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6.3 Hedging variable-rate financial instruments
Publication date: 31 Jul 2022
us Derivatives & hedging guide
Cash flow hedges of variable-rate debt continue to be one of the most common hedging strategies. One reason is that they give a reporting entity the ability to separate its funding and liquidity management from its interest rate risk management, which helps it optimize the capital funding process. Second, the overall cost of funding can be reduced because derivatives help better match investors’ demand for investment types with the funding needs of issuing entities.
6.3.1 Accounting for cash flow hedges
In a qualifying cash flow hedge, a derivative’s entire gain or loss included in the assessment of effectiveness is recorded through OCI. ASC 815-30-35-3(b) indicates that the amounts in AOCI related to the fair value changes in the hedging instrument are released into earnings when the hedged item affects earnings. This is to align the earnings impact of the hedged item and the hedging instrument.
Excerpt from ASC 815-30-35-3(b)
b. Amounts in accumulated other comprehensive income related to the derivative designated as a hedging instrument included in the assessment of hedge effectiveness are reclassified to earnings in the same period or periods during which the hedged forecasted transaction affects earnings in accordance with paragraphs 815-30-35-38 through 35-41 and presented in the same income statement line item as the earnings effect of the hedged item in accordance with paragraph 815-20-45-1A. The balance in accumulated other comprehensive income associated with the hedged transaction shall be the cumulative gain or loss on the derivative instrument from inception of the hedge less all of the following:
1. [Subparagraph superseded by Accounting Standards Update No. 2017-12].
1a. The derivative instrument's gains or losses previously reclassified from accumulated other comprehensive income into earnings pursuant to paragraphs 815-30-35-38 through 35-41.
1b. The cumulative amount amortized to earnings related to excluded components accounted for through an amortization approach in accordance with paragraph 815-20-25-83A.
1c. The cumulative change in fair value of an excluded component for which changes in fair value are recorded currently in earnings in accordance with paragraph 815-20-25-83B.
2. [Subparagraph superseded by Accounting Standards Update No. 2017-12].
In determining how to reclassify amounts in AOCI into earnings, reporting entities should consider both the amount and timing of reclassification. ASC 815-30-35-3(b) notes that the amount of AOCI should equal the cumulative gain or loss on the hedging instrument since hedge inception, less (1) previously reclassified gains and losses, and (2) amounts related to excluded components already recognized in earnings.
Figure DH 6-3 illustrates what the balance in AOCI represents.
Figure DH 6-3
Components related to hedging in AOCI
Components related to hedging in AOCI
When an economic hedging relationship continues even though hedge accounting was not permitted in a specific period (e.g., because the retrospective effectiveness assessment for that period indicated that the relationship had not been highly effective), the cumulative gains or losses under ASC 815-30-35-3(b) excludes the gains or losses occurring during that period. That situation may arise if the reporting entity had previously determined that the hedging relationship would be highly effective on a prospective basis.
The amounts deferred in AOCI related to the fair value changes in the hedging instrument are generally released into the reporting entity’s earnings when the hedged item affects earnings.
Excerpt from ASC 815-30-35-38
Amounts in accumulated other comprehensive income that are included in the assessment of effectiveness shall be reclassified into earnings in the same period or periods during which the hedged forecasted transaction affects earnings (for example, when a forecasted sale actually occurs) and shall be presented in the same income statement line item as the earnings effect of the hedged item in accordance with paragraph 815-20-45-1A.
The timing of reclassification may also vary depending on the nature of the hedged item. Reporting entities need to consider when the hedged item will affect earnings when determining the appropriate timing to release the amounts in AOCI.
6.3.1.1 Reclassifying AOCI to earnings for hedges involving options
When a purchased option (including a combination of options that comprise either a net purchased option or a zero-cost collar) is used as a hedging instrument and a reporting entity assesses effectiveness using the total change in the option’s cash flows, a question arises as to how to reclassify amounts in AOCI to earnings.
