Chapter 7 — Common Issues Related to Cash Flows

7.4 Derivatives

ASC 230-10

Cash Receipts and Payments Related to Hedging Activities

45-27 Generally, each cash receipt or payment is to be classified according to its nature without regard to whether it stems from an item intended as a hedge of another item. For example, the proceeds of a borrowing are a financing cash inflow even though the debt is intended as a hedge of an investment, and the purchase or sale of a futures contract is an investing activity even though the contract is intended as a hedge of a firm commitment to purchase inventory. However, cash flows from a derivative instrument that is accounted for as a fair value hedge or cash flow hedge may be classified in the same category as the cash flows from the items being hedged provided that the derivative instrument does not include an other-than-insignificant financing element at inception, other than a financing element inherently included in an at-the-market derivative instrument with no prepayments (that is, the forward points in an at-the-money forward contract) and that the accounting policy is disclosed. If the derivative instrument includes an other-than-insignificant financing element at inception, all cash inflows and outflows of the derivative instrument shall be considered cash flows from financing activities by the borrower. If for any reason hedge accounting for an instrument that hedges an identifiable transaction or event is discontinued, then any cash flows after the date of discontinuance shall be classified consistent with the nature of the instrument.

In accordance with the general principle in ASC 230-10-45-27, the presentation of cash flows associated with derivatives depends on the nature of the underlying instrument. Such presentation would therefore be affected by whether the instrument contains an other-than-insignificant financing element, regardless of whether the derivative is a hedging instrument. In situations in which an arrangement contains an other-than-insignificant financing element, the borrower and lender under the derivative instrument classify cash flows related to the derivative instrument as financing activities and investing activities, respectively.

The table below summarizes common cash flow classifications for various derivative transactions. These classifications are discussed in more detail throughout this section.

Derivative Instrument	Classification of the Derivative’s Cash Flows
Derivatives with an other-than-insignificant financing element at inception	Financing activities (for the deemed borrower4) and generally investing activities (for the deemed lender)
Derivatives acquired or originated for trading purposes	Operating activities
Hedging derivatives	Investing activities or In the same category as the cash flows from the item being hedged
Nonhedging derivatives	Investing activities or In accordance with the nature of the derivative instrument as it is used in the context of the entity’s business (if an economic hedge)

7.4.1 Determining Whether an Other-Than-Insignificant Financing Element Exists

ASC 815-10

45-11 An instrument accounted for as a derivative instrument under this Subtopic that, at its inception, includes off-market terms, or requires an up-front cash payment, or both often contains a financing element. Identifying a financing element within a derivative instrument is a matter of judgment that depends on facts and circumstances.

45-12 If an other-than-insignificant financing element is present at inception — other than a financing element inherently included in an at-the-market derivative instrument with no prepayments (that is, the forward points in an at-the-money forward contract) — then the borrower shall report all cash inflows and outflows associated with that derivative instrument in a manner consistent with financing activities as described in paragraphs 230-10-45-14 through 45-15.

45-13 An at-the-money plain-vanilla interest rate swap that involves no payments between the parties at inception would not be considered as having a financing element present at inception even though, due to the implicit forward rates derived from the yield curve, the parties to the contract have an expectation that the comparison of the fixed and variable legs will result in payments being made by one party in the earlier periods and being made by the counterparty in the later periods of the swap's term.

45-14 If a derivative instrument is an at-the-money or out-of-the-money option contract or contains an at-the-money or out-of-the-money option contract, a payment made at inception to the writer of the option for the option's time value by the counterparty shall not be viewed as evidence that the derivative instrument contains a financing element.

45-15 In contrast, if the contractual terms of a derivative instrument have been structured to ensure that net payments will be made by one party in the earlier periods and subsequently returned by the counterparty in the later periods of the derivative instrument's term, that derivative instrument shall be viewed as containing a financing element even if the derivative instrument has a fair value of zero at inception.

ASC 815-10-45-12 requires the deemed borrower of a financing element in a derivative instrument to classify cash flows associated with the derivative instrument as financing activities in accordance with ASC 230-10-45-14 and 45-15 if “an other-than-insignificant financing element is present at inception — other than a financing element inherently included in an at-the-market derivative instrument with no prepayments (that is, the forward points in an at-the-money forward contract).” For example, an up-front payment that does not represent compensation for the initial time value associated with an at-the-money or out-of-the-money option may represent a financing element. To determine whether a financing element is other than insignificant, an entity often needs to use judgment and consider its specific facts and circumstances. We have observed in practice that when making this determination, some entities have compared the financing element with a reference amount (e.g., a comparison to the present value of an at-the-market derivative’s fully prepaid amount).

