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

The evaluation of whether the forecasted transaction is probable of occurring is highly judgmental; “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” and thus the likelihood of occurrence is significantly greater than what is indicated by the phrase more likely than not. Although ASC 815 and ASC 450 do not establish bright lines, we believe that a transaction may be considered probable of occurring when there is at least a 75%-80% chance that it will occur on the specified date. In addition, there should be compelling evidence to support management’s assertion that the forecasted transaction is probable.

In addition to the impact on qualifying for hedge accounting, the assessment of whether the forecasted transaction is probable also impacts potential discontinuation of the hedge. The guidance on discontinuation of a cash flow hedge in ASC 815-30-40-1 through 40-5 explains how to address a change in the probability of a forecasted transaction subsequent to the initial designation of the hedging relationship. The impact of changes will depend on the reporting entity’s expectations regarding the possibility or probability of the originally forecasted transaction occurring at a certain time or not at all, as summarized in Figure 3-13 and further discussed below.

Figure 3-13
Impact on hedge accounting of a change in the probability of a forecasted transaction

As summarized in Figure 3-13, ASC 815-30-40-1 requires that if any of the cash flow hedge accounting criteria are no longer met, the hedging relationship should be discontinued; amounts previously deferred in accumulated other comprehensive income should continue to be deferred and recognized as the forecasted transaction impacts earnings or recognized in full immediately when the transaction is probable of not occurring. Changes in the fair value of the derivative instrument are recorded in earnings going forward, unless the instrument is designated as a hedging instrument in a new hedging relationship.

We understand that the SEC staff believes management should formally document 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. The SEC staff takes the position that although one instance of a changed assertion does not constitute a pattern, recurrence will quickly raise a red flag. The consequences (e.g., possible restatement) are serious; therefore, reporting entities need to be able to support their assertion that forecasted transactions are probable of occurring if cash flow hedge accounting is being sought.

In assessing the probability of the forecasted transaction occurring, a reporting entity should consider its past history in executing similar types of hedging transactions and its success in accurately forecasting these transactions. For example, a regulated utility may have a long history of buying a certain amount of power to support retail load during the third quarter of the year. It may be relatively easy to support a forecasted transaction that represents only a portion of the historical purchases and current forecast (and would become increasingly difficult as the percentage hedged increases). In contrast, if a power company has a new peaking facility and intends to sell into a new market, it may be more difficult to support a probable level of sales, compared to selling into a region where it has a longstanding history of successfully forecasting its sales.

The FASB specifically addresses the length of time that is expected to pass before a forecasted transaction is projected to occur and the quantity involved in the forecasted transaction as key considerations in assessing probability.

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. For example, a power generation facility that is hedging its exposure to sales of power would need to forecast its wholesale load requirements and other non-derivative power sales to determine the total forecasted sales eligible for hedge accounting. This forecast should not include any derivative power sales contracts or any fixed-priced sales transactions, because neither a derivative nor a fixed-price firm commitment can be designated as the hedged item in a cash flow hedge.

Absent a contractual commitment for volumes, 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 of market demand. Similarly, if a power company produces energy using natural gas and wants to hedge its supply, it may be difficult to support designating a high percentage of its forecasted purchases of natural gas if energy sales are highly dependent on volatile markets.

Reporting entities should also consider the guidance in ASC 815-20-25-16(a) when assessing the probability of the forecasted transaction.

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 its hedge continues to qualify. See Figure 3-14 for further information.

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, 20X2). However, in many cases delivery will be expected during a defined period rather than on a specific date. For example, deliveries of energy 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 specifically regarding uncertainty within a range.

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 it is no longer probable of occurring as originally documented, in general, the hedge should be discontinued. However, ASC 815-30-40-4 provides guidance in cases where it is still reasonably possible that the transaction will occur within two months of the original timing.

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 accumulated other comprehensive income should be immediately reclassified to earnings. See DH 9.1.2 for further information on discontinuation of cash flow hedges.

In addition to changes in timing of the forecasted transaction, there may be other events or changes in the transaction that cause it to be no longer probable of occurring. The possibility of such changes should be considered in evaluating the probability of the forecasted transaction.