ASC 815-30-35-41B explains that the fair value of a cap at inception of a hedge relationship that is hedging multiple payments should be allocated to the respective caplets at inception of the hedging relationship. Further, each respective allocated fair value amount should be reclassified to earnings from AOCI when each of the hedge transactions impacts earnings. This is referred to as the “caplet” method. It applies to a purchased option regardless of whether it is at the money, in the money, or out of the money at hedge inception.
Excerpt from 815-30-35-41B
For example, the fair value of a single cap at the inception of a hedging relationship of interest rate risk on variable-rate debt with quarterly interest payments over the next two years should be allocated to the respective caplets within the single cap on a fair value basis at the inception of the hedging relationship. The change in each respective allocated fair value amount should be reclassified out of accumulated other comprehensive income into earnings when each of the hedged forecasted transactions (the eight interest payments) affects earnings. Because the amount in accumulated other comprehensive income is a net amount composed of both derivative instrument gains and derivative instrument losses, the change in the respective allocated fair value amount for an individual caplet that is reclassified out of accumulated other comprehensive income into earnings may possibly be greater than the net amount in accumulated other comprehensive income.
The caplet method is an appropriate way to reclassify the amounts out of AOCI when the entire change in cash flows of an option is used to assess effectiveness, but not when time value is excluded, as discussed in Amortizing time value in hedges of interest rate risk in DH 6.3.1.2.
Assessing effectiveness of a hedging relationship based on the entire change in the option’s cash flows (i.e., focusing on the terminal value, the expected future pay-off amount at maturity) is discussed in DH 9.6.
6.3.1.2 Excluded components
As part of its risk management strategy, a reporting entity may exclude certain components of a hedging instrument’s change in fair value from the assessment of hedge effectiveness. ASC 815-20-25-82 indicates that these include:
- For forwards and futures contracts (and swaps) when the spot method is used:
- The change in the fair value of the contract related to the changes in the difference between the spot price and the forward or futures price (sometimes referred to as forward points)
- For currency swaps (designated in fair value and cash flow hedges):
- The portion of the change in fair value of a currency swap attributable to a cross-currency basis spread
- For options (including eligible collars):
- Time value (the difference between the change in fair value and the change in undiscounted intrinsic value)
- Volatility value (the difference between the change in fair value and the change in discounted intrinsic or minimum value)
- The following components of time value:
- Passage of time (theta)
- Volatility (vega)
- Interest rates (rho)
A reporting entity must elect a policy for recognizing excluded components that is consistently applied for similar hedges. There are two choices for recognition: an amortization approach (ASC 815-20-25-83A) or a mark-to-market approach (ASC 815-20-25-83B). The amortization approach is the default method, and the mark-to-market approach is the alternative.
Excerpt from ASC 815-20-25-83A
For fair value and cash flow hedges, the initial value of the component excluded from the assessment of effectiveness shall be recognized in earnings using a systematic and rational method over the life of the hedging instrument. Any difference between the change in fair value of the excluded component and amounts recognized in earnings under that systematic and rational method shall be recognized in other comprehensive income. [Emphasis added.]
Excerpt from ASC 815-20-25-83B
For fair value and cash flow hedges, an entity alternatively may elect to record changes in the fair value of the excluded component currently in earnings.
The initial value attributable to an excluded component depends on the type of derivative. When the time value of an option contract is the excluded component, the time value generally is the option premium paid (provided the option is at or out of the money at inception). The value attributable to forward points in a forward contract is the undiscounted difference between the market forward rate and the spot rate. The fair values of the excluded components change over time as markets change but must converge to zero by the maturity of the hedging instrument. Because of that, the FASB permits a systematic and rational amortization method.
ASU 2019-04 clarified that entities that do not separately report earnings (e.g., certain not-for-profit entities) cannot make the election to record changes in the fair value of the excluded component in AOCI and amortize amounts into earnings.
Amortizing time value in hedges of interest rate risk
When a reporting entity excludes all or a portion of the time value in an option-based derivative, such as a cap or floor, from the assessment of effectiveness, and elects to recognize it using an amortization approach, it must determine a systematic and rational method for recognizing the time value in earnings. We believe that the caplet method, which is used when the total changes in fair value of a cap/floor is used to assess hedge effectiveness (i.e., time value is not an excluded component), is not an appropriate method.
