR at the beginning of the period
(which affects the current period’s swap settlement and
the 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,
20X6
The table below shows (1)
the three-month LIBOR at the beginning of the period
(which affects the current period’s swap settlement and
the 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:
September 30,
20X6
The table below shows (1)
the three-month LIBOR at the beginning of the period
(which affects the current period’s swap settlement and
the 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:
December 31,
20X6
The table below shows (1)
the three-month LIBOR at the beginning of the period
(which affects the current period’s swap settlement and
the 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:
March 31,
20X7
The table below shows (1)
the three-month LIBOR at the beginning of the period
(which affects the current period’s swap settlement and
the 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,
20X7
The table below shows (1)
the three-month LIBOR at the beginning of the period
(which affects the current period’s swap settlement and
the 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:
September 30,
20X7
The table below shows (1)
the three-month LIBOR at the beginning of the period
(which affects the current period’s swap settlement and
the 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:
December 31,
20X7
The table below shows (1)
the three-month LIBOR at the beginning of the period
(which affects the current period’s swap settlement and
the 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:
March 31,
20X8
The table below shows (1)
the three-month LIBOR at the beginning of the period
(which affects the current period’s swap settlement and
the 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,
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 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:
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.
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 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 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:
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 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,
20X7
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:
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 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 for the period.
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 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:
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
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, 20X4
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, 20X5
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:
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.
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.
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
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:
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
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, 20X3
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, 20X4
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, 20X5
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:
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
3
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
Chapter 5 — Foreign Currency Hedges
Chapter 5 — Foreign Currency Hedges
5.1 Overview
The requirements for applying hedge accounting to foreign currency exposures are
consistent with the general concepts outlined in ASC 815. However, because of the
unique nature of a foreign currency exposure and its interaction with the
measurement and translation guidance in ASC 830, there are a number of special
considerations related to foreign currency hedges that affect the eligible hedged
items and hedging instruments as well as the mechanics and application of hedge
accounting.
This chapter focuses on the key foreign currency exposures that are affected by the
functional currency concepts of ASC 830, which include the following, as outlined in
ASC 815-20-25-26:
- An unrecognized foreign-currency-denominated firm commitment
- A recognized foreign-currency-denominated asset or liability
- A foreign-currency-denominated forecasted transaction
- The forecasted functional-currency-equivalent cash flows associated with a recognized asset or liability
- A net investment in a foreign operation.
5.1.1 Types of Foreign Currency Hedging Relationships
The type of hedging relationship that an entity applies to a foreign currency
exposure has a substantial impact on the hedge accounting mechanics. Other
features of a hedging relationship that affect the mechanics of the accounting
include:
- The effectiveness assessment method selected (see Section 2.5.2.1.1).
- The components of the hedging instrument that are excluded from the hedge effectiveness assessment (see Section 2.5.2.1.2.1).
- Changes in qualifying events or the discontinuation of hedge accounting.
ASC 815 allows three types of foreign currency hedging relationships provided
that all qualifying criteria are met. The type of relationship that an entity
applies is largely driven by the risk exposure that it wants to hedge (i.e., the
hedged item). The permissible combinations of hedged items and hedging
instruments by foreign currency hedging relationship type are as follows:
Hedging Relationship Type
|
Possible Types of Foreign-Currency-Denominated Hedged
Items (See ASC 815-20-25-28)
|
Permitted Hedging Instruments
|
---|---|---|
Foreign currency fair value hedge (see
Section
5.2)
|
Recognized asset or liability (including AFS
securities)
|
Derivative
|
Unrecognized firm commitment
|
Derivative or nonderivative
| |
Foreign currency cash flow hedge (see
Section
5.3)
|
|
Derivative
|
Net investment hedge (see Section 5.4)
|
Net investment in a foreign operation
|
Derivative or nonderivative
|
While each of the relationship types has separate qualification requirements, an
entity must first identify the source of the foreign currency exposure and the
reporting level at which a hedging relationship may exist.
5.1.2 Understanding Foreign Currency Exposures and Hedge Accounting Eligibility
ASC 815-20
25-30 Both of the following
conditions shall be met for foreign currency cash flow
hedges, foreign currency fair value hedges, and hedges
of the net investment in a foreign operation:
- For consolidated financial
statements, either of the following conditions is
met:
- The operating unit that has the foreign currency exposure is a party to the hedging instrument.
- Another member of the
consolidated group that has the same functional
currency as that operatingunit is a party to the hedging instrument and there is no intervening subsidiary with a different functional currency. See guidance beginning in paragraph 815-20-25-52 for conditions under which an intra-entity foreign currency derivative can be the hedging instrument in a cash flow hedge of foreign exchange risk.
- The hedged transaction is denominated in a currency other than the hedging unit’s functional currency.
Irrespective of the type of hedging relationship being
designated, when determining eligibility for hedge accounting, an entity should
identify (1) the exposure to foreign currencies and (2) where the exposure
arises within the consolidated entity. As discussed in the next subsection, with
some exceptions, the operating unit with the foreign currency exposure must be a
party to the hedging instrument. Therefore, the source of a foreign currency
exposure must be identified to determine whether the entity with the hedging
instrument can pursue hedge accounting for that exposure.
5.1.2.1 Identifying the Source of Exposure
ASC 815-20
Hedged Items
and Transactions Involving Foreign Exchange
Risk
25-23 Under the functional
currency concept of Topic 830, exposure to a foreign
currency exists only in relation to a specific
operating unit’s designated functional currency cash
flows. Therefore, exposure to foreign currency risk
shall be assessed at the unit level.
25-24 A unit has exposure to
foreign currency risk only if it enters into a
transaction (or has an exposure) denominated in a
currency other than the unit’s functional
currency.
25-25 Due to the requirement
in Topic 830 for remeasurement of assets and
liabilities denominated in a foreign currency into
the unit’s functional currency, changes in exchange
rates for those currencies will give rise to
exchange gains or losses, which results in direct
foreign currency exposure for the unit but not for
the parent entity if its functional currency differs
from its unit’s functional currency.
25-26 The functional currency
concepts of Topic 830 are relevant if the foreign
currency exposure being hedged relates to any of the
following:
- An unrecognized foreign-currency-denominated firm commitment
- A recognized foreign-currency-denominated asset or liability
- A foreign-currency-denominated forecasted transaction
- The forecasted functional-currency-equivalent cash flows associated with a recognized asset or liability
- A net investment in a foreign operation.
25-27 Because a parent entity
whose functional currency differs from its
subsidiary’s functional currency is not directly
exposed to the risk of exchange rate changes due to
a subsidiary transaction that is denominated in a
currency other than a subsidiary’s functional
currency, the parent cannot qualify for hedge
accounting for a hedge of that risk. Accordingly, a
parent entity that has a different functional
currency cannot qualify for hedge accounting for
direct hedges of a subsidiary’s recognized asset or
liability, unrecognized firm commitment or
forecasted transaction denominated in a currency
other than the subsidiary’s functional currency.
Also, a parent that has a different functional
currency cannot qualify for hedge accounting for a
hedge of a net investment of a first-tier subsidiary
in a second-tier subsidiary.
The identification of a foreign currency exposure is
determined by the ASC 830 concept of functional currencies. In line with
this concept, ASC 815-20-25-23 through 25-27 require entities to identify
exposures to foreign currencies at the individual operating unit level
(e.g., subsidiary) from the perspective of each operating unit’s own
functional currency.
Because an exposure is assessed at an operating unit level,
the functional currency of each operating unit will affect the
identification of a foreign currency exposure on an individual operating
unit basis as well as at the various levels of consolidation. This
distinction is important for entities operating in multiple environments
because a foreign currency exposure at one level of the consolidated entity
may not reflect a foreign currency exposure at another level of the
consolidated structure.
The focus on the functional currency is one feature that
distinguishes foreign currency exposures and related hedging requirements
from general hedge accounting strategies. For example, an entity that hedges
the contractually specified interest rate risk of a term loan would be
exposed to the contractually specified interest rate risk irrespective of
the entity’s functional currency. By contrast, the determination of a
foreign currency exposure is directly related to an entity’s functional
currency (e.g., a forecasted euro-denominated-sale may represent a foreign
currency exposure for one entity but not another).
Further, the exposures at each level of the consolidation
structure are affected by the mechanics of consolidation and the
requirements of ASC 830, as contemplated in ASC 815-20-25-27. For instance,
on an individual operating unit level, a transaction denominated in a
foreign currency would be subject to ASC 830-20 and represent a foreign
currency exposure that could directly affect earnings. Such an exposure
through earnings would also be present on a consolidated basis in instances
in which the subsidiaries have the same functional currency as the parent,
thereby allowing the parent entity to have a direct line to the
exposure.
Conversely, on a consolidated basis, a subsidiary whose
functional currency differs from the parent would be subject to ASC 830-30
and translated upon consolidation, with a CTA recorded in OCI. Therefore,
the parent entity would have neither a direct exposure nor a direct line to
the exposures of the foreign subsidiary.
Example 5-1
Identifying the
Exposure at Each Reporting Level
Parent Co. has a USD functional
currency and consolidates a subsidiary, Sub Co,
which has a euro (EUR) functional currency.
Scenario 1 —
Sub Co. Has Forecasted EUR-Denominated
Sales
On a reporting-unit basis, Sub Co.
would not have a foreign currency exposure related
to its forecasted EUR-denominated sales because the
sales are denominated in its functional currency.
Further, Parent Co. is not directly exposed to the
exchange rate risk. Therefore, neither Parent Co.
nor its subsidiary would be permitted to designate
the foreign currency risk on the forecasted
EUR-denominated sales as a hedged risk.
Scenario 2 —
Sub Co. Has Forecasted USD-Denominated
Sales
On a reporting-unit basis, Sub Co.
has a foreign currency exposure related to its
forecasted USD-denominated sales because its
functional currency is the EUR. Therefore, Sub Co.
could designate this exposure as its hedged
item.
Conversely, Parent Co. would not
have a direct exposure because upon consolidation,
Sub Co.’s financial statements are subject to the
translation guidance of ASC 830-30.
5.1.2.2 Identifying the Eligible Party to the Hedging Instrument
Once the source of a foreign currency exposure has been
identified, it is necessary to establish which entity must hold the hedging
instrument for hedge accounting to be permissible. In accordance with ASC
815-20-25-30(a), hedge accounting may be applied on a consolidated level if
either (1) the entity with the foreign currency exposure holds the hedging
instrument directly or (2) the parent entity holds the hedging instrument
provided that it has the same functional currency as the subsidiary with the
exposure and there are no intervening subsidiaries with a different
functional currency. As noted in Section 2.4.1.3.1, in scenarios in
which the hedging instrument is held by the parent, internal derivatives can
be used to allow for hedge accounting on a stand-alone level.
Thus, while the application of hedge accounting generally
requires the operating unit with the foreign currency exposure to be a party
to the hedging instrument (either via an external or qualifying internal
derivative), as an exception to this requirement, ASC 815-20-25-32
establishes that a parent entity may look through to the foreign currency
exposure if no intervening subsidiaries with different functional currencies
exist. By focusing on the intervening subsidiaries, the guidance recognizes
and contemplates the step-by-step consolidation mechanics, as affected by
ASC 830-30.
To be eligible for hedge accounting, the entity with the
hedging instrument is required to have either direct exposure or a direct
line to the exposure, or both.
Example 5-2
Identifying the
Eligible Party to the Hedge
Assume the following organizational
structure, with the noted functional currency for
each entity:
In this scenario, SimpleBand may
qualify to use its hedging instruments to directly
hedge foreign currency exposures arising from
subsidiaries Cymbal Co. and Saxophone Co. on a
consolidated basis. However, SimpleBand would not be
permitted to hedge the foreign currency exposures of
Skyscraper Co. because that subsidiary has a
different functional currency (EUR) than SimpleBand
(USD). In addition, SimpleBand would not be
permitted to hedge the foreign currency exposures of
BeBop Co., even though they share the same
functional currency, because the intervening
Skyscraper Co. has a different functional currency.
Therefore, all exposures at the BeBop Co. level
would first be translated into the functional
currency of Skyscraper Co. (EUR), which would then
be translated into the functional currency of
SimpleBand (USD). In this way, SimpleBand would not
be exposed to the foreign currency exposure of BeBop
Co.
If either Skyscraper Co. or BeBop
Co. wants to hedge its foreign currency exposures,
the reporting unit would need to enter into a
hedging instrument and designate the hedging
relationship at its stand-alone level. The impacts
of hedge accounting would survive consolidation.
Further, while SimpleBand would be
permitted to hedge Cymbal Co.’s and Saxophone Co.’s
exposure at the consolidated level with its own
hedging instruments, neither Cymbal Co. nor
Saxophone Co. would be permitted to apply hedge
accounting on its stand-alone statements unless it
(1) transacts in an intercompany hedging instrument
with the parent entity or (2) holds its own hedging
instrument, as noted in the next section.
5.1.2.3 Central Risk Management
ASC 815-20
Internal Derivatives as Hedging
Instruments in Cash Flow Hedges of Foreign Exchange
Risk
25-61 An internal derivative
can be a hedging instrument in a foreign currency
cash flow hedge of a forecasted borrowing, purchase,
or sale or an unrecognized firm commitment in the
consolidated financial statements only if both of
the following conditions are satisfied:
-
From the perspective of the member of the consolidated group using the derivative instrument as a hedging instrument (the hedging affiliate), the criteria for foreign currency cash flow hedge accounting otherwise specified in this Section are satisfied.
-
The member of the consolidated group not using the derivative instrument as a hedging instrument (the issuing affiliate) either:
-
Enters into a derivative instrument with an unrelated third party to offset the exposure that results from that internal derivative
-
If the conditions in paragraphs 815-20-25-62 through 25-63 are met, enters into derivative instruments with unrelated third parties that would offset, on a net basis for each foreign currency, the foreign exchange risk arising from multiple internal derivative instruments. In complying with this guidance the issuing affiliate could enter into a third-party position with neither leg of the third-party position being the issuing affiliate’s functional currency to offset its exposure if the amount of the respective currencies of each leg are equivalent with respect to each other based on forward exchange rates.
-
25-62 If an issuing affiliate
chooses to offset exposure arising from multiple
internal derivatives on an aggregate or net basis,
the derivative instruments issued to hedging
affiliates shall qualify as cash flow hedges in the
consolidated financial statements only if all of the
following conditions are satisfied:
-
The issuing affiliate enters into a derivative instrument with an unrelated third party to offset, on a net basis for each foreign currency, the foreign exchange risk arising from multiple internal derivatives.
-
The derivative instrument with the unrelated third party generates equal or closely approximating gains and losses when compared with the aggregate or net losses and gains generated by the derivative instruments issued to affiliates.
-
Internal derivatives that are not designated as hedging instruments are excluded from the determination of the foreign currency exposure on a net basis that is offset by the third-party derivative instrument. Nonderivative contracts shall not be used as hedging instruments to offset exposures arising from internal derivatives.
-
Foreign currency exposure that is offset by a single net third-party contract arises from internal derivatives that mature within the same 31-day period and that involve the same currency exposure as the net third-party derivative instrument. The offsetting net third-party derivative instrument related to that group of contracts shall meet all of the following criteria:
-
It offsets the aggregate or net exposure to that currency.
-
It matures within the same 31-day period.
-
It is entered into within three business days after the designation of the internal derivatives as hedging instruments.
-
- The issuing affiliate meets
both of the following conditions:
-
It tracks the exposure that it acquires from each hedging affiliate.
-
It maintains documentation supporting linkage of each internal derivative and the offsetting aggregate or net derivative instrument with an unrelated third party.
-
-
The issuing affiliate does not alter or terminate the offsetting derivative instrument with an unrelated third party unless the hedging affiliate initiates that action.
25-63 If the issuing
affiliate alters or terminates any offsetting
third-party derivative (which should be rare), the
hedging affiliate shall prospectively cease hedge
accounting for the internal derivatives that are
offset by that third-party derivative
instrument.
Many consolidated entities use a central risk management or
central treasury function to transact risk management instruments and enter
into hedging relationships with their subsidiaries. Because a central
treasury function manages the risks of the entire entity, such an
arrangement (1) promotes improved efficiency and economies of scale and (2)
allows an entity to hedge net risk exposures (e.g., if subsidiary A is
“long” an exposure and subsidiary B is “short” the same exposure, the
central treasury function might choose to hedge the net risk exposure of the
consolidated entity).
Although ASC 815 generally does not permit hedge accounting
for net exposures (see Section 2.2.2.2), the FASB created an exception for
situations in which a subsidiary within a consolidated entity uses an
internal derivative to hedge the foreign currency exposure arising from an
unrecognized firm commitment or a forecasted borrowing,1 purchase, or sale. Such hedges can be accounted for as cash flow
hedges in the consolidated financial statements if the conditions in ASC
815-20-25-61 are satisfied. First, the hedge must meet all the criteria for
foreign currency cash flow hedge accounting (from the perspective of the
hedging entity within the consolidated group). Second, the other party to
the hedging derivative within the consolidated group (i.e., the nonhedging
entity) must either (1) enter into another derivative with a third party
outside the consolidated group that offsets the risk exposure of the
internal derivative or (2) if certain additional criteria (described below)
are satisfied, enter into a derivative with an unrelated third party that
offsets, for each foreign currency, the net foreign currency exposure
arising from multiple internal derivatives (this type of activity typically
would be carried out by a central treasury function).
If an entity chooses to offset exposures arising from
multiple internal derivatives on an aggregate or net basis (e.g., through a
central treasury function or “issuing affiliate”), those internal
derivatives issued to the hedging members of the consolidated group would
qualify for cash flow hedge accounting in the consolidated financial
statements only if all the conditions in ASC 815-20-25-62 are met.
ASC 815 includes a detailed example of offsetting exposures
arising from multiple internal derivatives on an aggregate or net basis. See
the example below.
ASC 815-30
Example 19:
Hedge Accounting in the Consolidated Financial
Statements Applied to Internal Derivatives That
Are Offset on a Net Basis by Third-Party
Contracts
55-113 This Example
illustrates the application of paragraphs
815-20-25-61 through 25-63, specifically, the
mechanism for offsetting risks assumed by a Treasury
Center using internal derivatives on a net basis
with third-party contracts. This Example does not
demonstrate the computation of fair values and as
such makes certain simplifying assumptions.
55-114 Entity XYZ is a U.S.
entity with the U.S. dollar (USD) as both its
functional currency and its reporting currency.
Entity XYZ has three subsidiaries: Subsidiary A is
located in Germany and has the Euro (EUR) as its
functional currency, Subsidiary B is located in
Japan and has the Japanese yen (JPY) as its
functional currency, and Subsidiary C is located in
the United Kingdom and has the pound sterling (GBP)
as its functional currency. Entity XYZ uses its
Treasury Center to manage foreign exchange risk on a
centralized basis. Foreign exchange risk assumed by
Subsidiaries A, B, and C through transactions with
external third parties is transferred to the
Treasury Center via internal contracts. The Treasury
Center then offsets that exposure to foreign
currency risk via third-party contracts. To the
extent possible, the Treasury Center offsets
exposure to each individual currency on a net basis
with third-party contracts.
55-115 On January 1,
Subsidiaries A, B, and C decide that various
foreign-currency-denominated forecasted transactions
with external third parties for purchases and sales
of various goods are probable. Also on January 1,
Subsidiaries A, B, and C enter into internal foreign
currency forward contracts with the Treasury Center
to hedge the foreign exchange risk of those
transactions with respect to their individual
functional currencies. The Treasury Center has the
same functional currency as the parent entity
(USD).
55-116 Subsidiaries A, B, and
C have the following foreign currency exposures and
enter into the following internal contracts with the
Treasury Center.
55-117 Subsidiaries A, B, and
C designate the internal contracts with the Treasury
Center as cash flow hedges of their foreign currency
forecasted purchases and sales. Those internal
contracts may be designated as hedging instruments
in the consolidated financial statements if the
requirements of this Subtopic are met. From the
subsidiaries’ perspectives, the requirements of
paragraph 815-20-25-61 for foreign currency cash
flow hedge accounting are satisfied as follows:
-
From the perspective of the hedging affiliate, the hedging relationship must meet the requirements of paragraphs 815-20-25-30 and 815-20-25-39 through 25-41 for cash flow hedge accounting. Subsidiaries A, B, and C meet those requirements. In each hedging relationship, the forecasted transaction being hedged is denominated in a currency other than the subsidiary’s functional currency, and the individual subsidiary that has the foreign currency exposure relative to its functional currency is a party to the hedging instrument. In addition, the criteria in Section 815-20-25 are met. Specifically, each subsidiary prepares formal documentation of the hedging relationships, including the date on which the forecasted transactions are expected to occur and the amount of foreign currency being hedged. The forecasted transactions being hedged are specifically identified, are probable of occurring, and are transactions with external third parties that create cash flow exposure that would affect reported earnings. Each subsidiary also documents its expectation of high effectiveness based on the internal derivatives designated as hedging instruments.
-
The affiliate that issues the hedge must offset the internal derivative either individually or on a net basis. The Treasury Center determines that it will offset the exposure arising from the internal derivatives with Subsidiaries A, B, and C on a net basis with third-party contracts. Each currency for which a net exposure exists at the Treasury Center is offset by a third-party contract based on that currency.
55-118 To determine the net
currency exposure arising from the internal
contracts with Subsidiaries A, B, and C, the
Treasury Center performs the following analysis.
55-119 For Subsidiaries A, B,
and C to designate the internal contracts as hedging
instruments in the consolidated financial
statements, the Treasury Center must meet certain
required criteria outlined in paragraphs
815-20-25-62 through 25-63 in determining how it
will offset exposure arising from multiple internal
derivatives that it has issued. Based on a
determination that those requirements are satisfied
(see the following paragraph, the Treasury Center
determines the net exposure in each currency with
respect to USD (its functional currency). The
Treasury Center determines that it will enter into
the following three third-party foreign currency
forward contracts. The Treasury Center enters into
the contracts on January 1. The contracts mature on
June 30.
55-120 From the Treasury
Center’s perspective, the required criteria in
paragraphs 815-20-25-62 through 25-63 are satisfied
as follows:
-
The issuing affiliate enters into a derivative instrument with an unrelated third party to offset, on a net basis for each foreign currency, the foreign exchange risk arising from multiple internal derivatives, and the derivative instrument with the unrelated third party generates equal or closely approximating gains and losses when compared with the aggregate or net losses and gains generated by the derivative instruments issued to affiliates. The Treasury Center enters into third-party derivative instruments to offset the exposure of each foreign currency on a net basis. The Treasury Center offsets 100 percent of the net exposure to each currency; that is, the Treasury Center does not selectively keep any portion of that exposure. In this Example, the Treasury Center’s third-party contracts generate losses that are equal to the losses on internal contracts designated as hedging instruments by Subsidiaries A, B, and C (see analysis beginning in the following paragraph).
-
Internal derivatives that are not designated as hedging instruments and all nonderivative instruments are excluded from the determination of the foreign currency exposure on a net basis that is offset by the third-party derivative instrument. The Treasury Center does not include in the determination of net exposure any internal derivatives not designated as hedging instruments or any nonderivative instruments.
-
Foreign currency exposure that is offset by a single net third-party contract arises from internal derivatives that involve the same currency and that mature within the same 31-day period. The offsetting net third-party derivative instrument related to that group of contracts must offset the aggregate or net exposure to that currency, must mature within the same 31-day period, and must be entered into within 3 business days after the designation of the internal derivatives as hedging instruments. The Treasury Center’s third-party net contracts involve the same currency (that is, not a tandem currency) as the net exposure arising from the internal derivatives issued to Subsidiaries A, B, and C. The Treasury Center’s third-party derivative instruments mature within the same 31-day period as the internal contracts that involve currencies that are offset on a net basis. In this Example, for simplicity, all internal contracts and third-party derivative instruments are entered into on the same date.
-
The issuing affiliate tracks the exposure that it acquires from each hedging affiliate and maintains documentation supporting linkage of each derivative instrument and the offsetting aggregate or net derivative instrument with an unrelated third party. The Treasury Center maintains documentation supporting linkage of third-party contracts and internal contracts throughout the hedge period.
-
The issuing affiliate does not alter or terminate the offsetting derivative instrument with an unrelated third party unless the hedging affiliate initiates that action. If the issuing affiliate does alter or terminate the offsetting third-party derivative (which should be rare), the hedging affiliate must prospectively cease hedge accounting for the internal derivatives that are offset by that third-party derivative. Based on Entity XYZ’s policy, the Treasury Center may not alter or terminate the offsetting derivative instrument with an unrelated third party unless the hedging affiliate initiates that action.
-
If an internal derivative that is included in determining the foreign currency exposure on a net basis is modified or dedesignated as a hedging instrument, compliance must be reassessed. For simplicity, this Example does not involve a modification or dedesignation of an internal derivative.
55-121 At the end of the
quarter, each subsidiary determines the functional
currency gains and losses for each contract with the
Treasury Center.
55-122 At the end of the
quarter, the Treasury Center determines its gains or
losses on third-party contracts.
55-123 Journal Entries at
March 31 (Note: All journal entries are in USD.)
Subsidiaries’
Journal Entries
German
Subsidiary A
There is no entry for Contract 1
because the USD gain or loss is zero.
Japanese
Subsidiary B
There is no entry for Internal
Contract 4 because the USD gain or loss is zero.
UK Subsidiary
C
Treasury
Center’s Journal Entries
Journal Entries
for Internal Contracts With Subsidiaries
There is no entry for Internal
Contract 1 because the USD gain or loss is zero.
Journal Entries
for Third-Party Contracts
Results in
Consolidation
55-124 In consolidation, the
amounts in the balance sheets of Subsidiaries A, B,
and C reflecting derivative instrument assets and
derivative instrument liabilities arising from
internal derivatives acquired from the Treasury
Center eliminate against the Treasury Center’s
derivative instrument liabilities and derivative
instrument assets arising from internal derivatives
issued to the subsidiaries. The amount reflected in
consolidated other comprehensive income reflects the
net entry to other comprehensive income of
Subsidiaries A, B, and C. The Treasury Center’s
gross derivative instrument asset and gross
derivative instrument liability arising from
third-party contracts are also reflected in the
consolidated balance sheet. Based on the assumptions
in this Example, the Treasury Center’s net loss on
third-party derivative instruments used to offset
the exposure, on a net basis, of internal contracts
with Subsidiaries A, B, and C equals the net loss on
internal contracts with the subsidiaries. Therefore,
within the Treasury Center, the gains on internal
contracts issued to Subsidiaries A, B, and C, and
the losses on third-party contracts are equal and
offsetting. If the Treasury Center’s net gain or
loss on third-party contracts does not equal the net
gain or loss on internal derivatives designated as
hedging instruments by affiliates, the difference
must be recognized in consolidated other
comprehensive income.
55-125 The reclassification
of amounts out of consolidated other comprehensive
income is based on Subsidiaries A, B, and C’s
internal contracts with the Treasury Center. That
is, the reclassification of amounts out of
consolidated other comprehensive income into
earnings is based on the timing and amounts of the
individual subsidiaries’ forecasted transactions. In
this Example, at June 30, the forecasted
transactions at Subsidiaries A, B, and C have been
consummated and the net debit amount in consolidated
other comprehensive income of 3 has been
reversed.
The conditions in ASC 815-20-25-62 only apply when an entity
wants to use a central treasury function that offsets exposures arising from
multiple internal derivatives on an aggregate or net basis. Those conditions
do not apply to entities that use intra-entity derivatives in hedging
relationships if each of those derivatives is also offset with a derivative
entered into with a third party, as discussed in Section 2.4.1.3.1.
The exception that permits an entity to hedge foreign
currency risk for net cash flow exposures by currency type may not be
applied to (1) foreign currency fair value hedges, (2) hedges of net
investments in foreign operations, or (3) hedges of cash flow exposures
related to recognized foreign-currency-denominated assets or liabilities,
even if such assets or liabilities resulted from a specifically identified
forecasted transaction that was initially designated as a cash flow
hedge.
5.1.3 Hedging on an After-Tax Basis
ASC 815-20
25-3 Concurrent designation
and documentation of a hedge is critical; without it, an
entity could retroactively identify a hedged item, a
hedged transaction, or a method of measuring
effectiveness to achieve a desired accounting result. To
qualify for hedge accounting, there shall be, at
inception of the hedge, formal documentation of all of
the following: . . .
b. Documentation requirement
applicable to fair value hedges, cash flow hedges, and
net investment hedges: . . .
2. The entity’s risk management objective and
strategy for undertaking the hedge, including
identification of all of the following: . .
.
vi. If the entity is
hedging foreign currency risk on an after-tax
basis, that the assessment of effectiveness,
including the calculation of ineffectiveness, will
be on an after-tax basis (rather than on a pretax
basis). . . .
ASC 815-30
35-5 If an entity has
designated and documented that it will assess
effectiveness and measure hedge results of a cash flow
hedge of foreign currency risk on an after-tax basis as
permitted by paragraph 815-20-25-3(b)(2)(vi), the
portion of the gain or loss on the hedging instrument
that exceeded the loss or gain on the hedged item shall
be included as an offset to the related tax effects in
the period in which those tax effects are
recognized.
ASC 815-35
35-3 If an entity has
designated and documented that it will assess
effectiveness and measure hedge results on an after-tax
basis as permitted by paragraph 815-20-25-3(b)(2)(vi),
the portion of the gain or loss on the hedging
instrument that exceeded the loss or gain on the hedged
item shall be included as an offset to the related tax
effects in the period in which those tax effects are
recognized.
35-19 The assessment of
hedge effectiveness due to such differences between the
hedging derivative instrument and the hedged net
investment considers the following:
-
Different notional amounts. If the notional amount of the derivative instrument designated as a hedge of the net investment does not match the portion of the net investment designated as being hedged, hedge effectiveness shall be assessed by comparing the following two values:
-
The change in fair value of the actual derivative instrument designated as the hedging instrument
-
The change in fair value of a hypothetical derivative instrument that has a notional amount that matches the portion of the net investment being hedged and a maturity that matches the maturity of the actual derivative instrument designated as the net investment hedge. See paragraph 815-35-35-26 for situations in which the hedge of a net investment in a foreign operation is hedging foreign currency risk on an after-tax basis, as permitted by paragraph 815-20-25-3(b)(2)(vi). . . .
-
35-26 Paragraph
815-20-25-3(b)(2)(vi) permits hedging foreign currency
risk on an after-tax basis, provided that the
documentation of the hedge at its inception indicated
that the assessment of effectiveness and measurement of
hedge results will be on an after-tax basis (rather than
on a pretax basis). If an entity has elected to hedge
foreign currency risk on an after-tax basis, it shall
adjust the notional amount of its derivative instrument
appropriately to reflect the effect of tax rates. In
that case, the hypothetical derivative instrument used
to assess effectiveness shall have a notional amount
that has been appropriately adjusted (pursuant to the
documentation at inception) to reflect the effect of the
after-tax approach.
FASB Statement 52 permitted entities to apply hedge accounting for foreign currency exposures on an after-tax basis because it is common for a parent to assert that profits in a foreign subsidiary will be indefinitely reinvested for tax purposes. In such cases, the effects of a hedging instrument on the parent would be subject to the parent’s taxing jurisdiction. FASB Statement 133 carried forward those provisions of Statement 52, which are now incorporated into ASC
815-20-25-3(b)(2)(vi).
While hedging on an after-tax basis occurs most often with hedges of net
investments in foreign operations, hedging on an after-tax basis is not limited
to net investment hedges. Entities should consider the tax effects on both the
hedging instrument and the hedged item in assessing the effectiveness of the
hedging relationship. In addition, if tax rates change, an entity should
consider how those changes in rates affect the effectiveness assessment. If an
entity is using an after-tax hedging strategy for cash flow or net investment
hedges, the portion of the gain or loss on the hedging instrument that exceeds
the loss or gain, respectively, on the hedged item should be included as an
offset to the related tax effects in the period in which such effects are
recognized.
Footnotes
1
While ASC 815-20-25-61 discusses hedging forecasted
borrowings for foreign currency risk, note that the forecasted
issuance of foreign-currency-denominated debt does not give rise to
a foreign currency risk related to the principal amount of the debt
before it is issued. There is no earnings exposure from the
potential changes in cash flows attributable changes in foreign
currency exchange rates for the principal amount of debt in a
forecasted issuance of foreign-currency-denominated debt. However,
forecasted interest payments related to the forecasted issuance of
foreign-currency-denominated debt may be hedged for foreign currency
risk. An entity may hedge the foreign currency risk related to the
principal, interest payments, or both for recognized
foreign-currency-denominated debt.
5.2 Foreign Currency Fair Value Hedges
Hedging Relationship Type
|
Possible Types of Foreign-Currency-Denominated Hedged Items
(See ASC 815-20-25-28)
|
Permitted Hedging Instruments
|
---|---|---|
Foreign currency fair value hedge
|
Recognized asset or liability (including AFS securities)
|
Derivative
|
Unrecognized firm commitment
|
Derivative or nonderivative
|
As indicated in the ASC master glossary and discussed in Chapter 3, a fair value hedge is “[a] hedge of the exposure to
changes in the fair value of a recognized asset or liability, or of an unrecognized
firm commitment, that are attributable to a particular risk.” The changes in that
fair value must have the potential to affect reported earnings. When an entity
elects to hedge a foreign-currency-denominated asset or liability for changes in
fair value that are attributable to changes in foreign currency exchange rates,
additional guidance is needed because the hedged item in many cases is already
subject to remeasurement under ASC 830-20.
5.2.1 Hedged Items in a Foreign Currency Fair Value Hedge
A hedged item would only have exposure to changes in fair value that are
attributable to changes in foreign currency exchange rates if it is an existing
foreign-currency-denominated asset or liability or an unrecognized firm
commitment to purchase or sell an asset with a price that is a fixed amount of a
foreign currency.
ASC 815-20
25-37 This paragraph
identifies possible hedged items in fair value hedges of
foreign exchange risk. If every applicable criterion is
met, all of the following are eligible for designation
as a hedged item in a fair value hedge of foreign
exchange risk:
-
Recognized asset or liability. A derivative instrument can be designated as hedging the changes in the fair value of a recognized asset or liability (or a specific portion thereof) for which a foreign currency transaction gain or loss is recognized in earnings under the provisions of paragraph 830-20-35-1. All recognized foreign-currency-denominated assets or liabilities for which a foreign currency transaction gain or loss is recorded in earnings shall qualify for the accounting specified in Subtopic 815-25 if all the fair value hedge criteria in this Section (including the conditions in paragraph 815-20-25-30(a) through (b)) are met.
-
Available-for-sale debt security. A derivative instrument can be designated as hedging the changes in the fair value of an available-for-sale debt security (or a specific portion thereof) attributable to changes in foreign currency exchange rates. The designated hedging relationship qualifies for the accounting specified in Subtopic 815-25 if all the fair value hedge criteria in this Section (including the conditions in paragraph 815-20-25-30(a) through (b)) are met.
-
Subparagraph superseded by Accounting Standards Update No. 2016-01.
-
Unrecognized firm commitment. Paragraph 815-20-25-58 states that a derivative instrument or a nonderivative financial instrument that may give rise to a foreign currency transaction gain or loss under Topic 830 can be designated as hedging changes in the fair value of an unrecognized firm commitment, or a specific portion thereof, attributable to foreign currency exchange rates.
In a manner consistent with ASC 815-20-25-37, if the relevant hedge accounting
requirements are met, foreign currency exposures associated with (1) a
recognized asset or liability, (2) an AFS security (subject to some
restrictions), and (3) an unrecognized firm commitment may qualify as the hedged
item in a fair value hedge of foreign currency risk.
5.2.1.1 Recognized Foreign-Currency-Denominated Asset or Liability
A foreign currency exposure on a recognized asset or liability may qualify as
the hedged item in a fair value hedging relationship provided that the asset
or liability is subject to the measurement provisions of ASC 830-20-35-1.
The application of the foreign currency measurement requirements of ASC
830-20 is not viewed as measurement of the exposure at fair value, with
changes in fair value recognized in earnings, because the remeasurement of
the foreign-currency-denominated asset or liability is only based on changes
in the foreign currency spot exchange rate, as noted in ASC 815-20-25-29. In
that way, foreign currency exposures associated with recognized assets and
liabilities are not precluded from qualifying as the hedged item. However,
an asset or liability that is carried at fair value, with changes in fair
value recognized in earnings (e.g., an equity security subject to ASC 321),
would not qualify as the hedged item even if it is a
foreign-currency-denominated asset or liability that is subject to ASC
830-20.
Also, as noted in Section 2.3.2.2, a
recognized asset or liability must be denominated in a foreign currency for
it to have exposure to changes in foreign currency exchange rates.
Therefore, recognized nonfinancial assets do not qualify to be the hedged
item in a foreign currency fair value hedge.
5.2.1.1.1 Recognized Foreign-Currency-Denominated Asset or Liability — Fair Value Hedge or Cash Flow Hedge?
Under ASC 815-20-25-28, an entity may enter into the following types of
foreign currency hedges for a recognized asset or liability: (1) a fair
value hedge of the recognized asset or liability, or a specific portion
thereof (including an AFS debt security), and (2) a cash flow hedge of
the forecasted functional currency cash flows associated with the
recognized asset or liability. For such hedges, ASC 815-20-25-71(b) and
(c) state that a nonderivative financial instrument cannot be designated
as the hedging instrument.
Foreign-currency-denominated assets and liabilities have exposure to
changes in both fair value and functional-currency cash flows when
foreign currency exchange rates change. Consequently, entities have the
choice of applying either fair value hedges (see ASC 815-20-25-37(a)) or
cash flow hedges (see ASC 815-20-25-38(b)) to offset the foreign
currency risk of recognized foreign-currency-denominated assets and
liabilities. In some cases, if the entity wants to hedge more than one
risk, the type of hedging relationship applied will be determined by the
nonforeign currency risk. For example, if an entity wants to hedge
fixed-rate foreign-currency denominated debt for both interest rate risk
and foreign currency risk, it would designate a fair value hedging
relationship because changes in interest rates affect the debt’s fair
value.
In addition, the type of hedge that an entity can designate depends on
whether the hedge is intended to eliminate all the variability in the
hedged item’s functional currency cash flows, which would be a
requirement for any cash flow hedge of the entity’s exposure to foreign
currency risk under ASC 815-20-25-39(d) (see Section
5.3.3.1.1). Accordingly, risk management strategies in
which the foreign currency exposure of a recognized asset or liability
is swapped into a variable-rate exposure in an entity’s functional
currency will not qualify for cash flow hedging because the hedged
items’ functional currency cash flows would still be subject to
variability.
The table below provides examples of the type of hedge that would be
appropriate for an entity to designate to implement the listed risk
management strategies. In each scenario, the foreign currency exposure
is swapped into the entity’s functional currency, which is assumed to be
USD. Depending on the nature of the strategy, the entity could designate
an instrument such as a currency swap, forward contract, or combined
interest rate and currency swap (CIRCUS) as the hedging derivative.
Issued by Entity With USD Functional Currency
|
Risk Management Strategy
|
Type of Hedge Under ASC 815
|
---|---|---|
Fixed-rate foreign-currency-denominated debt
|
Swap into fixed-rate USD debt
|
Fair value or cash flow hedge of foreign currency
risk
|
Fixed-rate foreign-currency-denominated debt
|
Swap into variable-rate USD debt
|
Fair value hedge of foreign currency and interest
rate risk
|
Floating-rate foreign-currency-denominated
debt
|
Swap into fixed-rate USD debt
|
Cash flow hedge of foreign currency and interest
rate risk
|
Floating-rate foreign-currency-denominated
debt
|
Swap into floating-rate USD debt
|
Fair value hedge of foreign currency risk
|
An entity that enters into a cross-currency interest rate swap to hedge
foreign-currency-denominated debt for changes in its fair value
attributable to foreign currency risk may exclude the cross-currency
basis spread in the swap from the hedge effectiveness assessment in
accordance with ASC 815-20-25-82(e). In doing so, the recognition of the
accrual of the periodic interest settlements on the swap in earnings is
considered a systematic and rational method of recognizing the initial
value of the excluded component.
In addition, we believe that if all the following conditions are met, an
entity may apply the critical-terms-match method (see Section 2.5.2.2) to a hedge of
foreign-currency-denominated debt for changes in its fair value
attributable to changes in the foreign currency spot exchange rate:
-
The debt is fixed-rate foreign-currency-denominated debt.
-
The hedging instrument is a fixed-for-fixed cross-currency interest rate swap.
-
The notional amount of the foreign currency leg of the swap matches the principal amount of the debt that is designated as the hedged item throughout the term of the hedging relationship.
-
The two currencies underlying the exchange rate of the swaps match the functional currency of the entity and the currency in which the debt is denominated.
-
Either of the following:
-
The cross-currency basis spread is excluded from the assessment of hedge effectiveness.
-
The interest payments on the foreign currency leg of the swap match the designated portion of the hedged interest payments (both timing and amount).
-
-
The swap has standard terms (see Section 5.4.2.1.1.1) and its fair value at hedge inception is zero.
See Example 5-7 for a detailed example of an entity
using a fixed-for-fixed cross-currency interest rate swap to hedge
fixed-rate foreign-currency-denominated debt.
5.2.1.1.2 AFS Securities
Foreign currency exposures on AFS debt securities may be identified as a
hedged item in a fair value hedging relationship. While an AFS debt
security is measured at fair value, changes in fair value (including
those changes resulting from changes in foreign currency exchange rates)
are recognized in OCI, not in earnings. Accordingly, an AFS debt
security is not prohibited from being a hedged item.
An entity may choose to simply hedge the foreign currency risk related to
the principal amount of an AFS debt security by entering into a forward
contract.
Example 5-3
Weekapaug Regional Bank, an entity with a USD
functional currency, acquires a EUR-denominated
AFS debt security with a principal amount of EUR
10 million that matures in two years. It enters
into a forward contract to sell EUR 10 million in
exchange for USD 12.5 million in two years.
Weekapaug could elect to designate the forward
contract as a fair value hedge of the AFS debt
security for changes in its fair value
attributable to changes in the EUR/USD exchange
rate.
An entity may also use a compound derivative, such as a CIRCUS, to hedge
the foreign currency and interest exposures on a fixed-rate AFS debt
security that is denominated in a foreign currency. ASC 320-10-35-36
requires an entity to record the entire change in the fair value of a
foreign-currency-denominated AFS security in OCI (unless there is an
impairment loss, which is recognized in earnings) rather than record the
foreign currency component of that change in fair value through
earnings, as would be required under ASC 830.
Example 5-4
Weekapaug Regional Bank, an entity with USD
functional currency, has a five-year fixed-rate
100 million EUR-denominated debt security and
classifies the investment as an AFS security.
Weekapaug wants to enter into a derivative to
“convert” the security to the equivalent of a
USD-denominated variable-interest-rate investment.
To do so, it enters into a CIRCUS in which (1) at
maturity, it exchanges EUR 100 million for a fixed
number of USD and (2) each quarter, it pays a
fixed rate of interest in EUR and receives a
variable rate of interest in USD. This strategy
eliminates the risk of changes in the security’s
fair value that are attributable to foreign
currency and interest rate exposures (see
Section
5.2.1.1.1). The CIRCUS should be
accounted for as a fair value hedge of the AFS
debt security as long as it is highly effective
and all other conditions of ASC 815-20-25-37 are
satisfied.
Section 5.2.1.1.1 notes that an
entity may designate a recognized foreign-currency-denominated asset,
including an AFS debt security, as the hedged item in a fair value or
cash flow hedging relationship. The type of relationship that an entity
applies is likely to be determined by the terms of the AFS debt security
(e.g., fixed- or floating-rate) and the type of derivative used (e.g., a
forward contract or CIRCUS). See Section 5.2.3.2.1
for further discussion of the accounting for foreign currency fair value
hedges of AFS debt securities.
5.2.1.2 Firm Commitments
Firm commitments generally qualify as a hedged item in a fair value hedging
relationship. However, foreign currency exposures on firm commitments may
affect both the firm commitment’s fair value (in a fair value hedge) as well
as the forecasted cash flows related to the firm commitment (in a cash flow
hedge).
Even though firm commitments are required to have a fixed price, a cash flow
exposure may arise because that price is not required to be denominated in
the entity’s functional currency. As a result, foreign currency exposures on
firm commitments may be eligible as a hedged item in either a fair value or
a cash flow hedging relationship, depending on the manner in which it is
designated.
The following firm commitments are precluded from qualifying as the hedged
item in a foreign-currency-related fair value hedge:
- Intercompany commitments — Such commitments would not meet the definition of a firm commitment because they are not with a third party (see Section 3.1.1). However, an entity may hedge forecasted transactions related to certain intercompany commitments that have foreign currency exposure in a cash flow hedging relationship (see Section 5.3.1.1.1).
- Firm commitments to enter into a business combination — ASC 815-20-25-43(c)(5) specifically prohibits such commitments from qualifying as the hedged item in a fair value hedge.
5.2.2 Hedging Instruments in a Foreign Currency Fair Value Hedge
Generally, only derivative instruments are permissible hedging instruments in a
fair value hedging relationship. However, as noted in Section 2.4.2, certain nonderivative instruments may qualify as
the hedging instruments in a fair value hedge of the foreign currency risk of an
unrecognized firm commitment. For a nonderivative to qualify, it must be subject
to the measurement criteria of ASC 830-20, as required by ASC 815-20-25-58.
Therefore, a nonderivative instrument that is measured at fair value, with
changes in fair value recognized in earnings, would not qualify.
5.2.3 Accounting for Foreign Currency Fair Value Hedges
ASC 815-25
Changes Involving Foreign Exchange Risk
35-15 Gains and losses on a
qualifying foreign currency fair value hedge shall be
accounted for as specified in Section 815-25-40 and
paragraphs 815-25-35-1 through 35-10.
35-16 If a nonderivative
instrument qualifies as a hedging instrument under
paragraph 815-20-25-58, the gain or loss on the
nonderivative hedging instrument attributable to foreign
currency risk shall be the foreign currency transaction
gain or loss as determined under Subtopic 830-20. The
foreign currency transaction gain or loss on a hedging
instrument shall be determined, consistent with
paragraph 830-20-35-1, as the increase or decrease in
functional currency cash flows attributable to the
change in spot exchange rates between the functional
currency and the currency in which the hedging
instrument is denominated. That foreign currency
transaction gain or loss shall be recognized currently
in earnings along with the change in the carrying amount
of the hedged firm commitment.
35-17 Paragraph not
used.
35-18 Remeasurement of
hedged foreign-currency-denominated assets and
liabilities is based on the guidance in Subtopic 830-20,
which requires remeasurement based on spot exchange
rates, regardless of whether a fair value hedging
relationship exists.
As noted in Chapter 3, in a typical
qualifying fair value hedging relationship, an entity would record the change in
the hedging instrument’s fair value in current-period earnings, except for
amounts that are excluded from the hedge effectiveness assessment (see Section 3.4). It would also adjust the carrying
amount of the hedged item for the change in its fair value attributable to the
risk being hedged. The adjustment to the carrying amount for the change in the
hedged item’s fair value would also be recognized in current-period earnings.
For qualifying fair value hedges, all amounts recognized in earnings related to
both the hedging instrument and the hedged item are presented in the same income
statement line item and should be related to the risk being hedged (see
Section 5.2.3.3 for further discussion of income
statement classification).
The accounting for a qualifying foreign currency fair value hedge requires some
slight modifications to the typical fair value hedging model because of a couple
of factors:
-
The hedging instrument is not always a derivative instrument that is remeasured at fair value in accordance with ASC 815. Nonderivative instruments may be used to hedge unrecognized firm commitments for foreign currency risk.
-
The hedged item may already be subject to the measurement requirements of ASC 830-20 (i.e., foreign-currency-denominated assets and liabilities).
The measurement of the hedging instrument and the hedged item are discussed
separately in the next sections.
5.2.3.1 Accounting for the Hedging Instrument in a Foreign Currency Fair Value Hedge
The subsequent measurement and timing of the recognition of a hedging
instrument are not affected or altered upon its designation in a hedging
relationship. Instead, the hedging instrument will continue to be measured
in a consistent manner as if no hedge designation had been made, with the
resulting gains and losses recognized through earnings, as follows:
Hedging Instrument
|
Subsequent Measurement
|
Basis for Valuing the Instrument
|
---|---|---|
Derivative
|
Fair value in accordance with ASC 815, with changes
in fair value recognized in earnings
|
Fair value (forward rate) — The fair value
measurement principle focuses on changes in the
market rates (e.g., often the forward exchange rates
when the instrument matures at future dates) between
the functional currency and the currency of the
derivative.
|
Nonderivative
|
In accordance with ASC 830-20, with changes in
measurement recognized in earnings
|
Spot rate — The measurement principle in
accordance with ASC 830-20 focuses on changes in the
spot exchange rates between the functional currency
and the currency of the hedging instrument, which is
not affected by hedge accounting, as noted in ASC
815-25-35-16.
|
In a manner consistent with the above discussion, a key feature that
distinguishes a derivative from a nonderivative hedging instrument is the
basis of subsequent measurement. Accordingly, an entity should consider the
manner in which a hedging instrument is measured when determining its
hedging strategy and how to designate the hedging relationship. For example,
when using a nonderivative instrument as the hedging instrument in a foreign
currency fair value hedging relationship, an entity cannot exclude any
components of the nonderivative instrument from the assessment of
effectiveness. In addition, an entity would be likely to choose to assess
hedge effectiveness on the basis of changes in the hedged item’s fair value
that are attributable to changes in the spot exchange rate because the
hedging instrument is remeasured on the basis of changes in the spot
exchange rate. All amounts recognized in earnings related to the change in
the measurement of the hedging instrument and the hedged item are presented
in the same income statement line item and should be related to the risk
being hedged.
5.2.3.2 Accounting for the Hedged Item in a Foreign Currency Fair Value Hedge
As discussed in Chapter 3, in a
qualifying fair value hedging relationship, the hedged item is remeasured
for changes in its fair value that are attributable to the hedged risk.
