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10.2 Discontinuance – general guidance
Publication date: 31 Jul 2022
us Derivatives & hedging guide
Applying hedge accounting is an election; it may be voluntarily discontinued on an individual hedge basis without the discontinuation of other similar hedges. Hedge accounting must be discontinued if the hedging relationship no longer meets the qualifying criteria. ASC 815-25-40-1 and ASC 815-30-40-1 require that a reporting entity discontinue hedge accounting for fair value and cash flow hedges if:
- the hedging relationship no longer qualifies for hedge accounting or ceases to be highly effective;
- the derivative expired or was sold, terminated, or exercised; or
- the reporting entity elects to discontinue hedge accounting.
The dedesignation of a hedging relationship and the designation of a new hedging relationship is not a change in accounting principle under ASC 250, Accounting Changes and Error Corrections. However, as it relates to portfolio layer method hedging relationships, certain changes to how dedesignations are sequenced would be considered a change in accounting principle under ASC 250. See DH 10.3.8 for additional information on portfolio layer hedges.
10.2.1 Redesignating a new hedging relationship
After discontinuance of a prior hedge, a reporting entity may establish a new hedging relationship prospectively that involves either the same or a new derivative, or the same or a new hedged item, as long as the new hedging relationship satisfies the qualifying criteria for hedge accounting.
Once hedge accounting is discontinued, subsequent redesignation of an existing derivative in a new hedging relationship may be challenging because the derivative will typically have a fair value other than zero due to changes in market conditions since inception of the instrument. Off-market terms in a derivative create a financing element that may be a source of mismatch between the hedged item and hedging instrument that (in many cases) must be considered in determining whether the new hedging relationship is highly effective and can qualify for hedge accounting. The more off-market the derivative, the greater the possible mismatch and the less likely the proposed hedging relationship will be highly effective. The degree to which an off-market derivative will impact the assessment of effectiveness may depend on the method of assessing effectiveness (see DH 9 for discussion of assessing effectiveness).
Question DH 10-1
Does hedge accounting prohibit terminating or dedesignating a hedging relationship and redesignating a new hedging relationship with the same hedged item on a recurring basis?
Does hedge accounting prohibit terminating or dedesignating a hedging relationship and redesignating a new hedging relationship with the same hedged item on a recurring basis?
PwC response
No. ASC 815 has no specific prohibition against terminating one hedge and initiating another, nor does it set limitations on the frequency of such terminations and redesignations. Delta-neutral and dynamic hedging are examples of strategies that involve dedesignations and redesignations. In delta-neutral hedging, the quantity of the hedging instrument is constantly adjusted to maintain a desired hedge ratio. Dynamic hedging may involve a single derivative, or more commonly, it involves a number of derivatives to make the hedge highly effective for a hedge period of one or several days to a week. Dynamic and delta-neutral hedging strategies are eligible for hedge accounting provided that reporting entities can (1) properly track all of the changes (i.e., terminations and redesignations) and (2) demonstrate that all other qualifying criteria, such as high effectiveness, have been met. Dynamic hedging is addressed in DH 6.2.2.2 and DH 9.2.4.
10.2.2 Change in the critical terms of the hedging relationship
Generally, if a critical term of a hedging relationship is modified, the existing hedging relationship must be discontinued. If a reporting entity wishes to continue hedge accounting, it must create a new hedging relationship. ASC 815-20-55-56 and ASC 815-30-35-37A provide an exception for a change in the hedged risk in a cash flow hedge of a forecasted transaction.
Excerpt from ASC 815-20-55-56
If 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. However, as discussed in paragraph 815-30-35-37A, a change to the hedged risk in a cash flow hedge of a forecasted transaction does not result in an automatic dedesignation of the hedging relationship if the hedging instrument continues to be highly effective at achieving offsetting cash flows associated with the hedged item attributable to the revised hedged risk.
If the designated hedged risk changes during the life of a hedging relationship, an entity may continue to apply hedge accounting if the hedging instrument is highly effective at achieving offsetting cash flows attributable to the revised hedged risk. The guidance in paragraph 815-20-55-56 does not apply to changes in the hedged risk for a cash flow hedge of a forecasted transaction.
10.2.2.1 Changes to hedged items
Some modifications to the hedged item that would require dedesignation of a hedging relationship include:
- Certain changes to the documented key terms of a forecasted transaction (e.g., changing from hedging the purchase of a commodity in November to the purchase of a commodity in February)
- Substitution of a new debt issuance for an existing debt issuance in a fair value hedge of interest rate risk of a specified debt issuance
- Addition or removal of a floor or cap to or from the agreement (or adjustment of the terms)
10.2.2.2 Changes to hedging instruments
Some modifications to the hedging instrument that would require dedesignation of a hedging relationship include:
- Changes to the payment or maturity dates
- Modifications to a payment term of the derivative (changing the coupon on an interest rate swap or changing the strike price of a forward or option)
- Addition or removal of a floor or cap to or from the instrument
- Significant increase in credit risk such that the likelihood that the counterparty will not default ceases to be probable
- “Blend and extend” transactions in which a current derivative is settled by entering into a new derivative with similar terms and the gain or loss on the original contract is settled by the new contract having off-market terms
Changes to the counterparty to a derivative (novations)
Novations of a derivative contract may occur for a number of reasons, including regulatory requirements (such as to effect central clearing of certain transactions), financial institution mergers, intercompany transactions, or financial institutions voluntarily exiting a particular derivative business or a customer relationship.
As discussed in ASC 815-25-40-1A for fair value hedges and ASC 815-30-40-1A for cash flow hedges, a change in the counterparty to a derivative hedging instrument in an existing hedging relationship would not, in and of itself, be considered a termination of the derivative. However, a reporting entity needs to evaluate whether it is probable that the counterparty will perform under the contract as part of its ongoing effectiveness assessment. Therefore, a novation of a derivative to a counterparty with a sufficiently high credit risk could still result in dedesignation of the hedging relationship.
Credit Support Annexes
A Credit Support Annex (CSA) is an appendix to the ISDA master document establishing rules for the receiving and posting of collateral by each party to the ISDA contract. Adding a CSA is a modification that changes the credit risk of the derivative instrument. Given the existence of netting provisions within agreements, entering into a new individual derivative transaction can also impact the credit risk of other derivatives. Since any new derivatives do not typically call into question the existing designations of other derivatives with the same counterparty under the same ISDA master agreement, we do not believe that subsequent executions of the most common CSA agreements would call into question the existing hedge designations of the derivatives.
Legal nature of variation margin
In some arrangements, the legal nature of variation margin payments is collateral, and in others, it is a settlement payment. See DH 1.3.2.1 for discussion of collateralized-to-market and settled-to-market transactions.
Because variation margin is paid or received on a daily basis, a question arises as to whether a derivative would need to be dedesignated and redesignated on a daily basis to maintain a hedging relationship when it is deemed a settlement payment. In an industry preclearance submission, the SEC staff did not object to a view that these settlement payments would not require daily dedesignation and redesignation if the terms of the derivative, such as the notional amount and fixed and floating rates, are not reset to market rates on a daily basis. As a result, these settlement payments would not result in the extinguishment of one instrument and the execution of a new instrument on a daily basis.
PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
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