In particular, power markets continue to change and evolve. For example, some markets in recent years have increased the specificity of pricing by moving from nodal pricing to locational marginal pricing. In addition, a hedging derivative or normal purchases and normal sales contract designated as the hedged item could specify the substitution of a pricing point (location) or index to be used in the event the pricing index specified in the contract is no longer available.

A new market structure or the requirement to use a different index may result in or be an indication of a lack of liquidity at the existing location, which may call into question whether the forecasted transaction is still probable of occurring. For example, a change from a nodal market to locational margin pricing may result in a decline in liquidity for pricing locations that were previously used by market participants. The elimination or reduced liquidity of trading points may result in such points no longer having a risk profile that correlates with the original hedged transaction. As a result, reporting entities would need to consider whether existing hedges are still effective or whether they should be de-designated and re-designated.

When there is a market structure change or other pricing changes, reporting entities will also need to consider the impact on prospective effectiveness assessments for future transactions. There may be a lack of historical pricing information in the new market to support the effectiveness test prospectively. Reporting entities that have an accounting policy to use historical pricing information in their effectiveness assessments will need to consider what other information may be available to support the prospective tests, such as forward pricing information. Due to the lack of historical information, judgment and rigor will be needed in performing effectiveness tests using forward pricing information. Any new market structure with significant changes will also need to be incorporated into future hedge designations. See UP 3.5.4 for further information on evaluating hedge effectiveness.

Simplified Examples 3-27 through 3-30 illustrate the impact of various types of changes in the forecasted transaction. In addition, ASC 815-30-55-100 through 55-105 provide case studies to illustrate this guidance.

EXAMPLE 3-27
Hedge accounting — natural gas sales shortfall compared to forecast

In October 2012, Guava Gas Company (GGC) enters into a cash flow hedge of the sale of the first 10,000 MMBtus of natural gas per month in each of January through March 2013. The probability of the forecasted transaction was supported by GGC’s current forecast, for which it had performed backtesting of its accuracy. GGC has also met all of the other requirements for cash flow hedge accounting. In January 2013, GGC sells only 8,000 MMBtus of natural gas.

How should GGC account for its shortfall in sales in January?

The amounts deferred in accumulated other comprehensive income related to the 8,000 MMBtus of January sales would be released to net income because the forecasted transaction occurred. GGC has already designated and hedged the first 10,000 MMBtus of sales of natural gas in February 2013. Therefore, the shortfall of 2,000 MMBtus in January 2013 cannot carry over as the “first” sales in February 2013. However, if GGC can support that it will sell additional natural gas in February 2013 (e.g., the sale of the volumes from 10,001 MMBtus through 12,000 MMBtus), then the amount previously deferred in accumulated other comprehensive income related to 2,000 MMBtus of shortfall in January 2013 should continue to be deferred because the forecasted transaction will occur within two months of the originally designated time period. The deferred amounts in AOCI would then be released to net income in February as the deliveries in excess of the first 10,000 MMBtus occur. GGC will also need to reevaluate whether the hedge is still effective, which may not be the case because of the change in time period for a portion of the forecasted sales.

If it is remote that GGC will have sales in excess of 10,000 MMBtus in February or March (two months beyond the initial designated period) then the forecasted transaction has become probable of not occurring. In that case, the hedging relationship should be discontinued and the amounts deferred in AOCI should be immediately released into earnings.

EXAMPLE 3-28
Hedge accounting — change in forecasted natural gas sales

In October 2014, Ivy Power Producers (IPP) enters into a natural gas swap contract to fix the price of 50,000 MMBtus of natural gas purchases per month for the period from January through March 2015. Based on IPP’s forecast, it expects to buy 100,000 MMBtus per month during this period. IPP designates and documents the swap as a cash flow hedge of its forecasted purchase of the first 50,000 MMBtus of natural gas purchased each month during the period. The natural gas purchased will be used to generate power at the Maple Generating Station. Assume all of the criteria for hedge accounting have been met.

In February 2015, due to a drop in power prices, IPP decides to purchase, rather than generate power for sales to its customers. As a result, IPP purchases only 20,000 MMBtus of natural gas in February 2015. In addition, IPP believes it is remote that it will purchase more than 10,000 MMBtus of natural gas in March through June 2015, therefore determining that it is probable its forecasted transaction will not occur.

How should IPP account for the changes in its forecast?

