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For fixed-rate financial instruments, a reporting entity may want to economically convert a financial instrument’s cash flows from a fixed rate to a variable rate. This is referred to as a fair value hedge.

6.4.1 Accounting for fair value hedges

Gains and losses on a qualifying fair value hedge should be accounted for in accordance with ASC 815-25-35-1.

Excerpt from 815-25-35-1

Gains and losses on a qualifying fair value hedge shall be accounted for as follows:
a. The gain or loss on the hedging instrument shall be recognized currently in earnings, except for amounts excluded from the assessment of effectiveness that are recognized in earnings through an amortization approach in accordance with paragraph 815-20-25-83A. All amounts recognized in earnings shall be presented in the same income statement line item as the earnings effect of the hedged item.
b. The gain or loss (that is, the change in fair value) on the hedged item attributable to the hedged risk shall adjust the carrying amount of the hedged item and be recognized currently in earnings.

Unlike hedge accounting for cash flow hedges, which results in special accounting for the derivative designated in the cash flow hedging relationship, hedge accounting for fair value hedges results in special accounting for the designated hedged item.
The application of fair value hedge accounting requires (1) the changes in value of the designated hedging instrument and (2) the changes in value (attributable to the risk being hedged) of the designated hedged item to be recognized currently in earnings. As a result, any mismatch between the hedged item and hedging instrument is recognized currently in earnings.

6.4.1.1 Adjusting the carrying amount of the hedged item

In a fair value hedge of an asset, a liability, or a firm commitment, the hedging instrument should be reflected on the balance sheet at its fair value, but the hedged item may often be reflected on the balance sheet at a value that is different from both its historical cost and fair value, unless the total amount and all the risks were hedged when the item was acquired. This is because the hedged item is adjusted each period only for changes in fair value that are attributable to the risk that has been hedged since the inception of the hedge.
For example, if a reporting entity were to hedge the risk of changes in the benchmark interest rate on a nonprepayable fixed-rate loan, the carrying amount of the loan would be adjusted only for the change in fair value that is attributable to the hedged risk (interest rate risk) and would not be adjusted for changes in fair value that are attributable to the unhedged risks (e.g., credit risk).
When initially designating the hedging relationship and preparing the contemporaneous hedge documentation, a reporting entity must specify how hedge accounting adjustments will be subsequently recognized in income. The recognition of hedge accounting adjustments—also referred to as basis adjustments—will differ depending on how other adjustments of the hedged item’s carrying amount will be reported in earnings. See DH 6.4.7.

6.4.1.2 Accounting for a firm commitment that has been hedged

If a firm commitment is designated as a hedged item, the changes in the fair value of the hedged commitment are recorded in a manner similar to how a reporting entity would account for any hedged asset or liability that it records. That is, changes in fair value that are attributable to the risk being hedged are recognized in earnings and recognized on the balance sheet as an adjustment to the hedged item’s carrying amount. Because firm commitments normally are not recorded, accounting for the change in the fair value of the firm commitment results in the reporting entity recognizing the firm commitment on the balance sheet. Subsequent changes in fair value will be recognized as basis adjustments to the carrying amount of the firm commitment.

6.4.1.3 Excluded components

As discussed in DH 6.3.1.2, 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. The same components of a hedging instrument may be excluded for fair value hedges as for cash flow hedges, and the same recognition models are available.

6.4.2 Types of risks eligible for fair value hedge accounting

ASC 815-20-25-12(f) permits a reporting entity to hedge the following risks individually or in combination in a fair value hedge of a financial asset or liability.

Excerpt from ASC 815-20-25-12(f)

  1. The risk of changes in the overall fair value of the entire hedged item [DH 6.4.4]
  2. The risk of changes in its fair value attributable to changes in the designated benchmark interest rate (referred to as interest rate risk) [DH 6.4.5]
  3. The risk of changes in its fair value attributable to changes in the related foreign currency exchange rates (referred to as foreign exchange risk) [DH 8]
  4. The risk of changes in its fair value attributable to both of the following (referred to as credit risk) [FV 8]
    1. Changes in the obligor’s creditworthiness
    2. Changes in the spread over the benchmark interest rate with respect to the hedged item’s credit sector at inception of the hedge.

6.4.2.1 Hedging multiple risks

As specified in ASC 815-20-25-12(f), reporting entities can hedge both the interest rate risk and the foreign currency risk on the same hedged item. For example, in an investment in a foreign currency-denominated, fixed-rate, available-for-sale debt security, it could:
  • Enter into a single derivative instrument that hedges the security's interest rate and foreign currency exchange rate risks (e.g., a cross-currency interest rate swap), or
  • Enter into a receive-variable, pay-fixed interest rate swap denominated in the same foreign currency as that of the available-for-sale debt security to hedge the interest rate risk and simultaneously enter into a separate foreign exchange contract to hedge the foreign currency risk, or
  • Enter into a receive-variable, pay-fixed interest rate swap denominated in the same foreign currency as that of the available-for-sale debt security and simultaneously enter into a separate foreign exchange contract and jointly designate the instruments as a hedge of the security’s interest rate and foreign currency exchange risks.
Hedging the interest rate and foreign exchange risk in a financial instrument or group of financial instruments is discussed in DH 8.

6.4.3 Eligible hedged items in a fair value hedge

ASC 815 requires that the designated hedged item in a fair value hedge be a recognized asset or liability or an unrecognized firm commitment. An unrecognized asset or liability that does not embody a firm commitment is not eligible for fair value hedge accounting.
Hedge accounting may be applied to fair value hedging relationships when they fulfill the general qualifying criteria discussed in DH 6.2 and the criteria specific to fair value hedges in ASC 815-20-25-12.

Excerpt from ASC 815-20-25-12

An asset or a liability is eligible for designation as a hedged item in a fair value hedge if all of the following additional criteria are met:
  1. The hedged item is specifically identified as either all or a specific portion of a recognized asset or liability or of an unrecognized firm commitment.
  2. The hedged item is a single asset or liability (or a specific portion thereof) or is a portfolio of similar assets or a portfolio of similar liabilities (or a specific portion thereof), in which circumstance:
    1. If similar assets or similar liabilities are aggregated and hedged as a portfolio, the individual assets or individual liabilities shall share the risk exposure for which they are designated as being hedged. The change in fair value attributable to the hedged risk for each individual item in a hedged portfolio shall be expected to respond in a generally proportionate manner to the overall change in fair value of the aggregate portfolio attributable to the hedged risk. See the discussion beginning in paragraph 815-20-55-14 for related implementation guidance. An entity may use different stratification criteria for the purposes of Topic 860 impairment testing and for the purposes of grouping similar assets to be designated as a hedged portfolio in a fair value hedge.
    2. If the hedged item is a specific portion of an asset or liability (or of a portfolio of similar assets or a portfolio of similar liabilities), the hedged item is one of the following:
      1. A percentage of the entire asset or liability (or of the entire portfolio). An entity shall not express the hedged item as multiple percentages of a recognized asset or liability and then retroactively determine the hedged item based on an independent matrix of those multiple percentages and the actual scenario that occurred during the period for which hedge effectiveness is being assessed.
      2. One or more selected contractual cash flows, including one or more individual interest payments during a selected portion of the term of a debt instrument (such as the portion of the asset or liability representing the present value of the interest payments in any consecutive two years of a four-year debt instrument). Paragraph 815-25-35-13B discusses the measurement of the hedged item in hedges of interest rate risk.

6.4.3.1 Eligible hedged items in a fair value hedge – prepayment options

Reporting entities often seek to hedge the prepayment risk of financial instruments that have specific call/put dates or are prepayable at any time after issuance. In this regard, ASC 815-20-25-6 indicates that prepayment risk per se cannot be designated as a hedged risk. However, ASC 815-20-25-6 permits a hedge of the option component of a prepayable instrument as the hedged item, thus achieving the same economic result. ASC 815-20-25-12(b)(2)(iii) specifically lists an embedded put or call option that is not separated as an eligible hedged item even though, on a standalone basis, derivatives do not qualify as hedged items.
ASC 815-20-25-12(d) indicates that a hedged item in a fair value hedge can be a prepayment option embedded in a held-to-maturity debt security. In that case, the hedged risk is the risk of changes in the entire fair value of the option.
It may be difficult, however, to obtain a hedging instrument that is highly effective in offsetting the impact of prepayment risk.
Reporting entities cannot hedge prepayment risk in items derived from prepayable instruments, such as mortgage servicing rights or interest-only strips, since the items do not themselves contain prepayment options. However, some entities may choose not to designate mortgage servicing rights or interest-only strips in hedging relationships given the availability of fair value options under ASC 860-50 or ASC 825-10, respectively.

6.4.3.2 Eligible hedged items in a fair value hedge – earnings exposure

ASC 815-20-25-12(c) identifies earnings exposure as a criterion that must be met for an asset or liability to be the hedged item. The change in fair value of a hedged item attributable to the risk being hedged must have the potential to change the amount that could be recognized in earnings. This criterion is based on the premise that the objective of hedge accounting is to allow the gain or loss on a hedging instrument and the loss or gain on a designated hedged item to be recognized in earnings at the same time.

6.4.3.3 Eligible hedged items in a fair value hedge – external party

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).

6.4.3.4 Hedging held-to-maturity debt securities

ASC 815-20-25-12(d) provides guidance on the eligibility of held-to-maturity debt securities for designation as a hedged item in a fair value hedge.

ASC 815-20-25-12(d)

If the hedged item is all or a portion of a debt security (or a portfolio of similar debt securities) that is classified as held to maturity in accordance with Topic 320, the designated risk being hedged is the risk of changes in its fair value attributable to credit risk, foreign exchange risk, or both. If the hedged item is an option component of a held-to-maturity security that permits its prepayment, the designated risk being hedged is the risk of changes in the entire fair value of that option component. If the hedged item is other than an option component of a held-to-maturity security that permits its prepayment, the designated hedged risk also shall not be the risk of changes in its overall fair value.

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. For this reason, ASC 815-20-25-43(c)(2) indicates that interest rate risk may not be the hedged risk in a fair value hedge of held-to-maturity debt securities. 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. In addition, hedging foreign exchange risk or the fair value of embedded prepayment options in held-to-maturity securities is permitted, as discussed in DH 6.4.3.1.

6.4.3.5  Eligible hedged items in a fair value hedge –leases

ASC 815-20-25-12(b)(2)(iv) indicates that a hedged item may be the residual value in a lessor’s net investment in a direct financing or sales-type lease.
Although the residual value in a lessor’s net investment in a direct financing or sales-type lease may be designated as the hedged item, many contracts that are used as the hedging instrument in such a hedge may qualify for the scope exception in ASC 815-10-15-13 and ASC 815-10-15-59(d). A reporting entity should examine its hedging instruments to determine whether they meet the definition of a derivative or are scoped out. If a hedging instrument does not fall within the scope of ASC 815, the corresponding transaction does not qualify for hedge accounting because only derivatives may be designated as hedging instruments with certain limited exceptions, as discussed in DH 8.2.2.
See DH 4.6.3 for a discussion of certain features of leases that may meet the definition of a derivative and thus need to be separated from the lease agreement and accounted for individually.

6.4.3.6 Eligible hedged items in a fair value hedge – firm commitments

A firm commitment is a binding agreement with a third party for which all significant terms are specified (e.g., quantity, price, timing of the transaction). The definition of a firm commitment requires that the fixed price be specified in terms of a currency (or an interest rate).
ASC 815 specifies that a firm commitment must include a disincentive for nonperformance that is sufficiently large to make performance probable. The determination of whether a sufficiently large disincentive for nonperformance exists under each firm commitment will be judgmental based upon the specifics and facts and circumstances. Example 13 in ASC 815-25-55-84 indicates that the disincentive for nonperformance need not be explicit in the contract. Rather, the disincentive may be present in the form of statutory rights (that exist in the legal jurisdiction governing the agreement) that allow a reporting entity to pursue compensation in the event of nonperformance (e.g., if the counterparty defaults) that is equivalent to the damages that the entity suffers as a result of the nonperformance.
Question DH 6-9 discusses whether an intercompany commitment can be considered “firm” and, therefore, be eligible for designation as a fair value hedged item.
Question DH 6-9
Can an intercompany commitment ever be considered “firm” and, therefore, be eligible for designation as a fair value hedged item?
PwC response
No. As defined in ASC 815-25-20, a firm commitment must be entered into with an unrelated third party. However, even though a foreign currency-denominated intercompany commitment may not be eligible for designation as a fair value hedged item, the functional currency variability in the foreign currency cash flows under that commitment may be eligible for designation as a hedged forecasted transaction in a cash flow hedge. The functional currency equivalent of the foreign currency cash that is to be paid or received on the commitment will fluctuate based on changes in the exchange rate; therefore, the transaction has a hedgeable cash flow exposure.

6.4.3.7 Items ineligible to be hedged items in fair value hedges

In addition to the guidance discussed in DH 6.4.3 through DH 6.4.3.6, ASC 815-20-25-43(c) provides additional restrictions on items that cannot be hedged items in fair value hedges.

Excerpt from ASC 815-20-25-43(c)

  1. If the entire asset or liability is an instrument with variable cash flows, an implicit fixed-to-variable swap (or similar instrument) perceived to be embedded in a host contract with fixed cash flows [see below]
  2. For a held-to-maturity debt security, the risk of changes in its fair value attributable to interest rate risk [DH 6.4.3.4]
  3. An asset or liability that is remeasured with the changes in fair value attributable to the hedged risk reported currently in earnings [see below]
  4. An equity investment in a consolidated subsidiary [DH 6.2.2.1]
  5. A firm commitment either to enter into a business combination or to acquire or dispose of a subsidiary, a noncontrolling interest, or an equity method investee [DH 6.2.2.1]
  6. An equity instrument issued by the entity and classified in stockholders’ equity in the statement of financial position
  7. A component of an embedded derivative in a hybrid instrument—for example, embedded options in a hybrid instrument that are required to be considered a single forward contract under paragraph 815-10-25-10 cannot be designated as items hedged individually in a fair value hedge in which the hedging instrument is a separate, unrelated freestanding option.

Implicit embedded features
If the entire asset or liability is an instrument with variable cash flows, ASC 815-20-25-43(c)(1) states the hedged item cannot be deemed to be an implicit fixed-to-variable swap (or similar instrument) perceived to be embedded in a host contract with fixed cash flows. In other words, a reporting entity may not consider a variable-rate instrument to be implicitly embedded in a fixed-rate instrument to achieve a fair value hedge.
No remeasurement for changes in fair value
ASC 815-20-25-43(c)(3) does not permit hedge accounting for hedged items that are remeasured for changes in fair value because both the gains or losses on the hedging instrument and the offsetting losses or gains on the hedged item would be recorded in the income statement and would tend to naturally offset each other.

6.4.3.8 Portfolio of similar assets/liabilities

ASC 815-20-25-12(b)(1) describes the “similar assets/liabilities test” that is required for fair value hedges of groups (portfolios) of assets or liabilities. Reporting entities seeking to fair value hedge a portfolio of assets or liabilities must generally perform a rigorous quantitative assessment at inception of the hedging relationship to document that the portfolio of assets or liabilities is eligible for designation as the hedged item in a fair value hedging relationship.

Excerpt from ASC 815-20-25-12(b)

The hedged item is a single asset or liability (or a specific portion thereof) or is a portfolio of similar assets or a portfolio of similar liabilities (or a specific portion thereof), in which circumstance:
  1. If similar assets or similar liabilities are aggregated and hedged as a portfolio, the individual assets or individual liabilities must share the risk exposure for which they are designated as being hedged. The change in fair value attributable to the hedged risk for each individual item in a hedged portfolio must be expected to respond in a generally proportionate manner to the overall change in fair value of the aggregate portfolio attributable to the hedged risk.

Consistent with the ASC 815 prohibition on macro hedging, the designation of a group of assets or liabilities in a single hedging relationship is limited to only those similar assets or liabilities that share the same risk exposure for which they are designated as being hedged. ASC 815-20-55-14 indicates that the concept of similar assets or liabilities is interpreted very narrowly. The fair value of each individual item in the portfolio must be expected to change proportionate to the change in the entire portfolio. For example, when the changes in the fair value of the hedged portfolio attributable to the hedged risk alter that portfolio’s fair value by 10% during a reporting period, the change in the fair value that is attributable to the hedged risk of each item in the portfolio should also be expected to be within a fairly narrow range of 10%.

Excerpt from ASC 815-20-55-14

If the change in fair value of a hedged portfolio attributable to the hedged risk was 10 percent during a reporting period, the change in the fair values attributable to the hedged risk for each item constituting the portfolio should be expected to be within a fairly narrow range, such as 9 percent to 11 percent. In contrast, an expectation that the change in fair value attributable to the hedged risk for individual items in the portfolio would range from 7 percent to 13 percent would be inconsistent with requirement in that paragraph [ASC 815-20-25-12(b)(1)].

ASC 815-20-55-15 provides guidance on aggregating a portfolio.

ASC 815-20-55-15

In aggregating loans in a portfolio to be hedged, an entity may choose to consider some of the following characteristics, as appropriate:
  1. loan type
  2. loan size
  3. nature and location of collateral
  4. interest rate type (fixed or variable)
  5. coupon interest rate or the benchmark rate component of the contractual coupon cash flows (if fixed)
  6. scheduled maturity or the assumed maturity if the hedged item is measured in accordance with paragraph 815-25-35-13B
  7. prepayment history of the loans (if seasoned)
  8. expected prepayment performance in varying interest rate scenarios.

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 fixed-rate nonprepayable financial assets together in a single hedging relationship, when those financial assets all have the same benchmark component of the coupon, payment dates, and assumed maturity date (under the partial term hedging guidance), 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 be performed at that time.
Question DH 6-10 discusses whether a financial institution that economically hedges interest rate spread through a macro hedge strategy can quality for hedge accounting.
Question DH 6-10
A financial institution economically hedges its interest rate spread through a macro hedge strategy, whereby hedging instruments are not linked to identifiable assets, liabilities, firm commitments, or forecasted transactions. Can such a strategy qualify for hedge accounting?
PwC response
No. Absent linkage to an identifiable asset, liability, firm commitment, or forecasted transaction (or a group of similar items), there is no objective method of either assessing the effectiveness of the hedging instruments or ultimately recognizing the results of the hedging instruments in income.

6.4.4 Hedging the total change in fair value

When the hedged risk is the total variability in fair value, as permitted by ASC 815-20-25-12(f)(1), the total change in fair value on the hedged item is offset in the income statement by the change in fair value of the hedging instrument. However, more effective hedges (with less impact to the income statement) may result if a reporting entity hedges just interest rate risk, as discussed in DH 6.4.5.

6.4.5 Hedging the change in fair value-benchmark interest rate

The Master Glossary defines interest rate risk differently for variable-rate and fixed-rate instruments. For recognized fixed-rate instruments, interest rate risk is defined as the change in fair value due to the change in the benchmark rate.

Partial definition from the Master Glossary

Interest Rate Risk: For recognized fixed-rate financial instruments, interest rate risk is the risk of changes in the hedged item’s fair value attributable to changes in the designated benchmark interest rate. For forecasted issuances or purchases of fixed-rate financial instruments, interest rate risk is the risk of changes in the hedged item’s cash flows attributable to changes in the designated benchmark interest rate.

6.4.5.1 Designating the benchmark interest rate

The Master Glossary defines the benchmark interest rate.

Definition from the ASC Master Glossary

Benchmark Interest Rate: A widely recognized and quoted rate in an active financial market that is broadly indicative of the overall level of interest rates attributable to high-credit-quality obligors in that market. It is a rate that is widely used in a given financial market as an underlying basis for determining the interest rates of individual financial instruments and commonly referenced in interest-rate-related transactions.
In theory, the benchmark interest rate should be a risk-free rate (that is, has no risk of default). In some markets, government borrowing rates may serve as a benchmark. In other markets, the benchmark interest rate may be an interbank offered rate.

Additionally, ASC 815-20-25-6A defines the list of eligible benchmark interest rates in the US as the following.
  • Interest rates of direct obligations of the US government
  • LIBOR swap rate
  • Fed Funds Effective Swap Rate (also referred to as the Overnight Index Swap Rate or OIS)
  • Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Rate
  • Secured Overnight Financing Rate (SOFR) Overnight Index Swap Rate
The benchmark interest rate(s) a reporting entity selects will, at a minimum, be used to discount the hedged item’s projected cash flows.
Reporting entities may elect any of the benchmark interest rates on a hedge-by-hedge basis.
Benchmark interest rates outside the US
The list of benchmark rates in ASC 815 is for the US market. The guidance does not specifically address markets outside the US, except that ASC 815-20-55-128 references Euribor as an eligible benchmark interest rate for euro-denominated financial assets or liabilities. It provides an example of a reporting entity designating an interest rate swap to hedge its exposure to changes in fair value of its euro-denominated debt obligation that is attributable to changes in Euribor interest rates.
The benchmark interest rate should be a risk-free rate, but may be an interbank offered rate that is not entirely free of risk. Euribor, for example, is sponsored by the European Banking Federation, is widely recognized, and is quoted in an active financial market by banks with high credit ratings. It is the rate at which euro interbank term deposits are offered by one prime bank to another prime bank. Reporting entities will need to consider the definition in ASC 815 when determining the eligibility of rates outside the US.

6.4.6 Measuring the hedged item

ASC 815-25-35-1 requires the carrying amount of the hedged item to be adjusted for the fair value changes attributable to the hedged risk (commonly referred to as basis adjustments). When the hedged risk is the overall fair value of the entire hedged item, the measurement of the hedged item should be consistent with ASC 820. However, when the hedged item is a financial asset or liability and the hedged risk is interest rate risk, ASC 815 provides two ways to project cash flows on the hedged item when measuring the changes in fair value of hedged item: total contractual coupon cash flows or the benchmark component of the contractual coupon cash flows.
Reporting entities can elect to use either the total coupon cash flows or the benchmark component of the coupon cash flows to measure the hedged item on a hedge-by-hedge basis. The ability to elect a method to measure the hedged item on a hedge-by-hedge basis is analogous to the ability to choose one of multiple benchmark interest rates, as discussed in DH 6.4.5.1. For reporting entities with a borrowing rate that is close to the benchmark rate, there may limited differences in hedge results and earnings impact under either method.
The methodology to measure the gain or loss should be consistent with the original documented risk management strategy. When the risk designated is changes in fair value due to changes in the benchmark interest rate, documentation should include details related to:
  • The designated benchmark rate
  • Whether the contractual coupon or benchmark component of the contractual coupon will be used to project cash flows on the hedged item
  • The portion of the term of the financial instrument being hedged
  • The prepayment features embedded in the instrument, and whether those features will be considered in the measurement of the hedged item due to fluctuations in only the benchmark interest rate or all factors that would impact prepayment

6.4.6.1 Measuring the hedged item based on contractual coupon cash flows

When using the total contractual coupon cash flows to measure the hedged item, reporting entities are not permitted to exclude some of the hedged item’s contractual cash flows (e.g., the portion of the interest coupon that is in excess of the benchmark rate) at any point in the hedging relationship. No specific guidance is provided regarding the yield curve with which the hedged item’s estimated cash flows should be discounted.
When using the total contractual coupon cash flows to determine the change in fair value of the hedged item attributable to the hedged risk, there will always be some amount of earnings mismatch when a fixed-rate interest-bearing asset or liability is being hedged for changes in the benchmark interest rate under the long-haul method. This is due to the difference between the interest coupon and the benchmark rate at inception of the hedging relationship, which is not economically reflected in the terms of the interest rate swap. The only way to avoid this result in a fair value hedge of the benchmark interest rate when the hedged item is measured based on total contractual coupon cash flows is to qualify for the shortcut method, which assumes that the change in the fair value of the hedged item attributable to the benchmark rate is equal to the change in the fair value of the interest rate swap. However, as discussed in DH 9.4, the shortcut method is limited to only those hedging relationships that meet strict criteria.
Question DH 6-11 discusses the factors that should be considered in the estimation of changes in a debt’s fair value attributable to a hedged risk.
Question DH 6-11
DH Corp enters into an interest rate swap to hedge the risk of changes in a benchmark interest rate on fixed-rate debt. When recording the change in the fair value of the hedged item attributable to the hedged risk using the total contractual cash flows, should the following factors be considered in the estimation of changes in the debt’s fair value attributable to the hedged risk (interest rate risk)?
  • Changes in the entity’s credit quality
  • Changes in sector credit spreads
  • Liquidity of the hedged item
PwC response
No. The provisions of ASC 815 indicate that, in accounting for the hedged item, DH Corp should adjust the carrying amount of the debt each reporting period solely to reflect changes in the debt’s value that are attributable to the risk being hedged.
In this example, the risk being hedged comprises changes in the debt’s fair value caused by changes in a benchmark interest rate. Accordingly, in estimating the changes in the debt’s fair value for purposes of applying the guidance, DH Corp should not consider changes that are attributable to entity-level or sector-level credit risk or liquidity. However, those factors should be considered when disclosing the fair value of DH Corp’s financial instruments pursuant to ASC 825 and ASC 820.
The risks should be considered in determining the fair value of the derivative hedging instrument, which is measured at its full fair value.

6.4.6.2 Measuring the hedged item based on the benchmark component

Measuring the hedged item in a fair value hedge based on the benchmark component of the coupon is permitted for fair value hedges of fixed-rate assets or liabilities, regardless of whether the coupon or yield is more or less than the benchmark rate. While “benchmark component” is not defined, it is meant to represent the current on-market benchmark rate as of the designation of the hedging relationship. In other words, the benchmark component may be viewed as the rate on the fixed leg of a swap that:
  • is at-market (has a fair value of zero) on the designation date,
  • has a floating leg with no spread, and
  • has the same terms as the hedged item.
For example, if LIBOR is designated as the benchmark interest rate:
  • The benchmark component of five-year non-callable fixed-rate debt is the fixed rate of an at-market LIBOR-flat (i.e., LIBOR with no spread) five-year swap.
  • The benchmark component of five-year fixed-rate debt callable in year three is the fixed rate of an at-market LIBOR-flat five-year swap that is cancellable in year three.
If the swap used as the hedging instrument is executed contemporaneously with the start of the hedging relationship, is at-market, and has the same terms as the hedged item, use of the benchmark component of the contractual coupon will result in the following.
  • The fixed rate on a LIBOR-flat swap and the fixed rate on the hedged item would match. As such, only potential mismatches in discount rates for the hedged item and hedging instrument would generate earnings volatility for the hedging relationship.
  • The initial value of the bond for hedge accounting purposes will be par. This eliminates the need for the “pull-to-par” calculations (highlighted in Example DH 6-3).
This will be true regardless of when the hedged item was issued in relation to the hedge designation date. If the debt was issued the same day or three years prior to execution of the hedged relationship, use of the benchmark component will still result in the debt’s initial value for hedge accounting purposes being par. This is because the benchmark component of the coupon is determined at the date of hedge designation. As a result, its use helps to alleviate the tension associated with using the shortcut method of assessing effectiveness for a “late-term” hedge, that is, one designated in a period after the hedged item was issued, as discussed in DH 9.4.2.8.
When measuring the hedged item based on the total contractual coupon cash flows, a reporting entity will sometimes add a fixed spread to the hedged item’s discount rate. That is typically done to force the initial value of the hedged item for hedge accounting purposes to be equal to par. Since use of the benchmark component of the contractual coupon cash flows results in the hedged item’s initial value being par (when those cash flows are discounted using the benchmark interest rate), we do not expect entities to add a spread to the discount rate when electing to use the benchmark component of the cash flows to measure the hedged item.
ASC 815 does not prescribe a specific method for a reporting entity to calculate changes in fair value attributable to the benchmark interest rate. In practice, reporting entities may use two methodologies to estimate the change in value attributable to the risk being hedged (i.e., the basis adjustment), referred to as the Example 9/120C and Example 11/FAS 138 methods.
Example 9/120C method
The first method is described in ASC 815-25-55-55 (Example 9) and is often referred to as the “120C method” (as originally described in paragraph 120C of FAS 133).

ASC 815-25-55-55

Under this method, the change in a hedged item’s fair value attributable to changes in the benchmark interest rate for a specific period is determined as the difference between two present value calculations that use the remaining cash flows as of the end of the period and reflect in the discount rate the effect of the changes in the benchmark interest rate during the period.

Excerpt from ASC 815-25-55-56

Both present value calculations are computed using the estimated future cash flows for the hedged item, which would be either its remaining contractual coupon cash flows or the LIBOR benchmark rate component of the remaining contractual coupon cash flows determined at hedge inception as illustrated by the following Cases:

  1. Using the full contractual coupon cash flows (Case A)
  2. Using the LIBOR benchmark rate component of the contractual coupon cash flows (Case B).

Under the 120C method, the change in the fair value of the hedged item over a specific period of time is calculated as the difference between:
  • the present value of the cash flows as of the end of the period using the benchmark rate at the beginning of the period, and
  • the present value of the cash flows as of the end of the period using the benchmark rate at the end of the period.
In other words, this method compares end-of-period cash flows associated with the hedged item discounted using the benchmark rate at the beginning and end of the specified period. Accordingly, the change in fair value attributable to changes in the benchmark rate (designated hedged risk) from the beginning of the period to the end of the period is isolated. This results in the change in fair value due to the passage of time being excluded from the measurement of the hedged item.
Absent any amortization policies, reporting entities using the Example 9 method may be left with “hanging” basis adjustments in the carrying value of the hedged item resulting in earnings volatility upon maturity of the hedged item (unless the hedging relationship is terminated earlier). Accordingly, reporting entities may choose to amortize basis adjustments each reporting period, as discussed in DH 6.4.7.
While the guidance does not specify the method of amortization, we believe the basis adjustment should be accounted for in the same manner as other components of the carrying amount of that asset or liability (e.g., the interest method).
Reporting entities should ensure basis adjustments are fully amortized upon the maturity of the hedged item.
Example 11/FAS 138 method
The more common method of measuring changes in fair value of a hedged item attributable to changes in a benchmark interest rate is illustrated in ASC 815-25-55-72 through ASC 815-25-55-77 (Example 11) and is often referred to as the “FAS 138 method” (since it was originally illustrated in the FASB staff’s examples issued in conjunction with FAS 138). Under this method, the changes in the fair value of the hedged item over a specific period of time are calculated as the difference between:
  • the present value of the cash flows as of the beginning of the period using the benchmark rate at the beginning of the period, and
  • the present value of the cash flows as of the end of the period using the benchmark rate at the end of the period.
Accordingly, the change in fair value attributable to changes in the benchmark interest rate (designated as the hedged risk) from the beginning of the period to the end of the period includes not only changes in the benchmark interest rate but also the change due to the passage of time. Adjustments may need to be made for the receipt/payment of cash.
When a reporting entity projects cash flows on the debt using the total contractual coupon (as discussed in DH 6.4.6.1), a debt instrument’s present value is different from its book or par value at hedge inception since the total interest coupons are typically different from the benchmark rate. At maturity, the debt’s present value will equal its par or redemption amount. In this scenario, the cumulative changes in present value of the debt instrument over the hedge period are not zero when using the present value technique under the Example 11 method. This is often referred to as the “pull-to-par” effect.
To illustrate this pull-to-par concept (pulling the present value of the debt at hedge inception to par upon maturity), consider a reporting entity with outstanding debt with a $100 principal balance and $105 present value at hedge inception. However, because the initial present value did not equal the par value, application of the Example 11 method without an additional adjustment would result in a $5 gain at maturity of the hedged item. This would occur because under the Example 11 method, even if the benchmark interest rate did not change after hedge inception, the initial present value amount of the contractual cash flows would migrate toward par value over time. Consequently, the cumulative change in fair value not attributable to changes in a benchmark rate amounts to ($5) over the hedge period (a decline from a $105 present value at hedge inception to a $100 fair value at hedge maturity). The ($5) is the portion of the change in the present value calculations not attributable to a change in a benchmark interest rate, but to the natural migration of the initial present value to par over time. Therefore, the reporting entity would adjust the periodic basis adjustments on the hedged item to further isolate the change in value attributable to the hedged risk.
Specifically, a reporting entity should calculate the change in present value that would occur in each of the remaining reporting periods over the remaining term of the five-year debt assuming that the benchmark rate does not change. That calculated amount for each reporting period should be subtracted from the basis adjustments calculated under the Example 11 method for each corresponding reporting period to determine the net basis adjustment to be recognized.
In the first reporting period following hedge inception, the present value of $105 may have become $110 by the end of the period. The calculation that assumed no change in the benchmark rate would indicate that, if rates had not changed, the present value would have decreased from $105 to $103 as it migrates back to par. This difference of $2 would need to be subtracted from the basis adjustment calculation of $5 ($110 – $105) resulting in $7 ($5 – (-$2)) as the net basis adjustment to be recognized against the hedged item. Consistently adjusting the basis adjustment each reporting period correctly accounts for any differences that existed at inception between the present value of future cash streams and par.
The Example 11 method is more common in practice than the Example 9 method, partly because the calculation of the change in fair value from the beginning of the period to the end of the period (including the passage of time) is supported by many Treasury valuation systems. Some Treasury valuation systems may not have the ability to isolate the change in value of the hedged item without the passage of time, as prescribed under the Example 9 method.
We believe the Example 11 method will continue to be more prevalent in practice after adoption of ASU 2017-12 now that the pull-to-par concerns have been mitigated through the ability to measure the hedged item using the benchmark component of the contractual coupon cash flows (as discussed in DH 6.4.6.2). Measuring the hedged item based upon the benchmark component of the contractual coupon cash flows will, in most cases, equate the hedged item’s present value to par at hedge inception, as illustrated in Example DH 6-2.
EXAMPLE DH 6-2
Measuring the hedged item based on the benchmark rate component of the contractual coupon under the Example 11 method
On January 1, 20X1, DH Corp issued a $100,000, sever-year fixed-rate noncallable debt instrument with an annual 10% interest coupon at par. Two years after issuance, on December 31, 20X2, when the LIBOR swap rate for five years is 7% and the debt remains on the books at a carrying value equal to par, DH Corp enters into an on-market five-year receive-fixed (7%) pay-LIBOR interest rate swap and designates it as the hedging instrument in a fair value hedge of the $100,000 liability due to changes in the benchmark interest rate (this is often referred to as a “late hedge”). DH Corp chooses to measure the hedged item based on the benchmark rate component of the contractual coupon cash flows.
The variable leg of the interest rate swap resets each year on December 31 for the payments due the following year. At the time of hedge designation, the debt is recorded on DH Corp’s books at $100,000. The present value of the debt including its full $10,000 annual contractual coupons discounted at the benchmark interest rate is approximately $112,300. However, when only the benchmark rate component of the coupon is used (i.e., 7%, resulting in $7,000 per annum assumed cash flows), the present value of the debt discounted at the hedge inception benchmark rate is equal to the par value of the debt. The incremental $3,000 per year of cash flows on the debt is not considered in the measurement of the hedged item due to the hedged risk since DH Corp chooses to measure the hedged item based upon the benchmark rate component of the contractual coupon cash flows.
Benchmark interest rates are as follows.
Year
LIBOR swap rate
20X2
7%
20X3
6.5%
20X4
6.0%
20X5
5.5%
20X6
5.0%
20X7
4.5%
How should DH Corp account for the fair value hedge using the benchmark rate component of the contractual coupon under the Example 11 method to measure the hedged item?
Analysis
When discounting the benchmark rate component of the contractual coupon cash flows at the designated benchmark interest rate, the present value of the bond’s cash flows at the inception of the hedging relationship will equal par. When using the full contractual coupon, the present value of the cash flows would be greater than par. As a result, a pull-to-par adjustment resulting from this premium (i.e., the $12,300 explained above and as used in Example DH 6-3) would otherwise be required to ensure the carrying value of the hedged item is equal to par at the maturity of the hedging relationship. Under the benchmark rate component of the contractual coupon, this premium may not exist. Under the Example 11 method, when a hedged item begins at par and is subsequently adjusted away from par due to changes in the benchmark rate, the calculations will return the hedged item back to par as it approaches the designated maturity. This is observable in years 20X6 and 20x7. In this example, interest rates decline each period by 50 basis points. A fixed-rate instrument should increase in present value when rates decline. However, as the instrument gets closer to the designated maturity, the changes in value calculated under the Example 11 method will revert the debt to par because the effects of discounting diminish as maturity approaches.
The calculations in this example are simplified by assuming that the interest rate applicable to a payment due at any future date is the same as the rate for a payment at any other future date (that is, the yield curve is flat for the term of the swap), and that all rates change only once per year on December 31 of each year.
DH Corp records the following journal entries (for the purposes of this example, any credit valuation adjustment (CVA) or debit valuation adjustment (DVA) impacts on the valuation of the swap have been ignored).
December 31, 20X3
Dr. Interest expense
$1,713
Cr. Debt
$1,713
To record the change in fair value of debt for change in benchmark interest rates
($7,000x[(1-(1.065)-4)x(0.065)-1]+$100,000x(1.065)-4 = $101,713 minus $100,000)
Dr. Swap contract
$1,713
Cr. Interest expense
$1,713
To record the change in fair value of the swap
($7,000x[(1-(1.065)-4)x(0.065)-1]- $6,500x[(1-(1.065)-4)x(0.065)-1])
Dr. Interest expense
$10,000
Cr. Cash
$10,000
To record payment of interest on the debt ($100,000 @ 10%)
Note: No cash settlement on the swap to be recorded as the fixed and floating legs were both 7% for 20x3
December 31, 20X4
Dr. Interest expense
$960
Cr. Debt
$960
To record the change in fair value of debt for change in benchmark interest rates
($7,000x[(1-(1.06)-3)x(0.06)-1]+$100,000x(1.06)-3 = $102,673 less $101,713)
Dr. Swap contract
$960
Cr. Interest expense
$960
To record the change in fair value of the swap
($7,000x[(1-(1.06)-3)x(0.06)-1]-$6,000x[(1-(1.06)-3)x(0.06)-1] = $2,673 less $1,713)
Dr. Interest expense
$10,000
Cr. Cash
$10,000
To record payment of interest on the debt ($100,000 @ 10%)
Dr. Cash
$500
Cr. Interest expense
$500
To record the settlement on the swap (receive fixed $7,000, pay float $6,500)
December 31, 20X5
Dr. Interest expense
$96
Cr. Debt
$96
To record the change in fair value of debt for change in benchmark interest rates
($7,000x[(1-(1.055)-2)x(0.055)-1]+$100,000x(1.055)-2 = $102,769 less $102,673)
Dr. Swap contract
$96
Cr. Interest expense
$96
To record the change in fair value of the swap
($7,000x[(1-(1.055)-2)x(0.055)-1]- $5,500x[(1-(1.055)-2)x(0.055)-1] = $2,769 less $2,673)
Dr. Interest expense
$10,000
Cr. Cash
$10,000
To record payment of interest on the debt ($100,000 @ 10%)
Dr. Cash
$1,000
Cr. Interest expense
$1,000
To record the settlement on the swap (receive fixed $7,000, pay float $6,000)
December 31, 20X6
Dr. Debt
$865
Cr. Interest expense
$865
To record the change in fair value of debt for change in benchmark interest rates
($7,000x[(1-(1.05)-1)x(0.05)-1]+$100,000x(1.05)-1 = $101,904 less $102,769)
Dr. Interest expense
$865
Cr. Swap contract
$865
To record the change in fair value of the swap
($7,000x[(1-(1.05)-1)x(0.05)-1]- $5,000x[(1-(1.05)-1)x(0.05)-1] = $1,904 less $2,769)
Dr. Interest expense
$10,000
Cr. Cash
$10,000
To record payment of interest on the debt ($100,000 @ 10%)
Dr. Cash
$1,500
Cr. Interest expense
$1,500
To record the settlement on the swap (receive fixed $7,000, pay float $5,500)
December 31, 20X7
Dr. Debt
$1,904
Cr. Interest expense
$1,904
To record the change in fair value of debt for change in benchmark interest rates
($7,000x[(1-(1.045)-0)x(0.045)-0]+$100,000x(1.045)-0 = $100,000 less $101,904)
Dr. Interest expense
$1,904
Cr. Swap contract
$1,904
To record the change in fair value of the swap
No future settlements as swap has matured so fair value is zero ($0-$1,904)
Dr. Interest expense
$10,000
Cr. Cash
$10,000
To record payment of interest on the debt ($100,000 @ 10%)
Dr. Cash
$2,000
Cr. Interest expense
$2,000
To record the settlement on the swap (receive fixed $7,000, pay float $5,000)

Example DH 6-3 illustrates how to exclude the “pull-to-par” effect from the measurement of the hedged item under the Example 11 method when the hedged item is measured using the full contractual coupon cash flows under ASC 815-25-35-13. We observe that when confronted with the differences in complexity between Example DH 6-2 and Example DH 6-3, most reporting entities will choose to use the benchmark rate component of the contractual coupon with the Example 11 method.
EXAMPLE DH 6-3
Measuring the hedged item based upon the total contractual coupon using the Example 11 method
On January 1, 20X1, DH Corp issued a $100,000, seven-year fixed-rate noncallable debt instrument with an annual 10% interest coupon at par. Two years after issuance, on December 31, 20X2, when the LIBOR swap rate for five-year debt is 7% and the debt remains on the books at a carrying value equal to par, DH Corp enters into an on-market five-year receive-fixed (7%) pay-LIBOR interest rate swap and designates it as the hedging instrument in a fair value hedge of the $100,000 liability due to the change in the benchmark interest rate. DH Corp chooses to measure the hedged item based on the total contractual coupon cash flows.
The variable leg of the interest rate swap resets each year on December 31 for the payments due the following year. At the time of hedge designation, the debt is recorded on DH Corp’s books at $100,000; however, the present value of the contractual cash flows of the debt discounted at the benchmark interest rate is approximately $112,300, a difference from par of $12,300.
Benchmark interest rates are as follows.
Year
LIBOR swap rate
20X2
7%
20X3
6.5%
20X4
6.0%
20X5
5.5%
20X6
5.0%
20X7
4.5%
How should DH Corp account for the fair value hedge using the total contractual coupon cash flows under the Example 11 method to measure the hedged item?
Analysis
If the book value of the debt is simply adjusted for the total change in value due to both interest rate changes and the changes in time, the pull-to-par effects of a debt’s change in value from a premium (i.e., the $12,300 in this example) down to par would, over time, bring the debt’s ultimate carrying value down to $87,700 by crediting the income statement in 20X3, 20X4, 20X5, 20X6, and 20X7. This amount is not reflective of a change in fair value due to changes in the benchmark interest rate. It would result in a $12,300 loss at maturity; the debt will be settled for $100,000 when the book value is $87,700. (Reference the lower line in the below graph.)
To avoid this outcome, pull-to-par effects must be removed from the changes in fair value of the hedged item due to changes in the hedged risk calculation. To isolate the pull-to-par effects, the hedge accounting needs to be adjusted for the effects of $12,300 of premium on the same debt instrument with rates remaining at the 7% initial hedge rate throughout the time of the hedge until maturity. The pull-to-par effect can be determined by calculating the change in fair value in each period after the hedge designation date, assuming no changes in discount rates (see the impact of passage of time in the following table).
Consistent with the example in ASC 815-25-55-54, the calculations in this example are simplified by assuming that the interest rate applicable to a payment due at any future date is the same as the rate for a payment at any other future date (that is, the yield curve is flat for the term of the swap), and that all rates may change only once per year on December 31 of each year.
Change in present value of the cash flows due to both
interest rates and time remaining until maturity
Date
12/31/X2
12/31/X3
12/31/X4
12/31/X5
12/31/X6
12/31/X7
Totals
Present value (PV)
$112,301
$111,990
$110,692
$108,308
$104,762
$100,000
Total change in present value (TC)
N/A
$310
$1,298
$2,384
$3,547
$4,762
$12,301

Isolate the change in time adjustment under Example 11 method
while keeping rates constant at 7%
Date
12/31/X2
12/31/X3
12/31/X4
12/31/X5
12/31/X6
12/31/X7
Present value
$112,301
$110,162
$107,873
$105,424
$102,804
$100,000
Change in present value due to passage of time (∆ t)
N/A
$2,139
$2,289
$2,449
$2,620
$2,804
$12,301

Compute changes in fair value due to changes in the benchmark interest rate
Date
12/31/X2
12/31/X3
12/31/X4
12/31/X5
12/31/X6
12/311/X7
Total change in present value
$310
$1,298
$2,384
$3,547
$ 4,762
$12,301
Less impact of passage of time
–∆ t
$ 2,139
$2,289
$2,449
$2,620
$2,804
$12,301
Change in present value due to changes in benchmark interest rate
($1,829)
($991)
($65)
$927
$1,958
$0
A
c
e
G
i
Change in fair value of the swap
$1,713
$960
$96
($865)
($1,905)
$0
B
d
f
H
j
Earnings impact – difference in interest expense
($116)
($30)
$31
$62
$53
December 31, 20X3
Dr. Interest expense
$1,829
Cr. Debt
$1,829
To record the change in fair value of debt for change in benchmark interest rates
(a)
Dr. Swap contract
$1,713
Cr. Interest expense
$1,713
To record the change in fair value of the swap
(b)
Dr. Interest expense
$10,000
Cr. Cash
$10,000
To record payment of interest on the debt ($100,000 @ 10%)
Note: No cash settlement on the swap to be recorded, as the fixed and floating legs were both 7% for 20x3
December 31, 20X4
Dr. Interest expense
$991
Cr. Debt
$991
To record the change in fair value of debt for change in benchmark interest rates
(c)
Dr. Swap contract
$960
Cr. Interest expense
$960
To record the change in fair value of the swap
(d)
Dr. Interest expense
$10,000
Cr. Cash
$10,000
To record payment of interest on the debt ($100,000 @ 10%)
Dr. Cash
$500
Cr. Interest expense
$500
To record the settlement on the swap (receive fixed $7,000, pay float $6,500)
December 31, 20X5
Dr. Interest expense
$65
Cr. Debt
$65
To record the change in fair value of debt for change in benchmark interest rates
(e)
Dr. Swap contract
$96
Cr. Interest expense
$96
To record the change in fair value of the swap
(f)
Dr. Interest expense
$10,000
Cr. Cash
$10,000
To record payment of interest on the debt ($100,000 @ 10%)
Dr. Cash
$1,000
Cr. Interest expense
$1,000
To record the settlement on the swap (receive fixed $7,000, pay float $6,000)
December 31, 20X6
Dr. Debt
$927
Cr. Interest expense
$927
To record the change in fair value of debt for change in benchmark interest rates
(g)
Dr. Interest expense
$865
Cr. Swap contract
$865
To record the change in fair value of the swap
(h)
Dr. Interest expense
$10,000
Cr. Cash
$10,000
To record payment of interest on the debt ($100,000 @ 10%)
Dr. Cash
$1,500
Cr. Interest expense
$1,500
To record the settlement on the swap (receive fixed $7,000, pay float $5,500)
December 31, 20X7
Dr. Debt
$1,958
Cr. Interest expense
$1,958
To record the change in fair value of debt for change in benchmark interest rates
(i)
Dr. Interest expense
$1,905
Cr. Swap contract
$1,905
To record the change in fair value of the swap
(j)
Dr. Interest expense
$10,000
Cr. Cash
$10,000
To record payment of interest on the debt ($100,000 @ 10%)
Dr. Cash
$2,000
Cr. Interest expense
$2,000
To record the settlement on the swap (receive fixed $7,000, pay float $5,000)

6.4.6.3 Partial-term hedging

A partial-term hedge is a hedge for a portion of the time to maturity of a fixed-rate asset or liability, for example, the first two years of a four-year bond. ASC 815-20-25-12(b)(2)(ii) provides for partial-term hedging.

ASC 815-20-25-12(b)(2)

If the hedged item is a specific portion of an asset or liability (or of a portfolio of similar assets or a portfolio of similar liabilities), the hedged item is one of the following:

  1. A percentage of the entire asset or liability (or of the entire portfolio). An entity shall not express the hedged item as multiple percentages of a recognized asset or liability and then retroactively determine the hedged item based on an independent matrix of those multiple percentages and the actual scenario that occurred during the period for which hedge effectiveness is being assessed.
  2. One or more selected contractual cash flows, including one or more individual interest payments during a selected portion of the term of the instrument (such as the portion of the asset or liability representing the present value of the interest payments in any consecutive two years of a four-year debt instrument). Paragraph 815-25-35-13B discusses the measurement of the change in fair value of the hedged item in partial-term hedges of interest rate risk using an assumed term.

ASC 815-25-35-13B provides measurement guidance for partial-term fair value hedging of interest rate risk.

ASC 815-25-35-13B

For a fair value hedge of interest rate risk in which the hedged item is designated as selected contractual cash flows in accordance with paragraph 815-20-25-12(b)(2)(ii), an entity may measure the change in the fair value of the hedged item attributable to interest rate risk using an assumed term that begins when the first hedged cash flow begins to accrue and ends when the last hedged cash flow is due and payable. The assumed issuance of the hedged item occurs on the date that the first hedged cash flow begins to accrue. The assumed maturity of the hedged item occurs on the date in which the last hedged cash flow is due and payable. An entity may measure the change in fair value of the hedged item attributable to interest rate risk in accordance with this paragraph when the entity is designating the hedged item in a hedge of both interest rate risk and foreign exchange risk. In that hedging relationship, the change in carrying value of the hedged item attributable to foreign exchange risk shall be measured on the basis of changes in the foreign currency spot rate in accordance with paragraph 815-25-35-18. Additionally, an entity may have one or more separately designed partial-term hedging relationships outstanding at the same time for the same debt instrument (for example. 2 outstanding hedging relationships for consecutive interest cash flows in Years 1-3 and consecutive interest cash flows in Years 5-7 of a 10 year debt instrument.

Under a partial-term hedging strategy, an interest rate swap with a term of two years may be designated as hedging the corresponding interest payments of a fixed-rate debt instrument with a longer term of, say, four years. Thus, the four-year debt instrument is economically (i.e., synthetically) converted into an instrument whose interest rate floats with the market for two years (i.e., the hedged period) and is fixed for the other two years.
Mechanically, partial-term hedging under the new guidance is achieved by assuming that the term of the hedged item is the same as the term of the hedging instrument. The reporting entity should assume that any payments made at the contractual maturity of the hedged item are made at the conclusion of the hedge term (i.e., at the end of the partial-term period). Without this assumption, the hedge would likely not be highly effective.
See DH 6.4.7.1 for discussion of amortization of basis adjustments in partial-term hedges.
Question DH 6-12 discusses whether an entity would be permitted to enter into a partial-term hedge involving a forward contract to acquire a fixed-rate bond.
Question DH 6-12
On 1/1/20X1, DH Corp enters into a forward contract to purchase a fixed-rate bond of a private company on 6/30/20X1. The bond matures in 10 years and is prepayable by the issuer after 7 years. Once acquired, the bond will be classified as an available-for-sale debt security by DH Corp. The forward contract is not deemed to be a derivative pursuant to ASC 815 (i.e., it does not meet the net settlement criteria) and it is measured at fair value with changes in fair value recognized in other comprehensive income in accordance with ASC 815-10-35-5.

Can DH Corp begin a fair value hedge on 1/1/20X1 of the non-callable period by designating a forward starting 7-year pay fixed receive-variable interest rate swap with a forward start date of 6/30/20X1 and apply the partial-term hedging guidance in ASC 815-25-35-13B?
PwC response
No. For partial-term hedges under ASC 815-25-35-13B, a reporting entity may enter into a fair value hedge of interest rate risk in which the hedged item is designated as the selected contractual cash flows, including one or more individual interest payments, in accordance with ASC 815-20-25-12(b)(2)(ii). On 1/1/20X1, DH Corp does not own the contractual rights to the bond’s series of individual cash flows, it is merely the counterparty to the forward contract. The forward contract has a single cash flow at settlement on 6/30/20X1 and does not have a series of contractual cash flows that includes one or more individual interest payments. DH Corp should not look through the forward contract to the fixed-rate bond’s contractual interest cash flows as the fixed-rate bond is not owned by DH Corp until the settlement of the forward contract. Therefore, on 1/1/20X1 the callable bond is not yet a recognized financial asset that is eligible to be a hedged item. DH Corp would have an instrument with one or more interest payments once the forward contract is settled and the fixed-rate bond is acquired on 6/30/20X1. At that point DH Corp could designate a hedge relationship using the partial-term hedge guidance under ASC 815-25-35-13B if all of the criteria to obtain hedge accounting are met. The forward starting swap will likely not have a fair value of zero on 6/30/20X1, which may impact an assessment of effectiveness.

Question DH 6-13 discusses whether an entity would be permitted to enter into a partial-term hedge involving a zero coupon bond.
Question DH 6-13

On 1/1/20X1, DH Corp purchases a zero-coupon bond upon issuance of the bond at a significant discount to its par amount. The zero-coupon bond will mature in five years on 12/31/20X5. Can DH Corp enter into a fair value hedge to hedge the effective interest rate accruals for the first two years of the zero-coupon bond with an interest rate swap maturing on 12/31/20X2 using the partial-term hedging guidance in ASC 815-20-25-12(b)(ii)?
PwC response
No. ASC 815-20-25-12(b)(2)(ii) states that for a partial-term fair value hedge, the hedged item must be designated as one or more selected contractual cash flows, including one or more individual interest payments during a selected portion of the term of a debt instrument. The zero-coupon bond has only a single contractual cash flow that will occur at maturity on 12/31/20X5. Therefore, there are no eligible contractual cash flows to be designated as the hedged item over the partial-term period from 1/1/20X1 through 12/31/20X3.

6.4.6.4 Measuring prepayment risk

In a fair value hedge of the benchmark interest rate risk in fixed-rate prepayable debt (that is not designated in a last-of-layer hedge), prepayment risk needs to be measured in one of two ways, considering:
  • only how fluctuations in the designated benchmark interest rate would affect the decision to settle the hedged item prior to its contractual maturity, or
  • all factors that would affect the decision to settle the hedged item prior to its contractual maturity.
When considering the effect of a prepayment option only as it relates to changes in the benchmark interest rate to assess hedge effectiveness and calculate the change in fair value of the hedged item, the reporting entity will only consider how the change in the benchmark interest rate, not other factors such as credit risk, will impact the decision to call or put the instrument. Limiting consideration of the prepayment option to only benchmark interest rate risk will likely make hedges of prepayable assets and liabilities more effective.
The decision to consider only how the benchmark interest rate impacts the decision to prepay is independent of the decision to measure the hedged item using the benchmark component of contractual cash flows. Reporting entities can use either the benchmark component or contractual coupon cash flows and still elect to evaluate the prepayment feature in this way.
Measuring prepayment risk in combination with the partial-term guidance
If the prepayment feature within the hedged item is outside the term of the hedging relationship, the measurement of the hedged item does not need to consider the prepayment risk. Figure DH 6-4 illustrates this point.
Figure DH 6-4
Considering optionality in measurement of hedged item
Hedging relationship 1
Hedging relationship 2
Hedged item
Bond A
Bond B
Stated maturity
9/30/2025
9/30/2025
Optionality
Callable starting 10/1/2024
Callable starting 10/1/2024
Designated hedged term end date
9/30/2024
9/30/2025
Hedged item measurement include optionality?
No
Yes
In Hedging relationship 2, the optionality is considered in measuring the hedged item because the hedge period extends past the option exercise date.

6.4.7 Amortizing basis adjustments

ASC 815-25-35-8 and ASC 815-25-35-9 provide guidance on amortizing basis adjustments in fair value hedges.

ASC 815-25-35-8

The adjustment of the carrying amount of a hedged asset or liability required by ASC 815-25-35-1(b) shall be accounted for in the same manner as other components of the carrying amount of that asset or liability. For example, an adjustment of the carrying amount of a hedged asset held for sale (such as inventory) would remain part of the carrying amount of that asset until the asset is sold, at which point the entire carrying amount of the hedged asset would be recognized as the cost of the item sold in determining earnings.

ASC 815-25-35-9

An adjustment of the carrying amount of a hedged interest-bearing financial instrument shall be amortized to earnings. Amortization shall begin no later than when the hedged item ceases to be adjusted for changes in its fair value attributable to the risk being hedged.

For an interest-bearing asset or liability, a reporting entity has two options in dealing with basis adjustments (1) defer the amortization of the hedged item’s basis adjustment or (2) immediately start amortizing any basis adjustment.
  • If amortization of the hedged item’s basis adjustment is deferred, a significant income statement impact may result in later periods, due to the approach of the hedged item’s maturity date, which would require the entity to “catch up” the basis of the hedged item to its par value over a shorter period.
  • In the case of a fair value hedge of interest rate risk that uses a swap contract, an entity would most likely want to start immediately amortizing any basis adjustments to offset the interest-accrual component of the changes in the swap’s fair value.
Reporting entities may defer amortization of a basis adjustment until the hedged interest-bearing asset or liability ceases to be adjusted for changes in fair value that are attributable to the risk that is being hedged. The policy election may simplify the accounting and record-keeping that an entity might otherwise have to undertake to track and properly account for basis adjustments.
Theoretically, amortization should start immediately. However, it might be complex and burdensome to amortize prior basis adjustments in the hedged item at the same time that the item’s basis continues to be adjusted for changes in value that are attributable to the hedged risk.
Depending on the methodology used to calculate the basis adjustment of the hedged item (discussed in DH 6.4.6.2), the choice that the reporting entity has made to begin amortization immediately may not be readily apparent without looking at the actual calculation of the basis adjustment. For example, if a reporting entity used the Example 11 method, the amortization that occurs is inherent in the basis adjustment calculation because it incorporates a “natural amortization.” The implicit “natural amortization” occurs because the difference between the beginning-of-the-period present value of the hedge item’s future cash flows and the end-of-the-period present value of the hedged item’s future cash flows, after adjustments for cash payments, is added to or subtracted from the carrying amount of the fixed rate debt. The “natural amortization” will result in the match of accounting and economics that the reporting entity wanted to obtain when it elected hedge accounting. The Example 11 method will result in a close offset between the changes in the fair value of the interest rate swap and the change in the carrying value of the hedged item because the calculation incorporates a benchmark interest rate-based factor for the “passage of time.”
In contrast, the reporting entity could choose to apply the Example 9 method. In that methodology, the difference between the two end-of-period present value cash flow streams will be added to or subtracted from the carrying amount of the fixed-rate debt. There is no passage of time captured or implicitly factored into the calculation, because both of the amounts are as of the end of the period. Therefore, no “natural amortization” will occur. If the reporting entity applies the Example 9 method, there will be a build-up in the debt’s basis adjustments that could result in gains or losses at maturity, and it would not get the full offset between changes in fair value of the swap and debt without separately amortizing the basis adjustments. To achieve the accounting offset between the hedging instrument and the hedged item, the reporting entity should begin amortization of the basis adjustment immediately through an appropriate amortization method. Using a market-based amortization method, the results of the “natural amortization” in the Example 11 method could be duplicated. Under the Example 9 method, the amortization of the basis adjustment would be more evident than under the Example 11 method, as the reporting entity would have to keep separate records and schedules to determine the amount of amortization each period.
When initially designating the hedging relationship and preparing the contemporaneous hedge documentation, a reporting entity must specify how hedge accounting adjustments will be subsequently recognized in income, and should elect a similar approach for similar hedges. This will prevent the entity from choosing to (1) defer amortization of basis adjustments that would result in a charge to current earnings and (2) currently amortize basis adjustments that result in an increase in earnings. We do not believe determining whether the effect of amortization is a debit or credit is an appropriate basis for distinguishing similar types of hedged items.
The recognition of basis adjustments will differ depending on how other adjustments of the hedged item’s carrying amount will be reported in earnings. For example, gains and losses on an interest-bearing debt instrument that are attributable to interest rate risk are amortized as a yield adjustment.
Further, if the hedged item is a portfolio of similar assets or liabilities, except a closed portfolio in a last-of-layer hedge, a reporting entity must allocate the hedge accounting adjustments to individual items in the portfolio. Information about such allocations is required, for example, when (1) the assets are sold or liabilities are settled, (2) the hedging relationship is discontinued, or (3) the hedged item is assessed for impairment. Last-of-layer hedges are addressed in DH 6.5.

6.4.7.1 Basis adjustments in partial-term hedges

If a reporting entity elects to amortize a basis adjustment in a partial-term hedge while the hedging relationship is in place, it would amortize the basis adjustment over the life of the hedge (that is, over the partial-term period). However, if the hedge is discontinued early, the remaining basis adjustment would be amortized in accordance with the guidance in ASC 310-20, Nonrefundable Fees and Other Costs. Thus, the amortization period may change upon termination.

6.4.7.2 Basis adjustments in fair value hedges of AFS debt securities

For fair value hedges of available-for-sale debt securities, ASC 815-25-35-6 requires that the basis adjustment be recognized in earnings, rather than through OCI, to offset the gain or loss on the hedging instrument. For example, if a reporting entity hedges only the risk of changes in fair value due to changes in the benchmark interest rate of a fixed-rate available-for-sale debt security, the guidance requires that (1) changes in the fair value that are due to benchmark interest rate risk be recorded in earnings while (2) changes in the fair value that are due to credit risk and other unhedged risks be recorded through OCI.

6.4.7.3 Purchased callable debt securities

ASC 310-20, Receivables — Nonrefundable Fees and Other Costs, indicates that premiums on callable debt securities purchased at a premium (i.e., a price in excess of par) should be amortized to the earliest call date (as opposed to through the maturity date). The Basis for Conclusions in ASU 2017-08, Premium Amortization on Purchased Callable Debt Securities, indicates that the guidance does not impact the amortization of basis adjustments from fair value hedges of interest rate risk. However, when the hedging relationship is discontinued and a hedge accounting basis adjustment remains, a reporting entity would follow the guidance in ASC 310-20.

6.4.7.4 Effect of basis adjustments on capitalization of interest

ASC 815-25-35-14 addresses how the rollout of a hedge’s effects should be treated for capitalization purposes. Amounts recorded in a reporting entity’s income statement as interest costs as a result of a fair value hedge of interest rate risk should be reflected in the capitalization rate under ASC 835-20, Capitalization of Interest, if a reporting entity elects to begin amortization of those adjustments during the period in which interest is eligible for capitalization.

6.4.7.5 Basis adjustments in last-of-layer hedges

See DH 6.5.3 for information on basis adjustments in last-of-layer hedges.

6.4.8 Impairment of hedged item

ASC 815-25-35-10 states that assets and liabilities that have been designated as hedged items in a fair value hedging relationship remain subject to the normal requirements for impairment assessment (or the assessment of the need to recognize an increase in an obligation) that are prescribed by other GAAP, for example:
  • Lower of cost or fair value under ASC 948-310-35-1, Accounting for Certain Mortgage Banking Activities
  • Impairment of loans under ASC 310-10-35-20, Accounting by Creditors for Impairment of a Loan
  • Impairment of securities under ASC 320-10-15-4, Accounting for Certain Investments in Debt and Equity Securities
  • Impairment of long-lived assets under ASC 360-10-35-20, Accounting for the Impairment or Disposal of Long-Lived Assets; and valuation of inventory under ASC 330-10-35-13, Inventory Pricing)
A reporting entity must apply the relevant impairment requirements after hedge accounting is applied for the period and the hedged item’s carrying amount has been adjusted to reflect changes in fair value that are attributable to the risk that is being hedged. Because the hedging instrument is recognized separately as an asset or a liability, its fair value or expected cash flows will not be considered in the application of the impairment assessments to the hedged asset or liability.
New guidance
ASU 2016-13, Financial Instruments—Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, is effective on January 1, 2020 for public business entities that are SEC filers with calendar year ends. It provides new impairment models for loans and AFS debt securities that will affect the guidance in this and the following sections. Preparers and other users of this guide should evaluate its impact on their application of hedge accounting.

6.4.8.1 Loan impairment

ASC 815-25-35-11 indicates that the measurement of impairment under ASC 310-10-35 is implicitly affected by hedge accounting by requiring the present value of expected future cash flows to be discounted by the new effective rate based on the adjusted recorded investment in a hedged loan, not the original effective rate.
ASC 310-10-35-31 requires that when the recorded investment of a loan has been adjusted under fair value hedge accounting, the effective rate is the discount rate that equates the present value of the loan’s future cash flows with that adjusted recorded investment. The adjustment under fair value hedge accounting of the loan’s carrying amount for changes in fair value attributable to the hedged risk should be considered to be an adjustment of the loan’s recorded investment. As discussed in ASC 310-10-35-31, the loan’s original effective interest rate becomes irrelevant once the recorded amount of the loan is adjusted for any changes in its fair value. Because ASC 815-25-35-10 requires that the loan’s carrying amount be adjusted for hedge accounting before the impairment requirements of ASC 310-10 are applied, the guidance implicitly supports using the new effective rate and the adjusted recorded investment.
The guidance in ASC 815-25-35-11 is applicable to all entities applying ASC 310-10 to financial assets that are hedged items in a fair value hedge regardless of whether those entities have delayed amortizing basis adjustments until the hedging relationship is dedesignated.
Question DH 6-14 discusses the impairment loss that should be recorded if the credit quality of a loan has deteriorated.
Question DH 6-14
On January 1, 20X1, DH Financial Institution hedges a 10-year, $50-million fixed-rate, nonprepayable loan receivable with an interest rate swap, perfectly matching the terms of the loan and qualifying for the shortcut method of accounting. On December 31, 20X3, the fair value of the swap is a loss of $800,000, and the carrying amount of the loan is $50.8 million (inclusive of the basis adjustment from the loss of $800,000 on the interest rate swap).

The borrower’s credit quality has deteriorated and the loan is considered impaired. In accordance with the requirements of ASC 310-10, DH Financial Institution computes the present value of expected future cash flows discounted at the loan’s new effective interest rate, considering the new carrying amount of the loan after being adjusted through hedge accounting (rather than at the loan’s original effective interest rate), as being $48 million.

What is the amount of the impairment loss that DH Financial Institution should record?
PwC response
DH Financial Institution should record an impairment loss of $2.8 million ($50.8 million carrying amount less the $48 million present value) on the loan through earnings as per ASC 310-10.
The fair value of the interest rate swap is not considered in the assessment of impairment for the loan.

6.4.8.2 Impairment of debt securities

A reporting entity that is holding investments may wish to reduce its exposure to changes in the fair value of its investments through a hedging transaction. Because of the special accounting rules under ASC 320 applicable to debt securities classified as available-for-sale and held to maturity, the application of hedge accounting is different from that for other investments.
Once hedge accounting has been applied, a reporting entity must perform an impairment assessment on the hedged item, including an assessment for other-than-temporary impairment. Therefore, if an other-than-temporary impairment exists on a hedged item, there may be cumulative amounts in other comprehensive income to be reclassified into the income statement that represented the portion of the change in the hedged item’s fair value attributable to risks not hedged.

6.4.9 Measuring the hedging instrument

When the hedging instrument is discounted by an Overnight Index Swap (OIS) rate (as discussed in FV 6.7.1), but the benchmark interest rate upon which the hedged item will be discounted is designated as LIBOR, US Treasury, or SIFMA, the difference in the discount rates will be a source of earnings volatility.
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