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10.3 Discontinuance of fair value hedges
Publication date: 29 Nov 2020
us Derivatives & hedging guide 10.3
A fair value hedge is discontinued when any of the following occurs:
- Hedge is no longer highly effective (DH 10.3.1)
- Hedging instrument is sold, extinguished, terminated, exercised, or expired (DH 10.3.2)
- Hedging instrument is dedesignated in its entirety (DH 10.3.3) or in part (DH 10.3.3.1), although it may be redesignated in a new hedging relationship (DH 10.3.4)
- Hedged item no longer meets the definition of a firm commitment in ASC 815-10-20 (DH 10.3.5)
- Hedged item is sold or extinguished, in its entirety (DH 10.3.6) or in part (DH 10.3.6.1)
- Last-of-layer hedge is fully or partially dedesignated (DH 10.3.8)
When a fair value hedging relationship is no longer intact or effective, a reporting entity should stop adjusting the carrying amount of the hedged item for changes in fair value due to the hedged risk. Unlike the accounting for the hedged item, if there were no components excluded from the assessment of effectiveness in the hedging relationship, the measurement of the derivative may not change when a fair value hedge is discontinued. If there were excluded components in the hedging relationship recognized in earnings under an amortization approach, when the derivative is no longer in the hedging relationship, that treatment would not be appropriate. As such, prospectively, the entire derivative should be measured at fair value through earnings, but without any offset, unless it is redesignated in a new hedging relationship.
Upon discontinuance of a fair value hedge, excluded components deferred in AOCI because they were recognized through an amortization approach are released to earnings consistent with how other components of the carrying amount of the hedged item are recognized in earnings. However, if the hedged item is derecognized, ASC 815-25-40-7 requires any amounts remaining in AOCI related to the excluded components to be recorded in earnings. Excluded components are discussed in DH 6.3.1.2 for financial items and DH 7.2.1.3 for nonfinancial items.
10.3.1 Hedge is no longer highly effective
If a fair value hedging relationship does not pass the prospective effectiveness test, hedge accounting should be discontinued going forward.
If a hedging relationship does not pass the retrospective effectiveness test, hedge accounting should be discontinued as of the last date when the hedged item was assessed and demonstrated high effectiveness. The reporting entity would stop adjusting the carrying amount of the hedged item for the hedged risk as of that date, unless it can determine a specific point that it failed to be effective.
Adjustments to the carrying amount of the hedged item (basis adjustments) should be recognized in earnings consistent with how other components of the carrying amount of the hedged item are recognized in earnings. For example, adjustments to the basis of an interest-bearing loan are recognized in accordance with ASC 310-20, Receivables - Nonrefundable Fees and Other Costs.
Assume a reporting entity determines that a hedging relationship did not pass the retrospective and prospective effectiveness assessments during its monthly effectiveness assessment on July 31, 20X1. Hedge accounting should be discontinued as of June 30, 20X1, the last date on which the hedged item was assessed and demonstrated high effectiveness. The reporting entity would stop adjusting the carrying amount of the hedged item for the hedged risk as of that date, unless it can determine a specific point in July of 20X1 on which it failed to be effective.
For a discontinued fair value hedge in which the hedged item is not derecognized, ASC 815-25-40-7 indicates that amounts related to the excluded components remaining in AOCI should be recorded in earnings in the same manner as other components of the carrying amount of the hedged item are recognized in earnings.
10.3.2 Hedging instrument is sold, terminated, exercised, or expired
At maturity of a derivative, any final amounts due are settled, there are no further rights or obligations of either party, and the fair value of the expired contract (after final settlement) is zero. There is no further accounting for the derivative because it no longer exists.
Similarly, a derivative settled in its entirety with the counterparty prior to its maturity date, or sold or novated/assigned to a third party no longer exists from the perspective of the reporting entity.
For a discontinued fair value hedge in which the hedged item is not derecognized, basis adjustments are recognized in earnings consistent with how other components of the carrying amount of the hedged item are recognized in earnings. For example, adjustments to the basis of an interest-bearing loan are recognized in accordance with ASC 310-20. In addition, ASC 815-25-40-7 indicates that amounts related to the excluded components remaining in AOCI are recorded in earnings in the same manner as basis adjustments.
10.3.3 Hedging instrument is dedesignated
When a fair value hedging instrument is dedesignated, continues to exist, and is not redesignated in a new hedging relationship, the hedging instrument should be measured at fair value with changes recorded in current earnings prospectively. However, there is no basis adjustment on the hedged item to fully or partially offset the gain or loss on the derivative.