Because IPP has determined that it is probable that the forecasted transaction will not occur, it should de-designate the hedging relationship and record subsequent changes in the fair value of the swap through earnings. In addition, the amounts previously deferred in accumulated other comprehensive income should be immediately released into earnings because the forecasted transaction is now probable of not occurring.

EXAMPLE 3-29
Hedge accounting — change in forecasted power sales

In October 2014, Ivy Power Producers (IPP) enters into a receive fixed ($90/MWh), pay floating swap for the hourly amount of 200 MWs of energy during on-peak hours for the period January 1, 2015 through March 31, 2015. The contract is designated as a hedge of forecasted power sales from the Maple Generating Station. The swap notional is based on IPP’s forecast of power sales. In January 2015, IPP’s plant is shut down due to a forced outage and no power is produced. IPP does not expect the plant to be back online until May 2015; therefore, it determines that it is probable the forecasted transaction will not occur.

How should IPP account for the changes in its forecast?

Because IPP has determined it is probable that the forecasted transaction will not occur, it should terminate the hedging relationship immediately and record subsequent changes in the fair value of the swap through earnings. In addition, the amounts deferred in accumulated other comprehensive income should be immediately released into earnings. Because IPP does not expect to be able to sell until at least May 2015, the sales are probable of not occurring within two months of the original time period of January through March 2015.

EXAMPLE 3-30
Hedge accounting — forecasted transaction is no longer probable

As of December 31, 2014, Ivy Power Producers (IPP) has hedged its forecasted purchases of natural gas of 200,000 MMBtus for the month of March 2015 using a combination of different hedging instruments. The derivatives are designated using a first-in, first-out methodology (i.e., the first derivative entered into for the specified period hedges the first sales in the month, the next derivative hedges the next sales in the month, and so forth). IPP designates the sequencing of the hedges at the time of contract execution to have an effective hedging relationship.

On December 31, 2014, IPP determines that 50,000 MMBtus of forecasted purchases in March 2015 and within two months are probable of not occurring.

How should IPP account for the hedged transactions in the sequence that are not probable of occurring?

Another key characteristic for a forecasted transaction to qualify for hedge accounting is that it should represent an earnings exposure for the reporting entity. Therefore, in accordance with ASC 815-20-25-15(c), a forecasted transaction must be with a party external to the reporting entity (although intercompany hedges for foreign currency exposures are permitted). In addition, the forecasted transaction should present a risk of changing cash flows that could impact reporting earnings (for the hedged risk).

Because a forecasted transaction must be with a party external to the reporting entity to qualify as an earnings exposure, the effects of any intercompany hedges between a parent and its subsidiaries or among subsidiaries should be reversed in the consolidated financial statements (other than hedges of foreign exchange risk). However, as long as the parent and subsidiary have the same functional currency, a subsidiary can apply hedge accounting to a hedge of a forecasted intercompany transaction in its stand-alone financial statements. At the subsidiary reporting level, that transaction is with an external party.

In addition, although a reporting entity cannot apply hedge accounting for non-foreign-currency-denominated intercompany forecasted transactions at the consolidated level, it is acceptable to hedge different exposures at different reporting levels. For example, a parent company may enter into a natural gas swap and designate that swap as a cash flow hedge of forecasted sales of natural gas by one of its subsidiaries. In this scenario, the parent company may apply hedge accounting in the consolidated financial statements if the swap was designated to hedge a risk exposure at the consolidated reporting level, the forecasted transaction is with an external party, and all other hedge accounting criteria are met. The subsidiary, however, will not apply hedge accounting in its stand-alone financial statements because the derivative instrument is not held at that level.

A key consideration when establishing an accounting hedge is the appropriate designation of the risk to be hedged and appropriate matching of the risk with the hedging instrument. In accordance with ASC 815-20-25-15(i), the hedged risk in a forecasted sale or purchase of a nonfinancial item (such as a commodity) should be the risk of changes in total cash flows related to all price changes of the commodity.¹²

Therefore, a reporting entity cannot designate the price of natural gas as the hedged risk in a forecasted purchase of power, because the cash flow risk from the change in the price of natural gas is only a portion of the overall risk of the changes in cash flows relating to power.