The caplet method allows the time value associated with each caplet to be deferred through OCI until each caplet’s respective hedged item occurs. The guidance that describes the caplet method links to the general guidance on reclassifying gains or losses on derivatives in cash flow hedges to income when the forecasted transactions impact earnings. In contrast, when the time value is excluded, the guidance on reclassifying the amounts deferred in AOCI to income is in ASC 815-20-25-83A. In other words, the reporting entity needs to use a systematic and rational approach for recognizing the excluded amounts in earnings. Further, the reporting entity needs to recognize the excluded components over the life of the hedging relationship. Thus, waiting until the forecasted transaction impacts earnings to begin amortization, as is done under the caplet method when the time value is not excluded, is not appropriate.
We believe a systematic and rational method for recognizing time value must result in a portion of the excluded component being recognized in earnings during each reporting period between the hedge designation date and the occurrence of the hedged transaction. Because the caplet method allows for the time value of each caplet to be reclassified from AOCI only during the period in which the hedged transaction occurs, we do not believe it to be a systematic and rational method to recognize time value when it is excluded from the assessment of hedge effectiveness.
We believe that, in certain circumstances, recognizing the total premium paid for a cap/floor on a straight-line basis may be a systematic and rational method to recognize time value when it is excluded from the assessment of hedge effectiveness.
Example DH 6-1 illustrates the accounting for an excluded component recognized using an amortization approach.
EXAMPLE DH 6-1
Excluded component recognized through an amortization approach
Excluded component recognized through an amortization approach
On June 1, 20X1, DH Corp, a USD-functional currency entity, designated a three-year euro/US dollar forward contract with a fair value of zero to sell 100 million euro on June 30, 20X4 as a cash flow hedge of the first 100 million of 1 billion in forecasted euro revenues to be received on June 30, 20X4. The current spot rate for 1 euro is $1.3597 and the forward rate to June, 30 20X4 for 1 euro is $1.3892. The spot rate at June 30, 20X4 is $1.1427.
DH Corp demonstrated that the sales were probable based on historical experience, detailed sales forecasts for each quarter for the next three years, and long-range plans that support the probability of ongoing activities in Europe. The counterparty to the forward contract is of high credit quality.
DH Corp elects to exclude the forward points from the assessment of effectiveness and recognize them through an amortization approach. At June 1, 20X1, the undiscounted forward points have an initial value of $2,950,000. That is, the contracted forward rate of $1.3892 minus the trade-date spot rate of $1.3597 times 100 million euro notional equals $2,950,000 of initial value for the forward points.
Date |
Change in fair value of forward contract Gain/(loss) |
Amount recorded through OCI (A) |
Amortization reclassified from AOCI to earnings (B) |
AOCI balance (Prior period balance + A + B) |
Dr./(Cr.) |
Dr./(Cr.) |
Dr./(Cr.) |
Dr./(Cr.) |
|
6/1/20X1 |
||||
6/30/20X1 |
(1,321,751) |
1,321,751 |
79,730 |
1,401,481 |
9/30/20X1 |
9,314,204 |
(9,314,204) |
239,189 |
(7,673,534) |
12/31/20X1 |
5,886,096 |
(5,886,096) |
239,189 |
(13,320,441) |
3/31/20X2 |
14,201,846 |
(14,201,846) |
239,189 |
(27,283,098) |
6/30/20X2 |
(3,670,887) |
3,670,887 |
239,189 |
(23,373,022) |
9/30/20X2 |
351,075 |
(351,075) |
239,189 |
(23,484,907) |
12/31/20X2 |
2,753,320 |
(2,753,320) |
239,189 |
(25,999,038) |
3/31/20X3 |
(4,574,448) |
4,574,448 |
239,189 |
(21,185,401) |
6/30/20X3 |
3,173,130 |
(3,173,130) |
239,189 |
(24,119,342) |
9/30/20X3 |
(1,124,767) |
1,124,767 |
239,189 |
(22,755,386) |
12/31/20X3 |
7,629,698 |
(7,629,698) |
239,189 |
(30,145,894) |
3/31/20X4 |
(750,206) |
750,206 |
239,189 |
(29,156,499) |
6/30/20X4 |
(7,217,310) |
7,217,310 |
239,189 |
(21,700,000) |
Total |
24,650,000 |
(24,650,000) |
2,950,000 |
How should DH Corp recognize the forward points under an amortization approach?
