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A reporting entity may designate a derivative as a hedge of the exposure to the variability in expected future cash flows that is attributable to a particular risk, such as a change in price (a cash flow hedge). This exposure may be associated with an existing recognized asset or liability (such as forecasted sales of inventory) or a forecasted transaction (such as forecasted purchases or sales of a commodity).
The primary purpose of a cash flow hedge is to link together the income statement recognition of the hedging instrument and a hedged transaction whose changes in cash flows are expected to offset each other. For a reporting entity to achieve this offsetting or “matching” of cash flows, the change in the fair value of the derivative instrument included in the assessment of effectiveness is (1) initially reported as a component of other comprehensive income and (2) later reclassified into earnings in the same period or periods during which the hedged transaction affects earnings (e.g., when a forecasted sale occurs).
A common example of a cash flow hedge of a nonfinancial item is the hedge of a forecasted sale or purchase of a commodity, such as natural gas, with forward, future or option contracts.

7.3.1 Types of risks eligible for cash flow hedging

A cash flow hedge of a recognized asset or liability or a forecasted transaction must meet the general hedge criteria, as discussed in DH 7.2. In addition, in a cash flow hedge of the forecasted purchase or sale of a nonfinancial asset, ASC 815-20-25-15(i) limits the risks that may be hedged.

Excerpt from ASC 815-20-25-15(i)

If the hedged transaction is the forecasted purchase or sale of a nonfinancial asset, the designated risk being hedged is any of the following:
  1. The risk of changes in the functional-currency-equivalent cash flows attributable to changes in the related foreign currency exchange rates
  2. The risk of changes in the cash flows relating to all changes in the purchase price or sales price of the asset reflecting its actual location if a physical asset (regardless of whether that price and the related cash flows are stated in the entity’s functional currency or a foreign currency), not the risk of changes in cash flows relating to the purchase or sale of a similar asset in a different location
  3. The risk of variability in cash flows attributable to changes in a contractually specified component.

See further discussion of additional criteria related to hedges of contractually specified components in DH 7.3.3. See also a discussion of foreign currency hedges in DH 8.

7.3.2 Eligible hedged items in a cash flow hedge of a nonfinancial item

Hedge accounting may be applied to cash flow hedging relationships when the relevant general qualifying criteria discussed in DH 7.2 and the criteria specific to cash flows hedges in ASC 815-20-25-13 and ASC 815-20-25-15 are met.

Excerpt from ASC 815-20-25-13

An entity may designate a derivative instrument as hedging the exposure to variability in expected future cash flows that is attributable to a particular risk. That exposure may be associated with either of the following:
  1. An existing recognized asset or liability (such as all or certain future interest payments on variable-rate debt)
  2. A forecasted transaction (such as a forecasted purchase or sale).

Cash flow hedges are frequently used to hedge the forecasted purchase or sale of a commodity, such as natural gas, coal, power, or fuel oil. A cash flow hedge can also be used to hedge (1) the future purchase of physical inventory (to protect against the risk of changes in the price of the inventory prior to the forecasted purchase) or (2) the future sale of physical inventory (to protect against the risk of changes in the sales price prior to the forecasted sale).
ASC 815-20-25-20 defines a forecasted transaction.

Definition from ASC 815-20-20

Forecasted Transaction: A transaction that is expected to occur for which there is no firm commitment. Because no transaction or event has yet occurred and the transaction or event when it occurs will be at the prevailing market price, a forecasted transaction does not give an entity any present rights to future benefits or a present obligation for future sacrifices.

In addition to needing to meet the basic criteria for hedge accounting, ASC 815-20-25-15 outlines the additional criteria for a forecasted transaction to qualify as the hedged transaction in a cash flow hedge. The key requirements include the following:
  • The transaction is specifically identified as either a single transaction or group of transactions.
  • The transaction is probable of occurring.
  • The transaction represents an exposure to variable cash flows that impacts earnings and is with a third party.
  • The transaction is not the acquisition of an asset or incurrence of a liability that will subsequently be measured at fair value, such as a derivative (i.e., a reporting entity cannot hedge a derivative with a derivative).
  • If the hedged item is a nonfinancial transaction (e.g., a purchase or sale with physical delivery), the risk being hedged should be for all of the cash flows relating to the forecasted purchase or sale (i.e., the variability in all cash flows, including transportation to the item’s location should be hedged), or for a contractually specified component.
See DH 7.3.3 for further discussion of cash flow hedges involving a contractually specified component of a forecasted transaction. Each of the other requirements is further discussed in this section.

7.3.2.1 The forecasted transaction is specifically identified

When hedging a forecasted transaction, reporting entities have flexibility to hedge individual transactions or groups of individual transactions that share similar risks.

ASC 815-20-25-15(a)

The forecasted transaction is specifically identified as either of the following:
  1. A single transaction
  2. A group of individual transactions that share the same risk exposure for which they are designated as being hedged. A forecasted purchase and a forecasted sale shall not both be included in the same group of individual transactions that constitute the hedged transaction.

In either case, the cash flow hedge documentation should identify the forecasted transaction with sufficient specificity. The documentation requirement is further detailed in ASC 815-20-25-3(d)(1)(vi).

ASC 815-20-25-3(d)(1)(vi)

The hedged forecasted transaction shall be described with sufficient specificity so that when a transaction occurs, it is clear whether that transaction is or is not the hedged transaction. Thus, a forecasted transaction could be identified as the sale of either the first 15,000 units of a specific product sold during a specified 3-month period or the first 5,000 units sold in each of 3 specific months, but it could not be identified as the sale of the last 15,000 units of that product sold during a 3-month period (because the last 15,000 units cannot be identified when they occur, but only when the period has ended).