However, a reporting entity could potentially use a natural gas derivative as a cash flow hedge of the entire forecasted purchase or sale of power. The reporting entity would need to designate all of the cash flows relating to the forecasted purchase of power as the hedged risk, and the change in fair value of the natural gas derivative should be expected to be highly effective at offsetting the total changes in those cash flows. All other hedge criteria should also be met. This hedging relationship may be highly effective in circumstances where power prices are highly correlated to natural gas. However, some ineffectiveness would be expected because changes in power prices are not entirely due to the change in natural gas prices.

¹²Foreign exchange risk alone may be a designated risk in a hedge of a forecasted purchase or sale of a nonfinancial asset. For the purposes of this section, we discuss only price risk. See DH 7.7.2 for further information on designating foreign currency risk in a cash flow hedge.

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 815-20-25-22¹³ to permit a 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 definition of both a firm commitment and a derivative instrument.

Simplified Example 3-31 provides an illustration of an all-in-one hedge transaction.

EXAMPLE 3-31
Hedge accounting — all-in-one hedge of natural gas

Ivy Power Producers (IPP) enters into a contract for the purchase of 10,000 MMBtus of natural gas per day in the month of July 2014 for $3.00/MMBtu. The contract meets the definition of a derivative. IPP determines that the contract is not eligible for the normal purchases and normal sales scope exception because it may be subject to net settlement as a result of its default provisions. Management has determined that the contract is probable of being physically settled.

¹³Guidance originally issued as DIG Issue G2, Cash Flow Hedges: Hedged Transactions That Arise From Gross Settlement of a Derivative (“All-in-One” Hedges).

Reporting entities should also consider the impact on an existing hedge when there are changes in the hedging instrument. In particular, if a hedging instrument is terminated, the hedge should be de-designated.

In considering changes to derivatives designated as hedging instruments, one specific area of concern is when a derivative is modified and/or novated such that there is a new counterparty, as discussed in the following questions.

Subsequent to the inception of a hedging relationship, a derivative counterparty may decide to novate the contract and engage a new counterparty. It may also modify the terms of the contract by altering the pricing. This raises a question as to whether the reporting entity would be able to continue the original hedging relationship when the swap is novated.

When a contract is novated, and the original terms of the contract are modified, it effectively results in a termination of the existing contract and the creation of a new contract. For the original hedging relationship to remain intact, the original terms of the hedging derivative should remain unchanged (other than for changes that are not substantive). A change such as pricing is considered substantive. Although hedge accounting is discontinued, a reporting entity may designate the novated swap as a hedging instrument in a new hedging relationship, provided it meets the conditions required for hedge accounting. The fair value on the date of novation would need to be considered in the evaluation of effectiveness and measurement of ineffectiveness of the new hedging relationship.

As discussed in Question 3-38, contract modifications and novations generally result in the de-designation of an existing hedge. Under Title VII of the Dodd-Frank Act, certain derivatives that are executed in the over-the-counter market may be required to be cleared through derivative clearing organizations or clearing agencies, resulting in novations of the existing contracts.

The SEC staff has responded to questions about the accounting impact of these novations, particularly with respect to hedge accounting. The SEC staff has indicated that it would not object to a conclusion that, for accounting purposes, the original derivative contract is not considered terminated and replaced with a new derivative contract, nor would it object to the continuation of the existing hedging relationship, provided that other terms of the contract have not been changed. The SEC staff’s views apply to the following circumstances that are potentially applicable to utilities and power companies:

Changes to the terms of the over-the-counter derivative contract that are a direct result of the novation of the contract to the central counterparty would not preclude the continuation of hedge accounting. For example, contractual collateral requirements of the original contract may change as a direct result of the novation, because the original counterparties must now comply with the contractual collateral requirements of the central counterparty. This guidance should not be interpreted as permitting any novation of a derivative contract to be viewed as a continuation of an existing derivative contract. The SEC staff’s view is focused solely on the instances outlined above.

It depends. A reporting entity may have outstanding exchange-traded derivative transactions (e.g., futures contracts, swaps) that have been designated as hedging instruments in cash flow hedging relationships. An exchange may choose to offset these against other derivative transactions held by the reporting entity prior to the settlement of the transactions as a result of margin posting or other purposes.

