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Hedging Handbook

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Hedging Handbook

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Hedging

As amended by ASU 2017-12

Handbook

US GAAP

September 2018

kpmg.com/us/frv
Contents
Foreword...................................................................................................... 1
About this publication .................................................................................. 2
1. Executive summary ........................................................................... 4
2. General hedging requirements .......................................................... 14
3. Qualifying criteria for fair value hedges ............................................. 155
4. Accounting for fair value hedges ....................................................... 211
5. Qualifying criteria for cash flow hedges ............................................ 293
6. Accounting for cash flow hedges ...................................................... 379
7. Hedging foreign currency exposures ................................................ 479
8. Net investment hedges ..................................................................... 595
9. Hedge effectiveness ......................................................................... 642
10. Private companies ............................................................................. 843
11. Effective dates and transition ............................................................ 865
Appendices .................................................................................................. 897
Index of Q&As ................................................................................... 897
Index of examples ............................................................................. 919
KPMG Financial Reporting View .................................................................. 927
Acknowledgments ....................................................................................... 928

© 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member
firms affiliated with KPMG International Cooperative, a Swiss entity. All rights reserved.
Hedging 1
Foreword

Perspectives on a complex
area
When the first comprehensive hedge accounting guidance was issued in 1998,
the accounting requirements in this area were widely acknowledged as the
most detailed and complex in US GAAP.
Since then, we have seen ongoing changes made to the requirements. For a
long time, the changes added to the rules and complexity. But more recently,
the changes have been focused on reducing operational burden, expanding the
use of hedge accounting and better reflecting risk management practices.
Throughout all of these changes, one constant has been that hedge accounting
itself has remained optional. Even after electing to apply hedge accounting,
optionality has been a hallmark of the underlying accounting requirements. The
guidance in this area has always included various alternatives for different
strategies and methods for aspects such as measuring and assessing hedging
relationships – and now those options have expanded.
Our objective with this publication is to help you focus effectively and efficiently
on the hedge accounting alternatives and requirements. We provide you with
insights, examples and perspectives based on our years of experience in this
area – so you can understand your options and decide which alternatives are
right for you.

Kimber Bascom and Mark Northan

Department of Professional Practice, KPMG LLP

About this publication

The purpose of this Handbook is to assist you in understanding the new
hedging standard following the targeting improvements issued in August 2017.

Accounting literature and scope

This Handbook focuses on hedge accounting under ASC 815, Derivatives and
Hedging, as amended by Accounting Standards Update No. 2017-12, Targeted
Improvements to Accounting for Hedging Activities, which was issued in
August 2017 and first becomes effective in 2019.
The scope of ASC 815 (including the definition of a derivative) and embedded
derivatives will be addressed in future updates to this Handbook. In the
meantime, guidance on these topics is included in KPMG’s publication,
Derivatives and hedging (pre-ASU 2017-02), which provides guidance for
entities that have not yet adopted 2017-12.
In addition, KPMG’s publication on the targeted improvements to hedge
accounting under ASU 2017-12 provides a focused discussion of the specific
amendments in the ASU.

Organization of the text

Each chapter of this Handbook includes excerpts from FASB’s Accounting
Standards Codification® and overviews of the relevant requirements. Our in-
depth guidance is explained through Q&As that reflect the questions we are
encountering in practice. We include observations and examples to explain key
concepts.
Our commentary is referenced to the Codification and to other literature, where
applicable. The following are examples.
— 815-20-25-3 is paragraph 25-3 of ASC Subtopic 815-20.
— ASU 2017-12.BC148 is paragraph 148 of the basis for conclusions to
ASU 2017-12.
— FAS 133.BC423 is paragraph 423 of the basis for conclusions to
FASB’s Statements of Financial Accounting Standards No. 133, Accounting
for Derivative Instruments and Hedging Activities.
— DIG Issue is in relation to the Derivative Implementation Group
— 2006 AICPA Conf is the 2006 AICPA National Conference on Current SEC
and PCAOB Developments. These references are hyperlinked to the source
material on the SEC’s website.

Pending content
In some cases, the Codification is subject to content that becomes effective
after ASU 2017-12. For example, ASU 2016-13, Financial Instruments—Credit
Losses (Topic 326), includes consequential amendments to Topic 815.
When an excerpt from the Codification is affected by pending content:
— the specific sentences that have been superseded are struck out and the
added text is underlined; and
— the amended sentences are marked as pending content.

Future developments
As more people turn their attention to the application of the new hedging
standard, more questions are arising and the interpretations of the principles in
the standard continue to evolve. This means that some positions may change,
and positions on new issues will emerge, as we get closer to implementation.
For the Questions in this Handbook where we are aware of ongoing
discussions and the potential for a position to change, we have indicated that in
our interpretive response.
In addition, the FASB is currently working on a project to provide further
guidance on when an entity would be able to change the hedged risk and/or the
hedged forecasted transaction when the guidance on cash flows hedging is
applied. This project has the potential to significantly impact our guidance for
cash flow hedges. Currently the FASB is collecting external feedback related to
this project. Summaries of the potential Codification improvements discussed
at the March 2018 Board meeting are included in chapters 2, 5 and 6 (see
Future Developments).

Abbreviations
We use the following abbreviations in this Handbook.
AFS Available-for-sale
AOCI Accumulated other comprehensive income
CTA Cumulative translation adjustment
DIG Derivatives Implementation Group
FCD Foreign currency denominated
HTM Held-to-maturity
LIBOR London Interbank Offered Rate
NYMEX New York Mercantile Exchange
OCI Other comprehensive income
PEH Perfectively effective hypothetical (derivative)
SIFMA Securities Industry and Financial Markets Association

1. Executive summary
Topic 815 provides guidance on accounting for derivative instruments and
hedging activities.
Derivative instruments are assets or liabilities that are recorded on the balance
sheet at fair value. If the derivative instrument does not qualify for hedge
accounting, changes in fair value are recorded in earnings.
Hedge accounting is designed to allow an entity to hedge risks inherent in
certain transactions by using derivative instruments. It is elective and subject to
several criteria. If a hedging relationship meets these criteria, the accounting
varies based on the type of risk(s) being hedged and the type of hedge.
Topic 815 provides for three different types of hedges.
 Fair value hedge. A hedge of the exposure to changes in the fair value of a
recognized asset or liability, or of an unrecognized firm commitment, that is
attributable to a particular risk.
 Cash flow hedge. A hedge of the exposure to variability in the future cash
flows of a recognized asset or liability, or of a forecasted transaction, that is
attributable to a particular risk.
 Net investment hedge. A hedge of the exposure to foreign currency risk
of a net investment in a foreign operation.

General qualifying criteria

Hedge accounting is permitted only if all applicable criteria are met. There are
five general criteria that apply to fair value hedges and cash flow hedges, some
of which also apply to net investment hedges.

Criterion 1 Criterion 2 Criterion 3 Criterion 4

Eligibility of Eligibility of
Eligibility of Hedge
hedged items hedging
hedged risk(s) effectiveness
or transactions instruments

Criterion 5: Formal documentation

There are also specific qualifying criteria based on the type of hedge and the
type of risk(s) being hedged. Topic 815 also specifically prohibits certain items
and transactions from hedge accounting.
If any eligibility criteria cease to be met, the hedging relationship must be
discontinued – i.e. hedge dedesignation.
Read more: chapter 2

Qualifying criteria for fair value hedges

In addition to the general qualifying criteria, Topic 815 specifies certain items,
risks and hedging instruments that are eligible to be designated in a fair value
hedge.

Criterion 1: Items eligible for fair value hedges

Only recognized assets or liabilities, or unrecognized firm commitments, are

eligible to be designated as the hedged item in a fair value hedge. Topic 815
allows different strategies when hedging certain risks.

Individual recognized assets and

Firm commitments
liabilities

Portfolios of similar assets and liabilities

Portion (or percentage) of hedged item

Hedging only Partial-term

Residual
benchmark hedge of Embedded put Last-of-layer
value in a
interest rate interest rate or call option method
lease
component risk

Criterion 2: Risks eligible for fair value hedges

The risks eligible to be designated in a fair value hedge are different for financial
and nonfinancial items.

Financial items Nonfinancial items

Interest  Changes in the Not applicable.

rate risk benchmark interest rate
for recognized fixed-
rate financial
instruments.

Credit Includes: Not applicable.

risk — changes in the obligor’s
creditworthiness; and
— changes in the credit
spread over the
benchmark interest
rate.

Foreign — Changes in the related — Changes in the related

currency foreign currency foreign currency
risk exchange rates. exchange rates if the firm
commitment is
denominated in a foreign
currency.

Financial items Nonfinancial items

Price risk — Total change in the fair — Total change in the fair
value. value.

Criterion 3: Hedging instruments eligible for fair value hedges

There are no additional eligibility criteria or limitations specific to fair value

hedges, other than fair value hedges involving foreign currency risk.
Read more: chapter 3

Accounting for fair value hedges

The fair value hedge accounting model can change how the hedged item is
measured on the balance sheet.
Hedged items are subject to other applicable US GAAP – e.g. an asset or
liability measured at amortized cost. However, the hedging instrument is
measured at fair value with changes in fair value reported in earnings. This
creates a mismatch between the measurement of the hedged item and
hedging instrument. Fair value hedge accounting allows an entity to measure
the hedged item at fair value based on changes in the hedged risk.
In general, the fair value hedge accounting model has two main elements.

Hedging instrument Hedged item

A derivative hedging instrument is Changes in the fair value of the hedged
recognized at fair value on the balance item that are attributable to the hedged
sheet with changes in fair value risk are recognized as an adjustment to
recognized in earnings, other than the amortized cost basis of the hedged
amounts related to excluded item. The offsetting entry is a gain or
components that are recognized through loss that is recognized in earnings.
an amortization approach.

The following diagram shows the general accounting and presentation for a
highly effective fair value hedge (assuming there are no excluded components).

Hedging instrument Hedged item

Changes in fair value

Gain or loss recognized Change in value attributable to

in earnings hedged risk recognized in earnings

Income statement presentation

Recorded in the same income statement line item where the

earnings effect of the hedged item is presented

The effect is to offset gains or losses on the hedging instrument with gains or
losses on the hedged item that are attributable to the hedged risk within one
line item of the income statement.
The adjustment to the amortized cost basis of the hedged item from applying
fair value hedge accounting is referred to as a basis adjustment. Basis
adjustments are accounted for in the same manner as other components of the
amortized cost basis of the hedged item.
Read more: chapter 4

Qualifying criteria for cash flow hedges

In addition to the general qualifying criteria, Topic 815 specifies certain
transactions, risks and hedging instruments that are eligible to be designated in
a cash flow hedge.

Criterion 1: Transactions eligible for cash flow hedges

Cash flows from existing recognized assets or liabilities or forecasted

transactions are eligble to be designated as the hedged transaction in a cash
flow hedge.

Cash flows from existing recognized Forecasted transactions – e.g. forecasted

assets and liabilities purchases or sales

Group of similar forecasted

All-in-one hedge
transactions

Criterion 2: Risks eligible for cash flow hedges

The risks eligible to be designated in a cash flow hedge are different for
financial and nonfinancial assets and liabilities.

Financial assets and Nonfinancial assets and

liabilities liabilities

Interest Either: Not applicable.

rate risk — changes in a
contractually specified
interest rate for
variable-rate financial
instruments or
forecasted issuances or
purchases of variable-
rate financial
instruments; or
— changes in the
benchmark interest
rate for forecasted
issuances or purchases
of fixed-rate financial
instruments.

Financial assets and Nonfinancial assets and

liabilities liabilities

Credit Includes: Not applicable.

risk — risk of default;
— changes in the obligor’s
creditworthiness; and
— changes in the credit
spread over the
contractually specified
interest rate or the
benchmark interest
rate.

Foreign — Changes in the related — Changes in the related

currency foreign currency foreign currency
risk exchange rates. exchange rates of foreign
currency denominated
forecasted transactions or
firm commitments.

Price risk  Total change in the Either:

cash flows related to  all changes in the
the asset or liability – purchase price or sales
e.g. all changes in the price of the asset – i.e.
purchase price or sales price risk; or
price.
 changes in a contractually
specified component – i.e.
a component of price risk.

Criterion 3: Hedging instruments eligible for cash flow hedges

In addition to the general qualifying criteria and limitations of hedging

instruments, there are eligibility criteria specific to cash flow hedges. This
includes additional requirements that must be met in order to designate a basis
swap as the hedging instrument in a cash flow hedge.
Read more: chapter 5

Cash flow hedge accounting

The cash flow accounting model allows changes in the fair value of the
derivative instrument to be recorded in OCI instead of earnings.
Hedged transactions are probable future transactions that are not yet
recognized on the balance sheet or in earnings. Instead of recognizing the
forecasted transaction in advance, cash flow hedge accounting defers the
recognition of changes in the fair value of the derivative instrument.
In general, the cash flow hedge accounting model works as follows.
— A derivative hedging instrument is recorded at fair value in the balance
sheet. Changes in its fair value that are included in the assessment of
hedge effectiveness are reported in OCI.

— The amounts in AOCI are recognized in earnings – in the same income

statement line item as the effect of the hedged transaction – when the
hedged transaction affects earnings.
The following shows the general accounting and presentation for a highly
effective cash flow hedging relationship (assuming there are no excluded
components).

Hedging instrument Hedged transaction

Continue to apply otherwise

Entire change in fair value
applicable GAAP based on the
recorded in OCI
nature of the hedged transaction

Reclassified from AOCI into

Hedged transaction affects
earnings when hedged transaction
earnings
affects earnings

Offset of hedging instrum ent in sam e income statement

line item as earnings impact of hedged item

The effect of the above is to defer earnings recognition of changes in fair value
of the hedging instrument (that are included in the assessment of
effectiveness) until the hedged transaction affects earnings.
When a cash flow hedge is discontinued, the net derivative gain or loss
reported in AOCI generally is not recognized immediately in earnings. Instead, it
is reclassified into earnings when the hedged forecasted transaction is reported
in earnings. However, the net derivative gain or loss reported in AOCI is
immediately reclassified into earnings if it is probable that the hedged
forecasted transaction will not occur in the original period specified in the hedge
documentation or within an additional two-month period (unless extenuating
circumstances apply).
Read more: chapter 6

Hedging foreign currency exposures

Foreign currency risk is the risk of changes in a hedged item’s fair value
or functional currency equivalent cash flows attributable to changes in the
related foreign currency exchange rates.
Foreign currency hedges use the cash flow, fair value or net investment
models. However, there are additional criteria for hedged items or transactions
and hedging instruments to be eligible for designation in a foreign currency
hedge.

There are general qualifying criteria applicable to all foreign currency hedges:
— Hedging instrument. The entity with the foreign currency exposure needs
to be a party to the hedging instrument.

— Hedged item or transaction. The hedged transaction needs to be

denominated in a currency other than the entity’s functional currency.
In addition, there are qualifying criteria specific to the type of foreign currency
hedge. For foreign currency fair value and cash flow hedges, only certain
hedged items or transactions and hedging instruments are eligible.

Criterion 1: Eligibility of
hedged items or Criterion 3: Eligibility of
transactions hedging instruments

Foreign FCD asset or liability Derivative

currency fair
value hedge Unrecognized FCD firm Derivative
commitment or
Nonderivative financial
instrument

Foreign FCD asset or liability Derivative

currency cash
flow hedge
Unrecognized FCD firm Derivative
commitment

FCD forecasted transaction Derivative

The accounting for foreign currency fair value and cash flow hedges is the same
as for all other fair value hedges and cash flow hedges, respectively. However,
Topic 815 provides additional guidance for certain items and transactions
designated in a fair value or a cash flow hedge of foreign currency risk.
Read more: chapter 7

Net investment hedges

Net investment hedges are subject only to the following hedging criteria.

General — Hedging instrument. The entity with the foreign currency

qualifying exposure needs to be a party to the hedging instrument.
criteria for all
foreign — Hedged item or transaction. The hedged net investment
currency needs to be denominated in a currency other than the
hedges entity’s functional currency.

Hedge The hedging instrument must be both designated and effective

effectiveness as an economic hedge of the net investment.
The entity assesses effectiveness at least quarterly and
whenever financial statements are issued or earnings are
reported.

Formal The entity formally documents the hedging relationship.

documentation

In general, the net investment hedge accounting model works as follows.

— When a net investment is translated into the entity’s reporting currency, the
effects of translation are recognized in CTA in AOCI.
— The changes in fair value of the derivative hedging instrument (or foreign
currency transaction gains or losses of a FCD nonderivative hedging
instrument) that are included in the effectiveness assessment are
recognized in CTA in AOCI. These amounts remain in CTA until the sale,
exchange or liquidation of the foreign operation.
The following diagram shows the general accounting and presentation for a net
investment hedging relationship (assuming there are no excluded components).

Hedging instrument Hedged item – Net investment in

(derivative or nonderivative) foreign operation

Entire change in fair value

Apply Topic 830, including
of derivative (or transaction gain or
recording translation gains
loss of nonderivative) hedging
or losses in CTA
instrum ent recorded in CTA

Reclassified when hedged Reclassified when hedged

net investment is sold, net investment is sold,
exchanged or liquidated exchanged or liquidated

Record in the same income statement line item 1

Note:
In certain situations, a portion of the translation gain or loss should be reclassified from
CTA to noncontrolling interest.

The following diagram summarizes how effectiveness is assessed.

Percentage of
Absolute value of change Absolute value of change
offset
in fair value or cash flows in fair value or cash flows
To be highly
of hedging instrument of hedged item or
effective, should be
(other than excluded transaction due to hedged
within the range of
components) risk
80%–125%

Quantitative vs. qualitative. Topic 815 requires the initial (prospective)

Private companies
Although hedge accounting can be an effective way to mitigate income
statement volatility from reporting derivative instruments at fair value, many
private companies find the hedging requirements under the general hedge
accounting guidance to be onerous.
To provide relief to private companies seeking to meet hedge accounting
requirements, the FASB provided some relief.

Simplified hedge accounting approach

Topic 815 provides a simplified hedge accounting approach to account for
interest rate swaps that are used to hedge the variability in cash flows of
variable-rate borrowings. If the criteria to apply the simplified hedge accounting
approach are met, a private company:

Hedge — may assume perfect hedge effectiveness for the qualifying

effectiveness cash flow hedging relationships;
— is exempt from quarterly hedge effectiveness testing because
perfect effectiveness is assumed;

Hedge — has additional time to prepare the required hedge

documentation documentation; and

Hedging — is allowed to measure the interest rate swap designated in the

instrument cash flow hedging relationship at settlement value instead of
fair value.

Additional relief when simplified hedge accounting is not

applied
For hedging relationships not under simplified hedge accounting, a private
company may take advantage of the following relief:

Hedge — relaxed timing of documentation requirements; and

documentation

Hedge — relaxed timing of initial and subsequent quarterly hedge

effectiveness effectiveness assessments.

These relaxed requirements are also available to certain not-for-profit entities.

2.3.30 Should prepayment risk be considered when assessing

effectiveness for a fair value hedge of interest rate risk?
2.3.40 Can other rates in the United States be used as benchmark
rates?
2.3.50 What rates can be used as benchmark rates outside the
United States?
2.3.60 Can an entity hedge the variability in a contractually
specified inflation index that is a component of an interest
coupon?
2.3.70 Can a variable rate set via an auction process qualify as a
contractually specified interest rate?
2.3.80 Can interest rate risk or price risk related to the forecasted
purchase of a debt security that will be classified as HTM
be hedged in a cash flow hedge?
Examples
2.3.10 Fair value hedge of changes in the benchmark interest rate
for a variable-rate debt obligation
2.3.20 Hedging more than one risk at a time
2.4 Hedged risks of nonfinancial items and transactions
2.4.10 Overview
Examples
2.4.10 Comparison of cash flow hedges and fair value hedges of
inventory
2.4.20 Cash flow hedge of total price risk excluding the foreign
currency component
2.5 Limitations on hedged items, transactions and risks
2.5.10 Overview
2.5.20 Equity method investments and noncontrolling interests
2.5.30 Equity securities in scope of Topic 321
2.5.40 Equity instruments issued by the entity and transactions
with shareholders
2.5.50 Intercompany transactions
2.5.60 Business combinations
2.5.70 Assets and liabilities remeasured with changes in fair value
reported in earnings
2.5.80 Strategic risk
2.5.90 Macro hedges
Questions
2.5.10 Can an entity apply hedge accounting to an item or
transaction of an equity method investee?

2.5.20 Can an entity hedge exposure to assets or liabilities of an

investee that is proportionately consolidated?
2.5.30 Are items classified in temporary or mezzanine equity
eligible for designation as a hedged item?
2.5.40 Can an entity hedge compensation expense related to
stock appreciation rights?
2.5.50 Can intercompany transactions be hedged for eligible risks
at the stand-alone financial statement level of a subsidiary?
2.5.60 Is an entity allowed to hedge a forecasted issuance of debt
that is contingent on a business combination?
2.5.70 Can an entity hedge total assets or liabilities of a disposal
group classified as held-for-sale?
2.5.80 Can assets measured at the lower of cost or market be
designated as hedged items?
Examples
2.5.10 Forecasted transaction of an equity method investee
2.5.20 Contract to sell a wholly owned subsidiary
2.5.30 Forecasted transaction to purchase debt securities that will
be classified as trading under Topic 320
2.5.40 Forecasted transaction to purchase a derivative instrument
2.6 Hedging instruments
2.6.10 Overview
2.6.20 Common types of derivative instruments
2.6.30 Proportion of a derivative
2.6.40 Combination of derivatives
Questions
2.6.10 What is the difference between a forward contract and a
futures contract?
2.6.20 Can an option with multiple underlyings be used as a
hedging instrument?
2.6.30 Can different proportions of the same derivative instrument
be designated in different hedging relationships?
2.6.40 Can the first 10 years of a 15-year interest rate swap be
designated as a portion of the hedging instrument?
2.6.50 Can additional derivative instruments be added to an
existing hedging relationship?
2.6.60 When should two freestanding derivatives be viewed as a
single derivative instrument?

Examples
2.6.10 Hedging strategy using a fixed-for-floating interest rate
swap
2.6.20 Hedging strategy using a purchased option
2.6.30 Separating an interest rate swap into components that
represent different risks
2.6.40 Interest rate swap to hedge a portion of a hedged item or
transaction
2.6.50 Combination of an interest rate swap and put option to
hedge fixed-rate debt with an embedded call option
2.6.60 Multiple instruments to hedge interest rate risk
2.6.70 Two concurrent swaps not viewed as a unit
2.7 Limitations on hedging instruments
2.7.10 Overview
2.7.20 Nonderivative instruments
2.7.30 Intercompany derivatives
2.7.40 Hybrid instruments and compound derivatives
2.7.50 Special rule for written options
2.7.60 Special rule: Combination of options
Questions
2.7.10 Can a contract that meets the definition of a derivative after
acquisition by an entity qualify as a hedging instrument?
2.7.20 Is a subsidiary with exposure to the hedged risk required to
be a party to the hedging instrument to apply hedge
accounting at the consolidated level?
2.7.30 Is an intercompany derivative eligible to be designated as a
hedging instrument in the stand-alone financial statements
of a subsidiary?
2.7.40 Can a parent offset an intercompany derivative with a third-
party derivative and apply hedge accounting in the
consolidated financial statements?
2.7.50 Is an interest rate swaption a purchased option or a written
option?
2.7.60 How does an entity measure the potential gain or loss on
the combination of the written option (or net written option)
and the hedged item?
2.7.70 How often should the written option test be performed?
2.7.80 Is the written option test performed using the strike price
contained in the option contract or the current price of the
underlying?
2.7.90 Can a covered call strategy qualify for hedge accounting?

2.7.100 What is a collar?

2.7.110 Is the written option test required for a combination of a
written option and a non-option derivative?
2.7.120 When a hedging relationship is dedesignated and
redesignated, is a combination of options reassessed to
determine if it is a net written or net purchased option?
2.7.130 Are knock-out and knock-out/knock-in provisions considered
written options?
Examples
2.7.10 Written option does not qualify for hedge accounting
2.7.20 Written option qualifying as a hedge of an embedded call
option in a debt obligation
2.7.30 Written option qualifying as a hedge of an embedded cap in
a long-term supply contract
2.7.40 Evaluation of whether a combination of options is a net
written option
2.7.50 Applying the net written option test to collar-based hedging
relationship
2.7.60 Indexed-amortizing swap considered to be a net written
option
2.8 Hedge effectiveness
2.8.10 Overview
2.9 Hedge documentation requirements
2.9.10 Overview
2.9.20 Documenting the risk management objective and strategy
2.9.30 Documenting assessment of hedge effectiveness
2.9.40 Timing of initial hedge documentation, including initial
effectiveness assessment
2.9.50 Documentation requirements for fair value hedges
2.9.60 Documentation requirements for cash flow hedges
Observation
Some entities may not benefit from the ability to delay initial
quantitative prospective effectiveness assessments
Question
2.9.10 What is the level of detail needed to satisfy the hedge
documentation requirements?
Examples
2.9.10 Importance of timing of formal documentation of the
hedge
2.9.20 Timing requirements for initial hedge documentation

2.9.30 Formal documentation for a fair value hedge of a firm

commitment
2.9.40 Formal documentation for a cash flow hedge of a
forecasted transaction
2.9.50 Formal documentation of forecasted purchases of fuel
when hedging price risk
2.10 Discontinuing hedge accounting – general guidance
2.10.10 Overview
2.10.20 Change in eligibility or critical terms of hedged items or
transactions
2.10.30 Change in eligibility or critical terms of hedging instrument
2.10.40 Change in hedged risk
2.10.50 Change in hedge effectiveness
2.10.60 Partially dedesignating a hedging relationship
2.10.70 Redesignating a hedging relationship
Future developments
Questions
2.10.10 If an entity concludes that some (but not all) forecasted
transactions are no longer probable, is it required to
discontinue a cash flow hedging relationship?
2.10.20 Does adding to or deleting from a portion of a hedged item
or transaction (or portfolio or group of hedged items or
transactions) require dedesignation of the hedging
relationship?
2.10.30 Is a fair value hedging relationship required to be
discontinued if an entity repurchases and subsequently
resells (reissues) some of its own debt?
2.10.40 How does a decrease in the balance of the last of layer
expected to remain outstanding at the end of the hedge
term affect a last-of-layer hedging relationship?
2.10.50 How is hedge accounting discontinued for a hedged item
that no longer meets the definition of a firm commitment?
2.10.60 Is a hedging relationship required to be discontinued if the
hedging instrument is a combination of derivatives and the
combination is rebalanced?
2.10.70 Does modification of a hedging instrument’s collateral
requirements require a hedge to be discontinued?
2.10.80 Why would a derivative novation occur?
2.10.90 If a hedging relationship has not been highly effective
retrospectively, but is expected to be prospectively, is
hedge accounting required to be discontinued
prospectively?

2.10.100 Under what conditions may an entity partially dedesignate a

hedging relationship?
2.10.110 How does an entity partially dedesignate a hedging
instrument?
2.10.120 What should an entity consider when redesignating an
existing derivative instrument?
2.10.130 Is there a limit on the frequency of dedesignating and
redesignating a hedging relationship?
Examples
2.10.10 Discontinuance of hedging relationship when an unrelated
party is acquired
2.10.20 Hedge discontinuation because the hedging relationship is
no longer highly effective
2.10.30 Partial decrease of hedged item in a fair value hedge
2.10.40 Partial reduction of items in a group of hedged forecasted
transactions (cash flow hedge)
2.10.50 Partial termination of a hedging instrument

2.1 How the standard works

Hedge accounting is designed to allow an entity to hedge risks inherent in
certain transactions by using derivative instruments. It is elective and subject to
several criteria. If a hedging relationship meets these criteria, the accounting
varies based on the type of risk(s) being hedged and the type of hedge.
The basic risks that an entity may hedge include:

Interest rate risk Foreign currency risk

Credit risk Price risk

Topic 815 provides for three different types of hedges.

 Fair value hedge. A hedge of the exposure to changes in the fair value of a
recognized asset or liability, or of an unrecognized firm commitment, that is
attributable to a particular risk.
 Cash flow hedge. A hedge of the exposure to variability in the future cash
flows of a recognized asset or liability, or of a forecasted transaction, that is
attributable to a particular risk.
 Net investment hedge. A hedge of the exposure to foreign currency risk
of a net investment in a foreign operation.
Subtopic 815-20 requires an entity to meet certain criteria for the combination
of the hedging instrument and the hedged item or transaction (the ‘hedging
relationship’) to qualify for hedge accounting.

Criterion 1 Criterion 2 Criterion 3 Criterion 4

Eligibility of Eligibility of
Eligibility of Hedge
hedged items hedging
hedged risk(s) effectiveness
or transactions instruments

Criterion 5: Formal documentation

Hedge accounting is permitted only if all of the applicable criteria are met.

General qualifying The five general criteria that apply to fair value hedges
criteria and cash flow hedges are described in this chapter.
(chapter 2) Some of the general qualifying criteria also apply to net
investment hedges, as discussed in section 8.2.

Qualifying criteria for Qualifying criteria specific to the eligibility of hedged items,
fair value hedges hedged risks and hedging instruments in a fair value hedge
(chapter 3) is described in chapter 3.

Qualifying criteria for Qualifying criteria specific to the eligibility of hedged items,
cash flow hedges hedged risks and hedging instruments in a cash flow
(chapter 5) hedge is described in chapter 5.

Qualifying The general qualifying criteria applicable to all foreign

criteria for currency hedges is described in section 7.3.10.
hedges of foreign This chapter also focuses on criteria specific to foreign
currency risk currency fair value and cash flow hedges.
(chapter 7)

Qualifying criteria for Net investment hedges are only subject to certain
net investment qualifying criteria.
hedges
(section 8.2)

Hedge effectiveness This chapter discusses the general requirements for

(chapter 9) assessing hedge effectiveness and the specific
requirements for various assessment methods.

2.2 Hedged items and transactions

Criterion 1 Criterion 2 Criterion 3 Criterion 4

Eligibility of Eligibility of
Eligibility of Hedge
hedged items hedging
hedged risk(s) effectiveness
or transactions instruments

Criterion 5: Formal documentation

2.2.10 Overview
The objective of a hedge is to reduce or eliminate exposures to changes in
the fair value or cash flows associated with an asset, liability or transaction.
Topic 815 specifies certain items and transactions that are eligible for
designation as hedged items or transactions in a fair value or cash flow hedge.
These are summarized in the table below.

Criterion 1: Items and transactions eligible for hedge accounting

Fair value hedge Cash flow hedge

(section 3.3) (section 5.3)
Recognized All or a specific portion (or All or specified future cash flows
financial percentage) of a recognized from an existing recognized
instruments asset or liability – e.g. a asset or liability – e.g. all or
and financial or nonfinancial certain future interest payments
nonfinancial asset or liability on variable-rate debt
assets / (section 3.3.10). (section 5.3.10). [815-20-25-13(a)]
liabilities [815-20-25-12(a)] Foreign currency denominated
Foreign currency assets or liabilities
denominated assets or (section 7.6.50). [815-20-25-38(b)]
liabilities (sections 7.4.30
and 7.4.40). [815-20-25-37(a) –
25-37(b)]

Firm All or a specific portion of Firm commitments related only

commitments an unrecognized firm to the following:
commitment — firm commitments for
(section 3.3.20). which payment is fixed
[815-20-25-12(a)] in a currency other than
Foreign currency the functional currency
denominated unrecognized of the entity (section
firm commitments 7.6.40); or
(section 7.4.50). — all-in-one hedges
[815-20-25-37(d)] (section 5.3.90).
[815-20-25-21, 25-42]

Forecasted Prohibited for fair value A forecasted transaction – e.g. a

transactions hedges. forecasted purchase or sale
(section 5.3.20). [815-20-25-13(b)]

Criterion 1: Items and transactions eligible for hedge accounting

Fair value hedge Cash flow hedge

(section 3.3) (section 5.3)
Foreign currency denominated
transactions (section 7.6.30).
[815-20-25-38]

Portfolio or A portfolio of similar assets A group of similar forecasted

group or liabilities (section 3.3.40). transactions (section 5.3.60).
[815-20-25-12(b)(1)] [815-20-25-15(a)]
The last of layer associated
with a closed portfolio of
prepayable financial assets
(section 3.3.100). [815-20-25-
12A]

Portion (or A specific portion (or Any specified cash flows,

percentage) percentage) of a including (but not limited to) the
recognized asset or first cash flows received or paid
liability or unrecognized in a particular period (sections
firm commitment 5.3.70 and 5.3.80). [815-20-55-21,
(section 3.3.60), including: 55-33A]
— hedging only the
benchmark interest
rate component
(section 3.3.70);
— partial-term hedge
of interest rate risk
(section 3.3.80);
— embedded put or
call options
(section 3.3.90); or
— residual value in a
lessor’s net
investment in a
lease.
[815-20-25-12(b)(2), 815-25-35-
13, 35-13B]

Recognized financial instruments, nonfinancial assets and liabilities, firm

commitments and forecasted transactions need to meet the following
thresholds to be eligible hedged items.

Is the item or transaction a

type specifically prohibited from
being hedged? Yes
(section 2.5)

Does the item or transaction have

exposure to changes in fair value or
Item or transaction not
cash flows for the risk being hedged
No eligible to be hedged
that could affect earnings?
(section 2.2.30)

Yes

Does the item or transaction meet the

criteria specific to a fair value (section
3.3), cash flow (section 5.3) or net
investment (section 8.2) hedge (as No
applicable)?

Yes

Item or transaction
eligible to be hedged

Cash flow hedges. For the remainder of this Handbook, both the cash flows
related to a recognized asset or liability and the cash flows related to a
forecasted transaction are referred to as the forecasted transaction or the
hedged transaction.

All or certain future cash flows

from existing recognized Forecasted transactions
assets and liabilities

Both referred to as a forecasted

transaction or a hedged transaction

Net investment hedges. In addition to the items and transactions eligible for
fair value and cash flow hedges, an entity can hedge its net investment in a
foreign operation. Investments in foreign operations include investments in
incorporated and unincorporated foreign operations with a functional currency
other than the functional currency of the parent. See section 8.2 for guidance
on qualifying criteria specific to net investment hedges.

Question 2.2.10
What is the difference between a firm commitment
and a forecasted transaction?

Interpretive response: The following table summarizes the key characteristics

of a firm commitment and a forecasted transaction.

Firm A firm commitment is a (legally) binding agreement between

commitment unrelated parties that specifies all significant terms and includes a
disincentive for nonperformance that is sufficiently large to make
performance probable. The key features of a firm commitment are
the specificity of its terms (i.e. the quantity, fixed price and timing),
probability of occurrence and enforceability.
For further guidance and discussion of qualifying criteria related to
firm commitments, see section 3.3.20.

Forecasted A forecasted transaction is essentially a future transaction that is

transaction probable and does not meet the definition of a firm commitment.
Forecasted transactions can be contractually established or
probable because of an entity’s past or expected business
practices.
For further guidance and discussion of qualifying criteria related to
forecasted transactions, see section 5.3.20.

One of the key differences is that firm commitments have fixed prices, which
create exposures that are similar to those that exist for recognized assets and
liabilities with fixed terms. In contrast, forecasted transactions will occur at
prevailing market rates or prices in the future, which cause exposure to
variability in future cash flows.
Forecasted transactions are only eligible for cash flow hedge accounting. In
contrast, firm commitments are only eligible for fair value hedge accounting,
with the exception of the following, which are eligible to be designated in cash
flow hedges:

— foreign currency risk related to firm commitments for which payment

is fixed in a currency other than the functional currency of the entity (see
section 7.6.40)
— firm commitments that meet the definition of a derivative – i.e. all-in-one
hedges (see section 5.3.90).
In certain cases, an entity may select, designate and document the hedging
relationship in a manner that allows the entity to use the hedging model that it
wishes. For example, an entity may designate existing inventory as the hedged
item in a fair value hedge or the forecasted sale of that inventory as the hedged
transaction in a cash flow hedge.
Therefore, it is important that the hedged item or transaction be appropriately
identified and documented.

2.2.20 Overview of hedged risks

In addition to the requirements for hedged items and transactions, the risk
associated with these items and transactions needs to qualify for hedge
accounting. The primary requirement is that it must result in exposure to a
change in fair values or cash flows that could affect reported earnings (see
section 2.2.30).
The basic risks that an entity may hedge include:

Interest rate risk Foreign currency risk

Credit risk Price risk

The risks eligible to be hedged depend on whether the hedged item or

transaction is (or is related to) a financial instrument or a nonfinancial asset or
liability, and whether it results in an exposure to changes in fair values or future
cash flows.

Fair value hedge Cash flow hedge

The hedged risks relate to changes in The hedged risks relate to changes in
fair value due to fixed rates or prices. cash flows due to variable rates and
For example, a fixed-rate financial prices. For example, a variable-rate debt
instrument exposes its owner to the risk instrument exposes its issuer to
of changes in the financial instrument’s changes in interest payments due to its
fair value because of its fixed terms. variable terms.

In many cases, an entity can designate certain portions, or components, of the

total risk within the hedged item or transaction. Specifically, an entity is not
necessarily required to hedge the entire change in fair value or cash flows of
the hedged item or transaction.
Sections 2.3 and 2.4 provide an overview of the risks eligible to be hedged for
both financial instruments and nonfinancial assets and liabilities, respectively.
Net investment hedges. Topic 815 allows an entity to hedge the foreign
currency risk of a net investment in a foreign operation. An entity is exposed to
foreign currency risk when the functional currency of the foreign operation is
different from the functional currency of the parent. Section 8.2 provides
guidance on qualifying criteria specific to net investment hedges.

2.2.30 Exposure to earnings requirement

Excerpt from ASC 815-20

>> Hedged Item Criteria Applicable to Fair Value Hedges Only

25-12(c) The hedged item presents an exposure to changes in fair value
attributable to the hedged risk that could affect reported earnings. The

reference to affecting reported earnings does not apply to an entity that does
not report earnings as a separate caption in a statement of financial
performance, such as a not-for-profit entity (NFP), as discussed in
paragraphs 815-30-15-2 through 15-3.
>> Hedged Transaction Criteria Applicable to Cash Flow Hedges Only
25-15 A forecasted transaction is eligible for designation as a hedged
transaction in a cash flow hedge if all of the following additional criteria are
met:
…
c. The forecasted transaction meets both of the following conditions: …
2. It presents an exposure to variations in cash flows for the hedged risk
that could affect reported earnings.

Hedge accounting is allowed only for hedged items or transactions that have an
exposure to changes in fair value or variability in cash flows for the risk being
hedged that could affect reported earnings. [815-20-25-12(c), 25-15(c)(2)]

Exposure to changes
Hedged item or Hedged
in fair value or
transaction risk
variation in cash flows

Exposure to changes in fair values and variations in cash flows are different for
fair value and cash flow hedges.

Fair value hedge Cash flow hedge

Fixed cash flows create exposure to Variable-rate financial instruments and

changes in the fair value of the cash flows from forecasted transactions
associated asset, liability or firm create exposure to variability in
commitment. The exposure includes expected future cash flows.
increases or decreases in fair value.

Some transactions may subject an entity to variations in fair value or cash flows,
but lack the potential to affect reported earnings. These transactions would not
qualify as hedged items.
Overall, this requirement limits the items and transactions that are eligible for
hedge accounting. For example, intercompany transactions that will be
eliminated in consolidation would not affect earnings and therefore are not
eligible for hedge accounting at the consolidated level.
Section 2.5 outlines items and transactions that are not eligible for hedge
accounting due to this requirement, along with other items that are explicitly
prohibited from hedge accounting.

Foreign currency risk. An entity is permitted to hedge intercompany

transactions for foreign currency risk (see section 7.3.40). This risk is not
eliminated in consolidation, and therefore affects consolidated earnings. [815-20-
25-43(b)(4)]

Question 2.2.20
Must it be probable that variability in the hedged
transaction will actually occur and affect earnings?

Excerpt from ASC 815-20

>>>> Exposure to Variability in Cash Flows

55-18 The future sale of an asset or settlement of a liability that exposes an
entity (consistent with the criterion in paragraph 815-20-25-15(c)(2)) to the risk
of a change in fair value may result in recognizing a gain or loss in earnings
when the sale or settlement occurs. Changes in market price could change the
amount for which the asset or liability could be sold or settled and,
consequently, change the amount of gain or loss recognized. Forecasted
transactions that expose an entity to cash flow risk have the potential to
affect reported earnings because the amount of related revenue or expense
may differ depending on the price eventually paid or received. Thus, an entity
could designate the forecasted sale of a product at the market price at the date
of sale as a hedged transaction because revenue will be recorded at that future
sales price.

Interpretive response: No. Neither the cash flow hedging model nor the fair
value hedging model require it to be probable that the variability in cash flows
or fair value will actually occur and affect earnings. For cash flow hedges,
Topic 815 requires only that that the forecasted transaction is probable to occur
and that the variability in cash flows is possible and would affect earnings.
Similarly, for fair value hedges the risk must only have the potential to change
the amount that could be recognized in earnings. [815-20-25-15(b), 25-16(f), 55-18]
Cash flow hedges. For example, an insurance entity wants to enter into a cash
flow hedge to hedge the possibility that it may need to voluntarily increase the
interest rate used to credit interest on certain contract liabilities. The insurance
entity is not precluded from designating the future interest to be credited on its
contracts (either existing or newly written) provided that the interest-related
cash flows are probable and there is a possibility that there will be variability in
those cash flows that would affect earnings.
Notwithstanding this, it may be difficult for the insurance entity to identify a
derivative that will qualify for cash flow hedge accounting because interest
rates in the marketplace may not be highly effective at offsetting the entity’s
discretionary adjustment to the interest rate on the contract liabilities.
Fair value hedges. A mortgage bank wants to enter into a fair value hedge of a
fixed-rate mortgage loan. That mortgage loan may present an earnings
exposure to a bank because, as interest rates change, the amount at which the
bank can sell the loan also would change. There is no requirement for the
mortgage bank to sell the loan and realize the earnings effect. Nevertheless, the
bank is able to hedge the exposure related to the fixed-rate mortgage loan.

Example 2.2.10
Future sale of inventory that does not create
exposure to variations in cash flows
ABC Corp. wishes to hedge a forecasted sale of a product to a third party. The
terms of the forecasted sale include a fixed sales price because the buyer
agreed to purchase 100 units of the product for $100/unit on March 31, Year 1.
The forecasted sale does not meet the definition of a firm commitment and the
sale agreement does not meet the definition of a derivative.
Can ABC hedge the future sale in a cash flow hedge?
No. The forecasted sale does not present an exposure to variations in cash
flows that could affect reporting earnings. This is because the sales price of the
units to be sold is fixed.
In contrast, if the sales price is based on the market price on March 31, Year 1,
the forecasted transaction qualifies for designation in a cash flow hedging
relationship, assuming all other criteria are met.
Can ABC hedge the future sale in a fair value hedge?
No. Forecasted transactions cannot be designated as hedged items in a fair
value hedge.
In contrast, if there is a contract that meets the criteria for a firm commitment,
it would be eligible for fair value hedge accounting. The fixed price creates
exposure to changes in fair value due to changes in market prices to the date of
the sale.

2.3 Hedged risks of financial items and transactions

Criterion 1 Criterion 2 Criterion 3 Criterion 4

Eligibility of Eligibility of
Eligibility of Hedge
hedged items hedging
hedged risk(s) effectiveness
or transactions instruments

Criterion 5: Formal documentation

2.3.10 Overview

Excerpt from ASC 815-20

>> Hedged Item Criteria Applicable to Fair Value Hedges Only

25-12(f) If the hedged item is a financial asset or liability, a recognized loan
servicing right, or a nonfinancial firm commitment with financial components,
the designated risk being hedged is any of the following:
1. The risk of changes in the overall fair value of the entire hedged item
2. The risk of changes in its fair value attributable to changes in the
designated benchmark interest rate (referred to as interest rate risk)
3. The risk of changes in its fair value attributable to changes in the related
foreign currency exchange rates (referred to as foreign exchange risk)
4. The risk of changes in its fair value attributable to both of the following
(referred to as credit risk):
i. Changes in the obligor’s creditworthiness
ii. Changes in the spread over the benchmark interest rate with respect
to the hedged item’s credit sector at inception of the hedge.
5. If the risk designated as being hedged is not the risk in paragraph 815-20-
25-12(f)(1), two or more of the other risks (interest rate risk, foreign
currency exchange risk, and credit risk) may simultaneously be designated
as being hedged.
>> Hedged Transaction Criteria Applicable to Cash Flow Hedges Only
25-15(j) If the hedged transaction is the forecasted purchase or sale of a
financial asset or liability (or the interest payments on that financial asset or
liability) or the variable cash inflow or outflow of an existing financial asset or
liability, the designated risk being hedged is any of the following:
1. The risk of overall changes in the hedged cash flows related to the asset or
liability, such as those relating to all changes in the purchase price or sales
price (regardless of whether that price and the related cash flows are
stated in the entity’s functional currency or a foreign currency)
2. For forecasted interest receipts or payments on an existing variable-rate
financial instrument, the risk of changes in its cash flows attributable to
changes in the contractually specified interest rate (referred to as interest
rate risk). For a forecasted issuance or purchase of a debt instrument (or
the forecasted interest payments on a debt instrument), the risk of
changes in cash flows attributable to changes in the benchmark interest
rate or the expected contractually specified interest rate. See paragraphs
815-20-25-19A through 25-19B for further guidance on the designation of
interest rate risk in the forecasted issuance or purchase of a debt
instrument.
3. The risk of changes in the functional-currency-equivalent cash flows
attributable to changes in the related foreign currency exchange rates
(referred to as foreign exchange risk)
4. The risk of changes in its cash flows attributable to all of the following
(referred to as credit risk):
i. Default
ii. Changes in the obligor’s creditworthiness

iii. Changes in the spread over the contractually specified interest rate
or benchmark interest rate with respect to the related financial
asset’s or liability’s credit sector at inception of the hedge.
If the risk designated as being hedged is not the risk in paragraph 815-20-25-
15(j)(1), two or more of the other risks (interest rate risk, foreign exchange risk,
and credit risk) simultaneously may be designated as being hedged.

The following table outlines the risks associated with a financial instrument or
transaction that are eligible to be hedged.

Fair value hedge Cash flow hedge

Interest — Changes in the Either:

rate risk benchmark interest rate — changes in a contractually
for recognized fixed- specified interest rate for
rate financial variable-rate financial
instruments. [815-20-25- instruments or forecasted
12(f)(2)] issuances or purchases of
variable-rate financial
instruments; or
— changes in the benchmark
interest rate for forecasted
issuances or purchases of
fixed-rate financial
instruments. [815-20-25-
15(j)(2)]

Credit risk Includes: Includes:

— changes in the obligor’s — risk of default;
creditworthiness; and — changes in the obligor’s
— changes in the credit creditworthiness; and
spread over the — changes in the credit
benchmark interest spread over the
rate. [815-20-25-12(f)(4)] contractually specified
interest rate or the
benchmark interest rate.
[815-20-25-15(j)(4)]

Foreign — Changes in the related — Changes in the related

currency foreign currency foreign currency exchange
risk exchange rates. [815-20- rates. [815-20-25-15(j)(3)]
25-12(f)(3)]

Price risk — Total change in the fair — Total change in the cash
value. [815-20-25-12(f)(1)] flows related to the asset
or liability – e.g. all
changes in the purchase
or sales price. [815-20-25-
15(j)(1)]

Topic 815 focuses on these four risks because changes in the price associated
with any of these risks will directly affect the fair value or cash flows of a
financial asset or liability in a determinable or predictable manner.

Although recognized loan servicing rights and nonfinancial firm commitments

with financial components are not financial assets or liabilities, an entity can
hedge the same risks for them as those associated with financial items. [815-20-
25-12(f)]

The following sections provide an overview of risks for financial items and
transactions, as well as limitations on their eligibility to qualify for fair value or
cash flow hedge accounting.

2.3.20 Interest rate risk

Excerpt from ASC 815-20

>> Hedged Item and Transaction Criteria Applicable to both Fair Value
Hedges and Cash Flow Hedges
>>> Hedged Items Involving Interest Rate Risk
25-6 Hedges involving a benchmark interest rate are addressed in
paragraphs 815-20-25-12(f) and 815-20-25-12A (for fair value hedges) and
paragraph 815-20-25-15(j) (for cash flow hedges). Hedges involving a
contractually specified interest rate are addressed in paragraph 815-20-25-15(j)
(for cash flow hedges). The benchmark interest rate or the contractually
specified interest rate being hedged in a hedge of interest rate risk shall be
specifically identified as part of the designation and documentation at the
inception of the hedging relationship. Paragraphs 815-20-25-19A through 25-
19B provide guidance on the interest rate risk designation of hedges of
forecasted issuances or purchases of debt instruments. An entity shall not
simply designate prepayment risk as the risk being hedged for a financial asset.
However, it can designate the option component of a prepayable instrument
as the hedged item in a fair value hedge of the entity’s exposure to changes in
the overall fair value of that prepayment option, perhaps thereby achieving the
objective of its desire to hedge prepayment risk. The effect of an embedded
derivative of the same risk class shall be considered in designating a hedge of
an individual risk. For example, the effect of an embedded prepayment option
shall be considered in designating a hedge of interest rate risk.
20 Glossary
Interest Rate Risk – For recognized variable-rate financial instruments and
forecasted issuances or purchases of variable-rate financial instruments, interest
rate risk is the risk of changes in the hedged item’s cash flows attributable to
changes in the contractually specified interest rate in the agreement.
For recognized fixed-rate financial instruments, interest rate risk is the risk of
changes in the hedged item’s fair value attributable to changes in the
designated benchmark interest rate. For forecasted issuances or purchases of
fixed-rate financial instruments, interest rate risk is the risk of changes in the
hedged item’s cash flows attributable to changes in the designated benchmark
interest rate.

The interest rate risks eligible for hedge accounting depend on whether the
item or transaction has fixed or variable cash flows, and whether it is
designated in a fair value or cash flow hedge.
For example, for fixed-rate financial assets (or liabilities), changes in interest
rates may affect the fair value of a right to receive (or obligation to pay) cash or
other financial instruments in the future. An entity may want to lock in a
maximum (or minimum) value. Or, an entity may want to economically convert
cash flows (e.g. interest payments or receipts) from a fixed-rate to a variable-
rate.
Fair value hedges of interest rate risk. In a fair value hedge, interest rate risk
is the risk of changes in an item’s fair value attributable to changes in the
designated benchmark interest rate for fixed-rate financial instruments. [815-20-
25-12(f)(2)]

Fair value hedges of interest rate risk

Benchmark
Recognized fixed-rate
interest rate
financial instruments
(section 2.3.30)

Cash flow hedges of interest rate risk. A relationship that hedges exposure to
variability in interest payments or receipts on existing variable-rate financial
instruments is a cash flow hedge.
For recognized variable-rate financial instruments, interest rate risk is the risk of
changes in cash flows attributable to changes in the interest rate that is
contractually specified in the agreement (see section 2.3.40).
For the forecasted issuance or purchase of a debt instrument, an entity may
want to hedge exposure to variability in cash proceeds or the forecasted
interest payments on the future issuance or purchase of a debt instrument. An
entity may designate the hedged risk as the variability in cash flows attributable
to changes in the:
— benchmark interest rate (if the entity expects to issue or purchase fixed-rate
debt); or
— contractually specified interest rate (if the entity expects to issue or
purchase variable-rate debt).
For further guidance related to hedging the forecasted issuance or purchase of
debt instruments, see section 5.4.40. That section includes considerations for
entities that do not know whether the debt instrument will be fixed- or variable-
rate.

The following summarizes the interest rate risks for hedged transactions in cash
flow hedges.
Cash flow hedges of interest rate risk

Contractually specified
Recognized variable-rate
interest rate
financial instruments
(section 2.3.40)

Forecasted issuance or Benchmark

purchase of fixed-rate debt interest rate
(section 5.4.40) (section 2.3.30)

Forecasted issuance or Contractually specified

purchase of variable-rate debt interest rate
(section 5.4.40) (section 2.3.40)

Question 2.3.10
Can a variable-rate debt instrument qualify to be
designated in a fair value hedge?
Interpretive response: Yes, under certain circumstances. A variable-rate debt
instrument is exposed to changes in fair value due to changes in interest rates
between two interest reset dates. Therefore, an entity may be able to
designate a fair value hedge of a variable-rate debt instrument for a partial term
between the current and the next repricing dates. This is illustrated in
Example 2.3.10.

Example 2.3.10
Fair value hedge of changes in the benchmark
interest rate for a variable-rate debt obligation
On January 1, Year 1 ABC Corp. issues a floating-rate non-amortizing debt
instrument with a maturity of two years. The variable-rate liability resets every
six months at the six-month LIBOR rate. The six-month LIBOR rate on
January 1, Year 1 is 2.5%.
At the same time, ABC enters into a six-month interest rate swap agreement
with a notional amount equal to the face amount of the debt instrument. Under
the terms of the swap agreement, ABC will receive the six-month LIBOR rate
and pay the one-month LIBOR rate.
ABC wants to designate the interest rate swap as a fair value hedge of changes
in fair value of the variable-rate debt obligation attributable to changes in the
benchmark interest rate.

The variable-rate debt obligation has fair value exposure due to changes in
interest rates during the six-month period between LIBOR reset dates (e.g.
January 1, Year 1 to June 30, Year 1), even though the obligation would be at
fair value (due to changes in interest rates) on each reset date. Therefore, the
hedged risk could be the changes in fair value of the debt instrument due to the
six-month fixed nature of the LIBOR-based interest rate. ABC could hedge the
fixed six-month LIBOR rate (i.e. 2.5%) interest payments with a partial-term
hedge that ends on June 30, Year 1.
For guidance on partial-term hedges, see section 3.3.80.

Question 2.3.20
Can an entity hedge prepayment risk related to a
financial instrument?
Interpretive response: No. An entity may wish to hedge the prepayment risk
of financial instruments that have specific call/put dates, or are prepayable at
any time after issuance. However, prepayment risk is a subcomponent of
interest rate risk and cannot be designated as the hedged risk. An entity is not
permitted to hedge subcomponents of interest rate risk, credit risk or foreign
exchange risk. [815-20-25-6]
Fair value hedges. Although prepayment risk cannot be designated as the
hedged risk, an entity may achieve its objective of hedging prepayment risk by
designating the embedded option component of the prepayable instrument as
the hedged item in a fair value hedge (see section 3.3.90). Specifically, the
exposure would be limited to changes in the overall fair value of the
prepayment option. [815-20-25-6, 25-12(b)(2)(iii)]

Question 2.3.30
Should prepayment risk be considered when
assessing effectiveness for a fair value hedge of
interest rate risk?
Interpretive response: It depends. Although an entity is prohibited from
hedging prepayment risk (see Question 2.3.20), it is required to consider
prepayment risk when assessing hedge effectiveness and measuring the
change in fair value of the hedged item attributable to interest rate risk, with
certain exceptions.
If an entity uses the following fair value hedges of interest rate risk, it does not
consider prepayment risk for assessing hedge effectiveness and measuring the
change in fair value of the hedged item:
— partial-term hedges, depending on the term selected (see section 3.3.80);
and
— last-of-layer method (see sections 3.3.100 and 9.2.100).
Topic 815 also allows an entity to consider only the effect of changes in the
benchmark interest rate on the decision to prepay a financial instrument. If an

entity elects this approach, it does not consider in its assessment of hedge
effectiveness how other factors (e.g. credit risk) might affect the decision to
prepay the financial instrument. [815-20-25-6B]
For further discussion of hedging interest rate risk on prepayable financial
instruments, see section 3.4.10.

2.3.30 Interest rate risk: Benchmark interest rate

Excerpt from ASC 815-20

>> Hedged Item and Transaction Criteria Applicable to both Fair Value
Hedges and Cash Flow Hedges
>>> Hedged Items Involving Interest Rate Risk
>>>> Benchmark Interest Rate
25-6A In the United States, the interest rates on direct Treasury obligations of
the U.S. government, the London Interbank Offered Rate (LIBOR) swap rate,
the Fed Funds Effective Swap Rate (also referred to as the Overnight Index
Swap Rate), and the Securities Industry and Financial Markets Association
(SIFMA) Municipal Swap Rate are considered to be benchmark interest
rates. In each financial market, generally only the most widely used and quoted
rates may be considered benchmark interest rates.
20 Glossary
Benchmark Interest Rate – A widely recognized and quoted rate in an active
financial market that is broadly indicative of the overall level of interest rates
attributable to high-credit-quality obligors in that market. It is a rate that is
widely used in a given financial market as an underlying basis for determining
the interest rates of individual financial instruments and commonly referenced
in interest-rate-related transactions.
In theory, the benchmark interest rate should be a risk-free rate (that is, has no
risk of default). In some markets, government borrowing rates may serve as a
benchmark. In other markets, the benchmark interest rate may be an interbank
offered rate.

The benchmark interest rate can be designated as the hedged risk in fair value
hedges of interest rate risk for fixed-rate financial assets and cash flow hedges
of interest rate risk for forecasted issuances or purchases of fixed-rate financial
instruments (see section 5.4.40).
The benchmark interest rate is defined as a “widely recognized and quoted rate
in an active financial market that is broadly indicative of the overall level of
interest rates attributable to high-credit-quality obligors in that market.” [815-20
Glossary]

Topic 815 specifically identifies benchmark rates that are eligible to be

designated in a hedge.

US Treasury Rate

London Interbank Offered Rate (LIBOR) Swap Rate

Fed Funds Effective Swap Rate (Overnight Index Swap Rate)

SIFMA Municipal Swap Rate

Question 2.3.40
Can other rates in the United States be used as
benchmark rates?
Interpretive response: No. There are numerous indices outside of those
designated as benchmark interest rates that serve as a basis for pricing financial
instruments. Changes in indices other than those specifically identified as
benchmark interest rates (e.g. US Treasury Rate) cannot be the designated
hedged risk. This is because prime rates and other interest rate indices could
contain an element of credit risk.
However, an entity may apply hedge accounting when a hedging relationship
involves an interest rate swap with a variable leg based on an index other than
one of the specified benchmark interest rates. This is on the condition that the
risk being hedged is either the change in fair value or cash flows due to
changes in a benchmark interest rate or the change in the total fair value or
cash flows of the fixed-rate hedged item or forecasted transaction (assuming
that such relationships are highly effective).
For example, an entity may hedge a fixed-rate debt instrument with an interest
rate swap with a variable-rate leg based on the Prime rate if the risk being
hedged is changes in the overall fair value of the debt instrument. In such a
hedging relationship, the entity is required to determine whether the changes in
the fair value of the Prime-based swap will be highly effective in offsetting the
change in the total fair value of the debt instrument.
High effectiveness is more likely if the fair value of the debt instrument is not
affected by changes in credit risk or foreign currency risk or both.

Future developments

A proposed Accounting Standards Update was issued in February 2018 to add

the overnight index swap rate based on the secured overnight financing rate
(SOFR OIS) as a benchmark interest rate. [Proposed ASU]
At a September 2018 meeting, the FASB discussed comments received on the
proposed ASU and is expected to issue the final ASU by the end of 2018.

Question 2.3.50
What rates can be used as benchmark rates outside
the United States?
Interpretive response: In theory, the benchmark rate should be a risk-free rate
that meets the definition of a ‘benchmark interest rate’ in 815-20 Glossary. In
some foreign markets, the rate of interest on sovereign debt is considered the
risk-free rate, and is therefore considered the benchmark rate. However, in
other markets, the relevant interbank offered rate may be the best reflection of
the benchmark interest rate.
For example, we believe the Euro Interbank Offered Rate (Euribor swap rate)
may be used as the benchmark rate in euro currency countries. In Canada, the
Canadian Treasury Rate, in addition to the Bankers’ Acceptance Canadian
Deposit Offering Rate (BA CDOR), may be used as the benchmark rate. In the
United Kingdom, the Bank of England borrowing rate, in addition to the LIBOR
swap rate, may be used as the benchmark rate.

2.3.40 Interest rate risk: Contractually specified interest rate

for cash flow hedges

Excerpt from ASC 815-20

>>> Effect of Interest Rate Indexes

55-62 The effectiveness of a cash flow hedge of the variability in interest
payments of a variable-rate financial asset or liability, either existing or
forecasted, is affected by the contractually specified interest rate on which the
variability is based and the extent to which the hedging instrument provides
offset. If the cash flows on the hedging instrument and the contractually
specified interest rate of the hedged cash flows of the existing financial asset
or liability or the contractually specified interest rate of the variable-rate
financial asset or liability that is forecasted to be acquired or issued are based
on different indexes, the basis difference between those indexes would affect
the assessment of hedge effectiveness.
55-62A An entity may designate as the hedged risk only the change in cash
flows of the contractually specified interest rate, not an implied rate embedded
in the interest rate. For example, if an entity issues variable-rate debt based on
its own prime rate, it cannot designate the change in cash flows of the Fed
Funds Target rate or the Wall Street Journal prime rate as the hedged risk.

For cash flow hedges of interest rate risk of variable-rate financial instruments
or forecasted issuances or purchases of variable-rate financial instruments,
Topic 815 permits an entity to designate the hedged risk as the variability in
cash flows attributable to a contractually specified interest rate explicitly
referenced in the agreement. [815-20-25-15(j)(2)]

The contractually specified interest rate does not need to be a benchmark

interest rate. An entity can designate non-benchmark rates (e.g. prime lending
rates) as the hedged risk instead of hedging the overall changes in cash flows.
However, an entity is not permitted to designate an implied rate embedded in a
contractually specified interest rate. For example, if an entity issues variable-
rate debt based on its own prime rate, it cannot designate the hedged risk as
exposure to the Fed Funds Target rate or the Wall Street Journal prime rate.
[815-20-55-62A]

Hedge effectiveness. If the hedged item’s contractually specified rate (e.g.

entity-specific prime rate) does not exactly match the hedging instrument’s
variable rate, an entity needs to consider this difference in its hedge
effectiveness assessment. [815-20-25-6, 25-77, 55-62]
For example, assume a debt contract specifies the rate as a specified bank’s
prime lending rate plus 100 basis points. Although the specified bank’s prime
lending rate is not a benchmark interest rate, it can be the hedged risk because
it is contractually specified. If the bank entered into a LIBOR-based interest rate
swap to hedge the variable prime-based cash flows, it should consider the
variability in the prime lending rates compared to the LIBOR interest rates in
assessing hedge effectiveness.

Question 2.3.60
Can an entity hedge the variability in a
contractually specified inflation index that is a
component of an interest coupon?
Interpretive response: No. Topic 815 specifies that only contractually specified
interest rates are eligible to be designated in a cash flow hedge of interest rate
risk related to variable-rate financial instruments. [815-20-25-15(j)(2)]
An inflation index (e.g. Consumer Price Index) is not an interest rate, and
therefore is not eligible to be designated as the hedged risk even though it is
contractually specified.
At a September 2018 Board meeting, the FASB noted that an interest rate with
a fixed component plus a variable rate inflation index must be considered
together as the contractually specified interest rate. In addition, an entity could
not separately designate the benchmark rate component of the fixed-rate
coupon as the hedged risk in a fair value hedge (see Question 3.3.180). [FASB
meeting 09-18]

Question 2.3.70
Can a variable rate set via an auction process
qualify as a contractually specified interest rate?

Excerpt from ASC 815-20

20 Glossary

Auction rate notes – Auction rate notes are notes that generally have long-
term nominal maturities and interest rates that reset periodically through a
Dutch auction process, typically every 7, 28, or 35 days. At an auction, existing
holders of auction rate notes and potential buyers enter a competitive bidding
process through a broker-dealer, specifying the number of shares (units) to
purchase with the lowest interest rate they are willing to accept. Generally, the
lowest bid rate at which all shares can be sold at the notes’ par value
establishes the interest rate (also known as the clearing rate) to be applied until
the next auction.

Interpretive response: Yes. A variable rate set via an auction process – e.g. a
‘clearing rate’ on an auction rate security – qualifies as a contractually specified
interest rate if the rate is explicitly referenced in the variable-rate financial
instrument being hedged. [ASU 2017-12.BC81]
Therefore, we believe an entity can designate the forecasted interest payments
on an auction rate security as a contractually specified component in a cash
flow hedge if all other qualifying criteria are met.
Hedging instrument and hedge effectiveness. It may be difficult for an entity
to find a derivative instrument indexed to the auction rates. An entity could
designate a receive-variable, pay-fixed LIBOR interest rate swap as the hedging
instrument. However, the entity would need to demonstrate the hedging
relationship is highly effective at hedge inception and on an ongoing basis. This
includes considering the basis difference between the auction rates and LIBOR
(see section 9.2.10).
Failed auction. If there is a lack of demand and no clearing rate can be
established, the auction ‘fails’ and the entity needs to evaluate whether the
original hedging relationship can continue. In some instances, a failed auction
results in the existing holders retaining their positions at a rate set by using a
formula established by the instrument’s contractual terms. If the interest rate
changes from variable to fixed, the forecasted interest payments from the
auction rate security no longer create exposure to variability in expected future
cash flows and would no longer be eligible for hedge accounting.
In addition, if the hedged transaction (i.e. the variable interest payments) is not
probable or if the hedge is no longer highly effective as a result of a failed
auction, hedge accounting must be discontinued. See section 2.10 for guidance
on the discontinuation of hedge accounting.

2.3.50 Credit risk

Excerpt from ASC 815-20

20 Glossary
Credit Risk – For purposes of a hedged item in a fair value hedge, credit risk is
the risk of changes in the hedged item’s fair value attributable to both of the
following:
a. Changes in the obligor’s creditworthiness
b. Changes in the spread over the benchmark interest rate with respect to
the hedged item’s credit sector at inception of the hedge.
For purposes of a hedged transaction in a cash flow hedge, credit risk is the
risk of changes in the hedged transaction’s cash flows attributable to all of the
following:
a. Default
b. Changes in the obligor’s creditworthiness
c. Changes in the spread over the contractually specified interest rate or the
benchmark interest rate with respect to the related financial asset’s or
liability’s credit sector at inception of the hedge.

Some financial instruments involve future performance by a counterparty, such

as a counterparty’s obligation to deliver cash or another financial instrument. In
this instance, the holder of the instrument is subject to credit risk.
In theory, the benchmark rate represents the rate of interest required to
compensate an investor for its investment without consideration of default (e.g.
a risk-free rate). The credit spread represents the additional interest needed to
compensate an investor for the increased credit risk of a nonrisk-free borrower.
This credit spread has two components: a component related to counterparty
risk and a component related to credit sector risk.

Counterparty Risk that a counterparty will fail to comply with its contractual
risk obligations because of credit problems or other reasons.

Credit sector Risk inherent in the counterparty’s sector (e.g. industry,

risk geography and location). For example, a corporate bond issued
by an entity in Venezuela would likely have a higher credit
spread than a corporate bond issued by an entity in the United
States.

Counterparty risk and credit sector risk both directly affect the fair value of a
financial asset and its cash flows.

2.3.60 Foreign currency risk

Excerpt from ASC 815-20

20 Glossary
Foreign Exchange Risk – The risk of changes in a hedged item’s fair value or
functional-currency-equivalent cash flows attributable to changes in the related
foreign currency exchange rates.

Foreign currency denominated financial assets or liabilities are generally

exposed to changes in foreign exchange rates. Foreign exchange risk is the risk
related to changes in the related foreign exchange rates.
For further guidance on foreign currency risk and hedges, see chapter 7.

2.3.70 Price risk

Price risk is the risk related to the total change in fair value or cash flows.
Interest rate risk, credit risk and foreign currency risk are all subcomponents of
price risk, which relates to the entire hedged item or transaction.

Price risk

Interest rate Credit risk Foreign

risk currency risk

An entity is permitted to hedge more than one risk at a time, with the exception
of price risk because it would result in the same risk being hedged more than
once.
For example, an entity may not hedge the risk of overall changes in fair value of
a fixed-rate financial instrument if interest rate risk is also designated as a
hedged risk. However, an entity could designate both the interest rate risk and
credit risk.

2.3.80 Hedging multiple risks: Simultaneous hedges

Topic 815 considers each risk exposure separately. Therefore, an entity may
hedge more than one risk at a time, as long as each designated risk is
accounted for separately. [FAS 133.BC423]
This includes:
— more than one fair value or cash flow hedge of the same hedged item or
transaction (when different risk exposures are hedged with different
hedging instruments);

— both a fair value hedge and cash flow hedge of a single instrument (when
different risk exposures are being hedged); and
— different risk exposures within a single hedging relationship.
For example, an entity may designate the benchmark interest rate and credit
risk related to the same commercial loan in simultaneous fair value hedges.

First fair value hedge Second fair value hedge

Hedging Hedging
instrument 1 $ instrument 2
Interest
Credit risk Commercial loan rate risk
(Hedged item)

Alternatively, an entity could designate a cash flow hedge of a variable-rate

investment security related to the contractually specified interest rate and a fair
value hedge related to that issuer’s credit risk.

Fair value hedge Cash flow hedge

Hedging Hedging
instrument 1 instrument 2

Credit risk Interest

Variable-rate security rate risk
(Hedged item and
transaction)

Continuing the example, if the variable-rate security was denominated in a

foreign currency, an entity could designate a single cash flow hedge of both
interest rate risk and foreign currency risk using a cross-currency interest rate
swap.

Cash flow hedge

Cross-currency
interest rate swap
Interest Foreign currency
Hedging instrument
rate risk risk

Foreign currency denominated

variable-rate security
(Hedged transaction)

When the designated risk is the risk of overall changes in fair value or cash
flows related to a financial asset or liability (i.e. price risk), an entity is prohibited
from designating another risk associated with the same item. Otherwise the
same risk would be hedged more than once. [815-20-25-12(f)(5), 25-15(j)]

Because simultaneous hedges are permitted and the hedged item or

transaction may be subject to another hedge, it is critical to specify and
document at inception which item or transaction and its associated risk are
being hedged.

Example 2.3.20
Hedging more than one risk at a time
Investor Co., a US dollar functional currency entity, owns variable-rate
(three-month LIBOR) debt securities denominated in a foreign currency. These
debt securities are classified as AFS under Topic 320 (debt securities).
Assuming all hedge criteria have been met, Investor may designate any one or
more of the following risks of changes in cash flows attributable to changes in:
— interest rate risk (benchmark interest rate);
— foreign currency exchange rates; or
— credit risk.
Therefore, Investor could (1) enter into an interest rate swap to lock in the
amount of cash flows expected from interest earned on the securities; (2) enter
into a foreign currency forward contract to hedge foreign currency changes on
the principal amount; or (3) enter into a derivative instrument to compensate
Investor if the issuer’s credit deteriorates.
However, if Investor enters into another derivative to hedge the total changes in
fair value of the debt securities, and designates that derivative in a qualifying
hedging relationship, it cannot also simultaneously designate one of the above
risks as a hedged risk for the same debt securities. This is because Investor
would effectively be hedging the same risk(s) twice.

2.3.90 Limitations on hedged risks for HTM securities

Excerpt from ASC 815-20

>> Hedged Item Criteria Applicable to Fair Value Hedges Only

25-12(d) If the hedged item is all or a portion of a debt security (or a portfolio of
similar debt securities) that is classified as held to maturity in accordance with
Topic 320, the designated risk being hedged is the risk of changes in its fair
value attributable to credit risk, foreign exchange risk, or both. If the hedged
item is an option component of a held-to-maturity security that permits its
prepayment, the designated risk being hedged is the risk of changes in the
entire fair value of that option component. If the hedged item is other than an
option component of a held-to-maturity security that permits its prepayment,
the designated hedged risk also shall not be the risk of changes in its overall
fair value.

>> Hedged Transaction Criteria Applicable to Cash Flow Hedges Only

25-15(f) If the variable cash flows of the forecasted transaction relate to a debt
security that is classified as held to maturity under Topic 320, the risk being
hedged is the risk of changes in its cash flows attributable to any of the
following risks:
1. Credit risk
2. Foreign exchange risk.
>> Items Specifically Ineligible for Designation as a Hedged Item or
Transaction
25-43 Besides those hedged items and transactions that fail to meet the
specified eligibility criteria, none of the following shall be designated as a
hedged item or transaction in the respective hedges: …
c. With respect to fair value hedges only: …
1. For a held-to-maturity debt security, the risk of changes in its fair value
attributable to interest rate risk
d. With respect to cash flow hedges only: …
2. If variable cash flows of the forecasted transaction relate to a debt
security that is classified as held-to-maturity under Topic 320, the risk
of changes in its cash flows attributable to interest rate risk

If the hedged item or forecasted transaction relates to a debt security that is

classified as HTM under Topic 320 (debt securities), neither interest rate risk
nor price risk (e.g. total change in fair value or cash flows) are eligible to be
designated as the hedged risk. [815-20-25-12(d), 25-15(f), 25-43(c)(2), 25-43(d)(2)]

Eligible for HTM debt

Type of risk securities?

Interest rate risk

Credit risk

Foreign currency risk

Price risk

Topic 320 requires specific accounting for securities classified as HTM (i.e.
measurement at amortized cost) because the entity has indicated its intent to
hold the security to maturity, regardless of changes in interest rates or market
rates. Hedging exposure to these risks is thought to undermine the intent of the
HTM classification. [FAS 133.BC428]
An entity is permitted to hedge the risk of changes in the fair value or cash
flows of a HTM security attributable to credit risk and/or foreign currency risk.
The FASB decided to allow credit risk to be a designated hedged risk because it
is not inconsistent with Topic 320, which allows a sale or transfer of a HTM
debt security in response to significant deterioration in the credit quality of the
issuer of the security. [815-20-25-12(d), 25-15(f), FAS 133.BC430]

Foreign currency denominated HTM securities are monetary assets that are
exposed to changes in foreign exchange rates. Since guidance is provided in
Topic 830 (foreign currency) for reflecting the effect of changes in foreign
exchange rates on HTM securities, the Board concluded that the risk of
changes in foreign exchange rates in those securities qualifies as a hedgeable
risk. [FAS 133.BC411(c)]

Question 2.3.80
Can interest rate risk or price risk related to the
forecasted purchase of a debt security that will be
classified as HTM be hedged in a cash flow hedge?
Interpretive response: Yes. We believe an entity may hedge variability in cash
flows attributable to interest rate risk or price risk for a forecasted purchase of a
debt security that will be classified as HTM at acquisition. This assumes all cash
flow hedge criteria are met.
This type of hedge is not inconsistent with the assertion that amortized cost is
the appropriate measurement basis for a HTM security since the security is not
yet recognized.
This is different from forecasted transactions relating to debt securities that are
currently held and classified as HTM, for which an entity is prohibited from
hedging the variable cash flows attributable to interest rate risk or price risk. In
that case, the securities are already recognized and classified as HTM.

2.3.100 Limitations on financial assets and liabilities

measured at fair value

Excerpt from ASC 815-20

>> Hedged Transaction Criteria Applicable to Cash Flow Hedges Only

25-15(e) If the forecasted transaction relates to a recognized asset or liability,
the asset or liability is not remeasured with changes in fair value attributable to
the hedged risk reported currently in earnings.
>> Items Specifically Ineligible for Designation as a Hedged Item or
Transaction
25-43 Besides those hedged items and transactions that fail to meet the
specified eligibility criteria, none of the following shall be designated as a
hedged item or transaction in the respective hedges:
c. With respect to fair value hedges only:
3. An asset or liability that is remeasured with the changes in fair value
attributable to the hedged risk reported currently in earnings

An asset or liability that is remeasured with the changes in fair value attributable
to the hedged risk reported in earnings is not eligible for hedge accounting.
[815-20-25-15(e), 25-43(c)(3)]

Therefore, the following financial instruments are not eligible for hedge
accounting:
— debt securities classified as trading under Topic 320;
— assets or liabilities measured using the fair value option in Topic 825
(financial instruments) or Topic 815; or
— all equity securities in the scope of Topic 321 (see section 2.5.30).
A financial instrument measured at fair value through earnings should reflect
the total change in fair value required by other relevant accounting Topics,
rather than changes in fair value specific to only certain risks (e.g. interest rate
risk).
As a practical matter, an entity could offset earnings between the changes in
the fair value of the asset or liability and the derivative instrument without
applying hedge accounting (i.e. economic hedging).
For example, if an entity wants to use a derivative instrument to hedge the
exposure associated with changes in the fair value of a trading security,
accounting for the derivative instrument in accordance with Topic 815 would
naturally achieve offsetting changes (though not necessarily exact offset). This
is because changes in the fair values of each financial instrument would be
reflected in earnings each period.

2.4 Hedged risks of nonfinancial items and

transactions
Criterion 1 Criterion 2 Criterion 3 Criterion 4

Eligibility of Eligibility of
Eligibility of Hedge
hedged items hedging
hedged risk(s) effectiveness
or transactions instruments

Criterion 5: Formal documentation

2.4.10 Overview

Excerpt from ASC 815-20

>> Hedged Item Criteria Applicable to Fair Value Hedges Only

25-12(e) 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 shall 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.
>> Hedged Transaction Criteria Applicable to Cash Flow Hedges Only
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 the 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 additional criteria in paragraphs
815-20-25-22A through 25-22B for designating the variability in cash flows
attributable to changes in a contractually specified component as the
hedged risk.)
>>> Hedged Items in Cash Flow Hedges Only
>>>> Variable Price Component of a Purchase Contract as Hedged Item
55-19 This guidance discusses the implementation of paragraph 815-20-25-
15(i). An entity enters into a contract that requires it to pay a total contract price
based on the VWX sugar index on the date of purchase plus a variable basis
differential related to transportation costs. The entity may use a derivative
instrument whose underlying is the price of sugar or any other underlying for
which the derivative would be highly effective in achieving offsetting cash
flows in a cash flow hedge of its forecasted purchases under the contract. In
accordance with paragraph 815-20-25-15(i), the entity may designate as the risk
being hedged the risk of changes in the cash flows relating to all changes in
the purchase price of the items being acquired under the contract. The entity
also may designate the variability in cash flows attributable to changes in the
contractually specified component (VWX sugar index) as the hedged risk. In
that case, the entity not only must consider whether the VWX sugar index is
explicitly referenced in the purchase agreement but also must ensure that the
requirements in paragraph 815-20-25-22A are met. In both scenarios, the entity
must determine that all the criteria for cash flow hedges are satisfied, including
that the hedging relationship is highly effective in achieving offsetting cash
flows attributable to the hedged risk during the term of the hedge.
20 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.

The following table outlines the risks associated with a nonfinancial asset or
liability or transaction that are eligible to be hedged.

Fair value hedge Cash flow hedge

Price — Total change in the Either:

risk fair value. [815-20- — all changes in the
25-12(e)] purchase price or sales
price of the asset – i.e.
price risk; or [815-20-25-
15(i)(2)]
— changes in a
contractually specified
component – i.e. a
component of price risk
(see section 5.4.10).
[815-20-25-15(i)(3)]

Foreign — Changes in the — Changes in the related

currency related foreign foreign currency
risk currency exchange exchange rates of
rates if the firm foreign currency
commitment is denominated
denominated in a forecasted transactions
foreign currency. or firm commitments
[815-20-25-37] [815-20-25-15(i)(1)]

Nonfinancial assets, or a forecasted transaction that involves nonfinancial

assets, may expose an entity to numerous risks. For example, inventory
consisting of chocolate bars exposes the entity to fair value risk, or cash flow
price risk, associated with each major ingredient that goes into manufacturing a
chocolate bar – e.g. cocoa, sugar, butter and milk.
The aggregate components encompass the risk of all changes in the fair value
or cash flows related to the sales price of the chocolate bar.

Component Component Component

price risk price risk price risk

Price risk
(cocoa) (sugar) (milk & butter)

Cash flow hedges. For a cash flow hedge, an entity is permitted to designate
either:
— total price risk – e.g. the entire chocolate bar; or
— a contractually specified component of the purchase or sale of a
nonfinancial asset or liability – e.g. price risk related to cocoa in chocolate
bars.
Example 2.4.10 illustrates the different cash flow hedging strategies available
for a forecasted transaction to sell inventory. Section 5.4.10 provides guidance
for designating the contractually specified component as the hedged risk in a
cash flow hedge.
For a cash flow hedge of total price risk involving a forecasted transaction to
acquire a nonfinancial asset with a purchase price denominated in a foreign
currency, an entity is allowed to exclude the foreign currency component of a

hedged transaction (see Example 2.4.20). In other words, an entity is not

required to hedge the risk of changes in its functional currency equivalent cash
flows (i.e. all cash flows). [815-20-25-15(i)(2)]
Fair value hedges. For a fair value hedge, Topic 815 does not allow an entity to
designate a component of price risk. Rather, the designated risk is required to
be changes in the fair value of the entire asset or liability – i.e. total price risk.
For further discussion, see section 3.4.20.
This restriction on hedging a specific component of a nonfinancial item differs
from guidance on fair value hedges of financial assets or liabilities and cash flow
hedges of nonfinancial assets or liabilities, both of which allow an entity to
hedge only certain risk exposure(s).

See guidance on foreign currency risk and hedges in chapter 7.

Hedge effectiveness. Entities commonly use standardized contracts traded on

exchanges (e.g. futures contracts) to hedge risk exposures related to
nonfinancial items or transactions. These contracts may have critical terms that
do not exactly match the hedged item or transaction – i.e. different quantities,
locations, etc. A hedging relationship may not be perfectly effective when there
is a mismatch between the hedged item or transaction and the hedging
instrument (see section 9.2.10).

Example 2.4.10
Comparison of cash flow hedges and fair value
hedges of inventory

Cash flow hedges

Candy Co. has inventory consisting of chocolate bars, which exposes it to
variations in cash flows associated with the forecasted purchases of each major
ingredient that goes into manufacturing a chocolate bar (e.g. cocoa, sugar,
butter and milk), as well as the forecasted sales of the chocolate bars.

Total price risk

Candy could use a cocoa beans futures contract to hedge the forecasted sale of
chocolate bars, provided it can demonstrate that cocoa bean futures are highly
effective in offsetting the changes in the cash flows related to all changes in the
sales price – i.e. total price risk.
Contractually specified component price risk
Candy enters into a forward contract to sell chocolate bars at a price that is
based on a sugarcane index plus a fixed spread. The forward contract meets
the definition of a derivative in its entirety. The underlying (price of sugarcane) is
clearly and closely related to the asset being sold (chocolate bars).
Assuming that the forward contract is outside the scope of Topic 815 (for
example, if Candy applies the normal purchases and normal sales scope
exception), Candy may designate the contractually specified component (the
sugarcane index) of the forward contract as the hedged risk in the forecasted
sale of chocolate bars.

See guidance on the conditions that must be met for a contractually specified
component in an existing contract to be designated as the hedged risk in
section 5.4.20.

Foreign currency risk

Candy’s functional currency is the pound sterling (£).

On January 1, Year 1 Candy forecasts it will sell 10,000 chocolate bars on
March 31, Year 1 for $10,000. The forecasted sale meets the criteria to qualify
as a forecasted transaction.
Candy can hedge the risk of changes in functional currency equivalent cash
flows from January 1, Year 1 through the sale date (March 31, Year 1) by
entering into a forward contract to sell $10,000 and buy pound sterling based on
the current forward rate for an exchange on March 31, Year 1 – e.g. £0.75 =
$1.00.
Fair value hedges
Candy’s inventory of chocolate bars also exposes it to fair value risk associated
with each major ingredient that goes into manufacturing a chocolate bar – e.g.
cocoa, sugar, butter and milk.

Total price risk

Candy would not be able to designate the cocoa component of the chocolate
bar as the hedged risk.
However, Candy would be able to qualify for fair value hedge accounting if it
used a cocoa bean futures contract to hedge the fair value risk of its chocolate
bar inventory provided it can demonstrate that the cocoa bean futures are highly
effective in offsetting the changes in fair value associated with the inventory of
chocolate bars – i.e. total price risk.

Foreign currency risk

Candy’s functional currency is the pound sterling. Candy enters into a contract
to sell 10,000 chocolate bars at a fixed price of $1 per chocolate bar on
March 31, Year 1. The contract meets the definition of a firm commitment.
Candy can hedge the risk of changes in fair value of the firm commitment
resulting from changes in the £/$ exchange rates by entering into a foreign
currency forward contract to sell $10,000 and buy pound sterling on March 31,
Year 1, based on the current forward rate for an exchange on March 31, Year 1
– e.g. £0.75 = $1.00.
This hedging strategy should enable the sale of chocolate bars to be recorded at
£7,500 (the forward price inherent in the foreign currency forward contract),
regardless of the spot rate on the date of sale.

Example 2.4.20
Cash flow hedge of total price risk excluding the
foreign currency component
Goldco, an Australian gold producer, uses the Australian dollar (A$) as its
functional currency. Goldco wishes to hedge its exposure to US dollar
denominated forecasted gold sales and enters into a gold futures contract
denominated in US dollars (which are more readily available).
Goldco designates the hedged risk as all changes in cash flows excluding the
component of the cash flows related to changes in $/A$ exchange rates.
Hedge effectiveness. The hedge effectiveness assessment excludes the
effect of changes in currency exchange rates and instead is based primarily on
changes in gold prices. This enables Goldco to achieve a higher level of
assessed effectiveness.
If Goldco was required to hedge the risk of changes in its functional currency
equivalent cash flows (i.e. all cash flows), high effectiveness may be difficult to
achieve.

2.5 Limitations on hedged items, transactions and

risks
Criterion 1 Criterion 2 Criterion 3 Criterion 4

Eligibility of Eligibility of
Eligibility of Hedge
hedged items hedging
hedged risk(s) effectiveness
or transactions instruments

Criterion 5: Formal documentation

2.5.10 Overview

Excerpt from ASC 815-20

>> Items Specifically Ineligible for Designation as a Hedged Item or

Transaction
25-43 Besides those hedged items and transactions that fail to meet the
specified eligibility criteria, none of the following shall be designated as a
hedged item or transaction in the respective hedges:
a. Subparagraph not used
b. With respect to both fair value hedges and cash flow hedges:
1. An investment accounted for by the equity method in accordance with
the requirements of Subtopic 323-10 or in accordance with the
requirements of Topic 321

2. A noncontrolling interest in one or more consolidated subsidiaries

3. Transactions with stockholders as stockholders, such as either of the
following:
i. Projected purchases of treasury stock
ii. Payments of dividends.
4. Intra-entity transactions (except for foreign-currency-denominated
forecasted intra-entity transactions) between entities included in
consolidated financial statements
5. The price of stock expected to be issued pursuant to a stock option
plan for which recognized compensation expense is not based on
changes in stock prices after the date of grant.
c. With respect to fair value hedges only:
1. If the entire asset or liability is an instrument with variable cash flows,
an implicit fixed-to-variable swap (or similar instrument) perceived to be
embedded in a host contract with fixed cash flows
2. For a held-to-maturity debt security, the risk of changes in its fair value
attributable to interest rate risk
3. An asset or liability that is remeasured with the changes in fair value
attributable to the hedged risk reported currently in earnings
4. An equity investment in a consolidated subsidiary
5. A firm commitment either to enter into a business combination or to
acquire or dispose of a subsidiary, a noncontrolling interest, or an
equity method investee
6. An equity instrument issued by the entity and classified in
stockholders’ equity in the statement of financial position
7. A component of an embedded derivative in a hybrid instrument—for
example, embedded options in a hybrid instrument that are required to
be considered a single forward contract under paragraph 815-10-25-10
cannot be designated as items hedged individually in a fair value hedge
in which the hedging instrument is a separate, unrelated freestanding
option.
d. With respect to cash flow hedges only:
1. Subparagraph not used
2. If variable cash flows of the forecasted transaction relate to a debt
security that is classified as held-to-maturity under Topic 320, the risk
of changes in its cash flows attributable to interest rate risk
25-44 The earnings exposure criterion specifically precludes hedge accounting
for derivative instruments used to hedge items in (b)(3) through (b)(5) in the
preceding paragraph. However, intra-entity transactions may present an
earnings exposure for a subsidiary in its freestanding financial statements; a
hedge of an intra-entity transaction would be eligible for hedge accounting for
purposes of those statements.
>> Hedged Transaction Criteria Applicable to Cash Flow Hedges Only
25-15 A forecasted transaction is eligible for designation as a hedged
transaction in a cash flow hedge if all of the following additional criteria are
met: …
d. The forecasted transaction is not the acquisition of an asset or incurrence
of a liability that will subsequently be remeasured with changes in fair
value attributable to the hedged risk reported currently in earnings.

e. If the forecasted transaction relates to a recognized asset or liability, the

asset or liability is not remeasured with changes in fair value attributable to
the hedged risk reported currently in earnings.
f. If the variable cash flows of the forecasted transaction relate to a debt
security that is classified as held to maturity under Topic 320, the risk being
hedged is the risk of changes in its cash flows attributable to any of the
following risks:
1. Credit risk
2. Foreign exchange risk.
g. The forecasted transaction does not involve a business combination
subject to the provisions of Topic 805 or a combination accounted for by an
NFP that is subject to the provisions of Subtopic 958-805.
h. The forecasted transaction is not a transaction (such as a forecasted
purchase, sale, or dividend) involving either of the following:
1. A parent entity’s interests in consolidated subsidiaries
2. An entity’s own equity instruments.

In addition to those items and transactions that fail to meet the eligibility criteria
for designation in a hedge outlined in section 2.2, Topic 815 specifically
prohibits certain items and transactions from hedge accounting.
This section discusses the items and transactions that are prohibited from
hedge accounting, as well as limitations on the hedgeable risks for certain items
and transactions.

2.5.20 Equity method investments and noncontrolling

interests
Topic 815 prohibits equity method investments and noncontrollilng interests
from being designated as hedged items or transactions in a fair value or cash
flow hedge. [815-20-25-43b(1) – 25-43b(2)]
Under the equity method of accounting, an entity recognizes its share of profits
or losses in earnings, and adjusts the carrying amount of its investment. [323-10-
35-4]

Changes in the carrying amount are not based on changes in the market value
of the equity method investee’s shares, but are affected by changes in its
earnings. Under fair value hedge accounting, changes in the market value of the
shares would become part of the basis of an equity method investment. This
conflicts with the accounting prescribed in Topic 323 (equity method and joint
ventures) and could result in some amount of double counting the investor’s
share of its earnings. In addition, the FASB was concerned it would be difficult
to develop a method of implementing fair value or cash flow hedge accounting
for equity method investments that would be reasonable to understand.
[FAS 133.BC455, BC472]

For reasons similar to equity method investments, an entity is also prohibited

from hedging noncontrolling interests. [815-20-25-43(b)(2), FAS 133.BC456]
These restrictions also apply to firm commitments or forecasted transactions to
acquire or dispose of these investments. [815-20-25-15(h)(1), 25-43(c)(5)]

Net investment hedges. Topic 815 allows an entity to hedge the foreign
currency risk of a net investment in a foreign operation, which includes
subsidiaries, joint ventures and equity method investments (see chapter 8).

Question 2.5.10
Can an entity apply hedge accounting to an item or
transaction of an equity method investee?

Interpretive response: Generally, no. We believe an entity cannot apply hedge

accounting to the following items or transactions:
— recognized assets or liabilities of an equity method investee;
— a forecasted transaction between an equity method investee and a third
party; or
— a firm commitment of an equity method investee.
This is because there is no direct exposure to changes in fair value or variability
in cash flows that is attributable to an entity’s interest in the equity method
investment. Topic 815 does not necessarily require a subsidiary with exposure
to the hedged risk to be a party to the hedging instrument to apply hedge
accounting at the consolidated level (see Question 2.7.20). However, this only
applies to a consolidated subsidiary and is not available for equity method
investees. [815-20-25-46A]
Fair value hedges. A firm commitment between an entity and its equity
method investee is not permitted. This is because a firm commitment must be
between two unrelated parties (see section 3.3.20).
Cash flow hedges. An entity is not precluded from designating forecasted
transactions with equity method investees as hedged transactions, assuming
the effects of the forecasted transaction will not be eliminated and other
eligibility criteria are met (see Question 5.3.40).

Example 2.5.10
Forecasted transaction of an equity method investee
ABC owns 50% of JV (a joint venture) and uses the equity method to account
for its investment. JV has a $10 million LIBOR-rate debt obligation.
ABC is concerned that fluctuations in LIBOR may adversely affect the earnings
of JV and thereby affect its share of the earnings. To mitigate this risk, ABC
enters into a pay-fixed, receive-LIBOR interest rate swap to lock in the cost of
JV’s debt obligation.
Is ABC permitted to use cash flow hedge accounting?
No. To qualify for cash flow hedge accounting the forecasted transaction must:
1. be a transaction; and
2. present an exposure to cash flows for the hedged risk that could affect
reported earnings.

The effect of changes in LIBOR on JV’s income statement is not a transaction

from ABC’s perspective. In addition, neither ABC nor any of its consolidated
subsidiaries have any direct exposure to variability in cash flows that is
attributable to JV’s debt obligation. Therefore, we believe ABC may not use
cash flow hedge accounting in this instance.

Example 2.5.20
Contract to sell a wholly owned subsidiary
Parent enters into a contract to sell its wholly owned subsidiary to XYZ Corp. at
a fixed price in one year.
Can Parent hedge changes in the fair value of its wholly owned
subsidiary?
No. This transaction does not qualify as a fair value hedge because Topic 815
prohibits an equity investment in a consolidated subsidiary from being
designated as the hedged item in a fair value hedge. [815-20-25-43(c)(4)]
Can Parent hedge changes in the cash flows attributed to the sale of its
wholly owned subsidiary?
No. This transaction does not qualify as a cash flow hedge because Topic 815
prohibits hedging a transaction involving a parent entity’s interest in a
consolidated subsidiary. [815-20-25-15(h)(1)]

Question 2.5.20
Can an entity hedge exposure to assets or liabilities
of an investee that is proportionately consolidated?

Interpretive response: Yes. The proportionate consolidation method is applied

frequently in extractive industries when the investee is an unincorporated entity
(such as a partnership) and no investor is considered to have control.
A proportion of the underlying assets and/or liabilities of an investee that is
proportionately consolidated would be recognized in an entity’s financial
statements. Therefore, we believe an entity could hedge the recognized assets
or liabilities as if the investee were a consolidated subsidiary, subject to all of
the other qualifying criteria in Topic 815.

2.5.30 Equity securities in scope of Topic 321

Topic 815 prohibits designating equity securities in the scope of Topic 321
(equity securities) as hedged items in a fair value or cash flow hedge. [815-20-25-
43(b)(1)]

This includes the following:

— equity securities with readily determinable fair values that are measured at
fair value with gains/losses recognized currently in earnings; and [321-10-35-1]

— equity securities without readily determinable fair values that are measured
either (1) at fair value with gains/losses recognized currently in earnings, or
(2) using a measurement alternative (cost +/- fair value changes when there
are observable prices less impairment). [321-10-35-2]

2.5.40 Equity instruments issued by the entity and

transactions with shareholders
Equity instruments issued by the entity and classified in stockholder’s equity
are not eligible for hedge accounting, because they do not meet the definition
of assets or liabilities. Only recognized assets and liabilities are eligible to be
designated in a fair value hedge or a cash flow hedge. [815-20-25-12(a), 25-43(c)(6)]
Furthermore, changes in the market value of an entity’s own equity instruments
do not affect earnings, which is also a requirement to be designated as a
hedged item.
This restriction also applies to the following transactions:
— transactions with shareholders (including projected purchases of treasury
stock and payments of dividends); [815-20-25-43(b)(3)]
— firmly committed issuances of common and preferred stock; [815-20-25-
43(c)(6)]

— forecasted transactions (such as a forecasted purchase, sale or dividend)

involving an entity’s own equity instruments; and [815-20-25-15(h)(2)]
— forecasted stock issuances that are related to a stock option plan for which
no compensation expense (based on changes in stock prices after the date
of grant) is recognized. [815-20-25-43(b)(5)]

Question 2.5.30
Are items classified in temporary or mezzanine
equity eligible for designation as a hedged item?

Interpretive response: No. We believe that items classified in temporary or

mezzanine equity (e.g. certain preferred stock instruments) cannot be
designated as hedged items because they do not meet the definition of an
asset or liability.

Question 2.5.40
Can an entity hedge compensation expense related
to stock appreciation rights?

Excerpt from ASC 815-20

>>> Hedged Items in Cash Flow Hedges Only

>>>> Stock-Appreciation-Right Obligation as a Hedged Item
55-33 This guidance addresses the application of the criteria in Section 815-20-
25 to an unrecognized, nonvested stock appreciation right as a hedged item.
An unrecognized, nonvested stock appreciation right relates to the portion of
the stock appreciation right liability that has not yet been accrued. It does not
refer to future fair value changes in the recognized liability for the vested
portion of the stock appreciation right. To the extent that vesting of stock
appreciation rights is probable, a purchased call option indexed to an entity’s
own stock that is recorded as an asset and accounted for as a derivative
instrument may be designated as the hedging instrument in a hedge of cash
flow variability of expected future obligations associated with unrecognized,
nonvested stock appreciation rights if the option is classified as an asset in the
entity’s financial statements and the option is a derivative instrument subject
to Subtopic 815-10. Presumably, if using this strategy, hedge effectiveness
typically would be assessed based on changes in the entire value of the
purchased call option, rather than just the intrinsic value of the option because
the fair value of the unrecognized, nonvested stock appreciation rights likewise
consists of a time value portion and an intrinsic value portion. Because an
unrecognized, nonvested stock appreciation right results in exposure to cash
flow variability of expected future obligations that affects reported earnings, it
is eligible to be designated as being hedged. A stock appreciation right that is
recognized as a liability may not be designated as being hedged in a cash flow
hedge because the hedged cash flow variability in a recognized stock
appreciation right relates to a liability that is remeasured with changes in fair
value reported currently in earnings. The hedge of exposure to cash flow
variability in an unrecognized, nonvested stock appreciation right could be
expected to be highly effective. The entity’s stock price is the underlying for
both the unrecognized, nonvested stock appreciation right and the option on
the entity’s own stock. Changes in fair value of the purchased call option on
the entity’s own stock would be recorded in other comprehensive income
consistent with paragraph 815-30-35-3. As required by paragraphs 815-30-35-
38 through 35-41, the amount in other comprehensive income would be
reclassified into earnings concurrent with the recognition in earnings of
compensation cost on the stock appreciation right that relates to those fair
value changes that occurred during the hedge period over the requisite service
period.

Background: A stock appreciated right (SAR) is a form of compensation that

entitles employees to receive cash, stock or a combination of cash and stock in

an amount equivalent to any excess of the market value over a stated price
based on a stated number of shares of the employer’s stock.
Various factors, including the method of settlement, determine whether the
entity accounts for the SAR as a liability or an equity instrument. SAR awards
classified as liabilities are adjusted to fair value each reporting period with gains
and losses recognized as compensation expense. [718-30-35]
SAR awards also generally have vesting provisions (e.g. pro rata vesting over a
specified service period or vesting at a single date), and an entity recognizes the
related compensation expense over a service period. Typically, an entity will
want to hedge this compensation expense by using a purchased cash settled
call option on its own stock.
Interpretive response: An unrecognized nonvested SAR obligation presents
exposure to cash flow variability of expected future obligations that affects
reported earnings, and therefore is eligible to be designated as the hedged
forecasted transaction in a cash flow hedge (assuming vesting of the SAR is
probable).
Once a SAR is recognized as a liability, it may not be hedged because the
recognized liability is remeasured at fair value through earnings. This creates
complexity in hedging an unrecognized SAR obligation because the recognition
of the SAR liability occurs before vesting.
There are also considerations around whether the purchased call option would
meet the definition and scope of a derivative, which is a requirement to be
designated as the hedging instrument (see section 2.6). For the purchased call
option to be a derivative instrument, it needs to be classified as an asset.
However, certain contracts involving an entity’s own equity are classified as
equity, and therefore are not eligible to be considered a derivative instrument.
[815-10-15-74(a)]

Lastly, although an entity may want to hedge a SAR obligation, it may be

difficult to assert that the hedging relationship will be highly effective.
Therefore, cash flow hedges of SAR obligations are uncommon.

2.5.50 Intercompany transactions

Cash flows from intercompany transactions are eliminated in consolidation, and
therefore are not eligible for hedge accounting except for variability due to
changes in foreign currency exchange rates. This is because they do not
represent an exposure to earnings, which is a requirement for hedge
accounting. [815-20-25-12(c), 25-15(c)(2), 25-43(b)(4)]
For example, the risk of variable cash flows attributable to interest rate risk
related to variable-rate intercompany debt could not be hedged because
earnings of the consolidated entity are not affected by the transaction. Similarly,
equity investments in a consolidated entity are eliminated in consolidation and
are therefore not eligible for hedge accounting. [815-20-25-15(h)(1), 25-43(c)(4)]
In contrast, the risk of variable cash flows attributable to foreign currency
exchange risk related to a subsidiary’s intercompany debt denominated in a
foreign currency could be hedged because the earnings of the consolidated

entity are affected by the resulting foreign currency remeasurement gain or loss
related to the debt.

Foreign currency risk. An entity is permitted to hedge intercompany

transactions for foreign currency risk (see section 7.3.40). This risk is not
eliminated in consolidation, and therefore affects consolidated earnings. [815-20-
25-43(b)(4)]

Question 2.5.50
Can intercompany transactions be hedged for
eligible risks at the stand-alone financial statement
level of a subsidiary?
Interpretive response: Yes. Hedging intercompany transactions for other
eligible risks (such as interest rate risk) is permitted at the stand-alone financial
statement level of a subsidiary. At this level the risk affects earnings. However,
the effect of the hedge accounting needs to be reversed in the consolidated
financial statements that include the intercompany entities to the transaction.

2.5.60 Business combinations

The following items and transactions are ineligible for hedge accounting:
— firm commitment to either enter into a business combination or to acquire
or dispose of a subsidiary; [815-20-25-43(c)(5)]
— forecasted transaction involving a business combination; and [815-20-25-15(g)]
— forecasted purchase or sale involving a parent entity’s interest in a
consolidated subsidiary. [815-20-25-15(h)(1)]
For example, if an entity enters into a contract to acquire a business in
exchange for shares and/or cash, it may not apply hedge accounting for a
derivative instrument used to lock in the cost of acquiring the business.
Similarly, if an entity wishes to dispose of its 60% investment in a subsidiary, it
may not apply hedge accounting for a derivative instrument used to lock in the
forecasted sales price of the subsidiary.
The FASB prohibited firm commitments and forecasted transactions involving
a business combination from being designated as a hedged item or transaction
for reasons similar to the prohibition of equity method investments
(see section 2.5.20) and equity investments in a consolidated entity
(see section 2.5.50). [FAS 133.BC456, BC472–BC473]

Question 2.5.60
Is an entity allowed to hedge a forecasted issuance
of debt that is contingent on a business
combination?
Background: An entity may issue debt to finance the acquisition of another
business. While those debt issuances are contingent on a business acquisition,
they do not form part of the actual acquisition.
Interpretive response: We believe it may be acceptable to hedge the
forecasted issuance of debt that is contingent on consummation of a business
combination if the forecasted transaction does not directly affect the purchase
price or the acquisition accounting associated with the acquisition.
The forecasted issuance of debt in the functional currency of an acquirer that
provides it with the consideration necessary to complete a business
combination does not directly affect the purchase price or the acquisition
accounting associated with the acquisition. Rather, it is considered a financing
transaction separate from the acquisition.
To be eligible for cash flow hedge accounting, an entity needs to determine it is
probable that the business combination will be consummated and the
forecasted transaction will occur. The facts and circumstances related to the
forecasted business combination need to be evaluated to determine whether
the transaction is probable.
To the extent an entity concludes that a business combination is probable for
purposes of hedge accounting, an entity would also conclude that the business
combination is probable for purposes of SEC Rule 3-05 of Regulation S-X. This
regulation requires an entity to prepare audited financial statements of a
significant business acquired (or to be acquired) if the consummation of the
business combination is considered probable.
If the forecasted issuance of debt that is contingent on a business combination
qualifies for designation as a hedged transaction, an entity may wish to use a
deal contingent interest rate swap as the hedging instrument to hedge the
interest rate risk. This requires the entity to assess whether the deal contingent
swap is expected to be highly effective at achieving offsetting cash flows
attributable to the hedged risk. However, a deal contingent term in this type of
hedging instrument would generally be expected to reduce the effectiveness of
the hedging relationship, and could result in the hedging relationship being less
than highly effective. See Question 9.7.50 for further guidance on assessing
effectiveness of a hedging relationship that includes a deal contingent swap.

Question 2.5.70
Can an entity hedge total assets or liabilities of a
disposal group classified as held-for-sale?

Interpretive response: No. Topic 205 (presentation) requires an entity to

present total assets and total liabilities of a disposal group classified as held-for-
sale on the face of the balance sheet. [205-20-45-10]

The assets or liabilities of a disposal group classified as held-for-sale would not

qualify for fair value or cash flow hedge accounting. This is because (like hedges
of forecasted business combinations) they represent a group of dissimilar
assets and liabilities.

2.5.70 Assets and liabilities remeasured with changes in fair

value reported in earnings
An asset or liability that is remeasured with the changes in fair value attributable
to the hedged risk reported in earnings is not eligible for hedge accounting. This
restriction also applies to the forecasted acquisition (or incurrence) of an asset
(or liability) that will be remeasured at fair value. [815-20-25-15(d), 25-43(c)(3)]
Specifically, the FASB believes that hedge accounting should not provide an
opportunity to change the accounting for an asset or liability that would
otherwise be reported at fair value with changes currently recognized in
earnings. [FAS 133.BC405]
Section 2.3.100 provides guidance on this restriction as it relates to financial
assets and liabilities.
Topic 815 requires items that meet the definition of a derivative to be measured
at fair value, unless the item qualifies for any of the scope exceptions in
Subtopic 815-10. Therefore, contracts that meet the definition of a derivative
may not be designated as the hedged item or transaction unless they qualify
for one of the scope exceptions. Section 3.3.30 (fair value hedges) and
Question 5.3.10 (cash flow hedges) provide further guidance on the eligibility
of contracts that meet the definition of a derivative and a commonly used scope
exception (e.g. normal purchases and normal sales).

Question 2.5.80
Can assets measured at the lower of cost or market
be designated as hedged items?

Interpretive response: Yes. An entity is not prohibited from designating items

that are (or will be) measured at the lower of cost or market as the hedged item
in a fair value or cash flow hedge. For example, mortgage loans held for sale,
inventory held or the forecasted purchase of inventory.
These items may affect earnings as a result of the risk being hedged, such as
the risk of decrease in fair value of mortgage loans held for sale due to a change
in interest rates, or the risk of decrease in the cash flows of the forecasted sale
of inventory. However, they are (or will be, when recognized) measured at fair
value if the fair value declines below cost.
Consequently, they are not remeasured with changes in the fair value reported
currently in earnings. Therefore, assets measured at the lower of cost or market
are eligible to be designated as hedged items.

Example 2.5.30
Forecasted transaction to purchase debt securities
that will be classified as trading under Topic 320
Cash flow hedge
ABC Corp. wants to acquire municipal bonds three months from now. ABC will
classify them as trading debt securities under Topic 320.
The forecasted acquisition of trading securities does not qualify as a hedged
transaction in a cash flow hedge. These securities will be measured at fair value
with subsequent changes in fair value reported currently in earnings under
Topic 320. Therefore, hedge accounting is prohibited.
Fair value hedge
Similarly, ABC would be prohibited from applying fair value hedge accounting to
a firm commitment to purchase debt securities that will be classified as trading
debt securities under Topic 320.

Example 2.5.40
Forecasted transaction to purchase a derivative
instrument
ABC Corp. is considering entering into a derivative instrument three months
from today with a value indexed to the market price of XYZ Corp.’s common
stock. The instrument is a derivative under Topic 815.
The forecasted acquisition of the derivative instrument does not qualify as a
hedged transaction in a cash flow hedge. Derivative instruments are measured
at fair value with subsequent changes in fair value reported currently in earnings
under Topic 815. Therefore, hedge accounting is prohibited.

2.5.80 Strategic risk

Excerpt from ASC 815-20

>>> Strategic Risk Ineligible as Hedged Risk

55-40 The offset criterion in paragraph 815-20-25-75 precludes hedge
accounting for certain risk management techniques, such as hedges of
strategic risk. For example, a U.S. manufacturer, with no export business, that
designates a forward contract to buy U.S. dollars (USD) for Japanese yen (JPY)
as a hedge of its USD sales would fail the requirement that the cash flows of
the derivative instrument are expected to be highly effective in achieving
offsetting cash flows on the hedged transaction. A weakened JPY might allow
a competitor to sell goods imported from Japan more cheaply, undercutting
the domestic manufacturer’s prices and reducing its sales volume and
revenues. However, it would be difficult for the U.S. manufacturer to expect a

high degree of offset between a decline in U.S. sales revenue due to increased
competition and cash inflows on a foreign currency derivative instrument. Any
relationship between the exposure and the hedging derivative typically would
be quite indirect, would depend on price elasticities, and would be only one of
many factors influencing future results. In addition, the risk that a desired or
expected number of transactions will not occur, that is, the potential absence
of a transaction, is not a hedgeable risk for accounting purposes.

Topic 815 focuses on four risks that are expected to directly affect the fair value
of an asset or liability (or the cash flows of a forecasted transaction) in a
determinable or predictable manner. These are interest rate risk, credit risk,
foreign exchange risk and price risk.
An entity may engage in various activities to control or reduce other types of
economic risks (e.g. strategic risks); however, these may not be as
determinable or predictable. As such, these types of economic risks are not
eligible for hedge accounting.

2.5.90 Macro hedges

A macro hedging strategy is a risk management technique that uses derivatives
to manage risk – typically interest rate risk – from a portfolio of financial assets
and/or liabilities. However, this strategy does not link the derivative instrument
to identifiable assets, liabilities, firm commitments or forecasted transactions.
Instead, the risk is managed from a macro (or enterprise-wide) perspective.
Topic 815 does not permit a macro hedging strategy. [FAS 133.BC449]
To qualify for hedge accounting, the hedging instrument needs to be linked to a
specific hedged item or transaction. This is necessary to objectively assess
whether the hedging relationship is highly effective, and ultimately to apply
hedge accounting to the hedged items or transactions.

2.6 Hedging instruments

Criterion 1 Criterion 2 Criterion 3 Criterion 4

Eligibility of Eligibility of
Eligibility of Hedge
hedged items hedging
hedged risk(s) effectiveness
or transactions instruments

Criterion 5: Formal documentation

2.6.10 Overview

Excerpt from ASC 815-20

> Eligibility of Hedging Instruments

25-45 Either all or a proportion of a derivative instrument (including a

compound embedded derivative that is accounted for separately) may be
designated as a hedging instrument. Two or more derivative instruments, or
proportions thereof, may also be viewed in combination and jointly designated
as the hedging instrument. A proportion of a derivative instrument or derivative
instruments designated as the hedging instrument shall be expressed as a
percentage of the entire derivative instrument(s) so that the profile of risk
exposures in the hedging portion of the derivative instrument(s) is the same as
that in the entire derivative instrument(s). Subsequent references in the
Derivatives and Hedging Topic to a derivative instrument as a hedging
instrument include the use of only a proportion of a derivative instrument as a
hedging instrument. Whether a written option may be designated as a hedging
instrument depends on the terms of both the hedging instrument and the
hedged item as discussed beginning in paragraph 815-20-25-94.

The combination of the hedged item or transaction and the hedging instrument
is referred to as the hedging relationship.

Hedged item or Hedging Hedging

transaction instrument relationship

Only financial instruments or contracts that meet the definition of a derivative

under Topic 815 can be designated as the hedging instrument, with the
exception of certain foreign currency transactions. [815-20-25-71(a)(1)]
Topic 815 provides an entity with choices when designating the hedging
instrument, including: [815-20-25-45]
— all of a derivative instrument;
— a proportion of a derivative instrument (see section 2.6.30); or
— a combination of two or more derivative instruments (see section 2.6.40).
There are also limitations on certain derivatives being hedging instruments
(see section 2.7).
If the derivative does not meet the criteria for hedge accounting, or if it is not
designated as a hedging instrument, it is treated as a trading derivative
instrument under Topic 815. These instruments are recorded at fair value, with
any changes immediately recognized in earnings.

Foreign currency risk. For guidance on the eligibility of hedging

instruments in foreign currency hedges, see chapter 7.
Net investment hedges. For guidance on the eligibility of hedging instruments
in net investment hedges, see section 8.3.

2.6.20 Common types of derivative instruments

There are three general categories of derivatives: options, swaps and futures/
forwards. The following table includes examples of derivatives that are
commonly used as hedging instruments (not exhaustive).

Swaps Futures/Forwards Options

— Interest rate swaps — Futures contracts — Call options
— Commodity swaps (standardized and — Put options
— Equity swaps exchange traded) — Interest rate caps
— Foreign currency — Forward contracts — Interest rate floors
swaps — Interest rate collars
— Cross-currency
interest rate swaps
— Credit default swaps
— Total return swaps

There are other types of instruments that are a combination of two categories
of derivatives. For example, a forward-starting swap is an agreement to enter
into a swap that starts at a future date. Likewise, a swaption is an option to
enter into an interest rate swap when exercised.

Interest rate swaps

A swap is a contractual agreement between two parties to exchange cash
flows from one type of financial instrument for another.
The most widely used swap is the interest rate swap. An interest rate swap is a
contractual agreement between two parties to exchange one type of interest-
rate-based cash flows for another type of interest-rate-based cash flows on
specified dates in the future.
One type of interest rate swap that is typically used in both fair value and cash
flow hedging relationships is a fixed-for-floating interest rate swap. This type of
swap involves the exchange of fixed interest rate cash flows for floating
interest rate cash flows that change with a specific reference or index (e.g.
LIBOR, Commercial Paper, and Prime).
Floating rate
(e.g. LIBOR + 0.5%)

Fixed rate (e.g. 7.5%)

Counterparty A Counterparty B

Fixed-rate Variable-rate
cash flows cash flows

The fixed rate of the swap is typically set for the entire term of the swap,
whereas the floating rate is reset on specified reset dates. The frequency with
which the floating rate is reset is usually at the discretion of the two parties.

To determine the net settlements of a fixed-for-floating interest rate swap, the

applicable fixed rate and floating rate as of the reset date are multiplied by the
notional amount in effect at that date. The computed swap payments (i.e. the
computed difference) are then paid to or received from the counterparty, as
applicable, on designated settlement dates.
The hedging strategy when using a fixed-for-floating interest rate swap is
different for a fair value hedge and a cash flow hedge.

Fair value hedge Cash flow hedge

Converts fixed interest payments (or Converts variable-rate cash flows to
receipts) to variable. fixed cash flows.

Other types of swaps with periodic interest exchanges include the following.

Basis swaps An interest rate swap that exchanges two variable-rate interest
payments (e.g. a floating-for-floating interest rate swap).
For limitations on designating basis swaps in a cash flow hedge,
see section 5.5.10.
Cross-currency A contractual agreement between two parties to exchange
interest rate interest payments and principal denominated in two different
swaps currencies.
This exchange includes the following at different points in time.
— Initial exchange (at inception): a fixed principal amount of one
currency for a fixed principal amount of a different currency
(usually based on the spot rate on the date of the transaction).
— Periodic exchanges: periodic interest cash flows in the two
currencies of denomination based on the fixed principal
amounts of the two currencies exchanged at inception at
either a fixed or variable rate of interest.
— Final exchange (at maturity): fixed principal amounts
exchanged at inception.
A cross-currency interest rate swap (CCIRS) can be structured to
accomplish different objectives. For example, an entity can hedge
its exposure to both interest rate risk and foreign exchange risk –
e.g. a foreign currency denominated variable-rate debt hedged
using a receive-variable, pay-fixed CCIRS. Alternatively, it could
hedge its exposure only to foreign currency risk – e.g. a foreign
currency denominated fixed-rate debt hedged using a receive-
fixed, pay-fixed CCIRS.

Example 2.6.10
Hedging strategy using a fixed-for-floating interest
rate swap

Fair value hedge

ABC Corp. issues a fixed-rate debt instrument and wishes to hedge its
exposure to changes in fair value related to interest rate risk (i.e. benchmark
interest rate).

ABC can convert the fixed interest paid to variable by entering into an interest
rate swap to receive interest at a fixed rate and pay interest at a variable rate.
The floating interest rates protect ABC against fluctuations in the fair value of its
issued debt due to changes in interest rates. Converting the fixed interest
expense to variable interest expense that fluctuates with the market benchmark
interest rate allows ABC to benefit if the market benchmark interest rate
declines, and vice versa.
Cash flow hedge
ABC issues a variable-rate debt instrument and wishes to hedge its exposure to
variations in cash flows related to interest rate risk (i.e. contractually specified
interest rate).
ABC can convert interest paid to fixed by entering into an interest rate swap to
pay interest at a fixed rate and receive interest at a floating rate.
The interest rate swap essentially locks in a fixed rate and eliminates the
variability of the interest rate in ABC’s debt instrument. The fixed interest rate
does not fluctuate with the market.

Other swaps
The other basic types of swaps are summarized below.

Commodity Contractual agreement between two parties to exchange the

swaps market (or spot) price of an underlying commodity for a fixed price.
Equity swaps Contractual agreement between two parties to exchange a set of
future cash flows (i.e. ‘legs’ of the swap). One leg is usually based
on a floating rate (e.g. the floating leg) and the other leg is based
on the performance of shares or a share index (e.g. the equity leg).
Foreign Contractual agreement between two counterparties to exchange
currency foreign currency.
swaps
Credit default Buyer makes periodic payments to a seller (i.e. fee or premium) in
swaps exchange for an agreement that the seller will compensate the
buyer in the event that a debt issuer (i.e. the reference entity)
defaults or experiences a credit event.

Forwards/futures
Forward contracts are negotiated between two parties to purchase a specific
quantity of a commodity, a financial instrument or a foreign currency at a
specified price with delivery or settlement in the future.
Those contracts can be physically settled by receipt of the underlying for a
payment of cash or can be net cash settled by the parties, with one party
receiving a payment for the difference between the price of the underlying on the
date of the settlement (i.e. the spot price) and the forward price agreed to in the
contract multiplied by the notional amount of the contract (i.e. number of units).

Question 2.6.10
What is the difference between a forward contract
and a futures contract?

Interpretive response: Futures contracts are standardized and traded on a

regulated exchange, whereas forward contracts are agreements between two
parties that have varied terms and conditions.
The other key differences between forward contracts and futures contracts are
as follows.

Forward contracts Futures contracts

Underlying Available for essentially any Available only for certain
underlying if two parties agree underlyings (i.e. those underlyings
to the contract. with liquid markets) due to their
standardized nature.
Credit risk Affected by the Affected by the creditworthiness of
creditworthiness of the the exchange on which the
counterparty and the entity's contract trades.
own nonperformance risk.
Settlement Can either be gross (physically) Generally provide for net cash
settled or net cash settled. settlement.

Options
Unlike swaps, forwards and futures contracts that require an entity to buy or
sell an underlying instrument or to swap cash flows with another party, an
option contract provides an option holder with the right, but not the obligation,
to buy or sell an underlying instrument or to exchange cash flows with another
party.
The key features of options are as follows.

Terms of An option contract defines a price, referred to as the strike price, and
contract establishes the term of the option, referred to as the exercise period.
Call or put An option contract normally provides an option holder a call option or
option a put option.
— A call option is an agreement that gives the holder the right to
buy an underlying asset. This enables the holder to benefit from
an increase in the value of the underlying instrument above the
exercise price.
— A put option is an agreement that gives the holder the right to
sell an underlying asset. This enables the holder to benefit from
a decrease in the value of the underlying instrument below the
exercise price.
American or Options generally are either American or European depending on
European their exercisability. The holder of an American option can exercise
options the option at any time during the exercise period whereas the holder
of a European option can exercise an option only at maturity.

Option An option holder usually pays a premium for the right to exercise the
holder option. Because of the nature of an option, the holder benefits from
(buyer) favorable movements (either up or down depending on whether it is
a call or a put) in the price of the underlying instrument while risking
only the loss of the option premium that it paid for the contract.
Option An option writer is exposed to virtually unlimited loss in exchange for
writer the option premium.
(seller)
Time value An option comprises time value and intrinsic value.
and intrinsic — Time value represents the value of the time to the end of the
value exercise period, which is affected by volatility of the price of the
underlying, the remaining option term, and other economic
factors.
— Intrinsic value, commonly characterized by the term ’in the
money’ is the amount by which the value of the underlying
exceeds or is less than an option’s strike price depending on
whether the option is a call or put, respectively. In either case, it
normally can only be a positive amount – meaning that an option
cannot have an intrinsic value less than zero, even when
(economically) the option is underwater.

Options can be combined with other options (e.g. an interest rate collar that
combines a cap and a floor) or with other types of derivatives (e.g. an option
within a swap).
Before an entity can consider an option contract or a combination of option
contracts as a hedging instrument, it must determine whether the option or
combination is a net purchased option (i.e. an option purchased by the entity) or
a net written option (i.e. an option written by the entity). This determination is
not always as simple as it may seem.
If the option or combination is a net written option, the hedging relationship
must meet the written option test for the option to be a hedging instrument.
For further guidance, see sections 2.7.50 and 2.7.60.

Example 2.6.20
Hedging strategy using a purchased option

Fair value hedge

ABC Corp. issues a fixed-rate debt instrument and wishes to hedge its
exposure to changes in fair value related to decreases in the benchmark
interest rate.
When hedging only one side of a prescribed risk exposure (e.g. a decrease), the
hedging instrument must be effective at providing a one-sided offset.
ABC locks in a maximum value for the fixed-rate debt instrument by purchasing
an interest rate floor option. ABC will receive payment at the end of each period
in which the benchmark interest rate is below the agreed floor strike price.

Cash flow hedge

ABC issues a variable-rate debt instrument and wishes to hedge its exposure to
an increase in the contractually specified interest rate.
ABC locks in the maximum interest to be paid for the variable-rate debt
instrument by purchasing an interest rate cap option. ABC will receive payment
at the end of each period in which the benchmark interest rate is above the
agreed cap strike price.

Question 2.6.20
Can an option with multiple underlyings be used as
a hedging instrument?

Background: The financial marketplace develops complex option contracts that

simultaneously mitigate the effects of a variety of risks. Often, these complex
options contain multiple underlyings and are structured to achieve certain
economic results.
Interpretive response: Yes, if all hedge criteria are met, an option with multiple
underlyings can be used as a hedging instrument. This includes the following.
— The hedging relationship must be expected to be (and actually be) highly
effective throughout the hedge period. It is not permissible to designate (as
the hedged risk) a specific risk but only when another specific risk is also
present, even when a complex option contains two or more underlyings
that are economically related to those risks. For example, an entity cannot
define its hedging strategy as hedging the risk of changes in fair value due
to changes in the benchmark interest rate of a firm commitment to
purchase a fixed-rate bond, but only when oil prices are above a
certain level.
— If the hedged item or forecasted transaction is a group of individual items or
transactions, each item in the group must share the same risk exposure for
which they are designated as being hedged. See sections 3.3.30 and 5.3.60
regarding similarity for fair value and cash flow hedges, respectively.
See Example 16 in Subtopic 815-20 (reproduced below) for an example of
attempting to use an option with multiple underlyings as a hedging instrument.

FASB Example: Oil-linked interest rate cap as hedging

instrument

Excerpt from ASC 815-20

>> Example 16: Oil-Linked Interest Rate Cap as Hedging Instrument

55-156 This Example illustrates whether an oil-linked interest rate cap can be
designated in a qualifying hedging relationship.
55-157 Entity A enters into a complex option contract with multiple underlyings
for which no net premium is received. The payoffs under the contract are
nontraditional. Entity A wishes to designate the option in a cash flow hedging
relationship. Specifically, Entity A is an oil producer with five-year variable-rate
debt (indexed to three-month LIBOR) and is concerned that an environment of
falling oil prices and rising interest rates could affect its ability to meet
increasing interest payments on the variable-rate debt. To limit its exposure,
Entity A enters into a five-year oil-linked interest rate cap with a notional
amount equal to the principal amount of Entity A’s three-month LIBOR-based
variable-rate debt.
55-158 Under the terms of the oil-linked interest rate cap (a complex option),
Entity A receives specified payments if both of the following conditions exist:
a. 3-month LIBOR is greater than 7 percent
b. The price of oil is less than $25 per barrel.
55-159 Specifically, if both of the conditions in the preceding paragraph are
met, Entity A receives payments under the oil-linked interest rate cap equal to
the increased interest payments (that is, for floating-rate amounts above
7 percent) due on their floating-rate debt.
55-160 However, if the daily price of oil goes above $25 per barrel at any time
during a quarter, the option is knocked out for only that specific quarter. The
option’s knock-out feature is reset each quarter such that the interest rate
coverage is knocked out for a specific quarter only if the daily price of oil goes
above $25 per barrel at any time during that specific quarter. Thus, the option
limits Entity A’s exposure to increases in interest rates for all quarters in which
oil prices remain under $25 per barrel throughout the quarter.
55-161 The oil-linked interest rate cap cannot be designated in a hedge of the
variability in the difference between interest payments and sales proceeds on
oil. The oil-linked interest rate cap purchased by Entity A is attempting to hedge
Entity A’s exposure to variability in the net cash flows related to certain
revenue inflows and certain expense outflows. Entity A wishes to reduce the
risk that an increase in cash outflows due to increases in interest rates will
occur without a concurrent increase in cash inflows due to increases in the
price of oil per barrel. Those are separate and dissimilar risks that Entity A
wishes to hedge with a single derivative instrument. Thus, the hedged
forecasted transaction cannot be a group of oil sales inflows and interest
payment outflows. This Subtopic is not structured to permit hedge accounting

for strategies involving hedges of a spread between revenues and expenses as

Entity A is attempting to accomplish.
55-162 The oil-linked interest rate cap cannot be designated in a hedge of the
variability in interest cash flows attributable to changes in LIBOR above
7 percent. Entity A could not simply define its hedged risk as the risk of
changes in cash flows attributable to changes in the three-month LIBOR rate
for only those periods when the price of oil per barrel is below a specified
dollar amount.
55-163 If Entity A wanted to designate the oil-linked interest rate cap as a cash
flow hedge of the variability in interest payments on the LIBOR-based variable-
rate debt due to changes in interest rates above the contractually specified
7 percent rate in the interest rate cap, Entity A would be required to assess
effectiveness whenever interest rates were above that 7 percent rate.
Because the cap also has an underlying related to oil prices, there could be
times when interest rates will be above the contractually specified interest rate
in the cap but the complex option will not result in any cash flows because the
selling price of oil is not below the contractually specified price per barrel ($25).
In other words, the complex option will be out of the money but Entity A will
be required to assess the option’s effectiveness in offsetting the increase in
interest payments for the effect of the excess of 3-month LIBOR over
7 percent.
55-164 Generally, it would be unlikely that Entity A could conclude that the oil-
linked interest rate cap is expected to be highly effective in achieving offsetting
cash flows if it is reasonably possible that the oil-linked option will knock out
the cash inflows from the derivative instrument. In its assessment of the
effectiveness of the hedge of the interest payments on the variable-rate debt,
Entity A must consider the likelihood that the interest-rate protection from the
oil-linked interest rate cap may be knocked out due to oil prices exceeding the
contractually specified amount per barrel and it may not exclude from its
assessment of effectiveness those periods when the interest rate protection is
knocked out. For those quarters when the cap is knocked out, there are no
cash flows from the cap to be used to offset the change in the cash flows on
the hedged forecasted transaction.
55-165 In the unlikely event that Entity A was able to conclude that the
relationship was expected to be highly effective (because the complex option
was expected to be highly effective for all changes in the three-month LIBOR
rate above the contractually specified rate due to the remoteness that the price
of oil per barrel would not be below the contractually specified amount over
the contractual life of the debt), the complex option could be used as the
hedging derivative.
55-166 The oil-linked interest rate cap cannot be designated in a hedge of the
variability in proceeds from the forecasted sale of oil. If Entity A wanted to
designate the oil-linked interest rate cap as a cash flow hedge of the risk of
overall changes in the sales proceeds from the forecasted sale of oil below the
contractually specified price per barrel in the interest rate cap, the hedging
relationship would fail to qualify under paragraph 815-20-25-75(b) because the
cash inflows from the oil-linked interest rate cap are calculated based on the
debt’s principal amount and the excess of 3-month LIBOR over 7 percent.
Because the cash inflows from the oil-linked interest rate cap are unrelated to

the proceeds from oil sales, Entity A could not expect the proposed hedging
relationship to be highly effective at achieving offsetting cash flows.

2.6.30 Proportion of a derivative

An entity may designate all or a proportion of a derivative as the hedging
instrument. If a proportion is designated, it must be a percentage of the entire
derivative instrument.

Percentage of derivative instrument

(e.g. 70% of an interest rate swap)

This means the risk exposure profile in a proportion of a derivative instrument

must be the same as the entire derivative instrument. [815-20-25-71(a)(2)]
Similarly, an entity cannot separate a compound derivative instrument and
designate one dissimilar component as the hedging instrument
(see section 2.7.40). [815-20-25-71(a)(2)]
The following table includes examples of separate components of derivatives
that are not permitted as hedging instruments.

Type of derivative Example components not permitted to be designated

instrument as hedging instrument (not exhaustive)
Six-year interest rate — Separating periods of the interest rate swap as the
swap hedging instrument – e.g. a swap for the first three
years and another swap for the remaining three
years.
Cross-currency interest — Separating the interest rate swap component to
rate swap solely hedge interest rate risk.
— Separating the foreign currency swap component to
solely hedge foreign currency risk.
Interest rate swap — Separating the swap and written option components,
containing an and using only one component as the hedging
embedded written instrument.
option (e.g. an indexed-
amortizing swap)

Designating a proportion of a hedging instrument is a significantly different

concept from designating a portion of an asset, liability, firm commitment or
forecasted transaction as the hedged item or transaction.
The designated portion of the item or transaction can have characteristics
different from the entire item or transaction. For example, a call option
embedded in a debt obligation could be separately designated as the hedged
item. In contrast, as demonstrated in the table above, an embedded written
option within a derivative instrument cannot be separately designated as the
hedging instrument.

Question 2.6.30
Can different proportions of the same derivative
instrument be designated in different hedging
relationships?
Interpretive response: Yes. Topic 815 does not explicitly prohibit an entity
from designating different proportions of the same derivative instrument in
different hedging relationships.
For example, an entity with a $70 million debt instrument designates 70% of an
interest rate swap with a notional amount of $100 million to hedge interest rate
risk. The remaining 30% of the interest rate swap – i.e. $30 million notional
amount of the swap – is eligible to be designated in a different hedging
relationship, provided all other qualifying criteria have been met.
If the remaining proportion is not designated in a hedging relationship, it is
accounted for as a derivative instrument under Topic 815 with changes in fair
value recognized in earnings.

Question 2.6.40
Can the first 10 years of a 15-year interest rate swap
be designated as a portion of the hedging
instrument?
Interpretive response: No. An entity is prohibited from separating a derivative
instrument into components that represent different risks and designating one
of those components as the hedging instrument.
We believe separating a derivative instrument into different segments based on
the timing of interest payments or receipts would result in one portion of the
contract having different risks from those attributable to the entire derivative
contract.

Example 2.6.30
Separating an interest rate swap into components
that represent different risks
ABC Corp. issues a 10-year variable-rate debt instrument based on LIBOR. At
the same time, ABC enters into a 15-year interest rate swap to receive interest
at a variable rate (based on LIBOR) and to pay interest at a fixed rate.
ABC cannot hedge the variability in cash flows of the 10-year variable-rate debt
obligation using the first 10 years of the 15-year interest rate swap because the
first 10 years of the swap represents a portion (as opposed to a proportion) of
the entire derivative instrument.

Example 2.6.40
Interest rate swap to hedge a portion of a hedged
item or transaction
Cash flow hedge
Assume the same facts as Example 2.6.30, except that ABC enters into a
five-year interest rate swap.
ABC is permitted to hedge the variability in cash flows during the first five years
of the 10-year variable-rate debt instrument using a five-year interest rate swap.
Similarly, ABC can hedge variability in cash flows during the last five years of
the 10-year variable-rate debt instrument if the swap was entered into at the
beginning of the sixth year of the variable-rate debt instrument, or in the first
year if the swap was forward-starting.
Fair value hedge
ABC can designate a partial-term hedge for the last five years of a 10-year fixed-
rate debt instrument using a five-year forward-starting interest rate swap that
starts in Year 6. For guidance on partial-term hedges, see section 3.3.80.

2.6.40 Combination of derivatives

An entity can designate a combination of two or more derivative instruments as
the hedging instrument. For example, put and call options can be combined and
treated as one hedging instrument. In addition, either all or a proportion of the
combined derivative hedging instruments may be designated as the hedging
instrument.
Combining derivatives as the hedging instrument may be necessary for a
hedging relationship to be considered highly effective.
The following table demonstrates how an interest rate swap and an option
contract could be designated in a fair value or cash flow hedge for a hedged
item or transaction with an embedded option.