ASC 230-10-45-27 requires an entity to evaluate whether an other-than-insignificant financing element exists “at inception,” which is generally the date on which the entity entered into the derivative instrument. However, a modification made to the terms of the derivative instrument that changes the timing or amount of cash flows is in substance a new derivative instrument. Accordingly, the modification date would represent a new inception date, and an entity would need to evaluate whether an other-than-insignificant financing element exists on such date, if applicable. However, in the context of derivative instruments modified as a result of the elimination of a benchmark interest rate reference, we believe that an entity would not need to use the modification date as the inception date if the entity elects to apply the contract modification practical expedient provided under ASC 848.5 Therefore, an entity that elects to apply such a practical expedient would not need to reassess whether an other-than-insignificant financing element exists on the modification date and, as a result, no reassessment to the cash flow classification would be necessary.

7.4.2 Derivatives With an Other-Than-Insignificant Financing Element at Inception

Under ASC 230-10-45-27, if a derivative includes “an other-than-insignificant financing element at inception, other than a financing element inherently included in an at-the-market derivative instrument with no prepayments (that is, the forward points in an at-the-money forward contract),” the deemed borrower classifies all cash flows associated with that derivative instrument as financing activities. While ASC 230 addresses the deemed borrower’s classification of cash flows on a derivative with an other-than-insignificant financing element at inception, it does not explicitly address the deemed lender’s classification of such cash flows. In a manner consistent with the guidance in ASC 230-10-45-27, it is appropriate for a deemed lender to classify cash flows related to a derivative with an other-than-insignificant financing element at inception as investing activities; however, that classification may not be required in all circumstances. The example below illustrates the classification of cash flows related to an interest rate swap that is not a hedging derivative and contains an other-than-insignificant financing element.

Example 7-4

In year 1, Entity A issues a five-year, $100 million variable-rate corporate bond for which A pays the secured overnight financing rate (SOFR) annually. To minimize its exposure to fluctuations in interest rates, A also enters into an interest rate swap agreement with Bank B. Under the terms of the agreement, the fixed leg of the interest rate swap is 8 percent, while the interest rate at the inception of the instrument is 5 percent. Therefore, B will pay a premium to A at inception. That is, A is deemed to borrow the amount of the premium that would be repaid through higher payments under the derivative instrument. The interest rate swap is not designated as a hedging derivative.

Entity A concludes that the premium received at inception represents a financing element that is other than insignificant. Because the interest rate swap is not designated as a hedging derivative and contains an other-than-insignificant financing element at inception, A should generally classify the cash flows associated with the interest rate swap as financing activities in its statement of cash flows since A is the deemed borrower of the premiums received for the swap. By contrast, B is considered the deemed lender since B is making the premium payment at inception. Therefore, B should classify the cash flows associated with the interest rate swap as investing activities in its statement of cash flows.

Note that A’s classification of the cash flows related to the interest rate swap in this example would not be affected if A had concluded that the instrument were a hedging derivative.

The example below illustrates the classification of cash flows related to an interest rate swap that is not a hedging derivative and does not contain an other-than-insignificant financing element.

Example 7-5

Assume the same facts as in Example 7-4, except that Entity A concludes that the interest rate swap does not contain an other-than-insignificant financing element at inception. Accordingly, the cash flows associated with the interest rate swap should, on the basis of the guidance discussed in Section 7.4.5, be classified either as investing activities or in a manner consistent with the nature of the derivative instrument as it is used in the context of the entity’s business. The interest rate swap arrangement derives its periodic cash flows from an interest rate underlying and was entered into to alter the entity’s periodic interest payments. Therefore, because the cash payments for interest are classified as operating activities, it would be acceptable for A to classify the cash flows from the derivative as operating activities given the nature of the derivative instrument as it is used in the context of the entity’s business.

7.4.3 Derivatives Acquired or Originated for Trading Purposes

In accordance with ASC 230-10-45-19 through 45-21, cash receipts and payments resulting from purchases and sales of securities, loans, and other assets that are acquired specifically for resale must be classified as operating activities. Thus, a trading entity that acquires derivatives as part of its trading business should classify the cash flows from those derivatives as operating activities (provided that those derivatives do not contain an other-than-insignificant financing element at inception).

7.4.4 Hedging Derivatives

Under ASC 230-10-45-27, a cash receipt or payment related to a hedging derivative should generally “be classified according to its nature without regard to whether it stems from an item intended as a hedge of another item. For example, the proceeds of a borrowing are a financing cash inflow even though the debt is intended as a hedge of an investment, and the purchase or sale of a futures contract is an investing activity even though the contract is intended as a hedge of a firm commitment to purchase inventory.”

