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9.5 Critical terms match method for forwards
Publication date: 31 Mar 2024
us Derivatives & hedging guide
The critical terms match method in ASC 815-20-25-84 is only available for forwards or futures contracts in hedges of commodity risk or foreign exchange risk, not interest rate risk. Hedges of interest rate risk should apply the shortcut method in DH 9.4 or one of the other methods for interest rate risk. Although there may be certain situations when a cash flow hedge of interest rate risk using an interest rate swap will be perfectly effective, a reporting entity should not apply the critical terms match method in ASC 815-20-25-84 to a cash flow hedge of interest rate exposures.
If the critical terms of the hedging instrument and of the hedged item or hedged forecasted transaction are the same, the entity could conclude that changes in fair value or cash flows attributable to the risk being hedged are expected to completely offset at inception and on an ongoing basis. For example, an entity may assume that a hedge of a forecasted purchase of a commodity with a forward contract will be perfectly effective if all of the following criteria are met:
- The forward contract is for the purchase of the same quantity of the same commodity at the same time and location as the hedged forecasted purchase. Location differences do not need to be considered if an entity designates the variability in cash flows attributable to changes in a contractually specified component as the hedge risk and the requirements in paragraphs 815-20-25-22A through 25-22B are met.
- The fair value of the forward contract at inception is zero.
- Either of the following criteria is met:
- The change in the discount or premium on the forward contract is excluded from the assessment of effectiveness pursuant to paragraphs 815-20-25-81 through 25-83.
- The change in expected cash flows on the forecasted transaction is based on the forward price for the commodity.
ASC 815-20-25-84 points out that a hedge may be assumed to be perfectly effective when the conditions are satisfied. ASC 815-20-25-84 does not mean that a reporting entity (1) does not need to perform any assessments of effectiveness, or (2) may disregard known factors that would cause a hedge to not be perfectly effective.
However, if at inception, the critical terms of the hedging instrument and the hedged forecasted transaction are the same, a reporting entity can conclude that changes in cash flows attributable to the risk being hedged are expected to be completely offset by the hedging derivative. Therefore, the reporting entity may forego performing a quantitative effectiveness assessment in each period and instead document at the inception of the hedging relationship and on an ongoing basis throughout the hedging period that (1) the critical terms of the hedging instrument and the hedged item match (or have not changed since inception) and (2) it is probable that the counterparties to the hedging instrument and the hedged item will not default. If these two requirements are met, the entity may conclude that the hedge is perfectly effective. In that case, the change in the fair value of the components of the derivative included in the assessment of effectiveness can be viewed as a proxy for the present value of the change in cash flows attributable to the risk being hedged.
A reporting entity should document the quantitative method it will use to assess hedge effectiveness. Should the critical terms subsequently change and thus invalidate the assumption of perfect effectiveness, a full quantitative effectiveness assessment would be required (i.e., the long-haul method should be applied). The assessment of effectiveness to be used should the critical terms of the hedged item and hedging instrument no longer match has to be consistent with the method selected in the reporting entity’s original contemporaneous hedge documentation and completely documented at hedge inception to avoid the need to dedesignate when migrating to the quantitative effectiveness assessment.
Hedge accounting would need to be discontinued if there is any change in the critical terms and the entity does not document the quantitative method to assess effectiveness in these cases. Further, should it no longer be probable that the reporting entity or the counterparty to the hedging instrument or the hedged item will not default, hedge accounting should be discontinued.
9.5.1 Timing mismatches in a hedge using forwards
While the critical terms match method requires the critical terms to match between the derivative and the hedged item or hedged forecasted transaction, ASC 815-20-25-84A permits limited differences between the maturity of the derivative and the timing of occurrence of a group of hedged forecasted transactions.
In a cash flow hedge of a group of forecasted transactions in accordance with paragraph 815-20-25-15(a)(2), an entity may assume that the timing in which the hedged transactions are expected to occur and the maturity date of the hedging instrument match in accordance with paragraph 815-20-25-84(a) if those forecasted transactions occur and the derivative matures within the same 31-day period or fiscal month.
Based on paragraphs BC196 and BC197 in the Basis for Conclusions of ASU 2017-12, we believe the Board intended for this accommodation to only apply when the window of time specified for the hedged transactions is either 31 days or the fiscal month. For example, a reporting entity cannot apply the critical terms match method to a hedge that specifies a period extending from 31 days before the maturity of the derivative to 31 days after the maturity of the derivative as the window of time in which the group of forecasted transactions could occur (i.e., it cannot use a 62-day window).
If at inception of the hedging relationship or in any subsequent period the maturity of the derivative and the timing of occurrence of the hedged group of forecasted transactions is not or is no longer within the same 31-day period or fiscal month, the critical terms match method cannot be applied and a long-haul method must be used.
Example DH 9-1 discusses the use of critical terms match method to a hedge of a group of forecasted transactions.
EXAMPLE DH 9-1
Use of critical terms match method to a hedge of a group of forecasted transactions
Use of critical terms match method to a hedge of a group of forecasted transactions
In November of 20X1, DH Corp, a USD functional entity, decides to hedge the first 1 million euro (EUR) of its probable euro-denominated sales transactions expected to occur during the month of March 20X2 with a forward contract to receive 1.3 million USD and pay 1 million EUR maturing on March 15, 20X2. The derivative has a fair value of zero at inception. DH Corp uses the calendar month as its fiscal month and documents March 20X2 as the 31-day period to use for purposes of comparing the maturity of the derivative and the group of hedged forecasted transactions.
Can DH Corp use the critical terms match method for the hedge?
Analysis
Yes. For purposes of assessing whether the qualifying criteria for the critical terms match method are met for a group of forecasted transactions, DH Corp may assume that the hedging derivative matures at the same time as the occurrence of the forecasted transactions since both the derivative maturity and the forecasted transactions occur within the specified 31-day period. That is, if all of the other criteria to apply hedge accounting and the critical terms match method are met, DH Corp may ignore the timing difference between the dates of expected occurrence of the hedged forecasted transactions (throughout the month of March 20X2) and the maturity date of the derivative (March 15, 20X2) since they occur within the documented 31-day period.
If in a subsequent period, DH Corp determines that the hedged forecasted transactions will not occur within the documented 31-day period (e.g., they will occur on April 1, 20X2), DH Corp could no longer apply the critical terms match method. This is because DH Corp specified the month of March 20X2 as the 31-day period (March 1 through March 31) to use to compare the maturity of the derivative to the group of hedged forecasted transactions. DH Corp should also consider whether the hedged forecasted transaction remains probable of occurring within the time period originally specified, as discussed in DH 10.4.8.1.
9.5.1.1 Critical terms match method for all-in-one hedges
The critical terms match method may be used to assess effectiveness in all-in-one hedges. As discussed in DH 7.3.4, in an all-in-one hedge, a derivative that will be gross settled is 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. In effect, the hedged item and hedging instrument are the same.
Question DH 9-6
DH Gas Company executes 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 per day of $3/MMBtus in the month of July 20x4. Can DH Gas use the critical terms match method to assess effectiveness of the all-in-one hedge?
DH Gas Company executes 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 per day of $3/MMBtus in the month of July 20x4. Can DH Gas use the critical terms match method to assess effectiveness of the all-in-one hedge?
PwC response
Yes. The hedged item (the forecasted purchase of 10,000 MMBtus per day in July 20x4) and the hedging instrument (the firm commitment) are the same transaction; therefore, the critical terms match and the criteria in ASC 815-20-25-84 are met.
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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