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7.2 Introduction to hedges of nonfinancial items
Publication date: 31 Jul 2022
us Derivatives & hedging guide
Reporting entities that are exposed to risks from nonfinancial items mitigate them with derivatives, such as futures, forwards, call and put options, and swaps.
Contracts that meet the definition of a derivative and do not qualify for or are not otherwise designated under a scope exception are accounted for at fair value. If a reporting entity executes derivatives to manage risk associated with managing inventory or purchases or sales of commodities, it may seek to apply hedge accounting to such derivatives to minimize volatility associated with recording changes in fair value in the income statement. Risks are managed using hedging instruments to transform potentially variable cash flows to fixed cash flows (cash flow hedges), and conversely, fixed cash flows to potentially variable cash flows (fair value hedges). For effective cash flow hedges, changes in the fair value of the derivative are initially recorded through other comprehensive income (OCI) and remain deferred in accumulated other comprehensive income (AOCI) until the underlying forecasted transaction impacts earnings or the forecasted transaction is deemed probable of not occurring.
This section discusses general considerations related to all hedges of nonfinancial items, including matters related to the eligibility of the risk to be hedged, hedged items and transactions, and hedging instruments. It is followed by discussion of specific considerations for fair value and cash flow hedges.
7.2.1 Eligibility of risk to be hedged
A reporting entity may apply hedge accounting only to the eligible risks defined by ASC 815. Eligible risks represent a change in fair values or cash flows that could affect reported earnings and are:
- Price risk
- Interest rate risk
- Foreign exchange risk
- Credit risk
ASC 815 focuses on these four risks because a change in the price associated with one of these risks will ordinarily have a direct effect on the fair value of an asset or liability in a determinable or predictable manner. The hedged risk must result in exposure to a change in fair values or cash flows that could affect reported earnings, which is a requirement for all hedge accounting relationships.
From a nonfinancial perspective, a reporting entity may seek to manage price risk associated with raw materials or finished products. That risk could be the total price risk or the risk of a component of the price. Reporting entities may also separately hedge foreign exchange risk in a cash flow hedge of a forecasted purchase or sale of a nonfinancial asset. Risks such as liquidity, theft, weather, catastrophe, competition, and seasonality do not qualify for hedge accounting under ASC 815.
Figure DH 7-1 provides examples of the types of risks associated with nonfinancial items that are eligible for hedge accounting, together with the related hedged items, and the type of hedge accounting that may be applied. Whether hedge accounting is permitted for each hedging relationship depends on the specific terms of the hedged item and the hedging instrument.
Figure DH 7-1
Types of risks associated with nonfinancial items
Types of risks associated with nonfinancial items
Risk |
Hedged item |
Type of hedge |
Changes in fair value while holding inventory for consumption or sale
|
Recognized asset
Firm commitment to acquire inventory
|
Fair value hedge (DH 7.4)
|
Risk associated with purchasing commodities with variable cash flows
|
Forecasted transaction (in its entirety)
Contractually specified component of a forecasted transaction |
Cash flow hedge (DH 7.3)
|
Foreign exchange risk - Risk associated with settling commodity purchases or sales in a currency other than the entity’s functional currency
|
Forecasted transaction denominated in a foreign currency
|
Foreign currency hedge (see DH 8)
|
A reporting entity may apply different strategies to hedge the risks associated with nonfinancial transactions. In some circumstances, it may be more effective to hedge only a portion or component of the risk exposure.
7.2.1.1 Hedging component price risk
ASC 815 permits reporting entities to hedge a “contractually specified component” (i.e., a component of total price risk) of the cash flows related to a forecasted nonfinancial transaction. For example, purchase and sale contracts for nonfinancial assets may be priced based on a traded commodity index plus or minus a basis differential. If the traded commodity index is eligible to be designated as a contractually specified component, a reporting entity would not be required to designate the total price risk (i.e., overall variability in cash flows) associated with the hedged item as its hedged risk. As illustrated in Figure DH 7-2, a hedge of only a component of the price may result in a more effective hedge because delivery location and other basis differences would not be considered in the effectiveness assessment.
Figure DH 7-2
Total price risk versus component risk in a hedge of a nonfinancial item
Total price risk versus component risk in a hedge of a nonfinancial item
Often, a reporting entity will not be able to obtain a hedging instrument that perfectly offsets the risk associated with a nonfinancial item that an entity is looking to mitigate (i.e., the total price risk related to hedged item). Hedging instruments that are used to mitigate risk exposures related to nonfinancial items are often standardized contracts that are traded on exchanges (e.g., futures contracts) and the quantities, quality or grade, and delivery location may not match the hedged item. As a result, use of this type of contract may not fully mitigate the underlying risk. Similarly, for bilateral contracts (e.g., over-the-counter forwards, swaps), counterparties may not wish to absorb some risk exposures related to certain basis differentials.