ASC 815-30-40-1 provides specific guidance on when a hedging relationship should be discontinued. In making this assessment, the reporting entity should use judgment in evaluating whether the offsetting of contracts by an exchange results in the expiration, sale, or termination of the derivative instrument. The impact of offsetting by the exchange on an existing contract is a legal determination. Therefore, we believe reporting entities should consult with legal counsel to make this determination.

The long-haul method is permitted to be used to evaluate effectiveness for any hedging relationship. ASC 815-20-25 does not prescribe a specific method for assessing hedge effectiveness but instead requires that a reasonable method based on the objective of management’s risk management strategy and the nature of the hedging relationship be applied consistently to all similar hedges. This section addresses specific considerations in applying the long-haul method to commodity contracts.

Yes. A reporting entity may enter into a forward contract that it designates as the cash flow hedge of a forecasted commodity transaction. ASC 815-20-25-82(d) permits reporting entities to exclude the change in the fair value attributable to differences in spot prices and forward prices from effectiveness assessments.

Therefore, in assessing effectiveness, reporting entities may choose to consider changes in the forward contract’s fair value that are attributable only to changes in spot prices from one reporting period to the next. However, if this approach is used, some volatility in earnings will result, because the excluded portion of the change in fair value of the forward contract will be included in earnings as it occurs.

The variance reduction method is a form of long-haul effectiveness testing that allows a reporting entity to measure the extent to which the hedging instrument offsets the variance of the hedged item. This method is similar to regression analysis and is a statistical measure of the dispersion of the hedged item’s possible values. The variance reduction test compares the statistical variance of the fair value of the combined position of the hedged item and the hedging instrument to the statistical variance of the fair value of the hedged item alone.

In applying this method, a reporting entity will need to determine and document how large a reduction of the variability of the hedged item is needed to conclude that the hedge is considered highly effective. Practice has developed to state that a variance reduction or epsilon of .80 or greater would be needed for a hedging relationship to be considered highly effective. A variance reduction of 0.80 means that the hedging instrument has reduced the dispersion of the hedged item to 20% based on the following formula:

ε – Epsilon, the calculated variance reduction

s2H – Sample variance of the hedged position (the hedging instrument and the hedged item), which is the sum of the squared variances of the hedged position

s2Y – Sample variance of the hedged item, which is the sum of the squared variances of the hedged item alone

In calculating the sample variance of the hedged position and the hedged item, a reporting entity could use the historical monthly changes in prices for the hedged item and the derivative instrument. If the hedging relationship is deemed to be perfectly effective, the epsilon would be 1.0 because the numerator in the ratio (the dispersion of the combined hedged position) would be reduced to zero, thereby resulting in a ratio of zero. In practice, as long as the ratio is between .80 and 1.0, reporting entities generally conclude that the hedging relationship is considered highly effective.

Simplified Example 3-33 illustrates application of the variance reduction method.

EXAMPLE 3-33
Hedge accounting — application of the variance reduction method

Ivy Power Producers (IPP) owns the Camellia Generating Station, a 575 MW combined-cycle natural gas-fired generation facility. IPP is hedging forecasted purchases of natural gas for the Camellia power plant at Houston Ship Channel. IPP enters into a two-year NYMEX swap based on Henry Hub pricing to hedge its forecasted purchases of natural gas for Camellia.

The variance of the monthly changes in the Houston Ship Channel spot price for the 24-month period is 1.48. In addition, the variance of the monthly changes of the combined hedged position is 0.04.

Because the hedging instrument is priced at the Henry Hub location and the physical purchase of natural gas is priced at the Houston Ship Channel location, IPP’s hedge is subject to ineffectiveness. IPP decides to use the variance reduction method to assess the effectiveness of the hedge.

Is the hedge highly effective?

In applying the variance reduction method, IPP would calculate the sum of the variances of the combined hedged position and the sum of the variances of the hedged item based on historical data. Because this is a two-year hedge, the historical monthly prices for the prior 24 months would be used in the calculation. In this example, hedge effectiveness would be calculated as follows:

Often, for commodity hedges, reporting entities seek to evaluate effectiveness using the critical terms match method, because it provides simplicity as compared to a quantitative assessment. A reporting entity may execute a commodity contract for which the terms perfectly match the hedged item or transaction such that the changes in cash flows attributable to the risk being hedged are expected to completely offset at the inception of the contract and on an ongoing basis. In the case of a commodity contract, ASC 815 precludes the application of the shortcut method (which is only available for plain-vanilla interest rate swaps); however ASC 815-20-25-84 provides guidance on the use of a critical terms match method that can be used for commodity hedging relationships.