For a discontinued fair value hedge in which the hedged item is not derecognized, adjustments to the carrying amount of the hedged item are recognized in earnings consistent with how other components of the carrying amount of the hedged item are recognized in earnings. For example, adjustments to the basis of an interest-bearing loan are recognized in accordance with ASC 310-20. In addition, ASC 815-25-40-7 indicates that amounts related to the excluded components remaining in AOCI should be recorded in earnings in the same manner as basis adjustments.
10.3.3.1 Partial dedesignation of the hedging instrument
Within Example 19, Hedging a Portfolio of Fixed Rate Financial Assets, ASC 815-20-55-178 indicates that a partial dedesignation of a fair value hedge is permitted. In that example, a reporting entity dedesignated the portion of the notional amount of a swap that was in excess of the portfolio of fixed-rate loans that it had available to hedge. Changes in the fair value of the portion of the derivative that was dedesignated would be recorded in earnings with no offsetting basis adjustment to the hedged item from the point of partial dedesignation onward. However, changes in the fair value of the portion of the derivative that remains in the hedging relationship would be offset in earnings by changes in the fair value of the hedged item for the hedged risk.
The dedesignated portion of the derivative may be redesignated in a new hedging relationship.
10.3.4 Hedging instrument is dedesignated and redesignated
When a fair value hedging instrument is dedesignated and subsequently redesignated in a new fair value hedging relationship, the accounting for the derivative may change depending on the reporting entity’s elections for excluded components on the original and the new hedging relationships. As discussed in DH 10.3.3, for a discontinued fair value hedge in which the hedged item is not derecognized, basis adjustments and excluded components recognized in AOCI are recognized in earnings consistent with how other components of the carrying amount of the hedged item are recognized in earnings. Any excluded components in the new hedging relationship would be recognized in accordance with the reporting entity’s election, as discussed in DH 6.3.1.2 for hedges of financial items and DH 7.2.1.3 for hedges of nonfinancial items.
10.3.5 Hedged item no longer meets definition of a firm commitment
Although rare, when a hedged firm commitment no longer meets the definition of a firm commitment, 815-25-40-5 states that any asset or liability that was recognized under a fair value hedge through cumulative fair value adjustments of the firm commitment must be derecognized, and a corresponding gain or loss recorded in earnings.
A pattern of discontinuing hedge accounting and derecognizing firm commitments would call into question the application of hedge accounting to firm commitments in the future.
10.3.6 Hedged item is sold or extinguished in its entirety
The fair value hedge model provides for recording a basis adjustment on the hedged item. As a result, when the hedged item is sold or extinguished, the basis adjustment is derecognized with the hedged item and impacts any gain or loss recorded on sale or extinguishment of the hedged item.
Amounts in AOCI related to excluded components recognized through an amortization approach should be reclassified to earnings currently when the hedge is discontinued because the hedged item was derecognized, per the guidance in ASC 815-25-40-7.
Because the derivative is no longer in a hedging relationship, it is measured at fair value through current earnings without any offset, unless it is redesignated in another hedging relationship.
10.3.6.1 Hedged item is partially sold, prepaid, or extinguished
If part of the hedged item is sold, prepaid, or otherwise extinguished, consistent with the treatment of a full extinguishment discussed in DH 10.3.6, a portion of the basis adjustment is derecognized.
In the case of partial sale or extinguishment, we believe the portion of the amount in AOCI related to excluded components recognized through an amortization approach on the partially sold or prepaid derivative should be reclassified to earnings currently.
The hedging relationship may no longer be effective if a portion of the hedged item no longer exists. If so, the reporting entity will have to dedesignate the entire relationship (because it will no longer qualify for hedge accounting). Alternatively, it may partially dedesignate the hedging instrument if done concurrent with the change to the hedged item.
Example DH 10-1 illustrates a partial dedesignation of a hedging instrument when the hedged item is partially extinguished.
EXAMPLE DH 10-1
Partial dedesignation of hedging instrument upon partial extinguishment of hedged item
Partial dedesignation of hedging instrument upon partial extinguishment of hedged item
DH Corp issues $100 million of fixed-rate non-callable debt and enters into a receive-fixed/pay-floating interest rate swap with a notional amount of $70 million. DH Corp designates the interest rate swap as a fair value hedge of benchmark interest rate risk of 70% of the debt.
One year after issuing the debt, DH Corp repurchases $20 million of the debt in the market so that the new debt balance is $80 million.
What is the impact of the debt extinguishment on the hedging relationship?
Analysis
After the debt extinguishment, the amount of debt hedged would be $56 million (70% of the $80 million new debt balance). To maintain a highly effective hedge, DH Corp could partially dedesignate (concurrent with the extinguishment) the portion of the hedging instrument no longer needed once the debt balance decreases to $80 million. Once the unnecessary portion of the swap is dedesignated, $56 million of the notional amount would be designated as a hedge of the debt and $14 million would not.