However, ASC 815-25-35-18 notes that if the hedged item is a
foreign-currency-denominated asset or liability, hedge accounting does not
override the requirement of ASC 830-20 to remeasure those assets and
liabilities on the basis of foreign currency exchange spot rates “regardless
of whether a fair value hedging relationship exists.” In other words, ASC
830-20 already provides guidance on how to translate
foreign-currency-denominated assets and liabilities (i.e., remeasure on the
basis of changes in the foreign currency spot exchange rate), so if a
foreign-currency-denominated asset or liability is the hedged item in a
foreign currency fair value hedge, no further adjustments to the carrying
amount are needed for changes attributable to foreign currency risk as a
result of hedge accounting. However, if a foreign-currency-denominated asset
or liability is the hedged item in a qualifying fair value hedging
relationship that is being hedged for changes in fair value attributable to
risks other than foreign currency risk, the hedged item should be remeasured
for changes in its fair value attributable to those other risks before being
translated in accordance with ASC 830-20.
As with all qualifying fair value hedging relationships, the changes in the
hedged item’s carrying amount that result from the application of hedge
accounting are recorded currently in earnings and presented in the same
income statement line item as the changes in the derivative’s fair value,
which should be related to the risk being hedged. In some cases, if multiple
risks are being hedged, this could result in the changes in the hedged item
being recognized in multiple income statement line items.
Example 5-5
Remeasuring Foreign-Currency-Denominated Debt
Hedged for Interest Rate Risk and Foreign Currency
Risk
SimpleBand has a functional and reporting currency in
USD. On January 1, it obtains a EUR 1 million
fixed-rate debt facility and wants to hedge the
risks arising from its foreign-currency-denominated
fixed-rate debt facility in a fair value hedge.
SimpleBand designates as the hedged risks the
changes in fair value that are attributable both to
(1) changes in the foreign currency exchange rate
and (2) changes in the benchmark interest rate.
Assume that the hedge qualifies for hedge accounting
and the hedging relationship is highly
effective.
Accordingly, when subsequently measuring the hedged
item, SimpleBand would apply the following steps to
determine the gains or losses to be recorded for
each risk being hedged:
-
Step 1a — Determine the gain or loss attributable to the interest rate risk. The change in fair value attributable to changes in the benchmark interest rate of the foreign-currency-denominated debt facility is calculated in the facility’s contractual currency (the foreign currency).
-
Step 1b — The journal entry recorded for the gain or loss associated with the change in fair value attributable to changes in the benchmark interest rate is translated into SimpleBand’s functional currency by using the beginning-of-period foreign currency exchange spot rate.
-
Step 2 — Determine the transaction gain or loss associated with the ASC 830 remeasurement (the foreign currency exposure).
The above sequence of steps ensures that the hedged
item’s fair value is first identified on the basis
of its contractual currency (foreign currency fair
value). Subsequently, the measurement principles of
ASC 830-20 would be applied to isolate the effects
of the changes in foreign currency spot exchange
rates.
Assume the following USD/EUR exchange rates and fair
values for SimpleBand’s foreign-currency-denominated
fixed-rate debt facility at the beginning and end of
the year:
SimpleBand records the following journal entries for
the hedged item in the fair value hedging
strategy:
December 31
Thus, SimpleBand recognizes the following:
By contrast, if no hedge accounting had been applied
or if the hedged risk had been designated as being
only related to changes in fair value attributable
to changes in foreign currency exchange rates, the
debt facility would have been carried at $1.1
million instead of at $1.045 million, reflecting a
change of 0.10 in the spot rates on only the initial
principal amount (EUR 1 million). The resulting gain
of $100,000 differs from the gain of $95,000
associated with changes in the foreign exchange spot
rate because the carrying amount of the debt was
adjusted for changes in fair value attributable to
changes in the benchmark interest rate before it was
translated under ASC 830-20.
Therefore, while it is noted that the subsequent
measurement principles of ASC 830-20 apply
irrespective of whether the hedged item is
designated in a hedging relationship, the recognized
gains and losses associated with a change in the
spot rate are affected by whether other risks are
being hedged in addition to the foreign currency
exposure since this will affect the balance on which
the remeasurement principles of ASC 830-20 are
applied.
5.2.3.2.1 AFS Debt Securities
As discussed in Section 3.2.6, if the hedged item in a qualifying fair
value hedge is already measured at fair value, with changes in fair
value reported in OCI, no additional remeasurement of the hedged item is
required. However, once the item is designated in a qualifying hedge,
the portion of the change in fair value that is attributable to changes
in the designated risk is recognized in earnings instead of OCI. The
change in the fair value of a foreign-currency-denominated AFS debt
security, excluding the amount recorded in the allowance for credit
losses under ASC 326-30, is reported in OCI in accordance with ASC
320-10-35-36. If an entity is hedging an AFS debt security for changes
in its fair value attributable to changes in foreign currency exchange
rates, the transaction gain or loss that otherwise would have been
reported in OCI should be recognized in earnings for a qualifying
hedging relationship. As noted in Section 5.2.2, an entity may only use a derivative
instrument as the hedging instrument in a hedge of an AFS debt
security.
5.2.3.2.2 Unrecognized Firm Commitments
As discussed in Section 5.2.2, an entity may use either a derivative
instrument or a foreign-currency-denominated asset or liability as the
hedging instrument in a foreign currency fair value hedge of an
unrecognized firm commitment. Because firm commitments are not
foreign-currency-denominated assets or liabilities that are subject to
ASC 830-20, the guidance in ASC 815-20-35-18 that limits the
remeasurement of the hedged item to being based only on changes in spot
exchange rates is not applicable. Therefore, an entity may choose to
determine the change in a firm commitment’s fair value attributable to
changes in foreign currency exchange rates on the basis of either
forward rates or spot rates, which will in turn affect how the entity
(1) performs its hedge effectiveness assessments and (2) remeasures the
firm commitment in periods in which the relationship qualifies for hedge
accounting.
If an entity is using a nonderivative as the hedging instrument, it would
be likely to hedge the firm commitment for changes in fair value that
are attributable to changes in foreign currency exchange spot rates
since that would be consistent with how the hedging instrument is
remeasured under ASC 830-20. Such a hedge would produce the highest
level of effectiveness and reduce potential income statement volatility
because both the hedging instrument and the hedged item would be
remeasured by using spot rates.
By contrast, if an entity is using a derivative as the hedging
instrument, the remeasurement of the derivative will be based on forward
rates. However, a savvy hedger would choose between the following two
options, each of which could lead to a perfectly effective hedge if the
critical terms of the derivative match the critical terms of the firm commitment:
-
Hedge the firm commitment for changes in fair value attributable to changes in the foreign currency forward exchange rate. Under this option, the entity would remeasure the firm commitment for changes in fair value attributable to changes in the forward rates, which would be consistent with how the derivative is remeasured. The basis adjustments to the firm commitment would offset the remeasurement of the derivative and be incorporated into the basis of the item being purchased or sold under the firm commitment.
-
Hedge the firm commitment for changes in fair value attributable to changes in the foreign currency spot exchange rate and exclude components of the derivative from the effectiveness assessment. Under this option, the entity would remeasure the firm commitment for changes in fair value that are attributable to changes in the spot rate. The initial fair value of the excluded component would be recognized in earnings over the life of the hedging relationship (either by using a systematic and rational method or as the fair value of the excluded component changes), while the change in the derivative’s fair value attributable to changes in spot rates would be recognized in earnings each period. In this case, the basis adjustments to the firm commitment that only reflect changes in the spot rate would be incorporated into the basis of the item being purchased or sold under the firm commitment.
See Example 5-6 for an illustration of a foreign
currency fair value hedge of a firm commitment under both scenarios.
5.2.3.3 Income Statement Classification
As discussed in Section 3.1, all amounts recognized in earnings related to
both the hedging instrument and the hedged item in a qualifying fair value
hedging relationship are presented in the same income statement line item
and should be related to the risk being hedged. This requirement can be more
complicated for foreign currency fair value hedging relationships because
the hedged item may be hedged for multiple risks (e.g., foreign currency
risk and interest rate risk) and also because some entities use an after-tax
hedging strategy (see Section 5.1.3).
ASC 815-20
Income Statement Presentation of Hedging
Instruments
Scenario C
55-79AB Entity C
designates a fair value hedge of interest rate risk
and foreign currency risk in which the hedged item
is a foreign-currency-denominated fixed-rate
available-for-sale debt security. The derivative
designated as the hedging instrument is a
pay-fixed-rate (in foreign currency),
receive-floating-rate (in functional currency)
cross-currency interest rate swap. In this scenario,
Entity C’s objective is to convert the interest cash
flows of the fixed-rate security to floating-rate
and also to convert the cash flows of the security
(both interest cash flows and the principal cash
flow) from a foreign currency to Entity C’s
functional currency.
55-79AC The cross-currency
interest rate swap is a highly effective hedge of
both the interest rate risk and foreign currency
risk of the available-for-sale debt security.
Therefore, the change in fair value of the
cross-currency interest rate swap should be
presented in the same income statement line item or
items used to present the earnings effect of the
hedged item. Before applying hedge accounting,
Entity C recognizes the earnings effect of the
hedged item (that is, interest accruals on the
available-for-sale debt security) in an interest
income line item in the income statement and
recognizes all other changes in fair value in other
comprehensive income in accordance with paragraph
320-10-35-1(b). Entity C should present changes in
fair value of the hedging instrument (that is, the
interest accruals and all other changes in fair
value) in the same income statement line item used
to present the earnings effect of the hedged item.
However, if Entity C’s policy is to present the
effect of foreign exchange rate changes on the fair
value of the security that are recognized in
earnings after applying hedge accounting in
accordance with paragraph 815-25-35-6 in a different
income statement line item (consistent with its
presentation policies when reflecting other foreign
exchange rate changes), then the related changes in
fair value of the hedging instrument also should be
presented in that income statement line item.
55-79AD This scenario
illustrates that a single hedging instrument (a
cross-currency interest rate swap) may be highly
effective at offsetting changes in fair values or
cash flows associated with the hedged item in which
the earnings effect of the hedged item is presented
in more than one income statement line item. If a
hedging instrument is highly effective at offsetting
changes in fair values or cash flows of the hedged
item and the earnings effect of the hedged item is
presented in more than one income statement line
item, then the earnings effects of the hedging
instrument also should be presented in those
corresponding income statement line item(s).
If an entity is hedging multiple risks, the earnings effects of the hedging
instrument and the adjustments of the hedged item will need to be allocated
on the basis of how much each of the hedged risks affect the changes in the
measurement of the hedging instrument and hedged item. As noted in ASC
815-20-55-79AB through 55-79AD, an entity that is hedging a
foreign-currency-denominated fixed-rate debt security for changes in its
fair value attributable to both foreign currency risk and interest rate risk
would need to report (1) the changes in measurement attributable to changes
in the benchmark interest rate in interest income and (2) the changes in
measurement attributable to changes in the foreign currency exchange rates
in a separate line item. For example, if an entity reports gains or losses
resulting from changes in the foreign exchange rates of its investments as
investment gains or losses, the related changes in the measurement of the
hedging instrument and hedged item attributable to changes in foreign
currency risk should also be reported as investment gains or losses.
Similarly, if an entity is hedging foreign-currency-denominated fixed-rate
debt for changes in its fair value that are attributable to both foreign
currency risk and interest rate risk, the changes in the measurement of the
hedging instrument and hedged item should be allocated to interest expense
and transaction gains or losses.
In addition, as noted in ASC 815-25-35-7 and Section 5.1.3, if an entity is using an after-tax hedging
strategy, “the portion of the gain or loss on the hedging instrument that
exceeded the loss or gain on the hedged item shall be included as an offset
to the related tax effects in the period in which those tax effects are
recognized.”
5.2.4 Illustrative Examples
Example 5-6
Foreign Currency Fair Value Hedge of Firm
Commitment
Golden Age is a premium gold watch manufacturer with a
USD functional currency. On July 1, 20X1, Golden Age
enters into a firm commitment to purchase 1,000 ounces
of gold from a European gold supplier on December 30,
20X1, for EUR 1,151 per ounce. Golden Age separately
enters into a forward contract to purchase EUR 1,151,000
for USD 1,407,213 on December 30, 20X1, as a hedge of
the changes in the fair value of its firm commitment to
purchase gold that are attributable to changes in the
EUR/USD exchange rate. The table below shows (1) the
EUR/USD exchange rates (spot and forward) and (2) the
fair values of the forward contract as of July 1,
September 30, and December 30, 20X1.
The examples below illustrate the difference between (1)
designating the hedged risk as changes in the forward
exchange rate (Method 1) and (2) designating the hedged
risk as changes in the spot exchange rate, with the
excluded component recognized in earnings, by using a
systematic and rational amortization method (Method
2).
Method 1 — Forward Rate
Golden Age designates the forward contract as a hedge of
the changes in the firm commitment’s fair value that are
attributable to changes in the EUR/USD forward exchange
rate. The journal entries are as follows:
July 1, 20X1
No entry is required. The forward contract was entered
into at market (i.e., a fair value of zero), and the
firm commitment was entered into for no
consideration.
September 30, 20X1
December 30, 20X1
Method 2 — Spot Rate With Forward Points Excluded
From Assessment
Golden Age designates the forward contract as a hedge of
the changes in the firm commitment’s fair value that are
attributable to changes in the EUR/USD spot exchange
rate. It excludes the forward points in the forward
contract from the hedge effectiveness assessment and
will recognize the forward points’ initial fair value in
earnings by using a systematic and rational amortization
method.
The initial fair value of the excluded component is
calculated below.
The forward contract has a term of six months. As a
result of using the systematic and rational amortization
method, Golden Age will recognize $3,223 of the initial
fair value in earnings each quarter (as an expense).
The journal entries are as follows:
July 1, 20X1
No entry is required. The forward contract was entered
into at market (i.e., a fair value of zero) and the firm
commitment was entered into for no consideration.
September 30, 20X1
December 30, 20X1
Example 5-7
Fixed-for-Fixed Cross-Currency Interest Rate Swap
Hedging Fixed-Rate Debt Denominated in Foreign
Currency
Orcas Worldwide, an entity with a USD functional
currency, wishes to hedge its exposure to changes in its
SEK 50 million foreign-currency-denominated fixed-rate
debt attributable to changes in the USD/SEK foreign
currency exchange rate. The debt was issued on March 5,
20X6, with interest payable quarterly (on the last day
of each calendar quarter) at a rate of 1.75 percent per
year. Principal is payable at maturity (September 30,
20X7), and the debt is not prepayable. On March 5, 20X6,
Orcas enters into a fixed-for-fixed cross-currency
interest rate swap to hedge that risk. The terms of the
cross-currency interest rate swap are as follows:
-
Pay leg — USD 55,025,000 notional at a rate of 3.4 percent per annum.
-
Receive leg — SEK 50 million notional at a rate of 1.75 percent per annum.
-
Quarterly periodic settlements beginning March 31, 20X6.
-
Initial exchange — Orcas pays SEK 50 million and receives USD 55,025,000.
-
Final exchange — Orcas pays USD 55,025,000 and receives SEK 50 million.
-
Maturity date — September 30, 20X7.
Orcas designates the cross-currency interest rate swap as
a hedge of SEK 50 million of changes in the fair value
of the fixed-rate foreign-currency-denominated debt
attributable to changes in the USD/SEK foreign currency
exchange rate and designates the cross-currency interest
rate swap as hedging changes in the swap’s fair value
attributable to changes in the USD/SEK spot exchange
rate. Orcas assesses the effectiveness of the hedging
relationship by comparing (1) the changes in the swap’s
fair value (excluding the changes in fair value
attributable to changes in the cross-currency basis
spread) with (2) the changes in debt’s fair value that
are attributable to changes in the spot USD/SEK exchange
rate. Because the swap is an at-market swap with
standard terms, there are no excluded components to
recognize in earnings separately from the periodic
settlements. Orcas may assume that the hedge is
perfectly effective under ASC 815-20-25-84 and 25-85 because:
-
The two currencies underlying the exchange rate of the swap match the functional currency of Orcas (USD) and the currency in which the debt is denominated (SEK).
-
The notional amount of the foreign currency leg of the swap (SEK) matches the principal amount of the debt through the term of the hedge (maturity of the debt).
-
The maturity date of the swap matches the maturity date of the debt (i.e., the date the last hedged cash flow is due and payable).
-
The fair value of the swap at hedge inception is zero and the swap has standard terms.
-
The cross-currency basis spread is excluded from the assessment of hedge effectiveness.
For this example, assume that the critical terms of the
debt and the cross-currency swap match for the duration
of both instruments.
Below is a table of key
assumptions.
Orcas would record the
following journal entries for each reporting period to
account for the hedge and the translation of its
foreign-currency-denominated fixed-rate debt:
March 31,
20X6
Translation of the foreign-currency-denominated debt is
not required because the spot rate has not changed.
June 30,
20X6
September 30,
20X6
December 31,
20X6
March 31, 20X7
June 30,
20X7
September 30,
20X7
5.3 Foreign Currency Cash Flow Hedges
Hedging Relationship Type
|
Possible Types of Foreign-Currency Denominated Hedged Items
(See ASC 815-20-25-28)
|
Permitted Hedging Instruments
|
---|---|---|
Foreign currency cash flow hedge
|
|
Derivative
|
As discussed in the ASC master glossary and Chapter
4, 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. When an entity elects to hedge a
recognized asset or liability for changes in cash flows attributable to changes in
foreign currency exchange rates, additional guidance is needed because the hedged
item in many cases is already subject to measurement under ASC 830-20.
5.3.1 Hedged Items in a Foreign Currency Cash Flow Hedge
To have exposure to changes in cash flows that are attributable to changes in
foreign currency exchange rates, the hedged item must be either (1) an existing
foreign-currency-denominated asset or liability or (2) a forecasted transaction
that will be settled in a foreign currency, including certain intra-entity
transactions.
ASC 815-20
25-38 The conditions in the
following paragraph relate to a derivative instrument
designated as hedging the foreign currency exposure to
variability in the functional-currency-equivalent cash
flows associated with any of the following:
- A forecasted transaction (for example, a forecasted export sale to an unaffiliated entity with the price to be denominated in a foreign currency)
- A recognized asset or liability
- An unrecognized firm commitment
- A forecasted intra-entity transaction (for example, a forecasted sale to a foreign subsidiary or a forecasted royalty from a foreign subsidiary).
In a manner consistent with ASC 815-20-25-38, if the relevant cash flow hedge
accounting requirements are met, foreign currency exposures associated with any
of the following may qualify as the hedged item in a cash flow hedge of foreign
currency risk: (1) a forecasted transaction, including intra-entity
transactions, (2) a recognized foreign-currency-denominated asset or liability,
and (3) an unrecognized firm commitment.
5.3.1.1 Forecasted Transactions
Foreign currency exposures related to a forecasted transaction may qualify as
the hedged item in a cash flow hedging relationship. Note that entities are
permitted to hedge forecasted intra-entity foreign-currency-denominated
transactions on a consolidated basis, which is unique to foreign currency
cash flow hedging (see Section
5.3.1.1.1 for further discussion of hedging intra-entity
transactions).
Forecasted transactions that will be denominated in a foreign currency may
qualify as the hedged item in a cash flow hedging relationship if the
hedging relationship meets the conditions to qualify for cash flow hedge
accounting, as discussed in Chapter 4.
However, there are some considerations that are unique to foreign currency
cash flow hedges, which will be discussed in the remainder of this
section.
5.3.1.1.1 Forecasted Intra-Entity Transactions
Generally, intra-entity transactions cannot be designated hedged items on
a consolidated basis since such transactions would be eliminated upon
consolidation and would therefore not expose the group to a risk that
affects profit or loss. However, intra-entity
foreign-currency-denominated transactions represent an exception to this
rule in that foreign currency exposure from an intra-entity transaction
may not be fully eliminated upon consolidation as a result of the
application of ASC 830. In that way, the foreign currency exposure of a
probable forecasted intra-entity transaction may qualify for cash flow
hedge accounting provided that it gives rise to transaction gains or
losses through earnings in accordance with ASC 830-20, resulting in an
exposure that affects earnings on the reporting entity’s consolidated
basis.
Example 5-8
Intercompany Sales
SimpleBand, a U.S. company, manufactures a
product in a factory in the United States and
sells the product to its affiliates in Europe
under an intercompany sales agreement. The
functional currency of each affiliate is the local
currency, and all intercompany sales are
denominated in the local currency of the
affiliate.
SimpleBand enters into three foreign exchange
forward contracts, each with a notional amount of
EUR 50 million at the beginning of its fiscal
year. Provided that all relevant criteria are met,
SimpleBand may designate a hedge of the first EUR
150 million of its forecasted intercompany sales.
As long as the hedge is highly effective, the fair
value of the forward contracts will be recorded in
OCI and reclassified into earnings when the sales
are realized in the consolidated income statement
(i.e., when the affiliate recognizes revenue from
the sale to an unrelated third party).
The foreign currency risk of an intercompany dividend does not affect
earnings until it is declared, at which time it becomes an intercompany
receivable or payable. Thus, until it is declared, a forecasted dividend
has no earnings impact and does not qualify as a forecasted exposure
under ASC 815. In essence, a hedge of a forecasted intercompany dividend
usually represents a hedge of expected future earnings. Forecasted net
income is not a transaction; it results from many net transactions,
which under ASC 815 cannot be hedged in aggregate.
Once the dividend is declared, the parent will remeasure the dividend
receivable at prevailing spot rates until it is collected. However, the
parent could designate a derivative contract as the hedging instrument
to hedge the foreign currency risk of the foreign-currency-denominated
receivable.
5.3.1.1.2 Hedging Forecasted Transaction Through Settlement Date
ASC 815-20
25-34 The provisions of
this Section (including paragraph 815-20-25-28)
that permit a recognized
foreign-currency-denominated asset or liability to
be the hedged item in a fair value or cash flow
hedge of foreign currency exposure also pertain to
a recognized foreign-currency-denominated
receivable or payable that results from a hedged
forecasted foreign-currency-denominated sale or
purchase on credit. Specifically, an entity may
choose to designate either of the following:
-
A single cash flow hedge that encompasses the variability of functional currency cash flows attributable to foreign exchange risk related to the settlement of the foreign-currency-denominated receivable or payable resulting from a forecasted sale or purchase on credit
-
Both of the following separate hedges:
-
A cash flow hedge of the variability of functional currency cash flows attributable to foreign exchange risk related to a forecasted foreign-currency-denominated sale or purchase on credit
-
A foreign currency fair value hedge of the resulting recognized foreign-currency-denominated receivable or payable.
-
25-35 If two separate
hedges are designated, the cash flow hedge would
terminate (that is, be dedesignated) when the
hedged sale or purchase occurs and the
foreign-currency-denominated receivable or payable
is recognized.
25-36 The use of the same
foreign currency derivative instrument for both
the cash flow hedge and the fair value hedge is
not prohibited.
In many cases, a forecasted transaction exposes an entity to changes in
foreign currency exchange rates beyond the date the actual forecasted
transaction occurs because that transaction may give rise to a
foreign-currency-denominated receivable or payable that settles at a
future date. ASC 815 provides a couple of alternatives for entities that
want to hedge those forecasted transactions for foreign currency
exposure all the way to the settlement date of the resulting receivable
or payable. A hedge of the variability in cash flows related to a
forecasted transaction is a cash flow hedging relationship; however, an
entity hedging a recognized foreign-currency-denominated asset or
liability for foreign currency risk may hedge that risk as either a fair
value hedge (see Section 5.2.1.1)
or a cash flow hedge (see Section 5.3.1.2).
Therefore, if an entity wants to hedge both the forecasted transaction
and the foreign-currency-denominated asset or liability resulting from
that transaction, it may choose to designate that hedging relationship
as either of the following:
-
A single hedging relationship of the variability in both (1) the cash flows related to the forecasted transaction and (2) the cash flows related to the recognized foreign-currency-denominated receivable or payable.
-
First, a cash flow hedge of the variability in the cash flows related to the forecasted transaction, and then a separate fair value hedge of the foreign-currency-denominated receivable or payable.
Example 5-9
Hedge of Forecasted
Foreign-Currency-Denominated Sale Through
Receivable Settlement Date
GoldenAge (a USD functional entity) expects to
sell watches to a large customer on March 17,
20X1, in a sale denominated in EUR, with 90-day
payment terms (due June 15, 20X1). To hedge its
exposure to the foreign currency, GoldenAge enters
into a forward contract to exchange EUR for USD
that settles on June 15, 20X1. GoldenAge has two
alternatives for hedging the exposure up to the
expected collection date of the receivable (i.e.,
when it expects to receive the foreign
currency).
Alternative 1 — Combined Cash Flow
Hedge
GoldenAge designates the forward contract as a
cash flow hedge of the variability in the USD cash
flows attributable to changes in the EUR/USD
exchange rate related to the settlement of the
EUR-denominated receivable resulting from the
forecasted sale of watches on March 17, 20X1.
Thus, it is a combined hedge of both (1) the
changes in the USD cash flows from a sale that
will occur in a fixed amount of EUR and (2) the
transaction gains and losses GoldenAge will incur
on the receivable, once it is recognized. The
hedge does not need to be dedesignated when the
forecasted sale occurs.
Alternative 2 — Cash Flow Hedge of
Forecasted Sale and Fair Value Hedge of
EUR-Denominated Receivable
GoldenAge designates the derivative as a cash
flow hedge of the variability in the USD cash
flows attributable to changes in the EUR/USD
exchange rate related to the forecasted
EUR-denominated sale on credit. When the
forecasted sale occurs, GoldenAge must discontinue
the cash flow hedging relationship and could then
redesignate the forward as the hedging instrument
in a foreign currency fair value hedge of the
EUR-denominated receivable.
See Example 5-15 for
a detailed illustration of a hedge of the foreign
currency risk related to a forecasted transaction
through the settlement date of the receivable.
Connecting the Dots
If an entity uses a purchased option to hedge
the foreign currency risk related to a forecasted purchase or
sale through the settlement date of the payable or receivable
and would like to assess the effectiveness of the hedge by
evaluating the option’s terminal value (see Sections
2.5.2.1.2.2 and 4.1.3), it should consider
that the terminal value method may only be applied to a cash
flow hedging relationship. Accordingly, an entity that uses a
purchased option that settles on the same date as the forecasted
settlement of the payable or receivable resulting from a
forecasted purchase or sale would be likely to prefer to
document the hedging relationship as a single combined cash flow
hedging relationship of the variability in the cash flows
related to the forecasted settlement of the payable or
receivable resulting from the forecasted purchase or sale
(Alternative 1 in Example 5-9). In this
case, as long as the four criteria noted in ASC 815-20-25-129
are met, the hedging relationship may be considered perfectly
effective. See Example 5-16 for an illustration of the use of
the terminal value method for a purchased option hedging the
foreign currency risk related to the forecasted settlement of a
payable resulting from a forecasted purchase of inventory.
Alternatively, an entity may choose to designate
a cash flow hedge of the variability in functional currency cash
flows attributable to foreign exchange risk related to a
forecasted foreign-currency-denominated sale or purchase on
credit and then separately designate a foreign currency fair
value hedge of the resulting recognized
foreign-currency-denominated receivable or payable (Alternative
2 in Example
5-9). In that case, the entity would terminate
(dedesignate) the cash flow hedge when the hedged sale or
purchase occurs and the foreign-currency-denominated receivable
or payable is recognized. Such a strategy would not be
considered perfectly effective because cash flow hedging is only
applied until the date the forecasted purchase or sale occurs,
which does not match the option’s settlement date. In this
scenario, the “perfect” hypothetical option would have a
maturity date matching the date of the forecasted purchase or
sale, and hedge effectiveness would be assessed by comparing the
change in fair value of (1) the actual option with (2) the
hypothetical option. Under this hedging designation, once a
foreign-currency-denominated receivable or payable exists, only
fair value hedging may be applied. Even though this strategy
cannot be considered perfectly effective, hedge accounting is
not precluded.
5.3.1.1.3 Portfolio Hedging — Net Cash Flows
As discussed in Section 2.2.2.2,
ASC 815-20-25-15(a)(2) allows an entity to hedge a group of individual
transactions that have the same risk exposure. However, “[a] forecasted
purchase and a forecasted sale shall not both be included in the same
group of individual transactions that constitute the hedged
transaction.” ASC 815-20-25-39(c) provides consistent guidance on
foreign currency cash flow hedging relationships; it states, in part,
that “[i]f the hedged transaction is a group of individual forecasted
foreign-currency-denominated transactions, a forecasted inflow of a
foreign currency and a forecasted outflow of the foreign currency cannot
both be included in the same group.”
It is common for entities with significant operating activities in
foreign environments to both generate sales and incur expenses in those
environments. An entity is prohibited from designating the forecasted
sales and expenditures as the hedged item in the same hedging
relationship. However, it can determine its net forecasted cash inflows
or outflows and designate a portfolio of either forecasted sales or
forecasted expenses as the hedged item. For example, if an entity with a
USD functional currency expects to have sales of EUR 100 million and
expenses of EUR 80 million in the following month (i.e., a forecasted
net cash inflow of EUR 20 million), it could not designate as the hedged
item the forecasted net purchases and sales for the following month.
However, it may designate as the hedged item the first EUR 20 million of
sales in the following month.
Section 5.1.2.3 discusses the
exception for the use of a central treasury function to offset the
exposures arising from multiple internal derivatives on an aggregate or
net basis. An entity’s ability to use the function to enter into
derivatives with third parties that are related to the net exposure from
multiple hedging relationships does not override the prohibition on
hedging a portfolio of cash inflows and outflows in a single hedging
relationship.
5.3.1.1.4 Foreign-Currency-Denominated Debt Acquisition or Issuance
An entity may expect to issue debt that will be denominated in a foreign
currency. While this often occurs because the entity will be funding a
significant purchase in that currency, in some cases the entity may
simply want to take advantage of beneficial interest rates in a
particular economic environment. In either case, the forecasted issuance
of foreign-currency-denominated debt does not give rise to a foreign
currency risk related to the principal amount of the debt before it is
issued because there is no earnings exposure from the potential changes
in cash flows attributable to changes in foreign currency exchange
rates. However, forecasted interest payments related to the forecasted
issuance of foreign-currency-denominated debt may be hedged for foreign
currency risk. An entity may hedge the foreign currency risk related to
the principal, interest payments, or both for recognized
foreign-currency-denominated debt.
Foreign currency risk exposure related to the forecasted acquisition of a
foreign-currency-denominated debt instrument does not qualify for hedge
accounting for the same reason that the forecasted issuance of debt does
not qualify (i.e., there is no earnings exposure). However, hedges of
the interest receipts related to a forecasted acquisition of a debt
instrument for changes in cash flows attributable to changes in foreign
currency exchange rates may qualify for hedge accounting.
5.3.1.1.5 Hedges of Foreign Currency Exposure on Forecasted Business Acquisitions Prohibited
As noted in Section
2.2.1.3, ASC 815-20-25-15(g) prohibits the hedge of a
forecasted transaction involving a business combination. In addition,
even if an entity has entered into a firm commitment to acquire a
business in which the purchase price is denominated in a foreign
currency, it is prohibited from hedging the foreign currency exposure
related to that firm commitment, as noted in Section 5.2.1.2.
Example 5-10
Forecasted
Acquisition of a Foreign Business
On January 1, 20X0, Forbin, a
company with a USD functional currency, announces
a tender offer to acquire all of the common stock
of Rutherford, a British company. Forbin offers
GBP 6.90 for each share of Rutherford, GBP 3.5
billion in total. The transaction is expected to
close sometime in the third quarter of 20X0.
Forbin is exposed to foreign currency risk during
the tender period because a strengthening of the
pound will result in a higher cost to Forbin.
Fluff, an investment banker, provides Forbin with
a hedging proposal in which the currency exposure
would be mitigated by using at-the-money call
options on pounds. However, the forecasted
business combination does not meet the criteria to
qualify as the hedged item in a foreign currency
cash flow hedge since ASC 815-20-25-15(g)
prohibits hedges of forecasted transactions
involving business combinations; in addition, ASC
815-20-25-43(c) states that a firm commitment to
enter into a business combination cannot be the
hedged item in a fair value hedge.
Connecting the Dots
In a June 19, 2018, agenda request, the ISDA’s Accounting
Committee asked the FASB to consider an agenda topic that
“extends the ability to designate a fair value or cash flow
hedge of foreign currency exposure” related to either a firmly
committed or forecasted acquisition of a business. As of the
date of the publication of this Roadmap, the FASB has not added
this topic to its agenda.
5.3.1.2 Recognized Foreign-Currency-Denominated Asset or Liability
An entity may hedge a foreign-currency-denominated asset
or liability for changes in its cash flows that are attributable to
changes in foreign currency exchange rates under ASC 815-20-25-38(b). As
discussed in Section 5.2.1.1,
entities have the choice of applying either fair value hedging (see ASC
815-20-25-37(a)) or cash flow hedging (see ASC 815-20-25-38(b)) to
protect themselves from foreign currency risk for recognized
foreign-currency-denominated assets and liabilities.
ASC 815-20
25-39 A
hedging relationship of the type described in the
preceding paragraph qualifies for hedge accounting
if all the following criteria are met:
-
The criteria in paragraph 815-20-25-30(a) through (b) are met.
-
All of the cash flow hedge criteria in this Section otherwise are met, except for the criterion in paragraph 815-20-25-15(c) that requires that the forecasted transaction be with a party external to the reporting entity.
-
If the hedged transaction is a group of individual forecasted foreign-currency-denominated transactions, a forecasted inflow of a foreign currency and a forecasted outflow of the foreign currency cannot both be included in the same group.
-
If the hedged item is a recognized foreign-currency-denominated asset or liability, all the variability in the hedged item’s functional-currency-equivalent cash flows shall be eliminated by the effect of the hedge.
25-40 For
purposes of item (d) in the preceding paragraph,
an entity shall not specifically exclude a risk
from the hedge that will affect the variability in
cash flows. For example, a cash flow hedge cannot
be used with a variable-rate
foreign-currency-denominated asset or liability
and a derivative instrument based solely on
changes in exchange rates because the derivative
instrument does not eliminate all the variability
in the functional currency cash flows. As long as
no element of risk that affects the variability in
foreign-currency-equivalent cash flows has been
specifically excluded from a foreign currency cash
flow hedge and the hedging instrument is highly
effective at providing the necessary offset in the
variability of all cash flows, a less-than-perfect
hedge would meet the requirement in (d) in the
preceding paragraph. That criterion does not
require that the derivative instrument used to
hedge the foreign currency exposure of the
forecasted foreign-currency-equivalent cash flows
associated with a recognized asset or liability be
perfectly effective, rather it is intended to
ensure that the hedging relationship is highly
effective at offsetting all risks that impact the
variability of cash flows.
25-41 If
all of the variability of the
functional-currency-equivalent cash flows is
eliminated as a result of the hedge (as required
by paragraph 815-20-25-39(d)), an entity can use
cash flow hedge accounting to hedge the
variability in the functional-currency-equivalent
cash flows associated with any of the
following:
-
All of the payments of both principal and interest of a foreign-currency-denominated asset or liability
-
All of the payments of principal of a foreign-currency-denominated asset or liability
-
All or a fixed portion of selected payments of either principal or interest of a foreign-currency-denominated asset or liability
-
Selected payments of both principal and interest of a foreign-currency-denominated asset or liability (for example, principal and interest payments on December 31, 20X1, and December 31, 20X3).
Example 13: Eliminating All Variability in
Cash Flows
55-132
The following Cases illustrate the application of
paragraph 815-20-25-39(d) regarding whether all
the variability in a hedged item’s
functional-currency-equivalent cash flows are
eliminated by the effect of the hedge:
-
Difference in optionality (Case A)
-
b. Difference in reset dates (Case B)
-
Difference in notional amounts (Case C).
Case A: Difference in Optionality
55-133 An
entity has issued a fixed-rate
foreign-currency-denominated debt obligation that
is callable (that is, by that entity) and desires
to hedge its foreign currency exposure related to
that obligation with a fixed-to-fixed
cross-currency swap. A fixed-to-fixed currency
swap could be used to hedge the fixed-rate
foreign-currency-denominated debt instrument that
is callable even though the swap does not contain
a mirror-image call option as long as the terms of
the swap and the debt instrument are such that
they would be highly effective at providing
offsetting cash flows and as long as it was
probable that the debt instrument would not be
called and would remain outstanding.
Case B: Difference in Reset Dates
55-134 An entity has
issued a variable-rate
foreign-currency-denominated debt obligation and
desires to hedge its foreign currency exposure
related to that obligation. The entity uses a
variable-to-fixed cross-currency interest rate
swap in which it receives the same foreign
currency based on the variable rate index
contained in the debt obligation and pays a fixed
amount in its functional currency. If the swap
would otherwise meet this Subtopic’s definition of
providing high effectiveness in hedging the
foreign currency exposure of the debt instrument,
but there is a one day difference between the
reset dates in the debt obligation and the swap
(that is, the one day difference in reset dates
results in the hedge being highly effective, but
not perfectly effective), the variable-to-fixed
cross-currency interest rate swap could be used to
hedge the variable-rate
foreign-currency-denominated debt instrument even
though there is a one-day difference between the
reset dates or a slight difference in the notional
amounts in the debt instrument and the swap. This
would be true as long as the difference in reset
dates or notional amounts is not significant
enough to cause the hedge to fail to be highly
effective at providing offsetting cash flows.
Case C: Difference in Notional Amounts
55-135
This Case involves the same facts as in Case B,
except that there is no difference in the reset
dates. However, there is a slight difference in
the notional amount of the swap and the hedged
item. If the swap would otherwise meet this
Subtopic’s definition of providing high
effectiveness in hedging the foreign currency
exposure of the debt instrument, paragraph
815-20-25-39(d) does not preclude the swap from
qualifying for hedge accounting simply because the
notional amounts do not exactly match. The
mismatch attributable to the slight difference in
the notional amount of the swap and the hedged
item could be eliminated by designating only a
portion of the contract with the larger notional
amount as either the hedging instrument or hedged
item, as appropriate.
Under ASC 815-20-25-39(d), “[i]f the hedged item is a recognized
foreign-currency-denominated asset or liability, all the variability in
the hedged item’s functional-currency-equivalent cash flows shall be
eliminated by the effect of the hedge.” If viewed in isolation, ASC
815-20-25-39(d) appears to require the hedging instrument to perfectly
fix all variability in cash flows of the entire hedged
foreign-currency-denominated asset or liability. However, ASC
815-20-25-40 and the examples in ASC 815-20-55-132 through 55-135 help
illustrate that an entity must hedge all the different risks that result
in variability in the cash flows of the designated hedged item. For
example, to qualify for foreign currency cash flow hedge accounting, an
entity that issues variable-rate foreign-currency-denominated debt needs
to hedge the changes in cash flows that are attributable to both
interest rate risk and foreign currency risk. Such a hedge could
typically be achieved with a pay-fixed, receive-variable cross-currency
interest rate swap. Note that the interest rate index and the stated
currency for the variable leg of that cross currency interest rate swap
do not need to match the interest rate and currency of the hedged debt;
however, the cross-currency interest rate swap needs to be highly
effective at offsetting the changes in cash flows of the hedged debt
that are attributable to changes in interest rates and foreign currency
exchange rates.
In addition, ASC 815-20-25-41 clarifies that an entity may still hedge
selected contractual payments related to an existing
foreign-currency-denominated asset or liability. Specifically, an entity
may “hedge the variability in the functional-currency-equivalent cash
flows associated with any of the following:
-
All of the payments of both principal and interest of a foreign-currency-denominated asset or liability
-
All of the payments of principal of a foreign-currency-denominated asset or liability
-
All or a fixed portion of selected payments of either principal or interest of a foreign-currency-denominated asset or liability
-
Selected payments of both principal and interest of a foreign-currency-denominated asset or liability.”
In other words, if an entity wants to hedge the variability in the cash
flows of an existing foreign-currency-denominated asset or liability, it
first needs to identify the selected cash flows from the asset or
liability that it wishes to hedge. Those cash flows can be any or all
the cash flows (interest or principal, or both). An entity may hedge a
proportion of the cash flows selected, but if so, it must pick the same
proportion of the asset’s cash flows for each of the contractual cash
flows identified as the hedged item. Once the entity has identified the
contractual cash flows (or portions thereof) to be hedged, it must hedge
all of the risks that create variability in the
functional-currency-equivalent cash flows related to those contractual
cash flows.
Example 5-11
Hedging Foreign-Currency-Denominated
Variable-Rate Debt
PiperPiper has a USD functional currency. On
January 1, 20X1, it issues EUR 100 million of
EURIBOR-based debt, with interest payable annually
on December 31. The principal is due only at
maturity on December 31, 20X5. Below are some
examples of the different hedging instruments and
designated hedged items that PiperPiper is
considering.
Derivative
|
Hedged Item
|
Qualifies for Cash Flow Hedging?
|
---|---|---|
Five-year pay-USD-fixed, receive-EUR EURIBOR
swap with notional of EUR 100 million
|
All principal and interest cash flows of the
debt
|
Yes. PiperPiper may identify all of the
contractual cash flows of the debt as the hedged
item. The derivative eliminates all of the
variability in cash flows since it converts both
the variable interest rate and the foreign
currency into a fixed amount of functional
currency.
|
Five-year pay-USD-fixed USD, receive-EUR-LIBOR
swap with notional of EUR 100 million
|
All principal and interest cash flows of the
debt
|
Maybe. PiperPiper may identify all of the
contractual cash flows of the debt as the hedged
item. However, the interest rate underlying the
variable leg of the swap (LIBOR) is not the same
as the interest rate index for the variable-rate
debt (EURIBOR), so the swap would only qualify for
hedge accounting if it is highly effective at
offsetting the variability in
functional-currency-equivalent cash flows.
PiperPiper would not be prohibited from applying
hedge accounting because the swap hedges the
variability related to all risks that result in
variability in cash flows (i.e., interest rate
risk and foreign currency risk).
|
Pay USD, receive EUR forward with 70 million
EUR notional; matures on December 31, 20X5
|
70 percent of the principal payment of the debt
due on December 31, 20X5
|
Yes. PiperPiper may identify any individual
contractual cash flow of the debt, or a portion
thereof. In addition, the only source of
variability in functional-currency-equivalent cash
flows related to that principal payment due on
December 31, 20X5, is changes in EUR/USD exchange
rates (i.e., the changes in interest rates do not
affect the amount of principal due on December 31,
20X5). The forward contract eliminates the
variability attributable to that risk.
|
Five different pay USD, receive EUR forwards,
each with a EUR 4 million notional (based on the
EURIBOR rate at inception of the hedge multiplied
by the principal amount of the debt); maturity
dates are December 31 of 20X1, 20X2, 20X3, 20X4,
and 20X5
|
The forecasted interest payments for each of
the five years of the debt
|
No. While PiperPiper may identify the hedged
item as only the interest payments associated with
the debt (or a portion thereof) and not the
principal, it must eliminate the variability in
the functional-currency-equivalent cash flows. The
forward contracts do not eliminate such
variability because changes in EURIBOR will alter
the amount of interest due on each of those dates.
The forward contracts only hedge foreign currency
risk, not interest rate risk.
|
Example 5-12
Hedging
Foreign-Currency-Denominated Fixed-Rate
Debt
PiperPiper has a USD functional
currency. On January 1, 20X1, it issues EUR 100
million of fixed-rate debt, with interest of 5
percent payable annually on December 31. The
principal is due only at maturity on December 31,
20X5. Below are some examples of the different
hedging instruments and designated hedged items
that PiperPiper is considering.
Derivative
|
Hedged Item
|
Qualifies for Cash Flow
Hedging?
|
---|---|---|
Five-year pay-USD-fixed,
receive-EUR-fixed swap with notional of EUR 100
million
|
All principal and interest
cash flows of the debt
|
Yes. PiperPiper may identify
all the contractual cash flows of the debt as the
hedged item. The derivative eliminates all the
variability in cash flows since it converts all of
the payments into a fixed amount of functional
currency.
|
Pay USD, receive EUR forward
with 70 million EUR notional; matures on December
31, 20X5
|
70 percent of the principal
payment of the debt due on December 31, 20X5
|
Yes. PiperPiper may identify
any individual contractual cash flow of the debt,
or a portion thereof. In addition, the only source
of variability in functional-currency-equivalent
cash flows related to that principal payment due
on December 31, 20X5, is changes in EUR/USD
exchange rates (i.e., the changes in interest
rates do not affect the amount of principal due on
December 31, 20X5). The forward contract
eliminates the variability attributable to that
risk.
|
Five different pay-USD,
receive-EUR forwards, each with a notional of EUR
5 million; maturity dates are on December 31 of
20X1, 20X2, 20X3, 20X4, and 20X5
|
The forecasted interest
payments for each of the five years of the
debt
|
Yes. PiperPiper may identify
the hedged item as only the interest payments
associated with the debt (or a portion thereof)
and not the principal. In addition, because it is
fixed-rate debt, the only source of variability in
functional-currency-equivalent cash flows for
those interest payments is the changes in the
EUR/USD exchange rate. The forward contracts
eliminate the variability attributable to that
risk.
|
A pay-USD, receive-EUR forward
with a notional of EUR 5 million; matures on
December 31, 20X1
|
The forecasted interest
payment due on December 31, 20X1
|
Yes. PiperPiper may identify
the hedged item as any individual interest or
principal payment associated with the debt (or a
portion thereof). In addition, because it is
fixed-rate debt, the only source of variability in
functional-currency-equivalent cash flows related
to that interest payment is changes in the EUR/USD
exchange rate. The forward contract eliminates the
variability attributable to that risk.
|
5.3.1.3 Firm Commitments
ASC 815-20
Foreign Exchange Risk of a Firm Commitment as
Hedged Transaction in a Cash Flow Hedge
25-42
The reference in the definition of a forecasted
transaction indicating that a forecasted transaction
is not a firm commitment focuses on firm commitments
that have no variability. The reference does not
preclude a cash flow hedge of the variability in
functional-currency-equivalent cash flows if the
commitment’s fixed price is denominated in a foreign
currency. Although that definition of a firm
commitment requires a fixed price, it permits the
fixed price to be denominated in a foreign currency.
A firm commitment can expose the parties to
variability in their functional-currency-equivalent
cash flows. The definition of a forecasted
transaction also indicates that the transaction or
event will occur at the prevailing market price.
From the perspective of the hedged risk (foreign
exchange risk), the translation of the foreign
currency proceeds from the sale of the nonfinancial
assets will occur at the prevailing market price
(that is, current exchange rate). Example 14 (see
paragraph 815-20-55-136) illustrates the application
of this guidance.
It may seem counterintuitive that there is exposure to changes in cash flows
related to a firm commitment since the definition of a firm commitment
requires the price of the item being bought or sold to be fixed. However, as
noted in ASC 815-20-25-42, if that price is expressed as a fixed amount of a
foreign currency, there is exposure to changes in
functional-currency-equivalent cash flows attributable to changes in foreign
currency exchange rates.
The following firm commitments are precluded from qualifying as the hedged
item in a foreign-currency-related cash flow hedge:
-
Intercompany commitments — Such commitments do not meet the definition of a firm commitment because they are not with a third party (see Section 3.1.1). However, an entity may hedge forecasted transactions related to intercompany commitments that have foreign currency exposure in a cash flow hedging relationship (see Section 5.3.1.1.1).
-
Firm commitments to enter in a business combination — ASC 815-20-25-43(c) specifically prohibits such commitments from qualifying as the hedged item in a fair value hedge. ASC 815 is silent regarding whether such commitments are permissible as foreign currency cash flow hedges. We believe that it would be inappropriate to hedge a firm commitment to enter into a business combination for foreign currency risk under a cash flow hedging model for many of the same reasons that an entity is prohibited from hedging a forecasted transaction involving a business combination (see Section 2.2.1.3).
5.3.2 Hedging Instruments in a Foreign Currency Cash Flow Hedge
Derivative instruments are the only permissible hedging instruments in a foreign
currency cash flow hedging relationship. Certain nonderivative instruments may
qualify as the hedging instruments in some foreign currency fair value hedges
and net investment hedges, but nonderivative instruments are not permitted as
the hedging instrument in a foreign currency cash flow hedge.
5.3.3 Accounting for Foreign Currency Cash Flow Hedges
As noted in Chapter 4, in a typical
qualifying cash flow hedging relationship, an entity records the change in the
hedging instrument’s fair value in OCI, except for any changes in the fair value
of components that are excluded from the effectiveness assessment if the entity
elects to recognize such changes in current-period earnings (see Section 4.1.6). Amounts in AOCI are reclassified
into earnings when the hedged item affects earnings or when it becomes probable
that the forecasted transaction will not occur.
5.3.3.1 Unique Considerations for Foreign Currency Cash Flow Hedges
The accounting for a qualifying foreign currency cash flow hedge requires
some slight modifications to the typical cash flow hedging model in a few circumstances:
-
If an entity is hedging the variability in the functional-currency-equivalent cash flows of a recognized foreign-currency-denominated asset or liability that is remeasured at spot exchange rates in accordance with ASC 830, the initial time value of the hedging instrument should be recognized in earnings over the life of the hedging instrument, even if the entity does not exclude any components of the hedging instrument from the effectiveness assessment. See Section 5.3.3.1.1 for further discussion.
-
If an entity is hedging a forecasted intra-entity transaction, amounts recognized in OCI should be reclassified out of AOCI when the forecasted transaction affects earnings, which depends on when the related transaction with an external third-party affects earnings. See Section 5.3.3.1.2 for further discussion.
-
If an entity has designated and documented that it will assess effectiveness on an after-tax basis (see Section 5.1.3), the portion of the gain or loss on the hedging instrument that exceeds the loss or gain, respectively, on the hedged item should be included as an offset to the related tax effects in the period in which such effects are recognized. See Section 5.3.3.1.3 for further discussion.
5.3.3.1.1 Hedging Variability in Functional-Currency-Equivalent Cash Flows of Recognized Foreign-Currency-Denominated Asset or Liability
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: . . .
d. If a non-option-based contract is the
hedging instrument in a cash flow hedge of the
variability of the functional-currency-equivalent
cash flows for a recognized
foreign-currency-denominated asset or liability
that is remeasured at spot exchange rates under
paragraph 830-20-35-1, an amount that will both
offset the related transaction gain or loss
arising from that remeasurement and adjust
earnings for that period’s allocable portion of
the initial spot-forward difference associated
with the hedging instrument (cost to the purchaser
or income to the seller of the hedging instrument)
shall be reclassified each period from other
comprehensive income to earnings if the assessment
of effectiveness is based on total changes in the
non-option-based instrument’s cash flows. If an
option contract is used as the hedging instrument
in a cash flow hedge of the variability of the
functional-currency-equivalent cash flows for a
recognized foreign-currency-denominated asset or
liability that is remeasured at spot exchange
rates under paragraph 830-20-35-1 to provide only
one-sided offset against the hedged foreign
exchange risk, an amount shall be reclassified
each period to or from other comprehensive income
with respect to the changes in the underlying that
result in a change in the hedging option’s
intrinsic value. In addition, if the assessment of
effectiveness is based on total changes in the
option’s cash flows (that is, the assessment will
include the hedging instrument’s entire change in
fair value — its entire gain or loss), an amount
that adjusts earnings for the amortization of the
cost of the option on a rational basis shall be
reclassified each period from other comprehensive
income to earnings. This guidance is limited to
foreign currency hedging relationships because of
their unique attributes and is an exception for
foreign currency hedging relationships. . .