Analysis
DH Corp chose to use a straight-line approach as its systematic and rational amortization method for the initial value of the forward points. DH Corp would record the following journal entries in 20X1 and June 20X4. Entries for 20X2, 20X3, and March 20X4 would follow the same approach and use the amounts in the above table.
June 30, 20X1
Dr. Other comprehensive income |
$1,321,751 |
|
Cr. Forward contract |
$1,321,751 |
|
To record the change in fair value of the forward contract |
||
Dr. Other comprehensive income |
$79,730 |
|
Cr. Revenue |
$79,730 |
|
To record amortization of the initial value of the forward points ($2,950,000 x 1/37 months) in the same line as the euro revenue |
||
September 30, 20X1
Dr. Forward contract |
$9,314,204 |
|
Cr. Other comprehensive income |
$9,314,204 |
|
To record the change in fair value of the forward contract |
||
Dr. Other comprehensive income |
$239,189 |
|
Cr. Revenue |
$239,189 |
|
To record amortization of the initial value of the forward points ($2,950,000 x 3/37 months) in the same line as the euro revenue |
||
December 31, 20X1
Dr. Forward contract |
$5,886,096 |
|
Cr. Other comprehensive income |
$5,886,096 |
|
To record the change in fair value of the forward contract |
||
Dr. Other comprehensive income |
$239,189 |
|
Cr. Revenue |
$239,189 |
|
To record amortization of the initial value of the forward points ($2,950,000 x 3/37 months) in the same line as the euro revenue |
||
June 30, 20X4
Dr. Other comprehensive income |
$7,217,310 |
|
Cr. Forward contract |
$7,217,310 |
|
To record the change in fair value of the forward contract |
||
Dr. Other comprehensive income |
$239,189 |
|
Cr. Revenue |
$239,189 |
|
To record amortization of the initial value of the forward points ($2,950,000 x 3/37 months) in the same line as the euro revenue |
||
Dr. Cash |
$24,650,000 |
|
Cr. Forward contract |
$24,650,000 |
|
To settle the forward contract at its then fair value |
||
Dr. Accounts receivable |
$114,270,000 |
|
Cr. Revenue |
$114,270,000 |
|
To recognize euro sales on account of 100 million based upon the spot rate at the date of the sales transaction (100 million x spot rate of 1.1427) |
||
Dr. Other comprehensive income |
$21,700,000 |
|
Cr. Revenue |
$21,700,000 |
|
To release amounts deferred in AOCI to the income statement line item where the hedged item is recognized when the hedged item affects earnings |
||
At the conclusion of the hedging relationship, prior to the reclassification of the derivative gain from AOCI to earnings, the balance in AOCI is the spot-to-spot change on the hedging instrument, $21,700,000. When combined, the $114,270,000 of sales and $21,700,000 reclassification from AOCI to earnings results in a total revenue amount of $135,970,000, which is equal to 100 million euro remeasured at the spot rate on June 1, 20X1, the inception date of the hedging relationship. The initial value of the forward points of $2,950,000 was amortized to revenue over the life of the hedging instrument.
6.3.2 Types of risks eligible for cash flow hedge accounting
ASC 815-20-25-15(j) permits a reporting entity to hedge any of the following risks in a cash flow hedge.