Hedged item or
Hedging instrument
transaction

Fixed-rate debt Interest rate swap

Fair value
security with an +
hedge
embedded call option Option contract

Variable-rate debt
Interest rate swap
Cash flow security with an
+
hedge embedded option that
Option contract
caps the interest rate

The debt security’s fair value or cash flows could be affected in amounts that
are different from the interest rate swap’s fair value or cash flows due to the
embedded option.
The combination of two or more derivatives must be formally documented
(see section 2.9.20).

Example 2.6.50
Combination of an interest rate swap and put option
to hedge fixed-rate debt with an embedded call
option
ABC issues a 10-year fixed-rate debt instrument with a 7% interest coupon that
is callable at par at the end of Year 6. The embedded option is not required to
be bifurcated under Topic 815.
ABC decides to effectively convert the interest payments from fixed to variable
by entering into a 10-year receive-fixed, pay-variable interest rate swap.
For the interest rate swap to be designated as the hedging instrument, it needs
to be highly effective in offsetting changes in fair value of the debt attributable
to interest rate risk taking into account the effect of the embedded call option
(see section 3.4.10). This is because the embedded prepayment option is
exercisable during the hedge period – i.e. ten years.
In combination with the interest rate swap, ABC writes a put option on a swap
(i.e. a swaption) that provides ABC with the option to put (sell) an interest rate
swap in six years. The terms of the interest rate swap are such that ABC will
receive LIBOR and pay 7% interest.
To designate the combination of the interest rate swap and put option as the
hedging instrument, Topic 815 requires symmetry of the gain and loss potential
of the combined hedged position – i.e. the written option test
(see section 2.7.50).

Example 2.6.60
Multiple instruments to hedge interest rate risk

ABC Corp. has five-year variable-rate debt that is based on the Prime rate. ABC
wants to hedge the variability in interest payments and enters into the following
interest rate swaps:
— Pay LIBOR + 175 bps and receive Prime
— Pay fixed of 4.75% and receive LIBOR + 175 bps
In combination, these interest rate swaps would hedge the variability of the
contractually specified interest payment cash flows on the Prime-based debt.
ABC may jointly designate the swaps as the hedging instrument.

Question 2.6.50
Can additional derivative instruments be added to
an existing hedging relationship?
Interpretive response: No. When using multiple derivatives in a hedge, they
must be designated at the same time. An entity is not permitted to add
derivative instruments to an existing hedging relationship. This would be
considered a change in the hedging relationship and would require its
dedesignation (see section 2.10.30).
However, derivative instruments entered into at different times could be used
in a new hedging relationship involving an item that is already subject to another
hedge, assuming there is no duplication of hedged risk.
For example, an entity has a 10-year financial instrument denominated in a
foreign currency. In Year 1, the entity may wish to hedge interest rate risk by
entering into an interest rate swap in the foreign currency. If the entity wishes
to hedge foreign currency exposure at a later date, it could enter into a forward
contract to lock in an exchange rate. These are simultaneous hedges and would
be considered separate hedging relationships. For guidance on simultaneous
hedges, see section 2.3.80.

Question 2.6.60
When should two freestanding derivatives be
viewed as a single derivative instrument?
Interpretive response: Topic 815 generally does not provide for the
combination of separate financial instruments to be evaluated as a unit, unless
two or more derivative instruments in combination are jointly designated as a
hedging instrument. [815-10-25-6, 815-20-25-45]
However, there may be situations where an entity attempts to circumvent
US GAAP by entering into two separate derivative instruments. In this case,
Topic 815 requires the separate derivative instruments to be viewed as a unit
for recognition purposes. [815-10-25-6]
If the separate derivative instruments have all of the following characteristics,
an entity needs to consider whether the overall intent is to circumvent US
GAAP: [815-10-15-9, 815-10-25-6]
— separate derivative contracts are entered into contemporaneously and in
contemplation of one another;
— they are entered into with the same counterparty;
— they relate to the same risk; and
— there is no substantive business purpose for structuring the transactions
separately.
For example, an entity with a fixed-rate debt obligation may enter into an
interest rate swap and designate that swap as the hedging instrument in a fair
value hedge of the debt. Simultaneously it enters into another interest rate
swap with the same counterparty, with terms that are the exact mirror image of
the first swap, and treats the second swap as speculative.

In this instance, the entity needs to assess whether the combination of

derivatives should be considered as a unit. To make this assessment, the entity
needs to determine if the interest rate swaps were entered into in
contemplation of one another for the sole purpose of obtaining fair value hedge
accounting for the debt (which is not appropriate under US GAAP). If that was
the sole purpose, the entity should conclude that the purpose of the transaction
was not to enter into a bona fide hedging relationship involving the first swap.
If that is the case, the two swaps are viewed as a unit and do not qualify in the
hedging relationship because the two derivatives would not be expected to be
highly effective in offsetting changes in the fair value of the debt.
Such a determination will often be highly subjective and difficult to apply in
practice. Therefore, it will require a significant amount of judgment and will be
based on the facts and circumstances associated with the specific transaction
in question.

Example 2.6.70
Two concurrent swaps not viewed as a unit
The following example is adapted from Example 18 in Subtopic 815-10.
ABC Corp. is the issuer of fixed-rate debt. To hedge the fair value exposure of
the debt to interest rate risk, ABC enters into an interest rate swap (Swap 1).
Assume all criteria are met to apply hedge accounting.
ABC simultaneously enters into a second interest rate swap (Swap 2) with the
same counterparty and the exact mirror terms as Swap 1. ABC does not
designate Swap 2 as part of a hedging relationship.
For purposes of this example, ABC has a substantive business purpose for
structuring the transactions separately, and both Swap 1 and Swap 2 are
entered into in arms-length transactions (i.e. at market rates). Therefore,
Swap 2 is not entered into in contemplation of Swap 1.
Is ABC required to view the two swaps as a unit?
The swaps are entered into simultaneously with the same counterparty and
relate to the same risk, both of which may indicate the overall intent of the
transaction is to circumvent US GAAP.
However, Swap 2 is not entered into in contemplation of Swap 1 and the overall
transaction is not executed for the sole purpose of obtaining fair value hedge
accounting treatment for the debt. In other words, there is a substantive
business purpose for structuring the transactions separately and both swaps
are entered into in arms-length transactions. Therefore, the swaps should not
be viewed as a unit.
If it was determined that ABC entered into the transaction to circumvent US
GAAP, the two swaps would be viewed as a unit and ABC would not be
permitted to adjust the carrying amount of the debt to reflect changes in fair
value attributable to interest rate risk.

2.7 Limitations on hedging instruments

Criterion 1 Criterion 2 Criterion 3 Criterion 4

Eligibility of Eligibility of
Eligibility of Hedge
hedged items hedging
hedged risk(s) effectiveness
or transactions instruments

Criterion 5: Formal documentation

2.7.10 Overview

Excerpt from ASC 815-20

>> Instruments Specifically Ineligible for Designation as Hedging

Instruments
25-71 Besides those hedging instruments that fail to meet the specified
eligibility criteria, none of the following shall be designated as a hedging
instrument for the respective hedges:
a. With respect to fair value hedges, cash flow hedges, and net investment
hedges:
1. A nonderivative instrument, such as a U.S. Treasury note, except as
provided in paragraphs 815-20-25-58 through 25-59 and 815-20-25-66
2. Components of a compound derivative instrument representing
different risks
3. A hybrid financial instrument that an entity irrevocably elects under
paragraph 815-15-25-4 to initially and subsequently measure in its
entirety at fair value (with changes in fair value recognized in earnings)
4. A hybrid instrument for which an entity cannot reliably identify and
measure the embedded derivative instrument that paragraph 815-15-
25-1 requires be separated from the host contract
5. Any of the individual components of a compound embedded derivative
that is separated from the host contract.
b. With respect to fair value hedges only:
1. A nonderivative financial instrument as the hedging instrument in a fair
value hedge of the foreign currency exposure of a recognized asset or
liability.
2. A nonderivative financial instrument as the hedging instrument in a fair
value hedge of the foreign currency exposure of an available-for-sale
security.
c. With respect to cash flow hedges only:
1. A nonderivative financial instrument as a hedging instrument in a
foreign currency cash flow hedge.
d. With respect to net investment hedges only:
1. A compound derivative instrument that has multiple underlyings—one
based on foreign exchange risk and one or more not based on foreign
exchange (for example, the price of gold or the price of an S&P 500

contract), except as indicated in paragraph 815-20-25-67 for certain

cross-currency interest rate swaps
2. A derivative instrument and a cash instrument in combination as a
single hedging instrument (that is, an entity shall not consider a
separate derivative instrument and a cash instrument as a single
synthetic instrument for accounting purposes)

Topic 815 specifically prohibits the instruments listed in the above excerpt from
being designated as hedging instruments. This section discusses these
prohibited instruments, as well as limitations involving written options.

2.7.20 Nonderivative instruments

Nonderivative instruments are not eligible to be designated as hedging
instruments for fair value or cash flow hedges, except in limited circumstances
for fair value hedges of foreign currency risk and net investment hedges. [815-20-
25-71]

In general, the FASB believes that accounting for a nonderivative instrument as

a hedging instrument is inappropriate because: [FAS 133.BC246–BC247]
— hedge accounting may result in overriding the established measurement
principles for the nonderivative instrument simply because it is part of a
hedging relationship; and
— the accounting for nonderivative instruments is adequately addressed by
existing accounting literature.
If an entity uses a nonderivative instrument to economically hedge an item or a
forecasted transaction (e.g. a fixed-rate asset to hedge a fixed-rate liability), the
nonderivative instrument must be accounted for based on the relevant
accounting requirements for those instruments. Hedge accounting is generally
only allowed for hedging relationships that involve instruments that meet the
characteristics-based definition of a derivative.

Foreign currency risk. In a foreign currency fair value hedge, an

unrecognized FCD firm commitment may be hedged with a derivative or
nonderivative financial instrument (see section 7.4.60). [815-20-25-58]
Net investment hedges. An entity may designate a nonderivative FCD
financial liability as a hedging instrument for a net investment hedge (see
section 8.3.10).

Question 2.7.10
Can a contract that meets the definition of a
derivative after acquisition by an entity qualify as a
hedging instrument?

Excerpt from ASC 815-20

>>> Contingent Designation of a Hedging Instrument

55-44A A contract that meets the definition of a derivative instrument after
acquisition by an entity may be designated as a hedging instrument.
55-44B During the period in which the contract does not meet the definition of
a derivative instrument, that contract cannot be designated as the hedging
instrument in any hedging relationship. (However, the contract could potentially
be the hedged item in a fair value hedge or its cash flows could potentially be
the hedged transactions in a cash flow hedge.)
55-44C The contingent designation of a hedging relationship in which the
hedging instrument is not currently a derivative instrument but may become
one cannot justify the application of hedge accounting to fair value changes
occurring before inception of the hedge; the inception of that hedging
relationship would be the date on which the contract meets the definition of a
derivative instrument. If an entity had anticipated that a contract that was not a
derivative instrument at inception might later meet the definition of a derivative
instrument and has made a contingent designation of an all-in-one hedging
relationship to be effective upon the date that the contract meets the definition
of a derivative instrument, only the changes in the fair value of the new
derivative instrument occurring after the date the contract became a derivative
instrument would be recognized in other comprehensive income.

Interpretive response: Yes. However, the contract cannot be designated as a

hedging instrument during the period in which the contract does not meet the
definition of a derivative. [815-20-55-44A – 55-44B]
An entity cannot designate a hedging relationship based on an instrument that
is not currently a derivative, but may become one in the future. The inception of
that hedging relationship would not be until the contract meets the definition of
a derivative instrument. [815-20-55-44C]

2.7.30 Intercompany derivatives

Excerpt from ASC 815-20

> Eligibility of Hedging Instruments

>> Intra-entity Derivatives
25-46A There is no requirement in this Subtopic that the operating unit with
the interest rate, market price, or credit risk exposure be a party to the hedging
instrument. Thus, for example, a parent entity's central treasury function can
enter into a derivative instrument with a third party and designate it as the
hedging instrument in a hedge of a subsidiary’s interest rate risk for purposes
of the consolidated financial statements. However, if the subsidiary wishes to
qualify for hedge accounting of the interest rate exposure in its separate-entity
financial statements, the subsidiary (as the reporting entity) shall be a party to
the hedging instrument, which can be an intra-entity derivative obtained from
the central treasury function. Thus, an intra-entity derivative for interest rate
risk can qualify for designation as the hedging instrument in separate-entity
financial statements but not in consolidated financial statements. (As used in
this guidance, the term subsidiary refers only to a consolidated subsidiary. This
guidance shall not be applied directly or by analogy to an equity method
investee.)
25-46B An intra-entity derivative shall not be designated as the hedging
instrument if the hedged risk is any of the following:
a. The risk of changes in the overall fair value or cash flows of the entire
hedged item or transaction
b. The risk of changes in hedged item's or transaction's fair value attributable
to changes in the designated benchmark interest rate or cash flows
attributable to changes in the contractually specified interest rate or
designated benchmark interest rate
c. The risk of changes in hedged item's or transaction's fair value or cash
flows attributable to changes in credit risk.
d. The risk of variability in cash flows attributable to changes in a contractually
specified component to purchase or sell a nonfinancial asset.
Similarly, a derivative instrument contract between operating units within a
single legal entity shall not be designated as the hedging instrument in a hedge
of those risks. Only a derivative instrument with an unrelated third party can be
designated as the hedging instrument in a hedge of those risks in consolidated
financial statements.

Intra-entity derivatives (i.e. intercompany derivatives) are derivative instruments

between two members of a consolidated group. [815-20 Glossary]
Topic 815 explicitly prohibits an entity from designating an intercompany
derivative as the hedging instrument in the consolidated financial statements
for certain hedged risks, which is illustrated in the following table. [815-20-25-46B]

Intercompany derivative permitted in

Type of risk
consolidated financial statements?

Interest rate risk

Credit risk

Foreign currency risk

Price risk

This prohibition is because an intercompany derivative would be eliminated in

consolidation, thereby leaving the consolidated financial statements exposed to
changes in fair value or variability in cash flows.
Foreign currency risk. Topic 815 allows intercompany derivatives to be
designated as hedging instruments for hedges of foreign exchange risk if
certain conditions are met. See the following sections for further guidance:
— Fair value hedges (section 7.4.70);
— Cash flow hedges (section 7.6.60); and
— Net investment hedges (section 8.3.10).
For interest rate risk, credit risk and price risk, only a derivative instrument with
a third party can be designated as the hedging instrument in the consolidated
financial statements. [815-20-25-46B]

Question 2.7.20
Is a subsidiary with exposure to the hedged risk
required to be a party to the hedging instrument to
apply hedge accounting at the consolidated level?
Interpretive response: There is no requirement in Topic 815 that a subsidiary
with the exposure to the hedged risk(s) be a party to the hedging instrument.
For example, a parent entity’s central treasury function can enter into a
derivative contract with a third party and designate it as the hedging instrument
in a hedge of a subsidiary’s interest rate risk solely for purposes of the
consolidated financial statements. However, if the subsidiary wishes to qualify
for hedge accounting in its stand-alone financial statements, the subsidiary
must be a party to the hedging instrument.

Foreign currency risk. There are additional requirements when a

subsidiary with exposure to foreign currency risk is not a party to the hedging
instrument – i.e. the foreign currency derivative (see section 7.3.20): [815-20-25-
30]

— another member of the consolidated group that has the same functional
currency as the operating unit must be a party to the hedging instrument;
and
— there is no intervening subsidiary with a different functional currency.

Question 2.7.30
Is an intercompany derivative eligible to be
designated as a hedging instrument in the stand-
alone financial statements of a subsidiary?
Interpretive response: Yes. A subsidiary could enter into an intercompany
derivative obtained from a parent entity’s central treasury function and
designate it as the hedging instrument in its stand-alone financial statements.
However, that intercompany derivative instrument cannot be the hedging
instrument in the consolidated financial statements. Therefore, unless the
parent entity enters into an offsetting third-party derivative (see
Question 2.7.40), the hedge accounting applied at the subsidiary’s stand-alone
financial statements has to be reversed in consolidation.

Question 2.7.40
Can a parent offset an intercompany derivative with
a third-party derivative and apply hedge accounting
in the consolidated financial statements?
Interpretive response: Yes. If a parent entity’s central treasury function enters
into a derivative contract with an unrelated third party to completely offset the
risk arising from an intercompany derivative, that third-party derivative could be
designated as the hedging instrument in the consolidated financial statements.
However, the offset of the risk of those intercompany derivatives and third-
party derivatives must be done on an individual basis, not on a net or aggregate
basis.
Cash flow hedges. There is an exception for foreign currency cash flow
hedges of a forecasted transaction or an unrecognized firm commitment,
whereby the third-party derivative may offset the exposure to multiple
intercompany derivatives on a net basis for each foreign currency (see
section 7.6.70).

2.7.40 Hybrid instruments and compound derivatives

The following table summarizes the limitations on designating certain hybrid
instruments and compound derivatives (or portions thereof) as hedging
instruments.

Type of Definition Limitations on designation as

instrument hedging instruments
Hybrid A contract that contains both an Hybrid instruments that are
instrument embedded derivative and a host elected to be measured at fair
contract. [815-15 Glossary] value in their entirety cannot be
designated as hedging
instruments. [815-15-25-4, 815-20-
25-71(a)(3)]

Type of Definition Limitations on designation as

instrument hedging instruments
Embedded A derivative within a nonderivative Bifurcated embedded
derivative host contract. [815-15 Glossary] derivatives may be designated
An embedded derivative as a hedging instrument.
instrument must be separated
from the host contract and
accounted for as a derivative
instrument if certain criteria are
met. [815-15-25-1]
Compound The combination of two derivatives An entity cannot separate the
derivative into a single instrument. components of a compound
An example of a compound derivative and designate a
derivative is an option to enter into component with dissimilar risks
an interest rate swap when as a hedging instrument.
exercised – i.e. a swaption. [815-20-25-71(a)(2)]
For example, an entity cannot
separately designate the option
component of a swaption as
the hedging instrument.
Compound If a hybrid instrument contains An entity cannot designate as
derivative more than one embedded the hedging instrument any of
with more derivative feature that would the individual components of a
than one individually warrant separate compound derivative
embedded accounting as a derivative instrument that has been
derivative instrument, those embedded bifurcated from the host
features must be bundled together contract. [815-20-25-71(a)(5)]
as a single, compound embedded
derivative instrument. [815-15-25-7]
The compound embedded
derivative is then bifurcated and
accounted for separately from the
host contract. [815-15-25-7 – 25-10]

2.7.50 Special rule for written options

Excerpt from ASC 815-20

>>>> Hedge Effectiveness of Written Options

25-94 If a written option is designated as hedging a recognized asset or liability
or an unrecognized firm commitment (if a fair value hedge) or the variability in
cash flows for a recognized asset or liability or an unrecognized firm
commitment (if a cash flow hedge), the combination of the hedged item and
the written option provides either of the following:
a. At least as much potential for gains as a result of a favorable change in the
fair value of the combined instruments (that is, the written option and the
hedged item, such as an embedded purchased option) as exposure to
losses from an unfavorable change in their combined fair value (if a fair
value hedge)

b. At least as much potential for favorable cash flows as exposure to

unfavorable cash flows (if a cash flow hedge).
25-95 The written-option test in the preceding paragraph shall be applied only
at inception of the hedging relationship and is met if all possible percentage
favorable changes in the underlying (from zero percent to 100 percent) would
provide either of the following:
a. At least as much gain as the loss that would be incurred from an
unfavorable change in the underlying of the same percentage (if a fair value
hedge)
b. At least as much favorable cash flows as the unfavorable cash flows that
would be incurred from an unfavorable change in the underlying of the
same percentage (if a cash flow hedge).
25-96 The time value of a written option (or net written option) may be
excluded from the written-option test if, in defining how hedge effectiveness
will be assessed, the entity specifies that it will base that assessment on only
changes in the option’s intrinsic value. In that circumstance, the change in the
time value of the options would be excluded from the assessment of hedge
effectiveness in accordance with paragraph 815-20-25-82(a).
25-97 When applying the written-option test to determine whether there is
symmetry of the gain and loss potential of the combined hedged position for all
possible percentage changes in the underlying, an entity is permitted to
measure the change in the intrinsic value of the written option (or net written
option) combined with the change in fair value of the hedged item.

When hedging with a written option, Topic 815 requires that additional
conditions be met along with all the other hedge criteria.
In general, an option is a contract that provides the holder with the right, but not
the obligation, to buy or sell something in exchange for payment of a premium.
The premium compensates the writer of the option and is nonrefundable. The
writer of the option receives the premium either through payment of cash or
through favorable (i.e. nonmarket) terms contained in the option contract. The
writer of an option is considered to have a written option while the other party
to the contract holds a purchased option.
Right to buy
or sell

Purchased Option Option Written

option holder writer option

Premium

With option contracts, the holder and the writer have different exposures.

Option The option holder acquires the option to offset a possible future
holder risk.
The option is exercised when the terms are favorable to the option
holder. When market conditions cause the option to have no value
to the holder (i.e. the option is out of the money), the option is not
exercised.
Therefore, the maximum potential for loss is limited to the
premium paid.

Option The option writer is compensated up-front by a premium and

writer remains exposed to the risk of fluctuations in the price of the
underlying.
There is no limit to the option writer’s downside exposure if the
option is in the money, which is when terms are unfavorable to
the option writer.
The maximum potential for gain is limited to the initial premium
received. This is because the holder will not exercise an option
when it is out of the money, which is when terms are favorable to
the option writer.

Consequently, only the holder of the option stands to gain from the intrinsic
value of an option, while the writer is exposed to unlimited loss.
The FASB initially intended to prohibit hedge accounting for written options
because written options serve to reduce the potential for gain in the hedged
transaction while exposing the writer to unlimited loss. However, the FASB
decided to allow written options to be the derivative hedging instrument in very
limited circumstances. [FAS 133.BC396–BC 397]
For a written option to be designated as a hedging instrument: [815-20-25-94 – 25-
95]

— the hedged item or transaction must involve recognized assets or liabilities

or unrecognized firm commitments; and
— there must be symmetry of the gain and loss potential of the combined
hedged position (i.e. the written option test).
Hedge effectiveness. There are also a variety of issues associated with
assessing hedge effectiveness in hedging relationships involving option
contracts. These issues are discussed in section 9.2.90.

Question 2.7.50
Is an interest rate swaption a purchased option or a
written option?
Background: An interest rate swaption is an option to enter into a specified
interest rate swap at maturity of the option. In exchange for an option premium,
the buyer has the right, but not the obligation, to enter into a specified swap
agreement or, in some cases, receive cash proceeds for the fair value of that
swap agreement at the expiration of the option.

In essence, if the buyer of the swaption is in a gain position at the option’s

maturity, it will exercise the option. However, if the buyer is in a loss position at
the option’s maturity, it will not exercise the option.
Interpretive response: We believe an interest rate swaption represents a
purchased option from the perspective of the buyer.
In contrast, an interest rate swaption represents a written option from the
perspective of the writer and must pass the written option test to be eligible as
a hedging instrument (see Question 2.7.110).

Written option test

To qualify for hedge accounting, Topic 815 requires symmetry of the gain and
loss potential of the combined hedged position. The combination of the hedged
item or transaction and the written option needs to provide at least as much
potential for gains (or favorable cash flows) as potential for losses (or
unfavorable cash flows).

Hedged item or
Written option
transaction

Potential for gains (favorable cash flows)

≥
Potential for losses (unfavorable cash flows)

The written option test is met for a fair value or cash flow hedge if the following
is true.

Fair value hedge Cash flow hedge

Combination of the hedged item and Combination of the hedged transaction
written option provides at least as much and written option provides at least as
potential for gains that result from a much potential for favorable cash flows
favorable change in the underlying as resulting from a favorable change in the
exposure to losses that result from an underlying as it provides exposure to
unfavorable change in the underlying of unfavorable cash flows resulting from an
the same percentage. [815-20-25-95(a)] unfavorable change in the underlying of
the same percentage. [815-20-25-95(b)]

For example, this condition is met when the hedged item is an embedded
purchased option and the written option has characteristics that offset those of
the embedded purchased option. The purchased option must be one that is not
required to be separated from the host contract (e.g. because they are clearly
and closely related).

An entity may also use hedging strategies that involve a combination of option
contracts, which is discussed in section 2.7.60.

Question 2.7.60
How does an entity measure the potential gain or
loss on the combination of the written option (or
net written option) and the hedged item?
Interpretive response: For the written option test to be met, there needs to be
symmetry of gains and losses (or favorable and unfavorable cash flows) for all
possible percentage changes in the underlying. When applying the written
option test, an entity is permitted to exclude the time value of a written
option (or net written option) if the entity specifies that it will base its
effectiveness assessment only on changes in the option’s intrinsic value. For
guidance on excluding the time value from effectiveness assessments when
using options as the hedging instrument, see section 9.2.90. [815-20-25-96 – 25-97]
Therefore, when performing the written option test to determine whether there
is symmetry of the gain and loss potential of the combined hedged position for
all possible percentage changes in the underlying, an entity is permitted to
measure the change in the intrinsic value of the written option (or net written
option) combined with the change in fair value of the hedged item. Using this
approach results in a higher chance of achieving a symmetrical return.
Examples 2.7.10, 2.7.20 and 2.7.30 illustrate how to perform a written option
test considering only changes in the option’s intrinsic value.

Question 2.7.70
How often should the written option test be
performed?
Interpretive response: An entity is required to perform the written option test
only at the inception of the hedging relationship that involves a written option.
[815-20-25-95]

The requirement to consider this test only at inception exists because the price
of the underlying may change during the hedging relationship in such a way that
the written option approaches having intrinsic value, in which case the
symmetry requirement would not be met.
The other hedge criteria must be met throughout the life of the hedging
relationship.

Question 2.7.80
Is the written option test performed using the strike
price contained in the option contract or the current
price of the underlying?
Interpretive response: We believe the written option test should be performed
by reference to the strike price contained in the written option contract, and not
by reference to the current price of the underlying, with the exception of collar-
based hedging relationships (see Example 2.7.50).
For example, if the strike price of the written option is $50 and the current price
of the underlying is $20, the written option test is based on changes in prices of
the underlying from $50 (the strike price of the option).
If the written option test were based on changes from the current price of the
underlying, the written option test typically would be met when the written
option is significantly out of the money. This would permit an entity to apply
hedge accounting, which is contradictory to the limitations in Topic 815 for
written options.

Question 2.7.90
Can a covered call strategy qualify for hedge
accounting?

Excerpt from ASC 815-20

>>> No Hedge Accounting for Covered Call Strategies

55-45 This Subtopic does not permit hedge accounting for covered call
strategies (strategies in which an entity writes an option on an asset that it
owns) unless that asset is a call option that is embedded in another
instrument. In a covered call strategy, any loss on the written option will be
covered by the gain on the owned asset. A covered call strategy will not qualify
for hedge accounting because the risk profile of the combined position is
asymmetrical (the exposure to losses is greater than the potential for gains). In
contrast, the risk profile of the asset alone is symmetrical or better (the
potential for gains is at least as great as the exposure to losses). The symmetry
requirement for hedges with written options precludes a written option that is
used to sell a portion of the gain potential on an asset or liability from being
eligible for hedge accounting.

Background: A covered call strategy is when an entity owns an asset and

writes a call option on that same asset in an attempt to generate premium
income.
For example, ABC Corp. owns inventory with a market value of $10,000. ABC
writes a call option such that XYZ can purchase inventory from ABC at a price of

$10,000 (i.e. the strike price) at any time over the next 12 months. ABC
receives a premium of $1,000 for entering into the contract.
Interpretive response: Topic 815 explicitly prohibits an entity from applying
hedge accounting to covered call strategies. [815-20-55-45]
Although the fair value attributable to the written option is covered by the
increase in the fair value attributable to the owned asset (i.e. the inventory), the
covered call strategy changes the risk profile from symmetrical to asymmetrical.

Symmetrical exposure Asymmetrical exposure

The potential for favorable The potential for favorable changes
changes in fair value is at least as in fair value is sold to the holder of
great as the exposure to the option, but the writer retains
unfavorable changes in fair value. the exposure to unfavorable
changes, net of the option
premium.

Continuing the example, ABC is provided with a premium of $1,000. However,

the written option exposes ABC to unlimited economic loss in the event that
the market value of its inventory increases above $10,000. This is because ABC
is required to sell XYZ inventory at a price of $10,000, regardless of the market
price above $10,000.

Example 2.7.10
Written option does not qualify for hedge
accounting
Farm Inc. has 1 million pounds of cotton with a carrying amount of $800,000.
The market value of cotton is currently 90 cents per pound ($900,000).
Farm believes the market value of cotton is going to decline over the next
six months. To limit exposure from a decline in value, Farm writes a call option
that provides Jeans Co. with the ability to purchase Farm’s cotton at a price of
88 cents per pound. In return for writing this call option, Farm receives a
premium of $10,000.
All other criteria for hedge accounting have been met.
Written option test
The combination of the written option and the hedged item (i.e. 1 million
pounds of cotton) must provide as much potential for gain as potential for loss.

Potential for gain Potential for loss

— 15% increase in market value of — 15% decrease in market value of
cotton to $1.01 as compared to the cotton to 75 cents as compared to
88 cent strike price. the 88 cent strike price.
— Results in a cumulative net — Results in economic loss of
economic gain of $10,0001 on the $120,0002 from the combination of
combination of the written option the written option and hedged item.
and hedged item.

Notes:
The $130,000 potential economic gain on cotton for the increase in market value, as
compared with the 88 cent strike price of the written option, is fully offset by the
intrinsic value loss on the written option. This leaves Farm with $10,000 premium
received on the written option.
The $130,000 economic loss on cotton, as compared to the 88 cent strike price of the
written option, less $10,000 premium received on the written option. The written
option’s intrinsic value is zero.

This written option does not qualify for hedge accounting because the
combination of the written option and the hedged cotton inventory does not
always provide as much potential for gain as potential for loss.
Could Farm apply hedge accounting with a purchased option contract?
Yes, assuming all other hedge criteria are met. Farm could purchase a put
option from a third-party at a similar strike price of 88 cents per pound. This
would give Farm the right to sell 1 million pounds of cotton.
If the market value of cotton decreased to 75 cents, the option would be in the
money and Farm would exercise the option.
Unlike written options, purchased options do not expose the holder to unlimited
loss.

Example 2.7.20
Written option qualifying as a hedge of an
embedded call option in a debt obligation
ABC Corp. issues a five-year, $100,000 debt obligation. The interest rate on the
debt obligation is fixed at 10%. The debt obligation is callable by ABC in three
years at par.
ABC wishes to hedge the risk of a decrease in the fair value of the
embedded call option attributable to increases in interest rates. For guidance
on designating embedded put or call options in a fair value hedge, see
section 3.3.90.
ABC writes an option on a swap (i.e. a swaption) that provides Bank with the
option to put (sell) an interest rate swap to ABC in three years. The terms of the
interest rate swap are such that ABC will receive LIBOR and pay 10% on a
notional amount of $100,000 for two years. ABC receives a premium of $1,000
for writing this option.
All other criteria for hedge accounting have been met.
Written option test
Although many swaptions will not pass the written option test, in this instance
the written option (i.e. the swaption) qualifies for hedge accounting. In this
specific case, the combination of the written option and the embedded call
option will always provide as much potential for gain as potential for loss
because the terms of the written option are exactly the same as the terms of
the embedded call option.

Potential for gain Potential for loss

If interest rates decrease: If interest rates increase:
— ABC will call the debt obligation; and — ABC will not call the debt obligation;
— Bank will exercise its option. and
— Bank will not exercise its option.

In either case, ABC will receive $1,000 in premium for writing the option.

Example 2.7.30
Written option qualifying as a hedge of an
embedded cap in a long-term supply contract
ABC Corp. enters into a long-term supply contract with a vendor to purchase a
specified amount of a certain material. The purchase price is the current
monthly average list price for the quantity delivered each month, but not to
exceed $20 per pound. The current list price at the contract signing date is
$15 per pound.
The contract meets the definition of a firm commitment and the embedded price
cap is not required to be separated under Topic 815 (see Question 3.3.290).
ABC wishes to enter into a transaction to hedge the risk of changes in the fair
value of the embedded price cap (a purchased call option) in the supply
contract. For guidance on designating embedded put or call options in a fair
value hedge, see section 3.3.90.
Accordingly, ABC writes a net cash settled call option with Bank with a strike
price of $20 per pound and a notional amount equal to the quantity specified in
the supply contract. ABC receives a premium of $1,000 for writing this option.
Written option test
This written option would qualify for hedge accounting because the
combination of the written option and the embedded purchased call option will
always provide as much potential for gain as potential for loss. This is because
the terms of the options are the same.

Potential for gain Potential for loss

If market prices rise to $22 per pound: If the price of materials remains below
— the purchased call option will $20 per pound, neither the purchased nor
increase in value - i.e. there will be the written call option has intrinsic value.
intrinsic value resulting from the
ability to obtain the specified
materials at $20 per pound while the
market price has risen; and
— the intrinsic value of the written call
option will have an equal but
opposite value – i.e. from the
requirement to deliver the specified
materials at less than market prices.

In either case, ABC will receive $1,000 in premium for writing the option.

FASB Example: Attempted hedge of a forecasted sale with a

written call option

Excerpt from ASC 815-30

>> Example 4: Attempted Hedge of a Forecasted Sale with a Written Call

Option

55-17 This Example illustrates the application of the guidance in Subtopic 815-
20 and this Subtopic to an attempted hedge of a forecasted sale with a written
call option.
55-18 Entity J forecasts the sale in 9 months of 100 units of product with a
current market price of $95 per unit. Entity J's objective is to sell the upside
potential associated with the forecasted sale by writing a call option for a
premium. Entity J plans to use the premium from the call option as an offset to
decreases in future cash inflows from the forecasted sale that will occur if the
market price of the product decreases below $95. Accordingly, Entity J sells an
at-the-money call option on 100 units of product with a strike price of $95 for a
premium. The premium represents only the time value of the option. The
option is exercisable at any time within nine months.
55-19 Entity J’s objective of using the premium from the written call option as
an offset to any decrease in future cash inflows does not meet the notion of
effectiveness in this Subtopic. Future changes in the market price of the
entity's product will not affect the premium that Entity J received, which is all
related to time value in this example and thus is the maximum amount by
which Entity J can benefit. That is, Entity J cannot expect the cash flows on
the option to increase so that, at different price levels, a decrease in cash flows
from the forecasted sale would be offset by an increase in cash flows on the
option.

FASB Example: Fair value hedge of an embedded purchased

option with a written option

Excerpt from ASC 815-25

>> Example 6: Fair Value Hedge of an Embedded Purchased Option with a

Written Option

55-27 This Example illustrates the guidance in Sections 815-20-25, 815-20-35,

and 815-25-35 for how an entity may assess hedge effectiveness in a fair value
hedge of an embedded purchased option with a written option. Assume that
the hedge satisfied all of the criteria for hedge accounting at inception.

55-28 Entity F issues five-year, fixed-rate debt with an embedded (purchased)

call option and, with a different counterparty, writes a call option to neutralize
the call feature in the debt. The embedded call option and the written call
option have the same effective notional amount, underlying fixed interest rate,
and strike price. (The strike price of the option in the debt usually is referred to
as the call price.) The embedded option also can be exercised at the same
times as the written option. Entity F designates the written option as a fair
value hedge of the embedded prepayment option component of the fixed-rate
debt.
55-29 To assess whether the hedge is expected to be highly effective in
achieving offsetting changes in fair value, Entity F could estimate and compare
the changes in fair values of the two options for different market interest rates.
Because this Subtopic does not permit derivative instruments, including
embedded derivatives whether or not they are required to be accounted for
separately, to be separated into components, Entity F can only designate a
hedge of the entire change in fair value of the embedded purchased call option.
The resulting changes in fair value will be included currently in earnings.
Changes in the fair value of the written option also will be included currently in
earnings and presented in the same income statement line item as the
earnings effect of the hedged item. Any mismatch between the changes in fair
values of the hedging instrument and the hedged item attributable to the
hedged risk, thus, will be automatically reflected in earnings. (The hedge is
likely to have some earnings effect because the premium for the written call
option is unlikely to be the same as the premium for the embedded purchased
call option.)

2.7.60 Special rule: Combination of options

Excerpt from ASC 815-20

>>>> Determining Whether a Combination of Options is Net Written

25-88 This guidance addresses how an entity shall determine whether a
combination of options is considered a net written option subject to the
requirements of paragraph 815-20-25-94. A combination of options (for
example, an interest rate collar) entered into contemporaneously shall be
considered a written option if either at inception or over the life of the
contracts a net premium is received in cash or as a favorable rate or other
term. Furthermore, a derivative instrument that results from combining a
written option and any other non-option derivative instrument shall be
considered a written option. The determination of whether a combination of
options is considered a net written option depends in part on whether strike
prices and notional amounts of the options remain constant.

An entity may use a hedging strategy that involves a combination of option

contracts, for example an interest rate collar. If the combination of options
includes a written option, an entity first determines whether the combination of
options is a net purchased option or a net written option. This determination

partially depends on whether the strike prices and notional amounts of the
options remain constant (see further guidance below). [815-20-25-88]
If the combination is considered a net written option, the entity then
determines if the combination of option contracts meets the requirements of
the written option test. If the combination of options meets this test, it is
eligible to be a hedging instrument if the hedging criteria specific to the type of
hedge (e.g. fair value, cash flow) are met. The specific hedging criteria are
discussed in subsequent chapters.

Question 2.7.100
What is a collar?

Interpretive response: Collars are common derivative instruments that involve

combining a purchased option (which requires an entity to pay a premium) with
a written option (where an entity receives a premium).
This combination of options provides an entity with a desired amount of
protection against changes in fair values outside of a range of values (or
changes in cash flows outside a range of cash flows), while offsetting a portion
of the cost of the purchased option through the premium received on the
written option.

Question 2.7.110
Is the written option test required for a
combination of a written option and a non-option
derivative?
Interpretive response: Yes. A derivative that results from combining a written
option and any other non-option derivative is considered a written option and
must pass the written option test to be eligible as a hedging instrument. [815-20-
25-88]

Examples of derivative instruments that combine a written option and a non-

option derivative include a swaption (a written option on a swap) and an
indexed-amortizing swap.
In addition, when a derivative instrument is embedded in another derivative
instrument (e.g. an embedded written option), the entire derivative instrument
must qualify for hedge accounting. For example, an entity may not separate a
compound derivative instrument into two derivative instruments so that one
would qualify for hedge accounting, while the other would not
(see section 2.7.40). [815-20-25-71(a)(2)]

Conditions for combination to be a net purchased option

Excerpt from ASC 815-20

>>>>> Strike Prices and Notional Amounts Remain Constant

25-89 For a combination of options in which the strike price and the notional
amount in both the written option component and the purchased option
component remain constant over the life of the respective component, that
combination of options would be considered a net purchased option or a zero
cost collar (that is, the combination shall not be considered a net written option
subject to the requirements of paragraph 815-20-25-94) provided all of the
following conditions are met:
a. No net premium is received.
b. The components of the combination of options are based on the same
underlying.
c. The components of the combination of options have the same maturity
date.
d. The notional amount of the written option component is not greater than
the notional amount of the purchased option component.
25-90 If the combination of options does not meet all of those conditions, it
shall be subject to the test in paragraph 815-20-25-94. For example, a
combination of options having different underlying indexes, such as a collar
containing a written floor based on three-month U.S. Treasury rates and a
purchased cap based on three-month London Interbank Offered Rate (LIBOR),
shall not be considered a net purchased option or a zero cost collar even
though those rates may be highly correlated.
>>>>> Strike Prices and Notional Amounts Do Not Remain Constant
25-91 If either the written option component or the purchased option
component for a combination of options has either strike prices or notional
amounts that do not remain constant over the life of the respective
component, the assessment to determine whether that combination of options
can be considered not to be a written option under paragraph 815-20-25-88
shall be evaluated with respect to each date that either the strike prices or the
notional amounts change within the contractual term from inception to
maturity.
25-92 Even though that assessment is made on the date that a combination of
options is designated as a hedging instrument (to determine the applicability of
paragraph 815-20-25-94), it shall consider the receipt of a net premium (in cash
or as a favorable rate or other term) from that combination of options at each
point in time that either the strike prices or the notional amounts change, such
as either of the following circumstances:
a. If strike prices fluctuate over the life of a combination of options and no net
premium is received at inception, a net premium will typically be received
as a favorable term in one or more reporting periods within the contractual
term from inception to maturity.
b. If notional amounts fluctuate over the life of a combination of options and
no net premium is received at inception, a net premium or a favorable term

will typically be received in one or more periods within the contractual term
from inception to maturity.
25-93 In addition, a combination of options in which either the written option
component or the purchased option component has either strike prices or
notional amounts that do not remain constant over the life of the respective
component shall satisfy all of the conditions in paragraph 815-20-25-89 to be
considered not to be a written option (that is, to be considered to be a net
purchased option or zero cost collar) under paragraph 815-20-25-88. For
example, if the notional amount of the written option component is greater
than the notional amount of the purchased option component at any date that
the notional amount changes within the contractual term from inception to
maturity, the combination of options shall be considered to be a written option
under paragraph 815-20-25-88 and, thus, subject to the criteria in the following
paragraph.

All of the following conditions must be met at inception of the hedging

relationship for a combination of options to be considered a net purchased
option: [815-20-25-89]
— no net premium is received – either through payment in cash or another
asset, or through favorable terms contained in the contract – at inception or
at any point during the life of the option contracts that the combination
option comprises;
— the components of the combination option are based on the same
underlying;
— the components of the combination option have the same maturity date;
and
— the notional amount of the written option component is not greater than the
notional amount of the purchased option component.

Strike prices and notional amounts remain constant

If a combination of options with strike prices and notional amounts that remain
constant fails to meet all of the above criteria at inception of the hedging
relationship, it cannot be considered a net purchased option and is subject to
the written option test.
Strike prices and notional amounts do not remain constant
If the strike price or notional amount in either component does not remain
constant over the life of the respective component, the assessment of whether
the combination of options is a net written option or a net purchased option
should be assessed at each date that either the strike prices or the notional
amounts change. This includes considering a receipt of a net premium (in cash,
other assets or as a favorable rate or other term) from that combination of
options at each point in time that either the strike prices or the notional
amounts change. [815-20-25-91 – 25-92]
In addition, if any of the four conditions discussed above are not met at any
date that either the strike prices or notional amounts change, the entire contract
is considered a net written option. [815-20-25-89]

Question 2.7.120
When a hedging relationship is dedesignated and
redesignated, is a combination of options
reassessed to determine if it is a net written or net
purchased option?
Interpretive response: Yes. When redesignating a hedging relationship that
involved a combination of options, an entity must reassess whether the
combination is a net purchased option or a net written option. The new
assessment should be based on the current fair values of the options.
If the combined options are in a net liability position from a fair value
perspective, the combination is a net written option. This is because an entity
would have received proceeds from a net premium if it had entered into the
options at that time. Because it is considered a net written option, the entity
must perform the written option test at the inception of the new hedging
relationship.
If the combined options are in a net asset position from a fair value perspective,
the combination is a net purchased option and the entity does not need to
perform the written option test.

Example 2.7.40
Evaluation of whether a combination of options is a
net written option
The following is adapted from Example 20 in Subtopic 815-20 (reproduced
below).
On January 1, Year 1, ABC Corp. entered into two collar arrangements. The
details of the collar arrangements are as follows.
— No net premium was received by ABC at inception of the collar contracts.
— Both option contracts that comprise the collars are based on the same
underlying and have the same maturity date.
— The notional amounts of the purchased option component and the written
option component that comprise the two collars are equal and constant
over the life of the option contracts.
— The strike prices (cents per unit) of the two collars are as follows.

5-year
Year 2 Year 3 Year 4 Year 5 Year 6 avg.
Collar 1
Purchased put 98.3 98.3 98.3 98.3 98.3 98.3
Written call 110.6 110.6 110.6 110.6 110.6 110.6
Collar 2
Purchased put 108.5 108.5 91.5 91.5 91.5 98.3
Written call 108.5 108.5 108.5 110.4 117.2 110.6

When strike prices fluctuate over the life of a combination of options and no net
premium is received at inception, it is necessary to determine whether a net
premium is received as a favorable term in one or more periods within the
contractual term of the option contracts (from inception to maturity).
Collar 1: Net written option assessment
Collar 1 is a zero-cost collar and not a net written option. Because the strike
price and the notional amount in both the written option component and the
purchased option component remain constant over the life of the respective
components, the following conditions are assessed at inception of the hedging
relationship:
— no net premium was received;
— the components of the combination option are based on the same
underlying;
— the components of the combination option have the same maturity date;
and
— the notional amount of the written option component is not greater than the
notional amount of the purchased option component.
Therefore, the combination of options is not considered a written option and
ABC does not need to perform the written option test.
Collar 2: Net written option assessment
Collar 2 is a net written option. Because the strike prices of the written option
component and the purchased option component are not constant over the life
of the contract, ABC assesses whether the combination of options is a net
written option as of each date on which the strike prices change from inception
to maturity.
In general, when strike prices fluctuate over the life of a combination of options
and no net premium is received at inception, a net premium typically will be
received as a favorable term in one or more periods from inception to maturity.
For Collar 2, premiums are received in early periods as consideration for
entering into net written options in later periods. Specifically, the purchased put
option contains an average strike price over its life of 98.3. During Year 2 and
Year 3, the strike price of the purchased put option (108.5) is greater than that
average.
ABC can put the underlying to the counterparty during Year 2 and Year 3 at a
price that is higher than the average for all of the years combined. This premium
is received by ABC for Year 2 and Year 3 in return for accepting a lower than
average strike price of the purchased put option in Years 4 to 6 (i.e. 91.5).
Although the premium is not received in cash, it is received in more favorable
terms during the first two years of the contract when compared to the last
three years of the contract. Therefore, the collar is a net written option and the
additional written option test must be met for the collar to be the hedging
instrument in a hedging relationship.

Example 2.7.50
Applying the net written option test to collar-based
hedging relationship
The following is adapted from Example 30 in Subtopic 815-20 (reproduced
below).
ABC Corp. has LIBOR-indexed floating-rate debt. The current LIBOR rate is 6%.
To hedge its exposure to variability in expected future cash flows attributable to
changes in LIBOR swap rate (the contractually specified interest rate), ABC
enters into an interest rate collar with the following terms:
— purchased cap option with a strike rate of 8%; and
— written floor option with a strike rate of 5%.
The interest collar has the effect of limiting the interest rate of the floating-rate
debt to a range between 5% and 8%. ABC receives a net premium from the
bank based on market conditions as of the transaction date of the collar.
Net written option assessment
The combination of options (i.e. the interest rate collar) is a net written option
because ABC received a net premium. Therefore, ABC must perform the
written option test to determine whether the net written option is eligible to be
designated as the hedging instrument.
Written option test
The combination of the hedged transaction and the net written option must
provide at least as much potential for favorable cash flows as exposure to
unfavorable cash flows for all possible percentage changes in the LIBOR index.
[815-20-25-95]

Potential for gain Potential for loss

If LIBOR rates decrease by 50% to 3%: If LIBOR rates increase by 50% to 9%:
— economic gain on LIBOR-indexed — economic loss on LIBOR-indexed
debt based on 3% decrease in debt based on 3% increase in
LIBOR; LIBOR;
— cash outflows of 2% on written floor — intrinsic value of the written floor
option – i.e. intrinsic value loss based option is zero;
on difference between strike rate of — cash inflows of 1% on purchased
5% and decreased rate of 3%; cap option – i.e. intrinsic value gain
— intrinsic value of the purchased cap based on difference between strike
is zero; and rate of 8% and increased rate of 9%;
— total potential economic gain of — total potential economic loss of
100 bps1, based on net cash 200 bps2, based on net cash
outflows of 5%. outflows of 8%.
Notes:
Economic gain of 3% less loss on intrinsic value of written floor option of 2%.
Economic loss of 3% less gain on intrinsic value of purchased cap option of 1%.

The interest rate collar does not pass the written option test. This is because
the combined hedged position does not have symmetry of gain and loss

potential. Therefore, the combination of options is not an eligible hedging

instrument.

Example 2.7.60
Indexed-amortizing swap considered to be a net
written option
Interest rate swaps with notional amounts that amortize based on an index are
referred to as indexed-amortizing swaps. They are considered to be written
options because they combine an interest rate swap (a non-option derivative)
with a written option. As such, they are subject to the written option test if an
entity attempts to designate them in a hedging relationship.
The written option is the option provided to one of the parties to reduce the
amount on which interest payments will be exchanged based on a strike price
(the relevant index). As the index level is met, the party calls a portion of the
notional amount based on the terms of the derivative, and subsequent payment
provisions of the swap are based on that new notional amount.
When evaluating these instruments, an entity must consider whether it is the
writer or the purchaser of the option. The writer of the option receives at
inception or over the life of the contract a net premium either through payment
in cash, another asset, or through favorable terms contained in the contract. If
an entity receives a net premium, the combination of options will be considered
a net written option and the written option test must be performed to
determine if it is an eligible hedging instrument.
Indexed-amortizing swaps are different from amortizing swaps. The terms of
amortizing swaps call for scheduled reductions in the notional amount on which
the payment provisions are based and there is no optionality to that feature.
Therefore, amortizing swaps are neither net written options nor a combination
of options.

Question 2.7.130
Are knock-out and knock-out/knock-in provisions
considered written options?
Background: In certain derivative contracts, such as interest rate swaps and
foreign currency and commodity forward contracts, the terms of the instrument
contain knock-out or knock-out/knock-in provisions. These provisions allow the
counterparty to cease or modify payments normally due under the derivative
when the underlying exceeds a predetermined rate or price.
These features lower the cost of the derivative to the buyer by decreasing the
possible gain that would be generated by the derivative in the absence of the
feature that allows the counterparty to modify or cease payment.
For example, an entity enters into a pay-fixed, receive six-month LIBOR interest
rate swap agreement with a fixed leg of 6% and a variable leg of LIBOR. The
contract contains a knock-out/knock-in provision under which the net settlement

payments under the contract are $0 when six-month LIBOR equals or

exceeds 8%.
If six-month LIBOR subsequently drops below 8%, payments resume.
Therefore, when the entity would be receiving a 200 or greater basis point
spread, the net settlement becomes $0. If this provision were not included in
the contract, the cost of the swap to the entity would be higher (e.g. the pay-
fixed leg may have been more than 6%).
Interpretive response: These knock-out and knock-out/knock-in provisions are
considered written options, because a net premium is received in the form of a
favorable rate or other term in exchange for the provision.
When the provision (written option) is combined with a non-option derivative
(e.g. the interest rate swap), the entire contract is considered a net written
option. Therefore, the written option test must be performed to determine
whether the net written option is eligible to be designated as the hedging
instrument.
Written option test
The combination of the hedged item or transaction and the net written option
must provide at least as much potential for favorable cash flows as exposure to
unfavorable cash flows for all possible percentage changes in the LIBOR index.
[815-20-25-95]

Potential for gain Potential for loss

— The written option provision reduces — When the derivative is detrimental to
the potential gain or favorable cash the entity, there is no offsetting
flows in the derivative when it is knock-out or knock-in provision.
beneficial to the entity. — Fair value hedge. When combined
— Fair value hedge. When the written with the hedged item’s concurrent
option provision is combined with positive effect, the result is a neutral
the hedged item’s concurrent effect of the combined derivative
negative effect, the net result is a and hedged item position.
loss on the combined derivative and — Cash flow hedge. When combined
hedged item position. with the hedged transaction’s
— Cash flow hedge. When the written concurrent favorable cash flows, the
option provision is combined with result is a neutral effect of the
the hedged transaction’s unfavorable combined derivative and hedged
cash flows, the net result is an transaction position.
unfavorable cash flow on the
combined derivative and hedged
transaction position.

This table indicates a lack of symmetry in the potential for gains and losses.
Therefore, we believe circumstances are rare in which a derivative contract
containing a knock-out or knock-in provision meets the written option test to
qualify for hedge accounting.

FASB Example: Combination of options in which strike prices

or notional amounts do not remain constant

Excerpt from ASC 815-20

>> Example 20: Combination of Options in Which Strike Prices or

Notional Amounts Do Not Remain Constant

55-179 The following Cases illustrate the application of paragraph 815-20-25-91

to combinations of options in which either the strike price or the notional
amount in either the written option component or the purchased option
component can fluctuate over the life of the respective component:
a. Changes in strike prices (Case A)
b. Changes in notional amounts (Case B).
55-180 Cases A and B share the following assumptions:
a. An entity wishes to hedge its forecasted sales of a commodity by entering
into a five-year commodity-price collar.
b. Under the collar, the entity will do both of the following:
1. Purchase commodity-price put option components (a floor)
2. Write commodity-price call option components (a cap).
c. Each of the alternative collars discussed otherwise meets the criteria
established in paragraphs 815-20-25-89 through 25-90 including all of the
following:
1. No net premium is received at inception of the combination of options.
Paragraph 815-20-25-94 addresses, in part, whether a net premium is
received at any point during the life of the combination of options that
the strike price or notional amount is changed.
2. The components of the combination of options are based on the same
underlying (that is, the same commodity price).
3. The components of the combination of options have the same maturity
date.
4. The notional amount of the written option component is not greater
than the notional amount of the purchased option component.
Paragraph 815-20-25-94 addresses, in part, whether this criterion
should be applied to only the entire contractual term to maturity or to
some part thereof.
>>> Case A: Changes in Strike Prices
55-181 The following table presents both of the following:
a. Commodity prices implied by the forward price curve based on market
prices
b. The strike prices of two alternative collars.
The minimum prices for each collar represent the strike prices of the
purchased put options. The maximum prices for each collar represent the
strike prices of the written call options. (Assume that the notional amounts of
the two option components are identical and constant over the life of the
option components.)

(Cents Per Unit)

5-Year
20X2 20X3 20X4 20X5 20X6 Average
Forward price 100.0 103.9 105.6 106.4 106.7 104.5
Collar 1
Minimum 98.3 98.3 98.3 98.3 98.3 98.3
Maximum 110.6 110.6 110.6 110.6 110.6 110.6
Collar 2
Minimum 108.5 108.5 91.5 91.5 91.5 98.3
Maximum 108.5 108.5 108.5 110.4 117.2 110.6

55-182 Note that the 5-year averages of the minimum prices (98.3 cents) and
the maximum prices (110.6 cents) of the 2 collars are identical and are
consistent with the 5-year average implied by the forward price curve. (That is,
104.5 cents equals the average of the 98.3-cent minimum strike price and the
110.6-cent maximum strike price.) No net premium is received at inception for
either collar taking into consideration the entire contractual term of the
combination of options from inception to maturity.
55-183 For Collar 2, premiums are received in early periods as consideration for
entering into net written options in later periods. Specifically, the (higher-than-
average) strike prices in years 20X2 and 20X3 are received (that is, receipt of a
net premium) in return for accepting less favorable (lower-than-average) strike
prices in years 20X4 through 20X6 (that is, net written options). Thus, at the
inception of the hedge and over its life, Collar 2 would be subject to the
provisions of paragraph 815-20-25-94.
>>> Case B: Changes in Notional Amounts
55-184 The following table presents the notional amounts of two alternative
collars. (Assume that the strike prices of the two collars are identical and
constant over the life of the collars.)

(Notional Units)

Total
Notional 5-Year
20X2 20X3 20X4 20X5 20X6 Amount Average
Collar 3
Minimum 750 750 750 750 750 3,750 750
Maximum 750 750 750 750 750 3,750 750
Collar 4
Minimum 1,240 1,240 1,240 15 15 3,750 750
Maximum 250 250 250 1,500 1,500 3,750 750

55-185 Note that both the sum and average of the notional amounts of the
written option component for all periods are not greater than the sum and
average of the notional amounts of the purchased option component for all
periods.

55-186 For Collar 4, favorable terms are received in early periods (net
purchased options) as consideration for entering into net written options in
later periods. Specifically, the (higher-than-average) notional amounts on the
purchased put option in years 20X2 through 20X4 are received in return for
accepting a less favorable notional amount in years 20X5 and 20X6. Thus, at
the inception of the hedge and over its life, Collar 4 in Case B would be subject
to the provisions of paragraph 815-20-25-94.

FASB Example: Applying the net written option test to collar-

based hedging relationship

Excerpt from ASC 815-20

>> Example 30: Application of the Net Written Option Test to Collar-
Based Hedging Relationship

55-230 This Example illustrates the application of paragraph 815-20-25-95.

55-231 Entity X has LIBOR-indexed floating-rate debt. To hedge its exposure to
variability in expected future cash outflows attributable to changes in LIBOR
swap rate (the contractually specified interest rate), it enters into an interest
rate collar with a bank when the current LIBOR swap rate is 6 percent. The
collar also is indexed to LIBOR and consists of a purchased cap with the strike
rate equal to 8 percent and a written floor with the strike rate equal to
5 percent. The purchased cap goes into effect when LIBOR increases above
8 percent, and the written floor goes into effect when LIBOR decreases below
5 percent. Thus, the interest collar has the effect of limiting the interest rate of
the floating-rate debt to a range between 5 percent and 8 percent. On the
basis of market conditions as of the collar transaction date, Entity X received a
net premium from the bank.
55-232 In accordance with paragraphs 815-20-25-88 through 25-90, the
combination of options in the collar in this Example is a net written option from
Entity X’s perspective. Therefore, the written-option test in paragraphs 815-20-
25-94 through 25-95 must be applied to determine whether the hedging
relationship between the debt and the collar qualifies for cash flow hedge
accounting. That test requires that the combination of the hedged item and the
written option provides at least as much potential for favorable cash flows as
exposure to unfavorable cash flows for all possible percentage changes (from
zero percent to 100 percent) in the LIBOR index.
55-233 The following table shows the calculation of the favorable cash flows
and unfavorable cash flows for LIBOR changes of 50 percent.

Potential Cash Flows of the Combination of the Hedged Item and the Net Written
Option if LIBOR Moves Each Direction by the Same Percentage

LIBOR at LIBOR LIBOR

Inception Increase 50% Decrease 50%

Cash outflows on LIBOR-indexed debt 6.00% 9.00% 3.00%

Cash outflows on written floor 0.00 0.00 2.00

Less: Cash inflows on purchased cap 0.00 1.00 0.00

Net cash flow (outflows + / inflows -) 6.00% 8.00% 5.00%

Unfavorable Favorable

Change in cash flows of combination from inception

(in basis points) 200 -100

Percentage change in cash flows of combination from

inception 33.33% -16.67%

55-234 The calculations in the table in paragraph 815-20-55-233 demonstrate

that for a 50 percent fluctuation in the LIBOR rate, the collar would fail the
written-option test in paragraph 815-20-25-94 because a 50 percent favorable
change in LIBOR (that is, a decrease) would not provide at least as much
favorable cash flows as unfavorable cash flows that would result from a
50 percent unfavorable change in LIBOR (that is, an increase). Therefore, the
combination of options would not be an eligible hedging instrument.

2.8 Hedge effectiveness

Criterion 1 Criterion 2 Criterion 3 Criterion 4

Eligibility of Eligibility of
Eligibility of Hedge
hedged items hedging
hedged risk(s) effectiveness
or transactions instruments

Criterion 5: Formal documentation

2.8.10 Overview
Hedge accounting is permitted only if the hedging relationship is highly
effective at managing the risk being hedged (for a net investment hedge, the
hedging relationship must be effective as an economic hedge). Effectiveness
assessments are required to be performed prospectively at hedge inception and
both prospectively and retrospectively periodically thereafter (at least quarterly).

The following diagram summarizes how effectiveness is assessed.

Topic 815 requires the initial (prospective) assessment to be performed on a

quantitative basis unless the hedging relationship meets certain conditions.
Subsequent assessments may be performed on a quantitative basis, or on a
qualitative basis if certain conditions are met.
Additionally, Topic 815 provides the three methods that allow an entity to
assume a hedging relationship is perfectly effective if certain conditions are
met:
 shortcut method (see section 9.3);
 critical terms match method (see section 9.4); and
 simplified hedge accounting approach (see section 10.2).
Chapter 9 discusses the general requirements for assessing hedge
effectiveness and the specific requirements for various assessment methods.
For a net investment hedge, the hedging instrument must be both designated
and effective as an economic hedge of the net investment (see section 8.4).

2.9 Hedge documentation requirements

Criterion 1 Criterion 2 Criterion 3 Criterion 4

Eligibility of Eligibility of
Eligibility of Hedge
hedged items hedging
hedged risk(s) effectiveness
or transactions instruments

Criterion 5: Formal documentation

2.9.10 Overview

Excerpt from ASC 815-20

> Formal Designation and Documentation at Hedge Inception

To qualify for hedge accounting, there shall be, at inception of the hedge,
formal documentation of all of the following:
a. Subparagraph not used
b. Documentation requirement applicable to fair value hedges, cash flow
hedges, and net investment hedges:
1. The hedging relationship
2. The entity’s risk management objective and strategy for undertaking
the hedge, including identification of all of the following:
i. The hedging instrument.
ii. The hedged item or transaction.
iii. The nature of the risk being hedged.
iv. The method that will be used to retrospectively and
prospectively assess the hedging instrument's effectiveness in
offsetting the exposure to changes in the hedged item’s fair
value (if a fair value hedge) or hedged transaction’s variability in
cash flows (if a cash flow hedge) attributable to the hedged risk.
There shall be a reasonable basis for how the entity plans to
assess the hedging instrument’s effectiveness.

To qualify for hedge accounting, an entity must formally designate and

document certain elements of the hedging relationship.
While the form of this documentation is at the discretion of an entity’s
management, it must include the following.

General documentation requirements

Risk management objective and strategy

(section 2.9.20)

Assessment of
Hedging Hedged item or hedge
Nature of risk
instrument transaction effectiveness
(section 2.9.30)

There are general documentation requirements that must be met for all types of
hedges. In addition, there are incremental documentation requirements specific
to fair value hedges (see section 2.9.50) and cash flow hedges
(see section 2.9.60).
Section 2.9.40 explains when an entity must prepare the initial hedge
documentation, including results of the initial effectiveness assessment.
There are certain exceptions for some private companies adopting the
simplified hedge accounting approach and for private companies not adopting
the simplified hedge accounting approach. For further discussion of private
companies, see chapter 10.

Question 2.9.10
What is the level of detail needed to satisfy the
hedge documentation requirements?
Interpretive response: The level of detail required in hedge documentation is a
matter of judgment. However, the SEC staff has stated that the method used
to assess hedge effectiveness must be documented with sufficient specificity
that a third-party could perform the assessment and measurement based on
the documentation and arrive at the same result as the entity applying hedge
accounting. [1999 AICPA Conf]
We believe the required documentation around the hedging relationship should
also be specific enough to identify the specific hedged item or transaction and
the hedging instrument. For example, if the hedged item was a note payable, all
the relevant terms of the note should be documented or a reference to the note
term sheet should be made.

2.9.20 Documenting the risk management objective and

strategy
Topic 815 requires an entity to formally document, at inception of the hedge, its
risk management objectives and strategy for undertaking the hedge. The
primary objective of this requirement is to:
— identify the nature of the risk being hedged; and
— document how the derivative hedging instrument selected by the entity is
expected to achieve the entity’s objective of reducing its exposure to
changes in fair values or cash flows attributable to the designated risk.
This documentation is important because the method of assessing the
effectiveness of the relationship (discussed in chapter 9) must be consistent
with the originally documented objective and strategy for that particular hedging
relationship. [815-20-25-80]
The components of the formal documentation requirements around an entity’s
risk management objective and strategy are as follows.

Hedging Identify the derivative hedging instrument, including the proportion

instrument (i.e. all or some percentage) of the derivative instrument that is
designated as the hedging instrument (see sections 2.6 and 2.7).
[815-20-25-3(b)(i)]

If the hedging relationship involves a combination of two or more

derivatives, the documentation should identify the combination.

Hedged item Specifically identify the recognized asset or liability, firm

or transaction commitment, cash flows or forecasted transaction
(see section 2.2.10). If applicable, this includes the specific portion of
the hedged item or transaction, or the portfolio or group of hedged
items or transactions. [815-20-25-3(b)(ii)]
— If the fair value hedging relationship involves a portfolio of similar
assets and liabilities, see section 3.3.40 for further discussion of
hedge accounting qualifying criteria.

— If the cash flow hedging relationship involves a group of similar

forecasted transactions, see section 5.3.60 for further
discussion of hedge accounting qualifying criteria.
Document how the change in the fair value or cash flows on the
hedged item or transaction attributable to the risk being hedged will
be determined; this affects the assessment of effectiveness.
Section 2.9.50 discusses incremental documentation requirements
for fair value hedges related to:
— firm commitments; and
— last-of-layer method.
Section 2.9.60 discusses incremental documentation requirements
for cash flow hedges, including specific identification of the timing,
nature and amount of a hedged forecasted transaction.

Nature of the Identify the risk(s) being hedged – e.g. interest rate risk, credit risk,
risk being price risk and/or foreign exchange risk (see sections 2.3 and 2.4).
hedged [815-20-25-3(b)(i)]
For hedges of interest rate risk, identify the benchmark interest rate
(see section 2.3.30) or the contractually specified interest rate
(see section 2.3.40).
Section 2.9.60 discusses incremental documentation requirements
for cash flow hedges related to certain hedged risks – e.g.
specifying contractually specified components.

Assessment See section 2.9.30.

of hedge
effectiveness

Documentation of the hedged item or transaction and the risk being hedged
cannot be ambiguous. This will avoid circumstances that could call into question
which item, transaction or designated risk is part of a hedging relationship.
For example, an entity may hedge more than one risk at a time, as long as each
designated risk is accounted for separately; for guidance on accounting for
simultaneous hedges, see section 2.3.80. If a hedged item or transaction is already
subject to another hedging relationship, it is critical to specify and document which
item or forecasted transaction and its associated risk are being hedged.
Examples 2.9.30 and 2.9.40 illustrate the documentation requirements for fair
value hedges and cash flow hedges, respectively.

2.9.30 Documenting assessment of hedge effectiveness

Excerpt from ASC 815-20

> Formal Designation and Documentation at Hedge Inception

25-3(b)(2) The entity’s risk management objective and strategy for undertaking
the hedge, including identification of all of the following: …
iv. The method that will be used to retrospectively and prospectively assess
the hedging instrument's effectiveness in offsetting the exposure to

changes in the hedged item’s fair value (if a fair value hedge) or hedged
transaction’s variability in cash flows (if a cash flow hedge) attributable to
the hedged risk. There shall be a reasonable basis for how the entity plans
to assess the hedging instrument’s effectiveness.
01. An entity shall perform an initial prospective assessment of hedge
effectiveness on a quantitative basis (using either a dollar-offset test or
a statistical method such as regression analysis) unless one of the
following applies:
A. In a cash flow or fair value hedge, the entity applies the shortcut
method in accordance with paragraphs 815-20-25-102 through 25-
117.
B. In a cash flow or fair value hedge, the entity determines that the
critical terms of the hedging instrument and the hedged item
match in accordance with paragraphs 815-20-25-84 through 25-85.
C. In a cash flow hedge, the hedging instrument is an option, and the
conditions in paragraphs 815-20-25-126 and 815-20-25-129 through
25-129A are met.
D. In a cash flow hedge, a private company that is not a financial
institution as described in paragraph 942-320-50-1 applies the
simplified hedge accounting approach in paragraphs 815-20-25-133
through 25-138.
E. In a cash flow hedge, the entity assesses hedge effectiveness
under the change in variable cash flows method in accordance with
paragraphs 815-30-35-16 through 35-24, and all of the conditions in
paragraph 815-30-35-22 are met.
F. In a cash flow hedge, the entity assesses hedge effectiveness
under the hypothetical derivative method in accordance with
paragraphs 815-30-35-25 through 35-29, and all of the critical terms
of the hypothetical derivative and hedging instrument are the
same.
G. In a net investment hedge, the entity assesses hedge
effectiveness using a method based on changes in spot exchange
rates, and the conditions in paragraph 815-35-35-5 (for derivative
instruments) or 815-35-35-12 (for nonderivative instruments) are
met.
H. In a net investment hedge, the entity assesses hedge
effectiveness using a method based on changes in forward
exchange rates, and the conditions in paragraph 815-35-35-17A are
met.
02. The initial prospective quantitative hedge effectiveness assessment
using information applicable as of the date of hedge inception is
considered to be performed concurrently at hedge inception if it is
completed by the earliest of the following:
A. The first quarterly hedge effectiveness assessment date
B. The date that financial statements that include the hedged
transaction are available to be issued
C. The date that any criterion in Section 815-20-25 no longer is met
D. The date of expiration, sale, termination, or exercise of the hedging
instrument
E. The date of dedesignation of the hedging relationship

F. For a cash flow hedge of a forecasted transaction (in accordance

with paragraph 815-20-25-13(b)), the date that the forecasted
transaction occurs.
03. An entity also shall document at hedge inception whether it elects to
perform subsequent retrospective and prospective hedge
effectiveness assessments on a qualitative basis and how it intends to
carry out that qualitative assessment. See paragraphs 815-20-35-2A
through 35-2F for additional guidance on qualitative assessments of
effectiveness. In addition, the entity shall document which quantitative
method it will use if facts and circumstances of the hedging
relationship change and the entity must quantitatively assess hedge
effectiveness in accordance with paragraph 815-20-35-2D. An entity
must document that it will perform the same quantitative assessment
method for both initial and subsequent prospective hedge
effectiveness assessments. The guidance in paragraphs 815-20-55-55
through 55-56 applies if the entity wants to change its quantitative
method of assessing effectiveness after the initial quantitative
effectiveness assessment.
04. An entity that applies the shortcut method in paragraphs 815-20-25-102
through 25-117 may elect to document at hedge inception a
quantitative method to assess hedge effectiveness and measure
hedge results if the entity determines at some point during the term of
the hedging relationship that the use of the shortcut method was not
or no longer is appropriate. See paragraphs 815-20-25-117A through 25-
117D.
v. Subparagraph superseded by Accounting Standards Update No. 2017-12.
vi. If the entity is hedging foreign currency risk on an after-tax basis, that the
assessment of effectiveness will be on an after-tax basis (rather than on a
pretax basis).

Topic 815 requires an entity to document its assessment of hedge

effectiveness at inception of a hedging relationship and on an ongoing basis.
That is, an entity must provide documentation supporting why and how it
expects changes in the fair value or cash flows of the derivative hedging
instrument to offset changes in the fair value or cash flows of the hedged item
or transaction attributable to the hedged risk. In addition, in periodic
assessments, an entity must document how the derivative is expected to be
and has been highly effective in offsetting changes in fair value or cash flows
(hedge effectiveness testing – see chapter 9). [815-20-25-3(b)(2)(iv)]
The following table summarizes documentation requirements for hedge
effectiveness at inception of the hedging relationship and on an ongoing basis.

Documentation — Document analysis and results of initial (prospective)

at hedge effectiveness assessment. Unless the hedging relationship is
inception one of eight specified situations, an entity is required to
perform this assessment on a quantitative basis (see sections
9.2.20 and 9.6). [815-20-25-3(b)(2)(iv)(01-02)]
— Document method(s) that will be used to perform subsequent
(retrospective and prospective) effectiveness assessments.
[815-20-25-3(b)(2)(iv)]

— Shortcut method. Under the shortcut method, an entity

may elect to document at hedge inception a quantitative
method to assess hedge effectiveness if it is determined
at a later date that the shortcut method was not or is no
longer appropriate (see section 9.3).
— Critical terms match method and simplified hedge
accounting approach. If one of these methods is
applied, the entity follows the applicable guidance for
subsequent assessments (see sections 9.4 and 10.2,
respectively).
— Qualitative. If subsequent effectiveness assessments
will be performed on a qualitative basis, document how
those assessments will be performed. Additionally,
document which quantitative method will be used if facts
and circumstances change and the entity must
quantitatively assess hedge effectiveness; this method is
required to be the same as that used to support the
entity’s initial prospective hedge effectiveness
assessment. For guidance on electing qualitative
effectiveness assessments, see section 9.5.10.
— Quantitative. Document selected quantitative approach –
i.e. dollar-offset or statistical analysis (see section 9.6).

Documentation — Document analysis and results of subsequent prospective and

during the retrospective effectiveness assessments.
hedging — For critical terms match method, continued documentation of
relationship matching of critical terms at each effectiveness period. See
section 9.4.40 for further documentation criteria. [815-20-35-9]

See chapter 9 for comprehensive guidance on assessing hedge effectiveness,

both at inception and during the hedging relationship.

FASB Example: Documentation when critical terms of the

hedging instrument and hedged forecasted transaction match
While section 9.4 elaborates on the assessment of the critical terms match
method of a forecasted transaction, the following example illustrates the
documentation requirements of paragraph 815-20-25-3 for such a hedging
relationship.

Excerpt from ASC 815-20

>> Example 1A: Documentation When the Critical Terms of the Hedging
Instrument and Hedged Forecasted Transaction Match

55-80A This Example illustrates the documentation requirements in

paragraph 815-20-25-3 when the critical terms of the hedging instrument and
hedged forecasted transaction match in accordance with paragraphs 815-20-
25-84 through 25-85. On January 1, 20X1, Entity A, a U.S. dollar (USD)
functional currency entity, executes a forward contract to hedge a portion of its

exposure to Canadian Dollar- (CAD-) denominated forecasted sales expected to

occur in December 20X1. Entity A determines that all the critical terms of the
hedging instrument and hedged forecasted transaction match. It documents
the hedging relationship concurrently with the execution of the forward
contract in accordance with paragraph 815-20-25-3 as follows:
a. Risk management objective: To hedge against movements in the
USD/CAD exchange rate that will affect the USD value of future CAD
sales.
b. Hedged forecasted transaction: The first CAD 500,000 sales in December
20X1.
c. Hedging instrument: Foreign exchange forward contract to sell CAD
500,000 and receive USD 400,000 on December 31, 20X1. The fair value of
the forward contract at hedge inception is zero.
d. Method of assessing hedge effectiveness: Entity A will assess the
effectiveness on a qualitative basis at hedge inception. The critical terms of
the hedging instrument and hedged forecasted transaction can be
considered to match because the notional amounts and underlyings of the
hedging instrument and hedged forecasted transaction are the same and
the forecasted sales are expected to occur in the same fiscal month as the
maturity date of the hedging instrument. Therefore, the hedge is expected
to be perfectly effective. Subsequent assessments of effectiveness will be
performed by verifying and documenting whether the critical terms of the
hedging instrument and hedged forecasted transaction have changed
during the period in review and whether it remains probable that the
counterparty to the hedged item and hedged forecasted transactions will
not default. If there are no such changes in critical terms or counterparty
credit risk, Entity A will continue to conclude that the hedging relationship
is perfectly effective.

2.9.40 Timing of initial hedge documentation, including

initial effectiveness assessment

Excerpt from ASC 815-20

>>> Timing of Initial Quantitative Prospective Effectiveness Assessment

55-79C The following scenarios illustrate the application of paragraph 815-20-
25-3(b)(2)(iv)(02). Entity A documents all hedges in accordance with paragraph
815-20-25-3, including designating the hedging instrument, hedged item, and
method of assessing hedge effectiveness. It performs subsequent prospective
and retrospective hedge effectiveness assessments every three months on
the last day of the quarter in accordance with paragraph 815-20-25-79(a)
through (b). In the following scenarios, assume that the next quarterly
effectiveness assessment date is March 31, 20X1. Entity A also does not
dedesignate the hedging relationships in the following scenarios.

>>>> Scenario A
55-79D Entity A enters into a cash flow hedging relationship on January 15,
20X1, in which the hedged item is a forecasted transaction expected to occur
in one year. Because the hedged item and hedging instrument do not expire,
are not sold, or do not terminate before the quarterly effectiveness testing
date, Entity A may perform the initial prospective quantitative effectiveness
assessment at any time after hedge designation but no later than March 31,
20X1.
>>>> Scenario B
55-79E Entity A enters into a cash flow hedging relationship on March 28,
20X1, in which the hedged item is a forecasted transaction expected to occur
in one year. Entity A must perform the initial prospective quantitative
effectiveness assessment no later than March 31, 20X1.
>>>> Scenario C
55-79F On January 15, 20X1, Entity A enters into a cash flow hedging
relationship in which the hedged forecasted purchase of a nonfinancial asset is
expected to occur in two months. The purchase occurs as forecasted on
March 15, 20X1. Entity A must complete the initial prospective effectiveness
assessment at any time after hedge designation but no later than March 15,
20X1, when the forecasted purchase occurs.

The following table summarizes the required timing of the elements of initial
hedge documentation, including initial hedge effectiveness assessment, for all
entities other than certain private companies. See chapter 10 for requirements
for certain private companies and certain not-for-profit entities.

Element of hedge documentation Timing

All entities other than certain private companies and certain not-for-profit
entities
Initial prospective assessment of hedge Earliest of the following: [815-20-25-
effectiveness (if quantitative testing is 3(b)(2)(iv)(02)]
required). [815-20-25-3(b)(2)(iv)] — first quarterly hedge effectiveness
assessment date;
— date the financial statements that
include the hedged transaction are
available to be issued;
— date any hedge accounting criterion
is no longer met;
— date the hedging instrument expires
or is sold, terminated or exercised;
— date the hedging relationship is
dedesignated; or
— for a cash flow hedge of a
forecasted transaction (in
accordance with paragraph 815-20-
25-13(b)), date the forecasted
transaction occurs.
All other elements of hedge Concurrent with hedge designation.
documentation. [815-20-25-3] [815-20-25-3]

As noted in the table above, certain elements of the hedging relationship must
be documented at the designation of the hedging relationship, including the
identification of the hedging instrument, the nature of the risk, and the hedged
item or transaction. The hedging relationship cannot be designated
retroactively, as an entity would then have the benefit of hindsight and could
use that to designate hedging relationships that would provide a desired
financial result.

Example 2.9.10
Importance of timing of formal documentation of
the hedge
ABC Corp. purchased an option on January 1, Year 1. ABC intends to use the
option to hedge a qualifying forecasted purchase that it expects to occur in nine
months on September 1, Year 1.
On March 31, Year 1, ABC wishes to designate and document the hedge of its
exposure to variability in cash flows related to the forecasted transaction. It
cannot document and designate the hedging relationship such that hedge
accounting could be applied retrospectively from the date the option was
purchased (on January 1, Year 1).
However, ABC may formally document the existence of a qualifying hedge on
March 31, Year 1 and apply hedge accounting prospectively.
ABC will treat the option as a trading derivative for the three months to
March 31, Year 1 with changes in its fair value recognized immediately in
earnings.

Example 2.9.20
Timing requirements for initial hedge documentation
The following example is adapted in part from scenarios A to C in
paragraphs 815-20-55-79C to 55-79F.
The following scenarios demonstrate the required timing for preparing initial
hedge documentation for a hedging relationship that is not eligible for the
simplified hedge accounting approach (see Question 10.2.10) or documentation
relief for certain private companies and certain not-for-profit entities (see
Question 10.3.10).
The scenarios compare two different types of entities. This example does not
demonstrate the timing of performing quarterly hedge effectiveness
assessments, which is discussed in section 9.2.20.
Entities
The following two types of entities are compared in each scenario.
— Bank is a private financial institution. Because Bank is a financial institution,
it does not qualify for the special guidance applicable to certain private
companies that is described in chapter 10.

— PublicCo is an SEC registrant.

Both entities are required to document at hedge inception all elements of the
hedging relationship except the initial prospective effectiveness assessment.
The following assumptions are relevant to all scenarios.
— Bank and PublicCo are required to perform the initial prospective
effectiveness assessment quantitatively.
— Bank and PublicCo perform retrospective quarterly hedge effectiveness
assessments every three months on the last day of the quarter, with the
first date being March 31, Year 1.
— In no scenario does Bank or PublicCo dedesignate the hedging relationship
before the end of the hedged term. Additionally, before the date of the
forecasted transaction, the hedged transaction and hedging instrument do
not expire, are not sold and do not terminate.
— The forecasted transaction occurs as expected.
Scenario 1: Hedging relationship begins earlier in the quarterly period
Bank and PublicCo each enter into a cash flow hedging relationship on
March 15, Year 1, in which the hedged transaction is a forecasted transaction
expected to occur in one year.
Quarterly hedge Quarterly hedge Date annual financial
Hedge effectiveness effectiveness statements are available
inception assessment assessment to be issued
March 15, Year 1 June 30, Year 1 December 31, Year 1 February 26, Year 2

A B

Quarterly hedge Quarterly hedge Hedged forecasted

effectiveness effectiveness transaction occurs
assessment assessment January 15, Year 2
March 31, Year 1 September 30, Year 1

Bank and PublicCo: On this date, the initial hedge documentation is

A required to include all elements except the initial prospective quantitative
effectiveness assessment.

Bank and PublicCo: By this date, the initial prospective quantitative

B
effectiveness assessment must be performed and documented.

Scenario 2: Hedging relationship begins later in the quarterly period

Bank and PublicCo each enter into a cash flow hedging relationship on
March 15, Year 1, in which the hedged transaction is a forecasted transaction
expected to occur in one year.

Quarterly hedge Quarterly hedge

Hedge effectiveness effectiveness Hedged forecasted
inception assessment assessment transaction occurs
March 15, Year 1 June 30, Year 1 December 31, Year 1 March 15, Year 2

A B

Quarterly hedge Quarterly hedge Date annual financial

effectiveness effectiveness statements are available
assessment assessment to be issued
March 31, Year 1 September 30, Year 1 February 26, Year 2

Bank and PublicCo: On this date, the initial hedge documentation is

A required to include all elements except the initial prospective quantitative
effectiveness assessment.

Bank and PublicCo: By this date, the initial prospective quantitative

B
effectiveness assessment must be performed and documented.

Scenario 3: Hedging relationship has a shorter duration

Bank and PublicCo each enter into a cash flow hedging relationship on
January 15, Year 1, in which the hedged transaction is a forecasted transaction
expected to occur in two months.
Date annual financial
Hedge Hedged forecasted statements are available
inception transaction occurs to be issued
January15, March 15, June 30, December 31, February 26,
Year 1 Year 1 Year 1 Year 1 Year 2

A B

March 31, September 30,

Year 1 Year 1

Bank and PublicCo: On this date, the initial hedge documentation is

A required to include all elements except the initial prospective
quantitative effectiveness assessment.

Bank and PublicCo: By this date, the initial prospective quantitative

B
effectiveness assessment must be performed.

Observation
Some entities may not benefit from the ability to
delay initial quantitative prospective effectiveness
assessments
The FASB acknowledged that the ability to complete the initial quantitative
prospective effectiveness assessment after hedge designation may not provide
relief for entities that either have a significant volume of hedging relationships
or that frequently dedesignate and redesignate hedging relationships.
However, those entities usually have systems and processes in place that are
capable of performing those assessments concurrently with hedge designation.
[ASU 2017-12.BC177]

2.9.50 Documentation requirements for fair value hedges

Excerpt from ASC 815-20

> Formal Designation and Documentation at Hedge Inception

25-3(c) Documentation requirement applicable to fair value hedges only:
1. For a fair value hedge of a firm commitment, a reasonable method for
recognizing in earnings the asset or liability representing the gain or loss on
the hedged firm commitment.
2. For a hedging relationship designated under the last-of-layer method, an
analysis to support the entity’s expectation that the hedged item is
anticipated to be outstanding as of the hedged item’s assumed maturity
date (see paragraph 815-20-25-12A(a) for additional guidance).

In addition to the general documentation requirements discussed above

at section 2.9.10, there are incremental documentation requirements specific to
fair value hedges relating to firm commitments and hedging relationships
designated under the last-of-layer method.

Firm Documentation includes a reasonable method for recognizing in

commitments earnings the asset or liability that represents the gain or loss on the
(section 3.3.20) hedged firm commitment. [815-20-25-3(c)(1)]
Question 4.4.10 contains guidance on subsequent accounting for
assets or liabilities recognized as a result of applying fair value
hedge accounting to an unrecognized firm commitment.
Last-of-layer Analysis to support the entity’s expectation that the hedged item
(section (e.g. last-of-layer) will be outstanding at the hedged item’s assumed
3.3.100) maturity date. [815-20-25-3(c)(2)]
Question 3.3.320 contains guidance on what is needed to support
the entity’s expectation that the last-of-layer will remain outstanding
at the end of the hedge term.

The following is an example of the formal documentation expected for a fair

value hedge of a firm commitment.

Example 2.9.30
Formal documentation for a fair value hedge of a
firm commitment
ABC Corp. is a US dollar functional currency entity. On January 1, Year 1, ABC
enters into a firm commitment to purchase a machine from a British
manufacturer for 10,000 pounds sterling (£) in 12 months.
ABC chooses to hedge its exposure to changes in fair value of the firm
commitment attributable to foreign currency exchange rates. It enters into a
12-month forward contract with Euro Bank to exchange a fixed amount of
US dollars for a fixed amount of euros (€) because it has determined that
changes in the exchange rate for $/€ correlate with changes in the exchange
rate for $/£. Except for the currency in which the forward contract will be
settled (¬ rather than £), the terms of the forward contract match those of the
firm commitment.
ABC prepares the following documentation on January 1, Year 1.
Hedging relationship and risk management objective and strategy
On January 1, Year 1, ABC entered into a firm commitment to purchase a
machine from a British manufacturer for £10,000 in 12 months. As a result,
ABC is exposed to changes in the fair value of this commitment during the next
12 months due to changes in the exchange rate for $/£.
ABC’s risk management objective is to lock in the fair value (cost) of the firm
commitment in its functional currency. ABC meets this objective by entering
into a 12-month forward contract to exchange a fixed amount of US dollars for a
fixed amount of euros. It expects that the amount of euros received under the
contract will be sufficient to satisfy the pounds sterling obligation inherent in
the firm commitment. That is, changes in the fair value of the forward contract
caused by fluctuations in the exchange rate for $/€ are expected to be highly
effective in offsetting changes in the fair value of the firm commitment caused
by fluctuations in the exchange rate for $/£.
ABC designates the forward contract (the hedging instrument) as a hedge of its
exposure to changes in fair value attributable to changes in the foreign currency
exchange rates for $/£ related to the firm commitment.
Hedging instrument
ABC identifies the following forward contract as the derivative hedging
instrument.
— Date of forward contract = January 1, Year 1
— Notional amount = €10,000 for equivalent US dollars
— Rate: Forward exchange rate for $/€ at inception of contract
— Term = 12 months
— Settlement = net cash due on December 31, Year 1

Hedged item
Changes in the fair value of the firm commitment to purchase a machine from a
British manufacturer for £10,000 in 12 months attributable to changes in the
exchange rate for $/£. The change in the fair value of the firm commitment
caused by such exchange rate fluctuations will be measured based on the total
changes in the forward exchange rates for $/£.
Method for recognizing in earnings the firm commitment asset or liability
Any changes in the fair value of the firm commitment caused by fluctuations in
the exchange rates during the period in which the hedge is in effect will be
reflected as an asset or liability. When the forward contract is closed and the
machine is purchased (December 31, Year 1), the firm commitment asset or
liability balance will be reclassified as an addition to, or subtraction from, the
carrying amount of the machine. This carrying amount will be recognized in
earnings in accordance with ABC’s normal depreciation policy.
Hedge effectiveness at inception

Prospectively During the 12 months before inception of the forward contract, the
fluctuations in the 12-month forward exchange rate for $/€ were
very similar to fluctuations in the 12-month forward exchange rate
for $/£.
ABC’s cumulative dollar-offset method documented that a
comparison of the fluctuations in the two forward exchange rates
ranged from 90%–110% over the past 12 months.
Based on these findings, it is expected that such a relationship will
continue during the next 12 months, which is the period that the
hedging relationship between the forward contract and the firm
commitment will be in place.

Hedge effectiveness testing method – documented at inception of the

hedging relationship
On a quarterly basis, ABC will assess effectiveness by updating the analysis
performed coincident with the hedge designation to reflect the quarter’s
fluctuations in the two exchange rates. It will consider the risk of default by the
counterparty to the forward contract and its own nonperformance risk in this
assessment.

Retrospectively ABC will evaluate whether the hedging relationship has been
highly effective during the quarter just ended by comparing the
cumulative dollar fluctuations in the forward exchange rates for $/€
and $/£ (where the cumulative period is the period to date from
the inception of the hedging relationship) at each quarter end.
Prospectively On a quarterly basis, ABC will determine whether it expects the
hedging relationship to continue to be highly effective based on
the updated analysis.

If certain criteria are met, ABC may elect to perform the quarterly effectiveness
testing on a qualitative basis. For further guidance on performing effectiveness
testing on a qualitative basis, see section 9.5.

2.9.60 Documentation requirements for cash flow hedges

Excerpt from ASC 815-20

> Formal Designation and Documentation at Hedge Inception

25-3 Concurrent designation and documentation of a hedge is critical; without
it, an entity could retroactively identify a hedged item, a hedged transaction,
or a method of assessing effectiveness to achieve a desired accounting result.
To qualify for hedge accounting, there shall be, at inception of the hedge,
formal documentation of all of the following: …
d. Documentation requirement applicable to cash flow hedges only:
1. For a cash flow hedge of a forecasted transaction, documentation
shall include all relevant details, including all of the following:
i. The date on or period within which the forecasted transaction is
expected to occur.
ii. The specific nature of asset or liability involved (if any).
iii. Either of the following:
01. The expected currency amount for hedges of foreign
currency exchange risk; that is, specification of the exact
amount of foreign currency being hedged
02. The quantity of the forecasted transaction for hedges of
other risks; that is, specification of the physical quantity (that
is, the number of items or units of measure) encompassed
by the hedged forecasted transaction.
iv. If a forecasted sale or purchase is being hedged for price risk,
the hedged transaction shall not be specified in either of the
following ways:
01. Solely in terms of expected currency amounts
02. As a percentage of sales or purchases during a period.
v. The current price of a forecasted transaction shall be identified
to satisfy the criterion in paragraph 815-20-25-75(b) for offsetting
cash flows.
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 of a specific
product 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).
vii. If the hedged risk is the variability in cash flows attributable to
changes in a contractually specified component in a
forecasted purchase or sale of a nonfinancial asset, identification
of the contractually specified component.
viii. If the hedged risk is the variability in cash flows attributable to
changes in a contractually specified interest rate for forecasted

interest receipts or payments on a variable-rate financial asset or

liability, identification of the contractually specified interest rate.

In addition to the general documentation requirements discussed

in section 2.9.10, there are incremental documentation requirements specific to
76T 76T

cash flow hedges. These primarily relate to documentation around the specific
identification of a forecasted transaction.
As discussed in section 5.3.30, a forecasted transaction needs to be described
with sufficient specificity such that when the transaction occurs, it is clear
whether that transaction is or is not the hedged transaction. Topic 815 requires
an entity to formally document certain details around the specific identification
of the forecasted transaction, including:

Timing Timing of when the forecasted transaction is expected to occur (e.g.

specific date or period). [815-20-25-3(d)(1)(i)]
If a forecasted transaction is expected to occur within a timeframe,
but the date within that timeframe is uncertain, an entity may
document a range of time to comply with this requirement. For
guidance around uncertainty of timing within a range, see
section 5.3.40.
Nature Specific nature of the asset or liability involved, or first cash flows
received or paid to a specific amount in a particular period (without
reference to the specific asset or liability). [815-20-25-3(d)(1)(ii)]
For guidance around specifically identifying the single forecasted
transaction (or group of forecasted transactions), see section 5.3.30.
Quantity The hedged quantity (e.g. specific number of items or units of
measure) for hedges of price risk, interest rate risk and/or credit
risk. [815-20-25-3(d)(1)(ii)(02)]
Current The current market price of the forecasted transaction, both at
market price inception of the hedge and subsequently. [815-20-25-3(d)(1)(v)]
This information is necessary to determine the change in expected
cash flows.
An entity should also document at inception how it will calculate the
change in the cash flows of the hedged forecasted transaction
attributable to the risk being hedged because how this is calculated
affects the assessment of effectiveness.
Foreign The expected currency amount for hedges of foreign currency risk.
currency [815-20-25-3(d)(1)(iii)(01)]
amount
Contractually The contractually specified component for hedges of exposure to
specified changes in a contractually specified component related to
component forecasted transactions of nonfinancial assets or liabilities (see
section 5.4.10). [815-20-25-3(d)(1)(vii)]
Contractually The contractually specified interest rate for hedges of exposure to
specified changes in a contractually specified interest rate related to
interest rate forecasted transactions of financial assets or liabilities
(see section 2.3.40). [815-20-25-3(d)(1)(viii)]
76T 76T

Price risk For hedges of price risk, the hedged transaction should not be
specified: [815-20-25-3(d)(1)(iv)]
— solely in terms of expected currency amounts; or
— as a percentage of sales or purchases during a period.

Examples
The examples in this section demonstrate the formal documentation for certain
cash flow hedging relationships, for entities not applying guidance specific to
certain private companies or not-for-profit entities.
— Formal documentation for a cash flow hedge of a forecasted transaction
(Example 2.9.40).
— Formal documentation for forecasted purchases of fuel when hedging price
risk (Example 2.9.50).
Formal documentation required by certain private companies and not-for-profit
entities is discussed in chapter 10.

Example 2.9.40
Formal documentation for a cash flow hedge of a
forecasted transaction
On January 1, Year 1, ABC Corp. issues a five-year, $100,000,000 debt
obligation. The interest rate on the debt obligation is variable at the six-month
LIBOR plus 1.5%.
ABC enters into a five-year interest rate swap with a notional amount of
$100,000,000 to receive interest at six-month LIBOR and pay interest at a fixed
rate of 8.5% on January 15, Year 1. The debt obligation reprices and requires
payments to be made on July 1 and January 1 of each year. The swap reprices
and requires payments to be made or received on July 15 and January 15 of
each year.
ABC prepares the following documentation on January 15, Year 1.
Hedging relationship and risk management objective and strategy
On January 1, Year 1, ABC issued a five-year, $100,000,000 debt obligation.
The interest rate on the debt obligation is variable at six-month LIBOR plus
1.5%. As a result, ABC is exposed to variability in cash flows related to changes
in its forecasted interest payments as six-month LIBOR (the benchmark interest
rate) changes.
ABC’s risk management objective is to lock in the interest cash outflows on this
debt obligation. ABC meets this objective by entering into a five-year interest
rate swap with a notional amount of $100,000,000 to receive interest at a
variable rate equal to six-month LIBOR and to pay interest at a fixed rate of
8.5%. ABC designates the swap (the hedging instrument) as a cash flow hedge
of the interest rate risk associated with the benchmark rate of six-month LIBOR
attributable to the forecasted interest payments on its five-year, $100,000,000
variable-rate debt obligation (the hedged forecasted transactions).

Hedging instrument
ABC identifies the following interest rate swap as the derivative hedging
instrument.
— Date of Swap = January 15, Year 1
— Notional amount = $100,000,000
— Premium paid = $0
— Term = Five years maturing on January 14, Year 6
— Fixed leg = 8.5% per annum
— Fixed leg payer = ABC
— Floating leg = six-month LIBOR, repricing July 15 and January 15 of each
year
— Floating leg payer = Bank A
— Settlement = net cash due in arrears on July 15 and January 15 of each
year.
Hedged forecasted transaction
Forecasted interest payments are to be made on July 1 and January 1 of each
year on its five-year $100,000,000 debt obligation issued January 1, Year 1 and
maturing on December 31, Year 6. The interest payments on the $100,000,000
debt obligation are repriced on July 1 and January 1 of each year, with
payments due in arrears. As interest expense is accrued on the debt obligation,
amounts in AOCI related to that expense will be reclassified into earnings.
Hedge effectiveness at inception

Prospectively ABC has designated the risk of changes in its interest cash flows
on its five-year, $100,000,000 debt obligation issued January 1,
Year 1 attributable to changes in six-month LIBOR (the benchmark
interest rate) as the hedged risk.
Although the variable leg of the hedging instrument is equal to six-
month LIBOR and ABC is hedging interest rate risk, ABC cannot
automatically conclude that the hedging relationship would have
been highly effective over the period equivalent to the designated
hedging relationship. This is because the variable leg of the swap
that is designated as the hedging instrument reprices at different
dates from the variable leg of the debt obligation. As a result, the
changes in the variable interest payments of the debt may not
offset the changes in the cash flows of the swap.
ABC concluded that the hypothetical derivative is a swap with
terms that identically match the terms of the variable-rate debt
obligation (i.e. would meet the criteria of the shortcut method) and
is equivalent to the hedging instrument in this hedging relationship
except that the variable leg of the swap would reprice and require
payment or receipt on July 1 and January 1 of each year.
As a result, ABC performed a regression analysis to compare the
period-by-period change in the fair value of the hypothetical
derivative to the change in fair value of the actual derivative on a
quarterly basis for the preceding 20 years.
Based on this analysis, ABC concluded that the hedging
relationship would have been highly effective historically for the
equivalent of at least four hedging periods.

Based on the regression analysis completed, it is expected that on an ongoing

basis the hedging relationship will remain effective throughout the hedging
relationship.
Hedge effectiveness testing method – documented at the inception of the
hedging relationship
On a quarterly basis, ABC will assess effectiveness by updating the analysis
performed coincident with the hedge designation (to reflect the most recent
change in interest rates). It will consider the risk of default by the counterparty
to the swap contract and its own nonperformance risk in this assessment.

Retrospectively ABC will evaluate whether the hedging relationship has been
highly effective during the quarter just ended by updating the
regression analysis performed at the inception of the hedge. In
performing that regression analysis, ABC will use the same
number of data points used in the prospective analysis performed
at inception, except that the earliest data points will be discarded
and replaced with data points that have occurred after the
inception of the hedge.
Prospectively On a quarterly basis, ABC will determine whether it expects the
hedging relationship to continue to be highly effective based on
the updated analysis.

If certain criteria are met, ABC may elect to perform the quarterly effectiveness
testing on a qualitative analysis basis. For further guidance on performing
effectiveness testing on a qualitative basis, see section 9.5.

Example 2.9.50
Formal documentation of forecasted purchases of
fuel when hedging price risk
This example illustrates the documentation of a hedging strategy for a group of
similar forecasted purchases. In addition to documenting the overall hedging
strategy, an entity needs to formally document (at inception) each individual
hedging relationship that is designated using the hedging strategy. This could
be a supplement to the documentation of the overall hedging strategy.
Risk management objective and strategy
Freight Co. (Freight) purchases fuel at various locations (e.g. New York Harbor,
US Gulf Coast, Singapore) on an ongoing basis. Because its transport
operations involve both air and ground transport, Freight regularly purchases
both jet and diesel fuel.
Fuel costs make up a substantial part of Freight’s total operating expenses. This
exposes the overall profitability and operating cash flows to the variability in the
market price for fuel. Freight’s objective is to hedge this variability, which is
limited to changes in prices at various locations. This is because fixed delivery
costs from the locations have been negotiated.
Freight’s strategy for achieving this objective is to use futures and purchased
options with notional amounts and underlying indices that will be highly
effective at hedging that variability.

Nature of the risk being hedged

The hedged risk is defined as the risk of overall changes in cash outflows (i.e.
price risk) for the purchase of fuel. Freight’s exposure to changes in the overall
price of fuel will be affected by both the type of fuel expected to be purchased
(e.g. jet fuel or diesel fuel) and the location.
As discussed above, the variability in the overall cash outflows for the purchase
of fuel is limited to changes in spot prices at various locations because
delivery costs are fixed. The hedge period for individual relationships is typically
three months.
Hedging instrument
The individual hedging relationships associated with this overall strategy may
link multiple derivative contracts in combination to either completely eliminate
the variability in cash flows associated with the forecasted purchases of fuel or
eliminate the variability in cash flows when the overall price exceeds a specified
threshold.
Derivatives will be linked to groups of forecasted purchases based on their
similarity to the overall price risk associated with the forecasted purchases.
Similarity of overall price risk will be based on both the type and location of fuel
expected to be purchased.
The hedging instruments will be futures or purchased options indexed to either:
— the NYMEX Heating Oil or NY Harbor No. 2 index (generally used for
relationships involving forecasted purchases of jet fuel); or
— the NYMEX West Texas Intermediate Crude Oil index (generally used for
relationships involving forecasted purchases of diesel fuel).
These indices generally exhibit high correlation with the changes in market
prices for the hedged forecasted purchases. However, instruments with other
underlying indices may be used if Freight is able to demonstrate high
effectiveness.
A new hedging relationship will be designated each time a derivative is linked to
a specified group of similar forecasted purchases.
Hedged forecasted transaction
The hedged forecasted transaction is defined as the first purchases of gallons
of fuel over the 30-day period beginning on the first day of the month in which
the derivative contract matures/settles that:
1. in aggregate represent the number of gallons (or equivalent barrels) equal to
the notional amount of the hedging instrument; and
2. are not currently being hedged by another derivative instrument or were not
previously identified in a relationship originally designated earlier in priority
that has been terminated for which amounts remain in AOCI.
Individual relationships will link hedging instruments to a specified group of
similar forecasted purchases.
Only those individual forecasted purchases that are considered to be similar
with respect to the risk being hedged are included within the same hedging
group of forecasted transactions.

Because the overall price of a gallon of fuel is significantly affected by both the
type of fuel and the location of the purchase, Freight will identify groups of
hedged forecasted transactions first by type and then more specifically by
location. For example, each forecasted purchase within a particular group will
be for the same type, either jet fuel or diesel fuel. However, there may be
multiple groups of forecasted jet fuel purchases based on the location at which
the jet fuel is expected to be purchased.
Similarity assessment
To demonstrate that each group is similar, Freight will perform a regression
analysis to show that the changes in expected prices for the purchases of fuel
at each location within the group are highly correlated with each other.
Example 5.3.30 continues this example, illustrating the similarity assessment.
Hedge effectiveness
For the forecasted transactions to qualify for hedge accounting, Freight needs
to demonstrate that the hedging instrument is highly effective at hedging the
overall price risk for each individual group. Example 9.6.20 continues this
example, illustrating regression analysis to quantitatively assess effectiveness
for a cash flow hedge of total price risk for a group of similar transactions.

2.10 Discontinuing hedge accounting – general

guidance
2.10.10 Overview

Excerpt from ASC 815-20

55-56 This Subtopic permits a hedging relationship to be dedesignated (that is,

discontinued) at any time. (See paragraphs 815-25-40-1(c) and 815-30-40-1(c).)
If an entity wishes to change any of the critical terms of the hedging
relationship (including the method designated for use in assessing hedge
effectiveness), as documented at inception, the mechanism provided in this
Subtopic to accomplish that change is the dedesignation of the original hedging
relationship and the designation of a new hedging relationship that
incorporates the desired changes. However, as discussed in paragraph 815-30-
35-37A, a change to the hedged risk in a cash flow hedge of a forecasted
transaction does not result in an automatic dedesignation of the hedging
relationship if the hedging instrument continues to be highly effective at
achieving offsetting cash flows associated with the hedged item attributable to
the revised hedged risk. The dedesignation of an original hedging relationship
and the designation of a new hedging relationship represents the application of
this Subtopic and is not a change in accounting principle under Topic 250, even
though the new hedging relationship may differ from the original hedging
relationship only with respect to the method designated for use in assessing
the hedge effectiveness of that hedging relationship. Although paragraph 815-
20-35-19 refers to discontinuing an existing hedging relationship and then
designating and documenting a new hedging relationship using an improved

method for assessing effectiveness, that reference was not meant to imply
that the perceived improved method had to be justified as a preferable method
of applying an accounting principle under Topic 250.

Excerpt from ASC 815-25

> Discontinuing Hedge Accounting

40-1 An entity shall discontinue prospectively the accounting specified in
paragraphs 815-25-35-1 through 35-6 for an existing hedge if any one of the
following occurs:
a. Any criterion in Section 815-20-25 is no longer met.
b. The derivative instrument expires or is sold, terminated, or exercised.
c. The entity removes the designation of the fair value hedge.

Excerpt from ASC 815-30

> Discontinuing Hedge Accounting

40-1 An entity shall discontinue prospectively the accounting specified in
paragraphs 815-30-35-3 and 815-30-35-38 through 35-41 for an existing hedge
if any one of the following occurs:
a. Any criterion in Section 815-30-25 is no longer met.
b. The derivative instrument expires or is sold, terminated, or exercised.
c. The entity removes the designation of the cash flow hedge.

Hedge accounting is elective and is permitted only for hedging relationships

that meet all of the qualifying criteria. Therefore, if any eligibility criteria cease to
be met the hedging relationship must be discontinued – i.e. hedge
dedesignation.
An entity may also be required to dedesignate the hedging relationship if it
decides to change any of the critical terms of the originally documented
hedging relationship. As a result, it is important for an entity to properly
document the hedging relationship at its inception, including documentation
around the methods for assessing effectiveness (see formal documentation
requirements in section 2.9).
The following table provides an overview of circumstances that would require
an entity to discontinue or partially dedesignate a hedging relationship:

Change in — Hedged item or transaction no longer meets the eligibility

eligibility or criteria. [815-25-40-1(a), 815-30-40-1(a)]
critical terms of — Modification of hedged item or transaction such that critical
hedged items or terms of the original hedging relationship have changed.
transactions [815-20-55-56]
(section 2.10.20)

Change in — Hedging instrument no longer meets the eligibility criteria.

eligibility or [815-25-40-1(a), 815-30-40-1(a)]
critical terms of — Hedging instrument expires or is sold, terminated or
hedging exercised. [815-25-40-1(b), 815-30-40-1(b)]
instrument — Modification of hedging instrument such that critical terms
(section 2.10.30) of the original hedging relationship have changed. [815-20-55-
56]

Change in — Change in the hedged risk, with the exception of a cash

hedged risk flow hedge of a forecasted transaction in certain
(section 2.10.40) circumstances. [815-20-55-56]

Change in hedge — Hedge is no longer highly effective on a retrospective

effectiveness and/or prospective basis, with certain exceptions (see
(section 2.10.50) Question 2.10.90). [815-25-40-1(a), 815-30-40-1(a)]
— Change in quantitative method to assess hedge
effectiveness, including whether a component of the
hedging instrument is excluded from the assessment (see
section 9.6.40). [815-20-55-56]

Elective An entity may elect to discontinue the hedging relationship.

dedesignation [815-25-40-1(c), 815-30-40-1(c)]

If an entity dedesignates a hedge, it could establish a new hedging relationship

that involves the same item, transaction, risk and/or derivative instrument if all
qualifying criteria are met for the new hedging relationship. See guidance on
redesignating hedging relationships in section 2.10.70.
See the following sections for guidance on accounting for discontinued hedges:
— Fair value hedges (section 4.5);
— Cash flow hedges (section 6.5); and
— Net investment hedges (section 8.5.40).

For guidance on partially dedesignating hedging relationships,

see section 2.10.60.

2.10.20 Change in eligibility or critical terms of hedged items

or transactions
Hedge accounting must be discontinued when the hedged item or transaction
no longer meets the qualifying criteria outlined in section 2.2.
— Fair value hedge. The hedged item must be specifically identified as either
a specific portion of a single recognized asset or liability, a firm commitment
or a portfolio of similar assets or liabilities. Therefore, any unanticipated
changes to the hedged item (or portfolio) impacting the originally
documented hedging relationship would require full dedesignation or partial
dedesignation.
— Cash flow hedge. Forecasted cash flows relating to existing or forecasted
assets or liabilities are the hedged transactions in a cash flow hedge. A

cash flow hedge should be discontinued when the forecasted transaction is

no longer probable as described in the original hedge documentation.
— Net investment hedges. Net investment hedges of foreign operations
include investments in incorporated and unincorporated foreign operations.
Therefore, changes in ownership or changes in the net investment balance
may require dedesignation.
The following table illustrates changes in the eligibility or critical terms of
hedged items or transactions that would require full dedesignation or partial
dedesignation.

Fair value hedge Cash flow hedge Net investment hedge

— Hedged item (or — Forecasted — Complete sale or
portions thereof) is transaction is no substantial
sold or extinguished. longer probable liquidation of foreign
— Adding to or deleting (Question 2.10.10 operation
from a portion of a and section 6.5.20). (section 8.5.20).
hedged item or — Existing recognized — Other events
portfolio of hedged asset or liability is leading to a loss of
items sold or control of the
(Question 2.10.20). extinguished. investment in
— Items in a hedged — Entity is no longer foreign entity
portfolio no longer exposed to (section 8.5.20).
pass the similarity test variability in cash — Partial sale of
(section 3.3.40). flows (i.e. investment in
— Hedged firm forecasted foreign operation
commitments are transaction (section 8.5.20).
modified such that becomes a firm — Changes in the net
they no longer meet commitment) investment balance
the definition of a firm (Example 6.5.30). should be monitored
commitment — Adding to or to determine
(Question 2.10.50). deleting from a whether the
— For last-of-layer portion of a hedging relationship
hedges, forecasted should be
Question 2.10.40. transaction or group redesignated to
of hedged reflect a revised
transactions balance
(Question 2.10.20). (section 8.2.20).

Future developments

At a March 2018 meeting, the FASB discussed potential Codification

improvements that may extend an entity’s ability to change the hedged risk
and/or the hedged forecasted transaction (see Question 5.4.90). This will
include clarification related to how broadly or narrowly the hedged transaction is
defined and whether a change in the hedged risk constitutes a change in the
hedged transaction. [FASB meeting 03-18]

Example 2.10.10
Discontinuance of hedging relationship when an
unrelated party is acquired
Cash flow hedges
ABC Corp. applies hedge accounting to a forecasted transaction to purchase a
nonfinancial asset from XYZ (a third party) for its exposure to price risk.
Later, ABC acquires a controlling interest in XYZ. Because XYZ is no longer a
‘party external to the reporting entity’, the forecasted transaction is not eligible
for designation as a hedged transaction (see section 5.3.50).
Furthermore, intercompany transactions are not eligible for hedge accounting
unless the hedged risk is variability due to changes in foreign currency
exchange rates (see section 2.5.50).
Therefore, ABC is required to discontinue the hedging relationship.
Fair value hedges
Similarly, ABC would be required to discontinue a hedging relationship involving
a firm commitment to purchase a nonfinancial asset from XYZ. To be eligible for
hedge accounting, a firm commitment must be between two unrelated parties
(see section 3.3.20).

Question 2.10.10
If an entity concludes that some (but not all)
forecasted transactions are no longer probable, is it
required to discontinue a cash flow hedging
relationship?
Interpretive response: Yes. We believe the entity must discontinue cash flow
hedge accounting for the specific forecasted transactions that are no longer
probable, even if the entire hedging relationship is highly effective. If the
conditions for a partial dedesignation are met (see Questions 2.10.100 and
2.10.110), the entity may choose to partially dedesignate the hedging
relationship. Otherwise, we would generally expect the entity to fully
dedesignate the hedging relationship, however there may be other acceptable
approaches based on the specific facts and circumstances.
Scenario 1 of Example 2.10.40 illustrates a partial dedesignation when an entity
concludes that some forecasted transactions in a group or series of forecasted
transactions are no longer probable. In that example, the hedging instrument is
a forward contract. We believe the same general concepts in that example
would apply when the hedging instrument is an option or an interest rate swap,
although there may be additional complexities in those situations.

Question 2.10.20
Does adding to or deleting from a portion of a
hedged item or transaction (or portfolio or group of
hedged items or transactions) require
dedesignation of the hedging relationship?
Interpretive response:
Fair value hedges
It depends. The following table summarizes when fair value hedging
relationships should be dedesignated because of additions or deletions.

Change Is dedesignation required?

Increase in Yes. We would consider an increase to the portion of a hedged
hedged item or item or the addition of new items to a portfolio of hedged items
addition to a as a change in the critical terms of the hedging relationship. This
hedged requires discontinuation of the hedging relationship.
portfolio We believe reselling (reissuing) a portion of an entity’s own debt
is not considered an addition in this context (see
Question 2.10.30).
Decrease in Yes. If there is a reduction in the balance of a hedged item or
hedged item or portfolio of hedged items, we believe this is a change to the
deletion from a critical terms of the original hedging relationship and would
hedged require full or partial dedesignation of the hedging relationship.
portfolio We believe that scheduled loan amortizations of principal,
prepayments or writeoffs are not considered deletions in this
context. In addition, we believe repurchasing a portion of an
entity’s own debt is not a deletion in this context (see
Question 2.10.30).

This response does not apply to hedges using the last-of-layer method (see
Question 2.10.40).
Cash flow hedges
It depends on the method used to specifically identify the transaction (or group
of transactions) in the original hedging relationship. The following table
summarizes when cash flow hedging relationships should be dedesignated
because of additions to or deletions from a portion of a hedged transaction or
group of transactions.

Change / hedged
transaction Is dedesignation required?
Increase in hedged transaction or addition to a group of transactions
Hedged transaction Yes. We believe that adding transactions to a specific item or
identified as relating group of items represents a change in a critical term of the
to a specific original hedging relationship, which requires dedesignation of
individual asset or the original hedging relationship.
liability (or group
thereof)
Hedged transaction It depends. We believe an entity may continue the hedging
identified as first relationship as long as it is probable that it will continue to

Change / hedged
transaction Is dedesignation required?
cash flows received receive (or pay) the specified cash flows. In other words, any
or paid up to a changes to the composition of existing assets or liabilities
specific amount in a generating the cash flows would not affect the designated
particular period hedging relationship.
(without reference This assumes the total dollar amount of the forecasted
to the specific asset transaction(s) has not changed.
or liability)
Decrease in hedged transaction or deletion from a group of transactions
Hedged transaction Yes. We believe that reducing a portion of a specific item or
identified as relating deleting from the composition of a specific group represents a
to a specific change in the probability of the identified hedged forecasted
individual asset or transactions for the hedging relationships related to the
liability (or group reduced balance of an item or the individual item(s) removed
thereof) from the group. Consequently, the hedging relationships for
the forecasted transactions that are no longer probable must
be discontinued. [815-20-55-99]
We believe that in certain circumstances an entity would have
the option of partially dedesignating a proportion of the
hedging instrument if certain criteria are met
(see section 2.10.60).
Otherwise, we would generally expect the entity to fully
dedesignate the hedging relationship, however there may be
other acceptable approaches based on the specific facts and
circumstances.
Missed forecast. If it is probable that a portion of the
forecasted transaction will not occur, we believe an entity
must immediately reclassify into earnings related amounts in
AOCI (unless the purchase will occur within an additional two-
month period or extenuating circumstances apply) and also
consider this missed forecast when evaluating whether it has
a pattern of missing forecasts that calls into question its ability
to predict future transactions. See section 6.5.20, including
Question 6.5.110.
Hedged transaction It depends. Any reductions to related assets or liabilities might
identified as first not affect the designated hedging relationship. As long as an
cash flows received entity determines it is probable that it will continue to receive
or paid up to a (or pay) the originally designated cash flows (e.g. first LIBOR-
specific amount in a based interest payments received), the original hedging
particular period relationship can continue if it remains highly effective. [815-20-
(without reference 55-95]
to the specific asset If an entity concludes it is not probable that it will receive (or
or liability) pay) some of the originally designated cash flows, the entity
must discontinue the hedging relationship for those
forecasted transactions that are no longer probable.
We believe that in certain circumstances an entity would have
the option of partially dedesignating a proportion of the
hedging instrument if certain criteria are met
(see section 2.10.60).
Otherwise, we would generally expect the entity to fully
dedesignate the hedging relationship, however there may be
other acceptable approaches based on the specific facts and
circumstances.

Change / hedged
transaction Is dedesignation required?
Missed forecast. If it is probable that a portion of the
forecasted transaction will not occur, we believe an entity
must immediately reclassify into earnings related amounts in
AOCI (unless the purchase will occur within an additional two-
month period or extenuating circumstances apply) and also
consider this missed forecast when evaluating whether it has
a pattern of missing forecasts that calls into question its ability
to predict future transactions. See section 6.5.20, including
Question 6.5.110.

The FASB has discussed updates that may extend an entity’s ability to change
the hedged risk to the hedged forecasted transaction (see Question 5.4.90). As
a result, revisions to this interpretive response may be provided in a future
edition.

Question 2.10.30
Is a fair value hedging relationship required to be
discontinued if an entity repurchases and
subsequently resells (reissues) some of its own
debt?
Background: In certain situations, an entity issues public debt and also acts as
a market-maker for that debt. As a market-maker, the entity is expected to
acquire and subsequently resell (reissue) some of the debt.
Interpretive response: It depends on whether the hedging relationship
remains highly effective. We believe the entire debt issuance may be
designated as the hedged item, rather than designating the individual debt
certificates as a portfolio of hedged items.
This is consistent with:
— paragraph 470-60-15-4 regarding troubled debt restructurings, which states
that a bond constitutes one payable even though there are many
bondholders.
— paragraph 320-10-35-20 regarding investment securities, which states that
securities of the same issuer bearing the same CUSIP number can be
aggregated and treated as a single security when assessing and measuring
impairment.
When the hedged item is designated as an individual debt issuance,
acquisitions and resales (reissues) of a portion of the debt issuance result in the
outstanding principal balance of the designated hedged item fluctuating. In this
instance, the balance of the designated hedged item is merely fluctuating and
therefore this is not considered an additional item designated as the hedged
item or portfolio in the context of Question 2.10.20 or a partial dedesignation
(see section 2.10.60). In other words, it is not considered to be a change in the
critical terms of the hedging relationship. These fluctuations will result in the
hedging relationship not being perfectly effective.

This lack of perfect effectiveness will occur even if the hedged item is
designated as a portion of the entire debt issuance (e.g. 90% of the entire
issuance). In that situation, if an entity acquires a portion of the debt issuance,
the hedged balance would be 90% of the new outstanding principal balance. In
the initial and ongoing assessments of effectiveness, the entity is required to
consider the effect of the market making activities. This may result in the entity
concluding that the relationship will not be or has not been highly effective,
which would require the hedging relationship to be fully or partially
dedesignated.

Question 2.10.40
How does a decrease in the balance of the last of
layer expected to remain outstanding at the end of
the hedge term affect a last-of-layer hedging
relationship?
Background: Topic 815 permits an entity to designate a fixed amount of a
closed portfolio of prepayable financial assets as the hedged item in a fair value
hedge of interest rate risk if the entity expects that the designated amount will
remain outstanding at the end of the hedge term – i.e. last of layer (see
section 3.3.100). [815-20-25-12(b)(2), 25-12A]
An entity is required to support its expectation that the last of layer will remain
outstanding at the end of the hedge term. In this analysis, the entity assumes
that as prepayments, defaults and other events affecting the timing and amount
of cash flows occur, they will first be applied to the portion of the closed
portfolio that is not part of the designated last of layer (see Question 3.3.320).
[815-20-25-12A]

Excerpt from ASC 815-25

>> Hedged Item Is Designated under the Last-of-Layer Method

40-8 For a hedging relationship designated under the last-of-layer method in
accordance with paragraph 815-20-25-12A, an entity shall discontinue (or
partially discontinue) hedge accounting in either of the following
circumstances:
a. If the entity cannot support on a subsequent testing date that the hedged
item (that is, the designated last of layer) is anticipated to be outstanding in
accordance with paragraph 815-25-35-7A, it shall at a minimum discontinue
hedge accounting for the portion of the hedged item no longer expected to
be outstanding at the hedged item’s assumed maturity date.
b. If on a subsequent testing date the outstanding amount of the closed
portfolio of prepayable financial assets or one or more beneficial interests
is less than the hedged item, the entity shall discontinue hedge
accounting.

Interpretive response: There are two situations in which a hedging relationship

designated using the last-of-layer method in a closed portfolio of prepayable
financial assets is discontinued, as illustrated in the following diagram.
[815-25-40-8]

Scenario 1: Scenario 2:
Partial discontinuation Full discontinuation

Amount outstanding in portfolio

Amount outstanding in portfolio
on testing date exceeds last of
on testing date is less than the
Occurs when: layer (i.e. hedged item) but last
designated last of layer (i.e.
of layer not expected to remain
hedged item)
outstanding at end of hedge term

Hedge
The portion of the last of layer
accounting is
no longer expected to remain The entire hedging relationship
discontinued
outstanding at end of hedge term
for:

By allowing partial dedesignation of a last-of-layer hedging relationship, an entity

can reduce the amount of the hedged item based on updated estimates of the
balance expected to remain outstanding at the end of the hedge term,
assuming it is not less than the current balance of the portfolio.
The FASB acknowledged that estimating the balance expected to remain at the
hedged item’s assumed maturity date resembles a cash flow hedging
concept. However, the tainting threshold for cash flow hedges in
paragraph 815-30-40-5 should not be applied to the last-of-layer method. This
means that a pattern of partially dedesignating a last-of-layer hedging
relationship would not call into question an entity’s ability to accurately predict
the balance remaining at the end of the hedge term or the propriety of using the
last-of-layer method in the future. [ASU 2017-12.BC119]
For guidance on partially and fully discontinuing hedge accounting for a last-of-
layer hedge, see section 4.5.30.

Question 2.10.50
How is hedge accounting discontinued for a hedged
item that no longer meets the definition of a firm
commitment?

Excerpt from ASC 815-25

>> Hedged Item No Longer Meets Definition of Firm Commitment

40-5 If a fair value hedge of a firm commitment is discontinued because the
hedged item no longer meets the definition of a firm commitment, the entity
shall do both of the following:

a. Derecognize any asset or liability previously recognized pursuant to

paragraph 815-25-35-1(b) (because of an adjustment to the carrying amount
for the firm commitment)
b. Recognize a corresponding loss or gain currently in earnings.
40-6 A pattern of discontinuing hedge accounting and derecognizing firm
commitments would call into question the firmness of future hedged firm
commitments and the entity's accounting for future hedges of firm
commitments.

If the hedged item in a fair value hedge is a firm commitment that later ceases
to meet the definition of a firm commitment (e.g. because the counterparty
terminated the agreement), the asset or liability previously recognized is
recognized in earnings immediately. This is because the firm commitment no
longer exists. [815-25-40-5]
Situations in which this occurs are expected to be rare. A pattern of
discontinuing hedge accounting of firm commitments because the contracts
ceased to meet the definition of a firm commitment may call into question
whether future arrangements represent firm commitments and (as a result) the
ability to apply hedge accounting for future firm commitments. [815-25-40-6]

2.10.30 Change in eligibility or critical terms of hedging

instrument
Hedge accounting must be discontinued when the hedging instrument no
longer meets the qualifying criteria outlined in section 2.6.
The following are examples of changes in the eligibility or critical terms of a
hedging instrument that would require dedesignation:
— hedging instrument expires or is sold, terminated or exercised;
— hedging instrument is no longer highly effective at offsetting changes in fair
value or cash flows of the hedged item or transaction (see section 2.10.50);
— a change in the creditworthiness of the counterparty or an entity’s own
nonperformance risk that causes the hedge to no longer be highly effective
(see section 9.2.60);
— rebalancing a combination of hedging instruments (see Question 2.10.60);
— hedging instrument is dedesignated in its entirety; and
— changes to contractual terms (e.g. strike price, maturity dates, or
embedded put or call options).
An entity may also elect to partially dedesignate a hedging relationship by
partially dedesignating the hedging instrument (see section 2.10.60).

Question 2.10.60
Is a hedging relationship required to be
discontinued if the hedging instrument is a
combination of derivatives and the combination is
rebalanced?
Background: Some entities hedge portfolios of similar assets or liabilities using
a combination of derivatives as hedging instruments. Additions or deletions (a
rebalancing) to either the portfolio of derivatives or hedged items may be
needed to achieve high effectiveness, such as in a delta-neutral dynamic
hedging strategy or a dynamic hedging relationship involving a tailing strategy
(see section 9.2.50). For guidance on designating a combination of derivatives
as the hedging instrument, see section 2.6.40.
Interpretive response: Yes. Rebalancing a portfolio of derivatives changes the
composition of the derivative hedging instruments specified in the original
hedge documentation and therefore represents a change in the hedging
relationship. As a result, an entity would be required to dedesignate the current
hedging relationship and could redesignate a new hedging relationship.
Fair value hedges. For guidance on amortization of the basis adjustment when
a portfolio of hedged items that is hedged by a combination of hedging
instruments is rebalanced, see Question 4.5.10.

Question 2.10.70
Does modification of a hedging instrument’s
collateral requirements require a hedge to be
discontinued?
Interpretive response: No. We believe that neither the modification of
collateral requirements nor the addition of a new guarantor results in the
existing derivative being viewed as terminated. This is because the substantive
terms of the derivative (e.g. strike price or maturity date) did not change. As a
result, we do not believe these changes cause discontinuation of any
associated hedging relationship.
However, the fair value of the derivative instrument may be affected by these
changes, which may affect hedge effectiveness.

Derivative novation

Excerpt from ASC 815-20

55-56A For the purposes of applying the guidance in paragraph 815-20-55-56, a

change in the counterparty to a derivative instrument that has been designated
as the hedging instrument in an existing hedging relationship would not, in and
of itself, be considered a change in a critical term of the hedging relationship.

Excerpt from ASC 815-25

> Discontinuing Hedge Accounting

40-1A For the purposes of applying the guidance in paragraph 815-25-40-1, a
change in the counterparty to a derivative instrument that has been designated
as the hedging instrument in an existing hedging relationship would not, in and
of itself, be considered a termination of the derivative instrument.

Excerpt from ASC 815-30

> Discontinuing Hedge Accounting

40-1A For the purposes of applying the guidance in paragraph 815-30-40-1, a
change in the counterparty to a derivative instrument that has been designated
as the hedging instrument in an existing hedging relationship would not, in and
of itself, be considered a termination of the derivative instrument.

Novation refers to the replacement of one party to a derivative instrument with

a new party, whereby the original party transfers all rights and obligations to the
latter party. In some situations, the derivative instrument that is the subject of
the novation might be designated as the hedging instrument in a hedging
relationship.
A novation is not considered a termination of the hedging instrument, but rather
is a change in the counterparty to a derivative instrument. Therefore, when a
novation occurs an entity is typically not required to discontinue the hedging
relationship.
However, if a derivative instrument novation involves a new counterparty with
creditworthiness different from that of the old counterparty, the entity should
consider that change in creditworthiness in determining whether the hedging
relationship continues to be highly effective and qualifies for hedge accounting.
Similarly, if a novation leads to changes in security or cash collateral posting
requirements, those changes should also be incorporated into an entity’s
assessment of hedge effectiveness.

Question 2.10.80
Why would a derivative novation occur?

Interpretive response: Derivative novation may occur for a variety of reasons

including but not limited to:
— in response to laws or regulatory requirements;

— when the derivative counterparty merges with and into a surviving entity
that assumes the same rights and obligations that existed under a
preexisting derivative instrument of the merged entities;
— when the derivative counterparty novates a derivative instrument to an
entity under common control with the derivative counterparty;
— when the derivative counterparty decides to exit a particular derivative
business or relationship; or
— for an over-the-counter (OTC) derivative entered into after applying the
mandatory clearing requirement of the Dodd-Frank Act, when the
counterparties agree in advance to clear the contract through a central
counterparty according to standard market terms and conventions.

2.10.40 Change in hedged risk

Topic 815 requires an entity to discontinue hedge accounting when the critical
terms of the original hedging relationship have changed, with the exception of
changes to hedged risk when hedging forecasted transactions. [815-20-55-56]
— Fair value hedges. If there is a change to the hedged risk in a fair value
hedge, this would be considered a change in the critical terms of the
hedging relationship and an entity is required to dedesignate the hedging
relationship.
— Cash flow hedges. If there is a change to the hedged risk in a cash flow
hedge for a forecasted transaction, an entity is not required to automatically
dedesignate the hedging relationship if the hedging relationship continues
to be highly effective. See section 5.4.60 for guidance on changing the
hedged risk when hedging forecasted transactions. [815-30-35-37A]
— Net investment hedges. A net investment hedge is a hedge of the
exposure to foreign currency risk of a net investment in a foreign operation.
If there is a change to the functional currency of the hedged net
investment, an entity is required to dedesignate the hedging relationship.
See paragraphs 4.021 to 4.033 in KPMG’s Handbook, Foreign Currency, for
additional guidance on changing the functional currency of an entity.

2.10.50 Change in hedge effectiveness

Hedge accounting must be discontinued when the hedging relationship is no
longer highly effective. The date at which hedge accounting must be
discontinued depends on whether the hedging relationship failed the
prospective effectiveness test or the retrospective effectiveness test.

Failure to
meet… Discontinuance
Prospective — Discontinue hedge accounting prospectively.
effectiveness
assessment

Failure to
meet… Discontinuance
Retrospective — Discontinue hedge accounting as of the last date on which
effectiveness effectiveness testing indicated relationship was highly
assessment effective, or date of a specific event or change in
circumstance. [815-25-40-3 – 40-4]
— Hedging relationship not eligible for partial dedesignation
(see Question 2.10.100).

For additional guidance on hedging relationships that are no longer highly

effective, see the following.
— Fair value hedges. For guidance on identifying the date hedge accounting
should be discontinued, see section 4.5.20.
— Cash flow hedges. For guidance on identifying the date hedge accounting
should be discontinued, including circumstances when a change in
creditworthiness causes a hedge to cease being highly effective, see
Questions 6.5.30 and 6.5.40.
— Net investment hedges. For guidance on discontinuing a hedging
relationship that is no longer effective as an economic hedge, see
section 8.5.40.
Changing quantitative methods for assessing effectiveness. A change in
the quantitative method for assessing effectiveness – including whether a
component of the hedging instrument is excluded from the assessment of
effectiveness – is considered a change in the hedging relationship that requires
an entity to dedesignate and redesignate the hedging relationship. For guidance
on requirements when an entity changes its quantitative method for assessing
effectiveness, see section 9.6.40.

Question 2.10.90
If a hedging relationship has not been highly
effective retrospectively, but is expected to be
prospectively, is hedge accounting required to be
discontinued prospectively?
Interpretive response: Not necessarily. Generally, if an entity determines that
a hedging relationship has not been retrospectively highly effective at the
current assessment date, it does not apply hedge accounting for the period
between the previous assessment date and the current assessment date. This
means that the change in fair value of the hedged item (for fair value hedges)
is not recognized as a basis adjustment or the change in fair value of the
hedging instrument (for cash flow hedges) is recognized in earnings (rather
than OCI) for the assessment period. The entity may discontinue the current
hedging relationship and designate the derivative in a new hedging relationship
(see section 2.10.70).
However, if the hedging relationship is expected to be prospectively highly
effective, the hedging relationship is not required to be discontinued
prospectively. We believe these circumstances should be limited. For example,

if an entity can provide sufficient evidence to support its conclusion that the
hedging relationship was not highly effective in a previous effectiveness
assessment period due to an unusual, discrete event that is not expected to
occur in future effectiveness assessment periods, we believe the hedging
relationship is not required to be discontinued prospectively.

Example 2.10.20
Hedge discontinuation because the hedging
relationship is no longer highly effective
ABC has 20,000 barrels of West Texas Grade A crude oil in its inventory. To
hedge the fair value of this oil, ABC enters into a six-month futures contract on
20,000 barrels of West Texas Grade B crude oil.
ABC has entered into a futures contract on West Texas Grade B (rather than
Grade A) crude oil because it is more economical and futures contracts on West
Texas Grade B crude oil historically have been highly effective in achieving
offsetting changes in fair value of West Texas Grade A crude oil inventory.
During the first three months of the futures contract, ABC determined that the
hedging relationship was highly effective. However, at the end of the fourth
month, ABC’s management determined that the hedging relationship is no
longer highly effective on a prospective basis; this is because of a major fire
(during the fourth month of the hedging relationship) in one of the oil wells that
produces West Texas Grade B crude oil.
ABC is required to stop applying hedge accounting as of the latest date that it
can be demonstrated that the hedging relationship was highly effective, which
would be the date of the fire. For guidance on applying hedge accounting
through the date that an event or change in circumstance resulted in the hedge
no longer being highly effective, see section 4.5.20 (fair value hedges) and
Question 6.5.30 (cash flow hedges).
However, ABC could later redesignate the futures contract in a fair value
hedging relationship with its West Texas Grade A crude oil inventory (i.e. a new
hedging relationship) if it concluded that the hedging relationship was expected
to be effective in the future and all the other hedge criteria are met.

2.10.60 Partially dedesignating a hedging relationship

Question 2.10.100
Under what conditions may an entity partially
dedesignate a hedging relationship?