If a reporting entity designates the hedged risk as only a component of total price risk, changes in the value of the hedged item related to any basis differential are excluded from the hedging relationship, and thus, also excluded from the assessment of effectiveness. As a result, risk management strategies may qualify for hedge accounting – and may even be perfectly effective – even when a hedging instrument does not address the entire change in cash flows. See DH 7.3.3.
7.2.1.2 Hedging multiple risks
ASC 815 requires each designated risk to be accounted for separately. As such, simultaneous fair value and cash flow hedge accounting is not permitted for hedges of the same risk because there is only one earnings exposure. Once the change in the value of a hedged item that is attributable to a particular risk has been offset by the change in the value of a hedging derivative, another derivative cannot be an effective hedge of the same risk. However, if a reporting entity has only hedged a portion of a designated risk (e.g., it expects to procure 30,000 MMBtus of natural gas in October 20X1 at a specified location and has only hedged purchases of 20,000 MMBtus), it could use a second derivative to hedge the remaining exposure, if the forecasted transaction is probable and all other hedging requirements are met.
7.2.1.3 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 discusses the items that may be excluded, including components of the change in time value (theta, vega, and rho), as well as spot and forward or futures price differences.
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.
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. This election should be applied consistently to similar hedges in accordance with paragraph 815-20-25-81 and shall be disclosed in accordance with paragraph 815-10-50-4EEEE.
The initial value attributable to an excluded component (that may be amortized over the life of the hedging instrument) 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 difference between the market forward rate and the spot rate, undiscounted. The fair values of these 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.
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 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. We believe that 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.
Presentation of excluded components is discussed in FSP 19.4.
7.2.2 Eligibility of item or transaction to be hedged
To reduce exposure to changes in the fair value and cash flows associated with recognized balances and future transactions, reporting entities can hedge:
- an existing recognized asset or liability (fair value or cash flow hedge);
- a firm commitment (fair value hedge);
- a forecasted transaction resulting from a firm commitment (“all in one” cash flow hedge);
- a forecasted transaction in its entirety (cash flow hedge); or
- a contractually specified component of a forecasted transaction (cash flow hedge).
7.2.2.1 General eligibility criteria
The item or transaction to be hedged must present an earnings exposure and cannot be something that is already measured at fair value through earnings (or a forecasted acquisition of an asset or incurrence of a liability that subsequently will be similarly remeasured at fair value). Thus, items meeting the definition of a derivative are not permitted to be the hedged item in a hedging relationship. However, an instrument that meets the definition of a derivative under ASC 815 but qualifies for, and is designated under, the normal purchases and normal sales exception may be designated as a hedged item if the qualifying criteria are met. See Question DH 7-9 for further discussion.
Earnings exposure / Third party
In accordance with ASC 815, hedge accounting is appropriate only when there is a hedgeable risk arising from a transaction with an external party and that risk must represent an exposure that could affect earnings. This concept is consistent for all designated hedges under ASC 815, including fair value, cash flow, and foreign currency hedges, except that the hedged transaction does not need to be with an external party for certain forecasted foreign currency intercompany transactions.
7.2.2.2 Items or transactions that are not eligible for hedge accounting
ASC 815-20-25-15 and ASC 815-20-25-43 discuss certain items that are prohibited from being the hedged item in a fair value or cash flow hedge, including:
- An asset or liability measured at fair value with changes in fair value reported currently in earnings or a forecasted transaction to purchase such an asset or liability
- A firm commitment or forecasted transaction for a business combination
- A firm commitment or forecasted transaction involving either: (1) a parent entity’s interests in consolidated subsidiaries or (2) an entity’s own equity interests
- The risk of a transaction not occurring
Question DH 7-1
Can inventory carried at fair value be the hedged item in a fair value hedge?
Can inventory carried at fair value be the hedged item in a fair value hedge?
PwC response
No. ASC 815-20-25-43(c)(3) states that assets or liabilities remeasured through earnings cannot be designated as a hedged item or transaction.
ASC 815 does not require special accounting for these hedged items 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.
Question DH 7-2
Can a reporting entity designate a forecasted transaction of an equity method investee as the hedged item in a cash flow hedge?