.
35-6 Remeasurement of the
hedged foreign-currency-denominated assets and
liabilities is based on the guidance in Topic 830,
which requires remeasurement based on spot
exchange rates, regardless of whether a cash flow
hedging relationship exists.
Under the cash flow hedging model, if a qualifying hedging relationship
is highly effective, all changes in the derivative’s fair value that are
included in the effectiveness assessment are recognized in OCI. However,
in a foreign currency cash flow hedging relationship involving a
foreign-currency-denominated asset or liability, the remeasurement of
that asset or liability under ASC 830 is based only on changes in the
spot exchange rate. ASC 815-30-35-3(d) requires an entity to reclassify
amounts out of AOCI and into earnings if they are related to and offset
the transaction gain or loss on the hedged asset or liability. If the
entity includes the total changes in the hedging instrument’s fair value
in the effectiveness assessment, there will be a mismatch between (1)
the gains and losses on the derivative that are recognized in OCI and
(2) the amounts that would be reclassified out of AOCI to offset the
transaction gains and losses on the hedged asset or liability. As a
result, ASC 815-30-35-3(d) also requires an entity to recognize the
difference (referred to as the “cost or income” from the hedging
instrument) in earnings over the life of the hedging relationship. The
calculation of the “cost or income” and the method for recognizing that
amount in earnings over the life of the hedging relationship depends on
the nature of both the derivative and the hedged item. The table below
summarizes the alternatives.
Derivative Type
|
Cost or Income
|
Hedged Item — Method of Recognition in
Earnings
|
---|---|---|
Forward
|
The initial difference between the spot and
forward rates
|
Interest-bearing asset or liability — interest
method
Non-interest-bearing asset or liability — either
interest method or pro rata method
Combined hedge of forecasted transaction through
settlement date — based on either initial forward
rates or pro rata method
|
Option
|
Time value of option
|
All assets and liabilities — rational method of
amortization
|
ASC 815-30-35-9 describes how to apply the guidance in ASC 815-30-35-3(d)
to a single combined hedging relationship involving a forward contract
hedging the change in cash flows attributable to foreign currency risk
related to the settlement of a foreign-currency-denominated receivable
or payable resulting from a forecasted sale or purchase on credit (see
Section 5.3.1.1.2). However,
ASC 815-30-35-9(b) provides broader guidance on how to recognize the
initial spot-forward difference in earnings, depending on the nature of
the hedged item. ASC 815-30-35-9(b) states:
The functional currency interest rate implicit in the hedging
relationship as a result of entering into the forward contract
is used to determine the amount of cost or income to be ascribed
to each period of the hedging relationship. The cash flow
hedging model for recognized foreign-currency-denominated assets
and liabilities requires use of the interest method at the
inception of the hedging relationship to determine the amount of
cost or income to be ascribed to each relevant period of the
hedging relationship. However, for simplicity, in hedging
relationships in which the hedged item is a short-term
non-interest-bearing account receivable or account payable, the
amount of cost or income to be ascribed each period can also be
determined using a pro rata method based on the number of days
or months of the hedging relationship. In addition, in a
short-term single cash flow hedging relationship that
encompasses the variability of functional-currency-equivalent
cash flows attributable to foreign exchange risk related to the
settlement of a foreign-currency-denominated receivable or
payable resulting from a forecasted sale or purchase on credit,
the amount of cost or income to be ascribed each period can also
be determined using a pro rata method or a method that uses two
foreign currency forward exchange rates. The first foreign
currency forward exchange rate would be based on the maturity
date of the forecasted purchase or sale transaction. The second
foreign currency forward exchange rate would be based on the
settlement date of the resulting account receivable or account
payable.
Example 18 in ASC 815-30-55-106 through 55-112 shows a
detailed illustration of an entity hedging a forecasted purchase of
inventory on credit through the settlement date of the payable. The
example includes an illustration of how to allocate the “cost or income”
under both the pro rata method and the method that uses two foreign
currency forward rates. In our experience, most entities apply the pro
rata method. See Examples 5-13 and 5-15 for detailed illustrations of
entities applying a single hedging relationship to a forecasted
transaction through the settlement date of the related receivable or
payable under the pro rata method.
The guidance in ASC 815-30-35-3(a) does not apply to the
components of the derivative that are excluded from the effectiveness
assessment (see Section 4.1.6) or to any hedging relationship in which
an entity is applying the terminal value method (see Section 4.1.3).
See Example
5-14 for an illustration of an entity that hedges a
forecasted purchase of inventory through the settlement date of the
related payable and excludes the forward points of the derivative from
the effectiveness assessment. See Example 5-16 for an illustration
of an entity using the terminal value method for a hedge of a forecasted
purchase of inventory with a purchased option.
5.3.3.1.2 Hedging Forecasted Intra-Entity Transactions
ASC 815-30
Example 14: Reclassifying Amounts From a
Cash Flow Hedge of a Forecasted
Foreign-Currency-Denominated Intra-Entity
Sale
55-86 This Example
illustrates the application of paragraphs
815-20-25-30 and 815-20-25-39 through 25-41. This
Example has the following assumptions:
- Parent A is a multinational corporation that has the U.S. dollar (USD) as its functional currency.
- Parent A has the following two
subsidiaries:
- Subsidiary B, which has the Euro (EUR) as its functional currency
- Subsidiary C, which has the Japanese yen (JPY) as its functional currency.
-
Subsidiary B manufactures a product and has a forecasted sale of the product to Subsidiary C that will be transacted in JPY.
55-87 Eventually,
Subsidiary C will sell the product to an unrelated
third party in JPY. Subsidiary B enters into a
forward contract with an unrelated third party to
hedge the cash flow exposure of its forecasted
intra-entity sale in JPY to changes in the EUR-JPY
exchange rate.
55-88 The transaction in this
Example meets the hedge criteria of paragraphs
815-20-25-30 and 815-20-25-39 through 25-41, which
permits a derivative instrument to be designated
as a hedge of the foreign currency exposure of
variability in the functional-currency-equivalent
cash flows associated with a forecasted
intra-entity foreign-currency-denominated
transaction if certain criteria are met.
Specifically, the operating unit having the
foreign currency exposure (Subsidiary B) is a
party to the hedging instrument; the hedged
transaction is denominated in JPY, which is a
currency other than Subsidiary B’s functional
currency; and all other applicable criteria in
Section 815-20-25 are satisfied.
55-89 Subsidiary B
measures the derivative instrument at fair value
and records the gain or loss on the derivative
instrument in accumulated other comprehensive
income. In the consolidated financial statements,
the amount in other comprehensive income
representing the gain or loss on a derivative
instrument designated in a cash flow hedge of a
forecasted foreign-currency-denominated
intra-entity sale should be reclassified into
earnings in the period that the revenue from the
sale of the manufactured product to an unrelated
third party is recognized and presented in
earnings in the same income statement line item as
the earnings effect of the hedged item. The
reclassification into earnings in the consolidated
financial statements should occur when the
forecasted sale affects the earnings of Parent A.
Because the consolidated earnings of Parent A will
not be affected until the sale of the product by
Subsidiary C to the unrelated third party occurs,
the reclassification of the amount of derivative
gain or loss from other comprehensive income into
earnings in the consolidated financial statements
should occur upon the sale by Subsidiary C to an
unrelated third party.
55-90 This guidance is
relevant only with respect to the consolidated
financial statements. In Subsidiary B’s separate
entity financial statements, the reclassification
of the amount of the derivative instrument gain or
loss from other comprehensive income into earnings
should occur in the period the forecasted
intra-entity sale is recorded because Subsidiary
B’s earnings are affected by the change in the
EUR-JPY exchange rate when the sale to Subsidiary
C occurs.
As discussed in Section 5.3.1.1, an
entity may hedge foreign-currency-denominated forecasted intra-entity
transactions in a foreign currency cash flow hedge for changes in cash
flows attributable to foreign currency risk as long as those
transactions ultimately result in a transaction with an external third
party. Example 14 in ASC 815-30-55-86 through 55-90 illustrates a few
important concepts for hedging forecasted intra-entity transactions:
-
The forecasted transaction is the intra-entity transaction, so hedge accounting related to that transaction ceases when the intra-entity transaction occurs.
-
Amounts recognized in OCI related to that intra-entity transaction are reclassified out of AOCI when the transaction with the unrelated third party occurs (i.e., when the transaction affects earnings for the consolidated financial statements).
-
The timing of reclassification from AOCI in the stand-alone financial statements of individual subsidiaries may differ from the timing in the consolidated financial statements.
5.3.3.1.3 Hedging on an After-Tax Basis
ASC 815-30
35-5 If
an entity has designated and documented that it
will assess effectiveness and measure hedge
results of a cash flow hedge of foreign currency
risk on an after-tax basis as permitted by
paragraph 815-20-25-3(b)(2)(vi), the portion of
the gain or loss on the hedging instrument that
exceeded the loss or gain on the hedged item shall
be included as an offset to the related tax
effects in the period in which those tax effects
are recognized.
If an entity is hedging on an after-tax basis, as discussed in Section 5.1.3, the portion of the gain
or loss on the hedging instrument that exceeds the loss or gain,
respectively, on the hedged item should be included as an offset to the
related tax effects in the period in which such effects are recognized.
Only the amount necessary to offset the loss or gain on the hedged item
is recognized in OCI as part of the hedging relationship.
5.3.3.2 Income Statement Classification
As discussed in Section 4.1, all
amounts in AOCI for a qualifying cash flow hedging relationship (1) should
be reclassified into earnings when the forecasted transaction affects
earnings and (2) are presented in the same line item as the earnings effect
of 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 are generally immediately
reclassified from AOCI (see Section
4.1.5.2 for further discussion of the accounting for
discontinued cash flow hedges).
In a manner similar to the accounting for fair value hedging relationships
(see discussion in Section 5.2.3.3),
if an entity is hedging multiple risks, the earnings effect of the amounts
reclassified out of AOCI will need to be allocated on the basis of how much
each of the hedged risks affected the changes in the hedging instrument’s
fair value that were recorded in OCI. For example, an entity hedging
foreign-currency-denominated variable-rate debt for changes in cash flows
that are attributable to both foreign currency risk and interest rate risk
would need to allocate amounts reclassified out of AOCI to interest expense
and transaction gains or losses.
In addition, if the entity is using an after-tax hedging strategy, as
discussed in Section 5.1.3, the
portion of the gain or loss on the hedging instrument that exceeded the loss
or gain, respectively, on the hedged item should be included as an offset to
the related tax effects in the period in which such effects are
recognized.
5.3.4 Illustrative Examples
Example 5-13
Hedging Forecasted Foreign-Currency-Denominated
Purchase of Inventory Through Payable Settlement
Date
On January 1, 20X1, BeBop Co., an entity with a USD
functional currency, forecasts the purchase of EUR 1
million of inventory on April 30, 20X1. The resulting
EUR-denominated payable is expected to be settled on
June 30, 20X1. BeBop Co. enters into a forward contract
on January 1, 20X1, to sell USD 980,873 and buy EUR 1
million on June 30, 20X1, and designates it as a
combined hedge of the variability in cash flows
attributable to changes in the USD/EUR exchange rate
from the forecasted settlement of a
foreign-currency-denominated payable resulting from its
forecasted purchase of inventory. BeBop Co. will assess
the effectiveness of the hedge on the basis of the total
changes in the forward contract’s fair value (i.e., it
will not exclude any components of the forward contract
from the effectiveness assessment). BeBop Co. elects to
ascribe the initial difference between the forward rate
and spot rate to each period by using the pro rata
method, as allowed by ASC 815-30-35-9(b). The USD/EUR
spot exchange rate on January 1, 20X1, was 1.0064. In
other words, BeBop Co. could buy EUR 1 million for USD
993,641 on January 1, 20X1.
The allocation of the initial difference between the
forward rate and spot rate under the pro rata method is
as follows:
Assume that (1) the forecasted transactions remain
probable throughout the entire hedging relationship and
will occur when expected and (2) the inventory is sold
on July 31, 20X1, for $1.3 million.
Note that for simplicity, it is assumed that the forward
contract’s fair value is equal to the forward rate as of
the date of valuation less the contractual exchange rate
multiplied by the notional; discounting is ignored. The
reclassification of amounts from AOCI into earnings is
reported in the same income statement line item in which
the hedged transaction is reported. In this example,
since this strategy effectively combines two
transactions (the purchase of inventory and the
settlement of a payable) into one hedging relationship,
(1) amounts related to hedging the changes in foreign
currency risk associated with the inventory will be
recognized in cost of goods sold and (2) amounts related
to the recognized payable will be recognized in
transaction gains and losses.
BeBop Co. records the following journal entries:
January 1, 20X1
No entry is required. The forward contract was entered
into at-the-money.
March 31, 20X1
The rate for a USD/EUR forward settling on June 30, 20X1,
is 0.9308. Therefore, the forward contract has a
positive fair value of $93,472.
April 30, 20X1
The table below shows (1) the relevant spot and forward
rates on April 30, 20X1, (2) the forward contract’s fair
values on March 31, 20X1, and April 30, 20X1, and (3)
the change in the forward contract’s fair value.
The journal entries are as follows:
June 30, 20X1
The table below shows (1) the spot rate on June 30, 20X1,
(2) the forward contract’s fair values on April 30,
20X1, and June 30, 20X1, and (3) the change in the
forward contract’s fair value.
The journal entries are as follows:
July 31, 20X1
BeBop Co. sells the inventory for $1.3 million. The
journal entries are as follows:
Example 5-14
Hedging Forecasted
Foreign-Currency-Denominated Purchase of Inventory
Through Payable Settlement Date — Excluded
Component
On January 1, 20X1, BeBop Co., an entity
with a USD functional currency, forecasts the purchase
of EUR 1 million of inventory on April 30, 20X1. The
resulting EUR-denominated-payable is expected to be
settled on June 30, 20X1. BeBop Co. enters into a
forward contract on January 1, 20X1, to sell USD 980,873
and buy EUR 1 million on June 30, 20X1. It designates
the contract as a combined hedge of the variability in
cash flows attributable to changes in the USD/EUR
exchange rate from the forecasted settlement of a
foreign-currency-denominated payable resulting from its
forecasted purchase of inventory. BeBop Co. will assess
the effectiveness of the hedge on the basis of the
changes in the spot exchange rate (i.e., it will exclude
the forward/spot component of the forward contract from
the effectiveness assessment). BeBop Co. elects to
amortize the initial difference between the forward rate
and spot rate evenly over the life of the hedging
relationship. The USD/EUR spot exchange rate on January
1, 20X1, is 1.0064; therefore, BeBop Co. could buy EUR 1
million for USD 993,641 on that date.
The allocation of the initial difference
between the forward rate and spot rate for amortization
over the hedging period is as follows:
Assume that (1) the forecasted
transactions remain probable throughout the entire
hedging relationship and will occur when expected and
(2) the inventory is sold on July 31, 20X1, for $1.3
million.
Note that for simplicity, it is assumed
that the forward contract’s fair value is equal to the
forward rate as of the date of valuation less the
contractual exchange rate multiplied by the notional;
discounting is ignored. The reclassification of amounts
from AOCI into earnings is reported in the same income
statement line item in which the hedged transaction is
reported. In this example, since this strategy
effectively combines two transactions (the purchase of
inventory and the settlement of a payable) into one
hedging relationship, (1) amounts related to hedging the
changes in foreign-currency risk associated with the
inventory will be recognized in cost of goods sold and
(2) amounts related to the payable will be recognized in
transaction gains and losses.
BeBop Co. records the following journal
entries:
January 1,
20X1
No journal entry is required. The
forward contract was entered into at-the-money.
March 31,
20X1
The rate for a USD/EUR forward settling
on June 30, 20X1, is 0.9308. Therefore, the forward
contract has a positive fair value of $93,472. The
journal entry as of March 31, 20X1, is as follows:
April 30,
20X1
The table below shows (1) the relevant
spot and forward rates on April 30, 20X1, and (2) the
forward contract’s fair values on March 31, 20X1, and
April 30, 20X1.
The journal entries are as follows:
June 30,
20X1
The table below shows (1) the spot rate
on June 30, 20X1, (2) the forward contract’s fair values
on April 30, 20X1, and June 30, 20X1, and (3) the change
in the forward contract’s fair value.
The journal entries are as follows:
July 31,
20X1
BeBop Co. sells the inventory for $1.3
million. The journal entries are as follows:
Example 5-15
Hedging Forecasted
Foreign-Currency-Denominated Sale of Inventory
Through Receivable Settlement Date
On January 1, 20X1, Golden Age, an
entity with a USD functional currency, forecasts the
sale of EUR 1 million of inventory on April 30, 20X0.
The resulting euro receivable is expected to be settled
on June 30, 20X1. Golden Age enters into a forward
contract on January 1, 20X1, to buy USD 980,873 and sell
EUR 1 million on June 30, 20X1. It designates the
contract as a combined hedge of the variability in cash
flows attributable to changes in the USD/EUR exchange
rate from the forecasted settlement of a
foreign-currency-denominated receivable on June 30,
20X1, resulting from its forecasted sale of inventory on
April 30, 20X0. Golden Age will assess the effectiveness
of the hedge on the basis of the total changes in the
forward contract’s fair value (i.e., it will not exclude
any components of the forward contract from the
effectiveness assessment). Golden Age elects to ascribe
the initial difference between the forward rate and spot
rate to each period by using the pro rata method, as
allowed by ASC 815-30-35-9(b). The USD/EUR spot exchange
rate on January 1, 20X1, is 1.0064; therefore, Golden
Age could sell EUR 1 million for USD 993,641 on that
date.
The allocation of the initial difference
between the forward rate and spot rate for amortization
over the hedging period is as follows:
Assume that the forecasted transactions
remain probable throughout the entire hedging
relationship and will occur when expected.
Note that for simplicity, it is assumed
that the forward contract’s fair value is equal to the
forward rate as of the date of valuation less the
contractual exchange rate multiplied by the notional;
discounting is ignored. The reclassification of amounts
from AOCI into earnings is reported in the same income
statement line item in which the hedged transaction is
reported. In this example, since this strategy
effectively combines two transactions (the sale of
inventory and the settlement of a receivable) into one
hedging relationship, (1) amounts related to hedging the
changes in foreign-currency risk associated with the
sale of inventory will be recognized in revenue and (2)
amounts related to the receivable will be recognized in
transaction gains and losses.
Golden Age records the following journal
entries:
January 1,
20X1
No entry is required. The forward
contract was entered into at-the-money.
March 31,
20X1
The rate for a USD/EUR forward settling
on June 30, 20X1, is 0.9308. Therefore, the forward
contract has a negative fair value of $93,472. The
journal entry is as follows:
April 30,
20X1
The table below shows (1) the relevant
spot and forward rates as of April 30, 20X1, (2) the
forward contract’s fair values on March 31, 20X1, and
April 30, 20X1, and (3) the change in the forward
contract’s fair value.
The journal entries are as follows:
June 30,
20X1
The table below shows (1) the spot rate
as of June 30, 20X1, (2) the fair values of the forward
contract on April 30, 20X1, and June 30, 20X1, and (3)
the change in the forward contract’s fair value:
The journal entries are as follows:
Example 5-16
Purchased Option
Hedging Forecasted Foreign-Currency-Denominated
Purchase of Inventory Through Settlement Date —
Terminal Value Method
On January 1, 20X2, Golden Age, an
entity with a USD functional currency, forecasts the
purchase of EUR 1 million of inventory on March 31,
20X1. The resulting EUR payable is expected to be
settled on June 30, 20X2. Golden Age enters into a
European option contract on January 1, 20X2, to sell USD
942,300 and buy EUR 1 million on June 30, 20X2. It
designates the contract as a combined hedge of the
variability in cash flows attributable to changes in the
USD/EUR exchange rate from the forecasted settlement of
the euro-denominated payable on June 30, 20X2, resulting
from its euro-denominated forecasted purchase on March
31, 20X2. Entering into this type of a purchased option
is in compliance with Golden Age’s overall risk
management policy. It pays a premium of $28,866 for the
option.
Golden Age formally documents the
hedging relationship at the inception of the hedge. In
accordance with its policy, Golden Age will (1) assess
effectiveness on the basis of the total changes in the
option’s cash flows and (2) compare the option’s
terminal value to the expected change in forecasted cash
flows for USD/EUR spot exchange rates above 0.9423 (see
ASC 815-20-25-126 through 25-129). Golden Age may assume
perfect effectiveness because (1) the terms of the
option perfectly match the forecasted purchase of EUR
and (2) the option cannot be exercised before maturity
(i.e., the criteria in ASC 815-20-25-129 are
satisfied).
The table below shows the spot rates and
fair values of the option as of January 1, March 31, and
June 30, 20X2.
Assume that (1) the forecasted
transactions remain probable throughout the entire
hedging relationship and will occur when expected, (2)
the payable is settled on June 30, 20X2, and (3) the
inventory is sold on July 31, 20X2, for $1.3
million.
Golden Age records the following journal
entries:
January 1,
20X2
March 31,
20X2
June 30,
20X2
No entry is necessary for the settlement
of the option because it expires unexercised
(out-of-the-money).
July 31,
20X2
5.4 Net Investment Hedging
Hedging Relationship Type
|
Possible Types of Foreign-Currency-Denominated Hedged Items
(See ASC 815-20-25-28)
|
Permitted Hedging Instruments
|
---|---|---|
Net investment hedge
|
Net investment in a foreign operation
|
Derivative or nonderivative
|
A net investment hedge is a hedge of the foreign currency exposure of a net
investment in a foreign operation. Such an exposure is a result of the translation
of the investment into the parent’s functional currency in accordance with ASC 830.
The resulting gains and losses from translation are recognized in OCI as CTAs. The
application of net investment hedging allows entities to defer recognizing the gains
and losses on the hedging instrument that are included in the effectiveness
assessment as a CTA in OCI in a manner consistent with the classification of the CTA
that arises from the hedged item. As in cash flow hedging relationships, the gains
and losses recognized in the CTA are reclassified into earnings when the hedged item
(i.e., the net investment in foreign operations) affects earnings (see
Section 5.4.3 for further discussion).
The concept of hedging a net investment in foreign operations, which is made up of
assets and liabilities, is unique to this type of hedging relationship. Unlike fair
value and cash flow hedging relationships, a net investment hedge permits hedge
accounting to be applied to a group of items (the net investment) that typically
includes both assets and liabilities that in many cases would not be considered
similar items. Because of the unique nature of this hedging relationship, distinct
qualification criteria must be met to qualify for this type of hedging.
5.4.1 Hedging Instruments in a Net Investment Hedge
ASC 815-20
25-66 A derivative
instrument or a nonderivative financial instrument that
may give rise to a foreign currency transaction gain or
loss under Subtopic 830-20 can be designated as hedging
the foreign currency exposure of a net investment in a
foreign operation provided the conditions in paragraph
815-20-25-30 are met. A nonderivative financial
instrument that is reported at fair value does not give
rise to a foreign currency transaction gain or loss
under Subtopic 830-20 and, thus, cannot be designated as
hedging the foreign currency exposure of a net
investment in a foreign operation.
25-67 Hedging instruments
that are eligible for designation in a net investment
hedge include, among others, both of the following:
- A receive-variable-rate, pay-variable-rate
cross-currency interest rate swap, provided both
of the following conditions are met:
-
The interest rates are based on the same currencies contained in the swap.
-
Both legs of the swap have the same repricing intervals and dates.
-
- A receive-fixed-rate, pay-fixed-rate cross-currency interest rate swap. A cross-currency interest rate swap that has two fixed legs is not a compound derivative instrument and, therefore, is not subject to the criteria in (a).
25-68 A cross-currency
interest rate swap that has either two variable legs or
two fixed legs has a fair value that is primarily driven
by changes in foreign exchange rates rather than changes
in interest rates. Therefore, foreign exchange risk,
rather than interest rate risk, is the dominant risk
exposure in such a swap.
25-68A Under the guidance in
paragraph 815-20-25-71(d)(1), a cross-currency interest
rate swap with one fixed-rate leg and one floating-rate
leg cannot be designated as the hedging instrument in a
net investment hedge.
An entity may use either a derivative or certain nonderivative instruments as
hedging instruments in a net investment hedge. To qualify as a hedging
instrument, a nonderivative instrument must be subject to the measurement
requirements of ASC 830-20. ASC 815-20-25-66 notes that any nonderivative
instrument that is reported at fair value does not qualify as a hedging
instrument in a net investment hedging relationship because it “does not give
rise to a foreign currency transaction gain or loss under Subtopic 830-20.”
Since the translation of net investments in foreign operations is based on
changes in foreign currency exchange rates in accordance with ASC 830, ASC 815
requires the remeasurement of the hedging instrument to be predominantly based
on changes in foreign currency exchange rates. That requirement limits the types
of derivatives that can be used as hedging instruments in net investment hedges
to those whose fair value is predominantly based on changes in foreign currency
exchange rates. Accordingly, many compound derivatives and all synthetic
instruments are precluded from qualifying as hedging instruments within net
investment hedging relationships.
Generally, ASC 815 does not permit the use of a compound derivative that has
multiple underlyings as the hedging instrument in a net investment hedge. As
discussed in Section 2.4.1.3.4, the only
compound derivatives that an entity may use as the hedging instrument in a net
investment hedging relationship are:
-
Receive-variable-rate, pay-variable-rate cross-currency interest rate swaps in which (1) the interest rates are based on the same currencies contained in the swap and (2) both legs of the swap have the same repricing intervals and dates.
-
Receive-fixed-rate, pay-fixed-rate cross-currency interest rate swaps.
ASC 815-20-25-71(d) precludes synthetic instruments that consist of a combination
of a debt instrument and derivative instrument from qualifying as hedging
instruments in a net investment hedging relationship. If such instruments were
viewed as one, the measurement principles of the individual components under ASC
830-20 and ASC 815 would be contravened. ASC 815-20-55-49 and 55-50 provide an
example of a synthetic instrument:
55-49 A debt instrument denominated in the investor’s functional
currency and a cross-currency interest rate swap cannot be accounted for
as synthetically created foreign-currency-denominated debt to be
designated as a hedge of the entity’s net investment in a foreign
operation.
55-50 For example, a parent entity that has the U.S. dollar (USD)
as its functional and reporting currency has a net investment in a
Japanese yen- (JPY-) functional-currency subsidiary. The parent borrows
in euros (EUR) on a fixed-rate basis and simultaneously enters into a
receive-EUR, pay-Japanese yen currency swap (for all interest and
principal payments) to synthetically convert the borrowing into a
yen-denominated borrowing. The parent entity cannot designate the
EUR-denominated borrowing and the currency swap in combination as a
hedging instrument for its net investment in the JPY-functional-currency
subsidiary.
5.4.2 Accounting for a Net Investment Hedge
ASC 815-35
35-1 The gain
or loss on a hedging derivative instrument (or the
foreign currency transaction gain or loss on the
nonderivative hedging instrument) that is designated as,
and is effective as, an economic hedge of the net
investment in a foreign operation shall be reported in
the same manner as a translation adjustment (that is,
reported in the cumulative translation adjustment
section of other comprehensive income).
35-2 The
hedged net investment shall be accounted for consistent
with Topic 830. The provisions of Subtopic 815-25 for
recognizing the gain or loss on assets designated as
being hedged in a fair value hedge do not apply to the
hedge of a net investment in a foreign operation.
As in a cash flow hedging relationship, the hedged item is not adjusted in a net
investment hedging relationship. The gain or loss on the hedging instrument in a
qualifying net investment hedging relationship is reported in the CTA component
of OCI in a manner consistent with the translation of the net investment under
AC 830. There are two circumstances that result in a modification to this model:
-
An entity designates a derivative as the hedging instrument in a qualifying net investment hedging relationship and assesses the effectiveness of the hedging relationship under the spot method (see Section 5.4.2.1.1.1).
-
An entity elects to hedge on an after-tax basis (see Section 5.4.2.2).
5.4.2.1 Differences in Methods of Assessing Effectiveness
ASC 815-35
35-4 If a derivative
instrument is used as the hedging instrument, an
entity may assess the effectiveness of a net
investment hedge using either a method based on
changes in spot exchange rates (as specified in
paragraphs 815-35-35-5 through 35-15) or a meth-od
based on changes in forward exchange rates (as
specified in paragraphs 815-35-35-17 through 35-26).
This guidance can also be applied to purchased
options used as hedging instruments in a net
investment hedge. However, an entity shall
consistently use the same method for all its net
investment hedges in which the hedging instrument is
a derivative instrument; use of the spot method for
some net investment hedges and the forward method
for other net investment hedges is not permitted. An
entity may change the method that it chooses to
assess the effectiveness of its net investment
hedges in accordance with paragraphs 815-20-55-55
through 55-56A.
Section 2.5.2.1.2.5 discusses the two
different methods for assessing the effectiveness of a net investment
hedging relationship. The table below summarizes the different types of
hedging instruments and the effectiveness assessment methods available for
each type of instrument.
Hedging Instrument
|
Effectiveness Assessment Methods
|
---|---|
Nonderivative instrument
|
Spot method
|
Derivative instrument
|
Spot method or forward method
|
As indicated in ASC 815-35-35-4, an entity must “consistently use the same
method for all its net investment hedges in which the hedging instrument is
a derivative instrument.” It is not permitted to “use . . . the spot method
for some net investment hedges and the forward method for other net
investment hedges.” For most entities, the selection of an assessment method
is driven by the difference in the accounting for the relationships under
each method. These differences are described in Sections
5.4.2.1.1 (the spot method) and
5.4.2.1.2 (the forward method).
ASC 815-35-35-4 also notes that an “entity may change the method that it
chooses to assess the effectiveness of its net investment hedges in
accordance with paragraphs 815-20-55-55 through 55-56A.” However, in a
manner consistent with the overall guidance for changing assessment methods
(see Section 2.5.4), a change in methods:
-
May only be done if the entity can demonstrate that the new method of assessing effectiveness is an “improved method,” in accordance with ASC 815-20-35-19 and ASC 815-20-55-56.
-
Would apply to all net investment hedging relationships in which the hedging instrument is a derivative.
-
Would be accomplished for any outstanding hedging relationship by dedesignating the original hedging relationship and then designating a new hedging relationship.
ASC 815-20-55-56 notes that the requirement to demonstrate that the new
method of assessing effectiveness is an “improved method” does not mean that
the new method must be deemed “preferable” under ASC 250; however, once an
entity switches from one method to the other and asserts that the new method
is “improved,” it would most likely be unable to switch back to its original
method of assessing hedge effectiveness at a later date because it would be
difficult to support an argument that the original method has reverted to
being an “improved” method.
5.4.2.1.1 The Spot Method
5.4.2.1.1.1 Hedging Instrument Is a Derivative
ASC 815-35
Hedging Instrument Is a Derivative
Instrument
35-5A An entity shall
recognize in earnings the initial value of the
component excluded from the assessment of
effectiveness using a systematic and rational
method over the life of the hedging instrument.
Any difference between the change in fair value of
the excluded component and amounts recognized in
earnings under that systematic and rational method
shall be recognized in the same manner as a
translation adjustment (that is, reported in the
cumulative translation adjustment section of other
comprehensive income).
35-5B An entity
alternatively may elect to record changes in the
fair value of the excluded component currently in
earnings. This election shall be applied
consistently to similar hedges in accordance with
paragraph 815-20-25-81.
35-6 The interest accrual
(periodic cash settlement) components of
qualifying receive-variable-rate,
pay-variable-rate and receive-fixed rate,
pay-fixed-rate cross-currency interest rate swaps
shall also be reported directly in earnings.
35-7 The change in fair
value of the derivative instrument attributable to
changes in the spot rate shall be reported in the
same manner as a translation adjustment (that is,
reported in the cumulative translation adjustment
section of other comprehensive income).
If an entity designates a derivative instrument in a hedge of a net
investment in foreign operations and elects to assess hedge
effectiveness under the spot method, it must recognize the excluded
component’s initial value in earnings over the life of the hedging
relationship in a manner similar to any other relationship in which
components are excluded from the effectiveness assessment. The
default treatment under ASC 815 is to recognize the initial value of
the excluded component in earnings by using a systematic and
rational method. Alternatively, as noted in ASC 815-35-35-5B, an
entity may elect to record the changes in the excluded component’s
fair value currently in earnings.
ASC 815-35-35-6 notes that the “interest accrual (periodic cash
settlement) components of qualifying receive-variable-rate,
pay-variable-rate and receive-fixed rate, pay-fixed-rate
cross-currency interest rate swaps shall also be reported directly
in earnings.”
If an entity designates an at-market cross-currency interest rate
swap (i.e., its fair value is zero) with standard terms as the
hedging instrument and recognizes the periodic interest accruals in
earnings, there are no other excludable components to recognize in
earnings. A standard cross-currency interest rate swap has the
following terms:
-
The exchange of currencies at inception and the return of those same amounts upon final settlement of the swap are based on the spot exchange rate at the inception of the derivative.
-
The periodic interest accruals are calculated in the same manner for each settlement:
-
For a fixed-for-fixed swap, each leg has the same fixed rate for the life of the swap.
-
For a variable-for-variable swap:
-
Each leg has the same contractually specified rate over the life of the swap.
-
Any fixed spread added to a leg of the swap is the same fixed spread over the life of the swap.
-
The contractually specified interest rates for both legs are based on comparable interest rate curves (e.g., three-month LIBOR and three-month commercial paper rates are not considered comparable under ASC 815-35-35-18(b)).
-
-
5.4.2.1.1.1.1 Hedging With Derivatives That Are Off-Market or Have Nonstandard Terms
The designation of a derivative that is off-market (i.e., its
fair value is other than zero at hedge inception) or has other
than standard terms (see Section
5.4.2.1.1.1) as a hedging instrument in a net
investment hedge raises other accounting issues. Such a
situation may arise when an entity designates (1) a preexisting
cross-currency interest rate swap instead of a new at-market
cross-currency interest rate swap or (2) a cross-currency
interest rate swap that is highly structured. If a net
investment hedging relationship includes an off-market
derivative, an entity must consider the derivative’s initial
fair value as representing an in-substance financing that must
be factored into the accounting for the new hedging
relationship.
For example, if a fixed-for-fixed cross-currency interest rate
swap has a fair value of $1 million (an asset) at the time of
designation, that initial fair value indicates that the entity
will either receive $1 million more or pay $1 million less (on a
present value basis) than it would have if it had designated an
at-market swap as the hedging instrument at hedge inception. As
a result of this implicit financing element, there is an
additional excluded component (other than the forward points and
the cross-currency basis spread) that the entity must amortize
into earnings, which is essentially the “interest” on the
financing element of the swap.
In a public FASB meeting on February 14,
2018, the staff indicated that when the hedging instrument in a
net investment hedge (in which effectiveness is assessed by
using the spot method) is a cross-currency interest rate swap
that is off-market at hedge inception, an entity should amortize
the excluded component in a manner that would not violate the
guidance in ASC 815-35-35-6 and 35-7. The FASB staff clarified
that “at the end of the hedging relationship, only amounts of
the swap related to spot changes on the notional amount of the
net investment [that occurred during the life of the hedge]
should remain in” the CTA. Such amounts would be computed as the
product of (1) the notional amount and (2) the difference
between the market-based foreign currency spot exchange rates at
hedge maturity and hedge inception. Therefore, an entity can
apply any systematic and rational amortization approach in which
the off-market amount of the swap would equal zero at the end of
the hedging relationship. The staff cautioned, however, that any
structuring of the designated hedging cross-currency swap
designed to “achieve a specific accounting result [would not be]
considered rational in the context of a systematic and rational
approach.” The Board agreed with the staff’s conclusions.
To ensure that the off-market amount of a swap is amortized to
zero by the end of the hedging relationship, an entity may be
able to use one the following amortization methods (not all-inclusive):
-
At hedge inception, compute the time value or basis spread component of the fair value of the swap as the difference between its full fair value and its intrinsic value (the intrinsic value would be computed as the notional amount multiplied by the difference between the foreign currency spot exchange rates at (1) hedge inception and (2) the inception of the actual swap contract). Over the life of the hedging swap, amortize that time value component into earnings on a straight-line basis and recognize the interest settlements on the actual off-market swap in income each period.
-
Determine what the interest settlements would be for a hypothetical swap that has a fair value of zero at hedge inception2 and use those amounts as the basis for amortizing the initial value of the excluded component (attributable to the forward points and the cross-currency basis spread) out of CTA and into earnings in each period. In addition, the entity would separately determine the amount of “interest” on the implicit financing component3 and amortize that amount into earnings over the life of the hedging instrument on either a straight-line basis or by using an effective interest method.
As indicated above, the FASB staff noted that when an entity
chooses its amortization method for the excluded component of a
hedging instrument that is off-market at hedge inception, it
must be mindful that any structuring of the designated
cross-currency swap designed to achieve a specific accounting
result would not be considered a rational method of amortization
in the context of the systematic and rational amortization
approach required under ASC 815-35-35-5A. The amortization
method described in the first bullet above is more likely to be
susceptible to inappropriate structuring than the method
described in the second bullet; therefore, entities using the
method in the first bullet should closely review the terms of
the hedging swap to ensure that those terms would result in a
rational amortization pattern.
For example, a cross-currency interest rate swap could be
structured so that the rates earlier in the swap are
below-market and the rates later in the swap are above-market,
which would also represent an in-substance financing
arrangement.
5.4.2.1.1.1.2 Income Statement Classification
ASC 815-35 is silent on the income statement classification of amounts related to excluded components of the derivative that are recognized in earnings in connection with a hedging relationship in which the spot method is used. We believe that the FASB intended to allow entities to continue the practice they had used before the issuance of FASB Statement 133. In many cases, entities had viewed
the “cost or income” of derivatives related to foreign currency
hedging as a financing cost, so they had recognized such amounts,
whether positive or negative, in interest expense. For many
entities, the decision to recognize such costs in interest expense
was also driven by the fact that they may also have issued
foreign-currency-denominated debt to finance the foreign operations.
We believe that an entity should establish a reasonable,
consistently applied income statement classification policy and
disclose that policy in its financial statements.
See Examples 5-18 and
5-19 for detailed illustrations of the application
of the spot method to a net investment hedge involving a forward
contract and Example 5-21 for an illustration of the application
of the spot method to a net investment hedge involving a
cross-currency interest rate swap.
5.4.2.1.1.2 Hedging Instrument Is a Nonderivative Instrument
ASC 815-35
Hedging Instrument Is Not a Derivative
Instrument
35-12 The
translation gain or loss determined under Subtopic
830-30 by reference to the spot exchange rate
between the transaction currency of the debt and
the functional currency of the investor (after tax
effects, if appropriate) shall be reported in the
same manner as the translation adjustment
associated with the hedged net investment (that
is, reported in the cumulative translation
adjustment section of other comprehensive income)
if both of the following conditions are met:
-
The notional amount of the nonderivative instrument matches the portion of the net investment designated as being hedged.
-
The nonderivative instrument is denominated in the functional currency of the hedged net investment.
In that circumstance, the hedging relationship
would be considered perfectly effective, and no
prospective quantitative effectiveness assessment
is required at hedge inception (see paragraph
815-20-25-3(b)(2)(iv)(01)).
If an entity designates a nonderivative instrument as the hedging
instrument in a qualifying net investment hedge, it must apply the spot
method because the hedging instrument is remeasured at spot rates in
accordance with ASC 830-20. ASC 815-35-35-12 states, in part, that if
the “notional amount of the nonderivative instrument matches the portion
of the net investment . . . being hedged” and “is denominated in the
[same] functional currency” as the net investment, the translation gain
or loss on the nonderivative instrument is recognized in a CTA along
with the translation adjustment associated with the net investment. We
believe that even in situations in which one of the two conditions in
ASC 815-35-35-12 is not met, as long as the hedging relationship
qualifies for hedge accounting, the entire translation gain or loss on
the nonderivative instrument is recognized in a CTA in a manner
consistent with the guidance in ASC 815-35-35-1.
In some cases, a nonderivative instrument is both the hedging instrument
in a net investment hedge and the hedged item in a fair value hedge. For
example, an entity may designate a pay-variable, receive-fixed interest
rate swap as a fair value hedge of foreign-currency-denominated
fixed-rate debt for changes in its fair value that are attributable to
changes in the benchmark interest rate. As a result of the fair value
hedge, the carrying amount of the debt will be adjusted for changes in
its fair value that are attributable to changes in the designated
benchmark interest rate. This debt may also be the hedging instrument in
a hedge of a net investment in foreign operations.
Changing Lanes
In its November 2019 proposed
ASU of Codification improvements to hedge
accounting, the FASB proposed to eliminate the recognition and
presentation mismatch related to these “dual hedges” (described
above) that results from adjusting the carrying amount of the
debt in a fair value hedge.
At the October 11, 2023, FASB meeting, the Board decided to
affirm the proposed amendments to eliminate the recognition and
presentation mismatch related to dual hedges. Under the proposed
amendments, an entity would eliminate that mismatch by excluding
the foreign-currency-denominated debt instrument’s fair value
hedge basis adjustment from the net investment hedge
effectiveness assessment. As a result, an entity would
immediately recognize the gains and losses from the
remeasurement of the debt instrument’s fair value hedge basis
adjustment at the spot exchange rate in earnings. Entities would
be prohibited from applying this guidance by analogy to other
circumstances.
5.4.2.1.2 The Forward Method
ASC 815-35
35-17 Under a method based
on changes in forward exchange rates, an entity
shall report all changes in fair value of the
derivative instrument in the same manner as a
translation adjustment (that is, reported in the
cumulative translation adjustment section of other
comprehensive income), including the following
amounts:
-
The time value component of purchased options
-
The interest accrual/periodic cash settlement components of qualifying receive-variable-rate, pay-variable-rate and receive-fixed-rate, pay-fixed-rate cross-currency interest rate swaps.
Under the forward method, an entity would report all
changes in the derivative instrument’s fair value in the CTA portion of
OCI for a qualifying net investment hedging relationship. See Example 5-17 for
a detailed illustration of a forward contract hedging a net investment
in foreign operations under the forward method and Example 5-20 for
a detailed illustration of a fixed-for-fixed cross-currency interest
rate swap hedging a net investment in foreign operations under the
forward method.
5.4.2.2 Hedging on an After-Tax Basis
ASC 815-35
35-3 If an entity has
designated and documented that it will assess
effectiveness and measure hedge results on an
after-tax basis as permitted by paragraph
815-20-25-3(b)(2)(vi), the portion of the gain or
loss on the hedging instrument that exceeded the
loss or gain on the hedged item shall be included as
an offset to the related tax effects in the period
in which those tax effects are recognized.
As indicated in ASC 815-35-35-3, if an entity has designated and documented
that it will be hedging on an after-tax basis, as permitted by ASC
815-20-25-3(b)(2)(vi), “the portion of the gain or loss on the hedging
instrument that [exceeds] the loss or gain” from translating the net
investment is recognized as an offset to the related tax effects in the
period in which those tax effects are recognized. See Section 5.1.3 for further discussion of
hedging on an after-tax basis.
5.4.3 Discontinuing a Net Investment Hedge
Gains and losses on the hedging instrument that are recorded in the CTA portion
of OCI are treated consistently with all other amounts in the CTA related to a
net investment in foreign operations. ASC 830-30 includes guidance on the
circumstances under which a CTA may be released, including scenarios involving
(1) full and substantially complete liquidations and (2) partial sales and
liquidations. See Section 5.4 of
Deloitte’s Roadmap Foreign Currency
Matters.
ASC 815-35
40-1 When applying the
guidance in paragraph 815-35-35-5A and a hedge is
discontinued, any amounts that have not yet been
recognized in earnings shall remain in the cumulative
translation adjustment section of accumulated other
comprehensive income until the hedged net investment is
sold or liquidated in accordance with paragraphs
830-30-40-1 through 40-1A.
In accordance with ASC 815-35-40-1, if an entity discontinues a hedging
relationship in which a derivative was the hedging instrument and the spot
method was applied, any amounts that were recognized in the CTA related to
excluded components that have not yet been recognized in earnings should remain
in the CTA.
We do not believe that it would be appropriate for an entity to effectively
“freeze” amounts in CTA that are related to excluded components by dedesignating
a hedging relationship and immediately redesignating it in exactly the same
manner with the same hedging instrument and hedged net investment in foreign
operations.
As discussed in Section 2.5.2.2.4, because
of the nature of the hedged item, the process for periodically monitoring a net
investment hedging relationship is a bit unique. The balance of an entity’s net
investment in foreign operations is subject to change in each reporting period
on the basis of (1) the operating results of the investee and (2) capital
transactions between the entity and the investee (dividends, etc.). Accordingly,
the entity should continually assess the balance of the net investment to ensure
that it is not overhedged before the start of a reporting period (i.e., when it
would be performing the prospective assessment for the upcoming period). If the
balance of the net investment drops below the amounts designated as the hedged
item, the entity would need to consider the one of following alternatives:
-
Dedesignate the proportion of the hedging relationship related to the “shortfall” of the net investment.4 Any portion of the hedging instrument that is no longer in the net investment hedge could potentially be (1) designated in a new hedging relationship or (2) simply reported at fair value in subsequent periods, with changes in fair value recognized in earnings.
-
Dedesignate the entire hedging relationship and redesignate a new one. The entity would need to identify a different notional amount for the hedged net investment because the amount of the hedged item cannot exceed the balance of the net investment. As discussed in Section 2.5.2.2.4, an entity could purposely overhedge the net investment, but the new hedging relationship would need to be highly effective and the entity could not assume perfect effectiveness.
-
Dedesignate the entire hedging relationship and consider whether to either designate the hedging instrument in a new hedging relationship or simply report it at fair value in subsequent periods, with changes in fair value recognized in earnings.
5.4.4 Illustrative Examples
Example 5-17
Forward Contract Hedging a Net Investment in Foreign
Operations (Forward Method)
SimpleBand, a U.S. multinational company, has a wholly
owned German subsidiary, Skyscraper Co., with a euro
functional currency. SimpleBand’s investment in
Skyscraper Co. is EUR 10 million. In accordance with ASC
830, SimpleBand records the translation adjustments
related to its German subsidiary in the CTA component of
OCI.
On June 30, 20X0, SimpleBand enters into a six-month
forward contract to sell EUR 10 million for USD
11,772,000 (a EUR/USD forward rate of 1.1772). The
EUR/USD spot exchange rate on June 30, 20X0, is 1.1667.
SimpleBand designates the forward contract as a hedge of
the foreign currency exposure of its net investment in
Skyscraper Co.
SimpleBand elects to apply the forward method to assess
the effectiveness of the hedge. The hedging relationship
is considered to be perfectly effective under ASC
815-35-35-17A because:
-
The notional amount of the forward matches the portion of the net investment designated as being hedged.
-
The underlying of the forward (EUR/USD) is related solely to the foreign exchange rate between the functional currency of Skyscraper Co. (EUR) and the functional currency of SimpleBand (USD).
For this example, assume that the net investment in
Skyscraper Co. does not decline below EUR 10 million.
Skyscraper Co. records the following journal
entries:
June 30, 20X1
No entry is required. The forward contract is
at-the-money.
September 30, 20X1
The table below shows (1) the three-month EUR/USD forward
rate as of September 30, 20X1, (2) the forward
contract’s fair values at the beginning and end of the
period, and (3) the change in the forward contract’s
fair value.
The table below shows (1) the EUR/USD spot exchange rates
at beginning and end of the period and (2) the related
CTA for Skyscraper Co. in accordance with ASC 830.
The journal entries are as follows:
December 31, 20X1
The table below shows (1) the EUR/USD
spot exchange rate as of December 31, 20X1, (2) the
forward contract’s fair values at the beginning and end
of the period, and (3) the change in the forward
contract’s fair value.
The table below shows (1) the EUR/USD spot exchange rates
at the beginning and end of the period and (2) the
related CTA for Skyscraper Co. in accordance with ASC
830.
The journal entries are as follows:
Example 5-18
Forward Contract Hedging a Net Investment in Foreign
Operations (Spot Method — Systematic and Rational
Amortization)
Assume the same facts as in Example
5-17, except that SimpleBand elects to
assess the effectiveness of the hedging relationship by
using the spot method. The hedging relationship is
considered to be perfectly effective under ASC
815-35-35-5 because:
-
The notional amount of the forward matches the portion of the net investment designated that is being hedged.
-
The underlying of the forward (EUR/USD) is related solely to the foreign exchange rate between the functional currency of Skyscraper Co. (EUR) and the functional currency of SimpleBand (USD).
SimpleBand elects to recognize the initial value of the
excluded component (the forward/spot difference) in
earnings over the life of the hedging relationship in a
systematic and rational basis. It has a consistently
applied policy of recognizing the earnings effect of the
excluded components of derivatives related to net
investment hedges in interest expense because it views
those components as a financing cost of the derivatives.
The calculation of the excluded component’s initial value
(i.e., the difference between the forward and spot
rates) is as follows:
For this example, assume that the net investment in
Skyscraper Co. does not decline below EUR 10 million.
Skyscraper Co. records the following journal
entries:
June 30, 20X1
No entry is required. The forward contract is
at-the-money.
September 30, 20X1
The table below shows (1) the three-month EUR/USD forward
rate as of September 30, 20X1, (2) the forward
contract’s fair values at the beginning and end of the
period, and (3) the change in the forward’s fair
value.
The table below shows (1) the EUR/USD spot exchange rates
at the beginning and end of the period and (2) the
related CTA for Skyscraper Co. in accordance with ASC
830.
The journal entries are as follows:
December 31, 20X1
The table below shows (1) the EUR/USD spot exchange rate
as of December 31, 20X1, (2) the forward contract’s fair
values at the beginning and end of the period, and (3)
the change in the forward’s fair value.
The table below shows (1) the EUR/USD spot exchange rates
at the beginning and end of the period and (2) the
related CTA for Skyscraper Co. in accordance with ASC
830.