DH Corp may redesignate the $14 million of swap notional in a new hedging relationship, including as a hedge of the originally unhedged portion of the debt.
10.3.7 Amortization of basis adjustments upon discontinuance
When a reporting entity discontinues a fair value hedging relationship of an interest-bearing asset or liability by either dedesignating or terminating the derivative, the basis adjustment should generally be amortized over the remaining life of the hedged item, with the amortization included in interest income or interest expense. Amortization must commence when the hedged item ceases to be adjusted for changes in fair value attributable to the hedged risk.
If the hedged item is not an interest-bearing financial instrument and the hedge is discontinued, the basis adjustment is generally recognized in the income statement when the hedged item impacts earnings in the same line item. For example, if a hedge of a commodity held in inventory is discontinued, the basis adjustment to the inventory balance would be recognized in earnings when the inventory is sold (as part of cost of goods sold).
Basis adjustments to interest-bearing and non-interest-bearing assets should be considered in ongoing impairment analyses.
10.3.7.1 Basis adjustment on a redesignated hedged item
Any subsequent hedging relationship following a dedesignation would be considered a new designation accounted for prospectively. If the new hedging relationship is a fair value hedge, changes in the fair value of the hedged item that are attributable to the hedged risk from the date of the new designation onward will result in an adjustment of the carrying amount of the hedged item and offset the fair value changes of the derivative currently in earnings. Both changes in value (i.e., on the hedged item and the derivative) should be measured from the date that the new hedging relationship was established.
If a new hedging instrument is designated as a hedge of 100% of the existing hedged item for the same hedged risk, the carrying amount of the hedged item would resume being adjusted.
If only a portion of an item is redesignated as the hedged item in a new hedging relationship, only that portion of the carrying amount of the hedged item attributable to the risk being hedged will be adjusted for changes in fair value due to the hedged risk. The remaining portion of the hedged item would not be measured at fair value for the risk being hedged because it is not part of the hedging relationship.
Whether full or partial redesignation, basis adjustments from previous hedging relationships that were hedging interest rate risk of interest bearing hedged items generally should be amortized over the hedged item’s remaining contractual life.
10.3.7.2 Amortization of basis adjustments in partial-term hedges
For interest-bearing assets and liabilities, if a partial-term hedge is discontinued early, the remaining basis adjustment would be amortized in accordance with the applicable guidance for the hedged item. For example, for hedges of interest bearing loans, amortization of the basis adjustment would be calculated in accordance with ASC 310-20. Thus, the amortization period may change upon termination because basis adjustments amortized while the partial-term hedge is in place are amortized over the assumed term of the hedged item while amortization upon discontinuance under ASC 310-20 may be over the contractual life.
10.3.8 Discontinuance of last-of-layer hedges
As described in ASC 815-25-35-7A, when a hedged item qualifies and is designated under the last-of-layer method, the reporting entity is required to perform an analysis at each effectiveness assessment date to determine whether the amount representing the hedged item is still expected to be fully outstanding as of the assumed maturity date.
ASC 815-25-40-8 indicates that the entire last-of-layer hedging relationship must be discontinued in full when, on a testing date, the outstanding amount of the closed portfolio is less than the amount hedged. A last-of-layer hedge can be partially discontinued when the reporting entity cannot, on a forward-looking basis, support that the hedged item will be outstanding through the assumed maturity date of the hedged portfolio. In that case, the reporting entity may dedesignate the portion of the derivative related to the portion of the hedged layer no longer expected to be outstanding. Upon discontinuance, whether full or partial, the outstanding basis adjustment, or a portion of it, is allocated to the individual assets in the closed portfolio and amortized over a period consistent with amortization of other discounts or premiums on the assets.
Reporting entities that are proactive in partially designating may be able to avoid a situation in which full dedesignation is required.
10.3.8.1 Allocating basis adjustments of a last-of-layer hedge
If a last-of-layer hedging relationship is partially discontinued before the hedged item’s assumed maturity date, the reporting entity needs to use a systematic and rational method to allocate the outstanding basis adjustment associated with the amount of the hedged item that is dedesignated as of the discontinuance date to the individual assets in the portfolio. ASC 815-25-40-9 states that those amounts will then be amortized consistently with other discounts and premiums on the related assets.
If a last-of-layer hedging relationship is fully discontinued before the hedged item’s assumed maturity date because the reporting entity breached the layer designated as the hedged item, the basis adjustment would be divided using a systematic and rational method:
- The proportion of the basis adjustment associated with the amount by which the hedged item exceeds the amount outstanding in the closed portfolio is recognized in earnings.
- The remaining outstanding basis adjustment is allocated to the remaining assets in the portfolio using a systematic and rational method.
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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