Excerpt from ASC 815-20-25-15(j)
- The risk of overall changes in the hedged cash flows related to the asset or liability, such as those relating to all changes in the purchase price or sales price (regardless of whether that price and the related cash flows are stated in the entity’s functional currency or a foreign currency) [DH 6.3.4]
- For forecasted interest receipts or payments on an existing variable-rate financial instrument, the risk of changes in its cash flows attributable to changes in the contractually specified interest rate (referred to as interest rate risk). For a forecasted issuance or purchase of a debt instrument (or the forecasted interest payments on a debt instrument), the risk of changes in cash flows attributable to changes in the benchmark interest rate or the expected contractually specified interest rate. … [DH 6.3.5]
- The risk of changes in the functional-currency-equivalent cash flows attributable to changes in the related foreign currency exchange rates (referred to as foreign exchange risk) [DH 8]
- The risk of changes in its cash flows attributable to all of the following (referred to as credit risk):
- Default
- Changes in the obligor’s creditworthiness
- Changes in the spread over the contractually specified interest rate or benchmark interest rate with respect to the related financial asset’s or liability’s credit sector at inception of the hedge.
If the risk is not the change in total cash flows as listed in ASC 815-20-25-15(j)(1), a reporting entity can jointly designate two or more of the other risks in ASC 815-20-25-15(j).
ASC 815-20-25-15(f) and ASC 815-20-25-43(d) provide guidance on eligible hedged risks for held-to-maturity debt securities.
If the variable cash flows of the forecasted transaction relate to a debt security that is classified as held to maturity under Topic 320, the risk being hedged is the risk of changes in its cash flows attributable to any of the following risks:
- Credit risk
- Foreign exchange risk.
Excerpt from ASC 815-20-25-43(d)
…none of the following shall be designated as a hedged item or transaction in the respective hedges:
2. If variable cash flows of the forecasted transaction relate to a debt security that is classified as held-to-maturity under Topic 320, the risk of changes in its cash flows attributable to interest rate risk
The notion of hedging the interest rate risk in a security classified as held-to-maturity is inconsistent with the held-to-maturity classification under ASC 320, which requires the reporting entity to hold the security until maturity regardless of changes in market interest rates.
However, hedging credit risk is permitted. It is not viewed as inconsistent with the held-to-maturity assertion since ASC 320 permits sales or transfers of a held-to-maturity security in response to significant deterioration in credit quality of the security.
6.3.3 Eligible hedged items in a cash flow hedge
Hedge accounting may be applied to cash flow hedging relationships when they fulfill the relevant general qualifying criteria discussed in DH 6.2 and the criteria specific to cash flow hedges in ASC 815-20-25-13 through ASC 815-20-25-15.
6.3.3.1 Earnings exposure
One of the criteria specific to cash flow hedges is that the forecasted transaction presents an earnings exposure. Without an “earnings exposure” criterion, there would be no way to determine the period in which the derivative gain or loss should be included in earnings. The earnings exposure criterion specifically precludes hedge accounting for derivatives that are used to hedge:
- Transactions with shareholders, such as dividend payments or projected purchases of Treasury stock
- Intercompany transactions (except for foreign-currency-denominated forecasted intercompany transactions) in consolidated financial statements
- Forecasted stock issuances that are related to a stock option plan for which no compensation expense (based on changes in stock prices) is recognized
6.3.3.2 No remeasurement for changes in fair value
ASC 815-20-25-15(d) and ASC 815-20-25-15(e) state that the hedged item/transaction cannot be a forecasted acquisition of an asset or incurrence of a liability that subsequently will be remeasured at fair value or a forecasted transaction that relates to an asset or liability that is remeasured with changes in fair value reported currently in earnings. ASC 815 does not permit hedge accounting for these items because the gains or losses on the hedging instrument and the offsetting losses or gains on the hedged item both would be recorded in the income statement under other GAAP and would tend to naturally offset each other.
6.3.3.3 External party
Cash flow hedge accounting is appropriate only when there is a hedgeable risk arising from a transaction with an external party (although certain intercompany hedges for foreign currency exposures are permitted). Accounting allocations or intercompany transactions, in and of themselves, do not give rise to economic exposure, and therefore, do not qualify as hedgeable forecasted transactions.