If a reporting entity concludes that application of the critical terms match method of assessing effectiveness is appropriate, it is still required to assert and to document that the hedging instrument is expected to be perfectly effective in offsetting the hedged risk at the inception of the hedge.

The assessment should be updated quarterly; however, subsequent assessments can be limited to confirming that there have been no changes to the terms of the hedging instrument and forecasted transaction, as well as an updated analysis of potential for counterparty default. If there are changes or adverse developments, the reporting entity should measure ineffectiveness and quantitatively assess whether the hedge is expected to continue to be highly effective.

The SEC staff has expressed its view that known sources of variability that are not perfectly matched should be considered when evaluating hedge effectiveness (including when using the critical terms match method). The SEC staff further stated that when a reporting entity has inappropriately assumed there is no ineffectiveness in a relationship and did not measure the amount of the ineffectiveness, the error should be quantified as if the designated hedging relationship did not qualify for hedge accounting under ASC 815 (i.e., the hedge accounting should be reversed from inception, potentially leading to restatement if the impact is material).

The SEC staff expects that registrants will not ignore such sources of potential ineffectiveness but rather will prepare a quantitative analysis to support their assertions about hedge effectiveness. Specifically, where there are known sources of potential ineffectiveness, the SEC staff expects that a quantitative analysis will demonstrate that the hedge will nevertheless be expected to always be effective and that any ineffectiveness would be de minimis.

Therefore, as part of critical terms match hedging, reporting entities should:

These activities are further described below. The SEC staff did not prescribe the method(s) to be used to perform this analysis; ASC 815 allows considerable latitude in the manner in which hedge effectiveness can be supported. A reporting entity should determine the appropriate methodology based on its specific facts and circumstances. The analysis should be updated as necessary to address any changes impacting the initial analysis.

Without supporting analysis, the SEC staff believes it is inappropriate to assume that there is no ineffectiveness in a hedging relationship when there is a known source of variability that has not been perfectly matched. However, the SEC staff has accepted the application of hedge accounting in situations where the registrant has (1) identified the source of ineffectiveness; (2) evaluated the possible impacts and sufficiently demonstrated that the possible ineffectiveness would be de minimis; and (3) documented a quantitative analysis that demonstrated a continuing and realistic expectation of effectiveness. As a result, we recommend that reporting entities perform and document the following analyses:

Common potential sources of ineffectiveness in commodity hedges:

In addition, the SEC staff has focused on potential ineffectiveness arising from differences in maturity dates and settlement/payment dates between the hedging instrument and the hedged forecasted transaction. The SEC staff believes that a difference between the hedged forecasted transaction date and the derivative instrument’s maturity, or a difference between the settlement dates of the forecasted transaction and the derivative instrument, are known potential sources of variability (i.e., ineffectiveness) that should be addressed in the registrant’s hedge documentation.

As noted above, the SEC staff expects registrants to identify all potential sources of ineffectiveness in a hedging relationship. However, the registrant has some flexibility in the manner in which such differences are addressed. The overall objective is to perform an analysis (in part, quantitatively) that supports the registrant’s underlying assertion that the hedging relationship was and will be expected to be highly effective, and that the aggregate and periodic amounts of any ineffectiveness would be de minimis (thus supporting the use of the critical terms match method). The reporting entity should determine the appropriate approach and level of analysis based on its specific facts and circumstances.

After the initial assessment, on a quarterly basis, reporting entities should review their documentation, affirm that the underlying assertions are still appropriate, and, if necessary, update their prior analyses. Reporting entities will need to determine the appropriate amount of quantitative analysis on a quarterly basis, based on the specific facts and circumstances of their hedging relationships. In some cases, it may be appropriate to update the quantitative analysis performed at inception based on current data; in other situations, it may be sufficient to review the original assertion and adjust the analysis as applicable for any changes in the factors that support the initial conclusion. The quarterly procedures related to ineffectiveness should be documented as part of the critical terms match quarterly documentation.

The following simplified examples illustrate considerations in applying the critical terms match method, including sample hedge documentation as well as the evaluation and documentation of potential sources of ineffectiveness.