However, an entity may classify the cash flows from a derivative instrument that is accounted for as a fair value hedge or a cash flow hedge (and that does not contain an other-than-insignificant financing element at inception) in the same category as the cash flows from the items being hedged as long as the entity has elected and disclosed such classification as its accounting policy. Otherwise, the entity should classify the cash flows from the derivative as an investing activity under ASC 230-10-45-27. If periodic settlement payments are required for the hedging derivative in a fair value or cash flow hedging relationship, the cash flow classification of any termination or settlement payment should generally be consistent with the classification of the periodic settlements.

If a derivative instrument (that does not contain an other-than-insignificant financing element at inception) is designated as a hedging instrument in a hedge of the foreign currency exposure related to a net investment in a foreign operation, the cash flows from the derivative, including the cash flows associated with the forward elements of the derivative, should generally be classified as cash flows related to investing activities. This classification is consistent with both the nature of the derivative and the nature of the hedged item. If, however, an entity assesses the effectiveness of the net investment hedging relationship by using the spot method, it is also acceptable for the entity to classify the cash flows associated with the excluded component (e.g., the periodic settlement payments in a cross-currency interest rate swap) according to their nature (i.e., as operating activities consistent with the classification of interest payments and receipts) provided that such classification is applied consistently and disclosed. However, the cash flow classification of any termination or settlement payment for the derivative should be consistent with the nature of the hedged item (i.e., as an investing activity, because sales or purchases of the net investment would be an investing activity).

The examples below illustrate an entity’s classification approaches when its accounting policy is to classify cash flows in the same category as the cash flows from the items being hedged.

Example 7-6

Entity A designates a forward-starting swap as a hedge of the forecasted issuance of fixed-rate debt. The entity plans to issue debt at par at the then-current market interest rate (i.e., the market interest rate as of the date the debt is issued) and will therefore have no variability in debt proceeds; however, each of the probable interest payments resulting from the debt is exposed to variability up until the date of issuance. Accordingly, the forward-starting swap is a hedge of the interest payments and the related cash flows should be classified as operating activities in the statement of cash flows.

Example 7-7

Entity B designates a forward-starting swap as a hedge of the forecasted issuance of fixed-rate debt. The entity plans to issue debt at a stipulated, fixed interest rate (4 percent, regardless of current market rates as of the date the debt is issued). As a result, the debt proceeds will be variable (i.e., the debt will be issued at a discount or a premium) because market rates will change during the period leading up to the actual debt issuance date. The interest payments are not exposed to variability (since the entity has already determined the coupon it intends to pay). Therefore, the forward-starting swap is a hedge of the forecasted debt proceeds, and the cash flows on the derivative should be classified as financing activities in the statement of cash flows.

7.4.5 Nonhedging Derivatives

If a nonhedging derivative (1) does not contain an other-than-insignificant financing element at inception and (2) was not acquired or originated for trading purposes, as addressed in Sections 7.4.1 and 7.4.3, respectively, an entity should apply the guidance discussed below.

Cash flows pertaining to physically settled derivatives related to the entity’s ongoing revenue-producing and cost-generating activities should generally be classified as operating activities in accordance with ASC 230-10-45-16(a) and ASC 230-10-45-17(a). For all other nonhedging derivatives, ASC 230 does not specifically require an entity to classify cash flows as investing activities; thus, an entity can make an accounting policy election to apply either of the following approaches to nonhedging derivatives:

Classify the cash flows related to all other nonhedging derivatives as investing activities.
Classify the cash flows related to all other nonhedging derivatives in accordance with the nature of the derivative instrument as it is used in the context of the entity’s business.

When the cash flows associated with nonhedging derivatives are material, an entity should disclose its policy for classifying the cash flows associated with such instruments.

The table below outlines acceptable classifications for nonhedging derivatives in the statement of cash flows. Note that, in the examples, none of the derivatives contain an other-than-insignificant financing element at inception. Furthermore, when alternative classifications are acceptable, the entity’s accounting policy election regarding the classification of cash flows related to other nonhedging derivatives will dictate the proper classification.

