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 term “forecasted transaction” is not intended to include transactions that qualify as firm commitments even though the settlement of such transactions occurs in the future.
Hedges of forecasted transactions (which involve variability in cash flows) are considered cash flow hedges since the price is not fixed. Forecasted transactions may be designated as hedged transactions in cash flow hedges, provided the following additional criteria in the standard are met.
When identifying the hedged item in a cash flow hedge, it is necessary to provide sufficient specificity about the hedged item so that there is no doubt as to what is being hedged. For example, if a reporting entity is hedging a future interest payment, it must specify the exact time period—for instance, “the first $1 million in variable interest payments in the month of December 20XX,” or “the $1 million of interest payments to be paid on December 15, 20XX on Debt Instrument X.” It would be insufficient to identify the hedged item in this scenario as “interest payments to be paid in December 20XX,” or “the last interest payments to be made on Debt Instrument X in the fourth quarter of 20XX.”
By designating the “first x dollars” of interest payments during the period, the reporting entity will not be locked into a specific date, and if for some reason the interest payment does not occur on that date, it will have more flexibility in assessing whether the forecasted transaction occurred.
illustrates the requirement that the hedged transaction be specifically identified.
Excerpt from ASC 815-20-55-80
Entity A determines with a high degree of probability that it will issue $5,000,000 of fixed-rate bonds with a 5-year maturity sometime during the next 6 months, but it cannot predict exactly when the debt issuance will occur. That situation might occur, for example, if the funds from the debt issuance are needed to finance a major project to which Entity A is already committed but the precise timing of which has not yet been determined. To qualify for cash flow hedge accounting, Entity A might identify the hedged forecasted transaction as, for example, the first issuance of five-year, fixed-rate bonds that occurs during the next 6 months.
In this situation, the first issuance of the specified bonds may qualify as a hedged item even though the precise timing of issuance has not been determined. For further guidance regarding a forecasted transaction that is expected (probable) to occur on a specific date but whose timing involves some uncertainty within a range, see ASC 815-20-25-16
(c) and the illustrative example in ASC 815-20-55-100
through ASC 815-20-55-104
The occurrence of the forecasted transaction is probable
A transaction is “probable” when “the future event or events are likely to occur.” The term requires that the likelihood of occurrence be significantly greater than “more likely than not.”
Assessing the probability that a forecasted transaction will occur requires judgment. While ASC 815
and ASC 450
do not establish bright lines, we believe that a transaction may be considered probable of occurring when there is at least an 80% chance that it will occur on the specified date or within the specified time period. There should be compelling evidence to support management’s assertion that it is probable that a forecasted transaction will occur, and, in compiling that evidence, management should bear in mind that this assertion is more difficult to support than an assertion that it is more-likely-than-not that a transaction will occur.
provides the following additional guidance on determining the probability of a forecasted transaction.
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 all of 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).
Further, as discussed in ASC 815-20-55-25
, both (1) the length of time that is expected to pass before a forecasted transaction is projected to occur and (2) the quantity of products or services that are involved in the forecasted transaction are considerations in determining probability. The guidance indicates that 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 the assertion that it is probable.
In addition to the impact on qualifying for hedge accounting, the assessment of whether the forecasted transaction is probable of occurring also impacts potential discontinuance of the hedge and whether to reclassify amounts deferred in AOCI. See DH 10.4.8.1
for further information.
In its formal hedge documentation, management should specify the circumstances that were considered in concluding that a transaction is probable. If a reporting entity has a pattern of subsequently determining that forecasted transactions are no longer probable of occurring, the appropriateness of management’s previous assertions and its ability to make future assertions regarding forecasted transactions may be called into question. See DH 10.4
Reporting entities should also consider the guidance in ASC 815-20-25-16
(a). In addition to requiring entities to continually assess the likelihood of the counterparty’s compliance with the terms of the hedging derivative, they are required to perform an assessment of their own creditworthiness and that of the counterparty (if any) to the hedged forecasted transaction to determine whether the forecasted transaction is probable.
This assessment should be performed at least quarterly at the time of hedge effectiveness testing. If the probability of the forecasted transaction changes as a result of a change in counterparty creditworthiness, the reporting entity would need to evaluate whether it continues to qualify for hedge accounting.
Timing of the forecasted transaction
When designating a forecasted transaction in a cash flow hedge, there may be a specific date on which the transaction is expected to occur (e.g., a forecasted interest payment will be made on December 15, 20X2). However, in many cases, a transaction may be expected to occur in a defined period rather than on a specific date. ASC 815-20-25-16
provides guidance on uncertainty of timing within a range.
Excerpt from ASC 815-20-25-16(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.
Uncertainty within a time period does not preclude hedge accounting as long as the forecasted transaction is identified with sufficient specificity. The reporting entity should continue to monitor the expected timing of the forecasted transaction. If there is a change in the timing of the forecasted transaction such that it is no longer probable of occurring as originally documented, in general, the hedge should be discontinued. ASC 815-30-40-4
provides guidance on the treatment of derivative gains/losses deferred in AOCI when it is still probable or reasonably possible that the transaction will occur within two months of the originally specified time period.
Excerpt from ASC 815-30-40-4
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.
If it is determined that the forecasted transaction has become probable of not occurring within the documented time period plus a subsequent two-month period, then the hedging relationship should be discontinued and amounts previously deferred in AOCI should be immediately reclassified to earnings. See DH 10.4
for further information on discontinuance of cash flow hedges.
Question DH 6-5 discusses whether the designation of a five-year interest rate swap as a hedge of the variable-rate interest payments for the first five years of a fifteen-year debt instrument qualifies for cash flow hedge accounting.
Question DH 6-5
Would the designation of a five-year interest rate swap as a hedge of the variable-rate interest payments for the first five years of a fifteen-year debt instrument qualify for cash flow hedge accounting?
Yes. Each of the designated variable cash flows from the financial instrument would be considered a separate hedged forecasted transaction. The swap eliminates the variability in cash flows for each individual forecasted transaction.
This view would be used for both the assessment of effectiveness and the accounting for the cash flow hedge.
Question DH 6-6 discusses whether an entity can designate a forward starting swap as a cash flow hedge of the variability of interest cash flows with variable-rate debt expected to be issued in conjunction with an acquisition.
Question DH 6-6
DH Corp is contemplating the acquisition of 100% of Company X. In conjunction with the anticipated acquisition, DH Corp is planning to issue variable-rate debt to fund the acquisition. To mitigate its future exposure of its forecasted debt issuance to changes in interest rates, DH Corp enters into a forward starting interest rate swap through which DH Corp receives a variable rate (six-month LIBOR) and pays a fixed rate starting at the time the debt is expected to be issued and continuing over the expected term of the debt. At inception, the critical terms of the interest rate swap are expected to match all of the critical terms of the variable rate debt expected to be issued.
May DH Corp designate the forward starting swap as a cash flow hedge of the variability of interest cash flows associated with its variable-rate debt, which is expected to be issued in conjunction with the acquisition of Company X?
Generally, no. In this case, the forecasted transactions (the future interest payments associated with DH Corp’s expected issuance of variable-rate debt) are contingent on the consummation of a business combination; that is, DH Corp will not incur the debt if the business combination is not consummated. Although the forecasted transactions do not directly impact the purchase accounting associated with the acquisition and there should be no significant difficulty in determining when to reclassify the gain/ loss on the derivative, the forecasted transactions must also be considered probable of occurring.
In assessing the probability of the interest costs associated with the financing of a proposed acquisition, an assessment of the likelihood that the business combination will be completed within the prescribed timeframe is necessary. In almost all cases, business combinations will have too many contingencies to assert that the forecasted transactions are probable at the date of announcement. These contingencies may include regulatory approval, shareholder approval, completion of due diligence, availability of financing, likelihood of competing offers, and the nature of contractual provisions that enable one of the parties to back out.
Additionally, the length of time until consummation of the transaction would need to be considered. Even when contingencies do not exist, if there is more than a very short time period (e.g., more than a week) between hedge execution and the expected closing date of the transaction, it may not be possible to assert that the business combination is probable due to potential changes in market conditions or other factors.
Many times, a reporting entity may enter into the derivative before being able to demonstrate that the forecasted interest payments are probable of occurring. As a result, if they are later able to demonstrate that the forecasted transaction is probable, the hedging relationship may not be perfectly effective because the derivative is off-market at the hedge designation date.
Question DH 6-7 asks if a forecasted purchase of a marketable debt security can be a hedged transaction.
Question DH 6-7
Can the forecasted purchase of a marketable debt security be a hedged transaction?
Yes, if it is probable. ASC 815-20-25-16
(b) requires the forecasted acquisition of a marketable debt security to be probable for it to be a hedged item in a cash flow hedge. ASC 815-20-25-16
(b) specifically addresses how to evaluate probability when an option is the hedging instrument. That guidance indicates that the evaluation of whether the forecasted transaction is probable of occurring should be independent of the terms and nature of the derivative designated as the hedging instrument. That is, the probability of the marketable debt security being acquired should be evaluated without consideration of whether the option has an intrinsic value other than zero.
Hedging a group of forecasted transactions—updated September 2021
indicates that a group of transactions, such as forecasted variable-rate debt interest payments, may be designated as the hedged item in a cash flow hedge.
If the hedged transaction is a group of individual transactions, as contemplated in ASC 815-20-55-22
, ASC 815-20-25-15
(a)(2) requires that those individual hedged items or transactions share the “same risk exposure” for which they are designated as being hedged (e.g., risk of changes in cash flows due to changes in the contractually specified interest rate). Thus, if a particular forecasted transaction does not share the risk exposure that is germane to the transactions being hedged, that transaction cannot be part of the group that is being hedged. As a result, the guidance precludes forecasted interest payments and forecasted interest receipts from being grouped together since the risk exposures are different. ASC 815-20-55-23
further specifies that when hedging the forecasted interest payments on several variable-rate debt instruments, the interest payments (or interest receipts) must vary with the same index to qualify for hedging with a single derivative. Therefore, a group of LIBOR-based interest payments (or receipts) could not be combined with US prime-based interest payments or receipts within the same hedging relationship.
For fair value hedges, ASC 815-20-25-12
(b)(1) also requires that the individual hedged items in a hedged group share the same risk exposure for which they are as being hedged. In addition, ASC 815-20-55-14
provides guidance for the quantitative evaluation of whether a portfolio of assets or liabilities share the same risk exposure in a fair value hedge. This quantitative test, known as the “similar assets/liabilities test,” is specific to fair value hedges. ASC 815-20-25-15
does not specifically require reporting entities to perform this test for cash flow hedges of groups of individual transactions. However, we believe that in most circumstances a quantitative test is needed for cash flow hedges when the hedged item is a portfolio of forecasted transactions that are similar but not identical.
In certain limited circumstances when the terms of the individual hedged items in the portfolio are aligned, a qualitative similar assets/liabilities test may be appropriate. For example, if a reporting entity intends to hedge a group of variable-rate nonprepayable financial assets together in a single hedging relationship when those financial assets all have the same contractually specified interest rate index and all reset and pay on the same dates, it may be able to qualitatively support that the individual items in the portfolio share the same risk exposure for which they are designated as being hedged. The determination of whether a quantitative or qualitative analysis is sufficient is judgmental and will depend on the nature of the items being hedged.
When facts and circumstances regarding the portfolio change, we expect a reporting entity to reconsider its similar assets/liabilities test. When changes are significant such that the original conclusion is no longer valid without additional support, we would expect a new comprehensive analysis to be performed at that time.
Consistent with the requirement for hedges of individual forecasted transactions, when hedging a group of forecasted transactions, the forecasted transactions need to be identified with sufficient specificity to make it clear whether a particular transaction is a hedged transaction when it occurs. For example, a reporting entity that expects to receive variable interest may identify the hedged forecasted transaction as the first LIBOR-based interest payments received during a four-week period that begins one week before each quarterly due date for the next five years on its $100 million LIBOR-based loan.