Background: We believe an entity may partially dedesignate a hedging

relationship for a variety of reasons, including but not limited to:
— a decrease in the balance of a hedged item or deletion from a hedged
portfolio (see Question 2.10.20);

— a portion of the forecasted transaction or group of transactions is no longer

probable (see Questions 2.10.10 and 2.10.20); or
— the entity elects to partially dedesignate the hedging relationship.
Interpretive response: We believe an entity may partially dedesignate a
hedging relationship if all of the following conditions are met:
— The entity concurrently modifies the original hedge documentation to
reflect updated proportions of the hedging instrument and/or hedged item
or forecasted transaction. This is based on the requirement for an entity to
prepare hedge documentation concurrent with the hedge designation
(see section 2.9.40). [815-20-25-3]
— The original hedging relationship has been highly effective on a
retrospective basis. This assessment is based on the hedged item(s) or
forecasted transaction(s) as designated in the original formal hedge
documentation (as opposed to the formal hedge documentation as updated
to reflect the partial dedesignation). Changes to the hedged items or
transactions subsequent to hedge inception would be factored into the
assessment – i.e. specific forecasted transactions that are not probable
would be excluded from the effectiveness assessment for a cash
flowhedge.
— The partially dedesignated hedging instrument is expected to be
prospectively highly effective at offsetting changes in the fair value or
cash flows of the hedged item or transaction. This assessment is based on
the hedged item(s) or forecasted transaction(s) as designated in the formal
hedge documentation after it had been updated to reflect the partial
designation.
— Hedge ratio. When partially dedesignating a hedging relationship, we
believe the same hedge ratio – i.e. the ratio of the amount of the hedged
item or transaction to the notional amount of the hedging instrument – that
was included in the original hedging relationship needs to be maintained in
the partially dedesignated hedging relationship.
This response does not apply to fair value hedges using the last-of-layer
method (see Question 2.10.40).

Question 2.10.110
How does an entity partially dedesignate a hedging
instrument?
Interpretive response: If the criteria to partially designate the hedging
relationship are met (see Question 2.10.100), we believe a decrease to the
notional amount of a derivative designated as the hedging instrument can be
achieved in either of the following ways.
— Decreasing the proportion of the derivative designated as the hedging
instrument. An entity can modify the hedge documentation to reduce the
proportion of the derivative instrument designated in the hedging
relationship. The proportion of the derivative instrument no longer
designated as part of the hedging relationship is eligible to be designated in

a new hedging relationship. This is illustrated in Examples 2.10.30 (fair

value hedge) and 2.10.40 (cash flow hedge).
— Partially terminating the derivative hedging instrument. We believe the
hedging instrument can be partially terminated such that the notional of the
hedging instrument is decreased. In this situation, the originally
documented proportion of the hedging instrument continues to be the
designated proportion, although of a smaller notional amount. To partially
terminate a hedging instrument without dedesignating and redesignating
the entire hedging relationship, the only change in the terms of the hedging
instrument should relate to the reduction in the notional amount. There can
be no other changes to the critical terms of the original agreement. This is
illustrated in Example 2.10.50.

Example 2.10.30
Partial decrease of hedged item in a fair value hedge
ABC entered into an interest rate swap to hedge exposure to interest rate risk
on $60 million of $100 million outstanding debt. ABC documents the hedged
item as 60% of the principal amount of $100 million.
The original hedging relationship includes the following.
— Principal amount of debt: 60% of the outstanding debt balance (the initial
hedged item is therefore $60 million)
— Swap notional amount: 100% of the interest rate swap notional amount
Because both amounts are initially $60 million, the initial hedge ratio is 1:1.
Scenario 1: Partial repayment of principal and partial dedesignation
ABC subsequently repays $10 million principal of the outstanding debt (i.e.
10%). This is not a scheduled principal payment. Since the hedged item is 60%
of the outstanding debt balance, and the outstanding debt has been reduced to
$90 million, the hedged item is reduced to $54 million.
ABC wishes to partially dedesignate 10% (or $6 million) of the notional amount
of the interest rate swap to align it with the remaining amount of the hedged
item.
ABC performs retrospective and prospective hedge effectiveness assessments.

Retrospective – 100% of the interest rate swap ($60 million notional) is

original hedging determined to be highly effective retrospectively at hedging
relationship exposure to interest rate risk on the remaining amount of the
hedged item ($90 million principal outstanding × 60% =
$54 million principal).
Prospective – 90% of the interest rate swap ($60 million notional × 90% =
original hedging $54 million notional) is determined to be highly effective
relationship prospectively at hedging exposure to interest rate risk on the
remaining amount of the hedged item ($90 million principal
outstanding × 60% = $54 million principal).

In addition, the hedge ratio of the partially dedesignated hedging relationship

remains 1:1 – i.e. $54 million remaining amount of hedged item to $54 million
notional amount of the hedging instrument.
Therefore, ABC may partially dedesignate the hedging relationship.
ABC elects to partially dedesignate 10% (or $6 million) of the notional amount
of the interest rate swap. Concurrently, ABC modifies the hedge documentation
to reflect the reduced amounts of the hedged item and hedging instrument.

Updated hedging Accounting considerations

relationship
60% designated Subsequent changes in the fair value of the proportion of the
portion of swap no longer designated as part of the hedging relationship
outstanding portion (i.e. $6 million notional) are recognized in earnings. This
of debt balance: proportion of the hedging instrument is eligible to be
$54 million1 principal designated in a new hedging relationship. [815-25-40-2]
90% designated The cumulative basis adjustment recognized at the date of
proportion of swap: prepayment is part of the amortized cost basis used to
$54 million2 notional determine the gain or loss related to the prepayment.
For additional guidance on partially discontinuing fair value
hedge accounting, see Question 4.5.20.
Notes:
$90 million principal outstanding × 60% = $54 million principal.
$60 million total notional of the swap × 90% = $54 million notional.

Alternatively, ABC could partially dedesignate the hedging relationship by

terminating a proportion of the interest rate swap (see Example 2.10.50).
Scenario 2: Partial repayment of principal and full dedesignation
ABC subsequently repurchases $25 million on its outstanding debt (i.e. 25%).
This is not a scheduled principal payment.
ABC wishes to partially dedesignate 25% (or $15 million) of the notional amount
of the interest rate swap to align it with the remaining amount of the hedged
item.
ABC performs a retrospective effectiveness assessment.

Retrospective – 100% of the interest rate swap ($60 million notional) is

original hedging determined to be not highly effective retrospectively at
relationship hedging exposure to interest rate risk on the remaining
amount of the hedged item ($75 million principal outstanding
× 60% = $45 million principal).

Because the original hedging relationship is not highly effective retrospectively,

ABC cannot partially dedesignate the hedging relationship. Instead, ABC must
fully dedesignate the hedging relationship.

Example 2.10.40
Partial reduction of items in a group of hedged
forecasted transactions (cash flow hedge)
ABC Corp. is a car manufacturer. On January 1, Year 1, ABC forecasts it will
purchase 100,000 tons of steel on December 31, Year 1. ABC’s contracts to
purchase steel are typically at a price based on the NYSE American Steel Index.
ABC enters into a forward derivative contract indexed to the NYSE American
Steel Index to purchase 100,000 tons of steel that will mature on December 31,
Year 1.
ABC documents as the hedged risk the variability in cash flows attributable to
changes in the contractually specified NYSE American Steel Index in the not-
yet-existing purchase contract. Assume all criteria are met to qualify for hedge
accounting.
The hedge ratio is 1:1 – i.e. forecasted purchase of 100,000 tons to a hedging
instrument with a notional of 100,000 tons.
Scenario 1: It is probable that 10% of the original forecasted transaction
will not occur
On July 1, Year 1, ABC determines it is probable that the purchase of 10,000
tons of steel will not occur. ABC concludes it is probable that it will continue to
purchase 90,000 tons of steel on December 31, Year 1.
ABC wishes to partially dedesignate 10% (or 10,000 tons) of the notional
amount of the forward contract to align it with the amount of steel purchases
that remain probable (i.e. 90,000 tons).
ABC performs retrospective and prospective hedge effectiveness assessments.

Retrospective – 100% of the forward contract (100,000 tons notional) is

original hedging determined to be highly effective retrospectively at hedging
relationship exposure to the contractually specified NYSE American Steel
Index on the remaining amount of the hedged forecasted
transaction (90,000 tons).
Prospective – 90% of the forward contract (100,000 tons notional × 90% =
original hedging 90,000 tons) is highly effective prospectively at hedging
relationship exposure to the contractually specified NYSE American Steel
Index on the remaining amount of the hedged forecasted
transaction (90,000 tons).

In addition, the hedge ratio of the partially dedesignated hedging relationship

remains 1:1 – i.e. forecasted purchase of 90,000 tons to a hedging instrument
with a notional of 90,000 tons.
Therefore, ABC may partially dedesignate the hedging relationship.
ABC partially dedesignates 10,000 tons of the notional amount of the forward
contract. Concurrently, ABC modifies the hedge documentation to reflect the
reduced amounts of the hedged transaction and hedging instrument.

Updated hedging Accounting considerations

relationship
Forecasted Subsequent changes in the fair value of the proportion of the
transaction: 90,000 forward contract no longer designated as part of the hedging
tons of steel relationship (i.e. 10,000 tons of notional) are recognized in
earnings, rather than AOCI. This proportion of the hedging
90% designated
instrument is eligible to be designated in a new hedging
proportion of
relationship.
forward contract:
90,000 tons of steel1 Amounts in AOCI at the date of partial dedesignation are
allocated between the forecasted transactions that remain in
the hedging relationship and those that were dedesignated.
Because it is probable that the purchase of 10,000 tons will
not occur, the amount of AOCI allocated to the purchase of
10,000 tons is immediately reclassified into earnings unless
the purchase will occur within an additional two-month period
or extenuating circumstances apply.
For additional guidance on partially discontinuing cash flow
hedge accounting, see Question 6.5.20.
Note:
Total notional amount of forward contract (i.e. 100,000 tons of steel) × 90% = 90,000
tons of steel.

Because it is probable that a portion of the originally forecasted transactions will

not occur, ABC is required to consider this as a missed forecast when
evaluating whether it has a pattern of missing forecasts that calls into question
its ability to predict future transactions (see Question 6.5.110).
Scenario 2: Probable 25% of the forecasted transaction will not occur and
full dedesignation
On July 1, Year 1, ABC determines it is probable that the purchase of
25,000 tons of steel will not occur. ABC concludes it is probable that it will
continue to purchase 75,000 tons of steel on December 31, Year 1.
ABC wishes to partially dedesignate 25% (or 25,000 tons) of the notional
amount of the forward contract to align it with the amount of steel purchases
that remain probable (i.e. 75,000 tons).
ABC performs a retrospective hedge effectiveness assessment.

Retrospective – 100% of the forward contract (100,000 tons notional) is not

original hedging highly effective retrospectively at hedging exposure to the
relationship contractually specified NYSE American Steel Index on the
remaining amount of the hedged forecasted transaction
(75,000 tons).

Because the original hedging relationship is not highly effective retrospectively,

ABC cannot partially dedesignate the hedging relationship. Instead, ABC must
fully dedesignate the hedging relationship.
Because it is probable that the purchase of 25,000 tons of steel will not occur,
ABC is required to immediately reclassify related amounts from AOCI into
earnings unless the purchase will occur within an additional two-month period
or extenuating circumstances apply (see section 6.5.20). Additionally, ABC is
required to consider this as a missed forecast when evaluating whether it has a

pattern of missing forecasts that calls into question its ability to predict future
transactions (see Question 6.5.110).

Example 2.10.50
Partial termination of a hedging instrument
Assume the same facts and circumstances as in Example 2.10.30 (Scenario 1:
Partial repayment of principal and partial dedesignation), except that ABC
partially terminates the interest rate swap.
After paying down $10 million on its outstanding debt balance (originally
$60 million principal), ABC negotiates with the counterparty of the interest rate
swap to reduce the notional amount from $60 million to $54 million. ABC
settles the fair value of the interest rate swap related to the $6 million reduced
notional with the counterparty. The swap agreement is amended to reflect the
reduced notional amount of $54 million. No other critical terms or conditions are
changed.
The hedge ratio of the partially dedesignated hedging relationship remains 1:1 –
i.e. $54 million hedged item to $54 million hedging instrument. Hedge
accounting continues to be applied to the reduced notional amount of the
interest rate swap. Concurrently, ABC modifies the hedge documentation to
reflect the reduced amounts of the hedged transaction and hedging instrument.

2.10.70 Redesignating a hedging relationship

Excerpt from ASC 815-20

>> Hedged Transaction Criteria Applicable to Cash Flow Hedges Only

25-15A This Topic places no limitations on an entity's ability to prospectively
designate, dedesignate, and redesignate a qualifying hedge of the same
forecasted transaction.

Excerpt from ASC 815-25

> Discontinuing Hedge Accounting

40-2 In the circumstances discussed in paragraph 815-25-40-1, the entity may
elect to designate prospectively a new hedging relationship with a different
hedging instrument or, in the circumstances described in (a) and (c) in
paragraph 815-25-40-1, a different hedged item or a hedged transaction if the
hedging relationship meets the criteria specified in Section 815-20-25 for a fair
value hedge or a cash flow hedge.

Excerpt from ASC 815-30

> Discontinuing Hedge Accounting

40-3 Furthermore, the entity may elect to designate prospectively a new
hedging relationship with a different hedging instrument or, in the
circumstances described in paragraph 815-30-40-1(a) and 815-30-40-1(c), a
different hedged transaction or a hedged item if the hedging relationship
meets the applicable criteria for a cash flow hedge or a fair value hedge.

An entity may redesignate a new hedging relationship that involves either: [815-
25-40-2, 815-30-40-3]

— the same hedged item or transaction and a different (or modified) hedging
instrument;
— the same hedging instrument with a different (or modified) hedged item or
transaction; or
— the same hedged item or transaction and the same hedging instrument.
The redesignated hedging relationship must meet all of the qualifying criteria
and be formally documented.
The dedesignation and redesignation of a new hedging relationship is not a
change in accounting principle under Topic 250 (accounting changes and errors).
Hedge accounting is applied prospectively at inception of the redesignated
hedging relationship. [815-20-55-56, 815-25-40-2, 815-30-40-3]
Net investment hedges. Entities are required to periodically assess whether a
net investment hedge needs to be dedesignated and redesignated based on
changes in the net investment balance. For further discussion, see
section 8.2.20.

Question 2.10.120
What should an entity consider when redesignating
an existing derivative instrument?
Background: If an entity redesignates an existing derivative instrument in a
new hedging relationship, the derivative will typically have a fair value other
than zero because of changes in market conditions since inception of the
hedging instrument. In other words, the derivative will be off-market at
redesignation.
Interpretive response: These off-market terms should be considered when
determining whether the new relationship is expected to be highly effective and
can qualify for hedge accounting.
There are additional considerations for the following.
— Cash flow hedges involving derivative hedging instruments with multiple
cash flows or periodic cash settlements (e.g. interest rate swaps). For
these hedging relationships, amounts in AOCI that are related to the initial
fair value are required to be reclassified into earnings on a systematic and

rational basis over the periods during which the hedged forecasted
transactions affect earnings (see section 6.3.20). [815-30-35-41A]
— Net investment hedges. When an entity changes from the forward to the
spot method for assessing effectiveness of a net investment hedge, a non-
zero fair value of the derivative instrument creates some complexity when
determining the value of the excluded component at the time of
redesignation. In a February 2018 FASB meeting, the Board discussed
methodologies for amortizing the excluded component, including the off-
market element of a derivative instrument that could occur at the time of
redesignation. For further discussion, see Question 8.4.100.

Question 2.10.130
Is there a limit on the frequency of dedesignating
and redesignating a hedging relationship?
Interpretive response: No. Topic 815 does not limit the frequency of
dedesignating and redesignating hedging relationships. There are hedging
strategies that require frequent dedesignation and redesignation – i.e. dynamic
hedging strategies (see Question 2.10.60 and section 9.2.50).
However, a pattern of dedesignating hedging relationships in certain
circumstances may limit an entity’s ability to designate similar hedging
relationships in the future:
— Cash flow hedges. A pattern of dedesignating hedging relationships when
it is probable that a forecasted transaction will not occur calls into question
an entity’s ability to accurately predict forecasted transactions and use
hedge accounting in the future for similar forecasted transactions. See
Question 6.5.110 regarding factors that are considered when evaluating
whether missed forecasts represent a pattern. [815-30-40-5]
— Fair value hedges. A pattern of dedesignating hedging relationships
because a contract no longer meets the definition of a firm commitment
calls into question whether contracts entered into in the future are firm
commitments that are eligible for hedge accounting (see Question 2.10.50).
[815-25-40-6]

3. Qualifying criteria for fair

value hedges
Detailed contents
3.1 How the standard works
3.2 Objective of a fair value hedge
3.3 Eligibility of hedged items
3.3.10 Basic requirements
3.3.20 Firm commitments: Definition and identification
3.3.30 Firm commitments: Limitation on contracts that meet the
definition of a derivative
3.3.40 Portfolio of similar assets or liabilities
3.3.50 Hedging portfolios: Assessing similar risks for a portfolio of
loans
3.3.60 Portion (or percentage) of a hedged item
3.3.70 Hedging portions of financial items: Benchmark interest
rate component
3.3.80 Hedging portions of prepayable financial instruments:
Partial-term hedges of interest rate risk
3.3.90 Hedging portions of items: Embedded put or call options
3.3.100 Last-of-layer method
Questions
3.3.10 Can unrecognized assets or liabilities ever be hedged items
in a fair value hedge?
3.3.20 When hedging an unrecognized firm commitment, is the
risk related to changes in forward or spot prices?
3.3.30 Do loan commitments or interest rate locks meet the
definition of a firm commitment?
3.3.40 Can a price that varies with the market price of a fixed
quantity of an item qualify as a fixed price?
3.3.50 Can a price specified in a foreign currency be a fixed price?
3.3.60 Is there a requirement for the economic disincentive to be
explicitly stated in a contract?
3.3.70 Can the disincentive for nonperformance be in the form of
opportunity cost?
3.3.80 Can the disincentive for nonperformance be in the form of
a potential writeoff?

3.3.90 Can a firm commitment that is accounted for as a derivative

ever qualify as a hedging instrument?
3.3.100 Are there acceptable ranges when evaluating shared risk
exposure?
3.3.110 How often should the evaluation of the similarity of items
hedged in a portfolio be performed?
3.3.120 Are periodic similarity tests required to be performed on a
quantitative basis?
3.3.130 Should the similarity assessment for servicing rights use
the same risk characteristics as those used in the
impairment assessment under Topic 860?
3.3.140 Can a first cash flows received (paid) approach be used in a
fair value hedge?
3.3.150 Which key characteristics of a loan are considered when
evaluating whether individual loans share similar risk
exposure?
3.3.160 Can an entity designate a portion or percentage of a
nonfinancial item as the hedged item?
3.3.170 Which benchmark interest rate may be used for
measurement purposes when hedging only the benchmark
rate component?
3.3.180 May an entity separately designate the fixed rate subject to
inflation adjustments as a benchmark rate component?
3.3.190 Why would an entity designate only the benchmark rate
component?
3.3.200 If an entity uses the benchmark rate component to
measure the change in fair value of a hedged item, must it
do so for all similar hedging relationships?
3.3.210 When will a partial-term hedge improve effectiveness?
3.3.220 Can an entity designate a partial-term hedge using an
assumed term that ends on or before the initial date a
financial instrument can be prepaid?
3.3.230 Can the partial-term hedge guidance and the guidance for
hedging only the benchmark rate component be applied to
the same hedging relationship?
3.3.240 Must specific conditions be met to apply partial-term
hedging in a fair value hedge of interest rate risk?
3.3.250 Can an entity apply hedge accounting to more than one
partial term of a single instrument?
3.3.260 When multiple partial terms are hedged in separate
hedging relationships, do the terms need to be
consecutive?
3.3.270 Can an entity hedge multiple risks when applying partial-
term hedging guidance?

3.3.280 Is an entity permitted to hedge the risk of changes in the

fair value of an embedded call option in an HTM security
that is prepayable?
3.3.290 Can an entity hedge the fair value exposure of options
embedded in contracts that qualify as firm commitments?
3.3.300 What is a ‘closed portfolio’?
3.3.310 What conditions must be met for a last-of-layer hedge to
pass the similarity test qualitatively?
3.3.320 What is needed to support the entity’s expectation that the
last of layer will remain outstanding at the end of the hedge
term?
3.3.330 Must an entity assert it is ‘probable’ that the balance of the
last of layer will remain outstanding at the end of the hedge
term?
3.3.340 What financial instruments can be included in the portfolio
under the last-of-layer method?
3.3.350 Can the last-of-layer method be applied to a portfolio of
financial liabilities?
3.3.360 Can an entity hedge multiple layers under the last-of-layer
method?
Examples
3.3.10 Letter of intent to purchase steel
3.3.20 Contract based on fair value at future date
3.3.30 Contract with fixed price specified in a currency other than
the entity’s functional currency
3.3.40 Payments made pursuant to royalty agreements
3.3.50 Firm commitment to purchase silver with a forward
contract
3.3.60 Specific portion of a foreign currency denominated firm
commitment
3.3.70 Designating a fair value hedge of interest rate risk using the
partial-term approach
3.3.80 Hedging interest rate risk and foreign currency risk in a
partial-term hedge
3.4 Eligibility of hedged risks
3.4.10 Interest rate risk hedges of prepayable financial
instruments
3.4.20 Limitations on price risk for nonfinancial items
Questions
3.4.10 Why would an entity elect to consider only the effect of
changes in the benchmark interest rate on the decision to
prepay the financial instrument?

3.4.20 Is an entity required to consider only how changes in the

benchmark interest rate affect the decision to prepay?
3.4.30 What instruments are considered prepayable under
paragraph 815-20-25-6B?
3.4.40 How does paragraph 815-20-25-6B apply to nonconvertible
debt with an embedded contingent call or put option?
3.4.50 Does paragraph 815-20-25-6B apply to interest rate risk
hedges related to debt conversion options?
3.4.60 Does the election to consider only how changes in the
benchmark interest rate affect the decision to prepay a
debt instrument have to be applied to all prepayable
hedged items?
Examples
3.4.10 Applying paragraph 815-20-25-6B to a callable bond
3.4.20 Applying paragraph 815-20-25-6B to a nonconvertible bond
with an embedded contingent put
3.4.30 Fair value hedge of gold watch inventory with a gold
futures contract
3.5 Hedging instruments in fair value hedges
3.5.10 Overview

3.1 How the standard works

The objective of a fair value hedge is to reduce or eliminate the exposure to a
change in fair value that is associated with an item due to its fixed price or rate.
Topic 815 requires that certain criteria be met for a hedging relationship to
qualify for fair value hedge accounting.

Criterion 1 Criterion 2 Criterion 3 Criterion 4

Eligibility of Eligibility of
Eligibility of Hedge
hedged items hedging
hedged risk(s) effectiveness
or transactions instruments

Criterion 5: Formal documentation

Topic 815 specifies certain items that are eligible for designation as a hedged
item in a fair value hedge.

Criterion 1: Items eligible for fair value hedges (section 3.3)

Individual recognized assets and

Firm commitments
liabilities
(section 3.3.20)
(section 3.3.10)

Portfolio of similar assets and liabilities

(section 3.3.40)

Portion (or percentage) of hedged item

(section 3.3.60)

Hedging only Partial-term

benchmark hedge of Embedded put Last-of-layer Residual
interest rate interest or call options method value in a
component rate risk (section 3.3.90) (section 3.3.100) lease1
(section 3.3.70) (section 3.3.80)

Note:
1. Paragraph 815-20-25-12(b)(2)(iv).

Additionally, the risk(s) associated with the hedged item needs to qualify for
hedge accounting. The risks eligible to be designated in a fair value hedge are
different for financial and nonfinancial items.

Criterion 2: Risks eligible for fair value hedges

Financial items Nonfinancial items

(section 2.3) (section 2.4)

Interest  Changes in the Not applicable.

rate risk benchmark interest rate
for recognized fixed-
rate financial
instruments.

Credit Includes: Not applicable.

risk — changes in the obligor’s
creditworthiness; and
— changes in the credit
spread over the
benchmark interest
rate.

Foreign — Changes in the related — Changes in the related

currency foreign currency foreign currency
risk exchange rates. exchange rates if the firm
commitment is
denominated in a foreign
currency.

Price risk — Total change in the fair — Total change in the fair
value. value.

Section 3.4 provides detail around the eligibility criteria for hedged risks that are
specific to fair value hedges, including:
— interest rate risk on prepayable financial instruments; and
— limitations on price risk for nonfinancial items.

Foreign currency risk. For further guidance on hedging foreign currency

risk, see chapter 7.

Criterion 3: Hedging instruments eligible for fair value hedges

General criteria for all General limitations on all hedging

hedging instruments (section 2.6) instruments (section 2.7)

Chapter 2 discusses the general criteria and limitations on hedging instruments

for all hedges. There are no additional eligibility criteria or limitations specific to
fair value hedges, other than fair value hedges involving foreign currency risk
(see section 7.6.20).

Criterion 4: Hedge effectiveness (chapter 9)

A derivative hedging instrument can qualify as a hedging instrument only if the

entity expects the changes in fair value of the instrument to be – and the

changes in fair value of the instrument actually are – effective at offsetting

changes in fair value of the hedged item.

Criterion 5: Formal documentation for fair value hedges

Formal documentation requirements Formal documentation requirements

for all hedges specific to fair value hedges
(section 2.9) (section 2.9.50)

3.2 Objective of a fair value hedge

Fair value hedges are structured to reduce or eliminate the exposure resulting
from a hedged item’s fixed price or rate. Common examples of transactions
that create such exposure are:
— lending money at fixed-rates;
— purchasing fixed-rate debt securities;
— issuing fixed-rate debt obligations; and
— making certain fixed-price commitments to purchase or sell assets and
incur liabilities.
Such transactions expose an entity to changes in the fair value of the item. For
example, when an entity holds a fixed-rate security, the entity bears the risk of
a change in the market price of the security through the date on which it
matures or is sold.
The following table includes common examples of fair value exposures and
hedging strategies.

Hedged item Fair value exposure Hedging strategy

Recognized assets and liabilities
Fixed-rate Interest rate risk Convert the interest received to variable by
assets entering into an interest rate swap. Terms
of the swap call for receipt of interest at a
variable rate and payment of interest at a
fixed rate.
Price risk Lock in a minimum value by purchasing a
put option to sell the asset at a specified
price.
Fixed-rate Interest rate risk Convert the interest paid to variable by
liabilities entering into an interest rate swap. Terms
of the swap call for receipt of interest at a
fixed rate and payment of interest at a
variable rate.
Price risk Lock in a maximum value by purchasing an
interest rate floor option.
Firm commitments
Commitment Changes in fair value Participate in changes in market interest
to issue a due to changes in rates from the commitment date through
fixed-rate market interest rates the date of issuance by entering into an
debt to date of issuance interest rate futures contract to purchase
obligation US Treasury securities.
Commitment Changes in fair value Participate in changes in the fair value of
to purchase due to changes in the inventory to date of purchase by
inventory market prices to date entering into a forward contract to sell
of purchase inventory.
Commitment Changes in fair value Participate in changes in the fair value of
to sell due to changes in the inventory to date of sale by entering
inventory market prices to date into a forward contract to purchase
of sale inventory.

3.3 Eligibility of hedged items

Criterion 1 Criterion 2 Criterion 3 Criterion 4

Eligibility of Eligibility of
Eligibility of Hedge
hedged items hedging
hedged risk(s) effectiveness
or transactions instruments

Criterion 5: Formal documentation

Section 3.3 discusses the criteria that must be met for items to be eligible for
fair value hedge accounting. Topic 815 also prohibits certain items from hedge
accounting, which are discussed in section 2.5.

Foreign currency risk. For guidance on the eligibility of hedged items in a

fair value hedge of foreign currency risk, see section 7.4.10.

3.3.10 Basic requirements

Excerpt from ASC 815-20

>> Hedged Item Criteria Applicable to Fair Value Hedges Only

25-11 An entity may designate a derivative instrument as hedging the
exposure to changes in the fair value of an asset or a liability or an identified
portion thereof (hedged item) that is attributable to a particular risk if all
applicable criteria in this Section are met.
25-12 An asset or a liability is eligible for designation as a hedged item in a fair
value hedge if all of the following additional criteria are met:
a. The hedged item is specifically identified as either all or a specific portion
of a recognized asset or liability or of an unrecognized firm commitment.

Only recognized assets or liabilities, or unrecognized firm commitments, are

eligible to be designated as the hedged item in a fair value hedge. [815-20-25-12]

Question 3.3.10
Can unrecognized assets or liabilities ever be
hedged items in a fair value hedge?
Interpretive response: Yes, but only if they embody a firm commitment. The
FASB decided that an unrecognized asset or liability that does not embody a
firm commitment should not be eligible for designation as a hedged item. This
is because fair value hedge accounting for an unrecognized asset or liability (e.g.
an internally developed core deposit intangible) would result in recognizing a
portion of it. [FAS 133.BC437]

For example, a contingent liability should only be recorded if the contingency is

probable and the amount of the liability can be reasonably estimated under
Topic 450 (contingencies). It should not be recognized earlier through the
application of hedge accounting.
However, an entity is permitted to designate unrecognized firm commitments,
including one that is embodied in an unrecognized asset or liability (e.g.
mortgage servicing rights), as the hedged item in a fair value hedge. [815-20-55-11]

Question 3.3.20
When hedging an unrecognized firm commitment,
is the risk related to changes in forward or spot
prices?
Interpretive response: Either. A firm commitment is subject to exposures that
are similar to those of an existing asset or liability because they embody certain
rights to benefits or obligations to make sacrifices. When the hedged item is an
unrecognized firm commitment, entities are required to estimate its fair value.
In doing so, entities may base their estimate of fair value on forward prices
(because a firm commitment relates to rights or obligations that will be realized
in the future) or on spot prices.
Therefore, when hedging changes in the fair value of a firm commitment
attributable to changes in prices (i.e. price risk or foreign currency risk), entities
may designate the risk being hedged as either changes in forward prices or
changes in spot prices.

3.3.20 Firm commitments: Definition and identification

Excerpt from ASC 815-20

20 Glossary
Firm Commitment – An agreement with an unrelated party, binding on both
parties and usually legally enforceable, with the following characteristics:
a. The agreement specifies all significant terms, including the quantity to be
exchanged, the fixed price, and the timing of the transaction. The fixed
price may be expressed as a specified amount of an entity’s functional
currency or of a foreign currency. It may also be expressed as a specified
interest rate or specified effective yield. The binding provisions of an
agreement are regarded to include those legal rights and obligations
codified in the laws to which such an agreement is subject. A price that
varies with the market price of the item that is the subject of the firm
commitment cannot qualify as a fixed price. For example, a price that is
specified in terms of ounces of gold would not be a fixed price if the
market price of the item to be purchased or sold under the firm
commitment varied with the price of gold.

b. The agreement includes a disincentive for nonperformance that is

sufficiently large to make performance probable. In the legal jurisdiction
that governs the agreement, the existence of statutory rights to pursue
remedies for default equivalent to the damages suffered by the
nondefaulting party, in and of itself, represents a sufficiently large
disincentive for nonperformance to make performance probable for
purposes of applying the definition of a firm commitment.
>>>> Application of the Definition of a Firm Commitment
55-10 This implementation guidance discusses whether certain items meet the
definition of a firm commitment for purposes of paragraph 815-20-25-12.
55-11 A firm commitment that represents an asset or liability that a specific
accounting standard prohibits recognizing (such as a lessor’s noncancellable
operating lease or an unrecognized mortgage servicing right) may nevertheless
be designated as the hedged item in a fair value hedge.
55-12 A mortgage banker’s unrecognized interest rate lock commitment does
not qualify as a firm commitment (because as an option it does not obligate
both parties) and thus is not eligible for fair value hedge accounting as the
hedged item. (However, a mortgage banker’s forward sale commitments,
which are derivative instruments that lock in the prices at which the
mortgage loans will be sold to investors, may qualify as hedging instruments in
cash flow hedges of the forecasted sales of mortgage loans.)

The hedged item in a fair value hedging relationship can be an unrecognized

firm commitment. Topic 815 defines a firm commitment by specifying certain
characteristics that must be present, which are summarized below. [815-20
Glossary]

Does the agreement meet the definition of a firm commitment?

(all characteristics must be included)

Agreement is between two unrelated parties

Agreement is binding or (legally) enforceable on both parties

Agreement contains all of the following characteristics:

Contract specifies all Fixed price must be a Includes a disincentive for

significant terms (e.g. specified amount or nonperformance that is
quantity, fixed price and specified interest rate (or sufficiently large to make
timing) effective yield) performance probable

Examples of firm commitments that could be eligible for designation as hedged

items include:
— an agreement to purchase a specified quantity of assets at a specified price
and date;
— an agreement to purchase a particular machine in one year at a specified
price; and
— a royalty agreement that provides for fixed periodic payments at specific
time intervals; if no minimum amount is specified, the agreement would
not meet the definition of a firm commitment because the quantity to be
exchanged would be unknown.

Agreement is between two unrelated parties

A firm commitment must be between two unrelated parties. As a result,
transactions with parties such as equity method investees, affiliates,
unconsolidated joint ventures, consolidated entities, shareholders and directors
are excluded from being firm commitments.

Agreement is binding or (legally) enforceable on both parties

To meet the definition of a firm commitment, the agreement must be binding
on both parties.
The FASB noted that an agreement that is binding on one party but not the
other is an option rather than a firm commitment. They believe the fundamental
nature of a financial instrument should not be ignored. [FAS 133.BC441]
Firm commitments that meet the definition of a derivative (e.g. options) are not
eligible to be designated in a fair value hedge. See discussion of this limitation
in section 3.3.30.

Example 3.3.10
Letter of intent to purchase steel
ABC Corp. is a manufacturing entity. A major component of ABC’s
manufacturing (steel) is purchased from Metal Inc., an unrelated supplier. Steel
is readily available from a number of suppliers and there is little cost associated
with switching suppliers.
To ensure availability of steel, ABC has signed a letter of intent with Metal that
specifies the likely requirements. The letter of intent is not legally binding and
includes a fixed price. ABC is not required to pay a penalty if the letter of intent
is cancelled.
Does the letter of intent with Metal meet the definition of a firm
commitment?
No. The definition of a firm commitment requires a legally binding agreement.
Among other things, this agreement also lacks a sufficiently large economic
disincentive restricting ABC from changing suppliers. ABC is not required to pay

a penalty for cancelling the contract, steel is readily available from other
suppliers and there is little cost to ABC for switching suppliers.

Question 3.3.30
Do loan commitments or interest rate locks meet
the definition of a firm commitment?
Background: Loan commitments and interest rate lock commitments are
legally binding commitments to extend credit to a counterparty under certain
pre-specified terms and conditions, with the interest rate and the maximum
loan amounts set before funding. [815-10 Glossary]
Interpretive response: Neither a commitment to originate a loan nor an
interest rate lock commitment obligate the potential borrower. Therefore, they
do not meet the definition of a firm commitment and cannot be the hedged
item in a fair value hedge. [815-20-55-12]

Characteristics of significant terms (including fixed price and

disincentive for nonperformance)
The significant terms an agreement needs to specify include:
— the quantity to be exchanged;
— the fixed price; and
— the timing of the transaction.
The definition of a firm commitment requires that the fixed price be specified in
terms of a currency (or an interest rate) rather than an index, or in terms of the
price or a number of units of an asset other than a currency (e.g. ounces of gold).
In addition, the agreement 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 requires
judgment based on the facts and circumstances of each contract.

Question 3.3.40
Can a price that varies with the market price of a
fixed quantity of an item qualify as a fixed price?
Interpretive response: No. The definition of a firm commitment explicitly
states that a price that varies with the market price of an item that is the
subject of the firm commitment cannot qualify as a fixed price.
For example, an agreement to purchase a gold ring in one year would not be a
firm commitment if payment were based on a fixed quantity of gold. This is
because the price of gold is not fixed. The price of the fixed quantity of gold
varies with the market price of the gold.
However, a contract with a price that varies with the market price of an item
may qualify as a hedged item in a cash flow hedge of a forecasted transaction.

Example 3.3.20
Contract based on fair value at future date
ABC Corp. enters into a contract to sell in one month 100,000 bushels of wheat
to XYZ at the then fair value. If ABC cancels this contract, it will be required to
pay a $50,000 penalty to XYZ.
Does the contract meet the definition of a firm commitment?
No. Because this contract provides for the sale of wheat to XYZ at fair value as
opposed to a fixed price, it does not qualify as a firm commitment.

Question 3.3.50
Can a price specified in a foreign currency be a fixed
price?
Interpretive response: Yes. A fixed price may be expressed as a specific
amount of an entity’s functional currency or of a foreign currency.
The price of a foreign currency denominated firm commitment is not fixed in
terms of the entity’s functional currency. However, Topic 815 explicitly allows
foreign currency denominated firm commitments to be designated in fair value
hedges of foreign currency risk (see section 7.4.50).
A firm commitment in a currency other than the entity’s functional currency also
exposes the entity to variability in cash flows due to changes in foreign currency
exchange rates. Therefore, such commitments are also eligible to be
designated in cash flow hedges of foreign currency risk (see section 7.6.40).

Example 3.3.30
Contract with fixed price specified in a currency
other than the entity’s functional currency
ABC Corp. is a manufacturing entity with a functional currency of the US Dollar.
A major component in its manufacturing process (CPUs) comes from Asia
Corp., an unrelated Japanese supplier. No other supplier has a product that
meets ABC’s specifications.
To ensure CPU availability, ABC enters into a contract with Asia to purchase a
minimum of 1,000 CPUs each month for the next 12 months. The cost of each
CPU is 10,000 yen. There are significant penalties if the contract is broken.
Does the contract meet the definition of a firm commitment?
Yes. The definition of a firm commitment requires a fixed price and quantity,
that the timing of the transaction be known, and that the agreement include a
sufficiently large disincentive for nonperformance to make performance
probable. ABC’s commitment has all of these features.
The fixed price may be expressed as a specific amount of an entity’s functional
currency or of a foreign currency (see Question 3.3.50). The fixed price has
been specified in yen, a currency other than ABC’s functional currency.

Therefore, this foreign currency denominated firm commitment is eligible for

designation in a fair value foreign currency hedge if all other criteria are met
(see sections 7.3 and 7.4).
Example 3.3.60 continues this example, illustrating the designation of a specific
portion of a foreign currency denominated firm commitment as the hedged
item.
Cash flow hedges. Because this foreign currency denominated firm
commitment also exposes ABC to variability in cash flows due to changes in
currency rates, it is also eligible to be a hedged transaction in a cash flow hedge
of foreign currency risk (see sections 7.3 and 7.6).

Example 3.3.40
Payments made pursuant to royalty agreements
ABC Corp. pays royalties on each of the two products it sells. ABC’s functional
currency is the US Dollar.
For one of its products, ABC pays King Corp. royalties of 10% of its revenue on
all US sales. The royalty payments are made on January 15 and July 15 each
year in US Dollars. ABC has a very stable sales history and has consistently
achieved its stated budgets. It expects to make royalty payments of $5,000,000
on each of January 15 and July 15.
For its second product, ABC pays Queen PLC royalties on all sales in the UK of
a product licensed from Queen. The royalties are paid in pounds sterling (£) and
equal to £200,000 per quarter plus 2% of the quarterly revenue in excess of
£5,000,000. The royalties are due 10 business days after the quarter-end. ABC
expects to pay Queen £300,000 per quarter.
In both instances, ABC is subject to an enforceable contract with a third party
and can estimate the quantity/price and timing of the payments with a high
level of precision.
Does the agreement with King meet the definition of a firm commitment?
No. The definition of a firm commitment requires that the commitment have a
fixed price and quantity to be exchanged. The royalty payments due under this
contract depend solely on sales levels.
Those sales levels are not determinable in advance and the royalty agreement
does not include contractual minimums. Therefore, the fixed price and quantity
requirements for a firm commitment have not been satisfied.
Cash flow hedges. However, this contract may qualify as a hedged transaction
in a cash flow hedge because the anticipated payments due under the contract
may qualify as forecasted transactions.
Does the agreement with Queen meet the definition of a firm
commitment?
Yes, because there is a £200,000 minimum contractual payment. That amount
is not variable and is due to Queen regardless of revenue. The remaining
amounts (i.e. any royalty payable over £200,000) should be considered in the
same manner as the agreement with King.

Therefore, this foreign currency denominated firm commitment is eligible for

designation in a fair value foreign currency hedge if all other criteria are met
(see sections 7.3 and 7.4).

Question 3.3.60
Is there a requirement for the economic
disincentive to be explicitly stated in a contract?

Excerpt from ASC 815-25

>> Example 13: Definition of Firm Commitment

55-84 This Example illustrates a circumstance in which statutory remedies for

default constitute a disincentive for nonperformance in applying the
definition of a firm commitment. Entity A enters into an agreement to purchase
4,000 barrels of a common solvent from a chemical entity at $200 per barrel
on June 1, 2000. The provisions of the agreement do not include a specific
disincentive for nonperformance that is sufficiently large to make performance
probable. However, the laws of the legal jurisdiction to which the agreement is
subject provide a disincentive for nonperformance if Entity A does not take
delivery of the barrels pursuant to the agreement. The solvent is not readily
convertible to cash. Therefore, because the governing legal jurisdiction
provides statutory rights to pursue remedies for default equivalent to the
damages suffered, the agreement includes a disincentive for nonperformance
that is sufficiently large to make performance probable for purposes of applying
the definition of a firm commitment.

Interpretive response: A sufficiently large disincentive for nonperformance is

required for a contract to be a firm commitment. This penalty does not need to
be explicitly contained in the contract.
This requirement would be met if the legal jurisdiction that governs the
agreement provides statutory remedies for default equivalent to the damages
suffered by the non-defaulting party, even though the agreement itself does not
include an explicit monetary penalty for nonperformance. [815-20-55-84]
In other words, the sufficiently large disincentive for nonperformance criterion
can be met if the counterparty to a transaction may initiate legal remedies that
constitute a sufficiently large disincentive. [815-20 Glossary]
This is illustrated in Subtopic 815-25’s FASB Example 13 above.

Question 3.3.70
Can the disincentive for nonperformance be in the
form of opportunity cost?

Background: A manufacturer enters into a commitment to purchase certain

raw materials from one supplier. The transaction is considered probable
because to purchase the same raw materials from other suppliers would be
significantly more expensive.
Interpretive response: A disincentive for nonperformance cannot be in the
form of opportunity costs. Such a disincentive is not included in an agreement,
nor is it part of the legal rights or obligations codified in the laws to which such
agreements are subject. Therefore, an agreement with a disincentive based
solely on opportunity cost does not qualify as a firm commitment.

Question 3.3.80
Can the disincentive for nonperformance be in the
form of a potential writeoff?

Background: A significant amount of capitalized assets related to an in-process

project may be considered worthless if certain materials needed to complete a
project are not purchased from a particular supplier.
Interpretive response: A disincentive for nonperformance cannot be in the
form of a potential writeoff. Such a disincentive is not included in an agreement,
nor is it part of the legal rights or obligations codified in the laws to which such
agreements are subject. Therefore, an agreement with a disincentive based
solely on a potential write-off does not qualify as a firm commitment.

3.3.30 Firm commitments: Limitation on contracts that

meet the definition of a derivative

Excerpt from ASC 815-20

>>> Normal Purchases and Normal Sales as Hedged Items or

Transactions
25-7 A contract that is not subject to the requirements of Subtopic 815-10
because it qualifies for the normal purchases and normal sales scope exception
may be designated as a hedged item in a fair value hedge, if the provisions of
this Section are met. As the hedged item, the contract would be accounted for
under fair value hedge accounting. Similarly, the purchase under that contract
may be the hedged transaction in a cash flow hedge, if the provisions of
paragraph 815-20-25-15 are met. For cash flow hedges, the special accounting
applies to the hedging instrument, not to the purchase contract that is related
to the hedged forecasted transaction.

25-8 In emphasizing the conditions in the definition of a derivative instrument

in paragraphs 815-10-15-83 through 15-139, paragraphs 815-10-15-13 through
15-82 essentially exempt contracts that meet the definition of a derivative
instrument from the requirements of Subtopic 815-10 applicable to derivative
instruments. However, paragraphs 815-10-15-13 through 15-82 are not
intended to preclude such contracts from being subject to the requirements of
Subtopic 815-10 applicable to the hedged item in a fair value hedge.
25-9 A contract that qualifies for the normal purchases and normal sales
exception will typically satisfy the criteria for a firm commitment and will not be
recognized on an entity’s financial statements because of the exclusion from
recognition under Subtopic 815-10 or other Topics. The transaction under a
contract that qualifies for the normal purchases and normal sales exception but
does not satisfy the criteria for a firm commitment because the contract does
not contain a fixed price may be the hedged transaction in a cash flow hedge.

If a firm commitment is also a derivative instrument in the scope of

Subtopic 815-10, it cannot be designated as a hedged item in a fair value hedge.
Rather, it is accounted for as a derivative instrument.
A firm commitment is not in the scope of Topic 815 if it meets the normal
purchases and normal sales scope exception in Subtopic 815-10 (or any other
scope exception in that Subtopic). Therefore, a firm commitment that is a
derivative instrument but that qualifies for this exception and is not accounted
for as a derivative can be a hedged item in a fair value hedge. [815-20-25-7]
Normal purchases and normal sales are contracts that provide for the purchase
or sale of something other than a financial instrument or derivative instrument
that will be delivered in quantities expected to be used or sold by the entity
over a reasonable period in the normal course of business. [815-10-15-22]
Although the requirements for a derivative instrument to qualify for this
exception are beyond the scope of this publication, an instrument will not
qualify for the exception unless it meets these minimum
requirements. [815-10-15-25]
— the asset under the contract is delivered in quantities expected to be used
or sold by the entity over a reasonable period in the normal course of
business;
— the contract does not have a price based on an underlying that is not
clearly and closely related to the asset being sold or purchased
(see Question 5.4.50 for the requirements to meet this criterion); and
— the entity documents the designation of the contract as a normal purchase
or a normal sale.
The following decision tree provides an overview of the considerations to
determine whether a firm commitment is eligible to be designated as a hedged
item in a fair value, cash flow or foreign currency hedge.

Forecasted transaction may

Does contract meet the be eligible for designation as
definition of a firm a transaction in a cash flow hedge if
commitment? No certain criteria are met
(section 5.3)

Yes

Does contract meet the

No
definition of a derivative
Contract is eligible to be
under Subtopic 815-10?
designated in a fair value hedge

OR
Yes
If the contract has a fixed price
Do any of the exemptions in denominated in a currency other than an
paragraph 815-10-15-13 apply entity’s functional currency, it may qualify
(e.g. normal purchases and as a hedged item in a cash flow hedge of
normal sales)? Yes foreign currency risk (section 7.6)

Contract may qualify as a hedging

instrument in an all-in-one
cash flow hedge
(section 5.3.90)

Question 3.3.90
Can a firm commitment that is accounted for as a
derivative ever qualify as a hedging instrument?

Interpretive response: Yes. If a firm commitment does not meet any of the
scope exceptions in paragraph 815-10-15-13 (e.g. normal purchases and normal
sales scope exception), it is treated as a derivative and may be used as the
hedging instrument in a hedging relationship. For example, it may qualify as a
hedging instrument for the forecasted purchase or sale that will result from the
firm commitment. This is referred to as an ‘all-in-one’ cash flow hedge
(see section 5.3.90).

Example 3.3.50
Firm commitment to purchase silver with a forward
contract
ABC Corp. produces silver platters for sale to department stores. The sales
price of the silver platters depends in large part on the market price of silver at
the date of sale. ABC has a contract to purchase 100,000 ounces of silver from
DEF at $4.99 per ounce on December 31, Year 1.

If ABC does not purchase the silver from DEF, it will be required to pay DEF a
substantial penalty of $300,000. ABC is not required to make an up-front cash
payment. There is no net settlement provision in the contract. Further, the
quantities of silver delivered under the contract are expected to be used by ABC
over a reasonable period in the normal course of business.
ABC is concerned about fluctuations in the price of silver during the
commitment period. This would cause the inventory to be recorded at prices
other than the market price at the date of purchase. Therefore, ABC wishes to
enter into a transaction to hedge the risk of changes in the fair value of the
forward contract due to changes in the market price of silver.
Does the forward contract meet the definition of a firm commitment?
Yes. The agreement specifies all significant terms, including the quantity to be
exchanged, the fixed price and the timing of the transaction. The agreement
also includes a disincentive for nonperformance that is sufficiently large to
make performance probable. Therefore, the forward contract meets the
definition of a firm commitment.
Does the contract meet the definition of a derivative under Subtopic 815-
10?
Yes. The contract meets the definition of a derivative under Subtopic 815-10
because: [815-10-15-83]
— it has an underlying and a notional amount – i.e. price of silver, and 100,000
ounces of silver;
— no initial investment is required; and
— the contract provides for delivery of an asset (i.e. silver) that is readily
convertible to cash.
Do any of the exemptions in paragraph 815-10-15-13 apply (e.g. normal
purchases and normal sales)?
Yes. Although the contract meets the definition of a derivative, it qualifies for
the normal purchases and sales scope exception based on the following.
— The quantities of silver delivered under the contract are expected to be
used over a reasonable period in the normal course of business. [815-10-15-
27]
— The contract does not include a price adjustment. Therefore, ABC is not
required to assess whether the underlying is clearly and closely related to
the asset being purchased. [815-10-15-30]
— ABC documents the designation of the contract as a normal purchase or a
normal sale.
Does the forward contract qualify to be designated as a hedged item?
Yes. The forward contract may present an earnings exposure to ABC because
as the market price of silver changes, the amount at which ABC can sell the
silver platters will also change. As a result, ABC can hedge the exposure related
to the forward contract assuming all other eligibility criteria are met.
Example 4.3.40 continues this example, illustrating the accounting for a fair
value hedge of a firm commitment to purchase silver with a forward contract.

3.3.40 Portfolio of similar assets or liabilities

Excerpt from ASC 815-20

>> Hedged Item Criteria Applicable to Fair Value Hedges Only

25-12(b)(1) If similar assets or similar liabilities are aggregated and hedged as a
portfolio, the individual assets or individual liabilities shall 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 shall
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. See
the discussion beginning in paragraph 815-20-55-14 for related implementation
guidance. An entity may use different stratification criteria for the purposes of
impairment testing and for the purposes of grouping similar assets to be
designated as a hedged portfolio in a fair value hedge.
>>>> Determining Whether Risk Exposure is Shared within a Portfolio
55-14 This implementation guidance discusses the application of the guidance
in paragraph 815-20-25-12(b)(1) that the individual assets or individual liabilities
within a portfolio hedged in a fair value hedge 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 that paragraph.

For assets or liabilities to be aggregated and hedged as a portfolio, at the

inception of the hedging relationship and on an ongoing basis, each asset or
liability individually needs to: [815-20-25-12(b)(1)]
— share the same risk exposure as the risk designated as being hedged; and
— be expected to respond proportionately to the total change in fair value of
the hedged portfolio attributable to the hedged risk.

Question 3.3.100
Are there acceptable ranges when evaluating
shared risk exposure?

Interpretive response: Topic 815 provides an example illustrating an

acceptable range of changes in fair value.
If the change in the fair value of a hedged portfolio attributable to the hedged
risk were 10%, then the change in fair values attributable to the hedged risk for
each item in the portfolio should be within a relatively narrow range, such as
9%–11% (i.e. 90%–110% of the change in fair value of the hedged portfolio
attributable to the hedged risk of 10%). The example further illustrates that a

range of 7%–13% (i.e. 70%–130% of the change in fair value of the hedged
portfolio attributable to the hedged risk of 10%) would indicate the items are
not similar. [815-20-55-14]
Based on this example, we believe that items in a portfolio are similar if the
change in fair value of each individual item in the portfolio attributable to the risk
being hedged is expected to move in the same direction within 80%–120% of
the percentage change in the fair value of the aggregate hedged portfolio
attributable to the hedged risk.
Therefore, if the change in the fair value of a hedged portfolio is 5%, the
acceptable range for each individual item in the portfolio would be 4%–6% – i.e.
80%–120% of the 5% change in total fair value of portfolio.
However, in certain circumstances we believe an entity could perform a
qualitative assessment when evaluating shared risk exposure.
See Questions 3.3.120 and 3.3.150.

Question 3.3.110
How often should the evaluation of the similarity of
items hedged in a portfolio be performed?

Interpretive response: To continue applying hedge accounting, hedged items

in the portfolio must continue to be similar. Therefore, the similarity test should
be performed prospectively on a recurring basis. We believe the evaluation of
‘similar’ should be performed each period that hedge effectiveness is assessed.
For example, if it were expected over the course of the next hedge assessment
period that the portfolio would not continue to be similar as a consequence of
changes in market factors, an entity cannot continue applying hedge accounting.
However, there is an exception for hedges applying the last-of-layer method,
whereby an entity is permitted to perform this assessment only at hedge
inception (see Question 3.3.310).

Question 3.3.120
Are periodic similarity tests required to be
performed on a quantitative basis?

Interpretive response: Not necessarily. Instead of performing a quantitative

assessment each period, we believe an entity could perform a qualitative
assessment in certain circumstances. This will require judgment and should be
based on a variety of factors, including the extent of the quantitative analysis
performed at inception of the hedge and the nature of the items being hedged.
For example, an entity could perform detailed stress testing around changes in
market factors to develop a range based on impact to the similarity of items in a
portfolio. In other words, whether changes in market factors would cause items
to be outside the acceptable range for concluding that each individual item
shares similar risk exposure. Any subsequent similarity assessments could be

limited to monitoring whether hedged items are trending within the range
originally expected and confirming that market factors did not change in a way
that wasn’t originally considered in the stress testing.
If facts and circumstances regarding the portfolio change, or changes are not
within the range originally expected, the entity should perform a quantitative
assessment to determine whether the items continue to be similar.

Question 3.3.130
Should the similarity assessment for servicing
rights use the same risk characteristics as those
used in the impairment assessment under
Topic 860?

Excerpt from ASC 815-20

>>>> Servicing Rights as a Hedged Item

55-16 Paragraph 815-20-25-12(b)(1) provides criteria under which similar assets
or similar liabilities may be aggregated and hedged as a portfolio under a fair
value hedge, requiring, in part, that the individual assets or individual liabilities
share the risk exposure for which they are designated as being hedged.
Servicers of financial assets that designate a hedged portfolio by aggregating
servicing rights within one or more risk strata used under paragraph 860-50-35-
9 would not necessarily comply with the requirement in paragraph 815-20-25-
12(b)(1) for portfolios of similar assets because the risk strata under
paragraph 860-50-35-9 can be based on any predominant risk characteristic,
including date of origination or geographic location.

Interpretive response: An entity is required by Topic 860 (transfers and

servicing) to aggregate servicing rights for purposes of assessing impairment.
This includes stratifying servicing assets within a class based on one or more of
the predominant risk characteristics of the underlying financial assets. Those
characteristics may include financial asset type, size, interest rate, date of
origination, term and geographic location. For mortgage loans, financial asset
type refers to the various conventional or government guaranteed or insured
mortgage loans and adjustable-rate or fixed-rate mortgage loans. [860-50-35-9]
When considering the similarity of the individual items to determine whether
they can be hedged as a portfolio, an entity is not required to aggregate
servicing rights in the same manner as when assessing impairment. That is
because the risk strata used for impairment testing may not be sufficient to
satisfy the similarity requirements for portfolio hedging. [815-20-55-16]

Question 3.3.140
Can a first cash flows received (paid) approach be
used in a fair value hedge?
Background: For a cash flow hedge, the hedged transaction can be identified
as the first cash flows received or paid to a specific amount in a particular
period (without reference to the specific asset or liability) when hedging a group
of transactions (see section 5.3.30).
Interpretive response: No. A first cash flows received (paid) approach does not
require an entity to specifically identify the asset or liability for which the
forecasted transaction relates. In general, Topic 815 requires fair value hedge
accounting to be applied to individual assets or liabilities or portions of individual
assets or liabilities, including those hedged in a portfolio (see section 4.3.30 for
guidance on portfolio-level basis adjustments). Therefore, we believe an entity
needs to specifically identify the individual assets or liabilities (or portions
thereof) within the portfolio as the hedged item, with the exception of the last-
of-layer method. [FAS 133.432, ASU-2017.BC109]
Under the last-of-layer method, the hedged item can be designated as a
stated amount remaining in a closed portfolio of prepayable assets
(see section 3.3.100). The designation of the hedged item under this method is
effectively the inverse of how the hedged item is designated when a first cash
flows received (or paid) approach is used for a cash flow hedge. [815-20-25-12A,
ASU2017.BC109–BC110]

3.3.50 Hedging portfolios: Assessing similar risks for a

portfolio of loans

Excerpt from ASC 815-20

>>>> Determining Whether Risk Exposure is Shared within a Portfolio

55-15 In aggregating loans in a portfolio to be hedged, an entity may choose to
consider some of the following characteristics, as appropriate:
a. Loan type
b. Loan size
c. Nature and location of collateral
d. Interest rate type (fixed or variable)
e. Coupon interest rate or the benchmark rate component of the contractual
coupon cash flows (if fixed)
f. Scheduled maturity or the assumed maturity if the hedged item is
measured in accordance with paragraph 815-25-35-13B
g. Prepayment history of the loans (if seasoned)
h. Expected prepayment performance in varying interest rate scenarios.

Topic 815 provides characteristics to be considered when assessing similarity in

a portfolio of loans, including the type of loan and its scheduled maturity. [815-20-
55-15]

For individual loans to be considered similar and aggregated in a portfolio, there

must be an expectation that the change in fair value attributable to the hedged
risk for each individual loan responds in a generally proportionate manner to the
overall change in fair value of the portfolio attributable to the hedged risk – i.e.
changes in interest rates, which may also require consideration of prepayment
risk.

Question 3.3.150
Which key characteristics of a loan are considered
when evaluating whether individual loans share
similar risk exposure?
Interpretive response: It depends. By defining the portfolio of loans in a
restrictive manner (e.g. similar settlement terms, collateralized by property in
the same geographic region, similar scheduled maturities and similar interest
rates), each loan in a portfolio may be expected to meet the similarity test. That
is, each loan may be considered to have the same exposure to prepayment risk
since each loan has a similar prepayment option. [815-20-55-176]
However, there are some fair value hedging strategies that provide
opportunities for an entity to designate the hedged components of financial
instruments within a portfolio in a manner that will result in those items sharing
the same maturity and/or coupon rate (solely for hedge accounting purposes).

Benchmark rate Fixed-rate financial instruments can have the same

component benchmark rate component designated as the hedged item.
(section 3.3.70)

Partial-term hedges Maturities of financial instruments can be defined as the

(section 3.3.80) same partial term.

Last-of-layer Assumes all prepayable financial assets in a closed portfolio

method have the same maturity and benchmark coupon rate.
(section 3.3.100)

An entity may designate the hedged item and the benchmark rate component
(e.g. LIBOR) to be the same.
For example, assume an entity wants to aggregate and hedge a portfolio of five
loans.

Hedge using partial-term and

Contractual terms of loans benchmark rate components
Remaining Remaining
maturity Interest rate maturity Interest rate
Loan 1 24 months 6% 17 months LIBOR component
Loan 2 17 months 5% 17 months LIBOR component
Loan 3 21 months 7% 17 months LIBOR component
Loan 4 26 months 5% 17 months LIBOR component
Loan 5 28 months 6% 17 months LIBOR component

If the entity hedges the portfolio using the benchmark interest rate component
and/or the partial-term guidance, it may be more likely that it could assess
similarity qualitatively (see Question 3.3.120). In the example above, applying
these approaches in combination would allow the entity to assume all five loans
have the identical coupon rate (i.e. the LIBOR component of the fixed interest
coupons) and mature on the identical date (i.e. in 17 months).
However, depending on the type of hedge, an entity may still need to consider
items such as loan type, collateral, prepayment expectations, etc. For example,
a more complex similarity test is required if the entity aggregates loans based
on contractual terms. This is illustrated in Subtopic 815-20’s Example 19 below.

FASB Example: Hedging a portfolio of fixed-rate financial

assets

Excerpt from ASC 815-20

>> Example 19: Hedging a Portfolio of Fixed-Rate Financial Assets

55-173 This Example illustrates the application of paragraphs 815-20-25-

12(b)(1) and 815-20-25-75 to a hedge of a portfolio of fixed-rate financial assets.
55-174 Entity A has a portfolio of seasoned, one to four family, fixed-rate
mortgages that it wishes to designate as the hedged item in a fair value hedge
of the benchmark interest rate (LIBOR). Each loan within the portfolio has
similar settlement terms, is collateralized by property in the same geographic
region, and has similar scheduled maturities. The loans are all within a
specified interest rate band and are prepayable at par; each of the loans
contained in the portfolio is expected to react in a generally proportionate
manner to changes in the benchmark interest rate based on calculations
performed by Entity A.
55-175 Entity A enters into a pay-fixed, receive-LIBOR interest rate swap with
a fair value of zero at the inception of the hedging relationship. The stated
maturity of the interest rate swap is consistent with the stated maturities of
the loans. The notional amount of the interest rate swap amortizes based on a
schedule that is expected to approximate the principal repayments of the loans
(excluding prepayments). There is no optionality included in the interest rate
swap. As part of its documented risk management strategy associated with
this hedging relationship, on a quarterly basis, Entity A intends to do both of
the following:
a. Assess effectiveness of the existing hedging relationship on a quantitative
basis for the past three-month period
b. Consider possible changes in value of the hedging derivative and the
hedged item over the next three months in deciding whether it has an
expectation that the hedging relationship will continue to be highly
effective at achieving offsetting changes in fair value.
55-176 Entity A’s portfolio of loans satisfies the requirements of
paragraph 815-20-25-12(b)(1) regarding the grouping of similar assets because
the portfolio of loans has been defined in a restrictive manner and Entity A

determined, by calculation, that each of the loans contained in the portfolio is

expected to react in a generally proportionate manner to changes in the
benchmark interest rate. Even though certain of the loans may prepay, each
loan still may be considered to have the same exposure to prepayment risk
because each loan has a similar prepayment option. When aggregating loans in
a portfolio, an entity is permitted to consider among other things prepayment
history of the loans (if seasoned) and expected prepayment performance in
varying interest rate scenarios.
55-177 Entity A's documented hedging strategy meets the requirements of
paragraph 815-20-25-75 for a prospective assessment of effectiveness
provided the entity established that the hedging relationship is expected to be
highly effective in achieving offsetting changes in fair value attributable to the
hedged risk during the period that the hedge is designated.
55-178 Paragraph 815-20-25-79(a) explains that a probable future change in fair
value will be more heavily weighted than a reasonably possible future change.
For example, Entity A could assign a probability weighting to each possible
future change in value of the hedged portfolio. Depending on the level of
market interest rates and the expected prepayment rates for the types of loans
in the hedged portfolio, Entity A may reach a conclusion that the change in fair
value of the swap will be highly effective at offsetting the change in the value
of the portfolio of loans, inclusive of the prepayment option. As a result of this
analysis, management would conclude that hedge accounting is permitted for
the hedging relationship for the next three-month period. Management is
required to assess the effectiveness of the existing hedging relationship for the
past three-month period. If necessary, the notional amount of the swap in
excess of the portfolio balance at the end of each three-month period must be
dedesignated to allow high effectiveness to continue in the future.

3.3.60 Portion (or percentage) of a hedged item

Excerpt from ASC 815-20

of a four-year debt instrument). Paragraph 815-25-35-13B discusses the

measurement of the hedged item in hedges of interest rate risk.
iii. A put option or call option (including an interest rate cap or price cap or an
interest rate floor or price floor) embedded in an existing asset or liability
that is not an embedded derivative accounted for separately pursuant to
paragraph 815-15-25-1.
iv. The residual value in a lessor’s net investment in a direct financing or
sales-type lease.

>> Example 2: Portions and Portfolios of Individual Items as Hedged Item

55-81 This Example illustrates the application of paragraph 815-20-25-12.

55-82 An entity that issues $100 million of fixed-rate debt may wish to hedge
50 percent of its fair value exposure to interest rate risk, as permitted by
paragraph 815-20-25-12(b)(2). To accomplish that, the entity could enter into an
interest rate swap with a notional amount of $50 million. The paragraph 815-
20-25-104(a) criterion is satisfied because the entity has designated as a fair
value hedge 50 percent of the contractual principal amount as the hedged item
and has entered into an interest rate swap with a notional amount that
matches the hedged principal amount.
55-83 If $100 million of fixed-rate debt were issued in increments of $1,000
individual bonds, the entity could aggregate 50,000 of those individual bonds as
a portfolio to equal the notional amount of the swap, as permitted by
paragraph 815-20-25-12(b)(1) (for the purposes of this Example, it is assumed
that the hedge satisfies the portfolio requirements of that paragraph).

An entity can hedge a portion or percentage of an asset, liability or firm

commitment. However, the specific portion (or percentage) must be identified.
For example, an entity could hedge 70% of its exposure to interest rate risk
related to a specified debt obligation by designating 70% of the principal
amount of the debt as the hedged item, and entering into an interest rate swap
with a notional amount equal to the portion of the debt designated as the
hedged item.

Interest rate risk. Topic 815 also provides an entity with additional choices
when designating the hedged item in a fair value hedge of interest rate risk,
which include both of the following.

Benchmark rate Benchmark rate component of fixed-coupon interest cash

component flows.
(section 3.3.70)

Partial-term hedges Selected contractual cash flows, including one or more

(section 3.3.80) selected consecutive interest payments, for part of the
financial instrument’s remaining term.

Question 3.3.160
Can an entity designate a portion or percentage of a
nonfinancial item as the hedged item?

Interpretive response: It depends. If a nonfinancial asset or liability (other than

a recognized loan servicing right or a nonfinancial firm commitment with
financial components) is the hedged item, the designated risk being hedged is
the risk of changes in the fair value of the entire hedged asset or liability (i.e.
price risk). [815-20-25-12(e)]
Therefore, an entity is unable to designate only a portion or percentage of the
nonfinancial asset or liability as the hedged item. For guidance on limitations
when hedging price risk for nonfinancial assets and liabilities in a fair value
hedge, see section 3.4.20.

Foreign currency risk. However, if the hedged item is a foreign currency

denominated firm commitment to purchase a nonfinancial asset in a fair value
hedge of foreign currency risk, we believe an entity can designate a specific
portion as the hedged item when hedging foreign currency risk. For
guidance on hedging foreign currency denominated firm commitments,
see section 7.4.50.
Cash flow hedges. The restriction on hedging a specific component of a
nonfinancial item differs from guidance for cash flow hedges, which allows an
entity to hedge a contractually specified component.

Example 3.3.60
Specific portion of a foreign currency denominated
firm commitment
This example uses the same facts and circumstances as Example 3.3.30. For
ease of reference, they are summarized below.
ABC Corp. is a manufacturing entity with a functional currency of the US Dollar.
A major component in its manufacturing process (CPUs) comes from Asia
Corp., an unrelated Japanese supplier. No other supplier has a product that
meets ABC’s specifications. To ensure CPU availability, ABC enters into a
contract with Asia to purchase a minimum of 1,000 CPUs each month for the
next 12 months. The cost of each CPU is 10,000 yen. There are significant
penalties if the contract is broken.
Assume the contract meets the definition of a firm commitment and all other
eligibility criteria are met.

Foreign currency risk

ABC wishes to hedge foreign currency risk associated with the first 500 units
being acquired each month. In this instance, ABC has identified a specific
portion of the firm commitment because there is no uncertainty as to which
units are being hedged. Therefore, the first 500 units being acquired each
month can be designated as the hedged item. For guidance on fair value
hedges of foreign currency risk, see section 7.4.

However, ABC cannot designate the hedged item as being the foreign currency
exposure associated with any 500 units being acquired each month. Because
the hedged item could be any 500 units acquired during the month, ABC has
not identified a specific portion as the hedged item. This portion of the firm
commitment would not be eligible for hedge accounting.

Price risk

ABC cannot hedge price risk associated with a portion of the firm commitment
to purchase CPUs. For limitations on price risk for nonfinancial items,
see section 3.4.20.

Prohibition of preset hedge coverage ratios for servicing right

assets

Excerpt from ASC 815-20

>>> Prohibition of Preset Hedge Coverage Ratios

55-63 Subtopic 860-50 requires that if an entity subsequently measures
servicing assets and servicing liabilities using the amortization method, any
impairment of servicing assets, which is the amount by which the carrying
amount of the servicing assets for an individual stratum exceeds their fair
value, be recognized in current earnings. However, an increase in the fair value
above the carrying amount of servicing assets for an individual stratum may not
be recognized in current earnings.
55-64 Entities that service certain types of financial assets may wish to
designate as the hedged item in a fair value hedge a prespecified percentage
of the total change in fair value of those servicing rights (attributable to the
hedged risk) that varies based on changes in a specified independent variable.
Because the prespecified percentage for each specified independent variable
can be presented in a rectangular array, that method of determining the
hedged item retroactively based on the actual independent variable is
sometimes referred to as the matrix method. Under that approach, at the end
of the hedge assessment period, the entity would determine the hedged item
and assess hedge effectiveness by determining retrospectively which hedge
coverage ratio would be applied to the servicing right asset to identify the
hedged item for that period. That approach is in contrast to designating the
hedged item at the inception of the hedge by specifying a single percentage of
that recognized servicing right asset as the hedged item.
55-65 In a fair value hedge of a portion of a recognized servicing right asset
subsequently measured using the amortization method and its related
impairment analysis, an entity may not designate the hedged item at the
inception of the hedge by initially specifying a series of possible percentages of
the servicing right asset (that is, preset hedge coverage ratios) and then
determining at the end of the assessment period what specific percentage of
the servicing right asset is the actual hedged item for that period based on the
change in a specified independent variable during that period. Such a matrix
method would not be a valid application of the provisions of this Subtopic.

55-66 Paragraph 815-20-25-12(b)(2)(i) precludes an entity from expressing the

hedged item as multiple percentages of a recognized asset or liability and then
retroactively determining 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.
55-67 There is a limited exception under paragraph 815-20-25-10 in which a
collar that is comprised of one purchased option and one written option that
have different notional amounts is designated as the hedging instrument, and
the hedged item is specified as two different proportions of the same asset
based on the upper and lower rate or price range of the asset referenced in
those two options.

An entity may designate a specific percentage of a recognized servicing asset

as the hedged item at inception. However, an entity may not designate a series
of possible percentages of servicing right assets (referred to as preset hedge
coverage ratios) that each correspond to a specified independent variable (e.g.
an interest rate). [815-20-55-65]
Under this approach, at the end of the hedge assessment period, an entity
would determine the hedged item and measure hedge effectiveness by
determining retrospectively which hedge coverage ratio would be applied when
designating the hedged item for that period. In other words, the percentage of
assets being hedged changes after hedge inception and is not determinable
until the end of the hedge period.
This is different from designating a specific percentage of the recognized
servicing right asset as the hedged item at inception.
There is one exception to the general concept that a single percentage of the
entire asset or liability (or portfolio) must be designated at inception of the
hedge as the hedged item. This strategy incorporates a collar that has different
notional amounts for the purchased and written option components
(see Question 9.2.290).

3.3.70 Hedging portions of financial items: Benchmark

interest rate component

Excerpt from ASC 815-20

>> Hedged Item Criteria Applicable to Fair Value Hedges Only

25-12 An asset or liability is eligible for designation as a hedged item in a fair
value hedge if all of the following additional criteria are met: …
f. If the hedged item is a financial asset or liability, a recognized loan
servicing right, or a nonfinancial firm commitment with financial
components, the designated risk being hedged is any of the following: …
2. The risk of changes in its fair value attributable to changes in the
designated benchmark interest rate (referred to as interest rate risk)

Excerpt from ASC 815-25

>> Changes Involving Interest Rate Risk

Interest rate risk. Topic 815 provides an entity with a choice of measuring
the change in a hedged item’s fair value attributable to the changes in the
benchmark interest rate based on either the hedged item’s: [815-25-35-13]
— entire contractual coupon cash flows; or
— the benchmark rate component of the contractual coupon cash flows
determined at inception of the hedging relationship.
This election affects an entity’s assessment of hedge effectiveness and fair
value hedge accounting because of its effect on the measurement of the
hedged item. [815-25-35-13A]
Section 4.3.20 provides detailed guidance on using either the hedged item’s
entire contractual coupon cash flows or using the benchmark rate component
of the contractual coupon cash flows to measure the change in the hedged
item’s fair value.

Question 3.3.170
Which benchmark interest rate may be used for
measurement purposes when hedging only the
benchmark rate component?
Interpretive response: Topic 815 uses the term ‘benchmark rate’ component
of the contractual coupon cash flows. We believe ‘benchmark rate’ refers to the
Benchmark Interest Rate as defined in the Master Glossary.
An entity may use any rate that meets the Master Glossary definition of a
Benchmark Interest Rate to measure the change in the hedged item’s fair value
attributable to interest rate risk. In the United States, the interest rates on direct
Treasury obligations of the US government, the LIBOR swap rate, the Fed
Funds Effective Swap Rate (also referred to as the Overnight Index Swap Rate)
and the SIFMA Municipal Swap Rate are considered to be benchmark interest
rates. For more information on benchmark interest rates,
see section 2.3.30. [815-20-25-6A, 815-20 Glossary]

Question 3.3.180
May an entity separately designate the fixed rate
subject to inflation adjustments as a benchmark
rate component?
Interpretive response: No. At a September 2018 Board meeting, the FASB
noted an entity could not separately designate the benchmark interest rate
component of an otherwise fixed interest rate as the hedged item in a fair value
hedge if the fixed interest rate was subject to inflation adjustments. This is
because the overall rate is considered to be a variable rate, as opposed to a
fixed rate, and interest rate components of variable rate instruments can only
be the hedged risk when they are contractually specified. [FASB meeting 09-18]
For example, an entity owns fixed-rate debt instruments with an inflation-
adjusted principal that fluctuates based on an inflation index. Interest payments
are calculated based on the fixed rate and the inflation-adjusted principal
balance. Because of the inflation adjustment, the rate is not considered to be a
fixed-rate. As a result, the entity would not be able to hedge a benchmark
component in a fair value hedge.
Because these are considered variable-rate instruments, the entity may hedge
the variability in cash flows using a cash flow hedge.

Question 3.3.190
Why would an entity designate only the benchmark
rate component?
Interpretive response: For hedge accounting purposes, using only the
benchmark rate component of the contractual coupon cash flows of a financial
instrument can provide a better offset between the changes in the fair values of
the hedging instrument (e.g. an interest rate swap) and hedged item
attributable to interest rate risk. Therefore, we expect that many entities will
use the benchmark rate component.
Certain hedging relationships could even be perfectly effective; see Case B of
Subtopic 815-25’s Example 9 in section 4.3.20. [815-25-55-61C]
In addition, using the benchmark rate component for hedge accounting may
better reflect how entities manage interest rate risk. For example, assume a
bond has a 5% interest coupon. If the benchmark rate component is 3%, the
additional 2% could be viewed as a reflection of credit risk.

Benchmark rate
component (3%) Entire
contractual cash
flows
(5% interest
Credit risk coupon)
(2%)

Using the entire contractual coupon cash flows to assess hedge effectiveness
incorporates credit risk into the hedge effectiveness assessment. If an entity’s
risk management strategy is to hedge only the changes in the benchmark
interest rate without hedging credit spreads, applying hedge accounting to the
total contractual coupon results in misalignment between the risk management
strategy and hedge accounting.

Question 3.3.200
If an entity uses the benchmark rate component to
measure the change in fair value of a hedged item,
must it do so for all similar hedging relationships?
Interpretive response: No. For fair value hedges, the election to use either the
entire contractual coupon or the benchmark rate component cash flows to
measure the change in the hedged item’s fair value attributable to interest rate
risk is made on a hedge-by-hedge basis. [ASU 2017-12.BC129]

3.3.80 Hedging portions of prepayable financial

instruments: Partial-term hedges of interest rate risk

Excerpt from ASC 815-25

>>> Partial-Term Hedges of Interest Rate Risk

35-13B For a fair value hedge of interest rate risk in which the hedged item
is designated as selected contractual cash flows in accordance with
paragraph 815-20-25-12(b)(2)(ii), an entity may measure the change in the fair
value of the hedged item attributable to interest rate risk using an assumed
term that begins when the first hedged cash flow begins to accrue and ends
when the last hedged cash flow is due and payable. The assumed maturity of
the hedged item occurs on the date in which the last hedged cash flow is due
and payable.

Topic 815 provides an entity with a choice of designating the hedged item
in a fair value hedge of interest rate risk as either: [815-20-25-12(b)(2)(ii)]
— the entire financial instrument (or a percentage of it) for its entire remaining
term; or
— selected consecutive interest payments with the assumption that the
principal payment occurs at the end of the hedge term (partial-term hedge).
For example, an entity issues a noncallable, five-year fixed-rate debt instrument.
The entity could designate a fair value hedge of interest rate risk for the entire
term or designate a partial-term hedge for the first two years of its term
(see Example 3.3.70). [815-25-55-95]

The following illustrates a partial-term hedge.

Year 1 Year 2 Year 3 Year 4 Year 5

Assumes principal payment

occurs at end of Year 2.

For partial-term hedges, an entity measures the change in the hedged item’s
fair value attributable to interest rate risk using an assumed term that reflects
only the designated cash flows and assumes that the principal payment occurs
at the end of the hedge term. [815-25-35-13B]

Question 3.3.210
When will a partial-term hedge improve
effectiveness?

Interpretive response: A partial-term hedge may enable an entity to better

align hedge accounting with its interest rate risk management strategies.
Assume an entity uses a two-year interest rate swap to hedge the first two
years of fixed-rate interest payments on a noncallable, five-year fixed-rate bond.
The entity could consider the bond’s entire contractual term when assessing
hedge effectiveness and measuring the change in the bond’s fair value
attributable to interest rate risk. However, the changes in the fair value of a two-
year interest rate swap would generally not be expected to offset the changes
in the fair value of a noncallable, five-year fixed-rate bond. Therefore, the entity
would likely be unable to conclude that the hedging relationship would be highly
effective.
Instead, an entity may designate a partial-term hedge. In this case, the principal
repayment of the hedged item is assumed to occur at the end of the hedge
term. This results in more favorable assessment of hedge effectiveness and
measurement of the hedged item. [815-25-35-13B]

Question 3.3.220
Can an entity designate a partial-term hedge using
an assumed term that ends on or before the initial
date a financial instrument can be prepaid?
Interpretive response: Yes. An entity could designate the partial term such
that it ends before (or on) the initial date on which a financial instrument can be
prepaid – e.g. the first day a bond can be called. Therefore, the hedged item is
not prepayable during the hedge term. In such cases, an entity does not
consider prepayment risk when assessing hedge effectiveness and measuring
the change in the hedged item’s fair value attributable to interest rate
risk. [ASU 2017-12.BC106]

For further discussion of hedging prepayable financial instruments,

see sections 3.4.10 and 3.3.100 (last-of-layer method).

Question 3.3.230
Can the partial-term hedge guidance and the
guidance for hedging only the benchmark rate
component be applied to the same hedging
relationship?
Interpretive response: Yes. An entity may:
— designate only part of the remaining term of a financial instrument as the
hedged item in a fair value hedge of interest rate risk; and [815-25-35-13B]
— elect to measure the change in the hedged item’s fair value using only the
benchmark rate component of the contractual coupon cash flows. [815-25-35-13]

Question 3.3.240
Must specific conditions be met to apply partial-
term hedging in a fair value hedge of interest rate
risk?
Interpretive response: Yes. The interest payments being hedged must be
consecutive interest payments. For example, an entity may designate the first
five years of interest payments of a 10-year bond as a hedged item. [815-20-25-
12(b)(2)(ii), 815-25-35-13B]

The partial term may begin after inception of the financial instrument. For
example, an entity may designate the interest payments in Years 4–6 of the
bond as the hedged item, along with an appropriate hedging instrument (e.g. a
forward-starting three-year interest rate swap) as a fair value hedge.

Question 3.3.250
Can an entity apply hedge accounting to more than
one partial term of a single instrument?

Background: An entity may wish to designate two or more partial terms from a
single financial instrument as separate hedged items in separate hedging
relationships. For example, the first five years of interest payments of a bond as
a hedged item in a fair value hedge, and the next five years of interest
payments of the same bond as a hedged item in a separate fair value hedge.
Interpretive response: At a March 2018 Board meeting, the FASB noted that
the partial-term hedging guidance can be applied simultaneously to multiple
partial-term hedging relationships for a single debt instrument. In other words,
an entity is permitted to designate more than one partial term of a financial
instrument as separate hedged items. [FASB meeting 03-18]

Question 3.3.260
When multiple partial terms are hedged in separate
hedging relationships, do the terms need to be
consecutive?
Interpretive response: No. At a March 2018 meeting, the FASB noted an
example of simultaneous partial-term hedges where an entity designates
consecutive interest cash flows in Years 1–3 and consecutive interest cash
flows in Years 5–7 of a 10-year bond. [FASB meeting 03-18]
Therefore, we believe there is no requirement for the terms of multiple partial-
term hedges to be consecutive.

Example 3.3.70
Designating a fair value hedge of interest rate risk
using the partial-term approach
The following example is adapted from the facts outlined in the Example 15 in
Subtopic 815-25 (reproduced in section 4.3.20).
On January 1, Year 1, ABC Corp. issues a noncallable, five-year, $100 million
debt instrument with a 3% semiannual interest coupon. On the same date,
ABC also enters into a two-year interest rate swap with a notional amount of
$100 million.
ABC elects to apply partial-term hedging guidance by:
— designating the cash flows associated with the first two years of the debt
issuance as the hedged item; and
— identifying interest rate risk as the hedged risk.
The assumed term of the hedged item is two years – i.e. the same term as the
interest rate swap.
Partial-term begins after inception
The partial term may begin after inception of the financial instrument. For
example, ABC could designate the cash flows associated with Years 2–4 as the
hedged item. The hedging instrument would be a forward-starting three-year
interest rate swap.
Multiple partial-term hedges
ABC could designate multiple partial-term hedges. For example, in addition to
designating the cash flows associated with Years 1–2 of the issued debt, ABC
could also designate cash flows associated with Years 4–5.
The hedging instruments would be two interest rate swaps: one associated with
the first two years of the debt instrument, and the second a forward-starting
two-year interest rate swap that aligns with the cash flows for Years 4–5.

Question 3.3.270
Can an entity hedge multiple risks when applying
partial-term hedging guidance?

Interpretive response: The guidance for partial-term hedges focuses solely on

fair value hedges of interest rate risk. However, at a September 2018 Board
meeting the FASB noted that this guidance could also be applied to a single fair
value hedge of both interest rate risk and foreign currency risk. [FASB meeting
09-18]

Therefore, we believe the partial-term guidance cannot be applied to:

— hedges of only foreign currency risk.
— hedges that include credit risk or price risk.

Example 3.3.80
Hedging interest rate risk and foreign currency risk
in a partial-term hedge

On January 1, Year 1, ABC Corp. issues a noncallable, five-year, €100 million

debt instrument with a 3% semiannual interest coupon denominated in euros.
ABC’s functional currency is the US Dollar.
On the same date, ABC also enters into a two-year cross-currency interest rate
swap with a notional amount of €100 million.
ABC may elect to apply partial-term hedging guidance by:
— designating the cash flows associated with the first two years of the euro-
denominated debt issuance as the hedged item; and
— identifying both the interest rate risk and foreign currency risk as the
hedged risks.
The assumed term of the hedged item would be two years – i.e. the same term
as the cross-currency interest rate swap.
Hedge effectiveness. Topic 815 allows an entity to exclude the portion of the
change in fair value of a currency swap attributable to the cross-currency basis
spread (see section 9.2.70). This may result in a more highly effective hedge
when designating a cross-currency interest rate swap in a fair value hedge of
interest rate risk and foreign currency risk.
For guidance on hedging a combination of foreign currency risk and other risks,
see section 7.3.40 (hedging multiple risks).

3.3.90 Hedging portions of items: Embedded put or call

options

Excerpts from ASC 815-20

>> Hedged Item Criteria Applicable for Fair Value Hedges Only
25-12(b)(2) 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: …
iii. A put option or call option (including an interest rate cap or price cap or an
interest rate floor or price floor) embedded in an existing asset or liability
that is not an embedded derivative accounted for separately pursuant to
paragraph 815-15-25-1.
> Items Specifically Ineligible for Designation as a Hedged Item or
Transaction
25-43 Besides those hedged items and transactions that fail to meet the
specified eligibility criteria, none of the following shall be designated as a
hedged item or transaction in the respective hedges: …
c. With respect to fair value hedges only:
1. If the entire asset or liability is an instrument with variable cash flows,
an implicit fixed-to-variable swap (or similar instrument) perceived to be
embedded in a host contract with fixed cash flows.
…
7. A component of an embedded derivative in a hybrid instrument—for
example, embedded options in a hybrid instrument that are required
to be considered a single forward contract under paragraph 815-10-25-
10 cannot be designated as items hedged individually in a fair value
hedge in which the hedging instrument is a separate, unrelated
freestanding option.

On a stand-alone basis, derivatives cannot be designated as hedged items.

However, Topic 815 specifically allows embedded put or call options that are
not separated to be hedged items in a fair value hedge, with some
limitations. [815-20-25-12(b)(2)(iii)]
The following table summarizes the embedded put or call options that are
explicitly prohibited from being designated as the hedged item.

Re-characterization An entity is prohibited from re-characterizing a variable-rate

of a financial financial instrument as a fixed-rate financial instrument with
instrument an embedded interest rate swap in an effort to achieve fair
value hedging. The FASB did not intend for an entity to be
able to hedge a contractual provision that creates variability
in future cash flows as a fair value hedge rather than a cash
flow hedge. [815-20-25-43(c)(1), FAS 133.BC435]
Component of an An entity is prohibited from hedging a component of an
embedded embedded derivative in a hybrid instrument. For example,
derivative assume the combination of two embedded options (e.g. a
purchased put option and a written put option) in a single
hybrid instrument is viewed as a single forward contract. An
entity cannot separately designate either the purchased put
option or the written put option as the hedged item. [815-10-
25-10, 815-20-25-43(c)(7)]

If an entity does not separately identify an embedded derivative as the hedged

item in a fair value hedge of interest rate risk, and the hedge is not designated
using the last-of-layer method, it must consider the effect of the embedded
derivative of the same risk class when designating a hedge of an individual risk,
if that embedded derivative is exercisable during the hedge period. For
example, the effect of an embedded prepayment option must be considered in
designating a hedge of interest rate risk (see section 3.4.10). [815-20-25-6]

Question 3.3.280
Is an entity permitted to hedge the risk of changes
in the fair value of an embedded call option in an
HTM security that is prepayable?
Interpretive response: Yes. Interest rate risk and price risk are not eligible to
be designated as hedged risks for a debt security that is classified as HTM.
However, Topic 815 allows an entity to hedge the risk of changes in the fair
value of an embedded call option in a HTM debt security that is
prepayable. [815-20-25-12(d)]
For example, an entity purchased a five-year callable debt security and classified
it as HTM. The callable feature of the security represents a call option held by
the issuer of the security. The entity may purchase a put option to hedge the
written call option component (i.e. prepayment feature) of the HTM debt
security and designate it as a hedge of the changes in fair value of the call
option.

Question 3.3.290
Can an entity hedge the fair value exposure of
options embedded in contracts that qualify as firm
commitments?

Excerpt from ASC 815-20

>>>> Application of the Definition of Firm Commitment

55-13 A supply contract for which the contract price is fixed only in certain
circumstances (such as if the selling price is above an embedded price cap or
below an embedded price floor) meets the definition of a firm commitment for
purposes of designating the hedged item in a fair value hedge. Provided the
embedded price cap or floor is considered clearly and closely related to the
host contract and therefore is not accounted for separately under
paragraph 815-15-25-1, either party to the supply contract can hedge the fair
value exposure arising from the cap or floor.

Background: The term ‘fixed price’ as it relates to a firm commitment

encompasses: [815-20 Glossary, 815-20-55-13]
— situations in which the price is always fixed; and
— situations in which the price is fixed through the existence of an embedded
option that is not separated from the host contract – e.g. price caps or
floors in a long-term supply or purchase contract.
Interpretive response: The fair value exposure of the cap or the floor in supply
contracts is eligible for fair value hedge accounting. The embedded caps and
floors typically are not required to be separated from the host contracts
because their economic characteristics and risks are clearly and closely related
to the economic characteristics and risks of the host contract. [815-20-55-13]
For example, an entity enters into a long-term supply contract with a customer
to sell a specified amount of a certain material with a selling price equal to the
monthly average list price for the month for the quantity delivered, not to
exceed $15 per pound (requiring physical delivery). [815-20-55-85]
The entity could purchase a cash-settled call option with a strike price of
$15 per pound and a notional amount equal to the quantity specified in the
supply contract. It could then designate it as a fair value hedge of the risk of
changes in the fair value of the embedded written price cap in the supply
contract, provided the other criteria for a fair value hedge are met. [815-20-55-87]
An option embedded in a nonderivative contract may be a purchased option that
an entity hedges with a written option in an effort to monetize the value of the
purchased option (see Example 3 in Subtopic 815-20 below).

FASB Example: Firm commitment with embedded price caps

or floors

Excerpt from ASC 815-20

>> Example 3: Firm Commitment as Hedged Item in Relation to Long-

Term Supply Contracts with Embedded Price Caps or Floors

55-84 This Example illustrates the application of paragraph 815-20-25-12 and

the definition of firm commitment in relation to long-term supply contracts with
embedded price caps or floors.
55-85 Entity A enters into a long-term supply contract with a customer to sell a
specified amount of a certain material. The selling price is the current monthly
average list price for the quantity delivered each month but not to exceed
$15 per pound. The current list price at the contract signing date is $12 per
pound. The contract can be settled only by physical delivery. The contract also
includes a penalty provision that is sufficiently large to make performance
probable. The customer is not required to make an up-front cash payment for
the written option (that is, the price cap) in the supply contract. Consequently,
the supply contract is neither a recognized asset nor a recognized liability at
inception.
55-86 The supply contract in its entirety does not meet the definition of a
derivative instrument due to the absence of a net settlement characteristic—
that is, the contract does not permit or require net settlement (see guidance
beginning in paragraph 815-10-15-100), there is no market mechanism (see
guidance beginning in paragraph 815-10-15-110), and it does not require
delivery of an asset that is readily convertible to cash (see guidance
beginning in paragraph 815-10-15-119). Pursuant to the guidance in
paragraph 815-15-25-19, the embedded cap on the selling price is an option
that does not warrant separate accounting under Subtopic 815-15 because it is
clearly and closely related to the host supply contract. In addition, because the
supply contract is not remeasured with changes in fair value reported currently
in earnings, it meets the criteria in paragraph 815-20-25-43(c)(3) to qualify as a
hedged item in a fair value hedge.
55-87 Entity A wishes to enter into a transaction to hedge the risk of changes
in the fair value of the embedded written price cap in the supply contract.
Accordingly, it purchases a cash-settled call option with a strike price of
$15 per pound and a notional amount equal to the quantity specified in the
supply contract. In accordance with the guidance in paragraph 815-20-25-12, a
supply contract for which the contract price is fixed only under certain
circumstances (such as when market prices are above an embedded price cap)
meets the definition of a firm commitment for purposes of designating the
hedged item in a fair value hedge. Therefore, if the selling price in a supply
contract is subject to a cap, a floor, or both, either party to the contract is
eligible to apply fair value hedge accounting in a hedging relationship to hedge
the fair value exposure of the cap or floor. For the range of monthly average list
prices above $15 per pound, the contract has a fixed $15 per pound price.
Thus, Entity A may designate the written cap embedded in the supply contract

as the hedged item in a fair value hedging relationship provided the other
criteria for a fair value hedge are met. The embedded written cap in this
Example is a specific portion of the contract that is subject to the risk of
changes in fair value due to changes in the list price of the underlying
materials. Because it is not accounted for separately from the supply contract,
the embedded written cap may be designated as the hedged item in a fair
value hedge. Paragraph 815-20-25-12 allows a nonbifurcated call option that is
embedded in a supply contract to be the hedged item in a fair value hedge
regardless of whether that supply contract is a recognized asset or liability or
an unrecognized firm commitment.

3.3.100 Last-of-layer method

Excerpt from ASC 815-20

>> Hedged Item Criteria Applicable to Fair Value Hedges Only

25-12A For a closed portfolio of prepayable financial assets or one or more
beneficial interests secured by a portfolio of prepayable financial instruments,
an entity may designate as the hedged item a stated amount of the asset or
assets that are not expected to be affected by prepayments, defaults, and
other factors affecting the timing and amount of cash flows if the designation
is made in conjunction with the partial-term hedging election in paragraph 815-
20-25-12(b)(2)(ii) (this designation is referred to throughout Topic 815 as the
“last-of-layer method”).
a. As part of the initial hedge documentation, an analysis shall be completed
and documented to support the entity’s expectation that the hedged item
(that is, the designated last of layer) is anticipated to be outstanding as of
the hedged item’s assumed maturity date in accordance with the entity’s
partial-term hedge election. That analysis shall incorporate the entity’s
current expectations of prepayments, defaults, and other events affecting
the timing and amount of cash flows associated with the closed portfolio
of prepayable financial assets or beneficial interest(s) secured by a portfolio
of prepayable financial instruments.
b. For purposes of its analysis, the entity may assume that as prepayments,
defaults, and other events affecting the timing and amount of cash flows
occur, they first will be applied to the portion of the closed portfolio of
prepayable financial assets or one or more beneficial interests that is not
part of the hedged item (that is, the designated last of layer).
>>>> Determining Whether Risk Exposure Is Shared Within a Portfolio
55-14 This implementation guidance discusses the application of the guidance
in paragraph 815-20-25-12(b)(1) that the individual assets or individual liabilities
within a portfolio hedged in a fair value hedge 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 that paragraph.
55-14A If both of the following conditions exist, the quantitative test described
in paragraph 815-20-55-14 may be performed qualitatively and only at hedge
inception:
a. The hedged item is a closed portfolio of prepayable financial assets or one
or more beneficial interests designated in accordance with paragraph 815-
20-25-12A.
b. An entity measures the change in fair value of the hedged item based on
the benchmark rate component of the contractual coupon cash flows in
accordance with paragraph 815-25-35-13.
Using the benchmark rate component of the contractual coupon cash flows
when all assets have the same assumed maturity date and prepayment risk
does not affect the measurement of the hedged item results in all hedged
items having the same benchmark rate component coupon cash flows.
>>> Consideration of Prepayment Risk Using the Last-of-Layer Method
25-118A In a fair value hedge of interest rate risk designated under the last-of-
layer method in accordance with paragraph 815-20-25-12A, an entity may
exclude prepayment risk when measuring the change in fair value of the
hedged item attributable to interest rate risk.

Excerpt from ASC 815-25

> Estimating the Remaining Balance under the Last-of-Layer Method

35-7A When the hedged item is designated and accounted for under the last-
of-layer method in accordance with paragraph 815-20-25-12A, an entity shall
perform and document at each effectiveness assessment date an analysis that
supports the entity’s expectation that the hedged item (that is, the designated
last of layer) is still anticipated to be outstanding as of the hedged item’s
assumed maturity date. That analysis shall incorporate the entity’s current
expectations of prepayments, defaults, and other events affecting the timing
and amount of cash flows using a method consistent with the method used to
perform the analysis in paragraph 815-20-25-12A(a).

Topic 815 permits an entity to designate a fixed amount of a closed

portfolio of prepayable financial assets as the hedged item in a fair value hedge
of interest rate risk if the entity expects that the designated amount will
remain outstanding at the end of the hedge term (i.e. last of layer). One or more
beneficial interests secured by a portfolio of prepayable financial instruments
may also be designated as a last of layer. [815-20-25-12A]
If an entity uses the last-of-layer method, it does not consider prepayment risk
for assessing hedge effectiveness and measuring the change in fair value of the
hedged item attributable to interest rate risk. For example, an entity has a $1
billion closed portfolio of 15-year prepayable mortgage loans. It expects that

$300 million will remain outstanding at the end of 10 years. The entity may
designate the $300 million portion of the mortgage portfolio as the hedged item
in a fair value hedge of interest rate risk for 10 years. [815-20-25-12(b)(2), 25-12A, 25-
118A, ASU 2017-12.BC113]

This example is illustrated below.

$1bn

$300m

5 yr 10 yr 15 yr

The entity then treats the last of layer as a nonprepayable item for hedge
effectiveness assessment and measurement purposes. Consequently, it can
designate a 10-year $300 million plain vanilla interest rate swap as the hedging
instrument. [815-20-25-118A, ASU 2017-12.BC113]
To apply the last-of-layer method to a portfolio of prepayable financial assets,
certain conditions must be met.
What conditions must be met to apply the last-of-layer method?
(all conditions must be met)

Hedged last of Portfolio only

Assets in
layer is includes
Must be a portfolio share
Apply partial- expected to assets that
closed the same risk
term hedge remain are
portfolio exposure (i.e.
guidance outstanding at prepayable
(see the ‘similarity’
(see section the end of the during the
Question test)
3.3.80) hedge term hedge term
3.3.300) (see Question
(see Question (see Question
3.3.310)
3.3.320) 3.3.340)

Formal documentation. There are additional requirements related to the initial

hedge documentation. Specifically, an entity needs to document its analysis
supporting its expectation that the designated last of layer (i.e. the hedged item)
will remain outstanding at the end of the hedge term. This analysis must be
performed and documented at each effectiveness assessment date. [815-20-25-
3(c)(2)]

Question 3.3.300
What is a ‘closed portfolio’?

Interpretive response: To apply the last-of-layer method, the portfolio must be

a closed portfolio. That is, a portfolio of financial assets to which no other
financial assets will be added during the hedge term and for which the assets
are not designated in any other interest rate hedging relationship. [815-20-25-12A]
Current guidance is not clear as to whether an entity would be able to remove
assets from a closed portfolio on a discretionary basis. At a September 2018
meeting, the FASB clarified that financial assets could be sold or voluntarily
transferred from the closed portfolio, but cannot be added or replaced. [FASB
meeting 09-18]

This means that an entity can remove financial assets from the closed portfolio
in a last-of-layer hedge without dedesignating the hedging relationship. This is
because the hedged item, which is only the last-of-layer portion of the portfolio,
was not changed.

Question 3.3.310
What conditions must be met for a last-of-layer
hedge to pass the similarity test qualitatively?

Interpretive response: To apply the last-of-layer method, the prepayable

financial assets in the closed portfolio should share the same risk exposure for
the risk being hedged – i.e. the same benchmark interest rate risk. In other
words, they must pass the similarity test. [815-20-25-12A, 55-14]
An entity is permitted to assess similarity qualitatively, and is permitted to
perform this assessment only at hedge inception, only when it: [815-20-25-12A, 55-
14A, ASU 2017-12.BC112]

— applies the partial-term hedge guidance (see section 3.3.80); and

— elects to hedge only the benchmark rate component of the contractual
coupon cash flows (see section 3.3.70).
When an entity applies the partial-term hedge guidance, it assumes that the
maturities of all assets in the closed portfolio are identical. [ASU 2017-12.BC112]
Further, using the benchmark rate component when all assets have the same
assumed maturity (partial-term) has the same effect as all of the assets in the
closed portfolio having the same benchmark rate coupon. [ASU 2017-12.BC112]
The assets that comprise the closed portfolio will likely have different coupon
payment dates. We believe an entity is not required to consider differences in
coupon payment dates when performing its qualitative assessment because
coupon payment dates are not one of the criteria in performing the similarity
test qualitatively. [815-20-55-14A, ASU 2017-12.BC112]

Question 3.3.320
What is needed to support the entity’s expectation
that the last of layer will remain outstanding at the
end of the hedge term?
Interpretive response: An entity is required to perform and document an
analysis supporting its expectation that the last of layer (i.e. the hedged item)
will remain outstanding at the end of the hedge term. This is done as part of the
initial hedge documentation and on each effectiveness assessment date. [815-20-
25-12A, 815-25-35-7A, ASU 2017-12.BC113]

The analysis should incorporate the entity’s current expectations of

prepayments, defaults and other events affecting the timing and amount of
cash flows associated with the closed portfolio of prepayable financial assets
(or beneficial interests secured by a portfolio of prepayable financial assets). We
believe these expectations should be consistent with the entity’s expectations
and estimates prepared for other purposes (e.g. the allowance for credit
losses). [815-20-25-12A, 815-25-35-7A, ASU 2017-12.BC113]
In this analysis, the entity assumes that as prepayments, defaults and other
events affecting the timing and amount of cash flows occur, they will first be
applied to the portion of the closed portfolio (or one or more beneficial interests)
that is not part of the designated last of layer. [815-20-25-12A]

Question 3.3.330
Must an entity assert it is ‘probable’ that the
balance of the last of layer will remain outstanding
at the end of the hedge term?
Interpretive response: No. An entity need not assert that it is ‘probable’ that
the last of layer (i.e. the hedged item) will remain outstanding at the end of the
hedge term. [ASU 2017-12.BC115]
Instead, the entity only needs to have an expectation that the last of layer will
remain outstanding at the end of the hedge term and should support that
expectation (see Question 3.3.320). We believe the FASB intended this to be a
lower threshold than probable.

Question 3.3.340
What financial instruments can be included in the
portfolio under the last-of-layer method?

Interpretive response: The financial instruments in the portfolio from which

the last of layer is derived are comprised solely of assets that are prepayable
(e.g. mortgage loans) during the hedge term and that would be eligible as a
hedged item in a fair value hedge. At its February 2018 Board meeting, the
FASB clarified that financial instruments considered prepayable for the purpose
of applying paragraph 815-20-25-6B would also be considered to be prepayable
for the purpose of applying the last-of-layer method. [Staff interpretation]

For a discussion of what is considered prepayable for the purpose of applying

paragraph 815-20-25-6B, see Question 3.4.30.
The last-of-layer method can also be applied to a beneficial interest, or a
portfolio of beneficial interests collateralized by prepayable financial
instruments. The FASB decided to allow the last-of-layer method to be applied
to these types of beneficial interests because their cash flows are generated
from a portfolio of prepayable financial instruments. Therefore, the economic
substance of their cash flows is the same as that of a portfolio of prepayable
financial assets. [ASU 2017-12.BC124]

Question 3.3.350
Can the last-of-layer method be applied to a
portfolio of financial liabilities?

Interpretive response: No. The FASB did not extend the last-of-layer method
to financial liabilities.
An important part of the FASB’s rationale for providing the last-of-layer method
was the high degree of uncertainty about which individual assets would prepay.
For financial assets, this uncertainty exists because the borrower controls the
decision of whether to prepay the asset – not the entity looking to hedge. For
financial liabilities, there is less uncertainty about prepayments because
the entity looking to hedge the liability controls the decision to prepay. [ASU
2017-12.BC126]

Question 3.3.360
Can an entity hedge multiple layers under the last-
of-layer method?

Background: An entity may wish to designate multiple layers under the last-of-
layer method. For example, assume an entity has a $1 billion closed portfolio of 15-
year prepayable mortgage loans. The entity may wish to designate $300 million
of the portfolio expected to be outstanding at the end of ten years and $700
million of the portfolio expected to be outstanding at the end of five years.
$1bn

$700m

$300m

5 yr 10 yr 15 yr

Interpretive response: At a March 2018 meeting, the FASB stated that entities
should not apply a multiple-layer hedging strategy under the last-of-layer
method.
The FASB is undertaking a narrow-scope project to determine whether hedging
multiple layers should be permitted. As a result, revisions to this interpretive
response may be provided in a future edition.

3.4 Eligibility of hedged risks

Criterion 1 Criterion 2 Criterion 3 Criterion 4

Eligibility of Eligibility of
Eligibility of Hedge
hedged items hedging
hedged risk(s) effectiveness
or transactions instruments

Criterion 5: Formal documentation

Sections 2.3 and 2.4 provide an overview of the eligible hedged risks for both
financial and nonfinancial items, including limitations on certain risks for hedged
items.
This section provides detail around the eligibility criteria of hedged risks that are
specific to fair value hedges, including:
— interest rate risk on prepayable financial instruments (section 3.4.10); and
— limitations on price risk for nonfinancial items (section 3.4.20).

Foreign currency risk. For further guidance on foreign currency risk as it

relates to fair value hedges, see chapter 7.

3.4.10 Interest rate risk hedges of prepayable financial

instruments

Excerpt from ASC 815-20

>>> Hedged Items Involving Interest Rate Risk

25-6 Hedges involving a benchmark interest rate are addressed in
paragraphs 815-20-25-12(f) and 815-20-25-12A (for fair value hedges) and
paragraph 815-20-25-15(j) (for cash flow hedges). Hedges involving a
contractually specified interest rate are addressed in paragraph 815-20-25-15(j)
(for cash flow hedges). The benchmark interest rate or the contractually
specified interest rate being hedged in a hedge of interest rate risk shall be
specifically identified as part of the designation and documentation at the
inception of the hedging relationship. Paragraphs 815-20-25-19A through 25-
19B provide guidance on the interest rate risk designation of hedges of

forecasted issuances or purchases of debt instruments. An entity shall not

simply designate prepayment risk as the risk being hedged for a financial asset.
However, it can designate the option component of a prepayable instrument
as the hedged item in a fair value hedge of the entity’s exposure to changes in
the overall fair value of that prepayment option, perhaps thereby achieving the
objective of its desire to hedge prepayment risk. The effect of an embedded
derivative of the same risk class shall be considered in designating a hedge of
an individual risk. For example, the effect of an embedded prepayment option
shall be considered in designating a hedge of interest rate risk.
>>>> Fair Value Hedges of Interest Rate Risk in Which the Hedged Item
Can Be Settled before Its Scheduled Maturity
25-6B An entity may designate a fair value hedge of interest rate risk in which
the hedged item is a prepayable instrument in accordance with paragraph 815-
20-25-6. The entity may consider only how changes in the benchmark interest
rate affect the decision to settle the hedged item before its scheduled maturity
(for example, an entity may consider only how changes in the benchmark
interest rate affect an obligor’s decision to call a debt instrument when it has
the right to do so). The entity need not consider other factors that would affect
this decision (for example, credit risk) when assessing hedge effectiveness.
Paragraph 815-25-35-13A discusses the measurement of the hedged item.

Excerpt from ASC 815-25

>>> Measuring the Fair Value of a Prepayable Instrument in Hedges of

Interest Rate Risk
35-13A In a hedge of interest rate risk in which the hedged item is a
prepayable instrument in accordance with paragraph 815-20-25-6, the factors
incorporated for the purpose of adjusting the carrying amount of the hedged
item shall be the same factors that the entity incorporated for the purpose of
assessing hedge effectiveness in accordance with paragraph 815-20-25-6B. For
example, if an entity considers only how changes in the benchmark interest
rate affect an obligor’s decision to prepay a debt instrument when assessing
hedge effectiveness, it shall consider only that factor when adjusting the
carrying amount of the hedged item. The election to consider only how
changes in the benchmark interest rate affect an obligor’s decision to prepay a
debt instrument does not affect an entity’s election to use either the full
contractual coupon cash flows or the benchmark rate component of the
contractual coupon cash flows determined at hedge inception for purposes of
measuring the change in fair value of the hedged item in accordance with
paragraph 815-25-35-13.

Interest rate risk. When the hedged risk is changes in interest rates on a
financial instrument with a prepayment option, an entity considers the
prepayment option when measuring the change in the hedged item’s fair value
attributable to interest rate risk unless the hedged item is not prepayable during
the hedge term. For example, partial-term hedges using an assumed term that

ends before (or on) the initial date a financial instrument can be prepaid
(see Question 3.3.220).
Topic 815 allows an entity to consider only the effect of changes in the
benchmark interest rate on the decision to prepay a financial instrument. If an
entity elects this approach, it does not consider in its assessment of hedge
effectiveness how other factors (e.g. credit risk) might affect the decision to
prepay the financial instrument. [815-20-25-6B]
The factors that an entity uses to measure the change in the hedged item’s fair
value are the same factors that it uses for assessing hedge effectiveness. [815-25-
35-13A]

Question 3.4.10
Why would an entity elect to consider only the
effect of changes in the benchmark interest rate on
the decision to prepay the financial instrument?
Interpretive response: Electing this alternative will make achieving hedge
accounting more likely and provide a better accounting offset between the
hedging instrument and the hedged item when hedge accounting is achieved.
In a fair value hedge, an entity measures the change in the hedged item’s fair
value attributable to interest rate risk. If the hedged item is or will become
prepayable during the hedge term, the entity incorporates the effect of the
prepayment option into this measurement. [815-20-25-6]
One way to incorporate the effect of the prepayment option is to measure the
change in the hedged item’s fair value without the prepayment option, and then
add the change (positive or negative) in the fair value of the prepayment option.
When determining the change in the fair value of the prepayment option, an
entity may elect to consider only the effect that changes in the benchmark
interest rate have on the decision to prepay the hedged instrument. This
approach helps align an entity’s hedge accounting and risk management
activities, and it more accurately reflects the change in the fair value of the
hedged item attributable to interest rate risk. [ASU 2017-12.BC99]

Question 3.4.20
Is an entity required to consider only how changes
in the benchmark interest rate affect the decision to
prepay?
Interpretive response: No. This is an election for each hedging relationship.
An entity can also continue to consider all factors (e.g. credit risk, liquidity,
interest rates) when measuring the change in the fair value of the option to
prepay. [815-20-25-6B]

Question 3.4.30
What instruments are considered prepayable under
paragraph 815-20-25-6B?

Interpretive response: The term ‘prepayable’ is defined in the Master

Glossary as “able to be settled by either party before its scheduled
maturity.” [815-25 Glossary]
At the February 2018 Board meeting, the FASB noted that it intended for
paragraph 815-20-25-6B to apply to financial instruments that are prepayable
according to the Master Glossary definition, except for instruments that are only
prepayable before maturity upon the occurrence of an event related to the
debtor's credit risk. [Staff interpretation]
In addition, the FASB clarified that the following financial instruments are
considered prepayable for purposes of paragraph 815-20-25-6B:
— nonconvertible debt with currently exercisable embedded non-contingent
call or put options;
— nonconvertible debt with embedded options that are exercisable during the
hedge term solely based on the passage of time;
— nonconvertible debt with embedded contingent call or put options; and
— debt that is convertible into the issuer’s shares during the hedge term.
However, certain instruments that are considered prepayable for purposes of
paragraph 815-20-25-6B may not be considered prepayable for other purposes.
For example, the following debt instruments would be considered prepayable
for purposes of paragraph 815-20-25-6B, but are not considered prepayable for
purposes of applying the shortcut method (see section 9.3):
— fixed-rate debt that is callable at its then fair value;
— fixed-rate debt that includes a make-whole provision; and
— debt that includes a contingent acceleration clause that permits the issuer
to accelerate the debt’s maturity only upon the occurrence of a specified
event that (1) is not probable at the time the debt was issued; (2) is
unrelated to changes in any market variable, including benchmark interest
rates; and (3) is related to regulatory or legislative actions, or other similar
events that are beyond the control of the debt issuer or holder.
For the application of paragraph 815-20-25-6B to nonconvertible debt with
embedded contingent call or put options and convertible debt, see
Questions 3.4.40 and 3.4.50, respectively.

Example 3.4.10
Applying paragraph 815-20-25-6B to a callable bond
ABC Corp. issues a 10-year fixed-rate bond that is callable any time starting
after Year 5. ABC designates the entire term of the bond as the hedged item
and designates a 10-year receive-fixed, pay-variable interest rate swap as the
hedging instrument in a fair value hedge of interest rate risk.
ABC elects to assess hedge effectiveness considering only changes in the
benchmark interest rate when evaluating whether it will call the debt before its

scheduled maturity – i.e. it does not consider other factors that could affect the
exercise of the call option.
If ABC did not make this election, it would have considered all factors (e.g.
credit risk, liquidity, interest rates) that could result in calling the bond before its
maturity when measuring the change in fair value of the call option – e.g. ABC
would have considered changes in its own creditworthiness because such
changes could affect its decision to refinance the bond.

Question 3.4.40
How does paragraph 815-20-25-6B apply to
nonconvertible debt with an embedded contingent
call or put option?
Interpretive response: Contingent calls and puts are options that become
exercisable upon the occurrence of an event.
If the call or put option is exercisable contingent on an event that is not
explicitly linked to interest rates (e.g. it is linked to a change in control or an
initial public offering by the issuer) and the contingency is substantive, the
entity can ignore the option until the contingent event occurs. Once the
contingent event occurs, the call or put option is currently exercisable and the
entity considers only how changes in the benchmark interest rate affect the
decision to settle the debt instrument before its scheduled maturity.
If the call or put option is exercisable contingent on an event explicitly linked to
the benchmark interest rate (e.g. callable if LIBOR exceeds 2.0%), an entity
should measure the hedged item’s fair value attributable to interest rate risk
considering:
— fluctuations in interest rates that would cause the occurrence of the
contingent event; and
— the probability of exercise given the interest rate scenario (only considering
the effect of the benchmark interest rate).

Example 3.4.20
Applying paragraph 815-20-25-6B to a
nonconvertible bond with an embedded contingent
put
ABC Corp. issues a nonconvertible bond. If ABC sells a substantial asset, the
bond holder can put the bond back to ABC any time after the sale.
ABC designates the bond as a hedged item in a fair value hedge. Because the
put option is not currently exercisable and its exercisability is contingent on an
event that is not explicitly linked to interest rates, ABC does not consider the
put option for purposes of assessing hedge effectiveness and measuring the
change in fair value of the bond attributable to interest rate risk until ABC sells a
substantial asset.

If ABC sells a substantial asset, the option would become non-contingent and
ABC would then consider how changes in the designated benchmark interest
rate would affect the holder’s decision to exercise the put option for
assessment and measurement purposes.

Question 3.4.50
Does paragraph 815-20-25-6B apply to interest rate
risk hedges related to debt conversion options?

Background: A debt instrument that is convertible into a fixed number of the

issuer’s equity shares may have an interest rate significantly less than the
interest rate on a similar debt instrument that is not convertible.
Therefore, changes in interest rates generally do not significantly affect the
decision to exercise a call or put option embedded in a convertible debt
instrument. Instead, that decision is typically based on the issuer’s or holder’s
view of the current and future expectations of the:
— underlying equity instrument’s price;
— volatility of the equity instrument’s price; and
— dividend yield on the equity instrument.
Interpretive response: Yes. At the February 2018 Board meeting, the FASB
concluded that an entity may apply the guidance in paragraph 815-20-25-6B for
interest rate risk hedges related to convertible debt. Equity price changes
typically have a significant effect on the conversion option’s fair value.
However, if an entity applies the guidance in paragraph 815-20-25-6B, it ignores
how changes in equity prices affect the holder’s decision to exercise the
conversion option when assessing hedge effectiveness and measuring the
change in the hedged item’s fair value attributable to interest rate risk. [Staff
interpretation]

Question 3.4.60
Does the election to consider only how changes in
the benchmark interest rate affect the decision to
prepay a debt instrument have to be applied to all
prepayable hedged items?
Interpretive response: No. For fair value hedges, the election to consider only
how changes in the benchmark interest rate affect the decision to prepay the
hedged item when measuring its change in fair value attributable to interest
rate risk is made on a hedge-by-hedge basis. [ASU 2017-12.BC129]

3.4.20 Limitations on price risk for nonfinancial items

Price risk. Fair value hedge accounting is permitted for nonfinancial assets
and liabilities (other than a recognized loan servicing right or nonfinancial firm

commitment with financial components) when the designated hedged risk is

the risk of changes in the fair value of the entire asset or liability (i.e. price
risk). [815-20-25-12(e)]
Therefore, an entity is prohibited from disaggregating the risk profile of a
nonfinancial asset or liability and designating one component of the profile as
the hedged risk. This is because changes in the fair value of an ingredient or
component of a nonfinancial asset or liability generally do not have a predictable
and separately measurable effect on the fair value of the item that is
comparable to the effect of, for example, the change in the market interest
rates on the price of a bond. [FAS 133.BC416]
However, an entity could hedge its exposure to total price risk and achieve
results similar to hedging a component of a nonfinancial asset (or liability).
Topic 815 permits a derivative instrument with the price of a component as its
underlying to hedge changes in the fair value of the entire nonfinancial asset (or
liability). To qualify for hedge accounting, the derivative instrument (based on
the underlying component) must be highly effective at offsetting changes in fair
value of the entire asset (or liability).

Example 3.4.30
Fair value hedge of gold watch inventory with a gold
futures contract
Goldco, a gold watch manufacturer, would not qualify for fair value hedge
accounting if it used a gold futures contract to hedge the gold component of its
gold watch inventory.
However, Goldco would be able to qualify for fair value hedge accounting if it
used a gold futures contract to hedge the fair value risk of its gold watch
inventory provided it can demonstrate that the gold futures contract is highly
effective in offsetting the changes in fair value associated with the inventory of
gold watches (i.e. total price risk).

3.5 Hedging instruments in fair value hedges

Criterion 1 Criterion 2 Criterion 3 Criterion 4

Eligibility of Eligibility of
Eligibility of Hedge
hedged items hedging
hedged risk(s) effectiveness
or transactions instruments

Criterion 5: Formal documentation

3.5.10 Overview
There is no additional guidance specific to fair value hedges regarding the
eligibility of hedging instruments, other than fair value hedges involving foreign
currency risk.

Foreign currency risk. For guidance on the eligibility of hedging

instruments in a fair value hedge of foreign currency risk, see section 7.4.10.

4. Accounting for fair value

hedges
Detailed contents
4.1 How the standard works
4.2 Fair value hedge accounting model
4.2.10 Overview
4.2.20 Excluded components
Question
4.2.10 Are changes in the fair value of a hedged AFS debt security
recognized in earnings?
Examples
4.2.10 Accounting for a hedge that lacks perfect offset
4.2.20 Comparison of approaches to recognize excluded
component (time value) for a hedge of an AFS debt security
with a put option
4.3 Measuring the hedged item (basis adjustments)
4.3.10 Overview
4.3.20 Hedges involving interest rate risk
4.3.30 Portfolio-level basis adjustments
Questions
4.3.10 May a basis adjustment be measured using a method
different from that used to assess effectiveness?
4.3.20 Is it appropriate to use the change in fair value of the
hedging instrument to measure the basis adjustment?
4.3.30 Do the principles of Topic 820 apply when measuring a
basis adjustment?
4.3.40 Does a basis adjustment result in the hedged item being
measured at its fair value?
4.3.50 When the hedged risk is overall changes in fair value, can
any of the contractual cash flows be excluded from the
basis adjustment measurement?
4.3.60 What discount rate should be applied when calculating the
change in fair value of the hedged item attributable to
changes in the benchmark rate?
4.3.70 When the hedged risk is the benchmark interest rate, are
changes in sector credit spreads, issuer credit risk or

liquidity spreads included in the measurement of the basis

adjustment?
4.3.80 What is the benchmark rate component if the hedged item
is a nonprepayable financial instrument?
4.3.90 What is the benchmark rate component if the hedged item
is a prepayable financial instrument?
4.3.100 What is the benchmark rate component if the hedged item
has a premium or discount at hedge inception?
4.3.110 Can the benchmark rate component of the contractual
coupon be used if it is greater than the entire coupon?
4.3.120 Does Topic 815 prescribe a method to be used for
measuring the basis adjustment when the benchmark
interest rate is hedged?
4.3.130 When the last-of-layer method is used, is it necessary to
allocate the basis adjustment?
4.3.140 When assets in the portfolio from which the last of layer is
derived are sold during the hedge term, is the related basis
adjustment allocated to individual assets?
Examples
4.3.10 Fair value hedge of inventory after initial recognition
4.3.20 Accounting for the hedge of long-term debt with an interest
rate swap (shortcut method)
4.3.30 Accounting for a fair value hedge of the LIBOR swap rate in
a fixed-rate noncallable note
4.3.40 Accounting for a hedge of a firm commitment to purchase
silver with a forward contract
4.3.50 Benchmark rate component for assessment and
measurement
4.3.60 Change in fair value attributable to changes in LIBOR – all
contractual cash flows included
4.4 Subsequent accounting for basis adjustments
4.4.10 Overview
4.4.20 Interest-bearing financial instruments
4.4.30 Measuring impairment
Questions
4.4.10 For firm commitments, what is the subsequent accounting
for assets (liabilities) recognized due to applying fair value
hedge accounting?
4.4.20 When is amortization of the basis adjustment for interest-
bearing financial instruments required to begin?
4.4.30 Over what period are basis adjustments of interest-bearing
financial instruments amortized?

4.4.40 Do basis adjustments for interest-bearing borrowings affect

the capitalization of interest?
KPMG observation
Measurement of credit losses on financial instruments
4.5 Discontinuing hedge accounting
4.5.10 Overview
4.5.20 Hedge relationship is no longer highly effective
4.5.30 Last-of-layer hedging relationships
Questions
4.5.10 Does amortization begin if a portfolio of hedged items that
is hedged by a combination of derivatives is rebalanced?
4.5.20 What is the accounting for a partially dedesignated fair
value hedging relationship?
4.5.30 How is the outstanding basis adjustment allocated to the
individual items in a portfolio on a full discontinuation?
Examples
4.5.10 Accounting for the termination of an interest rate swap
hedging fixed-rate debt
4.5.20 Identifying the date a hedging relationship ceased to be
highly effective
4.5.30 Discontinuation of a last-of-layer method hedge

4.1 How the standard works

A fair value hedge is a hedge of the exposure to changes in the fair value of a
recognized asset or liability, or of an unrecognized firm commitment, that are
attributable to a particular risk.
In general, the fair value hedge accounting model has two main elements.

Hedging instrument Hedged item

A derivative hedging instrument is Changes in the fair value of the hedged
recognized at fair value on the balance item that are attributable to the hedged
sheet with changes in fair value risk are recognized on the balance
recognized in earnings, other than sheet as an adjustment to the
amounts related to excluded amortized cost basis of the hedged
components that are recognized through item. The offsetting entry is a gain or
an amortization approach. loss that is recognized in earnings.

The following diagram shows the general accounting and presentation for a
highly effective fair value hedge (not including excluded components).

Hedging instrument Hedged item

Changes in fair value

Change in value
Gain or loss recognized
attributable to hedged risk
in earnings
recognized in earnings

Income statement presentation

Recorded in the same income statement line item where the

earnings effect of the hedged item is presented

The effect is to offset gains or losses on the hedging instrument with gains or
losses on the hedged item that are attributable to the hedged risk within one
line item of the income statement.
Basis adjustments. The adjustment to the amortized cost basis of the hedged
item from applying fair value hedge accounting is referred to as a basis
adjustment. Basis adjustments are accounted for in the same manner as other
components of the amortized cost basis of the hedged item.

4.2 Fair value hedge accounting model

4.2.10 Overview

Excerpts from Subtopic 815-20

35-1 Paragraph 815-10-35-2 states that the accounting for subsequent changes
in the fair value (that is, gains or losses) of a derivative instrument depends
on whether it has been designated and qualifies as part of a hedging
relationship and, if so, on the reason for holding it. Specifically, subsequent
gains and losses on derivative instruments shall be accounted for as follows:
…
b. Fair value hedge. The gain or loss on a derivative instrument designated
and qualifying as a fair value hedging instrument as well as the offsetting
loss or gain on the hedged item attributable to the hedged risk shall be
recognized currently in earnings in the same accounting period, as provided
in paragraphs 815-25-35-1 through 35-6. The gain or loss on the hedging
derivative or nonderivative instrument in a hedge of a foreign-currency-
denominated firm commitment and the offsetting loss or gain on the
hedged firm commitment shall be recognized currently in earnings in the
same accounting period, as provided in paragraphs 815-20-25-58 through
25-59. The gain or loss on the hedging derivative instrument in a hedge of
an available-for-sale debt security and the offsetting loss or gain on the
hedged available-for-sale debt security shall be recognized currently in
earnings in the same accounting period.
> Income Statement Classification
45-1A For qualifying fair value and cash flow hedges, an entity shall present
both of the following in earnings in the same income statement line item that
is used to present the earnings effect of the hedged item:
a. The change in the fair value of the hedging instrument that is included in
the assessment of hedge effectiveness
b. Amounts excluded from the assessment of hedge effectiveness in
accordance with paragraphs 815-20-25-83A through 25-83B.
See paragraphs 815-20-55-79W through 55-79AD for related implementation
guidance.
45-1D While the Derivatives and Hedging Topic does not specify whether
certain income statement line items are either permitted or appropriate, the
other hedging-related Subtopics in this Topic do contain specific disclosure
requirements for those items. See Section 815-10-50 and Subtopics 815-25,
815-30, and 815-35.
> Statement of Cash Flows
45-2 For guidance on the classification of cash receipts and payments related
to hedging activities, see paragraph 230-10-45-27.
> Other Comprehensive Income
45-3 An entity shall display as a separate classification within other
comprehensive income the net gain or loss on derivative instruments

designated and qualifying as fair value or cash flow hedging instruments that
are reported in comprehensive income pursuant to paragraphs 815-20-25-65,
815-20-25-83A, and 815-30-35-3.

Excerpt from ASC 815-25

> Changes in Fair Value in General

35-1 Gains and losses on a qualifying fair value hedge shall be accounted for
as follows:
a. 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.
b. 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.
35-4 Although a hedging relationship must comply with an entity’s established
policy range of what is considered highly effective pursuant to paragraphs 815-
20-25-75 through 25-85 for that relationship to qualify for hedge accounting,
that compliance does not assure perfect offset between the gain or loss on the
hedging instrument and the hedged item attributable to the hedged risk. Any
gain or loss on the hedging instrument that does not offset the gain or loss on
the hedged item attributable to the hedged risk is recognized in earnings in the
same income statement line item as the earnings effect of the hedged item in
accordance with paragraph 815-20-45-1A.
35-6 If a hedged item is otherwise measured at fair value with changes in fair
value reported in other comprehensive income (such as an available-for-sale
debt security), the adjustment of the hedged item’s carrying amount discussed
in paragraph 815-25-35-1(b) shall be recognized in earnings rather than in other
comprehensive income to offset the gain or loss on the hedging instrument.
> Entities That Do Not Report Earnings
35-19 An entity that does not report earnings as a separate caption in a
statement of financial performance (for example, a not-for-profit entity [NFP] or
a defined benefit pension plan) shall recognize the gain or loss on a hedging
instrument as a change in net assets in the period of change unless the
hedging instrument is designated as a hedge of the foreign currency exposure
of a net investment in a foreign operation. In that circumstance, the provisions
of paragraphs 815-20-25-66 and 815-35-35-1 through 35-2 shall be applied.
Entities that do not report earnings shall recognize the changes in the carrying
amount of the hedged item pursuant to paragraphs 815-25-35-1 and 815-25-35-
4 in a fair value hedge as a change in net assets in the period of change.

In general, the fair value hedge accounting model has two main elements.
[815-25-35-1]

— Hedging instrument. A derivative hedging instrument is recognized at fair

value on the balance sheet with changes in fair value recognized in
earnings, other than amounts related to excluded components that are
recognized through an amortization approach (see section 4.2.20).
— Hedged item. Changes in the fair value of the hedged item that are
attributable to the hedged risk are recognized on the balance sheet as an
adjustment to the amortized cost basis of the hedged item. The offsetting
entry is a gain or loss that is recognized in the same income statement line
item as the gain or loss on the hedging instrument (see section 4.3).
The effect of the fair value hedge accounting model is to offset gains or losses
on the hedging instrument with gains or losses on the hedged item within one
line item of the income statement. If the hedging relationship is: [815-25-35-4]
— Perfectly effective. These amounts exactly offset each other.
— Not perfectly effective. The extent to which these changes do not
perfectly offset is reflected in a single line item of the income statement.
When the earnings effect of the hedged item is presented in more than one line
item, the change in the fair value of the hedging instrument is allocated to the
different line items. [815-20-55-79Z – 55-79AD]

Question 4.2.10
Are changes in the fair value of a hedged AFS debt
security recognized in earnings?

Interpretive response: Yes, to the extent that the changes in fair value are
attributable to the hedged risk. When the hedged item is measured at fair value
with the changes in fair value reported in OCI (e.g. AFS debt securities),
changes in the hedged item’s fair value attributable to the risk being hedged are
recognized in earnings rather than OCI. However, the unrealized gain or loss
that arose between the time the hedged item was initially recognized and the
time it was designated in a hedging relationship (if any) continues to be
recognized in AOCI. Additionally, changes in fair value after inception of the
hedging relationship that are not attributable to the hedged risk are recognized
in AOCI. See also Question 4.3.40. [815-25-35-6]

Hedged item (basis adjustments)

The adjustment to the amortized cost basis of the hedged item from applying
fair value hedge accounting is referred to as a basis adjustment.
Hedged items continue to be subject to other applicable US GAAP, including for
assessing impairment (see section 4.4.30). Basis adjustments are accounted for
in the same manner as other components of the amortized cost basis of the
hedged item. Topic 815 provides additional guidance regarding how basis
adjustments are considered when applying other applicable GAAP for interest-
bearing financial instruments (see section 4.4.20).

When a fair value hedge is discontinued, the basis adjustment generally is not
recognized immediately in earnings. Instead, it remains part of the amortized
cost basis of the hedged item and continues to be accounted for in the same
manner as other components of the amortized cost basis. The basis adjustment
is included in the gain or loss calculation if the hedged item is derecognized
(see section 4.5.10).

Hedging instruments
As discussed in section 4.2.20, Topic 815 permits an entity to exclude certain
components of a hedging instrument from the assessment of a fair value
hedge’s effectiveness. The following table summarizes the timing and
presentation for recognizing in earnings changes in a derivative hedging
instrument’s fair value that arise during the hedging relationship, depending on
whether the change in fair value relates to a component that is included or
excluded from the effectiveness assessment.

Timing of earnings recognition Presentation in

Component for changes in fair value income statement
Changes in fair value Recognized in earnings Same line item as the
that are included in the immediately effect of hedged item
assessment of hedge
effectiveness

Initial value of the Depends on the approach Same line item as the
excluded component elected (see section 4.2.20): effect of hedged item
and the subsequent
— Amortization approach.
changes in its fair value
The initial fair value of an
excluded component is
recognized in earnings using
a systematic and rational
method. Any difference
between the change in the
fair value of the excluded
component and the amounts
recognized in income are
included in OCI.
— Mark-to-market approach.
Changes in fair value are
recognized in earnings
immediately – i.e. as the
changes occur.

Examples
The following examples demonstrate the fair value hedge accounting model:
— Accounting for a hedge that lacks perfect offset (Example 4.2.10).
— Income statement presentation of hedging instruments (FASB
paragraphs 815-20-55-79W – 55-79Y).

Example 4.2.10
Accounting for a hedge that lacks perfect offset
On January 1, Year 1, ABC Corp. designates a derivative as the hedging
instrument in a fair value hedge of interest rate risk on a recognized fixed-rate
debt obligation. On that date, ABC formally documents that the hedging
relationship is expected to be highly effective – i.e. the derivative hedging
instrument is expected to be highly effective in achieving offsetting changes in
fair value attributable to the hedged risk (interest rate risk) during the period that
the hedge is designated. ABC also documents that its established policy for the
range of the extent of that offset that is considered highly effective is 80%–
125%.
During the three months ended March 31, Year 1, changes in the fair values of
the derivative hedging instrument and the hedged debt attributable to the
hedged risk are as follows.

Fair value
increase (decrease)
Derivative hedging instrument $(50,000)
Hedged debt attributable to the hedged risk (interest rate risk) 45,000
Hedge effectiveness1 111%
Note:
$50,000 ÷ $45,000.

Because the hedging relationship was highly effective during the three months
ended March 31, Year 1 in achieving offsetting changes in fair value attributable
to the hedged risk, ABC applies fair value hedge accounting for the period.
ABC records the following journal entry.

Debit Credit
Interest expense 50,000
Derivative hedging instrument 50,000
To record change in fair value of derivative
hedging instrument.
Debt 45,000
Interest expense 45,000
To record change in fair value of hedged item
attributable to hedged risk.

Although the hedging relationship is highly effective, ABC’s net income reflects
the $5,000 loss on the derivative hedging instrument that exceeds the gain on
the hedged item. This amount reflects the extent to which the hedging
relationship is not perfectly effective.

Excerpts from Subtopic 815-20

>>> Income Statement Presentation of Hedging Instruments

55-79W Paragraph 815-20-45-1A requires an entity to present the change in
the fair value of the hedging instrument included in the assessment of hedge
effectiveness and the amount excluded from the assessment of hedge
effectiveness in the same income statement line item that is used to present
the earnings effect of the hedged item. The following scenarios include
implementation guidance on the meaning of the phrase the same income
statement line item that is used to present the earnings effect of the hedged
item.
>>>> Scenario A
55-79X Entity A designates a fair value hedge of interest rate risk in which the
hedged item is a portfolio of fixed-rate loans. The derivative designated as the
hedging instrument is a receive-floating-rate, pay-fixed-rate interest rate swap.
In this scenario, Entity A’s objective is to convert the interest cash flows on the
portfolio of fixed-rate loans to floating-rate.
55-79Y The interest rate swap is a highly effective hedge of the interest rate
risk of the portfolio of fixed-rate loans. Therefore, the change in the fair value of
the interest rate swap should be presented in the same income statement line
item used to present the earnings effect of the hedged item. Before applying
hedge accounting, the earnings effect of the hedged item (that is, the interest
accruals) is presented in an interest income line item. Therefore, Entity A
should present all changes in the fair value of the hedging instrument (that is,
the interest accruals and all other changes in fair value) in the same interest
income line item in the income statement.

4.2.20 Excluded components

Topic 815 permits an entity to exclude certain components of a hedging
instrument – for example, the time value of an option – from the assessment
of hedge effectiveness (see section 9.2.70).
An entity can recognize the initial value of the excluded components in earnings
using either of the following approaches. [815-20-25-83A – 25-83B]
— Amortization approach. A systematic and rational method over the life of
the hedging instrument.
— Mark-to-market approach. A method that recognizes all fair value changes
of the excluded components currently in earnings, consistent with legacy
US GAAP.
An entity presents amounts related to excluded components that are
recognized in earnings in the same income statement line item that is used to
present the earnings effect of the hedged item. [815-20-45-1A]
When using the amortization approach, any difference between the change in
the fair value of the excluded component and the amounts recognized in
income are included in OCI each period. Net gains or losses on derivative

hedging instruments that are included in AOCI are displayed as a separate

classification within AOCI. [815-20-25-83A, 45-3]
The tax effect of amounts recorded in OCI also should be charged or credited
directly to OCI. See KPMG’s Handbook, Accounting for Income Taxes, including
paragraphs 9.043 and 9.050, for further information.
Any amounts associated with the excluded component remaining in AOCI
when a fair value hedge is discontinued are recorded in earnings in the same
manner as other components of the amortized cost basis of the hedged asset
or liability when the hedged item continues to exist (see section 4.5.10).

Examples
The following FASB example describes approaches for assessing effectiveness
in a fair value hedge of a recognized asset (US Treasury bond) with a purchased
option when time value is excluded – i.e. time value is an excluded component.
As discussed in section 9.4.20 (and consistent with paragraph 815-20-35-16 and
the discussion in section 9.2.60). We believe the critical terms match method is
precluded for fair value hedging relationships in the vast majority of
circumstances.
The FASB example is followed by a KPMG example that illustrates assessing
effectiveness in the fair value hedge described in the FASB example when the
recognized asset is classified as an available for sale security. It includes two
scenarios, illustrating and comparing the mark-to-market and amortization
approaches for recognizing the excluded component.

Excerpt from ASC 815-25

>> Example 5: Fair Value Hedge of U.S. Treasury Bond with Put Options

55-23 This Example illustrates the guidance in Sections 815-20-25, 815-20-35,

and 815-25-35 for how an entity may assess hedge effectiveness in a fair value
hedge of a U.S. Treasury bond with put options. Assume that the hedge
satisfied all of the criteria for hedge accounting at inception.
55-24 Entity E owns a U.S. Treasury bond and wants to protect itself against
the fair value exposure to declines in the price of the bond. Entity E purchases
an at-the-money put option on a U.S. Treasury security with the same terms
(remaining maturity, notional amount, and interest rate) as the U.S. Treasury
bond held and designates the option as a hedge of the fair value exposure of
the U.S. Treasury bond. Entity E plans to hold the put option until it expires.
55-25 Because Entity E plans to hold the put option (a static hedge) rather than
manage the position with a delta-neutral strategy, it could assess whether it
expects the hedge to be highly effective at achieving offsetting changes in fair
value by calculating and comparing the changes in the intrinsic value of the
option and changes in the price (fair value) of the U.S. Treasury bond for
different possible market prices. In assessing the expectation of effectiveness
on an ongoing basis, Entity E also must consider the actual changes in the fair

value of the U.S. Treasury bond and in the intrinsic value of the option during
the hedge period.
55-26 However, because the pertinent critical terms of the option and the bond
are the same in this Example, Entity E could expect the changes in value of the
bond attributable to changes in interest rates and changes in the intrinsic value
of the option to offset completely during the period that the option is in the
money. That is, the hedging relationship will be perfectly effective because
Entity E has chosen to exclude changes in the option’s time value from the
assessment of hedge effectiveness. Entity E may elect to account for changes
in the time value of the option through an amortization approach in accordance
with paragraph 815-20-25-83A or through a mark-to-market approach in
accordance with paragraph 815-20-25-83B. Under either of those approaches,
it should present the portion of excluded components recognized in earnings in
the same income statement line item as the earnings effect of the hedged
item in accordance with paragraph 815-20-45-1A.

Example 4.2.20
Comparison of approaches to recognize excluded
component (time value) for a hedge of an AFS debt
security with a put option
ABC Corp. purchases at par a US Treasury bond with a face value of
$15,000,000 that it classifies as AFS.
On January 1, Year 1, the fair value of the US Treasury bond is $18,500,000 and
ABC wants to protect itself against the fair value exposure to declines in the
price of the bond. Therefore, ABC purchases an at-the-money put option on a
US Treasury security with the same terms (remaining maturity, notional
amount, and interest rate) as the US Treasury bond it holds. ABC pays a
premium of $200,000.
ABC designates the put option as the hedging instrument in a hedge of the
changes in fair value of the US Treasury bond. ABC plans to hold the put option
until it expires.
The following additional facts are relevant.
— All criteria for hedge accounting have been met.
— ABC will assess hedge effectiveness by comparing changes in the intrinsic
value of the put option with changes in the fair value of the US Treasury
bond. Because the option provides only one-sided protection, effectiveness
is required to be assessed during only those periods in which the put option
has an intrinsic value.
— The hedging relationship is expected to be perfectly effective.
— At inception, ABC concluded that the changes in the intrinsic value of
the option will be highly (100%) effective at offsetting the changes in
the fair value of its investment in the US Treasury bond.
— On an ongoing basis, ABC will ascertain and document that the hedging
relationship has been, and will continue to be, highly (100%) effective.

— The changes in fair values of both the US Treasury bond and the put option
that are attributable to credit risk are nominal and are disregarded for
purposes of this example.
— The put option is fully collateralized
— Credit risk associated with the US Treasury bond is considered to be
nominal.
— ABC elects to exclude changes in the time value of the option from the
assessment of hedge effectiveness.
— The debt security’s fair value is as shown in the following table.

Date Fair value

January 1, Year 1 $18,500,000
March 31, Year 1 19,000,000
June 30, Year 1 18,300,000
September 30, Year 1 18,000,000
December 31, Year 1 17,750,000

— The fair value, intrinsic value and time value of the put option are as follows.

Intrinsic
1
Date Fair value value Time value
January 1, Year 1 $200,000 $ - $200,000
March 31, Year 1 180,000 - 180,000
June 30, Year 1 350,000 200,000 150,000
September 30, Year 1 550,000 500,000 50,000
December 31, Year 1 750,000 750,000 -
Note:
Fair value less intrinsic value.

For simplicity, this example makes the following assumptions.

— It ignores the effect of commissions and other transaction costs, initial
margins and income taxes.
— ABC prepares financial reports at the end of every quarter.
— ABC settles the put option through delivery of the US Treasury bond on
December 31, Year 1.
Scenario 1: Mark-to-market approach
Journal entries – January 1, Year 1
ABC records the following journal entry at January 1, Year 1.

Debit Credit
Put option 200,000
Cash 200,000
To record purchase of put option.

There would also be a memorandum entry made on January 1, Year 1

documenting the existence of this hedging relationship.
Journal entries – March 31, Year 1
ABC records the following journal entries.

Debit Credit
Gains (losses) on AFS debt securities 20,000
Put option 20,000
To record change in time value of put option.
US Treasury bond – AFS 500,000
OCI – Gains on AFS debt securities 1
500,000
To record change in fair value of US Treasury
bond.
Note:
The entire change in fair value of the US Treasury bond is recorded in OCI, because
there was no change in the intrinsic value of the put option.

Journal entries – June 30, Year 1

ABC records the following journal entries.

Debit Credit
Gains (losses) on AFS debt securities 30,000
Put option 30,000
To record change in time value of put option.
Put option 200,000
Gains (losses) on AFS debt securities 200,000
To record change in intrinsic value of put option.
OCI – Gains on AFS debt securities1 500,000
Gains (losses) on AFS debt securities 1
200,000
US Treasury bond – AFS 700,000
To record change in fair value of investment in US
Treasury bond.
Note:
The loss on the investment that is recognized in earnings is limited to the change in
the put option’s intrinsic value (i.e. the hedged risk). The remainder of the change in
fair value is recorded in OCI.

Journal entries – September 30, Year 1

ABC records the following journal entries.

Debit Credit
Gains (losses) on AFS debt securities 100,000
Put option 100,000
To record change in time value of put option.
Put option 300,000
Gains (losses) on AFS debt securities 300,000
To record change in intrinsic value of put option.
Gains (losses) on AFS debt securities1 300,000
US Treasury bond – AFS 300,000
To record change in fair value of investment in US
Treasury bond.
Note:
The entire loss on this investment is recognized in earnings because it is equal to the
change in the put option’s intrinsic value (i.e. the hedged risk).

Journal entries – December 31, Year 1

ABC records the following journal entries.

Debit Credit
Gains (losses) on AFS debt securities 50,000
Put option 50,000
To record change in time value of the put option.
Put option 250,000
Gains (losses) on AFS debt securities 250,000
To record change in intrinsic value of put option.
Gains (losses) on AFS debt securities1 250,000
US Treasury bond – AFS 250,000
To record change in fair value of investment in US
Treasury bond.
Cash 18,500,000
US Treasury bond – AFS 17,750,000
Put option 750,000
To record settlement of put option through
delivery of US Treasury bond.
AOCI – Gains on AFS debt securities 3,500,000
Gains (losses) on AFS debt securities 3,500,000
To record realized gain on sale of investment in
US Treasury bond.

Note:
The entire loss on this investment is recognized in earnings because it is equal to the
change in the put option’s intrinsic value (i.e. the hedged risk).

Financial statement excerpts

At the end of each period, ABC’s financial statements reflect the following
related to this hedging relationship.

3 months 6 months 9 months Year

ended ended ended ended
Account Mar 31 Jun 30 Sep 30 Dec 31
Balance sheet – assets
Debt securities AFS $19,000,000 $18,300,000 $18,000,000 -
Put option 180,000 350,000 550,000 -
Balance sheet – equity
AOCI – Gains (losses) on
AFS debt securities $4,000,000 $3,500,000 $3,500,000 -
Income statement
Gains (losses) on AFS
debt securities $(20,000) $(50,000) $(150,000) $3,300,000
Disclosures under subparagraphs 815-10-50-4EE(a) – 50-4EE(c)
Carrying amount of AFS
debt securities on the
balance sheet that are
hedged assets1 [815-10-
50-4EE(a), 50-4EE(c)] $19,000,000 $18,300,000 $18,000,000 -
Amortized cost of AFS
debt securities
designated in fair value
hedges2 15,000,000 14,800,000 14,500,000 -
Increase (decrease) in
fair value of hedged AFS
debt securities
recognized in earnings
due to fair value hedge
accounting3 [815-10-50-
4EE(b)] - (200,000) (500,000) -
Other changes in fair
value (recognized in
AOCI)4 4,000,000 3,500,000 3,500,000 -
Notes:
Carrying amount represents the fair value at that date.
Amortized cost at January 1, Year 1 ($15,000,000, which equals the purchase price
since there were no premiums or discounts) + Increase (decrease) in fair value of
hedged AFS debt securities recognized in earnings due to fair value hedge accounting
(see Note 3).
Fair value at that date - fair value at January 1, Year 1. This amount represents the
cumulative basis adjustment (i.e. amount of fair value hedge adjustments) included in

the carrying amount at that date. This equals the intrinsic value of the put option
because the hedging relationship was perfectly effective.
Fair value at that date - amortized cost at January 1, Year 1 ($15,000,000, which equals
the purchase price because there were no premiums or discounts) - Increase
(decrease) in fair value of hedged AFS debt securities recognized in earnings due to
fair value hedge accounting.

The $3,300,000 gain on AFS debt securities for the year ended December 31,
Year 1 represents the following.
— $3,500,000 unrealized gain in AOCI as of the date of inception of the
hedging relationship. Although the US Treasury bond’s fair value fell to
$17,750,000, ABC was able to lock in a $18,500,000 sale price as a result of
entering into the put option. Therefore, it was able to realize the gain of
$3,500,000 (less the premium paid for the option).
Because the intrinsic value of the put option was perfectly effective at
offsetting changes in the fair value of the US Treasury bond, each change in
the intrinsic value of the put option recognized in earnings was offset by an
equal amount that represents the change in the fair value of the US
Treasury bond.
— $200,000 premium paid for the put option. This was recognized in
earnings as the fair value of the time value portion of the put option
changed over time.

Scenario 2: Amortization approach – straight-line method

The following table shows the effect on earnings and AOCI of the time value
using the straight-line method:

Recognized in
earnings –
Total change in amortization of Recognized in
time value initial time value AOCI
Date (A) (B) (A) - (B)
March 31, Year 1 $ 20,000 $ 50,000 $(30,000)
June 30, Year 1 30,000 50,000 (20,000)
September 30, Year 1 100,000 50,000 50,000
December 31, Year 1 50,000 50,000 -
$200,000

Journal entries – January 1, Year 1

ABC records the following journal entry at January 1, Year 1.

Debit Credit
Put option 200,000
Cash 200,000
To record purchase of put option.

There would also be a memorandum entry made on January 1, Year 1

documenting the existence of this hedging relationship.

Journal entries – March 31, Year 1

ABC records the following journal entries.

Debit Credit
OCI – Fair value hedge excluded component 20,000
Put option 20,000
To record change in fair value of excluded
component (time value).
Gains (losses) on AFS debt securities 50,000
OCI – Gains on AFS debt securities 50,000
To record amortization of excluded component
(time value).
US Treasury bond – AFS 500,000
OCI – Gains on AFS debt securities 1
500,000
To record change in fair value of US Treasury
bond.
Note:
There was no change in the intrinsic value of the purchased put option. As a result,
amortization of the excluded component is recognized but there are no other changes
in the fair value of the option to recognize.

Journal entries – June 30, Year 1

ABC records the following journal entries.

Debit Credit
OCI – Fair value hedge excluded component 30,000
Put option 30,000
To record change in fair value of excluded
component (time value).
Gains (losses) on AFS debt securities 50,000
OCI – Gains on AFS debt securities 50,000
To record amortization of excluded component
(time value).
Put option 200,000
Gains (losses) on AFS debt securities 200,000
To record change in intrinsic value of put option.
OCI – Gain on AFS debt securities1 500,000
Gains (losses) on AFS debt securities1 200,000
US Treasury bond – AFS 700,000
To record change in fair value of investment in US
Treasury bond.

Note:
The loss on this investment that is recognized in earnings is limited to the change in
the put option’s intrinsic value (i.e. the hedged risk). The remainder of the change in
fair value of the investment is recorded in OCI.

Journal entries – September 30, Year 1

ABC records the following journal entries.

Debit Credit
OCI – Fair value hedge excluded component 100,000
Put option 100,000
To record change in fair value of excluded
component (time value).
Gains (losses) on AFS debt securities 50,000
OCI – Gains on AFS debt securities 50,000
To record amortization of excluded component
(time value).
Put option 300,000
Gains (losses) on AFS debt securities 300,000
To record change in intrinsic value of put option.
Gains (losses) on AFS debt securities1 300,000
US Treasury bond – AFS 300,000
To record change in fair value of US Treasury
bond.
Note:
The entire loss on this investment is recognized in earnings because it is equal to the
change in the put option’s intrinsic value (i.e. the hedged risk).

Journal entries – December 31, Year 1

ABC records the following journal entries.

Debit Credit
OCI – Fair value hedge excluded component 50,000
Put option 50,000
To record change in fair value of excluded
component (time value).
Gains (losses) on AFS debt securities 50,000
OCI – Gains on AFS debt securities 50,000
To record amortization of excluded component
(time value).
Put option 250,000
Gains (losses) on AFS debt securities 250,000
To record change in intrinsic value of put option.

Debit Credit
Gains (losses) on AFS debt securities 1
250,000
US Treasury bond – AFS 250,000
To record change in fair value of US Treasury
bond.
Cash 18,500,000
US Treasury bond – AFS 17,750,000
Put option 750,000
To record settlement of put option through
delivery of US Treasury bond.
AOCI – Gains on AFS debt securities 3,500,000
Gains (losses) on AFS debt securities 3,500,000
To record realized gain on sale of investment in
US Treasury bond.
Note:
The entire loss on this investment is recognized in earnings because it is equal to the
change in the put option’s intrinsic value (i.e. the hedged risk).

Financial statement excerpts

At the end of each period, ABC’s financial statements reflect the following
related to this hedging relationship.

3 months 6 months 9 months Year

ended ended ended ended
Account Mar 31 Jun 30 Sep 30 Dec 31
Balance sheet – assets
AFS debt securities $19,000,000 $18,300,000 $18,000,000 -
Put option 180,000 350,000 550,000 -
Balance sheet – equity
AOCI – Gains (losses) on
AFS debt securities $4,000,000 $3,500,000 $3,500,000 -
AOCI – Fair value hedge
excluded component (30,000) (50,000) - -
Income statement
Gains (losses) on AFS
debt securities $(50,000) $ (100,000) $(150,000) $3,300,000
Disclosures under subparagraphs 815-10-50-4EE(a) – 50-4EE(c)
Carrying amount of AFS
debt securities on the
balance sheet that are
hedged assets1 [815-10-
50-4EE(a), 50-4EE(c)] $19,000,000 $18,300,000 $18,000,000 -

3 months 6 months 9 months Year

ended ended ended ended
Account Mar 31 Jun 30 Sep 30 Dec 31
Amortized cost of AFS
debt securities
designated in fair value
hedges2 15,000,000 14,800,000 14,500,000 -
Increase (decrease) in
fair value of hedged AFS
debt securities
recognized in earnings
due to fair value hedge
accounting3 [815-10-50-
4EE(b)] - (200,000) (500,000) -
Other changes in fair
value (recognized in
AOCI)4 4,000,000 3,500,000 3,500,000 -
Notes:
Carrying amount represents the fair value at that date.
Amortized cost at January 1, Year 1 ($15,000,000, which equals the purchase price
since there were no premiums or discounts) + Increase (decrease) in fair value of
hedged AFS debt securities recognized in earnings due to fair value hedge accounting
(see Note 3).
Fair value at that date - fair value at January 1, Year 1. This amount represents the
cumulative basis adjustment (i.e. amount of fair value hedge adjustments) included in
the carrying amount at that date. This equals the intrinsic value of the put option
because the hedging relationship was perfectly effective.
Fair value at that date - amortized cost at January 1, Year 1 ($15,000,000, which equals
the purchase price because there were no premiums or discounts) - Increase
(decrease) in fair value of hedged AFS debt securities recognized in earnings due to
fair value hedge accounting.

The $3,300,000 gain on AFS securities for the year ended December 31, Year 1
represents the following.
— $3,500,000 unrealized gain in AOCI as of the date of inception of the
hedging relationship. Although the US Treasury bond’s fair value fell to
$17,750,000, ABC was able to lock in a $18,500,000 sale price as a result of
entering into the put option. Therefore, it was able to realize the gain of
$3,500,000 (less the premium paid for the option).
Because the intrinsic value of the put option was perfectly effective at
offsetting changes in the fair value of the US Treasury bond, each change in
the intrinsic value of the put option recognized in earnings was offset by an
equal amount that represents the change in the fair value of the US
Treasury bond.
— $200,000 premium paid for the put option. This was recognized in
earnings evenly over the term of the put option using an amortization
approach (i.e. straight-line method).

The following table compares the earnings effect of the excluded component
under each method.
3 months ended
Approach March 31 June 30 September 30 December 31 Total

Mark-to-market
(Scenario 1) $20,000 $30,000 $50,000 $100,000 $200,000
Amortization
(Scenario 2) 50,000 50,000 50,000 50,000 200,000
Difference $(30,000) $(20,000) $ - $ 50,000 $ -

4.3 Measuring the hedged item (basis adjustments)

4.3.10 Overview
The amortized cost basis of a hedged item in a fair value hedge (i.e. the
hedged asset, liability or firm commitment) is adjusted for its change in fair
value that is attributable to the risk being hedged. This adjustment is referred to
as a basis adjustment. [815-25-35-1]
Additional considerations apply when:
— the hedged risk is interest rate risk (section 4.3.20); and
— basis adjustments are determined at a portfolio level (section 4.3.30).

Question 4.3.10
May a basis adjustment be measured using a
method different from that used to assess
effectiveness?
Interpretive response: No. A basis adjustment is measured consistently with
the entity’s risk management strategy and the method used to assess the
hedging relationship’s effectiveness.
For example, in a fair value hedge of a firm commitment, an entity assesses
hedge effectiveness based on the entire gain or loss on the derivative hedging
instrument – i.e. including the time value component. In this situation, the basis
adjustment is also based on the total change in its fair value – i.e. including the
time value component.
In contrast, if the hedged item is a recognized asset or liability, its fair value is
measured based on current prices – e.g. spot prices for a commodity. As a
result, the entity’s risk management strategy and assessment of effectiveness
likely considers only changes in spot prices of the hedging derivative
instrument – i.e. time value of an option contract is an excluded component
(see section 9.2.70). In this situation, the basis adjustment is limited to changes
in the fair value of the hedged item attributable to changes based on spot
prices.

See also Example 4.3.50 regarding the benchmark rate component for
effectiveness assessment and basis adjustment measurement.

Question 4.3.20
Is it appropriate to use the change in fair value of
the hedging instrument to measure the basis
adjustment?
Interpretive response: It depends. When the shortcut method is used (see
section 9.3), the change in fair value of the hedging instrument is used as a
proxy to measure the change in fair value of the hedged item with no effect on
net income – i.e. the income statement reflects perfect effectiveness of the
hedging relationship.
This approach for measuring the hedged item’s fair value is not appropriate
when the shortcut method is not used. As a result, differences may arise
between measurement of the hedging instrument and the basis adjustment,
resulting in the hedge not being perfectly effective and creating volatility in
earnings.
For example, such a difference may result when the discount rate used to
measure the fair value of a derivative hedging instrument is not the same as the
benchmark interest rate designated as the hedged risk.

Question 4.3.30
Do the principles of Topic 820 apply when
measuring a basis adjustment?

Interpretive response: Yes. Although the hedged item may not be measured
at fair value (see Question 4.3.40), we believe the measurement of changes in
the fair value of the hedged item attributable to the hedged risk(s) should follow
the principles of Topic 820 (fair value measurement).
See also KPMG’s Q&A: Fair value measurement, including Question B70 and
Section O, Application issues: Derivatives and hedging.

Question 4.3.40
Does a basis adjustment result in the hedged item
being measured at its fair value?

Interpretive response: Not necessarily. A basis adjustment is measured based

on changes in the fair value that are attributable to the hedged risk that
occurred since the hedged item was designated in the hedging relationship. As
a result, the hedged item’s measurement may not be fair value on the balance
sheet unless it is required to be measured at fair value under other applicable
US GAAP (e.g. an AFS debt security).

The following two situations demonstrate when a hedged item’s amortized cost
basis (including the basis adjustment) does not represent the hedged item’s fair
value.
— Hedge designated after initial recognition of the hedged item carried
at amortized cost. If an asset or liability is not designated in a hedging
relationship until after it is initially recognized, any unrealized gain or loss
that arose between initial recognition and the time it was designated in a
hedging relationship is not recognized.
— Hedged risk is a specific risk rather than total changes in fair value. If
the hedged risk is changes in fair value attributable to only a specific risk,
the basis adjustment is measured based only on changes in fair value
attributable to the specific risk rather than all changes in fair value of the
hedged item. For example, if the hedged risk for a fixed-rate debt obligation
relates to the benchmark interest rate, only changes in fair value
attributable to changes in the benchmark interest rate are recognized and
changes due to other factors (e.g. credit risk) are not.

Question 4.3.50
When the hedged risk is overall changes in fair
value, can any of the contractual cash flows be
excluded from the basis adjustment measurement?
Interpretive response: No. When the hedged risk is overall changes in fair
value, all contractual cash flows of the hedged item are considered when
measuring the basis adjustment.

Examples
The following examples demonstrate measuring the basis adjustment.
— Fair value hedge of inventory after initial recognition (Example 4.3.10).
— Accounting for the hedge of long-term debt with an interest rate swap
(shortcut method) (Example 4.3.20).
— Accounting for a fair value hedge of the LIBOR swap rate in a fixed-rate
noncallable note (Example 4.3.30).
— Accounting for a hedge of a firm commitment to purchase silver with a
forward contract (Example 4.3.40).

Example 4.3.10
Fair value hedge of inventory after initial recognition
ABC Corp. purchased 10,000 units of widget inventory three months ago for
$100,000. Since that time, the widgets have increased in value to $150,000.
Because ABC carries its inventory at the lower of cost or net realizable value,
ABC has not recognized the $50,000 appreciation in this inventory.

To hedge the fair value of this inventory, ABC purchases a put option to sell
10,000 widgets at a price of $15 each. ABC assesses effectiveness using the
option’s intrinsic value – i.e. ABC excludes time value from its assessment of
effectiveness. ABC elects to use the mark-to-market approach for recognizing
changes in the fair value of the excluded component (time value).
At the next reporting date, the intrinsic value of the option and fair value of the
inventory have changed as reflected in the following table.

Intrinsic value
increase (decrease)
Put option $20,000
Inventory (20,000)

ABC records the following journal entry.

Debit Credit
Put option 20,000
Cost of goods sold 20,000
To record change in intrinsic value of put option
(hedging instrument).
Cost of goods sold 20,000
Inventory 20,000
To record change in fair value of inventory
attributable to hedged risk.

In addition, ABC would record a journal entry to recognize the change in the fair
value of the excluded component (i.e. time value of option) as cost of goods
sold.
After the above journal entry is recognized, the inventory’s cost basis is
$80,000, which represents the carrying amount of the inventory at inception of
the hedge ($100,000) less the change in its fair value during the hedge period
($20,000).
The preexisting gain on the inventory at inception of the hedge is not
recognized on the balance sheet. As a result, even though the fair value of the
hedged inventory is $130,000, applying the fair value hedge accounting
requirements results in it being carried at an amount below its fair value. In
essence, if the hedge is effective, the fair value hedge accounting approach has
the effect of locking in the $50,000 gain that existed at the beginning of the
hedge. This excludes the cost of the option (time value) – which is excluded
from the assessment of effectiveness and is recognized as cost of goods sold
during the hedging relationship.
If the inventory’s fair value was equal to $130,000 at the date it was sold and
the put option also settled on that date, ABC would record the following journal
entry (other than related to the cost of the excluded component).

Debit Credit
Cash 130,000
Cost of goods sold 80,000
Sales revenue 130,000
Inventory 80,000
To record revenue from sale of inventory with
related cost of goods sold.
Cash 20,000
Put option 20,000
To record settlement of the put option.

Example 4.3.20
Accounting for the hedge of long-term debt with an
interest rate swap (shortcut method)
On January 1, Year 1, ABC Corp. issues a three-year $1,000,000 debt obligation
bearing a fixed interest rate of 10%. ABC simultaneously enters into a
three-year interest rate swap with a notional amount of $1,000,000 to receive
interest at a fixed rate of 9.5% and pay interest at a variable rate equal to
six-month LIBOR. The combination of the interest rate swap and debt obligation
results in ABC effectively paying an interest rate equal to six-month LIBOR plus
50 basis points.
Both the debt obligation and interest rate swap require payments to be made or
received on June 30 and December 31 of each year. The variable rate on the
interest rate swap resets on January 1 and July 1 of each year. No premium is
paid or received for the interest rate swap.
ABC designates the interest rate swap as a fair value hedge of the changes in
fair value of the fixed-rate debt obligation attributable to changes in the
benchmark interest rate – i.e. six-month LIBOR.
The following additional facts are relevant.
— All criteria for hedge accounting using the shortcut method have been met
(see section 9.3). There have been no changes in creditworthiness that
would alter the effectiveness of the hedging relationship.
— The six-month LIBOR rates on the annual interest rate swap reset dates are
as follows.

Date 6-month LIBOR

January 1, Year 1 9.5%
January 1, Year 2 8.5%
January 1, Year 3 10.5%

— Payments made (received) are as follows.

December 31
Year 1 Year 2 Year 3
Fixed-rate debt obligation 1
$100,000 $100,000 $100,000
Interest rate swap 2
- (10,000) 10,000
Net effect $100,000 $90,000 $110,000
Notes:
Principal amount of the debt obligation $1,000,000 × the fixed interest rate of
10%.
Notional amount of the interest rate swap $1,000,000 × (6-month LIBOR at the
beginning of the year less 9.5%).

— Assumed fair value amounts (after cash settlements, which is referred to as

‘clean’ pricing) are as follows.

December 31
Year 1 Year 2 Year 3
Asset (liability)
Interest rate swap $ 150,000 $ 90,000 $ -
Fixed-rate debt obligation (due
solely to changes in the
benchmark interest rate) 1 1,150,000 1,090,000 -
Change in fair value – gain
(loss)
Interest rate swap 150,000 (60,000) (90,000)
Fixed-rate debt obligation 1
$(150,000) $60,000 $90,000
Note:
Under the shortcut method, the change in fair value of the interest rate swap
(hedging instrument) is used as a proxy to measure the change in the fair value of
the fixed-rate debt obligation (hedged item).

For simplicity, this example makes the following assumptions.

— It ignores the effect of commissions and other transaction costs, initial
margins and income taxes.
— It is based on annual periods; normally the assessment of effectiveness and
fair value adjustments of the hedged item and derivative would be done at
least quarterly.
— Journal entries are demonstrated for annual periods although payments are
made on June 30 and December 31 of each year and the interest rate swap
resets on January 1 and July 1 of each year.
— Journal entries (for all years) are presented gross for illustrative purposes
but could be combined.

Journal entries – January 1, Year 1

Debit Credit
Cash 1,000,000
Fixed-rate debt obligation 1,000,000
To record issuance of fixed-rate debt obligation.

A memorandum entry is also made on January 1, Year 1 documenting the

existence of this hedging relationship. The financial records of ABC are not
otherwise affected as of this date because the interest rate swap had a fair
value of zero at inception.
Journal entries – December 31, Year 1
ABC records the following journal entries.

Debit Credit
Interest expense 100,000
Cash 100,000
To record interest expense on fixed-rate debt
obligation.
Interest rate swap 150,000
Interest expense 150,000
To record change in fair value of interest rate
swap (hedging instrument).
Interest expense 150,000
Fixed-rate debt obligation 150,000
To record change in fair value of fixed-rate debt
obligation due to changes in interest rates.

Journal entries – December 31, Year 2

ABC records the following journal entries.

Debit Credit
Interest expense 100,000
Cash 100,000
To record interest expense on fixed-rate debt
obligation.
Interest expense 60,000
Interest rate swap 60,000
To record change in fair value of interest rate
swap (hedging instrument).

Debit Credit
Fixed-rate debt obligation 60,000
Interest expense 60,000
To record change in fair value of fixed-rate debt
obligation due to changes in interest rates.
Cash 10,000
Interest expense 10,000
To record net interest cash receipt on interest rate
swap as a decrease in interest expense.

Journal entries – December 31, Year 3

ABC records the following journal entries.

Debit Credit
Interest expense 100,000
Cash 100,000
To record interest expense on fixed-rate debt
obligation.
Interest expense 90,000
Interest rate swap 90,000
To record change in fair value of interest rate
swap (hedging instrument).
Fixed-rate debt obligation 90,000
Interest expense 90,000
To record change in fair value of fixed-rate debt
obligation due to changes in interest rates.
Interest expense 10,000
Cash 10,000
To record net interest cash payment on interest
rate swap as an increase in interest expense.
Fixed-rate debt obligation 1,000,000
Cash 1,000,000
To record cash paid by the borrower on maturity
of the fixed-rate debt obligation.

Financial statement excerpts

At the end of Years 1–3, ABC’s financial statements reflect the following.

Account Year 1 Year 2 Year 3

Balance sheet – assets
Interest rate swap $150,000 $90,000 -
Balance sheet – liabilities
Debt obligation $1,150,000 $1,090,000 -
Income statement
Interest expense $100,0001 $90,0002 $110,0003
Disclosures under 815-10-55-4EE
Carrying amount of debt obligations on
the balance sheet that are hedged
liabilities [815-10-50-4EE(a), 50-4EE(c)] $1,150,000 $1,090,000 -
Cumulative amount of fair value hedge
adjustments included in the carrying
amount of hedged debt obligations
[815-10-50-4EE(b)] $150,000 $90,000 -
Notes:
For Year 1, this can be computed as (9.5% LIBOR at the beginning of the year +
0.50%) × $1,000,000 = $100,000.
For Year 2, this can be computed as (8.5% LIBOR at the beginning of the year +
0.50%) × $1,000,000 = $90,000.
For Year 3, this can be computed as (10.5% LIBOR at the beginning of the year +
0.50%) × $1,000,000 = $110,000.

Under the shortcut method, the hedging relationship is assumed to be perfectly

effective. As a result, recording both the changes in fair value of the interest
rate swap (derivative hedging instrument) and the changes in fair value of the
fixed-rate debt obligation (hedged item) due to changes in 6-month LIBOR
(benchmark interest rate) have the effect of converting the interest expense on
the 10% fixed-rate debt obligation to six-month LIBOR plus 50 basis points.

Example 4.3.30
Accounting for a fair value hedge of the LIBOR swap
rate in a fixed-rate noncallable note
On January 1, Year 1, ABC Corp. issues at par a $100,000 BBB-rated,
two-year noncallable note at a fixed rate of 10%. Interest is paid annually on
December 31.
Also on January 1, Year 1, ABC enters into a two-year interest rate swap based
on the 12-month LIBOR swap rate. Under the terms of the swap, ABC will
receive fixed interest at 7% and pay variable interest at 12-month LIBOR. The
variable leg of the swap resets each year on December 31 for the payments
due the following year. The shortcut method cannot be used because the

interest rate swap resets annually and the shortcut method requires the
frequency of repricing generally to be three to six months. [815-20-25-105(c)]
On January 1, Year 1, ABC designates the interest rate swap as the hedging
instrument in a fair value hedge. The hedge objective and strategy is to hedge
the change in the fair value of the $100,000 BBB-rated, two-year debt obligation
due to changes in the benchmark interest rate (12-month LIBOR) with a two-
year $100,000 interest rate swap to receive 7% and pay 12-month LIBOR.
Through the interest rate swap, ABC effectively converts its fixed-rate
obligation to a 12-month LIBOR-based variable-rate obligation. This results in an
effective variable rate of approximately 12-month LIBOR plus 3% because the
receiving leg of the swap is fixed at 7% compared to the debt obligation’s 10%.
The assessment of hedge effectiveness is made by comparing the cumulative
change in the fair value of the hedged item attributable to changes in the
benchmark interest rate with the cumulative changes in the fair value of the
interest rate swap.
The change in the fair value of the debt obligation attributable to interest rate
risk is calculated based on the full contractual cash flows of the debt obligation.
Further, it is based on:
— the note’s coupon rate (i.e. its market interest rate at inception) adjusted for
changes in the benchmark interest rate from inception to the beginning of
the period for which the change in fair value is being calculated; and
— the note’s coupon rate adjusted for changes in the benchmark interest rate
from inception to the end of that period.
This example has been simplified by assuming that the interest rate applicable
to all payments is the same – i.e. the yield curve is flat.
The following additional facts are relevant.
— All criteria for hedge accounting have been met (see chapters 2 and 3).
— The 12-month LIBOR swap rates reset as follows.

Date 12-month LIBOR

January 1, Year 1 7.0%
December 31, Year 1 7.5%

— Payments made (received) are as follows.

December 31, December 31,

Year 1 Year 2
Debt obligation1 $10,000 $10,000
Interest rate swap 2
- 500
Net effect $10,000 $10,500
Notes:
Principal amount of the debt obligation $100,000 × the fixed interest rate of 10%.
Notional amount of the interest rate swap $100,000 × (12-month LIBOR at the
beginning of the year less 7.0% received on the fixed leg).

— Changes in the fair value of the debt obligation attributable to interest rate
risk (12-month LIBOR) are as follows (after settlement of interest).

December 31, Year 1

Principal and interest payment due at end of Year 2 $110,000

Market rate at inception of hedge adjusted for changes in LIBOR,
at beginning of Year 1 10.00%
Present value based on market rate as adjusted, beginning of
period $100,000
Market rate at inception of hedge adjusted for changes in LIBOR,
at end of period 10.50%
Present value based on market rate as adjusted, end of period 1
$99,548
Change in fair value attributable to changes in LIBOR $(452)
Note:
Final principal and interest amounts of the debt obligation of $110,000 ($100,000
+ $10,000) discounted at 10.50%.

December 31, Year 2

Principal payment due at end of Year 2 (equals present value
$100,000
because it is due immediately)
Change in fair value attributable to changes in LIBOR $452

— Fair value amounts of the interest rate swap are as follows (assumed).

December 31, December 31,

Year 1 Year 2
asset asset
(liability) (liability)
Interest rate swap (liability) before settlement (465)1 (500)2
Interest rate swap (liability) after settlement (465) -
Notes:
Because the yield curve is assumed to be flat, the fair value of $465 represents
the present value of the assumed net settlement of $500 in one year’s time
based on 7.5% LIBOR rate at December 31, Year 1.
The increase of $35 is due to the passage of time (note that the benchmark rate did
not change) and is calculated as the $465 fair value at December 31, Year 1 × 7.5%.

— Hedge effectiveness at December 31, Year 1 is as follows.

Change in fair value of the interest rate swap $465

Change in fair value of the debt obligation attributable to interest
rate risk 452
Hedge effectiveness 1
102.9%
Extent to which hedge is not perfectly effective2 $13
Notes:
$465 ÷ $452.
$465 - $452.

For simplicity, this example makes the following assumptions.

Debit Credit
Cash 100,000
Debt obligation 100,000
To record issuance of $100,000, 2-year debt
obligation.

There would also be a memorandum entry made on January 1, Year 1

documenting the existence of this hedging relationship. The financial records of
ABC would not otherwise be affected as of this date because the interest rate
swap had a fair value of zero at inception.
Journal entries – December 31, Year 1
ABC records the following journal entries.

Debit Credit
Interest expense 10,000
Cash 10,000
To record interest expense on debt obligation.
Debt obligation 452
Interest expense 452
To record change in fair value of debt obligation
due to changes in interest rates.
Interest expense 465
Interest rate swap 465
To record change in fair value of interest rate
swap (hedging instrument).

Journal entries – December 31, Year 2

ABC records the following journal entries.

Debit Credit
Interest expense 10,000
Cash 10,000
To record interest expense on debt obligation.

Debit Credit
Interest expense 452
Debt obligation 452
To record change in fair value of debt obligation
due to changes in interest rates.
Interest expense 35
Interest rate swap 35
To record change in fair value of interest rate
swap (hedging instrument).
Interest rate swap 500
Cash 500
To record net interest cash payment of interest
rate swap (hedging instrument).
Debt obligation 100,000
Cash 100,000
To record settlement of debt obligation.

Financial statement excerpts

At the end of Years 1–2, ABC’s financial statements reflect the following.

Account Year 1 Year 2

Balance sheet – liabilities
Debt obligation $99,548 -
Interest rate swap 465 -
Income statement
Interest expense $10,0131 $10,4872
Disclosures under 815-10-55-4EE
Carrying amount of debt obligations on the balance sheet
that are hedged liabilities [815-10-50-4EE(a), 50-4EE(c)] $99,548 -
Cumulative amount of fair value hedge adjustments
included in the carrying amount of hedged debt
obligations [815-10-50-4EE(b)] 452 -
Notes:
For Year 1, interest expense reflects the following.
— Effective interest of 12-month LIBOR at the most recent reset date (7%) + the
fixed spread (3%) = 10% ($10,000).
— The extent to which the hedging relationship is not perfectly effective ($13).
For Year 2, interest expense reflects the following.
— Effective interest of 12-month LIBOR at the most recent reset date (7.5%) + the
fixed spread (3%) = 10.5% ($10,500).
— The slight difference in the expected effective rate of 10.5% and the actual rate
of 10.49% ($10,487 ÷ 100,000) is due to the fact that the hedging relationship
was not perfectly effective.

Through the interest rate swap, ABC converted its fixed-rate obligation to a
12-month LIBOR-based variable-rate obligation. This results in an effective
variable rate of approximately 12-month LIBOR plus 3% because the receiving
leg of the swap is fixed at 7% compared to the debt obligation’s 10%.

Example 4.3.40
Accounting for a hedge of a firm commitment to
purchase silver with a forward contract
This example continues from Example 3.3.50; for ease of reference, this
example includes the full fact pattern.
ABC Corp. produces silver platters for sale to department stores. The sales
price of the silver platters depends in large part on the market price of silver as
of the date of sale. ABC has a contract to purchase 100,000 ounces of silver
from DEF at $4.99 per ounce on December 31, Year 1. This transaction is
considered a normal purchase as defined by Topic 815; therefore, the forward
contract is not recognized and measured as a derivative.
If ABC does not purchase the silver from DEF, it will be required to pay DEF a
substantial penalty of $300,000 – i.e. ABC’s contract with DEF is a firm
commitment. ABC is not required to make an up-front cash payment.
ABC is concerned that – as a result of fluctuations in the price of silver during
the commitment period – the inventory would be recorded at other than market
price at the date of purchase. Therefore, to hedge against the fluctuations in fair
value of its firm commitment due to changes in the market price of silver, ABC
enters into an over-the-counter silver forward contract on July 1, Year 1 that
settles in cash on a net basis on December 31, Year 1. The forward contract
requires ABC to sell 100,000 ounces of silver at $4.99 per ounce.
The forward contract is designated as a fair value hedge of ABC’s firm
commitment to purchase 100,000 ounces of silver from DEF in six months.
The following additional facts are relevant.
— The relationship is expected to be highly effective. ABC will assess hedge
effectiveness based on the changes in the forward price of silver.
— At inception, ABC concludes and documents that the hedging
relationship is expected to be highly effective.
— On an ongoing basis, ABC will ascertain and document that the hedging
relationship has been, and will continue to be, highly effective.
— Credit risk (and changes in credit risk) are assumed to be nominal.
— The basis adjustment recognized in earnings related to the firm
commitment will equal the changes in the fair value of the forward contract.
— All criteria for hedge accounting have been met (see chapters 2 and 3).
— The forward contract is at market rates; therefore, no cash is exchanged at
inception of the contract.
— The spot and forward price of silver, and the fair value of the forward
contract, are as follows.

1
Fair value
Forward asset Change in
Spot price price (liability) fair value
July 1, Year 1 $5.00 $4.99 $ - N/A
September 1, Year 1 4.98 4.95 3,960 $ 3,960
December 31, Year 1 5.10 N/A (11,000) (14,960)
Note:
Measured using the change in forward rates, discounted at an appropriate
discount rate

— The forward contract settles on December 31, Year 1 with ABC paying
$11,000 = $100,000 × ($4.99 - $5.10).
For simplicity, this example makes the following assumptions.
— It ignores the effect of commissions and other transaction costs, initial
margins and income taxes.
— ABC’s silver purchase contract is considered a normal purchase (see
section 3.3.30).
— The hedging relationship is perfectly effective.
Journal entries – July 1, Year 1
A memorandum entry is made on July 1, Year 1 documenting the existence of
this hedging relationship. ABC’s financial records are otherwise not affected as
of this date because the forward contract is at market rates.
Journal entries – September 30, Year 1
ABC records the following journal entries.

Debit Credit
Forward contract to sell silver 3,960
Cost of goods sold 3,960
To record change in fair value of forward contract
attributable to discounted change in forward rate.
Cost of goods sold 3,960
Firm commitment to purchase silver 3,960
To record change in fair value of firm commitment
to purchase silver.

At September 1, Year 1, ABC’s financial statements reflect the following.

Account Amount
Balance sheet – assets
Forward contract to sell silver $3,960
Balance sheet – liabilities
Firm commitment to purchase silver 3,960

Account Amount
Income statement
Cost of goods sold -

Journal entries – December 31, Year 1

ABC records the following journal entries.

Debit Credit
Cost of goods sold 14,960
Forward contract to sell silver 14,960
To record change in fair value of forward contract
attributable to discounted change in forward rate.
Firm commitment to purchase silver 14,960
Cost of goods sold 14,960
To record change in fair value of firm commitment
to purchase silver.
Forward contract to sell silver 11,000
Cash 11,000
To record settlement of forward contract at
December 31, Year 1.
Silver inventory 510,000
Firm commitment to purchase silver 11,000
Cash 499,000
To record purchase of 100,000 ounces of silver at
$4.99 per ounce pursuant to contract with DEF.

At December 31, Year 1, ABC’s financial statements reflect the following.

Account Amount
Balance sheet – assets
Silver inventory $510,000
Income statement
Cost of goods sold -

ABC enters into this hedging transaction because of concerns that changes in
silver prices would cause fluctuations in the fair value of the firm commitment
to purchase silver. The silver inventory includes the realized gain on the firm
commitment of $11,000. Since silver prices increased, ABC realized a gain of
$11,000 on the firm commitment to purchase silver from DEF. This gain is
offset by an $11,000 loss on the forward contract to sell silver. Therefore, even
though ABC pays $499,000 for the silver inventory (i.e. the contract price), the
inventory is recorded at the current market price of $510,000 (i.e. the purchase
price plus the fair value of the firm commitment).

4.3.20 Hedges involving interest rate risk

Excerpt from ASC 815-25

>> Changes Involving Interest Rate Risk

35-13 In calculating the change in the hedged item’s fair value attributable to
changes in the benchmark interest rate (see paragraph 815-20-25-12(f)(2)),
the estimated coupon cash flows used in calculating fair value shall be based
on either the full contractual coupon cash flows or the benchmark rate
component of the contractual coupon cash flows of the hedged item
determined at hedge inception.
>>> Measuring the Fair Value of a Prepayable Instrument in Hedges of
Interest Rate Risk
35-13A In a hedge of interest rate risk in which the hedged item is a
prepayable instrument in accordance with paragraph 815-20-25-6, the factors
incorporated for the purpose of adjusting the carrying amount of the hedged
item shall be the same factors that the entity incorporated for the purpose of
assessing hedge effectiveness in accordance with paragraph 815-20-25-6B. For
example, if an entity considers only how changes in the benchmark interest
rate affect an obligor’s decision to prepay a debt instrument when assessing
hedge effectiveness, it shall consider only that factor when adjusting the
carrying amount of the hedged item. The election to consider only how
changes in the benchmark interest rate affect an obligor’s decision to prepay a
debt instrument does not affect an entity’s election to use either the full
contractual coupon cash flows or the benchmark rate component of the
contractual coupon cash flows determined at hedge inception for purposes of
measuring the change in fair value of the hedged item in accordance with
paragraph 815-25-35-13.
>>> Partial-Term Hedges of Interest Rate Risk
35-13B For a fair value hedge of interest rate risk in which the hedged item
is designated as selected contractual cash flows in accordance with
paragraph 815-20-25-12(b)(2)(ii), an entity may measure the change in the
fair value of the hedged item attributable to interest rate risk using an assumed
term that begins when the first hedged cash flow begins to accrue and ends
when the last hedged cash flow is due and payable. The assumed maturity of
the hedged item occurs on the date in which the last hedged cash flow is due
and payable.

Interest rate risk. When the risk being hedged is the benchmark interest
rate, an entity may choose to measure the change in the hedged item’s fair
value attributable to the changes in the benchmark interest rate based on either
(see section 3.3.70): [815-25-35-13]
— the entire contractual coupon cash flows of the hedged item; or
— the benchmark rate component of the contractual coupon cash flows of the
hedged item determined at inception of the hedging relationship.
When the hedged item is a prepayable financial instrument, the entity is
required to consider the prepayment option when measuring the basis

adjustment. An entity can elect either of the following two approaches (see
section 3.4.10): [815-20-25-6B, 815-25-35-13A]
— consider only the effect of changes in the benchmark interest rate on the
decision to prepay a financial instrument; or
— consider all factors (e.g. credit risk, liquidity, interest rates) when measuring
the change in fair value of the call option.
As discussed in Question 4.3.10, a basis adjustment is measured consistently
with the method an entity uses to assess the hedging relationship’s
effectiveness. As a result, the approaches elected with respect to assessing
hedge effectiveness also affect the measurement of the basis adjustment
when the hedged risk is the benchmark interest rate and/or when hedging
interest rate risk of a prepayable financial instrument. [815-25-35-13A]
For partial-term hedges of interest rate risk (see section 3.3.80), the basis
adjustment is measured assuming the hedged item has a term that reflects
only the designated cash flows and assumes that the principal payment occurs
at the end of the hedge term. [815-25-35-13B]

Question 4.3.60
What discount rate should be applied when
calculating the change in fair value of the hedged
item attributable to changes in the benchmark rate?
Interpretive response: Subtopic 815-25 does not specify the discount rate to
use to calculate the change in the fair value of the hedged item. [815-25-55-56A]
For purposes of determining the change in fair value attributable to changes in
the benchmark interest rate, we believe the discount rate can be either:
— the benchmark interest rate designated as being hedged; or
— the market interest rate of the hedged item at inception of the hedge,
adjusted for changes in the benchmark interest rate being hedged.
See also Example 4.3.60, which illustrates this response.

Question 4.3.70
When the hedged risk is the benchmark interest
rate, are changes in sector credit spreads, issuer
credit risk or liquidity spreads included in the
measurement of the basis adjustment?
Interpretive response: No. These components of an interest rate do not
represent components of the benchmark interest rate. As a result, when the
hedged risk is changes in fair value attributable to changes in the benchmark
interest rate, changes in these components are excluded.

Question 4.3.80
What is the benchmark rate component if the
hedged item is a nonprepayable financial
instrument?
Interpretive response: We believe the benchmark rate component of the
contractual coupon cash flows is the swap rate (i.e. the fixed leg) on an interest
rate swap that at hedge inception has a fair value of zero and has no spread on
its floating leg.
See also Example 4.3.50, which illustrates this response.

Question 4.3.90
What is the benchmark rate component if the
hedged item is a prepayable financial instrument?

Interpretive response: In addition to the factors described in Question 4.3.80,

we believe an entity would also have to consider the prepayment option in the
financial instrument when determining the benchmark rate component of the
contractual coupon cash flows. For example, an entity issues a 10-year fixed-
rate bond that is prepayable after Year 7. The entity hedges the debt by
entering into a 10-year interest rate swap that may be cancelled without penalty
after Year 7 whereby it receives 2.75% and pays three-month LIBOR. The
benchmark rate component is the swap rate on a cancellable swap – i.e. 2.75%.
It would not be the swap rate on a similar but non-cancellable swap.

Question 4.3.100
What is the benchmark rate component if the
hedged item has a premium or discount at hedge
inception?
Interpretive response: We believe the benchmark rate component of the
contractual coupon cash flows of a financial instrument issued or acquired at a
premium or discount is the same as if the instrument was issued or acquired at
par at hedge inception. This is the case regardless of whether the financial
instrument is acquired or issued before hedge inception (a late hedge). We view
the premium or discount as a source of incremental spread that is not part of
the benchmark rate component.

Question 4.3.110
Can the benchmark rate component of the
contractual coupon be used if it is greater than the
entire coupon?
Interpretive response: Yes. An entity may measure the change in the hedged
item’s fair value attributable to interest rate risk using the benchmark rate
component of its contractual coupon cash flows even when the benchmark rate
component is greater than the contractual coupon rate (a sub-benchmark rate).
[ASU 2017-12.BC95]

The benchmark rate component of a fixed-rate asset or liability could be greater

than the asset’s or liability’s contractual coupon rate. This can happen if an
entity issues or acquires a debt instrument, and subsequently designates it as a
hedged item (a late hedge) and interest rates have changed between the date
the entity recognized the instrument and the date it designated the hedge.
[ASU 2017-12.BC92]

This can also happen if, for example, an entity issues a bond with a 3% coupon
at a time when similar bonds are being issued with a 5% coupon. In this case,
the bond is issued at a discount. The benchmark rate component, determined
as explained in Example 4.3.50, could be 4%, which is higher than the
contractual coupon of 3%.

Question 4.3.120
Does Topic 815 prescribe a method to be used for
measuring the basis adjustment when the
benchmark interest rate is hedged?
Interpretive response: No. Topic 815 provides examples of how to measure
the basis adjustment when the hedged risk is changes in fair value due to
changes in the benchmark interest rate but does not prescribe the particular
method.
The following table summarizes two methods illustrated in Topic 815.

FASB Example Description Comments

Example 9 In this example, the change in — Because the method in
fair value of the hedged item Example 9 measures the
[815-25-55-53 –
55-61C] due to changes in the periodic change in the fair
benchmark interest rate is value of the hedged item (i.e.
Reproduced measured by comparing the the periodic basis
below present values of the adjustment) using the cash
remaining cash flows1 at the flows at the end of the
end of the period when period only, it does not
discounted by the benchmark capture changes in fair value
rate2: due to the passage of time.
— at the beginning of the — As a result, a basis
period; versus adjustment for time value
— at the end of the period. will remain at the end of the
hedge term even if the
hedge term coincides with

FASB Example Description Comments

maturity of the hedged item.
To avoid this, entities may
want to consider amortizing
the basis adjustment during
the hedge term (see
section 4.4.20).

Example 11 Under these examples, the — If the method in Examples 11

change in fair value of the and 16 is used, the periodic
[815-25-55-72 –
55-77] hedged item due to changes basis adjustment captures
in the benchmark interest rate the change in fair value due
and is measured by comparing the to the passage of time
Example 16 present value of the because it compares the
remaining cash flows1: present value of the cash
[815-25-55-100 –
— at the beginning of the flows at the end of the
55-108]
period discounted by the period with the present value
Both reproduced
benchmark rate2 at the of the cash flows at the
below beginning of the period.
beginning of the period;
versus — However, under this method,
— at the end of the period a basis adjustment may
discounted by the remain unless an entity
benchmark rate2 at the elects to begin amortizing it
end of the period. during the hedge term when
the entity elects to use all
contractual cash flows rather
than the benchmark
component of contractual
cash flows. This occurs
because the instrument’s
coupon rate typically includes
a credit spread over the
benchmark rate. As a result,
the present value of cash
flows at inception of the
hedge when discounted at
the benchmark rate will differ
from the instrument’s par
amount.

Notes:
The remaining cash flows may be either the benchmark component of contractual
cash flows or all contractual cash flows.
As an alternative to using the applicable benchmark rate at the beginning and end of
the period, the discount rates used may be, respectively:
— the market rate at inception of the hedge as adjusted for changes in the
benchmark rate through the beginning of the period; and
— the market rate at inception of the hedge as adjusted for changes in the
benchmark rate through the end of the period. See Question 4.3.60 and
Example 4.3.60.

To avoid a basis adjustment remaining at the end of the hedge term, we

anticipate that many entities will elect to use the method described in
Examples 11 and 16 and to use the benchmark rate component (rather than full
contractual cash flows) to measure the basis adjustment.

Examples
The following KPMG and FASB examples demonstrate fair value hedges
involving interest rate risk.
— Benchmark rate component for assessment and measurement
(Example 4.3.50).
— Fair value hedge of the LIBOR swap rate in a $100,000 BBB-Quality 5-Year
Fixed-Rate Noncallable Note (Subtopic 815-25’s Example 9).
— Change in fair value attributable to changes in LIBOR – all contractual cash
flows included (Example 4.3.60).
— Fair value hedge of the LIBOR swap rate in a $100 million A1-quality 5-year
fixed-rate noncallable debt (Subtopic 815-25’s Example 11).
— Fair value hedge of interest rate risk using the partial-term approach
(Subtopic 815-25’s Example 15).
— Fair value hedge of the LIBOR swap rate in a $100 million A1-quality 5-year
fixed-rate noncallable debt (Subtopic 815-25’s Example 16).

Example 4.3.50
Benchmark rate component for assessment and
measurement
This example illustrates the response in Question 4.3.80.
ABC Corp. issues a 10-year bond with a 5% coupon at par. On the same day,
ABC enters into a 10-year interest rate swap whereby it receives 3% and pays
the three-month LIBOR rate. ABC designates the bond as the hedged item and
the interest rate swap as the hedging instrument in a fair value hedge of
interest rate risk.
ABC does not apply the shortcut method and elects to use the benchmark rate
component of the bond’s contractual coupon cash flows to measure the change
in the bond’s fair value attributable to changes in the benchmark interest rates.
At hedge inception, the fair value of the swap is zero and there is no spread on
the floating leg of the swap. Therefore, ABC uses 3% (i.e. the fixed leg of the
swap, which is referred to as the swap rate in the 10-year interest rate swap) as
the benchmark rate component to measure the change in the bond’s fair value
attributable to interest rate risk.

Excerpt from ASC 815-25

>> Example 9: Fair Value Hedge of the LIBOR Swap Rate in a $100,000
BBB-Quality 5-Year Fixed-Rate Noncallable Note

55-53 This Example illustrates one method that could be used pursuant to
paragraph 815-20-25-12(f)(2) in determining the hedged item’s change in fair
value attributable to changes in the benchmark interest rate. Other methods
could be used in determining the hedged item’s change in fair value

attributable to changes in the benchmark interest rate as long as those

methods meet the criteria in that paragraph. For simplicity, commissions and
most other transaction costs, initial margin, and income taxes are ignored
unless otherwise stated. Assume that there are no changes in
creditworthiness that would alter the effectiveness of the hedging relationship.
55-54 On January 1, 20X0, Entity GHI issues at par a $100,000 BBB-quality
5-year fixed-rate noncallable debt instrument with an annual 10 percent interest
coupon. On that date, Entity GHI enters into a 5-year interest rate swap based
on the LIBOR swap rate and designates it as the hedging instrument in a fair
value hedge of the $100,000 liability. Under the terms of the interest rate
swap, Entity GHI will receive fixed interest at 7 percent and pay variable
interest at LIBOR. The variable leg of the interest rate swap resets each year
on December 31 for the payments due the following year. This Example has
been simplified by assuming that the interest rate applicable to a payment due
at any future date is the same as the rate for a payment at any other date
(that is, the yield curve is flat). During the hedge period, the gain or loss on
the interest rate swap will be recorded in earnings. The Example assumes
that immediately before the interest rate on the variable leg resets on
December 31, 20X0, the LIBOR swap rate increased by 50 basis points to
7.50 percent, and the change in fair value of the interest rate swap for the
period from January 1 to December 31, 20X0, is a loss in value of $1,675.
55-55 Under this method, the change in a hedged item’s fair value attributable
to changes in the benchmark interest rate for a specific period is determined as
the difference between two present value calculations that use the remaining
cash flows as of the end of the period and reflect in the discount rate the
effect of the changes in the benchmark interest rate during the period.
55-56 Both present value calculations are computed using the estimated future
cash flows for the hedged item, which would be either its remaining
contractual coupon cash flows or the LIBOR benchmark rate component of the
remaining contractual coupon cash flows determined at hedge inception as
illustrated by the following Cases:
a. Using the full contractual coupon cash flows (Case A)
b. Using the LIBOR benchmark rate component of the contractual coupon
cash flows (Case B).
55-56A This Example illustrates two approaches for computing the change in
fair value of the hedged item attributable to changes in the benchmark interest
rate. This Subtopic does not specify the discount rate that must be used to
calculate the change in fair value of the hedged item.
55-56B In Cases A and B in this Example, Entity GHI presents the total change
in the fair value of the hedging instrument (that is, the interest accruals and all
other changes in fair value) in the same income statement line item (in this
case, interest expense) that is used by Entity GHI to present the earnings
effect of the hedged item before applying hedge accounting in accordance
with paragraph 815-20-45-1A.
>>> Case A: Using the Full Contractual Coupon Cash Flows
55-57 In this Case, assume Entity GHI elected to calculate the change in the
fair value of the hedged item attributable to interest rate risk on the basis of
the full contractual coupon cash flows of the hedged item. Accordingly, both

present value calculations in accordance with paragraph 815-25-55-55 are

computed using the remaining contractual coupon cash flows as of the end of
the period and the discount rate that reflects the change in the designated
benchmark interest rate during the period. The method chosen by Entity GHI in
this Case requires that the discount rate be based on the market interest rate
for the hedged item at the inception of the hedging relationship. The discount
rates used for those present value calculations would be, respectively:
a. The discount rate equal to the market interest rate for that hedged item at
the inception of the hedge adjusted (up or down) for changes in the
benchmark rate (designated as the interest rate risk being hedged) from
the inception of the hedge to the beginning date of the period for which
the change in fair value is being calculated
b. The discount rate equal to the market interest rate for that hedged item at
the inception of the hedge adjusted (up or down) for changes in the
designated benchmark rate from the inception of the hedge to the ending
date of the period for which the change in fair value is being calculated.
55-58 Entity GHI elected to subsequently assess hedge effectiveness on a
quantitative basis. In Entity GHI's quarterly assessments of hedge
effectiveness for each of the first three quarters of year 20X0 in this Example,
there was zero change in the hedged item’s fair value attributable to changes
in the benchmark interest rate because there was no change in the LIBOR
swap rate. However, in the assessment for the fourth quarter 20X0, the
discount rate for the beginning of the period is 10 percent (the hedged item’s
original market interest rate with an adjustment of zero), and the discount rate
for the end of the period is 10.50 percent (the hedged item’s original market
interest rate adjusted for the change during the period in the LIBOR swap rate
[+ 0.50 percent]).
December 31, 20X0
Calculate the present value using the beginning-of-period discount rate of
10 percent:

$10,000pmt, 10%i, 4n, PV = $ 31,699 (interest payments)

$100,000fv, 10%i, 4n, PV = $ 68,301 (principal payment)
Total present value $100,000

55-59 Calculate the present value using the end-of-period discount rate of
10.50 percent (that is, the beginning-of-period discount rate adjusted for the
change during the period in the LIBOR swap rate of 50 basis points).

$10,000pmt, 10.50%i, 4n, PV = $ 31,359 (interest payments)

$100,000fv, 10.50%i, 4n, PV = $ 67,073 (principal payment)
Total present value $ 98,432

55-60 The change in fair value of the hedged item attributable to the change in
the benchmark interest rate is $100,000 – $98,432 = $1,568 (the fair value
decrease in the liability is a gain on debt).
55-61 When the change in fair value of the hedged item ($1,568 gain)
attributable to the risk being hedged is compared with the change in fair value
of the hedging instrument ($1,675 loss), a mismatch of $107 results that will

be reported in earnings, because both changes in fair value are recorded in

earnings. The change in the fair value of the hedging instrument will 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.
>>> Case B: Using the LIBOR Benchmark Rate Component of the
Contractual Coupon Cash Flows
55-61A In this Case, assume Entity GHI elected to calculate the change in the
fair value of the hedged item attributable to interest rate risk on the basis of
the benchmark rate component of the contractual coupon cash flows
determined at hedge inception. Accordingly, both present value calculations in
accordance with paragraph 815-25-55-55 are computed using the remaining
benchmark rate component of contractual coupon cash flows as of the end
period and the discount rate that reflects the change in the designated
benchmark rate during the period. The discount rates used by Entity GHI in this
Case would be, respectively:
a. The benchmark rate (designated as the interest rate risk being hedged) as
of the beginning date of the period for which the change in fair value is
being calculated
b. The designated benchmark rate as of the ending date of the period for
which the change in fair value is being calculated.
55-61B Entity GHI elected to subsequently assess hedge effectiveness on a
quantitative basis. In Entity GHI’s quarterly assessments of hedge
effectiveness for each of the first three quarters of year 20X0, there was no
change in the hedged item’s fair value attributable to changes in the
benchmark interest rate because there was no change in the LIBOR swap rate.
However, in the assessment for the fourth quarter 20X0, the discount rate for
the beginning of the period is 7 percent, and the discount rate for the end of
the period is 7.50 percent reflecting the change during the period in the LIBOR
swap rate. The change in fair value of the hedged item attributable to the
change in the benchmark interest risk for the period January 1, 20X0, to
December 31, 20X0, is a gain of $1,675, calculated as follows.
December 31, 20X0
Calculate the present value using the beginning-of-period benchmark interest
rate:

$7,000pmt, 7%i, 4n, PV = $ 23,710 (benchmark component of coupon

payments)
$100,000fv, 7%i, 4n, PV = $ 76,290 (principal payment)

Total present value $100,000

Calculate the present value using the end-of-period benchmark interest rate:

$7,000pmt, 7.50%i, 4n, PV = $ 23,445 (benchmark component of coupon

payments)
$100,000fv, 7.50%i, 4n, PV = $ 74,880 (principal payment)

Total present value $ 98,325

Change in value $ 1,675

55-61C Because the change in fair value of the hedged item ($1,675 gain)
attributable to the risk being hedged is the same as the change in fair value of
the hedging instrument ($1,675 loss), there is perfect offset and, therefore, a
zero net earnings effect.

Example 4.3.60
Change in fair value attributable to changes in LIBOR
– all contractual cash flows included
As discussed in Question 4.3.60, Subtopic 815-25 does not specify the discount
rate that must be used to calculate the change in the fair value of the hedged
item. We believe there are two acceptable discount rates that may be used,
which are illustrated in this example as follows.
— Scenario 1: the discount rate is the designated benchmark interest rate
(LIBOR).
— Scenario 2: the discount rate is the market interest rate of the hedged item
at inception of the hedge, adjusted for changes in the designated
benchmark interest rate (LIBOR).
Borrower hedges the changes in fair value attributable to changes in LIBOR (a
Benchmark Interest Rate) of a $1 million, five-year, 4% fixed-rate debt
obligation issued at par on January 1, Year 1. Interest is paid quarterly. The
hedge is designated at inception of the debt obligation (i.e. January 1, Year 1).
Borrower elects to calculate the change in the fair value of the debt obligation
that is due to interest rate risk on the basis of the full contractual coupon cash
flows of the debt obligation. Therefore, the cash flows being discounted at each
date are the remaining contractual cash flows:
— interest of $10,000 at the end of each quarter; and
— principal of $1 million due on maturity of the debt.
LIBOR is as follows.

Date LIBOR
January 1, Year 1 2.50%
March 31, Year 1 3.00%
June 30, Year 1 3.25%

The quarterly interest payments were made before determining the change in
fair value.
Scenario 1: Discount rate is LIBOR
If the discount rate is LIBOR, the change in fair value of the total contractual
cash flows that is attributable to changes in LIBOR is calculated at March 31,
Year 1 as follows.

Quarterly interest payments, for 19 remaining quarters $ 190,000

Principal payment at end of 19 remaining quarters 1,000,000
Total $1,190,000
LIBOR at beginning of period 2.50%
Present value based on LIBOR at beginning of period $775,317
LIBOR at end of period 3.00%
Present value based on LIBOR at end of period $713,524
Change in fair value attributable to changes in LIBOR $(61,793)

Similarly, the change in fair value of the total contractual cash flows that is
attributable to changes in LIBOR is calculated at June 30, Year 1 as follows.

Quarterly interest payments, for 18 remaining quarters $ 180,000

Principal payment at end of 18 remaining quarters 1,000,000
Total $1,180,000
LIBOR at beginning of period 3.00%
Present value based on LIBOR at beginning of period $724,930
LIBOR at end of period 3.25%
Present value based on LIBOR at end of period $696,987
Change in fair value attributable to changes in LIBOR $(27,943)

Scenario 2: Discount rate is the market interest rate at inception of the

hedge as adjusted for changes in LIBOR
If the discount rate is the market interest rate at inception of the hedge as
adjusted for changes in LIBOR, the change in fair value of the total contractual
cash flows that is attributable to changes in LIBOR is calculated at March 31,
Year 1 as follows.

Quarterly interest payments, for 19 remaining quarters $ 190,000

Principal payment at end of 19 remaining quarters 1,000,000
Total $1,190,000
Market rate at inception of hedge adjusted for changes in LIBOR, at
beginning of period 4.00%
Present value based on market rate as adjusted, beginning of period $605,982
Market rate at inception of hedge adjusted for changes in LIBOR, at
end of period 4.50%
Present value based on market rate as adjusted, end of period $559,235
Change in fair value attributable to changes in LIBOR $(46,747)

Similarly, the change in fair value of the total contractual cash flows that is
attributable to changes in LIBOR is calculated at June 30, Year 1 as follows.

Quarterly interest payments, for 18 remaining quarters $ 180,000

Principal payment at end of 18 remaining quarters 1,000,000
Total $1,180,000
Market rate at inception of hedge adjusted for changes in LIBOR, at
beginning of period 4.50%
Present value based on market rate as adjusted, beginning of period $574,400
Market rate at inception of hedge adjusted for changes in LIBOR, at
end of period 4.75%
Present value based on market rate as adjusted, end of period $552,951
Change in fair value attributable to changes in LIBOR $(21,449)

Excerpt from ASC 815-25

>> Example 11: Fair Value Hedge of the LIBOR Swap Rate in a
$100 Million A1-Quality 5-Year Fixed-Rate Noncallable Debt

55-72 This Example illustrates application of the guidance in Sections 815-20-

25, 815-20-35, and 815-25-35 to a fair value hedge of the LIBOR swap rate in a
$100 million A1-quality 5-year fixed-rate noncallable debt. Assume that an
entity elected to calculate the change in the fair value of the hedged item
attributable to LIBOR interest rate risk using the full contractual coupon cash
flows of the hedged item.
55-73 On April 3, 20X0, Global Tech issues at par a $100 million A1-quality
5-year fixed-rate noncallable debt instrument with an annual 8 percent interest
coupon payable semiannually. On that date, Global Tech enters into a 5-year
interest rate swap based on the LIBOR swap rate and designates it as the
hedging instrument in a fair value hedge of the $100 million liability. Under the
terms of the interest rate swap, Global Tech will receive a fixed interest rate at
8 percent and pay variable interest at LIBOR plus 78.5 basis points (current
LIBOR 6.29 percent) on a notional amount of $101,970,000 (semiannual
settlement and interest reset dates). A duration-weighted hedge ratio was
used to calculate the notional amount of the interest rate swap necessary to
offset the debt’s fair value changes attributable to changes in the LIBOR
swap rate.
55-74 This Example has the following assumptions:
a. PV01 debt = 4.14
b. PV01 interest rate swap = 4.06
c. Hedge ratio = PV01 debt / PV01 interest rate swap = 4.14/4.06 = 1.0197
d. Interest rate swap notional = 1.0197 x $100 million = $101,970,000.
e. For simplicity, commissions and most other transaction costs, initial
margin, and income taxes are ignored unless otherwise stated. Assume
that there are no changes in creditworthiness that would alter the
effectiveness of the hedging relationship.

55-75 The Example assumes that the LIBOR swap rate increased 100 basis
points to 7.29 percent on June 30, 20X0. The change in fair value of the
interest rate swap for the period from April 3 to June 30, 20X0, is a loss of
$4,016,000. The change in fair value of the debt attributable to changes in the
benchmark interest rate for the period April 3 to June 30, 20X0, is calculated as
follows.

Principal Coupon Cash Flow – Cash Flow – Present

Period Balance Rate Interest Principal Value
0.5 $ 100,000,000 0.08 2,000,000 - 1,956,464
1.5 $ 100,000,000 0.08 4,000,000 - 3,744,429
2.5 $ 100,000,000 0.08 4,000,000 - 3,583,185
3.5 $ 100,000,000 0.08 4,000,000 - 3,428,885
4.5 $ 100,000,000 0.08 4,000,000 - 3,281,230
5.5 $ 100,000,000 0.08 4,000,000 - 3,139,933
6.5 $ 100,000,000 0.08 4,000,000 - 3,004,721
7.5 $ 100,000,000 0.08 4,000,000 - 2,875,331
8.5 $ 100,000,000 0.08 4,000,000 - 2,751,513
9.5 $ 100,000,000 0.08 4,000,000 100,000,000 68,458,689
Present
value 96,224,380

55-76 As of June 30, 20X0, 9.5 periods remain and the cash flows are
discounted at 9 percent, determined as the initial 8-percent yield plus a
100 basis point increase attributable to the 100 basis point increase in the
LIBOR swap rate. The accrual for the first quarter interest was excluded. The
following journal entries illustrate the interest rate swap and debt fair value
changes, attributable to changes in the LIBOR swap rate, excluding accruals.

Debit Credit
Debt $ 3,775,620
Interest expense $ 3,775,620

Interest expense $ 4,016,000

Swap liability $ 4,016,000

55-77 The net earnings effect of the hedging relationship was $240,380
because of the mismatch between the change in the fair value of the hedging
instrument and the change in fair value of the hedged item. In accordance with
paragraph 815-20-45-1A, Global Tech presents the entire change in the fair
value of the hedging instrument (including interest accruals and all other
changes in fair value) in the same income statement line item (in this case,
interest expense) that is used by Global Tech to present the earnings effect of
the hedged item before applying hedge accounting.

Excerpt from ASC 815-25

>> Example 15: Fair Value Hedge of Interest Rate Risk Using the Partial-
Term Approach

55-94 This Example illustrates the application of paragraphs 815-20-25-

12(b)(2)(ii) and 815-25-35-13B to the designation and measurement of a hedged
item as a portion of the term of a financial instrument in a hedge of interest
rate risk. Assume that Entity S elected to calculate fair value changes in the
hedged item attributable to interest rate risk on the basis of the benchmark
rate component of the contractual coupon cash flows of the hedged item
determined at hedge inception.
55-95 On January 1, 20X1, Entity S issues a noncallable, 5-year, $100 million
debt instrument with a 3 percent semiannual interest coupon. On that date,
the issuer also enters into a 2-year interest rate swap with a notional amount of
$100 million. Entity S designates the swap as a fair value hedge of the fixed-
rate debt attributable to interest rate risk for the first two years of its term in
accordance with the guidance in paragraph 815-20-25-12(b)(2)(ii). The swap
pays LIBOR and receives a fixed rate of 2 percent, with semiannual payments.
The swap has a fair value of zero at inception. The designated benchmark
interest rate is the LIBOR swap rate. For ease of calculation, the yield curve is
assumed to be flat at the level of the current benchmark interest rate. For
simplicity, commissions and most other transaction costs, initial margin, and
income taxes are ignored unless otherwise stated. Assume that there are no
changes in creditworthiness that would alter the effectiveness of the hedging
relationship.
55-96 This Example assumes that the LIBOR swap rate increased by 50 basis
points to 2.5 percent on June 30, 20X1. The change in fair value of the interest
rate swap for the period January 1, 20X1, to June 30, 20X1, is a loss in value
of $731,633.
55-97 In calculating the change in fair value of the debt attributable to changes
in the benchmark interest rate in accordance with paragraph 815-25-35-13B,
Entity S determines that the assumed term of the hedged item is two years
because it is hedging only the cash flows associated with the first two years of
its debt issuance. The change in fair value of the debt attributable to changes in
the benchmark interest rate for the period January 1, 20X1, to June 30, 20X1,
is a gain of $731,633, calculated as follows.

January 1, 20X1—beginning balance

$1,000,000pmt, 1.00%i, 4n, 100,000,000fv, PV = $ 100,000,000
June 30, 20X1—ending balance
$1,000,000pmt, 1.25%i, 3n, 100,000,000fv, PV = 99,268,367
Change in value $ 731,633

55-98 As of June 30, 20X1, the change in fair value of the debt attributable to
the benchmark interest rate is calculated by discounting the benchmark rate
component of the contractual coupon cash flows using the benchmark interest
rate at June 30, 20X1 (2.5 percent annual rate and 1.25 percent for each

semiannual period). The change in fair value of the debt and the change in fair
value of the swap result in perfect offset in current-period earnings. In
accordance with paragraph 815-20-45-1A, Entity S presents the total change in
the fair value of the hedging instrument (that is, the interest accruals and all
other changes in fair value) in the same income statement line item (in this
case, interest expense) that is used by Entity S to present the earnings effect
of the hedged item before applying hedge accounting.
55-99 Although this Example illustrates the hedged item as the first
two years of interest payments associated with an existing debt instrument,
paragraph 815-20-25-12(b)(2)(ii) permits one interest payment or any
consecutive interest payments associated with an existing debt instrument
to be designated as the hedged item.

Excerpt from ASC 815-25

>> Example 16: Fair Value Hedge of the LIBOR Swap Rate in a
$100 Million A1-Quality 5-Year Fixed-Rate Noncallable Debt

55-100 The following Cases illustrate application of the guidance in

Sections 815-20-25, 815-20-35, and 815-25-35 to a fair value hedge of the
LIBOR swap rate in a $100 million A1-quality 5-year fixed-rate noncallable debt:
a. Using the full contractual coupon cash flows (Case A)
b. Using the benchmark rate component of the contractual coupon cash
flows (Case B).
55-101 On July 2, 20X0, Entity XYZ issues at par a $100 million A1-quality
5-year fixed-rate noncallable debt instrument with an annual 8 percent interest
coupon payable semiannually. On that date, Entity XYZ enters into a 5-year
interest rate swap based on the LIBOR swap rate and designates it as the
hedging instrument in a fair value hedge of interest rate risk of the $100 million
liability. Under the terms of the interest rate swap, Entity XYZ will receive a
fixed interest rate at 8 percent and pay variable interest at LIBOR plus
200 basis points (current LIBOR 6 percent) on a notional amount of
$100 million (semiannual settlement and interest reset dates). For simplicity,
commissions and most other transaction costs, initial margin, and income
taxes are ignored unless otherwise stated. Assume that there are no changes
in creditworthiness that would alter the effectiveness of the hedging
relationship. The Example also assumes that the yield curve is flat and that the
LIBOR swap rate increased 100 basis points to 7 percent on December 31,
20X0. The change in fair value of the interest rate swap for the period from
July 2, 20X0, to December 31, 20X0, is a loss of $3,803,843.
55-102 In both Cases A and B in this Example, Entity XYZ presents the total
change in the fair value of the hedging instrument (that is, the interest accruals
and all other changes in fair value) in the same income statement line item (in
this case, interest expense) that is used by Entity XYZ to present the earnings
effect of the hedged item before applying hedge accounting in accordance
with paragraph 815-20-45-1A.

>>> Case A: Using the Full Contractual Coupon Cash Flows

55-103 In this Case, assume that Entity XYZ elected to calculate fair value
changes in the hedged item attributable to interest rate risk using the full
contractual coupon cash flows of the hedged item. The change in fair value of
the debt attributable to changes in the benchmark interest rate for the period
July 2, 20X0, to December 31, 20X0, is a gain of $3,634,395, calculated as
follows.

July 2, 20X0—beginning balance

$4,000,000pmt, 4.0%i, 10n, 100,000,000fv, PV = $ 100,000,000
December 31, 20X0—ending balance
$4,000,000pmt, 4.5%i, 9n, 100,000,000fv, PV = 96,365,605
Change in value $ 3,634,395

55-104 As of December 31, 20X0, the fair value of the debt attributable to
interest rate risk is calculated by discounting the full contractual coupon cash
flows at the debt’s original market rate with a 100 basis point adjustment
related to the increase in the LIBOR swap rate (50 basis point adjustment on a
semiannual basis). The following journal entries illustrate the interest rate swap
and debt fair value changes attributable to changes in the LIBOR swap rate.
Debt $ 3,634,395
Interest expense $ 3,634,395

Interest expense 3,803,843

Swap liability 3,803,843

55-105 The net earnings effect of the hedge is $169,448 due to the mismatch
between the changes in fair value of the hedging instrument and the hedged
item attributable to the changes in the benchmark interest rate.
>>> Case B: Using the Benchmark Rate Component of the Contractual
Coupon Cash Flows
55-106 In this Case, assume that Entity XYZ elected to calculate fair value
changes in the hedged item attributable to interest rate risk using the
benchmark rate component of the contractual coupon cash flows of the
hedged item determined at hedge inception. The change in fair value of the
debt attributable to changes in the benchmark interest rate for the period
July 2, 20X0, to December 31, 20X0, is a gain of $3,803,843, calculated as
follows.

July 2, 20X0—beginning balance

$3,000,000pmt, 3.0%i, 10n, 100,000,000fv, PV = $ 100,000,000
December 31, 20X0—ending balance
$3,000,000pmt, 3.5%i, 9n, 100,000,000fv, PV = 96,196,157
Change in value $ 3,803,843

55-107 As of December 31, 20X0, the fair value of the debt attributable to
interest rate risk is calculated by discounting the benchmark rate component of
the contractual coupon cash flows using the benchmark interest rate at
December 31, 20X0 (7 percent annual rate; 3.5 percent for each semiannual

period). The following journal entries illustrate the interest rate swap and debt
fair value changes attributable to changes in the LIBOR swap rate.

Debt $ 3,803,843
Interest expense $ 3,803,843
Interest expense 3,803,843
Swap liability 3,803,843

55-108 The net earnings effect of the hedge is zero due to the perfect offset in
fair value changes between the hedging instrument and the hedged item
attributable to the changes in the benchmark interest rate.

4.3.30 Portfolio-level basis adjustments

When the hedged item is a portfolio of similar assets or liabilities (see
section 3.3.40), the basis adjustment is measured at the portfolio level.
Generally, a portfolio-level basis adjustment is allocated to the individual items
in the portfolio. This allocation generally is necessary to determine the
amortized cost basis for the items in the portfolio for purposes of complying
with other applicable US GAAP, both during and after the hedging relationship,
such as:
— applying impairment guidance (see section 4.4.30)
— preparing disclosures;
— measuring the gain or loss when an item in the portfolio is sold or
otherwise disposed of; and
— determining amortization when the hedged item is a financial instrument for
which interest rate risk was hedged (see section 4.4.20).
A systematic and rational method is used to allocate the portfolio-level basis
adjustment to the individual items in the portfolio.

Question 4.3.130
When the last-of-layer method is used, is it
necessary to allocate the basis adjustment?

Excerpt from ASC 815-10

> Basis Adjustment Considerations under the Last-of-Layer Method

50-5B For hedging relationships designated under the last-of-layer method, an
entity may need to allocate the outstanding basis adjustment to meet the
objectives of disclosure requirements in other Topics. For purposes of those
disclosure requirements, the entity may allocate the basis adjustment on an
individual asset basis or on a portfolio basis using a systematic and rational
method.

Interpretive response: In a portfolio hedge that is other than a last-of-layer

hedge, all individual items in the portfolio are hedged items. However, in a last-
of-layer hedge, only the items that constitute the last of layer that is treated as a
nonprepayable item are being hedged (see section 3.3.100). The individual
items in that layer are not known during the hedge term. This is because the
individual items that may prepay, default or be sold are unknown before the
actual event occurs. As a result, it is not clear to which items in the closed
portfolio the basis adjustment relates – nor consequently to which items the
basis adjustment should be allocated.
For disclosures, Topic 815 provides guidance that the portfolio-level basis
adjustment may be allocated on an individual asset basis or on a portfolio basis
using a systematic and rational method. However, Topic 815 does not provide
guidance for whether or how to allocate the outstanding portfolio-level basis
adjustment during the hedge term for any other purpose. [815-10-50-5B]
At its March 28, 2018 meeting, the FASB added a narrow scope project to its
agenda to address when and how an entity is permitted or required to allocate a
last-of-layer basis adjustment to the individual assets in the closed portfolio. As
a result, revisions to this interpretive response may be provided in a future
edition.

Question 4.3.140
When assets in the portfolio from which the last of
layer is derived are sold during the hedge term, is
the related basis adjustment allocated to individual
assets?
Interpretive response: It depends on whether the balance remaining in the
portfolio exceeds the designated last of layer.
— If an entity sells an asset from the closed portfolio and the balance
remaining in the portfolio after the sale exceeds the designated last of
layer, the entity does not need to allocate any of the remaining basis
adjustment to the asset that was sold as it would not be part of the last-of-
layer. See Question 4.3.130 regarding the FASB’s narrow scope project on
the allocation of basis adjustments. [ASU 2017-12.BC121(a)]
— If the sale of the asset causes the remaining balance in the portfolio to be
less than the last of layer, the entity discontinues the entire hedging
relationship and follows Steps 1 to 3 in Question 4.5.30 as part of full
discontinuation. See also Example 4.5.30 (Scenario 2). [815-25-40-8(b)]

4.4 Subsequent accounting for basis adjustments

4.4.10 Overview

Excerpt from ASC 815-25

> Changes in Fair Value of Hedged Item

35-8 The adjustment of the carrying amount of a hedged asset or liability
required by paragraph 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.

Basis adjustments generally are accounted for in the same manner as other
components of the hedged item’s amortized cost basis. Basis adjustments
related to interest-bearing financial instruments are amortized to earnings over a
period that depends on when amortization commences (see section 4.4.20).
[815-25-35-8 – 35-9A]

The following table provides examples of the subsequent accounting for the
basis adjustment, including the timing and method for its recognition in
earnings.

Timing and method of recognizing the basis

Hedged item adjustment in earnings
Asset held for sale (e.g. The basis adjustment remains part of the asset’s
inventory) amortized cost basis until the asset is sold. When
the asset is sold, its entire carrying amount (including
the basis adjustment) is recognized as the cost of
the item sold in determining earnings. [815-25-35-8]

Interest-bearing financial The basis adjustment is amortized to earnings.

instrument (e.g. long-term Amortization is required to begin no later than when
borrowing) the hedged item ceases to be adjusted for changes
in its fair value attributable to the risk being hedged
(see section 4.4.20). [815-25-35-9 – 35-9A]

Firm commitments We expect the entity to account for the firm

commitment in the same manner as it will account
for the related asset or liability once it is recognized
(see Question 4.4.10).

Formal documentation. If the hedged item is a firm commitment, the initial

hedge documentation is required to include the method (which must be
reasonable) for recognizing in earnings the asset or liability that represents the
gain or loss on the hedged firm commitment (see section 2.9.50). [815-20-25-
3(c)(1)]

Question 4.4.10
For firm commitments, what is the subsequent
accounting for assets (liabilities) recognized due to
applying fair value hedge accounting?
Interpretive response: In a hedge of a firm commitment (rather than of a
recognized asset or liability), adjustments of the hedged item (firm
commitment) result in the recognition of assets or liabilities.
For firm commitments to purchase inventory we expect those earnings
adjustments will follow the entity’s existing inventory accounting policies.
Specifically, the asset (or liability) recognized due to applying fair value hedge
accounting will be included in the cost of inventory when the inventory is
purchased (i.e. when the firm commitment is settled). As a result, it will be
recognized in earnings when the related inventory is sold; this includes
consideration of the inventory method, e.g. FIFO, LIFO, average cost.
For firm commitments that relate to assets or liabilities that are prohibited from
being recognized – such as those embodied in a lessor’s non-cancellable
operating lease or an unrecognized mortgage servicing right – an entity will
need to develop a policy for the earnings adjustments.

FASB Example: Fair value hedge of a commodity inventory

Excerpt from ASC 815-25

>> Example 7: Fair Value Hedge of a Commodity Inventory

55-30 The following Cases illustrate application of the guidance in

Sections 815-20-25, 815-20-35, and 815-25-35 to a fair value hedge of a
commodity inventory:
a. The terms of the hedging derivative have been negotiated such that the
hedging relationship is perfectly effective (Case A).
b. The hedging relationship is not perfectly effective (Case B).
55-31 To simplify the illustration and focus on basic concepts, the derivative
instrument in Cases A and B is assumed to have no time value. In practice, a
derivative instrument used for a fair value hedge of a commodity would have a
time value that would change over the term of the hedging relationship. The
changes in that time value may be accounted for through an amortization
approach in accordance with paragraph 815-20-25-83A or a mark-to-market
approach in accordance with paragraph 815-20-25-83B. Under either of those
approaches, the portion of excluded components recognized in earnings should
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.
55-32 Other Examples in this Section illustrate accounting for the time value
component of a derivative instrument.

55-33 For simplicity, commissions and most other transaction costs, initial
margin, and income taxes are ignored unless otherwise stated. Assume that
there are no changes in creditworthiness that would alter the effectiveness of
the hedging relationship.
55-34 Cases A and B share all of the following assumptions:
a. Entity ABC decides to hedge the risk of changes during the period in the
overall fair value of its entire inventory of Commodity A by entering into a
derivative instrument, Derivative Z.
b. On the first day of Period 1, Entity ABC enters into Derivative Z and neither
receives nor pays a premium (that is, the fair value at inception is zero).
c. Entity ABC designates the derivative instrument as a hedge of the changes
in fair value of the inventory due to changes in the price of Commodity A
during Period 1.
d. The hedging relationship qualifies for fair value hedge accounting. Entity
ABC will assess effectiveness on a quantitative basis both initially and
subsequently by comparing the entire change in fair value of Derivative Z
with the change in the market price of the hedged commodity inventory.
>>> Case A: Perfect Effectiveness in the Hedging Relationship
55-35 In this Case, Entity ABC expects the hedge to be perfectly effective
because both of the following conditions exist:
a. The notional amount of Derivative Z matches the amount of the hedged
inventory (that is, Derivative Z is based on the same number of bushels as
the number of bushels of the commodity that Entity ABC designated as
hedged).
b. The underlying of Derivative Z is the price of the same variety and grade of
Commodity A as the inventory at the same location.
55-36 At inception of the hedge, Derivative Z has a fair value of zero and the
hedged inventory has a carrying amount of $1,000,000 and a fair value of
$1,100,000. On the last day of Period 1, the fair value of Derivative Z has
increased by $25,000, and the fair value of the inventory has decreased by
$25,000. The inventory is sold, and Derivative Z is settled on the last day of
Period 1. The following table illustrates the accounting for the situation
described in this Case.

Debit (Credit)
(a)
Cash Derivative Inventory Earnings
Period 1
Recognize change in fair
value of derivative $ 25,000 $ (25,000)
Recognize change in fair
value of inventory $ (25,000) 25,000
Recognize revenue from
sale $ 1,075,000 (1,075,000)
Recognize cost of sale of
inventory (975,000) 975,000
Recognize settlement of
derivative 25,000 (25,000)
Total $ 1,100,000 $ - $ (1,000,000) $ (100,000)

a. For presentation purposes, the change in the fair value of the hedging instrument is in
the same income statement line item as the hedged item.

55-37 If Entity ABC had sold the hedged inventory at the inception of the
hedge, its gross profit on that sale would have been $100,000. This Case
illustrates that, by hedging the risk of changes in the overall fair value of its
inventory, Entity ABC recognized the same gross profit at the end of the hedge
period even though the fair value of its inventory decreased by $25,000.
>>> Case B: Hedging Relationship Is Not Perfectly Effective
55-38 The hedge in Case A was perfectly effective because the gain on
Derivative Z exactly offsets the loss on the inventory. However, in this Case,
assume the terms of Derivative Z do not perfectly match the inventory and its
fair value has increased by $22,500 as compared with the decline in fair value
of the inventory of $25,000. The mismatch of $2,500 has to be recognized in
earnings and presented in the same income statement line item as the
earnings effect of the hedged item. The following table illustrates the
accounting for the situation described in this Case.

Debit (Credit)
(a)
Cash Derivative Inventory Earnings
Period 1
Recognize change in fair
value of derivative $ 22,500 $ (22,500)
Recognize change in fair
value of inventory $ (25,000) 25,000
Recognize revenue from
sale $ 1,075,000 (1,075,000)
Recognize cost of sale of
inventory (975,000) 975,000
Recognize settlement of
derivative 22,500 (22,500)
Total $ 1,097,500 $ - $ (1,000,000) $ (97,500)
a. For presentation purposes, the change in the fair value of the hedging instrument is in
the same income statement line item as the hedged item.

55-39 The difference between the effect on earnings in Case B and the effect
on earnings in Case A is $2,500.

4.4.20 Interest-bearing financial instruments

Excerpt from ASC 815-25

> Changes in Fair Value of Hedged Item

35-9 An adjustment of the carrying amount of a hedged interest-bearing
financial instrument shall be amortized to earnings. Amortization shall begin

no later than when the hedged item ceases to be adjusted for changes in its
fair value attributable to the risk being hedged.
35-9A For an outstanding hedging relationship, any amortization of
adjustments to the carrying amount of the hedged item shall be performed
assuming that the amortization period is the remaining life of the hedging
relationship. For a discontinued hedging relationship, all remaining adjustments
to the carrying amount of the hedged item shall be amortized over a period
that is consistent with the amortization of other discounts or premiums
associated with the hedged item in accordance with other Topics (for example,
Subtopic 310-20 on receivables—nonrefundable fees and other costs).

Question 4.4.20
When is amortization of the basis adjustment for
interest-bearing financial instruments required to
begin?
Interpretive response: Amortization is required to begin no later than when
the interest-bearing financial instrument (hedged item) ceases to be adjusted
for changes in its fair value attributable to the risk being hedged. However, an
entity may begin amortization earlier depending on its accounting policy.
[815-25-35-9]

See comments about the FASB examples in Question 4.3.120 for a situation in
which an entity may wish to begin amortization before the hedged item ceases
to be adjusted for changes in its fair value attributable to the risk being hedged.

Question 4.4.30
Over what period are basis adjustments of interest-
bearing financial instruments amortized?

Interpretive response: It depends on whether amortization begins during the

hedging relationship or after the hedging relationship has been discontinued, as
shown in the following table. [815-25-35-9A]

When amortization begins Amortization period

During the hedging relationship The remaining life of the hedging
relationship, unless the hedging
relationship is discontinued. For a partial-
term hedge, amortization is therefore
over the partial term.
After the hedging relationship is A period that is consistent with the
discontinued – hedge is discontinued for amortization of other discounts or
reasons other than derecognition of the premiums associated with the hedged
hedged item item under other applicable US GAAP –
e.g. Subtopic 310-20 (receivables –
nonrefundable fees and other costs).

When amortization begins Amortization period

Because the amortization period during
the hedging relationship is different from
the amortization period after the hedging
relationship is discontinued, a hedge
discontinuation may result in a change to
the amortization period if amortization
was started during the hedging
relationship (e.g. for a partial-term
hedge).
After the hedging relationship is The basis adjustment is derecognized
discontinued – hedged item is together with the hedged item (i.e.
derecognized immediately).

Question 4.4.40
Do basis adjustments for interest-bearing
borrowings affect the capitalization of interest?

Background: Subtopic 835-20 (capitalization of interest) requires capitalizing

interest cost as part of the historical cost of acquiring certain assets. The
amount capitalized in a period is based on applying a capitalization rate to the
average amount of accumulated expenditures for a qualifying asset during the
period. The capitalization rate to be used is based on rates for borrowings
outstanding during the period. [835-20-05-1, 30-3]

Excerpt from ASC 815-25

>> Interaction with Capitalization Rate for Assets under Construction

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.

Interpretive response: Whether basis adjustments for interest-bearing

borrowings affect the capitalization rate depends on whether the basis
adjustments are being amortized during the period for which interest costs are
capitalized.
Only amounts recorded in an entity’s income statement as interest costs that
are included in the assessment of effectiveness are included in the
capitalization rate that is used to determine capitalized interest. Those amounts
include amortization of basis adjustments recognized during the period for
interest-bearing borrowings. [815-25-35-14]

FASB Example: Fair value hedge of fixed-rate interest-bearing

debt

Excerpt from ASC 815-25

>> Example 8: Fair Value Hedge of Fixed-Rate Interest-Bearing Debt

55-40 This Example demonstrates the guidance in Subtopic 815-20 and this
Subtopic as applied to the mechanics of reporting an interest rate swap used
as a fair value hedge of an interest-bearing liability. It is not intended to
demonstrate how to compute the fair value of an interest rate swap or an
interest-bearing liability. This Example has been simplified by assuming that the
interest rate applicable to a payment due at any future date is the same as the
rate for a payment due at any other date (that is, the yield curve is flat).
Although that is an unrealistic assumption, it makes the amounts used easier
to understand without detracting from the purpose of the Example. For
simplicity, commissions and most other transaction costs, initial margin, and
income taxes are ignored unless otherwise stated. Assume that there are no
changes in creditworthiness that would alter the effectiveness of the hedging
relationship.
55-41 The fair values of the interest rate swap in this Example are determined
using the zero-coupon method. The zero-coupon method is not the only
acceptable method. Explanations of other acceptable methods of determining
the fair value of an interest rate swap can be obtained from various published
sources. Fair values also may be available from dealers in interest rate swaps
and other derivative instruments.
55-42 In this Example, the term and notional amount of the interest rate swap
match the term and principal amount of the interest-bearing liability being
hedged. The fixed and variable interest rates used to determine the net
settlements on the interest rate swap match the current yield curve, and the
sum of the present values of the expected net settlements is zero at inception.
Thus, paragraphs 815-20-25-102 through 25-106 permit the reporting entity to
assume perfect effectiveness. Assessment of effectiveness at one of the
interest rate swap’s repricing dates would confirm the validity of that
assumption.
55-43 A shortcut method (see paragraphs 815-20-25-102 through 25-106) can be
used to produce the same reporting results as the method illustrated in this
Example. This shortcut is only appropriate for a fair value hedge of a fixed-rate
asset or liability using an interest rate swap and only if the assumption of perfect
effectiveness is appropriate. The steps in the shortcut method are as follows:
a. Determine the difference between the fixed rate to be received on the
interest rate swap and the fixed rate to be paid on the bonds.
b. Combine that difference with the variable rate to be paid on the interest
rate swap.
c. Compute and recognize interest expense using that combined rate and the
fixed-rate liability’s principal amount. (Amortization of any purchase
premium or discount on the liability also must be considered, although that
complication is not incorporated in this Example.)

d. Determine the fair value of the interest rate swap.

e. Adjust the carrying amount of the interest rate swap to its fair value and
adjust the carrying amount of the liability by an offsetting amount.
55-44 Amounts determined using the shortcut method and the facts in this
Example will match the amounts in paragraph 815-25-55-48 even though the
shortcut does not involve explicitly amortizing the hedge accounting
adjustments on the debt. That is, the quarterly adjustments of the debt and
explicit amortization of previous adjustments will have the same net effect on
earnings as the shortcut method.
55-45 A slightly different shortcut method for interest rate swaps used as cash
flow hedges is illustrated in Example 6 (see paragraph 815-30-55-24).
55-46 On July 1, 20X1, Entity ABC borrows $1,000,000 to be repaid on
June 30, 20X3. On that same date, Entity ABC also enters into a two-year
receive-fixed, pay-variable interest rate swap. Entity ABC designates the
interest rate swap as a hedge of the changes in the fair value of the fixed-rate
debt attributable to changes in the designated benchmark interest rate.
Entity ABC designates changes in London Interbank Offered Rate (LIBOR)
swap rates as the benchmark interest rate in hedging interest rate risk. The
terms of the interest rate swap and the debt are as follows.

Interest Rate Swap Fixed-Rate

Debt
Trade date and borrowing date(a) July 1, 20X1 July 1, 20X1
Termination date and maturity date June 30, 20X3 June 30, 20X3
Notional amount and principal amount $1,000,000 $1,000,000
Fixed interest rate(a) 6.41% 6.41%
Variable interest rate 3-month USD LIBOR Not applicable
Settlement dates and interest End of each calendar End of each calendar
payment dates (a) quarter quarter

Reset dates End of each calendar Not applicable

quarter through
March 31, 20X3
a. These terms need not match for the assumption of perfect effectiveness to be
appropriate. (See paragraphs 815-20-25-102 through 25-110.)

55-47 The USD LIBOR rates that are in effect at inception of the hedging
relationship and at each of the quarterly reset dates are assumed to be as
follows.

Reset date 3-Month LIBOR Rate

7/1/X1 6.41%
9/30/X1 6.48%
12/31/X1 6.41%
3/31/X2 6.32%
6/30/X2 7.60%
9/30/X2 7.71%
12/31/X2 7.82%
3/31/X3 7.42%

55-48 The following table summarizes the fair values of the debt and the
interest rate swap at each quarter end, the details of the changes in the fair
values during each quarter (including accrual and payment of interest, the
effect of changes in rates, and level-yield amortization of hedge accounting
adjustments), the expense for each quarter, and the net cash payments for
each quarter. The calculations of fair value of both the debt and the interest
rate swap are made using LIBOR. (A discussion of the appropriate discount
rate appears in paragraph 815-20-25-111.)
Fixed-Rate Interest Rate
Debt Swap Expense Net Payment
July 1, 20X1 $ (1,000,000) $ -
Interest accrued (16,025) - $ (16,025)
Payments (receipts) 16,025 - $ 16,025
Effect of change in rates 1,149 (1,149) -
September 30, 20X1 (998,851) (1,149) $ (16,025) $ 16,025
Interest accrued (16,025) (19) $ (16,044)
Payments (receipts) 16,025 175 $ 16,200
Amortization of basis
adjustments (156) - $ (156)
Effect of changes in rates (993) 993 -
December 31, 20X1 (1,000,000) - $ (16,200) $ 16,200
Interest accrued (16,025) - $ (16,025)
Payments (receipts) 16,025 - $ 16,025
Amortization of basis
adjustments - - -
Effect of changes in rates (1,074) 1,074 -
March 31, 20X2 (1,001,074) 1,074 $ (16,025) $ 16,025
Interest accrued (16,025) 17 $ (16,008)
Payments (receipts) 16,025 (225) $ 15,800
Amortization of basis
adjustments 208 - 208
Effect of changes in rates 12,221 (12,221) - $ 15,800
June 30, 20X2 (988,645) (11,355) $ (15,800) $ 15,800
Interest accrued (16,025) (216) $ (16,241)
Payments (receipts) 16,025 2,975 $ 19,000
Amortization of basis
adjustments (2,759) - (2,759)
Effect of changes in rates 789 (789) -
September 30, 20X2 (990,615) (9,385) $ (19,000) $ 19,000
Interest accrued (16,025) (181) $ (16,206)
Payments (receipts) 16,025 3,250 $ 19,275
Amortization of basis
adjustments (3,069) - (3,069)
Effect of changes in rates 532 (532) -
December 31, 20X2 (993,152) (6,848) $ (19,275) $ 19,275
Interest accrued (16,025) (134) $ (16,159)
Payments (receipts) 16,025 3,525 $ 19,550
Amortization of basis
adjustments (3,391) - (3,391)
Effect of changes in rates (978) 978 -
March 31, 20X3 (997,521) (2,479) $ (19,550) $ 19,550

Fixed-Rate Interest Rate

Debt Swap Expense Net Payment
Interest accrued (16,025) (46) $ (16,071)
Payments (receipts) 1,016,025 2,525 $ 1,018,550
Amortization of basis
adjustments (2,479) - (2,479)
June 30, 20X3 $ - $ - $ (18,550) $ 1,018,550

55-49 The preceding table demonstrates two important points that explain why
the shortcut method described in paragraphs 815-25-55-43 through 55-45
produces the same results as the computation in the preceding table if the
hedging relationship is perfectly effective:
a. In every quarter, the effect of changes in rates on the interest rate swap
completely offsets the effect of changes in rates on the debt. That is as
expected because the hedge is perfectly effective.
b. In every quarter except the last when the principal is repaid, the expense
equals the cash payment.
55-50 The following table illustrates the computation of interest expense using
the shortcut method described in paragraphs 815-25-55-43 through 55-45. The
results are the same as the results computed in the preceding table.
(a) (b) (c) (d) (e)
Difference Variable Debt’s Interest
between Rate on Sum Principal Expense
Quarter Ended Fixed Rates Swap (a) + (b) Amount ([c] x [d]) ÷ 4
September 30, 20X1 0.00% 6.41% 6.41% $ 1,000,000 $ 16,025
December 31, 20X1 0.00% 6.48% 6.48% 1,000,000 16,200
March 31, 20X2 0.00% 6.41% 6.41% 1,000,000 16,025
June 30, 20X2 0.00% 6.32% 6.32% 1,000,000 15,800
September 30, 20X2 0.00% 7.60% 7.60% 1,000,000 19,000
December 31, 20X2 0.00% 7.71% 7.71% 1,000,000 19,275
March 31, 20X3 0.00% 7.82% 7.82% 1,000,000 19,550
June 30, 20X3 0.00% 7.42% 7.42% 1,000,000 18,550

55-51 As stated in the introduction to this Example, a flat yield curve is

assumed for simplicity. An upward-sloping yield curve would have made the
computations more complex. Paragraph 815-25-55-47 would have shown
different interest rates for each quarterly repricing date, and the present value
of each future payment would have been computed using a different rate (as
described in paragraph 815-25-55-41). However, the basic principles are the
same. As long as the hedging relationship meets the criteria for the shortcut
method, perfect effectiveness can be assumed.
55-52 In this Example of a fair value hedge of fixed-rate interest-bearing debt, it
is assumed that Entity ABC elects to immediately begin amortizing the
adjustments of the carrying amount of the fixed-rate debt while the hedge is
still in place. Because the change in fair value of the interest rate swap
attributable to the passage of time is recognized as interest expense by
Entity ABC, the amounts recorded as expenses in the table in paragraph 815-
25-55-48 would be eligible for capitalization under Subtopic 835-20.

4.4.30 Measuring impairment

Excerpt from Subtopic 310-10

>>>> Impact of Hedging

35-31 Section 815-25-35 implicitly affects the measurement of impairment
under this Topic by requiring the present value of expected future cash flows
to be discounted by the new effective rate based on the adjusted recorded
investment in a hedged loan. When the recorded investment of a loan has
been adjusted under fair value hedge accounting, the effective rate is the
discount rate that equates the present value of the loan’s future cash flows
with that adjusted recorded investment. The adjustment under fair value hedge
accounting of the loan’s carrying amount for changes in fair value attributable
to the hedged risk under Section 815-25-35 shall be considered to be an
adjustment of the loan’s recorded investment. Paragraph 815-25-35-11
explains that the loan’s original effective interest rate becomes irrelevant once
the recorded amount of the loan is adjusted for any changes in its fair value.
Pending Content
Transition Date: (P) December 16, 2019; (N) December 16, 2020 ¦ Transition
Guidance: 326-10-65-1
35-31 Paragraph superseded by Accounting Standards Update No. 2016-13.

Excerpt from Subtopic 326-20

Pending Content
Transition Date: (P) December 16, 2019; (N) December 16, 2020 ¦ Transition
Guidance: 326-10-65-1
>> Effect of a Fair Value Hedge on the Discount Rate When Using a
Discounted Cash Flow Model
55-9 Section 815-25-35 implicitly affects the measurement of credit losses
under this Topic by requiring the present value of expected future cash flows
to be discounted by the new effective interest rate based on the adjusted
amortized cost basis in a hedged loan. When the amortized cost basis of a
loan has been adjusted under fair value hedge accounting, the effective
interest rate is the discount rate that equates the present value of the loan’s
future cash flows with that adjusted amortized cost basis. The adjustment
under fair value hedge accounting of the loan’s carrying amount for changes
in fair value attributable to the hedged risk under Section 815-25-35 shall be
considered to be an adjustment of the loan’s amortized cost basis.
Paragraph 815-25-35-11 explains that the loan’s original effective interest rate
becomes irrelevant once the recorded amount of the loan is adjusted for any
changes in its fair value.

Excerpt from ASC 815-25

Pending Content
Transition Date: (P) December 16, 2019; (N) December 16, 2020 | Transition
Guidance: 326-10-65-1
>> Impairment or Credit Losses of Hedged Item
35-10 An asset or liability that has been designated as being hedged and
accounted for pursuant to this Section remains subject to the applicable
requirements in generally accepted accounting principles (GAAP) for assessing
impairment or credit losses 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 paragraph 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.
>>> Interaction with Measurement of Credit Losses Loan Impairment
35-11 This Subtopic implicitly affects the measurement of credit losses
impairment under Section 310-10-35 Subtopic 326-20 on financial instruments
measured at amortized cost by requiring the present value of expected future
cash flows to be discounted by the new effective rate based on the adjusted
amortized cost basis recorded investment in a hedged loan. Paragraph 326-
20-55-9 310-10-35-31 requires that, when the amortized cost basis recorded
investment of a loan has been adjusted under fair value hedge accounting, the
effective rate is the discount rate that equates the present value of the loan’s
future cash flows with that adjusted amortized cost basis recorded investment.
That paragraph states that the adjustment under fair value hedge accounting of
the loan’s carrying amount for changes in fair value attributable to the hedged
risk under this Subtopic shall be considered to be an adjustment of the loan’s
amortized cost basis recorded investment. As discussed in that paragraph, the
loan’s original effective interest rate becomes irrelevant once the recorded
amount of the loan is adjusted for any changes in its fair value. Because
paragraph 815-25-35-10 requires that the loan’s amortized cost basis carrying
amount be adjusted for hedge accounting before the impairment requirements
of Subtopic 326-20 310-10 are applied, this Subtopic implicitly supports using
the new effective rate and the adjusted amortized cost basis recorded
investment.
35-12 This guidance applies to all entities applying Subtopic 326-20 310-10 to
financial assets that are hedged items in a fair value hedge, regardless of
whether those entities have delayed amortizing to earnings the adjustments of
the loan’s amortized cost basis carrying amount arising from fair value hedge
accounting until the hedging relationship is dedesignated. The guidance on
recalculating the effective rate is not intended to be applied to all other
circumstances that result in an adjustment of a loan’s amortized cost basis
carrying amount.

The hedged item in a fair value hedge remains subject to other applicable US
GAAP for assessing impairment. Impairment guidance generally is applied after
fair value hedge accounting is applied to the hedged item – i.e. after any basis
adjustment is recognized. [815-25-35-10]
When assessing impairment, the fair value or cash flows of the derivative
hedging instrument generally do not affect the determination of whether the
hedged item is impaired. To do so would be inconsistent with the fact that the
derivative is a separate asset or liability. However, see Question 6.4.10
regarding application of the full cost method of accounting for entities with oil
and gas producing activities.
Specific guidance is provided when measuring impairment for a loan that is
deemed impaired under Subtopic 310-10 (receivables). When a loan is the
hedged item in a fair value hedging relationship, basis adjustments from
applying fair value hedge accounting adjust the recorded investment in the loan.
For loans deemed impaired, Subtopic 310-30 requires impairment to be
measured based on the present value of expected future cash flows discounted
at the loan’s effective interest rate (unless a practical expedient is applied or
foreclosure is probable). [815-25-35-11, 310-10--35-31]
Because a basis adjustment changes the recorded investment in a loan, the
loan’s original effective interest rate becomes irrelevant. As a result, the
effective interest rate to be used when measuring impairment for an impaired
loan that is the hedged item in a fair value hedge is the new effective rate
implicit in the adjusted amortized cost basis of the hedged loan – i.e. the
amortized cost basis including basis adjustments. In this situation, the effective
rate is the discount rate that equates the present value of the loan’s future cash
flows with the adjusted recorded investment in the loan. This guidance applies
even if the basis adjustments are not being amortized because the entity has
elected to delay amortizing basis adjustments until the hedging relationship is
dedesignated. [815-25-35-11 – 35-12]

FASB Example: Interaction with loan impariment

Excerpt from ASC 815-25

>> Example 14: Interaction with Measurement of Credit Losses

Pending Content
Transition Date: (P) December 16, 2019; (N) December 16, 2020 | Transition
Guidance: 326-10-65-1
55-85 This Example illustrates the application of paragraph 815-25-35-11
involving the interaction of hedge accounting and measurement of credit
losses in Subtopic 326-20 on financial instruments measured at amortized cost
loan impairment accounting. The following Cases also illustrate the effect of
the two approaches to calculate the change in the fair value of the hedged item
attributable to interest rate risk discussed in paragraph 815-25-35-13 on that
interaction, as follows:

a. Using the full contractual coupon cash flows (Case A)

b. Using the benchmark rate component of the contractual coupon cash
flows (Case B).
55-86 Entity A formally documents a qualifying fair value hedge (for fair value
changes attributable to changes in the designated benchmark interest rate)
between a fixed-rate loan receivable from Entity B and an interest rate swap.
The 5-year, fixed-rate loan to Entity B has a principal amount of $1,000,000
payable at maturity and interest payable annually at a 10 percent rate. For
simplicity, commissions and most other transaction costs, initial margin, and
income taxes are ignored unless otherwise stated. Assume that there are no
changes in creditworthiness that would alter the effectiveness of the hedging
relationship.
55-87 One year after inception of the hedging relationship, the following
conditions exist:
a. Subparagraph superseded by Accounting Standards Update No. 2017-12.
b. There has been an adverse change to Entity B’s creditworthiness.
c. The LIBOR swap rate (the designated benchmark interest rate) has
decreased from 6 percent to 5.5 percent.
55-88 Assume that the repayment of the loan is not dependent on the
underlying collateral. In applying the requirements of Subtopic 326-20 310-10
to the loan, Entity A evaluates the loan for credit losses on an individual basis
because it does not have similar risk characteristics with other loans in the
portfolio and uses a discounted cash flow approach. Entity A determines that
the loan is impaired and that the present value of expected future cash flows
discounted at the loan’s effective interest rate at inception of the loan is
$930,000. (See row C in the table in paragraph 815-25-55-90, which presents
calculations—at the end of the first year of the loan’s term—of the net present
value of current estimates of expected future cash flows based on the loan’s
original effective interest rate.)
>>> Case A: Using the Full Contractual Coupon Cash Flows
55-88A In this Case, assume that the entity elected to calculate fair value
changes in the hedged item attributable to interest rate risk using the full
contractual coupon cash flows of the hedged item. One year after inception of
the hedging relationship, the change in the hedged item’s fair value attributable
to changes in the LIBOR swap rate (the designated benchmark interest rate) is
a gain of $16,022. (See row B in the table in paragraph 815-25-55-90, which
presents calculations—at the end of the first year of the loan’s term—of the
net present value of contractual cash flows based on the loan’s original
effective interest rate adjusted for a 50 basis point decrease in the LIBOR
swap rate.)
55-89 After adjusting the amortized cost basis carrying amount of the hedged
loan by $16,022 (pursuant to paragraph 815-25-35-1(b)) for the increase in the
hedged item’s fair value attributable to changes in the benchmark interest rate,
Entity A should apply the guidance in Subtopic 326-20 Section 310-10-35 by
doing both of the following:
a. Comparing the amortized cost basis recorded investment of the loan after
the effect of the fair value hedge, or $1,016,022, to the $944,901 present
value of expected future cash flows discounted using the rate that reflects

the rate of return implicit in the loan after adjusting the amortized cost
basis carrying amount of the hedged loan pursuant to paragraph 815-25-
35-1(b) (that is, 9.5 percent)
b. Recognizing Recording an impairment by creating a valuation allowance for
credit losses (with the offsetting entry charged to expense) for the
difference of $71,121 ($1,016,022 – $944,901).
55-90 Following are calculations (at the end of the first year of the loan’s term)
of the net present value of the contractual cash flows and the creditor’s best
estimate of expected future cash flows based on the loan’s original effective
interest rate and the new implicit rate.
Net Present Assumed Cash Flow in Year
Value at
End of
Rate Year 1 2 3 4 5
A. Original cash
flows and original
effective rate 10.0% $ 1,000,000 $ 100,000 $100,000 $100,000 $1,100,000
B. Original cash
flows and new
implicit rate 9.5% $ 1,016,022 $100,000 $100,000 $100,000 $1,100,000
C. Expected future
cash flows and
original effective
rate 10.0% $ 930,000 $ 93,000 $ 93,000 $ 93,000 $1,023,000
D. Expected future
cash flows and
new implicit rate 9.5% $ 944,901 $ 93,000 $ 93,000 $ 93,000 $ 1,023,000

>>> Case B: Using the Benchmark Rate Component of the Contractual

Coupon Cash Flows
55-91 In this Case, assume that Entity A elected to calculate fair value changes
in the hedged item attributable to interest rate risk using the benchmark rate
component of the contractual coupon cash flows of the hedged item
determined at hedge inception. One year after inception of the hedging
relationship, the change in the hedged item’s fair value attributable to changes
in the LIBOR swap rate (the designated benchmark interest rate) is a gain of
$17,526, which is calculated as follows.

At the beginning of the loan’s term

$60,000pmt, 6%i, 5n, 1,000,000fv, PV = $ 1,000,000
At the end of the first year of the loan’s term
$60,000pmt, 5.5%i, 4n, 1,000,000fv, PV = $ 1,017,526
Change in value $ (17,526)

55-92 After adjusting the carrying amount amortized cost basis of the hedged
loan by $17,526 (in accordance with paragraph 815-25-35-1(b)) for the increase
in the hedged item’s fair value attributable to changes in the benchmark
interest rate, Entity A should apply the guidance in Subtopic 326-20 Section
310-10-35 by doing both of the following:
a. Comparing the amortized cost basis recorded investment of the loan after
the effect of the fair value hedge, or $1,017,526, to the $946,299 present
value of expected future cash flows discounted using the rate that reflects

the rate of return implicit in the loan after adjusting the amortized cost
basis carrying amount of the hedged loan in accordance with paragraph
815-25-35-1(b) (that is, 9.45 percent that equates the adjusted amortized
cost basis carrying amount of the loan with the present value of the
contractual cash flows of the loan)
b. Recognizing an allowance for credit losses impairment by creating a
valuation allowance (with the offsetting entry charged to expense) for the
difference of $71,227 ($1,017,526 – $946,299).
55-93 Following are calculations (at the end of the first year of the loan’s term)
of the net present value of the benchmark rate component of the contractual
cash flows and the creditor’s best estimate of expected future cash flows
based on the loan’s original effective interest rate and the new implicit rate. In
row B, the net present value at the end of the first year is equal to the net
present value of the benchmark rate component of the contractual coupon
cash flows discounted at the 5.5 percent benchmark rate.
Net Present Assumed Cash Flow in Year
Value at
End of
Rate Year 1 2 3 4 5
A. Original cash flows
and original
effective rate 10.0% $ 1,000,000 $ 100,000 $ 100,000 $ 100,000 $1,100,000
B. Original cash flows
and new implicit
rate 9.45% $ 1,017,526 $ 100,000 $ 100,000 $ 100,000 $1,100,000
C. Expected future
cash flows and
original effective
rate 10.0% $ 930,000 $ 93,000 $ 93,000 $ 93,000 $1,023,000
D. Expected future
cash flows and
new implicit rate
impairment 9.45% $ 946,299 $ 93,000 $ 93,000 $ 93,000 $ 1,023,000

KPMG observation
Measurement of credit losses on financial
instruments
In June 2016, the FASB issued ASU 2016-13, Measurement of Credit Losses
on Financial Instruments.
Subtopic 326-20 (financial instruments – credit losses) does not prescribe a
specific method that must be used to estimate the allowance for credit losses.
Methods that may be used include discounted cash flow methods and other
methods. Subtopic 326-20 distinguishes between a discounted cash flow
method and other methods. [326-20-30-3, 55-6 – 55-7]
Non-discounted cash flow methods. In estimating expected credit losses of
the amortized cost basis for an asset (or group of assets) using a method other
than a discounted cash flow method, the estimate needs to reflect the

expected loss of principal and the effect of unamortized premiums and

discounts, including fair value hedge accounting adjustments. [326-20-30-5]
Discounted cash flow methods. When a discounted cash flow method is
used, additional guidance is provided. Because a basis adjustment changes the
amortized cost basis of a loan, the loan’s original effective interest rate
becomes irrelevant. As a result, the relevant effective interest rate is the new
effective rate implicit in the adjusted amortized cost basis of the hedged loan –
i.e. the amortized cost basis including basis adjustments. [815-25-35-11, 326-20-55-9]
In this situation, the effective rate is the discount rate that equates the present
value of the loan’s future cash flows with the adjusted amortized cost basis.
This guidance applies even if the basis adjustments are not being amortized
because the entity has elected to delay amortizing basis adjustments until the
hedging relationship is dedesignated. [815-25-35-11 – 35-12, 326-20-55-9]
See KPMG’s Handbook, Credit impairment.

4.5 Discontinuing hedge accounting

4.5.10 Overview

Excerpt from ASC 815-25

> Discontinuing Hedge Accounting

>> Amounts Excluded from the Assessment of Effectiveness under an
Amortization Approach
40-7 When applying the guidance in paragraph 815-20-25-83A, any amounts
remaining in accumulated other comprehensive income associated with
amounts excluded from the assessment of effectiveness shall be recorded in
earnings in the current period if the hedged item is derecognized. For all other
discontinued fair value hedges, any amounts associated with the excluded
component remaining in accumulated other comprehensive income shall be
recorded in earnings in the same manner as other components of the carrying
amount of the hedged asset or liability in accordance with paragraphs 815-25-
35-8 through 35-9A.

The following table provides an overview of circumstances that would require

an entity to discontinue or partially dedesignate a hedging relationship.

Change in — Hedged item no longer meets the eligibility criteria [815-25-

eligibility or 40-1(a)]
critical terms of — Hedged firm commitments are modified such that they no
hedged items or longer meet the definition of a firm commitment (see
transactions Question 2.10.50)
(section 2.10.20)
— Modification of hedged item or transaction such that critical
terms of the original hedging relationship have changed
[815-20-55-56]

Change in — Hedging instrument no longer meets the eligibility criteria

eligibility or [815-25-40-1(a)]
critical terms of — Hedging instrument expires or is sold, terminated or
hedging exercised [815-25-40-1(b)]
instrument
— Modification of hedging instrument such that critical terms
(section 2.10.30)
of the original hedging relationship have changed [815-20-55-
56]

Change in — Change in the hedged risk [815-20-55-56]

hedged risk
(section 2.10.40)

Change in hedge — Hedge is no longer highly effective on a retrospective

effectiveness and/or prospective basis, with certain exceptions (see
(section 2.10.50) Question 2.10.90) [815-25-40-1(a), 815-30-40-1(a)]
— Change in quantitative method to assess hedge
effectiveness, including whether a component of the
hedging instrument is excluded from the assessment (see
section 9.6.40) [815-25-55-56]

Elective An entity may elect to discontinue the hedging relationship.

dedesignation [815-30-40-1(c)]

Treatment of hedging instruments. When hedge accounting is discontinued,

if the derivative instrument has not expired and has not been sold, terminated
or exercised, it may be used as the hedging instrument in a new hedging
relationship as long as the hedge criteria are met for the new relationship.
Unless it is designated as the hedging instrument in a new cash flow or net
investment hedging relationship, the derivative instrument continues to be
recorded on the balance sheet at fair value and all changes in fair value
(including changes related to the previously excluded components) are reflected
in earnings. [815-25-40-2]
Treatment of hedged items. When hedge accounting is discontinued, the
entity may designate prospectively the previously hedged item in a new
hedging relationship with a different hedging instrument as long as the hedge
criteria are met for the new relationship. Otherwise, changes in the fair value
are no longer recognized as basis adjustments.
The following diagram illustrates how to account for the hedged item and
hedging instrument after hedge accounting is discontinued. [815-25-40-7]

Accounting for discontinued hedging relationships

(if not designated in new hedging relationship)

Hedging instrument, including

Hedged item
excluded components

Basis adjustment remains in Amount in AOCI associated

At date of
hedged item’s amortized cost with previously excluded
discontinuance:
basis component remains in AOCI

Recorded in earnings, including

When fair value
changes in fair value of previously
subsequently Do not record change in earnings
excluded
changes:
component

Record amount remaining in AOCI

When hedged Include basis adjustment
associated with
item is remaining in amortized cost basis
previously excluded
derecognized: in gain/loss computation
component in earnings

The following table provides examples of how a basis adjustment (and any
amount that remains in AOCI associated with excluded components) is
accounted for after a hedge is discontinued.

Timing and method of recognizing the basis adjustment

(and amount remaining in AOCI associated with excluded
Hedged item components) in earnings
Inventory The basis adjustment remains part of the hedged inventory’s
cost basis until it is sold (subject to ongoing impairment
tests). When the asset is sold, its entire cost basis (including
the basis adjustment) is recognized as part of the cost of the
item sold. [815-25-35-8]
Similarly, the amount remaining in AOCI associated with an
excluded component (if any) remains in AOCI until the
inventory is sold, at which time it is recognized in earnings
immediately. [815-25-40-7]

Long-term loan The basis adjustment is treated like a premium or discount

receivable with a and is amortized as interest income using the effective yield
$100,000 basis method. The amortization period after the hedge is
adjustment that discontinued is a period that is consistent with the
increased its amortization of other discounts or premiums associated with
amortized cost the hedged item under other applicable US GAAP – e.g.
basis (i.e. an Subtopic 310-20. [815-25-35-9, 35-9A]
interest-bearing Similarly, the amount remaining in AOCI associated with an
financial excluded component (if any) when the hedge is discontinued
instrument) is amortized as interest income over a period that is
consistent with other premiums and discounts associated
with the hedged item. [815-25-40-7]

Question 4.5.10
Does amortization begin if a portfolio of hedged
items that is hedged by a combination of
derivatives is rebalanced?
Background: Some entities hedge portfolios of similar assets or liabilities using
a combination of derivatives as hedging instruments (see section 2.6.40).
Additions or deletions (a rebalancing) to either the portfolio of hedged items or
derivative hedging instruments require a discontinuation of the hedging
relationship (see Question 2.10.60). An entity that is required to discontinue a
hedging relationship upon a rebalancing may decide to redesignate the portfolio
of hedged items in a new hedging relationship.
Interpretive response: If a hedging relationship is discontinued and the original
hedged items are redesignated in a relationship hedging the same risks with a
rebalanced combination of derivatives, we do not believe amortization of the
basis adjustment is required to begin. This is because the hedged items
continue to be hedged for changes in fair value attributable to the same risk.
Similarly, if the original hedged items are redesignated with additional items
added to the portfolio of hedged items in a relationship hedging the same risks,
we do not believe amortization is required to begin. However, if the original
hedged items are redesignated in a relationship specifically hedging a different
risk, amortization should begin.
This response does not relate to hedges using the last-of-layer method (see
section 4.5.30).

Example 4.5.10
Accounting for the termination of an interest rate
swap hedging fixed-rate debt
On January 1, Year 1, ABC Corp. issues a five-year, $10,000,000 debt
obligation. The debt obligation requires annual interest payments at a fixed rate
of 10% with principal payable at maturity.
Simultaneously, ABC enters into a five-year interest rate swap with a notional
amount of $10,000,000 to receive interest at a fixed rate of 10% and pay
interest at a variable rate equal to three-month LIBOR.
The interest rate swap is designated and is effective as a hedge of changes in
the fair value of the debt obligation due to changes in three-month LIBOR, the
designated benchmark interest rate.
On December 31, Year 3, ABC terminates the interest rate swap and
discontinues hedge accounting. It pays $1,000,000 to the counterparty, which is
the interest rate swap’s fair value at the date of termination. As a result of ABC
having applied hedge accounting, the carrying amount of the fixed-rate debt
obligation is $9,000,000 at December 31, Year 3.
ABC accounts for the $1,000,000 basis adjustment on the fixed-rate debt
obligation as a discount on the debt obligation and accretes that amount as

interest expense over the remaining life of the debt obligation using the
effective yield method.
The following table summarizes the remaining payments on December 31,
Year 3 and the new effective rate for the debt obligation. The new effective rate
is the rate that equates the adjusted amortized cost basis of the debt obligation
with the present value of future cash flows.

Annual interest payments for remaining 2 years $ 2,000,000

Principal payment at end of 2 remaining years 10,000,000
Total $12,000,000
Original effective rate 10.00%
Present value at original effective rate $10,000,000
Amortized cost basis (with basis adjustment) $9,000,000
New effective rate based on adjusted amortized cost basis (rounded) 16.25%

For simplicity, this example makes the following assumptions.

— It ignores the effect of commissions and other transaction costs, initial
margins and income taxes.
— It is based on annual periods; normally the assessment of effectiveness and
fair value adjustments of the hedged item and derivative would be done at
least quarterly.
The following journal entries are required to be made for Year 4 and Year 5.
Journal entries – December 31, Year 4
ABC records the following journal entries.

Debit Credit
Interest expense 1,000,000
Cash 1,000,000
To record interest payment on debt obligation.
Interest expense 462,500
Fixed-rate debt obligation 462,500
To accrete basis adjustment on fixed-rate debt
obligation using effective yield method.1
Note:
($9,000,000 beginning amortized cost basis (with basis adjustment) × 16.25%
effective rate) - $1,000,000 cash interest expense.

Journal entries – December 31, Year 5

ABC records the following journal entries.

Debit Credit
Interest expense 1,000,000
Cash 1,000,000
To record interest payment on debt obligation.

Debit Credit
Interest expense 537,500
Fixed-rate debt obligation 537,500
To amortize basis adjustment on fixed-rate debt
obligation using effective yield method.1
Fixed-rate debt obligation 10,000,000
Cash 10,000,000
To record repayment of fixed-rate debt obligation
on December 31, Year 5.
Note:
($9,462,500 beginning amortized cost basis (with basis adjustment) × 16.25%
effective rate) - $1,000,000 cash interest expense (rounded).

Financial statement excerpts

At the end of Years 4 and 5, ABC’s financial statements reflect the following.

Account Year 4 Year 5

Balance sheet – liabilities
Debt obligation $9,462,5001 -
Income statement
Interest expense $1,462,5002 $1,537,5003
Disclosures under 815-10-55-4EE
Carrying amount of debt obligations on the balance sheet
that are hedged liabilities [815-10-50-4EE(a), 50-4EE(c)] $9,462,500 -
Cumulative amount of fair value hedge adjustments
included in the carrying amount of hedged debt
obligations [815-10-50-4EE(b)] 537,5004 -
Cumulative amount of fair value hedge adjustments
remaining for hedged debt obligations for which hedge
accounting has been discontinued [815-10-50-4EE(d)] 537,5004 -
Notes:
$9,000,000 beginning amortized cost basis (with basis adjustment) + $462,500
amortization of the basis adjustment.
$9,000,000 beginning amortized cost basis (with basis adjustment) × 16.25% effective
rate.
$9,462,500 beginning amortized cost basis (with basis adjustment) × 16.25% effective
rate (rounded).
$1,000,000 basis adjustment - $462,500 amortized during Year 4.

Question 4.5.20
What is the accounting for a partially dedesignated
fair value hedging relationship?

Interpretive response: We believe it is acceptable to partially dedesignate

a fair value hedging relationship under certain circumstances (see
section 2.10.60). When an entity partially dedesignates a fair value hedging
relationship, hedge accounting should be partially discontinued as follows.
— Treatment of dedesignated portion of hedging instrument. Unless it is
designated as the hedging instrument in a new cash flow or net investment
hedging relationship, the dedesignated portion of the derivative instrument
continues to be recorded on the balance sheet at fair value and all changes
in fair value (including changes related to the previously excluded
components) are reflected in earnings.
— Treatment of hedged item (basis adjustment). The cumulative basis
adjustment is part of the amortized cost basis of a hedged item. If an entity
partially dedesignates a hedging relationship, it is necessary to allocate the
basis adjustment between the portion of the hedged item that continues to
be hedged versus the portion that is not; also, it may be necessary to
allocate a portfolio level basis adjustment to individual items in the portfolio
(see section 4.3.30). This is because the basis adjustment recognized
through the date of the partial dedesignation relates (in part) to the items
that have been partially dedesignated while further changes to the
cumulative basis adjustment will relate only to items that continue to be
hedged.
Subsequent accounting for the portion of the basis adjustment allocated to
the previously hedged item depends on whether it continues to be
recognized and on the nature of the hedged item. For example, if a portion
of the originally designated hedged item has been derecognized, the basis
adjustment is part of the amortized cost basis used to determine the gain or
loss recorded on derecognition. As another example, if the dedesignated
hedged item is a portion of a financial instrument that has not been
derecognized, the entity is required to amortize the related basis
adjustment over a period that is consistent with the amortization of other
discounts or premiums associated with the hedged item under other
applicable US GAAP. For guidance on accounting for basis adjustments, see
section 4.4.
This response does not relate to hedges using the last-of-layer method (see
section 4.5.30).

4.5.20 Hedge relationship is no longer highly effective

Excerpt from ASC 815-25

>> Noncompliance with Effectiveness Criterion

40-3 In general, if a periodic assessment indicates noncompliance with the
effectiveness criterion in paragraphs 815-20-25-75 through 25-80, an entity
shall not recognize the adjustment of the carrying amount of the hedged item
described in paragraphs 815-25-35-1 through 35-6 after the last date on which
compliance with the effectiveness criterion was established.
40-4 However, if the event or change in circumstances that caused the
hedging relationship to fail the effectiveness criterion can be identified, the
entity shall recognize in earnings the changes in the hedged item’s fair value
attributable to the risk being hedged that occurred before that event or change
in circumstances.

A quarterly hedge effectiveness assessment may indicate that a hedging

relationship is no longer highly effective and the hedge relationship is
discontinued as a result. In that case, generally no changes in the fair value of
the hedged item attributable to the hedged risk are recorded after the last date
on which effectiveness testing indicated the relationship was highly effective.
This date is presumably the date of the immediately preceding quarterly
effectiveness assessment. [815-25-40-3]
However, if an event or change in circumstances caused the relationship to fail
to be highly effective, the change in fair value of the hedged item attributable to
the hedged risk is recognized through the date on which the entity can
demonstrate that the hedging relationship was highly effective. [815-25-40-4]
Additionally, if a hedging relationship had not been highly effective
retrospectively, but is expected to be highly effective prospectively, hedge
accounting is not required to be discontinued prospectively (see
Question 2.10.90).

Example 4.5.20
Identifying the date a hedging relationship ceased to
be highly effective
On January 1, Year 1, ABC Corp. designated a forward contract for which the
underlying is a soybean meal index as the hedging instrument in a hedge of
changes in fair value of its cottonseed meal inventory. ABC performs its
quarterly hedge effectiveness assessments using the period-by-period dollar-
offset approach.
When ABC performs its quarterly hedge effectiveness assessment for the
quarterly period ended December 31, Year 1, ABC identifies that the hedging
relationship was not highly effective in the period being assessed.

ABC identifies that the cause of the relationship ceasing to be highly effective
was a storm that damaged the soybean harvest on December 1, Year 1. The
storm caused a shortage in soybean meal and an increase in the soybean meal
index, but did not affect the fair value of cottonseed meal inventory. ABC
determines that the hedging relationship was highly effective through
November 30, Year 1. Accordingly, ABC applies hedge accounting through
November 30, Year 1, then discontinues hedge accounting.
If ABC had been unable to identify an event or change in circumstances that
caused the relationship to fail to be highly effective, ABC would not apply hedge
accounting for the quarterly period ended December 31, Year 1 – i.e. hedge
accounting would be applied only through September 30, Year 1. Additionally,
ABC would discontinue the hedging relationship unless the hedging relationship
is expected to be highly effective prospectively.

4.5.30 Last-of-layer hedging relationships

Excerpt from ASC 815-25

>> Hedged Item Is Designated under the Last-of-Layer Method

40-9 If a last-of-layer method hedging relationship is discontinued (or partially
discontinued), the outstanding basis adjustment (or portion thereof) as of the
discontinuation date shall be allocated to the individual assets in the closed
portfolio using a systematic and rational method. An entity shall amortize those
amounts over a period that is consistent with the amortization of other
discounts or premiums associated with the respective assets in accordance
with other Topics (for example, Subtopic 310-20 on receivables–nonrefundable
fees and other costs).

As discussed in section 3.3.100, Topic 815 permits an entity to designate a

fixed amount of a closed portfolio of prepayable financial assets as the hedged
item in a fair value hedge of interest rate risk if the entity expects the
designated amount will remain outstanding at the end of the hedge term (i.e.
last of layer).
There are two situations in which a hedging relationship designated using the
last-of-layer method in a closed portfolio of prepayable financial assets is
discontinued, as illustrated in the following diagram (see Question 2.10.40).
[815-25-40-8]

Scenario 1: Scenario 2:
Partial discontinuation Full discontinuation

Amount outstanding in portfolio

Hedge
The portion of the last of layer
accounting is
no longer expected to remain The entire hedging relationship
discontinued
outstanding at end of hedge term
for:

Under a partial discontinuation, the entity allocates the portion of the cumulative
basis adjustment related to the discontinued portion to the individual assets in
the portfolio at the date of partial discontinuation using a systematic and rational
method. It also uses a method to amortize those amounts over a period that is
consistent with the amortization of other discounts or premiums associated
with the respective assets. [815-25-40-9]

Question 4.5.30
How is the outstanding basis adjustment allocated
to the individual items in a portfolio on a full
discontinuation?
Interpretive response: The following table indicates the steps we believe an
entity should take when it is required to discontinue the entire hedging
relationship as a result of the outstanding amounts in the portfolio falling below
the last-of-layer amount on the testing date.

We believe an entity should recognize in earnings the portion of the

cumulative basis adjustment related to the difference between the full
Step 1
amount of the last of layer and the current outstanding amount of the
portfolio.
Allocate the remaining portion of the basis adjustment to the individual
Step 2
assets in the closed portfolio.
Amortize the amounts allocated to the individual assets in the closed
Step 3 portfolio over a period that is consistent with the amortization of other
discounts or premiums associated with the respective assets.

Given the consequences of full discontinuation, an entity may want to forecast

conservatively. In addition, it may want to closely monitor the portfolio balance,
and if necessary, proactively make a partial discontinuation.

Example 4.5.30
Discontinuation of a last-of-layer method hedge
ABC Corp. has a closed portfolio of $1 billion of prepayable fixed-rate assets. It
designates a hedging relationship comprising a last of layer of $300 million from
the closed portfolio as the hedged item and a $300 million plain-vanilla interest
rate swap under which ABC pays a fixed rate and receives the 3-month
LIBOR rate.
Scenario 1: Partial discontinuation
At a subsequent testing date, ABC has $500 million in prepayable fixed-rate
assets remaining in the closed portfolio and its current expectation has changed
such that it now expects only $250 million of the portfolio to remain outstanding
at the end of the hedge term. Therefore, ABC discontinues hedge accounting
related to 1/6th (($300 million - $250 million) ÷ $300 million) of the last of layer.
However, it may continue hedge accounting on the remaining 5/6th of the last
of layer.
ABC allocates the portion of the cumulative basis adjustment related to the
discontinued portion (i.e. 1/6th of the cumulative basis adjustment) to the
remaining individual assets in the portfolio (i.e. the $500 million) using a
systematic and rational method. ABC then amortizes those amounts using a
method that is consistent with the amortization of other discounts or premiums
associated with the respective assets.
Scenario 2: Full discontinuation
Assume the same facts as in Scenario 1, except that ABC never changed its
expectation and therefore never made a partial discontinuation. Rather, on a
subsequent testing date, it determines that the current outstanding amount of
the closed portfolio of prepayable financial assets is $270 million. The current
outstanding amount of the portfolio is less than the designated last of layer
($300 million).
Therefore, ABC is required to discontinue the hedging relationship entirely and
performs the following steps.

ABC recognizes in earnings 1/10th (($300 million - $270 million) ÷

$300 million) of the cumulative basis adjustment related to the difference
Step 1
between the full amount of the designated last of layer and the current
outstanding amount of the portfolio.
ABC allocates the remaining portion of the basis adjustment to the
Step 2
individual assets in the closed portfolio ($270 million).
ABC amortizes the remaining portion of the basis adjustment as
calculated in Step 2 using a method that is consistent with the
Step 3
amortization of other discounts or premiums associated with the
respective assets.

5. Qualifying criteria for cash

flow hedges
Detailed contents
Detailed contents
5.1 How the standard works
5.2 Objective of a cash flow hedge
5.3 Eligibility of hedged transactions
5.3.10 Basic requirements
5.3.20 Forecasted transactions: Definition
5.3.30 Forecasted transactions: Specific identification
5.3.40 Forecasted transactions: Probability
5.3.50 Forecasted transactions: Party external to the reporting
entity
5.3.60 Group of similar forecasted transactions
5.3.70 Hedging a group of transactions: First-payments-received
(paid) approach on a group of variable-rate loans
5.3.80 Hedging a group of transactions: Layering with first-
payments-received (paid) approach
5.3.90 All-in-one hedge
Future developments
Future developments
Questions
5.3.10 Can a contract that qualifies for the normal purchases and
normal sales scope exception qualify as a hedged
transaction?
5.3.20 Does a change in the probability assessment of a hedged
transaction affect the ability to apply hedge accounting?
5.3.30 Does a change in the expected timing of a forecasted
transaction affect the ability to apply hedge accounting?
5.3.40 What is the difference between a ‘party external to the
reporting entity’ and an ‘unrelated party’?
5.3.50 Can both forecasted purchases and sales be included in a
group for hedge accounting?
5.3.60 How does an entity assess whether forecasted
transactions of nonfinancial assets or liabilities share similar
risk exposure?

5.3.70 Can the first-payments-received (paid) approach be used to

hedge credit risk?
5.3.80 How does an entity assess whether the cash flows from
variable-rate financial instruments share the same risk
exposure?
5.3.90 How does an entity specifically identify the forecasted
transaction when using the layering approach for first-
payments-received (paid)?
5.3.100 If additional layers are added, or if existing layers are
removed, is an entity required to dedesignate and
redesignate other hedging relationships within the layers?
5.3.110 When does a hedging relationship move up the priority
chain into a vacated tranche of a discontinued hedging
relationship?
5.3.120 Can a new or redesignated hedging relationship replace a
vacated tranche earlier in the priority chain?
5.3.130 If a hedging relationship within a priority chain is
redesignated, what happens to the hedging relationships
later in the priority chain?
5.3.140 Can a new hedging relationship be inserted earlier in the
priority chain than an active hedging relationship?
5.3.150 Which risks are eligible to be designated in an all-in-one
hedge?
5.3.160 Is an all-in-one hedge assumed to be perfectly effective?
Examples
5.3.10 Probability of transaction to purchase steel
5.3.20 Assessing the probability of the forecasted acquisition of a
marketable debt security
5.3.30 Forecasted purchases of fuel when hedging price risk –
similarity assessment
5.3.40 Group of variable-rate loans that do not share similar risk
exposure
5.3.50 Layering approach: Swap matures and related amounts
reclassified from AOCI
5.3.60 Layering approach: Swap terminated and related amounts
not reclassified from AOCI
5.3.70 Layering approach: Additional swap terminated and new
swap designated at end of priority chain
5.3.80 Layering approach: Swap terminated with interest
payments on a portion of principal remaining probable
5.3.90 Layering approach: Swap early in priority chain matures
subsequent to other swap terminations
5.3.100 Layering approach: Redesignation of swaps
5.3.110 All-in-one hedge of forecasted sales of gold

5.3.120 All-in-one hedge of forecasted sales of loans

5.4 Eligibility of hedged risks
5.4.10 Contractually specified component price risk for
nonfinancial items
5.4.20 Contractually specified component price risk: Existing
contracts
5.4.30 Contractually specified component price risk: Not-yet-
existing contracts
5.4.40 Interest rate risk on the forecasted issuance or purchase of
debt instruments
5.4.50 Hedging interest rate risk on forecasted issuances of fixed-
rate debt: Rollover strategies
5.4.60 Changing the hedged risk
Questions
5.4.10 Can an entity hedge an index or rate that is not specified in
the contract?
5.4.20 If the contract price includes a variable basis spread, can an
entity hedge the contractually specified component?
5.4.30 Can an entity hedge a contractually specified component of
a forecasted purchase or sale of a nonfinancial asset in a
spot market transaction?
5.4.40 What conditions need to be met to designate a
contractually specified component as the hedged risk?
5.4.50 What are the requirements to meet the clearly and closely
related criteria?
5.4.60 What threshold is required to support an entity’s
expectation that the criteria to designate a contractually
specified component will be met?
5.4.70 How does an entity assess whether forecasted issuances
or purchases of short-term, fixed-rate debt in a rollover
strategy share similar interest rate risk exposure?
5.4.80 Should deposit/investment arrangements without
contractually stipulated maturity dates be characterized as
rollovers of fixed-rate instruments?
5.4.90 Does the ability to change the hedged risk also extend to
the hedged forecasted transaction?
Examples
5.4.10 Contractually specified component
5.4.20 Underlying index or price as a contractually specified
component
5.4.30 Contract not accounted for as derivative because normal
purchases and normal sales scope exception is met

5.4.40 Contractually specified component is not eligible to be the

hedged risk
5.4.50 Contract pricing with underlying that is clearly and closely
related
5.4.60 Contractually specified component in not-yet-existing
contracts
5.4.70 Forecasted issuance of fixed-rate debt
5.4.80 Forecasted issuance of debt when it is not known whether
the interest rate will be fixed or variable
5.4.90 Hedging interest rate risk on a group of individual
transactions related to a rollover strategy
5.4.100 Change in hedged risk for a contractually specified
component in not-yet-existing contracts
5.4.110 Defining hedged risk for a cash flow hedge of interest rate
payments of You Pick ‘Em debt
5.5 Hedging instruments in cash flow hedges
5.5.10 Special rule for basis swaps
5.5.20 Limitations on mixed-attribute derivative commodity
contracts
Questions
5.5.10 How is the hedged forecasted transaction defined in a cash
flow hedging relationship involving a basis swap?
5.5.20 How does an entity assess whether a basis swap is highly
effective at offsetting changes in the net interest cash
flows?
5.5.30 Can an entity hedge net interest cash flows from a group of
recognized assets or liabilities in a cash flow hedging
relationship involving a basis swap?
5.5.40 Can an entity apply the first-payments-received (paid)
approach when designating the net interest cash flows in a
hedging relationship involving a basis swap?
5.5.50 Is a cash flow hedge with a basis swap automatically
dedesignated if there is a change to the contractually
specified interest rate?
5.5.60 Can basis swaps other than those involving interest rates
be designated as a hedging instrument?
Examples
5.5.10 Basis swap that qualifies for cash flow hedge accounting
5.5.20 Basis swap that does not qualify for cash flow hedge
accounting
5.5.30 First-payments-received (paid) approach with basis swap as
the hedging instrument

5.1 How the standard works

The objective of a cash flow hedge is to reduce or eliminate exposure to
variability in expected future cash flows that affect earnings.
Topic 815 requires that certain criteria be met for a hedging relationship to
qualify for cash flow hedge accounting. The criteria are organized as follows.

Criterion 1 Criterion 2 Criterion 3 Criterion 4

Eligibility of Eligibility of
Eligibility of Hedge
hedged items hedging
hedged risk(s) effectiveness
or transactions instruments

Criterion 5: Formal documentation

Topic 815 specifies certain items and transactions that are eligible for
designation as a hedged transaction in a cash flow hedge.

Criterion 1: Transactions eligible for cash flow hedges (section 5.3)

Cash flows from existing recognized Forecasted transactions – e.g. forecasted

assets and liabilities purchases or sales
(section 5.3.10) (section 5.3.20)

Group of similar forecasted

All-in-one hedge
transactions
(section 5.3.90)
(section 5.3.60)

Additionally, the risk(s) associated with the hedged transaction also needs to
qualify for hedge accounting. The risks eligible to be designated in a cash flow
hedge are different for financial and nonfinancial assets and liabilities.

Criterion 2: Risks eligible for cash flow hedges

Financial assets and Nonfinancial assets and

liabilities liabilities
(section 2.3) (section 2.4)

Interest Either: Not applicable.

rate risk — changes in a
contractually specified
interest rate for
variable-rate financial
instruments or
forecasted issuances or
purchases of variable-
rate financial
instruments; or

— changes in the
benchmark interest

rate for forecasted

issuances or purchases
of fixed-rate financial
instruments.

Credit Includes: Not applicable.

risk — risk of default;
— changes in the obligor’s
creditworthiness; and
— changes in the credit
spread over the
contractually specified
interest rate or the
benchmark interest
rate.

Foreign — Changes in the related — Changes in the related

currency foreign currency foreign currency
risk exchange rates. exchange rates of foreign
currency denominated
forecasted transactions or
firm commitments.

Price risk  Total change in the Either:

Section 5.4 discusses the eligibility criteria for hedged risks that are specific to
cash flow hedges, including:
— contractually specified component price risk for nonfinancial items;
— interest rate risk on the forecasted issuance or purchase of debt
instruments; and
— changing the hedged risk.

Foreign currency risk. For further guidance on hedging foreign currency

risk, see chapter 7.

Criterion 3: Hedging instruments eligible for cash flow hedges

Eligibility criteria
General criteria for all General limitations on
specific to cash flow
hedging instruments all hedging instruments
hedges
(section 2.6) (section 2.7)
(section 5.5)

Section 5.5 discusses the eligibility criteria of hedging instruments that are
specific to cash flow hedges, including:
— special rule for basis swaps; and
— limitations on mixed-attribute derivative commodity contracts.

Criterion 4: Hedge effectiveness (chapter 9)

A derivative hedging instrument can qualify as a hedging instrument only if the

entity expects the instrument to be (and the instrument actually is) effective at
offsetting changes in cash flows of the hedged transaction.

Criterion 5: Formal documentation for cash flow hedges

Formal documentation Formal documentation requirements

requirements for all hedges specific to cash flow hedges
(section 2.9) (section 2.9.60)

5.2 Objective of a cash flow hedge

Cash flow hedges are structured to reduce or eliminate variability in expected
future cash flows due to changes in variable rates or prices. A cash flow hedge
is designed to ensure that the amount and timing of those cash flows are either
fixed or will change in a single direction (i.e. only increase or decrease).
For example, an entity may wish to eliminate all fluctuations in the cash flows
associated with variable-rate debt, or may seek to reduce only the exposure to
increases in the variable interest rate.
The following are common examples of cash flow exposures and hedging
strategies.

Hedged Cash flow exposure /

transaction hedged risk Hedging strategy
Recognized assets and liabilities
Variable-rate Exposure to variability in — Convert the interest received to
assets interest receipts. fixed by entering into an
interest rate swap for receipt of
interest at a fixed rate and
payment of interest at a
variable rate.
— Lock in a minimum yield by
purchasing an interest rate floor
option.

Variable-rate Exposure to variability in — Convert the interest paid to

liabilities interest payments. fixed by entering into an
interest rate swap for receipt of
interest at a variable rate and
payment of interest at a fixed
rate.
— Lock in a maximum cost of
funds by purchasing an interest
rate cap option.

Forecasted transactions
Forecasted Exposure to variability in Lock in a minimum price on the
sale of a market prices to date of forecasted sale of a mortgage loan
mortgage sale. by purchasing a put option.
loan
Forecasted Exposure to variability in Fix the interest rate on the
issuance of a market interest rates to date forecasted issuance of debt by
fixed-rate of issuance. entering into an interest rate lock
debt agreement or forward-starting
interest rate swap.
Forecasted Exposure to variability in Fix the interest rate on the
issuance of a contractually specified forecasted issuance of debt by
variable-rate interest rates to date of entering into an interest rate lock
debt issuance. agreement or forward-starting
interest rate swap.

Hedged Cash flow exposure /

transaction hedged risk Hedging strategy
Forecasted — Exposure to variability in Lock in the cost of a forecasted
purchase of market prices to date of purchase price of inventory, or a
inventory purchase. contractually specified component,
— Exposure to variability in by entering into a forward contract
market prices of a to purchase inventory or the specific
contractually specified component.
component to date of
purchase.

Forecasted — Exposure to variability in Lock in the sales price of inventory,

sale of market prices to date of or a contractually specified
inventory sale. component, by entering into a
— Exposure to variability in forward contract to sell inventory or
market prices of a the specific component.
contractually specified
component to date of
sale.

5.3 Eligibility of hedged transactions

Criterion 1 Criterion 2 Criterion 3 Criterion 4

Eligibility of Eligibility of
Eligibility of Hedge
hedged items hedging
hedged risk(s) effectiveness
or transactions instruments

Criterion 5: Formal documentation

This section discusses the criteria for transactions to be eligible for cash flow
hedge accounting. Topic 815 also prohibits certain transactions from being
hedged, which are discussed in section 2.5.

Foreign currency risk. For guidance on the eligibility of hedged

transactions in a cash flow hedge of foreign currency risk, see section 7.6.10.

5.3.10 Basic requirements

Excerpt from ASC 815-20

>> Hedged Transaction Criteria Applicable to Cash Flow Hedges Only

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:

a. An existing recognized asset or liability (such as all or certain future interest

payments on variable-rate debt)
b. A forecasted transaction (such as a forecasted purchase or sale).
Note that the glossary definition of transaction is intended to clearly
distinguish a transaction from an internal cost allocation or an event that
happens within an entity.
25-14 For purposes of this Subtopic and Subtopic 815-30, the individual cash
flows related to a recognized asset or liability and the cash flows related to a
forecasted transaction are both referred to as a forecasted transaction or
hedged transaction.

Cash flows from existing recognized assets or liabilities or forecasted

transactions are eligible to be designated as the hedged transaction in a cash
flow hedge.
In Topic 815 and throughout this publication, both the cash flows related to a
recognized asset or liability and the cash flows related to a forecasted
transaction are referred to as the forecasted transaction or the hedged
transaction.

5.3.20 Forecasted transactions: Definition

Excerpt from ASC 815-20

20 Glossary
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.
>> Hedged Transaction Criteria Applicable to Cash Flow Hedges Only
25-15 A forecasted transaction is eligible for designation as a hedged
transaction in a cash flow hedge if all of the following additional criteria are
met:
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.
b. The occurrence of the forecasted transaction is probable.
c. The forecasted transaction meets both of the following conditions:
1. It is a transaction with a party external to the reporting entity (except as
permitted by paragraphs 815-20-25-30 and 815-20-25-38 through 25-
40).

2. It presents an exposure to variations in cash flows for the hedged risk

that could affect reported earnings.

A forecasted transaction is essentially a future transaction that is probable and

does not meet the definition of a firm commitment. A firm commitment is a
(legally) binding agreement between unrelated parties that specifies all
significant terms (e.g. quantity, fixed price) and includes a disincentive for
nonperformance that is sufficiently large to make performance probable (see
section 3.3.20). [815-20 Glossary]
Forecasted transactions are eligible only for cash flow hedge accounting, while
firm commitments are generally eligible only for fair value hedge accounting.
Certain criteria must be met for a forecasted transaction to be eligible for
designation as a hedged transaction.
Does forecasted transaction meet eligibility criteria for cash flow hedges?
(all criteria must be met)

Must be with a party

Must be specifically
Must be probable external to the
identified
(section 5.3.40) reporting entity
(section 5.3.30)
(section 5.3.50)

Question 5.3.10
Can a contract that qualifies for the normal
purchases and normal sales scope exception qualify
as a hedged transaction?

Excerpt from ASC 815-20

>>> Normal Purchases and Normal Sales as Hedged Items or

Interpretive response: Yes. A contract that meets the definition of a

derivative but qualifies for the normal purchases and normal sales exception in

Subtopic 815-10 (or any other scope exception in that Subtopic) is eligible to be
designated as a hedged transaction.
In contrast, if the contract meets the definition of a derivative and does not
meet any of the scope exceptions in Subtopic 815-10, it cannot be designated
as a hedged transaction. Rather, it is accounted for as a derivative instrument.
Normal purchases and normal sales are contracts that provide for the purchase
or sale of something other than a financial instrument or derivative instrument
that will be delivered in quantities expected to be used or sold by the entity
over a reasonable period in the normal course of business. [815-10-15-22]
Although the requirements for a derivative instrument to qualify for this
exception are beyond the scope of this publication, an instrument will not
qualify for the exception unless it meets these minimum requirements:
[815-10-15-22 – 15-51]

— the asset under the contract is delivered in quantities expected to be used

or sold by the entity over a reasonable period in the normal course of
business;
— the contract does not have a price based on an underlying that is not
clearly and closely related to the asset being sold or purchased (see
Question 5.4.50 for the requirements to meet this criterion); and
— the entity documents the designation of the contract as a normal purchase
or a normal sale.
The purchase or sale under a variable-price contract that qualifies for the normal
purchases and normal sales exception may be designated as the hedged
transaction in a cash flow hedge for the forecasted purchase or sale of the
asset underlying the contract.
For an example of a contract not accounted for as derivative because
the normal purchases and normal sales scope exception is met, see
Example 5.4.30.

5.3.30 Forecasted transactions: Specific identification

Excerpt from ASC 815-20

>> Hedged Transaction Criteria Applicable to Cash Flow Hedges Only

>> Example 1: Designation and Documentation of Hedged Forecasted

Transaction

55-80 This Example illustrates the requirement in paragraph 815-20-25-3(d)(1)

for specific identification of the hedged transaction. Entity A determines with a
high degree of probability that it will issue $5,000,000 of fixed-rate bonds with
a 5-year maturity sometime during the next 6 months, but it cannot predict
exactly when the debt issuance will occur. That situation might occur, for
example, if the funds from the debt issuance are needed to finance a major
project to which Entity A is already committed but the precise timing of which
has not yet been determined. To qualify for cash flow hedge accounting, Entity
A might identify the hedged forecasted transaction as, for example, the first
issuance of five-year, fixed-rate bonds that occurs during the next six months.

To qualify for cash flow hedge accounting, an entity must specifically identify
the single forecasted transaction (or group of transactions) that gives rise to the
cash flow exposure that is being hedged. [815-20-25-15(a)]
Does forecasted transaction meet eligibility criteria for cash flow hedges?
(all criteria must be met)

Must be with a party

Must be specifically
Must be probable external to the
identified
reporting entity

The specifically identified transaction may be: [815-20-25-3(d)(1), 25-15(a)]

— the specific asset or liability for which the forecasted transaction relates; or
— the first cash flows received or paid to a specific amount in a particular
period (without reference to the specific asset or liability) when hedging a
group of similar forecasted transactions (see sections 5.3.60 and 5.3.70).
The key is that the designation is specific enough so that when the transaction
occurs, it is clear whether that transaction is or is not the hedged transaction.
[815-20-25-3(d)(1)]

Formal documentation. Topic 815 requires an entity to formally document

certain details around the specifically identified forecasted transaction,
including: [815-20-25-3(d)(1)]
— timing of when the forecasted transaction is expected to occur;
— specific asset or liability involved (if applicable); and
— the expected currency amount and/or the physical quantity (e.g. number of
items or unit of measure).
For further guidance on the formal documentation requirements when hedging
a forecasted transaction, see section 2.9.60.

Foreign currency risk. If the hedged forecasted transaction is

denominated in a foreign currency, an entity needs to specify the exact amount
of foreign currency being hedged. Hedges of foreign currency exposures are
discussed in detail in section 7.6.30.

Future developments

At a March 2018 meeting, the FASB discussed potential Codification

improvements that may extend an entity’s ability to change the hedged risk
and/or the hedged forecasted transaction (see Question 5.4.90). This would
include clarifying how broadly or narrowly the hedged transaction is defined and
whether a change in the hedged risk constitutes a change in the hedged
transaction. [FASB meeting 03-18]

5.3.40 Forecasted transactions: Probability

Excerpt from ASC 815-20

>> Hedged Transaction Criteria Applicable to Cash Flow Hedges Only

25-15 A forecasted transaction is eligible for designation as a hedged
transaction in a cash flow hedge if all of the following additional criteria are
met: …
b. The occurrence of the forecasted transaction is probable.
>>> Timing and Probability of the Hedged Forecasted Transaction
25-16 Example 4 (see paragraph 815-20-55-88) illustrates that how the hedged
forecasted transaction is designated and documented in a cash flow hedge is
critically important in determining whether it is probable that the hedged
forecasted transaction will occur. The following guidance expands on the
timing and probability criteria in paragraphs 815-20-25-3 and 815-20-25-15(b): …
e. The term probable requires a significantly greater likelihood of occurrence
than the phrase more likely than not.
f. The cash flow hedging model does not require that it be probable that any
variability in the hedged transaction will actually occur—that is, in a cash
flow hedge, the variability in future cash flows must be a possibility, but
not necessarily a probability. However, the hedging derivative must be
highly effective at achieving offsetting cash flows whenever that variability
in future interest does occur.
>>>> Probability of a Forecasted Transaction
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 the following circumstances
in assessing the likelihood that a transaction will occur.
a. The frequency of similar past transactions
b. The financial and operational ability of the entity to carry out the transaction

c. 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)
d. The extent of loss or disruption of operations that could result if the
transaction does not occur
e. The likelihood that transactions with substantially different characteristics
might be used to achieve the same business purpose (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).

To qualify for cash flow hedge accounting, a forecasted transaction needs to be

probable. [815-20-25-15(b)]

Does forecasted transaction meet eligibility criteria for cash flow hedges?
(all criteria must be met)

Must be with a party

Must be specifically
Must be probable external to the
identified
reporting entity

Topic 815 defines probable as ’the future event or events are likely to occur.’
The term ‘probable’ requires a significantly greater likelihood of occurrence than
the phrase ‘more likely than not’. [815-20-25-16(e)]
The assessment of the likelihood that a transaction will occur is not based
solely on management’s intent, but rather is supported by observable facts and
circumstances. This is illustrated in Example 5.3.10. [815-20-55-24]
In addition to the considerations in paragraph 815-20-55-24, Topic 815 provides
guidance to consider when assessing the timing and probability of forecasted
transactions: [815-20-25-16]
— time until forecasted transaction is expected to occur;
— quantity of forecasted transaction;
— effect of counterparty creditworthiness;
— probability of forecasted acquisition of a marketable debt security; and
— uncertainty of timing within a range.
Each of these topics is discussed in the subsections that follow.
Formal documentation. In its formal hedge documentation, an entity should
specify the circumstances that were considered in concluding that a transaction
is probable. For further guidance on the formal documentation requirements
when hedging a forecasted transaction, see section 2.9.60.

Question 5.3.20
Does a change in the probability assessment of a
hedged transaction affect the ability to apply hedge
accounting?
Interpretive response: Yes. A change in the probability of the forecasted
transaction may affect whether the hedging relationship remains eligible for
hedge accounting. For further discussion, see Question 2.10.10 and 6.5.20.
If an entity has a pattern of determining that it is probable that hedged
forecasted transactions will not occur, the appropriateness of management’s
previous assertions and its ability to make future assertions regarding
forecasted transactions may be called into question. [815-30-40-5]

Example 5.3.10
Probability of transaction to purchase steel
ABC Corp. produces consumer goods called widgets.
The CEO recently decided to expand its operations to include the manufacturing
of the equipment used to produce widgets. This will require Board approval for
the change in business strategy.
This change will require ABC to purchase steel to manufacture the equipment.
ABC has not purchased steel before, but has several possible suppliers. It
expects to purchase steel from Steelco within six months but does not have a
firm commitment with Steelco. ABC wants to lock in the purchase price of the
steel.
Can ABC designate the overall changes in cash flows related to the
forecasted purchase of steel as a hedged transaction?
It depends. ABC needs verifiable evidence to conclude the transaction is
probable before it is eligible to be designated as a hedged transaction.
There are certain facts that could make it difficult to assert that the transaction
is probable, including:
— there are no past purchases of steel;
— if the Board doesn’t approve the strategy change, ABC will not be able to
carry out the transaction; and
— ABC could decide to purchase the equipment instead of manufacturing it in-
house.
However, ABC may be able to provide other observable information to support
its assertion that the forecasted purchase of steel is probable.

Time until transaction occurs and quantity of transaction

Excerpt from ASC 815-20

>>>> Probability of a Forecasted Transaction

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.

Both the length of time until a forecasted transaction is projected to occur and
the quantity of the forecasted transaction is considered in determining
probability. [815-20-55-25]
For example, a forecasted sale of manufactured goods projected to occur in five
years may be less likely than a forecasted transaction expected to occur in one
year. Or for an entity whose historical sales volumes are closer to 1,000 units
per month, forecasted sales of 1,000 units in a particular month may be more
likely than forecasted sales of 2,500 units in that month.

Effect of counterparty creditworthiness on probability

Excerpt from ASC 815-20

>>> Timing and Probability of the Hedged Forecasted Transaction

25-16(a) Effect of counterparty creditworthiness on probability. An entity using
a cash flow hedge shall assess the creditworthiness of the counterparty to the
hedged forecasted transaction in determining whether the forecasted
transaction is probable, particularly if the hedged transaction involves payments
pursuant to a contractual obligation of the counterparty.

When assessing the probability that a transaction will occur, an entity should
also consider the effect of counterparty creditworthiness. A counterparty to a
transaction may fail to comply with the contractual terms of an agreement
because of credit problems or other reasons. [815-20-25-16(a)]
An entity should assess the likelihood that the counterparty will make the
contractual payments or deliveries.
Hedge effectiveness. In addition, an entity’s own creditworthiness and risk of
nonperformance is relevant in its hedge effectiveness assessments. For further
discussion of how counterparty credit risk and the entity’s own nonperformance
risk may affect the effectiveness of a hedging relationship, see section 9.2.60.

Probability of forecasted acquisition of a marketable debt

security

Excerpt from ASC 815-20

>>> Timing and Probability of the Hedged Forecasted Transaction

25-16(b) Probability of forecasted acquisition of a marketable debt security. To
qualify for cash flow hedge accounting for an option designated as a hedge of
the forecasted acquisition of a marketable debt security, an entity must be able
to establish at the inception of the hedging relationship that the acquisition of
the marketable debt security is probable, without regard to the means of
acquiring it. In documenting the hedging relationship, the entity shall specify
the date on or period within which the forecasted acquisition of the security
will occur. The evaluation of whether the forecasted acquisition of a
marketable debt security is probable of occurring shall be independent of the
terms and nature of the derivative instrument designated as the hedging
instrument. Specifically, in determining whether an option designated as a
hedge of the forecasted acquisition of a marketable debt security may qualify
for cash flow hedge accounting, the probability of the forecasted transaction
being consummated shall be evaluated without consideration of whether the
option designated as the hedging instrument has an intrinsic value other than
zero.
>>>> Forecasted Acquisition of a Marketable Debt Security
55-27 This discussion provides additional information on the forecasted
acquisition of a marketable debt security as a hedged item (see paragraph 815-
20-25-16[b]).
55-28 An entity seeking to reduce the variability of the price at which it will
acquire a marketable debt security in the future might use a forward contract
to fix the price today.
55-29 With a forward contract, the typical settlement is the delivery of the
marketable debt security at a later date at the pre-fixed price.
55-30 With a purchased option, the typical settlement might be the delivery of
the marketable debt security at the ceiling price, or the holder may allow the
purchased option to expire unexercised.
55-31 Therefore, to qualify for cash flow hedge accounting in this
circumstance, the entity shall be able to establish that it is probable that it will
acquire the marketable debt security by any of the following means:
a. Exercising the option designated as the hedging instrument if it is in the
money
b. Purchasing the security in the marketplace at its prevailing market price if
the option is out of the money.
55-32 If the entity expects to acquire the marketable debt security only by
exercising the option and only if the option were in the money, a cash flow
hedging relationship typically would not be designated because acquisition of
the security is contingent and thus would not be considered probable.

An entity may designate a purchased option or warrant as the hedging

instrument in a cash flow hedge of the forecasted acquisition of the marketable
security to which the option or warrant relates (i.e. the forecasted transaction).
To qualify for cash flow hedge accounting, the forecasted transaction needs to
be probable. The evaluation of whether the forecasted acquisition of the
marketable security is probable must be independent of the hedging
instrument. Specifically, an entity needs to assert that the marketable debt
security will be purchased regardless of whether the option or warrant is in the
money. [815-20-25-16(b), 55-32]

Example 5.3.20
Assessing the probability of the forecasted
acquisition of a marketable debt security
ABC Corp. purchases an option contract that gives it the right to purchase a
marketable debt security at a fixed price. ABC would like to designate the
option as a cash flow hedge of the variability in cash flows associated with the
forecasted purchase of the marketable debt security.
ABC establishes it is probable that it will acquire the security by either:
[815-20-55-31]

— exercising the option designated as the hedging instrument if it is in the

money; or
— purchasing the security at its prevailing market price if the option is out of
the money.
Therefore, the forecasted acquisition of the marketable debt security is
considered probable and eligible for cash flow hedge accounting.
Alternatively, if ABC determines the marketable debt security would be
acquired only on exercise of the option (i.e. option is in the money), it is
probable the forecasted acquisition will not occur and therefore the transaction
is not eligible for cash flow hedge accounting. This is because the acquisition of
the security is contingent on the market price of the security.

Uncertainty of timing within a range

Excerpt from ASC 815-20

>>> Timing and Probability of the Hedged Forecasted Transaction

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. See paragraph 815-30-40-4 for related

guidance and Example 5 (see paragraph 815-20-55-100), which illustrates the

application of this paragraph.
25-16(d) Importance of timing in both documentation and hedge effectiveness.
Although documenting only the period within which the forecasted transaction
will occur is sufficient to comply with the requirements of paragraph 815-20-
25-3, compliance with Section 815-20-35 and paragraph 815-20-25-75(b)
requires that the best estimate of the forecasted transaction’s timing be both
documented and used in assessing hedge effectiveness. As explained in
paragraphs 815-20-25-84 and 815-20-25-120 through 25-121, the time value of
money is likely to be important in the assessment of cash flow hedge
effectiveness, especially if the entity plans to use a rollover or tailing strategy
to hedge its forecasted transaction. The use of time value of money requires
information about the timing of cash flows.
>>>> Specificity to Timing of a Forecasted Transaction
55-26 Paragraph 815-20-25-3(d)(1)(vi) requires an entity to identify the hedged
forecasted transaction with sufficient specificity to make it clear whether a
particular transaction is a hedged transaction when it occurs. Paragraph 815-20-
25-3(d)(1)(i) requires that an entity document the date on or period within which
the forecasted transaction is expected to occur. An entity should not be able to
choose when to reclassify into earnings a gain or loss on a hedging instrument
in accumulated other comprehensive income after the gain or loss has
occurred by asserting that the instrument hedges a transaction that has or has
not yet occurred. However, this Subtopic does not require that an entity be
able to specify at the time of entering into a hedge the date on which the
hedged forecasted transaction will occur.

Topic 815 requires an entity to specify and document the date or period within
which the forecasted transaction is expected to occur. If a forecasted
transaction is expected to occur within a timeframe, but the date within that
timeframe is uncertain, an entity may document a range of time to comply with
this requirement. [815-20-25-3(d)(1), 25-16(c)]
This flexibility allows some forecasted transactions with uncertain timing to be
considered probable within a range. For example, an entity could document that
a hedged forecasted transaction is a foreign currency denominated payment to
a subcontractor to be paid within a five-year contract period for a construction
project. As long as it remains probable that the forecasted transaction will occur
by the end of the originally projected five-year period, cash flow hedge
accounting could continue assuming all other eligibility criteria are met.
[815-20-55-102]

Hedge effectiveness. More precision is likely required to assess effectiveness

of a forecasted transaction when using an estimated period. This is because the
time value of money is likely to be important in the assessment of cash flow
hedge effectiveness (see section 9.2.110), especially if an entity plans to use a
rollover or tailing strategy. In those analyses, cash flow estimates need to
involve estimating points in time when those cash flows will occur. [815-20-25-
16(d)]

However, an entity may elect to exclude the forward points/time value

component of a derivative from the effectiveness assessment. For guidance on

excluding certain components of a hedging instrument’s cash flows from the

effectiveness assessment, see section 9.2.70.

Question 5.3.30
Does a change in the expected timing of a
forecasted transaction affect the ability to apply
hedge accounting?
Interpretive response: It depends. If the expected timing of a forecasted
transaction changes, but is still within the range originally documented, an
entity will need to assess effectiveness based on a newly revised best estimate
of the cash flows. If it is no longer probable that the forecasted transaction will
occur within the originally specified time period, the transaction no longer
qualifies for hedge accounting (see Question 2.10.10 and section 6.5.20).
Hedge effectiveness. An entity must document and use its best estimate of
timing of the forecasted transaction, which needs to be more specific than the
period used to support the probability that the forecasted transaction will occur.
This could lead to situations where – at some point during the hedge period – it
remains probable that the forecasted transaction will occur within the specified
time range, but the hedge is no longer highly effective due to changes in the
expected timing of the forecasted transaction. Additionally, circumstances may
change over time causing the expected timing used in effectiveness
assessments to change, even though the revised expected timing would still be
within the original range. The entity would have to consider that change
because the change would likely affect the assessment of effectiveness.

FASB Example: Hedged forecasted transaction when timing

involves some uncertainty within a range
The FASB example below illustrates a hedged forecasted transaction that has
uncertainty of timing within a range.

Excerpt from ASC 815-20

>> Example 5: Hedged Forecasted Transaction When Timing Involves

Some Uncertainty within a Range

55-100 This Example Illustrates the application of paragraph 815-20-25-16(c).

55-101 A general contractor enters into a long-term contract to build a power
plant. The long-term contract is to be completed within five years. As part of
the construction project, the general contractor expects to subcontract a
portion of the construction to a foreign entity with a functional currency
different from its own. Because the subcontractor will be paid in its functional
currency, the general contractor will have a foreign currency exposure that it
desires to hedge. At the start of the project, the general contractor concludes
it is probable that the subcontract work will be completed and paid for at the

end of Year 2. However, the general contractor knows that the timing of a
subcontractor’s work, and thus the foreign-currency-denominated payment for
its work, may possibly be delayed by a period of more than two months, even
though it is probable that the overall project will remain on schedule in meeting
the ultimate completion date. The contractor intends to hedge the exposure by
using a forward contract with a maturity date that coincides with the current
expected date of payment (that is, a two-year foreign currency forward) and
the expected notional amount of the forecasted transaction.
55-102 The general contractor could document (as required by paragraph 815-
20-25-3(d)(1)) that the hedged forecasted transaction is the foreign-currency-
denominated payment to the foreign subcontractor to be paid within the five-
year contract period of the overall project (which is the originally specified time
period referred to in paragraphs 815-30-40-4 through 40-5). In accordance with
paragraph 815-20-25-16(c), as long as it remains probable that the forecasted
transaction will occur by the end of the originally projected five-year period of
the overall project, cash flow hedge accounting for that hedging relationship
would continue. Consequently, if the subcontractor’s payment is delayed by
more than two months, but less than three years and two months, then the
forecasted transaction would still be considered probable of occurrence within
the originally specified time period.
55-103 If the expected timing of the forecasted transaction changes, the
contractor must first apply the requirements of paragraph 815-30-35-3 using its
originally documented hedging strategy and the newly revised best estimate of
the cash flows, and then reevaluate whether continuing hedge accounting is
appropriate, pursuant to the requirements of paragraphs 815-30-40-1 through
40-3. If hedge accounting is discontinued prospectively, the derivative
instrument's gains or losses in other comprehensive income should be
accounted for pursuant to paragraphs 815-30-35-38 through 35-41 (unless
paragraphs 815-30-40-4 through 40-5 require reclassification into earnings).
55-104 If a quantitative assessment of hedge effectiveness is applied and the
assessment of effectiveness is based on changes in forward rates, the most
recent best estimate would be based on the current forward rate for the
hedged transaction relevant for the probable date that the transaction will
occur. If the assessment of effectiveness is based on changes in spot rates,
the best estimate would be based on the current spot rate.

5.3.50 Forecasted transactions: Party external to the

reporting entity

Excerpt from ASC 815-20

>> Hedged Transaction Criteria Applicable to Cash Flow Hedges Only

25-15(c) The forecasted transaction meets both of the following conditions:
1. It is a transaction with a party external to the reporting entity (except as
permitted by paragraphs 815-20-25-30 and 815-20-25-38 through 25-40).

2. It presents an exposure to variations in cash flows for the hedged risk that
could affect reported earnings.

For a forecasted transaction to qualify as a hedged transaction, it generally

needs to be a transaction with a party external to the reporting entity. [815-20-25-
15(c)(1)]

Does forecasted transaction meet eligibility criteria for cash flow hedges?
(all criteria must be met)

Must be with a party

Must be specifically
Must be probable external to the
identified
reporting entity

Therefore, transactions between a parent and its consolidated subsidiaries do

not qualify for hedge accounting at the consolidated level.

Foreign currency risk. Topic 815 provides an exception allowing cash flow
hedges of foreign currency risk to hedge forecasted intercompany foreign
currency denominated transactions (see section 7.3.40). [815-20-25-43(b)(4)]
However, a subsidiary may apply cash flow hedge accounting to a forecasted
transaction in its stand-alone financial statements if the transaction is with a
‘party external to the reporting entity’ in the stand-alone financial statements.

Question 5.3.40
What is the difference between a ‘party external to
the reporting entity’ and an ‘unrelated party’?
Interpretive response: To qualify as a hedged transaction, a forecasted
transaction needs to be with a ‘party external to the reporting entity’. [815-20
Glossary, 815-20-25-15(c)(1)]

We believe using the term ‘party external to the reporting entity’ limits the
prohibition on hedging forecasted transactions only to transactions with entities
that are consolidated by the reporting entity.
As a result, we believe transactions with parties such as equity method
investees, affiliates, unconsolidated joint ventures, shareholders and directors
are not excluded from being forecasted transactions in a cash flow hedge. This
assumes the effects of the forecasted transaction will not be eliminated or the
forecasted transaction is not specifically prohibited (e.g. forecasted sale of an
equity method investment) and all other criteria are met.
Firm commitments. In contrast, a firm commitment needs to be between two
‘unrelated parties’. [815-20 Glossary]
Topic 815 does not define an ‘unrelated party.’ However, we believe the term
‘related party’ generally includes all parties specified in Topic 850 (related
parties).

As a result, we believe transactions with parties such as equity method

investees, affiliates, unconsolidated joint ventures, shareholders and directors
are precluded from being firm commitments.

5.3.60 Group of similar forecasted transactions

Excerpt from ASC 815-20

>> Hedged Transaction Criteria Applicable to Cash Flow Hedges Only

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.
>>>> Grouping Individual Transactions
55-20 It sometimes will be impractical (perhaps impossible) and not cost-
effective for an entity to identify each individual transaction that is being
hedged. An example is a group of sales or purchases over a period of time to
or from one or more parties. This Subtopic permits an entity to aggregate
individual forecasted transactions for hedging purposes in some
circumstances. As it does for a hedge of a single forecasted transaction,
paragraph 815-20-25-3(d)(1)(vi) requires that an entity identify the hedged
transactions with sufficient specificity that it is possible to determine which
transactions are hedged transactions when they occur.
55-21 For example, an entity that expects to sell at least 300,000 units of a
particular product in its next fiscal quarter might designate the sales of the first
300,000 units as the hedged transactions. Alternatively, it might designate the
first 100,000 sales in each month as the hedged transactions. It could not,
however, simply designate any sales of 300,000 units during the quarter as the
hedged transaction because it then would be impossible to determine whether
the first sales transaction of the quarter was a hedged transaction. Similarly,
an entity could not designate the last 300,000 sales of the quarter as the
hedged transaction because it would not be possible to determine whether
sales early in the quarter were hedged or not.
55-22 Under the guidance in this Subtopic, 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:
a. Forecasted sales of a particular product to numerous customers within a
specified time period, such as a month, a quarter, or a year
b. Forecasted purchases of a particular product from the same or different
vendors at different dates within a specified time period
c. Forecasted interest payments on several variable-rate debt instruments
within a specified time period.

55-23 At the time of hedge designation only, the transactions in each group
must share the risk exposure for which they are being hedged. For example,
the interest payments in the group in (c) in the preceding paragraph shall vary
with the same index to qualify for hedging with a single derivative instrument.

For a group (rather than an individual transaction) to be designated as the

hedged transaction, the transactions must share the same risk exposure for
which they are being hedged. The analysis to determine whether transactions
share the same risk exposure in a cash flow hedge is generally qualitative.
Similar to a single forecasted transaction, a group of transactions must be
identified with sufficient specificity so that it is possible to determine which
transactions are the hedged transactions when they occur. The specifically
identified group of transactions may be:
— a specific group of assets or liabilities for which the forecasted transaction
relates; or
— the first cash flows received or paid up to a specific amount in a particular
period (without reference to the specific asset or liability).
For example, an entity expects to sell at least 300,000 units of a particular
product in its next fiscal quarter. [815-20-25-21]

Is the designation specific enough to qualify

for hedge accounting?
Yes No
Specific group of assets or Sales of the first Any sales of 300,000
liabilities to which forecasted 300,000 units units during the
transaction relates quarter
First cash flows received or Sales of the first Sales of the last
paid to a specific amount in a 100,000 units in each 300,000 units
particular period month

The entity could not designate any sales of 300,000 units during the quarter as
the hedged transaction because it would be impossible to determine whether
an individual sale during the quarter was a hedged transaction. In addition, the
entity could not designate the last 300,000 sales because it would not be
possible to determine whether sales during the quarter were hedged until the
quarter had ended.

Future developments

At a March 2018 meeting, the FASB discussed potential Codification

For example, future amendments may be provide entities with the ability to
retrospectively designate a particular transaction as the hedged transaction,
within certain parameters. This may give an entity the ability to determine
which purchases or sales were hedged in a prior reporting period. In other
words, an entity may not have to know which transactions are the hedged
transactions when they occur.

Question 5.3.50
Can both forecasted purchases and sales be
included in a group for hedge accounting?
Interpretive response: No. A hedged group of transactions cannot include both
cash inflows and outflows, such as forecasted purchases and sales. Although
the forecasted purchases and sales may be based on the same underlying, they
have opposite exposures. [815-20-25-15(a)(2)]

Question 5.3.60
How does an entity assess whether forecasted
transactions of nonfinancial assets or liabilities
share similar risk exposure?
Interpretive response: Individual transactions in the hedged portfolio need to
share the same risk exposure for which they are designated as being hedged.
For nonfinancial assets and liabilities, the designated risk being hedged is either:
[815-20-25-15(i)(2) – 25-15(i)(3)]

— all changes in the purchase price or sales price of the asset (i.e. price risk);
or
— changes in a contractually specified component (i.e. component price risk).
The different risk exposures require different qualitative and quantitative
considerations.

Risk Qualitative considerations Quantitative considerations

Price For forecasted purchases or sales An entity also needs to

risk of nonfinancial assets to be demonstrate that the
considered similar when hedging forecasted transactions are
price risk, we believe the purchases expected to be similar based
or sales need to first involve the on changes in the overall
same asset of the same grade. market price of the forecasted
Therefore, forecasted purchases or purchases or sales, including
sales of individually unique assets the asset’s physical location
would not qualify for aggregation. (see Question 9.2.20).
An entity should also consider We believe the quantitative
whether the physical location of assessment of similar risks for
individual transactions in a group fair value hedges can be used
affects whether they share similar for cash flow hedges (see
risk exposure. For example, section 3.3.40).
purchasing jet fuel in the United
States may have risk exposures

Risk Qualitative considerations Quantitative considerations

different from jet fuel purchased in
Singapore.
For an illustration of grouping
forecasted purchases when
hedging price risk, see
Example 5.3.30.
Component We believe individual purchases or Because each transaction
price risk sales of different asset grades or in within a group needs to be
different locations may be based on the identical
considered similar in a hedge of a contractually specified
contractually specified component if component, the forecasted
each of the transactions is based on transactions are expected to
the identical contractually specified be similar. This is because all
component. For example, an entity items in the group share the
may determine that individual same risk exposure to the
purchases of different plastic contractually specified
grades have exposure to changes in component.
the same contractually specified Therefore, we believe
plastic index. performing a quantitative
For an illustration of grouping assessment of similar risks is
forecasted purchases when not necessary.
hedging component price risk, see
Subtopic 815-30’s Example 23 later
in this section.

Example 5.3.30
Forecasted purchases of fuel when hedging price risk
– similarity assessment
This is a continuation of Example 2.9.50. For ease of reference, key facts from
that example are summarized below.
Freight Co. purchases both jet fuel and diesel fuel at various locations across
the US and internationally.

Types of fuel Locations

Jet fuel NY Harbor
Diesel fuel US Gulf Coast
LA
Singapore
Rotterdam

Hedged risk. Freight wants to hedge its exposure to variability in the overall
cash outflows (i.e. price risk) for the purchase of fuel due to changes in spot
prices at various locations.

Hedged forecasted transaction. The hedged forecasted transaction is defined

as the first purchases of gallons of fuel over the 30-day period beginning on the
first day of the month in which the derivative contract matures/settles that:
1. in aggregate represent the number of gallons (or equivalent barrels) equal to
the notional amount of the hedging instrument; and
2. are not currently being hedged by another derivative instrument or were not
previously identified in a relationship originally designated earlier in priority
that has been terminated for which amounts remain in AOCI.
Assessing similarity of individual forecasted purchases within the group
The overall price of a gallon of fuel is significantly affected by both the type of
fuel and the location of the purchase. Therefore, Freight expects purchases of
jet fuel to have risk exposure different from purchases of diesel fuel.
Furthermore, fuel purchased at different locations may have different risk
exposures.
Only individual forecasted purchases that are similar to the risk being hedged
can be included within the same hedging relationship. Freight preliminarily
identifies transactions within each of the following groups as having similar risk
exposure, based first by type of fuel and then more specifically by location:
— Group 1: Jet fuel; NY Harbor, US Gulf Coast, LA
— Group 2: Jet fuel; Singapore, Rotterdam
— Group 3: Diesel fuel; NY Harbor, US Gulf Coast
— Group 4: Diesel fuel; LA
To demonstrate that each group is similar, Freight performs a regression
analysis to show that the changes in expected prices for the purchases of fuel
at each location within the group are highly correlated with each other.
Because similarity is assessed at both inception and on an ongoing basis,
Freight will update its analysis each time the hedging relationships are assessed
for effectiveness (i.e. on a quarterly basis). Freight will also monitor both jet fuel
and diesel fuel prices by location on a weekly basis for changes in general price
trends to determine whether it needs to reconsider its similarity test.
Hedge effectiveness. For the forecasted transactions to qualify for hedge
accounting, Freight also needs to demonstrate that the hedging instrument is
highly effective at hedging the overall price risk for each individual group.
Example 9.6.20 continues this example, illustrating regression analysis to
quantitatively assess effectiveness for a cash flow hedge of total price risk for a
group of similar transactions.

FASB Example: Cash flow hedge of a forecasted purchase of

inventory for which commodity exposure is managed
centrally

Excerpt from ASC 815-30

>> Example 23: Designation of a Cash Flow Hedge of a Forecasted

Purchase of Inventory for Which Commodity Exposure Is Managed
Centrally

55-142 This Example illustrates the application of the guidance in Subtopic 815-
20 and this Subtopic to the designation of a cash flow hedge of a forecasted
purchase of inventory in which the commodity exposure is managed centrally
at the aggregate level. Assume the entity elects to perform subsequent
assessments of hedge effectiveness on a qualitative basis and all hedge
documentation requirements were satisfied at inception.
55-143 Entity Q is seeking to hedge the variability in cash flows associated
with commodity price risk of its monthly plastic purchases for the next
12 months. It has two different manufacturing plant locations (Plant A and
Plant B) that are purchasing five different grades of plastic from Supplier A. The
plastic purchase price for each month is based on the month-end Joint Plastic
(JP) index and a fixed basis differential component. The fixed basis differential
offered by the supplier is determined by:
a. The grade of the plastic purchased
b. The distance between the plant location and supplier location.
55-144 At January 1, 20X1, Entity Q enters into a supply agreement with
Supplier A to purchase plastic over the next 12 months. The respective
agreements allow Entity Q to purchase the various grades of plastic at both of
its plant locations as the need arises over the following year. The following
table summarizes the pricing provisions contained in the supply agreement for
each grade of plastic.

Grade 1 Grade 2 Grade 3 Grade 4 Grade 5

Plant A JP + $0.14 JP + $0.11 JP + $0.09 JP + $0.05 JP – $0.02
Plant B JP + $0.16 JP + $0.12 JP + $0.07 JP + $0.06 JP – $0.03

55-145 Entity Q’s risk management objective is to hedge the variability in the
purchase price of plastic attributable to changes in the JP index of the first
80,000 pounds of plastic purchased in each month regardless of grade or plant
location delivered to. To accomplish this objective, Entity Q executes 12
separate forward contracts at January 1, 20X1, to purchase plastic as follows.

Settlement Date Notional Amount Underlying Index

Jan forward January 30, 20X1 80,000 (lbs) JP

Feb forward February 28, 20X1 80,000 (lbs) JP
Mar forward March 30, 20X1 80,000 (lbs) JP
April forward April 30, 20X1 80,000 (lbs) JP
May forward May 30, 20X1 80,000 (lbs) JP
June forward June 30, 20X1 80,000 (lbs) JP
July forward July 30, 20X1 80,000 (lbs) JP
Aug forward August 30, 20X1 80,000 (lbs) JP
Sep forward September 30, 20X1 80,000 (lbs) JP
Oct forward October 30, 20X1 80,000 (lbs) JP
Nov forward November 30, 20X1 80,000 (lbs) JP
Dec forward December 30, 20X1 80,000 (lbs) JP

55-146 Entity Q determines that the variable JP index referenced in the supply
agreement constitutes a contractually specified component and that the
requirements to designate variability in the cash flows attributable to changes
in a contractually specified component as the hedged risk in paragraph 815-20-
25-22A are met.
55-147 Because Entity Q determined that it will purchase at least 80,000
pounds of plastic each month in the coming 12 months to fulfill its expected
manufacturing requirements, it documents that the hedged item (that is, the
forecasted transaction within each month) is probable of occurring. Entity Q
designates each forward contract as a cash flow hedge of the variability in cash
flows attributable to changes in the contractually specified JP index on the first
80,000 pounds of plastic purchased (regardless of grade or plant location
delivered to) for the appropriate month. The individual purchases of differing
grades of plastic by Plant A and Plant B during each month share the risk
exposure to the variability in the purchase price of the plastic attributable to
changes in the contractually specified JP index. Therefore, the individual
transactions in the hedged portfolio of plastic purchases for each month share
the same risk exposure for which they are designated as being hedged in
accordance with paragraph 815-20-25-15(a)(2).
55-148 In accordance with paragraph 815-20-25-3(b)(2)(iv)(01)(B), if Entity Q has
determined the critical terms of the hedged item and hedging instrument
match, it may elect to assess effectiveness qualitatively both at inception of
the hedging relationship and on an ongoing basis on the basis of the following
factors in accordance with paragraphs 815-20-25-84 through 25-85:
a. The hedging instrument’s underlying matches the index upon which plastic
purchases will be determined (that is, the JP Index).
b. The notional of the hedging instrument matches the forecasted quantity
designated as the hedged item.
c. The date on which the derivatives mature matches the timing in which the
forecasted purchases are expected to be made. That is, the quantity of the
hedged item, 80,000 pounds, is an aggregate amount expected to be

purchased over the course of the respective month (that is, the same
31-day period) in which the derivative matures.
d. Each hedging instrument was traded with at-market terms (that is, it has
an initial fair value of zero).
e. Assessment of effectiveness will be performed on the basis of the total
change in the fair value of the hedging instrument.
f. Although the amount of plastic being hedged each period is a cumulative
amount across multiple grades of plastic, the basis differentials between
grades of plastic and location are not required to be included in
assessments of effectiveness because Entity Q has designated the
variability in cash flows attributable to changes in the JP index (the
contractually specified component) as the hedged risk within its purchases
of plastics.

5.3.70 Hedging a group of transactions: First-payments-

received (paid) approach on a group of variable-rate
loans

Excerpt from ASC 815-20

>>>> First-Payments-Received Technique in Hedging Variable Interest

Payments on a Group of Loans
55-33A A first-payments-received technique for identifying the hedged
forecasted transactions (that is, the hedged interest payments) may be used in
a cash flow hedge of interest rate risk associated with interest payments for a
rolling portfolio of prepayable interest-bearing loans (or other interest-bearing
financial assets), provided all other conditions for a cash flow hedge have been
met. Such a technique involves identifying the hedged forecasted transactions
in a cash flow hedge as the first interest payments based on the contractually
specified interest rate received by an entity during each recurring period of a
specified length and beginning date for the period covered by the hedging
instrument. Example 4, Case A (see paragraphs 815-20-55-91 through 55-96)
illustrates this technique.
55-33B Similarly, a comparable first-payments-made technique may be used to
identify the hedged forecasted transactions in a cash flow hedge of the
contractually specified rate-based interest payments for a group of the
reporting entity’s financial liabilities, provided all other conditions for a cash
flow hedge have been met.
55-33E This implementation guidance regarding use of a first-cash-flows
technique also may be applied to a cash flow hedging relationship in which the
hedging instrument is a basis swap as discussed beginning in paragraph 815-
20-25-50. However, use of that technique for those basis-swap hedging
relationships may not be common because that paragraph limits designating a
basis swap as the hedging instrument to cash flow hedges of the contractually
specified interest payments of only recognized financial assets and liabilities
existing at the inception of the hedge, whereas the first-cash-flows technique
is typically applied to the contractually specified interest payments for rolling

portfolios whose composition of financial assets changes over the period of

the hedge.

In a cash flow hedge of interest rate risk, an entity may use a first-
payments-received (paid) approach for identifying the hedged forecasted
transaction. This approach can be used for interest rate risk associated with
interest payments for a rolling portfolio of prepayable interest-bearing loans, or
other interest-bearing financial assets, provided all other conditions for a cash
flow hedge are met.
When using this approach, the specifically identified group of transactions may
be the first interest payments based on the contractually specified interest rate
received by an entity during each recurring period of a specified length and
beginning date for the period covered by the hedging instrument.
For example, an entity may specifically identify the hedged forecasted
transaction as the first three-month LIBOR-based interest payments received
each quarter for the next two years on its $100 million LIBOR-based loan.
See Example 4 in Subtopic 815-20 (reproduced below) for an illustration of
hedging variable interest payments on a group of variable-rate loans.

Question 5.3.70
Can the first-payments-received (paid) approach be
used to hedge credit risk?
Interpretive response: No. We believe that when the designated risk being
hedged is the risk of changes in cash flows solely attributable to credit, the
entity must document the specific asset or liability for which the forecasted
transaction relates.
In other words, no replacement or substitution is permitted without affecting
the original hedging relationship.

Question 5.3.80
How does an entity assess whether the cash flows
from variable-rate financial instruments share the
same risk exposure?
Interpretive response: Under the first-payments-received (paid) approach, an
entity is hedging forecasted interest payments for a group of variable-rate
financial instruments for exposure to changes in cash flows attributable to
changes in an interest rate index (i.e. the contractually specified interest rate).
Under this approach, each variable-rate financial instrument within the group
must vary with the same interest rate index to qualify for hedge accounting
with a single derivative instrument. [815-20-55-23]
Therefore, three-month LIBOR-based interest payments cannot be grouped
with US Prime-based interest payments, even if a historical analysis of the
movement in these rates indicates they are highly correlated.

We believe the same index is interpreted to be exactly the same index. For
example, if a particular interest rate is published on a 30-day and a 60-day basis,
an interest payment that varies on a 30-day rate and an interest payment that
varies on a 60-day rate would not vary with the same index. Therefore, they
would not be eligible for grouping as a single hedged transaction.
However, in a March 2018 meeting, the FASB discussed potential
Codification improvements related to an entity’s ability to change the hedged
risk and whether that extends to the hedged forecasted transaction (see
Question 5.4.90). These amendments may provide additional guidance that
could affect our interpretation that each variable-rate financial instrument must
have exactly the same index to be eligible for grouping in a portfolio hedge. As a
result, revisions to this interpretive response may be provided in a future
edition.

Example 5.3.40
Group of variable-rate loans that do not share similar
risk exposure
Bank has a pool of variable-rate commercial mortgages. The interest rates on
these mortgages are based on US Treasury, Canadian Treasury or LIBOR. A
historical analysis of the movement in these rates indicates that they are highly
correlated.
Can Bank designate the pool of variable-rate commercial mortgages as
the hedged transaction in a cash flow hedge of interest rate risk?
No. The forecasted interest payments on several variable-rate debt instruments
must vary with the same index to qualify for hedge accounting with a single
derivative instrument. Therefore, Bank cannot designate the pool of commercial
mortgages with interest rates based on multiple indices as the hedged
transaction in a cash flow hedge.

FASB Example: Variable interest payments on a group of

variable-rate, interest-bearing loans as hedged item

Excerpt from ASC 815-20

>> Example 4: Variable Interest Payments on a Group of Variable-Rate,

Interest-Bearing Loans as Hedged Item

55-88 The following Cases illustrate the implications of two different

approaches to designation of variable interest payments on a group of variable-
rate, interest-bearing loans:
a. Designation based on first payments received (Case A)
b. Designation based on a specific group of individual loans (Case B).

55-89 For Cases A and B, assume Entity A and Entity B both make to their
respective customers London Interbank Offered Rate- (LIBOR-) indexed
variable-rate loans for which interest payments are due at the end of each
calendar quarter, and the LIBOR-based interest rate resets at the end of each
quarter for the interest payment that is due at the end of the following quarter.
Both entities determine that they will each always have at least $100 million
of those LIBOR-indexed variable-rate loans outstanding throughout the next
3 years, even though the composition of those loans will likely change to some
degree due to prepayments, loan sales, and potential defaults.
55-90 This Example does not address cash flow hedging relationships in which
the hedged risk is the risk of overall changes in the hedged cash flows related
to an asset or liability, as discussed in paragraph 815-20-25-15(j)(1).
>>> Case A: Designation Based on First Payments Received
55-91 In this Case, Entity A wishes to hedge its interest rate exposure to
changes in the quarterly interest receipts on $100 million principal of those
LIBOR-indexed variable-rate loans by entering into a 3-year interest rate swap
that provides for quarterly net settlements based on Entity A receiving a fixed
interest rate on a $100 million notional amount and paying a variable LIBOR-
based rate on a $100 million notional amount.
55-92 In a cash flow hedge of interest rate risk, Entity A may identify the
hedged forecasted transactions as the first LIBOR-based interest payments
received by Entity A during each 4-week period that begins 1 week before
each quarterly due date for the next 3 years that, in the aggregate for each
quarter, are payments on $100 million principal of its then existing LIBOR-
indexed variable-rate loans. The LIBOR-based interest payments received by
Entity A after it has received payments on $100 million aggregate principal
would be unhedged interest payments for that quarter.
55-93 The hedged forecasted transactions for Entity A in this Case are
described with sufficient specificity so that when a transaction occurs, it is
clear whether that transaction is or is not the hedged transaction.
55-94 Because Entity A has designated the hedging relationship as hedging the
risk of changes attributable to changes in the LIBOR interest rate in Entity A’s
first LIBOR-based interest payments received, any prepayment, sale, or credit
difficulties related to an individual LIBOR-indexed variable-rate loan would not
affect the designated hedging relationship.
55-95 Provided Entity A determines it is probable that it will continue to receive
interest payments on at least $100 million principal of its then existing LIBOR-
indexed variable-rate loans, Entity A can conclude that the hedged forecasted
transactions in the documented cash flow hedging relationships are probable
of occurring.
55-96 An entity may not assume perfect effectiveness in such a hedging
relationship as described in paragraph 815-20-25-102 because the hedging
relationship does not involve hedging the interest payments related to the
same recognized interest-bearing loan throughout the life of the hedging
relationship. Consequently, at a minimum, Entity A must consider the timing of
the hedged cash flows vis-à-vis the swap’s cash flows when assessing
effectiveness.

>>> Case B: Designation Based on a Specific Group of Individual Loans

55-97 In this Case, Entity B wishes to hedge its interest rate exposure to
changes in the quarterly interest receipts on $100 million principal of those
LIBOR-indexed variable-rate loans by entering into a 3-year interest rate swap
that provides for quarterly net settlements based on Entity B receiving a fixed
interest rate on a $100 million notional amount and paying a variable LIBOR-
based rate on a $100 million notional amount. Entity B initially designates cash
flow hedging relationships of interest rate risk and identifies as the related
hedged forecasted transactions each of the variable interest receipts on a
specified group of individual LIBOR-indexed variable-rate loans aggregating
$100 million principal but then some of those loans experience prepayments,
are sold, or experience credit difficulties.
55-98 This Case addresses whether the original cash flow hedging
relationships remain intact if the composition of the group of loans whose
interest payments are the hedged forecasted transactions is changed by
replacing the principal amount of the specified loans with similar variable-rate
interest-bearing loans. Entity B cannot conclude that the original cash flow
hedging relationships have remained intact if the composition of the group of
loans whose interest payments are the hedged forecasted transactions is
changed by replacing the principal amount of the originally specified loans with
similar variable-rate interest-bearing loans. Paragraph 815-20-25-15(a) requires
that, for a cash flow hedge, the forecasted transaction be specifically identified
as a single transaction or group of transactions. At inception, the entity
designated cash flow hedging relationships for each of the variable interest
receipts on a specified group of variable-rate loans. If a loan within the group
experiences a prepayment, has been sold, or experiences an unexpected
change in its expected cash flows due to credit difficulties, the remaining
hedged interest payments to Entity B specifically related to that loan are now
no longer probable of occurring. Pursuant to paragraphs 815-30-40-1 through
40-3, Entity B must discontinue the hedging relationships with respect to the
hedged forecasted transactions that are now no longer probable of occurring.
However, had the hedged forecasted transactions been designated in a
manner similar to that described in Case A, the consequences of a loan’s
prepayment, a loan sale, or an unexpected change in a loan’s expected cash
flows due to credit difficulties would not have been the same. How the
forecasted transaction in a cash flow hedge is designated can have a
significant effect on the application of the Derivatives and Hedging Topic.
55-99 Changing the composition of the specified individual loans within the
group of variable-rate interest-bearing loans due to prepayment, a loan sale, or
an unexpected change in a loan’s expected cash flows due to credit difficulties
reflects a change in the probability of the identified hedged forecasted
transactions for the hedging relationships related to the individual loans
removed from the group of variable-rate interest-bearing loans. Consequently,
the hedging relationships for future interest payments that are no longer
probable of occurring must be terminated. The provisions related to
immediately reclassifying a derivative instrument's gain or loss out of
accumulated other comprehensive income into earnings are based on the
hedged forecasted transaction being probable that it will not occur—not no
longer being probable of occurring—and includes consideration of an additional
two-month period of time. After the discontinuation of the hedging
relationships for interest payments related to the individual loans removed

from the group of variable-rate interest-bearing loans and the reclassification

into earnings of the net gain or loss in accumulated other comprehensive
income related to those hedging relationships, the derivative instrument (or a
proportion thereof) specifically related to the hedging relationships that have
been terminated is eligible to be redesignated as the hedging instrument in a
new cash flow hedging relationship. However, paragraph 815-30-40-5 warns
that a pattern of determining that hedged forecasted transactions are probable
of not occurring would call into question both the entity’s ability to accurately
predict forecasted transactions and the propriety of using hedge accounting in
the future for similar forecasted transactions.

5.3.80 Hedging a group of transactions: Layering with first-

payments-received (paid) approach
When hedging groups of forecasted transactions using a first-payments-
received (paid) approach, an entity may choose to enter into multiple derivative
contracts and layer these contracts such that each derivative is designated in a
separate individual hedging relationship.
For example, an entity has a LIBOR-based loan portfolio in excess of $1 billion
in principal. The entity currently has two swaps that it wishes to use to hedge
the variability in some of the interest payments from the portfolio. While the
entity intends to hold these swaps to maturity, it may elect to add more swaps
in the future as the principal of the portfolio grows or as the entity decides to
hedge more interest payments from the existing portfolio.
The illustration below demonstrates an example layering approach where an
entity identifies the hedged transactions in two separate hedging relationships.

Hedged transaction Hedging instrument Hedging relationship

$1bn LIBOR-based

First interest payments

$100m Swap 1: 1st hedging
received on principal of
loan portfolio

$100 million notional relationship

$100 million

$150m Interest payments

Swap 2: 2nd hedging
received on the next $150
$150 million notional relationship
million of principal

This example is in the context of hedging interest receipts. However, the

layering approach for first-payments-received (paid) can be applied to other
forecasted transactions, including forecasted sales or expenses in a foreign
currency, sales of nonfinancial items, etc.

Question 5.3.90
How does an entity specifically identify the
forecasted transaction when using the layering
approach for first-payments-received (paid)?
Interpretive response: For each hedging relationship within the layer, an entity
should specifically identify the hedged forecasted transaction as the first
payments received (paid) after:
1. cash flows identified as hedged forecasted transactions in an active
hedging relationship; and
2. probable cash flows previously identified in a hedging relationship that was
terminated (i.e. is inactive), such that some portion of the gain or loss on
the dedesignated hedging relationship remains in AOCI.
We believe that using this layering approach meets all the requirements in
Topic 815 to identify – for each of the individual hedging relationships – the
hedged forecasted transactions with sufficient specificity, meaning the
transaction being hedged can be identified when it occurs.
Formal documentation. An entity is required to apply a hedge documentation
approach that considers the ‘priority chain’ when designating forecasted
transactions. This is because complexities arise when an entity is:
— actively managing groups of existing relationships (e.g. terminating or
dedesignating derivatives before maturity); or
— experiencing shortfalls of forecasted transactions.
The following questions and examples in this section provide our view on how
to address such complex hedging situations.

Question 5.3.100
If additional layers are added, or if existing layers
are removed, is an entity required to dedesignate
and redesignate other hedging relationships within
the layers?
Interpretive response: No. We believe the layering approach provides an entity
with the flexibility to add additional hedging relationships (i.e. add layers) and/or
remove existing relationships (i.e. remove layers), without having to
dedesignate and redesignate other hedging relationships. This is because no
change to the identification of the hedged forecasted transactions associated
with the other relationships is required.
The designation of each relationship will always identify the hedged forecasted
transactions as the first payments received after:
1. cash flows identified as hedged forecasted transactions in an active
hedging relationship; and
2. probable cash flows previously identified in a hedging relationship that was
terminated (i.e. is inactive), such that some portion of the gain or loss on
the dedesignated hedging relationship remains in AOCI.

Adding a layer
Adding a derivative to the existing layers will put that relationship at the end of
the priority chain, such that it will be designated as hedging the first forecasted
transactions occurring after (1) and (2) above, without affecting the designation
of those earlier relationships.
For example, an entity has two active hedging relationships:
— Swap 1 is designated as hedging the first interest payments made on
$100 million of principal of a LIBOR-based loan portfolio and is currently
hedging interest payments on principal $1–$100 million.
— Swap 2 is designated as hedging the first interest payments made on
$150 million of principal of a LIBOR-based loan portfolio and is currently
hedging interest payments on principal $100,000,001–$250 million.
The following illustration summarizes the two active hedging relationships.

Hedged transaction Hedging instrument Hedging relationship

$1bn LIBOR-based

First interest payments

$100m Swap 1: 1st hedging
received on principal of
loan portfolio

$100 million notional relationship

$100 million

$150m Interest payments

Swap 2: 2nd hedging
received on the next $150
$150 million notional relationship
million of principal

The entity could designate the first payments received on the next $50 million
of principal of the LIBOR-based loan portfolio that (1) are not currently being
hedged by a previously designated hedging relationship earlier in the priority
chain or (2) were not included in a terminated hedging relationship with
amounts remaining in AOCI earlier in the priority chain.

$100m 1st hedging relationship

$1bn LIBOR-based
loan portfolio

$150m 2nd hedging relationship

Hedged transaction Hedging instrument Hedging relationship

$50m
First interest payments Additional swap with 3rd hedging
received each month on the $50 million notional relationship
next $50 million of principal

Removing a layer
If a derivative matures such that a relationship earlier in the priority chain
terminates, the forecasted transactions for hedging relationships later in the
priority chain will not be affected. This is because an entity would continue to
hedge the first payments received after:
1. those that are already hedged in active hedging relationships; and
2. those that were previously identified in a hedging relationship that has been
terminated with amounts remaining in AOCI.

If no amounts remain in AOCI, the forecasted transactions with active

relationships or inactive relationships that continue to have amounts in AOCI
will move up in the priority chain. This is because the original identification of
the forecasted transaction has been described with sufficient specificity to
identify it when it occurs and has not changed as a result of the maturity.
For example, if Swap 1 matured, the first hedging relationship would be
discontinued and the second and third hedging relationships would continue. If
no gains/losses related to Swap 1 remained in AOCI, the second and third
hedging relationships would move up the priority chain. Alternatively, if Swap 1
was terminated early and some of its gains/losses remained in AOCI, the
second and third hedging relationships would not move up the priority chain.

Amounts remaining in No amounts remaining in

AOCI for Swap 1 AOCI for Swap 1

$100m 1st hedging relationship

$1bn LIBOR-based

$150m 2nd hedging relationship

loan portfolio

$150m 2nd hedging relationship $50m 3rd hedging relationship

$50m 3rd hedging relationship

For guidance on when amounts related to a swap are reclassified from AOCI,
see section 6.3.10. In general, the gain or loss related to a derivative that is
terminated before maturity remains in AOCI unless it is probable that the
forecasted transaction will not occur.
Hedge effectiveness. When a relationship moves up in the priority chain, the
perfectly effective hypothetical (PEH) derivative instrument associated with that
relationship must be adjusted to reflect the most recent best estimate of the
forecasted transactions that are identified with that relationship for purposes of
assessing hedge effectiveness. For further discussion of the PEH derivative,
see section 9.7.30.

Question 5.3.110
When does a hedging relationship move up the
priority chain into a vacated tranche of a
discontinued hedging relationship?
Interpretive response: We believe when an entity dedesignates a hedging
relationship under the layering approach, all the ongoing relationships occurring
later in the priority chain maintain their position until all amounts associated with
the discontinued relationship have been reclassified from AOCI. However, the
ongoing relationships could be repositioned in the priority chain through a
formal dedesignation and redesignation (see Question 5.3.120).

Continuing the layering approach example in Question 5.3.100, assume Swap 1

is terminated early and only interest payments on $150 million of principal
remain probable.

Correct: Swap 2 maintains Incorrect: Swap 2 automatically

position in priority chain moves up in priority chain
Interest
1st hedging relationship payments
$1bn LIBOR-based

$100m terminated with amounts of $150

2nd hedging relationship
loan portfolio

remaining in AOCI $150m

million
remain
$150m 2nd hedging relationship probable

For Swap 1, no reclassification of amounts from AOCI is necessary because the

first payments received on $100 million of principal (determined based on its
original position in the priority chain) are still probable.
Swap 2 maintains its position in the priority chain:

Correct: Swap 2 maintains position in Incorrect: Swap 2 automatically

priority chain moves up in priority chain
Swap 2’s relationship must be fully or Swap 2’s relationship may continue
partially discontinued because the undisturbed.
relationship is no longer expected to Interest payments on $150 million are
be highly effective and a portion of the still probable and the first payments
forecasted transaction is no longer received can be attributed entirely to
probable of occurring (see Swap 2 because it has moved up into
section 6.5.20). Swap 1’s position in the priority chain.
Swap 2 has a notional amount of
$150 million and only interest payments
on $50 million remain probable after
interest payments on the first
$100 million of principal continue to be
identified with Swap 1 to support
retaining amounts in AOCI.

An entity is required to discontinue hedge accounting for those specific hedged

forecasted transactions that are no longer probable.
The entity is required to reclassify amounts from AOCI for any specific
forecasted transactions that it is probable will not occur (i.e. interest payments
related to $100 million of the principal balance). For guidance on the
discontinuation of hedge accounting when it is probable a forecasted
transaction will not occur, see section 6.5.20.
Missed forecast. If it is probable that a forecasted transaction will not occur, an
entity must consider this missed forecast when evaluating whether it has a
pattern of missing forecasts that calls into question its ability to predict future
transactions (see Question 6.5.110).

Question 5.3.120
Can a new or redesignated hedging relationship
replace a vacated tranche earlier in the priority
chain?
Interpretive response: Yes. Ongoing relationships can be repositioned in the
priority chain through a formal dedesignation and redesignation, with certain
limitations (see Question 5.3.140).
Continuing with the example in Question 5.3.110 assuming Swap 1 was
terminated, the entity would be permitted to formally redesignate a new
relationship using Swap 2 to hedge the first payments received on $150 million
of principal without regard to the fact that the interest payments on $100 million
of that $150 million in expected remaining principal are also supporting the
retention of amounts in AOCI related to Swap 1.

Before redesignation of After redesignation of

nd nd
2 hedging relationship 2 hedging relationship

Interest
$1bn LIBOR-based

1st hedging relationship

payments
loan portfolio

$100m terminated with amounts Redesignated 2nd hedging of $150

remaining in AOCI $150m
relationship million
remain
$150m 2nd hedging relationship probable

We believe this strategy executed through formal redesignation is appropriate

because:
— it requires recognition in the financial statements for the effect of a shortfall
in forecasted transactions based on each relationship’s original position in
the priority chain;
— it does not allow an entity to cherry pick which amounts from AOCI will be
reclassified from the shortfall – a shortfall will always affect the last
relationship in the priority chain first regardless of which swaps are
terminated or dedesignated; and
— it requires an entity that must stop a hedging relationship due to a shortfall
in forecasted transactions to formally redesignate that hedging relationship
to continue hedge accounting.

Question 5.3.130
If a hedging relationship within a priority chain is
redesignated, what happens to the hedging
relationships later in the priority chain?
Interpretive response: When a hedging relationship is dedesignated within a
priority chain and amounts remain in AOCI for that relationship, for an entity to
formally re-hedge the position that was vacated (with a new or existing

derivative), it needs to redesignate all the relationships that follow the

dedesignated relationship in the priority chain.
Therefore, it cannot re-order/re-position certain relationships within the priority
chain without formally redesignating all the relationships from the point at
which the chain was broken.
For example, assume the same facts and circumstances in the example used in
Question 5.3.120, except for the following:
— Swap 3 is designated as hedging interest payments on the next $50 million
of principal; and
— the entity terminates Swap 1, but interest payments on $200 million
principal remain probable.
If an entity wishes to re-hedge the position that Swap 1 vacated with one of the
remaining swaps, it needs to dedesignate both Swaps 2 and 3 and then
formally redesignate one or both, assuming there are enough interest payments
that remain probable.

Before redesignation After redesignation

1st hedging relationship Interest

$100m terminated with amounts Redesignated 2nd
$1bn LIBOR-based

payments
remaining in AOCI $150m of $200
hedging relationship
loan portfolio

million
$150m 2nd hedging relationship Redesignated 3rd remain
$50m probable
hedging relationship

$50m 3rd hedging relationship

Question 5.3.140
Can a new hedging relationship be inserted earlier
in the priority chain than an active hedging
relationship?
Interpretive response: No. If a new relationship is layered on to an existing
priority chain, that relationship must be designated to immediately follow the
latest active relationship in the chain without disturbing any of the other
relationships.
An entity may re-hedge a layer of forecasted transactions that was previously
identified in a terminated hedging relationship with amounts remaining in AOCI,
provided that terminated relationship was designated later in the priority chain
than the latest active hedging relationship.

Earlier in priority chain

Hedging relationship terminated

with amounts remaining in AOCI

New / redesignated
Latest active hedged relationship
hedging relationship

Hedging relationship terminated

with amounts remaining in AOCI

Later in priority chain

This occurs because the latest active relationship has not been dedesignated.
Therefore, it and all the relationships before it in the prior chain (active and
inactive for which amounts remain in AOCI), remain in their originally
designated positions.
For example, assume the entity in Question 5.3.100 started with just the two
original swaps (Swaps 1 and 2). The entity terminates Swap 1, but interest
payments on $250 million principal are still probable.
After considering Swap 2’s original position in the priority chain after terminated
Swap 1 – because amounts remain in AOCI for Swap 1 – forecasted interest
payments on $150 million of principal relationship remain probable and Swap 2
continues to be highly effective.
Assume the entity later elects to newly designate Swap 3. Swap 3 may be
designated to immediately follow Swap 2 without disturbing Swap 2’s
relationship, but it would also remain behind Swap 1. If swaps designated after
Swap 2 had been terminated with amounts remaining in AOCI, Swap 3 may re-
hedge interest payments on the inactive layers in the priority chain after
Swap 2.
This occurs because Swap 2’s relationship has not been dedesignated.
Therefore, Swap 2 and all the relationships before Swap 2 (active and inactive
for which amounts remain in AOCI – Swaps 1 and 2 in this case) remain in their
originally designated positions in the priority chain.
Therefore, for Swap 3 to be eligible for hedge accounting, in addition to the
other hedge accounting criteria, there must be probable forecasted interest
payments on principal equal to or greater than the notional amounts of Swap 1,
Swap 2 and Swap 3 combined.

1st hedging relationship terminated with Interest

$100m
$1bn LIBOR-based

amounts remaining in AOCI payments

loan portfolio

of $250
million
$150m 2nd hedging relationship remain
probable

3rd hedging relationship

In this example, there are not sufficient forecasted transactions that are
probable for Swap 3 to be eligible for hedge accounting.

Example 5.3.50
Layering approach: Swap matures and related
amounts reclassified from AOCI
Designation of original hedging relationships
ABC Corp. has five swaps, each with a notional amount of $10,000. ABC
wishes to hedge interest payments on $50,000 in total principal and designates
five different hedging relationships as follows.
— Swap 1 is designated as hedging the first interest payments made on
$10,000 of principal expected to occur each month for the next five years.
At inception of the hedge, Swap 1 is hedging interest payments on principal
$1–$10,000.
— Swap 2 is designated as hedging the first interest payments made on
$10,000 of principal expected to occur each month for the next five years
that (1) are not currently being hedged in another hedging relationship (i.e.
hedged by a swap that is earlier in priority – in this case Swap 1) or (2) were
not included in a terminated hedging relationship with amounts remaining in
AOCI earlier in the priority chain. No relationships currently fall into category
(2) because no relationships designated earlier in priority have been
discontinued after Swap 2’s designation. At inception of the hedge, Swap 2
is hedging interest payments on principal $10,001–$20,000.
— Swaps 3, 4 and 5 are all designated similar to the designation for Swap 2.
— All of the swaps have different maturities.
The following illustration summarizes the five hedging relationships.

Hedging Hedging
Hedged transaction
instrument relationship

$1– Interest payments on principal 1st hedging

Swap 1
$10,000 of $1–$10,000 relationship

$10,001– Interest payments on principal 2nd hedging

Swap 2
of $10,001–$20,000 relationship
$50,000 loan portfolio

$20,000

$20,001– Interest payments on principal 3rd hedging

Swap 3
$30,000 of $20,001–$30,000 relationship

$30,001– Interest payments on principal 4th hedging

Swap 4
$40,000 of $30,001–$40,000 relationship

$40,001– Interest payments on principal 5th hedging

Swap 5
$50,000 of $40,001–$50,000 relationship

Swap 3 matures and no amounts remaining in AOCI

When Swap 3 matures, the third hedging relationship is terminated and there
are no amounts remaining in AOCI.
The hedging relationships involving Swaps 1, 2, 4 and 5 continue.
When a swap in the priority chain matures and all amounts related to the
instrument have been reclassified out of AOCI, all the swaps that follow in the
priority chain move up automatically without being dedesignated/redesignated.
When Swap 3 matures, Swap 4 is still hedging the first interest payments made
on $10,000 of principal expected to occur each month for the next five years
that:
1. are not currently being hedged by a previously designated hedging
relationship earlier in the priority chain (Swaps 1 and 2); or
2. were not included in a terminated hedging relationship with amounts
remaining in AOCI earlier in the priority chain.
Therefore, Swaps 4 and 5 will move up in the priority chain. The following
illustration summarizes the hedging relationships after the maturity of Swap 3.

$1– Interest payments on principal 1st hedging

Swap 1
$10,000 of $1–$10,000 relationship

$10,001– Interest payments on principal 2nd hedging

Swap 2
of $10,001–$20,000 relationship
$50,000 loan portfolio

$20,000

$20,001– Interest payments on principal 4th hedging

Swap 4
$30,000 of $20,001–$30,000 relationship

$30,001– Interest payments on principal 5th hedging

Swap 5
$40,000 of $30,001–$40,000 relationship

$40,001–
$50,000

Hedge effectiveness. ABC is required to adjust the PEH derivatives associated

with the fourth and fifth hedging relationships to reflect any changes in the
most recent best estimates of forecasted transactions associated with the new
tranches of interest payments.

Example 5.3.60
Layering approach: Swap terminated and related
amounts not reclassified from AOCI
Assume the same facts and circumstances as in Example 5.3.50, except that
the hedging relationship involving Swap 3 is terminated early. However, all
amounts of the originally specified hedged forecasted transactions remain
probable, including the interest payments on principal $20,001–$30,000, which
were being hedged by Swap 3. Therefore, the amounts related to Swap 3 are
not immediately reclassified from AOCI.

The hedging relationships involving Swaps 1, 2, 4 and 5 continue.

When a swap in the priority chain is terminated and amounts related to the
hedging relationship have not been reclassified out of AOCI, all the swaps that
follow in the priority will not move up.
When Swap 3 is terminated, Swap 4 is still hedging the first interest payments
made on $10,000 of principal expected to occur each month for the next five
years that:
1. are not currently being hedged in a previously designated hedging
relationship earlier in the priority chain (Swaps 1 and 2), or
2. were not included in a terminated hedging relationship with amounts
remaining in AOCI earlier in the priority chain (Swap 3).
Therefore, Swaps 4 and 5 will not move up in the priority chain. The following
illustration summarizes the hedging relationships after the termination of
Swap 3.

$1– Interest payments on principal 1st hedging

Swap 1
$10,000 of $1–$10,000 relationship

$10,001– Interest payments on principal 2nd hedging

Swap 2
of $10,001–$20,000 relationship
$50,000 loan portfolio

$20,000

$20,001–
3rd hedging relationship terminated with amounts remaining in AOCI
$30,000

$30,001– Interest payments on principal 4th hedging

Swap 4
$40,000 of $30,001–$40,000 relationship

$40,001– Interest payments on principal 5th hedging

Swap 5
$50,000 of $40,001–$50,000 relationship

The gain or loss on Swap 3 is reclassified from AOCI when interest payments
on principal $20,001–$30,000 affect earnings. For further discussion on cash
flow hedge accounting, see section 6.2.10. Once amounts related to Swap 3
are fully reclassified out of AOCI, Swaps 4 and 5 will automatically move up in
the priority chain.
Hedge effectiveness. In this example, ABC does not adjust the PEH derivatives
associated with the fourth and fifth hedging relationships because they
continue to hedge the same tranche of forecasted transactions and their terms
have not changed.

Example 5.3.70
Layering approach: Additional swap terminated and
new swap designated at end of priority chain
Assume the same facts and circumstances as in Example 5.3.60, except that
ABC also terminates Swap 5 and amounts are not immediately reclassified from

AOCI. In addition, ABC obtains Swap 6 and wishes to designate a new hedging
relationship. This requires ABC to add Swap 6 to the end of the existing
priority chain.
An entity is not permitted to move the existing priority chain without
dedesignating and redesignating the current hedging relationships that were
originally designated as following the vacated tranche. Therefore, ABC is not
permitted to insert Swap 6 to hedge interest payments on principal $20,001–
$30,000 (the tranche previously hedged by Swap 3) without dedesignating and
redesignating Swap 4. This is because doing so would break the existing
priority chain.
Instead, ABC identifies Swap 6 as hedging the first interest payments made on
$10,000 of principal expected to occur each month for the next five years that:
1. are not currently being hedged in a previously designated hedging
relationship earlier in the priority chain (Swaps 1, 2 and 4); or
2. were not included in a terminated hedging relationship with amounts
remaining in AOCI earlier in the priority chain (Swap 3).
Swap 6 may fill in the position vacated by Swap 5. Although Swap 5 was
terminated before Swap 6's designation and related amounts remain in AOCI, it
was originally designated later in the priority chain than the latest active
relationship (i.e. Swap 4).
However, Swap 6 remains behind relationships designated earlier in the priority
chain than Swap 4 that were terminated with amounts remaining in AOCI (i.e.
Swap 3). This occurs because Swap 4's relationship has not been
dedesignated. Accordingly, the fourth hedging relationship and all the
relationships before it, both active and terminated with amounts remaining in
AOCI (i.e. Swaps 1-3), remain in their originally designated positions in the
priority chain.
This designation results in Swap 6 hedging interest payments on principal
$40,001–$50,000. The following illustration summarizes the hedging
relationships after the termination of Swap 5 and the addition of Swap 6.

$1– Interest payments on principal 1st hedging

Swap 1
$10,000 of $1–$10,000 relationship

$10,001– Interest payments on principal 2nd hedging

Swap 2
of $10,001–$20,000 relationship
$50,000 loan portfolio

$20,000

$20,001– 3rd hedging relationship terminated with amounts remaining in AOCI and was
$30,000 designated earlier in priority chain than Swap 4.

$30,001– Interest payments on principal 4th hedging

Swap 4
$40,000 of $30,001–$40,000 relationship

$40,001– Interest payments on principal 6th hedging

Swap 6
$50,000 of $40,001–$50,000 relationship

The gain or loss on Swaps 3 and 5 is reclassified from AOCI when interest
payments on principal $20,001–$30,000 and $40,001–$50,000 affect earnings,
respectively.
Hedge effectiveness. In this example, ABC does not adjust the PEH derivatives
associated with the first, second or fourth hedging relationships because they
continue to hedge the same tranches of forecasted transactions and their terms
have not changed.

Example 5.3.80
Layering approach: Swap terminated with interest
payments on a portion of principal remaining
probable
This example uses the same five hedging relationships originally designated in
Example 5.3.50.
ABC terminates Swap 3 and the hedging relationship is discontinued.
Additionally, interest on only $40,000 of principal remains probable. It is
probable that interest payments on $10,000 of principal will not occur.
Because interest payments on principal $20,001–$30,000 (i.e. Swap 3’s
forecasted transaction) are still probable, amounts related to Swap 3 will remain
in AOCI. Therefore, Swap 4 will not move up in priority and continues to hedge
interest payments on principal $30,001–$40,000.
Because it is probable that interest payments on principal $40,001–$50,000 will
not occur, ABC is required to terminate the original hedging relationship for
each of the forecasted transactions that are not probable. Therefore, ABC is
required to dedesignate Swap 5 and immediately reclassify any amounts in
AOCI into earnings.
The following illustration summarizes the hedging relationships after the
termination of Swaps 3 and 5.

$1– Interest payments on principal 1st hedging

Swap 1
$10,000 of $1–$10,000 relationship

$10,001– Interest payments on principal 2nd hedging

Swap 2
of $10,001–$20,000 relationship
$50,000 loan portfolio

$20,000

$20,001–
3rd hedging relationship terminated with amounts remaining in AOCI
$30,000

$30,001– Interest payments on principal 4th hedging

Swap 4
$40,000 of $30,001–$40,000 relationship

$40,001–
$50,000

The gain or loss on Swap 3 is reclassified from AOCI when interest payments
on principal $20,001–$30,000 affect earnings.
Hedge effectiveness. In this example, ABC does not adjust the PEH derivative
associated with the first, second or fourth hedging relationships because they
continue to hedge the same tranches of forecasted transactions and their terms
have not changed.

Example 5.3.90
Layering approach: Swap early in priority chain
matures subsequent to other swap terminations
Assume the same facts as in Example 5.3.80, except that Swap 1 matures after
the termination of Swaps 3 and 5. All amounts related to Swaps 1 and 5 have
been reclassified out of AOCI.
The hedging relationships involving Swaps 2 and 4 continue and move up the
priority chain. In addition, the amounts remaining in AOCI related to the
discontinued Swap 3 move up the priority chain.
The following illustration summarizes the hedging relationships after the
termination of Swaps 1, 3 and 5.

$1– Interest payments on principal 2nd hedging

Swap 2
$10,000 of $1–$10,000 relationship

$10,001– 3rd hedging relationship terminated with amounts remaining in AOCI

$50,000 loan portfolio

$20,000

$20,001– Interest payments on principal 4th hedging

Swap 4
$30,000 of $20,001–$30,000 relationship

$30,001–
$40,000

$40,001–
$50,000

The gain or loss on Swap 3 is reclassified from AOCI when interest payments
on principal $10,001–$20,000 affect earnings.
Hedge effectiveness. In addition, ABC is required to adjust the PEH derivatives
associated with the second and fourth hedging relationships to reflect any
changes in the most recent best estimates of forecasted transactions
associated with the new tranches of interest payments.

Example 5.3.100
Layering approach: Redesignation of swaps
Assume the same facts as in Example 5.3.80. However, ABC now wishes to
hedge all interest payments on principal that remains probable (i.e. $1–$40,000).
To hedge interest payments on $20,001–$30,000 that were previously hedged
by Swap 3, ABC needs to dedesignate and redesignate all swaps prioritized
later than Swap 3 (i.e. Swap 4). This is because a new swap cannot leapfrog
Swap 4 in the priority chain, as demonstrated in Example 5.3.70 (i.e. a new
swap cannot replace Swap 3’s position in the priority chain). As a reminder,
Swap 3 was previously terminated with amounts remaining in AOCI.
Therefore, ABC decides to dedesignate Swap 4 and formally redesignate both
Swaps 4 and 5 (similar to hedges in the previous examples) to hedge interest
payments on principal $20,001–$30,000 and $30,001–$40,000, respectively.
The newly redesignated Swap 4 may re-hedge the tranche previously hedged
by Swap 3, even though amounts remain in AOCI pertaining to Swap 3.
If any relationships had been designated earlier in the priority chain than Swap 2
and were terminated with amounts remaining in AOCI, Swaps 4 and 5 would
also remain behind those relationships because Swap 2's relationship had not
been dedesignated. Therefore, all the relationships designated before Swap 2 in
the priority chain (active and inactive for which amounts remain in AOCI) would
remain in their originally designated positions.
The following illustration summarizes the hedging relationships after the
redesignation of Swaps 4 and 5.

$1– Interest payments on principal 1st hedging

Swap 1
$10,000 of $1–$10,000 relationship

$10,001– Interest payments on principal 2nd hedging

Swap 2
of $10,001–$20,000 relationship
$50,000 loan portfolio

$20,000

$20,001– Interest payments on principal Redesignated 4th

Swap 4
$30,000 of $20,001–$30,000 hedging relationship

$30,001– Interest payments on principal Redesignated 5th

Swap 5
$40,000 of $30,001–$40,000 hedging relationship

$40,001–
$50,000

The gain or loss on Swap 3, which was terminated in Example 5.3.80, is

reclassified from AOCI when the related interest payments on principal $20,001–
$30,000 affect earnings. For amounts remaining in AOCI related to Swap 4 before
its dedesignation and redesignation, the gain or loss is reclassified from AOCI
when the related interest payments on principal $30,001–$40,000 affect
earnings.

5.3.90 All-in-one hedge

Excerpt from ASC 815-20

>> All-in-one hedge

25-21 Paragraph 815-10-15-4 states that, if a contract meets the definition of
both a derivative instrument and a firm commitment under the Derivatives and
Hedging Topic (as illustrated in Example 8 [see paragraph 815-20-55-111]), then
an entity shall account for the contract as a derivative instrument unless one of
the exceptions in this Topic applies. In that circumstance, either of the
following may be true:
a. The forecasted transaction and the derivative instrument used to hedge it
are with the same counterparty.
b. The derivative instrument is the same contract under which the entity
executes the forecasted transaction.
25-22 Assuming other cash flow hedge criteria are met, a derivative instrument
that will involve 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 a forecasted transaction that will occur upon gross
settlement of the derivative instrument itself (an all-in-one hedge). This
guidance applies to fixed-price contracts to acquire or sell a nonfinancial or
financial asset that are accounted for as derivative instruments under this Topic
provided the criteria for a cash flow hedge are met.
20 Glossary
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.

In many cases, a firm commitment (such as a forward contract) can itself meet
the definition of a derivative. If the derivative does not meet any of the scope
exceptions in Subtopic 815-10, it must be recorded at fair value through
earnings and cannot be designated as the hedged item or transaction in a fair
value or cash flow hedge. [815-10-15-4, 815-20-25-21]
However, if the derivative instrument (i.e. the contract) is expected to be
settled gross through a delivery of the underlying asset, an entity may
designate the derivative instrument as a hedge of the implicit forecasted
transaction that created the need for the fixed-price contract in the first place.
This is referred to as an ‘all-in-one’ hedge. [815-20-25-22]

Hedged transaction Hedging instrument

Implicit forecasted purchase
Fixed-price contract
or sale that created need for
(see qualifying criteria below)
the contract

An entity that is concerned about variability in cash flows from its forecasted
purchases or sales can economically fix the price of those purchases or sales by
entering into a fixed-price contract. If the fixed-price purchase or sale contract is
a derivative instrument, it is eligible to be a hedging instrument. In addition, the
entity may hedge the forecasted purchase or sale that implicitly caused it to
enter into the fixed-price contract.
An all-in-one hedge is most commonly used with forecasted transactions
related to nonfinancial assets, where contracts for the purchase or sale of a
commodity that is readily convertible to cash do not meet the ‘normal
purchases and normal sales’ scope exclusion. However, all-in-one hedges can
also be applied to financial assets. Examples 5.3.110 and 5.3.120 illustrate the
application of all-in-one hedges for nonfinancial assets and financial assets,
respectively. [815-20-25-22]
The criteria that must be met for a contract to qualify for designation in an all-in-
one hedge are summarized in the following diagram.

Qualifying criteria for designation as hedging instrument in an all-in-one hedge

(all criteria must be met)

Contract meets the definition of a firm commitment (see section 3.3.20)

Contract meets the definition of a derivative and does not qualify for any scope
exceptions in Subtopic 815-10

Contract is expected to be settled gross

Gross settlement of a contract involves delivery of an asset in exchange for

payment of cash or other assets. This is different from net settlement, which
typically involves payment for the change in a contract’s value. [815-20-55-112]
In addition to the contract meeting the above criteria to be the hedging
instrument, the implicit forecasted purchase or sale needs to meet the
qualifying criteria to be designated as a hedged transaction in a cash flow
hedge. This includes a requirement that the implicit forecasted transaction
presents an exposure to variations in cash flows for the hedged risk that could
affect earnings. [815-20-25-15(c)(2)]
The contract meets the definition of a firm commitment only if its price is fixed.
However, the implied forecasted purchase or sale exposes an entity to
variability in cash flows (which is a requirement to be a hedged transaction)
because the total consideration paid or received is variable. Total consideration
is the fixed amount of cash paid or received and the fair value of the fixed-price
purchase or sale contract, which is a derivative instrument recognized as an
asset or liability that may fluctuate over time. [815-20-55-113 – 55-114]

Question 5.3.150
Which risks are eligible to be designated in an all-in-
one hedge?
Interpretive response: An all-in-one hedge must be a hedge of total variability
in cash flows (i.e. total price risk), not a hedge of a contractually specified
component.
Topic 815 allows an entity to designate a contractually specified component of a
hedged transaction. However, the proportion of a derivative that is designated as
the hedging instrument must have the same risk exposure profile as the entire
derivative instrument (see section 2.6.30). Therefore, an entity cannot designate a
contractually specified component of the derivative as the hedging instrument.
Because the derivative instrument is the same contract under which the
transactions will be purchased or sold, we believe an entity is precluded from
designating a contractually specified component as the hedged risk.

Example 5.3.110
All-in-one hedge of forecasted sales of gold
Goldco wants to manage the price risk associated with forecasted sales of gold.
To do so, it enters into a forward contract to sell gold at a fixed price.
The forward gold sales contract contains a net settlement provision and meets
the definition of a derivative instrument. The contract does not meet any of the
scope exclusions in Subtopic 815-10.
As a derivative instrument, the forward gold sales contract is recorded at fair
value with changes in fair value reported in earnings. However, the forward
contract may be designated as an all-in-one hedge of total price risk provided
the contract is expected to be settled gross. Goldco expects to deliver the gold
in exchange for cash.
Goldco can designate the fixed-price forward gold sales contract (i.e. the
derivative instrument) as a cash flow hedge of the variability of the
consideration to be received for the sale of gold (i.e. the forecasted transaction)
even though the derivative instrument is the same contract under which the
gold itself will be sold.

Example 5.3.120
All-in-one hedge of forecasted sales of loans
Bank wants to manage the total price risk associated with forecasted sales of
loans that it originates by entering into a forward loan sale agreement to sell
mortgage loans at a fixed price.
The forward contract meets the definition of a firm commitment and a
derivative. The contract does not meet any of the scope exclusions in
Subtopic 815-10.

Bank expects to gross settle the contract by transferring the mortgage loans in
exchange for cash. Therefore, all criteria have been met for an all-in-one hedge
of total price risk.
Bank can designate the fixed-price forward loan sales agreement (i.e. the
derivative instrument) as a cash flow hedge of the variability of the
consideration to be received for the sale of mortgage loans (i.e. the forecasted
transaction) even though the derivative instrument is the same contract under
which the mortgage loans themselves will be sold.

Question 5.3.160
Is an all-in-one hedge assumed to be perfectly
effective?
Interpretive response: It depends. If the hedging relationship is designated at
the inception of the fixed price contract and the contract is at market terms (i.e.
contract has a fair value of zero), we believe an entity can assume that the all-in-
one hedging relationship will be perfectly effective.
Under these circumstances, changes in the fair value of the derivative
instrument (i.e. the contract) are expected to entirely offset the change in cash
flows attributable to the change in the entire price of the hedged transaction.
This is because the hedged transaction and the hedging instrument are in effect
the same. Therefore, an entity may use the critical terms match method to
assess effectiveness of an all-in-one hedge. For further guidance on the
conditions that must be met to apply the critical terms match method, which
assumes perfect effectiveness, see section 9.4.
If the hedging relationship is not designated at inception of the fixed price
contract, the contract will not have a fair value of zero at inception of the
hedging relationship. This may result in a hedge that is not perfectly effective.
See section 9.7 for guidance on assessing effectiveness of cash flow hedges
when the critical terms are not the same – e.g. because the fair value of the
forward contract is not zero at inception of the hedging relationship.

FASB Example: All-in-one hedges

Excerpt from ASC 815-20

>> Example 8: All-in-One Hedges

55-111 The following Cases illustrate the application of paragraph 815-20-25-

21:
a. Purchase of a nonfinancial asset (Case A)
b. Purchase of a financial asset (Case B).
55-112 Settling a forward contract gross involves delivery of an asset in
exchange for the payment of cash or other assets and is differentiated from

settling net, which typically involves a payment for the change in a contract’s
value as the method of settling the contract.
55-113 A forecasted purchase or sale meets the definition of forecasted
transaction and, if it is probable, meets the criteria in paragraph 815-20-25-15
for designation as a hedged transaction. An entity concerned about variability in
cash flows from its forecasted purchases or sales can economically fix the
price of those purchases or sales by entering into a fixed-price contract.
Because the fixed-price purchase or sale contract is a derivative instrument, it
is eligible for use as a hedging instrument.
55-114 The forecasted purchase or sale at a fixed price is eligible for cash flow
hedge accounting because the total consideration paid or received is variable.
The total consideration paid or received for accounting purposes is the sum of
the fixed amount of cash paid or received and the fair value of the fixed price
purchase or sale contract, which is recognized as an asset or liability, and
which can vary over time.
>>> Case A: Purchase of a Nonfinancial Asset
55-115 Entity A plans to purchase a nonfinancial asset. To fix the price to be
paid (that is, to hedge the price), Entity A enters into a contract that meets the
definition of a firm commitment with an unrelated party to purchase the asset
at a fixed price at a future date. Assume that the terms of the contract (such as
net settlement under the default provisions) or the nature of the asset cause
the contract to meet the definition of a derivative instrument and the contract
is not excluded by paragraphs 815-10-15-13 through 15-82 from the scope of
the Derivatives and Hedging Topic. As such, Entity A has entered into a
derivative instrument under which it is expected to take delivery of the asset.
Entity A may designate the fixed-price purchase contract (that is, the derivative
instrument) as a cash flow hedge of the variability of the consideration to be
paid for the purchase of the asset (that is, the forecasted transaction) even
though the derivative instrument is the same contract under which the asset
itself will be acquired.
>>> Case B: Purchase of a Financial Asset
55-116 Entity B plans to purchase U.S. government bonds and expects to
classify those bonds in its available-for-sale portfolio. To fix the price to be paid
(that is, to hedge the price), Entity B enters into a contract that meets the
Derivatives and Hedging Topic's definition of a firm commitment with an
unrelated party to purchase the bonds at a fixed price at a future date. Assume
the contract meets the definition of a derivative instrument and is not excluded
by paragraphs 815-10-15-13 through 15-82 from the scope of this Topic. As
such, Entity B has entered into a derivative instrument under which it is
expected to take delivery of the asset. Entity B may designate the fixed-price
purchase contract (that is, the derivative instrument) as a cash flow hedge of
the variability of the consideration to be paid for the purchase of the bonds
(that is, the forecasted transaction) even though the derivative instrument is
the same contract under which the asset itself will be acquired.

5.4 Eligibility of hedged risks

Criterion 1 Criterion 2 Criterion 3 Criterion 4

Eligibility of Eligibility of
Eligibility of Hedge
hedged items hedging
hedged risk(s) effectiveness
or transactions instruments

Criterion 5: Formal documentation

Sections 2.3 and 2.4 provide an overview of the eligible hedged risks for both
financial and nonfinancial instruments, including limitations on certain risks for
hedged transactions.
Section 5.4 provides detail around eligibility criteria of hedged risks that are
specific to cash flow hedges, including:
— contractually specified component price risk for nonfinancial items (see
sections 5.4.10 to 5.4.30);
— interest rate risk on the forecasted issuance or purchase of debt
instruments (see sections 5.4.40 to 5.4.50); and
— changing the hedged risk (see section 5.4.60).

Foreign currency risk. For further guidance on foreign currency risk as it

relates to cash flow hedges, see chapter 7.

5.4.10 Contractually specified component price risk for

nonfinancial items

Excerpt from ASC 815-20

>>>> Determining Whether a Contractually Specified Component Exists

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 will be 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 commodities
exchange it is noted that prices are 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. After an entity determines that a
contractually specified component exists, it must assess whether the variability
in cash flows attributable to changes in the contractually specified component
may be designated as the hedged risk in accordance with paragraphs 815-20-
25-22A through 25-22B.

20 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.

Price risk. For a cash flow hedge of a forecasted transaction that involves a
nonfinancial asset or liability, an entity is permitted to designate either:
— all changes in the purchase price or sales price (i.e. total price risk); or
— a contractually specified component of the purchase or sale of a
nonfinancial asset or liability (i.e. contractually specified component price
risk).
A contractually specified component is 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.
Additionally, 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 will be purchased or sold. [815-20 Glossary,
815-20-55-26A]

Once a contractually specified component is identified, it needs to be included

in either:

Existing contracts — An existing contract that meets the definition of a

(section 5.4.20) derivative and qualifies for the normal purchases and
normal sales scope exception, which requires a price
based on an underlying that is clearly and closely related
to the asset being sold or purchased. [815-20-25-22A(a)]
or
— An existing contract that does not meet the definition of a
derivative and includes a price based on an underlying
that is clearly and closely related to the asset being sold
or purchased. [815-20-25-22A(b)]

Not-yet-existing A not-yet-existing contract if the entity expects that the

contracts contract, when executed, will meet the criteria outlined for
(section 5.4.30) existing contracts. [815-20-25-22B]

Example 5.4.10
Contractually specified component
At the beginning of Year 1, ABC Corp. enters into a contract to purchase natural
gas at Location 1. The contract specifies the purchase price per unit of measure
as the NYMEX Henry Hub futures price plus a fixed basis reflecting local
supply/demand and transportation.
The NYMEX Henry Hub futures price meets the definition of a contractually
specified component. Therefore, ABC is eligible to designate the NYMEX Henry
Hub futures price as the hedged risk in its cash flow hedge of forecasted
purchases of natural gas.

Question 5.4.10
Can an entity hedge an index or rate that is not
specified in the contract?

Background: A contract to buy or sell a nonfinancial asset is based on a price

that is derived/calculated by reference to another index or rate pursuant to
market convention. The contract does not specify how the price is calculated.
Interpretive response: No. We believe the FASB’s intent in permitting hedges
of components (e.g. indices, rates) is to allow such hedges only when the
components are specified in the contract or a contract that supports the price.
The FASB considered, but rejected, an approach that would have permitted
hedge accounting for components that are not contractually specified when it is
market convention to use the component as the underlying basis for
determining the price of the overall product. The FASB rejected this approach
because the concept of market convention would: [ASU 2017-12.BC58]
— be difficult to define across industries;
— lead to confusion when there is no market convention or multiple market
conventions; and
— potentially be difficult to demonstrate objectively to third parties.
Therefore, if the contract (or a contract that supports the price) does not specify an
index or rate, an entity cannot designate it as a contractually specified component.

Example 5.4.20
Underlying index or price as a contractually specified
component
At the beginning of Year 1, ABC Corp. enters into a contract to purchase
Commodity X in Canada. The contract specifies the purchase price per unit of
measure is based on the Industry Standard price at the time of delivery.
Although not defined in the contract, ABC considers it is market convention that
the Industry Standard price is calculated as the XYZ index plus a fixed basis
reflecting transportation. ABC is not permitted to designate the XYZ index as a
contractually specified component because the XYZ index is not specified in the
contract (or a contract that supports the price).

Question 5.4.20
If the contract price includes a variable basis
spread, can an entity hedge the contractually
specified component?
Interpretive response: It depends. If the contract pricing includes a variable
basis spread, an entity should evaluate whether it has exposure to the
contractually specified component.

We believe it would be inappropriate to identify the hedged risk as a

contractually specified component in a contract with pricing structured such
that an entity does not have exposure to the contractually specified component.
For example, an entity has a contract with a price defined as ABC index plus a
variable spread based on the difference between ABC index and XYZ index. The
entity should evaluate whether it has exposure to the ABC index, or whether its
exposure is actually to the XYZ index.

Question 5.4.30
Can an entity hedge a contractually specified
component of a forecasted purchase or sale of a
nonfinancial asset in a spot market transaction?
Interpretive response: It depends. Topic 815 contemplates that an entity is
able to hedge a contractually specified component of a forecasted purchase or
sale in a spot market transaction if the component is specifically referenced in
an agreement that supports the price at which the asset will be purchased or
sold.
The FASB did not elaborate on the nature or form of contracts that could
contain a contractually specified component or whether a contract/agreement
needs to be entered into before completion of the spot purchase or sale
transaction.
However, Topic 815 provides examples of circumstances in which a component
is considered specifically referenced in the contract, such as when a pre-
defined formula is incorporated into agreements that govern either: [815-20-55-
26A]

— the transaction – i.e. an agreement between the counterparties to the spot

purchase transaction; or
— the market exchange on which the transaction will take place.
It is not clear how broadly this guidance was intended to be interpreted. In a
March 2018 meeting, the FASB clarified that if an entity does not have a
contract at hedge inception (e.g. a not-yet-existing contract), it needs to develop
an expectation that when the transaction is entered into:
— the written agreement for a forecasted purchase or sale will contain an
explicitly referenced contractually specified component;
— the pricing formula that references the explicitly referenced contractually
specified component will determine the price of the nonfinancial item;
— the requirements for cash flow hedge accounting will be met; and
— the agreement will be substantive.
Setting these expectations will require judgment. The FASB established a
project group to monitor implementation in this area, and we expect this issue
to be the subject of future discussions. As a result, revisions to this interpretive
response may be provided in a future edition.

5.4.20 Contractually specified component price risk:

Existing contracts

Excerpt from ASC 815-20

>> Hedged Transaction Criteria Applicable to Cash Flow Hedges Only

>>> Eligibility Criteria for Designating the Variability in Cash Flows
Attributable to Changes in a Contractually Specified Component for the
Purchase or Sale of a Nonfinancial Asset as the Hedged Risk
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:
a. 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.
b. 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.

After an entity determines that a contractually specified component exists, it

needs to determine whether it can designate that risk as the hedged risk.

Question 5.4.40
What conditions need to be met to designate a
contractually specified component as the hedged
risk?
Interpretive response: We believe the following conditions need to be met for
a contractually specified component to be designated as the hedged risk:
— the contractually specified component is included in a contract that is not
being accounted for as a derivative in the scope of Topic 815 (either
freestanding or bifurcated); and
— the contract has pricing that is clearly and closely related to the asset being
sold or purchased (see Question 5.4.50).
Topic 815 states that 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 is eligible to be designated as the hedged risk. [815-20-25-22A]
However, the FASB’s intention in applying the normal purchases and normal
sales scope exception in combination with the embedded derivatives guidance

was to prevent any extraneous pricing feature from being designated as the
hedged risk. The FASB was concerned that an entity could inappropriately elect
hedge accounting by fabricating a contractually specified component that it
does not have price exposure to and then enter into a derivative to hedge that
component. [ASU 2017-12.BC53]
Therefore, we believe a contractually specified component is eligible to be
designated as the hedged risk only if the contract has pricing that is clearly and
closely related to the asset being sold or purchased. An extraneous
contractually specified component in a contract does not meet the clearly and
closely related criteria and therefore is not eligible to be the hedged risk.
This is also true for contracts that meet the definition of a derivative in their
entirety. For a contractually specified component to be eligible for designation
as the hedged risk, the existing contract must meet the normal purchases and
normal sales scope exception, which includes a requirement to meet the clearly
and closely related criteria. As discussed in section 2.5.70, freestanding
derivatives cannot be designated as hedged items or transactions because they
are remeasured with changes in fair value reported in earnings. [815-10-15-30 – 15-
34, 815-20-25-22A]

Question 5.4.50
What are the requirements to meet the clearly and
closely related criteria?
Interpretive response: For a contract to qualify for the normal purchases and
normal sales scope exception, it cannot have a price based on an underlying
that is not clearly and closely related to the asset being sold or purchased. As
discussed in Question 5.4.40, we believe a contractually specified component
within a contract must meet the clearly and closely related criteria to be eligible
for designation as a hedged risk. [815-10-15-30]
The underlying in a price adjustment feature may incorporate a purchase or sale
contract that is reasonably related to either the cost or the fair value of the
asset subject to the contract. In that case, generally the price adjustment
feature would not be an impediment for the contract to qualify for the normal
purchases and normal sales exception.
A price adjustment feature incorporated into a contract is not clearly and closely
related to the asset being sold or purchased in any of the following
circumstances. [815-10-15-32]
— The underlying is extraneous (i.e. irrelevant and not pertinent) to both the
changes in the cost and the changes in the fair value of the asset being sold
or purchased; this includes being extraneous to an ingredient or direct
factor in the customary or specific production of that asset.
— The magnitude and direction of the effect of the price adjustment is not
consistent with the relevancy of the underlying. That is, the magnitude of
the price adjustment based on the underlying is significantly
disproportionate to the effect of the underlying on the fair value or cost of
the asset being purchased or sold (or of an ingredient or direct factor, as
appropriate).

— The underlying is a currency exchange rate involving a foreign currency that

meets none of the criteria in paragraph 815-15-15-10(b).

Example 5.4.30
Contract not accounted for as derivative because
normal purchases and normal sales scope exception
is met
ABC Corp. enters into a forward contract to buy crude oil at a price that is based
on a crude oil futures price in the month of delivery plus a fixed basis differential
for transportation costs. There is no net settlement provision in the contract.
Furthermore, the quantities of crude oil delivered under the contract are
expected to be used by ABC over a reasonable period in the normal course of
business.
ABC has met two of the important elements needed to qualify for the normal
purchases and normal sales scope exception:
— the underlying (price of crude oil) is clearly and closed related to the asset
being purchased (crude oil); and [815-10-15-30 – 15-34]
— the quantities delivered under the contract are expected to be used over a
reasonable period in the normal course of business. [815-10-15-27 – 15-29]
All other criteria to apply the normal purchases and normal sales scope
exception are met, and therefore the contract is not accounted for as a
derivative under Topic 815.
Designating the contractually specified component
The conditions to designate the contractually specified component (the crude oil
futures price in the month of delivery, excluding the fixed basis differential) as
the hedged risk have been met because:
— the forward contract is not accounted for as a derivative under Topic 815;
and
— the contract pricing is clearly and closely related.

Example 5.4.40
Contractually specified component is not eligible to
be the hedged risk
Goldco, a gold miner, requires crude oil in its extraction business and enters
into a forward contract to buy crude oil at a price that is indexed to gold. The
forward contract meets the definition of a derivative in its entirety.
The price is based on an underlying (gold) that is not clearly and closely related
to the asset being purchased (crude oil).
Therefore, Goldco may not designate the contractually specified component
(i.e. the gold index) as the hedged risk.

Example 5.4.50
Contract pricing with underlying that is clearly and
closely related
Candy Co. enters into a forward contract to sell chocolate at a price that is
based on a sugar cane index plus a fixed spread. The forward contract meets
the definition of a derivative in its entirety.
The price of sugar is reasonably related to the cost and fair value of chocolate.
Even though the contract contains a price adjustment clause that is based on an
underlying (price of sugar) that is different from the asset being sold (chocolate),
it is not considered an impediment for the contract to meet the clearly and
closely related criteria.
Candy concludes that the underlying (price of sugar) is clearly and closed related
to the asset being sold (chocolate).
If Candy concludes that the forward contract should not be accounted for as a
derivative under Topic 815 (e.g. the other criteria to apply the normal purchases
and normal sales scope exception are met), it may designate the contractually
specified component (the sugar cane index) as the hedged risk.

5.4.30 Contractually specified component price risk: Not-

yet-existing contracts

Excerpt from ASC 815-20

>> Hedged Transaction Criteria Applicable to Cash Flow Hedges Only

>>> Eligibility Criteria for Designating the Variability in Cash Flows
Attributable to Changes in a Contractually Specified Component for the
Purchase or Sale of a Nonfinancial Asset as the Hedged Risk
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.

The ability to hedge a contractually specified component extends to a not-yet-

existing contract if the entity expects that the contract, when executed, will
meet the criteria in paragraph 815-20-25-22A, and all other cash flow hedge
criteria are met. [815-20-25-22B]

This means that an entity needs to consider whether the contract to be

executed will meet the conditions outlined in Question 5.4.40 for the
contractually specified component to be eligible to be a hedged risk.

Question 5.4.60
What threshold is required to support an entity’s
expectation that the criteria to designate a
contractually specified component will be met?
Interpretive response: There is no threshold related to an entity’s expectation
that the criteria will be met. The FASB cited the practical issues encountered in
applying the ‘probable’ threshold for hedging forecasted transactions and
determined that there does not need to be an expectation that it is probable
that the criteria will be met. [ASU 2017-12.BC56]
Once the contract is executed, an entity undergoes a more rigorous analysis to:
— assess whether the contract is accounted for as a derivative within the
scope of Topic 815; and
— evaluate the clearly and closely related guidance to determine if it can
continue to designate the contractually specified component as the hedged
risk.

Example 5.4.60
Contractually specified component in not-yet-
existing contracts
ABC Corp. expects to make future purchases from a supplier of natural gas in
December Year 1 at a price based on the NYMEX natural gas index plus a fixed
basis. This forward contract is expected to meet the definition of a derivative in
its entirety.
ABC expects the contractually specified component that will be in the contract
once it is executed to be the NYMEX natural gas index.
ABC further concludes that this contractually specified component will meet the
criteria to be a hedged risk because:
— the underlying (price of natural gas) is clearly and closed related to the asset
being purchased (natural gas); and
— the contract, once executed, will qualify for the normal purchases and
normal sales scope exception based on similar contracts executed in the
past – i.e. the forward contract will not be accounted for as a derivative
under Topic 815.
On January 1, Year 1, ABC enters into a futures contract indexed to the NYMEX
Henry Hub natural gas index to serve as the hedging instrument.
ABC determines that all of the requirements for cash flow hedge accounting are
met and the requirements to designate the contractually specified component
as the hedged risk will be met once the contract with the supplier is executed.

Therefore, ABC may designate the hedged risk as variability in cash flows
attributable to changes in the contractually specified NYMEX natural gas index
in the not-yet-existing purchase contract.
After contract with the supplier is executed
Once the contract with the supplier is executed, ABC is required to evaluate
whether the requirements to designate a contractually specified component for
existing contracts are met.
At the beginning of Year 1, ABC enters into a contract to purchase natural gas
at Location 1. The contract specifies the purchase price per unit of measure as
the NYMEX Henry Hub futures price plus a fixed basis reflecting local
supply/demand and transportation.
The NYMEX Henry Hub futures price meets the definition of a contractually
specified component. ABC concludes that:
— the forward contract will not be accounted for as a derivative under
Topic 815; and
— the contract pricing is clearly and closely related.
Therefore, ABC is eligible to designate the NYMEX Henry Hub futures price as
the hedged risk in its cash flow hedge of forecasted purchases of natural gas.

FASB Example: Contractually specified component in a not-

yet-existing contract

Excerpt from ASC 815-20

>>>> Contractually Specified Component in a Not-Yet Existing Contract

55-26B This guidance discusses the implementation of paragraphs 815-20-25-
22B and 815-30-35-37A. Entity A’s objective is to hedge the variability in cash
flows attributable to changes in a contractually specified component in
forecasted purchases of a specified quantity of soybeans on various dates
during June 20X1. Entity A has executed contracts to purchase soybeans only
through the end of March 20X1. Entity A’s contracts to purchase soybeans
typically are based on the ABC soybean index price plus a variable basis
differential representing transportation costs. Entity A expects that the
forecasted purchases during June 20X1 will be based on the ABC soybean
index price plus a variable basis differential.
55-26C On January 1, 20X1, Entity A enters into a forward contract indexed to
the ABC soybean index that matures on June 30, 20X1. The forward contract is
designated as a hedging instrument in a cash flow hedge in which the hedged
item is documented as the forecasted purchases of a specified quantity of
soybeans during June 20X1. As of the date of hedge designation, Entity A
expects the contractually specified component that will be in the contract once
it is executed to be the ABC soybean index. Therefore, in accordance with
paragraph 815-20-25-3(d)(1), Entity A documents as the hedged risk the
variability in cash flows attributable to changes in the contractually specified
ABC soybean index in the not-yet-existing contract. On January 1, 20X1,
Entity A determines that all requirements for cash flow hedge accounting are

met and that the requirements of paragraph 815-20-25-22A will be met in the
contract once executed in accordance with paragraph 815-20-25-22B. Entity A
also will assess whether the criteria in 815-20-25-22A are met when the
contract is executed.
55-26D As part of its normal process of assessing whether it remains probable
that the hedged forecasted transactions will occur, on March 31, 20X1,
Entity A determines that the forecasted purchases of soybeans in June 20X1
will occur but that the price of the soybeans to be purchased will be based on
the XYZ soybean index rather than the ABC soybean index. As of March 31,
20X1, Entity A begins assessing the hedge effectiveness of the hedging
relationship on the basis of the changes in cash flows associated with the
forecasted purchases of soybeans attributable to variability in the XYZ soybean
index. Because the hedged forecasted transactions (that is, purchases of
soybeans) are still probable of occurring, Entity A may continue to apply hedge
accounting if the hedging instrument (indexed to the ABC soybean index) is
highly effective at achieving offsetting cash flows attributable to the revised
contractually specified component (the XYZ soybean index). On April 30, 20X1,
Entity A enters into a contract to purchase soybeans throughout June 20X1
based on the XYZ soybean index price plus a variable basis differential
representing transportation costs.
55-26E If the hedging instrument is not highly effective at achieving offsetting
cash flows attributable to the revised contractually specified component, the
hedging relationship must be discontinued. As long as the hedged forecasted
transactions (that is, the forecasted purchases of the specified quantity of
soybeans) are still probable of occurring, Entity A would reclassify amounts
from accumulated other comprehensive income to earnings when the hedged
forecasted transaction affects earnings in accordance with paragraphs 815-30-
35-38 through 35-41. The reclassified amounts should be presented in the
same income statement line item as the earnings effect of the hedged item.
Immediate reclassification of amounts from accumulated other comprehensive
income to earnings would be required only if it becomes probable that the
hedged forecasted transaction (that is, the purchases of the specified quantity
of soybeans in June 20X1) will not occur. As discussed in paragraph 815-30-40-
5, a pattern of determining that hedged forecasted transactions are probable of
not occurring would call into question both an entity’s ability to accurately
predict forecasted transactions and the propriety of applying cash flow hedge
accounting in the future for similar forecasted transactions.

5.4.40 Interest rate risk on the forecasted issuance or

purchase of debt instruments

Excerpt from ASC 815-20

>> Hedged Transaction Criteria Applicable to Cash Flow Hedges Only

>>> Forecasted Issuances or Purchases of Debt Instruments
25-17 In this Subtopic, the phrase issuance of fixed-rate debt includes the
issuance of a zero-coupon instrument because the interest element in a zero-
coupon instrument is fixed at its issuance.
25-18 Provided the entity meets all the other cash flow hedging criteria, an
entity may designate as the hedged risk the risk of changes in either of the
following:
a. The coupon payments (or the interest element of the final cash flow if
interest is paid only at maturity) related to the forecasted issuance of fixed-
rate debt
b. The total proceeds attributable to changes in the benchmark interest rate
related to the forecasted issuance of fixed-rate debt.
The derivative instrument used to hedge either of these risks must provide
offsetting cash flows for the hedging relationship to be effective in accordance
with paragraph 815-20-35-3.
25-19 An entity shall not characterize its variable-rate debt as fixed-rate debt
that, at each interest reset date, is effectively rolled over to another issuance of
fixed-rate debt that has a new fixed interest rate until the next reset date.
25-19A In accordance with paragraph 815-20-25-6, if an entity designates a
cash flow hedge of interest rate risk attributable to the variability in cash flows
of a forecasted issuance or purchase of a debt instrument, it shall specify the
nature of the interest rate risk being hedged as follows:
a. If an entity expects that it will issue or purchase a fixed-rate debt
instrument, the entity shall designate the variability in cash flows
attributable to changes in the benchmark interest rate as the hedged risk.
b. If an entity expects that it will issue or purchase a variable-rate debt
instrument, the entity shall designate the variability in cash flows
attributable to changes in the contractually specified interest rate as the
hedged risk.
25-19B If an entity does not know at the inception of the hedging relationship
whether the debt instrument that will be issued or purchased will be fixed rate
or variable rate, the entity shall designate as the hedged risk the variability in
cash flows attributable to changes in a rate that would qualify both as a
benchmark interest rate if the instrument issued or purchased is fixed rate and
as a contractually specified interest rate if the instrument issued or purchased
is variable rate.

An entity can apply cash flow hedge accounting to the variability in cash
proceeds from a forecasted issuance or purchase of a debt instrument, or to
the forecasted interest payments on the future issuance or purchase of a debt
instrument.

Interest rate risk. An entity may specify the hedged risk based on its
expectation of the interest rate on the debt as follows. [815-20-25-19A]
— If the entity expects to issue or purchase fixed-rate debt, it designates the
hedged risk as the variability in cash flows attributable to changes in the
benchmark interest rate.
— If the entity expects to issue or purchase variable-rate debt, it designates
the hedged risk as the variability in cash flows attributable to changes in the
contractually specified interest rate.
If the entity does not know whether the debt instrument will have a fixed or
variable rate, it designates the hedged risk as variability in cash flows
attributable to changes in a rate that would qualify both as a benchmark interest
rate and a contractually specified interest rate. [815-20-25-19B]

Example 5.4.70
Forecasted issuance of fixed-rate debt
ABC Corp. forecasts that it will issue a five-year fixed-rate debt instrument in six
months. The debt’s fixed rate will be determined on the date it is issued and
will be based on current market interest rates.
ABC may designate the hedged risk as changes in either:
— the interest payments related to the forecasted issuance of fixed-rate debt;
or
— the total proceeds attributable to changes in the benchmark interest rate
related to the forecasted issuance of fixed-rate debt.
ABC wants to hedge its exposure to variability in cash flows related to changes
in its forecasted interest payments on the debt to be issued.
ABC enters into a forward-starting pay-fixed, receive-LIBOR interest rate swap
with a LIBOR leg to hedge the interest rate risk associated with the forecasted
interest payments. At inception of the hedge of the forecasted interest
payments, ABC designates the variability in cash flows attributable to changes
in the LIBOR rate as the hedged risk. The LIBOR rate may be designated as the
hedged risk because it is a benchmark interest rate.

Example 5.4.80
Forecasted issuance of debt when it is not known
whether the interest rate will be fixed or variable
Assume the same fact pattern as in Example 5.4.70 except that ABC Corp.
does not know whether the interest rate on the debt will be fixed or variable
rate.

ABC expects that if variable-rate debt is issued, the debt agreement will specify
the variable index as the LIBOR rate plus a spread.
ABC enters into a forward-starting pay-fixed, receive-LIBOR interest rate swap
to hedge the interest rate risk associated with the forecasted interest
payments. At inception of the hedge of the forecasted interest payments, ABC
designates the variability in cash flows attributable to changes in the LIBOR rate
as the hedged risk.
The LIBOR rate qualifies as a:
— benchmark interest rate if the debt issued is fixed-rate; and
— contractually specified interest rate if the debt issued is variable-rate.

5.4.50 Hedging interest rate risk on forecasted issuances of

fixed-rate debt: Rollover strategies
Interest rate risk. Cash flow hedging relationships for forecasted debt
issuances commonly include rollovers of short-term, fixed-rate debt such as
commercial paper or certificates of deposit issued by banks.
Commercial paper and similar instruments are issued on a fixed-rate discounted
basis with relatively short maturities (e.g. seven to 270 days). Specifically, the
issuer receives a single discounted amount as proceeds of the issuance and
makes a single payment of the stated amount at maturity. There are no periodic
interest payments. The interest rate established on the issuance of these fixed-
rate instruments is based on current market interest rates for a specific debtor.
An entity may seek to hedge the variability in cash flows that will or are
expected to occur when fixed-rate instruments mature and are reissued at
prevailing fixed rates of interest (i.e. rolled over). Because the debt is fixed-rate,
an entity can designate either the benchmark interest rate or the total change in
cash flows as the hedged risk.

Question 5.4.70
How does an entity assess whether forecasted
issuances or purchases of short-term, fixed-rate
debt in a rollover strategy share similar interest rate
risk exposure?
Interpretive response: To designate a group of forecasted transactions as the
hedged transactions, they must share the same risk exposure for which they
are being hedged. [815-20-55-23]
For hedging strategies involving rollovers of short-term, fixed-rate debt
issuances (or purchases), an entity has to demonstrate that the implicit index of
each individual fixed-rate instrument in the portfolio (based on its maturity) is
highly correlated with the benchmark interest rate designated as being hedged.
Because an entity is hedging the forecasted issuance of fixed-rate debt with an
interest rate that has yet to be determined, we believe the guidance for

assessing the similarity of interest payments related to variable-rate debt

instruments in Question 5.3.80 does not necessarily apply.

Example 5.4.90
Hedging interest rate risk on a group of individual
transactions related to a rollover strategy
This example has been adapted from a draft DIG Issue referred to as Agenda
Item 13-11.
ABC Corp. has an ongoing five-year commercial paper (CP) program involving a
series of issuances of short-term fixed-rate borrowings with varying maturities
(e.g. 7 days to 270 days) that are expected to rollover at each maturity date.
Each individual CP borrowing is issued at a fixed rate through its term to
maturity (at a discount, similar to a Treasury Bill or other zero-coupon
instrument). ABC expects a virtually constant average maturity of 30 days
across its entire portfolio of CP borrowings over the life of the program.
ABC wishes to hedge the forecasted interest payments arising from future
issuances of CP borrowings. It enters into a LIBOR-based interest rate swap
that reprices every 30 days to match the average rollover period.
Similarity test
ABC has to determine whether the portfolio of commercial paper issuances
share the same risk exposure. For guidance on the similarity test when hedging
a group of forecasted transactions, see section 5.3.60.
ABC expects interest payments on seven-day CP borrowings to have exposure
related to one-week LIBOR, whereas interest payments on 270-day CP
borrowings will have exposure related to nine-month LIBOR. To group
issuances with maturities ranging from seven days to 270 days, ABC has to
demonstrate that seven-day and nine-month LIBOR rates share the same risk
exposure.
To accomplish this, ABC performs regression analysis to determine whether
historical changes in the CP borrowing rates for each maturity ranging from
seven days to 270 days have been highly correlated with the seven-day and
nine-month LIBOR rates.
If ABC is unable to demonstrate high correlation, it may need multiple
groupings with narrower ranges of maturities. For example, ABC may consider
grouping issuances with maturities in the following ranges:
— 7 days – 30 days
— 31 days – 60 days
— 61 days – 90 days
— 91 days – 180 days
— 181 days – 270 days
Similarly, the hedging instruments for each grouping must have benchmark
interest rates that align with the maturities of each respective group.