When preparing hedge documentation, a reporting entity should ensure that there is sufficient specificity so that it is clear what forecasted transaction is being hedged so that when it occurs, it is clear whether or not it is hedged. The designation and documentation of the hedged transaction depends on the nature of the forecasted transaction and, absent an all-in-one hedge of a firm commitment (see DH 7.3.4), linkage back to a specific vendor, customer, or contract is not required. For example, if a reporting entity is selling a commodity into the open market, it should document details about the quantity, location, and timing of the forecasted sales, but it would not typically need to designate a specific contract or counterparty.
Reporting entities should consider how they describe the forecasted transaction in their documentation because it may impact the accounting upon discontinuance of the hedge. For example, if the documentation of a hedged transaction identifies forecasted sales to a specific counterparty, a subsequent conclusion that sales to that counterparty are probable of not occurring would lead to discontinuance of the hedging relationship and immediate release of amounts in AOCI. In contrast, if the designation is more general, changes in the customer mix alone would not affect the hedging designation, but it may impact the assessment of effectiveness.
Hedging a group of forecasted transactions
Provided that the forecasted transactions are identified with sufficient specificity, a reporting entity may hedge a group of forecasted transactions.

Excerpt from ASC 815-20-55-22

A single derivative instrument of appropriate size could be designated as hedging a given amount of aggregated forecasted transactions, such as any of the following:
  1. Forecasted sales of a particular product to numerous customers within a specified time period, such as a month, a quarter, or a year
  2. Forecasted purchases of a particular product from the same or different vendors at different dates within a specified time period

If the hedged transaction is a group of individual transactions, as contemplated in ASC 815-20-55-22, ASC 815-20-25-15(a)(2) requires that those individual hedged items or transactions share the “same risk exposure” for which they are designated as being hedged (e.g., risk of changes in cash flows due to changes in a commodity index). Thus, if a particular forecasted transaction does not share the risk exposure that is germane to the group of transactions being hedged, that transaction cannot be part of the group that is being hedged. As a result, the guidance precludes a forecasted purchase and a forecasted sale from being grouped together since the risk exposures are different.
Moreover, a group of commodity sales at the same delivery location could be considered to have a similar risk if all other features of the contract are aligned. However, if the commodity sales are at different locations or for different grades or types of the commodity, the variability of cash flows relating to those different locations or grades would need to be sufficiently correlated to support that the sales share the same risk exposure. In general, we would not expect a group including more than one commodity or different pricing structures (e.g., monthly, daily) to qualify for designation as the hedged item because the forecasted transactions would not qualify under the similar asset test. For example, it may be difficult to group physical transactions at the SoCal Border (a market hub for natural gas located in California) and Houston Ship Channel (a market hub for natural gas located in Houston, Texas).
For fair value hedges, ASC 815-20-25-12(b)(1) also requires that the individual hedged items in a hedged group share the same risk exposure for which they are as being hedged. In addition, ASC 815-20-55-14 provides guidance for the quantitative evaluation of whether a portfolio of assets or liabilities share the same risk exposure in a fair value hedge. This quantitative test, known as the “similar assets/liabilities test,” is specific to fair value hedges. ASC 815-20-25-15 does not specifically require reporting entities to perform this test for cash flow hedges of groups of individual transactions. However, we believe that in most circumstances, a quantitative test is needed for cash flow hedges when the hedged item is a portfolio of forecasted transactions that are similar but not identical.
In certain limited circumstances when the terms of the individual hedged items in the portfolio are aligned, a qualitative similar assets test may be appropriate. The determination of whether a quantitative or qualitative analysis is sufficient is judgmental and will depend on the nature of the commodity being hedged.
When facts and circumstances regarding the portfolio change, we expect reporting entities to reconsider their similar assets test. When changes are significant such that the original conclusion is no longer valid without additional support, we would expect a new comprehensive analysis to be performed at that time.
Example DH 7-4 illustrates the evaluation when a group of individual transactions is designated as a single hedged item.
EXAMPLE DH 7-4
Similar assets test — group of forecasted sales of natural gas
DH Gas Company sells natural gas at five locations in Texas. To mitigate cash flow volatility associated with fluctuating natural gas prices, DH Gas decides to hedge its forecasted sales. However, because it manages all of its sales in Texas as one portfolio, instead of designating a hedging relationship for each separate location, DH Gas designates all of its forecasted sales within one hedging relationship. The group of forecasted sales is hedged with NYMEX pay floating, receive fixed swaps based on the monthly Henry Hub index price. For purposes of this example, assume all physical sales are also based on a monthly index price.
Does DH Gas need to perform a similar assets test?
Analysis
To hedge the forecasted sales at all locations as a group (rather than individual transactions or locations), DH Gas performs a quantitative similar assets test at inception to demonstrate that the sales at all five of the locations have similar risks. In general, it may be difficult to pass the similar assets test when locations are geographically disbursed or when prices at some locations are impacted by congestion or other factors that would not impact all locations equally.
When facts and circumstances regarding the portfolio change, DH Gas would need to reconsider its similar assets test to confirm that the five locations continue to share similar risks. If at any point in the hedging relationship, one or more of the five locations fails the similar assets test, the entire hedging relationship should be dedesignated. However, DH Gas may be able to enter into a new hedging relationship with the remaining locations that continue to qualify under the similar assets test.
Another challenge in grouping transactions for hedge accounting is in establishing the perfect hypothetical derivative for purposes of assessing effectiveness. The reporting entity will need to make an initial assessment of the mix of transactions (e.g., 50% Houston Ship Channel, 50% Henry Hub) and would use that hypothetical derivative in its testing. The perfect hypothetical derivative would need to be updated if the forecast changes, which may reduce the effectiveness of the hedge in a particular period. In addition, if a reporting entity is unable to accurately forecast the mix of sales, it may not be able to apply a group method.

7.3.2.2 The forecasted transaction is probable of occurring

A key requirement to qualify to hedge a forecasted transaction is that the transaction is probable of occurring.

Excerpt from ASC 815-20-55-24

An assessment of the likelihood that a forecasted transaction will take place (see paragraph 815-20-25-15(b)) should not be based solely on management’s intent because intent is not verifiable. The transaction’s probability should be supported by observable facts and the attendant circumstances. Consideration should be given to all of the following circumstances in assessing the likelihood that a transaction will occur.

  1. The frequency of similar past transactions
  2. The financial and operational ability of the entity to carry out the transaction
  3. Substantial commitments of resources to a particular activity (for example, a manufacturing facility that can be used in the short run only to process a particular type of commodity)
  4. The extent of loss or disruption of operations that could result if the transaction does not occur
  5. The likelihood that transactions with substantially different characteristics might be used to achieve the same business purposes (for example, an entity that intends to raise cash may have several ways of doing so, ranging from a short-term bank loan to a common stock offering.

Further, as discussed in ASC 815-20-55-25, both (1) the length of time that is expected to pass before a forecasted transaction is projected to occur and (2) the quantity of products or services that are involved in the forecasted transaction are considerations in determining probability.

ASC 815-20-55-25

Both the length of time until a forecasted transaction is projected to occur and the quantity of the forecasted transaction are considerations in determining probability. Other factors being equal, the more distant a forecasted transaction is or the greater the physical quantity or future value of a forecasted transaction, the less likely it is that the transaction would be considered probable and the stronger the evidence that would be required to support an assertion that it is probable.

Therefore, a reporting entity should consider whether the volume of planned sales or purchases for the particular commodity, location, and timing for the forecasted transaction support a probable assertion. In making the probable assessment, the reporting entity should consider the volume of forecasted transactions (sales) and/or needs (purchases) compared to the designated hedge volume. Absent a contractual volume commitment, it may be challenging for a reporting entity to assert that a forecasted sale constituting a high percentage of its sales is probable due to potential volatility in market demand. Similarly, if a reporting entity is purchasing a specific commodity for use in production and wants to hedge its supply, it may be difficult to support designating a high percentage of its forecasted purchases if its sales are highly dependent on market conditions.
Assessing the probability that a forecasted transaction will occur requires judgment. “Probable” in the context of hedge accounting is used in the same manner as in ASC 450. Specifically, the term probable means that “the future event or events are likely to occur." Thus, although ASC 815 and ASC 450 do not establish bright lines, a probable likelihood of occurrence should be a significantly greater threshold than the 50% threshold associated with “more likely than not.” In addition, there should be compelling evidence to support management’s assertion that a forecasted transaction is probable.
In addition to the impact on initially qualifying for hedge accounting, a change in the probability of the forecasted transaction may impact whether discontinuance of the hedge is required and whether reclassification of amounts deferred in AOCI is required. See DH 10.4.8.1 for further information.
Documentation
In its formal hedge documentation, management should specify the circumstances that were considered in concluding that a transaction is probable. If a reporting entity has a pattern of determining that forecasted transactions are no longer probable of occurring, the appropriateness of management’s previous assertions and its ability to make future assertions regarding forecasted transactions may be called into question.
Counterparty creditworthiness
In addition to requiring entities to continually assess the likelihood of the counterparty’s compliance with the terms of the hedging derivative, they are required to perform an assessment of their own creditworthiness and that of the counterparty (if any) to the hedged forecasted transaction to determine whether the forecasted transaction is probable. See ASC 815-20-25-16(a).
This assessment should be performed at least quarterly at the time of hedge effectiveness testing. If the probability of the forecasted transaction changes as a result of a change in counterparty creditworthiness, the reporting entity would need to evaluate whether it continues to qualify for hedge accounting.
Timing of the forecasted transaction
When designating a forecasted transaction in a cash flow hedge, there may be a specific date on which the transaction is expected to occur (e.g., there is a contractual commitment for delivery on December 15, 20X1). However, in many cases, delivery will be expected during a defined period rather than on a specific date. For example, deliveries of a commodity may be expected to occur during the third quarter, but there may be uncertainty regarding the delivery month. ASC 815-20-25-16 provides guidance on the timing and probability of a forecasted transaction and uncertainty within a range.

Excerpt from ASC 815-20-25-16(c)

Uncertainty of timing within a range. For forecasted transactions whose timing involves some uncertainty within a range, that range could be documented as the originally specified time period if the hedged forecasted transaction is described with sufficient specificity so that when a transaction occurs, it is clear whether that transaction is or is not the hedged transaction. As long as it remains probable that a forecasted transaction will occur by the end of the originally specified time period, cash flow hedge accounting for that hedging relationship would continue.

Therefore, although uncertainty within a time period does not preclude hedge accounting (as long as the forecasted transaction is identified with sufficient specificity), the reporting entity should continue to monitor whether there are changes in the timing of the forecasted transaction. If there is a change in the timing of the forecasted transaction such that the forecasted transaction is no longer probable of occurring as originally documented, in general, the hedge should be discontinued. However, ASC 815-30-40-4 provides guidance when it is still reasonably possible that the transaction will occur within two months of the original timing.

Excerpt from ASC 815-30-40-4

The net derivative instrument gain or loss related to a discontinued cash flow hedge shall continue to be reported in accumulated other comprehensive income unless it is probable that the forecasted transaction will not occur by the end of the originally specified time period (as documented at the inception of the hedging relationship) or within an additional two-month period of time thereafter.

If it is determined that the forecasted transaction has become probable of not occurring within the documented time period plus a subsequent two-month period, then the hedging relationship should be discontinued and amounts previously deferred in AOCI should be immediately reclassified to earnings. The subsequent two-month period discussed in ASC 815-30-40-4 is relevant only in assessing when amounts should be reclassified to earnings from AOCI; it is not considered when determining if a hedge should be discontinued. A hedge should be discontinued if it is no longer probable the hedged forecasted transaction will occur by the end of the originally specified time period. See DH 10.4 for further information on discontinuance of cash flow hedges.
Question DH 7-8
If a reporting entity is uncertain about the timing of a forecasted transaction, can it use a range of time in designating its forecasted transaction?
PwC response
Yes, if the range is defined appropriately. As described in ASC 815-20-25-3, the hedged forecasted transaction needs to be documented with sufficient specificity so that it is clear what is being hedged. If only a general timeframe for occurrence of the forecasted transaction is documented, it may not be clear when the hedged transaction occurs. For example, if a reporting entity expects to sell at least 300,000 units of a particular product in its next fiscal quarter, it might designate the sales of the first 300,000 units during that quarter as the hedged transaction. Alternatively, it might designate the first 100,000 sales in each month of that quarter as the hedged transaction. By designating the hedged transaction as the first number of units sold during the specified period, a reporting entity is not “locked in” to a specific date, and if the transaction does not occur on that specific date, the reporting entity’s hedge will not be affected (as long as it occurs within the documented range).
It would be insufficient to identify the hedged item in this scenario as any sales of 300,000 units during the quarter or the last 300,000 sales of the quarter. By designating the hedge in either of these ways, a reporting entity would be able to select which transactions are the hedged transactions after the fact, which is inconsistent with the requirements in ASC 815-20-25-3(d)(1)(vi).
Question DH 7-9
Can a contract designated under the normal purchases and normal sales scope exception qualify as the hedged item (forecasted transaction) in a cash flow hedge?
PwC response
It depends. A derivative cannot be a hedged item, but once the normal purchases and normal sales scope exception (discussed in DH 3.2.4) is elected, the contract is no longer within the scope of ASC 815. ASC 815-20-25-7 through ASC 815-20-25-9 provides guidance on the designation of a normal purchase or normal sale contract as a hedged item. The contract can be designated as the hedged item in a fair value hedge if it meets the definition of a firm commitment, otherwise it could be the hedged transaction in a cash flow hedge.
Whether the contract is a firm commitment will depend on whether the contract contains a fixed price and a disincentive for nonperformance that is sufficiently large such that performance under the contract is probable (which is the definition of firm commitment from ASC 815-20-20). However, if the contract pricing is based on an index or other variable pricing, the reporting entity continues to have an earnings exposure and would be able to designate the contract as a forecasted transaction in a cash flow hedge, provided all the other criteria for cash flow hedging are met.

7.3.3 Contractually specified component

In addition to hedging the total cash flows associated with a forecasted transaction, ASC 815 also permits a reporting entity to hedge a contractually specified component of a forecasted transaction. As a result, a reporting entity may be able to designate certain hedging relationships that would not be effective if a reporting entity were required to hedge the entire change in cash flows of the hedged item. This may result in a more effective hedge, depending on the component identified and the terms of the related hedging instrument. In these situations, when determining how effective a hedging relationship is, a reporting entity would be able to compare the changes in the value (or cash flows) of the derivative to just the changes in the component that the reporting entity is managing, rather than needing to compare the derivative to the entire risk exposure.
For example, a manufacturer may enter into a contract to purchase natural gas at a future date. The contract is based on the price of natural gas at a specific location (e.g., Henry Hub) plus the transportation cost to a specified delivery point. Rather than manage the total risk associated with the natural gas purchase, the manufacturer may seek to mitigate just the risk associated with the prices at Henry Hub. Accordingly, it may enter into a derivative indexed to the price of natural gas at Henry Hub for the anticipated date of purchase. This risk would qualify as the hedged risk because the price of natural gas at Henry Hub is contractually specified.
To qualify as a cash flow hedge of a contractually specified component, a forecasted transaction must meet all of the criteria discussed in DH 7.2 and the additional criteria discussed in this section. After identifying a contractually specified component, a reporting entity should assess whether it is eligible to be designated as the hedged risk. This evaluation will depend on whether the reporting entity has an existing contract (DH 7.3.3.2) or forecasted transaction (DH 7.3.3.3).
Question DH 7-10
Can a reporting entity designate a contractually specified component of a firm commitment as the hedged risk in a cash flow hedge?
PwC response
No. The designation of a contractually specified component only applies to eligible forecasted purchases and sales of nonfinancial assets and does not apply to firm commitments.
A firm commitment does not expose a reporting entity to variable price risk and thus, generally cannot be the hedged item in a cash flow hedge. In some cases, a reporting entity may designate a firm commitment that is accounted for as a derivative as the hedging instrument in a cash flow hedge of a forecasted transaction that will be consummated upon gross settlement of the firm commitment itself (an “all-in-one” hedge, discussed in DH 7.3.4). However, an all-in-one hedge inherently involves variability of cash flows relating to all changes in the purchase or sale price of a specific asset at a specified location and thus evaluation of contractually specified components would not be applicable.

7.3.3.1 Identifying a contractually specified component

To qualify as the hedged risk, the item being hedged must qualify as a contractually specified component as defined in the ASC Master Glossary.

Definition from ASC Master Glossary

Contractually Specified Component: An index or price explicitly referenced in an agreement to purchase or sell a nonfinancial asset other than an index or price calculated or measured solely by reference to an entity’s own operations.

In accordance with this definition, the contractually specified component generally should be explicitly referenced in the agreement used to determine the purchase or sale price. In assessing whether the component is explicitly referenced, a reporting entity may also consider related agreements, as discussed in ASC 815-20-55-26A.

Excerpt from 815-20-55-26A

The definition of a contractually specified component is considered to be met if the component is explicitly referenced in agreements that support the price at which a nonfinancial asset is purchased or sold. For example, an entity intends to purchase a commodity in the commodity’s spot market. If as part of the governing agreements of the transaction or commodity exchange it is noted that the price is based on a pre-defined formula that includes a specific index and a basis, those agreements may be utilized to identify a contractually specified component.

The guidance that the contractually specified component may be “referenced in agreements that support the price” does not mean that the pricing can be based on market convention. The FASB considered expanding the allowable risks to include market convention, but ultimately rejected this approach, as discussed in the Background Information and Basis for Conclusions to ASU 2017-12:

Excerpt from BC58 in ASU 2017-12

In initial deliberations, the Board considered, but rejected, a variation of the contractually specified component model. This model would have encompassed all contractually specified components included in the Board’s decision plus components that are not contractually specified but for which it is the “market convention” to use the component as an underlying basis for determining the price of the overall product. That is, market participants in a particular commodities market would know the pricing conventions in that market. Under this alternative, a contract exists, but the components that would be eligible to be designated as the hedged item are not contractually specified. The Board rejected this model because the concept of market convention would be difficult to define across industries, would lead to confusion in instances in which there was no market convention or there were multiple market conventions, and potentially could be difficult to demonstrate objectively to third parties.

In some cases, a derivative that hedges the risk of a component of a price that is not contractually specified would still qualify as a highly effective hedge of all changes in the price of an asset reflecting its actual location, quantity, and grade (as applicable). For example, a natural gas swap priced to Henry Hub may be a highly effective hedge of a natural gas purchase at Houston Ship Channel, even if the Houston Ship Channel price does not specifically reference Henry Hub. If the hedge is highly effective, the impact of basis differences would not impact the reporting entity’s ability to defer the entire change in fair value of the derivative through OCI.

7.3.3.2 Contractually specified components in existing contracts

ASC 815 limits the contractually specified components that can be hedged in existing contracts.

ASC 815-20-25-22A

For existing contracts, determining whether the variability in cash flows attributable to changes in a contractually specified component may be designated as the hedged risk in a cash flow hedge is based on the following:
  1. If the contract to purchase or sell a nonfinancial asset is a derivative in its entirety and an entity applies the normal purchases and normal sales scope exception in accordance with Subtopic 815-10, any contractually specified component in the contract is eligible to be designated as the hedged risk. If the entity does not apply the normal purchases and normal sales scope exception, no pricing component is eligible to be designated as the hedged risk.
  2. If the contract to purchase or sell a nonfinancial asset is not a derivative in its entirety, any contractually specified component remaining in the host contract (that is, the contract to purchase or sell a nonfinancial asset after any embedded derivatives have been bifurcated in accordance with Subtopic 815-15) is eligible to be designated as the hedged risk.

In accordance with this guidance, to be eligible for hedge accounting, the contractually specified component cannot be extraneous or unrelated to the purchase or sale of the nonfinancial asset. Such pricing features would preclude application of the normal purchases and normal sales scope exception or would be separated from a host contract that is not a derivative in its entirety. However, the remaining host contract could then be evaluated to determine if it includes a contractually specified component that is eligible to be the hedged risk in a cash flow hedge.
Existing contracts that meet the definition of a derivative, but are not firm commitments, include contracts to purchase or sell commodities at the future spot market price, often including a transportation basis adjustment. These contracts may qualify for the normal purchases and normal sales scope exception; however, in practice, the contracts may not be designated as normal purchases and normal sales because the fair value is de minimis. A reporting entity that is interested in designating the contractually specified component of such contracts in a cash flow hedge would first need to evaluate the contract for the normal purchases and normal sales scope exception. If qualified, they would need to affirmatively elect the normal purchases and normal sales election.
If a contract does not meet the definition of a derivative in its entirety (e.g., because the contract does not have a notional amount, as would be the case in an index-based requirements contract), a reporting entity is required to evaluate whether the contract includes any embedded derivatives requiring bifurcation and then evaluate whether the contract contains a contractually specified component that would qualify for hedge accounting. In evaluating a contract without a notional amount, the reporting entity would need to assess whether the future purchases and sales are probable, similar to the evaluation that is performed for a forecasted transaction designated in a hedging relationship.

7.3.3.3 Contractual components in not-yet existing contracts

The ability to designate a contractually specified component is not limited to existing contracts. ASC 815-20-25-22B provides criteria for designating contractually specified components in forecasted purchases or sales of nonfinancial assets.

ASC 815-20-25-22B

An entity may designate the variability in cash flows attributable to changes in a contractually specified component in accordance with paragraph 815- 20-25-15(i)(3) to purchase or sell a nonfinancial asset for a period longer than the contractual term or for a not-yet-existing contract to purchase or sell a nonfinancial asset if the entity expects that the requirements in paragraph 815-20-25-22A will be met when the contract is executed. Once the contract is executed, the entity shall apply the guidance in paragraph 815-20-25-22A to determine whether the variability in cash flows attributable to changes in the contractually specified component can continue to be designated as the hedged risk. See paragraphs 815-20-55-26A through 55-26E for related implementation guidance.

Consistent with this guidance, a reporting entity may designate a contractually specified component of forecasted purchases or sales for which it has not entered into a contract if the expected future payment terms meet the criteria for existing contracts discussed in DH 7.3.3.2 (i.e., the pricing cannot include any extraneous pricing elements). Further, once the reporting entity executes a contract, the contract would need to be evaluated under ASC 815-20-25-22A to ensure that it still qualifies as a contractually specified component.
Question DH 7-11
When hedging a contractually specified component, can the spread added to the component be negative or variable?
PwC response
Yes. ASC 815 includes examples that address variable and negative spreads, as follows:
  • Example 22: Assessing Effectiveness of a Cash Flow Hedge of a Forecasted Purchase of Inventory with a Forward Contract (Contractually Specified Component), includes a variable spread for transportation in a hedge of a contractually specified component; and
  • Example 23: Designation of a Cash Flow Hedge of a Forecasted Purchase of Inventory for Which Commodity Exposure Is Managed Centrally, includes a negative spread in a hedge of a contractually specified component.

7.3.4 All-in-one hedges

A reporting entity may wish to manage the risk of changing cash flows due to price variability prior to the purchase or sale by entering into a firm purchase commitment. Generally, non-foreign-currency-denominated firm commitments are not eligible for designation as a hedged item in a cash flow hedging transaction because there is no variability in cash flows due to the fixed price in the firm commitment. However, the FASB provided an exception in ASC 815-20-25-22 to permit a non-foreign currency-denominated firm commitment to be designated as the hedging instrument in a cash flow hedge of a forecasted transaction that will be consummated upon gross settlement of the firm commitment itself. For a contract to qualify for designation in an all-in-one hedge, it must meet the definitions of both (1) a firm commitment and (2) a derivative.

Definition in ASC 815-20-20

All-in-One Hedge: In an all-in-one hedge, a derivative instrument that will involve gross settlement is designated as the hedging instrument in a cash flow hedge of the variability of the consideration to be paid or received in the forecasted transaction that will occur upon gross settlement of the derivative instrument itself.

Reporting entities often apply an all-in-one hedging strategy to firm commitments for commodities that do not qualify for the normal purchases and normal sales scope exception, which is discussed in DH 3.2.4.
An all-in-one hedge must be a hedge of total variability in cash flows, not a hedge of a contractually specified component.
Question DH 7-12
DH Gas Company enters into a contract for the purchase of 10,000 MMBtus of natural gas per day in the month of July 20x1 for $3.00/MMBtu. The contract meets the definition of a derivative, but DH Gas does not elect the normal purchases and normal sales scope exception. Management has determined that the contract is probable of being physically settled.

Can DH Gas designate the contract as an all-in-one hedge?
PwC response
Yes. DH Gas could designate the contract as an all-in-one hedge of the future purchase of natural gas because it has a firm commitment for the daily purchase of 10,000 MMBtus at a fixed price.
See DH 9.5.1.1 for information on how to assess effectiveness of an all-in-one hedge.

7.3.5  Accounting for cash flow hedges of nonfinancial items

In a qualifying cash flow hedge, a derivative’s entire gain or loss included in the assessment of effectiveness is recorded through OCI. ASC 815-30-35-3(b) indicates that the amounts in AOCI related to the fair value changes in the hedging instrument are released into earnings when the hedged item affects earnings. This is to align the earnings impact of the hedged item and the hedging instrument.

Excerpt from ASC 815-30-35-3(b)

Amounts in accumulated other comprehensive income related to the derivative designated as a hedging instrument included in the assessment of hedge effectiveness are reclassified to earnings in the same period or periods during which the hedged forecasted transaction affects earnings in accordance with paragraphs 815-30-35-38 through 35-41... The balance in accumulated other comprehensive income associated with the hedged transaction shall be the cumulative gain or loss on the derivative instrument from inception of the hedge less all of the following:
1a. The derivative instrument’s gains or losses previously reclassified from accumulated other comprehensive income into earnings pursuant to paragraphs 815 30-35-38 through 35-41.
1b. The cumulative amount amortized to earnings related to excluded components accounted for through an amortization approach in accordance with paragraph 815-20-25-83A.
1c. The cumulative change in fair value of an excluded component for which changes in fair value are recorded currently in earnings in accordance with paragraph 815-20-25-83B.

In determining how to reclassify amounts in AOCI into earnings, reporting entities should consider both the amount and timing of reclassification. ASC 815-30-35-3(b) notes that the amount of AOCI should equal the cumulative gain or loss on the hedging instrument since hedge inception, less (1) previously reclassified gains and losses, and (2) amounts related to excluded components already recognized in earnings.
Figure DH 7-3 illustrates what the balance in AOCI represents.
Figure DH 7-3
Components related to hedging in AOCI
View image
When an economic hedging relationship continues even though hedge accounting was not permitted in a specific period (e.g., because the retrospective effectiveness assessment for that period indicated that the relationship had not been highly effective), the cumulative gains or losses under ASC 815-30-35-3(b) exclude the gains or losses occurring during that period. This situation may arise if the reporting entity was applying hedge accounting to a hedging relationship, but (1) was forced to discontinue hedge accounting for a period when the hedge was not highly effective due an anomalous market event, and then (2) designated the derivative in a new hedge relationship of the same hedged item that is highly effective.

7.3.5.1 Reclassification of amounts in AOCI

The amounts deferred in AOCI related to the fair value changes in the hedging instrument are generally released into the reporting entity’s earnings when the hedged item/transaction affects earnings.

Excerpt from ASC 815-30-35-38

Amounts in accumulated other comprehensive income that are included in the assessment of effectiveness shall be reclassified into earnings in the same period or periods during which the hedged forecasted transaction affects earnings (for example, when a forecasted sale actually occurs) and shall be presented in the same income statement line item as the earnings effect of the hedged item in accordance with paragraph 815-20-45-1A.
ASC 815-30-35-39
If the hedged transaction results in the acquisition of an asset or the incurrence of a liability, the gains and losses in accumulated other comprehensive income that are included in the assessment of effectiveness shall be reclassified into earnings in the same period or periods during which the asset acquired or liability incurred affects earnings (such as in the periods that depreciation expense, interest expense, or cost of sales is recognized).

A change in the fair value of a derivative that is used to hedge price changes of anticipated inventory purchases is not deferred as a basis adjustment of the inventory, but is deferred in AOCI until earnings are impacted by the purchased item. In this situation, the gain or loss on the derivative would be deferred in AOCI until the inventory is sold or consumed in production.
For example, if a reporting entity is hedging a purchase of raw materials that will be held in inventory for resale or use in production of finished goods, it is important to understand the subsequent accounting for the materials purchased and when the related expense will be recorded in cost of goods sold. If the materials are held for resale, the recognition of the amounts deferred in AOCI should be recorded consistent with the inventory costing method (e.g., first-in, first-out; last-in, first-out; weighted average). If the materials are used in the production of finished goods, the amounts deferred in AOCI would not be reclassified until the finished goods are sold. Certain costing models, such as LIFO and average cost, often result in long-term deferrals in AOCI because the hedged inventory does not turn over for long periods of time.
Similarly, when a transaction involves the purchase of equipment, the gain or loss on the derivative that is deferred in AOCI should be reclassified to earnings as the equipment is depreciated. The amount of the derivative’s gain or loss that is taken out of AOCI and reclassified to earnings should be proportionate to the percentage of depreciation expense recorded each period.
Example DH 7-5 illustrates a cash flow hedge of a forecasted purchase of inventory with an option.
EXAMPLE DH 7-5
Cash flow hedge of a forecasted purchase of inventory, time value recognized through an amortization approach
DH Jewelry Manufacturing Corp purchases gold from its suppliers based on the market COMEX spot price. DH Jewelry decides to purchase New York COMEX call options on gold to hedge the price risk of its probable forecasted purchase of 200 ounces of gold on April 30, 20X1. The options give DH Jewelry the right, but not the obligation, to buy gold at a specific price.
  • If gold prices increase, the profit on the purchased call options will approximately offset the higher price that DH Jewelry must pay for the gold to be used in its manufacturing process.
  • If gold prices decline, DH Jewelry will lose the premium it paid for the call options, but can then buy gold at the lower price in the spot market.

On January 1, 20X1, DH Jewelry purchases two at-the-money spot call options for April 30, 20X1 delivery at $291 per ounce for a premium of $7.50 per ounce. Each call option is for a notional amount of 100 ounces of gold. The call options are derivatives under ASC 815 because of their contractual provisions, which permit net cash settlement. They protect DH Jewelry from the risk of gold prices increasing above $291 per ounce.
On April 30, 20X1, the spot price of gold is $316 per ounce. DH Jewelry settles its two April calls on April 30, 20X1 and buys 200 ounces of gold from its suppliers at the COMEX spot price.
Information regarding the transactions is summarized as follows:
Date
COMEX spot price of gold
Strike price - April call option
Option premium
Estimated option fair value
Change in estimated option fair value
January 1, 20X1
$291
$7.50
1,500
-
January 31, 20X1
3,100
1,600
February 28, 20X1
4,000
900
March 31, 20X1
4,500
500
April 30, 20X1
$316
5,000
500

The estimated option fair value at January 1, 20X1 includes only the time value (premium) of $1,500. In subsequent periods, the fair value includes both the remaining time value and the intrinsic value.
On January 20X1, DH Jewelry designates the hedging relationship as a cash flow hedge of the first 200 ounces of forecasted gold purchases during the month of April 20X1 at the then-spot gold price delivered to DH Jewelry’s facility. DH Jewelry assesses effectiveness based on the option’s intrinsic value and recognizes the time value using an amortization approach. Straight-line amortization is determined to be a systematic and rational approach.
How should DH Jewelry account for the hedging relationship?
Analysis
As a highly effective cash flow hedge of a forecasted purchase of a nonfinancial asset (gold), the call options’ change in fair value would be deferred through OCI and reclassified to earnings when the related inventory is sold. The time value would be amortized on a straight-line basis. The change in fair value, which includes the change in time value, would be recorded through OCI.
DH Jewelry would record the following journal entries for the hedging relationship.
January 1, 20X1
Dr. Call options
$1,500
Cr. Cash
$1,500
To record the premium paid on the purchase of the call options (2 options × 100 ounces per option × $7.50/ounce premium)
January 31, 20X1
Dr. Cost of goods sold
$375
Cr. Other comprehensive income
$375
To record straight-line amortization of the time value on the call options in the same line item as the hedged transaction ($1,500 divided by 4 months)
Dr. Call options
$1,600
Cr. Other comprehensive income
$1,600
To record the change in fair value of the call options
February 28, 20X1
Dr. Cost of goods sold
$375
Cr. Other comprehensive income
$375
To record straight-line amortization of the time value on the call options in the same line item as the hedged transaction ($1,500 divided by 4 months)
Dr. Call options
$900
Cr. Other comprehensive income
$900
To record the change in fair value of the call options
March 31, 20X1
Dr. Cost of goods sold
$375
Cr. Other comprehensive income
$375
To record straight-line amortization of the time value on the call options in the same line item as the hedged transaction ($1,500 divided by 4 months)
Dr. Call options
$500
Cr. Other comprehensive income
$500
To record the change in fair value of the call options
April 30, 20X1
Dr. Cost of goods sold
$375
Cr. Other comprehensive income
$375
To record straight-line amortization of the time value on the call options in the same line item as the hedged transaction ($1,500 divided by 4 months)
Dr, Call options
$500
Cr. Other comprehensive income
$500
To record the change in fair value of the call options
Dr. Cash
$5,000
Cr. Call options
$5,000
To record the cash settlement of the call options
Dr. Gold inventory
$63,200
Cr. Cash
$63,200
To record the purchase of 200 ounces of gold ($316 per ounce × 200 ounces)

The gain in AOCI will be reclassified to earnings when the related inventory is sold (i.e., when earnings are impacted) according to how DH Jewelry accounts for its inventory (e.g., LIFO, FIFO).
Alternatively, DH Jewelry could elect to assess effectiveness based on the terminal value of the option. In that case, the entire change in fair value of the option would be deferred through OCI if the hedge is highly effective. However, many manufacturers believe that an intrinsic value approach better reflects the true cost of inventory. The premium paid is akin to insurance that locks in the cost of the inventory.

7.3.5.2 Excluded components

As discussed in DH 7.2.1.3, a reporting entity’s risk management strategy may exclude certain components from the assessment of hedge effectiveness. Such amounts will be recognized in earnings either currently or following an amortization approach.

7.3.5.3 When a forecasted transaction becomes a firm commitment

Because ASC 815 prescribes different accounting provisions for hedges of forecasted transactions (as cash flow hedges) and firm commitments (as fair value hedges, discussed in DH 7.4.3.2), the question arises of how to account for a change in circumstances that results in the conversion of a forecasted transaction to a firm commitment (e.g., when a reporting entity enters into a purchase order specifying penalties that will apply if the counterparty does not fulfill its performance obligations with respect to a previously anticipated purchase of inventory).
A hedging instrument that was initially intended as a cash flow hedge of a forecasted transaction must be effective in offsetting the variability in future cash flows (i.e., the purpose of the derivative would be to lock in a fixed price for the forecasted transaction). However, once the reporting entity enters into a firm commitment, the price will be fixed, and the original objective of the hedge will no longer exist. A hedge of a firm commitment is a fair value hedge and a derivative must be effective in offsetting changes in the fair value of the firm commitment. Accordingly, the original derivative that was effective as a cash flow hedge will not be effective as a fair value hedge, and cash flow hedge accounting should be discontinued.
A reporting entity could subsequently designate the now-firm commitment as the hedged item in a fair value hedge and use a derivative instrument that is different from the one used for the cash flow hedge. In addition, the reporting entity may designate the firm commitment itself as an “all-in-one” cash flow hedge (see DH 7.3.4).
Regardless of the subsequent accounting for the firm commitment, the amount deferred in AOCI as a result of the initial cash flow hedge should be reclassified to earnings only when the original forecasted transaction (which has now become a firm commitment) impacts earnings.