EXAMPLE 3-34
Hedge accounting — critical terms match method of evaluating hedge effectiveness (monthly spot prices)

In October 2014, Ivy Power Producers enters into a swap for the purchase of 10,000 MMBtus per day of natural gas at a fixed price of $2.00/MMBtu at SoCal Border (a market hub for natural gas located in California) for the month of August 2015. Under the terms of the swap, IPP will pay $2.00 and will receive the monthly spot price at SoCal Border. The swaps are executed in anticipation of the forecasted purchase of at least 10,000 MMBtus per day of natural gas at the same location during the same period, at the monthly spot price. The hedging instrument will settle on July 31, 2015 and IPP will pay or receive the settlement amount on the fifth day of August 2015. IPP will pay for its physical purchases on the twentieth day of September 2015.

In this example, the hedging strategy is to hedge the changes in total cash flows by fixing the natural gas price through the fixed-for-floating index swap for the quantity needed to generate power. Although most of the critical terms (i.e., location, quantity, and price) match between the swap and the forecasted transaction, there is a difference in settlement dates because the financial swap and physical commodity purchase will settle on different dates, resulting in ineffectiveness arising out of the time difference in the value of cash.

Does the difference in settlement dates have a more than a de minimis impact?

Any source of potential ineffectiveness (even a difference in settlement date of a few days) should be considered in IPP’s hedge documentation and effectiveness assessment. A brief quantitative analysis should be included in the original hedging documentation.

The time value of the maximum expected settlement amount on the hedge would be calculated as follows:

The potential maximum impact is de minimis based on the time value of money compared to the total value of the hedge transaction. The analysis could also be performed on a periodic basis to support similar hedges (e.g., the analysis could be performed quarterly for all similar hedges executed in the quarter); however, the hedge documentation for each hedge should clearly reference the analysis and document the conclusion.

Alternatively, this, or a similar analysis of settlement differences for similar hedges could be performed on a global basis, such as through an analysis of average total monthly settlements. Reporting entities have flexibility in performing their analysis; however, the conclusion should be supported by a quantitative analysis for these types of differences.

In addition, IPP is still required to update its hedge effectiveness evaluation at least quarterly. However, when the critical terms match approach is used, the subsequent assessment of effectiveness can be performed by verifying and documenting that there has been no change in the critical terms of the hedging instrument or forecasted transaction during the period. IPP should consider if there have been any changes in circumstances or market interest rates that necessitate an update to its time value analysis. Finally, IPP should also specifically consider and document whether there have been any adverse developments with respect to counterparty credit risk during the period (see UP 3.5.2.2 Counterparty creditworthiness).

EXAMPLE 3-35
Hedge accounting — critical terms match method of evaluating hedge effectiveness (daily spot prices)

Assume the same facts as in Example 3-34, except that Ivy Power Producers will settle the forecasted physical transaction using the daily spot prices instead of monthly prices. In this example, the hedging strategy is to hedge the changes in total cash flows by fixing the natural gas price as of the beginning of the transaction month. Note—the mismatch in settlement dates described in Example 3-34 also applies here. However, this difference has been ignored in this example to focus on other effectiveness issues.

In this fact pattern, the critical terms relating to location and timing match; however, the pricing of the swap (based on the monthly index) does not match that of the forecasted transaction which will be settled using the daily spot prices. A daily/monthly pricing mismatch represents a basis difference. Although the forecasted purchases occur within the same month, there is a difference in maturity date between the hedging instrument (matures on August 1, 20X2) and the forecasted transaction (forecasted to occur each day throughout the month of August 20X2 with settlement in September 20X2). The difference in maturity date and the difference in the settlement index (monthly index for the hedging instrument compared with daily index for the physical transactions) will create ineffectiveness in the hedging relationship.

How should IPP determine the amount of ineffectiveness?

As a result of the basis mismatch, IPP should evaluate whether use of the critical terms match method is appropriate. If the critical terms match method is used, IPP would be expected to perform a quantitative analysis to support the assertion that any ineffectiveness due to the basis mismatch would be de minimis. It may be more appropriate to perform a long-haul assessment of effectiveness, essentially evaluating the relationship between the daily natural gas prices versus the monthly prices at the given location.

There are several ways reporting entities may perform this analysis, including: