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7.4 Fair value hedges of nonfinancial assets and liabilities
Publication date: 31 Jul 2022
us Derivatives & hedging guide
For recognized assets or liabilities and firm commitments, a reporting entity may enter into a fair value hedge to economically convert the cash flows from future use or sale to a market rate.
7.4.1 Risks eligible for fair value hedges of nonfinancial items
In a fair value hedge of a nonfinancial item, ASC 815-20-25-12(e) limits the risks that may be hedged.
If the hedged item is a nonfinancial asset or liability (other than a recognized loan servicing right or a nonfinancial firm commitment with financial components), the designated risk being hedged is the risk of changes in the fair value of the entire hedged asset or liability (reflecting its actual location if a physical asset). That is, the price risk of a similar asset in a different location or of a major ingredient may not be the hedged risk. Thus, in hedging the exposure to changes in the fair value of gasoline, an entity may not designate the risk of changes in the price of crude oil as the risk being hedged for purposes of determining effectiveness of the fair value hedge of gasoline.
Reporting entities are not permitted to designate the price risk of a similar asset in a different location or an ingredient or a component of a nonfinancial asset or liability as the hedged item. Hedges of nonfinancial assets and liabilities are limited to hedges of the risk of changes in the price of the entire hedged item (reflecting its actual location if a physical asset), except for nonfinancial firm commitments with financial components. A nonfinancial firm commitment with a financial component (e.g., the obligation to purchase inventory in a foreign currency) may be able to be designated as the hedged item in a fair value hedge if it meets one of the criteria in ASC 815-20-25-12(f), discussed in DH 7.2.1.
In contrast, as discussed in DH 7.3.3, in the forecasted purchase or sale of a nonfinancial asset, reporting entities are allowed to designate risk of variability of cash flows attributable to a contractually specified component of the price as the hedged risk. Therefore, a reporting entity may not use a rubber derivative as a fair value hedge of a component of the exposure to changes in the fair value of tires held in inventory, even though rubber is a component of tires. However, a reporting entity could use a rubber derivative as a cash flow hedge of changes in the market price of rubber as the hedged risk, if rubber is a contractually specified component in the price of the tires.
Further, the criterion in ASC 815-20-25-12(e) permits “cross” or “tandem” hedges. Therefore, the entity may be able to use the rubber derivative as a fair value hedge of the tire inventory if the price of rubber is highly correlated to the market price of tires. For it to do so, however, (1) the entire change in the fair value of the derivative must be expected to be highly effective at offsetting the entire change in the fair value or expected cash flows of the hedged item and (2) all of the remaining hedge criteria must be met. The reporting entity would need to consider all changes in the value of the tire inventory in its hedge effectiveness assessment.
7.4.2 Eligible hedged items in a fair value hedge
ASC 815 requires that the designated hedged item in a fair value hedge be a recognized asset or liability or an unrecognized firm commitment. An unrecognized asset or liability that does not embody a firm commitment is not eligible for fair value hedge accounting.
The hedged item in a fair value hedge must fulfill the general qualifying criteria discussed in DH 6.2 and the criteria specific to fair value hedges outlined in ASC 815-20-25-12. The types of hedged items that may qualify in fair value hedging relationships related to nonfinancial items are:
- A recognized asset or liability
- An unrecognized firm commitment
- A portfolio of similar assets and liabilities
- A specific portion of a recognized asset or liability
Specific considerations related to these requirements are further discussed in the following sections.
7.4.2.1 Recognized asset or liability
A recognized asset or liability, such as inventory, can be the hedged transaction in a fair value hedge if the specified criteria are met.
Fair value hedge of inventory
Production companies and users of commodities may need to manage exposure to the price of purchasing inputs and to changes in the value of their inventories during a holding period. A fair value hedge can be used to protect against the risk of a change in the value of physical inventory during the hedging period.
The risk identified as being hedged in a hedging transaction involving recognized nonfinancial assets, such as inventory, or a firm commitment may only be for overall changes in fair value (i.e., price risk) at the location of the inventory or the location at which the reporting entity intends to purchase or sell the inventory.
In contrast, the hedged risk identified in a cash flow hedge of a forecasted purchase or sale of inventory may also be the changes in a contractually specified component of the price or functional currency cash flows.
In practice, reporting entities often hedge the price risk associated with forecasted inventory purchases when changes in those prices cannot be passed onto their customers (i.e., through the subsequent sale of their product) because either the reporting entity has a fixed-price sales commitment or the marketplace is too competitive to allow for the pass-through of material cost increases. Reporting entities often hedge the price risk associated with forecasted inventory sales if their raw material or production costs are fixed and/or the pricing for their product in the marketplace is volatile. Because there is an opportunity to hedge the variability in either forecasted purchases or sales of inventory, many reporting entities do not find a need to enter into fair value hedges of their existing inventories. However, when a reporting entity has commodity inventories on hand, but cannot adequately forecast the timing of sales, it may be appropriate to consider entering into a fair value hedge.
Example DH 7-6 illustrates a fair value hedge of inventory using a collar.
EXAMPLE DH 7-6
Collar used to hedge inventory price risk
Collar used to hedge inventory price risk
DH Corp uses a purchased collar (i.e., a combination of a purchased and written option) that does not constitute a written option to hedge the price risk in the inventory it holds. It structures a collar consisting of (1) a purchased put with a strike price of $80 and (2) a written call with a strike price of $120.
DH Corp documents that its hedge strategy is to protect the inventory from fair value changes outside the specified range; it does not hedge changes in the fair value from $80 to $120.
How would DH Corp account for such a hedge?
Analysis
DH Corp would adjust the inventory to reflect only the changes in value caused by a drop in the price below $80 or an increase in the price above $120 (i.e., the collar would be effective in offsetting only losses that occur when the price is below $80 or gains that occur when the price is above $120). The inventory would not be adjusted for price fluctuations that fall within the range of $80 to $120. Accordingly, changes in the fair value of the collar that reflect price fluctuations within the range of $80 to $120 would be recorded in earnings, with no offsetting adjustments made to the carrying amount of the inventory.
In this hedging relationship, DH Corp may elect to exclude the time value of the option from its assessment of effectiveness and recognize the time value of the option using an amortization approach, as discussed in DH 7.2.1.3.
Example DH 7-7 illustrates a fair value hedge of commodity inventory using futures contracts.
EXAMPLE DH 7-7
Fair value hedge of commodity inventory using futures contracts
Fair value hedge of commodity inventory using futures contracts
On October 1, 20X1, DH Mining Corp (DH Mining), located in Colorado, has 10 million pounds of copper inventory in its warehouse located near Dinosaur, Colorado, at an average cost of $3.065 per pound. DH Mining would like to protect the value of the inventory from a possible decline in copper prices until its planned sale in February 20X2. To hedge the value of the inventory, DH Mining sells 400 copper contracts (each for 25,000 pounds) through the Chicago Mercantile Exchange’s COMEX Division at $3.19 per pound for delivery in February 20X2 to coincide with its expected physical sale of its copper inventory. The spot price on October 1, 20X1 is $3.13.
How should DH Mining Corp account for the hedging relationship?
Analysis
DH Mining would designate the hedging relationship as a fair value hedge of inventory. Assuming the hedge relationship is highly effective, if prices fall during the period prior to settlement, the gain from the short position in COMEX futures contracts would be expected to substantially offset the decline in the fair value of the copper inventory. The hedge relationship may not be perfectly effective due to locational differences between the inventory and the specific warehouses designated for goods delivery by the COMEX exchange contract, none of which is near the inventory’s location. This difference creates basis risk. In addition, DH Mining would likely elect to assess effectiveness based on changes in spot prices and exclude the difference between the spot rate ($3.13) and forward rate ($3.19) from the hedging relationship. In this case, DH Mining may elect to recognize the excluded component using a mark-to-market approach or an amortization approach as discussed in DH 7.2.1.3.
As a highly effective fair value hedge of the copper inventory, the futures contracts would be recognized on the balance sheet as assets or liabilities, and gains or losses on the futures contracts would be recognized currently in earnings, offset by the basis adjustment on the copper inventory.
7.4.2.2 Portfolio of similar assets and liabilities
ASC 815-20-25-12(b)(1) describes the similar assets/liabilities test that is required for fair value hedges of groups (portfolios) of assets or liabilities. Reporting entities seeking to fair value hedge a portfolio of assets or liabilities generally must perform a rigorous quantitative assessment at inception of the hedging relationship to document that the portfolio of assets or liabilities is eligible for designation as the hedged item in a fair value hedging relationship.
Excerpt from ASC 815-20-25-12(b)
The hedged item is a single asset or liability (or a specific portion thereof) or is a portfolio of similar assets or a portfolio of similar liabilities (or a specific portion thereof), in which circumstance:
- If similar assets or similar liabilities are aggregated and hedged as a portfolio, the individual assets or individual liabilities must share the risk exposure for which they are designated as being hedged. The change in fair value attributable to the hedged risk for each individual item in a hedged portfolio must be expected to respond in a generally proportionate manner to the overall change in fair value of the aggregate portfolio attributable to the hedged risk.
Consistent with the ASC 815 prohibition on macro hedging, the designation of a group of assets or liabilities in a single hedging relationship is limited to only those similar assets or liabilities that share the same risk exposure for which they are designated as being hedged. The concept of “similar” is interpreted very narrowly. The fair value of each individual item in the portfolio must be expected to change proportionate to the change in the entire portfolio. For example, when the changes in the fair value of the hedged portfolio attributable to the hedged risk alter that portfolio’s fair value by 10% during a reporting period, the change in the fair value that is attributable to the hedged risk of each item in the portfolio should also be expected to be within a fairly narrow range of 10%.
Excerpt from ASC 815-20-55-14
The individual assets or individual liabilities shall share the risk exposure for which they are designated as being hedged. If the change in fair value of a hedged portfolio attributable to the hedged risk was 10 percent during a reporting period, the change in the fair values attributable to the hedged risk for each item constituting the portfolio should be expected to be within a fairly narrow range, such as 9 percent to 11 percent. In contrast, an expectation that the change in fair value attributable to the hedged risk for individual items in the portfolio would range from 7 percent to 13 percent would be inconsistent with the requirement in [ASC 815-20-25-12(b)(1)].
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.
7.4.2.3 Proportion (percentage) of an asset or liability
ASC 815 also permits reporting entities to designate a specific portion of a recognized asset or liability as the hedged item in a fair value hedge.
If the hedged item is a specific portion of an asset or liability (or of a portfolio of similar assets or a portfolio of similar liabilities), the hedged item is one of the following:
- A percentage of the entire asset or liability (or of the entire portfolio). An entity shall not express the hedged item as multiple percentages of a recognized asset or liability and then retroactively determine the hedged item based on an independent matrix of those multiple percentages and the actual scenario that occurred during the period for which hedge effectiveness is being assessed.
In applying this guidance, the hedge documentation should specify how the percentage of the asset or liability will be determined. For example, if a reporting entity is hedging a portion of its inventory, it should specify the location, nature of the inventory, and the quantity of inventory being hedged.
This guidance refers to a percentage of an asset or liability. A partial-term hedge (in which only certain cash flows within an instrument are hedged) is not permitted for nonfinancial items.
7.4.2.4 Firm commitment
A firm commitment is a binding agreement with a third party for which all significant terms are specified (e.g., quantity, price, timing). The definition of a firm commitment requires that the fixed price be specified in terms of a currency (or an interest rate).
ASC 815 specifies that a firm commitment must include a disincentive for nonperformance that is sufficiently large to make performance probable. The determination of whether a sufficiently large disincentive for nonperformance exists under each firm commitment is judgmental based upon the specifics and facts and circumstances. Example 13 in ASC 815-25-55-84 indicates that the disincentive for nonperformance need not be an explicit part of a contract. Rather, the disincentive may be present in the form of statutory rights (that exist in the legal jurisdiction governing the agreement) that allow a reporting entity to pursue compensation in the event of nonperformance (e.g., if the counterparty defaults) that is equivalent to the damages that the entity suffers as a result of the nonperformance.
As an example, a reporting entity may enter into contracts to deliver nonfinancial assets to customers under firm commitments as part of normal business activities, but does not want to be exposed to the risk of price variability. The reporting entity could enter into a derivative to offset the changes in fair value of the firm commitment to deliver nonfinancial assets to its customers. If the firm commitment is designated as the hedged item in an effective hedge, changes in its fair value will be recognized on the balance sheet with the offset recorded to earnings.
Additionally, as noted in ASC 815-20-25-21, a derivative that satisfies the definition of a firm commitment and that will involve a gross settlement may be 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 itself (sometimes known as an “all-in-one hedge,” discussed in DH 7.3.4).
Figure DH 7-4 illustrates the alternative ways to account for a firm commitment.
Figure DH 7-4
Accounting for a firm commitment
Accounting for a firm commitment
View image
Question DH 7-15
Can a reporting entity designate a contractually specified component of a firm commitment as the hedged risk in a fair value hedge?
Can a reporting entity designate a contractually specified component of a firm commitment as the hedged risk in a fair value hedge?
PwC response
No. The designation of a contractually specified component only applies to cash flow hedges of eligible forecasted purchases and sales of nonfinancial assets and does not apply to firm commitments.
Firm commitments should be evaluated to determine if they are eligible for designation as the hedged item in a fair value hedge. However, ASC 815-20-25-12(e) requires that the designated risk being hedged in a fair value hedge of a nonfinancial asset or liability must involve the risk of changes in the fair value of the entire hedged asset or liability, reflecting the actual asset or liability and its physical location, or the related foreign currency risk.
7.4.2.5 Other eligible hedged items
ASC 815-20-25-12(b) also permits embedded puts and calls in a recognized asset or liability and the residual value in a lessor’s net investment in a direct financing or sales-type lease to be the hedged item in a fair value hedging relationship.
Although the residual value in a lessor’s net investment in a direct financing or sales-type lease may be designated as the hedged item, many contracts that are used as the hedging instrument in such a hedge may qualify for one of the scope exceptions in ASC 815-10-15-13, such as ASC 815-10-15-59(d), discussed in DH 3. A reporting entity should examine its hedging instruments to determine whether they meet the definition of a derivative or are scoped out. If a hedging instrument does not fall within the scope of ASC 815, the corresponding transaction does not qualify for hedge accounting because only derivatives may be designated as hedging instruments, with certain exceptions discussed in DH 8.
See DH 4.6.3 for a discussion of certain features of leases that may meet the definition of a derivative and thus need to be separated from the lease agreement and accounted for individually.
7.4.3 Accounting for fair value hedges of nonfinancial items
In accordance with ASC 815-10-30-1, all derivatives should be measured initially at fair value following the guidance of ASC 820, Fair Value Measurement. At each subsequent reporting period, all derivatives should be remeasured at fair value. Gains and losses on a qualifying fair value hedge should be accounted for in accordance with ASC 815-25-35-1.
Gains and losses on a qualifying fair value hedge shall be accounted for as follows:
- The gain or loss on the hedging instrument shall be recognized currently in earnings, except for amounts excluded from the assessment of effectiveness that are recognized in earnings through an amortization approach in accordance with paragraph 815-20-25-83A. All amounts recognized in earnings shall be presented in the same income statement line item as the earnings effect of the hedged item.
- The gain or loss (that is, the change in fair value) on the hedged item attributable to the hedged risk shall adjust the carrying amount of the hedged item and be recognized currently in earnings.
Unlike hedge accounting for cash flow hedges, which results in special accounting for the derivative designated in the cash flow hedging relationship, hedge accounting for fair value hedges results in special accounting for the designated hedged item.
The application of fair value hedge accounting requires both (1) the changes in value of the designated hedging instrument and (2) the changes in value (attributable to the risk being hedged) of the designated hedged item to be recognized currently in earnings. Accordingly, any mismatch between the hedged item and hedging instrument is recognized currently in earnings.
7.4.3.1 Adjusting the carrying amount of the hedged item
In a fair value hedge of an asset, a liability, or a firm commitment, the hedging instrument should be reflected on the balance sheet at its fair value, but the hedged item may often be reflected on the balance sheet at a value that is different from both its historical cost and fair value, unless the total amount and all the risks were hedged when the item was acquired. This is because the hedged item is adjusted each period only for changes in the fair value that are attributable to the risk that has been hedged since the inception of the hedge.