7.3.5.4 Accounting for a contractually specified component

A hedge of a contractually specified component of a forecasted transaction follows the same accounting model as other cash flow hedges. If the hedging instrument has pricing components that do not exactly match the contractually specified component in the hedged item, any differences would need to be considered when determining if the hedging instrument is highly effective.
Assuming that the hedge relationship is highly effective, the entire change in fair value of the hedging instrument (less excluded components, if any, as discussed in DH 7.2.1.3) would be recorded through OCI.

7.3.5.5 Cash flow hedges related to discontinued operations

If a reporting entity disposes of a component of its operations that met the requirements for classification of a discontinued operation, management should consider the original hedge documentation of the cash flows being hedged to determine whether amounts remaining in AOCI should be released. Refer to DH 10.4.6 for further discussion.
Refer to FSP 27.4.2.7 for considerations on the income statement presentation for cash flow hedges of items related to the disposal group.

7.3.6 Capitalization of interest

ASC 815 prohibits reporting gains or losses on cash flow hedging instruments as basis adjustments of the qualifying assets. Instead, ASC 815 requires reclassification of amounts deferred in AOCI into earnings in the same period(s) during which the hedged forecasted transaction affects earnings. ASC 815-30-35-45 provides specific guidance for cash flow hedges of borrowings related to plant under construction.

ASC 815-30-35-45

If the variable-rate interest on a specific borrowing is associated with an asset under construction and capitalized as a cost of that asset, the amounts in accumulated other comprehensive income related to the cash flow hedge of the variability of that interest shall be reclassified into earnings over the depreciable life of the constructed asset, because that depreciable life coincides with the amortization period for the capitalized interest cost of the debt.

When a swap is terminated early or the debt term extends beyond the construction period, reporting entities need to ensure proper attribution and accounting for the derivative gains and losses deferred in AOCI related to interest payments that were capitalized.

7.3.7 Impairment of a hedged item/transaction

ASC 815 requires immediate recognition of amounts deferred in AOCI if the combined impact of the hedging instrument and hedged item will lead to a loss in future periods.

Excerpt from ASC 815-30-35-40

If an entity expects at any time that continued reporting of a loss in accumulated other comprehensive income would lead to recognizing a net loss on the combination of the hedging instrument and the hedged transaction (and related asset acquired or liability incurred) in one or more future periods, a loss shall be reclassified immediately into earnings for the amount that is not expected to be recovered.

Question DH 7-13
DH Corp periodically purchases inventory and designates its next forecasted purchase of that inventory as the hedged item in a cash flow hedge. At the date that the inventory is purchased, a loss on the hedging instrument of $25 is in AOCI. In a subsequent period, the purchased inventory has a carrying amount of $100 and a fair value of $110. DH Corp expects to sell the inventory at a price equivalent to its fair value.

DH Corp determines that the combined value of the loss in AOCI and the carrying amount of the inventory (i.e., $125) exceeds the inventory’s fair value (i.e., $110), such that a net loss on the forecasted sale of the inventory will be recognized in a future period.

How should DH Corp account for the loss exposure?
PwC response
DH Corp would reclassify a $15 loss ($100 + $25 – $110) from AOCI into earnings because it does not expect to recover more than the inventory’s fair value.
Further, in accordance with ASC 815-30-35-42, for assets and liabilities with variable cash flows and for which the variable cash flows have been designated as the hedged item in a cash flow hedge, a reporting entity must assess impairment under other GAAP applicable to those assets or liabilities. For example, a reporting entity needs to consider whether the net realizable value of inventory has declined to an amount below its cost in a cash flow hedge of a forecasted sale of inventory. A reporting entity should apply those requirements after hedge accounting is applied for the period and without regard to the expected cash flows of the hedging instrument (i.e., gains and losses that are deferred in AOCI may not be used to assess either impairment or the need for an increase in an obligation of a hedged item).
If an impairment loss is recognized on a hedged item under other applicable GAAP, ASC 815-30-35-43 provides further guidance on accounting for any amounts deferred in AOCI.

ASC 815-30-35-43

If, under existing requirements in GAAP, an asset impairment loss or writeoff due to credit losses is recognized on an asset, or an additional obligation is recognized on a liability to which a hedged forecasted transaction relates, any offsetting net gain related to that transaction in accumulated other comprehensive income shall be reclassified immediately into earnings. Similarly, if a recovery is recognized on the asset or liability to which the hedged forecasted transaction relates, any offsetting net loss that has been accumulated in other comprehensive income shall be reclassified immediately into earnings.

In accordance with this guidance, if an impairment loss is recognized for an asset (to which a forecasted transaction relates), DH Corp should offset gains related to the forecasted transaction that were deferred in AOCI and reclassify them immediately to earnings. However, the amount of any gains reclassified to earnings should not be in excess of the impairment loss recognized.
Question DH 7-14
DH Corp periodically purchases inventory and designates its next forecasted purchase of that inventory as the hedged item in a cash flow hedge. DH Corp purchases inventory for $100. At the date that the inventory is purchased, there is a $25 gain on the hedging instrument deferred in AOCI. In a subsequent period, the fair value of the purchased inventory (carrying amount of $100) declines to $80 and should be written down to the lower of cost or net realizable value.

Should DH Corp recognize any of the gain in AOCI at the time of the impairment?
PwC response
DH Corp should recognize an impairment loss of $20 ($100 – $80) on its inventory. In addition, in the period in which the impairment is recorded, DH Corp should recognize a portion of the deferred gain from the hedge of the purchase of the inventory by reclassifying a gain of $20 (i.e., part of the total $25 deferred gain) from AOCI into earnings. As a result, there is no net impact to current earnings.
The remaining $5 gain in AOCI would continue to be deferred until the hedged forecasted transaction impacts earnings when the inventory is sold (or if a subsequent impairment is recognized).

PwC. All rights reserved. PwC refers to the US member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.

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