Question DH 6-3
A subsidiary entered into an interest rate swap that was designated in the consolidated financial statements as a cash flow hedge of forecasted LIBOR-based interest payments on variable-rate debt issued by the parent company. If the hedging relationship is designated and qualifies under ASC 815, how should the parent and the subsidiary account for the interest rate swap on a consolidated and standalone basis, respectively?
A subsidiary entered into an interest rate swap that was designated in the consolidated financial statements as a cash flow hedge of forecasted LIBOR-based interest payments on variable-rate debt issued by the parent company. If the hedging relationship is designated and qualifies under ASC 815, how should the parent and the subsidiary account for the interest rate swap on a consolidated and standalone basis, respectively?
PwC response
Because the interest rate swap was designated to hedge a risk exposure (variable-rate interest rate payments) at the consolidated reporting level, hedge accounting may be applied on a consolidated basis and the interest rate swap would be measured at fair value with changes recorded through OCI.
The subsidiary does not have the risk exposure at its reporting level; therefore, the swap would not qualify for hedge accounting and should be reported in the subsidiary’s standalone financial statements at fair value with changes in fair value recorded in earnings. If the subsidiary had an exposure to interest rate risk at its reporting level, the subsidiary could designate this interest rate swap as a hedge of that exposure if it met the ASC 815 hedge accounting criteria. It is possible to have one derivative hedge two different exposures at different reporting levels.
This conclusion would not necessarily extend to a foreign currency hedge because special rules apply to them. See DH 8.7 for information on hedging the foreign currency risk in intercompany transactions.
Question DH 6-4
Does ASC 815 permit an item to be initially designated as a hedged item in a cash flow hedge and later designated as a hedged item in a fair value hedge?
Does ASC 815 permit an item to be initially designated as a hedged item in a cash flow hedge and later designated as a hedged item in a fair value hedge?
PwC response
Yes, ASC 815 permits an item to be initially designated as a hedged item in a cash flow hedge and later designated as a hedged item in a fair value hedge as long as the transaction or item that is being hedged meets the respective criteria for either type of hedge. For example, a reporting entity could (1) designate a derivative as a hedge of interest payments related to an issuance of fixed-rate debt that is forecasted to take place within six months, (2) terminate the hedge when the debt is issued six months later, and (3) designate another derivative as a hedge of the fair value exposure of the fixed-rate debt.
Under these circumstances, the deferred gains or losses on the cash flow hedge would remain in AOCI until earnings are impacted by the originally forecasted interest payments each period, even though the related debt will have subsequently been designated as a hedged item in a fair value hedge. See DH 6.6.1 for discussion of a hedge of the forecasted issuance of fixed-rate debt.
6.3.3.4 Forecasted transactions
ASC 815-20-25-15 defines a forecasted transaction.
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.
Specific identification
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.
ASC 815-20-55-80 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
Assessing the probability that a forecasted transaction will occur requires judgment. A transaction is “probable” in the context of hedge accounting when “the future event or events are likely to occur.” Thus, although ASC 815 and ASC 450 do not establish bright lines, a probable likelihood of occurrence should be a significantly greater threshold than the 50% threshold associated with “more likely than not.”
In addition, there should be compelling evidence to support management’s assertion that it is probable that a forecasted transaction will occur.
ASC 815-20-55-24 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.
Documentation
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.
Counterparty creditworthiness
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
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?
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?
PwC response
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
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?
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?
PwC response
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
Can the forecasted purchase of a marketable debt security be a hedged transaction?
Can the forecasted purchase of a marketable debt security be a hedged transaction?
PwC response
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
ASC 815-20-55-22 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.
Question DH 6-8
Can a cash flow hedge of a group of forecasted interest receipts include as the hedged item different iterations of SOFR, such as overnight SOFR in arrears, overnight SOFR in advance, and one-month term SOFR as the hedged item?
Can a cash flow hedge of a group of forecasted interest receipts include as the hedged item different iterations of SOFR, such as overnight SOFR in arrears, overnight SOFR in advance, and one-month term SOFR as the hedged item?