For example, can DH Corp hedge the forecasted cash flows (e.g., the forecasted sales of gold) of its equity method investee by entering into a forward contract that would otherwise qualify for hedge accounting?
Can a reporting entity designate a forecasted transaction of an equity method investee as the hedged item in a cash flow hedge?
For example, can DH Corp hedge the forecasted cash flows (e.g., the forecasted sales of gold) of its equity method investee by entering into a forward contract that would otherwise qualify for hedge accounting?
PwC response
No. A forecasted transaction is not eligible for designation as a hedged transaction in a cash flow hedge when the transaction is between the reporting entity’s equity method investee and a third party.
Also, ASC 815-20-25-46A addresses the use of intra-entity derivatives as hedging instruments and states that the term “subsidiary” means consolidated subsidiary; therefore, the guidance cannot be applied to an equity method investee. As a result, a reporting entity is not allowed to apply hedge accounting to a forecasted transaction of an equity method investee since the reporting entity is not directly exposed to the risk. Similarly, a reporting entity would not be permitted to apply hedge accounting to a (1) recognized asset or liability or (2) firm commitment of an equity method investee.
Question DH 7-3
Can a reporting entity designate a forecasted transaction with an equity method investee as the hedged item in a cash flow hedge?
Can a reporting entity designate a forecasted transaction with an equity method investee as the hedged item in a cash flow hedge?
PwC response
Yes. A forecasted purchase or sale with an equity method investee can qualify as a hedgeable risk exposure under the cash flow hedging model if all of the other criteria for cash flow hedging are met.
Although ASC 815 states that forecasted transactions between members of a consolidated entity (except for intercompany transactions that are denominated in a foreign currency) are not hedgeable transactions, except in the standalone financial statements of a subsidiary, equity method investees are not members of the consolidated group so the prohibition is not applicable.
However, the hedge will need to be considered in the normal elimination entries in ASC 323-10-35 for preparing consolidated financial statements.
Question DH 7-4
Would the expected phase-out of a tax credit qualify as a hedged item in a cash flow hedge?
Would the expected phase-out of a tax credit qualify as a hedged item in a cash flow hedge?
PwC response
No. The expected phase-out of a tax credit would not fall within one of the cash flows included as a qualifying hedged item. A tax credit is not a specifically identified cash flow as it is only received through a reduction in the reporting entity’s overall tax liability and cannot be transferred or sold to a third party. Further, it does not meet any of the criteria in ASC 815-20-25-15(i) or 25-15(j) for the component items of a forecasted transaction that are eligible for designation in a hedging relationship.
Question DH 7-5
Would net assets of a discontinued operation that are presented as a single line item on the balance sheet qualify as a hedged item in a fair value hedge?
Would net assets of a discontinued operation that are presented as a single line item on the balance sheet qualify as a hedged item in a fair value hedge?
PwC response
No. Although the net assets of a discontinued operation are presented as one line item on the balance sheet, it represents a group of dissimilar assets and liabilities. Under ASC 815-20-25-12, only specific individual assets or liabilities, or groups of similar assets or liabilities, qualify as hedged items in fair value hedges. Exceptions to this rule are net investment hedges (DH 8.6) and portfolio layer method hedges (DH 6.5).
7.2.2.3 Dynamic hedging strategies
The guidance permits use of a dynamic hedging strategy, either (1) increasing or decreasing the quantity of hedging instruments necessary to achieve the objective of hedging a specific risk at a specific level or (2) changing the percentage of the hedged item that is designated. For example, a reporting entity may hedge the price risk on 80% of next year’s forecasted sales and later adjust the hedge strategy so that only 50% of next year’s forecasted sales are hedged. However, the reporting entity could never designate more than 100% of the forecasted transaction. The use of dynamic hedging strategies may require dedesignation and redesignation of hedging relationships that may create additional complexities.
7.2.3 Eligibility of instruments used to hedge
Generally, only a derivative as defined in ASC 815 can qualify as a hedging instrument; however, as discussed in DH 8, there are limited circumstances related to foreign currency hedging when a nonderivative instrument may be used. Forward or futures contracts are commonly used in hedges of nonfinancial assets and commodity purchases and sales. However, options, price caps, floors, and collars are also common products for hedging the risk of (1) price increases when forecasting purchases or (2) price decreases when holding inventory or forecasting sales.
ASC 815-20-25-71 specifically prohibits the use of certain items as the hedging instrument, including (1) a hybrid financial instrument that is measured at fair value and (2) the individual components of a compound derivative that are separated from the host contract.