Derivative Example	Classification of the Derivative’s Cash Flows
A manufacturing entity enters into a receive-variable, pay-fixed interest rate swap in conjunction with the issuance of a floating-rate debt instrument. The term of the interest-rate swap coincides with the term of the debt, and the variable leg on the swap is the same as the floating-rate index on the debt. The interest-rate swap was entered into to alter the economic interest cost related to the entity’s floating-rate debt.	Investing activities or operating activities. Classification as an investing activity is consistent with ASC 230-10-45-27. Classification as an operating activity is consistent with the nature of the derivative instrument as it is used in the context of the entity’s business. The derivative instrument derives its periodic cash flows on the basis of an interest rate underlying and was entered into to alter the entity’s interest costs. Cash payments for interest are classified as operating activities in accordance with ASC 230-10-45-17(d).
A real estate company enters into a variable-rate debt agreement that requires it to make interest payments indexed to SOFR and pay a spread quarterly. To limit its exposure to interest rates above 8 percent, which is above the current SOFR plus the spread, the company also enters into an interest rate cap arrangement. The company pays a premium to enter into the interest rate cap arrangement that is not considered an other-than-insignificant financing element.	Investing activities or operating activities. Classification as an investing activity is consistent with the guidance in ASC 230-10-45-27. Classification as an operating activity is consistent with the nature of the derivative instrument as it is used in the context of the entity’s business. The derivative instrument was entered into to mitigate a potential increase in the entity’s interest cost payments. Cash payments for interest costs are classified as operating activities in accordance with ASC 230-10-45-17(d).
A financial institution enters into a foreign currency forward contract that requires it to pay USD and receive EUR. The forward contract matures on the same date as the maturity of the principal amount of the institution’s EUR-denominated long-term debt. The forward contract was entered into to alter the USD-equivalent amount that must be paid at maturity of the debt.	Investing activities or financing activities. Classification as an investing activity is consistent with ASC 230-10-45-27. Classification as a financing activity is consistent with the nature of the derivative instrument as it is used in the context of the entity’s business. The derivative instrument derives its cash flows on the basis of a currency underlying and was entered into to alter the amount payable upon maturity of the institution’s debt. Cash payments made to repay amounts borrowed are classified as financing activities in accordance with ASC 230-10-45-15(b).
A power generator that uses a gas-fired plant to generate electricity enters into physically settleable forward gas purchase contracts that are within the scope of ASC 815. The gas purchased is used to run the power plant.	Operating activities. Since the derivative is physically settled and the gas purchased is used to operate the power plant, cash flows related to the derivative should be classified as an operating activity. Otherwise, the power generator could potentially reflect a significant amount of its cost-generating activities as investing activities.
A power generator that uses a gas-fired plant to generate electricity enters into futures contracts on gas to economically hedge its exposure to gas prices. The power generator does not plan to take delivery of the gas.	Investing activities or operating activities. Classification as an investing activity is consistent with ASC 230-10-45-27. Classification as an operating activity is consistent with the nature of the derivative instrument as it is used in the context of the entity’s business. The derivative may be considered part of the ongoing revenue-producing and cost-generating activities of the power generator. Cash receipts and payments related to sales and costs of goods sold are classified as operating activities in accordance with ASC 230-10-45-16 and 45-17. Note that since the derivative will be net settled, the power generator is not required to classify the cash flows as an operating activity.
An Internet advertising agency enters into a one-year futures contract on crude oil. The agency expects that crude oil prices will increase between the trade date and maturity date of the futures contract, resulting in a gain upon settlement. The agency does not plan to take delivery of the crude oil. The futures contract is not held for trading purposes.	Investing activities. Classification as an investing activity is consistent with ASC 230-10-45-27. Such classification is also consistent with the nature of the derivative instrument as it is used in the context of the entity’s business. The crude oil futures contract was entered into for speculative or investment purposes.
In year 1, Entity D issues a 10-year, $400 million variable-rate debt instrument. Entity D pays SOFR plus a spread of 200 basis points annually. To hedge its exposure to interest rate risk, D also enters into a receive-variable, pay-fixed interest rate swap agreement. In year 3, D terminated the interest rate swap arrangement.	Year 1: Investing activities or operating activities. Classification as an investing activity is consistent with the guidance in ASC 230-10-45-27. Classification as an operating activity is consistent with the nature of the derivative instrument as it is used in the context of the entity’s business. The derivative instrument derives its periodic cash flows on the basis of an interest rate underlying and was entered into to alter the entity’s interest costs. Cash payments for interest are classified as operating activities in accordance with ASC 230-10-45-17(d). Year 3: In a manner consistent with the classification of the periodic settlements, D should classify cash flows associated with the termination of the interest rate swap as investing activities or operating activities.

Footnotes

The “deemed borrower” refers to the party that benefits from a financing element in a derivative instrument in early periods of the instrument’s term. For example, a party that receives a premium upon entering into an arrangement because of the arrangement’s off-market terms is considered to be the deemed borrower.

See Section 8.2.2.2 of Deloitte’s Roadmap Hedge Accounting for more information about this practical expedient.

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