Hedge effectiveness
Because the terms of the forecasted debt issuances will vary from period to
period, ABC has to estimate the changes in the hedged forecasted cash flows
or construct a hypothetical derivative that represents the best estimate of the
future cash flows of each hedged portfolio. This requires an estimate of the
hedged forecasted cash flows at the beginning and end of the period for which
effectiveness is being assessed.
To do this, ABC could assume that the underlying portfolio is a single
instrument with a single maturity equal to the average maturity of the actual
portfolio (e.g. 30 days). The cash flow forecast would be developed by
assuming the hypothetical item will be continually reissued on its maturity for
the same average term as the average maturity.

Question 5.4.80
Should deposit/investment arrangements without
contractually stipulated maturity dates be
characterized as rollovers of fixed-rate instruments?
Interpretive response: No. Deposit/investment arrangements without
contractually stipulated maturity dates (e.g. money market deposits, negotiable
order of withdrawal (NOW) accounts and savings accounts), cannot be
characterized as a series of daily, or other periodic, rollovers of fixed-rate
instruments. This is true even if such arrangements permit both the financial
institution and the investor to cancel the arrangement at any time.
Instead, we believe these represent ongoing variable-rate arrangements.
Specifically, the daily, or other periodic, rollover of the arrangement is a
contractual continuation of a single debtor-creditor relationship. Accordingly,
because the interest rates on these arrangements typically do not vary explicitly
on a benchmark interest rate index, the risk being hedged would be either
overall changes in cash flows, or the contractually specified interest rate.
However, this assumes an entity would be able to find a derivative instrument
that is highly effective. This may be difficult due to the nature of the rate-setting
process for these products.
Interest rates for these products may be set based on factors other than
changes in the interest rate index of the derivative instrument. For example, the
rates may be set based on the need for funds, to calibrate the mix of the
sources of funds, celebration of a branch opening or other competitive factors.
In addition, the timing of the product’s rate-setting process may not coincide
with the derivative.

FASB Example: Prohibition on characterization of variable-

rate debt as rolled fixed-rate debt
The following FASB example illustrates that an entity cannot characterize
variable-rate debt as fixed-rate debt that is effectively rolled over at each
interest reset date. [815-20-25-19]

Excerpt from ASC 815-25

>> Example 6: Prohibition on Characterization of Variable-Rate Debt as

Rolled Fixed-Rate Debt

55-105 This Example illustrates the application of paragraph 815-20-25-19.

Consider an entity with existing variable-rate debt that is prepayable, resets
monthly based on a specified bank’s prime rate plus 1 percent as of the
beginning of each month, and matures in 5 years. Although the variable-rate
debt does, after each reset, have a fixed rate for each monthly period, it is
inappropriate to characterize that debt as a series of fixed-rate debt
instruments. When each reset occurs, it is not a new issuance of fixed-rate
debt based on current market interest rates for that debtor; instead, it is a
contractual continuation of a debtor-creditor relationship and the fixed rate for
each month is explicitly (and contractually) based on a specific index (a
specified bank’s prime rate).

5.4.60 Changing the hedged risk

Excerpt from ASC 815-30

>> Change in Designated Hedged Risk

Topic 815 requires an entity to discontinue hedge accounting when the critical
terms of the original hedging relationship have changed (see section 2.10), with
the exception of changes to hedged risk when hedging forecasted transactions.
[815-20-55-56]

A unique attribute of a cash flow hedge of a forecasted transaction is that:

[ASU 2017-12.BC65]

— an entity’s expectation about the terms of the transaction as established at

hedge inception may change during the forecast period; but
— the forecasted transaction may remain probable and the hedging
relationship may remain highly effective based on the revised terms.
Topic 815 specifies that if there is a change to the hedged risk in a cash flow
hedge of a forecasted transaction, an entity is not required to automatically
dedesignate the hedging relationship. Instead, it determines whether the
hedging instrument continues to be highly effective at achieving offsetting cash
flows attributable to the revised forecasted transaction. [815-30-35-37A]

Hedge accounting
Is hedging instrument
is discontinued
highly effective? No (section 6.5)

Yes

Hedge accounting
is continued

This guidance applies to both nonfinancial and financial risks, and is

demonstrated in the following examples.
— Contractually specified component in a not-yet existing contract
(Example 5.4.100).
— Changes in a cash flow hedge of forecasted interest payments with an
interest rate swap (see Subtopic 815-30’s Example 9 in section 6.5.10).

Example 5.4.100
Change in hedged risk for a contractually specified
component in not-yet-existing contracts
The following example is adapted from the example in paragraphs 815-20-55-
26B to 55-26E (reproduced in section 5.4.60).
Contractually specified component in not-yet-existing contract
On January 1, Year 1, ABC Corp. expects to make future purchases of
soybeans on December 31, Year 1. ABC’s contracts to purchase soybeans are
typically at a price based on XYZ soybean index plus a variable basis differential
for transportation costs.
ABC enters into a forward derivative contract indexed to the XYZ soybean index
that will mature on December 31, Year 1. The forward derivative is designated
as the hedging instrument in a cash flow hedge. The hedged transaction is the
forecasted purchase of a specified quantity of soybeans on December 31,
Year 1.
As of the date of the hedge designation, ABC expects that XYZ index will be the
contractually specified component in the contract once the contract is
executed. ABC documents as the hedged risk the variability in cash flows
attributable to changes in the contractually specified XYZ soybean index in the
not-yet-existing purchase contract.
On January 1, Year 1, ABC determines that all of the requirements for cash flow
hedge accounting are met and the requirements in paragraph 815-20-25-22A
will be met once the contract is executed.
Change in hedged risk
On July 1, Year 1, ABC executes a contract to purchase soybeans on
December 31, Year 1 at a price based on the DEF soybean index plus a variable
basis differential for transportation costs instead of the XYZ soybean index.

When ABC executes the contract on July 1, Year 1, it does not automatically
dedesignate the hedging relationship because the hedged risk changed from
XYZ soybean index to DEF soybean index. Instead, it evaluates whether the
hedge is highly effective considering the revised soybean index.
If the hedging relationship is not highly effective using the DEF soybean index,
ABC discontinues the hedging relationship.

Question 5.4.90
Does the ability to change the hedged risk also
extend to the hedged forecasted transaction?

Interpretive response: Current guidance is not clear as to whether the ability

to change the hedged risk also provides an ability to change the hedged
forecasted transaction.
At a March 2018 meeting, the FASB discussed potential Codification
improvements that include the following clarifications. [FASB meeting 03-18]
— The hedged forecasted transaction and hedged risk are distinct.
— The hedged risk may change, and an entity may retain hedge accounting if
the revised hedging relationship is highly effective even if a distinction is
not made between the hedged forecasted transaction and the hedged risk
in an entity’s hedge documentation.
— The hedged forecasted transaction may not be documented so broadly that
it could be changed to another transaction that does not share the same
risk exposure as the originally designated hedged forecasted transaction.
— If the hedging relationship based on the revised hedged risk is not highly
effective, the entity must cease hedge accounting; however, amounts
previously recorded in AOCI remain until the hedged forecasted transaction
affects earnings if the forecasted transaction is still probable.
— An entity may retrospectively designate a particular transaction as the
hedged transaction, within the following parameters.
— An entity must first identify hedged transactions based on the originally
documented hedged risk.
— Only when there are no other transactions or insufficient transactions
based on the originally documented hedged risk may the entity
consider transactions based on other risks.
— If a transaction occurred in a prior reporting period, it cannot be
retrospectively identified as a hedged transaction if it has already
affected reported earnings.
The FASB is in the process of collecting external feedback on these potential
amendments to the Codification. Revisions to this interpretive response may be
provided in a future edition.

Example 5.4.110
Defining hedged risk for a cash flow hedge of
interest rate payments of You Pick ‘Em debt
You Pick ‘Em debt is a type of variable-rate debt instrument with an option that
allows the debtor, on specified dates, to change the interest rate index (e.g.
one-month LIBOR, three-month LIBOR, US Treasury or Prime) on which its
interest payments are based.
ABC issues You Pick ‘Em debt and at each reset date, it may select the one-
month LIBOR rate, three-month LIBOR rate or the Prime rate.
ABC wishes to hedge the risk of changes in interest rates associated with this
instrument. It enters into a receive three-month LIBOR, pay-fixed interest rate
swap to hedge the variable interest payments.
Defining the forecasted transaction and hedged risk
ABC specifically identifies and defines the forecasted transaction as LIBOR
based payments on the specified You Pick ‘Em Debt.
ABC expects to select the three-month LIBOR at each reset date and
documents the hedged risk as variability in cash flows attributable to changes in
three-month LIBOR. ABC determines that all of the requirements for cash flow
hedge accounting are met.
Hedge effectiveness. ABC must select a specific tenor of LIBOR as the
hedged risk to support hedge effectiveness. The PEH derivative would be a
receive three-month LIBOR, pay-fixed interest rate swap. The terms of the PEH
do not need to consider the optionality of other rates that may be elected. This
is because ABC needs to perform a single hedge effectiveness assessment
based on the hedged risk currently expected to occur in the forecasted
transaction (i.e. three-month LIBOR). There is no requirement for ABC to
perform effectiveness tests associated with multiple potential hedged risks.
[ASU 2017-12.BC66–BC67]

For further guidance on PEH derivatives, see section 9.7.30.

ABC selects a different LIBOR tenor at reset date
ABC chooses to reset the interest rate during the period from three-month
LIBOR to one-month LIBOR. The forecasted interest payments remain
probable.
ABC does not automatically dedesignate the hedging relationship because the
hedged risk changed from three-month to one-month LIBOR. Instead, it
evaluates whether the hedge is highly effective considering the revised LIBOR
tenor – i.e. whether the hedging instrument (indexed to three-month LIBOR) is
highly effective at achieving offsetting cash flows attributable to the revised
contractually specified component (one-month LIBOR).
Further, the change in the designated hedged risk does not represent a missed
forecast for ABC because the interest payments remain probable. [ASU 2017-
12.BC66]

Hedge effectiveness. Because of the change in the LIBOR tenor from three-
month to one-month, the PEH must be adjusted to reflect the most recent best
estimate of the forecasted transactions that are identified with that relationship

for purposes of assessing hedge effectiveness. ABC performs an assessment

based on the hedged risk currently expected to occur, which is now one-month
LIBOR. [ASU 2017-12.BC66–BC67]
If the hedging relationship is not highly effective using one-month LIBOR, ABC
will discontinue the hedging relationship.
ABC selects Prime rate at reset date
If ABC chooses to reset the interest rate during the period from three-month
LIBOR to the Prime rate, the reset would be a change in hedged risk.
Current guidance is unclear as to whether this represents a change in the
hedging relationship that would require dedesignation, or if the hedging
relationship could continue if it remained highly effective. The FASB discussed
potential Codification improvements that would clarify this issue (see
Question 5.4.90). Revisions to this example may be provided in a future edition.

5.5 Hedging instruments in cash flow hedges

Criterion 1 Criterion 2 Criterion 3 Criterion 4

Eligibility of Eligibility of
Eligibility of Hedge
hedged items hedging
hedged risk(s) effectiveness
or transactions instruments

Criterion 5: Formal documentation

Topic 815 specifies certain criteria that must be met for financial instruments to
be eligible for designation as hedging instruments, the primary requirement
being that the instrument meets the definition of a derivative. Topic 815 also
specifically prohibits certain instruments and outlines limitations involving
written options. These concepts are discussed in sections 2.6 and 2.7.
Topic 815 includes additional guidance specific to cash flow hedges around the
eligibility of hedging instruments, including:
— special rules for basis swaps (see section 5.5.10); and
— limitations on mixed-attribute derivative commodity contracts (see
section 5.5.20).

Foreign currency risk. For guidance on the eligibility of hedging

instruments in a cash flow hedge of foreign currency risk, see section 7.6.10.

5.5.10 Special rule for basis swaps

Excerpt from ASC 815-20

> Hedging instrument in a Cash Flow Hedge of Basis Risk

25-50 If a hedging instrument is used to modify the contractually specified
interest receipts or payments associated with a recognized financial asset or
liability from one variable rate to another variable rate, the hedging instrument
shall meet both of the following criteria:
a. It is a link between both of the following:
1. An existing designated asset (or group of similar assets) with variable
cash flows
2. An existing designated liability (or group of similar liabilities) with
variable cash flows.
b. It is highly effective at achieving offsetting cash flows.
25-51 For purposes of paragraph 815-20-25-50, a link exists if both of the
following criteria are met:
a. The basis (that is, the rate index on which the interest rate is based) of one
leg of an interest rate swap is the same as the basis of the contractually
specified interest receipts for the designated asset.
b. The basis of the other leg of the swap is the same as the basis of the
contractually specified interest payments for the designated liability.
In this situation, the criterion in paragraph 815-20-25-15(a) is applied separately
to the designated asset and the designated liability.

A basis swap is a derivative instrument that is used to change the interest rate
characteristics of a variable-rate financial asset or liability from one variable-rate
index to another. Instead of fixing the cash flows associated with a variable-rate
instrument, a basis swap reduces basis risk by changing the variability of the
interest cash flows from one index to another.
Basis risk arises when an entity acquires a financial asset that is funded with a
financial liability. Both financial instruments have variable-rate cash flows, but
the variability of one position does not move in unison with the variability of the
other position.
For example, an entity that has a one-month LIBOR-based asset funded by a
Prime-based liability has economic basis risk between LIBOR and Prime interest
rates. If one-month LIBOR rates decrease significantly and Prime rates remain
unchanged, the entity would experience a significant change in the margin
between the interest rates associated with the two positions. A basis swap
could effectively alter future cash flows from a LIBOR basis to a prime basis, or
vice versa.

The following illustrates a basis swap strategy.

Variable-rate asset

One-month LIBOR
+ 300 basis points
Prime

Basis swap

One-month LIBOR Bank

Entity + 175 basis points (Basis swap
counterparty)
Prime

Variable-rate liability

By using a basis swap, an entity is able to lock in a net margin of 125 basis
points (bps)

Variable-rate liability Basis swap

Net receive
Pay Prime Receive Prime zero

Variable-rate asset Basis swap

Net receive
Receive one-month Pay one-month 125 bps
LIBOR + 300 bps LIBOR + 175 bps

Net margin
125 bps

Basis swaps do not reduce or eliminate the variability of cash flows associated
with the individual financial instruments. However, they reduce or eliminate the
variability of cash flows attributable to the combined asset-liability position.
Topic 815 only allows a basis swap to be used to modify the interest receipts of
a recognized financial asset and the interest payments of a recognized financial
liability. To designate a basis swap as the hedging instrument in a cash flow
hedging relationship, the following criteria must be met: [815-20-25-50]
— each leg of the basis swap is linked to a designated item with the same
underlying; and
— the basis swap is highly effective in achieving offsetting cash flows.

Basis swap links with same underlying

To qualify for hedge accounting, each leg of the basis swap must provide a link
between the variable-rate interest receipts associated with a recognized
financial asset and the variable-rate interest payments associated with a
recognized financial liability. This requirement mandates that each leg of the
basis swap be linked to a designated item with the same underlying. [815-20-25-
50(a), 25-51]

For example, an entity with one-month LIBOR-based assets funded by variable-

rate debt that has an interest rate of Prime is required to use a swap with one
leg based on one-month LIBOR and one leg based on the Prime rate. In
contrast, it cannot use a swap with one one-month LIBOR-based leg and one
leg based on the bond market association (BMA) rate. This is illustrated in the
following table, along with other combinations and whether the requirement is
met.

Variable-rate
Variable-rate asset liability Basis swap Permitted?
One-month LIBOR Prime One-month LIBOR and
Prime
One-month LIBOR Prime One-month LIBOR and
BMA rate
One-month LIBOR + Prime (One-month LIBOR +
300 bps 175 bps) and Prime
One-month LIBOR Prime Six-month LIBOR and
Prime

Basis swap is highly effective in offsetting net interest cash

flows
To qualify for hedge accounting, the basis swap must be highly effective in
achieving offsetting cash flows attributable to the hedged risk. [815-20-25-50(b)]
Specifically, the cash flows from the swap must be highly effective in achieving
offsetting cash flows attributable to the hedged risk of the hedged forecasted
net interest cash flows.

Question 5.5.10
How is the hedged forecasted transaction defined
in a cash flow hedging relationship involving a
basis swap?
Interpretive response: We believe a cash flow hedging relationship involving a
basis swap is considered a single hedging relationship.
As a result, an entity must identify the net interest cash flows (of the
recognized financial asset and recognized financial liability) as the hedged
forecasted transactions.

Interest payments Interest receipts of a Forecasted

from a recognized recognized variable- transactions: Net
variable-rate liability rate asset interest cash flows

Although each leg of the basis swap must be linked to the designated item with
the same underlying, the hedged forecasted transactions are the net interest
cash flows of those combined designated items. [815-20-25-51]
The ability to hedge the net interest cash flows of a recognized financial asset
and a recognized financial liability is not permitted anywhere else in Topic 815.
Formal documentation. The recognized financial asset, the recognized
financial liability, and the related net interest cash flows being hedged must be
specifically identified in the hedge documentation. [815-20-25-3(d)(1)]
When an entity designates a cash flow hedge of interest rate risk, it must
formally document the hedged risk as exposure to both contractually specified
interest rates. For example (using the basis swap strategy above).

Variable-rate liability Variable-rate asset

Changes in Prime Changes in one-month

rates LIBOR
Interest rate risk

Example 5.5.10
Basis swap that qualifies for cash flow hedge
accounting
Bank has a five-year $10,000,000 variable-rate commercial loan that earns one-
month LIBOR plus 4%. The loan is funded by a five-year, $10,000,000 debt
obligation that pays interest at Prime plus 1%.
To reduce its basis risk, Bank enters into a five-year basis swap with a notional
amount of $10,000,000 to receive interest at a variable rate equal to Prime and
to pay interest at a variable rate equal to one-month LIBOR plus 2%. The rates
and payment dates of the swap mirror those of the commercial loan and debt
obligation.
Bank identifies the basis swap as the hedging instrument in a hedging
relationship to hedge the risk of changes in the contractually specified interest
rates.
Bank links the one-month LIBOR-based leg of the basis swap to the
$10,000,000 commercial loan and the Prime-based leg of the basis swap to the
$10,000,000 debt obligation.
If the other requirements for hedge accounting have been met (including high
effectiveness), this basis swap would qualify for cash flow hedge accounting
because:
— the underlying asset is a recognized financial asset and the underlying
liability is a recognized financial liability, and both have been individually
identified;

— the basis swap is used to offset changes in the contractually specified

interest rates associated with the commercial loan and the debt obligation;
and
— each leg of the basis swap has been linked to a designated hedged
transaction with the same underlying.

Example 5.5.20
Basis swap that does not qualify for cash flow hedge
accounting
Bank has a five-year $10,000,000 variable-rate commercial loan that earns one-
month LIBOR.
ABC Corp. wants to obtain five-year, Prime-based funding. It can do so in
several ways, including:
— entering into a five-year debt obligation indexed to Prime;
— borrowing at fixed rates while simultaneously entering into an interest rate
swap that converts the fixed rate into Prime; or
— borrowing at variable rates linked to another index while simultaneously
entering into a basis swap that converts that other index to Prime.
ABC issues a five-year, $10,000,000 debt obligation. The interest rate on the
debt obligation is variable at one-month LIBOR.
ABC simultaneously enters into a five-year basis swap with a notional amount
of $10,000,000 to receive interest at a variable rate equal to one-month LIBOR
and to pay interest at a variable rate equal to Prime.
Based on the information presented, this strategy does not qualify for hedge
accounting because the swap has only one leg that could be linked to a
recognized financial asset or liability, not both legs. Among other requirements,
for a basis swap to qualify for hedge accounting, each leg of the swap must be
separately linked to a recognized financial asset and a recognized financial
liability.

Question 5.5.20
How does an entity assess whether a basis swap is
highly effective at offsetting changes in the net
interest cash flows?
Interpretive response: Although the interest rate index of each leg of the basis
swap must be identical to the contractually specified interest rates of the
underlying, an entity cannot automatically assume the hedge will perfectly
offset the net interest cash flows or always be highly effective.
For example, an entity should consider whether the recognized financial asset,
the recognized financial liability and/or the basis swap reprice or have payments
at different dates. This could affect whether the hedge is highly effective.

For an example of assessing effectiveness of a cash flow hedge with a basis

swap, see Subtopic 815-30’s Example 2 in section 9.2.10.

Question 5.5.30
Can an entity hedge net interest cash flows from a
group of recognized assets or liabilities in a cash
flow hedging relationship involving a basis swap?
Interpretive response: It depends. The hedged forecasted net interest cash
flows in a cash flow hedging relationship involving a basis swap may relate to a
group of recognized financial assets (or liabilities) that comprises similar
individual assets (or similar individual liabilities) with the same underlying.
However, the requirement that a group of individual transactions share the
same risk exposure for which they are being hedged (see section 5.3.60) must
be met separately for the group of assets and/or group of liabilities to qualify for
hedge accounting.

Question 5.5.40
Can an entity apply the first-payments-received
(paid) approach when designating the net interest
cash flows in a hedging relationship involving a
basis swap?
Background: In a cash flow hedge of interest rate risk, the specifically
identified group of transactions may be the first interest payments received
(paid) for a rolling portfolio of prepayable interest-bearing loans, or other
interest-bearing financial assets, provided all other conditions for a cash flow
hedge have been met. For further guidance, see section 5.3.70.

Excerpts from ASC 815-20

>>>> First-Payments-Received Technique in Hedging Variable Interest

Payments on a Group of Loans
55-33E This implementation guidance regarding use of a first-cash-flows
technique also may be applied to a cash flow hedging relationship in which the
hedging instrument is a basis swap as discussed beginning in paragraph 815-
20-25-50. However, use of that technique for those basis-swap hedging
relationships may not be common because that paragraph limits designating a
basis swap as the hedging instrument to cash flow hedges of the contractually
specified interest payments of only recognized financial assets and liabilities
existing at the inception of the hedge, whereas the first-cash-flows technique
is typically applied to the contractually specified interest payments for rolling
portfolios whose composition of financial assets changes over the period of
the hedge.

Interpretive response: Yes. An entity may apply the first-payments-received

(paid) approach to a cash flow hedging relationship in which the hedging
instrument is a basis swap. [815-20-55-33E]
However, using this approach may not be common because Topic 815 limits
designating a basis swap as a hedging instrument for contractually specified
interest receipts (or payments) associated with a recognized financial asset or
liability existing at hedge inception. In contrast, the first-payments-received
(paid) approach is typically applied to the contractually specified interest receipts
(or payments) for a rolling portfolio of financial liabilities (or assets) that change
over the life of the hedging relationship. [815-20-55-33E]
We believe the hedged net interest cash flows identified over the life of the
relationship may be associated with differing assets or liabilities within a
portfolio of identified similar assets or similar liabilities provided that:
— the entity is using the first-payments-received approach to identify the
hedged forecasted transactions; and
— all identified hedged cash flows are associated with assets or liabilities that
existed at the inception of the hedge.

Example 5.5.30
First-payments-received (paid) approach with basis
swap as the hedging instrument
Bank has a portfolio of variable-rate loans totaling $400 million in principal that
earn Prime plus 1%. These loans are funded by a portfolio of variable-rate
financial liabilities totaling $500 million in principal that pays one-month LIBOR
plus 4%.
To reduce its basis risk, Bank enters into a basis swap with a notional amount
of $100 million to receive interest at a variable rate equal to one-month LIBOR
plus 2% and to pay interest at a variable rate equal to Prime.
Bank uses the first-payments-received (paid) approach and identifies the
hedged transaction as follows:
— first Prime-based interest payments received at the beginning of each
quarter that are payments on $100 million principal of Prime-based loans
existing at inception of the hedge – e.g. Prime-based loans totaling
$400 million in principal; and
— first LIBOR-based interest payments at the beginning of each quarter that
are payments on $100 million principal of LIBOR-based debt obligations
existing at inception of the hedge – e.g. LIBOR-based loans totaling
$500 million in principal.

Question 5.5.50
Is a cash flow hedge with a basis swap
automatically dedesignated if there is a change to
the contractually specified interest rate?
Interpretive response: Yes. Because each leg of the basis swap must be
linked to the designated item with the same underlying, we do not believe an
entity could change the contractually specified interest rate without
dedesignating the hedging relationship.
For example, an entity designates the hedged forecasted transaction as interest
receipts and payments on a recognized asset and liability, respectively. The
hedged risk is identified as changes in the contractually specified interest rates,
being one-month LIBOR for the asset and Prime for the liability. Each leg of the
basis swap properly links to the index of the underlying.
If the contractually specified interest rate for the asset changed from one-
month LIBOR to a different index (e.g. BMA or six-month LIBOR), there would
be a mismatch and the requirement that each leg of the basis swap properly
link to the index of the underlying would no longer be met.

Question 5.5.60
Can basis swaps other than those involving interest
rates be designated as a hedging instrument?
Interpretive response: No. There are basis swaps for underlyings other than
interest rates. For example, the spot price of oil can be swapped for the spot
price of natural gas.
However, we believe an entity is prohibited from using basis swaps other than
those involving exchanges of interest rates in a cash flow hedging relationship.

5.5.20 Limitations on mixed-attribute derivative commodity

contracts

Excerpt from ASC 815-20

>>> Mixed-Attribute Derivative Commodity Contracts as Cash Flow

Hedging Instruments
55-46 Commodity contracts commonly have features of both fixed-price
contracts and variable-price contracts, such as an agreement to purchase a
commodity in the future at the prevailing market index price at that future date
plus or minus a fixed basis differential set at the inception of the contract.
Assume an example mixed-attribute contract has the characteristics of notional
amount, underlying, and no initial net investment and the commodity to be

delivered is readily convertible to cash pursuant to the guidance beginning in

paragraph 815-10-15-119.
55-47 Because that mixed-attribute contract is a derivative instrument and has
an underlying related solely to changes in the basis differential, that contract
(as a derivative instrument) would generally not be sufficiently effective if
designated as the sole hedging instrument in a cash flow hedge of the
anticipated purchase or sale of the commodity—a forecasted transaction
whose variability in cash flows is based on changes in both the basis
differential and the base commodity price. Because its underlying relates
solely to changes in the basis differential, the mixed-attribute contract would
essentially be hedging only a portion of the variability in cash flows. The entity
is not permitted to designate a cash flow hedging relationship as hedging only
the change in cash flows attributable to changes in the basis differential. For an
entity to be able to conclude that such a hedging relationship is expected to be
highly effective in achieving offsetting cash flows, the entity would need to
consider the likelihood of changes in the base commodity price as remote or
insignificant to the variability in hedged cash flows (for the total purchase or
sales price). However, the mixed-attribute contract may be combined with
another derivative instrument whose underlying is the base commodity price,
with the combination of those derivative instruments designated as the
hedging instrument in a cash flow hedge of the overall variability of cash flows
for the anticipated purchase or sale of the commodity. Such a combination
would address the risk of changes in both the basis differential and the base
commodity price.

Contracts with both a fixed and variable exercise price are commonly referred
to as mixed-attribute contracts or fixed-basis contracts. These are common in
the commodities industry.
For example, a buyer seeks to use crude oil in the production of unleaded
gasoline. In January, the buyer agrees to buy 1,000 barrels of a specific type of
crude oil in July from a seller at the July 1 West Texas Intermediate (WTI) price
index price plus $1.00 per barrel. The contract appears to be primarily a floating-
price contract, but includes a fixed margin above that price. While the fixed
$1.00 differential is commonly referred to as the basis differential, it reflects
multiple factors, such as quality of the oil, and the timing and location of
delivery.
In general, this type of mixed-attribute contract would qualify as a derivative
instrument. The basis differential is an underlying to the contract and changes in
the basis differential will affect the fair value of the contract as a whole.
However, the mixed-attribute contract is unlikely to be able to function as the
sole hedging instrument in a cash flow hedge of the anticipated purchase or
sale of the commodity. This is because that forecasted transaction is one
whose variability in cash flows is based on changes in both the basis differential
and the base commodity price (e.g. WTI price index). This type of derivative
contract would essentially be hedging only a portion of the variability in cash
flows (i.e. the basis differential). In other words, it doesn’t consider changes in
the base commodity price. [815-20-55-47]

However, this mixed-attribute contract may be effective if combined with

another derivative whose underlying is the base commodity price. This would
address both the basis differential and the base commodity price. [815-20-55-47]

6. Accounting for cash flow

hedges
Detailed contents
6.1 How the standard works
6.2 Cash flow hedge accounting model
6.2.10 Overview
6.2.20 Excluded components
Examples
6.2.10 Accounting for a cash flow hedge of a variable-rate loan
with an interest rate swap
6.2.20 Accounting for a cash flow hedge of a variable-rate debt
obligation with an interest rate swap that has a cap and a
floor
6.2.30 Accounting for a cash flow hedge of a forecasted purchase
of inventory with a forward contract (critical terms match –
forward value method)
6.2.40 Comparison of approaches to recognize the excluded
component for a cash flow hedge
6.2.50 Accounting for a cash flow hedge of forecasted purchase of
inventory with a call option (critical terms do not match –
intrinsic value method)
6.3 Reclassifying amounts from AOCI into earnings
6.3.10 Overview
6.3.20 Hedging instruments with periodic settlements
Questions
6.3.10 What method is used to reclassify amounts in AOCI into
earnings?
6.3.20 When are amounts in AOCI related to specific borrowings
associated with assets under construction reclassified into
earnings?
6.3.30 Why is a loss in AOCI reclassified into earnings if the
combination of the hedging instrument and hedged
transaction would result in a future loss?
6.3.40 Can an impairment loss be recognized before a forecasted
transaction occurs?

6.3.50 What are acceptable methods to reclassify the initial non-

zero fair value of a hedging instrument with periodic cash
settlements?
6.3.60 What method is appropriate to reclassify amounts from
AOCI when an interest rate swap with scheduled increases
in its fixed leg is used to hedge interest payments on
variable-rate debt?
6.3.70 What method is appropriate to reclassify amounts from
AOCI when multiple derivatives are used to hedge interest
payments on variable-rate debt?
Examples
6.3.10 Accounting for an all-in-one hedge of a forecasted
equipment purchase
6.3.20 Combination of loss reported in AOCI and hedged
transaction would give rise to a loss
6.3.30 Accounting for a cash flow hedge of a variable-rate, long-
term debt with an interest rate cap
6.4 Assessing impairment
6.4.10 Overview
Questions
6.4.10 Are the fair value or expected cash flows of a hedging
instrument ever considered when evaluating impairment of
an asset related to the hedged transaction?
6.4.20 Are net gains in AOCI reclassified if an impairment loss is
recognized on an existing asset to which a current or
previous hedged forecasted transaction relates?
Examples
6.4.10 Hedged asset is impaired and related amount in AOCI is a
net derivative loss
6.4.20 Hedged asset is impaired and related amount in AOCI is a
net derivative gain
6.5 Discontinuing hedge accounting
6.5.10 Overview
6.5.20 When it is probable a forecasted transaction will not occur
Future developments
Questions
6.5.10 If a hedging relationship has been retrospectively highly
effective, is hedge accounting required to be applied in the
previous period?
6.5.20 What is the accounting for amounts in AOCI related to a
partially dedesignated cash flow hedging relationship?

6.5.30 Is hedge accounting applied through the date an event

causes a hedging relationship to no longer be highly
effective?
6.5.40 Is it appropriate to assume the last date of high
effectiveness is the date insolvency is declared or
significant financial difficulties are disclosed?
6.5.50 Can amounts be reclassified from AOCI when a hedge is
discontinued, even if the forecasted transaction is
reasonably possible?
6.5.60 Does an entity consider an additional two-month period
when deciding whether to discontinue hedge accounting?
6.5.70 May an entity ignore the additional two-month period when
deciding whether to immediately reclassify amounts from
AOCI into earnings?
6.5.80 How is the additional two-month period considered when
an entity has a series of hedging relationships?
6.5.90 How common are extenuating circumstances that extend
the additional two-month period?
6.5.100 Where are amounts reclassified from AOCI into earnings in
connection with a missed forecast presented in the income
statement?
6.5.110 What factors are considered when evaluating whether
missed forecasts represent a pattern?
Examples
6.5.10 Terminating an interest rate swap used in a cash flow
hedge
6.5.20 Terminating a cash flow hedge when hedge designation is
removed
6.5.30 Accounting for amounts in AOCI when a hedged forecasted
transaction becomes a firm commitment
6.5.40 Dedesignation and redesignation of a hedging relationship
due to failing to qualify for cash flow hedge accounting in
one period
6.5.50 Identification of the date credit deterioration caused a
hedge to cease being highly effective
6.5.60 Whether a delay in a forecasted transaction is due to
extenuating circumstances that extend the additional two-
month period

6.1 How the standard works

A cash flow hedge is a hedge of the exposure to variability in the cash flows of
a recognized asset or liability, or of a forecasted transaction, that is attributable
to a particular risk.
In general, the cash flow hedge accounting model works as follows.
— A derivative hedging instrument is recorded at fair value in the balance
sheet. Changes in its fair value that are included in the assessment of
hedge effectiveness are reported in OCI.
— The amounts in AOCI are recognized in earnings – in the same income
statement line item as the effect of the hedged transaction – when the
hedged transaction affects earnings.
The following shows the general accounting and presentation for a highly
effective cash flow hedging relationship (this assumes there are no excluded
components).

Hedging instrument Hedged transaction

Continue to apply otherwise

Entire change in fair value applicable GAAP based on
recorded in OCI the nature of the hedged
transaction

Reclassified from AOCI to

Hedged transaction affects
earnings when hedged
earnings
transaction affects earnings

Offset of hedging instrument in same income statement

line item as earnings impact of hedged item

The effect of the above is to defer earnings recognition of changes in fair value
of the hedging instrument (that are included in the assessment of
effectiveness) until the hedged transaction affects earnings.
When a cash flow hedge is discontinued, the net derivative gain or loss
reported in AOCI generally is not recognized immediately in earnings. Instead, it
is reclassified into earnings when the hedged forecasted transaction is reported
in earnings. However, the net derivative gain or loss reported in AOCI is
reclassified into earnings immediately if it is probable that the hedged
forecasted transaction will not occur in the original period specified in the hedge
documentation or within an additional two-month period.

6.2 Cash flow hedge accounting model

6.2.10 Overview

Excerpt from Subtopic 815-20

35-1 Paragraph 815-10-35-2 states that the accounting for subsequent changes
in the fair value (that is, gains or losses) of a derivative instrument depends on
whether it has been designated and qualifies as part of a hedging relationship
and, if so, on the reason for holding it. Specifically, subsequent gains and
losses on derivative instruments shall be accounted for as follows: …
c. Cash flow hedge. The gain or loss on a derivative instrument designated
and qualifying as a cash flow hedging instrument shall be reported as a
component of other comprehensive income (outside earnings) and
reclassified into earnings in the same period or periods during which the
hedged forecasted transaction affects earnings, as provided in
paragraphs 815-30-35-3 and 815-30-35-38 through 35-41. If an entity
excludes a portion of the hedging instrument from the assessment of
hedge effectiveness in accordance with paragraph 815-20-25-82, the initial
value of the excluded component shall be recognized in earnings using a
systematic and rational method over the life of the hedging instrument
with any difference between the change in fair value of the excluded
component and amounts recognized in earnings under that systematic and
rational method recognized in other comprehensive income in accordance
with paragraph 815-20-25-83A. An entity also may elect to recognize the
excluded component of the gain or loss currently in earnings in accordance
with paragraph 815-20-25-83B. The gain or loss on the hedging derivative
instrument in a hedge of a forecasted foreign-currency-denominated
transaction shall be reported as a component of other comprehensive
income (outside earnings) and reclassified into earnings in the same period
or periods during which the hedged forecasted transaction affects
earnings, as provided in paragraph 815-20-25-65.
> Income Statement Classification
45-1A For qualifying fair value and cash flow hedges, an entity shall present
both of the following in earnings in the same income statement line item that
is used to present the earnings effect of the hedged item:
a. The change in the fair value of the hedging instrument that is included in
the assessment of hedge effectiveness
b. Amounts excluded from the assessment of hedge effectiveness in
accordance with paragraphs 815-20-25-83A through 25-83B.
See paragraphs 815-20-55-79W through 55-79AD for related implementation
guidance.
45-1B For cash flow hedges in which the hedged forecasted transaction is
probable of not occurring in accordance with paragraph 815-30-40-5, this
Subtopic provides no guidance on the required income statement classification
of amounts reclassified from accumulated other comprehensive income to
earnings.

45-1D While the Derivatives and Hedging Topic does not specify whether
certain income statement line items are either permitted or appropriate, the
other hedging-related Subtopics in this Topic do contain specific disclosure
requirements for those items. See Section 815-10-50 and Subtopics 815-25,
815-30, and 815-35.
> Statement of Cash Flows
45-2 For guidance on the classification of cash receipts and payments related
to hedging activities, see paragraph 230-10-45-27.
> Other Comprehensive Income
45-3 An entity shall display as a separate classification within other
comprehensive income the net gain or loss on derivative instruments
designated and qualifying as fair value or cash flow hedging instruments that
are reported in comprehensive income pursuant to paragraphs 815-20-25-65,
815-20-25-83A, and 815-30-35-3.

Excerpt from ASC 815-30

> Entities
15-2 The guidance in this Subtopic does not apply to the following entities:
a. Entities that do not report earnings. Those entities are not permitted to use
cash flow hedge accounting because they do not report earnings
separately.
15-3 Consistent with the provisions of Topic 958, this Subtopic does not
prescribe how a not-for-profit entity (NFP) should determine the components of
an operating measure, if one is presented. For guidance on the application of
this Subtopic by not-for-profit health care entities, see Subtopic 954-815.
> Subsequent Recognition and Measurement of Gains and Losses on
Hedging Instrument
35-3 When the relationship between the hedged item and hedging instrument
is highly effective at achieving offsetting changes in cash flows attributable to
the hedged risk, an entity shall record in other comprehensive income the
entire change in the fair value of the designated hedging instrument that is
included in the assessment of hedge effectiveness. More specifically, a
qualifying cash flow hedge shall be accounted for as follows: …
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 and presented in
the same income statement line item as the earnings effect of the hedged
item in accordance with paragraph 815-20-45-1A. 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:

1. Subparagraph superseded by Accounting Standards Update No. 2017-

12.
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.
2. Subparagraph superseded by Accounting Standards Update No.
2017-12.
If hedge accounting has not been applied to a cash flow hedging relationship in
a previous effectiveness assessment period because the entity’s retrospective
evaluation indicated that the relationship had not been highly effective in
achieving offsetting changes in cash flows in that period, the cumulative gain
or loss on the derivative referenced in (b) would exclude the gains or losses
occurring during that period. That situation may arise if the entity had
previously determined, for example, under a regression analysis or other
appropriate statistical analysis approach used for prospective assessments of
hedge effectiveness, that there was an expectation in which the hedging
relationship would be highly effective in future periods. Consequently, the
hedging relationship continued even though hedge accounting was not
permitted for a specific previous effectiveness assessment period.

A derivative hedging instrument that qualifies for cash flow hedge accounting
is measured at fair value in the balance sheet. Changes in its fair value that are
included in the assessment of hedge effectiveness are reported in OCI. Net
gains or losses on derivative hedging instruments that are included in AOCI are
displayed as a separate classification within AOCI. These amounts are
reclassified from AOCI into earnings – in the same income statement line item
as the effect of the hedged transaction – when the hedged transaction affects
earnings. When the earnings effect of the hedged transaction is presented in
more than one line item, the change in the fair value of the hedging instrument
is allocated to the different line items. [815-20-45-3, 55-79Z – 55-79AD, 815-30-35-3]
In contrast, changes in the derivative hedging instrument’s fair value related to
components that are excluded from the assessment of hedge effectiveness are
recognized in earnings using either an amortization approach or a mark-to-
market approach. When an amortization approach is used, the difference
between the amount that is amortized and the change in fair value of the
excluded component each period is recognized in OCI. [815-20-25-83A – 25-83B, 815-
30-35-3]

The following table summarizes the timing and presentation for recognizing in
earnings changes in a derivative hedging instrument’s fair value that arise
during the hedging relationship.

Presentation in income
Timing of earnings statement
recognition for changes in fair [815-20-45-1A – 45-1B, 55-
Component value 79Z – 55-79AD, 815-30-35-3]

Changes in fair value Reclassified from AOCI into Same line item as effect
that are included in earnings when the hedged of hedged transaction.2
the assessment of transaction affects earnings
However, Topic 815
hedge effectiveness1 (see sections 6.3 and 6.4).
provides no guidance
However, when it is probable when amounts are
that a forecasted transaction reclassified from AOCI
will not occur (i.e. a missed due to a missed forecast
forecast), related amounts in (see Question 6.5.110).
AOCI are immediately
reclassified into earnings (see
section 6.5.20).
Changes in fair value Depends on the approach Same line item as effect
of excluded elected (see section 6.2.20): of hedged transaction.2
components1 — Amortization approach. However, Topic 815
Recognized in earnings provides no guidance
using a systematic and when amounts are
rational method over the reclassified from AOCI
life of the hedging due to a missed forecast
instrument. However, (see Question 6.5.110).
when it is probable that a
forecasted transaction will
not occur (i.e. a missed
forecast), related amounts
in AOCI are immediately
reclassified into earnings
(see section 6.5.20).
— Mark-to-market
approach. Immediately
recognized in earnings (i.e.
as the changes occur).

Notes:
These amounts do not include changes in fair value arising during periods that the
hedging relationship was not highly effective retrospectively (see Question 2.10.90).
When the earnings effect of the hedged transaction is presented in more than one
line item, the change in the fair value of the hedging instrument is allocated to the
different line items.

The effect of the cash flow hedge accounting model is to defer earnings
recognition of changes in fair value of the hedging instrument (that are included
in the assessment of effectiveness) until the hedged transaction affects
earnings.
If the hedging relationship is:
— Perfectly effective. The net derivative gain or loss that is reclassified from
AOCI will exactly offset gains or losses on the hedged transaction that are
attributable to the hedged risk within one line item of the income
statement.

— Not perfectly effective. The extent to which the gains and losses on the
hedging instrument do not offset gains and losses on the forecasted
transaction is reflected in a single line item of the income statement.

Cumulative measurement
The amount recognized in AOCI for a derivative hedging instrument is a
cumulative measurement. This means that the balance in AOCI related to a
cash flow hedging instrument comprises the following. [815-30-35-3(b)]

Amounts arising
Amounts from changes in
previously fair value during
Cumulative Amounts
recognized in periods when the
change in fair previously
earnings related hedging
value of hedging reclassified into
to excluded relationship was
instrument since earnings
components not highly
inception (see section 6.3)
(see section effective on a
6.2.20) retrospective
basis

An example of an adjustment that may occur (in the right box) is discussed in
Question 2.10.90. In limited circumstances, it may be appropriate to continue
applying hedge accounting when the entity’s:
— retrospective hedge effectiveness assessment for the assessment period
indicates that the relationship was not highly effective; but
— prospective assessment indicates that the relationship is expected to be
highly effective in the future.

Discontinuance of hedging relationship

When a cash flow hedge is discontinued (see section 6.5), the net derivative
gain or loss reported in AOCI generally is not immediately recognized in
earnings. Instead, it generally is recognized in earnings when the hedged
forecasted transaction is reported in earnings (see section 6.3). However, a net
derivative gain or loss reported in AOCI is immediately reclassified into earnings
if it is probable that the hedged forecasted transaction will not occur in the
original period specified in the hedge documentation or within an additional two-
month period (see section 6.5.20).

Income tax considerations

The tax effect of gains or losses recorded in OCI also should be charged or
credited directly to OCI. This includes gains or losses arising from changes in
fair value of derivatives designated in qualifying cash flow hedging
relationships and from derivatives designated in qualifying fair value hedging
relationships for which an amortization approach is used to recognize excluded
components. See KPMG’s Handbook, Accounting for Income Taxes, including
paragraphs 9.043 and 9.050, for further information.

Examples
The examples in this section demonstrate cash flow hedge accounting.
— Accounting for a cash flow hedge of a variable-rate loan with an interest
rate swap (Example 6.2.10).
— Accounting for a cash flow hedge of a variable-rate debt obligation with an
interest rate swap that has a cap and a floor (Example 6.2.20).
— Accounting for a cash flow hedge of a forecasted purchase of inventory
with a forward contract (critical terms match – forward value method)
(Example 6.2.30).
— Accounting for a cash flow hedge of a variable-rate interest-bearing asset
(Subtopic 815-30’s Example 6).
— Reporting cash flow hedges in the income statement and AOCI
(Subtopic 815-30’s Example 12).

Example 6.2.10
Accounting for a cash flow hedge of a variable-rate
loan with an interest rate swap
On January 1, Year 1, Bank originates a three-year, $10,000,000 loan receivable
that matures on December 31, Year 3. The interest rate earned on the loan is
variable at 12-month LIBOR plus 2%.
Because it is concerned that 12-month LIBOR will decline, Bank simultaneously
enters into a three-year interest rate swap with a notional amount of
$10,000,000 to receive interest at a fixed rate equal to 7% and pay interest at a
variable rate equal to 12-month LIBOR.
The combination of the swap and the loan receivable results in a net cash
inflow of 9%. Both the loan receivable and interest rate swap require payments
to be made or received and to reprice on December 31.
Bank designates the swap as a cash flow hedge of the variability in interest
payments received on the loan attributable to the changes in the contractually
specified interest rate, which is 12-month LIBOR.
The following additional facts are relevant.
— All criteria for cash flow hedge accounting have been met.
— The hedging relationship was highly effective in all periods.
— 12-month LIBOR and related amounts are as follows.

12-month Swap net Loan Net

LIBOR on receipt for interest for interest for
1 2 3
Date January 1 the year the year the year
Year 1 7% $ - $900,000 $900,000
Year 2 6% 100,000 800,000 900,000
Year 3 5% 200,000 700,000 900,000

Notes:
$10,000,000 notional amount of the swap × (fixed rate - 12-month LIBOR for the
respective Year).
$10,000,000 principal amount of the loan × 12-month LIBOR + 2% for the
respective Year.
Swap net receipt for the year + Loan interest for the year.

— The fair value of the interest rate swap and changes therein at the end of
each accounting period (i.e. December 31) after cash settlement (which is
referred to as ‘clean’ pricing) are as follows.

Change in fair value

Date Fair value asset gain (loss)
Year 1 $300,000 $300,000
Year 2 125,000 (175,000)
Year 3 - (125,000)

For simplicity, this example makes the following assumptions.

— It ignores the effect of commissions and other transaction costs, initial
margins and income taxes.
— It is based on annual periods; normally the assessment of effectiveness and
related accounting entries would be performed at least quarterly.
— Journal entries (for all years) are presented gross for illustrative purposes
but could be combined.
— There has been no change in creditworthiness of either party that would
affect the likelihood of hedged transactions occurring.
Journal entries – January 1, Year 1
Bank records the following journal entry on January 1, Year 1.

Debit Credit
Loan receivable 10,000,000
Cash 10,000,000
To record origination of 12-month LIBOR + 2% loan.

There is also a memorandum entry made on January 1, Year 1 documenting the

existence of this hedging relationship. The financial records of Bank are not
otherwise affected as of this date because the interest rate swap had a fair
value of zero at inception.
Journal entries – December 31, Year 1
Bank records the following journal entries.

Debit Credit
Cash 900,000
Interest income 900,000
To record interest received on 12-month LIBOR +
2% loan.

Debit Credit
Interest rate swap 300,000
OCI – Gain (loss) on cash flow hedge 300,000
To record change in fair value of interest rate
swap (hedging instrument).

Journal entries – December 31, Year 2

Bank records the following journal entries.

Debit Credit
Cash 800,000
Interest income 800,000
To record interest received on 12-month LIBOR +
2% loan.
Cash 100,000
AOCI – Gain (loss) on cash flow hedge 100,000
To record cash paid on settlement of interest rate
swap in AOCI.
AOCI – Gain (loss) on cash flow hedge 100,000
Interest income 100,000
To reclassify into earnings amounts in AOCI as a
result of cash flow hedge.1
OCI – Loss on cash flow hedge 175,000
Interest rate swap 175,000
To record change in fair value of interest rate
swap (hedging instrument).
Note:
This is the adjustment required to bring interest income on the loan to $900,000.

Journal entries – December 31, Year 3

Bank records the following journal entries.

Debit Credit
Cash 700,000
Interest income 700,000
To record interest received on 12-month LIBOR +
2% loan.
Cash 200,000
AOCI – Gain (loss) on cash flow hedge 200,000
To record cash paid on settlement of interest rate
swap in AOCI.

Debit Credit
AOCI – Gain (loss) on cash flow hedge 200,000
Interest income 200,000
To reclassify into earnings amounts in AOCI as a
result of cash flow hedge.1
OCI – Loss on cash flow hedge 125,000
Interest rate swap 125,000
To record change in fair value of interest rate
swap (hedging instrument).
Cash 10,000,000
Loan receivable 10,000,000
To record cash received from borrower on
maturity of 12-month LIBOR +2% loan.
Note:
This is the adjustment required to bring interest income on the loan to $900,000.

Financial statement excerpts

At the end of Years 1–3, Bank’s financial statements reflect the following.

Account Year 1 Year 2 Year 3

Balance sheet – assets
Loan receivable $10,000,000 $10,000,000 -
Interest rate swap 300,000 125,000 -
Balance sheet – equity
AOCI – Gain (loss) on cash flow
hedge $300,000 $125,000 -
Income statement
Interest income $900,000 $900,000 $900,000

As a result of entering into the hedging relationship, Bank locked in a 9% rate

for the term of the loan. Because cash flow hedge accounting is used and the
hedge is highly effective, earnings do not reflect any volatility that would
otherwise result from changes in the interest rate swap’s fair value.
However, Bank’s OCI reflects volatility as a result of the requirement to report
the interest rate swap (derivative hedging instrument) at fair value on the
balance sheet. This is evidenced by the following roll-forward of AOCI.

Debit (credit)
Year 1 Year 2 Year 3
Opening balance $ - $300,000 $125,000
Cash settlement - 100,000 200,000
Reclassification to earnings - (100,000) (200,000)
Gain (loss) on the swap 300,000 (175,000) (125,000)
Closing balance $300,000 $125,000 $ -

Example 6.2.20
Accounting for a cash flow hedge of a variable-rate
debt obligation with an interest rate swap that has
a cap and a floor
On January 1, Year 1, ABC Corp. issues a three-year, $10,000,000 debt
instrument that matures on December 31, Year 3. The interest rate on the debt
instrument is variable at six-month LIBOR.
ABC is concerned that six-month LIBOR will increase above the current level.
Therefore, on January 1, Year 1, ABC enters into a three-year interest rate swap
with a notional amount of $10,000,000 to pay interest at a fixed rate equal to
7% and receive interest at a variable rate equal to six-month LIBOR. The terms
of the swap indicate that the variable rate to be paid to ABC is capped at 12%
and has a floor of 1%.
The debt reprices and requires payments to be made on January 1 of each year.
The swap reprices and requires payments to be made or received on January 1
of each year. No premium is paid or received to enter into the interest rate
swap.
ABC designates the swap as a cash flow hedge of the variability in interest
payments on the debt instrument attributable to the changes in the
contractually specified interest rate, which is six-month LIBOR.
The following additional facts are relevant.
— All criteria for cash flow hedge accounting have been met.
— The variable leg of the interest rate swap is capped at 12% and has a floor
of 1%, whereas the variable leg of the debt instrument does not contain
similar features.
— Before designating the interest rate swap as the hedging instrument of
the changes in cash flows of the interest payments on the debt
instrument due to changes in the contractually specified interest rate
(six-month LIBOR), ABC determines that the interest rate swap is not a
net written option (see section 2.7.60).
Based on statistical analysis, ABC concludes and documents that the
hedging relationship is expected to be highly effective at inception and
on an ongoing basis – i.e. the changes in the cash flows on the interest

rate swap and the changes in the present value of the expected future
cash flows of the forecasted interest payment on the debt are expected
to be highly effective in achieving offset. This is taking into account the
effect of the interest rate cap and floor on the swap.
That is, at inception and at each assessment period during the hedging
relationship, ABC determines that the interest rate cap and floor are
expected to be out of the money. Based on a probability-weighted
analysis of the range of possible changes in interest rates, the cap and
floor are expected to have minimal effect on changes in cash flows of
the swap, and the hedging relationship meets the requirement for an
expectation of high effectiveness at inception of the hedging
relationship. ABC notes that it could have entered into the same
interest rate swap on January 1, Year 1 without the cap and floor and
without paying or receiving a premium.
— ABC assesses effectiveness using the hypothetical derivative method. The
hypothetical swap is a three-year interest rate swap with a notional amount
of $10,000,000 to pay interest at a fixed rate equal to 7% and receive
interest at a variable rate equal to six-month LIBOR, whereby the payments
are made or received and six-month LIBOR will reprice on January 1 of
each year. There is no cap or floor in the hypothetical derivative.
— Six-month LIBOR and related amounts are as follows.

Swap net
Six-month payment Debt Net
LIBOR on for the interest for interest for
1 2 3
Date January 1 year the year the year
Year 1 7% $ - $700,000 $700,000
Year 2 6% 100,000 600,000 700,000
Year 3 5% 200,000 500,000 700,000
Notes:
$10,000,000 notional amount of the swap × (six-month LIBOR for the respective
Year - fixed rate).
$10,000,000 principal amount of the debt × six-month LIBOR for the respective
Year.
Swap net payment for the year + Debt interest for the year.

Change in fair value

Date Fair value liability gain (loss)
Year 1 $(300,000) $(300,000)
Year 2 (125,000) 175,000
Year 3 - 125,000

For simplicity, this example makes the following assumptions.

Debit Credit
Cash 10,000,000
Debt obligation 10,000,000
To record issuance of six-month LIBOR debt
obligation.

There is also a memorandum entry made on January 1, Year 1, documenting

the existence of this hedging relationship. ABC’s financial records are not
otherwise affected as of this date because the interest rate swap had a fair
value of zero at inception.
Journal entries – December 31, Year 1
ABC records the following journal entries.

Debit Credit
Interest expense 700,000
Cash 700,000
To record interest paid on six-month LIBOR debt
obligation.
OCI – Loss on cash flow hedge 300,000
Interest rate swap 300,000
To record change in fair value of interest rate
swap (hedging instrument).

Journal entries – December 31, Year 2

ABC records the following journal entries.

Debit Credit
Interest expense 600,000
Cash 600,000
To record interest paid on six-month LIBOR debt
obligation.

Debit Credit
AOCI – Loss on cash flow hedge 100,000
Cash 100,000
To record cash paid on settlement of interest rate
swap in AOCI.
Interest expense 100,000
AOCI – Loss on cash flow hedge 100,000
To reclassify into earnings amounts in AOCI as a
result of cash flow hedge.1
Interest rate swap 175,000
OCI – Loss on cash flow hedge 175,000
To record change in fair value of interest rate
swap (hedging instrument).
Note:
This is the adjustment required to bring interest expense on the debt to $700,000.

Journal entries – December 31, Year 3

ABC records the following journal entries.

Debit Credit
Interest expense 500,000
Cash 500,000
To record interest paid on six-month LIBOR debt
obligation.
AOCI – Loss on cash flow hedge 200,000
Cash 200,000
To record cash paid on settlement of interest rate
swap in AOCI.
Interest expense 200,000
AOCI – Loss on cash flow hedge 200,000
To reclassify into earnings amounts in AOCI as a
result of cash flow hedge.1
Interest rate swap 125,000
OCI – Loss on cash flow hedge 125,000
To record change in fair value of interest rate
swap (hedging instrument).
Debt obligation 10,000,000
Cash 10,000,000
To record cash paid by borrower on maturity of
the six-month LIBOR debt obligation.

Note:
This is the adjustment required to bring interest expense on the debt to $700,000.

Financial statement excerpts

At the end of Years 1–3, ABC’s financial statements reflect the following.

Account Year 1 Year 2 Year 3

Balance sheet – liabilities
Debt obligation $10,000,000 $10,000,000 -
Interest rate swap 300,000 125,000 -
Balance sheet – equity
AOCI – Gain (loss) on cash flow
hedge $(300,000) $(125,000) -
Income statement
Interest expense $700,000 $700,000 $700,000

As a result of entering into the hedging relationship, ABC locked in a 7% rate

for the term of the debt. Because cash flow hedge accounting is used and the
hedge is highly effective, earnings do not reflect any volatility that would
otherwise result from changes in the interest rate swap’s fair value.
— This is the case even though the terms of the interest rate swap included a
cap and a floor on the interest rate, because neither the cap nor the floor
was triggered during the hedging relationship. If the cap or the floor had
been triggered in any periods, the interest rate would not have been 7%
during those periods.
— The existence of the cap and floor in the interest rate swap – but not in the
debt – would cause the relationship to not be perfectly effective. This is
because these features would not affect the changes in cash flows of the
debt obligation, but would affect the fair value of the interest rate swap.
However, ABC’s OCI reflects volatility as a result of the requirement to report
the interest rate swap (derivative hedging instrument) at fair value in the
balance sheet. This is evidenced by the following roll-forward of AOCI.

Debit (credit)
Year 1 Year 2 Year 3
Opening balance $ - $(300,000) $(125,000)
Cash settlement - (100,000) (200,000)
Reclassification to earnings - 100,000 200,000
Gain (loss) on the swap (300,000) 175,000 125,000
Closing balance $(300,000) $(125,000) $ -

Example 6.2.30
Accounting for a cash flow hedge of a forecasted
purchase of inventory with a forward contract
(critical terms match – forward value method)
ABC Corp. purchases gold to use in its manufacturing process. On January 1,
Year 1, ABC determines that it will not be able to increase its sales prices
during the next year and therefore may suffer losses when it sells its product if
the price of gold rises.
ABC estimates that it has sufficient gold inventory to meet its manufacturing
needs for only the next six months and wants to hedge the forecasted
purchase of 10,000 ounces of gold that it expects to purchase on June 30,
Year 1. It has a contract with Supplier DEF for which the purchase price is
based on the spot price of gold at the date of purchase (a contractually specified
component).
To hedge against an increase in the market price of gold, on January 1, Year 1,
ABC enters into a forward contract to purchase gold. The forward contract
settles in cash for the difference between the price stated in the contract and
the spot price of gold on June 30, Year 1. The price stated in the forward
contract is $310 per ounce for 10,000 ounces of gold. The spot price of gold as
of January 1, Year 1 is $300 per ounce.
ABC designates the forward contract as a hedge of variability of cash flows
attributable to changes in the spot price of gold (a contractually specified
component) for its forecasted purchase of 10,000 ounces of gold on or around
June 30, Year 1.
The following additional facts are relevant.
— All criteria for cash flow hedge accounting have been met.
— ABC’s contract to purchase gold from Supplier DEF represents a derivative
for which the normal purchases and normal sales scope exception is
applied.
— ABC will assess hedge effectiveness based on the changes in the forward
price of gold.
— Given that the critical terms of the forward contract and the forecasted
purchase are the same, ABC concludes at inception and documents that
the hedging relationship is expected to be highly effective (in this example,
100% effective) in achieving offsetting cash flows attributable to changes in
the forward price of gold.
On an ongoing basis, ABC will ascertain and document that the critical
terms of the forward contract and the forecasted purchases have not
changed, including that there have been no adverse developments
concerning the risk of default by the counterparty to the forward contract or
its own nonperformance risk; therefore, not causing a different conclusion
about hedge effectiveness.
— Because the hedge is expected to be 100% effective, it is assumed that
the cumulative gains or losses on the forward contract will equal the
cumulative change in expected future cash flows on the forecasted
purchase of gold.

— The forward contract is at market rates; therefore, no cash is exchanged at

inception of the contract.
— The spot and forward prices per ounce of gold and the fair value of the
forward contract are as follows.

Change in
Forward expected
Spot price price future Fair value Change in
(per (per cash asset fair value
1 2
Date ounce) ounce) flows (liability) gain (loss)
Jan 1, Year 1 $300 $310 $ - $ - $ -
Mar 31, Year 1 310 315 50,000 49,008 49,008
Jun 30, Year 1 330 N/A 200,000 200,000 150,992
Notes:
10,000 ounce notional of the forward contract × (forward price for the respective date
- forward price at January 1, Year 1). The forward price at June 30, Year 1 is equal to
the spot price because it is the settlement date.
Present value of the change in expected future cash flows discounted at the risk-free
rate.

For simplicity, this example ignores the effect of commissions and other
transaction costs, initial margins and income taxes.
Journal entries – January 1, Year 1
There is a memorandum entry made on January 1, Year 1, documenting the
existence of this hedging relationship. ABC’s financial records are not otherwise
affected as of this date because the forward contract had a fair value of zero at
inception.
Journal entries – March 31, Year 1
ABC records the following journal entry.

Debit Credit
Forward contract 49,008
OCI – Gain on forward contract 49,008
To recognize in OCI change in fair value of forward
contract attributable to changes in forward price of
gold.

Journal entries – June 30, Year 1

ABC records the following journal entries.

Debit Credit
Forward contract 150,992
OCI – Gain on forward contract 150,992
To recognize in OCI change in fair value of
forward contract attributable to changes in
forward price of gold.

Debit Credit
Cash 200,000
Forward contract 200,000
To record cash received on settlement of forward
contract.
Gold inventory 3,300,000
Cash 3,300,000
To record purchase of 10,000 ounces of gold on
June 30, Year 1 at market price of $330 per
ounce.

Financial statement excerpts

At the end of March 31 and June 30, Year 1, ABC’s financial statements reflect
the following.

Account March 31 June 30

Balance sheet – assets
Gold inventory $ - $3,300,000
Forward contract 49,008 -
Balance sheet – equity
AOCI – Gain (loss) on forward contract $49,008 $200,000
Income statement
Cost of goods sold - -

ABC was concerned that gold prices would increase between January 1 and
June 30, Year 1 (the date of the forecasted purchase of the gold). Using a
forward contract as a hedging instrument ensured that the cost of its gold
inventory was not subject to fluctuations in the price of gold.
The $200,000 gain on the forward contract will remain in AOCI until the gold
inventory whose purchase was hedged is sold, at which point the gain will be
credited to the cost of the gold sold. Therefore, the cost of goods sold related
to the sale of the hedged forecasted purchase of gold inventory will be reported
in earnings at $3,100,000.

Excerpt from ASC 815-30

20 Glossary
Zero-Coupon Method – A swap valuation method that involves computing
and summing the present value of each future net settlement that would be
required by the contract terms if future spot interest rates match the forward
rates implied by the current yield curve. The discount rates used are the spot
interest rates implied by the current yield curve for hypothetical zero coupon
bonds due on the date of each future net settlement on the swap.

>> Example 6: Cash Flow Hedge of Variable-Rate Interest-Bearing Asset

55-24 This Example demonstrates the mechanics of accounting for an interest

rate swap used as a cash flow hedge of variable interest receipts in accordance
with the guidance in Subtopic 815-20 and this Subtopic. It is not intended to
demonstrate how to compute the fair value of an interest rate swap. As in
Example 8 (see paragraph 815-25-55-40), the zero-coupon method is used to
determine the fair values. (Unlike in that Example, the yield curve in this
Example is assumed to be upward sloping, that is, interest rates are higher for
payments due further into the future.) In this Example, the term, notional
amount, and repricing date of the interest rate swap match the term, repricing
date, and principal amount of the interest-bearing asset on which the hedged
interest receipts are due. The swap terms are at the market (as described in
paragraphs 815-20-25-104, 815-20-25-106, and 815-20-25-109), so it has a zero
value at inception. Thus, the reporting entity is permitted to assume that the
hedging relationship will achieve perfect offset in the variability of cash flows
of the hedged item.
55-25 As discussed beginning in paragraph 815-20-25-102, a shortcut method
can be used to produce the same reporting results as the method illustrated in
this Example. This shortcut is appropriate only if the assumption of perfect
offset applies for an interest rate swap used as a cash flow hedge of interest
receipts on a variable-rate asset (or interest payments on a variable-rate
liability). The steps in the shortcut method are as follows:
a. Determine the difference between the variable rate to be paid on the
interest rate swap and the variable rate to be received on the bond.
b. Combine that difference with the fixed rate to be received on the interest
rate swap.
c. Compute and recognize interest income using that combined rate and the
variable-rate asset’s principal amount. (Amortization of any purchase
premium or discount on the asset must also be considered, although that
complication is not incorporated in this Example.)
d. Determine the fair value of the interest rate swap.
e. Adjust the carrying amount of the interest rate swap to its fair value and
adjust other comprehensive income by an offsetting amount.
A slightly different shortcut method for interest rate swaps used as fair value
hedges is illustrated in Example 8 (see paragraph 815-25-55-40)
55-26 For simplicity, commissions and most other transaction costs, initial
margin, and income taxes are ignored unless otherwise stated. Assume that

there are no changes in creditworthiness that would alter the effectiveness of

the hedging relationship.
55-27 On July 1, 20X1, Entity XYZ invests $10,000,000 in variable-rate
corporate bonds that pay interest quarterly at a rate equal to the 3-month USD
LIBOR rate plus 2.25 percent. The $10,000,000 principal will be repaid on
June 30, 20X3.
55-28 Also on July 1, 20X1, Entity XYZ enters into a two-year receive-fixed,
pay-variable interest rate swap and designates it as hedging instrument in a
cash flow hedge of the variable-rate interest receipts on the corporate bonds.
The risk designated as being hedged is the risk of variability in cash flows
received attributable to changes in the contractually specified interest rate.
The terms of the interest rate swap and the corporate bonds are shown in the
following table.

Interest Rate Swap Corporate Bonds

Trade date and borrowing
date(a) July 1, 20X1 July 1, 20X1
Termination date June 30, 20X3 June 30, 20X3
Notional amount $10,000,000 $10,000,000
Fixed interest rate 6.65% Not applicable
Variable interest rate(b) 3-month USD LIBOR 3-month USD LIBOR +
2.25%
Settlement dates and interest End of each calendar End of each calendar
payment dates(a) quarter quarter
Reset dates End of each calendar End of each calendar
quarter through March 31, quarter through March 31,
20X3 20X3
(a) These terms need not match for the assumption of perfect offset to be appropriate.
(See paragraphs 815-20-25-102 through 25-110.)
(b) Only the interest rate basis (for example, LIBOR) must match. The spread over
LIBOR does not invalidate the assumption of perfect offset.

55-29 Because the conditions described in paragraphs 815-20-25-104 and 815-

20-25-106 are met, Entity XYZ is permitted to assume that there is perfect
offset in the hedging relationship and to recognize in other comprehensive
income the entire change in the fair value of the interest rate swap..
55-30 The three-month USD LIBOR rates in effect at the inception of the
hedging relationship and at each of the quarterly reset dates are assumed to be
as follows.

Reset Date 3-Month LIBOR Rate

7/1/X1 5.56%

9/30/X1 5.63%
12/31/X1 5.56%
3/31/X2 5.47%
6/30/X2 6.75%
9/30/X2 6.86%
12/31/X2 6.97%
3/31/X3 6.57%

55-31 Entity XYZ must reclassify to earnings the amount in accumulated other
comprehensive income as each interest receipt affects earnings. In
determining the amounts to reclassify each quarter, it is important to recognize
that the interest rate swap does not hedge the bonds. Instead, it hedges the
eight variable interest payments to be received. That is, each of the eight
quarterly settlements on the swap is associated with an interest payment to be
received on the bonds. Under the zero-coupon method discussed in paragraph
815-30-55-24, the present value of each quarterly settlement is computed
separately. Because each payment occurs at a different point on the yield
curve, a different interest rate must be used to determine its present value. As
each individual interest receipt on the bonds is recognized in earnings, the fair
value of the related quarterly settlement on the swap is reclassified to
earnings. The fair values and changes in fair values of the interest rate swap
and the effects on earnings and other comprehensive income for each quarter
are as follows.
Other
Comprehensive
Swap Debit Income Debit Earnings Debit Cash Debit
(Credit) (Credit) (Credit) (Credit)
July 1, 20X1 $ -
Interest accrued -
Payment (receipt) (27,250) $ 27,250
Effect of change in rates 52,100 $ (52,100)
Reclassification to
earnings 27,250 $ (27,250)
September 30, 20X1 24,850 (24,850) $ (27,250) $ 27,250
Interest accrued 330 (330)
Payment (receipt) (25,500) $ 25,500
Effect of change in rates 74,120 (74,120)
Reclassification to
earnings 25,500 $ (25,500)
December 31, 20X1 73,800 (73,800) $ (25,500) $ 25,500
Interest accrued 1,210 (1,210)
Payment (receipt) (27,250) $ 27,250
Effect of change in rates 38,150 (38,150)
Reclassification to
earnings 27,250 $ (27,250)
March 31, 20X2 85,910 (85,910) $ (27,250) $ 27,250
Interest accrued 1,380 (1,380)
Payment (receipt) (29,500) $ 29,500
Effect of change in rates (100,610) 100,610
Reclassification to
earnings 29,500 $ (29,500)

Other
Comprehensive
Swap Debit Income Debit Earnings Debit Cash Debit
(Credit) (Credit) (Credit) (Credit)
June 30, 20X2 (42,820) 42,820 $ (29,500) $ 29,500
Interest accrued (870) 870
Payment (receipt) 2,500 $ (2,500)
Effect of change in rates 8,030 (8,030)
Reclassification to
earnings (2,500) $ 2,500
September 30, 20X2 (33,160) 33,160 $ 2,500 $ (2,500)
Interest accrued (670) 670
Payment (receipt) 5,250 $ (5,250)
Effect of change in rates 6,730 (6,730)
Reclassification to
earnings (5,250) $ 5,250
December 31, 20X2 (21,850) 21,850 $ 5,250 $ (5,250)
Interest accrued (440) 440
Payment (receipt) 8,000 $ (8,000)
Effect of change in rates 16,250 (16,250)
Reclassification to
earnings (8,000) $ 8,000
March 31, 20X3 1,960 (1,960) $ 8,000 $ (8,000)
Interest accrued 40 (40)
Payment (receipt) (2,000) $ 2,000
Reclassification to
earnings 2,000 $ (2,000)
June 30, 20X3 $ - $ - $ (2,000) $ 2,000

55-32 The preceding table shows that, in each quarter, the net cash receipt or
payment on the swap equals the income or expense to be recorded. The net
effect on earnings of the interest on the bonds and the reclassification of gains
or losses on the interest rate swap are presented in the same income
statement line item as the earnings effect of the hedged item. The net
earnings effect is shown in the following table.
Earnings

Gains (Losses)
Reclassified from
Other
Comprehensive
For the Quarter Ending Interest on Bonds Income Net Effect
9/30/X1 $ 195,250 $ 27,250 $ 222,500
12/31/X1 197,000 25,500 222,500
3/31/X2 195,250 27,250 222,500
6/30/X2 193,000 29,500 222,500
9/30/X2 225,000 (2,500) 222,500
12/31/X2 227,750 (5,250) 222,500
3/31/X3 230,500 (8,000) 222,500
6/30/X3 220,500 2,000 222,500
Totals $ 1,684,250 $ 95,750 $ 1,780,000

55-33 In this Example, the shortcut method described in paragraph 815-30-55-

25 works as follows. The difference between the variable rate on the interest
rate swap and the variable rate on the asset is a net receipt of 2.25 percent.
That rate combined with the 6.65 percent fixed rate received on the interest
rate swap is 8.9 percent. The computed interest income is $890,000 per year

or $222,500 per quarter, which is the same as the amount in the table in the
preceding paragraph.

Excerpt from ASC 815-30

>> Example 12: Reporting Cash Flow Hedges in Comprehensive Income

and Accumulated Other Comprehensive Income

55-77 This Example illustrates application of the guidance in this Subtopic to

reporting cash flow hedges in comprehensive income and accumulated other
comprehensive income. For simplicity, commissions and most other
transaction costs, initial margin, and income taxes are ignored unless
otherwise stated. Assume that there are no changes in creditworthiness that
would alter the effectiveness of the hedging relationship.
55-78 Entity TUV's cash flow hedge transactions through the end of 20X4
include all of the following:
a. It continually purchases pork belly futures contracts to hedge its
anticipated purchases of pork belly inventory.
b. In 20X2, it entered into a Euro (EUR) forward exchange contract to hedge
the foreign currency risk associated with the expected purchase of a pork
belly processing machine with a five-year life that it bought from a vendor
in Germany at the end of 20X2.
c. In 20X2, it entered into a 10-year interest rate swap concurrent with the
issuance of 10-year variable rate debt (cash flow hedge of future variable
interest payments).
d. In January 20X4, it entered into a two-year Swiss franc (CHF) forward
exchange contract to hedge a forecasted export sale (denominated in CHF,
expected to occur in December 20X5) of hot dogs to a large customer in
Switzerland. In June 20X4, it closed the forward contract, but the
forecasted transaction is still expected to occur.
55-79 The following table reconciles the beginning and ending accumulated
other comprehensive income balances for 20X4. It supports the
comprehensive income display and disclosures that are required under Topic
220. It is assumed that there are no other amounts in accumulated other
comprehensive income. The after-tax amounts assume a 30 percent effective
tax rate.

Other Comprehensive Income—Debit (Credit)

Accumulated Accumulated
Other Changes in Other
Comprehensive Fair Value Comprehensive
Income as of Recognized in Reclassification Income as of
1/1/X4 20X4 Adjustments 12/31/X4
Derivatives
designated as
hedges of:
Inventory purchases $ 230 $ 85 $ (270) $ 45
Equipment purchase 120 (30) 90
Variable interest rate
payments (40) 10 5 (25)
Export sale - (50) - (50)
Before-tax totals $ 310 $ 45 $ (295) $ 60
After-tax totals $ 217 $ 32 $ (207) $ 42

55-80 The following tables illustrate an acceptable method, under the

provisions of Topic 220, of reporting the transactions described by this
Example in earnings, comprehensive income, and shareholders’ equity.

Effect of Selected Items on Earnings and Comprehensive Income

Year Ended December 31, 20X4
Debit (Credit)
Effect on earnings before taxes:
Cost of goods sold $ 270
Depreciation 30
Interest (5)
Total 295
Income tax effect (88)(a)
Effect on earnings after taxes $ 207
Other comprehensive income, net of tax:
Cash flow hedges:
Net derivative losses, net of tax effect of $13 32
Reclassification adjustments, net of tax effect
of $88 (207)
Net change (175)
Effect on total comprehensive income $ 32

(a) This Example assumes that it is appropriate under the circumstances, in accordance
with Topic 740, to recognize the related income tax benefit in the current year.

Effect of Selected Items on Shareholders’ Equity

Year Ended December 31, 20X4
Debit (Credit)
Accumulated other comprehensive income:
Balance on December 31, 20X3 $ 217
Net change during the year related to cash flow hedges (175)
Balance on December 31, 20X4 $ 42

6.2.20 Excluded components

Excerpt from ASC 815-30

> Subsequent Recognition and Measurement of Gains and Losses on

Hedging Instrument
35-3 When the relationship between the hedged item and hedging instrument
is highly effective at achieving offsetting changes in cash flows attributable to
the hedged risk, an entity shall record in other comprehensive income the
entire change in the fair value of the designated hedging instrument that is
included in the assessment of hedge effectiveness. More specifically, a
qualifying cash flow hedge shall be accounted for as follows:
a. An entity’s defined risk management strategy for a particular hedging
relationship may exclude a specific component of the gain or loss, or
related cash flows, on the hedging derivative from the assessment of
hedge effectiveness (as discussed in paragraphs 815-20-25-81 through 25-
83B). That excluded component of the gain or loss shall be recognized in
earnings either through an amortization approach in accordance with
paragraph 815-20-25-83A or through a mark-to-market approach in
accordance with paragraph 815-20-25-83B. Under either approach, the
amount recognized in earnings for an excluded component 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. For
example, if the effectiveness of a hedging relationship with an option is
assessed based on changes in the option’s intrinsic value, the changes in
the option’s time value would be excluded from the assessment of hedge
effectiveness and either may be recognized in earnings through an
amortization approach in accordance with paragraph 815-20-25-83A or
currently in earnings in accordance with paragraph 815-20-25-83B. …
>> Amounts Excluded from the Assessment of Effectiveness under an
Amortization Approach
40-6A When applying the guidance in paragraph 815-20-25-83A, if the hedged
forecasted transaction is probable of not occurring, any amounts remaining in
accumulated other comprehensive income related to amounts excluded from
the assessment of effectiveness shall be recorded in earnings in the current
period. For all other discontinued cash flow hedges, any amounts associated
with the excluded component remaining in accumulated other comprehensive
income shall be recorded in earnings when the hedged forecasted transaction
affects earnings.

If an entity has excluded components of the hedging instrument from its

assessment of hedge effectiveness, it recognizes the initial value of the
excluded components in earnings using either an amortization approach or a
mark-to-market approach. [815-20-25-83A – 25-83B]
— Amortization approach. The initial value of the excluded component is
amortized into earnings using a systematic and rational method over the life
of the hedging instrument. The difference between the amortized amount

and the change in the excluded component’s fair value is recognized in OCI
for the period.
— Mark-to-market approach. The entire change in fair value of the excluded
component is immediately recognized in earnings.
Under both methods, any amount recognized in earnings is presented in the
same income statement line item that is used to present the earnings effect of
the hedged transaction. [815-20-45-1A(b)]
Any amounts associated with the excluded component remaining in AOCI
when a cash flow hedge is discontinued are recognized in earnings when the
hedged forecasted transaction affects earnings. However, these amounts are
immediately recognized in earnings if it is probable that the forecasted
transaction will not occur within the originally specified period or within a two-
month period thereafter. See also section 6.5. [815-30-40-6A]

Examples
The following examples demonstrate cash flow accounting for excluded
components.
— Accounting for a derivative instrument’s gain or loss in a cash flow hedge –
effectiveness based on changes in intrinsic value (Subtopic 815-30’s
Example 10).
— Comparison of approaches to recognize the excluded component for a cash
flow hedge (Example 6.2.40).
— Accounting for a cash flow hedge of forecasted purchase of inventory with
a call option (critical terms do not match – intrinsic value method)
(Example 6.2.50).

Excerpt from ASC 815-30

>> Example 10: Accounting for a Derivative Instrument's Gain or Loss in a

Cash Flow Hedge—Effectiveness Based on Changes in Intrinsic Value

55-63 This Example illustrates application of the accounting guidance for cash
flow hedges described in paragraph 815-30-35-3. At the beginning of Period 1,
Entity XYZ purchases for $9.25 an at-the-money call option on 1 unit of
Commodity X with a strike price of $125.00 to hedge a forecasted purchase of
1 unit of that commodity projected to occur early in Period 5. Entity XYZ's
documented policy is to assess hedge effectiveness by comparing changes in
expected cash flows on the hedged transaction (based on changes in the
Commodity X spot price) with changes in the option contract’s intrinsic value.
Because the hedging instrument is a purchased call option, its intrinsic value
cannot be less than zero. If the price of the commodity is less than the option’s
strike price, the option is out-of-the-money. Its intrinsic value cannot decrease
further regardless of how far the commodity price falls, and the intrinsic value
will not increase until the commodity price increases to exceed the strike price.
Thus, changes in cash flows from the option due to changes in its intrinsic

value will offset changes in cash flows on the forecasted purchase only when
the option is in the money or at the money. That phenomenon is demonstrated
in Period 3 in the following table when the commodity price declines by $1.25.
Because the commodity price is $.75 below the option’s strike price, the
option’s intrinsic value declines by only $.50 (to zero). The effect reverses in
Period 4 when the commodity index price increases by $6.50 and the option’s
intrinsic value increases by $5.75. For simplicity, commissions and most other
transaction costs, initial margin, and income taxes are ignored unless
otherwise stated. Assume that there are no changes in creditworthiness that
would alter the effectiveness of the hedging relationship.
Period 1 Period 2 Period 3 Period 4

Assumptions
Ending market price of
Commodity X $ 127.25 $ 125.50 $ 124.25 $ 130.75
Ending fair value of option:
Time value $ 7.50 $ 5.50 $ 3.00 $ -
Intrinsic value 2.25 0.50 - 5.75
Total $ 9.75 $ 6.00 $ 3.00 $ 5.75
Change in time value $ (1.75) $ (2.00) $ (2.50) $ (3.00)
Change in intrinsic value 2.25 (1.75) (0.50) 5.75
Total current-period gain
(loss) on derivative $ 0.50 $ (3.75) $ (3.00) $ 2.75

Gain (loss) on derivative, adjusted

to remove the component excluded
from effectiveness test:
For the current period $ 2.25 $ (1.75) $ (0.50) $ 5.75
Cumulative 2.25 0.50 - 5.75

Change in expected future cash

flows on hedged transaction:
For the current period (2.25) 1.75 1.25 (6.50)
Cumulative (2.25) (0.50) 0.75 (5.75)

55-64 The following are the entries required to account for the cash flow
hedge. Note that consistent with paragraph 815-20-35-1(c), the change in fair
value of the hedging instrument that is included in the assessment of hedge
effectiveness is recorded in other comprehensive income for qualifying
hedging relationships. For this type of hedging relationship, Entity XYZ elects to
record changes in the option’s time value excluded from the assessment of
hedge effectiveness currently in earnings in accordance with paragraph 815-20-
25-83B. Amounts recorded in earnings should 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.

Debit (Credit)

Other
Comprehensive
Period Description Derivative Earnings Income
1 Adjust derivative to fair value and
other comprehensive income by
the calculated amount $ 0.50 $ 1.75 $ (2.25)
2 Adjust derivative to fair value and
other comprehensive income by
the calculated amount (3.75) 2.00 1.75
3 Adjust derivative to fair value and
other comprehensive income by
the calculated amount (3.00) 2.50 0.50
4 Adjust derivative to fair value and
other comprehensive income by
the calculated amount 2.75 3.00 (5.75)

55-65 Paragraph superseded by Accounting Standards Update No. 2017-12

55-66 The amount reflected in earnings relates to the component excluded
from the effectiveness test, that is, the time value component. The change in
cash flows from the hedged transaction was not fully offset in Period 3.
However, as described in paragraph 815-20-25-76, a purchased call option is
considered effective if it provides one-sided offset.

Example 6.2.40
Comparison of approaches to recognize the
excluded component for a cash flow hedge
In Subtopic 815-30’s Example 10, Entity XYZ elects to use the mark-to-market
method to account for the excluded component (in this case, the hedging
instrument’s time value). This example shows the effect on earnings if Entity
XYZ had elected to recognize the change in the excluded component using the
straight-line method (an example of an amortization approach).

Assumptions Period 1 Period 2 Period 3 Period 4

Fair value of the option
(end of period):
Time value $7.50 $5.50 $3.00 $ -
Intrinsic value 2.25 0.50 - 5.75
Total $9.75 $6.00 $3.00 $5.75
Change in time value (1.75) (2.00) (2.50) (3.00)
Change in intrinsic value 2.25 (1.75) (0.50) 5.75
Total current-period
gain (loss) on derivative $0.50 $(3.75) $(3.00) $2.75

Assumptions Period 1 Period 2 Period 3 Period 4

Amortization of initial time
value1 $(2.31) $(2.31) $(2.31) $(2.32)
Difference between
change in fair value of
excluded component
(time value) and its
amortization $0.56 $0.31 $(0.19) $(0.68)
Total change in time
value $(1.75) $(2.00) $(2.50) $(3.00)
Note:
Initial time value of the option $(9.25) ÷ 4 periods.

The following are the journal entries required to adjust the derivative to fair
value and OCI by its calculated amount.

(Debit) credit
Other comprehensive
1 2 3
Period Derivative Earnings income (loss)
1 $(0.50) $(2.31) $2.81
2 3.75 (2.31) (1.44)
3 3.00 (2.31) (0.69)
4 (2.75) (2.32) 5.07
Notes:
The total current-period gain (loss) on derivative.
The straight-line amortization of the option’s initial time value.
The difference between the total current-period gain (loss) on derivative less the
straight-line amortization of the option’s initial time value. It represents the intrinsic
value of the option plus the difference between the change in the fair value of the
excluded component (time value) and its amortization.

The following table compares the earnings effect of the excluded component
under the two methods:
— amortization approach (KPMG example); and
— mark-to-market approach (FASB example).

Approach Period 1 Period 2 Period 3 Period 4 Total

Amortization $2.31 $2.31 $2.31 $2.32 $9.25
Mark-to-market 1.75 2.00 2.50 3.00 9.25
Difference $0.56 $0.31 $(0.19) $(0.68) $ -

Example 6.2.50
Accounting for a cash flow hedge of forecasted
purchase of inventory with a call option (critical
terms do not match – intrinsic value method)
ABC Corp. expects to purchase 10,000 units of Commodity B on December 31,
Year 1. ABC is concerned that the market price of Commodity B will increase in
the interim, but wants to retain the ability to benefit if the market price falls.
On January 1, Year 1, ABC purchases for $10,000 an at-the-money call option
with Commodity A as the underlying. ABC purchased the call option on
Commodity A because it is more economical than purchasing a call option on
Commodity B. The call option is settled in net cash and enables ABC to
purchase 10,000 units of Commodity A at a strike price of $10.00 per unit on
December 31, Year 1.
ABC designates the purchased call option as a cash flow hedge of the market
price risk attributable to its forecasted purchase of 10,000 units of
Commodity B, which is expected to occur on December 31, Year 1.
The following additional facts are relevant.
— All criteria for cash flow hedge accounting have been met.
— Based on statistical analysis, ABC concluded and documented that the
hedging relationship is expected to be highly effective at inception and on
an ongoing basis – i.e. the changes in the spot rates of Commodity A are
highly effective at offsetting the changes in the cash flows of the purchase
price (at spot) of Commodity B.
— ABC will exclude changes in the time value of the option from the
assessment of the hedge’s effectiveness. ABC has elected to
recognize changes in the fair value of the excluded component (i.e.
time value) using the mark-to-market method (i.e. currently in earnings).
— ABC assesses effectiveness of the hedging relationship using the
hypothetical derivative method and considers only the changes in the
intrinsic value of that hypothetical derivative.
The hypothetical derivative is an at-the-money call option with
Commodity B as the underlying. The hypothetical derivative is settled in
net cash and enables ABC to purchase 10,000 units of Commodity B at
a strike price of $15.00 per unit on December 31, Year 1.
The difference between the strike price in the hypothetical derivative
and the actual derivative results from the different underlyings – i.e.
there is a basis difference between the hypothetical and actual
derivatives because the underlying of the forecasted purchase is
Commodity B and the underlying of the purchased call option is
Commodity A.
— The spot price, fair value, intrinsic value, time value and change in time
value of the call option related to Commodity A (i.e. the actual derivative)
are as follows.

Jan 1, Mar 31, Jun 30, Sep 30, Dec 31,

Year 1 Year 1 Year 1 Year 1 Year 1
Spot price $10.00 $10.10 $12.10 $12.30 $14.80
Fair value before
settlement:
Intrinsic value1 $ - $1,000 $21,000 $23,000 $48,000
Time value 2
10,000 8,000 5,000 1,000 -

Total fair value before

settlement $10,000 $9,000 $26,000 $24,000 $48,000
Change in intrinsic value 1,000 20,000 2,000 25,000
Change in time value (2,000) (3,000) (4,000) (1,000)

Total change in fair value

before settlement $(1,000) $17,000 $(2,000) $24,000
Settlement - - - - 48,000

Fair value after

settlement $10,000 $9,000 $26,000 $24,000 $ -

Note:
ABC measures intrinsic value as the difference between the strike price and the
spot price of the underlying asset (see Question 9.2.240).
Total fair value before settlement - Intrinsic value (see Question 9.2.230).

— The spot prices of Commodity B (i.e. spot price for the hypothetical
derivative) are $15.00 as of January 1, Year 1 and $19.78 as of
December 31, Year 1. Settlement for the hypothetical derivative would
have been $47,800.
— Because the hedging relationship was highly effective in all periods, the
financial statements will reflect the following.
— The fair value of the actual call option will be recorded on the balance
sheet.
— Changes in the time value of the actual call option will be recorded in
cost of goods sold (earnings) because ABC elected the mark-to-market
approach for the excluded component.
— AOCI will be adjusted to a balance that represents the cumulative
change in the intrinsic value of the actual call option.
For simplicity, this example makes the following assumptions.
— It ignores the effect of commissions and other transaction costs, initial
margins and income taxes.
— Journal entries (for all years) are presented gross for illustrative purposes
but could be combined.
Journal entries – January 1, Year 1
ABC records the following journal entry on January 1, Year 1.

Debit Credit
Purchased call option 10,000
Cash 10,000
To record purchase of call option on Commodity A.

There is also a memorandum entry made on January 1, Year 1, documenting

the existence of this hedging relationship.
Journal entries – March 31, Year 1
ABC records the following journal entries.

Debit Credit
Cost of goods sold 1
2,000
Purchased call option 1,000
OCI – Gain on purchased call option 2
1,000
To record change in fair value of purchased call
option on Commodity A (hedging instrument).
Notes:
Represents the change in value of the excluded component (time value), which is
recognized using the mark-to-market method (i.e. currently in earnings).
Represents the change in the intrinsic value of the derivative hedging instrument.

Journal entries – June 30, Year 1

ABC records the following journal entries.

Debit Credit
Cost of goods sold 1
3,000
Purchased call option 17,000
OCI – Gain on purchased call option2 20,000
To record change in fair value of purchased call
option on Commodity A (hedging instrument).
Notes:
Represents the change in value of the excluded component (time value), which is
recognized using the mark-to-market method (i.e. currently in earnings).
Represents the change in the intrinsic value of the derivative hedging instrument.

Journal entries – September 30, Year 1

ABC records the following journal entries.

Debit Credit
Cost of goods sold1 4,000
Purchased call option 2,000
OCI – Gain on purchased call option 2
2,000
To record change in fair value of purchased call
option on Commodity A (hedging instrument).
Notes:
Represents the change in value of the excluded component (time value), which is
recognized using the mark-to-market method (i.e. currently in earnings).
Represents the change in the intrinsic value of the derivative hedging instrument.

Journal entries – December 31, Year 1

ABC records the following journal entries.

Debit Credit
Cost of goods sold 1
1,000
Purchased call option 24,000
OCI – Gain on purchased call option 2
25,000
To record change in fair value of purchased call
option on Commodity A (hedging instrument).
Cash 48,000
Purchased call option 48,000
To record settlement of purchased call option on
Commodity A (hedging instrument).
Inventory – Commodity B3 197,800
Cash 197,800
To record purchase of Commodity B at market
rates.
Notes:
Represents the change in value of the excluded component (time value), which is
recognized using the mark-to-market method (i.e. currently in earnings).
Represents the change in the intrinsic value of the derivative hedging instrument
before settlement.
10,000 units of Commodity B × $19.78 per unit.

Financial statement excerpts

At the end of each quarter during Year 1, ABC’s financial statements reflect the
following.

Account 3 months 6 months 9 months Year

ended ended ended ended
Mar 31 Jun 30 Sep 30 Dec 31
Balance sheet – assets
Inventory - Commodity B $ - $ - $ - $197,800
Purchased call option 9,000 26,000 24,000 -
Balance sheet – equity
AOCI – Gain (loss) on
purchased call option $1,000 $21,000 $23,000 $48,000
Income statement
Cost of goods sold $2,000 $5,000 $9,000 $10,000

The effect of the hedge during the hedging relationship on the income
statement is a $10,000 increase to cost of goods sold. This represents the time
value of the purchased call option, which was excluded from the assessment of
effectiveness (with changes recognized using the mark-to-market approach –
i.e. currently in earnings).

Changes in the value of the excluded component (time value) are recognized
using the mark-to-market approach (i.e. when they occur). Because the hedged
transaction (the purchase of inventory) does not affect earnings until the
inventory is sold, this results in the changes in time value affecting cost of
goods sold (earnings) before the hedged transaction affects earnings.
The $48,000 gain on the call option remains in AOCI until the hedged
Commodity B inventory is sold. At that point, the $48,000 is reclassified into
earnings, reducing the inventory’s cost of goods sold. Therefore, the cost of
goods sold related to the sale of the hedged forecasted purchase of
Commodity B will be reported in earnings as $149,800 ($197,800 purchase
price - $48,000 gain on call option).
ABC was concerned that Commodity B prices would increase between
January 1 and December 31, Year 1 (the date of the forecasted purchase of
10,000 units of Commodity B). Using a purchased call option as a hedging
instrument reduced the effect of increased prices during the hedging
relationship. However, because the purchased call option was tied to price
changes of Commodity A – rather than Commodity B – the relationship was not
perfectly effective.
Had the relationship been perfectly effective:
— the amount recognized in AOCI as of December 31, Year 1 would have
been $47,800; and
— the cost of goods sold related to the sale of Commodity B would have been
$150,000 (10,000 units of Commodity B at the $15.00 spot price of
Commodity B at inception of the hedging relationship).
The extent to which the relationship was not perfectly effective ($200) is
recognized when the hedged forecasted transaction is reported in earnings.

6.3 Reclassifying amounts from AOCI into earnings

6.3.10 Overview

Excerpt from ASC 815-30

> Reclassifications from Accumulated Other Comprehensive Income into

Earnings
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. If an entity
excludes a component of a hedging instrument from the assessment of
effectiveness, an entity shall apply the guidance in paragraphs 815-20-25-83A
through 25-83B.
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).
35-40 However, 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..
35-41 For example, a loss shall be reported in earnings for a derivative
instrument that is designated as hedging the forecasted purchase of inventory
to the extent that the cost basis of the inventory plus the related amount
reported in accumulated other comprehensive income exceeds the amount
expected to be recovered through sales of that inventory. (Impairment
guidance is provided in paragraphs 815-30-35-42 through 35-43.)
>> Gains or Losses from Cash Flow Hedges of Debt That Is Extinguished
35-44 If the reclassification to earnings of the amount in accumulated
comprehensive income resulting from a cash flow hedge of debt is required
under this Subsection when that debt is extinguished, the amount reclassified
from accumulated comprehensive income to earnings shall be excluded from
extinguishment gain or loss.
> Hedging Relationship's Timing Involves Uncertainty within a Range
35-46 For forecasted transactions whose timing involves some uncertainty
within a range, paragraph 815-20-25-16(c) states that, as long as it remains
probable that the forecasted transaction will occur by the end of the originally
specified time period, cash flow hedge accounting for that hedging relationship
shall continue.

Net derivative gains or losses reported in AOCI that are included in the
assessment of effectiveness are reclassified into earnings in the same period(s)
that the forecasted hedged transaction is reported in earnings. [815-30-35-38 –
35-39]

However, if an entity expects that continued reporting of a net derivative loss in

AOCI would lead to recognizing a net loss on the combination of the hedging
instrument and hedged transaction (and related asset acquired or liability
incurred) in future periods, the loss is immediately reclassified into earnings
(see Question 6.3.30 and Example 6.3.20). For additional discussion of
assessing impairment, see section 6.4. [815-30-35-40 – 35-41]
When amounts are reclassified into earnings from AOCI, they are presented in
the same income statement line item as the effect of the hedged transaction. If
the event causing reclassification is extinguishment of debt, the amount
reclassified from AOCI into earnings is not included in the extinguishment gain
or loss. See also Question 6.5.100. [815-20-45-1A(a), 815-30-35-3, 35-38, 35-44]

Question 6.3.10
What method is used to reclassify amounts in AOCI
into earnings?

Interpretive response: Topic 815 does not specifically address the method for
reclassifying amounts in AOCI into earnings. We believe the method should be
consistent with the accounting policy used for recognizing income or expense
on the hedged transaction. [815-30-35-38 – 35-39]
The following table illustrates reclassifications into earnings of amounts from
AOCI that are included in the assessment of effectiveness, including the timing
and method for recognition in earnings. [815-30-35-38 – 35-39]

Hedged transaction Reclassification from AOCI

Forecasted acquisition of a The related amount in AOCI continues to be
depreciable asset reported in AOCI after the acquisition of the asset.
It is reclassified into earnings (as depreciation
expense) in the same periods that the entity
recognizes depreciation expense on the acquired
asset (e.g. straight line over the asset’s estimated
useful life).

Forecasted purchase of The related amount in AOCI is reclassified into

inventory earnings in the period that the sale of the inventory
whose purchase was hedged is recognized. This
includes consideration of the method used to
account for the inventory (e.g. FIFO, LIFO,
weighted-average cost).

Forecasted interest receipt or The related amounts in AOCI are reclassified into
payment on a financial asset earnings when interest is accrued on the hedged
or liability transaction.

Example 6.3.10
Accounting for an all-in-one hedge of a forecasted
equipment purchase
On September 1, Year 1, ABC Corp. forecasts that it will purchase equipment
on January 1, Year 2. The equipment’s current price is $100,000.
ABC is concerned that the price of the equipment will rise in the next three
months and enters into a forward purchase contract with Retailer to buy the
equipment for $102,000 (the at-market price for the equipment to be purchased
in three months). The forward purchase contract is binding on both ABC and
Retailer, specifies all significant terms, and includes a disincentive for
nonperformance that is sufficiently large to make performance probable.
Therefore, it meets the definition of a firm commitment.
Although ABC expects to settle the contract gross, the forward purchase
contract includes a clause that requires net settlement under its default

provisions. Retailer does not own the equipment. Therefore, it also meets the
definition of a derivative instrument.
ABC designates the forward purchase contract as a hedge of the variability in
cash flows attributable to price risk associated with the forecasted purchase of
equipment.
The following additional facts are relevant.
— All cash flow hedging criteria are met.
— The equipment’s price as of December 31, Year 1 is $110,000.
— The equipment has an estimated useful life of two years.
For simplicity, this example ignores the effect of commissions and other
transaction costs, initial margins and income taxes.
Journal entries – September 30, Year 1
There is a memorandum entry made on September 30, Year 1 documenting the
existence of this hedging relationship.
Journal entries – December 31, Year 1
ABC records the following journal entry.
Debit Credit
Forward purchase contract1 8,000
OCI – Gain on forward contract 8,000
To record change in fair value of forward contract
(derivative instrument).
Note:
Current price of the equipment ($110,000) less the fixed price of the equipment in the
forward purchase contract ($102,000).

Journal entries – January 1, Year 2

On January 1, Year 2, ABC takes delivery of the equipment and records the
following journal entry.

Debit Credit
Equipment1 110,000
Cash 102,000
Forward purchase contract 8,000
To record gross settlement of forward contract.
Note:
Cost of the equipment under the forward purchase contract ($102,000) plus the fair
value of the forward contract ($8,000).

Journal entries – December 31, Years 2-3

ABC records the following journal entries at the end of each of Years 2 and 3.

Debit Credit
Depreciation expense 1
55,000
Equipment – accumulated depreciation 55,000
To record depreciation expense on equipment
over its two-year useful life.
AOCI – Gain on forward contract 4,000
Depreciation expense2 4,000
To reclassify amounts in AOCI into earnings when
hedged forecasted transaction affects earnings.
Notes:
Equipment’s carrying amount of $110,000 ÷ 2 years (its useful life).
Amount in AOCI as of the date of the equipment’s purchase (i.e. the hedged
forecasted transaction) of $8,000 ÷ 2 years (its useful life).

Financial statement excerpts

At the end of Years 1–3, ABC’s financial statements reflect the following.

Account Year 1 Year 2 Year 3

Balance sheet – assets
Equipment $ - $110,000 $110,000
Equipment – accumulated
depreciation - (55,000) (110,000)
Forward contract 8,000 - -
Balance sheet – equity
AOCI – Gain (loss) on cash flow
hedge $8,000 $4,000 -
Income statement
Depreciation expense - $51,000 $51,000

Because the equipment is recorded as the sum of the cash paid under the
forward contract and the fair value of the forward contract, its carrying amount
to be depreciated is the current price of the equipment as of the purchase date.
However, depreciation expense on the equipment’s carrying amount is partially
offset because the $8,000 derivative gain reported in AOCI is reclassified into
earnings as the purchased equipment is depreciated. The effect of the amounts
reclassified from AOCI into earnings result in total net depreciation expense
over the estimated useful life of the equipment of $102,000, which is the
forward purchase price of the equipment.

Reclassifying AOCI when hedging relationship is discontinued

Excerpt from ASC 815-30

>> Example 20: Amounts Reclassified into Earnings for Purchased Option
Used in a Cash Flow Hedge

55-126 This Example illustrates when the hedging instrument's gain or loss
that is reported in accumulated other comprehensive income should be
reclassified out of accumulated other comprehensive income into earnings
under paragraph 815-30-35-36.
55-127 An entity forecasts that 1 year later it will purchase 1,000 ounces of
gold at then current market prices for use in its operations. The entity wishes
to protect itself against increases in the cost of gold above the current market
price of $275 per ounce. The entity purchases a 1-year cash-settled at-the-
money gold option on 1,000 ounces of gold, paying a premium of $10,000. If
the price of gold is above $275 at the maturity (settlement) date, the
counterparty will pay the entity 1,000 times the difference. If the price of gold
is $275 or below at the maturity date, the contract expires worthless. The
option cannot be exercised before its contractual maturity date. The entity
designates the purchased option contract as a hedge of the variability in the
purchase price (cash outflow) of the 1,000 ounces of gold for prices above
$275 per ounce. The entity would reclassify the purchased option’s gain or
loss that is reported in accumulated other comprehensive income in earnings
when the cost of the gold affects earnings (such as being included in cost of
goods sold) and present that gain or loss in the same income statement line
item as the earnings effect of the hedged item.

Question 6.3.20
When are amounts in AOCI related to specific
borrowings associated with assets under
construction reclassified into earnings?
Background: Subtopic 835-20 requires capitalizing interest cost as part of the
historical cost of acquiring certain assets. An entity’s financing plans may
associate a specific borrowing with such an acquisition. If the variability in
interest payments under a specific borrowing is hedged in a cash flow hedge
that is highly effective, gains and losses on the hedging instrument are
recognized in AOCI and are reclassified into earnings when the forecasted
transaction affects earnings. [835-20-05-1, 30-3, 30-7]

Excerpt from ASC 815-30

>> Forecasted Interest Payment Capitalized as a Cost of an Asset under

Construction
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 a 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 on the debt.

Interpretive response: If variable-rate interest on a specific borrowing is

capitalized as a cost of an asset under construction, amounts reported in AOCI
that were included in the assessment of effectiveness related to a cash flow
hedge of the variability of that interest are reclassified into earnings over the
depreciable life of the constructed asset. This is because that depreciable life
coincides with the amortization period for the capitalized interest cost on the
debt – i.e. the manner in which the hedged risk affects earnings. [815-30-35-45]
This guidance relates only to the amount reported in AOCI attributable to
interest incurred during the construction period. If the debt and the hedging
derivative remain outstanding after completion of the construction project, the
reclassification from AOCI for subsequent variability in interest is made when
the hedged variable interest is reported in earnings.

Question 6.3.30
Why is a loss in AOCI reclassified into earnings if
the combination of the hedging instrument and
hedged transaction would result in a future loss?
Interpretive response: When a net derivative loss is reported in AOCI related
to a hedged transaction in a cash flow hedge, it represents an amount that is
expected to offset a future gain (revenue) related to the hedged transaction. In
other words, the loss reported in AOCI offsets an unrecognized gain on the
hedged transaction that arose during the hedging relationship. However, market
prices may fall to the point that there are no longer anticipated revenues (gains)
being offset by the loss in AOCI.
If an entity does not expect to recover both the amount recognized as the cost
of the hedged transaction and the net derivative loss reported in AOCI when
the hedged item is sold, the amount that is not expected to be recovered is
immediately reclassified from AOCI into earnings. The FASB’s rationale for
including this guidance was that it could not justify delaying recognizing a
derivative loss in earnings when the loss is not expected to be recovered
through revenues from the hedged transaction. [815-30-35-40 – 35-41, FAS 133.BC499]

Example 6.3.20
Combination of loss reported in AOCI and hedged
transaction would give rise to a loss
ABC Corp. produces silver platters for sale to department stores. The sales
price of the silver platters depends in large part on the market price of silver as
of the date of sale.
ABC expects that it will purchase 100,000 ounces of silver on June 30, Year 1.
ABC has a contract with a supplier for which the purchase price is based on the
spot price of silver. ABC is concerned about fluctuations in the price of silver.
Therefore, on January 1, Year 1, ABC enters into an OTC silver forward contract
to purchase 100,000 ounces of silver at $16 per ounce on June 30, Year 1. The
forward contract will settle in cash on a net basis (i.e. for the difference
between the $16 per ounce stated price and the spot rate) on June 30, Year 1.
The forward contract is designated as a cash flow hedge of variability of cash
flows attributable to changes in the spot price of silver (a contractually specified
component) for ABC’s forecasted purchase of 100,000 ounces of silver on or
around June 30, Year 1. ABC’s contract to purchase silver from a supplier
represents a derivative for which the normal purchases and normal sales
exception is applied.
Throughout the hedging relationship, the hedge was highly effective. As a
result, ABC records changes in the fair value of the forward contract in OCI.
On June 30, Year 1, the spot price for silver is $15.50 per ounce. ABC
purchases 100,000 ounces of silver as forecast, and pays the market price of
$1,550,000. ABC also pays $50,000 to settle the forward contract, which
represents the fair value (liability) of the forward contract on June 30, Year 1
and therefore also represents the loss reported in AOCI related to the cash flow
hedge on that date.
As a result of the forward contract, ABC locked in a purchase price for the silver
of $1,600,000 (100,000 ounces at $16 per ounce). This is reflected in ABC’s
balance sheet on June 30, Year 1 as follows.

Account Amount (debit balances)

Silver platter inventory $1,550,000
AOCI – Loss on hedging instrument (forward contract) 50,000
Total amounts related to inventory for which the
purchase was hedged $1,600,000

Three months later on September 30, Year 1, the net realizable value of the
silver platter inventory to which the cash flow hedge relates is $2,030,000. The
inventory has a carrying amount of $2,000,000 – i.e. the initial purchase of silver
of $1,550,000 plus costs incurred after the silver was purchased.
In addition, ABC:
— uses the first-in-first-out (FIFO) method to account for its inventory; and
— continues to report in AOCI the loss on the forward contract.

As of September 30, Year 1, ABC evaluates the combination of the inventory

and the net loss on the forward contract that is reported in AOCI as follows.

Account Amount (debit balances)

Silver platter inventory $2,000,000
AOCI – Loss on hedging derivative 50,000
Total amounts related to hedged inventory1 2,050,000
Net realizable value of inventory 2,030,000
2
Amount that is not expected to be recovered $ 20,000
Notes:
Silver platter inventory + AOCI – Loss on hedging derivative.
Total amounts related to hedged inventory - Net realizable value of inventory.

ABC reclassifies $20,000 from AOCI into cost of goods sold – i.e. the same
income statement line item as the earnings effect of the hedged inventory will
be in when it is sold. This represents the amount recognized in ABC’s balance
sheet related to the silver platter inventory that is not expected to be recovered
through its sale.

Question 6.3.40
Can an impairment loss be recognized before a
forecasted transaction occurs?

Interpretive response: Yes. Ordinarily, forecasted transactions that are not

related to an existing asset are not subject to impairment assessments until the
assets are acquired. This is because forecasted transactions or events occur –
by definition – at the prevailing market price. However, the requirement to
review any amount in AOCI related to a current or previous hedging relationship
that represents a net loss may result in recognition of an impairment loss
before the forecasted transaction occurs.

6.3.20 Hedging instruments with periodic settlements

Excerpt from ASC 815-30

>> Non-Zero Fair Value of Hedging Derivative at Hedge Inception

35-41A An entity may designate a hedging derivative with periodic cash
settlements and a non-zero fair value at hedge inception as the hedging
instrument in a qualifying cash flow hedging relationship. In this situation,
amounts related to the initial fair value that are recorded in other
comprehensive income during the hedging relationship shall be reclassified
from accumulated other comprehensive income to earnings on a systematic
and rational basis over the periods during which the hedged forecasted

transactions affect earnings. Amounts reclassified to earnings shall be

presented in the same income statement line item as the earnings effect of
the hedged item. This guidance applies to both option-based and non-option-
based derivatives designated as hedging instruments in a cash flow hedge.
35-41B This paragraph illustrates a method of reclassifying amounts from
accumulated other comprehensive income to earnings when an option-based
derivative is designated as a hedging instrument and the assessment of
effectiveness is based on total changes in the derivative’s cash flows. Those
amounts include changes in fair value related to the derivative’s initial intrinsic
value in accordance with paragraph 815-30-35-41A. For example, the fair value
of a single cap at the inception of a hedging relationship of interest rate risk on
variable-rate debt with quarterly interest payments over the next two years
should be allocated to the respective caplets within the single cap on a fair
value basis at the inception of the hedging relationship. The change in each
respective allocated fair value amount should be reclassified out of
accumulated other comprehensive income into earnings when each of the
hedged forecasted transactions (the eight interest payments) affects earnings.
Because the amount in accumulated other comprehensive income is a net
amount composed of both derivative instrument gains and derivative
instrument losses, the change in the respective allocated fair value amount for
an individual caplet that is reclassified out of accumulated other comprehensive
income into earnings may possibly be greater than the net amount in
accumulated other comprehensive income.
35-41C This guidance has no effect on the accounting for fair value hedging
relationships. In addition, in determining the accounting for seemingly similar
cash flow hedging relationships, it would be inappropriate to analogize to this
guidance.

When an entity is hedging the variability of a single cash flow with a single
hedging instrument, the reclassification from AOCI into earnings is relatively
straightforward. However, when an entity is hedging the variability in multiple
cash flows with a single hedging instrument, the reclassification from AOCI into
earnings is more complex.
If a single derivative is used to hedge the variability in multiple cash flows, an
entity should reclassify an amount out of AOCI into earnings only when the
hedged forecasted transaction affects earnings. The amount that is reclassified
should equal the net derivative gain or loss within AOCI that will offset the
changes in the specific hedged forecasted transaction for the risk being
hedged.

Additional complexity: Derivative instrument has a non-zero

fair value at hedge inception
An additional complexity occurs when a single derivative with a non-zero fair
value at hedge inception is used to hedge the variability in multiple cash flows.
For example, if an interest rate swap with a fair value of zero at hedge inception
is used to hedge the payments on a variable-rate debt obligation, it may be
appropriate to reclassify amounts from AOCI based on the periodic net cash
settlements of the interest rate swap.

In contrast, if the interest rate swap has a non-zero fair value at hedge
inception, reclassifying amounts from AOCI based solely on the periodic net
cash settlements will not result in that initial fair value being reclassified from
AOCI into earnings by the end of the hedge term. Instead, the initial non-zero
fair value will remain in AOCI after all hedged interest payments have been
made and the swap has expired.
As a result of that additional complexity, Topic 815 provides specific guidance
related to hedging instruments with multiple cash flows or periodic cash
settlements (e.g. interest rate swaps, purchased caps) that have non-zero fair
values at hedge inception. In these situations, amounts in AOCI that are related
to the initial fair value are required to be reclassified into earnings on a
systematic and rational basis over the periods during which the hedged
forecasted transactions affect earnings. [815-30-35-41A]
When amounts are reclassified from AOCI related to an initial non-zero fair
value of a hedging instrument, they are presented in the same income
statement line item as the earnings effect of the hedged transaction. [815-30-
35-41A]

Question 6.3.50
What are acceptable methods to reclassify the
initial non-zero fair value of a hedging instrument
with periodic cash settlements?
Interpretive response: Topic 815 describes one acceptable method for
reclassifying the initial non-zero fair value of a hedging instrument with periodic
cash settlements into earnings. This is the ’caplet method’ used for interest
rate caps.
The caplet method involves associating the initial fair value of an interest rate
cap with each caplet within the rate cap, and reclassifying the amount of each
caplet from AOCI into earnings when the respective forecasted interest
payment occurs. [815-30-35-41B]
In addition to the caplet method, other systematic and rational methods that
may be appropriate for recognizing the initial fair value over the term of the
hedging relationship include:
— straight-line amortization – as interest expense is recognized in earnings
during the hedging relationship; or
— the interest method, resulting in a constant rate of interest expense during
the hedging relationship.
Whether the caplet method or another method is appropriate depends on the
nature and terms of the hedging instrument and the hedged transaction(s).

Question 6.3.60
What method is appropriate to reclassify amounts
from AOCI when an interest rate swap with
scheduled increases in its fixed leg is used to hedge
interest payments on variable-rate debt?
Background: ABC Corp. designates a pay-fixed, receive-floating interest rate
swap as a cash flow hedge of interest payments on variable-rate debt. The
interest rate on the pay-fixed leg of the swap increases at fixed intervals over
the life of the instrument, which is anticipated to result in lower cash outflows
during the early periods of the swap and better match the upward sloping yield
curve of market interest rates at inception of the instrument.
All hedge accounting criteria are met, including that the swap is expected to be
highly effective at offsetting changes in interest payment cash flows throughout
the life of the hedging relationship.
Interpretive response: We believe the net derivative gain or loss reported in
AOCI should be reclassified into earnings over the life of the hedging
relationship using the interest method, resulting in a constant rate of interest
expense over the life of the hedging relationship despite the increasing interest
rate on the pay-fixed leg of the swap. This treatment is consistent with
paragraphs 470-10-35-1 and 35-2, which require debt with a fixed increasing
interest rate to be accounted for under the effective interest method using the
contractual cash flows over the estimated term of that debt.
In this situation, the hedged transaction is a series of interest payments on
variable-rate debt. If each swap payment were related to each interest payment
individually, applying hedge accounting would result in an increasing rate of
interest expense over the course of the hedging relationship. We do not believe
it would be appropriate in this circumstance to view each interest payment as a
separate hedging relationship given the inherently interrelated nature of the
hedged interest payments and the swap instrument.

Question 6.3.70
What method is appropriate to reclassify amounts
from AOCI when multiple derivatives are used to
hedge interest payments on variable-rate debt?
Background: ABC Corp. issues variable-rate debt with a maturity of three
years. ABC separately enters into three derivative instruments: a one-year
interest rate swap, a forward-starting one-year interest rate swap that starts
one year in the future, and a forward-starting one-year interest rate swap that
starts two years in the future. The rates on the fixed legs of the three derivative
instruments differ – i.e. the longer duration derivatives have higher fixed rates.
ABC documents each derivative in a separate hedging relationship (i.e. three
hedging relationships in total), with each derivative hedging a different year of
variable-rate interest payments on ABC's debt.

All hedge accounting criteria are met for each relationship, including that each
swap is expected to be highly effective at offsetting changes in interest
payment cash flows throughout the life of its separate hedging relationship.
Interpretive response: We believe the net derivative gain or loss reported in
AOCI should be reclassified into earnings over the life of each separate hedging
relationship on an individual hedging relationship-by-relationship basis – e.g.
following the periodic net settlements on each interest rate swap.
The net result of applying hedge accounting for the three individual relationships
results in an increasing rate of interest expense over the course of the hedging
relationship. This result differs from that in Question 6.3.60 because it is the
result of three separately documented hedge accounting relationships with
three separate derivatives.

Example 6.3.30
Accounting for a cash flow hedge of a variable-rate,
long-term debt with an interest rate cap
On January 1, Year 1, ABC issues a $10,000,000 debt obligation that matures
on December 31, Year 3 (i.e. three years). The interest rate on the debt
obligation is variable at a rate of 12-month LIBOR plus 2%.
ABC is concerned that 12-month LIBOR may rise during the three-year term of
the debt obligation, but wants to retain the ability to benefit when it is below
8%. To protect itself from this exposure, ABC purchases for $300,000 an out-
of-the-money interest rate cap from Bank. The interest rate cap pays interest to
ABC when 12-month LIBOR exceeds 8%. The amount paid to ABC by Bank is
equal to $10,000,000 multiplied by (12-month LIBOR minus 8%) in those years
in which 12-month LIBOR exceeds 8%. The interest rate cap can be exercised
only at its contractual dates.
The combination of the cap and the debt obligation results in ABC paying
interest at a variable rate (12-month LIBOR plus 2%) not to exceed 10%. The
variable-rate debt obligation and interest rate cap both require payments to be
made on December 31 of each year. The variable rate on the debt obligation
and purchased interest rate cap reset on January 1 of each year.
ABC designates the purchased interest rate cap as a hedge of risk of changes in
cash flows of the forecasted interest payments that are attributable to the
changes in the contractually specified interest rate (i.e. 12-month LIBOR) that
exceed 8%.
The following additional facts are relevant.
— All criteria for cash flow hedge accounting have been met.
— ABC determines that:
— the critical terms of the interest rate cap completely match the related
terms of the hedged forecasted transactions;
— the strike price of the interest rate cap matches the specified level
beyond which the entity’s exposure is being hedged;

— the interest rate cap’s inflows at its periodic settlement dates

completely offset the changes in the hedged transaction’s cash
outflows for the risk being hedged.
— Given that the critical terms of the cap are identical to those of the debt
obligation, at inception of the hedge ABC concludes and documents that
the hedging relationship is expected to be highly effective (in this example,
100% effective) in achieving offsetting cash flows attributable to changes in
12-month LIBOR when 12-month LIBOR is greater than 8%.
On an ongoing basis, ABC will ascertain and document that the critical
terms of the cap and the debt obligation have not changed, including that
there have been no adverse developments concerning the risk of default by
the counterparty to the cap or its own nonperformance risk; therefore, not
causing a different conclusion about hedge effectiveness.
Because the cap is being used to purchase one-way protection against an
increase in 12-month LIBOR, ABC does not need to assess effectiveness if
12-month LIBOR is less than 8%.
— 12-month LIBOR and related amounts are as follows.

12-month Cap receipt Debt Net

LIBOR at for the interest for interest for
1 2 3
Date January 1 year the year the year
Year 1 7% $ - $ 900,000 $ 900,000
Year 2 9% (100,000) 1,100,000 1,000,000
Year 3 10% (200,000) 1,200,000 1,000,000
Notes:
Calculated as follows:
— When 12-month LIBOR for year is less than 8%, $0.
— When 12-month LIBOR for year is greater than 8%: the $10,000,000 notional
amount of the interest rate cap × (8% - 12-month LIBOR for the respective
year).
$10,000,000 principal amount of the debt × (12-month LIBOR + 2%) for the
respective year.
Cap receipt for the year + Debt interest for the year.

— The fair value of the interest rate cap and changes therein at the end of
each accounting period before cash settlement are as follows.

Jan 1, Dec 31, Dec 31, Dec 31,

Year 1 Year 1 Year 2 Year 3
Fair value before
settlement:
Intrinsic value1 $ - $ -4 $200,0005 $200,000
Time value 2
300,000 280,000 150,000 -
Total fair value
before settlement $300,000 $280,000 $350,000 $ 200,000

Jan 1, Dec 31, Dec 31, Dec 31,

Year 1 Year 1 Year 2 Year 3
Changes in fair value
after settlement:
Fair value after
settlement, beginning
of period $ - $300,000 $280,000 $150,000
Purchase of option 300,000 - - -
Change in intrinsic
value3 - - 200,000 100,000
Change in time value - (20,000) (130,000) (150,000)
Settlement of intrinsic
value - - (100,000) (200,000)
Fair value after
settlement, end of
period $300,000 $280,000 $250,000 $ -
Notes:
This example assumes that the intrinsic value of the cap is equal to the expected
future cash flows, holding constant the cap’s current period cash flow for the
remaining term of the hedge (see Question 9.2.250).
Total fair value before settlement - Intrinsic value before settlement.
Intrinsic value at respective date - Settlement at immediately preceding period-end -
Intrinsic value at immediately preceding period-end-)
As of December 31, Year 1, the cap’s current period cash flow is $0 because 12-
month LIBOR is less than 8%. Using the method explained in Note 1 above, the
current period cash flow of $0 is held constant for expected future cash flows. As a
result, the intrinsic value is assumed to be $0 as of December 31, Year 1 despite the
fact that the rate cap resets on the next day (January 1, Year 2).
As of December 31, Year 2, the cap’s current period cash flow is 1% (i.e. 9% - 8%) of
$1,000,000, or $100,000. The intrinsic value of $200,000 represents $100,000 related
to the current period and $100,000 related to the projected receipt for the next period
using the method explained in Note 1 above.

For simplicity, this example makes the following assumptions.

— It ignores the effect of commissions and other transaction costs, initial
margins and income taxes.
— It is based on annual periods; normally the assessment of effectiveness and
related accounting entries would be done at least quarterly.
— Journal entries (for all years) are presented gross for illustrative purposes
but could be combined.
Scenario 1: Intrinsic value method – excluded component (time value)
recognized in earnings using mark-to-market approach
In this scenario, ABC uses the intrinsic value method to assess effectiveness.
ABC excludes changes in the time value of the option from the assessment of
the hedge’s effectiveness.
ABC has elected to recognize changes in the fair value of the excluded
component (i.e. time value) using the mark-to-market method (i.e. currently in
earnings).

Journal entries – January 1, Year 1

ABC records the following journal entries on January 1, Year 1.

Debit Credit
Cash 10,000,000
Debt obligation 10,000,000
To record origination of 12-month LIBOR +
2% debt obligation.
Interest rate cap 300,000
Cash 300,000
To record purchase of interest rate cap at fair
value.

There is also a memorandum entry made on January 1, Year 1, documenting

the existence of this hedging relationship.
Journal entries – December 31, Year 1
ABC records the following journal entries.

Debit Credit
Interest expense 900,000
Cash 900,000
To record interest paid on 12-month LIBOR +
2% debt obligation.
Interest expense 20,000
Interest rate cap 20,000
To record change in time value of interest rate
cap.1
Note:
The entire change in fair value of the interest rate cap relates to the change in the
value of the excluded component (time value), which is recognized using the mark-to-
market method (i.e. currently in earnings).

Journal entries – December 31, Year 2

ABC records the following journal entries.

Debit Credit
Interest expense 130,000
Interest rate cap 130,000
To record change in time value of interest rate
cap.
Cash 100,000
Interest rate cap 100,000
To record cash received on settlement of interest
rate cap.
AOCI – Gain (loss) on interest rate cap 100,000
Interest expense 100,000
To reclassify into earnings amounts in AOCI that
hedged variable interest expense recognized in
earnings.
Note:
Represents the change in the intrinsic value of the interest rate cap before settlement.

Journal entries – December 31, Year 3

ABC records the following journal entries.

Debit Credit
Debt obligation 10,000,000
Cash 10,000,000
To record repayment of 12-month LIBOR +
2% debt obligation.
Note:
Represents the change in the intrinsic value of the interest rate cap before settlement.

Financial statement excerpts

At the end of Years 1–3, ABC’s financial statements reflect the following.

Account Year 1 Year 2 Year 3

As a result of entering into the hedging relationship, ABC effectively capped its
interest expense at 10% on the three-year debt obligation. During periods in
which the contractual terms of the debt obligation resulted in interest expense
greater than 10% (because 12-month LIBOR exceeded 8% plus the fixed
spread of 2%), the payments received from the interest rate cap effectively
reduced interest expense to 10% as illustrated below. However, recognition in
earnings of changes in the fair value of the cap due to changes in the excluded
component (time value) resulted in additional variability of total interest
expense.

Debit (credit)
Year 1 Year 2 Year 3
Interest on debt obligation $900,000 $1,100,000 $1,200,000
Reclassification to earnings from
AOCI - (100,000) (200,000)
Change in time value of interest
rate cap 20,000 130,000 150,000
Total interest expense $920,000 $1,130,000 $1,150,000

Scenario 2: Intrinsic value method – excluded component (time value)

recognized using straight-line method (an amortization approach)
As in Scenario 1, ABC uses the intrinsic value method to assess effectiveness
and ABC excludes changes in the time value of the option from the assessment
of the hedge’s effectiveness.
Unlike Scenario 1 in which ABC used the mark-to-market approach, in this
scenario ABC elects to recognize the initial value of the excluded component
(time value) using the straight-line method (an amortization approach) over the
life of the interest rate cap (the hedging instrument).
The following table shows the effect on earnings of the time value using the
straight-line method.

Dec 31, Dec 31, Dec 31,

Year 1 Year 2 Year 3
Amortization of initial time value1 $(100,000) $(100,000) $(100,000)
Difference between change in fair value
of time value and amortization of initial
time value 80,000 (30,000) (50,000)
Total change in time value $(20,000) $(130,000) $(150,000)
Note:
1. Initial time value of the interest rate cap of $300,000 ÷ 3 periods.

Journal entries – January 1, Year 1

ABC records the following journal entries on January 1, Year 1.

There is also a memorandum entry made on January 1, Year 1, documenting

the existence of this hedging relationship.
Journal entries – December 31, Year 1
ABC records the following journal entries.

Debit Credit
Interest expense 900,000
Cash 900,000
To record interest paid on 12-month LIBOR +
2% debt obligation.

Debit Credit
OCI – Gain (loss) on interest rate cap 20,000
Interest rate cap 20,000
To record change in time value of excluded
component in OCI.1
Interest expense 100,000
OCI – Gain (loss) on interest rate cap 100,000
To record amortization of excluded component
(time value).1
Note:
The entire change in fair value of the interest rate cap relates to the change in the
value of the excluded component (time value), which is recognized using the straight-
line method (an amortization approach).

Journal entries – December 31, Year 2

ABC records the following journal entries.

Debit Credit
Interest expense 1,100,000
Cash 1,100,000
To record interest paid on 12-month LIBOR +
2% debt obligation.
Interest rate cap 200,000
OCI – Gain (loss) on interest rate cap 200,000
To record change in intrinsic value of interest rate
cap.1
OCI – Gain (loss) on interest rate cap 130,000
Interest rate cap 130,000
To record change in fair value of excluded
component in OCI.
Interest expense 100,000
OCI – Gain (loss) on interest rate cap 100,000
To record amortization of excluded component.
Cash 100,000
Interest rate cap 100,000
To record cash received on settlement of interest
rate cap.
AOCI – Gain (loss) on interest rate cap 100,000
Interest expense 100,000
To reclassify into earnings amounts in AOCI that
hedged variable interest expense recognized in
earnings.

Note:
Represents the change in the intrinsic value of the interest rate cap before settlement.

Journal entries – December 31, Year 3

ABC records the following journal entries.

Debit Credit
Interest expense 1,200,000
Cash 1,200,000
To record interest paid on 12-month LIBOR +
2% debt obligation.
Interest rate cap 100,000
OCI – Gain (loss) on interest rate cap 100,000
To record change in intrinsic value of interest rate
cap.1
OCI – Gain (loss) on interest rate cap 150,000
Interest rate cap 150,000
To record change in fair value of excluded
component in OCI.1
Interest expense 100,000
OCI – Gain (loss) on interest rate cap 100,000
To record amortization of excluded component.
Cash 200,000
Interest rate cap 200,000
To record cash received on settlement of interest
rate cap.
AOCI – Gain (loss) on interest rate cap 200,000
Interest expense 200,000
To reclassify into earnings amounts in AOCI that
hedged variable interest expense recognized in
earnings.
Debt obligation 10,000,000
Cash 10,000,000
To record repayment of 12-month LIBOR +
2% debt obligation.
Note:
Represents the change in the intrinsic value of the interest rate cap before settlement.

Financial statement excerpts

At the end of Years 1–3, ABC’s financial statements reflect the following.

Account Year 1 Year 2 Year 3

As a result of entering into the hedging relationship, ABC effectively capped its
interest expense at 10% on the three-year debt obligation. During periods in
which the contractual terms of the debt obligation resulted in interest expense
greater than 10% (because 12-month LIBOR exceeded 8% plus the fixed
spread of 2%), the payments received from the interest rate cap effectively
reduced interest expense to 10% (plus amortization of the excluded component
– time value) as illustrated below.

Debit (credit)
Year 1 Year 2 Year 3
Interest on debt obligation $ 900,000 $1,100,000 $1,200,000
Reclassification into earnings from
AOCI - (100,000) (200,000)
Amortization of excluded
component (time value) 100,000 100,000 100,000
Total interest expense $1,000,000 $1,100,000 $1,100,000

Scenario 3: Terminal value method – caplet method used for recognizing

initial non-zero fair value
The assessment of effectiveness is documented based on total changes in the
purchased option’s cash flows – i.e. the assessment includes the purchased
option’s entire change in fair value. As explained in section 9.7.20, this approach
focuses on the rate cap’s terminal value – i.e. the expected pay-off at its
maturity date. As a result, the entity concludes that the hedging relationship is
considered perfectly effective and all changes in the purchased option’s fair
value will be recorded in AOCI.

Under this approach, the time value component of the interest rate cap is
included in the assessment of effectiveness – i.e. is not an excluded
component. As a result, the premium paid (which reflects time value and
results in the rate cap having a non-zero fair value at hedge inception) for the
interest rate cap is required to be recognized when the hedged transaction
affects earnings.
In this scenario, ABC elects to use the caplet method for recognizing the
premium paid when the hedged transactions affect earnings.
At inception of the hedging relationship, the interest rate cap consists of three
individual caplets with fair values that total the $300,000 premium paid for the
cap. The fair value of each of those caplets on January 1, Year 1 is as follows.

Caplet Fair value at inception

December 31, Year 11 $ -
December 31, Year 2 140,000
December 31, Year 3 160,000
Total $300,000
Note:
The debt’s interest rate for a payment period is set at the beginning of the period and
paid at the end of the period. That is, the first interest payment on December 31, Year
1 is based on 12-month LIBOR in effect at December 31, Year 1. Accordingly, the first
interest payment on December 31, Year 1 has no variability at the inception of the
hedging relationship and is not being hedged.

Journal entries – January 1, Year 1

ABC records the following journal entries on January 1, Year 1.

Debit Credit
Cash 10,000,000
Debt obligation 10,000,000
To record origination of 12-month LIBOR + 2%
debt obligation.
Interest rate cap 300,000
Cash 300,000
To record purchase of interest rate cap at fair
value.

There would also be a memorandum entry made on January 1, Year 1

documenting the existence of this hedging relationship.

Journal entries – December 31, Year 1

ABC records the following journal entries.
Debit Credit
Interest expense 900,000
Cash 900,000
To record interest paid on 12-month LIBOR + 2%
debt obligation.
OCI – Gain (loss) on interest rate cap 20,000
Interest rate cap 20,000
To record change in time value of interest rate
cap. 1
Note:
The entire change in fair value of the interest rate swap relates to the change in time
value of the interest rate cap.

Journal entries – December 31, Year 2

ABC records the following journal entries.

Debit Credit
Interest expense 1,100,000
Cash 1,100,000
To record interest paid on 12-month LIBOR + 2%
debt obligation.
Interest rate cap 200,000
OCI – Gain (loss) on interest rate cap 200,000
To record change in intrinsic value of interest rate
cap.1
OCI – Gain (loss) on interest rate cap 130,000
Interest rate cap 130,000
To record change in time value of interest rate
cap.
Cash 100,000
Interest rate cap 100,000
To record cash received on settlement of interest
rate cap.
AOCI – Gain (loss) on interest rate cap 100,000
Interest expense 100,000
To reclassify into earnings amounts in AOCI that
hedged variable interest expense recognized in
earnings.

Debit Credit
Interest expense 140,000
AOCI – Gain (loss) on interest rate cap 140,000
To reclassify original fair value of first caplet from
AOCI into earnings as debt interest payment
being hedged is reported in earnings.
Note:
Represents the change in the intrinsic value of the interest rate cap before settlement.

Journal entries – December 31, Year 3

ABC records the following journal entries.

Debit Credit
Interest expense 1,200,000
Cash 1,200,000
To record interest paid on 12-month LIBOR + 2%
debt obligation.
Interest rate cap 100,000
OCI – Gain (loss) on interest rate cap 100,000
To record change in intrinsic value of interest rate
cap.1
OCI – Gain (loss) on interest rate cap 150,000
Interest rate cap 150,000
To record change in time value of interest rate
cap.
Cash 200,000
Interest rate cap 200,000
To record cash received on settlement of interest
rate cap.
AOCI – Gain (loss) on interest rate cap 200,000
Interest expense 200,000
To reclassify into earnings amounts in AOCI that
hedged variable interest expense recognized in
earnings.
Interest expense 160,000
AOCI – Gain (loss) on interest rate cap 160,000
To reclassify original fair value of first caplet from
AOCI into earnings as debt interest payment
being hedged is reported in earnings.

Debit Credit
Debt obligation 10,000,000
Cash 10,000,000
To record repayment of 12-month LIBOR + 2%
debt obligation.
Note:
Represents the change in the intrinsic value of the interest rate cap before settlement.

Financial statement excerpts

At the end of Years 1–3, ABC’s financial statements reflect the following.

Account Year 1 Year 2 Year 3

Balance sheet – assets
Interest rate cap $280,000 $250,000 -
Balance sheet – liabilities
Debt obligation $10,000,000 $10,000,000 -
Balance sheet – equity
AOCI – Gain (loss) on cash flow
hedge $(20,000) $90,0001 -
Income statement
Interest expense $900,000 $1,140,000 $1,160,000
Note:
Represents the $100,000 intrinsic value of the interest rate cap less the $10,000
change (i.e. decrease) in time value of the interest rate cap that has not yet been
recognized in earnings. The $10,000 change in time value that has not yet been
recognized in earnings is calculated as the $150,000 total decrease in time value less
the initial time value of $140,000 associated with the first caplet that was recognized
in earnings.

As a result of entering into the hedging relationship, ABC effectively capped its
interest expense at 10% on the three-year debt obligation. During periods in
which the contractual terms of the debt obligation resulted in interest expense
greater than 10% (because the contractually specified interest rate – 12-month
LIBOR – exceeded 8% plus the fixed spread of 2%), the payments received
from the interest rate cap effectively reduced interest expense to 10% as
illustrated below. However, recognition in earnings of each caplet at its
expiration date resulted in variability of total interest expense.

Debit (credit)
Year 1 Year 2 Year 3
Interest on debt obligation $900,000 $1,100,000 $1,200,000
Reclassification of amounts from
AOCI that hedged the variable
interest expense into earnings - (100,000) (200,000)
Reclassification from AOCI of
caplet’s initial fair value - 140,000 160,000
Total interest expense $900,000 $1,140,000 $1,160,000

Comparison of scenarios – recognition of time value

The following table compares the amount by which earnings are decreased in
each period for recognition of the options’ time value under each method:

Approach Year 1 Year 2 Year 3 Total

Approach for recognizing time value when it is an excluded component
Mark-to-market approach
(Scenario 1) $20,000 $130,000 $150,000 $300,000
Amortization approach
(Scenario 2) 100,000 100,000 100,000 300,000
Method that includes time value in effectiveness assessment
Terminal value (Scenario 3) - $140,000 $160,000 $300,000

6.4 Assessing impairment

6.4.10 Overview

Excerpt from ASC 815-30

Pending Content
Transition Date: (P) December 16, 2019; (N) December 16, 2020 ¦ Transition
Guidance: 326-10-65-1
>> Interaction with Impairment and Credit Loss Principles
35-42 Existing requirements in generally accepted accounting principles
(GAAP) for assessing asset impairment or credit losses or recognizing an
increased obligation apply to an asset or liability that gives rise to variable cash
flows (such as a variable-rate financial instrument) for which the variable cash
flows (the forecasted transactions) have been designated as being hedged and
accounted for pursuant to paragraphs 815-30-35-3 and 815-30-35-38 through
35-41. Those impairment or credit loss requirements shall be applied each
period after hedge accounting has been applied for the period, pursuant to
those paragraphs. The fair value or expected cash flows of a hedging

instrument shall not be considered in applying those requirements. The gain or

loss on the hedging instrument in accumulated other comprehensive income
shall, however, be accounted for as discussed in paragraphs 815-30-35-38
through 35-41.
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 or corresponding 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 forecasted transaction relates, any offsetting net loss that has been
accumulated in other comprehensive income shall be reclassified immediately
into earnings.

An entity is required to apply the existing requirements in other applicable US

GAAP for:
— assessing asset impairment; and
— recognizing an increased obligation regarding an existing asset or liability for
which the variable cash flows have been or currently are designated as
being hedged.
Those requirements are performed after cash flow hedge accounting is applied
for the period. This includes performing those requirements after evaluating
whether a net derivative loss is reported in AOCI that should be reclassified
because, when combined with the hedged transaction, it would lead to a loss in
a future reporting period, as discussed in section 6.3.10. [815-30-35-42]
The following table shows examples of US GAAP that may be applicable for
impairment of assets that are related to hedged transactions in cash flow
hedging relationships.

Hedged transaction
(related asset or liability) Guidance for assessing impairment
Forecasted sale of a long- Subtopic 360-10 (property, plant and equipment)
lived asset that is
recognized on the balance
sheet

Inventory recognized on the Paragraphs 330-10-35-1A to 35-2:

balance sheet for which the — for inventory measured using LIFO or the retail
purchase was a hedged inventory method: lower of cost or market
forecasted transaction principles
— for inventory measured using all other methods:
lower of cost or net realizable value

Variability in cash flows Subtopic 310-10 (receivables)

associated with a specific
variable-rate commercial
loan receivable

Hedged transaction
(related asset or liability) Guidance for assessing impairment

Variability in cash flows Subtopic 948-310 (mortgage banking receivables)

associated with a specific based on the lower of cost or fair value
variable-rate held-for-sale
mortgage loan receivable

Variability in cash flows Subtopic 320-10 (debt securities)

associated with a specific
variable-rate debt security
classified as AFS

When applying applicable US GAAP for assessing asset impairment or

recognizing an increased obligation to an existing asset or liability, generally
neither the fair value (or the expected cash flows) of the related derivative
instruments nor any derivative gains or losses reported in AOCI related to the
hedging relationship should be considered. However, in three situations, an
entity may be required to reclassify certain amounts from AOCI into earnings
when considering the combination of the hedged transaction and the amount in
AOCI: [815-30-35-40, 35-42 – 35-43]
— A net derivative loss is reported in AOCI that, when combined with
the hedged transaction, would lead to a loss in a future reporting
period. As discussed in section 6.3.10, if an entity expects that continued
reporting of a loss in AOCI would lead to recognizing a net loss on the
combination of the hedging instrument and hedged transaction (and related
asset acquired or liability incurred) in one or more future periods, the loss is
immediately reclassified into earnings. This evaluation is required to be
performed before applying applicable US GAAP for assessing asset
impairment or recognizing an increased obligation to an existing asset
or liability.
— An impairment loss is recognized and a net derivative gain is reported
in AOCI. If an impairment loss is recognized on an existing asset or an
additional obligation is recognized on an existing liability to which a current
or previous hedged forecasted transaction relates, any offsetting net gain in
AOCI that relates directly to that transaction is reclassified into earnings.
— A recovery is recognized and a net derivative loss is reported in AOCI.
If a recovery is recognized, any related offsetting net loss in AOCI is
immediately reclassified into earnings.
Additionally, when impairment is recognized for a hedged asset, the entity
should consider whether:
— the likelihood of the forecasted transaction occurring has changed; and
— additional amounts are required to be reclassified from AOCI into earnings
due to such a change (see section 6.5.20).

Question 6.4.10
Are the fair value or expected cash flows of a
hedging instrument ever considered when
evaluating impairment of an asset related to the
hedged transaction?
Interpretive response: Generally, no. Ordinarily, the fair value or expected cash
flows of a derivative hedging instrument do not affect the determination of
whether an asset related to the hedged transaction is impaired because the
derivative is a separate asset or liability. [815-30-35-42]
However, the SEC staff has specific guidance for entities with oil- and gas-
producing activities that apply the full cost method of accounting. In this
situation, the prices to be received after taking into account cash flow hedging
arrangements are used to calculate the current price of the quantities of the
future production of oil and gas reserves covered by the hedges as of the
reporting date. The current price is then used to determine whether the
capitalized cost of the oil- and gas-producing entity exceeds the full cost
limitation. [932-360-S99-2]

Example 6.4.10
Hedged asset is impaired and related amount in
AOCI is a net derivative loss
This example is a modification of Example 6.3.20.
In that example, ABC Corp. uses a forward contract in a cash flow hedge of a
forecasted purchase of silver. As a result of the forward contract, ABC locks in a
purchase price for the silver of $1,600,000 (100,000 ounces at $16 per ounce).
After settlement of the forward contract and purchase of silver, ABC’s balance
sheet on June 30, Year 1 reflects the following amounts.

Account Amount (debit balances)

Silver platter inventory $1,550,000
AOCI – Loss on hedging instrument (forward contract) 50,000
Total amounts related to inventory for which the
purchase was hedged $1,600,000

Three months later on September 30, Year 1, the net realizable value of the
silver platter inventory to which the cash flow hedge relates is $1,975,000. The
inventory has a carrying amount of $2,000,000 – i.e. the initial purchase of silver
of $1,550,000 plus costs incurred after the silver was purchased.
In addition, ABC:
— uses the FIFO method to account for its inventory; and
— continues to report in AOCI the loss on the forward contract.

As of September 30, Year 1, ABC first evaluates the combination of the

inventory and the net loss on the forward contract that is reported in AOCI as
follows.

Account Amount (debit balances)

Silver platter inventory $2,000,000
AOCI – Loss on hedging derivative 50,000
Total amounts related to hedged inventory 1
2,050,000
Net realizable value of inventory 1,975,000
Portion of total amount that is not expected to be
2
recovered $75,000
Amount of AOCI – loss on hedging derivative to be
3
reclassified into earnings $50,000
Notes:
Silver platter inventory + AOCI – Loss on hedging derivative.
Total amounts related to hedged inventory – Net realizable value of inventory.
Represents the entire amount in AOCI – Loss on hedging derivative ($50,000).

ABC records the following journal entry.

Debit Credit
Cost of goods sold 50,000
AOCI – Loss on hedging derivative 50,000
To reclassify from AOCI to earnings a loss on
hedging derivative not expected to be recovered.

As of September 30, Year 1, ABC next evaluates whether the silver platter
inventory is impaired as follows.

Account Amount (debit balances)

Silver platter inventory $2,000,000
Net realizable value of inventory 1,975,000
1
Amount of impairment to recognize $25,000
Note:
Silver platter inventory - Net realizable value of inventory.

ABC records the following journal entry.

Debit Credit
Cost of goods sold 25,000
Inventory 25,000
To recognize impairment of inventory due to
market value being less than carrying amount.

As this example demonstrates, when the net realizable value is less than the
carrying amount of inventory, related net derivative losses reported in AOCI are

required to be reclassified into earnings in addition to (and in advance of)

recognition of the inventory’s impairment loss. This is because Topic 815 is
applied before the impairment guidance.

Question 6.4.20
Are net gains in AOCI reclassified if an impairment
loss is recognized on an existing asset to which a
current or previous hedged forecasted transaction
relates?
Interpretive response: When an impairment loss is recognized on an existing
asset to which a current or previous hedged forecasted transaction relates, it
generally is necessary to reclassify an offsetting net gain related to the
transaction (if any) from AOCI into earnings. However, before any offsetting net
gain in AOCI is reclassified into earnings, an entity should ascertain that the net
gain directly relates to that asset or liability being measured for impairment and
the measure for that impairment results from the risk being hedged. [815-30-35-43]
For example, if interest rate risk is hedged on a variable-rate financial asset and
results in a gain in AOCI, that gain would not be reclassified into earnings if an
impairment loss due to credit risk is recognized on the financial asset. This is
because the hedged risk that resulted in the gain in AOCI was interest rate risk
while the risk resulting in recognition of an impairment loss is credit risk.
Additionally, the entity would need to consider whether recognizing the
impairment loss indicates the likelihood of the forecasted transaction is no
longer probable (and may indicate it is probable that the forecasted transaction
will not occur). See section 6.5.20, which discusses the impact on hedge
accounting and the treatment of the net derivative gain or loss reported in AOCI
when the likelihood of the forecasted transaction is no longer probable.

Example 6.4.20
Hedged asset is impaired and related amount in
AOCI is a net derivative gain
This example is a modification of Example 6.3.20.
In that example, ABC Corp. uses a forward contract in a cash flow hedge of a
forecasted purchase of silver. As a result of the forward contract, ABC locked in
a purchase price for the silver of $1,600,000 (100,000 ounces at $16 per
ounce).
Unlike that example, it is now assumed that the spot price for silver is $16.30
per ounce. ABC purchases 100,000 ounces of silver as forecast, and pays the
market price of $1,630,000. Additionally, ABC receives $30,000 to settle the
forward contract, which represents the fair value (asset) of the forward contract
on June 30, Year 1. As a result, ABC’s balance sheet reflects a net derivative
gain in this example – rather than loss as in Example 6.3.20 – in AOCI after
settlement of the forward contract and purchase of silver.

After settlement of the forward contract and purchase of silver, ABC’s balance
sheet on June 30, Year 1 reflects the following amounts.

Account Amount
Silver platter inventory $1,630,000
AOCI – Gain on hedging instrument (forward contract) 30,000
Total amounts related to inventory for which the purchase
was hedged $1,600,000

Three months later on September 30, Year 1, the net realizable value of the
silver platter inventory to which the cash flow hedge relates is $1,975,000. The
inventory has a carrying amount of $2,000,000 – i.e. the initial purchase of silver
of $1,630,000 plus costs incurred after the silver was purchased.
In addition, ABC:
— continues to report in AOCI the gain on the forward contract; and
— uses the FIFO method to account for its inventory.
As of September 30, Year 1, ABC evaluates whether the silver platter inventory
is impaired as follows.

Account Amount (debit balances)

Silver platter inventory $2,000,000
Net realizable value of inventory 1,975,000
1
Amount of impairment to recognize $ 25,000
Note:
Silver platter inventory - Net realizable value of inventory.

ABC records the following journal entry.

Debit Credit
Cost of goods sold 25,000
Inventory 25,000
To recognize impairment of inventory due to
market value being less than carrying amount.

ABC performs an analysis to determine why the inventory’s net realizable value
is less than its cost. ABC concludes that it is primarily because of a decrease in
the spot price of silver (i.e. the hedged risk) after the silver was purchased.
Therefore, ABC evaluates the amount of the net gain on the forward contract
that is reported in AOCI by comparing it to the amount of the impairment loss
that was recognized.

Account Amount
Impairment loss recognized $25,000
AOCI – Gain on hedging instrument (forward contract) 30,000
Amount of AOCI – gain on hedging derivative to be
1
reclassified into earnings $25,000

Note:
Represents the lesser of the impairment loss recognized and the amount in AOCI
– Gain on hedging instrument (forward contract).

ABC records the following journal entry.

Debit Credit
AOCI – Gain on hedging derivative 25,000
Cost of goods sold 25,000
To reclassify from AOCI into earnings a gain on
hedging derivative to offset impairment loss
recognized on hedged transaction.

As this example demonstrates, when an impairment loss is recognized, net

derivative gains reported in AOCI related to the hedged forecasted transaction
are required to be reclassified into earnings to the extent of that impairment
loss.

6.5 Discontinuing hedge accounting

6.5.10 Overview

Excerpt from ASC 815-30

>> Change in Designated Hedged Risk

35-37A If the designated hedged risk changes during the life of a hedging
relationship, an entity may continue to apply hedge accounting if the hedging
instrument is highly effective at achieving offsetting cash flows attributable to
the revised hedged risk. The guidance in paragraph 815-20-55-56 does not
apply to changes in the hedged risk for a cash flow hedge of a forecasted
transaction.
> Discontinuing Hedge Accounting
40-2 In the circumstances discussed in paragraph 815-30-40-1, the net gain or
loss shall remain in accumulated other comprehensive income and be
reclassified into earnings as specified in paragraphs 815-30-35-38 through 35-
41. Example 16 (see paragraph 815-30-55-94) illustrates the application of
paragraph 815-30-35-3 if a hedging relationship is terminated.

The following table provides an overview of circumstances that would require

an entity to discontinue or partially dedesignate a hedging relationship.

Change in — Hedged transaction no longer meets the eligibility criteria

eligibility or [815-30-40-1(a)]
critical terms of — Modification of hedged transaction such that critical terms
hedged of the original hedging relationship have changed [815-20-55-
transactions 56]
(section 2.10.20)

Change in — Hedging instrument no longer meets the eligibility criteria

eligibility or [815-30-40-1(a)]
critical terms of — Hedging instrument expires or is sold, terminated or
hedging exercised [815-30-40-1(b)]
instrument
— Modification of hedging instrument such that critical terms
(section 2.10.30) of the original hedging relationship have changed [815-20-55-
56]

Change in — Change in the hedged risk, except in certain circumstances

hedged risk [815-20-55-56]
(sections 2.10.40
and 5.4.60)

Change in hedge — Hedge no longer highly effective on a retrospective

effectiveness and/or prospective basis, with certain exceptions (see
(section 2.10.50) Question 2.10.90) [815-30-40-1(a)]
— Change in quantitative method to assess hedge
effectiveness, including whether a component of the
hedging instrument is excluded from the assessment (see
section 9.6.40) [815-20-55-56]

Elective An entity may elect to discontinue the hedging relationship.

dedesignation [815-30-40-1(c)]

Future developments

Current guidance is not clear as to whether the ability to change the hedged risk
also provides an ability to change the hedged forecasted transaction (see
Question 5.4.90). The FASB discussed potential Codification improvements
related to this issue at a March 2018 meeting and is in the process of collecting
external feedback on these potential amendments. [FASB meeting 03-18]

Treatment of hedging instruments. If the derivative instrument remains

outstanding after hedge accounting is discontinued, it continues to be recorded
on the balance sheet at fair value. However, changes in the derivative’s fair
value (including changes in excluded components) are reflected in earnings –
rather than AOCI – unless the derivative is designated as the hedging
instrument in a new hedging relationship. It may be used as the hedging
instrument in a new hedging relationship as long as the hedging criteria are met
for the new relationship. [815-30-40-3]
Treatment of amounts remaining in AOCI and effect of discontinuation on
future hedging relationships. When a hedging relationship is discontinued,

accounting for the net derivative gain or loss reported in AOCI and the effect of
the discontinuation on future hedging relationships depends on several
considerations. Those considerations are summarized in the following decision
tree.

Has any one of the following occurred?

— Any of the hedging criteria are no
longer met
— The derivative has expired or been Continue the cash flow
sold, terminated or exercised No hedging relationship
— The entity has removed or partially
removed the hedge designation
(section 2.10)

Yes

Discontinue the cash flow hedging

relationship (or portion thereof)
prospectively

Continue

Is it probable that the originally

forecasted transaction will not occur
Reclassify the amount remaining
within the originally specified period or
in AOCI related to the hedging
within a two-month period thereafter?
relationship into earnings when the
No hedged forecasted transaction is
This evaluation is continuous as long as
reported in earnings
derivative gains or losses are reported in
(section 6.3.10)
AOCI related to a hedged forecasted
transaction (section 6.5.20)

Yes

Are there extenuating circumstances Yes

related to the nature of the originally
forecasted transaction that resulted in it Were these extenuating
being probable that it will not occur circumstances outside the control or
within the original period specified in the Yes influence of the entity?
hedge documentation or within a two- (This should be very rare)
month period thereafter?
(section 6.5.20) No

Reclassify the amount remaining

in AOCI related to the hedging
relationship into earnings immediately.

Consider whether the missed forecast results

in the entity having a pattern of missing
forecasts that calls into question its ability
to predict future transactions.
(see also Question 6.5.110)

Examples
The following examples demonstrate discontinuation of cash flow hedge
accounting.
— Terminating an interest rate swap used in a cash flow hedge
(Example 6.5.10).
— Terminating a cash flow hedge when hedge designation is removed
(Example 6.5.20).
— Accounting for amounts in AOCI when a hedged forecasted transaction
becomes a firm commitment (Example 6.5.30).
— Designation and discontinuance of a cash flow hedge of the forecasted
purchase of inventory (Subtopic 815-30’s Example 8).
— Changes in a cash flow hedge of forecasted interest payments with an
interest rate swap (Subtopic 815-30’s Example 9).

Example 6.5.10
Terminating an interest rate swap used in a cash
flow hedge
Three years ago, ABC Corp. entered into a five-year interest rate swap to
receive interest at a variable rate (US Treasury rates) and to pay interest at a
fixed rate. The swap was designated as a hedge of the risk of changes in its
cash flows attributable to changes in the contractually specified interest rate
(i.e. US Treasury rates) on a specific five-year, variable-rate debt obligation.
Since that time, interest rates have declined and ABC has recognized a liability
of $1,000,000 related to this interest rate swap (unrealized net loss), with an
offsetting charge of $1,000,000 reported in AOCI.
ABC pays the swap counterparty $1,000,000 to terminate the interest rate
swap and derecognizes the $1,000,000 liability related to the swap.
In this example, the hedging instrument is terminated but the hedged
transaction (interest cash flows on a specific five-year, variable-rate debt
obligation) continues to be probable. As a result, the net derivative loss reported
in AOCI related to the discontinued hedging relationship is reclassified into
earnings when the hedged forecasted transactions affect earnings – e.g. over
the remaining two-year life of the specific debt obligation.

Example 6.5.20
Terminating a cash flow hedge when hedge
designation is removed
Three years ago, ABC Corp. entered into a five-year interest rate swap to
receive interest at a fixed rate and to pay interest at a variable rate (six-month
LIBOR). The swap was designated as a hedge of the risk of changes in its cash
flows attributable to changes in the contractually specified rate (six-month
LIBOR) on a specific five-year, variable-rate (six-month LIBOR) AFS debt
security.

Since that time, interest rates decreased and ABC recognized an asset of
$1,000,000 relating to this interest rate swap (an unrealized net gain), with an
offsetting credit of $1,000,000 reported in AOCI.
ABC removes the hedging designation.
In this example, the hedging relationship has been discontinued but the hedged
transaction (interest cash flows on a specific five-year, variable-rate AFS debt
security) continues to be probable. As a result, the net derivative gain reported
in AOCI related to the discontinued hedging relationship is reclassified into
earnings when the hedged forecasted transactions affect earnings – e.g. over
the remaining two-year life of the specific debt security.
As of the date the hedging designation is removed, ABC accounts for the swap
as a nonhedging derivative instrument with all subsequent changes in its fair
value recognized currently in earnings unless it is designated as the hedging
instrument in a new hedging relationship that meets all of the relevant hedging
criteria.

Example 6.5.30
Accounting for amounts in AOCI when a hedged
forecasted transaction becomes a firm
commitment
On January 1, Year 1, ABC Corp. purchases a call option to hedge the total price
risk of a forecasted purchase of 10,000 units of inventory, which is expected to
occur in 12 months. At June 30, Year 1, a $5,000,000 net gain on the call option
remains in AOCI.
On July 1, Year 1, ABC enters into a firm commitment to acquire the 10,000
units of inventory in six months at a fixed price, thereby transforming the
forecasted transaction into a firm commitment.
When the hedged forecasted transaction becomes a firm commitment, it no
longer qualifies as a cash flow hedge because there is no variability in expected
future cash flows. As a result, ABC discontinues prospectively applying cash
flow hedge accounting to the forecasted transaction/call option hedging
relationship.
ABC continues to report the $5,000,000 net derivative gain in AOCI until the
date the hedged forecasted transaction is reported in earnings. Because the
hedged forecasted transaction is the purchase of inventory, the $5,000,000 gain
in AOCI will be reclassified into earnings when either the hedged inventory is
sold or impairment is recognized (sections 6.3.10 and 6.4.10).

Excerpt from ASC 815-30

>> Example 8: Designation and Discontinuance of a Cash Flow Hedge of

the Forecasted Purchase of Inventory

55-40 This Example illustrates the effect on earnings and other

comprehensive income of discontinuing a cash flow hedge by dedesignating
the hedging derivative under paragraph 815-30-40-1(c) before the variability of
the cash flows from the hedged forecasted transaction has been eliminated. It
also discusses the effect that the location of a physical asset has on the
effectiveness of a hedging relationship. For simplicity, commissions and most
other transaction costs, initial margin, and income taxes are ignored unless
otherwise stated. Assume that there are no changes in creditworthiness that
would alter the effectiveness of the hedging relationship.
55-41 On February 3, 20X1, Entity JKL forecasts the purchase of 100,000
bushels of corn on May 20, 20X1. The contract does not contain a contractually
specified component, and Entity JKL designates changes in cash flows related
to the forecasted transaction attributable to all changes in the purchase price as
the hedged risk. It expects to sell finished products produced from the corn on
May 31, 20X1. On February 3, 20X1, Entity JKL enters into 20 futures
contracts, each for the purchase of 5,000 bushels of corn on May 20, 20X1
(100,000 in total), and designates those contracts as a hedging instrument in a
cash flow hedge of the forecasted purchase of corn.
55-42 Entity JKL chooses to assess effectiveness by comparing the entire
change in fair value of the futures contracts to changes in the expected cash
flows on the forecasted transaction. Entity JKL estimates its expected cash
flows on the forecasted transaction based on the futures price of corn adjusted
for the difference between the cost of corn delivered to Chicago and the cost
of corn delivered to Minneapolis. Entity JKL does not choose to use a tailing
strategy (as described in paragraph 815-20-25-121). Entity JKL expects
changes in fair value of the futures contracts to be highly effective at offsetting
changes in the expected cash outflows for the forecasted purchase of corn
because both of the following conditions exist:
a. The futures contracts are for the same variety and grade of corn that
Entity JKL plans to purchase.
b. On May 20, 20X1, the futures price for delivery on May 20, 20X1 will be
equal to the spot price (because futures prices and spot prices converge as
the delivery date approaches).
However, the hedge may not achieve perfect offset between the hedged item
and hedging instrument because of the difference in the delivery location
between the hedging instrument and forecasted transaction.
55-43 Entity JKL will purchase corn for delivery to its production facilities in
Minneapolis, but the price of the futures contracts is based on delivery of corn
to Chicago. Changes in the difference between the price of corn delivered to
Chicago and the price of corn delivered to Minneapolis would result in not
achieving perfect offset between the hedged item and hedging instrument

and, if of significant magnitude, may preclude the hedging relationship from

achieving highly effective offset.
55-44 On February 3, 20X1, the futures price of corn for delivery to Chicago on
May 20, 20X1, is $2.6875 per bushel resulting in a total price of $268,750 for
100,000 bushels.
55-45 On May 1, 20X1, Entity JKL dedesignates the related futures contracts
and closes them out by entering into offsetting contracts on the same
exchange. As of that date, Entity JKL had recognized in accumulated other
comprehensive income gains on the futures contracts of $26,250. Entity JKL
still plans to purchase 100,000 bushels of corn on May 20, 20X1.
Consequently, the gains that occurred before dedesignation will remain in
other comprehensive income until the finished product is sold. If Entity JKL
had not closed out the futures contracts when it dedesignated them, any
further gains or losses would have been recognized in earnings.
55-46 On May 20, 20X1, Entity JKL purchases 100,000 bushels of corn, and on
May 31, 20X1, Entity JKL sells the finished product.
55-47 The futures prices of corn that are in effect on key dates are assumed to
be as follows.
Futures Price per Futures Price
Bushel for Delivery to Adjusted for Delivery
Chicago on May 20, to Minneapolis on
Date 20X1 May 20, 20X1
Inception of hedging relationship—February 3,
20X1 $ 2.6875 $ 2.7375
End of quarter—March 31, 20X1 3.1000 3.1500
Discontinue hedge—May 1, 20X1 2.9500 3.0000
Purchase of corn—May 20, 20X1 2.8500 2.9000

55-48 The changes in fair value of the futures contracts between inception
(February 3, 20X1) and discontinuation (May 1, 20X1) of the hedge are as
follows.
February 3– April 1–May 1,
March 31, 20X1 20X1
Futures price at beginning of period $ 2.6875 $ 3.1000
Futures price at end of period 3.1000 2.9500
Change in price per bushel 0.4125 (0.1500)
Bushels under contract (20 contracts @ 5,000 bushels
each) x 100,000 x 100,000
Change in fair value—gain (loss) $ 41,250 $ (15,000)

55-49 The following table displays the entries to recognize the effects of all of
the following:
a. Entering into futures contracts as a hedge of the forecasted purchase of
corn
b. Dedesignating and closing out the futures contracts
c. Completing the forecasted purchase of corn
d. Selling the finished products produced from the corn.
Because the difference in prices between corn delivered to Chicago and corn
delivered to Minneapolis ($.05 per bushel, as illustrated in paragraph 815-30-55-
47) did not change during the period of the hedge, the hedging relationship

achieved perfect offset between the hedged item and the hedging instrument.
If that difference had changed, the entire change in fair value of the futures
contracts would still have been recorded in accumulated other comprehensive
income until the discontinuation date assuming the hedging relationship
remained highly effective at offsetting variability in cash flows and the hedged
forecasted transaction was still probable of occurring.
Debit (Credit)

Other
Comprehensive
Cash Inventory Income Earnings (a)
March 31, 20X1 (end of
quarter)
Recognize change in fair
value of futures contracts $ 41,250 $ (41,250)
May 1, 20X1 (discontinue
hedge)
Recognize change in fair
value of futures contracts (15,000) 15,000
May 20, 20X1
Recognize purchase of
corn (290,000) $ 290,000
May 31, 20X1
Recognize cost of sale of
product (290,000) $ 290,000
Reclassify changes in fair
value of futures contracts
to earnings 26,250 (26,250)
Total $ (263,750) $ - $ - $ 263,750

(a) The change in the fair value of the hedging derivative is presented in the same income
statement line item as the earnings effect of the hedged item.

55-50 To simplify this Example and focus on the effects of the hedging
relationship, the margin account with the clearinghouse and certain amounts
that would be involved in a sale of Entity JKL's inventory (for example,
additional costs of production, selling costs, and sales revenue) have been
ignored.
55-51 The effect of the hedging strategy is that the cost of the corn recognized
in earnings when the finished product was sold was $263,750. If the hedging
relationship had not been discontinued early, the cost recognized in earnings
would have been $273,750, which was the futures price of the corn, adjusted
for delivery to Minneapolis, at the inception of the hedge. Without the strategy,
Entity JKL would have recognized $290,000, which was the price of corn
delivered to Minneapolis at the time it was purchased.

Excerpt from ASC 815-30

>> Example 9: Changes in a Cash Flow Hedge of Forecasted Interest

Payments with an Interest Rate Swap

55-52 The following Cases describe the effects on earnings and other
comprehensive income of certain changes in a cash flow hedging relationship:
a. The variability of the hedged interest payments is eliminated before the
hedging derivative expires (Case A).
b. The interest rate index that is the basis for the hedged interest payments
is changed to a different index before the hedging derivative expires
(Case B).
55-53 Cases A and B share the following assumptions. For simplicity,
commissions and most other transaction costs, initial margin, and income
taxes are ignored unless otherwise stated. Assume that there are no changes
in creditworthiness that would alter the effectiveness of the hedging
relationship.
55-54 Entity MNO enters into an interest rate swap (Swap 1) and designates it
as a hedge of the variable quarterly interest payments on Entity MNO's 5-year
$5 million borrowing program, initially expected to be accomplished by a series
of $5 million notes with 90-day terms. Entity MNO plans to continue issuing
new 90-day notes over the next 5 years as each outstanding note matures. The
interest on each note will be determined based on the contractually specified
LIBOR rate at the time each note is issued. Swap 1 requires a settlement
every 90 days, and the variable interest rate is reset immediately following
each payment. Entity MNO pays a fixed rate of interest (6.5 percent) and
receives interest at LIBOR. Entity MNO neither pays nor receives a premium at
the inception of Swap 1. The notional amount of the contract is $5 million, and
it expires in 5 years.
55-55 Because Swap 1 and the hedged forecasted interest payments are
based on the same notional amount, have the same reset dates, and are based
on the same contractually specified interest rate (that is, the LIBOR rate)
designated under paragraph 815-20-25-15(j)(2), Entity MNO may conclude that
the hedging relationship will perfectly offset changes in cash flows of the
hedged item attributable to the hedged risk and the hedging instrument
(absent a default by the interest rate swap counterparty).
55-56 This paragraph explains why the guidance in Example 4, Case B (see
paragraph 815-20-55-97) does not conflict with the guidance in this Example.
In the cash flow hedge in this Example, had the hedged forecasted transaction
been narrowly limited to the interest payments on specific future debt
issuances rather than on the five-year borrowing program, the failure to engage
in future debt issuances would cause the related derivative instrument net gain
or loss in other comprehensive income to be immediately reclassified into
earnings pursuant to paragraphs 815-30-40-4 through 40-5 because it would
have been probable that the hedged forecasted transactions would not occur.
Furthermore, if that failure is part of a pattern of hedged forecasted
transactions being probable of not occurring, it would call into question both an

entity's ability to accurately predict forecasted transactions and the propriety of

using hedge accounting in the future for similar forecasted transactions,
pursuant to paragraph 815-30-40-5. In contrast, in Example 4, Case B (see
paragraph 815-20-55-97), the hedged quarterly interest payments were directly
linked to Entity B's existing LIBOR-indexed floating-rate assets. When those
existing assets are later prepaid or sold, the future quarterly interest payments
on those specific assets are no longer probable of occurring (that is, no longer
probable of being received by Entity B). Consequently, the hedging
relationships for those future quarterly interest payments fail to meet the
criterion in paragraph 815-20-25-15(b) and must be discontinued under
paragraph 815-30-40-1. Because it is probable that the hedged quarterly
interest payments that were directly linked to assets that were prepaid or sold
will not occur, the related derivative instrument net gain or loss in other
comprehensive income must be immediately reclassified into earnings
pursuant to paragraphs 815-30-40-4 through 40-5.
>>> Case A: Variability of Hedged Forecasted Transactions Is Eliminated
55-57 At the end of the second year of the 5-year hedging relationship, Entity
MNO discontinues its practice of issuing 90-day notes. Instead, Entity MNO
issues a 3-year, $5 million note with a fixed rate of interest (7.25 percent).
Because the interest rate on the three-year note is fixed, the variability of the
future interest payments has been eliminated. Thus, Swap 1 no longer qualifies
for cash flow hedge accounting. However, the net gain or loss on Swap 1 in
accumulated other comprehensive income is not reclassified to earnings
immediately. Immediate reclassification is required (and permitted) only if it
becomes probable that the hedged transactions (future interest payments) will
not occur. The variability of the payments has been eliminated, but it still is
probable that they will occur. Thus, those gains or losses will continue to be
reclassified from accumulated other comprehensive income to earnings as the
interest payments affect earnings (as required by paragraphs 815-30-35-38
through 35-41) and presented in the same income statement line item as the
earnings effect of the hedged item. If the term of the fixed rate note had been
longer than three years, the amounts in accumulated other comprehensive
income still would have been reclassified into earnings over the next three
years, which was the term of the designated hedging relationship.
55-58 Rather than liquidate the pay-fixed, receive-variable Swap 1, Entity MNO
enters into a pay-floating, receive-fixed interest rate swap (Swap 2) with a
3-year term and a notional amount of $5 million. Entity MNO neither pays nor
receives a premium. Like Swap 1, Swap 2 requires a settlement every 90 days
and reprices immediately following each settlement. The relationship between
90-day interest rates and longer term rates has changed since Entity MNO
entered into Swap 1 (that is, the shape of the yield curve is different). As a
result, Swap 2 has different terms and its settlements do not exactly offset the
settlements on Swap 1. Under the terms of Swap 2, Entity MNO will receive a
fixed rate of 7.25 percent and pay interest at LIBOR.
55-59 The two swaps are not designated as hedging instruments and are
reported at fair value. The changes in fair value are reported immediately in
earnings and offset each other to a significant degree.

>>> Case B: Basis of Hedged Forecasted Transactions Is Changed

55-60 At the end of the second year of the 5-year hedging relationship,
Entity MNO discontinues its practice of issuing 90-day notes and issues a
3-year, $5 million note with a different contractually specified interest rate (that
is, an interest rate that is not LIBOR) that adjusts every 90 days. As of this
date, Entity MNO must begin performing assessments of effectiveness for the
hedging relationship by comparing changes in fair value of the hedging
instrument (indexed to LIBOR) with changes in the value of the hedged item
based on the revised contractually specified interest rate. Because the hedged
forecasted transactions (future interest payments) are still probable of
occurring, Entity MNO may continue to apply hedge accounting in accordance
with paragraph 815-30-35-37A if the hedging instrument (indexed to LIBOR) is
highly effective at achieving offsetting cash flows attributable to the revised
contractually specified interest rate.
55-61 If the revised hedging relationship is not determined to be highly
effective, the hedging relationship must be discontinued. However, the net
gain or loss on Swap 1 in accumulated other comprehensive income as of the
date Entity MNO issues the three-year note is not reclassified into earnings
immediately. Immediate reclassification would be required only if, as part of its
normal process of assessing whether it remains probable that the hedged
forecasted transaction will occur, Entity MNO determines that it is probable
that the hedged transactions (future interest payments) will not occur. In this
case, the expected amounts of those payments have changed (because they
will be based on a revised contractually specified interest rate instead of
LIBOR, as originally expected), but it still is probable that the payments will
occur. Thus, those gains or losses will continue to be reclassified to earnings
as the interest payments affect earnings and presented in the same income
statement line item as the earnings effect of the hedged item.

Accounting in the period a hedge is discontinued

The following Questions and Examples address several interpretive issues
regarding how to account for a cash flow hedge in the period it is discontinued.

Question 6.5.10
If a hedging relationship has been retrospectively
highly effective, is hedge accounting required to be
applied in the previous period?
Interpretive response: Yes. If an entity determines that a hedging relationship
had been retrospectively highly effective at the current assessment date, the
entity is required to apply hedge accounting.
This means that the amount reported in AOCI should be measured through the
date of the assessment (see section 6.2.10). This is the case even if the entity
believes the hedging relationship will not be highly effective on a prospective
basis or if the entity is discontinuing hedge accounting prospectively.

Example 6.5.40
Dedesignation and redesignation of a hedging
relationship due to failing to qualify for cash flow
hedge accounting in one period
On January 1, Year 1, ABC Corp. enters into a hedging relationship of a
forecasted transaction that will occur in Year 2. ABC documents that it will use
a regression analysis approach for its prospective assessment of effectiveness
and the period-by-period, dollar-offset method for its retrospective assessment
of effectiveness. The fair value of the hedging instrument is zero at inception.
On March 31, Year 1 (the first assessment period), ABC concludes that the
hedging relationship was highly effective retrospectively and is expected to
continue to be highly effective prospectively.
On June 30, Year 1 (the second assessment period), ABC concludes that the
hedging relationship was not highly effective retrospectively but is expected to
be highly effective prospectively. There are circumstances in which it is
appropriate to continue applying hedge accounting when a hedging relationship
is expected to be highly effective prospectively when it was not retrospectively
(see Question 2.10.90). However, ABC concludes that this is not one of those
limited circumstances – i.e. ABC does not identify any specific event during the
period that caused the hedging relationship not to be highly effective on a
retrospective basis. As a result, hedge accounting may not be applied in the
period just ended and the hedging relationship must be terminated.
On June 30, Year 1, ABC immediately redesignates the derivative to a new
hedging relationship with terms identical to the previous hedging relationship
(except that its retrospective and prospective assessments of effectiveness will
be based on regression analyses rather than by period-by-period dollar-offset).
On September 30, Year 1, and December 31, Year 1, ABC concludes that the
new hedging relationship was highly effective retrospectively and is expected
to continue to be highly effective prospectively.
The following data are also relevant.

Change in
derivative’s fair
Cumulative value during
change in current
derivative fair assessment
value during the period
Derivative fair hedging (Adjustment to
value relationship AOCI)
Assessment date asset (liability) gain (loss) (debit) credit
Original hedging relationship
March 31, Year 1 $(100) $(100) $(100)1
June 30, Year 1 (120) (120) -2
New hedging relationship
September 30, Year 1 $80 $200 $2001
December 31, Year 1 30 150 (50)1

Notes:
Because the hedge was highly effective in the retrospective assessment period, the
change in derivative fair value is recognized in OCI. It is calculated as the cumulative
change in derivative fair value during the hedge as of the current assessment date
less the cumulative change in the derivative fair value during the hedge as of the
previous assessment date.
Because the hedge was not highly effective in the retrospective assessment period,
hedge accounting is not applied. As a result, the change in the fair value of the
derivative is recognized in earnings rather than in OCI.

Journal entry – January 1, Year 1

There is a memorandum entry made on January 1, Year 1, documenting the
existence of this hedging relationship. ABC’s financial records are not otherwise
affected as of this date because the derivative hedging instrument had a fair
value of zero at inception.
Journal entries – March 31, Year 1
ABC records the following journal entry.

Debit Credit
OCI – Gains (losses) on cash flow hedging
derivatives 100
Derivative liability 100
To record change in fair value of derivative during
period as a result of applying hedge accounting.

Journal entries – June 30, Year 1

ABC records the following journal entry.

Debit Credit
Gains (losses) on derivatives (income statement) 20
Derivative liability 20
To record change in fair value of derivative during
period for which hedge accounting is not applied.

Journal entries – September 30, Year 1

ABC records the following journal entry.

Debit Credit
Derivative asset 1
80
Derivative liability 1
120
OCI – Gains (losses) on cash flow hedging
derivatives 200
To record change in fair value of derivative during
period as a result of applying hedge accounting.

Note:
The derivative instrument represented a liability as of June 30, Year 1 and an asset as
of September 30, Year 1.

Journal entries – December 31, Year 1

ABC records the following journal entry.

Debit Credit
OCI – Gains (losses) on cash flow hedging
derivatives 50
Derivative asset 50
To record change in fair value of derivative during
period as a result of applying hedge accounting.

Financial statement excerpts

At the end of each period, ABC’s financial statements reflect the following
related to this hedging relationship.

Account 3 months 6 months 9 months Year

ended ended ended ended
Mar 31 Jun 30 Sep 30 Dec 31
Balance sheet – assets
Derivatives - - $80 $30
Balance sheet – liabilities
Derivatives $100 $120 - -
Balance sheet – equity
AOCI – Gains
(losses) on cash
flow hedging
derivatives $(100) $(100) $100 $50
Income statement
Gains (losses) on
derivatives (P&L) - $(20) $(20) $(20)

Because the original hedging relationship was not highly effective under the
retrospective assessment of effectiveness during the second assessment
period, the entire change in the derivative’s fair value for that period is
recognized in earnings.
The net derivative gains or losses reported in AOCI related to the new hedging
relationship established subsequently includes changes in the derivative’s fair
value for the new hedging period – i.e. July 1, Year 1 to December 31, Year 1.

Question 6.5.20
What is the accounting for amounts in AOCI related
to a partially dedesignated cash flow hedging
relationship?
Background: We believe it is acceptable to partially dedesignate a cash flow
hedging relationship under certain circumstances (see section 2.10.60).
Interpretive response: The accounting when a hedging relationship is partially
dedesignated is summarized as follows.
Treatment of hedging instruments. The derivative instrument continues to be
recorded on the balance sheet at fair value. However, changes in its fair value
are recorded differently for the portion that was (versus was not) dedesignated
from the hedging relationship.
— Portion that remains designated in the hedging relationship: Changes in this
portion of the derivative’s fair value that are included in the effectiveness
assessment continue to be reported in OCI. Changes in the portion of the
fair value that relate to excluded components continue to be recognized in
earnings using either an amortization or mark-to-market approach (see
section 6.2). These amounts relate to the forecasted transactions that
continue to be hedged.
— Portion that is no longer designated: Subsequent changes in this portion of
the derivative’s fair value (including changes in excluded components) are
reflected in earnings – rather than OCI – unless this portion is designated as
the hedging instrument in a new hedging relationship.
Treatment of amounts remaining in AOCI and other considerations. When
a hedging relationship is partially dedesignated because some of the originally
forecasted transactions are no longer probable, a portion of the net derivative
gain or loss reported in AOCI at the time of partial dedesignation relates to the
forecasted transactions that continue to be hedged and another portion relates
to those forecasted transactions that are no longer hedged.
— Forecasted transactions that continue to be hedged: The entity
continuously evaluates the likelihood that the forecasted transactions will
occur. These amounts generally remain in AOCI until the period(s) that the
forecasted transactions are reported in earnings (see sections 6.3 and 6.4).
— Forecasted transactions that are no longer hedged: Until these transactions
occur, the entity continuously evaluates related amounts that remain in
AOCI. If at any time it is probable that the previously hedged forecasted
transactions will not occur in the originally specified period or within an
additional two months, related amounts remaining in AOCI are immediately
reclassified into earnings unless extenuating circumstances apply.
Additionally, this represents a missed forecast that the entity would be
required to consider when evaluating whether it has a pattern of missing
forecasts that calls into question its ability to predict future transactions
(see also Question 6.5.110).

Question 6.5.30
Is hedge accounting applied through the date an
event causes a hedging relationship to no longer be
highly effective?
Background: If in a fair value hedge an event or change in circumstances
results in the hedging relationship not being retrospectively highly effective for
the current period and the date that event or change in circumstances occurred
can be identified, the entity must apply fair value hedge accounting through that
date (see section 4.5.20). Topic 815 does not contain similar language for a cash
flow hedge. [815-25-40-4]
Interpretive response: Yes. Based on discussions with the FASB staff, we
believe cash flow hedge accounting should be applied through the date of such
an event or change.
When an entity determines that a hedging relationship had not been
retrospectively highly effective at the current assessment date, the entity
generally should discontinue hedge accounting (see section 2.10.50) and should
not recognize changes in the fair value of the hedging instrument in AOCI for
that assessment period.
However, if the entity is able to identify the event or change in circumstances
that resulted in the cash flow hedging relationship being discontinued, the
entity must apply hedge accounting up to the date of that event or change in
circumstances. All subsequent changes in fair value of the derivative that
occurred from that date to the current assessment date are reported in
earnings.

Question 6.5.40
Is it appropriate to assume the last date of high
effectiveness is the date insolvency is declared or
significant financial difficulties are disclosed?
Background: In some circumstances, an entity will be required to discontinue a
cash flow hedging relationship because the hedging relationship is not highly
effective due to changes in the creditworthiness of the counterparty to the
derivative (or in the entity's own nonperformance risk).
Interpretive response: Not necessarily. If a hedge is no longer highly effective
because of the counterparty’s creditworthiness or the entity’s nonperformance
risk, the hedging relationship is discontinued as of the date it is no longer
probable that the counterparty or the entity will not default. Careful analysis and
significant judgment are often necessary to determine this date.
Deterioration in credit can occur over a period of time. As a result, an entity
should review all available information, including the pricing of relevant
instruments in the financial markets to determine when the total changes in the
cash flows of the derivative hedging instrument began to deviate from the
changes in the cash flows of the hedged transaction due to changes in the
hedged risk. For example, credit spreads may widen to the point of causing the

changes in the fair value of a derivative to cease being highly effective at

offsetting changes in the cash flows of the hedged transaction in advance of
insolvency being declared, public disclosure of significant financial difficulties,
and/or a credit downgrade by the national rating agencies.

Example 6.5.50
Identification of the date credit deterioration
caused a hedge to cease being highly effective
On September 30, Year 1, ABC Corp. has a highly effective cash flow hedging
relationship that involves a derivative in an asset position with a fair value of
$18. ABC has not excluded any components from the assessment of
effectiveness; therefore, the cumulative change in the derivative’s fair value
(i.e. $18) is in AOCI at September 30, Year 1.
On December 31, Year 1, the fair value of the derivative hedging instrument
decreases to $1 due to credit deterioration of the derivative counterparty. As a
result, ABC determines that the cash flow hedging relationship was not highly
effective for the three months ended December 31, Year 1 and is not expected
to be highly effective on a prospective basis.
ABC performs an analysis and determines that the fair value of the derivative
was $16 on October 14, Year 1 but decreased overnight to $2 on October 15
because of a severe increase in the credit spread of the counterparty. ABC
determines that the hedging relationship was highly effective through
October 14, Year 1. Therefore, ABC applies hedge accounting through
October 14, Year 1 – i.e. ABC recognizes the change in fair value of the hedging
instrument through that date in AOCI.
ABC then discontinues hedge accounting. All changes in the fair value of the
derivative after October 14, Year 1 are reflected in earnings.

Excerpt from ASC 815-30

>> Example 16: Impact on Accumulated Other Comprehensive Income of

Issuing Debt with a Term That Is Shorter Than Originally Forecasted

55-94 This Example illustrates the effect on accumulated other comprehensive

income of issuing debt with a term that is shorter than originally forecasted.
55-95 Entity A expects to borrow $100 million over a 10-year period beginning
in 6 months. Entity A initially plans to issue $100 million of 10-year fixed-rate
debt at or near par at the then-current market interest rate; consequently,
Entity A will be exposed to variability in cash flows in the future quarterly
interest payments on the debt due to changes in credit risk and interest rate
risk that occur during this 6-month period before issuance. To hedge the risk of
changes in these 40 quarterly interest payments attributable to changes in the

benchmark interest rate for the 6-month period, Entity A does all of the
following:
a. It enters into a derivative instrument (for example, a forward-starting
interest rate swap).
b. It documents that it is hedging the variability in the 40 future quarterly
interest payments, attributable to changes in the benchmark interest rate,
over the next 10 years related to its 10-year $100 million borrowing
program that begins in 6 months.
c. It documents that it will assess the effectiveness of the hedging
relationship semimonthly on a quantitative basis.
55-96 Six months after inception of the hedging relationship, Entity A issues
debt. However, due to market conditions, Entity A decides in the week before
issuance that it will issue $100 million of fixed-rate debt with a 5-year maturity
and quarterly interest payments.
55-97 When Entity A decides that the term of the debt to be issued will differ
from the term of the debt originally expected to be issued, Entity A should not
immediately reclassify into earnings the entire net gain or loss in accumulated
other comprehensive income related to the derivative instrument. Instead,
Entity A must first apply the requirements of paragraph 815-30-35-3 using its
originally documented hedging strategy and the newly revised best estimate of
the cash flows. That is, the assessment of hedge effectiveness hould be
based on the most recent best estimate of the hedged forecasted transaction
as of the date that a cash flow hedge is discontinued prospectively.
55-98 Entity A's strategy is a cash flow hedge of 40 individual probable
quarterly interest payments. A cash flow hedge of future interest payments is
a hedge of a series of forecasted transactions; consequently, Entity A must
first determine the likelihood of whether and when each forecasted transaction
in the series will occur. If at any time during the hedging relationship Entity A
determines that it is no longer probable that any of the forecasted transactions
in the series will occur by the date (or within the time period) originally
specified, it must terminate the original hedging relationship for each of those
specific nonprobable forecasted transactions (even if the forecasted
transaction will occur within an additional two-month period of time after that
originally specified date).
55-98A When Entity A performs its semimonthly assessment of effectiveness
for the half-month period immediately preceding the issuance of the debt, it
could also possibly conclude that the hedging relationship is no longer
considered highly effective under paragraph 815-20-25-75 because the actual
variability in the hedged interest payments for Years 1–5 is now based on the
5-year borrowing rate—not on 10-year rates as expected at the inception of the
hedge when the entity selected the hedging derivative. In that circumstance,
the hedging relationship is terminated. After the hedging relationship is
terminated, Entity A must determine whether it is probable that any or all of
those specific nonprobable forecasted transactions will not occur by the date
(or within the time period) originally specified or within an additional two-month
period of time thereafter (see paragraphs 815-30-40-4 through 40-5).
55-99 When Entity A originally documented the hedging relationship, it was
hedging 40 forecasted transactions (forecasted quarterly interest payments)
that would begin in 6 months’ time and continue over a 10-year period. In this

Example, Entity A terminates the hedging relationship no later than on the date
it issues the 5-year debt (because the variability of the first 20 hedged
payments ceases on that date) and must determine the amount, if any, to be
reclassified into earnings from accumulated other comprehensive income
related to the net derivative gain or loss of the terminated cash flow hedge.
Because Entity A issued a 5-year debt instrument, Entity A would determine
that it is probable that the first 20 forecasted transactions would occur because
they are now contractual obligations. Entity A must determine that it is not
probable that any of the last 20 forecasted transactions will not occur to
continue reporting the net derivative gain or loss related to these forecasted
transactions in accumulated other comprehensive income. At issue is whether
it is probable that the five-year debt will not be replaced by new borrowings
that will involve the quarterly payment of interest. Provided that the entity
determines that it is not probable that any of the original 40 forecasted
transactions will not occur, Entity A must apply paragraph 815-30-35-3 and
continue to report an amount in accumulated other comprehensive income
based on the most recent best estimate of the hedged forecasted transactions
related to all 40 forecasted transactions and reclassify an appropriate amount
into earnings when each hedged forecasted transaction affects earnings and
present those amounts in the same income statement line item as the
earnings effect of the hedged item. If Entity A determines that it is probable
that any of those forecasted transactions will not occur either by the end of the
date (or within the time period) originally specified or within an additional two-
month period of time thereafter (see paragraphs 815-30-40-4 through 40-5),
Entity A should reclassify into earnings from accumulated other comprehensive
income the amount of the net derivative instrument gain or loss related to
those specific nonoccuring forecasted transactions. That amount should be
equivalent to the portion of the present value of the derivative instrument's
cash flows intended to offset the changes in the original forecasted
transactions for which Entity A has determined it is probable that they will not
occur by the date (or within the time period) originally specified or within an
additional two-month period of time thereafter. Thus, the nonoccurrence of
one of the hedged forecasted transactions described in this Example could
potentially jeopardize Entity A's ability to use cash flow hedge accounting in
the future for the situation described.

6.5.20 When it is probable a forecasted transaction will not

occur

Excerpt from ASC 815-30

> Discontinuing Hedge Accounting

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,
except as indicated in the following sentence. In rare cases, the existence of

extenuating circumstances that are related to the nature of the forecasted

transaction and are outside the control or influence of the reporting entity may
cause the forecasted transaction to be probable of occurring on a date that is
beyond the additional two-month period of time, in which case the net derivative
instrument gain or loss related to the discontinued cash flow hedge shall
continue to be reported in accumulated other comprehensive income until it is
reclassified into earnings pursuant to paragraphs 815-30-35-38 through 35-41.
40-5 If it is probable that the hedged forecasted transaction will not occur
either by the end of the originally specified time period or within the additional
two-month period of time and the hedged forecasted transaction also does not
qualify for the exception described in the preceding paragraph, that derivative
instrument gain or loss reported in accumulated other comprehensive income
shall be reclassified into earnings immediately. A pattern of determining that
hedged forecasted transactions are probable of not occurring would call into
question both an entity's ability to accurately predict forecasted transactions
and the propriety of using hedge accounting in the future for similar forecasted
transactions.
40-6 Derivative instrument gains and losses that had initially been reported in
other comprehensive income as a result of a cash flow hedge and then
reclassified to earnings (because the entity subsequently concluded that it was
probable that the forecasted transaction would not occur within the originally
specified time period or the additional period of time described in
paragraph 815-30-40-4) shall not later be reclassified out of earnings and back
into accumulated other comprehensive income due to a reassessment of
probabilities.

Hedge accounting is required to be discontinued when a forecasted transaction

is not probable. When a net derivative gain or loss related to the hedge of a
forecasted transaction is reported in earnings depends on the likelihood of the
forecasted transaction occurring within the original specified time period plus
two months. [815-30-40-4 – 40-5, 40-6A, 815-20-45-1B]
The following table summarizes the effect of different levels of likelihood of the
forecasted transaction occurring on the application of hedge accounting and the
treatment of amounts remaining in AOCI. [815-30-40-4 – 40-6]

Likelihood that the forecasted Impact on hedge accounting and

transaction will occur in the treatment of the net derivative gain or
originally specified time period loss reported in AOCI
Forecasted transaction is probable — Hedge accounting is permitted to
continue.
— Amounts in AOCI are reclassified into
earnings when the forecasted
transaction affects earnings
(section 6.3).

Forecasted transaction is reasonably — Hedge accounting must be discontinued.

possible but not probable Further changes in the hedging
instrument’s fair value are recognized in
earnings rather than in OCI unless it is
designated in a different cash flow
hedging relationship.

Likelihood that the forecasted Impact on hedge accounting and

transaction will occur in the treatment of the net derivative gain or
originally specified time period loss reported in AOCI
— Amounts in AOCI are reclassified into
earnings when the forecasted
transaction affects earnings (section 6.3).

It is probable that forecasted — Hedge accounting must be discontinued.

transaction will not occur (a ‘missed Further changes in the hedging
forecast’) instrument’s fair value are recognized in
earnings rather than in OCI unless it is
designated in a different cash flow
hedging relationship.
— Amounts in AOCI are immediately
reclassified into earnings, unless the
forecasted transaction will occur within
an additional two-month period or
extenuating circumstances apply (see
Question 6.5.90).

An entity continuously evaluates the likelihood of the hedged forecasted

transaction occurring as long as derivative gains or losses are reported in
AOCI related to a hedged forecasted transaction. Once an amount has been
reclassified from AOCI into earnings because it is probable that a transaction
will not occur, that amount is never reclassified back into AOCI from earnings,
even if the likelihood of the transaction occurring changes. [815-30-40-4 – 40-6A]
A pattern of missing forecasts (i.e. determining that it is probable that hedged
forecasted transactions will not occur by the end of the originally specified time
period or within the two months thereafter) calls into question an entity’s ability
to predict future transactions and the propriety of using cash flow hedge
accounting in the future for similar forecasted transactions. [815-30-40-6]

Question 6.5.50
Can amounts be reclassified from AOCI when a
hedge is discontinued, even if the forecasted
transaction is reasonably possible?
Interpretive response: No. If the forecasted transaction is still reasonably
possible, the net derivative gains or losses reported in AOCI (i.e. that arose
before the hedge was discontinued) continue to be reported in AOCI and to be
reclassified into earnings when the hedged forecasted transaction is reported in
earnings.
If it was permissible to immediately reclassify amounts reported in AOCI into
earnings when a forecasted transaction no longer is probable but is still
reasonably possible, an entity would have the opportunity to manipulate
earnings simply by changing its estimate of probability. As a result, net
derivative gains or losses reported in AOCI when a hedge is discontinued are
immediately reclassified into earnings only when an entity determines it is

probable that the forecasted transaction will not occur in the originally specified
time period or within a two-month period thereafter. [FAS 133.BC494]

Applying the additional two-month period

Question 6.5.60
Does an entity consider an additional two-month
period when deciding whether to discontinue
hedge accounting?
Interpretive response: No. An entity should not factor an additional two
months into its consideration when determining whether a cash flow hedging
relationship must be discontinued; instead, the entity should discontinue the
hedging relationship because the hedged forecasted transaction will not occur
within the originally specified time period.
The additional two-month period is relevant only after the entity discontinues a
cash flow hedging relationship and it is evaluating whether to reclassify
amounts related to the discontinued hedging relationship from AOCI into
earnings.
However, Topic 815 does provide flexibility for documenting – at inception of
the hedging relationship – when the forecasted transaction will occur if the
timing of the forecasted transaction involves some uncertainty within a range
(see section 5.3.40).

Question 6.5.70
May an entity ignore the additional two-month
period when deciding whether to immediately
reclassify amounts from AOCI into earnings?
Interpretive response: No. Once a hedging relationship has been discontinued,
an entity is required to evaluate the likelihood of the forecasted transaction
occurring within the originally specified time period plus an additional two
months. Including the additional two months in this evaluation is not optional.
[815-30-40-4]

See Question 6.5.80 regarding how to consider the additional two-month period
when an entity has a series of hedging relationships.

Excerpt from ASC 815-30

>> Example 17: Discontinuation of a Cash Flow Hedge

55-100 The following Cases illustrate the application of paragraphs 815-30-40-4

through 40-5 to changes in timing of a forecasted transaction in relation to an
originally specified time period:
a. Transactions to occur within two months of end of originally specified time
period (Case A)
b. Transactions not to occur within two months of end of originally specified
time period (Case B).
55-101 Cases A and B share the following assumptions. On January 1, an
entity enters into a hedge of the variability in the total cash flows of a
forecasted sale of the first 100 units of a specified product during the 3-month
period from February 1 to April 30. Gains and losses on the hedging instrument
are accumulated in other comprehensive income and reclassified into earnings
as sales occur and are presented in the same income statement line item as
the earnings effect of the hedged item. However, as of March 10, only 60 units
of the product have been sold and the entity determines that it is probable that
the sale of the remaining 40 units will not occur by April 30. As a result, the
entity must discontinue cash flow hedge accounting under the originally
designated hedging relationship as of March 10 (pursuant to paragraph 815-30-
40-1(a)).
>>> Case A: Transactions to Occur within Two Months of End of
Originally Specified Time Period
55-102 In this Case, the entity determines that it is probable that the sale of
the remaining 40 units will occur by June 20. Based on this new information,
the entity is permitted to designate a new cash flow hedge under which
subsequent derivative instrument gains and losses would receive cash flow
hedge accounting. This Example focuses on the derivative instrument gains
and losses that have been accumulated in other comprehensive income at
March 10 with respect to the remaining 40 unsold units. The derivative
instrument gains or losses accumulated in other comprehensive income
related to the sale of the remaining 40 units should not be reclassified into
earnings as of March 10 because the entity determined on that date that it is at
least reasonably possible that the forecasted transactions will occur within the
two-month period following April 30 (the end of the originally specified time
period).
>>> Case B: Transactions Not to Occur within Two Months of End of
Originally Specified Time Period
55-103 In this Case, the entity determined on March 10 that it is probable that
the sale of the remaining 40 units will not occur by June 30 but it was
reasonably possible that the sale would occur in July or August.
55-104 In that circumstance, the derivative instrument gains or losses
accumulated in other comprehensive income related to the sale of the
remaining 40 units must be reclassified into earnings as of March 10 because

the entity would have determined on that date that it is probable that the
forecasted transactions will neither occur by the end of the originally specified
time period (that is, April 30) nor within the allowable additional two-month
period of time (ending on June 30).
55-105 Furthermore, the example indicates no extenuating circumstances that
could justify applying the exception related to a forecasted transaction that is
probable of occurring on a date beyond the additional two-month period of
time.

Excerpt from ASC 815-30

>> Example 21: Effect on Accumulated Other Comprehensive Income

from Issuing Debt at a Date That Is Not the Same as Originally Forecasted

55-128 The following Cases illustrate the application of paragraph 815-30-40-5

in determining whether an entity should immediately reclassify into earnings
the entire net gain or loss related to the derivative instrument in accumulated
other comprehensive income when issuing debt at a date that is not the same
as originally forecasted:
a. Amounts are not reclassified immediately into earnings (Case A).
b. Amounts are reclassified immediately into earnings (Case B).
>>> Case A: Amounts Are Not Reclassified Immediately into Earnings
55-129 This Case has the following assumptions:
a. Entity A expects to borrow $100 million over a 10-year period beginning in
6 months.
b. Entity A initially plans to issue $100 million of 10-year fixed-rate debt at or
near par at the then-current market interest rate.
c. Entity A will be exposed to variability in cash flows for the future quarterly
interest payments on the debt due to changes in credit risk and interest
rate risk that occur during this six-month period before issuance.
d. To hedge the risk of changes in these 40 quarterly interest payments
attributable to changes in the benchmark interest rate for the 6-month
period, Entity A does both of the following:
1. Enters into a derivative instrument (for example, a forward-starting
interest rate swap)
2. Documents that it is hedging the variability in the 40 future quarterly
interest payments, attributable to changes in the benchmark interest
rate, over the next 10 years related to its 10-year $100 million
borrowing program that begins in 6 months.
e. Entity A documents that it will assess the effectiveness of the hedging
relationship semimonthly on a quantitative basis.
f. Six months after inception of the hedging relationship, Entity A decides to
delay the issuance of the 10-year debt for 3 months..
55-130 When Entity A decides to delay the issuance of the 10-year debt for
3 months, Entity A should not immediately reclassify into earnings the entire

net gain or loss in accumulated other comprehensive income related to the

derivative instrument. Entity A's strategy is a cash flow hedge of 40 individual
probable quarterly interest payments. A cash flow hedge of future interest
payments is a hedge of a series of forecasted transactions; consequently,
Entity A must first determine the likelihood of whether and when each
forecasted transaction in the series will occur. If at any time during the
hedging relationship Entity A determines that it is no longer probable that any
of the forecasted transactions in the series will occur by the date (or within the
time period) originally specified, it must terminate the original hedging
relationship for each of those specific nonprobable forecasted transactions—
even if the forecasted transaction will occur within an additional two-month
period of time after that originally specified date. Entity A need not terminate
the original hedging relationship for those specific forecasted transactions that
remain probable of occurring by the date or within the time period originally
specified. After the hedging relationship is terminated, Entity A must
determine whether it is probable that any or all of those specific nonprobable
forecasted transactions will not occur either by the date (or within the time
period) originally specified or within an additional two-month period of time
thereafter (see paragraphs 815-30-40-4 through 40-5). Entity A should reclassify
into earnings from accumulated other comprehensive income the amount of
the net derivative instrument gain or loss related to those specific nonprobable
forecasted transactions for which it is probable they will not occur. That
amount should be equivalent to the present value of the derivative
instrument's cash flows intended to offset the changes in the original
forecasted transactions for which Entity A has determined it is probable that
they will not occur by the date (or within the time period) originally specified or
within an additional two-month period of time thereafter.
55-131 In this Case, when Entity A originally documented the hedging
relationship, it was hedging 40 forecasted transactions (forecasted interest
payments) that would begin in 6 months’ time and continue over a 10-year
period. Because Entity A did not issue the debt instrument as originally
documented, Entity A would determine that it is probable that the first
forecasted transaction will not occur at the time forecasted; consequently,
Entity A must terminate the original hedging relationship with respect to that
first forecasted transaction. However, Entity A would also determine that it is
probable that the other 39 forecasted transactions will occur at the time
forecasted. After the hedging relationship is terminated for the specific
nonprobable first forecasted transaction, Entity A must determine whether it is
probable that specific nonprobable first forecasted transaction will not occur by
the forecasted date or within an additional two-month period of time
thereafter. In this Case, Entity A determines that it is probable that the first
hedged quarterly interest payment will not occur within two months of its
specified date. The amount reclassified into earnings from accumulated other
comprehensive income is the portion of the interest rate swap’s net gain or
loss equivalent to the present value of the cash flows from the interest rate
swap intended to offset the changes in the first forecasted transaction that is
probable not to occur.
>>> Case B: Amounts Are Reclassified Immediately into Earnings
55-132 This Case has the following assumptions:
a. Entity B expects to issue $100 million of 10-year, 9 percent debt in 6
months.

b. Because the debt will have a fixed interest rate of 9 percent, Entity B will
not be exposed to variability in the future quarterly interest payments at
9 percent, but it will be exposed to variability in the cash flows received as
proceeds on the debt due to changes in credit risk and interest rate risk
that occur during the 6-month period before issuance.
c. To hedge the risk of changes in the total proceeds attributable to changes
in the benchmark interest rate, Entity B does both of the following:
1. Enters into a derivative instrument (for example, a short position in U.S.
Treasury note futures contracts)
2. Documents that it is hedging the variability in the cash proceeds
attributable to changes in the benchmark interest rate to be received
from the 9 percent fixed-rate debt it will issue in 6 months and that it
will assess effectiveness on a quantitative basis.
d. Because Entity B plans to issue $100 million of 10-year, 9 percent debt
regardless of the then-current interest rate environment, the effect of
increases or decreases in interest rates will be reflected in issuing the debt
at a discount or a premium, respectively.
e. Six months after inception of the hedging relationship, Entity B decides to
delay the issuance of the debt for three months.
55-133 This strategy is a cash flow hedge of the variability in proceeds
attributable to changes in the benchmark interest rate to be received from the
issuance of debt in six months. A cash flow hedge of the proceeds attributable
to changes in the benchmark interest rate is a hedge of a single forecasted
transaction specified to occur in six months; consequently, when the single
forecasted transaction is no longer probable of occurring by the date (or within
the time period) originally specified, Entity B must terminate the hedging
relationship. After the hedging relationship is terminated, Entity B must
determine whether it is probable that the specific nonprobable forecasted
transaction will not occur by the date (or within the time period) originally
specified or within an additional two-month period of time thereafter. Because
Entity B decided to delay the issuance of the debt for a three-month period of
time, Entity B concludes that it is probable that the forecasted transaction will
not occur by the date (or within the time period) originally specified or within an
additional two-month period of time thereafter. Consequently, Entity B should
immediately reclassify into earnings the entire net gain or loss related to the
derivative instrument in accumulated other comprehensive income. Given the
guidance in paragraph 815-30-40-5, the nonoccurrence of the hedged
forecasted transactions described in this Case could potentially jeopardize
Entity B's ability to use cash flow hedge accounting in the future for the
situation described.

Question 6.5.80
How is the additional two-month period considered
when an entity has a series of hedging
relationships?
Background: Determining whether a hedged forecasted transaction will occur
in the originally specified time period or with an additional two-month period can
be complicated. It is particularly complicated when an entity enters into

separate derivative contracts to hedge forecasted transactions that will occur

over several periods and – at a later date – some of those forecasted
transactions are not expected to occur as originally documented.
For example, an entity initially expects to sell inventory in the amounts specified
and on the dates indicated in the following table. To hedge against changes in
prices of these forecasted sales, the entity purchases three forward contracts,
each having a notional amount and maturing on the date that coincides with the
forecasted unit sales. It designates the forward contracts as hedging
instruments in three separate hedging relationships.

Hedge # Date Forecast unit sales

1 March 31 80
2 April 30 20
3 May 31 30

Subsequent to the hedge inception dates, the entity believes that it will have
only 60 unit sales on March 31. It determines that Hedge #1 is not highly
effective and discontinues hedge accounting for that relationship. The entity
continues to believe the forecast unit sales on April 30 and May 31 are
probable.
The entity must evaluate the likelihood that the 80 unit sales that were forecast
to occur on March 31 will occur on March 31 or within an additional two-month
period. If it is probable that they will not occur during that timeframe, amounts
in AOCI related to the forecasted sales that it is probable will not occur are
immediately reclassified into earnings.
Interpretive response: We believe an entity makes an accounting policy
election when it chooses to consider transactions that are expected to occur
within the additional two-month period – but that are hedged transactions in
separate hedging relationships – in evaluating whether the net derivative gains
(losses) in AOCI should be reclassified into earnings immediately. This
accounting policy election must be consistently applied.

Accounting policy Summary of effects

Future transactions that — In the background example, the entity considers all
are designated in unit sales from March 31 through May 31 (i.e.
separate existing two months after March 31) – without regard to
hedging relationships whether they are hedged in separate existing hedging
are included when relationships – when evaluating whether it is probable
evaluating whether the that the 80 unit sales that were hedged in Hedge #1
net derivative gains will not occur. Because there are 20 unit sales
(losses) in AOCI should forecast to occur on April 30 and 30 on May 1, the
be immediately 80 unit sales from Hedge #1 are still at least
reclassified into reasonably possible (i.e. it is not probable that they will
earnings not occur) and the amounts in AOCI are not
immediately reclassified into earnings.
— Because the amounts in AOCI related to Hedge #1
under the updated forecast are expected to be
reclassified into earnings on March 31 (for 60 units)
and on April 30 (i.e. for 20 units), there are no longer
20 unit sales available for Hedge #2. As a result,
Hedge #2 is discontinued and the entity determines

Accounting policy Summary of effects

whether amounts in AOCI should be immediately
reclassified into earnings. All future transactions –
including the 30 sales expected to occur on May 31 –
are considered in this analysis.
— A similar process is applied to Hedge #3 as for
Hedge #2.
— If at any time it is probable that previously hedged
forecasted sales will not occur in the originally
specified period or an additional two months, net
derivative gains or losses reported in AOCI related to
those sales are immediately reclassified into earnings.
Additionally, this represents a missed forecast that the
entity would be required to consider when evaluating
whether it has a pattern of missing forecasts that calls
into question its ability to predict future transactions
(see also Question 6.5.110).
Future transactions that In the background example, the entity considers only
are designated in unhedged unit sales from March 31 through May 31 (i.e.
separate existing two months after March 31) when evaluating whether it is
hedging relationships probable that the 80 unit sales from Hedge #1 will not
are not included when occur. Because all future projected sales are hedged in
evaluating whether the separate hedging relationships, there are no sales during
net derivative gains the additional two-month period to consider.
(losses) in AOCI should As a result, the entity would conclude that it is probable
be immediately that the remaining 20 unit sales will not occur in the
reclassified into originally specified period or an additional two months and
earnings immediately reclassify net derivative gains or losses
reported in AOCI related to those sales into earnings.
Additionally, this represents a missed forecast that the
entity would be required to consider when evaluating
whether it has a pattern of missing forecasts that calls into
question its ability to adequately forecast future
transactions (see also Question 6.5.110).
Hedge #2 and Hedge #3 would be unaffected by the
20 unit sales that did not occur on March 31, provided the
missed forecast did not result in the entity concluding that
it could not accurately forecast future transactions.

Extending the two-month period due to extenuating

circumstances
In certain instances, the additional two months may be extended because of
extenuating circumstances that are related to the nature of the forecasted
transaction and are outside the control or influence of the entity.
In these cases, the net derivative gain or loss reported in AOCI related to the
discontinued cash flow hedge: [815-30-40-4]
— generally should continue to be reported in AOCI until the hedged
forecasted transaction occurs (see section 6.3); or

— earlier if the entity determines it is probable that the forecasted transaction

will not occur by the end of the original specified period plus the additional
extended period.

Question 6.5.90
How common are extenuating circumstances that
extend the additional two-month period?
Interpretive response: We believe it would be rare for extenuating
circumstances to result in the additional two-month period being extended. In
addition, we believe the extenuating circumstances should be identified at the
inception of the hedge and should not relate to subsequent economic
circumstances that have the effect of delaying the date of occurrence of the
forecasted transaction.
For example, the building and selling of locomotives takes a significant amount
of time and significant delays may occur that are outside the control of the
builder/seller. Estimating when a locomotive will be completed and sold is
difficult even if an entity considers an additional two-month period beyond its
best estimate. In this example, we believe the entity hedging the forecasted
sale of a locomotive can extend the two-month period to something more in
line with the process of building and selling locomotives when evaluating
whether net derivative gains or losses reported in AOCI should be immediately
reclassified into earnings. However, the period and extenuating circumstances
must be documented at inception of the hedging relationship.

Example 6.5.60
Whether a delay in a forecasted transaction is due
to extenuating circumstances that extend the
additional two-month period
On January 1, Year 1, ABC Corp. forecasts that it will sell 100 barrels of oil on
September 30, Year 1. To hedge the variability in overall changes in cash flows
of the forecasted sale, it enters into a net cash-settled forward contract to fix
the amount of proceeds it will receive on the sale of the oil on September 30,
Year 1. All the cash flow hedging requirements are met at inception of the
hedge.
On March 31, Year 1 (the first assessment period), ABC concludes that the
hedging relationship was highly effective retrospectively and is expected to
continue to be highly effective prospectively. ABC recognizes the change in fair
value of the forward (unrealized loss of $100,000) in AOCI.
On June 30, Year 1 (the second assessment period), ABC concludes that the
hedging relationship was not highly effective retrospectively and is not
expected to be highly effective prospectively; this is because there has been a
significant increase in the supply of oil in the marketplace. ABC did not identify
a specific event during the period that caused the hedging relationship not to be
highly effective on a retrospective basis. As a result, hedge accounting may not

be applied in the period just ended and the hedging relationship must be
discontinued prospectively.
On discontinuance of the cash flow hedging relationship, ABC concludes that it
is probable that the forecasted sale of 100 barrels of oil will not occur by
September 30, Year 1 or within a two-month period thereafter (i.e. by
November 30, Year 1) because of the significant projected oversupply of oil in
the marketplace during that period.
Although the delay in the final sale of the oil was caused by events outside
ABC’s control, the delay is not related to the nature of the forecasted
transaction. That is, the forecasted sale date of 100 barrels of oil is, by nature,
not difficult to estimate. Instead, the forecasted sale is delayed because of
economic factors that arose after the inception of the hedging relationship. As a
result, any derivative gains or losses reported in AOCI are reclassified into
earnings on June 30, Year 1.

Effect of missed forecasts

Question 6.5.100
Where are amounts reclassified from AOCI into
earnings in connection with a missed forecast
presented in the income statement?
Interpretive response: When an entity has a missed forecast, Topic 815 does
not provide specific presentation guidance for amounts immediately reclassified
from AOCI into earnings. [815-20-45-1B]
Because Topic 815 does not provide specific presentation guidance for missed
forecasts, an entity may exercise judgment in determining the income
statement classification. We believe an entity should apply a consistent policy
for amounts reclassified from AOCI into earnings, including amounts associated
with the excluded component. For example, an entity could choose a policy that
presents the effect of the hedging instrument in the income statement line
item where the missed forecasted transaction would have been recorded.

Question 6.5.110
What factors are considered when evaluating
whether missed forecasts represent a pattern?
Interpretive response: We believe instances in which it is probable that a
forecasted transaction will not occur should be rare. We understand that the
SEC staff will challenge management’s previous and future assertions about
forecasted transactions when a registrant displays a pattern of determining that
it is probable that hedged forecasted transactions will not occur.
Determining what constitutes a pattern is a matter of judgment based on
individual facts and circumstances. However, we believe the following should
be considered when determining whether there is a pattern in which it is
probable that forecasted transactions will not occur:

— the business or operating circumstances that led the entity to its

conclusion;
— whether the entity experienced other instances with similar forecasted
transactions. If so:
— when and what those business or operating circumstances were; and
— whether the current circumstances are different from the previous
instance(s);
— whether the circumstances or events that led to the conclusion were within
the control of the entity; and
— whether the entity anticipates a similar forecasted transaction in the near
future.

7. Hedging foreign currency

exposures
Detailed contents
7.1 How the standard works
7.2 Basic concepts in foreign currency hedges
7.3 General qualifying criteria for foreign currency hedges
7.3.10 Overview
7.3.20 Entity with foreign currency risk is party to the hedging
instrument
7.3.30 Currency other than functional currency
7.3.40 Other matters relevant to foreign currency hedges
Questions
7.3.10 Can an entity hedge recognized FCD assets and liabilities?
7.3.20 What risk(s) may be hedged in FCD assets and liabilities?
7.3.30 Can a parent entity that has a functional currency different
from its subsidiary hedge the subsidiary’s foreign currency
risk?
7.3.40 How is an operating unit evaluated when determining
whether foreign currency exposure can be hedged?
7.3.50 If a parent entity hedges its subsidiary’s foreign currency
risk, can the subsidiary recognize the effects of the hedge
in its stand-alone financial statements?
7.3.60 Can hedge accounting be applied if the hedged transaction
is denominated in the hedging entity’s functional currency
but the settlement amount is based on a foreign currency?
7.3.70 Are there limitations on hedging an intercompany FCD
transaction involving a recognized asset or liability?
7.3.80 Can an intercompany commitment be hedged?
7.3.90 If the hedged item affects more than one income
statement line item, where should the effect of the
hedging instrument be presented?
Examples
7.3.10 Currency other than functional currency
7.3.20 Settlement of hedged transaction is based on a foreign
currency
7.3.30 Forecasted purchase in foreign currency
Hedging 480
7. Hedging foreign currency exposures

7.4 Specific qualifying criteria for foreign currency fair value hedges
7.4.10 Overview
7.4.20 Eligibility of hedged items and hedging instruments in a fair
value hedge of foreign currency risk
7.4.30 Hedged item: Recognized assets or liabilities for which
transaction gains or losses are recognized in earnings
7.4.40 Hedged item: AFS debt securities
7.4.50 Hedged item: Unrecognized firm commitments
7.4.60 Hedging instrument: Nonderivative financial instrument
7.4.70 Hedging instrument: Internal derivatives
Questions
7.4.10 Can an entity hedge future interest payments of FCD debt
as an unrecognized firm commitment in a fair value hedge?
7.4.20 If a commitment to sell is based on the market price at the
time of shipment, can a portion of the price of each unit to
be sold be designated as the hedged item in a fair value
hedge?
7.4.30 Can a nonderivative financial instrument be used to hedge
an unrecognized firm commitment?
7.4.40 In the consolidated financial statements, can an
intercompany nonderivative financial instrument be used to
hedge an unrecognized firm commitment?
7.4.50 What are the practical implications of using a nonderivative
instrument to hedge an unrecognized firm commitment?
Examples
7.4.10 Commitment to sell at fair value – hedging a portion of the
price of each unit
7.4.20 Internal derivative with no offsetting third-party derivative
contract
7.4.30 Internal derivative with offsetting third-party derivative
contract
7.5 Accounting for foreign currency fair value hedges
7.5.10 Overview
7.5.20 Changes involving foreign currency risk
7.5.30 Examples of foreign currency fair value hedges
Observation
Hedging variable-rate FCD instruments
Observation
Calculating the fair value of a hedged unrecognized firm commitment
Hedging 481
7. Hedging foreign currency exposures

Questions
7.5.10 What model will result in less earnings volatility when
hedging only the foreign currency exposure of a recognized
financial asset or liability?
7.5.20 Is a partial-term fair value hedge of foreign currency risk
permitted?
7.5.30 If a cross-currency interest rate swap is used to hedge only
foreign currency risk, what can be excluded from hedge
effectiveness?
Examples
7.5.10 Partial-term foreign currency fair value hedge
7.5.20 Fair value hedge of a firm FCD purchase commitment with
a forward contract
7.5.30 Fair value hedge of a FCD AFS debt security with a forward
contract
7.6 Specific qualifying criteria for foreign currency cash flow hedges
7.6.10 Overview
7.6.20 Eligibility of hedged transactions and hedging instruments
in a cash flow hedge of foreign currency risk
7.6.30 Hedged transaction: Forecasted FCD transaction
7.6.40 Hedged transaction: Unrecognized firm commitments
7.6.50 Hedged transaction: Recognized assets and liabilities
7.6.60 Hedging instrument: Internal derivatives
7.6.70 Limitation on internal derivatives as hedging instruments:
Hedging on a net basis
Observation
Two separate hedges for a forecasted purchase on credit with the
same hedging instrument
Observation
Internal derivatives used for different hedging relationship
Questions
7.6.10 Can a group of forecasted transactions be hedged in a
single cash flow hedge?
7.6.20 Can the foreign currency exposure in a forecasted issuance
of FCD debt be hedged?
7.6.30 Can the foreign currency exposure in forecasted earnings
of a foreign subsidiary be hedged?
7.6.40 Can forecasted intercompany dividends be hedged?
7.6.50 Can an intercompany FCD transaction be hedged for overall
changes in fair value or cash flows?
Hedging 482
7. Hedging foreign currency exposures

7.6.60 Can an entity apply hedge accounting once the forecasted

transaction to purchase a FCD nonfinancial asset has
occurred?
7.6.70 Can an unrecognized FCD commitment with a related party
be hedged?
7.6.80 Can a commitment to sell in the future based on the
market price at the time of shipment be hedged in a cash
flow hedge?
7.6.90 Does the requirement that all variability in cash flows be
eliminated mean that the hedging instrument needs to be
perfectly effective?
7.6.100 May the fixed-rate interest payments denominated in a
foreign currency in a dual-currency bond be designated as
the hedged transaction?
7.6.110 Can the treasury center enter into a third-party derivative
with neither leg being its functional currency?
7.6.120 How does an entity determine if third-party derivatives
generate closely approximating gains/ losses compared
with the net gains/losses generated by the internal
derivatives?
7.6.130 Can internal derivatives that are not designated as hedging
instruments be included in determining the foreign
currency exposure to be offset on a net basis?
7.6.140 Does the linkage between each internal derivative and the
offsetting third-party derivative have to be documented at
the third-party derivative’s initiation?
7.6.150 Can the provisions for netting foreign currency risks be
used to offset exposures to FCD assets or liabilities or net
investment hedges?
7.6.160 If a forecasted transaction or firm commitment is being
hedged using an internal derivative, what is the effect
when the transaction or firm commitment occurs?
7.6.170 What is the effect of an issuing entity altering or modifying
an offsetting third-party derivative?
Examples
7.6.10 Forecasted cash inflows and outflows in foreign currency
7.6.20 Forecasted purchase in foreign currency
7.6.30 Applying the requirement to eliminate variability in all cash
flows
7.6.40 Hedging fixed-rate interest payments in a dual-currency
bond
7.6.50 Hedging the net exposure from internal derivatives
Hedging 483
7. Hedging foreign currency exposures

7.7 Accounting for foreign currency cash flow hedges

7.7.10 Overview
7.7.20 Recognized FCD assets and liabilities
7.7.30 Forecasted purchases and sales on credit
7.7.40 Examples of foreign currency cash flow value hedges
Questions
7.7.10 When are amounts in AOCI reclassified into earnings in a
hedge of a forecasted intercompany transaction?
7.7.20 How are gains and losses on a hedging instrument
recognized if an entity assesses effectiveness on an after-
tax basis?
7.7.30 Is a partial-term cash flow hedge of foreign currency risk
permitted?
7.7.40 For non-option contracts, how are amounts reclassified
from AOCI when hedge effectiveness is based on a
hedging instrument’s total change in cash flows?
7.7.50 For option contracts, how are amounts reclassified from
AOCI when hedge effectiveness is based on a hedging
instrument’s total change in cash flows?
Examples
7.7.10 Different maturities for hedged item and hedging
instrument
7.7.20 Cash flow hedge of variable-rate FCD debt with a variable
to fixed cross-currency interest rate swap (variable-to-fixed
scenario)
7.7.30 Cash flow hedge of a forecasted FCD purchase with a
forward contract
7.7.40 Cash flow hedge of recognized FCD payable with a forward
contract
7.7.50 Single cash flow hedge with a foreign currency purchased
option
Hedging 484
7. Hedging foreign currency exposures

7.1 How the standard works

Throughout this chapter, FCD means foreign currency denominated.

Foreign currency risk is the risk of changes in a hedged item’s fair value
or functional currency equivalent cash flows attributable to changes in the
related foreign currency exchange rates.
Foreign currency hedges use the cash flow, fair value or net investment
models. However, there are additional criteria for a hedged item or transaction
and hedging instrument to be eligible for designation in a foreign currency
hedge.

Criterion 1 Criterion 2 Criterion 3 Criterion 4

Eligibility of Eligibility of
Eligibility of Hedge
hedged items hedging
hedged risk(s) effectiveness
or transactions instruments

Criterion 5: Formal documentation

There are general qualifying criteria applicable to all foreign currency hedges:
— Hedging instrument. The entity with the foreign currency exposure needs
to be a party to the hedging instrument (see section 7.3.20).
— Hedged item or transaction. The hedged transaction needs to be
denominated in a currency other than the entity’s functional currency (see
section 7.3.30).
In addition, there are qualifying criteria specific to the type of foreign currency
hedge. This chapter will focus on the general qualifying criteria and the criteria
specific to foreign currency fair value and cash flow hedges. For guidance on
qualifying criteria specific to net investment hedges, see chapter 8.
This chapter builds on the previous discussion of qualifying criteria for fair value
hedges (see chapter 3) and cash flow hedges (see chapter 5). It also builds on
the foreign currency concepts in Topic 830 (foreign currency matters) that are
discussed in our Handbook, Foreign currency.
Foreign currency fair value hedge. An entity establishes a foreign currency
fair value hedge to hedge against changes in fair value due to changes in:
— foreign currency exchange rates; or
— both foreign currency exchange rates and interest rates (see section 7.4).
Foreign currency cash flow hedge. An entity establishes a foreign currency
cash flow hedge to hedge against changes in future cash flows due to changes
in foreign currency exchange rates (see section 7.6).
Hedging 485
7. Hedging foreign currency exposures

For each type of hedge, there are permitted hedged items and hedging
instruments.

Criterion 1: Eligibility of
hedged items or Criterion 3: Eligibility of
transactions hedging instruments

Foreign FCD asset or liability Derivative

currency fair
value hedge Unrecognized FCD firm Derivative
(section 7.4) commitment or
Nonderivative financial
instrument

Foreign FCD asset or liability Derivative

currency cash
flow hedge
Unrecognized FCD firm Derivative
(section 7.6) commitment

FCD forecasted transaction Derivative

The accounting for foreign currency fair value and cash flow hedges is the same
as for all other fair value hedges (see chapter 4) and cash flow hedges (see
chapter 6), respectively. However, Topic 815 provides additional guidance for
certain items and transactions designated in a fair value (see section 7.5) and
cash flow (see section 7.7) hedge of foreign currency risk.
Hedging 486
7. Hedging foreign currency exposures

7.2 Basic concepts in foreign currency hedges

A foreign currency hedge is a hedge of a foreign currency exposure. Foreign
currency exposure exists when a transaction, asset or liability, or net
investment in a foreign operation is denominated in a currency other than an
entity's functional currency. Therefore, an entity whose functional currency is
the US dollar has a foreign currency exposure only in instances when it has
transactions, assets or liabilities, or a net investment in a foreign operation
denominated in a currency other than the US dollar. [815-20-25-24]
Topic 830 states that an entity's functional currency “is the currency of the
primary economic environment in which the entity operates; normally, that is
the currency of the environment in which an entity primarily generates and
expends cash.” Topic 830 requires FCD assets and liabilities to be remeasured
to the entity’s functional currency at the spot rate through earnings. [830-10
Glossary]

A foreign currency hedging transaction allows an entity to hedge the resulting

variability in functional currency. When establishing a foreign currency hedging
transaction, an entity can use either the fair value or cash flow hedging models,
as explained in sections 7.5 and 7.7, respectively. In a foreign currency hedging
transaction, an entity is hedging the risk that foreign currency exchange rate
movements could have on its financial statements (i.e. a foreign currency risk).

7.3 General qualifying criteria for foreign currency

hedges
7.3.10 Overview
Regardless of the hedging model used in a foreign currency hedge (i.e. fair
value, cash flow or net investment model) a foreign currency hedge needs to
meet the following criteria: [815-20-25-30]
— the entity with the foreign currency exposure needs to be a party to the
hedging instrument (see section 7.3.20); and
— the hedged item or transaction needs to be denominated in a currency
other than the entity’s functional currency (see section 7.3.30).

Excerpt from ASC 815-20

>> Hedged Items and Transactions Involving Foreign Exchange Risk

25-26 The functional currency concepts of Topic 830 are relevant if the foreign
currency exposure being hedged relates to any of the following:
a. An unrecognized foreign-currency-denominated firm commitment
b. A recognized foreign-currency-denominated asset or liability
c. A foreign-currency-denominated forecasted transaction
d. The forecasted functional-currency-equivalent cash flows associated with a
recognized asset or liability
Hedging 487
7. Hedging foreign currency exposures

e. A net investment in a foreign operation.

25-27 Because a parent entity whose functional currency differs from its
subsidiary’s functional currency is not directly exposed to the risk of exchange
rate changes due to a subsidiary transaction that is denominated in a currency
other than a subsidiary’s functional currency, the parent cannot qualify for
hedge accounting for a hedge of that risk. Accordingly, a parent entity that has
a different functional currency cannot qualify for hedge accounting for direct
hedges of a subsidiary’s recognized asset or liability, unrecognized firm
commitment or forecasted transaction denominated in a currency other than
the subsidiary’s functional currency. Also, a parent that has a different
functional currency cannot qualify for hedge accounting for a hedge of a net
investment of a first-tier subsidiary in a second-tier subsidiary.
25-28 If the hedged item is denominated in a foreign currency, an entity may
designate any of the following types of hedges of foreign currency exposure:
a. A fair value hedge of an unrecognized firm commitment or a recognized
asset or liability (including an available-for-sale debt security)
b. A cash flow hedge of any of the following:
1. A forecasted transaction
2. An unrecognized firm commitment
3. The forecasted functional-currency-equivalent cash flows associated
with a recognized asset or liability
4. A forecasted intra-entity transaction.
c. A hedge of a net investment in a foreign operation.
25-29 The recognition in earnings of the foreign currency transaction gain or
loss on a foreign-currency-denominated asset or liability based on changes in
the foreign currency spot rate is not considered to be the remeasurement of
that asset or liability with changes in fair value attributable to foreign exchange
risk recognized in earnings, which is discussed in the criteria in paragraphs 815-
20-25-15(d) and 815-20-25-43(c). Thus, those criteria are not impediments to
either of the following:
a. A foreign currency fair value or cash flow hedge of such a foreign-currency-
denominated asset or liability
b. A foreign currency cash flow hedge of the forecasted acquisition or
incurrence of a foreign-currency-denominated asset or liability whose
carrying amount will be remeasured at spot exchange rates under
paragraph 830-20-35-1.
25-30 Both of the following conditions shall be met for foreign currency cash
flow hedges, foreign currency fair value hedges, and hedges of the net
investment in a foreign operation:
a. For consolidated financial statements, either of the following conditions is
met:
1. The operating unit that has the foreign currency exposure is a party to
the hedging instrument.
2. Another member of the consolidated group that has the same
functional currency as that operating unit is a party to the hedging
instrument and there is no intervening subsidiary with a different
functional currency. See guidance beginning in paragraph 815-20-25-52
for conditions under which an intra-entity foreign currency derivative
Hedging 488
7. Hedging foreign currency exposures

can be the hedging instrument in a cash flow hedge of foreign

exchange risk.
b. The hedged transaction is denominated in a currency other than the
hedging unit’s functional currency.

Question 7.3.10
Can an entity hedge recognized FCD assets and
liabilities?

Interpretive response: Yes. An overall limitation on any type of hedging

transaction is that the hedged item cannot be remeasured at fair value with
changes in fair value recognized in earnings. Therefore, an entity is not
permitted to hedge assets and liabilities that are remeasured for changes in fair
value attributable to the hedged risk reported currently in earnings (e.g. trading
securities) or forecasted transactions that become recognized and subsequently
remeasured for changes in fair value attributable to the hedged risk through
earnings. [815-20-25-15(d), 25-43(c)(3)]
However, the remeasurement of FCD monetary assets and liabilities to the
entity’s functional currency at the spot rate through earnings (in accordance
with Topic 830) is not a remeasurement at fair value. Therefore, FCD monetary
assets and liabilities can be the hedged item in a foreign currency hedge, if all
other hedge criteria are met. In addition, FCD AFS debt securities can also be
designated as hedged items even though they are nonmonetary assets (see
sections 7.4.40 and 7.6.50) [815-20-25-29]

Question 7.3.20
What risk(s) may be hedged in FCD assets and
liabilities?

Interpretive response: FCD assets and liabilities may be hedged for the
following risk(s):
— only for foreign currency risk; or
— for multiple risks simultaneously – e.g. foreign currency risk and interest
rate risk; for additional discussion on hedging multiple risks, see
section 7.3.40.
Hedging 489
7. Hedging foreign currency exposures

7.3.20 Entity with foreign currency risk is party to the

hedging instrument

Excerpt from ASC 815-20

>> Hedged Items and Transactions Involving Foreign Exchange Risk

25-23 Under the functional currency concept of Topic 830, exposure to a
foreign currency exists only in relation to a specific operating unit’s designated
functional currency cash flows. Therefore, exposure to foreign currency risk
shall be assessed at the unit level.
25-24 A unit has exposure to foreign currency risk only if it enters into a
transaction (or has an exposure) denominated in a currency other than the
unit’s functional currency.
25-25 Due to the requirement in Topic 830 for remeasurement of assets and
liabilities denominated in a foreign currency into the unit’s functional currency,
changes in exchange rates for those currencies will give rise to exchange gains
or losses, which results in direct foreign currency exposure for the unit but not
for the parent entity if its functional currency differs from its unit’s functional
currency.
25-27 Because a parent entity whose functional currency differs from its
subsidiary’s functional currency is not directly exposed to the risk of exchange
rate changes due to a subsidiary transaction that is denominated in a currency
other than a subsidiary’s functional currency, the parent cannot qualify for
hedge accounting for a hedge of that risk. Accordingly, a parent entity that has
a different functional currency cannot qualify for hedge accounting for direct
hedges of a subsidiary’s recognized asset or liability, unrecognized firm
commitment or forecasted transaction denominated in a currency other than
the subsidiary’s functional currency. Also, a parent that has a different
functional currency cannot qualify for hedge accounting for a hedge of a net
investment of a first-tier subsidiary in a second-tier subsidiary.
25-30 Both of the following conditions shall be met for foreign currency cash
flow hedges, foreign currency fair value hedges, and hedges of the net
investment in a foreign operation:
a. For consolidated financial statements, either of the following conditions is
met:
1. The operating unit that has the foreign currency exposure is a party to
the hedging instrument.
2. Another member of the consolidated group that has the same
functional currency as that operating unit is a party to the hedging
instrument and there is no intervening subsidiary with a different
functional currency. See guidance beginning in paragraph 815-20-25-52
for conditions under which an intra-entity foreign currency derivative
can be the hedging instrument in a cash flow hedge of foreign
exchange risk.

A required element of a foreign currency hedge is that the entity with the
foreign currency exposure is a party to the hedging instrument. This criterion
Hedging 490
7. Hedging foreign currency exposures

is necessary because under Topic 830’s functional currency approach, all

foreign currency exposures exist only in relation to an entity’s functional
currency. Therefore, exposure to foreign currency risk must be assessed at the
operating unit level. [815-20-25-23]
In consolidated financial statements, foreign currency risk is assessed at the
operating unit level. Therefore, the operating unit (e.g. parent, subsidiary) with
the foreign currency risk generally needs to be a party to the hedging
instrument. In consolidated financial statements, there is an exception that
allows another member of the consolidated group to be a party to the hedging
instrument in certain circumstances, as illustrated in the following flowchart.
[815-20-25-23, 25-30(a)]

Is the operating unit with

the foreign currency
Yes risk a party to the
hedging instrument?

Is another member of the

same consolidated group
a party to the hedging
instrument? No

Yes

Does this other member

have the same functional No Hedging
currency as the operating instrument not
unit with the foreign eligible
currency risk?

Yes

Is there a subsidiary with

a different functional
currency between the Yes
operating unit and member
that is a party to the
hedging instrument?

Hedging instrument
eligible to be designated
against the operating
unit’s exposure
Hedging 491
7. Hedging foreign currency exposures

Question 7.3.30
Can a parent entity that has a functional currency
different from its subsidiary hedge the subsidiary’s
foreign currency risk?
Interpretive response: No. A parent entity whose functional currency differs
from that of its subsidiary is not directly exposed to the risk of exchange rate
changes for a subsidiary's foreign currency transactions. Therefore, the parent
entity cannot hedge the subsidiary’s foreign currency risk. [815-20-25-27

Question 7.3.40
How is an operating unit evaluated when
determining whether foreign currency exposure can
be hedged?
Interpretive response: In consolidated financial statements, the operating unit
is evaluated by using a functional currency approach rather than a legal entity
approach. Therefore, if the subsidiary has the same functional currency as the
parent entity, the parent may enter into a hedging instrument that is designated
as the hedge of the subsidiary's foreign currency risk in the consolidated
financial statements. This is because when a subsidiary and its parent have the
same functional currency, they also have the same foreign currency exposure.
However, this same foreign currency exposure does not exist if there is an
intervening subsidiary with a functional currency different from that of the
parent between the parent and the subsidiary that has the foreign currency risk
being hedged.
The following illustrates application of this guidance, as does Subtopic 815-20’s
Example 11 that follows. For illustrative purposes, the discussion assumes that
the subsidiary’s functional currency is not yen and the forecasted transaction is
yen-denominated sales.
— Parent and subsidiary with different functional currencies. A US dollar
functional currency parent cannot directly hedge the foreign currency risk in
its euro functional currency subsidiary’s forecasted yen-denominated export
sales because the parent has no direct exposure to exchange risk for the
yen-denominated sales.
— Parent and subsidiary with same functional currencies. If both the
parent and subsidiary have the US dollar as their functional currency, the
parent can directly hedge the yen-denominated forecasted sales of the
subsidiary, provided there is no intervening subsidiary with a different
functional currency.
— Parent and subsidiary with same functional currencies and intervening
subsidiary. If both the parent and second-tier subsidiary have the US dollar
as their functional currency, and there is an intervening UK subsidiary with a
pound sterling functional currency, the US dollar functional currency parent
cannot directly hedge the second-tier US dollar functional currency
subsidiary’s yen-denominated forecasted sales.
Hedging 492
7. Hedging foreign currency exposures

This analysis also applies if another member of the consolidated group (instead
of the parent) enters into the hedging instrument. For example, a first-tier
subsidiary and its subsidiary (i.e. a second-tier subsidiary) have the same
functional currency. If that is the case, the first-tier subsidiary can hedge the
second-tier subsidiary’s foreign currency risk.

Excerpt from ASC 815-20

>> Example 11: Identifying an Intervening Subsidiary with a Different

Functional Currency

55-130 This Example illustrates the application of paragraph 815-20-25-30(a)(2).

If a dollar- (USD-) functional, second-tier subsidiary has a Euro (EUR) exposure,
the USD-functional consolidated parent entity could designate its USD–EUR
derivative instrument as a hedge of the second-tier subsidiary’s exposure if the
functional currency of the intervening first-tier subsidiary (that is, the parent of
the second-tier subsidiary) is also USD. In contrast, if the functional currency of
the intervening first-tier subsidiary was the Japanese yen (JPY) (thus requiring
the financial statements of the second-tier subsidiary to be translated into JPY
before the JPY-denominated financial statements of the first-tier subsidiary are
translated into USD for consolidation), the consolidated parent entity could not
designate its USD–EUR derivative instrument as a hedge of the second-tier
subsidiary’s exposure.

Question 7.3.50
If a parent entity hedges its subsidiary’s foreign
currency risk, can the subsidiary recognize the
effects of the hedge in its stand-alone financial
statements?
Interpretive response: No. To recognize the effects of hedge accounting in a
subsidiary's stand-alone financial statements, the subsidiary needs to enter into
the hedging instrument. In this case, the parent entered into the hedging
instrument to hedge the subsidiary’s foreign currency risk.
Hedging 493
7. Hedging foreign currency exposures

7.3.30 Currency other than functional currency

Excerpt from ASC 815-20

>> Hedged Items and Transactions Involving Foreign Exchange Risk

25-30 Both of the following conditions shall be met for foreign currency cash
flow hedges, foreign currency fair value hedges, and hedges of the net
investment in a foreign operation:…
b. The hedged transaction is denominated in a currency other than the
hedging unit’s functional currency.

To apply foreign currency hedge accounting, not only does the entity with the
foreign currency risk need to be a party to the hedging instrument, but the
hedged transaction needs to be denominated in a currency other than the
hedging entity’s functional currency. This is because foreign currency exposure
exists in relation to an entity's functional currency. [815-20-25-30(b)]

Example 7.3.10
Currency other than functional currency
Scenario 1: Functional currency is the same as the transaction currency
ABC Corp. is a euro functional currency entity that enters into euro-
denominated transactions. The euro-denominated transactions are not eligible
for foreign currency hedging because they do not present a foreign currency
exposure in relation to ABC’s functional currency.
Scenario 2: Parent and subsidiary functional currency is the same as the
transaction currency
ABC Corp.'s functional currency is the US dollar. It wants to enter into a foreign
currency forward contract to hedge the foreign currency risk of a subsidiary’s
US dollar purchases. Because ABC’s functional currency is the US dollar and
the hedged transaction is denominated in US dollars (i.e. there is no foreign
currency exposure for ABC), the hedged transaction does not meet the
‘currency other than functional currency’ requirement. Therefore, ABC may not
designate the forward contract as a foreign currency hedge.

Question 7.3.60
Can hedge accounting be applied if the hedged
transaction is denominated in the hedging entity’s
functional currency but the settlement amount is
based on a foreign currency?
Interpretive response: Yes. We believe hedge accounting may be applied for a
transaction that is settled in an entity's functional currency, but whose
settlement amount is determined by converting a specified amount of a foreign
Hedging 494
7. Hedging foreign currency exposures

currency into the entity's functional currency at the spot or average exchange
rate at the time of settlement.

Example 7.3.20
Settlement of hedged transaction is based on a
foreign currency
ABC Corp. (which has the US dollar as its functional currency) enters into an
agreement with a third party that entitles the third party to produce and
distribute one of ABC's products in exchange for quarterly royalty payments
based on a percentage of euro-denominated sales.
The calculation of the royalty payment is based on euro-denominated sales, but
the royalty payment received by ABC is in US dollars; the euro-denominated
sales are converted to US dollars using the average exchange rate for the
period. In this case, we believe that in effect the transaction is denominated in a
currency other than ABC's functional currency (i.e. payment based on euro).
Accordingly, ABC may designate its foreign currency risk on the forecasted
cash receipts in euro in a cash flow hedge.
In contrast, ABC may receive royalty payments in euros with the calculation of
such payments based on a percentage of US dollar denominated sales
converted to euros at the spot rate. In this case, ABC does not have foreign
currency exposure and may not designate the forecasted cash receipt in euros
in a cash flow hedge.

7.3.40 Other matters relevant to foreign currency hedges

The following topics, discussed in this section, apply to both fair value and
cash flow foreign currency hedges, and require special attention:
— intercompany transactions;
— hedging multiple risks; and
— tandem or cross-currency hedges.

Intercompany transactions
Eligibility of hedged items or transactions. An entity is permitted to hedge
forecasted intercompany foreign currency transactions and intercompany FCD
recognized assets and liabilities. For a discussion of internal derivatives, see
sections 7.4.70 (fair value hedges) and 7.6.60 (cash flow hedges). [815-20-25-28]
Hedging 495
7. Hedging foreign currency exposures

Question 7.3.70
Are there limitations on hedging an intercompany
FCD transaction involving a recognized asset or
liability?
Interpretive response: Yes. In consolidated financial statements, an
intercompany FCD transaction involving a recognized asset or liability can be the
hedged item as long as only the foreign currency risk is being hedged. Hedging
the foreign currency risk associated with an intercompany transaction is
permitted because the gain or loss created under Topic 830 when an
intercompany FCD transaction is remeasured to the entity’s functional currency
is not eliminated in consolidation. Therefore, the risk affects consolidated
earnings. [815-20-25-28 – 25-29]
In contrast, in consolidated financial statements, an intercompany FCD
transaction cannot be hedged for overall changes in fair value or cash flows,
interest rate or credit risk because these risks do not affect consolidated
earnings. The exposure to these risks of one party to the contract will be offset
by the opposite exposure of the other party within a consolidated group.
Therefore, any potential earnings exposure will be eliminated in consolidation.
However, for purposes of the subsidiary’s stand-alone financial statements, any
of the previously mentioned risks, including foreign currency risk, presents
exposure to that subsidiary’s earnings and are therefore eligible for hedge
accounting.

Question 7.3.80
Can an intercompany commitment be hedged?

Excerpt from ASC 815-10

b. The agreement includes a disincentive for nonperformance that is

Interpretive response: Yes, but only under the cash flow hedge model. An
unrecognized FCD firm commitment can be the hedged item in either a cash
flow hedge or a fair value hedge. However, the definition of a firm commitment
states that it must be with an unrelated party. Therefore, an intercompany
commitment does not meet the definition of a firm commitment and cannot be
hedged under the fair value hedge model. [815-20-25-28, 815-10 Glossary]
Nevertheless, a FCD intercompany commitment or a firm commitment with a
related party (e.g. subsidiary to subsidiary within a consolidated group, or entity
to related party outside the consolidated financial statements) is eligible to be
hedged in a cash flow hedge as a forecasted transaction. This is because the
criteria for forecasted transactions do not require the contract to be with an
unrelated party – an intercompany and related party commitment exposes an
entity to variability in the functional currency equivalent cash flows that could
affect reported earnings (see sections 7.6.20 and 7.6.40).

Hedging multiple risks

Excerpt from ASC 815-20

>> Hedged Item Criteria Applicable to Fair Value Hedges Only

1. The risk of overall changes in the hedged cash flows related to the
asset or liability, such as those relating to all changes in the purchase
price or sales price (regardless of whether that price and the related
cash flows are stated in the entity’s functional currency or a foreign
currency) …
If the risk designated as being hedged is not the risk in paragraph 815-20-
25-15(j)(1), two or more of the other risks (interest rate risk, foreign
exchange risk, and credit risk) simultaneously may be designated as being
hedged.

Eligibility of hedged risks. As discussed in section 2.3.80, for both fair value
and cash flow hedges, an entity may simultaneously hedge two or more risks
(e.g. foreign currency risk, interest rate risk and credit risk).
The following table summarizes various approaches to hedging foreign currency
risk and/or interest rate risk in either a fair value or cash flow model for
recognized FCD financial assets or liabilities. The table assumes that the US
dollar (USD) is the functional currency and that the interest rate is the
benchmark rate for a fair value hedge or the contractually specified interest rate
for a cash flow hedge.

Hedged item or
transaction Hedge objective Hedge result Hedge approach

Fixed-rate, FCD Reduce foreign USD variable-rate Fair value hedge of

instrument currency and interest and USD foreign currency
interest rate risk principal and interest rate
risk

Fixed-rate, FCD Fix variability due to USD fixed-rate Cash flow or fair
instrument foreign currency interest and USD value hedge1 of
risk principal foreign currency
risk

Fixed-rate, FCD Eliminate change in FCD variable-rate Fair value hedge of

instrument FCD fair value of interest and FCD FCD interest rate
instrument due to principal risk
FCD interest rate
risk

FCD trade payable or Fix variability due to USD fixed Cash flow or fair
receivable foreign currency payment amount value hedge1 of
risk foreign currency
risk

Variable-rate, FCD Fix variability of USD fixed interest Cash flow hedge
instrument principal and rate and USD of variability of
interest payments principal foreign currency
due to foreign and interest rate
currency and risk
interest rate risk2

Variable-rate, FCD Reduce variability of USD variable-rate Fair value hedge1

instrument foreign currency interest and USD of foreign currency
risk2 principal risk3
Hedging 498
7. Hedging foreign currency exposures

Hedged item or
transaction Hedge objective Hedge result Hedge approach

Variable-rate, FCD Reduce variability FCD fixed-rate Cash flow hedge

instrument due to interest rate interest and FCD of variability of FCD
risk principal interest rate risk

Variable-rate, FCD Fix variability of Fixed USD Cash flow or fair

instrument principal payment principal value hedge1 of
due to foreign foreign currency
currency risk risk for principal

Notes:
1. If no components are excluded from the assessment of hedge effectiveness, there
may be volatility in earnings for the fair value hedging model due to spot/forward
differences or currency basis spreads. Earnings volatility can be reduced if an entity
excludes the spot/forward difference or currency basis spreads from its assessment of
hedge effectiveness and elects to recognize the initial value of the excluded
component using an amortization approach. For additional discussion of excluded
components, see section 4.2.20.
2. Alternatively, the hedged item can be designated as the functional currency equivalent
cash flows of a specified amount of a variable-rate based foreign currency interest
payment(s). For example, if an entity has a 100,000 euro (€) variable-rate loan, it can
designate as the hedged item the first €3,000 of a specified variable-rate interest
payment(s) if it is probable that the hedged variable interest payment(s) will exceed
€3,000. Then the entity can enter into a cash flow hedge with a foreign currency
forward contract because all of the variability associated with the first €3,000 of the
variable interest payment(s) would be eliminated. For additional discussion, see
section 7.6.50. [815-20-25-41]
3. Alternatively, as demonstrated in the last approach in the table, if the hedged item is
designated to be the principal payment component only, the cash flow hedging model
can be used. As discussed in section 7.6.50, to apply cash flow hedging, all variability
of the hedged item’s functional currency cash flows must be eliminated by the effect
of the hedge. [815-20-25-39(d) – 25-41]

Question 7.3.90
If the hedged item affects more than one income
statement line item, where should the effect of the
hedging instrument be presented?
Interpretive response: When the earnings effect of the hedged item is
presented in more than one line item, the FASB concluded that it is appropriate
to present the change in the fair value of the hedging instrument in those same
line items. The change in the fair value of the hedging instrument should be
appropriately allocated to the different line items. [ASU 2017-12.BC134]
For example, if a hedging relationship involves hedging both the interest rate
risk and the foreign currency risk of an interest-earning asset or interest-bearing
liability denominated in a currency other than the entity’s functional currency,
the earnings effect of the hedged item is typically presented in:
— an interest income or interest expense line item; and
Hedging 499
7. Hedging foreign currency exposures

— another line item that the entity uses to present the spot remeasurement of
the FCD assets and liabilities under Topic 830 (e.g. foreign currency
transaction gain or loss).
The portion of the hedging instrument associated with converting the interest
cash flows from fixed-rate to floating-rate and/or from a foreign currency to the
entity’s functional currency is presented in interest income or interest expense,
except for the portion that the entity determines should be presented in the
income statement line item used to present the remeasurement of FCD assets
and liabilities. [ASU 2017-12.BC134]
The FASB examples below (paragraphs 815-20-55-79Z to 55-79AD) illustrate
one way that an entity might allocate the effect of the hedging relationship
between multiple income statement line items.

Excerpt from Subtopic 815-20

>>> Income Statement Presentation of Hedging Instruments

55-79W Paragraph 815-20-45-1A requires an entity to present the change in
the fair value of the hedging instrument included in the assessment of hedge
effectiveness and the amount excluded from the assessment of hedge
effectiveness in the same income statement line item that is used to present
the earnings effect of the hedged item. The following scenarios include
implementation guidance on the meaning of the phrase the same income
statement line item that is used to present the earnings effect of the hedged
item.
>>>> Scenario B
55-79Z Entity B designates a fair value hedge of foreign exchange risk in which
the hedged item is an issued variable-rate debt instrument denominated in a
currency other than Entity B’s functional currency. The derivative designated as
the hedging instrument is a receive-floating-rate (in foreign currency), pay-
floating-rate (in functional currency) cross-currency swap that requires an initial
and final exchange of notional amounts. In this scenario, Entity B’s objective is
to convert the cash flows of the debt instrument (both interest cash flows and
the principal cash flow) from a foreign currency to Entity B’s functional
currency.
55-79AA The currency swap is a highly effective hedge of the currency risk of
both the interest cash flows and the principal cash flows of the debt
instrument. Therefore, the change in fair value of the currency swap should be
presented in the same income statement line item(s) used to present the
earnings effects of the hedged item. Before applying hedge accounting,
Entity B presents the earnings effect associated with the hedged item in two
income statement line items. That is, interest accruals are presented in an
interest expense line item, and the spot remeasurement of the foreign-
currency-denominated debt under Topic 830 on foreign currency matters is
presented in a foreign currency transaction gain or loss line item. Therefore, in
this scenario, because the hedging instrument is highly effective at offsetting
changes in fair values associated with the hedged item that are reported in
more than one income statement line item, the effects of the hedging
Hedging 500
7. Hedging foreign currency exposures

instrument also should be presented in those corresponding income statement

line items. Entity B should present all changes in the fair value of the hedging
instrument (that is, the interest accruals and all other changes in fair value) in
the same interest expense line item that is used to present the earnings effect
of the hedged item before applying hedge accounting, except for the change in
the fair value of the hedging instrument that the entity determines should be
presented in the same foreign currency transaction gain or loss line item used
to present the spot remeasurement of the hedged item before applying hedge
accounting.
>>>> Scenario C
55-79AB Entity C designates a fair value hedge of interest rate risk and foreign
currency risk in which the hedged item is a foreign-currency-denominated
fixed-rate available-for-sale debt security. The derivative designated as the
hedging instrument is a pay-fixed-rate (in foreign currency), receive-floating-rate
(in functional currency) cross-currency interest rate swap. In this scenario,
Entity C’s objective is to convert the interest cash flows of the fixed-rate
security to floating-rate and also to convert the cash flows of the security (both
interest cash flows and the principal cash flow) from a foreign currency to
Entity C’s functional currency.
55-79AC The cross-currency interest rate swap is a highly effective hedge of
both the interest rate risk and foreign currency risk of the available-for-sale debt
security. Therefore, the change in fair value of the cross-currency interest rate
swap should be presented in the same income statement line item or items
used to present the earnings effect of the hedged item. Before applying hedge
accounting, Entity C recognizes the earnings effect of the hedged item (that is,
interest accruals on the available-for-sale debt security) in an interest income
line item in the income statement and recognizes all other changes in fair value
in other comprehensive income in accordance with paragraph 320-10-35-1(b).
Entity C should present changes in fair value of the hedging instrument (that is,
the interest accruals and all other changes in fair value) in the same income
statement line item used to present the earnings effect of the hedged item.
However, if Entity C’s policy is to present the effect of foreign exchange rate
changes on the fair value of the security that are recognized in earnings after
applying hedge accounting in accordance with paragraph 815-25-35-6 in a
different income statement line item (consistent with its presentation policies
when reflecting other foreign exchange rate changes), then the related
changes in fair value of the hedging instrument also should be presented in
that income statement line item.
55-79AD This scenario illustrates that a single hedging instrument (a cross-
currency interest rate swap) may be highly effective at offsetting changes in
fair values or cash flows associated with the hedged item in which the
earnings effect of the hedged item is presented in more than one income
statement line item. If a hedging instrument is highly effective at offsetting
changes in fair values or cash flows of the hedged item and the earnings effect
of the hedged item is presented in more than one income statement line item,
then the earnings effects of the hedging instrument also should be presented
in those corresponding income statement line item(s).
Hedging 501
7. Hedging foreign currency exposures

Tandem or cross-currency hedging

Excerpt from ASC 815-20

>> Hedged Items and Transactions Involving Foreign Exchange Risk

25-33 In some instances, it may not be practical or feasible to hedge in the
same currency and, therefore, a hedging instrument also may be denominated
in a currency for which the exchange rate generally moves in tandem with the
exchange rate for the currency in which the hedged item is denominated.

Eligibility of hedging instruments. Topic 815 does not require an entity to use
a derivative instrument denominated in the same foreign currency as the
hedged item. Instead, a hedging transaction can involve ‘tandem’ currencies –
i.e. currencies from two different countries that are highly correlated.
The requirement that a hedging relationship be highly effective also applies to
tandem currencies. Therefore, an entity may designate a hedging instrument
denominated in a tandem currency if, based on historical experience, it expects
that the hedging relationship between the hedged exposure in one currency
and the tandem currency will be highly effective. Subtopic 815-20’s Example 10
is a fair value hedge of a FCD firm commitment with a forward to purchase a
different currency (see section 7.5.30). [815-20-25-33]

Example 7.3.30
Forecasted purchase in foreign currency
ABC Corp.’s functional currency is the US dollar. It wants to hedge a firmly
committed Canadian-dollar sales transaction with an Australian-dollar-
denominated foreign currency forward contract.
ABC can use this forward contract as the hedging instrument in this hedge if
movements in the fair value of the forward contract are highly effective at
offsetting the fair value changes in the foreign currency exposure in a firmly
committed Canadian-dollar sales transaction.

7.4 Specific qualifying criteria for foreign currency fair

value hedges
7.4.10 Overview
To qualify for foreign currency fair value hedge accounting, a hedging
relationship must meet the following qualifying criteria.
Hedging 502
7. Hedging foreign currency exposures

General hedging requirements Chapter 2

Qualifying criteria for all fair value

Chapter 3
hedges

General qualifying criteria for all

Section 7.3
foreign currency hedges

Specific qualifying criteria for foreign

Section 7.4
currency fair value hedges

This section discusses the specific qualifying criteria for foreign currency fair
value hedges related to the eligibility of hedged items and hedging instruments.
.

Criterion 1 Criterion 2 Criterion 3 Criterion 4

Eligibility of Eligibility of
Eligibility of Hedge
hedged items hedging
hedged risk(s) effectiveness
or transactions instruments

Criterion 5: Formal documentation

Topic 815 permits foreign currency fair value hedges of the following items
using the following types of hedging instruments.

Criterion 1: Items eligible for fair Criterion 3: Hedging instruments

value hedges of foreign currency risk eligible for fair value hedges of
foreign currency risk

FCD recognized assets and liabilities

Derivative
(section 7.4.30)

AFS debt securities

Derivative
(section 7.4.40)

Derivative
Unrecognized firm commitments or
(section 7.4.50) Nonderivative financial instrument
(section 7.4.60)

Hedged items continue to be subject to other applicable US GAAP, including for

assessing impairment.
Hedging 503
7. Hedging foreign currency exposures

7.4.20 Eligibility of hedged items and hedging instruments

in a fair value hedge of foreign currency risk

Excerpt from ASC 815-20

>>> Items in Fair Value Hedges of Foreign Exchange Risk

25-37 This paragraph identifies possible hedged items in fair value hedges of
foreign exchange risk. If every applicable criterion is met, all of the following
are eligible for designation as a hedged item in a fair value hedge of foreign
exchange risk:
a. Recognized asset or liability. A derivative instrument can be designated as
hedging the changes in the fair value of a recognized asset or liability (or a
specific portion thereof) for which a foreign currency transaction gain or
loss is recognized in earnings under the provisions of paragraph 830-20-35-
1. All recognized foreign-currency-denominated assets or liabilities for
which a foreign currency transaction gain or loss is recorded in earnings
shall qualify for the accounting specified in Subtopic 815-25 if all the fair
value hedge criteria in this Section (including the conditions in paragraph
815-20-25-30(a) through (b)) are met.
b. Available-for-sale debt security. A derivative instrument can be designated
as hedging the changes in the fair value of an available-for-sale debt
security (or a specific portion thereof) attributable to changes in foreign
currency exchange rates. The designated hedging relationship qualifies for
the accounting specified in Subtopic 815-25 if all the fair value hedge
criteria in this Section (including the conditions in paragraph 815-20-25-
30(a) through (b)) are met.
c. Subparagraph superseded by Accounting Standards Update No. 2016-01.
d. Unrecognized firm commitment. Paragraph 815-20-25-58 states that a
derivative instrument or a nonderivative financial instrument that may give
rise to a foreign currency transaction gain or loss under Topic 830 can be
designated as hedging changes in the fair value of an unrecognized firm
commitment, or a specific portion thereof, attributable to foreign currency
exchange rates.

Hedged items. If the general criteria for all fair value hedges and general
criteria for all foreign currency hedges are met, the following items (or a specific
portion thereof) can be hedged items in a fair value hedge of foreign currency
risk: [815-20-25-37]
— recognized assets or liabilities for which transaction gains or losses are
recognized in earnings (section 7.4.30);
— AFS debt securities (section 7.4.40); and
— unrecognized firm commitments (section 7.4.50).

See section 3.3.60 for additional information about hedging portions of a

hedged item.
Absent from this list is a forecasted transaction. A forecasted transaction can be
the hedged item in a foreign currency cash flow hedge but not in a foreign
currency fair value hedge.
Hedging 504
7. Hedging foreign currency exposures

Hedging instruments. A derivative may be designated as the hedging

instrument for FCD recognized assets or liabilities, AFS debt securities and
unrecognized firm commitments. A nonderivative financial instrument can also
be designated as the hedging instrument for unrecognized firm commitments
(see section 7.4.60).
In addition, Topic 815 allows internal derivatives to be designated as hedging
instruments for fair value hedges of FCD recognized assets or liabilities if
certain conditions are met (see section 7.4.70).

7.4.30 Hedged item: Recognized assets or liabilities for

which transaction gains or losses are recognized in
earnings
If an item gives rise to foreign currency transaction gains or losses in earnings
under Topic 830 it may be a hedged item in a foreign currency fair value hedge.
Recognized FCD monetary assets and liabilities are remeasured into the
functional currency based on spot exchange rates. The remeasurement
represents a foreign currency transaction gain or loss that is recognized in
earnings. [830-20-35-1]

Hedged
FCD asset/liability: item? Why?
HTM debt securities Yes The remeasurement of FCD HTM securities,
Loans loans and debt obligations represent foreign
currency transaction gains or losses that are
Debt obligations
recognized in earnings.
Trading debt securities No FCD trading securities are measured at fair
value each reporting period with all fair value
changes recognized in earnings.
An entity is not permitted to hedge assets or
liabilities that are measured at fair value with
changes in fair value recognized in earnings.

FCD recognized assets or liabilities may be hedged with a derivative instrument.

7.4.40 Hedged item: AFS debt securities

AFS debt securities are nonmonetary assets for which the change in fair value
is expressed in an entity’s functional currency as the total of the changes in:
[320-10-35-36 – 35-37]

— the market price of the security expressed in the foreign currency due to
factors such as changes in interest rates and credit risk; and
— the currency exchange rates between the foreign currency and the entity’s
functional currency.
Although AFS debt securities do not give rise to transaction gains and losses, a
FCD AFS debt security (or specific portion thereof) may be the hedged item in a
foreign currency fair value hedge because it embodies cash flows denominated
Hedging 505
7. Hedging foreign currency exposures

in a foreign currency. FCD AFS debt securities may be hedged only with a
derivative instrument. [FAS 133.BC480]

7.4.50 Hedged item: Unrecognized firm commitments

Excerpt from ASC 815-20

>>> Hedging Instruments in Fair Value Hedges Involving Foreign

Exchange Risk
25-58 A derivative instrument or a nonderivative financial instrument that
may give rise to a foreign currency transaction gain or loss under Topic 830 can
be designated as hedging changes in the fair value of an unrecognized firm
commitment, or a specific portion thereof, attributable to foreign currency
exchange rates. The designated hedging relationship qualifies for the
accounting specified in Subtopic 815-25 if all the fair value hedge conditions in
this Section and the conditions in paragraph 815-20-25-30 are met.
25-59 The carrying basis for a nonderivative financial instrument that gives rise
to a foreign currency transaction gain or loss under Subtopic 830-20 is not
addressed by this Subtopic.
25-60 An entity may designate an intra-entity loan or other payable as the
hedging instrument in a foreign currency fair value hedge of an unrecognized
firm commitment and qualify for hedge accounting in the consolidated
financial statements. That designation is consistent with the ability under
paragraphs 815-20-25-58 through 25-59 to designate nonderivative instruments
as hedging instruments in foreign currency fair value hedges of firm
commitments. However, hedge accounting in the consolidated financial
statements shall only be applied if the member of the consolidated entity that
is the counterparty to the intra-entity loan has entered into a third-party
contract that offsets the foreign exchange exposure of that entity’s intra-entity
loan receivable. That is, the requirement in paragraphs 815-20-25-28 through
25-29 that an intra-entity derivative instrument designated as a hedging
instrument in a foreign currency fair value hedge be offset by a third-party
contract would also apply to intra-entity nonderivative instruments designated
as hedging instruments. To remain consistent with the notion that the intra-
entity contract is simply a conduit for the third-party exposure, an intra-entity
loan designated as a hedging instrument shall be offset by a third-party loan
(that is, it shall not be offset by a derivative instrument). Hedge accounting
shall be applied in consolidation only to those gains and losses occurring during
the period that the offsetting third-party loan is in place.

The definition of firm commitment for foreign currency hedges is used in the
same manner as for other fair value hedges. An unrecognized FCD firm
commitment (or specific portion thereof) is eligible to be a hedged item in a fair
value hedge of foreign currency exposure if its price is expressed in a specified
amount of currency. For additional discussion of whether a transaction meets
the definition of a firm commitment, see section 3.3.20. [815-20 Glossary]
Hedging 506
7. Hedging foreign currency exposures

In a foreign currency fair value hedge, an unrecognized FCD firm commitment

may be hedged with a derivative or a nonderivative financial instrument (e.g.
FCD debt). [815-20-25-58]

Question 7.4.10
Can an entity hedge future interest payments of
FCD debt as an unrecognized firm commitment in a
fair value hedge?

Excerpt from ASC 815-20

>>>> Foreign-Currency Denominated Interest Payments

55-35 An entity may not treat foreign-currency-denominated fixed-rate interest
coupon payments arising from an issuance of foreign-currency-denominated
fixed-rate debt as an unrecognized firm commitment that may be designated
as a hedged item in a foreign currency fair value hedge. (See paragraph 815-20-
25-23.) The foreign-currency exposure of the future interest payments would
not meet this Subtopic's definition of an unrecognized firm commitment
because the obligation is recognized on the balance sheet—that is, the carrying
amount of the foreign-currency-denominated fixed-rate debt incorporates the
entity’s obligation to make those future interest payments as well as the
repayment of principal. However, those fixed-rate interest payments could be
designated as the hedged transaction in a cash flow hedge.
55-36 Those fixed-rate interest payments might arise as follows. An entity
whose functional currency is the U.S. dollar issues fixed-rate debt denominated
in a foreign currency. The debt has a fixed interest coupon that is payable
semiannually in that foreign currency. The entity wishes to lock in, in U.S. dollar
functional currency terms, the future interest expense that will result from the
debt and enters into a derivative instrument to hedge the foreign currency risk
of the fixed foreign-currency-denominated interest coupon payments. For
example, the entity may enter into a foreign currency swap to receive an
amount of the foreign currency required to satisfy the interest coupon
obligation in exchange for U.S. dollars at each coupon date, or, alternatively, it
may enter into a strip of foreign currency forward contracts that provide for
receipt of an amount of foreign currency required to satisfy the interest coupon
obligation in exchange for the payment of U.S. dollars at each coupon date.
55-37 This guidance also applies to dual-currency bonds that provide for
repayment of principal in the functional currency and periodic fixed-rate interest
payments denominated in a foreign currency. Subtopic 830-20 applies to dual-
currency bonds and requires the present value of the interest payments
denominated in a foreign currency to be remeasured and the transaction gain
or loss recognized in earnings. Thus, those fixed-rate interest payments on a
dual-currency bond could be designated as the hedged transaction in a cash
flow hedge of foreign exchange risk.
Hedging 507
7. Hedging foreign currency exposures

Interpretive response: No. Future interest payments on existing FCD debt do

not meet the definition of an unrecognized firm commitment because the
obligation is recognized on the balance sheet. Therefore, the coupon payments
cannot be hedged in a foreign currency fair value hedge. However, the fixed-
rate interest payments may be designated as the hedged transaction in a cash
flow hedge. [815-20-55-35 – 55-36]
This guidance also applies to a dual-currency bond, which is a bond in which
principal and interest payments are denominated in different currencies. [815-20-
55-37]

Question 7.4.20
If a commitment to sell is based on the market price
at the time of shipment, can a portion of the price
of each unit to be sold be designated as the hedged
item in a fair value hedge?
Interpretive response: No. The definition of a firm commitment states, among
other things, that there must be a fixed price. If the price is the market price at
the time of shipment, it is not fixed until the time of shipment and therefore
would not qualify as a firm commitment. Therefore, it cannot be designated as
the hedged item in a fair value hedge.

Example 7.4.10
Commitment to sell at fair value – hedging a portion
of the price of each unit
ABC Corp. is a manufacturing company. Its functional currency is the US dollar.
ABC enters into a contract with a foreign customer to sell 10,000 units of
product each month. The price of the product is denominated in a foreign
currency and is determined as the market price on the date of shipment. There
are significant economic penalties resulting from breaking the contract.
Historically, the price of the product has ranged from 80 to 90 euros (€) per unit.
ABC wishes to hedge the currency exposure as a hedge of a firm commitment
and has proposed hedging the first €50 on each of its fixed quantity of units to
be sold. This means ABC’s hedging transaction is designed to protect ABC on
currency exposure on €50 per unit.
ABC contends that sales below €50 per unit are remote, as that term is used in
Topic 450 (contingencies). Therefore, effectively at least €500,000 (10,000 units
× €50 per unit) is fixed.
ABC cannot designate the first €50 on each unit sold as the hedged item in a
fair value hedge. The definition of a firm commitment is not met because the
price is the market price at the time of shipment; therefore, it is not fixed until
the time of shipment.
Hedging 508
7. Hedging foreign currency exposures

Foreign currency cash flow hedge as an alternative

However, the transaction can be structured as a cash flow hedge if ABC’s
transaction meets the requirements for a forecasted transaction. To be able to
designate the forecasted sales as the hedged item in a cash flow hedge, ABC
should be able to support that the specified currency amount of sales is
probable.
ABC determined it is probable that it will sell 10,000 units and the sales price
will be €80 per unit. Therefore, the foreign currency hedge may cover sales up
to €800,000 (10,000 units × €80 per unit).

7.4.60 Hedging instrument: Nonderivative financial

instrument
In a foreign currency fair value hedge, an unrecognized FCD firm commitment
may be hedged with a derivative or nonderivative financial instrument (e.g. FCD
debt). [815-20-25-58]

Question 7.4.30
Can a nonderivative financial instrument be used to
hedge an unrecognized firm commitment?

Interpretive response: Yes, as long as the nonderivative financial instrument

gives rise to foreign currency transaction gains or losses under Topic 830 – i.e.
the nonderivative instrument must be remeasured to the entity’s functional
currency at the spot rate through earnings. [815-20-25-58]
An instrument reported at fair value cannot be a hedging instrument. Therefore,
a financial instrument for which an entity elects the fair value option under
Topic 825 cannot be a hedging instrument because it does not give rise to a
foreign currency transaction gain or loss.

Question 7.4.40
In the consolidated financial statements, can an
intercompany nonderivative financial instrument be
used to hedge an unrecognized firm commitment?
Interpretive response: It depends. An intercompany FCD nonderivative
financial instrument (e.g. intercompany borrowing or receivable) can be a
hedging instrument in a foreign currency fair value hedge in the consolidated
financial statements if: [815-20-25-60]
— the nonderivative instrument gives rise to foreign currency transaction gains
or losses; and
— the counterparty to the intercompany instrument has entered into an
unrelated third-party nonderivative financial instrument that offsets the
Hedging 509
7. Hedging foreign currency exposures

foreign currency exposure acquired from the entity that has the firm
commitment.
Subtopic 815-20’s Example 17 below illustrates these concepts.
The requirement to enter into an offsetting instrument with a third party in this
situation is also a requirement when the hedging instrument is an internal
derivative, rather than a nonderivative, as explained in section 7.4.70.