The journal entries are as follows:
Example 5-19
Forward Contract Hedging a Net Investment in Foreign
Operations (Spot Method — Change in the Fair Value
of Excluded Components in Earnings)
Assume the same facts as in Example 5-18, except
that SimpleBand elects to assess the effectiveness of
the hedging relationship by using the spot method and
recognizes the changes in the excluded component’s fair
value (the forward/spot difference) in current earnings,
as allowed by ASC 815-35-35-5B. SimpleBand has a
consistently applied policy of recognizing the earnings
effect of the excluded components of derivatives related
to net investment hedges in interest expense because it
views those components as a financing cost of the
derivatives.
For this example, assume that the net investment in
Skyscraper Co. does not decline below EUR 10 million.
Skyscraper Co. records the following journal
entries:
June 30, 20X1
No entry is required. The forward contract is
at-the-money.
September 30, 20X1
The table below shows (1) the three-month EUR/USD forward
rate as of September 30, 20X1, (2) the forward
contract’s fair values at the beginning and end of the
period, and (3) the change in the forward contract’s
fair value.
The table below shows (1) the EUR/USD spot exchange rates
at the beginning and end of the period and (2) the
related CTA for Skyscraper Co. in accordance with ASC
830.
The journal entries are as follows:
December 31, 20X1
The table below shows (1) the EUR/USD spot exchange rate
as of December 31, 20X1, (2) the forward contract’s fair
values at the beginning and end of the period, and (3)
the change in the forward contract’s fair value.
The table below shows (1) the EUR/USD spot exchange rates
at the beginning and end of the period and (2) the
related CTA for Skyscraper Co. in accordance with ASC
830.
The journal entries are as follows:
Example 5-20
Fixed-for-Fixed Cross-Currency Interest Rate Swap
Hedging Net Investment in Foreign Operations
(Forward Method)
TreyCo wishes to hedge its exposure to
changes in its SEK 50 million net investment in its
foreign subsidiary (Kasvot) that are attributable to
changes in the USD/SEK foreign currency exchange rate.
On March 5, 20X6, TreyCo enters into a fixed-for-fixed
cross-currency interest rate swap to hedge that risk.
The terms of the cross-currency interest rate swap are
as follows:
-
Pay leg — SEK 50 million notional at a rate of 1.75 percent per annum.
-
Receive leg — USD 55,025,000 notional at a rate of 3.4 percent per annum.
-
Quarterly periodic settlements beginning March 31, 20X6.
-
Initial exchange — TreyCo receives SEK 50 million and pays USD 55,025,000.
-
Final exchange — TreyCo receives USD 55,025,000 and pays SEK 50 million.
-
Maturity date — September 30, 20X7.
TreyCo designates the cross-currency interest rate swap
as a hedge of SEK 50 million of the beginning balance of
its net investment in Kasvot and elects to assess the
effectiveness of the hedging relationship by using the
forward method. TreyCo may assume that the hedge is
perfectly effective under ASC 815-35-35-17A because:
-
The swap’s notional amount matches the amount of the net investment being hedged.
-
The swap’s underlying is related solely to the foreign currency exchange rate between the functional currency of the parent (USD) and the functional currency of the hedged subsidiary (SEK).
For this example, assume that the net investment in
Kasvot does not decline below SEK 50 million.
Below is a table of key assumptions.
TreyCo would record the following journal entries for
each reporting period to account for the hedge and the
translation of its net investment in Kasvot:
March 31, 20X6
Translation of the foreign subsidiary is not required
because the spot rate has not changed.
June 30, 20X6
September 30, 20X6
December 31, 20X6
March 31, 20X7
June 30,
20X7
September 30,
20X7
Example 5-21
Fixed-for-Fixed Cross-Currency Interest Rate Swap
Hedging Net Investment in Foreign Operations (Spot
Method)
Assume the same facts as in Example 5-20, except
that TreyCo elects to assess the effectiveness of the
hedging relationship by using the spot method. Because
the swap is an at-market swap with standard terms, there
are no excluded components to recognize in earnings
separately from the periodic settlements. TreyCo has a
consistently applied policy of recognizing the earnings
effect of the excluded components of derivatives related
to net investment hedges in interest expense because it
views those components as a financing cost of the
derivatives.
TreyCo may assume that the hedge is perfectly effective
under ASC 815-35-35-5 because:
-
The swap’s notional amount matches the amount of the net investment being hedged.
-
The swap’s underlying is related solely to the foreign currency exchange rate between the functional currency of the parent (USD) and the functional currency of the hedged subsidiary (SEK).
For this example, assume that the net investment in
Kasvot does not decline below SEK 50 million.
Below is a table of key assumptions.
TreyCo would record the following journal entries for
each reporting period to account for the hedge and the
translation of its net investment in Kasvot:
March 31, 20X6
Translation of the foreign subsidiary is not required
because the spot rate has not changed.
June 30, 20X6
September 30, 20X6
December 31, 20X6
March 31, 20X7
June 30, 20X7
September 30, 20X7
Footnotes
2
The terms of the hypothetical derivative should
reflect those of a receive-fixed-rate,
pay-fixed-rate cross-currency interest rate swap
that has (1) a fair value of zero at hedge
inception and (2) terms (other than the notional
amount and fixed interest rate on the leg whose
interest payments are not denominated in the
functional currency of the designated hedged net
investment) that match those of the actual hedging
derivative (e.g., maturity date, repricing, and
payment frequencies of any interim settlements).
Furthermore, the notional amount of the leg of the
hypothetical swap denominated in the functional
currency of the net investment being hedged should
match the amount of that hedged net investment.
The notional amount of the leg that matches the
hedging entity’s functional currency would be set
by converting the foreign-currency-denominated leg
on the basis of the current foreign exchange rate
(i.e., the spot foreign currency exchange rate at
hedge inception). The interest rate on the
functional currency leg would then be set at
whatever rate results in the swap’s having a fair
value of zero at inception of the hypothetical
derivative.
3
This element can be determined by looking at
the difference between the payments on the
off-market (actual) swap and the payments on the
at-market (hypothetical) swap. The difference
between the fair value of the swap and the
undiscounted “extra” payments is the interest
element that would be amortized out of CTA on a
systematic and rational basis in a manner
consistent with the treatment of other excluded
components under the amortization approach.
4
See Sections 3.5.1.3.1 and
4.1.5.1.3.1 for a discussion of partial
dedesignations for fair value hedges and cash flow hedges.
The concepts are similar for a net investment hedge, as
supported by ASC 815-35-55-1.
Chapter 6 — Presentation and Disclosures
Chapter 6 — Presentation and Disclosures
6.1 Overview
This chapter discusses financial statement presentation and
disclosure matters related to hedging activities, including the use of derivatives
in risk mitigation activities to which hedge accounting is not applied. However, in
line with the topic of this Roadmap, the chapter is mainly focused on the
presentation and disclosure of hedging instruments and hedged items. In some
instances, we discuss presentation and disclosure requirements that are broadly
applicable to all derivatives to provide a bit more context related to hedging
activities. For comprehensive discussion of financial statement presentation and
disclosure matters related to derivatives not designated in qualifying hedging
relationships, see Chapter 7 of Deloitte’s
Roadmap Derivatives.
6.2 Balance Sheet
ASC 815-10
25-1 An entity
shall recognize all of its derivative instruments in its
statement of financial position as either assets or
liabilities depending on the rights or obligations under the
contracts.
30-1 All
derivative instruments shall be measured initially at fair
value.
35-1 All
derivative instruments shall be measured subsequently at
fair value.
Derivatives within the scope of ASC 815 must be (1) recognized on the balance sheet
as assets or liabilities and (2) measured at fair value in each reporting period.
The application of hedge accounting does not affect the recognition of derivatives
as assets or liabilities. Also, as noted in Sections
5.2.3.1 and 5.4.2.1.1.2, in the
limited circumstances in which a foreign-currency-denominated asset or liability
qualifies as the hedging instrument in a foreign currency hedge, the hedging
instrument is still subject to the measurement and reporting provisions of ASC
830.
6.2.1 Balance Sheet Offsetting
6.2.1.1 Conditions for Offsetting Derivatives
ASC 815-10
45-1 Subtopic 210-20
establishes the criteria for offsetting amounts in
the balance sheet.
As noted in ASC 815-10-45-1, “the criteria for offsetting
amounts in the balance sheet” are established by ASC 210-20. Specifically,
ASC 210-20-45-1 identifies four conditions that must all be met to offset
asset and liability amounts:
-
Each of two parties owes the other determinable amounts.
-
The reporting party has the right to set off the amount owed with the amount owed by the other party.
-
The reporting party intends to set off.
-
The right of setoff is enforceable at law.
6.2.1.1.1 Each of Two Parties Owes the Other Determinable Amounts
The first condition in ASC 210-20-45-1 is that each of two parties must
owe the other a determinable amount. Under this condition, the assets
and the liabilities need to involve the same two counterparties.
Example 6-1
Swaps With Several Counterparties — Which
Counterparties Qualify for Offsetting?
Cactus Co. has four interest rate swaps with the
following counterparties and respective fair values:
-
Swap 1 with Banker A — fair value of $1 million.
-
Swap 2 with Banker B — fair value of ($400,000).
-
Swap 3 with Banker C — fair value of $500,000.
-
Swap 4 with Banker A — fair value of ($700,000).
The net fair value of the four swaps is
$400,000.
Cactus Co. evaluates which of
the four swaps could qualify for offsetting on the
balance sheet. In accordance with the condition in
ASC 210-20-45-1(a), Cactus Co. cannot offset
amounts that arise from different counterparties.
Therefore, the only swaps that could potentially
qualify for offsetting would be those involving
Banker A (i.e., swaps 1 and 4). As long as the
other criteria in ASC 210-20-45-1 and ASC
815-10-45-5 are met for swaps 1 and 4, Cactus Co.
could record a derivative asset for $300,000,
representing its net relationship with Banker
A.
6.2.1.1.2 Right to Set Off
The second condition in ASC 210-20-45-1 is that the reporting entity must
have “the right to set off the amount owed with the amount owed by the
other party.” ASC 210-20-20 defines the right of setoff as “a debtor’s
legal right, by contract or otherwise, to discharge all or a portion of
the debt owed to another party by applying against the debt an amount
that the other party owes to the debtor.” In many cases, derivative
instruments may be subject to a master netting arrangement, which is
described as follows in ASC 815-10-45-5:
A master netting arrangement exists if the reporting entity has
multiple contracts, whether for the same type of derivative
instrument or for different types of derivative instruments,
with a single counterparty that are subject to a contractual
agreement that provides for the net settlement of all contracts
through a single payment in a single currency in the event of
default on or termination of any one contract.
6.2.1.1.3 Intent to Set Off
The third condition in ASC 210-20-45-1 is that the reporting entity must
have the intent to exercise its “right to set off the amount owed with
the amount owed by the other party.” However, ASC 815-10-45-3 provides
an exception for derivatives (and associated amounts) related to the
intent to set off.
ASC 815-10
45-3 The following
guidance addresses offsetting certain amounts
related to derivative instruments. For purposes of
this guidance, derivative instruments include
those that meet the definition of a derivative
instrument but are not included in the scope of
this Subtopic.
45-4 Paragraph superseded
by Accounting Standards Update No. 2018-09.
45-5 In accordance with
paragraph 210-20-45-1, but without regard to the
condition in paragraph 210-20-45-1(c), a reporting
entity may offset fair value amounts recognized
for derivative instruments and fair value amounts
recognized for the right to reclaim cash
collateral (a receivable) or the obligation to
return cash collateral (a payable) arising from
derivative instrument(s) recognized at fair value
executed with the same counterparty under a master
netting arrangement. Solely as it relates to the
right to reclaim cash collateral or the obligation
to return cash collateral, fair value amounts
include amounts that approximate fair value. The
preceding sentence shall not be analogized to for
any other asset or liability. The fair value
recognized for some contracts may include an
accrual component for the periodic unconditional
receivables and payables that result from the
contract; the accrual component included therein
may also be offset for contracts executed with the
same counterparty under a master netting
arrangement. A master netting arrangement exists
if the reporting entity has multiple contracts,
whether for the same type of derivative instrument
or for different types of derivative instruments,
with a single counterparty that are subject to a
contractual agreement that provides for the net
settlement of all contracts through a single
payment in a single currency in the event of
default on or termination of any one contract.
45-6 A reporting entity
shall make an accounting policy decision to offset
fair value amounts pursuant to the preceding
paragraph. The reporting entity’s choice to offset
or not must be applied consistently. A reporting
entity shall not offset fair value amounts
recognized for derivative instruments without
offsetting fair value amounts recognized for the
right to reclaim cash collateral or the obligation
to return cash collateral. A reporting entity that
makes an accounting policy decision to offset fair
value amounts recognized for derivative
instruments pursuant to the preceding paragraph
but determines that the amount recognized for the
right to reclaim cash collateral or the obligation
to return cash collateral is not a fair value
amount shall continue to offset the derivative
instruments.
45-7 A reporting entity
that has made an accounting policy decision to
offset fair value amounts is not permitted to
offset amounts recognized for the right to reclaim
cash collateral or the obligation to return cash
collateral against net derivative instrument
positions if those amounts either:
-
Were not fair value amounts
-
Arose from instruments in a master netting arrangement that are not eligible to be offset.
Under the exception in ASC 815-10-45-5, an entity does not need to
consider whether it intends to set off amounts owed under a master
netting arrangement executed with the counterparty when evaluating the
conditions for offsetting those amounts on the balance sheet. As long as
the other three conditions in ASC 210-20-45-1 are met, an entity may
elect to net the following amounts, subject to the master netting
arrangement, regardless of whether it intends to set off of its rights
and obligations:
-
Fair value amounts recognized for derivatives.
-
Fair value amounts recognized for the right to reclaim cash collateral that arises from derivatives (receivables).
-
Fair value amounts recognized for the obligation to return cash collateral arising from derivatives (payables).
-
Any accrual component of the periodic unconditional receivable and payable under the derivatives that is included in the contracts’ fair value.
As noted above, an entity may enter into multiple derivative contracts
with the same counterparty under a master netting arrangement that
provides for a single net settlement of all financial instruments
covered by the agreement in the event of default on, or termination of,
any one contract. In some cases, such arrangements may require either
entity to post collateral with the other entity, depending on which
entity is in a net asset position.
For example, under some master netting arrangements, the
entity that is not in the net asset position is required to provide cash
collateral to the entity that is in the net asset position. After
the cash collateral is posted, the entity that is not in the net asset
position has a right to reclaim the cash collateral (a receivable) and
the counterparty has an obligation to return the cash collateral (a
payable). If the other three conditions in ASC 210-20-45-1 are met, all
of the amounts could be offset on the balance sheet.
However, it is not appropriate for an entity to offset separately
recorded accrued receivables or payables against the fair value amounts
of derivative assets or liabilities and associated fair value amounts
for cash collateral receivables or payables entered into with the same
counterparty. Physically settled derivatives (e.g., forward contracts to
purchase or sell commodities or bonds) require delivery of an asset.
Upon delivery of the asset underlying the physically settled derivative,
but before the cash payment, an entity removes the derivative from its
balance sheet and records separate inventory and accrued payable
balances (see Example 6-2). Therefore, for
contracts involving multiple deliveries, an entity often has a current
payable for the latest delivery and a derivative asset or liability for
any remaining deliveries. Once a receivable or payable (other than for
cash collateral) is reported separately from its related derivative,
however, that receivable or payable can no longer be offset against
derivative assets or liabilities and associated cash collateral
receivables or payables that are carried at fair value.
For net-cash-settled derivatives (e.g., fixed-for-floating interest rate
swaps), there may be no separately recorded inventory or accrued
receivable or payable line item. Instead, the fair value of the
derivative may include an accrual component, as described in ASC 815-10-45-5:
[A] reporting entity may offset fair value amounts recognized for
derivative instruments and fair value amounts recognized for the
right to reclaim cash collateral (a receivable) or the
obligation to return cash collateral (a payable) arising from
derivative instrument(s) recognized at fair value executed with
the same counterparty under a master netting arrangement. . . .
The fair value recognized for some contracts may include an
accrual component for the periodic unconditional receivables and
payables that result from the contract; the accrual
component included therein may also be offset for
contracts executed with the same counterparty under a master
netting arrangement. [Emphasis added]
Such an accrual component may exist in the fair value of a
net-cash-settled derivative because it is common for a time lag to exist
between (1) the date on which the floating price of the contract is set
and (2) the date on which cash settlement occurs (e.g., if the contract
settlement amount is based on the price of an index established on March
31 even though the contract does not cash-settle until April 30). The
fact that the recorded fair value of a net-cash-settled derivative
contains an accrual component does not affect an entity’s ability to
offset contracts that are carried at fair value. The accrual component
is not separately reported from its related derivative.
If all the conditions in ASC 210-20-45-1 are satisfied, it still may be
possible to offset separately recorded accrued receivables and payables
against similar separately recorded payables or receivables held by the
same counterparty.
Example 6-2
Accrued Payables in Multiple-Delivery
Contract
Maize Company enters into a
derivative contract on January 1, 20X8, to buy 100
bushels of corn at $10 per bushel on both January
31, 20X8, and February 28, 20X8, for delivery to a
specified location. The contract is accounted for
at fair value. Assume that the right of setoff
exists and that Maize’s policy under ASC 210-20
and ASC 815-10-45-4 through 45-7 is to offset fair
value amounts. The market price of corn on January
1, 20X8, is $10 per bushel. From January 1, 20X8,
through January 31, 20X8, the price of corn rises
to $12 per bushel.
The table below shows the accounting for the
derivative during the first period. (For
simplicity, only the first-period effects are
shown in the table. The derivative contract has
another settlement in February 20X8, which is not
shown. The price of corn is assumed to be the same
in January 20X8 and February 20X8, and present
value is not considered in the measurement of the
derivative’s fair value.)
The table illustrates that as of January 31,
20X8, the physically settled derivative results in
a separately recorded accrued payable balance of
$1,000 for the first-period settlement, and the
remaining derivative amount represents the
derivative asset related to the delivery that will
occur in period 2. The accrued payable represents
a discrete obligation that cannot be offset
against the related derivative balance despite
Maize’s election to set off under ASC 210-20 and
ASC 815-10-45-4 through 45-7.
ASC 815-10-45-6 notes that an entity “shall make an accounting policy
decision to offset fair value amounts . . . [and the] choice to offset
or not must be applied consistently.” In addition, ASC 815-10-45-6
clarifies that an entity “shall not offset fair value amounts recognized
for derivative instruments without offsetting fair value amounts
recognized for the right to reclaim cash collateral or the obligation to
return cash collateral.” However, if an entity determines that the
amount recognized for such a cash collateral receivable or payable is
not at, or does not approximate, the fair value amount, those amounts
should not be offset against the derivatives.
6.2.1.1.4 Set Off Enforceable at Law
The last condition in ASC 210-20-45-1 that must be met to offset assets
and liabilities on the balance sheet is that the right to set off must
be legally enforceable.
6.2.1.1.5 Allocation of Fair Value for Items Subject to Master Netting Arrangement
An entity that elects to offset fair value amounts in accordance with ASC
210-20 and ASC 815-10-45-4 through 45-7 is required to offset (1) fair
value amounts recognized for derivative instruments and (2) fair value
amounts recognized for the right to reclaim cash collateral (a receivable) or the obligation to return cash collateral (a payable) arising from a derivative instrument (or instruments) recognized at fair value and “executed with the same counterparty under a master netting arrangement.” FASB Staff Position (FSP) FIN 39-1 amended the guidance in FASB Interpretation 39, which is now codified in ASC 815-10-45-4 through 45-7, to include the receivables and payables related to cash collateral. In paragraph A8 of the Background Information and Basis for Conclusions of FSP FIN 39-1, the Board made the following observation:
Master netting arrangements may include instruments that either (a) do not meet the definition of a derivative instrument or (b) meet the definition of a derivative instrument but are not recognized at fair value due to the scope exceptions in Statement 133 and other applicable GAAP. The Board agreed that
including these instruments in a master netting arrangement
would not preclude a reporting entity from offsetting fair value
amounts recognized for derivative instruments under the same
master netting arrangement as those instruments. Because this
Interpretation permits offsetting of fair value amounts
recognized for the right to reclaim cash collateral or the
obligation to return cash collateral arising from derivative
instruments recognized at fair value only, the Board agreed that
the reporting entity should determine the amount of the cash
collateral receivable or payable that can be offset against the
net derivative position using a reasonably supportable
methodology.
In paragraph A8 of FASB FSP FIN 39-1, the Board noted that a master netting arrangement also may include instruments that either (1) “do not meet the definition of a derivative instrument” (e.g., an accrued receivable or payable) or (2) “meet the definition of a derivative instrument but are not included in the scope of Statement 133 [codified
in ASC 815-10]” (e.g., normal purchases and normal sales contracts). The
Board indicated that such instruments did “not preclude a reporting
entity from offsetting fair value amounts recognized for derivative
instruments under the same master netting arrangement.” However, an
entity cannot offset a receivable or payable for the right to reclaim or
obligation to return cash collateral that is not associated with a
derivative instrument recognized at fair value. Therefore, an entity
must “determine the amount of the cash collateral receivable or payable
that can be offset against the net derivative position using a
reasonably supportable methodology.”
No one method is appropriate or preferable in all circumstances;
selecting an appropriate allocation method depends on the specific facts
and circumstances associated with the arrangement. Any method that
results in an arbitrary allocation of all cash collateral receivables or
payables — either entirely to contracts that qualify for the right of
setoff under ASC 210-20-45-1 and ASC 815-10-45-5 or entirely to
contracts that do not qualify for the right of setoff — is not
reasonable and would be inappropriate. An entity should document its
allocation method and apply that method consistently.
In addition, ASC 815-10-50-8 requires an entity that elects to offset
fair value amounts to separately disclose (1) cash collateral receivable
or payable amounts that are offset against net derivative positions and
(2) amounts for cash collateral receivables or payables under master
netting arrangements that were not offset against net derivative
positions because they were not eligible for the right of setoff (see
Section 6.6.4).
Without specific guidance on allocation, entities should develop a method
that is appropriate for the circumstances. To assess whether a proposed
method is reasonable, they should consider the following:
-
Is there an allocation formula specified in the master netting arrangement? If the master netting arrangement dictates the level of collateral that must be provided for each contract covered by the agreement on the basis of a specified formula, that formula should be used to determine the level of collateral associated with derivatives carried at fair value. If the arrangement does not explicitly describe how to calculate and allocate collateral, it may be appropriate for the entity to consult with its legal counsel to understand how the collateral arrangement works.
-
Does the master netting arrangement provide any means of determining how the collateral would be allocated if a default occurred under the arrangement?
-
If the level of collateral is negotiated between the parties to the master netting arrangement, does the negotiation history provide a basis for a reasonable allocation?
-
Would it be appropriate to allocate the collateral according to the fair value of each contract subject to the master netting arrangement? It may be reasonable to do so in certain situations (e.g., if the level of collateral is based on the total fair value of the contracts covered by the master netting arrangement), such as the following:
-
Example 1 — Assume that the fair values of the contracts covered by the master netting arrangement are as follows:In this case, the terms of the master netting arrangement require the counterparty to post collateral because the entity is in a net asset position (on the basis of the contracts’ fair value). Thus, the entity records a cash collateral payable, which is recognized at an amount that approximates fair value. Under this method, three-fifths of the cash collateral payable would be allocable to the derivative contracts and must be offset against those derivative contracts in the entity’s statement of financial position.
-
Example 2 — Assume that the fair values of the contracts covered by the master netting arrangement are as follows:In this case, the terms of the master netting arrangement require the entity to post collateral to the counterparty because the entity is in a net liability position (on the basis of the contracts’ net fair value). Thus, the entity records a cash collateral receivable, which is recognized at an amount that approximates fair value. In this example, the requirement to post cash collateral is driven entirely by the entity’s net liability position in normal purchases and normal sales contracts that do not qualify for the right of setoff under ASC 210-20-45-1 and ASC 815-10-45-5. Therefore, it would not be appropriate for the entity to allocate any of its cash collateral receivable to the derivative contracts that qualify for the right of setoff.
-
6.2.1.2 Offsetting Derivatives and Hedged Items
ASC 815-10
45-2 None of the
provisions in this Subtopic support netting a
hedging derivative’s asset (or liability) position
against the hedged liability (or asset) position in
the balance sheet.
ASC 815-10-45-2 notes that there is no specific guidance in ASC 815 that
supports netting a hedging instrument’s asset or liability position against
the hedged liability or asset in the balance sheet. The derivative and
hedged item must meet the conditions in ASC 210-20 for offsetting.
6.2.2 Classification as Current or Noncurrent
ASC Master Glossary
Current
Assets
Current assets is used to designate cash
and other assets or resources commonly identified as
those that are reasonably expected to be realized in
cash or sold or consumed during the normal operating
cycle of the business. See paragraphs 210-10-45-1
through 45-4.
Current
Liabilities
Current liabilities is used principally
to designate obligations whose liquidation is reasonably
expected to require the use of existing resources
properly classifiable as current assets, or the creation
of other current liabilities. See paragraphs 210-10-45-5
through 45-12.
ASC 815 does not include any specific guidance on classifying
derivative assets or liabilities on a classified balance sheet; however, ASC
210-10-45 provides general guidance on the classification of assets and
liabilities. The ASC master glossary specifies that current assets are “those
that are reasonably expected to be realized in cash or sold or consumed during
the normal operating cycle of the business,” and current liabilities are those
that are “reasonably expected to require the use of existing resources properly
classifiable as current assets, or the creation of other current
liabilities.”
ASC 210-10
45-3 A one-year time period
shall be used as a basis for the segregation of current
assets in cases where there are several operating cycles
occurring within a year. However, if the period of the
operating cycle is more than 12 months, as in, for
instance, the tobacco, distillery, and lumber
businesses, the longer period shall be used. If a
particular entity has no clearly defined operating
cycle, the one-year rule shall govern.
As noted in ASC 210-10-45-3, a typical operating cycle is one
year, although in some circumstances the operating cycle could be longer. The
remainder of this discussion assumes that an entity’s operating cycle is one
year.
A derivative asset or liability should be classified on the
basis of its settlement terms. If a derivative matures within a year of the
balance sheet date, it should be classified as a current asset or liability. If
(1) the counterparty to a derivative has an unconditional right to terminate or
settle the arrangement within a year of the balance sheet date and (2) the
derivative is a liability (i.e., it has a negative fair value), it should be
classified as a current liability.
In addition, if a derivative involves multiple settlements
(e.g., an interest rate swap), an entity will need to use judgment in allocating
the derivative into its current and noncurrent portions. We believe that the
fair value related to the cash flows that are required to occur within one
year of the balance sheet date would represent the current asset or
current liability portion, whereas the fair value related to the cash flows that
are required to occur after one year of the balance sheet date would
represent the noncurrent asset or liability portion. It is possible for the
current portion of a derivative to be an asset and the noncurrent portion to be
a liability, and vice versa.
6.3 Income Statement
6.3.1 Qualifying Hedging Relationships
ASC 815-20
45-1A For qualifying fair
value and cash flow hedges, an entity shall present both
of the following in earnings in the same income
statement line item that is used to present the earnings
effect of the hedged item:
-
The change in the fair value of the hedging instrument that is included in the assessment of hedge effectiveness
-
Amounts excluded from the assessment of hedge effectiveness in accordance with paragraphs 815-20-25-83A through 25-83B.
See paragraphs 815-20-55-79W through 55-79AD for related
implementation guidance.
As discussed in Section 3.1, gains and
losses on the derivative and the hedged item that are attributable to the hedged
risk in a qualifying fair value hedging relationship are recognized in earnings
and presented in the same income statement line item, which should be related to
the risk being hedged. As discussed in Section
4.1, changes in fair value attributable to components of the
hedging instrument that are included in the assessment of hedge effectiveness in
a qualifying cash flow hedging relationship are recorded in OCI. The changes in
fair value that are recorded in OCI are reclassified from AOCI into earnings
when the hedged item affects earnings and presented in earnings in the same line
item as the earnings effect of the hedged item.
In accordance with ASC 815, if the results of a qualifying hedging relationship
are recognized in earnings, they generally must be recognized in the income
statement line item related to the risk being hedged. For example, an entity
that is hedging interest payments on outstanding debt with an interest rate swap
should recognize any related gains and losses in interest expense. There are a
few exceptions to this rule, which are discussed in the next sections.
Chapters 3, 4, and 5 provide detailed
examples, many of which illustrate the income statement classification of gains
and losses related to qualifying hedging relationships.
6.3.1.1 Forecasted Transaction Will Probably Not Occur
ASC 815-20
45-1B For cash flow hedges
in which the hedged forecasted transaction is
probable of not occurring in accordance with
paragraph 815-30-40-5, this Subtopic provides no
guidance on the required income statement
classification of amounts reclassified from
accumulated other comprehensive income to
earnings.
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 are generally reclassified out
of AOCI (see Section 4.1.5.2). ASC 815
is silent on the income statement classification of such amounts in this
circumstance. 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. The 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, entities are not precluded
from deciding to do so.
6.3.1.2 Excluded Components of Net Investment Hedge
ASC 815-20
45-1C For qualifying net
investment hedges, an entity shall present in the
same income statement line item that is used to
present the earnings effect of the hedged net
investment those amounts reclassified from
accumulated other comprehensive income to earnings.
This Subtopic provides no guidance on the required
income statement classification of amounts excluded
from the assessment of effectiveness in net
investment hedges.
As discussed in Section 5.4.2.1.1.1.2,
ASC 815-35 is silent on the income statement classification of amounts
related to excluded components of the derivative that are recognized in
earnings in connection with a hedging relationship in which the spot method is used. We believe that the FASB intended to allow entities to continue the practice they had used before the issuance of Statement 133. In many cases,
entities had viewed the “cost or income” of derivatives related to foreign
currency hedging as a financing cost, so they had recognized such amounts,
whether positive or negative, in interest expense. For many entities, the
decision to recognize such costs in interest expense was also driven by the
fact that they may also have issued foreign-currency-denominated debt to
finance the foreign operations. We believe that an entity should establish a
reasonable, consistently applied income statement classification policy and
disclose that policy in its financial statements.
6.3.1.3 Hedging on an After-Tax Basis
ASC 815-20-25-3(b)(2)(vi) allows an entity to hedge foreign currency risks on
an after-tax basis. If an entity uses an after-tax hedging strategy for cash
flow or net investment hedges, the portion of the gain or loss on the
hedging instrument that exceeds the loss or gain, respectively, on the
hedged item should be included as an offset to the related tax effects in
the period in which such effects are recognized (see Section 5.1.3).
6.3.2 Economic Hedging
In an economic hedge, an entity enters into a derivative to manage a risk (e.g.,
interest rate, currency, credit, or commodity), but the relationship is not
accounted for as a hedge under ASC 815. In such cases, either (1) the hedging
relationship fails to meet the rigorous requirements for hedge accounting or (2)
the hedging entity concludes that the costs of implementing hedge accounting
outweigh the benefits and thus does not designate the derivative in a qualifying
hedging relationship.
ASC 815 is silent on classification in the income statement of gains and losses
related to derivatives that are not in qualifying hedging relationships.
Consequently, there is diversity in practice regarding the presentation of such
results.
In a speech at the 2003 AICPA Conference on Current SEC
Developments, Gregory Faucette, a professional accounting fellow in the OCA,
made extensive comments on the income statement classification of derivatives.
Mr. Faucette addressed the following topics:
-
The classification of gains and losses on derivatives used in economic hedges in multiple income statement categories.
-
The inclusion of gains and losses on derivatives used in economic hedges in inappropriate financial statement captions.
With respect to the first topic, Mr. Faucette indicated that it would be
inappropriate for an entity to present gains and losses on a nonhedging
derivative under multiple captions in its income statement. For example, an
entity should not classify separately the unrealized gains and losses on an
economic derivative under the caption “risk management activities” while
classifying realized gains and losses on the same derivative (e.g., periodic or
final cash settlements) in a separate revenue or expense line item that may be
associated with the underlying in the economic hedge. Mr. Faucette’s discussion
echoed SEC staff comments made at the September
2003 AICPA SEC Regulations Committee’s joint meeting with
the SEC staff. At that meeting, the staff cited the following examples:
-
If an insurance company purchases a derivative to economically hedge the benefits paid on equity-indexed annuity products, it should record the premium paid for the derivative, the mark-to-market adjustment, and any realized gain or loss in the same line item on the income statement, despite the fact that the derivative is an economic hedge.
-
If net interest expense or income (e.g., net cash payments) is periodically recognized for an interest rate swap that does not qualify for hedge accounting, it should be recorded in the same line item as any unrealized and realized gains or losses recognized for that instrument.
With respect to the second topic, at the 2003 AICPA Conference on Current SEC
Developments, Mr. Faucette cited the following example of inappropriate income
statement classification of the results of a derivative used as an economic hedge:
For example, a financial institution classifying in the provision for
loan losses all changes in credit derivatives used as economic hedges
would not seem appropriate given the importance of that line item to
certain credit quality analyses.
The guidance from the SEC staff clearly addresses its views on an inappropriate
classification of credit derivatives in the income statements of financial
institutions. Also, it suggests that registrants should (1) carefully consider
whether it is appropriate to classify the results of derivatives used as
economic hedges in captions that are included in the determination of operating
income and (2) document the justification for such classification.
Typically, the income statement consequences of derivatives used as economic
hedges should be classified consistently with other gains and losses on
financial instruments or in accordance with specialized industry practice, if
any. Because many companies that are not financial institutions only incur such
gains and losses infrequently, classification as other income or expense is
common.
If a company classifies the income statement impact of derivatives used as
economic hedges in captions that would be considered part of operating income,
the factors to be considered include the following:
-
Is there a clear justification for the presentation that the company has chosen? Is there a clear relationship between the derivative activity and the other transactions classified in the same income statement caption?
-
Does the company have a documented policy for its income statement presentation and is that policy consistently followed?
-
Is it remote that the changes in the fair value or cash flows of the derivative could distort trends, especially in captions that are significant to users of the registrant’s financial statements?
-
Companies should consider significant timing differences between unrealized changes in the fair values of (1) the derivative used as an economic hedge and (2) the hedged item. For example, if cash flows on the derivative will not occur for a significant period, the unrealized changes in the derivative’s fair value easily might distort an income statement caption that includes current transactions that settle in a short period.
-
Has the company fully complied with the disclosure requirements of ASC 815-10-50?
-
Has the company considered the guidance in ASC 815-10-55-62 for physically settled derivative contracts that are not held for trading purposes?
See Section 7.3 of Deloitte’s Roadmap
Derivatives for discussion of
income statement geography for derivatives not held for hedging purposes (i.e.,
not in either qualifying hedges or economic hedges).
6.4 Statement of Comprehensive Income
ASC 220-10
45-1
This Subtopic requires an entity to report comprehensive
income either in a single continuous financial statement or
in two separate but consecutive financial statements.
45-10A
Items of other comprehensive income include the following: .
. .
d. Gains and losses on derivative instruments that
are designated as, and qualify as, cash flow hedges
(see paragraph 815-20-35-1(c))
dd. For derivatives that are designated in
qualifying hedging relationships, the difference
between changes in fair value of the excluded
components and the initial value of the excluded
components recognized in earnings under a systematic
and rational method in accordance with paragraphs
815-20-25-83A and 815-35-35-5A. . . .
ASC 815-20
45-3
An entity shall display as a separate classification within
other comprehensive income the net gain or loss on
derivative instruments designated and qualifying as fair
value or cash flow hedging instruments that are reported in
comprehensive income pursuant to paragraphs 815-20-25-65,
815-20-25-83A, and 815-30-35-3.
ASC 220 requires an entity to report comprehensive income in either a single
continuous financial statement or two separate but consecutive financial statements.
Amounts recorded in OCI related to qualifying hedging relationships should be
reported in the statement of comprehensive income. Such amounts include:
-
Gains on losses on derivatives that are designated in qualifying cash flow hedging relationships.
-
Any difference between (1) the changes in the fair value of excluded components of the hedging instrument and (2) the initial value of the excluded components that is recognized in earnings under a systematic and rational method.
In accordance with ASC 220, amounts recorded in OCI should be reported net of any tax
effect.
6.5 Cash Flow Statement
See Section 7.4 of Deloitte’s Roadmap Statement of Cash Flows for a detailed
discussion of the classification of cash flows for derivatives on the statement of
cash flows.
6.6 Disclosures
The disclosure requirements of ASC 815 apply to all interim and annual reporting
periods for which a balance sheet and income statement are presented. For the
remainder of the discussion about disclosures, all references to qualifying hedging
instruments include both derivatives and nonderivative instruments that are
designated in qualifying hedging relationships. Since this Roadmap focuses on hedge
accounting, it does not discuss the disclosure requirements in ASC 815-10-50-4J
through 50-4L for entities that write credit derivatives. For information about the
disclosure requirements related to fair value measurements, see Deloitte’s Roadmap
Fair Value Measurements and Disclosures (Including
the Fair Value Option).
ASC 815-10
50-4I
If information on derivative instruments (or nonderivative
instruments that are designated and qualify as hedging
instruments pursuant to paragraphs 815-20-25-58 and
815-20-25-66) is disclosed in more than a single note to
financial statements, an entity shall cross-reference from
the derivative instruments (or nonderivative instruments)
note to other notes in which derivative-instrument-related
information is disclosed.
Disclosures about derivatives and hedging activities are not
required to be presented in a single footnote to the financial statements. However,
ASC 815-10-50-4I notes that if the disclosures required by ASC 815-10-50 are made in
more than one footnote, an entity should provide a cross-reference from the footnote
regarding the derivative instruments (or nonderivative hedging instruments) to the
other notes in which information about derivatives and hedging activities is
disclosed.
6.6.1 Qualitative Disclosures About Objectives of Derivatives
ASC 815-10
General
50-1 An entity with
derivative instruments (or nonderivative instruments
that are designated and qualify as hedging instruments
pursuant to paragraphs 815-20-25-58 and 815-20-25-66)
shall disclose information to enable users of the
financial statements to understand all of the
following:
-
How and why an entity uses derivative instruments (or such nonderivative instruments)
-
How derivative instruments (or such nonderivative instruments) and related hedged items are accounted for under Topic 815
-
How derivative instruments (or such nonderivative instruments) and related hedged items affect all of the following:
-
An entity’s financial position
-
An entity’s financial performance
-
An entity’s cash flows.
-
50-1A An entity that holds
or issues derivative instruments (or nonderivative
instruments that are designated and qualify as hedging
instruments pursuant to paragraphs 815-20-25-58 and
815-20-25-66) shall disclose all of the following for
every annual and interim reporting period for which a
statement of financial position and statement of
financial performance are presented:
-
Its objectives for holding or issuing those instruments
-
The context needed to understand those objectives
-
Its strategies for achieving those objectives
-
Information that would enable users of its financial statements to understand the volume of its activity in those instruments.
50-1B For item (d) in
paragraph 815-10-50-1A, an entity shall select the
format and the specifics of disclosures relating to its
volume of such activity that are most relevant and
practicable for its individual facts and circumstances.
Information about the instruments in items (a) through
(c) in paragraph 815-10-50-1A shall be disclosed in the
context of each instrument’s primary underlying risk
exposure (for example, interest rate, credit, foreign
exchange rate, interest rate and foreign exchange rate,
or overall price). Further, those instruments shall be
distinguished between those used for risk management
purposes and those used for other purposes. Derivative
instruments (and nonderivative instruments that are
designated and qualify as hedging instruments pursuant
to paragraphs 815-20-25-58 and 815-20-25-66) used for
risk management purposes include those designated as
hedging instruments under Subtopic 815-20 as well as
those used as economic hedges and for other purposes
related to the entity’s risk exposures.
50-2 The instruments
addressed by items (a) through (c) in paragraph
815-10-50-1A shall be distinguished between each of the
following:
-
Derivative instruments (and nonderivative instruments as noted in items (1)(i) and (1)(iii) of this paragraph) used for risk management purposes, distinguished between each of the following:
-
Derivative instruments (and nonderivative instruments) designated as hedging instruments, distinguished between each of the following:
-
Derivative instruments (and nonderivative instruments) designated as fair value hedging instruments
-
Derivative instruments designated as cash flow hedging instruments
-
Derivative instruments (and nonderivative instruments) designated as hedging instruments for hedges of the foreign currency exposure of a net investment in a foreign operation.
-
-
Derivative instruments used as economic hedges and for other purposes related to the entity’s risk exposures.
-
-
Derivative instruments used for other purposes.
50-3 If the simplified hedge
accounting approach (see paragraphs 815-20-25-133
through 25-138) is applied in accounting for a
qualifying receive-variable, pay-fixed interest rate
swap, the settlement value of that swap may be used in
place of fair value when disclosing the information
required by this Section or in providing other fair
value disclosures, such as those required under Topic
820 on fair value. For the purposes of complying with
these disclosure requirements, amounts disclosed at
settlement value will be subject to all of the same
disclosure requirements as amounts disclosed at fair
value. Any amounts disclosed at settlement value shall
be clearly stated as such and disclosed separately from
amounts disclosed at fair value.
50-4 For derivative
instruments not designated as hedging instruments under
Subtopic 815-20, the description shall indicate the
purpose of the derivative activity.
50-5 Qualitative disclosures
about an entity’s objectives and strategies for using
derivative instruments (and nonderivative instruments
that are designated and qualify as hedging instruments
pursuant to paragraphs 815-20-25-58 and 815-20-25-66)
may be more meaningful if such objectives and strategies
are described in the context of an entity’s overall risk
exposures relating to all of the following:
-
Interest rate risk
-
Foreign exchange risk
-
Commodity price risk
-
Credit risk
-
Equity price risk.
Those additional qualitative disclosures, if made, should
include a discussion of those exposures even though the
entity does not manage some of those exposures by using
derivative instruments. An entity is encouraged, but not
required, to provide such additional qualitative
disclosures about those risks and how they are
managed.
50-5A The quantitative
disclosures about derivative instruments may be more
useful, and less likely to be perceived to be out of
context or otherwise misunderstood, if similar
information is disclosed about other financial
instruments or nonfinancial assets and liabilities to
which the derivative instruments are related by
activity. Accordingly, in those situations, an entity is
encouraged, but not required, to present a more complete
picture of its activities by disclosing that
information.
An entity with derivatives or nonderivative hedging instruments should disclose
information to enable financial statement users to understand how and why it
uses derivatives (including those nonderivative instruments designated as
hedging instruments) in the context of its operations.
ASC 815-10-50-1 requires disclosures about the following:
-
How and why an entity uses derivative instruments (or . . . nonderivative [hedging] instruments)
-
How derivative instruments (or . . . nonderivative [hedging] instruments) and related hedged items are accounted for under Topic 815
-
How derivative instruments (or . . . nonderivative [hedging] instruments) and related hedged items affect all of the following:
-
An entity’s financial position [i.e., balance sheet]
-
An entity’s financial performance [i.e., comprehensive income statements]
-
An entity’s cash flows [i.e., cash flow statement].
-
In addition, ASC 815-10-50-1A requires an entity to describe in the footnotes the
objectives, context, and strategies for holding or issuing derivatives or
nonderivative hedging instruments. ASC 815-10-50-1B clarifies that this
discussion should be “in the context of each instrument’s primary underlying
risk exposure (for example, interest rate, credit, foreign exchange rate,
interest rate and foreign exchange rate, or overall price).” Such disclosures
should be broken down further between those used for “risk management purposes”
and those used for other purposes. According to ASC 815-10-50-1B, instruments
used for risk management purposes include both those designated in qualifying
hedging relationships and “those used as economic hedges and for other purposes
related to the entity’s risk exposures.”
As part of the disclosure about instruments used for risk management purposes,
ASC 815-10-50-5 requires an entity to present a separate discussion about its
objectives and strategies for using qualifying hedging instruments “in the
context of [its] overall risk exposures relating to all of the following:
-
Interest rate risk
-
Foreign exchange risk
-
Commodity price risk
-
Credit risk
-
Equity price risk.”
ASC 815-10-50-5A encourages but does not require entities to disclose “similar
information . . . about other financial instruments or nonfinancial assets and
liabilities to which the [hedging] instruments are related by activity.”
ASC 815-10-50-2 notes that the disclosures required by ASC 815-10-50-1A(a)–(c)
(i.e., related to the entity’s objectives for holding derivatives and strategies
for achieving those objectives) should be provided separately on the basis of
the entity’s purpose for holding the derivatives, broken down as follows:
-
Derivative instruments (and nonderivative [hedging] instruments . . . ) used for risk management purposes, distinguished between each of the following:
-
[Qualifying] hedging instruments, distinguished between each of the following:
-
[Those] designated as fair value hedging instruments
-
[Those] designated as cash flow hedging instruments
-
[Those] designated as [hedges] of a net investment in a foreign operation.
-
-
Derivative instruments used as economic hedges and for other purposes related to the entity’s risk exposures.
-
-
Derivative instruments used for other purposes.
ASC 815-10-50-4 requires an entity to describe the purpose of any activities
involving derivatives that are not designated in qualifying hedging
relationships. SEC registrants should be mindful that if any metrics are
reported related to economic hedging or other general risk management
activities, they must consider the guidance in the SEC’s non-GAAP measure rules
when making any adjustments. For further discussion of non-GAAP measures, see
Deloitte’s Roadmap Non-GAAP Financial Measures and
Metrics.
As indicated in ASC 815-10-50-3, if an entity is applying the simplified hedge
accounting approach (see Sections 2.5.2.2.5 and 4.2.1.1.5), the swap’s settlement value may be
used in place of its fair value for any required disclosures of fair value.
Example 20 in ASC 815-10-55-181, which is reproduced below, provides an
illustration of these disclosures as well as the fair value hedge basis
adjustment disclosures discussed in Section 6.6.2.1.3.
ASC 815-10
55-181 This Example
illustrates the disclosure of objectives and strategies
for using derivative instruments by underlying risk,
including volume of activity (see paragraph
815-10-50-1A(d)). It also illustrates the fair value
hedge basis adjustment disclosures in paragraphs
815-10-50-4EE through 50-4EEE.
The Entity is exposed to certain
risks relating to its ongoing business operations. The
primary risks managed by using derivative instruments
are commodity price risk and interest rate risk. Forward
contracts on various commodities are entered into to
manage the price risk associated with forecasted
purchases of materials used in the Entity’s
manufacturing process. Interest rate swaps are entered
into to manage interest rate risk associated with
fixed-rate loans issued by the Entity’s financing
subsidiary.
FASB ASC 815-10 requires that an
entity recognize all derivative instruments as either
assets or liabilities at fair value in the statement of
financial position. In accordance with that Subtopic,
the Entity designates commodity forward contracts as
cash flow hedges of forecasted purchases of commodities
and interest rate swaps as fair value hedges of
fixed-rate receivables.
Cash Flow Hedges
For derivative instruments that are
designated and qualify as a cash flow hedge, the gain or
loss on the derivative instrument is reported as a
component of other comprehensive income and reclassified
into earnings in the same period or periods during which
the hedged transaction affects earnings and is presented
in the same income statement line item as the earnings
effect of the hedged item. Gains and losses on the
derivative instrument representing hedge components
excluded from the assessment of effectiveness are
recognized currently in earnings and are presented in
the same line of the income statement expected for the
hedged item.
As of December 31, 20X2, the Entity
had the following outstanding commodity forward
contracts that were entered into to hedge forecasted
purchases:
Fair Value Hedges
For derivative instruments that are
designated and qualify as a fair value hedge, the gain
or loss on the derivative instrument as well as the
offsetting loss or gain on the hedged item attributable
to the hedged risk are recognized in current earnings.
The Entity includes the gain or loss on the hedged items
(that is, fixed-rate receivables) in the same line item
— interest income — as the offsetting loss or gain on
the related interest rate swaps.
As of December 31, 20X2, and 20X1,
the following amounts were recorded on the balance sheet
related to cumulative basis adjustments for fair value
hedges.
As of December 31, 20X2, and 20X1,
the total notional amount of the Entity’s
pay-fixed/receive-variable interest rate swaps was $79
and $82, respectively.
Pending Content (Transition Guidance: ASC
815-20-65-6)
55-181 [See Section 9.7.]
6.6.2 Overall Quantitative Disclosures
ASC 815-10
50-4A An entity that holds
or issues derivative instruments (and nonderivative
instruments that are designated and qualify as hedging
instruments pursuant to paragraphs 815-20-25-58 and
815-20-25-66) shall disclose all of the following for
every annual and interim reporting period for which a
statement of financial position and statement of
financial performance are presented:
-
The location and fair value amounts of derivative instruments (and such nonderivative instruments) reported in the statement of financial position
-
The location and amount of the gains and losses on derivative instruments (and such nonderivative instruments) and related hedged items reported in any of the following:
-
The statement of financial performance
-
The statement of financial position (for example, gains and losses initially recognized in other comprehensive income).
-
-
The total amount of each income and expense line item presented in the statement of financial performance in which the results of fair value or cash flow hedges are recorded.
50-4E The quantitative
disclosures required by paragraphs 815-10-50-4A through
50-4CCC shall be presented in tabular format. If a
proportion of a derivative instrument is designated and
qualifying as a hedging instrument and a proportion is
not designated and qualifying as a hedging instrument,
an entity shall allocate the related amounts to the
appropriate categories within the disclosure tables.
Example 21 (see paragraph 815-10-55-182) illustrates the
disclosures described in paragraphs 815-10-50-4A through
50-4E.
ASC 815-10-50-4A establishes overall requirements for quantitative disclosure
related to the impact of derivatives (and nonderivative hedging instruments) on
an entity’s balance sheet, income statement, and statement of OCI. Each of these
requirements is discussed in further detail in the next sections.
ASC 815-10-50-4E notes that the quantitative disclosures required in ASC
815-10-50-4A through 50-4CCC must “be presented in tabular format.” Many of the
quantitative disclosures required by ASC 815 require entities to separate the
presentation of derivatives designated in qualifying hedging relationships from
the presentation of those that are not in qualifying hedging relationships.
According to ASC 815-10-50-4E, “[i]f a proportion of a derivative instrument is
designated and qualifying as a hedging instrument and a proportion is not
designated and qualifying as a hedging instrument, an entity shall allocate the
related amounts to the appropriate categories within the disclosure tables.” See
Examples 6-5 and 6-6.