The accounting for changes in the fair value of the hedged item is discussed in ASC 815-25-35-8.
The adjustment of the carrying amount of a hedged asset or liability required by ASC 815-25-35-1(b) shall be accounted for in the same manner as other components of the carrying amount of that asset or liability. For example, an adjustment of the carrying amount of a hedged asset held for sale (such as inventory) would remain part of the carrying amount of that asset until the asset is sold, at which point the entire carrying amount of the hedged asset would be recognized as the cost of the item sold in determining earnings.
When initially designating the hedging relationship and preparing the contemporaneous hedge documentation, a reporting entity must specify how hedge accounting adjustments will be subsequently recognized in income. The recognition of hedge accounting adjustments—also referred to as basis adjustments—will differ depending on how other adjustments of the hedged item’s carrying amount will be reported in earnings. For example:
- Hedge accounting adjustments on a firm commitment to purchase inventory would be recognized in income when the purchased inventory is sold
- Hedge accounting adjustments for an operating lease with substantial cancellation penalties do not have an obvious pattern of accounting and would need to follow the substance of the agreement
Further, if the hedged item is a portfolio of similar assets or liabilities, a reporting entity must allocate the hedge accounting adjustments to individual items in the portfolio. Information about such allocations is required, for example, when (1) the assets are sold or liabilities are settled, (2) the hedging relationship is discontinued, (3) the hedged item is assessed for impairment and (4) for the purposes of presentation and disclosures.
7.4.3.2 Recognition and measurement of a hedged firm commitment
If a firm commitment is designated as a hedged item, the change in fair value of the hedged commitment is recorded in a manner similar to how a reporting entity would account for any hedged asset or liability that it records. That is, changes in fair value that are attributable to the risk that is being hedged would be recognized in earnings and, on the balance sheet, recognized as an adjustment of the hedged item’s carrying amount. Because firm commitments normally are not recorded, accounting for the change in the fair value of the firm commitment would result in the reporting entity recognizing the firm commitment on the balance sheet. The recognition of subsequent changes in fair value would adjust the carrying amount of the firm commitment.
7.4.3.3 Fair value hedges related to discontinued operations
Refer to FSP 27.4.2.7 for considerations when a hedged item included in a fair value hedge is part of a component that qualifies for discontinued operations.
7.4.4 Impairment of a hedged item
ASC 815-25-35-10 provides guidance on the accounting for impairment of a hedged item.
Excerpt from ASC 815-25-35-10
An asset or liability that has been designated as being hedged … remains subject to the applicable requirements in generally accepted accounting principles (GAAP) for assessing impairment for that type of asset or for recognizing an increased obligation for that type of liability. Those impairment or credit loss requirements shall be applied after hedge accounting has been applied for the period and the carrying amount of the hedged asset or liability has been adjusted pursuant to 815-25-35-1(b). Because the hedging instrument is recognized separately as an asset or liability, its fair value or expected cash flows shall not be considered in applying those impairment or credit loss requirements to the hedged asset or liability.
In accordance with this guidance, nonfinancial assets that have been designated as hedged items in fair value hedging relationships remain subject to the normal requirements for impairment assessment. For example, reporting entities should continue to apply the valuation requirements of ASC 330, Inventory, and the impairment requirements of ASC 360, Accounting for the Impairment or Disposal of Long-Lived Assets.
A reporting entity must apply those impairment requirements after hedge accounting is applied for the period and the hedged item’s carrying amount has been adjusted to reflect changes in fair value that are attributable to the risk that is being hedged.
7.4.5 Capitalization of interest
The interest cost recognized in earnings related to fair value hedges should be reflected in the amount of interest subject to capitalization, as addressed in ASC 815-25-35-14.
Amounts recorded in an entity’s income statement as interest costs shall be reflected in the capitalization rate under Subtopic 835-20. Those amounts could include amortization of the adjustments of the carrying amount of the hedged liability, under paragraphs 815-25-35-9 through 35-9A, if an entity elects to begin amortization of those adjustments during the period in which interest is eligible for capitalization.
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