7.2.3.1 Using proportions of derivatives / Multiple derivatives
ASC 815 allows an entire derivative or a proportion of a derivative, as well as multiple derivatives together (or proportions of them), to be designated as a hedging instrument. However, a derivative cannot be separated into different time periods or different components because those would have different risk profiles.
Excerpt from ASC 815-20-25-45
Either all or a proportion of a derivative instrument (including a compound embedded derivative that is accounted for separately) may be designated as a hedging instrument. Two or more derivative instruments, or proportions thereof, may also be viewed in combination and jointly designated as the hedging instrument. A proportion of a derivative instrument or derivative instruments designated as the hedging instrument shall be expressed as a percentage of the entire derivative instrument(s) so that the profile of risk exposures in the hedging portion of the derivative instrument(s) is the same as that in the entire derivative instrument(s).
Multiple derivatives, whether entered into at the same time or at different times, may be designated as a hedge of the same item. ASC 815-20-25-45 clarifies that two or more derivatives may be viewed in combination and be jointly designated as the hedging instrument. For example, a reporting entity can designate two purchased options as a hedge of the same hedged item even if the options are acquired at different times. However, an entity is not permitted to hedge the same portion of a hedged item for the same risk more than once as that would not be a hedging transaction (it would be “over hedging”).
ASC 815-20-25-45 requires that the proportion of the derivative being designated be expressed as a percentage of the derivative’s notional amount over the entire term (e.g., 40% of 20,000 MMBtus over the entire term of a one-year natural gas swap). In some instances, that percentage may not be explicitly documented. If (1) the designated proportion of the notional amount and (2) the total notional amount of the derivative hedging instrument are documented in such a way that the percentage can be calculated, then the hedge designation would meet the requirement. We believe that the term “expressed as a percentage” was meant to emphasize that the proportion of the derivative designated as the hedging instrument has the same profile of risk exposures as that of the entire derivative.
A reporting entity may also use proportions of a derivative in separate hedging relationships. For example, if 40% of the notional of a natural gas swap is used in one hedging relationship, all or a proportion of the remaining notional could be used in a separate hedging relationship. Each individual hedging relationship would have to be assessed separately to determine whether it meets the requirements for hedge accounting.
7.2.3.2 Separating a derivative into components
Separating a derivative into components representing different risks so that the components can be designated as a hedging instrument is not permitted. For example, if a reporting entity were to enter into a compound derivative for the purchase of natural gas and power, it would not be permitted to separate the natural gas component to solely hedge the natural gas price risk. This would not be a proportion of a total derivative.
Question DH 7-6
Can a reporting entity select only certain months of a one-year derivative with monthly settlements to hedge forecasted transactions of those specific months?
Can a reporting entity select only certain months of a one-year derivative with monthly settlements to hedge forecasted transactions of those specific months?
PwC response
No. ASC 815 precludes designating a portion of a derivative that represents different risks as a hedging instrument. ASC 815-20-25-45 requires a proportion of a derivative designated as a hedging instrument to match the risk profile of the entire derivative. For example, a company could designate 25% of the entire one-year derivative as a hedging instrument. It could not, however, designate the first three months of the derivatives payments as a hedging instrument.
As an alternative, the reporting entity could enter into separate contracts for different time periods during the year and designate the separate contracts as hedges.
7.2.3.3 Written options as hedging instruments
A written option requires the seller (writer) of the option to fulfill the obligation of the contract should the purchaser (holder) choose to exercise it. In return for providing that option to the holder, the writer receives a premium from the holder. For example, a written call option provides the purchaser of that option the right to call, or buy, a commodity, financial or equity instrument at a price during or at a time specified in the contract. The writer would be required to honor that call. As a result, written options provide the writer with the possibility of unlimited loss, but limit any gain to the amount of the premium received. In other words, written options can have the opposite effect of what a hedge is intended to accomplish. Thus, they are generally not permitted to be used as hedging instruments.
However, there are circumstances when a written option may be a more cost-effective strategy than using other instruments—for example, when used to hedge the call option feature in fixed-rate debt rather than issuing fixed-rate debt that is not callable. If a reporting entity wishes to use a written option as a hedging instrument, the instrument must pass the “written option test.” The test includes a requirement to ensure that, when considering the written option in combination with the hedged item, the “upside” potential (for gains or favorable cash flows) is equal to or greater than the “downside” potential (for losses or unfavorable cash flows), as described in ASC 815-20-25-94.
The written option test applies specifically to recognized assets, liabilities, or unrecognized firm commitments. As a result, we do not believe that a written option (or a net written option) can qualify as a hedging instrument in a hedge of a forecasted transaction.
If a written option is designated as hedging a recognized asset or liability or an unrecognized firm commitment (if a fair value hedge) or the variability in cash flows for a recognized asset or liability or an unrecognized firm commitment (if a cash flow hedge), the combination of the hedged item and the written option provides either of the following:
- At least as much potential for gains as a result of a favorable change in the fair value of the combined instruments (that is, the written option and the hedged item, such as an embedded purchased option)as exposure to losses from an unfavorable change in their combined fair value (if a fair value hedge).
- At least as much potential for favorable cash flows as exposure to unfavorable cash flows (if a cash flow hedge).
The combined position’s relative potential for gains and losses is only evaluated at hedge inception. It is based on the effect of a change in price, and the possibility for upside should be as great as the possibility for downside for all possible price changes.
Excluding time value from the written option test
ASC 815-20-25-96 allows a reporting entity to exclude the time value of a written option from the written option test, provided that the entity also specifies that it will base its assessment of effectiveness only on the changes in the option’s intrinsic value.
Covered calls
ASC 815-20-55-45 precludes hedge accounting for “covered call” strategies. In writing a covered call option, a reporting entity provides a counterparty with the option of purchasing an asset (that the entity owns) at a certain strike price. In some cases, the reporting entity may then purchase an option to buy the same underlying at a higher strike price. A reporting entity may enter into this type of structure to generate income by selling some, but not all, of the upside potential of the securities that it owns. Under such a strategy, the net written option does not qualify for hedge accounting because the potential gain is less than the potential loss.
Combination of options
Hedging strategies can include various combinations of instruments, for example, forward contracts with written options, swaps with written caps, or combinations of one or more written and purchased options. A derivative that results from combining a written option and a non-option derivative is considered a written option. Reporting entities considering using a combination of instruments that include a written option as a hedging derivative should evaluate whether they have, in effect, a net written option and therefore are required to meet and document the results of the written option test.
ASC 815-20-25-89 outlines certain requirements for a combination of options to qualify as a net purchased option or zero-cost collar, in which case the written option test is not required.
For a combination of options in which the strike price and the notional amount in both the written component and the purchased option component remain constant over the life of the respective component, that combination of options would be considered a net purchased option or a zero cost collar (that is, the combination shall not be considered a net written option subject to the requirements of 815-20-25-94) provided all of the following conditions are met:
- No net premium is received.
- The components of the combination of options are based on the same underlying.
- The components of the combination of options have the same maturity date.
- The notional amount of the written option component is not greater than the notional amount of the purchased option component.
ASC 815-20-25-89 applies only when the strike price and the notional amount in both the written and purchased option components of a combination of options remain constant over the life of the respective components. If either or both the strike price or notional amounts change, the assessment to determine whether the combination of options is a written option is evaluated with respect to each date that either the strike price or the notional amount changes.
If a combination of options fails to meet all of the criteria in ASC 815-20-25-89, it cannot be considered a net purchased option and is subject to the written option test. For example, if a collar includes a written floor based on the three-month Treasury rate and a purchased cap based on three-month LIBOR, the underlyings of the components are not the same, and therefore, the collar would be considered a net written option subject to the written option test.
A combination of options entered into contemporaneously is considered a written option if either at inception or over the life of the options a net premium is received in cash or as a favorable rate or other term. Further, a derivative that results from combining a written option and any other non-option derivative is a written option.
Under certain circumstances, a reporting entity that has combined two options might attempt to satisfy the requirement that the hedge provide as much potential for gains as it does for losses. However, the entity would not be permitted to apply hedge accounting to the combined position unless it were to satisfy this requirement for all possible price changes.
Redesignation of a combination of options
When redesignating a hedging relationship involving a zero-cost collar or a combination of options, a reporting entity needs to re-assess whether the combination of options is a net purchased option or a net written option. The new assessment is based on their current fair values. For example, assume a reporting entity has a collar that at its inception was not considered a net written option and was designated in a hedging relationship. The reporting entity later dedesignates the original hedging relationship and wants to designate the existing collar in a new hedging relationship. In this situation, if the existing collar is deemed a net written option on the date of redesignation, the reporting entity would need to perform the written option test at the inception of the new hedging relationship based on the economics of the collar on that date.
Question DH 7-7
If a noncancellable swap with no embedded options has an initial value of $100,000, would it be considered a written option?
If a noncancellable swap with no embedded options has an initial value of $100,000, would it be considered a written option?
PwC response
No. The $100,000 received at the initiation of the contract is not a premium received for a written option. The swap contract does not contain an option element. Rather, the initial value of $100,000 is an indication that the contract is off-market. The counterparty to the contract is paying for this initial value and expects to be repaid through future periodic settlements.
In essence, the swap contract contains a financing element. If it is more than insignificant, a reporting entity needs to consider ASC 815-10-45-11 through ASC 815-10-45-15. If the $100,000 financing element is significant enough to disqualify the entire swap contract from meeting the definition of a derivative, then the contract should be accounted as a debt host and evaluated for whether it contains an embedded derivative that should be bifurcated (see DH 4 for a discussion of embedded derivatives).
Example DH 7-1 illustrates application of the written option test in a cash flow hedge using a collar.
EXAMPLE DH 7-1
Using a three-way zero-cost collar as a hedging instrument
Using a three-way zero-cost collar as a hedging instrument
In January 20X1, DH Gas Company (DH Gas) hedges its November 20X3 forecasted natural gas sales at Henry Hub, expected to be 10,000 MMBtus per day, by entering into a zero-cost collar comprised of two contracts with the same counterparty:
- A collar with a written call option for $8.00/MMBtu and a purchased put option for $4.00/MMBtu for 10,000 MMBtus
- A written put option for $3.75/MMBtu for 10,000 MMBtus
Both contracts were for 10,000 MMBtus per day at Henry Hub in the month of November 20X3, and the combination of these contracts does not result in any premium paid or received by DH Gas.
Is the written option test in ASC 815-20-25-94 required to be performed to determine if the collar is eligible to be designated at the hedging instrument in a hedge of DH Gas’ forecasted November 20X3 gas sales?
Analysis
Yes. In this example, the combination of options does not meet all four requirements in ASC 815-20-25-89 for a combination of options to qualify as a net purchased option or zero-cost collar. It provides for a total notional on the written options of 20,000 MMBtus per day, compared with 10,000 MMBtus per day on the purchased option component. As such, the hedging instrument does not meet the criteria in ASC 815-20-25-89(d) that the notional amount of the written option component is not greater than the notional amount of the purchased option, and is subject to the written option test.
As a net written option, the collar would not qualify as a hedging instrument because it does not provide at least as much potential for favorable cash flows as exposure to unfavorable cash flows, per ASC 815-20-25-94(b).
7.2.3.4 Contracts with fixed and variable pricing
ASC 815-20-55-46 and ASC 815-20-55-47 indicate that a commodity contract that has index pricing with a fixed spread cannot be designated as a hedging instrument in the cash flow hedge of a forecasted transaction (e.g., a contract for the purchase of natural gas at the NYMEX Henry Hub spot price plus $1.00). The guidance indicates that the underlying in these types of contracts is related only to changes in the basis differential (i.e., the fixed spread). As a result, using such an instrument to hedge a forecasted transaction when the variability in cash flows is based both on the basis spread and the index price would result in only a portion of the variability in cash flows being offset.
Excerpt from ASC 815-20-55-47
The entity is not permitted to designate a cash flow hedging relationship as hedging only the change in cash flows attributable to changes in the basis differential. For an entity to be able to conclude that such a hedging relationship is expected to be highly effective in achieving offsetting cash flows, the entity would need to consider the likelihood of changes in the base commodity price as remote or insignificant to the variability in hedged cash flows (for the total purchase or sales price). However, the mixed-attribute contract may be combined with another derivative instrument whose underlying is the base commodity price, with the combination of those derivative instruments designated as the hedging instrument in a cash flow hedge of the overall variability of cash flows for the anticipated purchase or sale of the commodity.
Reporting entities wishing to hedge a forecasted transaction using a derivative that is priced at index plus a fixed spread should evaluate whether the hedge will be effective at inception and on an ongoing basis.
Basis swaps
Basis swaps are similar to contracts with variable pricing plus a fixed spread in that a basis swap represents the difference between two locations or underlyings, and therefore, is used to limit such differences (similar to a fixed spread, which is generally intended to compensate for location differences). Because a basis swap does not fix the price, it cannot be used as a hedging instrument on a standalone basis. ASC 815-20-25-50 permits a reporting entity to use a basis swap as a hedge of interest-bearing assets and liabilities if specified criteria are met; however, this paragraph specifically mentions “a financial asset or liability” and states that the hedge is 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, ASC 815-20-25-50 restricts hedge accounting to interest-bearing assets and liabilities when a basis swap is involved.
However, a basis swap can be used in combination with a forward or futures contract as a combined (jointly designated) hedging instrument to hedge a forecasted transaction. For example, a reporting entity may use this strategy if the forecasted transaction will occur at a location for which there is no standalone index (e.g., hedging a forecasted transaction at Houston Ship Channel with a NYMEX future priced based on Henry Hub). The futures contract would be used to fix the price of natural gas and the basis swap would be used to bridge the two indices (i.e., from the NYMEX future to the actual location of the forecasted transaction, in this case Houston Ship Channel).
Example DH 7-2 and Example DH 7-3 illustrate the use of basis swaps in combination with other hedging instruments.
EXAMPLE DH 7-2
Use of a natural gas futures contract and basis swap in combination to hedge a forecasted transaction
Use of a natural gas futures contract and basis swap in combination to hedge a forecasted transaction
DH Gas Company (DH Gas) has forecasted sales of 10,000 MMBtus of natural gas per day in the month of April 20X1 at Houston Ship Channel. It decides to hedge the forecasted transactions.
On January 1, 20X1, DH Gas enters into a NYMEX futures contract priced based on Henry Hub for 10,000 MMBtus of natural gas per day for April 20X1. Subsequently, on February 15, 20X1, it enters into a receive Houston Ship Channel, pay Henry Hub basis swap for 10,000 MMBtus of natural gas per day in April 20X1. The total notional amount is 300,000 MMBtus.
Can DH Gas designate the futures contract as a cash flow hedge on January 1, 20X1?
Analysis
Yes. Assuming that all of the hedge criteria have been met, including the assessment that using the NYMEX futures contract will result in a highly effective hedge, DH Gas can designate the futures contract as a cash flow hedge of the total cash flows in the sale of natural gas expected to occur in April 20X1. This hedging relationship would not be perfectly effective due to the Henry Hub-Houston Ship Channel basis difference. As long as the hedge is highly effective, any mismatch would not be recorded in current earnings.
When DH Gas enters into the basis swap on February 15, 20X1, the original hedge would need to be dedesignated and redesignated if DH Gas wants the basis swap to be designated (jointly designated with the futures contract) as a hedge for accounting purposes. The basis swap cannot be designated by itself as the hedging instrument (because it does not fix the cash flows) and also cannot be added to the existing hedging relationship (without dedesignation and redesignation). Further, because the NYMEX futures contract will have a fair value on February 15, 20X1 other than zero, DH Gas would need to consider the impact of the fair value at the inception of the hedging relationship on hedge effectiveness.
In implementing this strategy, DH Gas may alternatively elect to retain the original hedging relationship and allow the basis swap to be recorded directly to earnings (rather than designating it in a hedge).
EXAMPLE DH 7-3
Use of combination hedging instruments to hedge forecasted purchases of natural gas by a manufacturer
Use of combination hedging instruments to hedge forecasted purchases of natural gas by a manufacturer
DH Steel Corp, a steel manufacturer, would like to hedge its natural gas cost expected to be incurred in October 20X1. DH Steel purchases natural gas at the first-of-month SoCal Border index price. Historical records show that DH Steel uses at least 50,000 MMBtus during October to support its operations.
On January 1, 20X1, DH Steel enters into a commodity forward contract for 50,000 MMBtus of natural gas to hedge the forecasted purchase of natural gas. It concludes that the forecasted transaction is probable based on its historical and forecasted purchases. Under the terms of the forward, it will pay $7.50/MMBtu and receive the Henry Hub spot price. There will be no physical deliveries under this forward contract, but rather a net cash settlement of the fixed and variable prices. Because the actual purchase of natural gas will be at SoCal Border, and not Henry Hub, DH Steel also enters into a basis forward contract between Henry Hub and SoCal Border to fix the forward price at SoCal Border during October 20X1. The basis spread at the time of execution was $0.50/MMBtu (i.e., DH Steel pays Henry Hub + $0.50 and receives SoCal on the basis forward contract).
On January 1, 20X1, DH Steel jointly designates the commodity forward and the basis forward in combination as a cash flow hedge of the variability of total cash flows associated with its first 50,000 MMBTUs of natural gas purchased in October 20X1 at the SoCal Border first of month index price.