For quantitative disclosures about hedging instruments related to the balance
sheet, only instruments that are in qualifying hedging relationships on the
balance sheet date should be included as hedging instruments. For quantitative
disclosures about hedging instruments related to the statements of financial
performance, gains and losses that were recognized while the hedging instrument
was in a qualifying hedging relationship should be included in qualifying
hedging activities, even if those hedging relationships are no longer in place
on the balance sheet date. Bifurcated embedded derivatives should be included in
disclosures about derivative instruments.
Example 6-3
Hedging Instrument Only in Hedging Relationship for
Portion of Period
At the beginning of a reporting period, Mercury
Provisions issues variable-rate debt and
contemporaneously enters into a pay-fixed,
receive-variable interest rate swap to hedge the cash
flow exposure created by the debt’s variable interest
payments. Mercury designates the swap as a cash flow
hedge at inception, and the swap meets all the criteria
for hedge accounting. Later, during the same reporting
period, Mercury decides to dedesignate the swap, thereby
discontinuing the cash flow hedge. Before dedesignation,
the swap’s fair value increased by $50, all of which was
recorded in OCI. After dedesignation, during the
remainder of the reporting period, the swap’s fair value
increased by another $40 and Mercury recognized
unrealized gains of $40 directly in earnings.
Because the interest rate swap was designated as the
hedging instrument in a cash flow hedge for the first
portion of the reporting period, the $50 unrealized gain
recorded in OCI must be disclosed in Mercury’s tabular
disclosures separately and apart from the $40 unrealized
gain on the swap that was recognized after dedesignation
of the cash flow hedge (i.e., when the interest rate
swap was no longer designated as a hedging instrument).
The $90 fair value of the derivative at the end of the
reporting period should be attributed to a nonhedging
derivative in the balance sheet disclosures because the
hedging relationship is no longer active as of the
reporting date.
Note that when a formerly designated hedge results in
reclassification of AOCI into earnings in future periods
(periods in which the hedge is not designated), an
entity should include the amounts reclassified out of
AOCI in its tabular disclosures of the gains/losses on
the hedging derivative.
6.6.2.1 Quantitative Disclosures Related to the Balance Sheet
ASC 815-10
50-4A An entity that holds
or issues derivative instruments (and nonderivative
instruments that are designated and qualify as
hedging instruments pursuant to paragraphs
815-20-25-58 and 815-20-25-66) shall disclose all of
the following for every annual and interim reporting
period for which a statement of financial position
and statement of financial performance are
presented:
- The location and fair value amounts of derivative instruments (and such nonderivative instruments) reported in the statement of financial position . . . .
50-4B The disclosures
required by item (a) in the preceding paragraph
shall comply with all of the following:
-
The fair value of derivative instruments (and nonderivative instruments that are designated and qualify as hedging instruments pursuant to paragraphs 815-20-25-58 and 815-20-25-66) shall be presented on a gross basis, even when those instruments are subject to master netting arrangements and qualify for net presentation in the statement of financial position in accordance with Subtopic 210-20 or paragraphs 815-10-45-5 through 45-7, as applicable.
-
Cash collateral payables and receivables associated with those instruments shall not be added to or netted against the fair value amounts.
-
Fair value amounts shall be presented as separate asset and liability values segregated between each of the following:
-
Those instruments designated and qualifying as hedging instruments under Subtopic 815-20, presented separately by type of contract (for example, interest rate contracts, foreign exchange contracts, equity contracts, commodity contracts, credit contracts, other contracts, and so forth)
-
Those instruments not designated as hedging instruments, presented separately by type of contract.
-
-
The disclosure shall identify the line item(s) in the statement of financial position in which the fair value amounts for these categories of derivative instruments are included.
Amounts required to be reported for nonderivative
instruments that are designated and qualify as
hedging instruments pursuant to paragraphs
815-20-25-58 and 815-20-25-66 shall be the carrying
value of the nonderivative hedging instrument, which
includes the adjustment for the foreign currency
transaction gain or loss on that instrument.
50-4E The quantitative
disclosures required by paragraphs 815-10-50-4A
through 50-4CCC shall be presented in tabular
format. If a proportion of a derivative instrument
is designated and qualifying as a hedging instrument
and a proportion is not designated and qualifying as
a hedging instrument, an entity shall allocate the
related amounts to the appropriate categories within
the disclosure tables. Example 21 (see paragraph
815-10-55-182) illustrates the disclosures described
in paragraphs 815-10-50-4A through 50-4E.
ASC 815-10-50-4A(a) requires an entity to provide a tabular disclosure of the
location and fair value of derivative instruments and nonderivative hedging
instruments reported on the balance sheet. ASC 815-10-50-40B provides more
details on how to comply with ASC 815-10-50-4A(a) by clarifying the
following items:
-
The fair value of derivatives and nonderivative hedging instruments should “be presented on a gross basis,” even if those amounts are offset with other derivative instruments in accordance with ASC 210-20 (see Section 6.6.2.1.1).
-
Payables and receivables related to cash collateral associated with derivatives should “not be added to or netted against the fair value amounts” (see Section 6.6.2.1.2).
-
Assets and liabilities should be presented separately, and the fair value amounts should be segregated between the following:
-
Instruments that are designated in qualifying hedging relationships, “presented separately by type of contract (for example, interest rate contracts, foreign exchange contracts, equity contracts, commodity contracts, credit contracts, other contracts, and so forth).”
-
Instruments that are not designated as hedging contracts, “presented separately by type of contract” (see above).
-
-
The disclosure should “identify the line item(s)” on the balance sheet in which the derivatives are included for each of these categories.
-
For nonderivative hedging instruments included in the tabular disclosures, entities should report the carrying value of the nonderivative instrument in accordance with ASC 830.
ASC 815-10-55-182 provides an illustrative example of the tabular disclosures
required by ASC 815-10-50-4A. The portion of the illustration related to the
balance sheet (as required by ASC 815-10-50-4A(a)) is reproduced below.
ASC 815-10
55-182 This Example
illustrates the disclosure in tabular format of fair
value amounts of derivative instruments and gains
and losses on derivative instruments as required by
paragraphs 815-10-50-4A through 50-4E:
. . .
6.6.2.1.1 Tabular Disclosure of Amounts That Are Offset in Accordance With ASC 210
If an entity elects to offset its derivative assets and liabilities in
accordance with ASC 815-10-45-1 through 45-7 and ASC 210-20-45-1 through
45-5, it presents those derivative assets and liabilities on a net basis
in the statement of financial position. As noted above, ASC
815-10-50-4B(a) requires entities to separately disclose the fair value
of all derivative assets and liabilities on a gross basis, “even when
[the derivative] instruments are subject to master netting arrangements
and qualify for net presentation in the statement of financial position
in accordance with Subtopic 210-20.” Accordingly, an entity may be
required to show on the balance sheet (1) gross derivative asset
balances that are reported as “contra” liabilities and (2) gross
derivative liability balances that are included as “contra” assets.
Example 6-4
Derivatives Subject to Offset — Balance Sheet
Line Item for Tabular Disclosure
Assume that TreyCo (1) has a portfolio of
derivatives containing contracts that are in both
asset and liability positions as of the reporting
date and (2) has appropriately elected, in
accordance with ASC 210-20, to present those
contracts net in its statement of financial
position as net liabilities within the line item
for “derivative liabilities.” TreyCo must still
present the gross derivative assets within that
portfolio as “derivative liabilities” in the
tabular disclosures. ASC 815-10-50-4B(d) requires
such disclosures to “identify the line item(s) in
the statement of financial position in which the
fair value amounts for these categories of
derivative instruments are included.”
In addition to providing the
required disclosure identifying the “line item(s)
in the statement of financial position in which
the fair value amounts for these categories of
derivative instruments are included,” an entity is
permitted to provide supplemental disclosure
regarding (1) the basis for its presentation in
the tabular disclosures, (2) the nature of the
relationship between the offsetting asset and
liability derivative contracts, and (3) how those
amounts are ultimately presented in the statement
of financial position. (It is recommended that the
entity provide such disclosure in a footnote to
the table.)
The following is an example of what TreyCo could
disclose to comply with requirements for the
tabular disclosure of the fair values of
derivative instruments in a statement of financial
position, including disclosure of which
instruments are subject to master netting
arrangements and presented net in the statement of
financial position:
6.6.2.1.2 Receivables or Payables Related to Cash Collateral From Derivatives
As discussed in Section 6.2.1.1.3, ASC 815-10-45-5 permits an entity to
“offset fair value amounts recognized for derivative instruments and
fair value amounts recognized for the right to reclaim cash collateral
(a receivable) or the obligation to return cash collateral (a payable)
arising from derivative instrument(s) recognized at fair value executed
with the same counterparty under a master netting arrangement.” ASC
815-10-45-6 notes that a “reporting entity shall not offset fair value
amounts recognized for derivative instruments without offsetting fair
value amounts recognized for the right to reclaim cash collateral or the
obligation to return cash collateral.” Moreover, ASC 815-10-50-4B(b)
states that “[c]ash collateral payables and receivables associated with
[the derivative] instruments shall not be added to or netted against the
fair value amounts.”
Although an entity is not permitted to net collateral payables or
receivables against the fair values of its derivatives in the tabular
disclosures, ASC 815-10-50 does not prohibit an entity from providing
supplemental disclosure in its tabular presentations. Therefore, an
entity may indicate — by adding a footnote to its tabular disclosure or
providing separate columnar presentation or another similar presentation
— the fair values of its collateral payables or receivables that are (1)
offset against the fair values of its derivative assets and liabilities
and (2) presented net in its statement of financial position. The entity
should consistently apply this presentation to all similar derivative
contracts and relationships. Also, any supplemental disclosure should
clearly indicate how the related amounts are presented in the statement
of financial position.
6.6.2.1.3 Basis Adjustments for Hedged Items in Fair Value Hedges
ASC 815-10
50-4EE An entity shall
disclose in tabular format the following for items
designated and qualifying as hedged items in fair
value hedges:
-
The carrying amount of hedged assets and liabilities recognized in the statement of financial position. For an available-for-sale debt security, the amount disclosed is the amortized cost basis.
-
The cumulative amount of fair value hedging adjustments to hedged assets and liabilities included in the carrying amount of the hedged assets and liabilities recognized in the statement of financial position.
-
The line item in the statement of financial position that includes the hedged assets and liabilities.
-
The cumulative amount of fair value hedging adjustments remaining for any hedged assets and liabilities for which hedge accounting has been discontinued.
The disclosures required by (b) and (d) shall
exclude cumulative basis adjustments related to
foreign exchange risk.
50-4EEE
For each line item disclosed in accordance with
paragraph 815-10-50-4EE(c) that includes hedging
relationships designated under the last-of-layer
method in accordance with paragraph 815-20-25-12A,
the following information shall be disclosed
separately:
-
The amortized cost basis of the closed portfolio(s) of prepayable financial assets or the beneficial interest(s)
-
The amount that represents the hedged item(s) (that is, the designated last of layer)
-
The basis adjustment associated with the hedged item(s) (that is, the designated last of layer).
Example 20 (see paragraph 815-10-55-181)
illustrates these disclosures.
Pending Content (Transition Guidance: ASC
815-20-65-6)
50-4EEE [See Section 9.7.]
50-5B For
hedging relationships designated under the
last-of-layer method, an entity may need to
allocate the outstanding basis adjustment to meet
the objectives of disclosure requirements in other
Topics. For purposes of those disclosure
requirements, the entity may allocate the basis
adjustment on an individual asset basis or on a
portfolio basis using a systematic and rational
method.
Pending Content (Transition Guidance: ASC
815-20-65-6)
50-5B [See Section 9.7.]
ASC 815 also requires additional disclosures related to fair value
hedging relationships. For example, under ASC 815-10-50-4EE, an entity
must present a separate tabular disclosure to inform financial statement
users about the following:
- For assets and liabilities that are currently the hedged item in
qualifying hedging relationships as of the balance sheet date:
-
The carrying amount.
-
The cumulative amount of basis adjustments.
-
The locations (i.e., line items) of such amounts on the balance sheet.
-
- The cumulative amount of remaining basis adjustments on assets and liabilities that were previously in fair value hedging relationships.
After the issuance of ASU 2017-12, the FASB staff clarified in a public
Board meeting that the purpose of the fair value hedge basis adjustment
disclosures is to provide financial statement users with the information
they need to evaluate the amount, timing, and uncertainty of future cash
flows associated with hedged assets or liabilities. Specifically, the
disclosures required by the ASU were designed to provide financial
statement users with additional information about fair value basis
adjustments that will not affect future cash flows; therefore, basis
adjustments that will affect future cash flows, such as foreign
exchange risk basis adjustments, are excluded from these requirements.
Thus, the ASU’s disclosure requirements would not apply to a fair value
hedging relationship in which the sole hedged risk is the changes in
fair value that are attributable to changes in a specified foreign
currency exchange rate. In addition, the FASB staff indicated that for a
hedged AFS debt security, the carrying amount that an entity should
disclose should be its amortized cost basis and not its fair value. The
Board agreed with both of these clarifications.
ASC 815-10-50-4EEE requires entities to provide additional disclosures
about the basis adjustments related to last-of-layer hedging
relationships (see Section
3.2.1.4). The following information must be disclosed separately:
-
The amortized cost basis of the hedged item (portfolio of assets or beneficial interest).
-
The designated last of layer.
-
The basis adjustment related to the hedged item.
ASC 815-10-50-5B notes that for such disclosures, an entity should use a
systematic and rational method to allocate the portfolio-level basis
adjustment arising from the last-of-layer hedging relationship to the
individual items within that portfolio. Any method selected should be
documented and consistently applied.
Example 20 in ASC 815-10-50-181 includes an illustration of these
disclosures (see Section
6.6.1).
Changing Lanes
In March 2022, the FASB issued ASU
2022-01, which clarifies the guidance in ASC
815 on fair value hedge accounting of interest rate risk for
portfolios of financial assets. ASU 2022-01 renames the
“last-of-layer” method the “portfolio layer” method and
addresses feedback from stakeholders regarding its application.
It also amends some of the presentation and disclosure
requirements related to portfolio layer method basis
adjustments. In addition, in the event a breach has occurred,
the ASU requires the portion of the basis adjustment related to
the breached portion of the portfolio to be reclassified into
interest income. See Chapter 9 for a more
thorough discussion of ASU 2022-01.
6.6.2.1.4 Derivatives With a Portion Classified as Current and a Portion Classified as Noncurrent
An entity may classify a portion of a derivative contract as current and
a portion as noncurrent in its classified balance sheet (see Section 6.2.2). Under ASC
815-10-50-4A(a) and ASC 815-10-50-4B, the entity is required to identify
the location of the fair value amounts included in the statement of
financial position. Therefore, in the tabular disclosures required by
those paragraphs, the entity should separately present the fair value
amounts of the derivative that are related to (1) the portion classified
as current and (2) the portion classified as noncurrent.
6.6.2.1.5 Derivatives With a Proportion Designated in a Qualifying Hedging Relationship
According to ASC 815-10-50-4E, “[i]f a proportion of a derivative
instrument is designated and qualifying as a hedging instrument and a
proportion is not designated and qualifying as a hedging instrument, an
entity shall allocate the related amounts to the appropriate categories
within the disclosure tables.”
Example 6-5
Proportion
of a Derivative in a Qualifying Hedge — Balance
Sheet Line Item for Tabular Disclosure
Reprise uses aluminum in its
day-to-day operations. It has forecasted a
purchase of two tons of aluminum on April 30,
20X8. On January 1, 20X7, Reprise enters into a
derivative contract and designates 60 percent of
that contract as a hedge of the variability in
future cash flows attributable to changes in the
forecasted purchase price of aluminum. The
contract has a fair value of $0 at inception.
As of December 31, 20X7, the
fair value of the entire derivative contract has
increased by $100. As long as the hedging
relationship is still deemed highly effective, the
60 percent of the gain ($60) that is attributable
to the hedging portion of the derivative is
recorded in OCI. Reprise records the remaining 40
percent of the gain ($40) that is attributable to
the proportion of the derivative that is
not a designated and qualifying hedging
instrument directly in earnings.
As of April 1, 20X8, the fair
value of the entire derivative contract has
increased by another $60. As long as the hedging
relationship is still deemed highly effective, the
60 percent of the gain ($36) that is attributable
to the hedging portion of the derivative is
recorded in OCI because the forecasted transaction
has not yet affected earnings. Reprise records the
remaining 40 percent of the gain ($24) that is
attributable to the proportion of the derivative
that is not a designated and qualifying
hedging instrument directly in earnings.
On April 30, 20X8, Reprise
purchases two tons of aluminum, and on May 4,
20X8, it sells its aluminum-based products to
consumers. Upon the sale of the aluminum-based
products, in accordance with ASC 815-30-35-38,
Reprise reclassifies the amounts recorded in AOCI
into earnings and presents them in the same income
statement line item as the earnings effect of the
hedged item (aluminum), or cost of sales in this
example. Cost of sales, as reported on the face of
the statement of financial performance, is $500
for the year ended December 31, 20X8.
Below is an example of a tabular
disclosure that Reprise could provide to reflect
amounts related to this derivative in accordance
with ASC 815-10-50-40A(a). See Example
6-6 for an illustration of the tabular
disclosure that Reprise could provide to reflect
amounts related to this derivative in the
statement of financial performance.
6.6.2.2 Quantitative Disclosures Related to Statements of Financial Performance
ASC 815-10
50-4A An entity that holds
or issues derivative instruments (and nonderivative
instruments that are designated and qualify as
hedging instruments pursuant to paragraphs
815-20-25-58 and 815-20-25-66) shall disclose all of
the following for every annual and interim reporting
period for which a statement of financial position
and statement of financial performance are
presented: . . .
b. The location and amount of the gains and
losses on derivative instruments (and such
nonderivative instruments) and related hedged
items reported in any of the following:
1. The statement of
financial performance
2. The statement of
financial position (for example, gains and losses
initially recognized in other comprehensive
income).
c. The total amount of each income and
expense line item presented in the statement of
financial performance in which the results of fair
value or cash flow hedges are recorded.
50-4C For qualifying fair
value and cash flow hedges, the gains and losses
disclosed pursuant to paragraph 815-10-50-4A(b)
shall be presented separately for all of the
following by type of contract (as discussed in
paragraph 815-10-50-4D) and by income and expense
line item (if applicable):
a. Derivative instruments (and nonderivative
instruments) designated and qualifying as hedging
instruments in fair value hedges and related
hedged items designated and qualifying in fair
value hedges.
b. The gains and losses on derivative
instruments designated and qualifying in cash flow
hedges included in the assessment of effectiveness
that were recognized in other comprehensive income
during the current period.
bb. Amounts excluded from the assessment of
effectiveness that were recognized in other
comprehensive income during the period for which
an amortization approach is applied in accordance
with paragraph 815-20-25-83A.
c. The gains and losses on derivative
instruments designated and qualifying in cash flow
hedges that are included in the assessment of
effectiveness and recorded in accumulated other
comprehensive income during the term of the
hedging relationship and reclassified into
earnings during the current period.
d. The portion of gains and losses on
derivative instruments designated and qualifying
in fair value and cash flow hedges representing
the amount, if any, excluded from the assessment
of hedge effectiveness that is recognized in
earnings. When disclosing this amount, an entity
shall disclose separately amounts that are
recognized in earnings through an amortization
approach in accordance with paragraph
815-20-25-83A and amounts recognized through
changes in fair value in earnings in accordance
with paragraph 815-20-25-83B.
1. Subparagraph
superseded by Accounting Standards Update No.
2017-12.
2. Subparagraph
superseded by Accounting Standards Update No.
2017-12.
e. Subparagraph superseded by Accounting
Standards Update No. 2017-12.
f. The gains and losses reclassified into
earnings as a result of the discontinuance of cash
flow hedges because it is probable that the
original forecasted transactions will not occur by
the end of the originally specified time period or
within the additional period of time discussed in
paragraphs 815-30-40-4 through 40-5.
g. The amount of net gain or loss recognized
in earnings when a hedged firm commitment no
longer qualifies as a fair value hedge.
50-4CC An entity shall
present separately by type of contract (as discussed
in paragraph 815-10-50-4D) the gains and losses
disclosed in accordance with paragraph
815-10-50-4A(b) for derivative instruments not
designated or qualifying as hedging instruments
under Topic 815 (see paragraph 815-10-50-4F).
50-4CCC For qualifying net
investment hedges, an entity shall present the gains
and losses disclosed in accordance with paragraph
815-10-50-4A(b) separately for all of the following
by type of contract (as discussed in paragraph
815-10-50-4D):
-
The gains and losses on derivative instruments (and nonderivative instruments) designated and qualifying in net investment hedges that were recognized in the cumulative translation adjustment section of other comprehensive income during the current period
-
The gains and losses on derivative instruments (and nonderivative instruments) designated and qualifying in net investment hedges recorded in the cumulative translation adjustment section of accumulated other comprehensive income during the term of the hedging relationship and reclassified into earnings during the current period
-
The portion of gains and losses on derivative instruments (and nonderivative instruments) designated and qualifying in net investment hedges representing the amount, if any, excluded from the assessment of hedge effectiveness.
50-4D Disclosures pursuant
to paragraphs 815-10-50-4C through 50-4CCC shall
both:
- Be presented separately by type of contract,
for example:
-
Interest rate contracts
-
Foreign exchange contracts
-
Equity contracts
-
Commodity contracts
-
Credit contracts
-
Other contracts.
-
- Identify the line item(s) in the statement of financial performance in which the gains and losses for these categories of derivative instruments (and nonderivative instruments that are designated and qualify as hedging instruments pursuant to paragraphs 815-20-25-58 and 815-20-25-66) are included.
50-4E The quantitative
disclosures required by paragraphs 815-10-50-4A
through 50-4CCC shall be presented in tabular
format. If a proportion of a derivative instrument
is designated and qualifying as a hedging instrument
and a proportion is not designated and qualifying as
a hedging instrument, an entity shall allocate the
related amounts to the appropriate categories within
the disclosure tables. Example 21 (see paragraph
815-10-55-182) illustrates the disclosures described
in paragraphs 815-10-50-4A through 50-4E.
ASC 815-10-50-4A(b) requires an entity to provide a tabular disclosure of the
locations and amounts of gains and losses on qualifying hedging instruments
and related hedged items in the statement of financial performance,
including those amounts that are recognized in OCI in the current period.
ASC 815-10-50-40A(c) requires those gains and losses to be further
disaggregated into amounts resulting from qualifying fair value hedging
relationships and amounts resulting from cash flow hedging
relationships.
ASC 815-10-50-4C breaks down the disclosure requirements into further detail.
It requires entities to separately disclose the following amounts in the
footnotes and to show how each amount affected the related income and
expense line item in the statement of operations:
-
Gains and losses on qualifying hedging instruments and related hedged items designated in fair value hedging relationships.
-
Gains and losses recognized in OCI for qualifying hedging instruments designated in cash flow hedging relationships.
-
Amounts recognized in OCI related to excluded components if the entity elected to amortize the initial value into earnings.
-
Amounts reclassified out of AOCI if the forecasted transactions in a cash flow hedging relationship affected earnings.
-
Amounts recognized in earnings related to excluded components broken down between:
-
Amounts recognized in earnings under an amortization approach.
- Amounts recognized in earnings under the change in fair value approach.
-
-
Amounts that were reclassified out of AOCI because it was probable that the forecasted transaction would not occur by the end of the originally specified time period or within the allowable additional time period.
-
Gains and losses that were recognized when a hedged firm commitment no longer qualified as a fair value hedge.
ASC 815-10-50-4CC requires entities to separately disclose gains and losses
on derivatives that were not designated in qualifying hedging
relationships.
In addition, ASC 815-10-50-4CCC requires entities to disclose the impact of
qualifying net investment hedging relationships on the statements of
financial performance. Entities must provide the following information
related to net investment hedges:
-
Gains and losses recognized in CTA.
-
Gains and losses reclassified out of CTA and into earnings.
-
Gains and losses related to excluded components.
According to ASC 815-10-50-4D, all of the disclosures required by ASC
815-10-50-4C through 50-4CCC must “be presented separately by type of
contract, for example:
-
Interest rate contracts
-
Foreign exchange contracts
-
Equity contracts
-
Commodity contracts
-
Credit contracts
-
Other contracts.”
Entities should also identify the appropriate line item in the statements of
financial performance for each of the above amounts.
ASC 815-10-55-182 provides an illustrative example of the tabular disclosures
required by ASC 815-10-50-4A. The portion of the example related to the
statements of financial performance (those required by ASC 815-10-50-4A(b)
and (c)) is reproduced below.
ASC 815-10
55-182 This Example
illustrates the disclosure in tabular format of fair
value amounts of derivative instruments and gains
and losses on derivative instruments as required by
paragraphs 815-10-50-4A through 50-4E: . . .
6.6.2.2.1 Derivatives With a Proportion Designated in a Qualifying Hedging Relationship
According to ASC 815-10-50-4E, “[i]f a proportion of a derivative
instrument is designated and qualifying as a hedging instrument and a
proportion is not designated and qualifying as a hedging instrument, an
entity shall allocate the related amounts to the appropriate categories
within the disclosure tables.”
Example 6-6
Proportion of Derivative in Qualifying Hedge —
Statements of Financial Performance Tabular
Disclosures
Reprise uses aluminum in its day-to-day
operations. It has forecasted a purchase of two
tons of aluminum on April 30, 20X8. On January 1,
20X7, Reprise enters into a derivative contract
and designates 60 percent of that contract as a
hedge of the variability in future cash flows
attributable to changes in the forecasted purchase
price of aluminum. The contract has a fair value
of $0 at inception.
As of December 31, 20X7, the
fair value of the entire derivative contract has
increased by $100. As long as the hedging
relationship is still deemed highly effective, the
60 percent of the gain ($60) that is attributable
to the hedging portion of the derivative is
recorded in OCI. Reprise records the remaining 40
percent of the gain ($40) that is attributable to
the proportion of the derivative that is
not a designated and qualifying hedging
instrument directly in earnings.
As of April 1, 20X8, the fair
value of the entire derivative contract has
increased by another $60. As long as the hedging
relationship is still deemed highly effective, the
60 percent of the gain ($36) that is attributable
to the hedging portion of the derivative is
recorded in OCI because the forecasted transaction
has not yet affected earnings. Reprise records the
remaining 40 percent of the gain ($24) that is
attributable to the proportion of the derivative
that is not a designated and qualifying
hedging instrument directly in earnings.
On April 30, 20X8, Reprise purchases two tons of
aluminum, and on May 4, 20X8, it sells its
aluminum-based products to consumers. Upon the
sale of the aluminum-based products, in accordance
with ASC 815-30-35-38, Reprise will reclassify the
amounts recorded in AOCI into earnings and present
such amounts in the same income statement line
item as the earnings effect of the hedged item
(aluminum), or cost of sales in this example. Cost
of sales, as reported on the face of the statement
of financial performance, is $500 for the year
ended December 31, 20X8.
Below is an example of tabular
disclosures that Reprise could provide to reflect
the effect of hedge accounting on the statements
of financial performance in accordance with ASC
815-10-50-40A(b) and (c). See Example 6-5 for an
illustration of the tabular disclosure that
Reprise could provide to reflect amounts related
to this derivative in the balance sheet.
6.6.2.2.2 Trading Derivatives
ASC 815-10
50-4F For derivative
instruments that are not designated or qualifying
as hedging instruments under Subtopic 815-20, if
an entity’s policy is to include those derivative
instruments in its trading activities (for
example, as part of its trading portfolio that
includes both derivative instruments and
nonderivative or cash instruments), the entity can
elect to not separately disclose gains and losses
as required by paragraph 815-10-50-4CC provided
that the entity discloses all of the following:
-
The gains and losses on its trading activities (including both derivative instruments and nonderivative instruments) recognized in the statement of financial performance, separately by major types of items, for example:
-
Fixed income/interest rates
-
Foreign exchange
-
Equity
-
Commodity
-
Credit.
-
-
The line items in the statement of financial performance in which trading activities gains and losses are included
-
A description of the nature of its trading activities and related risks, and how the entity manages those risks.
If the disclosure option in this paragraph is
elected, the entity shall include a footnote in
the required tables referencing the use of
alternative disclosures for trading activities.
Example 21 (see paragraph 815-10-55-182)
illustrates a footnote referencing the use of
alternative disclosures for trading activities.
Example 22 (see paragraph 815-10-55-184)
illustrates the disclosure of the information
required in items (a) and (b).
If an entity has a policy of including derivative instruments that are
not in qualifying hedging relationships in its trading activities, it
may elect to exclude such “trading derivatives” from its tabular
disclosures about gains and losses required by ASC 815-10-50-4CC.
However, if the entity elects to exclude trading derivatives, it should:
-
Include a footnote in the tabular disclosures that references this election for trading activities.
-
Present a description of (1) its trading activities and related risks and (2) how the entity manages those risks.
-
Disclose the gains and losses on its trading activities (including both derivatives and nonderivatives) separately by major types of items. ASC 815-10-50-4F provides the following examples of major types of items:
-
Fixed income/interest rates
-
Foreign exchange
-
Equity
-
Commodity
-
Credit.
-
However, if the derivative instruments are not held for trading purposes,
an entity may not elect to exclude such instruments from the tabular
disclosures required by ASC 815-10-50-4CC solely because they are not
designated in qualifying hedging relationships. For an entity to elect
to provide alternative disclosures for trading derivatives, its use of
the derivatives must meet the definition of trading in U.S. GAAP. The
ASC master glossary defines trading as follows:
An activity involving securities sold in the near term and held
for only a short period of time. The term trading contemplates a
holding period generally measured in hours and days rather than
months or years. See paragraph 948-310-40-1 for clarification of
the term trading for a mortgage banking entity.
Example 22 in ASC 815-10-55-184, which is reproduced
below, provides an illustration of quantitative disclosures related to
trading activities.
ASC 815-10
55-184 This Example
illustrates one approach for presenting the
quantitative information required under paragraph
815-10-50-4F when an entity elects the alternative
disclosure for gains and losses on derivative
instruments included in its trading activities.
The Example does not address all possible ways of
complying with the alternative disclosure
requirements under that paragraph. Many entities
already include the required information about
their trading activities in other disclosures
within the financial statements. Paragraph
815-10-50-4I states that, if information on
derivative instruments (or nonderivative
instruments that are designated and qualify as
hedging instruments pursuant to paragraphs
815-20-25-58 and 815-20-25-66) is disclosed in
more than a single note to financial statements,
an entity shall cross-reference from the
derivative instruments (or nonderivative
instruments) note to other notes in which
derivative-instrument-related information is
disclosed.
The revenue related to each category includes
realized and unrealized gains and losses on both
derivative instruments and nonderivative
instruments.
6.6.2.2.3 Not-for-Profit Entities
ASC 815-10
50-4G For purposes of the
disclosure requirements beginning in paragraph
815-10-50-4A, not-for-profit entities within the
scope of Topic 954 should present a similarly
formatted table. Those entities shall refer to
amounts within their performance indicator,
instead of in income, and amounts outside their
performance indicator, instead of in other
comprehensive income. Not-for-profit entities not
within the scope of Topic 954 shall disclose the
gain or loss recognized in changes in net assets
using a similar format. All not-for-profit
entities also would indicate which class or
classes of net assets (without donor restrictions
or with donor restrictions) are affected.
Under ASC 815-10-50-4G, not-for-profit entities within the scope of ASC
954 are required to present tabular disclosures related to the impact of
derivatives and hedging activities in tables that are formatted
similarly to those discussed above, even if those entities do not
present statements of income and OCI. In such disclosures, the term
“income” should be replaced by the entity’s “performance indicator” and
the term “other comprehensive income” should be replaced by “outside [of
the] performance indicator.”
If a not-for-profit entity (NFP) is not within the scope
of ASC 954, it should present the gain or loss recognized in changes in
net assets in a similar format and indicate which class or classes of
net assets are affected.
6.6.3 Liquidity Risk Disclosures
6.6.3.1 Credit-Risk-Related Contingent Features
ASC 815-10
50-4H An entity that holds
or issues derivative instruments (or nonderivative
instruments that are designated and qualify as
hedging instruments pursuant to paragraphs
815-20-25-58 and 815-20-25-66) shall disclose all of
the following for every annual and interim reporting
period for which a statement of financial position
is presented:
-
The existence and nature of credit-risk-related contingent features
-
The circumstances in which credit-risk-related contingent features could be triggered in derivative instruments (or such nonderivative instruments) that are in a net liability position at the end of the reporting period
-
The aggregate fair value amounts of derivative instruments (or such nonderivative instruments) that contain credit-risk-related contingent features that are in a net liability position at the end of the reporting period
-
The aggregate fair value of assets that are already posted as collateral at the end of the reporting period
-
The aggregate fair value of additional assets that would be required to be posted as collateral if the credit-risk-related contingent features were triggered at the end of the reporting period
-
The aggregate fair value of assets needed to settle the instrument immediately if the credit-risk-related contingent features were triggered at the end of the reporting period.
Amounts required to be reported for nonderivative
instruments that are designated and qualify as
hedging instruments pursuant to paragraphs
815-20-25-58 and 815-20-25-66 shall be the carrying
value of the nonderivative hedging instrument, which
includes the adjustment for the foreign currency
transaction gain or loss on that instrument. Example
23 (see paragraph 815-10-55-185) illustrates a
credit-risk-related contingent feature
disclosure.
The annual and interim disclosures required by ASC 815-10-50-4H are designed
to highlight liquidity risk associated with derivative liabilities that are
not fully collateralized, particularly the potential for collateral calls or
immediate settlement. The disclosures are focused on derivative liabilities
because, as a result of triggering events, an entity may be required deliver
cash or other assets as collateral or to settle such contracts early. Some
refer to the ASC 815-10-50-4H disclosures as “run on the bank” disclosures.
More commonly, they are referred to as “liquidity risk disclosures.”
6.6.3.1.1 Identification of Net Derivative Liabilities Subject to Liquidity Risk Disclosures
Entities may find it useful to perform the steps below when determining
which contracts are subject to the disclosure requirements in ASC
815-10-50-4H (note that steps 2 and 3 can be reversed if desired).
6.6.3.1.1.1 Step 1 — Identify All Derivative Liabilities Recognized at Fair Value
An entity performs this step on a gross basis at the contract level
(i.e., it does not offset a liability against an asset in accordance
with ASC 815-10-45-1 through 45-8 or other portfolio approach). The
remaining population of contracts should be consistent with the
derivative liabilities disclosed under ASC 815-10-50-4A and 50-4B
(see Section 6.6.2.1).
6.6.3.1.1.2 Step 2 — Identify the Subset of Derivative Liabilities That Are Fully Collateralized
On the basis of discussions with the FASB staff, we understand that
the scope of ASC 815-10-50-4H encompasses any derivative liabilities
(with credit-risk-related contingent features) that (1) are
accounted for at fair value under ASC 815 and (2) are not fully
collateralized as of the balance sheet date and therefore represent
a liquidity exposure to the entity. Note that a fully collateralized
derivative, by contrast, represents a derivative liability (from the
reporting entity’s perspective) for which the reporting entity has
posted sufficient collateral as of the balance sheet date to avoid
any additional payments upon an early settlement of the contract
(for this purpose, early settlement is presumed to occur as of the
balance sheet date on the basis of the derivative’s GAAP fair value
unless the contract explicitly refers to another early settlement
calculation). In other words, a derivative liability is considered
fully collateralized only if it is effectively “prepaid” (through
the collateral), which would eliminate any additional liquidity
exposure to the entity as of the balance sheet date.
The term “collateral” refers to assets provided to, or legally
restricted for the benefit of, a counterparty in support of an
obligation; to be considered collateral for a derivative liability,
the assets must be contractually linked to the derivative. Entities
should not consider letters of credit (LCs) posted with the
counterparty to be assets posted as collateral (see
Section 6.6.3.1.1.4 for further discussion
of LCs). In addition, when determining whether a derivative
liability is fully collateralized, an entity should not consider (1)
derivative assets recognized at fair value, (2) contracts subject to
the normal purchases and normal sales scope exception in ASC
815-10-15-13, or (3) receivables, or other items that are subject to
the same master netting arrangement as the derivative liability.
These amounts (whether related to open positions or receivables)
arise on the basis of separate transactions between the parties,
whereas collateral arises on the basis of terms and conditions
within a specific contract or master netting arrangement.
When an entity is determining whether a derivative liability is fully
collateralized, it is acceptable to adopt a consistent approach in
which the entity defines collateral as cash (in the same currency as
the derivative’s settlement) and thus only considers a derivative
liability fully collateralized when it is fully collateralized with
cash. This approach is consistent with the principle that the
derivative liability must effectively be prepaid (with no additional
liquidity exposure) as of the balance sheet date. Cash provided to a
counterparty is different from other forms of collateral in that it
carries no collection risk and is not subject to fluctuations in
value (as opposed to land, for example).
Note that for derivative liquidity disclosures,
entities should not think of “net” in the context of ASC 815-10-45-1
through 45-7 or ASC 210-20-45-1 through 45-53 (see Section 6.2.1). The meaning of the
term “net liability position,” as used in the ASC 815-10-50-4H
disclosure requirements, differs from how a net derivative asset or
liability may be determined under ASC 815-10-45-1 through 45-7 and
ASC 210-20-45-1 through 45-5. More specifically, under a master
netting arrangement with a single counterparty, an entity may have
both derivative asset and derivative liability contracts that, upon
satisfaction of the criteria in ASC 815-10-45-1 through 45-7 and ASC
210-20-45-1 through 45-5, may be offset and presented as a single
net asset in the entity’s balance sheet. Despite presentation as a
net asset, however, each individual derivative liability within that
master netting arrangement that has a credit-risk-related contingent
feature would be subject to the ASC 815-10-50-4H disclosures unless
the liability was fully collateralized.
Example 6-7
Derivative Not Fully Collateralized
Mercury Provisions has a forward to purchase
titanium that is a liability with a fair value of
$100 as of the balance sheet date. It has posted
collateral of $75, and if an early settlement
occurs on the balance sheet date, it would be
required to pay an additional $25 to the
counterparty. In this example, the derivative is
not fully collateralized because Mercury would
need to make an additional payment upon early
settlement.
After the contracts identified in step 2 are eliminated (i.e., step 1
population less step 2 subset), the remaining subset of derivative
contracts represents all derivative instruments considered to be in
a net liability position for the ASC 815-10-50-4H disclosures (i.e.,
derivative liability contracts that are not fully
collateralized).
6.6.3.1.1.3 Step 3 — Identify Remaining Subset of Derivative Contracts Containing Credit-Risk-Related Contingent Features
From the remaining contracts (derivative instruments in a net
liability position), the entity identifies the subset of derivative
contracts that contains one or more credit-risk-related contingent
features. When assessing whether individual features represent
credit-risk-related contingent features that must be disclosed under
ASC 815-10-50-4H, an entity should consider the following
guidelines, which were developed on the basis of discussions with
the FASB staff:
-
Disclosure is not limited to features that trigger cash payments. Although ASC 815-10-50-4H generally focuses on liquidity exposure, the guidance encompasses any feature that would require the use of an entity’s “assets.”
-
The feature could reside in a contract or governing arrangement (e.g., master netting arrangement). Many derivatives are executed under standard legal arrangements (e.g., ISDA agreements) that establish key terms and conditions and often provide for netting among the counterparties in certain situations. In such cases, the “master” arrangement typically serves as an umbrella governing each executed derivative, and it is therefore necessary to look to the master arrangement for contingent features. In these situations, the features within the master arrangement would be ascribed to the individual contracts covered by the arrangement. In other cases, a derivative contract may be a stand-alone legal instrument and any related contingent features would reside within the derivative contract itself.
-
The feature must be objective. More specifically, the feature must reference one or more specific contingent events and describe what the specific payment terms would be if the contingent event were to occur. For example, a feature requiring an entity to post $XX or XX percent of contract value with the counterparty if the entity’s credit rating drops below investment grade would be considered an objective feature. Material adverse-change clauses may or may not be objective. “General adequate assurance”1 clauses, which give each party in an arrangement the right to seek additional collateral if deemed necessary (but not on the basis of a specified credit event) are not considered objective, although entities are encouraged to provide supplemental disclosure about the existence of these types of provisions.
-
The feature should be directly related to credit events or measures of creditworthiness. Collateral requirements that are based solely on either (1) market indexes (e.g., interest rates or commodity prices) or (2) the fair value of a derivative or a portfolio would generally not be considered credit-risk-related contingent features since they are not driven by discrete credit events. Likewise, although many operational events affect credit, contingencies driven by operations generally are not considered credit-risk-related contingent features. Accordingly, events such as a decline in revenues or a loss of a major customer would not be considered credit-risk-related contingent features that must be disclosed under ASC 815-10-50-4H. However, contingencies that are based on an entity’s failure to maintain specified liquidity ratios (e.g., current ratio or quick ratio) or financial leverage ratios (e.g., debt ratio or debt-to-equity ratio) would generally be considered credit-risk-related contingent features.
-
Default provisions do not constitute credit-risk-related contingent features. Default provisions are triggered by an entity’s failure to perform under a particular contract. Contingent features, on the other hand, are generally related to factors or events that are external to the contract (e.g., a decline in a credit rating or a failure to maintain a minimum current ratio) and require incremental performance (e.g., posting of collateral) by one party or the other. Although some default events are ostensibly credit-driven, it is not necessary to identify credit-specific default provisions (e.g., payment delinquency or deficiency) and treat those events as credit-risk-related contingent features.
-
Cross-default provisions require special consideration. Unlike the default provisions discussed in guideline 5 above, cross-default provisions are related to factors that are external to an entity’s performance under the contract in question; accordingly, an entity must carefully consider the terms and conditions of such provisions to determine whether they are within the scope of ASC 815-10-50-4H. In some circumstances, a cross-default provision may constitute a credit-risk-related contingent feature (e.g., when a failure to make a required interest or principal payment on a debt instrument triggers a collateral call or early settlement of a derivative liability). In this case, the failure to make a required interest or principal payment could be viewed as a credit event. By contrast, a cross-default provision that is based on a failure to deliver goods under a commodity sales contract could be triggered by factors other than credit.
-
Bankruptcy and liquidation events do not constitute credit-risk-related contingent features.2 If payment is required only upon bankruptcy or final liquidation of the company, those features would not be considered credit-risk-related contingent features that must be disclosed under ASC 815-10-50-4H.
The following
examples illustrate the application of the above guidelines to
specific features that may exist in derivative contracts:
Features That Would Represent
Credit-Risk-Related Contingent Features
|
Features That Would Not Represent
Credit-Risk-Related Contingent Features
|
---|---|
A requirement to post a discrete amount of
collateral upon the occurrence of a credit rating
downgrade. The discrete amount could be expressed
as either a dollar amount or a percentage of the
contract’s fair value.
|
A material adverse change clause that allows an
entity to seek “performance assurance” in an
amount determined in a commercially reasonable
manner if and when the counterparty experiences a
change in condition (financial or otherwise) that
can be reasonably expected to impair the
counterparty’s ability to fulfill its
obligations.
|
A requirement to post a discrete amount of
collateral if a defined financial leverage ratio
(e.g., debt-to-equity ratio) falls below an
established threshold. The discrete amount could
be expressed as either a dollar amount or a
percentage of the contract’s fair value.
|
A requirement to settle a contract immediately
upon a company’s default under the contract in
question. This would include any default event
under the contract in question, including failure
to pay when payment is due.
|
A requirement to settle a
contract immediately upon the occurrence of a
credit rating downgrade.
|
A requirement to settle a contract immediately
upon the occurrence of a bankruptcy or liquidation
event.
|
A requirement to settle a contract immediately
if a defined financial leverage ratio (e.g.,
debt-to-equity ratio) falls below an established
threshold.
|
A requirement to post a discrete amount of
collateral if sales in a given quarter fall short
of published projections.
|
6.6.3.1.1.4 Letters of Credit Are Not Collateral
The credit enhancement requirements in many derivatives can be
satisfied by traditional collateral or standby LCs. A typical LC is
issued by a financial institution and authorizes the beneficiary of
the LC to draw specified amounts of cash upon the occurrence of
specified events (e.g., an event of default under the related
derivative by the posting party). Some contractual arrangements
require the posting of an LC with the counterparty at inception,
while others provide for ongoing collateral requirements that can be
satisfied by cash or LC and are triggered by events after inception
(e.g., the credit rating is downgraded or the fair value exposure
threshold is exceeded). In either case, the LC effectively
represents a “guarantee” from the issuing financial institution of
the payment obligations of the posting party. LCs represent a
backstop mechanism in case the posting party cannot pay and,
therefore, it is not necessarily expected that the LC beneficiary
will ever draw upon the LC. If the LC beneficiary does draw upon the
LC, the posting party has an obligation to repay the issuing
financial institution; in other words, the posting party continues
to have an obligation but the previous derivative obligation (to the
derivative counterparty) is replaced with a debt obligation (to the
issuing financial institution).
As described above, LCs are often provided or “posted” to derivative
counterparties in lieu of collateral. Many entities negotiate LC
facilities with financial institutions to provide ready access to
LCs to support derivative transactions. Such facilities generally
allow the entity to post LCs for the benefit of yet-to-be-identified
derivative counterparties in amounts determined by the issuing
entity and without incremental approval from the financial
institution after inception. These facilities require commitment
fees and function similarly to lines of credit in the sense that
they establish a borrowing or “posting” cap and provide for the
revolving use of available capacity under the arrangement for a
defined period.
Although paragraph A44 of the Background Information and Basis for Conclusions of FASB Statement 161 refers to “immediate payment”
requirements to a counterparty, the fundamental purpose of the
disclosures is to highlight the liquidity risk associated with
derivatives. Liquidity risk is not solely a function of immediate
exposure; therefore, arrangements such as LCs that allow an entity
to delay its payment obligations under a derivative do not remove
the related derivatives from the scope of the ASC 815-10-50-4H
credit-risk disclosures.
The above guidance applies regardless of whether unused LC capacity
creates the potential to use available LCs in lieu of collateral
upon the occurrence of a credit-risk-related contingency. While
available LCs do not affect the scope of the ASC 815-10-50-4H
disclosures, entities are encouraged to describe their ability to
use available capacity under LC facilities to satisfy collateral
calls when preparing disclosures under ASC 815-10-50-4H(d)–(f), and
it is important that entities highlight this ability so that they
can properly portray their true liquidity exposure related to
derivative liabilities. In connection with this disclosure, entities
should (1) indicate the remaining borrowing or posting capacity
under LC facilities, (2) describe the repayment terms if an LC is
drawn by the derivative counterparty and an obligation to the
issuing financial institution is created, and (3) consider the need
to provide cross-references to other footnote disclosures, such as
the debt footnote, in which LC information resides. In describing
unused LC capacity, entities should consider any factors that would
limit the use of such capacity to support derivative liabilities.
Such factors may include contractual or legal restrictions, other
financing needs, and management intent.
6.6.3.1.2 Liquidity Risk Disclosure Requirements
ASC 815-10
50-4H An entity that holds
or issues derivative instruments (or nonderivative
instruments that are designated and qualify as
hedging instruments pursuant to paragraphs
815-20-25-58 and 815-20-25-66) shall disclose all
of the following for every annual and interim
reporting period for which a statement of
financial position is presented:
-
The existence and nature of credit-risk-related contingent features
-
The circumstances in which credit-risk-related contingent features could be triggered in derivative instruments (or such nonderivative instruments) that are in a net liability position at the end of the reporting period
-
The aggregate fair value amounts of derivative instruments (or such nonderivative instruments) that contain credit-risk-related contingent features that are in a net liability position at the end of the reporting period
-
The aggregate fair value of assets that are already posted as collateral at the end of the reporting period
-
The aggregate fair value of additional assets that would be required to be posted as collateral if the credit-risk-related contingent features were triggered at the end of the reporting period
-
The aggregate fair value of assets needed to settle the instrument immediately if the credit-risk-related contingent features were triggered at the end of the reporting period.
Amounts required to be reported for
nonderivative instruments that are designated and
qualify as hedging instruments pursuant to
paragraphs 815-20-25-58 and 815-20-25-66 shall be
the carrying value of the nonderivative hedging
instrument, which includes the adjustment for the
foreign currency transaction gain or loss on that
instrument. Example 23 (see paragraph
815-10-55-185) illustrates a credit-risk-related
contingent feature disclosure.
Once the population of derivative liabilities
subject to the liquidity risk disclosures required in ASC
815-10-50-4H is identified (see Section
6.6.3.1.1), the preparation of the disclosure is
largely an aggregation exercise. For example, the ASC
815-10-50-4H(a) and (b) disclosures would describe the different
types of credit-risk-related contingent features that exist within
the individual derivative liabilities identified.
Likewise, under the ASC 815-10-50-4H(c) disclosure requirement, the
fair values of the individual derivative liabilities would be
aggregated (without consideration of offsetting collateral).
Finally, under the ASC 815-10-50-4H(d)–(f) disclosures, an entity
would aggregate (1) the collateral already posted as of the
reporting date for each of the individual derivative liabilities and
(2) the remaining liquidity exposure of each individual derivative
liability (if it is assumed that the worst-case credit contingency
for each individual derivative liability was triggered as of the
reporting date).
Example 23 in ASC 815-10-55-185, which is reproduced below, provides
an illustration of liquidity risk disclosures.
ASC 815-10
55-185 This Example
illustrates the disclosure of credit-risk-related
contingent features in derivative instruments as
required by paragraph 815-10-50-4H.
Contingent
Features
Certain of the Entity’s
derivative instruments contain provisions that
require the Entity’s debt to maintain an
investment grade credit rating from each of the
major credit rating agencies. If the Entity’s debt
were to fall below investment grade, it would be
in violation of these provisions, and the
counterparties to the derivative instruments could
request immediate payment or demand immediate and
ongoing full overnight collateralization on
derivative instruments in net liability positions.
The aggregate fair value of all derivative
instruments with credit-risk-related contingent
features that are in a liability position on
December 31, 2009, is $XX million for which the
Entity has posted collateral of $X million in the
normal course of business. If the
credit-risk-related contingent features underlying
these agreements were triggered on December 31,
2009, the Entity would be required to post an
additional $XX million of collateral to its
counterparties.
6.6.3.1.2.1 Multiple Credit-Risk-Related Triggers
Some derivative contracts contain multiple credit-risk-related
contingent features. For example, a contract may require an
entity to post escalating amounts of collateral with the
counterparty as the entity’s credit rating deteriorates along a
defined rating spectrum.
On the basis of discussions with the FASB staff, we understand
that the disclosure requirements in ASC 815-10-50-4H(d)–(f) are
meant to provide financial statement users with information
about the entity’s potential liquidity exposure under a
“worst-case” credit scenario. The worst-case exposure represents
the maximum amount of additional collateral or payment that
would be required (beyond what has already been posted) if the
credit-risk-related contingent feature providing the greatest
liquidity exposure to the entity is triggered at the end of the
reporting period, regardless of the likelihood of the feature
being triggered.
Note that with respect to the disclosures in ASC
815-10-50-4H(d)–(f), the worst-case credit scenario is based on
the population of credit-risk-related contingent features within
a contract and would not take into account the contract default
or bankruptcy of the entity, which is consistent with item 7 of
step 3 in the evaluation of credit-risk-related contingent
features in Section 6.6.3.1.1.
The ASC 815-10-50-4H(d)–(f) disclosures represent an aggregation
of the liquidity exposures associated with each derivative
liability on the basis of the credit-risk-related contingent
features specific to each derivative. Likewise, the assessment
of the worst-case credit exposure is performed at the individual
derivative level as opposed to being based on the single
contingency that would have the most significant liquidity
impact when applied across an entity’s entire derivative
portfolio.
The guidance expressed above applies equally to the ASC
815-10-50-4H(a) and (b) disclosures. In other words, entities
should focus their discussion of the “existence and nature of
credit-risk-related contingent features” on those features that
require the maximum amount of additional collateral or payment
(beyond what has already been posted) for each individual
derivative liability.
When multiple credit-risk-related contingent features exist
within individual derivative contracts, entities are encouraged
to consider supplemental disclosure to highlight the potential
liquidity exposure associated with each contingency. It is not
necessary to ascribe probabilities to the contingencies being
triggered nor is it appropriate to exclude contingencies on the
basis of a belief that the likelihood of their occurrence is
remote.
6.6.3.1.2.2 Disclosure of Nonderivative Positions
The liquidity disclosures in ASC 815-10-50-4H
are only required for derivatives recognized at fair value on
the balance sheet. However, an entity is encouraged to disclose
how contracts other than derivative instruments affect its
potential (or worst-case) liquidity exposure to derivatives
(i.e., whether the impact is an increased or decreased liquidity
exposure). For example, an entity may hold contracts subject to
the normal purchases and normal sales scope exception in ASC
815-10-15-13 or other accrual-based contracts that are governed
under the same master netting arrangement as the derivative
liability in question. If these contracts are in asset or
liability positions as of the end of the reporting period, they
could reduce or increase, respectively, the entity’s liquidity
exposure, as further indicated in the examples below. By
describing its entire liquidity exposure (including how
nonderivative instruments may affect its worst-case liquidity
exposure to derivatives), an entity is providing financial
statement users with more relevant information.
On the basis of discussions with the FASB staff, we understood
that there are two acceptable approaches (discussed below) to
developing the ASC 815-10-50-4H(d)–(f) disclosures. An entity
should apply its adopted approach consistently to all its master
netting arrangements and consider disclosing its approach in the
notes to the financial statements.
6.6.3.1.2.2.1 Approach 1
Under Approach 1, an entity determines the
potential collateral requirement on the basis of the fair
value (or other measure if explicitly referred to in the
derivative contract or master netting arrangement) of the
derivative liabilities disclosed under ASC
815-10-50-4H(c),3 offset only by derivative asset positions subject to
the same master netting arrangement. While this approach is
acceptable, the resulting disclosures often do not
accurately reflect an entity’s true liquidity exposure in
situations in which negative credit events occur and the
master netting arrangement also considers the effect of
nonderivative positions in determining the amount of
collateral required. Under this approach, an entity would
ignore nonderivative positions (e.g., normal purchases and
normal sales contracts, receivables, or payables), whether
additive or subtractive to potential posting or payment
requirements, when developing disclosures about its
worst-case liquidity exposure. This approach reflects the
narrow scope of ASC 815-10-50-4H (i.e., derivatives
only).
To comply with the ASC 815-10-50-4H(d)–(f)
disclosures, an entity that follows Approach 1 will most
likely need to allocate4 collateral posted under a master netting arrangement
to specific derivative liabilities.
6.6.3.1.2.2.2 Approach 2
Under Approach 2, when a master netting arrangement exists,
an entity determines its potential exposure on the basis of
the contractual relationship (i.e., all contracts subject to
the master netting arrangement) and the specific terms of
the credit-risk-related contingent features. Master netting
arrangements often govern the collateral posting
requirements for a basket of positions between
counterparties, typically on the basis of a net exposure
calculation. Under this approach, an entity is encouraged to
consider the effect of master netting arrangements and the
impact of all positions under the arrangements (including
derivative assets, normal purchases and normal sales
contracts, and other accrual positions) when developing the
disclosure of the entity’s worst-case liquidity
exposure.
As described in more detail in the last
example below, while the FASB staff agrees that the full
effects of master netting arrangements should be reflected
in the ASC 815-10-50-4H(d)–(f) disclosures, it would not
object to a disclosure that (1) considers potential offsets
to collateral postings or payment requirements (reductions
to liquidity exposure) that are driven by nonderivative
asset positions in master netting arrangements but (2)
ignores potential increases to an entity’s liquidity
exposure (beyond the exposure represented by the derivative
liability itself) created by nonderivative liabilities under
the same master netting arrangement.
Master netting arrangements could affect the
amount of additional collateral5 or payments that are required to be disclosed under
ASC 815-10-50-4H(e) and (f) in a variety of ways, including
the following:
-
Master netting arrangements could eliminate additional posting or payment requirements if the portfolio is flat or in an asset position to the reporting entity (in such a scenario, a credit-risk-related contingency, such as a credit downgrade, would not prompt a collateral call by the counterparty because the net relationship is an asset to the reporting entity). For example, consider the following positions comprising a relationship under a master netting arrangement as of the balance sheet date (from the perspective of the reporting entity):In this case, the entity would not be required to post any additional collateral because it has a net asset position with the counterparty. Therefore, the counterparty would have no right to ask for collateral (even in the event of a credit downgrade).
-
Master netting arrangements could reduce the amount of collateral that must be posted if the reporting entity has an offsetting net asset position with the counterparty when all positions other than derivative liabilities are taken into account. For example, consider the following positions comprising a relationship under a master netting arrangement as of the balance sheet date (from the perspective of the reporting entity):In this case, the most the counterparty could request is $75; therefore, this amount serves as a cap for the ASC 815-10-50-4H(d)–(f) disclosures. The additional posting requirement could be less than $75 depending on the specific credit features in the master netting arrangement (the worst-case objective feature could require posting of 50 percent of the relationship value, in which case the disclosed amount under this example would be $37.50).
-
Master netting arrangements could reduce the amount of collateral that must be posted if the reporting entity has already posted some collateral under the relationship. For example, consider the following positions comprising a relationship under a master netting arrangement as of the balance sheet date (from the perspective of the reporting entity):In this case, the most the counterparty could request is $75; therefore, this amount serves as a cap for the ASC 815-10-50-4H(d)–(f) disclosure. The $75 would then be reduced by any collateral already posted with the counterparty. Even though the $40 posted in this example is most likely related to both the derivative liabilities and normal purchases and normal sales liabilities, the master netting arrangement limits the amounts of additional collateral that could be required as of the balance sheet date to $35 and, accordingly, this amount reflects the entity’s true liquidity exposure. Therefore, $35 is presumed to be the amount required to be disclosed under ASC 815-10-50-4H(e) and (f) because it represents the worst-case exposure should the credit-risk-related contingent feature be triggered. The amount required to be disclosed under ASC 815-10-50-4H(e) and (f) could be less than $35 depending on the specific credit features in the master netting arrangement (the worst-case objective feature could require the posting of 50 percent of the relationship value, in which case the disclosed amount under this example would be $17.50).
-
Master netting arrangements could increase the amount of collateral that must be posted if the portfolio as a whole is a larger liability than the sum of the derivative liabilities (e.g., if the portfolio includes normal purchases and normal sales contracts that are out-of-the-money). This potential increase would not be a mandatory part of the disclosure (i.e., the increase is related to nonderivatives, so it is technically outside the scope of ASC 815). However, entities are encouraged to incorporate the effects of master netting arrangements since doing so (1) helps achieve symmetry (master netting arrangements could increase or decrease posting or payment requirements) and (2) more accurately reflects liquidity exposure if negative credit events occur. For example, consider the following positions comprising a relationship under a master netting arrangement as of the balance sheet date (from the perspective of the reporting entity):
-
Recommended application — In this case, the reporting entity’s exposure to credit features is based on a basket of liabilities (including some nonderivatives); therefore, the disclosure should reflect the true worst-case scenario when the overall relationship governed by the master netting arrangement is taken into account. Accordingly, $120 is presumed to be the amount that must be disclosed under ASC 815-10-50-4H(e) and (f) because it represents the worst-case exposure should the credit-risk-related contingent feature be triggered. The amount required to be disclosed under ASC 815-10-50-4H(e) and (f) could be less than $120 depending on the specific credit features in the master netting arrangement (the worst-case objective feature could require posting of 50 percent of the relationship value, in which case the disclosed amount under this example would be $60).
-
Acceptable application — The reporting entity’s exposure to credit-risk-related contingent features is based only on its derivative positions. Accordingly, $70 is presumed to be the amount required to be disclosed under ASC 815-10-50-4H(e) and (f), which could be less than $70 depending on the specific credit features in the master netting arrangement (the worst-case objective feature could require posting of 50 percent of the relationship value, in which case the disclosed amount under this example would be $35).
-
6.6.4 Balance Sheet Offsetting Disclosures
ASC 815-10
50-7 A reporting entity’s
accounting policy to offset or not offset in accordance
with paragraph 815-10-45-6 shall be disclosed.
50-7A A reporting entity
also shall disclose the information required by
paragraphs 210-20-50-1 through 50-6 for all recognized
derivative instruments accounted for in accordance with
Topic 815, including bifurcated embedded derivatives,
which are either:
- Offset in accordance with either Section 210-20-45 or Section 815-10-45
- Subject to an enforceable master netting arrangement or similar agreement.
50-8 A reporting entity
shall disclose the amounts recognized at the end of each
reporting period for the right to reclaim cash
collateral or the obligation to return cash collateral
as follows:
-
A reporting entity that has made an accounting policy decision to offset fair value amounts shall separately disclose amounts recognized for the right to reclaim cash collateral or the obligation to return cash collateral that have been offset against net derivative positions in accordance with paragraph 815-10-45-5.
-
A reporting entity shall separately disclose amounts recognized for the right to reclaim cash collateral or the obligation to return cash collateral under master netting arrangements that have not been offset against net derivative instrument positions.
-
A reporting entity that has made an accounting policy decision to not offset fair value amounts shall separately disclose the amounts recognized for the right to reclaim cash collateral or the obligation to return cash collateral under master netting arrangements.
Pending Content (Transition Guidance: ASC
105-10-65-7)
50-8C See paragraph 230-10-50-9 for
disclosure requirements related to where cash
flows associated with derivative instruments and
their related gains and losses are presented in
the statement of cash flows.
ASC 210-20
Offsetting of Derivatives, Repurchase Agreements, and
Securities Lending Transactions
50-1 The disclosure
requirements in paragraphs 210-20-50-2 through 50-5
apply to both of the following:
-
Subparagraph superseded by Accounting Standards Update No. 2013-01
-
Subparagraph superseded by Accounting Standards Update No. 2013-01
-
Recognized derivative instruments accounted for in accordance with Topic 815, including bifurcated embedded derivatives, repurchase agreements accounted for as collateralized borrowings and reverse repurchase agreements, and securities borrowing and securities lending transactions that are offset in accordance with either Section 210-20-45 or Section 815-10-45
-
Recognized derivative instruments accounted for in accordance with Topic 815, including bifurcated embedded derivatives, repurchase agreements and reverse repurchase agreements, and securities borrowing and securities lending transactions that are subject to an enforceable master netting arrangement or similar agreement, irrespective of whether they are offset in accordance with either Section 210-20-45 or Section 815-10-45.
50-2 An entity shall
disclose information to enable users of its financial
statements to evaluate the effect or potential effect of
netting arrangements on its financial position for
recognized assets and liabilities within the scope of
the preceding paragraph. This includes the effect or
potential effect of rights of setoff associated with an
entity’s recognized assets and recognized liabilities
that are in the scope of the preceding paragraph.
50-3 To meet the objective
in the preceding paragraph, an entity shall disclose at
the end of the reporting period the following
quantitative information separately for assets and
liabilities that are within the scope of paragraph
210-20-50-1:
-
The gross amounts of those recognized assets and those recognized liabilities
-
The amounts offset in accordance with the guidance in Sections 210-20-45 and 815-10-45 to determine the net amounts presented in the statement of financial position
-
The net amounts presented in the statement of financial position
-
The amounts subject to an enforceable master netting arrangement or similar agreement not otherwise included in (b):
-
The amounts related to recognized financial instruments and other derivative instruments that either:
- Management makes an accounting policy election not to offset.
- Do not meet some or all of the guidance in either Section 210-20-45 or Section 815-10-45.
-
The amounts related to financial collateral (including cash collateral).
-
-
The net amount after deducting the amounts in (d) from the amounts in (c).
50-4 The information
required by the preceding paragraph shall be presented
in a tabular format, separately for assets and
liabilities, unless another format is more appropriate.
The total amount disclosed in accordance with paragraph
210-20-50-3(d) for an instrument shall not exceed the
amount disclosed in accordance with paragraph
210-20-50-3(c) for that instrument.
50-5 An entity shall
provide a description of the rights of setoff associated
with an entity’s recognized assets and recognized
liabilities subject to an enforceable master netting
arrangement or similar agreement disclosed in accordance
with paragraph 210-20-50-3(d), including the nature of
those rights.
50-6 If the information
required by paragraphs 210-20-50-1 through 50-5 is
disclosed in more than a single note to the financial
statements, an entity shall cross-reference between
those notes.
Under ASC 815-10-50-7A, if an entity has derivative instruments that are either
(1) offset in accordance with ASC 210-20-45 (see Section 6.2.1) or (2) subject to a master netting arrangement or
similar arrangement, it is required to comply with the disclosure requirements
of ASC 210-20-50-1 through 50-6 (see above).
In addition, ASC 815-10-50-8 requires an entity to separately disclose the
amounts of any receivables and payables related to cash collateral under
derivative agreements that have been offset against net derivative positions in
accordance with ASC 815-10-45-5. If an entity has made an accounting policy
decision to not offset the receivables or payables related to cash collateral
under derivative agreements against the net derivative positions, it should
disclose the amount of those receivables and payables as well as its accounting
policy of not offsetting those amounts.
6.6.5 Accounting Policies Regarding Derivatives and Hedging Activities
An entity’s disclosures related to hedging activities should include the
following accounting policy decisions, if they are significant:
-
Whether the entity has offset the derivatives with the fair value amounts recognized for receivables and payables related to those derivatives in accordance with ASC 815-10-45-5 (see Section 6.2.1.1.3).
-
Whether the entity elects to record changes in the excluded components’ fair value (see Section 2.5.2.1.2.1) currently in earnings (see ASC 815-10-50-4EEEE).
-
Whether the entity has allocated significant portfolio-level credit adjustments to individual hedging instruments when performing hedge effectiveness assessments and what allocation method was used (see Section 2.5.2.1.2.6.3).
-
The income statement classification of amounts that are reclassified out of AOCI when it becomes probable that a forecasted transaction will not occur within two months of the timeframe originally designated (see Section 4.1.5.2).
-
The income statement classification of excluded components of derivatives in qualifying net investment hedging relationships.
-
The income statement classification of economic hedging activities.
-
The cash flow statement classification of derivatives.
-
The accounting for the premium paid (time value) to acquire an option that is classified as HTM or AFS (see ASC 815-10-50-9).
6.6.6 SEC Registrants
Other disclosures may be required by U.S. GAAP or SEC rules and
regulations. For example, ASC 825-10-50-20 and 50-21 require disclosures about
the concentrations of credit risk of all financial instruments, including
derivative instruments. In addition, SEC registrants should refer to the
disclosure requirements in SEC Regulation S-X, Rule 4-08(n). Registrants also
must comply with the requirements of SEC Regulation S-K, Item 305, in the
MD&A section of certain SEC filings.
Footnotes
1
For example, some contracts give
entities the ability to seek “performance
assurance” in an amount determined in a
commercially reasonable manner if and when the
counterparty experiences a change in condition
(financial or otherwise) that can be reasonably
expected to impair the counterparty’s ability to
fulfill its obligations. These clauses do not cite
specific trigger events (e.g., downgrade events)
and do not prescribe specific dollar amounts or
percentages of contract value that must be posted
as performance assurance.
2
This guidance addresses
disclosure requirements under ASC 815. If there is
substantial doubt about an entity’s ability to
continue as a going concern, it would most likely
be required to provide additional disclosures,
including disclosures that indicate the
consequences of bankruptcy or liquidation.
Going-concern considerations are beyond the scope
of this guidance.
3
ASC 815-10-50-4H(c) requires
entities to disclose the “aggregate fair value
amounts of derivative instruments . . . that contain
credit-risk-related contingent features that are in
a net liability position at the end of the reporting
period.”
4
When determining amounts already
posted, an entity may need to allocate posted
collateral among derivative and nonderivative
positions (e.g., if collateral is posted for a net
relationship liability under a master netting
arrangement and the relationship consists of
derivatives and nonderivatives). Allocation
approaches should be reasonable and consistently
applied. For guidance on allocation methods under
ASC 815-10-45-1 through 45-7 and ASC 210-20-45-1
through 45-5, see Section
6.2.1.1.5).
5
For simplicity, it is assumed in the
examples below that collateral requirements are
calculated by reference to the GAAP fair value of
the contract (or the portfolio when master netting
arrangements are considered) as of the balance sheet
date. If contracts (or master netting arrangements)
require posting of collateral on a different basis,
an entity should use the basis prescribed in the
contract to develop the disclosures under ASC
815-10-50-4H(d)–(f). It is also assumed in the
examples that the most a counterparty can request is
100 percent collateralization.
Chapter 7 — Adoption of ASU 2017-12
Chapter 7 — ASU 2017-12
7.1 Overview
As discussed in Section 1.2, in August 2017, the
FASB issued ASU 2017-12, which amended
the hedge accounting recognition and presentation requirements in ASC 815. The Board’s
objectives in issuing the ASU were to (1) improve the transparency and understandability
of information conveyed to financial statement users about an entity’s risk management
activities by better aligning the entity’s financial reporting for hedging relationships
with those risk management activities and (2) reduce the complexity of hedge accounting
and simplify its application by preparers.
ASU 2017-12 is now effective for all entities. Because the ASU significantly altered the
hedge accounting model by making it easier for an entity to achieve hedge accounting and
making that accounting better reflect the entity’s risk management activities, it is
important for entities to be aware of the key aspects of the hedge accounting standard
that changed upon its adoption.
7.2 Summary of Significant Changes to Accounting and Reporting
ASU 2017-12 made a number of changes to the hedge accounting model in
ASC 815. Many of these changes are discussed in earlier chapters. Key changes that
altered the accounting for and reporting of qualifying hedging relationships are
summarized below.
7.2.1 Elimination of the Concept of Separately Recognizing Periodic Hedge Ineffectiveness
ASU 2017-12 eliminated the concept of separately recognizing periodic hedge
ineffectiveness for cash flow and net investment hedges (however, under the
mechanics of fair value hedging, economic ineffectiveness is still reflected in
current earnings for those hedges). The Board believed that requiring an entity to
record the impact of both the effective and ineffective components of a hedging
relationship in the same financial reporting period and in the same income statement
line item makes that entity’s risk management activities and their effect on the
financial statements more transparent to financial statement users. See Section 6.3 for a more thorough discussion of the
presentation of hedge accounting results in the income statement.
7.2.2 Recognition and Presentation — Components Excluded From the Hedge Effectiveness Assessment
ASU 2017-12 continues to allow an entity to exclude the time value of options, or
portions thereof, and forward points from the assessment of hedge effectiveness. It
also permits an entity to exclude the change in the fair value of cross-currency
basis spreads in currency swaps from the effectiveness assessment.
As noted in Section 2.5.2.1.2.1, for excluded components in fair
value, cash flow, and net investment hedges, the base recognition model under ASU
2017-12 is an amortization approach. Although an entity will no longer be required
to record changes in the fair value of the excluded component currently in earnings,
it may elect to do so under the ASU. However, such an election will need to be
applied consistently to similar hedges.
ASU 2017-12 also requires that when the excluded components are recognized in
earnings, those amounts are recognized in the same income statement line item as the
change in fair value of the hedging instrument that is included in the hedge
effectiveness assessment, except for net investment hedging (see Section
6.3.1.2).
7.2.3 Amendments to Benchmark Interest Rates and the Definition of Interest Rate Risk
Previously, U.S. GAAP defined “interest rate risk” for both fair value and cash flow
hedges as the “risk of changes in a hedged item’s fair value or cash flows
attributable to changes in the designated benchmark interest rate.” ASU 2017-12
redefined “interest rate risk” as follows:
For recognized variable-rate financial instruments and forecasted issuances
or purchases of variable-rate financial instruments, interest rate risk is
the risk of changes in the hedged item’s cash flows attributable to changes
in the contractually specified interest rate in the agreement.
For recognized fixed-rate financial instruments, interest rate risk is the
risk of changes in the hedged item’s fair value attributable to changes in
the designated benchmark interest rate. For forecasted issuances or
purchases of fixed-rate financial instruments, interest rate risk is the
risk of changes in the hedged item’s cash flows attributable to changes in
the designated benchmark interest rate.
Thus, ASU 2017-12 eliminated the benchmark interest rate concept for variable-rate
financial instruments but retained it for fixed-rate financial instruments.
As indicated in the revised definition of interest rate risk, in cash flow hedges of
interest rate risk associated with forecasted issuances or purchases of debt, the
nature of the hedged risk will depend on the characteristics of the forecasted
transaction. An entity that expects to issue or purchase fixed-rate debt would hedge
the variability in cash flows associated with changes in the benchmark interest
rate; for a forecasted issuance or purchase of variable-rate debt, the entity would
hedge the variability in cash flows associated with changes in the contractually
specified rate. If the entity is unsure about the nature of its forecasted
transaction, it would designate as the hedged risk the variability in cash flows
attributable to a change in a rate that would qualify both as a benchmark interest
rate (if the forecasted transaction ultimately was fixed rate) and as a
contractually specified rate (if the forecasted transaction ultimately was variable
rate).
As discussed in Section 2.3.1.1, ASU 2017-12 also added the
SIFMA Municipal Swap Rate to those benchmark interest rates already permitted under
preadoption guidance to make it easier for entities to hedge interest rate risk for
fixed-rate tax-exempt financial instruments.
7.2.4 Fair Value Hedges of Interest Rate Risk
ASU 2017-12 simplified fair value hedges of interest rate risk by adding the following:
- The ability to determine the change in the hedged item’s fair value that is attributable to changes in the benchmark interest rate by using only the benchmark interest rate component of coupon cash flows (see Section 3.2.1).
- The ability to consider only how changes in the benchmark interest rate affect the decision to settle the hedged item before its scheduled maturity when calculating the change in the hedged item’s fair value that is attributable to interest rate risk (see Section 3.2.1.2).
- Partial-term hedging, which is the ability to measure the change in the hedged item’s fair value that is attributable to changes in the benchmark interest rate by “using an assumed term that begins when the first hedged cash flow begins to accrue and ends when the last hedged cash flow is due and payable.” Because the hedged item’s assumed maturity will be the date on which the last hedged cash flow is due and payable, a principal payment will be assumed to occur at the end of the specified partial term (see Section 3.2.1.1).
- A “last-of-layer method” that enables an entity to apply fair value hedging to closed portfolios of prepayable assets without having to consider prepayment risk or credit risk when measuring those assets. An entity can also apply the method to one or more beneficial interests (e.g., an MBS) secured by a portfolio of prepayable financial instruments (see Section 3.2.1.4).
7.2.5 Contractually Specified Components of Nonfinancial Assets
As discussed in Section 2.3.2.1, ASU 2017-12 added the ability
for entities to hedge the risk of changes to a contractually specified component of
the price of a forecasted purchase or sale of a nonfinancial asset. The ASU defines
a contractually specified component as “[a]n index or price explicitly referenced in
an agreement to purchase or sell a nonfinancial asset other than an index or price
calculated or measured solely by reference to an entity’s own operations.”
7.3 Effective Date
ASC 815-20
65-3 The following represents the
transition and effective date information related to Accounting
Standards Updates No. 2017-12, Derivatives and Hedging (Topic
815): Targeted Improvements to Accounting for Hedging
Activities, No. 2019-04, Codification Improvements to
Topic 326, Financial Instruments — Credit Losses, Topic 815,
Derivatives and Hedging, and Topic 825, Financial
Instruments, and No. 2019-10, Financial Instruments —
Credit Losses (Topic 326), Derivatives and Hedging (Topic
815), and Leases (Topic 842): Effective Dates:
- For public business entities, the pending content that links to this paragraph shall be effective for fiscal years beginning after December 15, 2018, and interim periods within those fiscal years.
- For all other entities, the pending content that links to this paragraph shall be effective for fiscal years beginning after December 15, 2020, and interim periods within fiscal years beginning after December 15, 2021.
- Early adoption, including adoption in an interim period, of the pending content that links to this paragraph is permitted. If an entity early adopts the pending content that links to this paragraph in an interim period, any adjustments shall be reflected as of the beginning of the fiscal year that includes that interim period (that is, the initial application date). . . .
For public business entities, ASU 2017-12 became effective for fiscal
years beginning after December 15, 2018, and interim periods therein. In November 2019,
the FASB issued ASU
2019-10, which deferred the effective date for all other entities.
For those entities, ASU 2017-12 became effective for fiscal years beginning after
December 15, 2020, and interim periods within fiscal years beginning after December 15,
2021.
In addition, in April 2019, the FASB issued ASU
2019-04, which included amendments to ASC 815 related to hedge
accounting. For entities that had not yet adopted ASU 2017-12 as of the issuance date of
ASU 2019-04, the effective date and transition requirements of ASU 2017-12 are the same
as those of ASU 2019-04.1 For entities that had adopted ASU 2017-12 as of the issuance date of ASU 2019-04,
the effective date of ASU 2019-04 is the earlier of the beginning of the first quarterly
period (if applicable) or the first annual period after the issuance date of ASU
2019-04, with early adoption permitted on or after that issuance date.
Footnotes
1
ASU 2019-04 includes Codification improvements related to several financial
instrument topics, not just ASC 815. All references to the effective date of ASU
2019-04 in this discussion apply only to the effective date of the amendments to
ASC 815.
7.4 Transition Provisions
ASC 815-20
65-3
The following represents the transition and effective date
information related to Accounting Standards Updates No.
2017-12, Derivatives and Hedging (Topic 815): Targeted
Improvements to Accounting for Hedging Activities,
No. 2019-04, Codification Improvements to Topic 326,
Financial Instruments — Credit Losses, Topic 815,
Derivatives and Hedging, and Topic 825, Financial
Instruments, and No. 2019-10, Financial
Instruments — Credit Losses (Topic 326), Derivatives and
Hedging (Topic 815), and Leases (Topic 842): Effective
Dates: . . .
d. For cash flow hedges and net investment hedges
existing (that is, the hedging instrument has not
expired, been sold, terminated, or exercised or the
entity has not removed the designation of the
hedging relationship) as of the date of adoption, an
entity shall apply the pending content that links to
this paragraph related to the elimination of the
separate measurement of ineffectiveness by means of
a cumulative-effect adjustment to accumulated other
comprehensive income with a corresponding adjustment
to the opening balance of retained earnings as of
the initial application date. . . .
Entities adopt the provisions of ASU 2017-12 by applying a modified
retrospective approach to existing hedging relationships2 as of the adoption date. Under this approach, entities with cash flow or net
investment hedges make (1) a cumulative-effect adjustment to AOCI so that the
adjusted amount represents the cumulative change in the hedging instruments’ fair
value since hedge inception (less any amounts that should have been recognized in
earnings under the new accounting model) and (2) a corresponding adjustment to
opening retained earnings as of the most recent period presented on the date of
adoption.
7.4.1 Transition Elections
ASC 815-20
65-3 The following represents the
transition and effective date information related to
Accounting Standards Updates No. 2017-12, Derivatives and
Hedging (Topic 815): Targeted Improvements to Accounting
for Hedging Activities, No. 2019-04, Codification
Improvements to Topic 326, Financial Instruments —
Credit Losses, Topic 815, Derivatives and Hedging, and
Topic 825, Financial Instruments, and No. 2019-10,
Financial Instruments — Credit Losses (Topic 326),
Derivatives and Hedging (Topic 815), and Leases (Topic
842): Effective Dates: . . .
e. An entity may elect any of the following
items upon adoption of the pending content that links to
this paragraph:
- For a fair value hedge of interest rate risk existing as of the date of adoption, an entity may modify the measurement methodology for a hedged item in accordance with either paragraph 815-20-25-6B or paragraph 815-25-35-13 without dedesignation of the hedging relationship. The cumulative basis adjustment carried forward shall be adjusted to an amount that reflects what the cumulative basis adjustment would have been at the initial application date had the modified measurement methodology been used in all past periods in which the hedging relationship was outstanding. When making this election, the benchmark rate component of the contractual coupon cash flows shall be determined as of the hedging relationship’s original inception date. The cumulative effect of applying this election shall be recognized as an adjustment to the basis adjustment of the hedged item recognized on the balance sheet with a corresponding adjustment to the opening balance of retained earnings as of the initial application date.
-
For the fair value hedges of interest rate risk for which an entity modifies the measurement methodology for the hedged item based on the benchmark rate component of the contractual coupon cash flows in accordance with (1) above, an entity may elect to rebalance the hedging relationship through any of the following approaches, including any combination of those approaches:
- Increasing the designated notional amount of the hedging instrument
- Decreasing the designated notional amount of the hedging instrument
- Increasing the designated proportion of the hedged item
- Decreasing the designated proportion of the hedged item.
An entity may not add a new hedging instrument or hedged item to an existing hedging relationship. If an entity applies the guidance in (iii) or (iv) above, the cumulative effect of changing the designated proportion of the hedged item shall be recognized as an adjustment to the basis adjustment of the hedged item recognized on the balance sheet with a corresponding adjustment to the opening balance of retained earnings as of the initial application date. - For fair value hedges existing as of the date of adoption in which foreign exchange risk is the hedged risk or one of the hedged risks and a currency swap is the hedging instrument, an entity may, without dedesignation, modify its hedge documentation to exclude the cross-currency basis spread component of the currency swap from the assessment of hedge effectiveness and recognize the excluded component through an amortization approach. The cumulative effect of applying this election shall be recognized as an adjustment to accumulated other comprehensive income with a corresponding adjustment to the opening balance of retained earnings as of the initial application date.
- For hedges existing as of the date of adoption that exclude a portion of the hedging instrument from the assessment of effectiveness, an entity may modify the recognition model for the excluded component from a mark-to-market approach to an amortization approach without dedesignation of the hedging relationship. The cumulative effect of applying this election shall be recognized as an adjustment to accumulated other comprehensive income with a corresponding adjustment to the opening balance of retained earnings as of the initial application date.
- An entity may modify documentation
without dedesignating an existing hedging
relationship to specify the following:
- For hedging relationships that currently use a quantitative method to assess effectiveness, that subsequent prospective and retrospective effectiveness assessments shall be performed qualitatively in accordance with paragraph 815-20-25-3(b)(2)(iv)(03)
- For hedging relationships that currently use the shortcut method to assess effectiveness, the quantitative method that would be used to perform assessments of effectiveness in accordance with paragraph 815-20-25-117A if the entity determines at a later date that use of the shortcut method was not or no longer is appropriate
- For cash flow hedging relationships in which an entity currently uses a quantitative method to assess effectiveness, that the critical terms of the hedging instrument and the hedged item match if the criteria in paragraphs 815-20-25-84 through 25-85 or paragraphs 815-20-25-129 through 25-129A are met and that subsequent prospective and retrospective effectiveness assessments shall be performed in accordance with paragraphs 815-20-35-9 through 35-12 or in accordance with paragraphs 815-20-25-126 through 25-129A and paragraphs 815-30-35-33 through 35-34.
- For cash flow hedges existing as of
the date of adoption in which the hedged risk is
designated as the variability in total cash flows
that meet the requirements to designate as the
hedged risk the variability in cash flows
attributable to changes in a contractually specified
component or a contractually specified interest
rate, an entity may:
- Modify the hedging relationship, without dedesignation, to specify the hedged risk is the variability in the contractually specified component or contractually specified interest rate
- Create the terms of the instrument used to estimate changes in value of the hedged risk (either under the hypothetical derivative method or another acceptable method in Subtopic 815-30) in the assessment of effectiveness on the basis of market data as of the inception of the hedging relationship
- Consider any ineffectiveness previously recognized on the hedging relationship as part of the transition adjustment in accordance with (d) above.
- An entity may reclassify a debt
security from held-to-maturity to available-for-sale
if the debt security is eligible to be hedged under
the last-of-layer method in accordance with
paragraph 815-20- 25-12A. Any unrealized gain or
loss at the date of the transfer shall be recorded
in accumulated other comprehensive income in
accordance with paragraph 320-10-35-10(c). That
reclassification, in and of itself, would not result
in any of the following:
- Call into question the entity’s assertion at the most recent reporting date that it had the intent and ability to hold to maturity those debt securities that continue to be classified as held-to-maturity
- Require the entity to designate the reclassified security in a hedging relationship under the last-of-layer method
- Restrict the entity from selling the reclassified security.
f. For private companies that are not
financial institutions as described in paragraph
942-320-50-1 and not-for-profit entities (except for
not-for-profit entities that have issued, or are a conduit
bond obligor for, securities that are traded, listed, or
quoted on an exchange or an over-the-counter market), the
elections in (e) above shall be determined before the next
interim (if applicable) or annual financial statements are
available to be issued.
g. For all other entities, the elections in
(e) above shall be determined before the first quarterly
effectiveness assessment date after the date of
adoption.
h. For fair value hedges existing as of the
date of adoption in which the hedged item is a tax-exempt
financial instrument, the hedged risk may be modified to
interest rate risk related to the Securities Industry and
Financial Markets Association (SIFMA) Municipal Swap Rate.
The modification shall be considered a dedesignation and
immediate redesignation of the hedging relationship. In this
situation, the cumulative basis adjustment of the hedged
item from the dedesignated hedging relationship shall be
amortized to earnings on a level-yield basis over a period
of time based on the applicable requirements in other
Topics. . . .
ASU 2017-12 provides the following transition elections, which may
be applied individually or in any combination:
-
Transition elections for all hedges that exist on the date of adoption:
-
An entity may modify the recognition model for excluded components from a mark-to-market approach to the amortization approach without having to dedesignate the hedging relationship by making (1) a cumulative-effect adjustment to AOCI and (2) a corresponding adjustment to opening retained earnings as of the initial application date.
-
An entity may modify hedge documentation without dedesignating those hedges to specify the following:
-
That subsequent prospective and retrospective hedge effectiveness assessments will be performed qualitatively.
-
For hedging relationships for which the entity uses the shortcut method, the quantitative method that the entity will use to perform assessments of effectiveness if it determines at a later date that use of the shortcut method was not or no longer is appropriate.
-
-
-
Transition elections for fair value hedges that exist on the date of adoption:
-
For fair value hedges of interest rate risk, an entity may elect to apply the revised measurement methods related to (1) using the benchmark rate component of contractual coupon cash flows to measure changes in the hedged item’s fair value that are attributable to changes in the benchmark interest rate or (2) considering only changes in benchmark interest rates in calculating prepayable financial instruments’ change in fair value that is attributable to interest rate risk. When making this election, which does not require dedesignation of the hedging relationship, an entity should:
-
Adjust the amount of any existing cumulative basis adjustment to what it would have been as of the adoption date had the entity applied the revised measurement method throughout the life of the hedging relationship and make a corresponding adjustment to the opening balance of retained earnings as of the initial application date.
-
Determine the benchmark rate component of the contractual coupon cash flows as of the hedging relationship’s original inception date.
-
-
An entity that elects to revise its measurement method to use the benchmark rate component of the contractual coupon cash flows also may elect to rebalance the hedging relationship by increasing or decreasing the designated notional amount of the hedging instrument or designated proportion of the hedged item. An entity may not add a new hedging instrument or hedged item to an existing relationship without dedesignating the existing relationship and redesignating a new hedging relationship. If an entity changes the designated proportion of the hedged item, the cumulative effect of changing the designated portion of the hedged item should be recognized as the related basis adjustment to the opening balance of retained earnings as of the initial application date.
-
An entity that uses cross-currency swaps to fair value hedge foreign exchange risk may, without dedesignating the hedging relationship, modify its hedge documentation to exclude the cross-currency basis spread component of the currency swap from its assessment of hedge effectiveness and recognize that excluded component through an amortization approach. The entity should adjust AOCI for the cumulative effect of applying this election as if it has been applied since the inception of the hedging relationship and make a corresponding adjustment to opening retained earnings as of the initial application date.
-
For existing fair value hedges in which the hedged item is a tax-exempt financial instrument, the hedged risk may be modified to changes in fair value attributable to the SIFMA Municipal Swap Rate. This modification would be considered a dedesignation and immediate redesignation. The cumulative basis adjustment from the dedesignated hedging relationship should be amortized to earnings on a level-yield basis over a period based on the applicable GAAP for that financial instrument.
-
-
Transition elections for cash flow hedges that exist on the date of adoption:
-
For cash flow hedging relationships in which an entity previously used a quantitative method to assess effectiveness, the entity may apply the critical-terms-match method (see Section 2.5.2.2.2) prospectively without having to dedesignate the hedge.
-
For cash flow hedges (1) in which the entity previously designated as the hedged risk the variability in total cash flows and (2) that now qualify for designation of the variability in cash flows attributable to changes in a contractually specified component or interest rate as the hedged risk, the entity may:
-
Modify the hedging relationship documentation to designate the variability in the contractually specified component or contractually specified interest rate as the hedged risk, without having to dedesignate the hedge.
-
Establish the terms of the instrument that it uses to estimate changes in the value of the hedged risk (under either the hypothetical derivative method or another acceptable method) in its hedge effectiveness assessment on the basis of market data as of the inception of the hedging relationship.
-
Consider any hedging relationship ineffectiveness previously recognized as part of the transition adjustment for cash flow hedges.
-
-
-
Additional transition election:
-
An entity may reclassify a debt security from HTM to AFS if the debt security is eligible to be hedged under the last-of-layer method. Any unrealized gain or loss on the transfer date should be recorded in AOCI in accordance with ASC 320-10-35-10(c).
-
Any reclassification, in and of itself, would not:
-
Call into question the entity’s assertion on the most recent reporting date that it had the intent and ability to hold to maturity those debt securities that continue to be classified as HTM.
-
Require the entity to designate the reclassified security in a last-of-layer hedging relationship.
-
Restrict the entity from selling the reclassified security.
-
-
Private companies that are not financial institutions as well as
not-for-profit entities (except those that have issued, or are a conduit bond
obligor for, securities that are traded, listed, or quoted on an exchange or an OTC
market) must make the transition elections before their next set of interim (if
applicable) or annual financial statements is available to be issued. All other
entities must make the elections before the first effectiveness testing date after
adoption.
7.4.1.1 Exception to Similar Methods of Assessment for Similar Hedges
ASC 815-20
65-3 The
following represents the transition and effective date
information related to Accounting Standards Updates No.
2017-12, Derivatives and Hedging (Topic 815):
Targeted Improvements to Accounting for Hedging
Activities, No. 2019-04, Codification
Improvements to Topic 326, Financial Instruments —
Credit Losses, Topic 815, Derivatives and Hedging,
and Topic 825, Financial Instruments, and No.
2019-10, Financial Instruments — Credit Losses (Topic
326), Derivatives and Hedging (Topic 815), and
Leases (Topic 842): Effective Dates: . . .
i. An entity is not required to apply
the guidance in paragraph 815-20-25-81 when comparing
hedging relationships executed before and after the date
of adoption of the pending content that links to this
paragraph for any of the following:
- Hedging relationships executed before the date of adoption assessed under the shortcut method for which hedge documentation was not amended as permitted by (e)(5)(ii) above, and hedging relationships executed after the date of adoption assessed under the shortcut method in accordance with paragraphs 815-20-25-117A through 25-117D
- Hedging relationships executed before the date of adoption for which the hedged risk was not amended to a contractually specified component or a contractually specified interest rate as permitted by (e)(6) above, and hedging relationships executed after the date of adoption for which the hedged risk is the variability in cash flows attributable to changes in a contractually specified component or a contractually specified interest rate
- Hedging relationships executed before the date of adoption for which the recognition of excluded components was not amended to an amortization approach as permitted by (e)(4) above, and hedging relationships executed after the date of adoption for which an amortization approach is elected in accordance with paragraph 815-20-25-83A. . . .
With respect to the transition elections to (1) amend shortcut
method hedge documentation, (2) change the designated hedged risk to the
variability in cash flows attributable to changes in a contractually specified
component or a contractually specified interest rate, and (3) apply the
amortization approach to recognized excluded components, an entity is not
required to apply the guidance in ASC 815-20-25-81, which states, in part, that
“[o]rdinarily, an entity shall assess effectiveness for similar hedges in a
similar manner, including whether a component of the gain or loss on a
derivative instrument is excluded in assessing effectiveness for similar
hedges.” Therefore, an entity may treat postadoption hedging relationships
differently than it treats similar preadoption hedging relationships.
7.4.2 Presentation and Disclosures
ASC 815-20
65-3 The following represents
the transition and effective date information related to
Accounting Standards Updates No. 2017-12, Derivatives
and Hedging (Topic 815): Targeted Improvements to
Accounting for Hedging Activities, No. 2019-04,
Codification Improvements to Topic 326, Financial
Instruments — Credit Losses, Topic 815, Derivatives
and Hedging, and Topic 825, Financial
Instruments, and No. 2019-10, Financial
Instruments — Credit Losses (Topic 326), Derivatives
and Hedging (Topic 815), and Leases (Topic 842):
Effective Dates: . . .
j. On a prospective basis only for existing hedging
relationships on the date of adoption (in all interim
periods and fiscal years ending after the date of
adoption), an entity shall:
- Present the entire change in the fair value of the hedging instrument in the same income statement line item as the earnings effect of the hedged item when the hedged item affects earnings (with the exception of amounts excluded from the assessment of hedge effectiveness in a net investment hedge) in accordance with paragraphs 815-20-45-1A and 815-20-45-1C
- Disclose the items in the pending content that links to this paragraph in Subtopic 815-10.
k. An entity shall provide the following disclosures
within Topic 250 on accounting changes and error
corrections:
- The nature of and reason for the change in accounting principle
- The cumulative effect of the change on the opening balance of each affected component of equity ornet assets in the statement of financial position as of the date of adoption
- The disclosures in (1) through (2) above in each interim and annual financial statement period in thefiscal year of adoption.
In each annual and interim reporting period in the fiscal year
of adoption, entities will also be required to provide certain disclosures
required by ASC 250 about (1) the nature and reason for the change in accounting
principle and (2) the cumulative effect of the change on the opening balance of
affected components of equity or net assets as of the date of adoption.
In all interim periods and fiscal years ending after the date of
adoption, entities should prospectively (1) present the entire change in the
fair value of a hedging instrument in the same income statement line item(s) as
the earnings effect of the hedged item when that hedged item affects earnings
(other than amounts excluded from the assessment of net investment hedge
effectiveness, for which ASU 2017-12 does not prescribe presentation) and (2)
provide the amended disclosures required by the new guidance (see Section 6.6).
Footnotes
2
This refers to hedging relationships in which “the hedging
instrument has not expired, been sold, terminated, or exercised” and that
have not been dedesignated by the entity as of the date of adoption.
Chapter 8 — Reference Rate Reform (ASC 848)
Chapter 8 — Reference Rate Reform (ASC 848)
8.1 Overview
In 2014, in response to concerns that interbank offered rates used in hundreds of
trillions of dollars of financial assets were unstable and being manipulated by some
of the banks, global regulators established committees to develop alternative rates
and processes for reporting those rates. At that time, the Federal Reserve Board and
the Federal Reserve Bank of New York convened the Alternative Reference Rates
Committee (ARRC) to identify a suitable alternative to the U.S. dollar LIBOR and to
create an adoption plan to facilitate the acceptance and use of one or more
alternative reference rates. In 2017, the ARRC identified the SOFR rate as its
preferred alternative rate.
The FASB’s reference rate reform project was established to address constituents’
concerns about certain accounting consequences that could result from the global
markets’ anticipated transition away from the use of LIBOR and other interbank
offered rates to alternative reference rates. The first phase of the reference rate
reform project resulted in the October 2018 issuance of ASU 2018-16, which amended ASC 815 to add the
SOFR OIS rate as a fifth U.S. benchmark interest rate (see Section
2.3.1.1).
The next phase of the reference rate reform project focused on concerns that, without
new guidance and relief, entities’ application of contract modification and hedging
requirements under U.S. GAAP to modifications triggered by reference rate reform
would be costly to implement and result in financial reporting that did not
faithfully represent management’s intent or risk management activities. In response,
the FASB issued ASU 2020-04 in March
2020. ASU 2020-04 added a new Codification topic, ASC 848, to provide temporary,
optional expedients related to contract modification accounting and hedge
accounting. For more information about the ASU, see Section 8.2.
In 2020, as part of global market participants’ efforts to
transition to using or referencing alternative reference rates, changes were made by
certain central clearing parties (CCPs) to the interest rates used for discounting
and for variation margin settlements and PAI.1 For example, on July 24, 2020, the CME changed the interest rate used in
certain euro contracts for discounting and PAI from the Euro Overnight Index Average
(EONIA) to the Euro Short-Term Rate (ESTR). In addition, on October 16, 2020, it
changed the interest rate used in U.S. dollar contracts for discounting and PAI from
the daily Effective Federal Funds Rate (EFFR) to SOFR. Interest rate transitions
such as the CME’s changes do not necessarily replace reference rates that are
expected to be discontinued (e.g., the daily EFFR is not expected to be
discontinued), and they are not limited to contracts that reference a rate that is
expected to be discontinued (e.g., the CME’s interest rate transition applies to all
U.S. dollar interest rate products, not only those that reference LIBOR or another
rate that is expected to be discontinued). The CME’s interest rate transitions, for
example, are intended to increase the trading volume in alternative reference rates
(e.g., ESTR and SOFR). Accordingly, not all of the discounting transition
modifications would be within the scope of ASC 848. In response to these concerns,
the FASB completed the third phase of its reference rate reform project by issuing
ASU
2021-01 in January 2021. See Section 8.3 for a discussion of the provisions
of ASU 2021-01.
In December 2022, the FASB issued ASU 2022-06 to defer the sunset date of ASC 848 until December
31, 2024. The ASU became effective upon issuance.
Publication of LIBOR on a representative basis was ceased for one-week and two-month
USD LIBOR settings after December 31, 2021. Publication of remaining USD LIBOR
settings was ceased after June 30, 2023.
Footnotes
1
PAI is also referred to as the price alignment amount (PAA)
by the London Clearing House, and price alignment (PA) by the CME.
8.2 Summary of ASU 2020-04
The relief provided by ASU 2020-04 is elective and applies “to all entities, subject to
meeting certain criteria, that have contracts, hedging relationships, and other
transactions that reference LIBOR or another reference rate expected to be discontinued
because of reference rate reform.” Optional expedients are provided for contract
modification accounting under the following Codification topics and subtopics:
- ASC 310, Receivables.
- ASC 470, Debt.
- ASC 840 or ASC 842, Leases.
- ASC 815-15, Derivatives and Hedging: Embedded Derivatives.
ASU 2020-04 also establishes (1) a general contract modification principle that entities
can apply in other areas that may be affected by reference rate reform and (2) certain
elective hedge accounting expedients.
The optional amendments in ASU 2020-04 are effective for all entities as
of March 12, 2020, through December 31, 2024.2 See Section 8.2.6 for
more information on the ASU’s effective and expiration dates.
8.2.1 Scope of ASC 848
The elective contract modification guidance in ASU 2020-04 applies to “contracts or
other transactions that reference [LIBOR] or a reference rate that is expected to be
discontinued as a result of reference rate reform” (an “affected rate”).
Connecting the Dots
ASU 2020-04 notes that an expectation that a reference rate will be
discontinued could be supported by:
-
A public statement or publication of information by or on behalf of the administrator of the relevant reference rate or by the regulatory supervisor for the administrator
-
Initiatives [undertaken] by a significant number of market participants or by market participants representing a significant number of transactions to move away from the reference rate
-
The production method for the calculation of the published reference rate [being] either:
- Fundamentally restructured
- Reliant on another rate that is expected to discontinue.
The Board chose to provide such guidance in lieu of providing a prescriptive
list of reference rates that fall within the scope of ASU 2020-04.
8.2.2 Contract Modification Relief
8.2.2.1 Scope
The elective guidance in ASU 2020-04 applies to modifications of contract terms
that will directly replace, or have the potential to replace, an affected rate
with another interest rate index, as well as certain contemporaneous
modifications of other contract terms related to the replacement of an affected
rate. As shown in the decision tree below, when contemporaneous modifications
are made, an entity’s eligibility to use the relief provided by ASC 848-20
(added by the ASU) depends on whether the contemporaneous modifications to the
other terms (1) could affect the amount or timing of contractual cash flows and
(2) are related to reference rate reform.
Eligibility
of Contemporaneous Contract Term Modifications for Relief Under the
ASU
3
The modification can be made in anticipation of the
reference rate discontinuance (i.e., before the reference rate is
actually discontinued).
ASU 2020-04 notes that changes in contract terms that are made to effect the
reference rate reform transition are considered related to the replacement of a
reference rate if they are not “the result of a business decision that is
separate from or in addition to changes to the terms of a contract to effect
that transition.” The table below provides examples of possible types of
modifications and indicates whether they generally would be considered related
to the replacement of a reference rate.
Related
|
Unrelated
|
---|---|
Changes to:
| |
|
|
The addition of:
| |
|
|
The addition of or changes to:
| |
| |
The addition or removal of a:
| |
| |
Other:
| |
|
The ASU further states that an entity should disregard circumstances in which
modified fallback terms include or have the potential to include a term
unrelated to reference rate reform if, when the fallback terms are added or
amended, the entity “determines that activation of the term unrelated to
reference rate reform is not probable of occurring if the fallback terms are
triggered.”
8.2.2.2 Contract Modification Expedients
The table below summarizes the optional expedients provided by ASU 2020-04 for
specific areas of the Codification that an entity could elect to apply to
qualifying contract modifications.
Codification Topic
|
Optional Expedients
|
---|---|
Receivables (ASC 310)
|
Account for the modification as if it was only minor (and
not an extinguishment) in accordance with ASC
310-20-35-10.
|
Debt (ASC 470)
|
Account for the modification as if it was not substantial
(i.e., do not treat as an extinguishment).
In applying the 10 percent cash flow test in ASC
470-50-40-10 for any subsequent contract modifications
made within a year, entities should consider only terms
and provisions that were in effect immediately following
the election of the optional expedient.
|
Leases (ASC 840 or ASC 842)
|
The modification will not (1) trigger reassessment of
lease classification and the discount rate or (2)
require the entity to remeasure lease payments or
perform the other reassessments or remeasurements that
would otherwise be triggered by a modification under ASC
840 or ASC 842 when that modification is not accounted
for as a separate contract.
The modification of terms on which variable lease
payments depend will not cause the lessee to remeasure
the lease liability. The effects of such changes will
instead be recognized in profit or loss in the period in
which the obligation for those payments is incurred.
|
Embedded derivatives (ASC 815-15)
|
The modification of the contract terms will not cause an
entity to reconsider its conclusion about whether that
contract contains an embedded derivative that is clearly
and closely related to the economic characteristics and
risks of the host contract.
|
Other contracts
|
Account for the modification “as an event that does not
require contract remeasurement at the modification date
or reassessment of a previous accounting determination
required under the relevant Topic or Industry
Subtopic.”
|
Under ASU 2020-04, an entity that elects to apply an expedient under a particular
Codification topic, subtopic, or industry subtopic must apply that expedient to
all contract modifications that are within the scope of the ASU and are
accounted for under that topic, subtopic, or industry subtopic. For example, if
an entity applies the expedient to a qualifying modification under ASC 840 or
ASC 842, it would also apply that expedient to all other qualifying
modifications accounted for under those topics. Similarly, an insurer that
applies the expedient under ASC 310 would apply that expedient to all contract
modifications that are within the scope of the ASU and accounted for under the
insurance-specific receivable guidance in ASC 944-310; however, the insurer
would not be required to apply expedients to the other ASC 944 subtopics.
Further, an entity that determines that a contract modification does not qualify
for the optional relief under a given topic or industry subtopic would not be
precluded from applying the optional expedients to other qualifying contract
modifications.
8.2.3 Hedging Relief
8.2.3.1 Changes in Critical Terms
ASU 2020-04 allows entities to amend their formal designation and documentation
of hedging relationships in certain circumstances as a result of reference rate
reform. Under the ASU, if specified criteria are met, entities may change
certain critical terms of existing hedging relationships that are affected or
expected to be affected by reference rate reform, and these changes would not,
in and of themselves, cause an entity to dedesignate the hedging relationship.
An entity may elect to apply (1) expedients related to hedge accounting to each
individual hedging relationship (and not necessarily to other similar hedging
relationships) and (2) multiple optional expedients for a single hedging
relationship and in different reporting periods. The optional expedients include:
-
Changing certain critical terms of a designated hedging instrument, a hedged item, or a forecasted transaction in fair value, cash flow, or net investment hedges that are affected, or expected to be affected, by reference rate reform.6
-
Changing either the designated notional amount or proportion of the hedging instrument, the hedged item, or both to rebalance a fair value hedge.7
-
Changing the hedging instrument designation in fair value or cash flow hedges to combine two or more derivatives (or proportions thereof) and jointly designate them as the hedging instrument.
-
Changing the method of assessing hedge effectiveness for cash flow hedges when either the hedging instrument or the hedged item references an affected rate and the new effectiveness assessment method is an optional expedient for cash flow hedges under ASC 848-50. The entity would not be required to demonstrate that the new method is either an improved or preferable method under ASC 250. An entity may elect to apply this expedient for existing hedging relationships either on the date on which it opts to apply an optional expedient or when it ceases to apply an optional expedient and reverts to the guidance in ASC 815-20 and ASC 815-30.
-
For fair value, cash flow, or net investment hedges, (1) changing the systematic and rational method used to recognize in earnings the components excluded from the effectiveness assessment and, if elected, (2) recognizing in current earnings any change in fair value of the excluded component (resulting from changes to the hedging instrument’s contractual terms) in the same income statement line as the earnings effect of the hedged item.
When an entity elects to apply an expedient, it must update its hedge
documentation to note any changes. Hedge documentation must be updated no later
than when the entity performs its first hedge effectiveness assessment after the
change is made in accordance with ASC 815-20-25-3(b)(2)(iv)(02) and ASC
815-20-25-3A.
As noted in ASC 848-30-25-5, an entity may change the terms of a hedging
instrument, a hedged item, or a forecasted transaction that is “expected to be
affected by reference rate reform.” In other words, an entity may elect some of
the expedients before either the hedging instrument or the hedged item is
modified as a result of reference rate reform. In addition, an entity may apply
an expedient to update its hedge documentation for a single hedging relationship
multiple times as long as each update meets the criteria for one of the
expedients.
Example 8-1
Hedging First Interest Payments Received
Weekapaug Regional Bank has a pay-variable (one-month
LIBOR), receive-fixed interest rate swap hedging first
monthly receipts of one-month LIBOR interest payments on
$100 million of loans each month for changes in cash
flows attributable to changes in the contractually
specified interest rate (i.e., one-month LIBOR).
Weekapaug is no longer originating any loans that are
indexed to one-month LIBOR. Therefore, while it
currently has more than $100 million of one-month
LIBOR-based loans, it expects such loans to be gradually
replaced by loans that have monthly payments based on
SOFR rates.
Weekapaug decides to change the hedged item to first
monthly receipts of either one-month LIBOR interest
payments or SOFR interest payments that are received on
loans with monthly payment frequency on $100 million of
loans each month. It is allowed to amend its hedge
designation documentation for this change without
considering it a dedesignation of the hedging
relationship in accordance with ASC 848-30-25-3 because
the hedged forecasted transactions before the change are
within the scope of ASC 848-20-15-2 and 15-3 (i.e., they
are based on LIBOR).
Weekapaug is likely to further amend the critical terms
of the hedging relationship if any of the following occur:
- The interest rate swap is modified or replaced with a SOFR-based swap before its termination date.
- Weekapaug decides to remove receipts of one-month LIBOR interest payments from the hedged item because (1) it is probable that Weekapaug will have receipts of monthly SOFR interest payments on at least $100 million of loans each month for the remaining term of the hedging relationship or (2) it can no longer assert that it reasonably expects that the hedged transactions will include any LIBOR-based payments.
Each of the amendments described above would qualify for
the expedients in ASC 848 because they are related to
the discontinuance of LIBOR. Weekapaug could not change
the hedged item from SOFR interest payments to Bloomberg
Short-Term Bank Yield Index interest payments without
dedesignating the hedging relationship because that
change is not within the scope of ASC 848-20-15-2 and
15-3.
ASU 2020-04 provides additional expedients for the different
types of hedges. An entity that elects to apply these expedients must update its
hedge documentation accordingly.
8.2.3.2 Fair Value Hedges
For existing hedges, ASU 2020-04 allows an entity to change the designated
benchmark interest rate and the component of cash flows if (1) the rate
referenced by the hedging instrument changes or (2) the designation of the
hedging instrument is changed to a combination of derivatives. Further, (1) the
benchmark interest rate designated at hedge inception should be an affected
rate, (2) the newly designated rate should be an eligible benchmark interest
rate, and (3) the entity must expect that the hedging relationship will be
highly effective prospectively.
For existing hedges for which the shortcut method is applied,
when an entity assesses whether the hedging relationship continues to meet the
shortcut criteria, it can, for the remainder of the hedging relationship
(including for periods after December 31, 20248), disregard the requirements that (1) the formula for computing net
settlements under the interest rate swap is the same for each net settlement and
(2) the hedging relationship does not contain any atypical terms or terms that
would invalidate an assumption of perfect effectiveness.
Connecting the Dots
When an entity elects to change the designated benchmark
interest rate in an existing fair value hedging relationship, it must
revise the rate it uses to discount the hedged item’s cash flows to
reflect the change. It also can either (1) choose not to adjust the
cumulative fair value hedge basis adjustment associated with the hedged
item (that consists of cumulative hedging adjustments that existed
immediately before the date of change) or (2) adjust that basis
adjustment to reflect the replacement benchmark interest rate. To
implement its approach, the entity can further adjust either the
remaining designated cash flows or the revised benchmark interest rate
used to discount the hedged cash flows (by including a spread
adjustment). The method an entity uses to apply these approaches is not
prescribed by the ASU; however, it must be reasonable and be
consistently applied to similar hedges. The entity would use the revised
benchmark interest rate (including any applicable spread adjustment) and
the remaining revised cash flows for the designated term of the hedged
item (including periods after December 31, 2024).
When an entity chooses to update the cumulative basis adjustment to
reflect the new benchmark interest rate, it must recognize the
adjustment currently in earnings in the same income statement line as
the earnings effect of the hedged item.
8.2.3.3 Cash Flow Hedges
Under ASU 2020-04, if the designated hedged risk in a cash flow hedge of a
forecasted transaction is the affected rate, an entity can continue to assert
that the forecasted transaction’s occurrence is probable despite the entity’s
expectations about the reference rate’s discontinuance; however, the entity must
continue to assess whether it is probable that the underlying forecasted
transaction (e.g., future interest payments) will occur.
Further, if an entity applies the change in hedged risk guidance to a hedging
relationship affected by reference rate reform, it may determine that the
hedging relationship can continue by electing an optional expedient method to
assess hedge effectiveness.
ASU 2020-04 also notes that if a forecasted transaction in a hedged group of
forecasted transactions references an affected rate, the entity may disregard
the requirement that the group of individual transactions share the same risk
exposure for which they are designated as being hedged; however, the other
requirements for hedging a group of forecasted transactions still must be met
(e.g., forecasted purchases cannot be combined in a group with forecasted
sales).
8.2.3.3.1 Expedients for Assessing Cash Flow Hedge Effectiveness
As noted above, ASU 2020-04 allows entities to apply certain optional
expedients to change a cash flow hedging relationship’s critical terms in
certain circumstances. The ASU provides additional cash flow hedge
expedients that offer relief to entities when they perform effectiveness
assessments for new or existing cash flow hedging relationships in which
either the hedged forecasted transaction or the hedging instrument
references an affected rate. These expedients allow the entity to ignore
certain requirements that a hedging relationship would have otherwise been
required to satisfy to qualify for application of the specified method of
assessing hedge effectiveness. For existing hedging relationships, the
entity should apply the optional practical expedient prospectively from the
date on which it first applies the expedient. An entity would use the
expedient for both prospective and retrospective effectiveness assessments
(retrospective assessments would go back only to the date on which the
entity first applied the expedient). An entity that elects to apply an
expedient must also amend its hedge documentation to reflect its new
effectiveness assessment method.
8.2.3.3.1.1 Expedients Related to Methods That Assume Perfect Hedge Effectiveness
The table below lists conditions that an entity can disregard when it
qualifies for and applies the relevant expedient and performs initial or
subsequent assessments of hedge effectiveness by using an assessment
method that allows for an assumption of perfect hedge effectiveness.
Method of Assuming Perfect Hedge
Effectiveness
|
Conditions
That May Be Disregarded
|
---|---|
Shortcut method
|
|
Assessment on the basis of an option’s terminal
value
|
|
Simplified hedge accounting approach
|
|
Change in variable cash flows method
|
|
Hypothetical derivative method
|
The
hypothetical derivative and the hedged items have
the same:
|
If a hedging relationship satisfies all the other criteria under the
specified method that would allow for an assumption of perfect hedge
effectiveness (after the criteria listed above are disregarded), the
entity may assume that the hedge will be perfectly effective.
8.2.3.3.1.2 Expedients Related to Quantitative Methods
ASU 2020-04 also permits
an entity to apply the following optional expedients for the specified
effectiveness assessment method when it performs either an initial or
subsequent quantitative assessment of cash flow hedge effectiveness:
Quantitative Method of Assessing Hedge
Effectiveness
|
Optional Expedients
|
---|---|
|
|
Assessment on the basis of an option’s terminal
value
|
If either the hedging instrument
or hedged item references an affected rate, an
entity may adjust the critical terms of the
perfectly effective hypothetical derivative used
to assess effectiveness to match those of the
hedging instrument for:
|
8.2.3.3.1.3 Expedients Related to a Qualitative Method
ASU 2020-04 also provides expedients for circumstances in which an entity
performs subsequent effectiveness assessments by using a qualitative
method. Under the ASU, an entity may perform subsequent qualitative
effectiveness assessments when the entity performs its initial test of
hedge effectiveness by using either (1) one of the effectiveness
assessment methods in ASC 815-20 and ASC 815-30 or (2) an optional
expedient method. An entity that elects to apply this optional expedient
may disregard the criteria in ASC 815-20-35-2A through 35-2F that it
would otherwise have had to satisfy to qualify for the use of subsequent
qualitative assessments.
Under the ASU, to conclude that a hedging relationship continues to
qualify for subsequent qualitative effectiveness assessments, an entity
“shall verify and document whenever financial statements or earnings are
reported and at least every three months,” that the relationship
satisfies the following criteria:
-
Either the hedging instrument or the hedged forecasted transaction references an affected rate.
-
No changes have been made to the hedging instrument’s or forecasted transaction’s terms other than those that are permitted under the ASU (see the discussion above about modifications that are subject to the ASU).
-
The likelihood of the counterparty’s compliance with the hedging instrument’s contractual terms has been considered by the entity.
No other facts or circumstances need to be assessed.
An entity that determines that it can no longer qualitatively assert that
a hedging relationship is highly effective would need to quantitatively
assess the hedging relationship’s effectiveness; however, the entity
could elect to apply any expedient for a quantitative assessment method
if the hedging relationship is eligible for that expedient.
Connecting the Dots
In ASU 2020-04’s Background Information and Basis for
Conclusions, the Board acknowledges that the cash flow hedge
expedients provide a great deal of flexibility and that their
application could result in an entity’s applying hedge
accounting to a hedging relationship that is not highly
effective. In addition, for many hedges, application of the
expedients would essentially suspend the requirement to perform
subsequent hedge effectiveness assessments. The Board believes,
however, that new and existing cash flow hedges that will be
affected by reference rate reform should be allowed to continue
because they reflect the entity’s intended risk management
strategy.
Further, the Board believes that the flexibility
afforded by the expedients is counterbalanced by (1) its
requirement that entities adopt ASU 2017-12 before they can qualify for
most of the expedients (only certain expedients are available
for entities that have not yet adopted ASU 2017-12) and (2) the
fact that the relief is available only for a limited time and
will sunset at the end of 2024.10 Specifically, in a qualifying cash flow hedge under ASU
2017-12, the portion of the change in the fair value of the
hedging instrument that is included in the assessment of hedge
effectiveness is initially recognized in OCI in each reporting
period. Amounts in AOCI will ultimately be reclassified into
earnings in the same period or periods in which the hedged
transaction affects earnings and will be recognized in the same
income statement line as the earnings effect of the hedged item.
Because of this presentation requirement, the Board observes in
paragraph BC88 of ASU 2020-04 that “the results of an entity’s
hedging relationships are reflected in an income statement line
item that is typically an important metric for entities that
have significant interest rate risk hedging programs. Therefore,
in the Board’s view, the results of systematically entering into
drastically ineffective hedges would raise questions on the part
of users of financial statements.”
8.2.3.3.2 Losing Eligibility to Use an Expedient
An entity must cease using an expedient for assessing hedge effectiveness for
a cash flow hedge if any of the following conditions occur:
-
Neither the hedging instrument nor the hedged item references an affected rate.
-
The expedient guidance is superseded.
-
The entity chooses to cease application of the expedient.
When it stops using an expedient, the entity must revert to applying the
qualifying criteria and effectiveness assessment methods in ASC 815-20 and
ASC 815-30. A change in the effectiveness assessment method would not, in
and of itself, trigger a need to dedesignate the hedging relationship;
however, the entity would need to update its hedge documentation
accordingly. For continuing hedging relationships, the entity would apply
the new method of assessing effectiveness both prospectively and
retrospectively from the date of change (i.e., when the new assessment
method is first applied).
8.2.4 HTM Debt Security Classification Relief
Under ASU 2020-04, an entity may make a one-time election to sell, or to transfer to
the AFS or trading classifications (or both sell and transfer), debt securities that
both (1) reference an affected rate and (2) were classified as HTM before January 1,
2020. An entity that makes this election is not required to apply it to all debt
securities meeting these criteria. Such sales or transfers would not call into
question the entity’s previous assertions about its intent and ability to hold those
securities to maturity. An entity making such a transfer is required to apply the
measurement guidance governing transfers in ASC 320-10-35-10 through 35-16 and
provide the disclosures required by ASC 320-10-50-10.
8.2.5 Disclosures
Entities are required to disclose the nature of and reason for their elections to
apply expedients in each interim and annual financial statement period in the fiscal
year of adoption.
8.2.6 Effective Dates, Transition, and Expiration Dates
The optional amendments are effective for all entities as of March
12, 2020, through December 31, 2024.11 The table below summarizes the effective dates and expiration dates by
category of expedient.
Type of Expedient
|
Effective Date/Expiration Date
|
---|---|
Contract modifications
|
|
Hedging relationships
|
|
Sale or transfer of HTM securities
|
|
Connecting the Dots
As indicated in ASC 848-10-65-1(c), only the following optional expedients
are available for entities that have not yet adopted ASU 2017-12:
-
Entities may change the “critical terms of a hedging relationship.”
-
Private companies may change the method for “assessing hedge effectiveness in a cash flow hedge . . . if the optional expedient method being elected is the simplified hedge accounting approach” for initial or subsequent hedge effectiveness assessments.
-
For cash flow hedges, entities may assume that the occurrence of the hedged forecasted transaction is probable.
-
When using a quantitative method to assess the effectiveness of cash flow hedges, entities may “assume that the reference rate will not be replaced for the remainder of the hedging relationships . . . if both the hedged forecasted transaction and the hedging instrument” reference an affected rate.
-
Private companies may disregard certain criteria when applying the simplified hedge accounting approach in initial or subsequent hedge effectiveness assessments.
Footnotes
2
As discussed in Section 8.1, on December 21, 2022, the
FASB issued ASU 2022-06 to defer the sunset date of ASC 848 until December 31,
2024. The ASU became effective upon issuance.
3
The modification can be made in anticipation of the
reference rate discontinuance (i.e., before the reference rate is
actually discontinued).
4
Under ASU 2020-04, the
“selection of a rate that is the last published
rate of an interest rate index that is
discontinued is not considered a stated fixed
rate.”
5
ASU 2020-04 provides that the
addition or removal of a prepayment or conversion
option is considered unrelated to the replacement
of a reference rate except for “the addition of a
prepayment option for which exercise is contingent
upon the replacement reference interest rate index
not being determinable in accordance with the
terms of the agreement.”
6
The expedient would also apply to hedging
instruments that are modified by (1) entering into a
derivative that fully offsets the original designated
hedging instrument and (2) contemporaneously entering into a
new derivative that has the modified contractual terms.
7
If the entity rebalances a fair value
hedging relationship by increasing or reducing the
designated portion of the hedged item, it must recognize the
cumulative effect of making that change as an adjustment to
the basis adjustment that would be recognized as a result of
changing the designated benchmark interest rate, in
accordance with ASC 848-40.
8
See footnote 2.
9
For a forecasted issuance or
purchase of fixed-rate debt in which the
designated hedged interest rate risk is a
benchmark interest rate, only the hedging
instrument must reference an affected rate.
10
See footnote 2.
11
See footnote 2.
12
See footnote 2.
13
See footnote 2.
14
Under ASU 2020-04, if any of
the following expedients are elected for hedging
relationships existing as of December 31, 2024
(see footnote 2), they will be retained through
the end of the hedging relationship:
- “An optional expedient to the systematic and rational method used to recognize in earnings the components excluded from the assessment of effectiveness.”
- “An optional expedient to the rate to discount cash flows associated with the hedged item and any adjustment to the cash flows for the designated term or the partial term of the designated hedged item in a fair value hedge.”
- “An optional expedient to not periodically evaluate [the specified] conditions in [ASC] 815-20-25-104(d) and (g) when using the shortcut method for a fair value hedge.”
15
See footnote 2.
8.3 Summary of ASU 2021-01
As briefly discussed in Section 8.1, the FASB issued ASU 2021-01 in
January 2021 to expand the scope of ASC 848 in response to discounting transition
activities in the marketplace. The optional amendments in ASU 2021-01 are effective for
all entities as of March 12, 2020, through December 31, 2024.16 See Section 8.3.6 for
more information on the ASU’s effective and expiration dates.
8.3.1 Scope of ASC 848 (ASC 848-10)
The FASB acknowledges that not all derivative contracts subject to the discounting
transition reference LIBOR or other interbank offered rates that are expected to be
discontinued. For example, the discounting transition will affect derivative
contracts that currently reference and will continue to reference other interest
rates (e.g., EFFR, SOFR, the SIFMA Municipal Swap Rate). However, the scope of ASC
848 established by ASU 2020-04 does not include such contracts. As stated in
paragraph BC10 of ASU 2021-01, ASC 848 was intended to provide relief related to
“contracts and transactions that reference LIBOR or a reference rate that is
expected to be discontinued as a result of reference rate reform.” Accordingly, ASU
2021-01 expands the scope of ASC 848 to include all affected derivatives and to
enable market participants to apply certain aspects of the contract modification and
hedge accounting expedients to derivative contracts affected by the discounting
transition.
In addition, ASU 2021-01 adds implementation guidance (codified in ASC 848-10-55-1)
to clarify which optional expedients in ASC 848 may be applied to derivative
instruments that do not reference LIBOR or a reference rate that is expected to be
discontinued, but that are being modified as a result of the discounting transition.
The ASU presents that implementation guidance in a table, which is reproduced
below.
Codification Subtopic
|
Provisions That Apply to Derivatives That Meet the Scope of
Paragraph 848-10-15-3A
|
---|---|
848-20
|
|
848-30
|
|
848-40
|
|
848-50
|
|
8.3.2 Contract Modifications (ASC 848-20)
As originally issued, the guidance in ASC 848-20-35-1 indicated that an entity that
elects to use a contract modification expedient under a particular Codification
topic, subtopic, or industry subtopic must apply the expedient to all contract
modifications accounted for under that guidance. ASU 2021-01 amends that guidance to
state that the election to apply the contract modification expedients to the
modifications related to the discounting transition is separate from the election to
apply the contract modification expedients to modifications related to broader
reference rate reform activities. In addition, the ASU clarifies that if an entity
elects to apply the contract modification expedients in ASC 848 to modifications
resulting from the discounting transition, it must apply those expedients to all
discounting transition modifications.
Connecting the Dots
ASC 848-20-35-4 and ASC 848-20-55-2 can be applied to derivative contracts
affected by the discounting transition. That is, an entity can conclude that
a contract previously determined to be a derivative in accordance with ASC
815 continues to meet the definition of a derivative and not a hybrid
instrument in situations in which the terms of the contract change as a
result of the discounting transition. Further, in accordance with ASC
815-10-45-11 through 45-15, an entity does not need to reassess whether the
contract includes a financing element.
8.3.3 Hedging — General (ASC 848-30)
ASU 2021-01 permits an entity to elect certain hedging relief if it
has designated a derivative as a hedging instrument in a hedging relationship and
the terms of the derivative (e.g., discount rate) have changed as a result of the
discounting transition.
Connecting the Dots
In situations in which a derivative is designated as a
hedging instrument in a hedging relationship and the interest rate used for
discounting cash flows to calculate variation margin settlements and PAI has
changed as a result of the discounting transition, questions have arisen
about whether the change was made to critical terms of the hedging
relationship. ASU 2021-01 clarifies that ASC 848-30-25-7 continues to apply
to the affected derivative; that is, a change in the interest rate as a
result of the discounting transition would not be considered a change to the
critical terms of a hedging relationship. An entity can continue to apply
hedge accounting without dedesignating the existing hedging relationship;
see ASC 848-10-55-1 (added by the ASU).
A cash settlement (or equivalent) may be exchanged to neutralize the change in the
fair value of a derivative affected by the discounting transition. If such a
derivative is designated as a hedging instrument in a cash flow hedging
relationship, that cash settlement may create a mismatch between the fair value of
the hedging instrument and the amount deferred in AOCI.
Under ASU 2021-01, an entity that assesses the effectiveness of a cash flow hedging
relationship by using a method that allows an assumption of perfect hedge
effectiveness is permitted to elect the relevant optional expedients and
subsequently apply the original effectiveness assessment method under which it
continues to assume that the hedge is perfectly effective after the discounting
transition. Alternatively, the entity can elect to change to any applicable
quantitative method of assessing the effectiveness of a cash flow hedge in ASC
815-20 and ASC 815-30 without dedesignating the hedging relationship. The ASU
requires an entity that originally applied a quantitative or qualitative method in
accordance with ASC 815-20 and ASC 815-30 to continue to apply the same method when
performing its subsequent effectiveness assessment of a cash flow hedging
relationship that was affected by the discounting transition.
In addition, for all cash flow hedging relationships affected by the discounting
transition, an entity can use a reasonable approach to adjust the amount recorded in
AOCI for the cash settlement (or equivalent) as a result of the discounting
transition. Any adjustment to AOCI would be recognized in the income statement in
the same manner as other reclassifications out of AOCI related to the hedging
relationship.
Connecting the Dots
ASC 848 does not specify the method an entity should use to adjust the amount
in AOCI for the cash settlement (or equivalent) as a result of the
discounting transition; rather, the guidance only requires the use of a
reasonable method. However, an entity should apply its elected method
consistently to similar hedges. An entity that does not elect to adjust the
amount recorded in AOCI as a result of the discounting transition should
ensure that this amount is reclassified into earnings when the hedged
transaction affects earnings or when it is probable that the hedged
transaction will no longer occur.
In fair value hedging relationships for which the shortcut method is used, a receipt
or payment of a cash settlement (or equivalent) as a result of the discounting
transition may also cause a mismatch in the cumulative change in the fair value of
the hedging instrument (e.g., an interest rate swap) and the cumulative-basis
adjustments applied to the hedged item (e.g., fixed-rate debt hedged for changes in
fair value because of changes in LIBOR). That is, the cumulative-basis adjustments
will not be naturally unwound as settlements occur on the hedging instrument. ASU
2021-01 addresses this issue by adding an optional expedient that permits an entity
to use a reasonable approach to adjust the cumulative-basis adjustment for the
amount equal to the fair value change in the hedging instrument (i.e., a cash
settlement or equivalent) as a result of the discounting transition. An entity could
also elect, as an optional expedient, to continue to apply the shortcut method when
assessing the effectiveness of the hedging relationship affected by the discounting
transition.
As originally issued, the guidance in ASC 848-30-25-9 provided that an entity may
combine two or more derivative instruments, or proportions of those instruments, to
be jointly designated as the hedging instrument in a hedging relationship without
dedesignating the hedging relationship in response to reference rate reform. ASU
2021-01 adds a provision to ASC 848-30-25-9(b) that allows an entity to subsequently
remove one or more, or proportions of, those derivatives without dedesignating the
hedging relationship. Further, the ASU adds that an entity that applies any of the
expedients in ASC 848 that allow an entity to assume perfect effectiveness may
disregard any condition that prohibits more than one derivative from being
designated as the hedging instrument.
In net investment hedging relationships involving receive-variable-rate,
pay-variable-rate cross-currency interest rate swaps that reference a rate within
the scope of ASC 848-10-15-3, an entity is not required to dedesignate the hedging
relationship if the index of one leg of the swap changes as a result of reference
rate reform. In that case, an entity may also disregard the condition in ASC
815-20-25-67(a)(2) that both legs of the swap have the same repricing intervals and
dates until (1) neither of the variable legs of the cross-currency interest rate
swap designated references a rate within the scope of ASC 848-10-15-3 or (2) the
guidance in ASC 848 is no longer applicable (e.g., when the provisions sunset).
Connecting the Dots
The optional expedient allowing the terms of a receive-variable-rate,
pay-variable-rate cross-currency interest rate swap that is the designated
hedging instrument in a net investment hedge to be modified as a result of
reference rate reform without requiring a dedesignation of the hedging
relationship is not directly related to the discounting transition. However,
the FASB decided to amend ASC 848 to clarify its intent regarding the impact
of reference rate reform on such derivatives on the basis of feedback
received from constituents since the issuance of ASU 2020-04.
8.3.4 Fair Value Hedges (ASC 848-40)
ASU 2021-01 provides that if a designated derivative is affected by the discounting
transition, an entity is allowed to change the designated benchmark interest rate
and the component of cash flows designated as the hedged item in a fair value
hedging relationship without dedesignating the hedging relationship.
As discussed above, the ASU allows an entity to continue to apply
the shortcut method when subsequently assessing the effectiveness of a fair value
hedging relationship affected by the discounting transition. This optional expedient
will be available for the remainder of the original hedging relationship, including
periods after December 31, 2024.17 However, if an entity also elects the expedient that permits it to add one or
more, or proportions of, derivatives to an existing hedging relationship for which
the shortcut method is applied, the entity cannot continue to apply the shortcut
method after December 31, 2024.18 That is, the entity must cease the application of the shortcut method after
December 31, 2024,19 and change to another effectiveness assessment method in ASC 815-20 and ASC
815-25.
Connecting the Dots
The election to apply any of the expedients discussed would not result in
dedesignation of the existing fair value hedging relationship, but the
entity would be required to update the hedge documentation to identify the
elections.
8.3.5 Cash Flow Hedges (ASC 848-50)
ASU 2021-01 provides that if a derivative affected by the discounting transition was
designated in a cash flow hedging relationship through the use of a hedge
effectiveness method under which perfect effectiveness was assumed, an entity may do
either of the following:
-
Apply the corresponding optional expedient to assume perfect effectiveness in accordance with the expedients previously provided by ASU 2020-04.
-
Change its effectiveness approach to a quantitative method in accordance with ASC 815-20 and 815-30.
Regardless of which alternative it selects, an entity can make its election without
dedesignating the hedging relationship.
In addition, ASU 2021-01 amends ASC 848-50-25-3 to allow an entity to change the
designated benchmark interest rate for any cash flow hedging relationship involving
the forecasted issuance or purchase of a fixed-rate debt instrument in which (1) the
designated hedged risk is variability in cash flows attributable to changes in the
benchmark rate and (2) the hedging instrument is affected by reference rate reform
in accordance with ASC 848-10-15-3 (i.e., the hedging instrument references LIBOR or
a reference rate that is expected to be discontinued as a result of reference rate
reform).
8.3.6 Effective Date and Transition
The amendments in ASU 2021-01 are
effective for all entities as follows:
Type of Expedient
|
Effective Date and Expiration Date
|
---|---|
Contract modifications
|
Entities should use either of the following approaches to
apply the amendments to modifications to the terms of the
derivatives affected by the discounting transition:
|
Hedging relationships20
|
Entities should apply the amendments to either of the
following types of eligible hedging relationships affected
by the discounting transition:
|
The amendments do not apply to (1) contract modifications made or
new hedging relationships entered into after December 31, 2024,21 or (2) existing hedging relationships evaluated for periods after December 31,
2024,22 unless an entity elects to apply certain optional expedients that permit the
accounting effects to be retained through the end of the hedging relationships that
extend beyond December 31, 2024. Under those optional expedients, an entity
would:
-
Use a reasonable approach to modify the basis adjustment in a fair value hedge accounted for under the shortcut method.
-
No longer periodically evaluate the conditions in ASC 815-20-25-104(d) and (g) when using the shortcut method for a fair value hedge. However, the entity’s application of the shortcut method would cease after December 31, 2024,23 if the entity elects the optional expedient to add one or more, or a proportion of, basis swaps to a fair value hedging relationship as a result of the discounting transition.
-
Use a reasonable approach to adjust the amount recorded in AOCI for a cash flow hedge affected by a receipt or payment of a cash settlement (or equivalent) as a result of the discounting transition.
-
Continue to use a subsequent assessment method under which perfect effectiveness is assumed in accordance with ASC 848-50-35-4 through 35-9 for a cash flow hedge if the entity elected the practical expedient that permits it to use a reasonable approach to adjust the amount recorded in AOCI as a result of the discounting transition.
Connecting the Dots
Under ASU 2021-01, any private company that has not yet adopted ASU 2017-12
is only allowed to elect the expedient permitting it to change the method
designated for use in assessing the effectiveness of a hedging relationship
if it elects the optional expedient under which it may apply “the simplified
hedge accounting approach for eligible private companies for subsequent
hedge effectiveness in paragraph 848-50-35-7” after the discounting
transition.
Footnotes
16
See footnote 2.
17
See footnote 2.
18
See footnote 2.
19
See footnote 2.
20
Under ASU 2021-01, if an entity
adopts any of the amendments related to a hedging
relationship and the entity is either (1) a private
company that is not a financial institution as
described in ASC 942-320-50-1 or (2) a
not-for-profit entity (other than a not-for-profit
entity that has issued, or is a conduit bond obligor
for, securities that are traded, listed, or quoted
on an exchange or an OTC market), the entity is
required to update its hedge documentation before
the next interim (if applicable) or annual financial
statements are available to be issued. All other
entities that adopt any such amendments are required
to update their hedge documentation no later than
when those entities perform the first quarterly
hedge effectiveness assessment after making any
elections in the ASU for that hedging
relationship.
21
See footnote 2.
22
See footnote 2.
23
See footnote 2.
Chapter 9 — ASU 2022-01
Chapter 9 — ASU 2022-01
9.1 Overview
In March 2022, the FASB issued ASU
2022-01, which clarifies the guidance in ASC 815 on fair value
hedge accounting of interest rate risk for portfolios of financial assets. The ASU
amends the guidance in ASU 2017-12
that, among other things, established the “last-of-layer” method (see Section 3.2.1.4) for making the fair value hedge
accounting for these portfolios more accessible. ASU 2022-01 renames that method the
“portfolio layer” method and addresses feedback from stakeholders regarding its
application.
9.2 Scope
Under current guidance, the last-of-layer method enables an entity
to apply fair value hedging to a stated amount of a closed portfolio of prepayable
financial assets (or one or more beneficial interests secured by a portfolio of
prepayable financial instruments) without having to consider prepayment risk or
credit risk when measuring those assets. ASU 2022-01 expands the scope of this
guidance to allow entities to apply the portfolio layer method to portfolios of all
financial assets, including both prepayable and nonprepayable financial assets. This
scope expansion is consistent with the FASB’s efforts to simplify hedge accounting
and allows entities to apply the same method to similar hedging strategies.
9.3 Multiple-Layer Hedges of a Single Closed Portfolio
Entities that apply the last-of-layer method designate, as the
hedged item in a fair value hedge of interest rate risk, a stated amount of the
asset or assets that are not expected to be affected by prepayments, defaults, or
other factors influencing the timing or amount of cash flows. The hedged item
represents a single layer in the closed portfolio. ASU 2022-01 expands the current
model to explicitly allow entities to designate multiple layers in a single
portfolio as individual hedged items. Because entities can designate multiple
hedging relationships with a single closed portfolio, a larger portion of the
interest rate risk associated with such a portfolio is eligible to be hedged under
ASU 2022-01 than under current guidance, which does not address multiple-layer
hedges.
ASU 2022-01 also addresses questions about the types of derivatives
that could be used as the hedging instrument in potential multiple-layer hedges.
Under the ASU, an entity has the flexibility to use any type of derivative or
combination of derivatives (e.g., spot-starting constant-notional swaps with
different term lengths, a combination of spot-starting and forward-starting
constant-notional swaps, amortizing-notional swaps) by applying the multiple-layer
model that aligns with its risk management strategy.
In its guidance on multiple-layer hedges of a single closed
portfolio, the ASU also clarifies that no assets may be added to a closed portfolio
once it is designated in a portfolio layer method hedge. However, at any time after
the initial hedge designation, new hedging relationships associated with the
portfolio may be designated and existing hedging relationships associated with the
portfolio may be dedesignated to align with an entity’s evolving strategy for
managing interest rate risk on a timely basis.
In a manner consistent with the guidance established by ASU 2017-12
on single-layer hedges, ASU 2022-01 requires an entity to perform a documented
analysis in each period to support an expectation that the aggregate amount of the
multiple hedged items (i.e., the hedged layers) will be outstanding for the periods
hedged. ASU 2022-01 also requires the partial or full dedesignation of a hedged
layer or layers upon an anticipated or actual breach (i.e., when the aggregate
amount of the hedged layers exceeds the amount of the closed portfolio). In either
case, the ASU requires an entity to determine which layer or layers to dedesignate
or partially dedesignate in accordance with its entity-wide accounting policy
election that specifies a systematic and rational approach for making such a
determination.
9.4 Accounting for Hedge Basis Adjustments Under the Portfolio Layer Method
ASU 2022-01 expands and clarifies the current guidance on accounting
for fair value hedge basis adjustments under the portfolio layer method for both
single-layer and multiple-layer hedges.
As it would for any other fair value hedge, an entity should adjust
the basis of the hedged item for the change in fair value that is attributable to
changes in the hedged risk (i.e., interest rate risk) as of each reporting date.
However, the hedged item (i.e., the hedged layer) in a portfolio layer method hedge
is related to multiple assets within a closed portfolio, but it is not necessarily
related to all of the assets within that portfolio. Accordingly, ASU 2022-01
clarifies that an entity would adjust the basis at the portfolio level and should
not allocate it to individual assets within the portfolio. There is no guidance on
such treatment under current requirements.
Further, the ASU does not change an entity’s current requirement to
allocate the portfolio-level basis adjustment to the individual assets within a
closed portfolio upon a dedesignation of a hedging relationship. The entity must,
however, (1) recognize the reversal of all basis adjustments associated with a
breach in interest income and (2) disclose the specific amount and cause of the
breach.
ASU 2022-01 also provides guidance on the relationship between the
portfolio layer method requirements and other areas of GAAP. It addresses questions
raised by stakeholders about the interaction between the last-of-layer method
guidance and ASC 326 or other impairment guidance (for entities that have not yet
adopted ASC 326) by explicitly prohibiting entities from considering basis
adjustments related to existing portfolio layer method hedges when measuring credit
losses on the assets included in the closed portfolio.
9.5 Presentation and Disclosure
If assets in a closed portfolio are presented within more than one
line item on the balance sheet, ASU 2022-01 requires an entity to use a systematic
and rational method to allocate the portfolio-level basis adjustment to the
associated line items. However, the ASU also clarifies that the entity should not
allocate those adjustments on a more disaggregated basis for any disclosures not
otherwise required by ASC 815. Rather, an entity should disclose the total amount of
the basis adjustments as a reconciling amount in any affected disclosures. ASU
2022-01 updates the current guidance, which states that the allocation of basis
adjustments may be required by other areas of GAAP.
As noted in Section 9.4, in the event of a
breach of a layer or layers, an entity must recognize any related reversal of basis
adjustments associated with that breach in interest income. In addition, ASC
815-10-50-5C requires an entity to disclose:
- The amount of the hedge basis adjustment recognized in current-period interest income because of the breach
- The circumstances that led to the breach.
In a manner consistent with the disclosure requirements for last-of-layer hedges (see
Section 6.6.2.1.3), the ASU amends ASC
815-10-50-4EEE to require entities to provide additional disclosures about how the
basis adjustments related to hedging relationships designated under the portfolio
layer method affect each line item on the balance sheet. Entities must separately
disclose the following information for each line item in which assets are included
in a qualifying portfolio layer method hedge:
- The amortized cost basis of the closed portfolio(s) of financial assets or the beneficial interest(s)
- The amount that represents the hedged item(s) (that is, the hedged layer or layers)
- The basis adjustment associated with the hedged item(s) (that is, the hedged layer or layers).
9.6 Effective Dates and Transition
ASU 2022-01’s amendments are effective as follows:
-
For public business entities, fiscal years beginning after December 15, 2022, and interim periods within those fiscal years.
-
For all other entities, fiscal years beginning after December 15, 2023, and interim periods within those fiscal years.
The guidance may be early adopted if an entity has adopted ASU
2017-12 for the corresponding period.
An entity that elects a multiple-layer hedging strategy should apply
the guidance in ASU 2022-01 prospectively. Further, aside from the disclosure
requirements in other areas of U.S. GAAP, an entity should apply the amendments
related to the fair value hedge basis adjustments under the portfolio layer method
on a modified retrospective basis by making a cumulative-effect adjustment to the
opening balance of retained earnings. An entity may choose to apply the other GAAP
disclosure requirements prospectively or retrospectively.
In addition, as of the adoption date, an entity may reclassify debt
securities that qualify as being in a portfolio layer hedging relationship from the
HTM category to the AFS category if the entity intends to include those securities
in a portfolio designated in a portfolio layer method hedge. An entity must
determine which securities to reclassify within 30 days of the adoption date of the
ASU and must include those reclassified securities within a portfolio layer method
hedging relationship within those 30 days.
9.7 Codification Guidance Added or Amended by ASU 2022-01
The Codification paragraphs below are added or amended by ASU
2022-01. See Section
9.6 for effective dates and transition.
ASC 815 — Glossary
Pending Content (Transition Guidance: ASC
815-20-65-6)
Hedged Layer
The hedged
item designated in a portfolio layer method
hedging relationship, representing a stated amount
or stated amounts of a closed portfolio of
financial assets or one or more beneficial
interests secured by a portfolio of financial
instruments that is not expected to be affected by
prepayments, defaults, or other factors affecting
the timing and amount of cash flows for the
designated hedge period.ASC 815-10
Pending Content (Transition Guidance: ASC
815-20-65-6)
50-4EEE For each line item
disclosed in accordance with paragraph
815-10-50-4EE(c) that includes hedging
relationships designated under the portfolio layer
method in accordance with paragraph 815-20-25-12A,
the following information shall be disclosed
separately:
- The amortized cost basis of the closed portfolio(s) of financial assets or the beneficial interest(s)
- The amount that represents the hedged item(s) (that is, the hedged layer or layers)
- The basis adjustment associated with the hedged item(s) (that is, the hedged layer or layers).
Example 20 (see paragraph 815-10-55-181)
illustrates these disclosures.
Basis Adjustment Considerations Under the
Portfolio Layer Method
50-5B For existing hedging
relationships designated under the portfolio layer
method, an entity shall not disclose the basis
adjustment on a more disaggregated basis than the
portfolio layer method closed portfolio to meet
the objectives of disclosure requirements in other
Topics unless that disaggregation is required in
accordance with paragraph 815-20-45-4. After an
entity allocates a basis adjustment in accordance
with paragraph 815-20-45-4 (if applicable), if
other Topics require the disclosure of the
amortized cost basis of assets included in the
closed portfolio on a basis that requires
disaggregating the assets included in the closed
portfolio, the entity shall exclude the portfolio
layer method basis adjustment from the amortized
cost basis of those assets. In that case, the
entity shall disclose the total amount of the
portfolio layer method basis adjustment excluded
from the amortized cost basis of the assets
included in the closed portfolio.
50-5C For
hedging relationships designated under the
portfolio layer method, if the outstanding amount
of the closed portfolio is less than the hedged
layer or layers in accordance with paragraph
815-25-40-8(b) (that is, a breach occurred), an
entity shall disclose:
- The amount of the hedge basis adjustment recognized in current-period interest income because of the breach
- The circumstances that led to the breach.
Example
20: Disclosure of Qualitative Information by
Underlying Risk and Hedge Basis Adjustment
Disclosures
55-181 This
Example illustrates the disclosure of objectives
and strategies for using derivative instruments by
underlying risk, including volume of activity (see
paragraph 815-10-50-1A(d)). It also illustrates
the hedge basis adjustment disclosures in
paragraphs 815-10-50-4EE through 50-4EEE.
The
Entity is exposed to certain risks relating to its
ongoing business operations. The primary risks
managed by using derivative instruments are
commodity price risk and interest rate risk.
Forward contracts on various commodities are
entered into to manage the price risk associated
with forecasted purchases of materials used in the
Entity’s manufacturing process. Interest rate
swaps are entered into to manage interest rate
risk associated with fixed-rate loans issued by
the Entity’s financing subsidiary.
FASB ASC
815-10 requires that an entity recognize all
derivative instruments as either assets or
liabilities at fair value in the statement of
financial position. In accordance with that
Subtopic, the Entity designates commodity forward
contracts as cash flow hedges of forecasted
purchases of commodities and interest rate swaps
as fair value hedges of fixed-rate
receivables.
Cash
Flow Hedges
For
derivative instruments that are designated and
qualify as a cash flow hedge, the gain or loss on
the derivative instrument is reported as a
component of other comprehensive income and
reclassified into earnings in the same period or
periods during which the hedged transaction
affects earnings and is presented in the same
income statement line item as the earnings effect
of the hedged item. Gains and losses on the
derivative instrument representing hedge
components excluded from the assessment of
effectiveness are recognized currently in earnings
and are presented in the same line of the income
statement expected for the hedged item.
As of
December 31, 20X2, the Entity had the following
outstanding commodity forward contracts that were
entered into to hedge edge forecasted
purchases:
Fair
Value Hedges
For
derivative instruments that are designated and
qualify as a fair value hedge, the gain or loss on
the derivative instrument as well as the
offsetting loss or gain on the hedged item
attributable to the hedged risk are recognized in
current earnings. The Entity includes the gain or
loss on the hedged items (that is, fixed-rate
receivables) in the same line item — interest
income — as the offsetting loss or gain on the
related interest rate swaps.
As of
December 31, 20X2, and 20X1, the following amounts
were recorded on the balance sheet related to
cumulative basis adjustments for fair value
hedges.
As of
December 31, 20X2, and 20X1, the total notional
amount of the Entity’s pay-fixed/receive-variable
interest rate swaps was $79 and $82,
respectively.
ASC 815-20
Pending Content (Transition
Guidance: ASC 815-20-65-6)
25-3 Concurrent designation
and documentation of a hedge is critical; without
it, an entity could retroactively identify a
hedged item, a hedged transaction, or a method of
assessing effectiveness to achieve a desired
accounting result. To qualify for hedge
accounting, there shall be, at inception of the
hedge, formal documentation of all of the
following:
-
Subparagraph not used
-
Documentation requirement applicable to fair value hedges, cash flow hedges, and net investment hedges:
-
The hedging relationship
-
The entity’s risk management objective and strategy for undertaking the hedge, including identification of all of the following:
-
The hedging instrument.
-
The hedged item or transaction.
-
The nature of the risk being hedged.
-
The method that will be used to retrospectively and prospectively assess the hedging instrument’s effectiveness in offsetting the exposure to changes in the hedged item’s fair value (if a fair value hedge) or hedged transaction’s variability in cash flows (if a cash flow hedge) attributable to the hedged risk. There shall be a reasonable basis for how the entity plans to assess the hedging instrument’s effectiveness.01. An entity shall perform an initial prospective assessment of hedge effectiveness on a quantitative basis (using either a dollar-offset test or a statistical method such as regression analysis) unless one of the following applies:A. In a cash flow or fair value hedge, the entity applies the shortcut method in accordance with paragraphs 815-20-25-102 through 25-117.B. In a cash flow or fair value hedge, the entity determines that the critical terms of the hedging instrument and the hedged item match in accordance with paragraphs 815-20-25-84 through 25-85.C. In a cash flow hedge, the hedging instrument is an option, and the conditions in paragraphs 815-20-25-126 and 815-20-25-129 through 25-129A are met.D. In a cash flow hedge, a private company that is not a financial institution as described in paragraph 942-320-50-1 applies the simplified hedge accounting approach in paragraphs 815-20-25-133 through 25-138.E. In a cash flow hedge, the entity assesses hedge effectiveness under the change in variable cash flows method in accordance with paragraphs 815-30-35-16 through 35-24, and all of the conditions in paragraph 815-30-35-22 are met.F. In a cash flow hedge, the entity assesses hedge effectiveness under the hypothetical derivative method in accordance with paragraphs 815-30-35-25 through 35-29, and all of the critical terms of the hypothetical derivative and hedging instrument are the same.G. In a net investment hedge, the entity assesses hedge effectiveness using a method based on changes in spot exchange rates, and the conditions in paragraph 815-35-35-5 (for derivative instruments) or 815-35-35-12 (for nonderivative instruments) are met.H. In a net investment hedge, the entity assesses hedge effectiveness using a method based on changes in forward exchange rates, and the conditions in paragraph 815-35-35-17A are met.02. The initial prospective quantitative hedge effectiveness assessment using information applicable as of the date of hedge inception is considered to be performed concurrently at hedge inception if it is completed by the earliest of the following:A. The first quarterly hedge effectiveness assessment dateB. The date that financial statements that include the hedged transaction are available to be issuedC. The date that any criterion in Section 815-20-25 no longer is metD. The date of expiration, sale, termination, or exercise of the hedging instrumentE. The date of dedesignation of the hedging relationshipF. For a cash flow hedge of a forecasted transaction (in accordance with paragraph 815-20-25-13(b)), the date that the forecasted transaction occurs.03. An entity also shall document at hedge inception whether it elects to perform subsequent retrospective and prospective hedge effectiveness assessments on a qualitative basis and how it intends to carry out that qualitative assessment. See paragraphs 815-20-35-2A through 35-2F for additional guidance on qualitative assessments of effectiveness. In addition, the entity shall document which quantitative method it will use if facts and circumstances of the hedging relationship change and the entity must quantitatively assess hedge effectiveness in accordance with paragraph 815-20-35-2D. An entity must document that it will perform the same quantitative assessment method for both initial and subsequent prospective hedge effectiveness assessments. The guidance in paragraphs 815-20-55-55 through 55-56 applies if the entity wants to change its quantitative method of assessing effectiveness after the initial quantitative effectiveness assessment.04. An entity that applies the shortcut method in paragraphs 815-20-25-102 through 25-117 may elect to document at hedge inception a quantitative method to assess hedge effectiveness and measure hedge results if the entity determines at some point during the term of the hedging relationship that the use of the shortcut method was not or no longer is appropriate. See paragraphs 815-20-25-117A through 25-117D.
- Subparagraph superseded by Accounting Standards Update No. 2017-12.
- If the entity is hedging foreign currency risk on an after-tax basis, that the assessment of effectiveness will be on an after-tax basis (rather than on a pretax basis).
-
-
- Documentation requirement
applicable to fair value hedges only:
- For a fair value hedge of a firm commitment, a reasonable method for recognizing in earnings the asset or liability representing the gain or loss on the hedged firm commitment.
- For one or more interest rate risk hedging relationships designated under the portfolio layer method, an analysis to support the entity’s expectation that the hedged layer or layers is anticipated to be outstanding for the designated hedge period (see paragraph 815-20-25-12A for additional guidance).
- Documentation requirement
applicable to cash flow hedges only:
-
For a cash flow hedge of a forecasted transaction, documentation shall include all relevant details, including all of the following:
- The date on or period within which the forecasted transaction is expected to occur.
- The specific nature of asset or liability involved (if any).
- Either of the following:01. The expected currency amount for hedges of foreign currency exchange risk; that is, specification of the exact amount of foreign currency being hedged02. The quantity of the forecasted transaction for hedges of other risks; that is, specification of the physical quantity (that is, the number of items or units of measure) encompassed by the hedged forecasted transaction.
-
If a forecasted sale or purchase is being hedged for price risk, the hedged transaction shall not be specified in either of the following ways:01. Solely in terms of expected currency amounts02. As a percentage of sales or purchases during a period.
-
The current price of a forecasted transaction shall be identified to satisfy the criterion in paragraph 815-20-25-75(b) for offsetting cash flows.
-
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).
-
If the hedged risk is the variability in cash flows attributable to changes in a contractually specified component in a forecasted purchase or sale of a nonfinancial asset, identification of the contractually specified component.
-
If the hedged risk is the variability in cash flows attributable to changes in a contractually specified interest rate for forecasted interest receipts or payments on a variable-rate financial asset or liability, identification of the contractually specified interest rate.
-
25-12A For a
closed portfolio of financial assets or one or
more beneficial interests secured by a portfolio
of financial instruments, an entity may designate
as the hedged item or items a hedged layer or
layers if the following criteria are met (this
designation is referred to throughout Topic 815 as
the “portfolio layer method”):
- As part of the initial hedge documentation, an analysis is completed and documented to support the entity’s expectation that the hedged item or items (that is, the hedged layer or layers in aggregate) is anticipated to be outstanding for the designated hedge period. That analysis shall incorporate the entity’s current expectations of prepayments, defaults, and other factors affecting the timing and amount of cash flows associated with the closed portfolio.
- For purposes of its analysis in (a), the entity assumes that as prepayments, defaults, and other factors affecting the timing and amount of cash flows occur, they first will be applied to the portion of the closed portfolio that is not hedged.
- The entity applies the partial-term hedging guidance in paragraph 815-20-25-12(b)(2)(ii) to the assets or beneficial interest used to support the entity’s expectation in (a). An asset that matures on a hedged layer’s assumed maturity date meets this requirement.
See paragraphs 815-25-55-1A
through 55-1E for implementation guidance related
to a closed portfolio with multiple hedged
layers.
25-12B After
a closed portfolio is established in accordance
with paragraph 815-20-25-12A, an entity may
designate new hedging relationships associated
with the closed portfolio without dedesignating
any existing hedging relationships associated with
the closed portfolio if the criteria in paragraph
815-20-25-12A are met for those newly designated
hedging relationships.
Consideration of Prepayment Risk Using the
Portfolio Layer Method
25-118A In a
fair value hedge of interest rate risk designated
under the portfolio layer method in accordance
with paragraph 815-20-25-12A, an entity may
exclude prepayment risk (if applicable) when
measuring the change in fair value of the hedged
item attributable to interest rate risk.
25-139
Concurrent with hedge inception, a private company
that is not a financial institution as described
in paragraph 942-320-50-1 shall document the
following:
- The hedging relationship in accordance with paragraph 815-20-25-3(b)(1)
- The hedging instrument in accordance with paragraph 815-20-25-3(b)(2)(i)
- The hedged item in accordance with paragraph 815-20-25-3(b)(2)(ii), including (if applicable) firm commitments or the analysis supporting a portfolio layer method designation in paragraph 815-20-25-3(c), or forecasted transactions in paragraph 815-20-25-3(d)
- The nature of the risk being hedged in accordance with paragraph 815-20-25-3(b)(2)(iii).
45-1CC If a
breach of a portfolio layer method hedge has
occurred in accordance with paragraph
815-25-40-8(b), an entity shall present in
interest income the basis adjustment associated
with the hedged layer (or portion thereof) that is
no longer outstanding.
45-4 For an
existing portfolio layer method hedge, if the
assets included in the same closed portfolio are
presented in different line items in the statement
of financial position, an entity shall allocate
the portfolio layer method basis adjustment to the
assets’ associated line items in the statement of
financial position using a systematic and rational
method.
55-4A This
implementation guidance on hedged items in fair
value hedges only is organized as follows:
- Subparagraph superseded by Accounting Standards Update No. 2017-12.
- Application of the definition of firm commitment
- Determining whether risk exposure is shared within a portfolio
- Servicing rights as a hedged item.
- Hedged layer in a portfolio layer method hedge.
55-14A If
both of the following conditions exist, the
quantitative test described in paragraph
815-20-55-14 may be performed qualitatively on a
hedge-by-hedge basis and only at hedge
inception:
- The hedged item is a hedged layer in a portfolio layer hedge designated in accordance with paragraph 815-20-25-12A.
- An entity measures the change in fair value of the hedged item based on the benchmark rate component of the contractual coupon cash flows in accordance with paragraph 815-25-35-13.
Using the benchmark rate
component of the contractual coupon cash flows
when all assets have the same assumed maturity
date and prepayment risk (if applicable) does not
affect the measurement of the hedged item results
in all hedged items having the same benchmark rate
component coupon cash flows.
55-14B If the
hedging instrument is a derivative with a notional
amount that changes over time (for example, an
amortizing-notional interest rate swap), the
condition in paragraph 815-20-55-14A(b) can be
satisfied because the swap has a contractual fixed
rate and, thus, the hedged item can be measured on
the basis of a single benchmark component of the
contractual coupon cash flows in accordance with
paragraph 815-25-35-13. An entity that designates
a derivative with a notional amount that changes
over time as a hedging instrument is designating a
single hedging relationship with a single
benchmark rate component of the contractual coupon
cash flows.
Hedged Item in a Portfolio
Layer Method Hedge
55-15A This
implementation guidance describes the hedged item
in a portfolio layer method hedge in several
scenarios.
Scenario A
55-15B For a
closed portfolio of financial assets of $100
million, Entity A designates a single hedged item
of $10 million of the assets that is expected to
be outstanding for the hedge period of Years 1–5.
Entity A designates as the hedging instrument a
spot-starting constant-notional pay-fixed,
receive-variable interest rate swap with a
notional amount of $10 million and a term of 5
years. In this single-layer hedge, the hedged
layer represents $10 million of assets in the
closed portfolio that is not expected to be
affected by prepayments, defaults, or other
factors affecting the timing or amount of cash
flows for the hedge period of Years 1–5.
Scenario B
55-15C For a
closed portfolio of financial assets of $100
million, Entity A designates a hedged item of $20
million of assets that is expected to be
outstanding for the hedge period of Years 1–3. It
also designates a hedged item of $10 million of
the assets in the closed portfolio that is
expected to be outstanding for the hedge period of
Years 1–5. For the $20 million hedged item, Entity
A designates as the hedging instrument a
spot-starting constant-notional pay-fixed,
receive-variable interest rate swap with a
notional amount of $20 million and a term of 3
years. For the $10 million hedged item, Entity A
designates as the hedging instrument a
spot-starting constant-notional pay-fixed,
receive-variable interest rate swap with a
notional amount of $10 million and a term of 5
years. In this scenario, there are two hedged
layers:
- A hedged layer representing $20 million of assets in the closed portfolio that is not expected to be affected by prepayments, defaults, or other factors affecting the timing or amount of cash flows for the hedge period of Years 1–3
- A hedged layer representing $10 million of assets in the closed portfolio that is not expected to be affected by prepayments, defaults, or other factors affecting the timing or amount of cash flows for the hedge period of Years 1–5.
Although the $10 million and
$20 million hedged layers are separately
designated, Entity A should consider the aggregate
hedged amount of $30 million in Years 1–3 when
assessing whether the hedged layers are
anticipated to be outstanding in accordance with
paragraphs 815-20-25-12A(a) and 815-25-35-7A.
Scenario C
55-15D For a
closed portfolio of financial assets of $100
million, Entity A designates a single hedged item
of $30 million for Year 1 that decreases to an
amount of $20 million for Year 2 and $10 million
for Year 3. Entity A designates a single
amortizing-notional swap as the hedging
instrument. In this single-layer hedge, the hedged
layer represents a $30 million stated amount for
Year 1, a $20 million stated amount for Year 2,
and a $10 million stated amount for Year 3, which
reflects the amortizing-notional swap’s
features.
Transition
Related to Accounting Standards Update No.
2022-01, Derivatives and Hedging (Topic 815):
Fair Value Hedging — Portfolio Layer
Method
65-6 The
following represents the transition and effective
date information related to Accounting Standards
Update No. 2022-01, Derivatives and Hedging
(Topic 815): Fair Value Hedging — Portfolio Layer
Method:
-
For public business entities the pending content that links to this paragraph shall be effective for fiscal years beginning after December 15, 2022, and interim periods within those fiscal years.
-
For all other entities, the pending content that links to this paragraph shall be effective for fiscal years beginning after December 15, 2023, and interim periods within those fiscal years.
-
Early adoption is permitted on any date on or after the issuance of Update 2022-01 for any entity that has adopted the amendments in Accounting Standards Update No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities, for the corresponding period. If an entity early adopts the pending content that links to this paragraph in an interim period, the cumulative-effect adjustment for adopting the amendments related to basis adjustments described in (e) shall be reflected as of the beginning of the fiscal year that includes the interim period (that is, the initial application date).
- An entity shall apply the pending content that links to this paragraph to designate more than one portfolio layer method hedging relationship for a single closed portfolio on a prospective basis as of the date of adoption of the amendments in this Update.
- An entity shall apply the pending content that links to this paragraph on basis adjustments, except for the pending content in Subtopic 815-10 (related to disclosures), on a modified retrospective basis by means of a cumulative-effect adjustment to the opening balance of retained earnings and the balance sheet line items (as appropriate) as of the date of initial application for portfolio layer method hedges existing as of the date of adoption of the amendments in this Update.
- An entity may elect to adopt the pending content that links to this paragraph in Subtopic 815-10 (related to disclosures) on a prospective basis from the date of initial application of the amendments in Update 2022-01 or on a retrospective basis to each prior period presented after the date of adoption of the amendments in Update 2017-12.
- An entity may reclassify one
or more debt securities from held to maturity to
available for sale if the debt securities are:
- Hedged under the portfolio layer method in accordance with paragraph 815-20-25-12A.
- Classified as held to maturity immediately before the date of adoption of the pending content that links to this paragraph.
- An entity reclassifying one
or more debt securities shall:
-
Determine which debt securities to reclassify no later than 30 days after the date of adoption of the pending content that links to this paragraph. For an entity that has not yet adopted the amendments in Update 2016-13, any unrealized gain or loss on the reclassified debt security at the date of reclassification shall be recorded in accumulated other comprehensive income. For an entity that has adopted the amendments in Update 2016-13, for each reclassified debt security it shall:
- Reverse in retained earnings any allowance for credit losses previously recorded on the held-to-maturity debt security at the date of reclassification.
- Reclassify the debt security to the available-for-sale category at its amortized cost basis (which is reduced by any previous writeoffs but excludes any allowance for credit losses).
- Determine whether an allowance for credit losses is necessary by following the guidance in Subtopic 326-30. If so, that allowance shall be recorded in retained earnings at the date of reclassification.
- Report in accumulated other comprehensive income any unrealized gain or loss on the debt security at the date of reclassification, excluding the amount recorded in the allowance for credit losses in accordance with (iii).
-
Include those reclassified debt securities in one or more closed portfolios that are designated in a portfolio layer method hedge no later than 30 days after the date of adoption of the pending content that links to this paragraph. Neither a minimum amount of the closed portfolio nor a minimum hedge period must be designated to meet this requirement.
-
An entity shall provide the disclosures in accordance with paragraph 320-10-50-10 for reclassified debt securities in the period of reclassification.
-
That reclassification, in and of itself, would not call into question the entity’s assertion at the most recent reporting date that it had the intent and ability to hold to maturity those debt securities that continue to be classified as held to maturity.
-
- An entity shall disclose the
following in the period that the entity adopts the
pending content that links to this paragraph:
- The nature of and reason for the change in accounting principle related to accounting for hedge basis adjustments.
- The effect of adoption on any line item in the statement of financial position, if material, as of the beginning of the first period for which the pending content that links to this paragraph is applied. Presentation of the effect on financial statement subtotals is not required.
-
The cumulative effect of the change on retained earnings or other components of equity in the statement of financial position as of the beginning of the first period for which the pending content that links to this paragraph is applied.
- An entity that issues interim financial statements shall provide the disclosures in (i) in each interim financial statement of the fiscal year of adoption and the annual financial statement of the fiscal year of adoption.
ASC 815-25
Pending Content (Transition
Guidance: ASC 815-20-65-6)
35-1 Gains and losses on a
qualifying fair value hedge shall be accounted for
as follows:
- The gain or loss on the hedging instrument shall be recognized currently in earnings, except for amounts excluded from the assessment of effectiveness that are recognized in earnings through an amortization approach in accordance with paragraph 815-20-25-83A. All amounts recognized in earnings shall be presented in the same income statement line item as the earnings effect of the hedged item.
- The gain or loss (that is, the change in fair value) on the hedged item attributable to the hedged risk shall adjust the carrying amount of the hedged item and be recognized currently in earnings except as described in (c).
- For one or more existing hedged layer or layers that are designated under the portfolio layer method in accordance with paragraph 815-20-25-12A, the gain or loss (that is, the change in fair value) on the hedged item attributable to the hedged risk shall not adjust the carrying value of the individual beneficial interest or individual assets in or removed from the closed portfolio. Instead, that amount shall be maintained on a closed portfolio basis and recognized currently in earnings.
35-6 If a hedged item is
otherwise measured at fair value with changes in
fair value reported in other comprehensive income
(such as an available-for-sale debt security), the
adjustment of the hedged item’s carrying amount
discussed in paragraph 815-25-35-1(b) shall be
recognized in earnings rather than in other
comprehensive income to offset the gain or loss on
the hedging instrument. If the hedged item is a
hedged layer designated in a portfolio layer
method hedge on a closed portfolio in accordance
with paragraph 815-20-25-12A and the closed
portfolio includes only available-for-sale debt
securities, the entire gain or loss (that is, the
change in fair value) on the hedged item
attributable to the hedged risk shall be
recognized in earnings rather than in other
comprehensive income to offset the gain or loss on
the hedging instrument. If the closed portfolio
includes available-for-sale debt securities and
assets that are not available-for-sale debt
securities, an entity shall determine the portion
of the change in fair value on the hedged item
attributable to the hedged risk associated with
the available-for-sale debt securities using a
systematic and rational method. That amount shall
be recognized in earnings rather than in other
comprehensive income. However, an entity shall not
adjust the carrying amount of the individual
available-for-sale debt securities included in the
closed portfolio in accordance with paragraph
815-25-35-1(c).
Existing Portfolio Layer Method
Hedges
35-7A For each closed
portfolio with one or more hedging relationships
designated and accounted for under the portfolio
layer method in accordance with paragraph
815-20-25-12A, an entity shall perform and
document at each effectiveness assessment date an
analysis that supports the entity’s expectation
that the hedged layer or layers in aggregate is
still anticipated to be outstanding for the
designated hedge period. That analysis shall
incorporate the entity’s current expectations of
prepayments, defaults, and other factors affecting
the timing and amount of cash flows associated
with the closed portfolio using a method
consistent with the method used to perform the
analysis in paragraph 815-20-25-12A(a) and
(b).
35-9 An adjustment of the
carrying amount of a hedged interest-bearing
financial instrument that is required by paragraph
815-25-35-1(b) and an adjustment that is
maintained on a closed portfolio basis in a
portfolio layer method hedge in accordance with
paragraph 815-25-35-1(c) shall be amortized to
earnings. Amortization shall begin no later than
when the hedged item ceases to be adjusted for
changes in its fair value attributable to the risk
being hedged.
35-9A If, as permitted by
paragraph 815-25-35-9, an entity amortizes the
adjustment to the carrying amount of the hedged
item during an existing partial-term hedge of an
interest-bearing financial instrument or amortizes
the basis adjustment in an existing portfolio
layer method hedge, the entity shall fully
amortize that adjustment by the hedged item’s
assumed maturity date in accordance with paragraph
815-25-35-13B. For a discontinued hedging
relationship, all remaining adjustments to the
carrying amount of the hedged item shall be
amortized over a period that is consistent with
the amortization of other discounts or premiums
associated with the hedged item in accordance with
other Topics (for example, Subtopic 310-20 on
receivables — nonrefundable fees and other costs).
See paragraphs 815-25-40-9 through 40-9A for
further guidance on accounting for a basis
adjustment attributable to a discontinued
portfolio layer method hedge.
35-10 An asset or liability
that has been designated as being hedged and
accounted for pursuant to this Section remains
subject to the applicable requirements in
generally accepted accounting principles (GAAP)
for assessing impairment or credit losses for that
type of asset or for recognizing an increased
obligation for that type of liability. Those
impairment or credit loss requirements shall be
applied after hedge accounting has been applied
for the period and the carrying amount of the
hedged asset or liability has been adjusted
pursuant to paragraph 815-25-35-1(b). A portfolio
layer method basis adjustment that is maintained
on a closed portfolio basis for an existing hedge
in accordance with paragraph 815-25-35-1(c) shall
not be considered when assessing the individual
assets or individual beneficial interest included
in the closed portfolio for impairment or when
assessing a portfolio of assets for impairment. An
entity may not apply this guidance by analogy to
other components of amortized cost basis. Because
the hedging instrument is recognized separately as
an asset or liability, its fair value or expected
cash flows shall not be considered in applying
those impairment or credit loss requirements to
the hedged asset or liability.
35-11 This Subtopic
implicitly affects the measurement of credit
losses under Subtopic 326-20 on financial
instruments measured at amortized cost by
requiring the present value of expected future
cash flows to be discounted by the new effective
rate based on the adjusted amortized cost basis in
a hedged loan. Paragraph 326-20-55-9 requires
that, when the amortized cost basis of a loan has
been adjusted under fair value hedge accounting,
the effective rate is the discount rate that
equates the present value of the loan’s future
cash flows with that adjusted amortized cost
basis. That paragraph states that the adjustment
under fair value hedge accounting for changes in
fair value attributable to the hedged risk under
this Subtopic shall be considered to be an
adjustment of the loan’s amortized cost basis. As
discussed in that paragraph, the loan’s original
effective interest rate becomes irrelevant once
the recorded amount of the loan is adjusted for
any changes in its fair value. Because paragraph
815-25-35-10 requires that the loan’s amortized
cost basis be adjusted for hedge accounting before
the requirements of Subtopic 326-20 are applied,
this Subtopic implicitly supports using the new
effective rate and the adjusted amortized cost
basis. A portfolio layer method basis adjustment
that is maintained on a closed portfolio basis for
an existing hedge in accordance with paragraph
815-25-35-1(c) shall not adjust the amortized cost
basis of the individual assets or individual
beneficial interest included in the closed
portfolio. An entity may not apply this guidance
by analogy to other components of amortized cost
basis.
35-12 This guidance applies
to all entities applying Subtopic 326-20 to
financial assets that are hedged items in a fair
value hedge, regardless of whether those entities
have delayed amortizing to earnings the
adjustments of the loan’s amortized cost basis
arising from fair value hedge accounting until the
hedging relationship is dedesignated. The guidance
on recalculating the effective rate is not
intended to be applied to all other circumstances
that result in an adjustment of a loan’s amortized
cost basis and is not intended to be applied to
the individual assets or individual beneficial
interest in an existing portfolio layer method
hedge closed portfolio.
35-13B For a fair value hedge
of interest rate risk in which the hedged item is
designated for a partial term in accordance with
paragraph 815-20-25-12(b)(2)(ii), an entity may
measure the change in the fair value of the hedged
item attributable to interest rate risk using an
assumed term that begins when the first hedged
cash flow begins to accrue and ends at the end of
the designated hedge period. The assumed issuance
of the hedged item occurs on the date that the
first hedged cash flow begins to accrue. The
assumed maturity of the hedged item occurs at the
end of the designated hedge period. An entity may
measure the change in fair value of the hedged
item attributable to interest rate risk in
accordance with this paragraph when the entity is
designating the hedged item in a hedge of both
interest rate risk and foreign exchange risk. In
that hedging relationship, the change in carrying
value of the hedged item attributable to foreign
exchange risk shall be measured on the basis of
changes in the foreign currency spot rate in
accordance with paragraph 815-25-35-18.
Additionally, an entity may have one or more
separately designated partial-term hedging
relationships outstanding at the same time for the
same debt instrument (for example, 2 outstanding
hedging relationships for consecutive interest
cash flows in Years 1‒3 and consecutive interest
cash flows in Years 5‒7 of a 10-year debt
instrument).
Hedged Item Is Designated Under the
Portfolio Layer Method
Voluntary Dedesignations
40-7A An entity may elect to
discontinue (or partially discontinue) hedge
accounting prospectively for all or a portion of
the hedged layer for one or more hedging
relationships associated with the closed portfolio
at any time if a breach has not occurred in
accordance with paragraph 815-25-40-8(b) and a
breach is not anticipated in accordance with
paragraph 815-25-40-8(a). If multiple hedged
layers are associated with the closed portfolio,
the entity may voluntarily elect to dedesignate
(or partially dedesignate) any hedges associated
with that closed portfolio.
Breaches of the Closed Portfolio
40-8 For one or more hedging
relationships designated under the portfolio layer
method in accordance with paragraph 815-20-25-12A,
an entity shall discontinue (or partially
discontinue) hedge accounting in the following
circumstances:
- If the entity cannot support on a subsequent testing date that the hedged layer or layers are anticipated to be outstanding for the designated hedge period in accordance with paragraph 815-25-35-7A (that is, a breach is anticipated), it shall discontinue (or partially discontinue) hedge accounting for one or more hedging relationships for the portion of the hedged item that is no longer anticipated to be outstanding for the designated hedge period
- If on a subsequent testing date the outstanding amount of the closed portfolio of financial assets or one or more beneficial interests is less than the hedged layer or layers (that is, a breach has occurred), the entity shall discontinue (or partially discontinue) hedge accounting for one or more hedging relationships for the portion of the hedged item that is no longer outstanding.
40-8A In the event of either
an anticipated breach (as described in paragraph
815-25-40-8(a)) or a breach that has occurred (as
described in paragraph 815-25-40-8(b)), if
multiple hedged layers are associated with a
closed portfolio, an entity shall determine which
hedge or hedges to discontinue (or partially
discontinue) in accordance with an accounting
policy election. That accounting policy election
shall specify a systematic and rational approach
to determining which hedge or hedges to
discontinue (or partially discontinue). An entity
shall establish its accounting policy no later
than when it first anticipates a breach or when a
breach has occurred (whichever comes first). After
an entity establishes its accounting policy, it
shall consistently apply its accounting policy to
all portfolio layer method breaches (anticipated
and occurred).
Accounting for Basis Adjustments
40-9 If a
portfolio layer method hedging relationship is
discontinued (or partially discontinued) in a
voluntary dedesignation in accordance with
paragraph 815-25-40-7A or in anticipation of a
breach in accordance with paragraph
815-25-40-8(a), the basis adjustment associated
with the dedesignated amount as of the
discontinuation date shall be allocated to the
remaining individual assets in the closed
portfolio that supported the dedesignated hedged
layer using a systematic and rational method. An
entity shall amortize those amounts over a period
that is consistent with the amortization of other
discounts or premiums associated with the
respective assets in accordance with other Topics
(for example, Subtopic 310-20 on receivables —
nonrefundable fees and other costs).
40-9A For a portfolio layer
method hedging relationship that is discontinued
because a breach has occurred in accordance with
paragraph 815-25-40-8(b), as of the
discontinuation date an entity shall:
- Determine the portion of the basis adjustment associated with the amount of the hedged layer that exceeds the closed portfolio (that is, the portion of the basis adjustment associated with the breach) using a systematic and rational method and immediately recognize that amount in interest income in accordance with paragraph 815-20-45-1CC
- Disclose the information specified in paragraph 815-10-50-5C for the breach.
A closed portfolio may simultaneously have a
layer or layers that have been breached and a
layer or layers that it anticipates will be
breached. In that case, an entity shall apply the
guidance in this paragraph for the breach or
breaches that have occurred and the guidance in
paragraph 815-25-40-9 for the anticipated breach
or breaches.
55-1 Paragraph superseded by
Accounting Standards Update No. 2022-01.
Implementation Guidance
Portfolio Layer Method Hedges — Multiple
Hedged Layers
55-1A This implementation
guidance demonstrates how an entity should apply
the following aspects of the portfolio layer
method if it elects to designate multiple hedged
layers of a single closed portfolio:
-
Performing the similar-asset assessment upon initial designation of a portfolio layer method hedge
-
Evaluating whether the entity may continue to apply the guidance for a portfolio layer method hedge after initial designation.
55-1B For the purposes of
illustrating the guidance in paragraph
815-25-55-1A, the implementation guidance in
paragraphs 815-25-55-1C through 55-1D assumes that
Entity A designates multiple hedged layers of a
closed portfolio of 5-year and 10-year prepayable
loans originated on the hedge inception date.
Similar-Asset Assessment at Hedge
Designation
55-1C Entity A designates
hedged layers with assumed maturity dates of three
years and seven years, respectively. When applying
the similar-asset assessment for a portfolio hedge
in accordance with paragraph 815-20-25-12(b)(1),
Entity A should consider all assets in the closed
portfolio for the 3-year hedged layer but consider
only the 10-year assets for the 7-year hedged
layer. That is, an entity should consider the
assets that support the hedged layer.
Subsequent Assessment
55-1D After initial hedge
designation, Entity A should continue to assess
whether the individual three-year and seven-year
hedged layers meet the requirements in paragraph
815-25-35-7A on the basis of the same assets used
to perform the similar-asset assessments in
accordance with paragraph 815-25-55-1C. For Years
1–3, the entity should consider whether the hedged
layers in aggregate are anticipated to be
outstanding.
Appendix A — Comparison of U.S. GAAP and IFRS Accounting Standards
Appendix A — Comparison of U.S. GAAP and IFRS Accounting Standards
Under U.S. GAAP, the primary sources of guidance on derivative
instruments and hedge accounting are ASC 815-20, ASC 815-25, ASC 815-30, and ASC 815-35.
Under IFRS Accounting Standards, the primary sources of such guidance are paragraphs
6.1.1 through 6.6.6 and B6.2.1 through B6.6.16 of IFRS 9. Other sources of hedge
accounting guidance in IFRS Accounting Standards include the illustrative examples in
IFRS 9 and Section G of “Guidance on Implementing IFRS 9 (2014) Financial
Instruments.”
This appendix focuses on comparing the requirements for hedge accounting
in U.S. GAAP and IFRS Accounting Standards. The guidance in both sets of standards
addresses measuring certain hedging instruments at fair value and, for fair value hedge
accounting, measuring hedged items at a fair-value-adjusted amount. For a discussion of
the key differences between U.S. GAAP and IFRS Accounting Standards regarding fair value
measurement, see Appendix B
of Deloitte’s Roadmap Fair Value
Measurements and Disclosures (Including the Fair Value
Option).
Both U.S. GAAP and IFRS Accounting Standards have general requirements
for hedge accounting as well as additional requirements for specific types of hedging
relationships (i.e., fair value or cash flow hedges, including foreign currency hedges,
or hedges of a net investment in a foreign operation). This appendix includes both
general and type-specific requirements. However, it does not discuss all the differences
between the hedging guidance in U.S. GAAP and IFRS Accounting Standards. For example,
the guidance in U.S. GAAP is significantly more detailed than that in IFRS Accounting
Standards on some issues that are highly technical and not broad-based; this appendix
does not address such differences.
Note also that this appendix highlights substantive differences between
U.S. GAAP and IFRS Accounting Standards that exist as of the date of the publication of
this Roadmap. Both the FASB and the IASB have projects under consideration that
ultimately may affect the information in this section.
The table below summarizes key differences between U.S. GAAP and IFRS
Accounting Standards related to the accounting for hedges.
Subject
|
U.S. GAAP (ASC 815)
|
IFRS Accounting Standards (IFRS 9)
|
---|---|---|
Guidance Applicable to All Hedges
| ||
“Highly effective” threshold to qualify for hedge accounting
|
The hedging instrument must be highly effective at offsetting
changes in fair value or cash flows (see Section
2.5).
|
The concept of a highly effective threshold does not exist;
instead, IFRS 9 requires that (1) there is an economic
relationship between the hedging instrument and the hedged item,
(2) credit risk does not dominate the value changes that result
from the economic relationship, and (3) the hedging
relationship’s hedge ratio reflects the hedge ratio of the
actual quantities of the hedging instrument and the hedged item
(see paragraph 6.4.1(c) of IFRS 9).
|
Quantitative assessment of hedge effectiveness
|
Entities are generally required to perform an initial prospective
quantitative hedge effectiveness assessment; however, if certain
criteria are met, they can elect to subsequently perform
prospective and retrospective effectiveness assessments
qualitatively unless facts and circumstances change (see
Section 2.5.2.2).
|
IFRS Accounting Standards do not specify a
method for assessing effectiveness. Entities are required to
make ongoing qualitative or quantitative assessments (at a
minimum on each reporting date) (see paragraphs B6.4.12 and
B6.4.13 of IFRS 9).
|
Hedge documentation and initial prospective quantitative hedge
effectiveness assessment
|
Entities must complete most hedge documentation at hedge
inception; however, they generally do not need to complete the
initial prospective quantitative hedge effectiveness assessment
until the first quarterly hedge effectiveness assessment date
(i.e., up to three months), although earlier completion may be
required in some circumstances. Private companies that are not
financial institutions and certain not-for-profit entities do
not need to perform and document the initial and subsequent
quarterly effectiveness assessments until the date the next
interim (if applicable) or annual financial statements are
available to be issued (however, these entities must document
certain aspects of the hedging relationship at hedge inception)
(see Section 2.6.1).
|
Entities are required to complete all documentation at hedge
inception (see paragraph 6.4.1(b) of IFRS 9).
|
Income statement presentation
|
Entities are required to present the change in the hedging
instrument’s fair value in the same income statement line
item(s) as the earnings effect of the hedged item (not including
any changes in fair value that are excluded from the
effectiveness assessments of net investment hedges, for which no
specific income statement presentation is prescribed). In
addition, no presentation is prescribed for amounts released
from AOCI when it is probable that a hedged forecasted
transaction will not occur (see Section
6.3).
|
IFRS Accounting Standards do not prescribe
income statement presentation of hedging results. Time value
components that are not designated as part of the hedging
instrument will generally be initially deferred in OCI and not
recognized in current earnings (see paragraph 6.5.15(b) of IFRS
9).
|
Voluntary dedesignation of a hedging relationship
|
Entities may voluntarily discontinue hedge accounting at any time
by removing the designation of the hedging relationship (see
Sections 3.5.1.3,
4.1.5.1.3, and
5.4.3).
|
Entities may perform dedesignation only when a hedging
relationship (or a part of a hedging relationship) ceases to
meet the qualifying criteria (see paragraphs B6.5.22 and B6.5.23
of IFRS 9).
|
Shortcut method
|
The shortcut method is permitted for hedging relationships
involving an interest rate swap and an interest-bearing
financial instrument that meet specific requirements.
If an entity elects the shortcut method and later determines that
it was not or is no longer appropriate, it can apply the
long-haul method as long as:
The qualifying criteria also enable partial-term fair value
hedges to qualify for shortcut accounting (see Section
2.5.2.2.1).
|
The shortcut method is not permitted.
|
Accounting for amounts excluded from the hedge effectiveness
assessment
|
Entities amortize the initial value of an excluded component into
earnings over the life of the hedging instrument by using a
systematic and rational method. In subsequent periods, they
recognize in OCI (as a CTA for net investment hedges) any
difference between the change in fair value of the excluded
component and amounts recognized in earnings under that
systematic and rational method.
All excluded component amounts (other than those related to net
investment hedges) are recognized in the same income statement
line item as the earnings effect of the hedged item.
Alternatively, an entity can elect to apply a mark-to-market
through earnings approach in a manner consistent with
preadoption guidance (see Section
2.5.2.1.2.1).
|
The change in the fair value of the excluded component is
initially recognized in OCI to the extent that it is related to
the hedged item and is accumulated in a separate component of
equity.
The subsequent accounting depends on whether (1) it has been
determined that the hedged item is transaction-related or
time-period related and (2) the hedged item will result in the
recognition of a nonfinancial asset or liability. IFRS 9
generally does not prescribe where such amounts should be
recognized in the income statement (i.e., other than amounts
that are recognized as basis adjustments to nonfinancial assets
or liabilities) (see paragraphs 6.5.15 and 6.5.16 of IFRS
9).
|
Guidance Applicable Only to Cash Flow Hedges
| ||
Measurement and recognition of hedge ineffectiveness — cash flow
hedges
|
If the relationship between the hedged item and hedging
instrument is highly effective at offsetting changes in the cash
flows attributable to the hedged risk, an entity should record
in OCI the entire change in the designated hedging instrument’s
fair value that is included in the hedge effectiveness
assessment (see Section 4.1).
|
Entities are required to measure and recognize hedge
ineffectiveness (other than that arising from cumulative cash
flow underhedges) in each reporting period (see paragraph
6.5.11(c) of IFRS 9).
|
Ability to designate a component of a forecasted purchase or sale
of a nonfinancial asset as a hedged item
|
Under ASU 2017-12, entities are permitted to designate the “risk
of variability in cash flows attributable to changes in a
contractually specified component” as the hedged risk in a cash
flow hedge of a forecasted purchase or sale of a nonfinancial
asset, if the hedge meets certain criteria (see
Section 2.3.2.1).
|
Entities may designate nonfinancial components as hedged items
under the principle that a component may be designated as a
hedged item if it is separately identifiable and reliably
measurable. There is no requirement that the component be
contractually specified (see paragraph 6.3.7 of IFRS 9).
|
Hedges of interest rate risk for variable-rate financial
instruments
|
Entities may designate the contractually specified interest rate
as the hedged risk. The concept of benchmark interest rate
hedging is not available for existing variable-rate financial
instruments (see Sections 2.3.1.1 and
4.2.1.1).
|
Entities may designate components that are separately
identifiable and reliably measurable (see paragraph 6.3.7 of
IFRS 9).
|
Application of critical-terms-match method to a cash flow hedge
of a group of forecasted transactions
|
Entities may use the critical-terms-match method
when hedging the cash flows of a group of forecasted
transactions if (1) those transactions occur within the same
31-day period or the same fiscal month in which the hedging
derivative matures and (2) all other method requirements are met
(see Section
2.5.2.2.2).
|
No formal approach exists; however, entities may be able to
qualitatively assess hedge effectiveness when the critical terms
of the hedging instrument match those of the hedged item (see
paragraph B6.4.14 of IFRS 9).
|
Guidance Applicable Only to Fair Value
Hedges
| ||
Eligible benchmark interest rates
|
The following are considered to be the benchmark
interest rates: interest rates on direct Treasury obligations of
the U.S. government, the LIBOR swap rate, the OIS Rate, SIFMA
Municipal Swap Rate, and the SOFR OIS rate (see Section
2.3.1.1).
|
Entities may designate components that are separately
identifiable and reliably measurable (see paragraph 6.3.7 of
IFRS 9).
|
Partial-term fair value hedges of interest rate risk
|
Entities may designate a partial term hedge by assuming that (1)
the term of the hedged item begins with the first hedged cash
flow and ends when the last hedged cash flow is due and payable
and (2) the hedged item matures on the date on which the last
hedged cash flow is due and payable (see Section
3.2.1.1).
|
Entities may perform partial term hedging (see paragraph 6.3.7 of
IFRS 9).
|
Measuring the change in the fair value of a hedged prepayable
instrument (e.g., callable debt)
|
Entities are allowed to consider only how changes in the
benchmark interest rate (as opposed to how all variables, such
as interest rate, credit, and liquidity factors) would affect
the exercise of the call or put option when assessing hedge
effectiveness and measuring the change in fair value of the debt
attributable to changes in the benchmark interest rate (see
Section 3.2.1.2).
|
IFRS Accounting Standards do not provide
specific guidance; however, for a layer component containing a
prepayment option to be eligible for fair value hedging,
entities must include the changes in the prepayment option’s
fair value that are attributable to changes in the hedged risk
when measuring the change in the hedged item’s fair value (see
paragraph B6.3.20 of IFRS 9).
|
Measuring the change in the fair value of the hedged item
attributable to the change in the benchmark interest rate in a
fair value hedge of interest rate risk
|
Entities are permitted to use either the benchmark rate component
of contractual coupon cash flows or the full contractual coupon
cash flows when calculating the change in the hedged item’s fair
value (see Section 3.2.1 and
Example 3-1).
|
Entities may designate the benchmark interest rate cash flows as
the hedged item if they are separately identifiable and reliably
measurable; however, a designated benchmark component of the
cash flows must be less than or equal to the total cash flows of
the entire item (see paragraphs 6.3.7 and B6.3.23 of IFRS
9).
|
Fair value hedges of interest rate risk in a closed portfolio of
prepayable financial instruments or a beneficial interest in a
portfolio of prepayable financial instruments
|
Because of the interplay between (1) the election for
partial-term fair value hedges and (2) the election to measure
the hedged item’s fair value by using the benchmark rate
component of its contractual coupon cash flows, entities are
able to hedge the fair value of a portion of a closed portfolio
of prepayable assets without having to consider prepayment risk
or credit risk when assessing hedge effectiveness and measuring
hedging results. An entity can also apply the method to one or
more beneficial interest(s) (e.g., an MBS) in a closed portfolio
of prepayable financial instruments (see Section
3.2.1.4).
|
IFRS Accounting Standards do not include a model
for fair value hedges of the interest rate risk of an open (or
closed) portfolio of financial assets or liabilities.
|
Appendix B — Titles of Standards and Other Literature
Appendix B — Titles of Standards and Other Literature
FASB Literature
ASC Topics
ASC 210, Balance Sheet
ASC 220, Income Statement — Reporting Comprehensive
Income
ASC 250, Accounting Changes and Error Corrections
ASC 310, Receivables
ASC 320, Investments — Debt Securities
ASC 321, Investments — Equity Securities
ASC 323, Investments — Equity Method and Joint
Ventures
ASC 326, Financial Instruments — Credit Losses
ASC 360, Property, Plant, and Equipment
ASC 470, Debt
ASC 805, Business Combinations
ASC 815, Derivatives and Hedging
ASC 820, Fair Value Measurement
ASC 825, Financial Instruments
ASC 830, Foreign Currency Matters
ASC 840, Leases
ASC 842, Leases
ASC 848, Reference Rate Reform
ASC 850, Related Party Disclosure
ASC 860, Transfers and Servicing
ASC 942, Financial Services — Depository and
Lending
ASC 944, Financial Services — Insurance
ASC 948, Financial Services — Mortgage Banking
ASC 954, Health Care Entities
ASC 958, Not-for-Profit Entities
ASC 960, Plan Accounting — Defined Benefit Pension
Plans
ASC 965, Plan Accounting — Health and Welfare Benefit
Plans
ASUs
ASU 2013-10, Derivatives and Hedging (Topic 815):
Inclusion of the Fed Funds Effective Swap Rate (or Overnight Index Swap
Rate) as a Benchmark Interest Rate for Hedge Accounting Purposes
ASU 2014-03, Derivatives and Hedging (Topic 815):
Accounting for Certain Receive-Variable, Pay-Fixed Interest Rate Swaps —
Simplified Hedge Accounting Approach
ASU 2016-01, Financial Instruments — Overall (Subtopic
825-10): Recognition and Measurement of Financial Assets and Financial
Liabilities
ASU 2016-05, Derivatives and Hedging (Topic 815): Effect
of Derivative Contract Novations on Existing Hedge Accounting
Relationships
ASU 2017-12, Derivatives and Hedging (Topic 815):
Targeted Improvements to Accounting for Hedging Activities
ASU 2018-16, Derivatives and Hedging (Topic 815):
Inclusion of the Secured Overnight Financing Rate (SOFR) Overnight Index
Swap (OIS) Rate as a Benchmark Interest Rate for Hedge Accounting
Purposes
ASU 2019-04, Codification Improvements to Topic 326,
Financial Instruments — Credit Losses, Topic 815, Derivatives and
Hedging, and Topic 825, Financial Instruments
ASU 2019-10, Financial Instruments — Credit Losses (Topic
326), Derivatives and Hedging (Topic 815), and Leases (Topic 842):
Effective Dates
ASU 2020-04, Reference Rate Reform (Topic 848):
Facilitation of the Effects of Reference Rate Reform on Financial
Reporting
ASU 2021-01, Reference Rate Reform (Topic 848):
Scope
ASU 2022-01, Derivatives and Hedging (Topic 815): Fair Value Hedging —
Portfolio Layer Method
ASU 2022-06, Reference Rate Reform (Topic 848): Deferral of the Sunset
Date of Topic 848
ASU 2023-06, Disclosure Improvements: Codification Amendments in Response
to the SEC’s Disclosure Update and Simplification Initiative
Concepts Statement
No. 7, Using Cash Flow
Information and Present Value in Accounting Measurements
Proposed ASUs
No. 2019-790, Derivatives and Hedging (Topic 815):
Codification Improvements to Hedge Accounting
No. 2022-001, Reference Rate Reform (Topic 848) and Derivatives and
Hedging (Topic 815): Deferral of the Sunset Date of Topic 848 and
Amendments to the Definition of the Secured Overnight Financing Rate
(SOFR) Overnight Index Swap Rate
Invitation to Comment
No. 2021-004, Agenda
Consultation
Staff Q&A
Topic 815, “Cash Flow Hedge
Accounting Affected by the COVID-19 Pandemic”
IFRS Literature
IFRS 9, Financial Instruments
ISDA Agenda Request
Cash Flow and Fair Value Hedges:
Hedging Foreign Exchange Risk Associated With Cross-Border Business
Acquisitions
SEC Literature
Regulation S-K
Item 305, “Quantitative and
Qualitative Disclosures About Market Risk”
Regulation S-X
Rule 4-08(n), “General Notes to
Financial Statements; Accounting Policies for Certain Derivative
Instruments”
Superseded Literature
Accounting Principles Board (APB) Opinion
APB 18, The Equity Method of
Accounting for Investments in Common Stock
Derivatives Implementation Group (DIG) Issues
E6, “The Shortcut Method and the Provisions That Permit the
Debtor or Creditor to Require Prepayment”
E10, “Application of the Shortcut Method to Hedges of a
Portion of an Interest-Bearing Asset or Liability (or Its Related Interest)
or a Portfolio of Similar Interest-Bearing Assets or Liabilities”
E15, “Continuing the Shortcut Method After a Purchase
Business Combination”
E18, “Designating A Zero-Cost Collar With Different Notional
Amounts As a Hedging Instrument”
E23, “Issues Involving the Application of the Shortcut
Method Under Paragraph 68”
F8, “Hedging Mortgage Servicing Right Assets Using Preset
Hedge Coverage Ratios”
G2, “Hedged Transactions That Arise From Gross Settlement of
a Derivative (“All in One” Hedges)”
G7, “Measuring the Ineffectiveness of a Cash Flow Hedge
Under Paragraph 30(b) When the Shortcut Method Is Not Applied”
G10, “Need to Consider Possibility of Default by the Counterparty to the
Hedging Derivative”
G20, “Assessing and Measuring the Effectiveness of a
Purchased Option Used in a Cash Flow Hedge”
H10, “Hedging Net Investment With the Combination of a
Derivative and a Cash Instrument”
FASB Interpretation
No. 39, Offsetting of Amounts
Related to Certain Contracts
FASB Staff Position (FSP)
No. FIN 39-1, Amendment of
FASB Interpretation No. 39
FASB Statements
No. 52, Foreign Currency Translation
No. 133, Accounting for Derivative Instruments and
Hedging Activities
No. 138, Accounting for Certain Derivative Instruments
and Certain Hedging Activities — an amendment of FASB Statement No.
133
No. 161, Disclosures About Derivative Instruments and
Hedging Activities
Appendix C — Abbreviations
Appendix C — Abbreviations
Abbreviation | Description |
---|---|
AFS | available for sale |
AICPA | American Institute of Certified Public Accountants |
AOCI | accumulated other comprehensive income |
APB | Accounting Principles Board |
ARRC | Alternative Reference Rates Committee |
ASC | FASB Accounting Standards Codification |
ASU | FASB Accounting Standards Update |
CCP | central clearing party |
CD | certificate of deposit |
CIRCUS | combined interest rate and currency swap |
CME | Chicago Mercantile Exchange |
CSX | Platts CAPP rail |
CTA | cumulative translation adjustment |
DIG | FASB Derivatives Implementation Group |
EFP | exchange-for-physical |
EFFR | Effective Federal Funds Rate |
EITF | FASB’s Emerging Issues Task Force |
EONIA | Euro Overnight Index Average |
ESTR | Euro Short-Term Rate |
EUR | euro |
EURIBOR | Euro Interbank Offered Rate |
FASB | Financial Accounting Standards Board |
FC | foreign currency |
FIFO | first in, first out |
FIN | FASB Interpretation Number |
FSP | FASB Staff Position |
GAAP | generally accepted accounting principles |
GBP | British pound sterling |
HDG | hot-dipped galvanized |
HR | hot rolled |
HTM | held to maturity |
IASB | International Accounting Standards Board |
IFRS | International Financial Reporting Standard |
ISDA | International Swaps and Derivatives Association |
JPY | Japanese yen |
LC | letter of credit |
LIFO | last in, first out |
LME | London Metals Exchange |
LIBOR | London Interbank Offered Rate |
MBS | mortgage-backed security |
MD&A | Management’s Discussion and Analysis |
NFP | not-for-profit entity |
OCA | SEC Office of the Chief Accountant |
OCI | other comprehensive income |
OIS | overnight index swap |
OTC | over the counter |
PA | price alignment |
PAA | price alignment amount |
PAI | price alignment interest |
PCAOB | Public Company Accounting Oversight Board |
P&L | profit and loss |
Q&A | question and answer |
SEC | U.S. Securities and Exchange Commission |
SEK | Swedish krona |
SIFMA | Securities Industry and Financial Markets Association |
SOFR | secured overnight financing rate |
TBA | to be announced |
UK | United Kingdom |
USD | U.S. dollar |
Appendix D — Roadmap Updates for 2023
Appendix D — Roadmap Updates for 2023
The table below summarizes the
substantive changes made in the 2023 edition of this Roadmap.
Amended Content
Section
|
Title
|
Description
|
---|---|---|
Modified content to reflect that ASU 2017-12 is now
effective for all entities.
Added reference to recently issued inaugural edition of
Deloitte’s Roadmap Derivatives.
| ||
Added reference to Deloitte’s Roadmap Derivatives.
| ||
Objective of Hedge Accounting
|
Added reference to Deloitte’s Roadmap Derivatives.
| |
History of Hedge Accounting Guidance
|
Modified content to reflect the effective dates of ASU
2017-12, ASU 2019-04, and ASU 2018-16.
Added content discussing issuance of ASU 2020-04 and ASU
2022-06.
Modified Changing Lanes discussion to
include recent FASB activity related to its project on
Codification improvements to hedge accounting.
| |
Contractually Specified Component of Existing
Contract
|
Added reference to Section
2.3.2 of Deloitte’s Roadmap Derivatives for
discussion of the application of the normal purchases
and normal sales scope exception.
Modified Changing Lanes discussion to
include recent FASB activity related to its project on
Codification improvements to hedge accounting.
| |
Contractually Specified Component of a Contract That Does
Not Yet Exist
|
Modified Changing Lanes discussion to
include recent FASB activity related to its project on
Codification improvements to hedge accounting.
| |
The Written Option Test
|
Added Changing Lanes discussion of
recent FASB decisions related to application of the net
written option test when the designated hedging
instrument in a cash flow hedge is a compound derivative
made up of a written option and a nonoption
derivative.
| |
Off-Market Derivatives
|
Added Connecting the Dots discussion of accounting
treatment of modified derivative contracts in light of
recent changes observed in U.S. interest rates.
| |
Contingent Prepayment Terms
|
Modified Changing Lanes discussion to
include recent FASB activity related to its project on
Codification improvements to hedge accounting.
| |
Credit Risk Hedging
|
Added reference to Section
2.3.2 of Deloitte’s Roadmap Derivatives for
discussion of the application of the scope exception for
certain financial guarantees.
| |
Illustrative Examples
|
Added reference in Example 3-12 to Section 2.3.2 of
Deloitte’s Roadmap Derivatives for discussion of
application of the normal purchases and normal sales
scope exception.
| |
Date or Range of Dates
|
Modified Changing Lanes discussion to
include recent FASB activity related to its project on
Codification improvements to hedge accounting.
| |
Illustrative Examples
|
Added reference in Examples 4-28, 4-29, and 4-31 to
Section 2.3.2
of Deloitte’s Roadmap Derivatives for discussion of
the application of the normal purchases and normal sales
scope exception.
| |
Hedging Instrument Is a Nonderivative Instrument
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Modified Changing Lanes discussion to
include recent FASB activity related to its project on
Codification improvements to hedge accounting.
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Overview
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Added reference to Deloitte’s Roadmap Derivatives.
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Economic Hedging
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Added reference to Section
7.3 of Deloitte’s Roadmap Derivatives for
discussion of income statement geography for derivatives
not held for hedging purposes.
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Balance Sheet Offsetting Disclosures
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Added pending content to reflect issuance of ASU
2023-06.
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Overview
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Modified content to reflect effective date of ASU
2017-12.
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Reference Rate Reform (ASC 848)
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Modified dates to reflect ASU 2022-06
deferral of ASC 848 sunset date.
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Overview
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Modified content to reflect issuance of ASU 2022-06 and
LIBOR sunset dates.
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