Search within this section
Select a section below and enter your search term, or to search all click Derivatives and hedging
Favorited Content
2.4 Accounting for a derivative
Publication date: 31 Mar 2024
us Derivatives & hedging guide
ASC 815 requires that derivative instruments within its scope be recognized and subsequently measured on the balance sheet at fair value in accordance with ASC 820, Fair Value Measurement. A contract that meets the definition of a derivative may not be within the scope of ASC 815 if it meets one of the scope exceptions in ASC 815-10-15-13. See DH 3 for information on ASC 815’s scope exceptions.
If a derivative is not designated as a hedge, changes in its fair value are recorded in current earnings. The accounting treatment of a derivative designated as a hedge depends on the type of hedging relationship. See DH 5 for information on hedge accounting. ASC 815 also specifies that synthetic asset accounting is prohibited, meaning that a freestanding derivative contract must be presented as its own unit of account on the balance sheet and cannot be combined with another freestanding financial instrument and accounted for together.
All derivatives should be initially recognized on trade date, regardless of whether payments are exchanged on trade date. For example, in a forward-starting interest rate swap contract, the parties may agree to begin exchanging cash flows at regular intervals beginning in a future period. Prior to that date, no cash flows may be exchanged (if the terms of the swap contract are “at the money”). However, the forward-starting swap contract should still be recorded on the date the contract was executed.
Subsequently, the derivative should be recorded at fair value through earnings each reporting period throughout the life of the swap, including in periods prior to any cash flows being exchanged (assuming the forward-starting swap is not designated into a hedging relationship). This is because the forward-starting swap will still be subject to changes in fair value due to changes in the interest rate underlying the contract among other factors even before cash flows are required to be exchanged.
Certain derivative contracts, such as options, may require an initial cash payment to enter into the contract. This day-one payment is often referred to as a “premium.” A premium payment is often required to purchase an option because the option provides the holder with potentially unlimited upside but no downside. If the option is in the money, the option holder will choose to exercise, but if the option is out of the money, the option holder can simply choose not to exercise the contract. The option writer is compensated for absorbing the risk of the contract through the premium charged to the option holder. For example, in an interest rate cap, one party to the contract agrees to compensate the other party if interest rates exceed a certain level, i.e., the cap rate. The party that would receive compensation if interest rates exceeded the contractual cap will typically pay an upfront premium payment to purchase the interest rate cap.
The premium amount paid for a freestanding option contract will generally be equal to the fair value of the contract upon initial recognition. The option purchaser recognizes a derivative asset equal to the premium amount paid, while the option writer recognizes a derivative liability equal to the premium amount received. These derivative assets and liabilities will continue to be remeasured to fair value through earnings in subsequent periods as the fair values change as a result of changes in the underlying and other factors.
Example DH 2-1 illustrates the accounting for an interest rate cap that is not designated in a hedging relationship.
EXAMPLE DH 2-1
Purchase of an interest rate cap
Purchase of an interest rate cap
DH Corp has issued a variable-rate term debt instrument that pays interest based on SOFR. DH Corp wishes to manage its exposure to potential increases in interest rates. On January 1, 20X1, DH Corp purchases an interest rate cap from Bank ABC.
- The underlying to the interest rate cap is SOFR.
- The terms of the contract stipulate that if the referenced SOFR rate exceeds 5% during the next five years, Bank ABC will compensate DH Corp for the amount SOFR exceeds the 5% cap multiplied by $1,000,000 (the notional amount of the contract).
- Bank ABC charges a premium payment of $10,000 to DH Corp to provide the interest rate cap. The $10,000 premium is assumed to be equal to the fair value of the interest rate cap on the date the contract was executed.
- The interest rate cap is not designated in a hedging relationship.
How should DH Corp initially record the interest rate cap on January 1, 20X1?
Analysis
On January 1, 20X1, DH Corp should initially record the interest rate cap on its balance sheet at fair value, which is equal to the premium amount paid.
Dr. Derivative asset
|
$10,000
|
|
Cr. Cash
|
10,000
|
Subsequently, the interest rate cap should be marked to fair value each reporting period with any change in fair value being recorded through earnings.
2.4.1 Derivative modifications
ASC 815 does not include guidance on how to account for derivative modifications. We believe that a modification to the terms of a derivative contract results in a termination of the original contract and creation of a new contract. This is consistent with the view expressed by the FASB in ASC 848, which offers practical expedients for contracts previously accounted for as derivatives that are modified as a result of reference rate reform. These practical expedients allow the contract to be accounted for in the same manner as prior to the modification. In contrast, modifications to derivative contracts that are outside of the scope of ASC 848 require a reassessment of whether the contract still meets the definition of a derivative. Often, this assessment may not be significantly different than the assessment performed for the original contract. For example, in a modification in which one underlying is replaced by a different underlying, the conclusion will generally not change since the new contract will still have an underlying (albeit a different one) and all other criteria for assessment of whether the contract meets the definition of a derivative will remain the same. Other times, the assessment may be relatively straightforward but result in a change in the conclusion reached; for example, when a net settlement provision in a contract is added or removed. In other circumstances, the assessment may be more complicated – for example, when evaluating the initial net investment test in a “blend and extend” transaction, described further in DH 2.4.1.1.
In accordance with ASC 815-10-25-3, if a contract previously accounted for as a derivative no longer meets the requirements to be accounted for under ASC 815, other applicable GAAP should be followed. Additionally, modifications to derivative contracts used as hedging instruments in hedging relationships will often cause the hedging relationship to be dedesginated. Refer to DH 10.2.2 for further discussion of accounting for changes to the critical terms of a hedging relationship.
2.4.1.1 Application of derivative modification analysis to a “blend and extend” transaction
A “blend and extend” transaction involves settling an existing interest rate swap contract by entering into a new interest rate swap with similar terms. The gain or loss on the initial swap is incorporated into the new swap contract by extending the maturity date past the maturity of the original swap and using off-market terms in the new swap. Often this will result in no initial economic change because the fair value of the new swap is the same as the fair value of the original swap due to the off-market terms at inception of the new swap. As described in DH 2.4.1, the new swap contract must be reassessed to determine if it still meets the definition of a derivative. In a blend and extend transaction, typically the new swap contract will continue to have an underlying (e.g., an interest rate) and notional amount, and the settlement provisions will not change from the original contract (net cash settled). However, assessing the new swap to determine if it meets the criteria in ASC 815-10-15-83(b) for having no initial net investment or an initial net investment that is smaller than would otherwise be required may be complicated because the terms of the derivative are off-market.
ASC 815-10-55-148 through 55-168 provide guidance on how to evaluate whether prepaid interest rate swaps meet the definition of a derivative under the initial net investment test. The same guidance would be used to evaluate a derivative resulting from a blend and extend transaction as the fair value of the original derivative serves as the initial net investment in the new off-market derivative.
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.
Link copied