DH Corp assumes the hedge is perfectly effective using the critical terms match method in ASC 815-20-25-84 as follows:
- The combination commodity forward and basis forward is for the same notional (50,000 MMBtus), same commodity (natural gas), same time (October 1, 20X1) and location (the basis swap effectively converts the pricing from Henry Hub location to SoCal Border, which is the location where the actual purchases will occur).
- The fair value of the commodity and basis forward contracts are zero at inception.
- The change in the expected cash flows of the forecasted transaction is based on the first-of-month forward price for the natural gas at the SoCal Border.
The spot and forward market prices for natural gas are as follows:
Date |
Henry Hub spot price |
SoCal spot price |
Henry Hub forward price— October |
SoCal forward price—October |
Difference in forward price |
January 1, 20X1 |
$7.50 |
$8.00 |
$0.50 |
||
March 31, 20X1 |
7.75 |
8.40 |
$0.65 |
||
June 30, 20X1 |
7.90 |
8.45 |
$0.55 |
||
September 30, 20X1 |
8.10 |
8.80 |
$0.70 |
||
October 1, 20X1 |
$8.10 |
$8.80 |
N/A |
N/A |
N/A |
The fair values of the commodity swap and basis forward contracts are as follows:
Date |
Fair value of commodity forward* |
Change in fair value of commodity forward* |
Fair value of forward on SoCal basis* |
Change in fair value of forward on SoCal basis* |
January 1, 20X1 |
- |
- |
||
March 31, 20X1 |
$12,138 |
$12,138 |
$7,283 |
$7,283 |
June 30, 20X1 |
19,705 |
7,567 |
2,463 |
(4,820) |
September 30, 20X1 |
29,995 |
10,290 |
9,998 |
7,535 |
October 1, 20X1 |
30,000 |
5 |
10,000 |
2 |
* Amounts are discounted at 6% per year. |
How should DH Corp account for the hedging relationship?
Analysis
As a highly effective cash flow hedge, the gain or loss on the derivative hedging instruments is recorded through OCI and reclassified from AOCI to earnings when the actual 50,000 MMBtus of natural gas purchased is expensed through cost of goods sold.
DH Steel Corp would make the following journal entries during the hedging relationship. No entry would be made at inception to record the fair values of the commodity or basis forward contracts because they were at-market at inception (i.e. they had a fair value of zero at inception).
March 31, 20X1 |
||
Dr. Commodity forward |
$12,138 |
|
Cr. Other comprehensive income |
$12,138 |
|
To record the change in fair value of the commodity forward |
||
Dr. Forward on SoCal basis |
$7,283 |
|
Cr. Other comprehensive income |
$7,283 |
|
To record the change in fair value of the forward on basis |
||
June 30, 20X1 |
||
Dr. Commodity forward |
$7,567 |
|
Cr. Other comprehensive income |
$7,567 |
|
To record the change in fair value of the commodity forward |
||
Dr. Other comprehensive income |
$4,820 |
|
Cr. Forward on SoCal basis |
$4,820 |
|
To record the change in fair value of the forward on basis |
||
September 30, 20X1 |
||
Dr. Commodity forward |
$10,290 |
|
Cr. Other comprehensive income |
$10,290 |
|
To record the change in fair value of the commodity forward |
||
Dr. Forward on SoCal basis |
$7,535 |
|
Cr. Other comprehensive income |
$7,535 |
|
To record the change in fair value of the forward on basis |
||
October 1, 20X1 |
||
Dr. Cash |
$40,000 |
|
Cr. Forward on SoCal basis |
$9,998 |
|
Cr. Commodity forward |
$29,995 |
|
Cr. Other comprehensive income |
$7 |
|
To record the change in fair value and settlement of the commodity and basis forwards (settlement period ignored for simplicity) |
||
October 31, 20X1 |
||
Dr. Natural gas expense |
$440,000 |
|
Cr. Accounts payable |
$440,000 |
|
To record the purchase and usage of the first 50,000 MMBtus of natural gas (50,000 MMBtus × SoCal Border spot price at first of month October 1, 20X1 price of $8.80/MMBtu) |
||
Dr. Accumulated other comprehensive income |
$40,000 |
|
Cr. Natural gas expense |
$40,000 |
|
To reclassify the gain on the swaps in AOCI to earnings |
||
Through the hedge, DH locks in the purchase price at $8.00, which is the SoCal forward price on January 1, 20X1 and the Henry Hub forward price plus the initial basis spread.
As an alternative, DH Steel may not need the basis swap if the purchase of natural gas and the derivative were based on the same or a highly correlated index.
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