PwC response
It depends. When hedging groups of forecasted transactions in a cash flow hedge, 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 and ASC 815-20-55-23 requires the interest payments (or interest receipts) to vary with the same index to qualify for hedging with a single derivative.
There is no definition of same index included within ASC 815 in the context of the similar asset test. However, in the context of the similar asset test we believe that same index can be interpreted to be the interest rate curve that the interest receipt is based on. Therefore, any interest receipt based on SOFR would qualify as varying with the same index for the purposes of the similar asset test.
However, to qualify as a cash flow hedge of a group of forecasted transactions, the interest receipts must share the same risk exposure. Since the different iterations of SOFR will not be identical in terms of interest reset dates, settlement dates, and calculation methodologies, among other items, we believe that a quantitative test will most likely be necessary in order to prove that the interest receipts share the same risk exposure. The results of this quantitative test will determine if overnight SOFR in arrears, overnight SOFR in advance, and one-month term SOFR can be included in the same hedging relationship.
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.
6.3.4 Hedging total change in cash flows
When the hedged risk is the total variability in cash flows, as permitted by ASC 815-20-25-15(j)(1), the reporting entity needs to compare the total change in cash flows on the hedged item/transaction to the change in fair value of the hedging instrument. This may result in less effective hedges than those hedged for just interest rate risk, as discussed in DH 6.3.5, although the entire gain/loss on the derivative may be deferred through OCI if the hedge is highly effective.
6.3.5 Hedging the contractually specified interest rate
The Master Glossary defines interest rate risk differently for variable-rate and fixed-rate instruments. For variable-rate instruments, interest rate risk is defined as the change in cash flows due to the change in the contractually specified interest rate.
Partial definition from the ASC Master Glossary
Interest Rate Risk: For recognized variable-rate financial instruments and forecasted issuances or purchases of variable-rate financial instruments, interest rate risk is the risk of changes in the hedged item’s cash flows attributable to changes in the contractually specified interest rate in the agreement.
When designating the risk of changes in a hedged item’s cash flows attributable to changes in the contractually specified interest rate, any cash flows related to the credit spread or changes in the spread over the contractually specified interest rate are excluded from the hedging relationship.
For example, in a cash flow hedge of a pool of prime-rate loans, differences between the spreads above the prime rate for the loans that are being hedged would not impact the eligibility of the hedging relationship.
See example 6: Cash Flow Hedge of Variable-Rate Interest-Bearing Asset, in ASC 815-30-55-24 for an illustration of the accounting for a cash flow hedge.
6.3.5.1 Changes in the hedged risk
There is a general principle in hedge accounting that a hedge needs to be dedesignated when any of the critical terms of the hedging relationship change. The guidance provides an exception if the change relates solely to the hedged risk in a cash flow hedge of a forecasted transaction and the revised hedging relationship remains highly effective.
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.
Reporting entities would have to assess effectiveness of the revised hedging relationship before continuing to apply hedge accounting.
6.3.5.2 Auction rate securities
Auction rate securities have their coupons determined by means of a Dutch auction, typically every 35 days or less. An issuer may structure a cash flow hedge of forecasted interest payments. The Basis for Conclusions in ASU 2017-12, Targeted Improvements to Accounting for Hedging Activities, specifies that a variable rate set via an auction process can be considered a contractually specified interest rate when it is the rate that is explicitly referenced in the variable-rate financial instrument being hedged.
If the Dutch auction fails, the reporting entity must ensure that the hedging strategy documented at inception of the hedging relationship is still valid. If the effect of the failed Dutch auction is that the hedged risk no longer exists (e.g., the interest rate on the auction rate security is now fixed) or that the hedging relationship is no longer highly effective, hedge accounting should be discontinued. See DH 10 for guidance on accounting for discontinued hedges.
6.3.6 Swapping one variable rate for another variable rate
ASC 815-20-25-50 and ASC 815-20-25-51 provide guidance on modifying interest receipts/payments from one variable rate to another variable rate. Often, this is achieved through a basis swap.
