ASC 815-20-25-126 through ASC 815-20-25-129A discuss the assessment of effectiveness for certain cash flow hedges involving options as hedging instruments. Unlike the critical terms match method for forwards, the guidance for options can be applied to hedges of interest rate risk (and other risks, such as foreign currency and commodity price risk).
For these hedging relationships to be considered perfectly effective, all of the conditions in ASC 815-20-25-126 and ASC 815-20-25-129 must be met. If the reporting entity concludes that the hedging relationship may be considered to be perfectly effective because all of the conditions are met, it (1) does not have to assess effectiveness quantitatively and (2) should record all changes in the hedging option’s fair value (including changes in the option’s time value) through OCI (until the hedged item impacts earnings).

Excerpt from ASC 815-20-25-126

  1. The hedging instrument is a purchased option or a combination of only options that comprise either a net purchased option or a zero-cost collar
  2. The exposure being hedged is the variability in expected future cash flows attributed to a particular rate or price beyond (or within) a specified level (or levels)
  3. The assessment of effectiveness is documented as being based on total changes in the option’s cash flows (that is, the assessment will include the hedging instrument’s entire change in fair value, not just changes in intrinsic value)
Excerpt from ASC 815-20-25-129
  1. The critical terms of the hedging instrument (such as its notional amount, underlying, maturity date, and so forth) completely match the related terms of the hedged forecasted transaction (such as, the notional amount, the variable that determines the variability in cash flows, and the expected date of the hedged transaction, and so forth)
  2. The strike price (or prices) of the hedging option (or combination of options) matches the specified level (or levels) beyond (or within) which the entity’s exposure is being hedged
  3. The hedging instrument’s inflows (outflows) at its maturity date completely offset the present value of the change in the hedged transaction’s cash flows for the risk being hedged, and
  4. The hedging instrument can be exercised only on a single date—its contractual maturity date.

If all of the conditions in ASC 815-20-25-126 are met, but any of the conditions in ASC 815-20-25-129 are not met in that not all of the critical terms match, the reporting entity would look to ASC 815-20-25-129 to determine the terms of the “perfect hypothetical derivative.” In other words, it would assess effectiveness by comparing the change in fair value of the actual hedging instrument and the change in fair value of a hypothetical hedging instrument that meets all of the criteria in ASC 815-20-25-129.
As an alternative to using the option’s entire terminal value to assess effectiveness, ASC 815-20-25-83A permits a reporting entity to exclude the initial value of an excluded component from the assessment of effectiveness and to recognize the amount in earnings using a systematic and rational method over the life of the hedging instrument. For example, if a hedge does not meet the criteria to be considered perfectly effective, the reporting entity may be able to recognize the initial value of an excluded component, like the time value, using a systematic and rational method over the life of the hedging instrument. See DH 9.3.3 for discussion of excluded components.

9.6.1 Timing mismatches in a hedge using options

While the criterion in ASC 815-20-25-129(a) is that the critical terms match between the derivative and the hedged item or hedged forecasted transaction, ASC 815-20-25-129A permits limited differences between the maturity date of the hedging instrument and the timing in which a group of hedged forecasted transactions are expected to occur.

ASC 815-20-25-129A

In a 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 815-20-25-129(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 that extends 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, a reporting entity would not be able to assume perfect effectiveness under the terminal value method for options, and a long-haul method must be used.
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