If a hedging instrument is used to modify the contractually specified interest receipts or payments associated with a recognized financial asset or liability from one variable rate to another variable rate, the hedging instrument shall meet both of the following criteria:
- It is a link between both of the following:
- An existing designated asset (or group of similar assets) with variable cash flows
- An existing designated liability (or group of similar liabilities) with variable cash flows
- It is highly effective at achieving offsetting cash flows.
For purposes of paragraph 815-20-25-50, a link exists if both of the following criteria are met:
- The basis (that is, the rate index on which the interest rate is based) of one leg of an interest rate swap is the same as the basis of the contractually specified interest receipts for the designated asset.
- The basis of the other leg of the swap is the same as the basis of the contractually specified interest payments for the designated liability.
In this situation, the criterion in paragraph 815-20-25-15(a) is applied separately to the designated asset and the designated liability.
The guidance in ASC 815-20-25-51 does not mean that receive or pay amounts have to be identical. For example, the criterion would be met if the pay leg of a swap was indexed to three-month LIBOR and the variable rate on the interest receipts was indexed to three-month LIBOR plus 100 basis points. However, the criterion would not be met if the interest receipts were based on a different rate, such as a different tenor of LIBOR (e.g., one-month LIBOR). ASC 815 does not permit a reporting entity to apply hedge accounting to this type of instrument since the variability in the net cash flows of the interest rate basis swap would not offset the variability in the cash flows associated with the financial instrument.
A basis swap can be an effective mechanism for locking in a spread or margin between variable interest-bearing assets and liabilities. If it is highly effective and meets the other cash flow hedge criteria, it will generally qualify for hedge accounting treatment.
The reporting entity should treat each leg of the basis swap, along with the respective designated asset and liability, as a separate hedging relationship and assess effectiveness separately for each relationship.
Basis swaps do not qualify as hedges of non-interest-bearing assets and liabilities because the guidance specifically refers to “a financial asset or liability” and states that the hedge must be used “to modify the interest receipts or payments associated with a “recognized” financial asset or liability from one variable rate to another variable rate.” Therefore, a forecasted transaction (e.g., the repricing or anticipated reissuance of short-term liabilities, such as certificates of deposit or commercial paper) cannot be a hedged item in a hedging relationship that involves a basis swap.
6.3.7 Interaction with credit loss and impairment principles
A variable-rate asset or liability that has been designated as the hedged item in a cash flow hedge remains subject to the applicable requirements in GAAP for assessing impairments or credit losses under ASC 326 for that type of asset or for recognizing an increased obligation for that type of liability.
Existing requirements in generally accepted accounting principles (GAAP) for assessing asset impairment or credit losses or recognizing an increased obligation apply to an asset or liability that gives rise to variable cash flows (such as a variable-rate financial instrument) for which the variable cash flows (the forecasted transactions) have been designated as being hedged and accounted for pursuant to paragraphs 815-30-35-3 and 815-30-35-38 through 35-41. Those impairment or credit loss requirements shall be applied each period after hedge accounting has been applied for the period, pursuant to those paragraphs. The fair value or expected cash flows of a hedging instrument shall not be considered in applying those requirements. The gain or loss on the hedging instrument in accumulated other comprehensive income shall, however, be accounted for as discussed in paragraphs 815-30-35-38 through 35-41.
If, under existing requirements in GAAP, an asset impairment loss or writeoff due to credit losses is recognized on an asset or an additional obligation is recognized on a liability to which a hedged forecasted transaction relates, any offsetting net gain related to that transaction in accumulated other comprehensive income shall be reclassified immediately into earnings. Similarly, if a recovery is recognized on the asset or liability to which the forecasted transaction relates, any offsetting net loss that has been accumulated in other comprehensive income shall be reclassified immediately into earnings.
If a reporting entity expects that at any time the continued deferral of a loss in AOCI will lead to the recognition of a net loss when combined with the hedged item in a future period, ASC 815-30-35-40 specifies that a loss should be immediately recognized in earnings for the amount that the entity does not expect to recover.
If the asset is impaired or written off due to credit losses, the reporting entity should also consider whether the probability of the forecasted transactions occurring has changed, as discussed in DH 10.4.8.1.
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