FASB Example: Nonderivative hedging instrument designated

in a fair value hedge of an unrecognized firm commitment

Excerpt from ASC 815-20

>> Example 17: Designation of an Intra-Entity Loan or Other Payable as

the Hedging Instrument in a Fair Value Hedge of an Unrecognized Firm
Commitment

55-167 This Example illustrates the application of paragraph 815-20-25-60.

55-168 A parent entity (Parent A) with the U.S. dollar (USD) as both its
functional currency and reporting currency has a subsidiary with a Euro (EUR)
functional currency (Subsidiary B). Subsidiary B enters into an unrecognized
firm commitment with a third party that will result in Japanese yen (JPY) cash
inflows. Concurrent with Subsidiary B entering into the firmly committed
contract, Parent A extends a loan to Subsidiary B denominated in JPY, which is
funded by a third-party, JPY-denominated borrowing by Parent A. Subsidiary B
wishes to designate its JPY-denominated intra-entity loan payable as the
hedging instrument in consolidated financial statements in a fair value hedge of
foreign currency exposure related to its JPY-denominated unrecognized firm
commitment to a third party.
55-169 In accordance with paragraph 830-20-35-1, at each balance sheet date,
Subsidiary B’s JPY-denominated intra-entity loan payable would be remeasured
from the foreign currency (JPY) into Subsidiary B’s functional currency (EUR) at
the current EUR/JPY spot rate. Similarly, Parent A’s intra-entity JPY-
denominated receivable and its third-party JPY-denominated loan payable are
remeasured from the foreign currency (JPY) into Parent A’s functional currency
(USD) at the current USD/JPY spot rate. The transaction gains or losses that
are generated from remeasurement into functional currency are recorded in
net income. If Subsidiary B designates its JPY-denominated intra-entity loan
payable as the hedging instrument in consolidated financial statements, the
transaction gains and losses related to the intra-entity loan payable would
offset the change in fair value of the firm commitment attributable to changes
in foreign exchange rates in the consolidated income statement.
55-170 In this Example, Subsidiary B’s JPY-denominated intra-entity payable
may be designated as a fair value hedge of the foreign exchange exposure
arising from the third-party JPY-denominated firm commitment. Parent A has
in place a third-party JPY-denominated borrowing that offsets the exposure of
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7. Hedging foreign currency exposures

its JPY-denominated intra-entity receivable from Subsidiary B during the period

the intra-entity loan receives hedge accounting.

Question 7.4.50
What are the practical implications of using a
nonderivative instrument to hedge an unrecognized
firm commitment?
Interpretive response: In contrast to a derivative hedging instrument whose
gain or loss is measured by reference to changes in total fair value, the gain or
loss on a nonderivative hedging instrument is measured by reference to
changes in spot exchange rates under Topic 830. [830-20-35-1 – 35-2]
Therefore, an entity should understand the potential accounting results and
differences in choosing the hedging instrument when hedging the foreign
currency exposure of a firm commitment. See the KPMG observation in
section 7.5.20 relating to calculating the fair value of a hedged unrecognized
firm commitment.

7.4.70 Hedging instrument: Internal derivatives

Excerpt from ASC 815-20

20 Glossary
Internal Derivative – A foreign currency derivative instrument that has been
entered into with another member of a consolidated group (such as a treasury
center).
Intra-entity Derivative – A derivative instrument contract between two
members of a consolidated group.
>> Hedged Items and Transactions Involving Foreign Exchange Risk
25-31 However, a subsidiary may enter into an intra-entity hedging instrument
with the parent entity, and that contract can be a hedging instrument in the
consolidated financial statements if the parent entity enters into an offsetting
contract (pursuant to paragraph 815-20-25-52 for the appropriate hedging
relationship) with an unrelated third party to hedge the exposure it acquired
from issuing the derivative instrument to the subsidiary that initiated the
hedge.
25-32 If a subsidiary has the same functional currency as the parent entity or
other member of the consolidated group, the parent entity or that other
member of the consolidated group may, subject to certain restrictions, enter
into a derivative instrument or nonderivative instrument that is designated as
the hedging instrument in a hedge of that subsidiary’s foreign exchange risk in
consolidated financial statements.
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>> Hedging Instruments in Hedges of Foreign Exchange Risk

25-51A The guidance on hedging instruments in hedges of foreign exchange
risk is organized as follows:
a. Intra-entity derivatives
b. Hedging instruments in fair value hedges involving foreign exchange risk
c. Internal derivatives as hedging instruments in cash flow hedges of foreign
exchange risk
d. Hedging instruments in net investment hedges.
>>> Intra-Entity Derivatives
25-52 A foreign currency derivative instrument that has been entered into with
another member of a consolidated group can be a hedging instrument in any of
the following hedging relationships only if that other member of the
consolidated group has entered into an offsetting contract with an unrelated
third party to hedge the exposure it acquired from issuing the derivative
instrument to the affiliate that initiated the hedge:
a. A fair value hedge
b. A cash flow hedge of a recognized foreign-currency-denominated asset or
liability
c. A net investment hedge in the consolidated financial statements.
25-53 Paragraph 815-20-25-46A states that there is no requirement in this
Subtopic that the operating unit with the interest rate, market price, or credit
risk exposure be a party to the hedging instrument and provides related
guidance.
25-54 An intra-entity derivative can be designated as a hedging instrument in
consolidated financial statements if condition (a) is met and either condition (b)
or (c) is met:
a. The hedged risk is either of the following:
1. The risk of changes in fair value or cash flows attributable to changes in
a foreign currency exchange rate
2. The foreign exchange risk for a net investment in a foreign operation.
b. In a fair value hedge or in a cash flow hedge of a recognized foreign-
currency-denominated asset or liability or in a net investment hedge in the
consolidated financial statements the counterparty (that is, the other
member of the consolidated group) has entered into a contract with an
unrelated third party that offsets the intra-entity derivative completely,
thereby hedging the exposure it acquired from issuing the intra-entity
derivative to the affiliate that designated the hedge.
c. In a foreign currency cash flow hedge of a forecasted borrowing, purchase,
or sale or an unrecognized firm commitment the counterparty has entered
into a derivative instrument with an unrelated third party to offset the
exposure that results from that internal derivative or, if the conditions in
paragraphs 815-20-25-62 through 25-63 are met, entered into derivative
instruments with unrelated third parties that would offset, on a net basis
for each foreign currency, the foreign exchange risk arising from multiple
internal derivative instruments.
25-55 The designation of intra-entity derivatives as hedging instruments for
hedges of foreign exchange risk enables entities to continue using a central
treasury function for derivative instruments with third parties and still comply
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7. Hedging foreign currency exposures

with the requirement in paragraph 815-20-25-30(a) that the operating unit with
the foreign currency exposure be a party to the hedging instrument.

Topic 815 makes a distinction between intra-entity derivatives and internal

derivatives. While both derivatives are between members of a consolidated
group, the definition of internal derivative is used for foreign currency
derivatives. For purposes of this chapter, both intra-entity and internal
derivatives are referred to as internal derivatives.
An internal derivative can be designated as a hedging instrument in a fair value
hedge of a FCD recognized asset or liability. However, an internal derivative
cannot be considered a derivative hedging instrument in the consolidated
financial statements unless the risk acquired through the internal derivative has
been offset with an unrelated third-party derivative contract.
Internal derivatives do not offset foreign currency exposure on a consolidated
basis. Instead, they merely transfer the exposure from one party to another and
may alter the form of the exposure if the functional currencies of the two
entities are different. Unless an internal derivative is offset by a contract that
transfers the exposure to an unrelated third party, the consolidated exposure
has not been offset.
Generally, for an internal derivative to qualify as a hedging instrument in the
consolidated financial statements, it has to be offset by an unrelated third-party
contract on an individual basis. Topic 815 permits a limited exception to offset
the net foreign currency exposure of internal derivatives used in a treasury
center with an unrelated third party for certain cash flow hedges (see
section 7.6.70). [815-20-25-52]

Example 7.4.20
Internal derivative with no offsetting third-party
derivative contract
Subsidiary has the euro (€) as its functional currency and is exposed to $/€
currency fluctuations on a $1,000,000 debt security. Subsidiary enters into a
foreign currency forward contract with Parent to sell $1,000,000 in three
months to hedge the impact of foreign currency fluctuations on the debt
security over the next three months. Subsidiary designates the forward as a fair
value hedge.
The forward contract eliminates Subsidiary’s foreign currency risk. However,
because the forward contract is an internal derivative, it does not offset the
foreign currency exposure on a consolidated basis. It merely transfers the
exposure so that Parent now has a $/€ currency exposure.
In the consolidated financial statements, the internal derivative cannot be
accounted for as a hedging instrument because it does not reduce the variability
of functional currency equivalent fair value on a consolidated basis. In
consolidation, the internal derivative is eliminated and Subsidiary’s original
exposure to foreign currency fluctuations exposure continues to exist.
In contrast, the internal derivative can qualify as a derivative hedging instrument
in Subsidiary’s stand-alone financial statements. If Subsidiary accounts for the
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7. Hedging foreign currency exposures

internal derivative using hedge accounting for purposes of its stand-alone

financial statements and Parent does not enter into an offsetting contract with a
third party, Parent will need to eliminate the hedge accounting entries made at
the subsidiary level when preparing the consolidated financial statements.

Example 7.4.30
Internal derivative with offsetting third-party
derivative contract
Assume the same facts as in Example 7.4.20 except that Parent enters into a
foreign currency forward contract with an unrelated third party to offset the
exposure it acquires from entering into the internal derivative with Subsidiary.
Specifically, Parent enters into a foreign currency forward contract to sell
US dollars with an unrelated third party and documents that the unrelated
third-party contract has been entered into to offset the specific contract
entered into with Subsidiary.
Parent has offset the exposure acquired from Subsidiary and on a consolidated
basis has eliminated its exposure to the variability in the functional currency
equivalent fair value of the US dollar security. Therefore, fair value hedge
accounting at the subsidiary level carries forward into the consolidated financial
statements as long as the hedge documentation is maintained at both the
subsidiary and parent levels linking the hedged exposure with the unrelated
third-party derivative contract. In Parent's stand-alone financial statements
before consolidation, the internal derivative and the unrelated third-party
derivative contract are accounted for as speculative derivative instruments
because hedge accounting is not permitted when a derivative instrument is
used to offset the risks arising from another derivative instrument.

7.5 Accounting for foreign currency fair value hedges

7.5.10 Overview
The accounting for foreign currency fair value hedges is the same as it is for all
other fair value hedges (see chapter 4). The following shows the general
accounting and presentation for a highly effective fair value hedge (not including
excluded components).
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7. Hedging foreign currency exposures

Hedging instrument Hedged item

Changes in fair value

Change in value
Gain or loss recognized
attributable to hedged risk
in earnings
recognized in earnings

Income statement presentation

Recorded in the same income statement line item where the

earnings effect of the hedged item is presented

In general, the fair value foreign currency hedge accounting model comprises
the following.

Derivative hedging Recognized at fair value on the balance sheet with

instrument changes in fair value recognized in earnings, other than
amounts related to excluded components. For additional
discussion of excluded components, see section 4.2.20.

Nonderivative Foreign currency transaction gains or losses under

hedging instrument Topic 830 reported in earnings. The foreign currency
transaction gain or loss is determined as the change in
functional currency cash flows attributable to the change in
spot exchange rates between the functional currency and
the currency in which the hedging instrument is
denominated.

Hedged item FCD assets or liabilities are remeasured to functional

currency based on spot exchange rates through earnings.
If multiple risks are being hedged, the carrying amount of
the hedged item is adjusted for each of the risks
(discussed below).

Hedges of multiple risks

In addition to hedging only foreign currency risk, an entity can hedge the
combination of foreign currency risk and other risks (see section 2.3.80). For
example, to mitigate the earnings volatility caused by entering into a foreign
currency fair value hedging relationship for a recognized interest-bearing
financial asset or liability, an entity could hedge the combination of foreign
currency risk and the benchmark interest rate risk.
Hedging the change in fair value attributable to changes in both the benchmark
interest rate and foreign currency exchange rate of a recognized FCD financial
asset or liability requires a two-step approach to adjust the basis of the hedged
item.
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7. Hedging foreign currency exposures

The hedged item is adjusted through earnings for the change in fair value
Step 1
attributable to a change in the foreign benchmark interest rate.

The basis-adjusted (for changes in foreign benchmark interest rates) FCD

Step 2 asset or liability is remeasured to the functional currency at the spot rate
through earnings.

If an entity excludes the cross-currency basis spread from its assessment of

hedge effectiveness (see section 9.2.70), the above approach effectively
eliminates any difference that will be reflected in earnings related to the
volatility in the cross-currency basis spread that is included in the measurement
of the hedging instrument. For additional discussion about the accounting for
the excluded component, see section 4.2.20.

Observation
Hedging variable-rate FCD instruments
If an entity is hedging the foreign currency risk of a variable-rate FCD instrument
and no components are excluded from the assessment of hedge effectiveness,
there may be volatility in earnings for the fair value hedging model due to spot-
forward differences or currency basis spreads.
Earnings volatility can be reduced if an entity excludes the spot-forward
difference or currency basis spreads from its assessment of hedge
effectiveness and elects to recognize the initial value of the excluded
component using an amortization approach. For additional discussion of
excluded components, see section 4.2.20.

7.5.20 Changes involving foreign currency risk

Excerpt from ASC 815-25

>> Changes Involving Foreign Exchange Risk

35-15 Gains and losses on a qualifying foreign currency fair value hedge shall
be accounted for as specified in Section 815-25-40 and paragraphs 815-25-35-1
through 35-10.
35-16 If a nonderivative instrument qualifies as a hedging instrument under
paragraph 815-20-25-58, the gain or loss on the nonderivative hedging
instrument attributable to foreign currency risk shall be the foreign currency
transaction gain or loss as determined under Subtopic 830-20. The foreign
currency transaction gain or loss on a hedging instrument shall be determined,
consistent with paragraph 830-20-35-1, as the increase or decrease in
functional currency cash flows attributable to the change in spot exchange
rates between the functional currency and the currency in which the hedging
instrument is denominated. That foreign currency transaction gain or loss shall
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7. Hedging foreign currency exposures

be recognized currently in earnings along with the change in the carrying

amount of the hedged firm commitment.
35-17 Paragraph Not Used
35-18 Remeasurement of hedged foreign-currency-denominated assets and
liabilities is based on the guidance in Subtopic 830-20, which requires
remeasurement based on spot exchange rates, regardless of whether a fair
value hedging relationship exists.

Observation
Calculating the fair value of a hedged unrecognized
firm commitment
How an entity calculates the changes in fair value related to foreign currency
risk when the hedged item is an unrecognized firm commitment depends on
the nature of the hedging instrument.
Hedging instrument is a derivative forward contract
If the hedging instrument is a derivative forward contract, an entity would not
have volatility in the income statement if the changes in fair value of the hedged
item are based on forward foreign currency exchange rates. Otherwise, if the
spot exchange rate were used to calculate the change in fair value of the firm
commitment due to changes in the foreign currency exchange rates, there
would be volatility in earnings. The volatility is because the change in fair value
of the derivative hedging instrument (which is calculated based on forward
rates) would not equal the change in the hedged firm commitment (which is
based on spot exchange rates).
Hedging instrument is a nonderivative financial instrument
When a FCD nonderivative financial instrument is the hedging instrument, an
entity would not have volatility in the income statement if the change in the fair
value of the hedged item is based on spot rates. Otherwise, if the forward
exchange rate were used to calculate the change in fair value of the firm
commitment due to changes in foreign currency exchange rates, there would
be volatility in earnings. The volatility is because the change in the nonderivative
hedging instrument (which is calculated based on spot rates) would not equal
the change in the hedged firm commitment (which is based on forward rates).

Question 7.5.10
What model will result in less earnings volatility
when hedging only the foreign currency exposure
of a recognized financial asset or liability?
Interpretive response: It depends.
If an entity is hedging a recognized FCD monetary financial asset or liability, the
assessment of effectiveness of the fair value hedging relationship due to
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7. Hedging foreign currency exposures

changes in foreign currency rates is affected by the interaction of Topics 815

and 830.
Topic 830 requires such assets and liabilities to be remeasured to functional
currency based on spot exchange rates. Therefore, the adjustment of these
assets and liabilities for changes in fair value due to changes in foreign currency
exchange rates is limited to the changes based on spot rates; however the
change in fair value of the derivative hedging instrument is based on forward
rates. If an entity does not exclude any components from its assessment of
hedge effectiveness, there will be earnings volatility for the spot-forward rate
difference. [830-20-35-1 – 35-2]
Cash flow hedges. If an entity does not exclude any components from its
assessment of hedge effectiveness and wants less earnings volatility, it may
elect to use the foreign currency cash flow hedging model.

Question 7.5.20
Is a partial-term fair value hedge of foreign currency
risk permitted?

Interpretive response: It depends.

— If effectiveness is based on changes in the spot rates of the hedging
instrument, an entity is permitted to enter into a partial-term fair value
hedge of foreign currency risk. Therefore, it does not need to hedge all of
the foreign currency exposure throughout the life of the hedged item. This
is because if the effectiveness of the hedging relationship is based solely
on changes in spot rates, it is not affected by the maturity date of the
hedging instrument or the hedged item. If an entity excludes the time value
of option and forward points (spot-forward difference) from its assessment
of hedge effectiveness, the excluded component should be accounted for
using either the mark-to-market approach or the amortization approach (see
section 4.2.20).
— If effectiveness is based on changes in the forward rates of the hedging
instrument, an entity is not permitted to enter into a partial-term fair value
hedge of foreign currency risk. We do not believe the guidance in
paragraph 815-25-35-13B that permits partial-term hedges of interest rate
risk (or interest rate risk and foreign currency risk) permits an entity to enter
into a partial-term hedge of only foreign currency risk when effectiveness is
based on forward rates.

Example 7.5.10
Partial-term foreign currency fair value hedge
If a US dollar functional currency entity has a 1,000,000 yen (¥) receivable with a
maturity of 60 days, it may enter into a forward contract to pay yen and receive
US dollars to hedge the risk of changes in fair value of that receivable due to
changes in the ¥/$ exchange rate.
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7. Hedging foreign currency exposures

If the effectiveness of the hedge is assessed based only on changes in the spot
rate of the hedging instrument, the maturity of the forward contract can be at
the end or at any point during those 60 days because the entity need not hedge
all of the foreign currency exposure throughout the hedged item’s life. The
excluded component should be accounted for using either the mark-to-market
approach or the amortization approach (see section 4.2.20).

Question 7.5.30
If a cross-currency interest rate swap is used to
hedge only foreign currency risk, what can be
excluded from hedge effectiveness?
Background: An entity is permitted to exclude certain items from its
assessment of hedge effectiveness including: [815-20-25-82]
— for forward or future contracts, the change in fair value of the contract
related to the spot-forward difference; and
— the portion of the change in fair value of a currency swap attributable to the
cross-currency basis spread.
Entities often use either a fixed-for-fixed or a floating-for-floating cross-currency
interest rate swap to hedge their exposure to foreign currency risk. For further
discussion on cross-currency interest rate swaps, see section 2.6.20, and for
the accounting for the cross-currency basis spread as an excluded component,
see section 4.2.20.
Interpretive response: We believe an entity may exclude the entire spot-
forward difference from its assessment of hedge effectiveness when using
either a fixed-for-fixed or a floating-for-floating cross-currency interest rate swap
to hedge its exposure to foreign currency risk.
We believe the guidance for net investment hedges in which only foreign
currency risk is hedged may be considered by analogy. An entity is permitted to
use a fixed-for-fixed or a floating-for-floating cross-currency interest rate swap
for a net investment hedge but is not permitted to use a fixed-for-floating
interest rate swap. See chapter 8 for additional information on net investment
hedges. [815-25-25-67 – 25-68A]
An entity is not permitted to use a compound derivative that has multiple
underlyings as a hedging instrument in a net investment hedge. A fixed-for-
fixed or a floating-for-floating cross-currency interest rate swap is not a
compound derivative because foreign currency rate changes primarily affect
changes in its fair value. These types of derivatives are economically similar to
foreign currency forward contracts. Therefore, similar to forward contracts, we
believe an entity may exclude the entire spot-forward difference from the
assessment of hedge effectiveness.

7.5.30 Examples of foreign currency fair value hedges

This section contains three examples illustrating the application of the foreign
currency fair value hedging principles to the following hedging relationships.
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7. Hedging foreign currency exposures

— Fair value hedge of a firm FCD purchase commitment with a forward

contract (Example 7.5.20);
— Fair value hedge of a FCD AFS debt security with a forward contract
(Example 7.5.30); and
— Fair value hedge of a firm commitment denominated in a foreign currency
with a forward to purchase a different currency (Subtopic 815-25’s
Example 10).
Each of the examples assumes that all criteria for hedge accounting, including
all required documentation, have been met at the onset of the hedging
relationship and at each period end.

Example 7.5.20
Fair value hedge of a firm FCD purchase
commitment with a forward contract
ABC Corp’s functional currency is the US dollar ($). On October 1, Year 1, ABC
enters into a firm commitment to purchase equipment for delivery on March 31,
Year 2 in pounds sterling (£). The price of the equipment is fixed at £10,000
with payment due on delivery.
Also on October 1, Year 1, ABC enters into a foreign currency forward contract
to buy £10,000 on March 31, Year 2. ABC will exchange $11,000 for £10,000 on
that date (forward rate $1.10 per £1).
ABC designates the foreign currency forward contract as a hedge of its risk of
changes in the fair value of the firm commitment resulting from changes in the
$/£ exchange rate. This hedging strategy should enable the equipment to be
recorded at $11,000 (the forward price inherent in the foreign currency forward
contract) at the time of purchase regardless of the then prevailing spot
exchange rate.
Spot rates, forward rates and fair value of the foreign currency forward contract
are as follows.

Spot Forward Change in

Date $/£ $/£ Fair value fair value
October 1, Year 1 £1 = $1.00 £1 = $1.10 $ - N/A
December 31, Year 1 £1 = $1.50 £1 = $1.40 2,8571 $ 2,857
March 31, Year 2 £1 = $1.15 N/A 500 (2,357)

Note:
1. The fair value is determined using the change in forward rates (1.40 - 1.10 ×
£10,000) discounted at an appropriate rate.
Hedge effectiveness. ABC assesses hedge effectiveness by comparing the
overall changes in fair value of the forward contract to the changes in fair value
of the firm commitment measured by reference to changes in the $/£ forward
exchange rates. Changes in the fair value of the foreign currency forward
contract related to changes in the £ forward price are expected to be 100%
effective in offsetting the changes in fair value of the firm commitment due to
changes in the $/£ forward exchange rate; this is because both are
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7. Hedging foreign currency exposures

denominated in the same currency and have the same terms. It is assumed that
the hedge is highly effective at inception and throughout the term.
Journal entries
ABC makes a memorandum entry on October 1, Year 1 to document the
existence of the hedging relationship. There is no entry for the foreign currency
forward contract because the contract is at market rates (i.e. fair value is zero).
Journal entries – December 31, Year 1

Debit Credit
Depreciation expense1 2,857
Firm commitment 2,857
To record change in fair value of foreign currency
firm commitment.
Forward contract 2,857
Depreciation expense 2,857
To record change in fair value of foreign currency
forward contract.

Note:
The change in fair value of the foreign currency firm commitment is recorded in the
same income statement line item that is used to present the earnings effect of the
hedged equipment (depreciation expense).

Journal entries – March 31, Year 2

Debit Credit
Firm commitment 2,357
Depreciation expense 2,357
To record change in fair value of foreign currency
firm commitment.
Depreciation expense 2,357
Forward contract 2,357
To record change in fair value of foreign currency
forward contract.
Equipment 11,500
Cash 11,500
To record purchase of equipment from UK
supplier at March 31, Year 2 spot rate (£1 =
$1.15).
Cash 500
Forward contract 500
To record settlement of foreign currency forward
contract.
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7. Hedging foreign currency exposures

Debit Credit
Firm commitment 500
Equipment 500
To adjust carrying amount of the equipment to
reflect hedge of firm commitment.

ABC’s hedging objective was to lock in the purchase price of the equipment at
the US dollar price based on the £ forward rate on October 1, Year 1. During the
period the hedge was in place, the US dollar weakened against pound sterling.
Without any hedge, the equipment would have cost $11,500 (£10,000 at the
spot exchange rate of £1 = $1.15). However, with the hedge, ABC limits its net
cash outflow to $11,000. The equipment is also recorded at $11,000.

Example 7.5.30
Fair value hedge of a FCD AFS debt security with a
forward contract
ABC Corp.’s functional currency is the US dollar ($). On April 1, Year 1, ABC
purchases a debt security for 1,000,000 pounds sterling (£) and classifies it as
an AFS security.
To hedge the fair value of its investment in the debt security against adverse
changes in the $/£ exchange rate, on April 1, Year 1 ABC purchases a forward
contract to sell £1,000,000 on June 30. ABC designates the forward as a hedge
of its risk of changes in fair value of its AFS debt security (for £1,000,000)
resulting from changes in the $/£ exchange rate between April 1 and June 30.
ABC determines that the change in fair value of the derivative is highly effective
at offsetting changes in fair value of the hedged AFS debt securities. ABC
elects to exclude the spot-forward difference for the effectiveness assessment
and account for the excluded component using the mark-to-market approach.
Bond prices, foreign currency exchange rates and fair value of ABC’s
investment are as follows.

Date Value in £ Spot $/£ Value in $

April 1 £1,000,000 £1 = $1.00 $1,000,000
June 30 1,050,000 £1 = $0.90 945,000

The change in fair value of the bond is attributable to both changes in the
exchange rates and market prices. The following are the changes attributable to
each.
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7. Hedging foreign currency exposures

Fair value change

Fair value due to changes in
Total change in bond change due to market price of
Date fair value USD exchange rates bond
June 30 $(55,000) $(100,000)1 $45,0002
Notes:
£1,000,000 × ($1.00 - $0.90).
£50,000 increase in value (£1,050,000 - £1,000,000) converted at the spot rate on
June 30 ($0.90).

The foreign currency exchange rates and fair value of the forward contracts are
as follows.

Spot Forward rate Fair value of

Date $/£ $/£ forward contract
April 1 £1 = $1.00 £1 = $0.95 N/A
June 30 £1 = $0.90 N/A $50,0001
Note:
£1,000,000 × ($0.95 - $0.90).

Journal entries – April 1, Year 1

Debit Credit
Investment in AFS security 1,000,000
Cash 1,000,000
To record purchase of AFS debt security at spot
rate of £1 = $1.00.

Journal entries – June 30, Year 1

Debit Credit
Forward contract 100,000
Gains/losses on AFS security 100,000
To record change in fair value of forward contract
due to changes in spot rate in same line item as
hedged item.
Gains/losses on AFS security 50,000
Forward contract 50,000
To record mark-to-market on excluded component
(spot-forward difference).
Gains/losses on AFS security 100,000
Investment in AFS security 100,000
To record change in fair value of AFS debt security
attributable to changes in exchange rates.
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7. Hedging foreign currency exposures

Debit Credit
Investment in AFS security 45,000
Other comprehensive income 45,000
To record change in fair value of AFS debt security
attributable to risk not being hedged.
Cash 50,000
Forward contract 50,000
To record settlement of forward contract.

FASB Example: Firm commitment denominated in foreign

currency with a forward to purchase a different currency

Excerpt from ASC 815-25

>> Example 10: Fair Value Hedge of a Firm Commitment Denominated in

a Foreign Currency with a Forward to Purchase a Different Currency

55-62 This Example illustrates application of the guidance in Sections 815-20-

25, 815-20-35, and 815-25-35 to a fair value hedge of a firm commitment to
purchase an asset for a price denominated in a foreign currency. In this
Example, the hedging instrument and the firm commitment are denominated
in different foreign currencies. Consequently, although the hedge is highly
effective at achieving offsetting changes in fair value, the hedge is not
perfectly effective, and there will be an earnings effect. (The entity in the
Example could have designed a perfectly effective hedge by using a hedging
instrument denominated in the same foreign currency as the firm commitment
with terms that match the appropriate terms in the firm commitment.) For
simplicity, commissions and most other transaction costs, initial margin, and
income taxes are ignored unless otherwise stated. Assume that there are no
changes in creditworthiness that would alter the effectiveness of the hedging
relationship.
55-63 Entity MNO's functional currency is the U.S. dollar (USD). On February 3,
20X7, Entity MNO enters into a firm commitment to purchase a machine for
delivery on May 1, 20X7. The price of the machine will be 270,000 Swiss
francs (CHF 270,000). Also on February 3, 20X7, Entity MNO enters into a
forward contract to purchase 240,000 Euros (EUR 240,000) on May 1, 20X7.
Entity MNO will pay USD 0.6125 per EUR 1 (a total of USD 147,000), which is
the current forward rate for an exchange on May 1, 20X7. Entity MNO
designates the forward contract as a hedge of its risk of changes in the fair
value of the firm commitment resulting from changes in the USD–CHF forward
exchange rate.
55-64 Entity MNO will assess effectiveness by comparing the overall changes
in the fair value of the forward contract to the changes in fair value in USD of
the firm commitment due to changes in USD–CHF forward exchange rates.
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7. Hedging foreign currency exposures

Entity MNO expects the forward contract to be highly effective as a hedge

because all of the following conditions exist:
a. EUR 240,000 is approximately equal to CHF 270,000 at the May 1, 20X1,
forward exchange rate in effect on February 3, 20X7.
b. Settlement of the forward contract and the firm commitment will occur on
the same date.
c. In recent years, changes in the value in USD of EUR over three-month
periods have been highly correlated with changes in the value in USD of
CHF over those same periods.
55-65 Although the hedging relationship has been determined to be highly
effective at achieving offsetting changes in fair value, the hedge will not be
perfectly effective and the difference between changes in the USD equivalent
of EUR 240,000 (the notional amount of the forward contract) and changes in
the USD equivalent of CHF 270,000 (the amount to be paid for the machine)
will affect earnings. The difference between the spot rate and the forward
exchange rate is not excluded from the assessment of hedge effectiveness
because changes in the fair value of the firm commitment are being measured
using forward exchange rates. Therefore, the entire change in the fair value of
the hedging instrument will be presented in earnings in the same income
statement line item as the earnings effect of the hedged item. If the hedged
item were a foreign-currency-denominated available-for-sale debt security
instead of a firm commitment, Topic 830 would have required its carrying value
to be measured using the spot exchange rate. In that case, the spot-forward
difference would have been recognized currently in earnings in the same
income statement line item as the earnings effect of the hedged item if it was
included in the assessment of effectiveness. The spot-forward difference also
may be excluded from the assessment of effectiveness and accounted for
through either an amortization approach or a mark-to-market approach in
accordance with paragraph 815-20-25-83A or paragraph 815-20-25-83B.
55-66 The forward exchange rates in effect on certain key dates are assumed
to be as follows.

USD-EUR Forward USD-CHF Forward

Exchange Rate for Exchange Rate for
Settlement on Settlement on
Date 5/1/X7 5/1/X7
Inception of the hedge—2/3/X7 USD 0.6125 = EUR 1 USD 0.5454 = CHF 1
Quarter end—3/31/X7 USD 0.5983 = EUR 1 USD 0.5317 = CHF 1
Machine purchase—5/1/X7 USD 0.5777 = EUR 1 USD 0.5137 = CHF 1

55-67 The USD equivalent and changes in the USD equivalent of the forward
contract and the firm commitment, the changes in fair value of the forward
contract and the firm commitment, and the earnings effect of the hedge on
those same key dates are shown in the following table. A 6 percent discount
rate is used in this Example.
Hedging 525
7. Hedging foreign currency exposures

2/3/X7 3/31/X7 5/1/x7

Forward contract
USD-EUR forward
exchange rate for
settlement on May 1,
20X7 USD 0.61 USD 0.60 USD 0.58
Units of currency (EUR) x 240,000 x 240,000 x 240,000
Forward price of
EUR 240,000 in USD 147,000 143,592 138,648
Contract price in USD (147,000) (147,000) (147,000)
Difference USD - USD (3,408.00) USD (8,352.00)
Fair value (present value USD
of the difference) - USD (3,391.00) USD (8,352.00)
Change in fair value
during the period USD (3,391.00) USD (4,961.00)

Firm commitment
USD-CHF forward
exchange rate for
settlement on May 1,
20X7 USD 0.55 USD 0.53 USD 0.51
Units of currency (CHF) x 270,000 x 270,000 x 270,000
Forward price of
CHF 270,000 in USD (147,258) (143,559) (138,699)
Initial forward price in
USD 147,258 147,258 147,258
Difference USD - USD 3,699.00 USD 8,559.00
Fair value (present value
of the difference) USD - USD 3,681.00 USD 8,559.00
Change in fair value
during the period USD 3,681.00 USD 4,878.00

Difference between
changes in fair values of
the forward contract
denominated in EUR
and the firm
commitment
denominated in CHF USD 290.00 USD (83.00)

55-68 This Subtopic requires that Entity MNO recognize currently in earnings
all changes in fair values of the forward contract. Because Entity MNO is
hedging the risk of changes in fair value of the firm commitment attributable to
changes in the forward exchange rates, this Subtopic also requires recognizing
those changes currently in earnings. Section 815-20-45 requires that those
changes be presented in earnings in the same income statement line item as
the earnings effect of the hedged item.
55-69 On May 1, 20X7, Entity MNO fulfills the firm commitment to purchase
the machine and settles the forward contract. The entries illustrating fair value
hedge accounting for the hedging relationship and the purchase of the machine
are summarized in the following table.
Hedging 526
7. Hedging foreign currency exposures

Debit (Credit)

Firm
Commit- Forward
Cash ment Contract Machine Earnings
March 31, 20X7
Recognize
change in fair
value of firm
commitment USD 3,681 USD (3,861)
Recognize
change in fair
value of
forward
contract USD (3,391) 3,391
(290)
April 30, 20X7
Recognize
change in fair
value of firm
commitment 4,878 (4,878)
Recognize
change in fair
value of
forward
contract (4,961) 4,961
83
May 1, 20X7
Recognize
settlement of
forward
contract USD (8,352) 8,352
Recognize
purchase of
machine (138,699) (8,559) USD 147,258
Total USD (147,051) USD - USD - USD 147,258 USD (207)

55-70 To simplify this Example and focus on the effects of the hedging
relationship, other amounts that would be involved in the purchase of the
machine by Entity MNO (for example, shipping costs and installation costs)
have been ignored.
55-71 The effect of the hedge is to recognize the machine at its price in CHF
(CHF 270,000) translated at the forward rate in effect at the inception of the
hedge (USD 0.5454 per CHF 1).
Hedging 527
7. Hedging foreign currency exposures

7.6 Specific qualifying criteria for foreign currency

cash flow hedges
7.6.10 Overview
To qualify for foreign currency cash flow hedge accounting, a hedging
relationship must meet the following qualifying criteria.

General hedging requirements Chapter 2

Qualifying criteria for all cash flow Chapter 5

hedges However, the criteria in paragraph 815-
20-25-15(c) (which requires that the
transaction be with a party external to the
entity) does not have to be met.

General qualifying criteria for all

Section 7.3
foreign currency hedges

Specific qualifying criteria for foreign

Section 7.6
currency cash flow hedges

This section discusses the specific qualifying criteria for foreign currency cash
flow hedges related to the eligibility of hedged transactions and hedging
instruments.

Criterion 1 Criterion 2 Criterion 3 Criterion 4

Eligibility of Eligibility of
Eligibility of Hedge
hedged items hedging
hedged risk(s) effectiveness
or transactions instruments

Criterion 5: Formal documentation

Topic 815 permits foreign currency cash flow hedges of FCD forecasted
transactions (including forecasted intercompany transactions), unrecognized
firm commitments and recognized assets and liabilities. Only a derivative may
be designated as the hedging instrument in a foreign currency cash flow hedge.

Criterion 1: Items eligible for cash Criterion 3: Hedging instruments

flow hedges of foreign currency risk eligible for cash flow hedges of
foreign currency risk

Forecasted transaction (including an

intercompany forecasted transaction) Derivative
(section 7.6.30)

Unrecognized firm commitments Derivative

(section 7.6.40)

Recognized asset or liability

(section 7.6.50) Derivative
Hedging 528
7. Hedging foreign currency exposures

Hedged items continue to be subject to other applicable US GAAP, including for

assessing impairment.

7.6.20 Eligibility of hedged transactions and hedging

instruments in a cash flow hedge of foreign currency
risk

Excerpt from ASC 815-20

>>> Items and Transactions in Cash Flow Hedges of Foreign Exchange

Risk
25-38 The conditions in the following paragraph relate to a derivative
instrument designated as hedging the foreign currency exposure to variability
in the functional-currency-equivalent cash flows associated with any of the
following:
a. A forecasted transaction (for example, a forecasted export sale to an
unaffiliated entity with the price to be denominated in a foreign currency)
b. A recognized asset or liability
c. An unrecognized firm commitment
d. A forecasted intra-entity transaction (for example, a forecasted sale to a
foreign subsidiary or a forecasted royalty from a foreign subsidiary).
25-39 A hedging relationship of the type described in the preceding paragraph
qualifies for hedge accounting if all the following criteria are met:
a. The criteria in paragraph 815-20-25-30(a) through (b) are met.
b. All of the cash flow hedge criteria in this Section otherwise are met, except
for the criterion in paragraph 815-20-25-15(c) that requires that the
forecasted transaction be with a party external to the reporting entity.
c. If the hedged transaction is a group of individual forecasted foreign-
currency-denominated transactions, a forecasted inflow of a foreign
currency and a forecasted outflow of the foreign currency cannot both be
included in the same group.
d. If the hedged item is a recognized foreign-currency-denominated asset or
liability, all the variability in the hedged item’s functional-currency-
equivalent cash flows shall be eliminated by the effect of the hedge.

Hedged transaction. A foreign currency cash flow hedge is designed to hedge

the foreign currency exposure to variability in functional currency equivalent
cash flows generated by a hedged transaction. This exposure to cash flows
generated by the following transactions can be hedged in foreign currency cash
flow hedges: [815-20-25-38]
— forecasted transaction, including an intercompany forecasted transaction
(section 7.6.30);
— unrecognized firm commitment (section 7.6.40); and
— recognized asset or liability (section 7.6.50).
Hedging 529
7. Hedging foreign currency exposures

Hedging instruments. Only a derivative may be designated as the hedging

instrument in a foreign currency cash flow hedge.
Topic 815 allows internal derivatives to be designated as hedging instruments
for cash hedges of foreign exchange risk if certain conditions are met; for
further discussion, see section 7.6.60.

7.6.30 Hedged transaction: Forecasted FCD transaction

The cash flows associated with a forecasted FCD transaction can be hedged in
a cash flow hedge (but not a fair value hedge). The forecasted transaction may
be with an unrelated or a related party (e.g. an intercompany transaction).
This section also discusses items related to when the following forecasted
transactions are the hedged transactions:
— forecasted intercompany transaction; and
— forecasted sales or purchases on credit.

Question 7.6.10
Can a group of forecasted transactions be hedged
in a single cash flow hedge?

Interpretive response: Yes. A group of similar forecasted transactions can be

hedged as one transaction. However, the group cannot include both forecasted
foreign currency inflows and outflows. An entity that forecasts sales and
purchases in the same foreign currency cannot net the forecasted sales and
purchases and hedge the net foreign currency exposure. The entity has to
separately hedge the forecasted sales and the forecasted purchases. [815-20-25-
39(c)]

Although an entity is not permitted to hedge the net foreign currency exposure,
it can hedge a gross exposure (that equals the net exposure) and qualify for
hedge accounting.

Example 7.6.10
Forecasted cash inflows and outflows in foreign
currency
ABC Corp. has a US dollar functional currency and forecasts that it will (1)
receive €1,000,000 (related to sales of its product) on May 15, Year 1 and (2)
pay €700,000 (related to purchases of inventory) on that day. Therefore, ABC
has a net receive position of €300,000.
ABC is not permitted to designate that net position as the hedged transaction
because it includes forecasted inflows and outflows. Instead, it may hedge the
foreign currency risk related to the forecasted receipt of €300,000 (related to
sales of its products) on May 15, Year 1 if all of the requirements for a cash
flow hedge are met.
Hedging 530
7. Hedging foreign currency exposures

Question 7.6.20
Can the foreign currency exposure in a forecasted
issuance of FCD debt be hedged?

Interpretive response: No. The foreign currency exposure associated with the
forecasted issuance of FCD debt cannot be hedged as a forecasted transaction
because it does not affect earnings. The change in the functional currency
equivalent proceeds an entity will receive on issuance of debt does not affect
earnings because changes in exchange rates from hedge inception to the
borrowing date will only affect the initial measurement of the liability.

Question 7.6.30
Can the foreign currency exposure in forecasted
earnings of a foreign subsidiary be hedged?

Interpretive response: No. An entity is not permitted to designate forecasted

earnings of a foreign subsidiary as a hedged transaction in a foreign currency
cash flow hedge because hedges of future earnings are not permitted.
However, an entity may designate the net investment in a foreign operation as
the hedged item. For additional discussion of net investment hedges, see
chapter 8. [FAS 133.BC485]

Forecasted intercompany transaction

Hedging a forecasted intercompany transaction is permitted because when an
intercompany transaction denominated in a currency other than an entity’s
functional currency is remeasured under Topic 830 it affects consolidated
earnings. Therefore, a forecasted intercompany transaction presents an
exposure to foreign currency risk. [815-20-25-28 – 25-29]

Question 7.6.40
Can forecasted intercompany dividends be hedged?

Interpretive response: No. Forecasted intercompany dividends either in

foreign or functional currency cannot be hedged as a forecasted transaction
because intercompany dividends do not affect earnings. A hedge of forecasted
intercompany dividends expected to be paid from future earnings is a hedge of
those future earnings. Hedges of future earnings are not permitted.
[FAS 133.BC485]

However, once FCD dividends are declared by the subsidiary and recognized as
dividends receivable/payable by the parent/subsidiary, they can be hedged as
recognized FCD assets/liabilities for changes in foreign currency exchange
rates.
Hedging 531
7. Hedging foreign currency exposures

Question 7.6.50
Can an intercompany FCD transaction be hedged
for overall changes in fair value or cash flows?

Interpretive response: No. An intercompany FCD transaction cannot be

hedged for overall changes in fair value or cash flows (e.g. price risk), interest
rate or credit risk because these risks do not affect consolidated earnings. The
exposure to these risks of one party to the contract will be offset by the
opposite exposure of the other party to the contract within a consolidated
group. Therefore, any potential earnings exposure will be eliminated in
consolidation.
However, from the perspective of a subsidiary's stand-alone financial
statements, any of the previously mentioned risks (that is, interest rate or credit
risk), as well as foreign currency risk, presents exposure to that subsidiary's
earnings and therefore are eligible for hedge accounting solely for purposes of
the subsidiary's stand-alone financial statements.

Forecasted purchases or sales on credit

Excerpt from ASC 815-20

>>> Sale or Purchase on Credit as a Hedged Item Involving Foreign

Exchange Risk
25-34 The provisions of this Section (including paragraph 815-20-25-28) that
permit a recognized foreign-currency-denominated asset or liability to be the
hedged item in a fair value or cash flow hedge of foreign currency exposure
also pertain to a recognized foreign-currency-denominated receivable or
payable that results from a hedged forecasted foreign-currency-denominated
sale or purchase on credit. Specifically, an entity may choose to designate
either of the following:
a. A single cash flow hedge that encompasses the variability of functional
currency cash flows attributable to foreign exchange risk related to the
settlement of the foreign-currency-denominated receivable or payable
resulting from a forecasted sale or purchase on credit
b. Both of the following separate hedges:
1. A cash flow hedge of the variability of functional currency cash flows
attributable to foreign exchange risk related to a forecasted foreign-
currency-denominated sale or purchase on credit
2. A foreign currency fair value hedge of the resulting recognized foreign-
currency-denominated receivable or payable.
25-35 If two separate hedges are designated, the cash flow hedge would
terminate (that is, be dedesignated) when the hedged sale or purchase occurs
and the foreign-currency-denominated receivable or payable is recognized.
Hedging 532
7. Hedging foreign currency exposures

25-36 The use of the same foreign currency derivative instrument for both the
cash flow hedge and the fair value hedge is not prohibited.

An entity can designate a cash flow hedge of the variability of functional

currency-equivalent cash flows attributable to foreign currency risk related to a
forecasted FCD sale or purchase on credit. In a forecasted FCD purchase or
sale on credit, an entity can choose to hedge foreign currency risk to the date:
— the purchase or sale will occur; or
— the FCD payable or receivable will be settled.
If an entity chooses to hedge the risk to the date the payable or receivable is
settled, it may use the same derivative instrument and designate either a single
cash flow hedge or two separate hedges. [815-20-25-34]
— Single cash flow hedge with a dual purpose. This alternative hedges the
foreign currency risk related to both the forecasted purchase or sale and
settlement of the FCD payable or receivable resulting from the forecasted
purchase or sale. [815-20-25-34(a), 815-30-35-9]
— Two separate hedges with the same hedging instrument. The first
hedge is a cash flow hedge that hedges the foreign currency risk related to
the forecasted purchase or sale. The first hedge is dedesignated when the
purchase or sale occurs. The second hedge is a fair value hedge of the
resulting payable or receivable. [815-20-25-34(b) – 25-36]
Generally, entities use a single cash flow hedge with a dual purpose to avoid
operational issues associated with using two separate hedges.

Example 7.6.20
Forecasted purchase in foreign currency
ABC Corp.’s functional currency is the US dollar. It forecasts that it will
purchase equipment from a supplier in Mexico for 100 Mexican pesos in six
months. It anticipates purchasing the equipment on credit and settling the
payable three months after purchase.
Single cash flow hedge with a dual purpose
To hedge the foreign currency risk inherent in this transaction for the hedge
term of nine months, ABC uses as the hedging instrument a forward contract
that matures in nine months (i.e. when it anticipates settling the payable). This
one instrument hedges the variability of functional currency cash flows
attributable to foreign currency risk related to the settlement of the FCD
payable resulting from a forecasted purchase on credit.
Two separate hedges with the same hedging instrument
To hedge the foreign currency risk inherent in this transaction, ABC establishes
a cash flow hedge by using a forward contract that matures in nine months to
hedge any foreign currency risk related to the forecasted purchase of
equipment. It also establishes a fair value hedge when the payable is
recognized with the same forward contract to hedge any change in the fair
value of the resulting liability due to foreign currency exchange rate fluctuations.
Hedging 533
7. Hedging foreign currency exposures

In this transaction, ABC dedesignates the cash flow hedge when it purchases
the equipment in six months.

Observation
Two separate hedges for a forecasted purchase on
credit with the same hedging instrument
For a forecasted FCD purchase or sale on credit, an entity may choose to hedge
the foreign currency risk to the date the payable or receivable is settled. An
entity may elect to hedge this risk by designating two separate hedges with the
same hedging instrument.
Hedge effectiveness. If the entity uses a single hedging instrument and
designates two separate hedges, the entity’s assessment of hedge
effectiveness using forward rates will need to consider the mismatch due to
the hedging instrument’s fair value being based on a time period to the
settlement date, while the change in forecasted cash flows is calculated based
on a shorter time period (through the sale or purchase date).
If the entity’s assessment of hedge effectiveness uses spot rates, the timing
mismatch will not impact hedge effectiveness.

Question 7.6.60
Can an entity apply hedge accounting once the
forecasted transaction to purchase a FCD
nonfinancial asset has occurred?
Interpretive response: Yes. If an entity has a foreign currency cash flow hedge
and is hedging the cash settlement of the forecasted acquisition of a FCD
nonfinancial asset (e.g. inventory) and the forecasted transaction occurs, it may
continue to apply hedge accounting. However, the entity no longer has a
forecasted transaction. Instead, it has a FCD monetary liability (i.e. payable) that
would separately be eligible to be designated as a fair value hedge of foreign
currency risk or continue to be eligible as a cash flow hedge of foreign currency
risk.

7.6.40 Hedged transaction: Unrecognized firm

commitments

Excerpt from ASC 815-20

>>>> Foreign Exchange Risk of a Firm Commitment as Hedged

Transaction in a Cash Flow Hedge
25-42 The reference in the definition of a forecasted transaction indicating that
a forecasted transaction is not a firm commitment focuses on firm
Hedging 534
7. Hedging foreign currency exposures

commitments that have no variability. The reference does not preclude a cash
flow hedge of the variability in functional-currency-equivalent cash flows if the
commitment’s fixed price is denominated in a foreign currency. Although that
definition of a firm commitment requires a fixed price, it permits the fixed price
to be denominated in a foreign currency. A firm commitment can expose the
parties to variability in their functional-currency-equivalent cash flows. The
definition of a forecasted transaction also indicates that the transaction or
event will occur at the prevailing market price. From the perspective of the
hedged risk (foreign exchange risk), the translation of the foreign currency
proceeds from the sale of the nonfinancial assets will occur at the prevailing
market price (that is, current exchange rate). Example 14 (see paragraph 815-
20-55-136) illustrates the application of this guidance.

>> Example 14: Hedging a Firm Commitment or Fixed-Price Agreement

Denominated in a Foreign Currency

55-136 The following Cases illustrate hedging foreign exchange risk under the
cash flow hedging model as discussed in paragraph 815-20-25-42 and others:
a. Firm commitment (Case A)
b. Fixed-price agreement (Case B).
>>> Case A: Firm Commitment
55-137 On January 1, an entity enters into an agreement to sell 1,000 tons of a
nonfinancial asset to an unrelated party on June 30. The agreement meets the
definition of a firm commitment. The firm commitment is denominated in the
buyer’s functional currency, which is not the seller’s functional currency.
Accordingly, the firm commitment exposes the seller to foreign currency risk.
The seller may hedge the foreign currency exposure arising from the firm
commitment under the fair value hedging model.
55-138 The seller may hedge its exposure to foreign currency risk under the
cash flow hedging model even though the agreement meets the definition of a
firm commitment. Accordingly, the seller may hedge the foreign currency
exposure arising from the firm commitment to sell 1,000 tons of the
nonfinancial asset under the cash flow hedging model, even though the seller
has previously hedged its foreign currency exposure arising from another
similar firm commitment under the fair value hedging model.
>>> Case B: Fixed-Price Agreement
55-139 On January 1, an entity enters into an agreement to sell 1,000 tons of a
nonfinancial asset to an unrelated party on June 30. Although the agreement in
this Case does not meet the definition of a firm commitment, the seller’s
assessment of the observable facts and circumstances is that performance
under the agreement is probable. The agreement is denominated in the
buyer’s functional currency, which is not the seller’s functional currency.
Accordingly, the foreign-currency-denominated fixed-price agreement exposes
the seller to foreign currency risk.
55-140 If the agreement does not meet the definition of a firm commitment,
but contains a fixed foreign-currency-denominated price, the seller may not
hedge the foreign currency risk relating to the agreement to sell the
nonfinancial asset under the fair value hedging model because the agreement
is not a recognized asset, a recognized liability, or a firm commitment, which
Hedging 535
7. Hedging foreign currency exposures

are the only items that can be designated as the hedged item in a fair value
hedge. However, the seller may hedge the foreign currency risk relating to the
agreement under the cash flow hedging model. The agreement is by definition
a forecasted transaction because the sale of the nonfinancial assets will occur
at the prevailing market price, that is, the fixed foreign-currency-denominated
market price converted into the seller’s functional currency at the prevailing
exchange rate when the transaction occurs. Therefore, because the agreement
includes a fixed foreign-currency-denominated price, the agreement exposes
the seller to variability in the functional-currency-equivalent cash flows.
Accordingly, the seller may not hedge the foreign currency risk relating to the
agreement to sell 1,000 tons of the nonfinancial asset under the fair value
hedging model but may hedge the foreign currency risk under the cash flow
hedging model.

An unrecognized FCD firm commitment (or specific portion thereof) is eligible to

be a hedged transaction in a cash flow hedge of foreign currency exposure if its
price is expressed in a specified amount of currency. It does not matter
whether that currency is the entity’s functional currency or a foreign currency as
long as the commitment exposes the entity to variability in its functional
currency equivalent cash flows. [815-20 Glossary]
The reference in the definition of a forecasted transaction indicating that a
forecasted transaction is not a firm commitment focuses on firm commitments
that have no variability. The reference does not preclude a cash flow hedge of
the variability in functional currency equivalent cash flows when the
commitment’s price is denominated in a foreign currency. [815-20 Glossary, 815-20-
25-42]

Question 7.6.70
Can an unrecognized FCD commitment with a
related party be hedged?

Interpretive response: Yes. FCD commitments with related parties may qualify
as forecasted transactions in a cash flow hedge because:
— the criteria for forecasted transactions do not include a criterion that the
contract be with an unrelated party (see Question 5.3.40); and
— the intercompany or related party commitment exposes an entity to
variability in functional currency equivalent cash flows that could affect
reported earnings.
A related party can be another entity within the entity’s consolidated group (e.g.
a subsidiary-to-subsidiary firm commitment). Alternatively, it can be with
another entity that is not within the entity’s consolidated group but is
nonetheless related to the entity.
However, a commitment with a related party cannot be the hedged item in a
fair value hedge because the definition of a firm commitment requires that the
commitment be with an unrelated party (see section 3.3.20).
Hedging 536
7. Hedging foreign currency exposures

Question 7.6.80
Can a commitment to sell in the future based on
the market price at the time of shipment be hedged
in a cash flow hedge?
Interpretive response: Yes. An entity may hedge the foreign currency risk
related to a commitment to sell a nonfinancial asset that is denominated in the
buyer’s functional currency, which is not the seller’s functional currency, under
the cash flow hedge model.
The agreement is by definition a forecasted transaction because the sale of the
nonfinancial asset will occur at the prevailing market price. Therefore, because
the agreement includes a fixed foreign currency denominated price, the
agreement exposes the entity to variability in the functional currency equivalent
cash flows. Therefore, the entity may hedge the foreign currency risk under
the cash flow hedge model [815-20-25-42, 55-139 – 55-140]
Example 7.4.10 is an example of a commitment to sell at fair value.

7.6.50 Hedged transaction: Recognized assets and liabilities

Excerpt from ASC 815-20

>>> Items and Transactions in Cash Flow Hedges of Foreign Exchange

Risk
25-39 A hedging relationship of the type described in the preceding paragraph
qualifies for hedge accounting if all the following criteria are met: …
d. If the hedged item is a recognized foreign-currency-denominated asset or
liability, all the variability in the hedged item’s functional-currency-
equivalent cash flows shall be eliminated by the effect of the hedge.
25-40 For purposes of item (d) in the preceding paragraph, an entity shall not
specifically exclude a risk from the hedge that will affect the variability in cash
flows. For example, a cash flow hedge cannot be used with a variable-rate
foreign-currency-denominated asset or liability and a derivative instrument
based solely on changes in exchange rates because the derivative instrument
does not eliminate all the variability in the functional currency cash flows. As
long as no element of risk that affects the variability in foreign-currency-
equivalent cash flows has been specifically excluded from a foreign currency
cash flow hedge and the hedging instrument is highly effective at providing the
necessary offset in the variability of all cash flows, a less-than-perfect hedge
would meet the requirement in (d) in the preceding paragraph. That criterion
does not require that the derivative instrument used to hedge the foreign
currency exposure of the forecasted foreign-currency-equivalent cash flows
associated with a recognized asset or liability be perfectly effective, rather it is
intended to ensure that the hedging relationship is highly effective at offsetting
all risks that impact the variability of cash flows.
Hedging 537
7. Hedging foreign currency exposures

25-41 If all of the variability of the functional-currency-equivalent cash flows is

eliminated as a result of the hedge (as required by paragraph 815-20-25-39(d)),
an entity can use cash flow hedge accounting to hedge the variability in the
functional-currency-equivalent cash flows associated with any of the following:
a. All of the payments of both principal and interest of a foreign-currency-
denominated asset or liability
b. All of the payments of principal of a foreign-currency-denominated asset or
liability
c. All or a fixed portion of selected payments of either principal or interest of
a foreign-currency-denominated asset or liability
d. Selected payments of both principal and interest of a foreign-currency-
denominated asset or liability (for example, principal and interest payments
on December 31, 20X1, and December 31, 20X3).

The cash flows associated with a FCD recognized asset or liability can be
hedged in a foreign currency cash flow hedge if the hedge eliminates all of the
variability in the functional currency equivalent cash flows. [815-20-25-39(d)]
An entity can designate all or part of the cash flows of a FCD recognized asset
or liability as a hedged transaction. Specifically, for either fixed- or variable-rate
assets or liabilities, an entity is permitted to hedge the variability in functional
currency equivalent cash flows for the following: [815-20-25-41]
— all payments of both principal and interest;
— all payments of principal only;
— all or a fixed portion of selected payments of either principal or interest; and
— selected payments of both principal and interest.
When a cash flow hedge will not eliminate all of a hedged transaction’s
variability, the entity can designate the asset or liability as the hedged item in a
foreign currency fair value hedge if all of the criteria for the hedge are met (see
section 7.4).
See section 7.7.40 for an example of a foreign currency cash flow hedge of
portions of a FCD financial asset or liability as the hedged transaction
(Subtopic 815-20’s Example 15).

Question 7.6.90
Does the requirement that all variability in cash
flows be eliminated mean that the hedging
instrument needs to be perfectly effective?
Interpretive response: No. The requirement to eliminate all variability in cash
flows is not intended to require that the hedging instrument be perfectly
effective. Rather, this requirement is intended to ensure that the hedging
relationship is highly effective at offsetting all risks that affect the variability of
cash flows. Therefore, as long as no element of risk from a hedge that will
affect the variability in cash flows has been specifically excluded from the
hedge, a less than perfect (but highly effective) hedge meets the requirement
to eliminate all variability in cash flows. [815-20-25-40]
Hedging 538
7. Hedging foreign currency exposures

Subtopic 815-20’s Example 13 (reproduced in this section) includes three

different fact patterns to illustrate whether all variability in a hedged
transaction’s functional currency equivalent cash flows are eliminated by the
effect of the hedging instrument when the hedging instrument is not perfectly
effective.

Example 7.6.30
Applying the requirement to eliminate variability in
all cash flows
Non-interest bearing assets and liabilities
ABC Corp. has a non-interest bearing FCD asset (e.g. an account receivable).
ABC wants to hedge the foreign currency risk with a forward currency contract.
Because this asset is non-interest bearing, all of the variability in its functional
currency equivalent cash flows is attributable to foreign currency exchange rate
changes.
Therefore, all of the variability will be eliminated by the forward currency
contract, meaning the asset is eligible for a foreign currency cash flow hedge.
The same result would apply to a non-interest bearing liability, such as an
account payable.
Fixed-rate interest bearing assets and liabilities
ABC has a fixed-rate yen-denominated loan and wants to hedge the foreign
currency risk with a forward currency contract. Because the yen interest
payments are fixed and the forward currency contract eliminates the remaining
variability in the loan’s functional currency equivalent cash flows, the loan is
eligible for a foreign currency cash flow hedge.
Variable-rate interest bearing assets and liabilities
ABC has a variable-rate yen-denominated loan. ABC wants to hedge the foreign
currency risk for both the principal and interest. For a hedge in this example to
be a foreign currency cash flow hedge, the hedging instrument needs to offset
the variability in cash flows for both foreign currency risk and interest rate risk.
ABC may use a floating-to-fixed cross-currency interest rate swap to hedge the
foreign exchange and interest rate risks. ABC is not able to use a forward
contract because it only eliminates the variability due to foreign currency
exchange rates.
Alternatively, ABC may designate as the hedged transaction the present value
of the principal amount of the variable-rate yen-denominated loan. ABC may use
a forward contact because it eliminates all of the hedged transaction’s
variability. This is because the interest payment component of the loan, whose
variability is not eliminated, is not part of the designated hedged transaction.
Hedging 539
7. Hedging foreign currency exposures

Question 7.6.100
May the fixed-rate interest payments denominated
in a foreign currency in a dual-currency bond be
designated as the hedged transaction?

Interpretive response: Yes, such interest payments may be designated as the

hedged transaction in a cash flow hedge of foreign currency risk. Topic 830
applies to dual-currency bonds and requires the present value of the interest
payments denominated in a foreign currency to be remeasured and the
transaction gain or loss recognized in earnings. Therefore, those fixed-rate
interest payments on a dual-currency bond could be designated as the hedged
transaction in a cash flow hedge of foreign currency risk.

Example 7.6.40
Hedging fixed-rate interest payments in a dual-
currency bond
ABC Corp., whose functional currency is the US dollar, issues dual-currency
bonds that provide for repayment of principal in US dollars and periodic fixed-
rate interest payments denominated in a foreign currency. ABC wishes to lock
in the US dollar functional currency future interest expense.
To hedge the foreign currency risk of the fixed FCD interest coupon payments,
ABC enters into a series of foreign currency forward contracts to receive an
amount of the foreign currency required to satisfy the coupon obligation in
exchange for US dollars at each coupon date. The fixed-rate interest payments
on the dual-currency bond could be designated as the hedged transaction in a
cash flow hedge of foreign currency risk.

FASB Example: Eliminating all variability in cash flows

Excerpt from ASC 815-20

>> Example 13: Eliminating All Variability in Cash Flows

55-132 The following Cases illustrate the application of paragraph 815-20-25-

39(d) regarding whether all the variability in a hedged item’s functional-
currency-equivalent cash flows are eliminated by the effect of the hedge:
a. Difference in optionality (Case A)
b. Difference in reset dates (Case B)
c. Difference in notional amounts (Case C).
>>> Case A: Difference in Optionality
55-133 An entity has issued a fixed-rate foreign-currency-denominated debt
obligation that is callable (that is, by that entity) and desires to hedge its foreign
Hedging 540
7. Hedging foreign currency exposures

currency exposure related to that obligation with a fixed-to-fixed cross-currency

swap. A fixed-to-fixed currency swap could be used to hedge the fixed-rate
foreign-currency-denominated debt instrument that is callable even though the
swap does not contain a mirror-image call option as long as the terms of the
swap and the debt instrument are such that they would be highly effective at
providing offsetting cash flows and as long as it was probable that the debt
instrument would not be called and would remain outstanding.
>>> Case B: Difference in Reset Dates
55-134 An entity has issued a variable-rate foreign-currency-denominated debt
obligation and desires to hedge its foreign currency exposure related to that
obligation. The entity uses a variable-to-fixed cross-currency interest rate swap
in which it receives the same foreign currency based on the variable rate index
contained in the debt obligation and pays a fixed amount in its functional
currency. If the swap would otherwise meet this Subtopic's definition of
providing high effectiveness in hedging the foreign currency exposure of the
debt instrument, but there is a one day difference between the reset dates in
the debt obligation and the swap (that is, the one day difference in reset dates
results in the hedge being highly effective, but not perfectly effective), the
variable-to-fixed cross-currency interest rate swap could be used to hedge the
variable-rate foreign-currency-denominated debt instrument even though there
is a one-day difference between the reset dates or a slight difference in the
notional amounts in the debt instrument and the swap. This would be true as
long as the difference in reset dates or notional amounts is not significant
enough to cause the hedge to fail to be highly effective at providing offsetting
cash flows.
>>> Case C: Difference in Notional Amounts
55-135 This Case involves the same facts as in Case B, except that there is no
difference in the reset dates. However, there is a slight difference in the
notional amount of the swap and the hedged item. If the swap would
otherwise meet this Subtopic's definition of providing high effectiveness in
hedging the foreign currency exposure of the debt instrument, paragraph 815-
20-25-39(d) does not preclude the swap from qualifying for hedge accounting
simply because the notional amounts do not exactly match. The mismatch
attributable to the slight difference in the notional amount of the swap and the
hedged item could be eliminated by designating only a portion of the contract
with the larger notional amount as either the hedging instrument or hedged
item, as appropriate.
Hedging 541
7. Hedging foreign currency exposures

7.6.60 Hedging instrument: Internal derivatives

Excerpt from ASC 815-20

>>> Intra-Entity Derivatives

25-52 A foreign currency derivative instrument that has been entered into with
another member of a consolidated group can be a hedging instrument in any of
the following hedging relationships only if that other member of the
consolidated group has entered into an offsetting contract with an unrelated
third party to hedge the exposure it acquired from issuing the derivative
instrument to the affiliate that initiated the hedge:
a. A fair value hedge
b. A cash flow hedge of a recognized foreign-currency-denominated asset or
liability
c. A net investment hedge in the consolidated financial statements.
25-53 Paragraph 815-20-25-46A states that there is no requirement in this
Subtopic that the operating unit with the interest rate, market price, or credit
risk exposure be a party to the hedging instrument and provides related
guidance.
25-54 An intra-entity derivative can be designated as a hedging instrument in
consolidated financial statements if condition (a) is met and either condition (b)
or (c) is met:
a. The hedged risk is either of the following:
1. The risk of changes in fair value or cash flows attributable to changes in
a foreign currency exchange rate
2. The foreign exchange risk for a net investment in a foreign operation.
b. In a fair value hedge or in a cash flow hedge of a recognized foreign-
currency-denominated asset or liability or in a net investment hedge in the
consolidated financial statements the counterparty (that is, the other
member of the consolidated group) has entered into a contract with an
unrelated third party that offsets the intra-entity derivative completely,
thereby hedging the exposure it acquired from issuing the intra-entity
derivative to the affiliate that designated the hedge.
c. In a foreign currency cash flow hedge of a forecasted borrowing, purchase,
or sale or an unrecognized firm commitment the counterparty has entered
into a derivative instrument with an unrelated third party to offset the
exposure that results from that internal derivative or, if the conditions in
paragraphs 815-20-25-62 through 25-63 are met, entered into derivative
instruments with unrelated third parties that would offset, on a net basis
for each foreign currency, the foreign exchange risk arising from multiple
internal derivative instruments.
25-55 The designation of intra-entity derivatives as hedging instruments for
hedges of foreign exchange risk enables entities to continue using a central
treasury function for derivative instruments with third parties and still comply
with the requirement in paragraph 815-20-25-30(a) that the operating unit with
the foreign currency exposure be a party to the hedging instrument.
Hedging 542
7. Hedging foreign currency exposures

As noted in section 7.4.70, Topic 815 makes a distinction between intra-entity

derivatives and internal derivatives. While both derivatives are between
members of a consolidated group, the term internal derivative is used for
foreign currency derivatives entered into between entities within a consolidated
group. For purposes of this chapter, both intra-entity and internal derivatives are
referred to as internal derivatives.
An internal derivative can be designated as a hedging instrument in a cash flow
hedge of a FCD recognized asset or liability, a forecasted borrowing, purchase
or sale, or an unrecognized firm commitment.
However, an internal derivative cannot be considered a derivative hedging
instrument in consolidated financial statements unless the risk acquired through
the internal derivative has been offset with an unrelated third-party derivative
contract. This is because internal derivatives do not offset foreign currency
exposure on a consolidated basis. Instead, they merely transfer the exposure
from one party to another and may alter the form of the exposure if the
functional currencies of the two entities are different. Unless an internal
derivative is offset by a contract that transfers the exposure to an unrelated
third party, the consolidated exposure has not been offset. [815-20-25-52, 25-54]
Generally, for an internal derivative to qualify as a hedging instrument in the
consolidated financial statements, it has to be offset by an unrelated third-party
contract on an individual basis. As described in section 7.6.70, Topic 815
permits a limited exception that cash flow hedges of a forecasted borrowing,
purchase or sale, or an unrecognized firm commitment can be hedged on a net
basis with contracts entered into with unrelated third parties. [815-20-25-52, 25-
54(c)]

Example 7.6.50
Hedging the net exposure from internal derivatives
Finance Co.’s functional currency is the US dollar. As the parent entity, it acts as
the central treasury function for all entities within its consolidated group,
including London Co. and Tokyo Co. London’s functional currency is the pound
sterling (£). Tokyo’s functional currency is the yen (¥).
London has a forecasted transaction in which it expects to receive $100 in
three months. To hedge this exposure, it enters into a foreign currency forward
contract with Finance to sell $100 and receive £75 in three months. Tokyo has a
forecasted transaction in which it will pay $150 in three months. To hedge its
exposure, it enters into a foreign currency forward contract with Finance to buy
$150 and pay ¥15,000 in three months.
As a result of these internal derivative contracts, Finance has a net position to
pay £75 and receive ¥15,000 in three months and therefore has an exposure to
both fluctuations in the $/£ exchange rate and the $/¥ exchange rate. Finance
offsets these two exposures by entering into two foreign currency forward
contracts with Bank, an unrelated third party, to buy £75 for $100 and to sell
¥15,000 for $150 in three months.
London and Tokyo can apply cash flow hedge accounting in their stand-alone
financial statements. London and Tokyo have foreign currency exposure as a
result of the forecasted transactions and have entered into the hedging
Hedging 543
7. Hedging foreign currency exposures

transaction with their parent. A derivative instrument used in a cash flow hedge
of a forecasted transaction may be between a parent and subsidiary. [815-20-25-
30(a), 815-20-25-61]

Finance cannot apply cash flow hedge accounting in its stand-alone financial
statements. The risks acquired from the subsidiaries by Finance were acquired
in the form of derivative instruments. The internal derivatives entered into by
Finance with London and Tokyo will be remeasured at fair value through
earnings. Items that are recorded at fair value with adjustments recognized
currently through earnings are not permitted to be designated as hedged
transactions (see section 2.5.70). The derivative contract entered into with Bank
to offset the risks acquired in the internal derivatives with the subsidiaries will
be accounted for as speculative (i.e. mark-to-market). The changes in the fair
value of all three of these derivative contracts will offset in earnings.
The consolidated group may apply cash flow hedge accounting. Finance
entered into two derivatives with an unrelated third party (Bank) to offset the
exposures that resulted from the internal derivatives. [815-20-25-61(b)(1)]

7.6.70 Limitation on internal derivatives as hedging

instruments: Hedging on a net basis

Excerpt from ASC 815-20

>>> Internal Derivatives as Hedging Instruments in Cash Flow Hedges of

Foreign Exchange Risk
25-61 An internal derivative can be a hedging instrument in a foreign currency
cash flow hedge of a forecasted borrowing, purchase, or sale or an
unrecognized firm commitment in the consolidated financial statements only if
both of the following conditions are satisfied:
a. From the perspective of the member of the consolidated group using the
derivative instrument as a hedging instrument (the hedging affiliate), the
criteria for foreign currency cash flow hedge accounting otherwise
specified in this Section are satisfied.
b. The member of the consolidated group not using the derivative instrument
as a hedging instrument (the issuing affiliate) either:
1. Enters into a derivative instrument with an unrelated third party to
offset the exposure that results from that internal derivative
2. If the conditions in paragraphs 815-20-25-62 through 25-63 are met,
enters into derivative instruments with unrelated third parties that
would offset, on a net basis for each foreign currency, the foreign
exchange risk arising from multiple internal derivative instruments. In
complying with this guidance the issuing affiliate could enter into a
third-party position with neither leg of the third-party position being the
issuing affiliate's functional currency to offset its exposure if the
amount of the respective currencies of each leg are equivalent with
respect to each other based on forward exchange rates.
25-62 If an issuing affiliate chooses to offset exposure arising from multiple
internal derivatives on an aggregate or net basis, the derivative instruments
Hedging 544
7. Hedging foreign currency exposures

issued to hedging affiliates shall qualify as cash flow hedges in the

consolidated financial statements only if all of the following conditions are
satisfied:
a. The issuing affiliate enters into a derivative instrument with an unrelated
third party to offset, on a net basis for each foreign currency, the foreign
exchange risk arising from multiple internal derivatives.
b. The derivative instrument with the unrelated third party generates equal or
closely approximating gains and losses when compared with the aggregate
or net losses and gains generated by the derivative instruments issued to
affiliates.
c. Internal derivatives that are not designated as hedging instruments are
excluded from the determination of the foreign currency exposure on a net
basis that is offset by the third-party derivative instrument. Nonderivative
contracts shall not be used as hedging instruments to offset exposures
arising from internal derivatives.
d. Foreign currency exposure that is offset by a single net third-party contract
arises from internal derivatives that mature within the same 31-day period
and that involve the same currency exposure as the net third-party
derivative instrument. The offsetting net third-party derivative instrument
related to that group of contracts shall meet all of the following criteria:
1. It offsets the aggregate or net exposure to that currency.
2. It matures within the same 31-day period.
3. It is entered into within three business days after the designation of the
internal derivatives as hedging instruments.
e. The issuing affiliate meets both of the following conditions:
1. It tracks the exposure that it acquires from each hedging affiliate.
2. It maintains documentation supporting linkage of each internal
derivative and the offsetting aggregate or net derivative instrument
with an unrelated third party.
f. The issuing affiliate does not alter or terminate the offsetting derivative
instrument with an unrelated third party unless the hedging affiliate
initiates that action.
25-63 If the issuing affiliate alters or terminates any offsetting third-party
derivative (which should be rare), the hedging affiliate shall prospectively cease
hedge accounting for the internal derivatives that are offset by that third-party
derivative instrument.
25-64 A member of a consolidated group cannot meet the offsetting criteria by
offsetting exposures arising from multiple internal derivative contracts on a net
basis for foreign currency cash flow exposures related to recognized foreign-
currency-denominated assets or liabilities. That prohibition includes situations
in which a recognized foreign-currency-denominated asset or liability in a fair
value hedge or cash flow hedge results from the occurrence of a specifically
identified forecasted transaction initially designated as a cash flow hedge.
25-65 A qualifying foreign currency cash flow hedge shall be accounted for as
specified in Subtopic 815-30.

Foreign currency risk of multiple internal derivatives can be hedged on a net

basis with contracts entered into by the issuing entity with unrelated third
parties if certain conditions are met. This type of hedge is permitted only for a
Hedging 545
7. Hedging foreign currency exposures

cash flow hedge associated with a forecasted borrowing, purchase or sale or an

unrecognized firm commitment.
The issuing entity is the member of the consolidated group that is not using the
derivative as a hedging instrument. The entities that may be involved when
internal derivatives are used are illustrated in the following diagram.

Parent

100% 100%
owned owned

Hedging Issuing Unrelated third

entity Internal entity Derivative party
derivative

FCD recognized asset or

liability, forecasted
purchase or sale or
unrecognized firm
commitment

The ability to offset risk on a net basis is intended to accommodate the practice
used by many organizations that manage risk on a centralized basis using a
treasury center function. The entity with the foreign currency risk to be hedged
enters into an internal derivative with the treasury center and designates the
internal derivative as the hedging instrument. The treasury center then offsets
the risk exposure it receives through the internal derivative by entering into a
derivative with a third party for the net exposure. To apply hedge accounting at
the consolidated group, a derivative needs to be entered into with a third party
for the net exposure.
Neither leg of the derivative with the third party is required to be in the issuing
entity’s functional currency (see Question 7.6.110). [815-20-25-61, 25-62]
If the issuing entity enters into offsetting third-party derivative contracts on an
aggregate or net basis for each currency, the following additional requirements
need to be met.
Hedging 546
7. Hedging foreign currency exposures

Do the third-party derivatives

generate equal or closely
approximating gains and
losses when compared with the
aggregate or net losses and
gains generated by the internal No
derivatives?

Yes

Do the internal derivatives mature

within the same 31-day period as
the offsetting
third-party derivative? No

Cash flow hedge

Yes accounting not
permitted
Is the offsetting third-party
derivative entered into within
three business days after the
internal derivatives are designated No
as hedging instruments?

Yes

Does the issuing entity track

the exposure from affiliates
and document linkage between
internal derivative and offsetting No
net derivative with unrelated third
party?

Yes

Cash flow hedge

accounting permitted

An issuing entity may not alter or terminate the offsetting third-party derivative
unless the hedging entity initiates the action. If the issuing entity alters or
terminates the offsetting instrument with a third party, hedge accounting would
prospectively cease for the internal derivatives that are offset by the third-party
derivative. [815-20-25-63]
Hedging 547
7. Hedging foreign currency exposures

Observation
Internal derivatives used for different hedging
relationship
Treasury centers that issue internal derivatives need to segregate those internal
derivatives issued for foreign currency fair value, net investment and recognized
asset or liability cash flow hedges (which are not permitted to be aggregated or
netted) from internal derivatives issued for cash flow hedges of forecasted
transactions or unrecognized firm commitments (which can be aggregated or
netted).
This segregation creates system and tracking issues for a treasury center that
issues internal derivatives for various hedging purposes. It will require the
treasury center to know the hedging relationship that the entity is establishing
with the internal derivative.

Question 7.6.110
Can the treasury center enter into a third-party
derivative with neither leg being its functional
currency?
Interpretive response: Yes. To achieve hedge accounting on a consolidated
basis, a treasury center can aggregate or net foreign currency exposures from
multiple internal derivatives and enter into one third-party derivative contract to
offset those exposures. The legs of the third-party contract do not need to be
denominated in the treasury center’s functional currency. In other words, the
treasury center does not need to enter into two derivatives, each of which has
the center’s functional currency as one of its legs.
Subtopic 815-20’s Example 18 (reproduced below) provides an example of a
subsidiary offsetting its exposure on a net basis. [815-20-25-61(b)(2)]

Excerpt from ASC 815-20

>> Example 18: Offsetting a Subsidiary’s Exposure on a Net Basis

55-171 This Example illustrates the application of paragraph 815-20-25-61(b)(2)

in offsetting a subsidiary’s exposure on a net basis in which neither leg of the
third-party position is in the treasury center’s functional currency.
55-172 If a U.S. dollar (USD) functional currency treasury center was short 390
Euros (EUR) and long 40,684.80 yen (JPY) after netting its exposures obtained
from internal derivatives and the forward exchange rate between EUR and
JPY was EUR 1.00 = JPY 104.32, then the treasury center could enter into a
third-party receive EUR 390, pay JPY 40,684.80 contract to offset the
exposures. In contrast, if the treasury center was short EUR 390 and long JPY
51,000, then the treasury center would need to enter into 2 third-party
contracts with the receive leg of the second third-party position being the
treasury center's functional currency. For example, the treasury center could
Hedging 548
7. Hedging foreign currency exposures

enter into a third-party receive EUR 390, pay JPY 40,684.80 contract to offset
the EUR exposure and partially offset the JPY exposure. It would then need to
enter into a receive functional currency, pay JPY contract to hedge the
remainder of its JPY exposure.

Question 7.6.120
How does an entity determine if third-party
derivatives generate closely approximating gains/
losses compared with the net gains/losses
generated by the internal derivatives?
Background: When internal derivatives are offset on a net basis by third-party
derivatives, those derivatives must generate closely approximating gains and
losses when compared with the net gains and losses generated by the internal
derivatives. [815-20-25-62(b)]
Interpretive response: Topic 815 does not specify how to determine whether
third-party derivatives generate closely approximating gains and losses when
compared with the net gains and losses generated by the internal derivatives.
However, we believe this requirement is much more stringent than the 80%–
125% range used to test if a hedge is highly effective.

Question 7.6.130
Can internal derivatives that are not designated as
hedging instruments be included in determining the
foreign currency exposure to be offset on a net
basis?
Interpretive response: No. Internal derivatives that are not designated as
hedging instruments are excluded from the determination of the foreign
currency exposure to be offset on a net basis. We believe an entity, through the
treasury center, is permitted to decide which internal derivatives will be
designated as a hedging instrument and the level or amount of the offsetting
contract it enters into with an unrelated third party. [815-20-25-62(c)]
For example, an entity can decide the level of foreign currency exposure it
wants to hedge (or not hedge) by identifying which internal derivatives are to be
offset with a third-party derivative and designated as hedging instruments for
consolidated financial statement purposes. Even if an internal derivative is not
designated as a hedging instrument for the consolidated financial statements, a
hedging entity may still be able to apply hedge accounting for that derivative in
its stand-alone financial statements.
The approach of deciding the level or amount of the offsetting contract appears
simple, but if a large number of internal derivatives exist, applying of this
approach could become very complex.
Hedging 549
7. Hedging foreign currency exposures

Question 7.6.140
Does the linkage between each internal derivative
and the offsetting third-party derivative have to be
documented at the third-party derivative’s
initiation?
Interpretive response: Yes, we believe the treasury center is required to
document the linkage of each internal derivative and the offsetting net third-
party derivative when it enters into the offsetting third-party derivative.

Question 7.6.150
Can the provisions for netting foreign currency risks
be used to offset exposures to FCD assets or
liabilities or net investment hedges?
Interpretive response: No. The provisions for aggregating or netting foreign
currency risk cannot be used to offset exposures arising from internal
derivatives related to recognized FCD assets or liabilities or net investment
hedges. [815-20-25-64]

Question 7.6.160
If a forecasted transaction or firm commitment is
being hedged using an internal derivative, what is
the effect when the transaction or firm
commitment occurs?
Interpretive response: As noted in Question 7.6.110, for cash flow hedges of
forecasted transactions and unrecognized firm commitments, a treasury center
may designate an internal derivative as the hedging instrument and offset it on
an aggregate or net basis with an unrelated third-party derivative.
There may be instances in which the designated internal derivative has not yet
matured when the hedged transaction occurs and becomes a recognized asset
or liability. At the point a forecasted transaction or firm commitment occurs, the
designated internal derivative that the treasury center aggregated or netted (for
purposes of entering into third-party derivative contracts) no longer qualifies for
hedge accounting in the consolidated financial statements. Therefore, the
internal derivative cannot be used to hedge the newly recognized asset or
liability.
Additionally, the treasury center would have to update the hedge
documentation that links the third-party derivative to the aggregate or net
remaining internal derivatives. If the conditions for netting foreign currency risks
in paragraphs 815-20-25-61 and 25-62 were initially met, the remaining internal
derivatives from this linked hedging relationship can continue to receive hedge
accounting in the consolidated financial statements.
Hedging 550
7. Hedging foreign currency exposures

If a hedging entity modifies the internal derivative (resulting in a dedesignation)

or dedesignates the hedging relationship, the treasury center has to reassess
compliance with the requirements in paragraphs 815-20-25-61 and 25-62 for
hedging the entity’s internal derivatives on a net basis. The treasury center also
has to update the hedging documentation that links the third-party derivative to
the aggregate or net internal derivatives being hedged.
The treasury center can enter into a third-party derivative to offset the effect for
the changed internal derivative and rebalance the offsetting hedging relationship
to 100%. Alternatively, it could redesignate the excess portion of the third-party
derivative to another hedging relationship or leave the existing third-party
derivative alone and have a speculative position on that portion of the third-party
derivative.

Question 7.6.170
What is the effect of an issuing entity altering or
modifying an offsetting third-party derivative?

Excerpt from ASC 815-30

> Alterations or Terminations of Offsetting Third-Party Derivative

Instruments
40-7 Paragraph 815-20-25-62 provides guidance on internal derivatives as
hedging instruments in cash flow hedges of foreign exchange risk.
Paragraph 815-20-25-63 states that, if an issuing affiliate alters or terminates
any offsetting third-party derivative instrument (which should be rare), the
hedging affiliate prospectively shall cease hedge accounting for the internal
derivatives that are offset by that third-party derivative instrument.

Interpretive response: If an issuing entity alters or modifies a third-party

derivative that is being used to offset the exposure it receives through the
internal derivative, the hedging entity discontinues hedge accounting for the
internal derivative prospectively. Topic 815 indicates that instances in which the
issuing affiliate alters or terminates the offsetting third-party derivative should
be rare. [815-30-40-7]

FASB Example: Hedging on a net basis

The following FASB example illustrates the appropriate accounting for an
internal derivative that has been offset on a net basis by a third-party derivative.
Hedging 551
7. Hedging foreign currency exposures

Excerpt from ASC 815-30

>> Example 19: Hedge Accounting in the Consolidated Financial

Statements Applied to Internal Derivatives That Are Offset on a Net Basis
by Third-Party Contracts

55-113 This Example illustrates the application of paragraphs 815-20-25-61

through 25-63, specifically, the mechanism for offsetting risks assumed by a
Treasury Center using internal derivatives on a net basis with third-party
contracts. This Example does not demonstrate the computation of fair values
and as such makes certain simplifying assumptions.
55-114 Entity XYZ is a U.S. entity with the U.S. dollar (USD) as both its functional
currency and its reporting currency. Entity XYZ has three subsidiaries:
Subsidiary A is located in Germany and has the Euro (EUR) as its functional
currency, Subsidiary B is located in Japan and has the Japanese yen (JPY) as its
functional currency, and Subsidiary C is located in the United Kingdom and has
the pound sterling (GBP) as its functional currency. Entity XYZ uses its Treasury
Center to manage foreign exchange risk on a centralized basis. Foreign exchange
risk assumed by Subsidiaries A, B, and C through transactions with external third
parties is transferred to the Treasury Center via internal contracts. The Treasury
Center then offsets that exposure to foreign currency risk via third-party
contracts. To the extent possible, the Treasury Center offsets exposure to each
individual currency on a net basis with third-party contracts.
55-115 On January 1, Subsidiaries A, B, and C decide that various foreign-
currency-denominated forecasted transactions with external third parties for
purchases and sales of various goods are probable. Also on January 1,
Subsidiaries A, B, and C enter into internal foreign currency forward contracts
with the Treasury Center to hedge the foreign exchange risk of those
transactions with respect to their individual functional currencies. The Treasury
Center has the same functional currency as the parent entity (USD).
55-116 Subsidiaries A, B, and C have the following foreign currency exposures
and enter into the following internal contracts with the Treasury Center.
Internal Contracts with
Treasury Center
Expected
Functional Transaction Currency
Subsidiary Currency Forecasted Exposures Date Received Currency Paid

A (German) EUR JPY payable 12,000 Jun 1 JPY 12,000 EUR 115(a)
(a)
GBP receivable 50 Jun 1 EUR 80 GBP 50
B (Japanese) JPY USD payable 100 Jun 15 USD 100 JPY 10,160(a)
(a)
EUR receivable 100 Jun 15 JPY 10,432 EUR 100
(a)
C (UK) GBP USD receivable 330 Jun 30 GBP 201 USD 330
(a) Computed based on forward exchange rates as of January 1.

55-117 Subsidiaries A, B, and C designate the internal contracts with the

Treasury Center as cash flow hedges of their foreign currency forecasted
purchases and sales. Those internal contracts may be designated as hedging
Hedging 552
7. Hedging foreign currency exposures

instruments in the consolidated financial statements if the requirements of this

Subtopic are met. From the subsidiaries’ perspectives, the requirements of
paragraph 815-20-25-61 for foreign currency cash flow hedge accounting are
satisfied as follows:
a. From the perspective of the hedging affiliate, the hedging relationship must
meet the requirements of paragraphs 815-20-25-30 and 815-20-25-39
through 25-41 for cash flow hedge accounting. Subsidiaries A, B, and C meet
those requirements. In each hedging relationship, the forecasted transaction
being hedged is denominated in a currency other than the subsidiary’s
functional currency, and the individual subsidiary that has the foreign
currency exposure relative to its functional currency is a party to the hedging
instrument. In addition, the criteria in Section 815-20-25 are met. Specifically,
each subsidiary prepares formal documentation of the hedging relationships,
including the date on which the forecasted transactions are expected to
occur and the amount of foreign currency being hedged. The forecasted
transactions being hedged are specifically identified, are probable of
occurring, and are transactions with external third parties that create cash
flow exposure that would affect reported earnings. Each subsidiary also
documents its expectation of high effectiveness based on the internal
derivatives designated as hedging instruments.
b. The affiliate that issues the hedge must offset the internal derivative either
individually or on a net basis. The Treasury Center determines that it will
offset the exposure arising from the internal derivatives with Subsidiaries
A, B, and C on a net basis with third-party contracts. Each currency for
which a net exposure exists at the Treasury Center is offset by a third-party
contract based on that currency.
55-118 To determine the net currency exposure arising from the internal
contracts with Subsidiaries A, B, and C, the Treasury Center performs the
following analysis.

Subsidiary Perspective—Internal Contracts with the Treasury Center

Contract with Currency Received (Currency Paid)

Subsidiary Treasury Center EUR JPY GBP USD
A (German) Internal Contract 1 (115) 12,000
Internal Contract 2 80 (50)
B (Japanese) Internal Contract 3 (10,160) 100
Internal Contract 4 (100) 10,432
C (UK) Internal Contract 5 201 (330)
Net exposure (135) 12,272 151 (230)

Treasury Center Perspective—Internal Contracts with the Subsidiaries

Contract with Currency Received (Currency Paid)
Subsidiary Treasury Center EUR JPY GBP USD
A (German) Internal Contract 1 115 (12,000)
Internal Contract 2 (80) 50
B (Japanese) Internal Contract 3 10,160 (100)
Internal Contract 4 100 (10,432)
C (UK) Internal Contract 5 (201) 330
Net exposure 135 (12,272) (151) 230
Hedging 553
7. Hedging foreign currency exposures

55-119 For Subsidiaries A, B, and C to designate the internal contracts as

hedging instruments in the consolidated financial statements, the Treasury
Center must meet certain required criteria outlined in paragraphs 815-20-25-62
through 25-63 in determining how it will offset exposure arising from multiple
internal derivatives that it has issued. Based on a determination that those
requirements are satisfied (see the following paragraph, the Treasury Center
determines the net exposure in each currency with respect to USD (its functional
currency). The Treasury Center determines that it will enter into the following
three third-party foreign currency forward contracts. The Treasury Center enters
into the contracts on January 1. The contracts mature on June 30.
Treasury Center’s Contracts with Unrelated Third Parties
Currency Brought (Currency Sold)
EUR JPY BP USD
Third-Party Contract 1 (135) 138 (a)
Third-Party Contract 2 12,272 (121) (a)
Third-Party Contract 3 151 (247) (a)
Net exposure (135) 12,272 151 (230)

(a) Computed based on forward exchange rates as of January 1.

55-120 From the Treasury Center’s perspective, the required criteria in

paragraphs 815-20-25-62 through 25-63 are satisfied as follows:
a. The issuing affiliate enters into a derivative instrument with an unrelated
third party to offset, on a net basis for each foreign currency, the foreign
exchange risk arising from multiple internal derivatives, and the derivative
instrument with the unrelated third party generates equal or closely
approximating gains and losses when compared with the aggregate or net
losses and gains generated by the derivative instruments issued to
affiliates. The Treasury Center enters into third-party derivative instruments
to offset the exposure of each foreign currency on a net basis. The
Treasury Center offsets 100 percent of the net exposure to each currency;
that is, the Treasury Center does not selectively keep any portion of that
exposure. In this Example, the Treasury Center’s third-party contracts
generate losses that are equal to the losses on internal contracts
designated as hedging instruments by Subsidiaries A, B, and C (see
analysis beginning in the following paragraph).
b. Internal derivatives that are not designated as hedging instruments and all
nonderivative instruments are excluded from the determination of the
foreign currency exposure on a net basis that is offset by the third-party
derivative instrument. The Treasury Center does not include in the
determination of net exposure any internal derivatives not designated as
hedging instruments or any nonderivative instruments.
c. Foreign currency exposure that is offset by a single net third-party contract
arises from internal derivatives that involve the same currency and that
mature within the same 31-day period. The offsetting net third-party
derivative instrument related to that group of contracts must offset the
aggregate or net exposure to that currency, must mature within the same
31-day period, and must be entered into within 3 business days after the
designation of the internal derivatives as hedging instruments. The
Treasury Center’s third-party net contracts involve the same currency (that
is, not a tandem currency) as the net exposure arising from the internal
Hedging 554
7. Hedging foreign currency exposures

derivatives issued to Subsidiaries A, B, and C. The Treasury Center’s third-

party derivative instruments mature within the same 31-day period as the
internal contracts that involve currencies that are offset on a net basis. In
this Example, for simplicity, all internal contracts and third-party derivative
instruments are entered into on the same date.
d. The issuing affiliate tracks the exposure that it acquires from each hedging
affiliate and maintains documentation supporting linkage of each derivative
instrument and the offsetting aggregate or net derivative instrument with
an unrelated third party. The Treasury Center maintains documentation
supporting linkage of third-party contracts and internal contracts throughout
the hedge period.
e. The issuing affiliate does not alter or terminate the offsetting derivative
instrument with an unrelated third party unless the hedging affiliate
initiates that action. If the issuing affiliate does alter or terminate the
offsetting third-party derivative (which should be rare), the hedging affiliate
must prospectively cease hedge accounting for the internal derivatives that
are offset by that third-party derivative. Based on Entity XYZ’s policy, the
Treasury Center may not alter or terminate the offsetting derivative
instrument with an unrelated third party unless the hedging affiliate
initiates that action.
f. If an internal derivative that is included in determining the foreign currency
exposure on a net basis is modified or dedesignated as a hedging
instrument, compliance must be reassessed. For simplicity, this Example
does not involve a modification or dedesignation of an internal derivative.
55-121 At the end of the quarter, each subsidiary determines the functional
currency gains and losses for each contract with the Treasury Center.
Beginning of
Period End of Period
Functional Functional
Currency Currency
Contract with Amount Amount Functional
Treasury Receive (Pay) Receive (Pay) Currency Gain US Dollar
Subsidiary Center (a) (a) (Loss) (b) Gain (Loss) (c)
A (German) Internal
Contract 1 (115) (115) - -
Internal
Contract 2 80 83 (3) (3)
B (Japanese) Internal
Contract 3 (10,160) (10,738) 578 5
Internal
Contract 4 10,432 10,421 11 -
C (UK) Internal
Contract 5 201 204 (3) (5)
Net USD Gain (Loss) (3)

a. Computed based on forward exchange rates as of January 1 and March 31.

b. For simplicity, functional currency gains or losses are not discounted in this Example.
c. Functional currency gains and losses converted to USD based on current spot rates.

55-122 At the end of the quarter, the Treasury Center determines its gains or
losses on third-party contracts.
Beginning of Period End of Period USD
USD Amount Amount Receive USD
Contract with Third Party Receive (Pay) (a) (Pay) (a) Gain (Loss) (b)
Hedging 555
7. Hedging foreign currency exposures

Third-Party Contract 1 138 131 7

Third-Party Contract 2 (121) (114) (7)
Third-Party Contract 3 (247) (244) (3)
Net USD Gain (Loss) (3)
a. Computed based on forward exchange rates as of January 1 and March 31.
b. For simplicity, gains or losses are not discounted in this Example.

55-123 Journal Entries at March 31 (Note: All journal entries are in USD.)
Subsidiaries’ Journal Entries
German Subsidiary A
There is no entry for Contract 1 because the USD gain or loss is zero.
Other comprehensive income $ 3
Derivative liability $ 3
To record the loss on Internal Contract 2.

Japanese Subsidiary B
Derivative asset $ 5
Other comprehensive income $ 5
To record the gain on Contract 3.
There is no entry for Internal Contract 4 because the USD gain or loss is zero.

UK Subsidiary C
Other comprehensive income $ 5
Derivative liability $ 5
To record the loss on Internal Contract 5.

Treasury Center’s Journal Entries

Journal Entries for Internal Contracts with Subsidiaries
There is no entry for Internal Contract 1 because the USD gain or loss is zero.
Derivative asset $ 3
Earnings $ 3
To record the gain on Internal Contract 2 with German Subsidiary A.

Earnings $ 5
Derivative liability $ 5
To record the gain on Internal Contract 3 with Japanese Subsidiary B.

There is no entry for Internal Contract 4 because the USD gain or loss is zero.
Derivative asset $ 5
Earnings $ 5
To record the gain on Internal Contract 5 with UK Subsidiary C.

Journal Entries for Third-Party Contracts

Derivative asset $ 7
Earnings $ 7
To record the gain on Third-Party Contract 1.

Earnings $ 7
Hedging 556
7. Hedging foreign currency exposures

Derivative liability $ 7
To record the loss on Third-Party Contract 2.

Earnings $ 3
Derivative liability $ 3
To record the loss on Third-Party Contract 3.

Results in Consolidation
Derivative asset $ 7
Other comprehensive income $ 3
Derivative liability $ 10

7.7 Accounting for foreign currency cash flow hedges

7.7.10 Overview

Excerpt from ASC 815-30

> Subsequent Recognition and Measurement of Gains and Losses on

Hedging Instrument
35-3 When the relationship between the hedged item and hedging instrument
is highly effective at achieving offsetting changes in cash flows attributable to
the hedged risk, an entity shall record in other comprehensive income the
entire change in the fair value of the designated hedging instrument that is
included in the assessment of hedge effectiveness. More specifically, a
qualifying cash flow hedge shall be accounted for as follows: …
a. An entity’s defined risk management strategy for a particular hedging
relationship may exclude a specific component of the gain or loss, or
related cash flows, on the hedging derivative from the assessment of
hedge effectiveness (as discussed in paragraphs 815-20-25-81 through 25-
83B). That excluded component of the gain or loss shall be recognized in
earnings either through an amortization approach in accordance with
paragraph 815-20-25-83A or through a mark-to-market approach in
accordance with paragraph 815-20-25-83B. Under either approach, the
amount recognized in earnings for an excluded component 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. For
example, if the effectiveness of a hedging relationship with an option is
assessed based on changes in the option’s intrinsic value, the changes in
the option’s time value would be excluded from the assessment of hedge
effectiveness and either may be recognized in earnings through an
amortization approach in accordance with paragraph 815-20-25-83A or
currently in earnings in accordance with paragraph 815-20-25-83B.
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 and presented in
Hedging 557
7. Hedging foreign currency exposures

the same income statement line item as the earnings effect of the hedged
item in accordance with paragraph 815-20-45-1A. 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:
1. Subparagraph superseded by Accounting Standards Update No. 2017-
12.
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.
2. Subparagraph superseded by Accounting Standards Update No. 2017-
12.
If hedge accounting has not been applied to a cash flow hedging relationship in
a previous effectiveness assessment period because the entity’s retrospective
evaluation indicated that the relationship had not been highly effective in
achieving offsetting changes in cash flows in that period, the cumulative gain
or loss on the derivative referenced in (b) would exclude the gains or losses
occurring during that period. That situation may arise if the entity had
previously determined, for example, under a regression analysis or other
appropriate statistical analysis approach used for prospective assessments of
hedge effectiveness, that there was an expectation in which the hedging
relationship would be highly effective in future periods. Consequently, the
hedging relationship continued even though hedge accounting was not
permitted for a specific previous effectiveness assessment period.
d. If a non-option-based contract is the hedging instrument in a cash flow
hedge of the variability of the functional-currency-equivalent cash flows for
a recognized foreign-currency-denominated asset or liability that is
remeasured at spot exchange rates under paragraph 830-20-35-1, an
amount that will both offset the related transaction gain or loss arising from
that remeasurement and adjust earnings for that period’s allocable portion
of the initial spot-forward difference associated with the hedging
instrument (cost to the purchaser or income to the seller of the hedging
instrument) shall be reclassified each period from other comprehensive
income to earnings if the assessment of effectiveness is based on total
changes in the non-option-based instrument’s cash flows. If an option
contract is used as the hedging instrument in a cash flow hedge of the
variability of the functional-currency-equivalent cash flows for a recognized
foreign-currency-denominated asset or liability that is remeasured at spot
exchange rates under paragraph 830-20-35-1 to provide only one-sided
offset against the hedged foreign exchange risk, an amount shall be
reclassified each period to or from other comprehensive income with
respect to the changes in the underlying that result in a change in the
hedging option’s intrinsic value. In addition, if the assessment of
effectiveness is 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—its entire gain or loss), an amount that adjusts earnings for the
Hedging 558
7. Hedging foreign currency exposures

amortization of the cost of the option on a rational basis shall be

reclassified each period from other comprehensive income to earnings.
This guidance is limited to foreign currency hedging relationships because
of their unique attributes and is an exception for foreign currency hedging
relationships.
35-6 Remeasurement of the hedged foreign-currency-denominated assets and
liabilities is based on the guidance in Topic 830, which requires
remeasurement based on spot exchange rates, regardless of whether a cash
flow hedging relationship exists.

The accounting for foreign currency cash flow hedges is the same as for all
other cash flow hedges (see chapter 6). The following shows the general
accounting and presentation for a highly effective cash flow hedge (not
including excluded components).

Hedging instrument Hedged transaction

Continue to apply
Entire change in fair value otherwise applicable GAAP
recorded in OCI based on the nature of
the hedged transaction

Reclassified from AOCI into

Hedged transaction affects
earnings when hedged
earnings
transaction affects earnings

Offset of hedging instrument in same income statement

line item as earnings impact of hedged item

Derivative hedging Recognized at fair value on the balance sheet with

instrument changes in fair value recognized in OCI, other than
amounts related to excluded components. For a discussion
of excluded components, see section 6.2.20.
The amount in AOCI is reclassified into earnings in the
same periods during which the hedged transaction affects
earnings.

Hedged transaction FCD monetary assets or liabilities are remeasured to the

functional currency based on spot exchange rates through
earnings. Therefore, the adjustment for these instruments
for changes in foreign currency exchange rates is limited to
changes based on spot rates.

The general cash flow hedging model requires amounts in AOCI to be

reclassified into earnings in the same period(s) during which the forecasted
Hedging 559
7. Hedging foreign currency exposures

transaction affects earnings. Such guidance also applies for cash flow hedges of
forecasted FCD intercompany transactions. However, the period of
reclassification may be different for stand-alone versus consolidated financial
statements (see Question 7.7.10).
The following topics specific to accounting for foreign currency cash flow
hedges are discussed in this section:
— hedges of recognized FCD assets and liabilities (section 7.7.20); and
— forecasted purchases or sales on credit (section 7.7.30).

Question 7.7.10
When are amounts in AOCI reclassified into
earnings in a hedge of a forecasted intercompany
transaction?
Interpretive response: The general cash flow hedging model requires amounts
in AOCI to be reclassified into earnings in the same period(s) during which the
forecasted transaction affects earnings.
If a subsidiary is hedging the functional currency equivalent cash flows of a
forecasted FCD intercompany transaction, the subsidiary reclassifies any
amounts in AOCI into earnings in the same period or periods during which its
forecasted transaction affects earnings for its stand-alone financial statements.
However, when the subsidiary is consolidated with other entities, any amounts
in AOCI are not reclassified into earnings unless and until the forecasted
transaction affects the consolidated earnings. An entity that hedges forecasted
FCD intercompany transactions under the cash flow hedge model needs to
track these differences.
Subtopic 815-30’s Example 14 illustrates the reclassification of amounts from
AOCI.

Excerpt from ASC 815-30

>> Example 14: Reclassifying Amounts from a Cash Flow Hedge of a

Forecasted Foreign-Currency-Denominated Intra-Entity Sale

55-86 This Example illustrates the application of paragraphs 815-20-25-30 and

815-20-25-39 through 25-41. This Example has the following assumptions:
a. Parent A is a multinational corporation that has the U.S. dollar (USD) as its
functional currency.
b. Parent A has the following two subsidiaries:
1. Subsidiary B, which has the Euro (EUR) as its functional currency
2. Subsidiary C, which has the Japanese yen (JPY) as its functional
currency.
c. Subsidiary B manufactures a product and has a forecasted sale of the
product to Subsidiary C that will be transacted in JPY.
Hedging 560
7. Hedging foreign currency exposures

55-87 Eventually, Subsidiary C will sell the product to an unrelated third party in
JPY. Subsidiary B enters into a forward contract with an unrelated third party to
hedge the cash flow exposure of its forecasted intra-entity sale in JPY to
changes in the EUR-JPY exchange rate.
55-88 The transaction in this Example meets the hedge criteria of
paragraphs 815-20-25-30 and 815-20-25-39 through 25-41, which permits a
derivative instrument to be designated as a hedge of the foreign currency
exposure of variability in the functional-currency-equivalent cash flows
associated with a forecasted intra-entity foreign-currency-denominated
transaction if certain criteria are met. Specifically, the operating unit having the
foreign currency exposure (Subsidiary B) is a party to the hedging instrument;
the hedged transaction is denominated in JPY, which is a currency other than
Subsidiary B’s functional currency; and all other applicable criteria in
Section 815-20-25 are satisfied.
55-89 Subsidiary B measures the derivative instrument at fair value and
records the gain or loss on the derivative instrument in accumulated other
comprehensive income. In the consolidated financial statements, the amount
in other comprehensive income representing the gain or loss on a derivative
instrument designated in a cash flow hedge of a forecasted foreign-currency-
denominated intra-entity sale should be reclassified into earnings in the period
that the revenue from the sale of the manufactured product to an unrelated
third party is recognized and presented in earnings in the same income
statement line item as the earnings effect of the hedged item. The
reclassification into earnings in the consolidated financial statements should
occur when the forecasted sale affects the earnings of Parent A. Because the
consolidated earnings of Parent A will not be affected until the sale of the
product by Subsidiary C to the unrelated third party occurs, the reclassification
of the amount of derivative gain or loss from other comprehensive income into
earnings in the consolidated financial statements should occur upon the sale by
Subsidiary C to an unrelated third party.
55-90 This guidance is relevant only with respect to the consolidated financial
statements. In Subsidiary B’s separate entity financial statements, the
reclassification of the amount of the derivative instrument gain or loss from
other comprehensive income into earnings should occur in the period the
forecasted intra-entity sale is recorded because Subsidiary B’s earnings are
affected by the change in the EUR-JPY exchange rate when the sale to
Subsidiary C occurs.

Question 7.7.20
How are gains and losses on a hedging instrument
recognized if an entity assesses effectiveness on an
after-tax basis?
Hedging 561
7. Hedging foreign currency exposures

Excerpt from ASC 815-30

> Subsequent Recognition and Measurement of Gains and Losses on

Hedging Instrument
35-5 If an entity has designated and documented that it will assess
effectiveness and measure hedge results of a cash flow hedge of foreign
currency risk on an after-tax basis as permitted by paragraph 815-20-25-
3(b)(2)(vi),the portion of the gain or loss on the hedging instrument that
exceeded the loss or gain on the hedged item shall be included as an offset to
the related tax effects in the period in which those tax effects are recognized.

Interpretive response: If an entity assesses effectiveness on an after-tax

basis, the portion of the gain or loss on the hedging instrument that exceeds
the loss or gain on the hedged item is included as an offset to the related tax
effect in the period in which the tax effects are recognized.

Question 7.7.30
Is a partial-term cash flow hedge of foreign
currency risk permitted?

Interpretive response: It depends.

If effectiveness is based on changes in the spot rates of the hedging
instrument, an entity is permitted to enter into a partial-term cash flow hedge of
foreign currency risk. Therefore, an entity does not need to hedge all of the
foreign currency exposure throughout the life of the hedged item.
Because the effectiveness is based on changes in the spot value, any changes
in the time value of the hedging instrument would be recognized in earnings
immediately (if the mark-to-market approach is elected) or amortized into
earnings (if the amortization approach is elected).

Example 7.7.10
Different maturities for hedged item and hedging
instrument
A US dollar functional currency entity expects to sell a product in 60 days for
1,000,000 yen (¥). It enters into a forward contract to pay yen and receive US
dollars to hedge the risk of changes in cash flows of that sale due to changes in
the ¥/$ exchange rate.
If the effectiveness of the hedge is assessed based only on changes in the spot
value of the hedging instrument, the maturity of the forward contract can be at
the end or at any point during those 60 days. The excluded component should
be accounted for using either the mark-to-market approach or the amortization
approach (see section 6.2.20).
Hedging 562
7. Hedging foreign currency exposures

Similarly, if the effectiveness of the hedge is assessed based on changes in

total cash flows of the hedging instrument, the maturity of the forward contract
can be at the end or at any point during those 60 days. Before such relationship
is entered into, the entity needs to consider the effect on its assessment of
hedge effectiveness due to the timing of the expected cash flows on the
forecasted transaction versus the timing of the cash flows for the forward
contract.

7.7.20 Recognized FCD assets and liabilities

Excerpt from ASC 815-30

> Subsequent Recognition and Measurement of Gains and Losses on

Hedging Instrument
35-3 When the relationship between the hedged item and hedging instrument
is highly effective at achieving offsetting changes in cash flows attributable to
the hedged risk, an entity shall record in other comprehensive income the
entire change in the fair value of the designated hedging instrument that is
included in the assessment of hedge effectiveness. More specifically, a
qualifying cash flow hedge shall be accounted for as follows: …
d. If a non-option-based contract is the hedging instrument in a cash flow
hedge of the variability of the functional-currency-equivalent cash flows for
a recognized foreign-currency-denominated asset or liability that is
remeasured at spot exchange rates under paragraph 830-20-35-1, an
amount that will both offset the related transaction gain or loss arising from
that remeasurement and adjust earnings for that period’s allocable portion
of the initial spot-forward difference associated with the hedging
instrument (cost to the purchaser or income to the seller of the hedging
instrument) shall be reclassified each period from other comprehensive
income to earnings if the assessment of effectiveness is based on total
changes in the non-option-based instrument’s cash flows. If an option
contract is used as the hedging instrument in a cash flow hedge of the
variability of the functional-currency-equivalent cash flows for a recognized
foreign-currency-denominated asset or liability that is remeasured at spot
exchange rates under paragraph 830-20-35-1 to provide only one-sided
offset against the hedged foreign exchange risk, an amount shall be
reclassified each period to or from other comprehensive income with
respect to the changes in the underlying that result in a change in the
hedging option’s intrinsic value. In addition, if the assessment of
effectiveness is 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—its entire gain or loss), an amount that adjusts earnings for the
amortization of the cost of the option on a rational basis shall be
reclassified each period from other comprehensive income to earnings.
This guidance is limited to foreign currency hedging relationships because
of their unique attributes and is an exception for foreign currency hedging
relationships.
Hedging 563
7. Hedging foreign currency exposures

Hedging recognized FCD monetary assets and liabilities is affected by the

interaction of Topic 815 and Topic 830. Topic 830 requires recognized FCD
monetary assets and liabilities to be remeasured to the functional currency
based on the spot exchange rate through earnings; therefore, the adjustment of
these recognized assets and liabilities for foreign exchange rates is limited to
the changes based on spot rates. A derivative used to hedge the foreign
currency risk (such as a foreign currency forward contract) on the FCD
monetary assets and liabilities is recognized on the balance sheet at fair value. If
the cash flow hedge is highly effective, the change in fair value of the derivative
is recognized in OCI while the remeasurement gain/loss of the monetary assets
and liabilities is recognized in earnings. This would result in earnings volatility.
Therefore, an exception to the general hedging guidance was provided for cash
flow hedges of recognized FCD assets and liabilities when an entity assesses
effectiveness based on total changes in the hedging instrument’s cash flows.
The FASB decided to permit this exception because it believes it is consistent
with its general principle of providing special hedge accounting to mitigate the
effects in earnings of different existing measurement criteria for FCD
transactions.
The following table describes this exception, which may not be applied by
analogy to other hedging relationships.

Hedging Assessment of hedge Amount to be reclassified from

instrument effectiveness AOCI into earnings
Non-option Based on total changes — Gain or loss to offset transaction
contract in cash flows of the non- gain or loss from remeasuring
option contract the asset/liability to functional
currency based on spot rates.
— Portion of cost attributable to
spot-forward difference
amortized in earnings using the
interest method.

Option contract Based on total changes — Gain or loss to offset transaction

in cash flows of the gain or loss from remeasuring
option contract the asset/liability to functional
currency based on spot rates
limited to the change in the
underlying that results in a
change in the option contract’s
intrinsic value.
— Portion of cost of the option
amortized in earnings on a
rational basis.

The following table describes the reclassification from AOCI into earnings if the
assessment of hedge effectiveness is not based on the hedging instrument’s
total change in cash flows.

Hedging Assessment of hedge Amount to be reclassified from

instrument effectiveness AOCI into earnings
Non-option Spot-forward difference — Gain or loss to offset transaction
contract excluded from gain or loss from remeasuring
Hedging 564
7. Hedging foreign currency exposures

assessment of hedge the asset/liability to functional

effectiveness currency based on spot rates.
— As discussed in section 6.2.20,
an entity can recognize the initial
value of the excluded
component in earnings using
either:
— Amortization approach. A
systematic and rational
method over the life of the
hedging instrument; or
— Mark-to-market approach.
A method that recognizes all
fair value changes of the
excluded component
currently in earnings

Option contract Based on changes in — Gain or loss to offset transaction

intrinsic value of the gain or loss from remeasuring
option contract the asset/liability to functional
currency based on spot rates
limited to the change in the
underlying that results in a
change in the option contract’s
intrinsic value
— As discussed in section 6.2.20,
an entity can recognize the initial
value of the excluded
component in earnings using
either:
— Amortization approach. A
systematic and rational
method over the life of the
hedging instrument; or
— Mark-to-market approach.
A method that recognizes all
fair value changes of the
excluded component
currently in earnings

The initial spot-forward difference for a forward contract or the premium paid
for an option contract represents the cost to the purchaser or income to the
seller of the hedging instrument.

Question 7.7.40
For non-option contracts, how are amounts
reclassified from AOCI when hedge effectiveness is
based on a hedging instrument’s total change in
cash flows?
Hedging 565
7. Hedging foreign currency exposures

Interpretive response: If a non-option contract is the hedging instrument, two

reclassifications from AOCI are required when hedge effectiveness is based on
the hedging instrument’s total change in cash flows.
— First, an amount is reclassified from AOCI each period to offset the
transaction gain or loss arising from the Topic 830 remeasurement of the
FCD asset or liability at the spot exchange rate.
— Second, an amount is reclassified from AOCI each period representing the
cost attributable to the spot-forward difference of the hedging derivative.
The cash flow hedging model for recognized FCD assets and liabilities requires
use of the interest method at the inception of the hedging relationship to
determine the amount of cost or income to be ascribed to each period of the
hedging relationship when the hedging instrument is a non-option contract.
Example 18 in Subtopic 815-30 (reproduced in this section) illustrates a method
of ascribing the amount of cost or income to each period using a pro rata
method based on the number of days in the hedging relationship. Such method
is based on the daily interest implicit in the forward contract. This is done by
dividing the forward-to-spot premium or discount by the number of days in the
non-option contract. The amount of daily interest is recognized for the number
of days in the period.

Question 7.7.50
For option contracts, how are amounts reclassified
from AOCI when hedge effectiveness is based on a
hedging instrument’s total change in cash flows?
Interpretive response: If the hedging instrument is a currency option-based
derivative and effectiveness is based on the total change in cash flows, an
amount is reclassified each period to or from AOCI with respect to the changes
in the underlying that result in a change in the hedging option's intrinsic value.
Intrinsic value is based on the spot rate of the underlying.
In-the-money option
When the option is in the money, this change parallels the guidance in
Topic 830 that requires the recognized asset or liability to be remeasured using
the spot rate. If the option's exercise price is in the money at the beginning and
end of the period, and the notional amount of the option and the balance of the
hedged asset or liability match, this reclassification would fully offset the
Topic 830 transaction gain or loss.
Out-of-the-money option
If the option's exercise price is out of the money at the end of the period, any
amounts previously reclassified from AOCI when the option was in the money
are reclassified to AOCI.
The cost of the currency option is amortized to earnings on a rational basis. The
amortization method is used at the inception of the hedging relationship to
determine the amount of cost or income to be ascribed to each period of the
hedging relationship. In our experience, most entities use a straight-line
Hedging 566
7. Hedging foreign currency exposures

amortization method for simplicity. The amount of daily cost is recognized for
the number of days in the period.
If the assessment of effectiveness is not based on the total change in cash
flows of an option contract, an amount is reclassified each period to or from
AOCI with respect to the changes in the underlying that result in a change in
the hedging option's intrinsic value. However, the changes in the option's time
value are recognized in earnings using either an amortization approach or a
mark-to-market approach.

7.7.30 Forecasted purchases and sales on credit

Excerpt from ASC 815-30

> Application to Single Cash Flow Hedge of a Forecasted Sales or

Purchase on Credit for Foreign Exchange Risk
35-9 For a single cash flow hedge that encompasses the variability of
functional-currency-equivalent cash flows attributable to foreign exchange risk
related to the settlement of a foreign-currency-denominated receivable or
payable resulting from a forecasted sale or purchase on credit, the guidance in
paragraph 815-30-35-3 is applied as follows:
a. The gain or loss on the derivative instrument that is included in the
assessment of hedge effectiveness is reported in other comprehensive
income during the period before the forecasted purchase or sale.
b. The functional currency interest rate implicit in the hedging relationship as
a result of entering into the forward contract is used to determine the
amount of cost or income to be ascribed to each period of the hedging
relationship. The cash flow hedging model for recognized foreign-currency-
denominated assets and liabilities requires use of the interest method at
the inception of the hedging relationship to determine the amount of cost
or income to be ascribed to each relevant period of the hedging
relationship. However, for simplicity, in hedging relationships in which the
hedged item is a short-term non-interest-bearing account receivable or
account payable, the amount of cost or income to be ascribed each period
can also be determined using a pro rata method based on the number of
days or months of the hedging relationship. In addition, in a short-term
single cash flow hedging relationship that encompasses the variability of
functional-currency-equivalent cash flows attributable to foreign exchange
risk related to the settlement of a foreign-currency-denominated receivable
or payable resulting from a forecasted sale or purchase on credit, the
amount of cost or income to be ascribed each period can also be
determined using a pro rata method or a method that uses two foreign
currency forward exchange rates. The first foreign currency forward
exchange rate would be based on the maturity date of the forecasted
purchase or sale transaction. The second foreign currency forward
exchange rate would be based on the settlement date of the resulting
account receivable or account payable.
c. For forecasted sales on credit, the amount of cost or income ascribed to
each forecasted period is reclassified from other comprehensive income to
Hedging 567
7. Hedging foreign currency exposures

earnings on the date of the sale. For forecasted purchases on credit, the
amount of cost or income ascribed to each forecasted period is reclassified
from other comprehensive income to earnings in the same period or
periods during which the asset acquired affects earnings. The
reclassification from other comprehensive income to earnings of the
amount of cost or income ascribed to each forecasted period is based on
the guidance in paragraphs 815-30-35-38 through 35-41.
d. The income or cost ascribed to each period encompassed within the
periods of the recognized foreign-currency-denominated receivable or
payable is reclassified from other comprehensive income to earnings at the
end of each reporting period.

As discussed in section 7.6.30, an entity can designate a single cash flow

hedge that encompasses the variability of functional currency equivalent cash
flows attributable to foreign currency risk related to settlement of the FCD
receivable or payable resulting from a forecasted sale or purchase on credit.
The accounting from the time the hedge is designated to the time the
receivable or payable is cash settled, can be summarized as follows.

Forecast period — The gain or loss on the hedging instrument included in

(before sale/purchase the assessment of effectiveness is reported in OCI
date) during the period before the purchase or sale date of a
forecasted foreign currency transaction.
— The spot-forward premium or discount, or option
premium is used to determine the amount of cost or
income to be ascribed to each period of the hedging
relationship. The amount to be ascribed each period
can be determined using a pro rata method based on
the number of days in the hedging relationship.
On the sale/purchase — For forecasted sales on credit, the amount of cost or
date income ascribed to the forecasted period to the date
of sale is reclassified from AOCI into earnings on the
date of the sale.
— For forecasted purchases on credit, the amount of
cost or income ascribed to the forecasted period is
reclassified from AOCI into earnings in the same
period(s) during which the asset acquired affects
earnings.
After sale/purchase — The income or cost ascribed to each period
date (during life of encompassed during the periods of the recognized
FCD receivable/ FCD receivable or payable that results from the
payable) forecasted sale or purchase is reclassified from AOCI
into earnings at the end of each reporting period.
— During the period in which the FCD receivable or
payable is recognized, an amount that will offset the
related transaction gain or loss arising from
remeasurement of the receivable or payable under
Topic 830 must be reclassified from AOCI each period
if the hedging instrument is a forward-based contract.
If the hedging instrument is an option-based contract,
any gain or loss to offset the transaction gain or loss
from remeasuring the asset/liability to functional
currency based on spot rates limited to the changes in
Hedging 568
7. Hedging foreign currency exposures

the underlying that result in a change in the option’s

intrinsic value must be reclassified to or from AOCI
each period.

The following FASB example illustrates these accounting requirements.

Excerpt from ASC 815-30

>> Example 18: Cash Flow Hedge of Forecasted Purchase or Sale on

Credit

55-106 This Example illustrates the application of paragraphs 815-30-35-9 and

815-20-25-34 through 25-36, which permit an entity to designate a single cash
flow hedge that encompasses the variability of functional-currency-equivalent
cash flows attributable to foreign exchange risk related to the settlement of a
foreign-currency-denominated receivable or payable resulting from a forecasted
sale or purchase on credit.
55-107 This Example has the following assumptions:
a. Entity A, a U.S. dollar (USD) functional currency entity, forecasts the
purchase of inventory on credit for FC 100,000 in 182 days with settlement
of the payable in 227 days. The purchase will occur July 15 on credit; the
resulting payable will settle August 29.
b. Entity A enters into a forward contract to purchase FC 100,000 in 227 days
at the forward rate of USD .6614 = FC 1.
c. Entity A designates a single cash flow hedge that encompasses the
variability of functional-currency-equivalent cash flows attributable to
foreign exchange risk related to the settlement of the foreign-currency-
denominated payable resulting from the forecasted purchase on credit.
d. After the initial quantitative effectiveness test, Entity A elects to assess
effectiveness on a quantitative basis based on forward rates.
55-108 Exchange rates are as follows.

8/29 7/15
Period Spot Forward Forward
1/14 0.6575 0.6614 0.6605
3/31 0.6757 0.6793
6/30 0.6689 0.6734
7/15 0.6761 0.6767
8/29 0.6798 0.6798

55-109 Entity A would record the following journal entries.

Debit (Credit)
Accum. Other
Forward Accounts Comprehensive
Cash Inventory Contract Payable Earnings Income
Inception 1/14 - - - - - -
March 31 entry
(76 days):
Mark forward to fair
value $ 1,703 $ (1,703)
Hedging 569
7. Hedging foreign currency exposures

June 30 entry
(91 days):
Mark forward to fair
value (526) 526
July 15 entries
(15 days):
Inventory purchase $ 67,610 $ (67,610)
August 29 entries
(45 days):
Mark forward to fair
value 663 (663)
Functional currency
transaction loss on
payable (370) $ 370
Adjustment for
paragraph 815-30-
35-3(d)—offset the
functional currency
transaction loss (370) 370
Adjustment for
paragraph 815-30-
35-3(d)—effect of
hedge (based on
implicit interest rate;
see paragraph 815-
30-55-112) 78 (78)
Settlement of
payable $ (67,980) 67,980
Settlement of
forward 1,840 (1,840)
$ (66,140) $ 67,610 $ - $ - $ 78 $ (1,548)

55-110 Upon sale of the inventory, Entity A would record cost of goods sold of
$67,610 and reclassify $1,548 from other comprehensive income to earnings
to achieve a net cost of goods sold of $66,062. The effect of the hedge would
result in a net cost to Entity A of $66,140 for the purchase of the inventory.
55-111 The amount of the adjustment under paragraph 815-30-35-3(d) is that
amount needed to ensure that a net amount in earnings reflects the effect of
the hedge through each reporting period up to and including the final
settlement of the payable.
55-112 The amount of cost or income to be ascribed to each period is
calculated as follows.
Daily interest rate implicit in the hedging relationship as a result of the forward
contract: $65,750 PV, $66,140 FV, 227n, i = 0.0026053%

1/14 $65,750
3/31 65,880 $130
6/30 66,036 156
7/15 66,062 26
8/29 66,140 78
$390

Method using two foreign currency forward exchange rates:

From 1/14 to 7/15
7/15 Forward Rate .6605
$66,050 – $65,750 = $ 300
From 7/16 to 8/29
8/29 Forward Rate .6614
Hedging 570
7. Hedging foreign currency exposures

$66,140 – $66,050 = 90
$ 390

Pro rata method:

From 1/14 to 7/15:
$390 x 182/227 = $ 313
From 7/16 to 8/29:
$390 x 45/227 77
$ 390

7.7.40 Examples of foreign currency cash flow value hedges

This section contains seven examples illustrating the application of the foreign
currency cash flow hedging principles to the following hedging relationships.
— Cash flow hedge of variable-rate FCD debt with a variable to fixed cross-
currency interest rate swap (variable-to-fixed scenario) (Example 7.7.20)
— Cash flow hedge of a forecasted FCD purchase with a forward contract
(Example 7.7.30)
— Cash flow hedge of recognized FCD payable with a forward contract
(Example 7.7.40)
— Single cash flow hedge with a foreign currency purchased option
(Example 7.7.50)
— Cash flow hedge of foreign currency exposure in a royalty arrangement
(Subtopic 815-30’s Example 11);
— Cash flow hedge of a fixed-rate FCD loan eliminating variability in the
functional currency equivalent cash flows (fixed-to-fixed scenario)
(Subtopic 815-30’s Example 13);
— Portions of a FCD financial asset or liability as hedged item (Subtopic 815-
20’s Example 15).
Each of the examples assumes that all criteria for hedge accounting, including
all required documentation, have been met at the onset of the hedging
relationship and at each period end.

Example 7.7.20
Cash flow hedge of variable-rate FCD debt with a
variable to fixed cross-currency interest rate swap
(variable-to-fixed scenario)
ABC Corp.’s functional currency is the US dollar. On January 1, Year 1, ABC
borrows 100,000 euro (€) at a variable rate of Euribor plus 50 basis points (bps).
The debt is due on December 31, Year 1. Also on January 1, Year 1, ABC enters
into a variable-to-fixed cross-currency interest rate swap (cross-currency swap)
in which it will receive Euribor plus 50 bps on €100,000 and pay fixed US dollars
at 6.373% on $102,000.
Hedging 571
7. Hedging foreign currency exposures

The swap matures on December 31, Year 1. There will be a final exchange of
principal at maturity of the cross-currency swap (ABC will receive €100,000 and
pay $102,000). The debt and the cross-currency swap will pay interest quarterly
on March 31, June 30, September 30 and December 31.
ABC designates the cross-currency swap as a cash flow hedge of the euro debt
for changes in the functional currency equivalent cash flows due to the variable
interest payments and changes in foreign currency exchange rates ($/€).
Hedge effectiveness. ABC assesses hedge effectiveness using the
hypothetical derivative method. Because the critical terms of the hedged item
and cross-currency swap match (notional amount of debt, interest indices,
settlement date, rate reset and maturity dates), the terms of the hypothetical
cross-currency swap match the actual cross-currency swap. Therefore, ABC
concludes that the hedge is highly effective. On an ongoing basis, ABC will
ascertain and document that the critical terms of the cross-currency swap and
the debt have not changed, including that there have been no adverse
developments concerning the risk of default by the counterparty to the cross-
currency swap or its own nonperformance risk, therefore not causing a different
conclusion about hedge effectiveness.
The spot exchange rate for $/€, flat Euribor swap rate, and US LIBOR rate over
the life of the hedge are as follows.

January 1 March 31 June 30 September December

30 31
Spot rate
($/€) 1.0200 1.0723 1.0723 1.1273 1.1851
Euribor
swap rate 5.160% 5.151% 5.040% 4.854% 4.480%
US LIBOR 6.000% 5.500% 6.000% 6.500% 7.000%

The remeasurement at spot of the debt and the fair value and changes in fair
value of the cross-currency swap, are shown in the following table.

January 1 March 31 June 30 September December

30 31
Spot rate 1.0200 1.0723 1.0723 1.1273 1.1851
Debt at
spot (in $)1 $(102,000) $(107,230) $(107,230) $(112,730) $(118,510)
Change in
period - (5,230) - (5,500) (5,780)
Fair value
of swap - 4,911 5,287 10,905 16,510
Change in
period - 4,911 376 5,618 5,605

Note:
€100,000 × spot rate.

The income statement effect of the debt and the cross-currency swap are as
follows for each quarter ended period.
Hedging 572
7. Hedging foreign currency exposures

March 31 June 30 September 30 December 31

Interest
expense1 (in €) €(1,415) €(1,413) €(1,385) €(1,339)
Interest
expense2 (in $) $(1,517) $(1,515) $(1,561) $(1,587)
Swap interest
settlement (108) (110) (64) (38)
Net interest
expense3 $(1,625) $(1,625) $(1,625) $(1,625)
Notes:
Based on Euribor plus 50bps on €100,000. For example, interest for the period
ended March 31 is (5.160% + 50 bps) ÷ 100 × ¼ × €100,000 = €1,415.
For simplicity, the variable euro interest expense is remeasured into the functional
currency ($) at the spot exchange rate at the end of the quarter.
Interest expense + swap interest settlement.

Journal entries – January 1, Year 1

ABC makes a memorandum entry on January 1, Year 1 to document the
existence of the hedging relationship. There is no entry for the cross-currency
swap because the contract is at market rates (i.e. fair value is zero).

Debit Credit
Cash 102,000
Debt obligation 102,000
To record €100,000 debt at spot rate of €1 =
$1.02.

Journal entries – March 31, Year 1

Debit Credit
Interest expense 1,517
Cash 1,517
To record interest payment on euro debt at
Euribor plus 50 bps. Remeasured at period end
spot rates for simplicity.
Other income/expense 5,230
Debt obligation 5,230
To record spot remeasurement of debt to
functional currency.
Interest expense 108
Cash 108
To record net interest cash payment on cross-
currency swap.
Cross-currency swap 4,911
OCI 4,911
Hedging 573
7. Hedging foreign currency exposures

Debit Credit
To record change in fair value of cross-currency
swap.
AOCI 5,230
Other income/expense 5,230
To reclassify amount out of AOCI to offset spot
remeasurement loss on debt obligation.

Journal entries – June 30, Year 1

Debit Credit
Interest expense 1,515
Cash 1,515
To record interest payment on euro debt at
Euribor plus 50 bps. Remeasured at period end
spot rates for simplicity.
Interest expense 110
Cash 110
To record net interest cash payment on cross-
currency swap.
Cross-currency swap 376
OCI 376
To record change in fair value of cross-currency
swap.

Journal entries – September 31, Year 1

Debit Credit
Interest expense 1,561
Cash 1,561
To record interest payment on euro debt at
Euribor plus 50 bps. Remeasured at period end
spot rates for simplicity.
Other income/expense 5,500
Debt obligation 5,500
To record spot remeasurement of debt to
functional currency.
Interest expense 64
Cash 64
To record net interest cash payment on cross-
currency swap.
Cross-currency swap 5,618
OCI 5,618
Hedging 574
7. Hedging foreign currency exposures

Debit Credit
To record change in fair value of cross-currency
swap.
AOCI 5,500
Other income/expense 5,500
To reclassify amount out of AOCI to offset spot
remeasurement loss on debt obligation.

Journal entries – December 31, Year 1

Debit Credit
Interest expense 1,587
Cash 1,587
To record interest payment on euro debt at
Euribor plus 50 bps. Remeasured at period end
spot rates for simplicity.
Other income/expense 5,780
Debt obligation 5,780
To record spot remeasurement of debt to
functional currency.
Interest expense 38
Cash 38
To record net interest cash payment on cross-
currency swap.
Cross-currency swap 5,605
OCI 5,605
To record change in fair value of cross-currency
swap.
AOCI 5,780
Other income/expense 5,780
To reclassify amount out of AOCI to offset spot
remeasurement loss on debt obligation.
Cash 16,510
Cross-currency swap1 16,510
To record cash receipt on settlement of notional
exchange of cross-currency swap.
Debt obligation 118,510
Cash 118,510
To record payment of €100,000 debt on maturity
at spot rate of €1 = $1.1851.
Note:
1. Receive $118,510 (€100,000 × spot rate of €1 = $1.1851) and pay $102,000.
Hedging 575
7. Hedging foreign currency exposures

By using a cross-currency swap, ABC eliminates its foreign exchange and

interest rate risk by locking in a forward rate on €100,000 at €1 = $1.02. This
enables ABC to effectively settle its euro-denominated debt for a fixed US dollar
amount ($102,000). ABC's net cash payment at maturity of the debt is
$102,000 ($118,510 - gain on the swap of $16,510).
ABC also converts the variable Euribor interest payments into a fixed US dollar
amount based on 6.373% of $102,000, thereby hedging its exposure to
changes in interest rates. As a result, the interest expense on the €100,000
debt, adjusted for the period swap interest settlement, totals $1,625 each
quarter.

Example 7.7.30
Cash flow hedge of a forecasted FCD purchase with
a forward contract
ABC Corp.’s functional currency is the US dollar. On January 14, Year 1 ABC
forecasts the purchase of inventory on credit for 100,000 Swiss francs (CHF).
The purchase is expected to occur July 15, Year 1. ABC enters into a foreign
currency forward contract to purchase CHF100,000 at $0.6614 = CHF1. ABC
designates a cash flow hedge of the functional currency equivalent cash flows
from the date the purchase is forecasted to be probable through the purchase
date.
Hedge effectiveness. ABC expects this hedging relationship to be perfectly
effective since the critical terms of the forecasted transaction match the foreign
currency forward contract. On an ongoing basis, ABC will ascertain and
document that the critical terms of the forward contract and the forecasted
purchase have not changed, including that there have been no adverse
developments concerning the risk of default by the counterparty to the forward
contract or its own nonperformance risk, therefore not causing a different
conclusion about hedge effectiveness.
The spot and forward exchange rates for $/CHF over the life of the hedge are as
follows.

Spot rate July 15 forward rate

January 14 0.6575 0.6614
March 31 0.6757 0.6793
June 30 0.6689 0.6734
July 15 0.6761 N/A

Journal entries – January 14, Year 1

ABC makes a memorandum entry on January 14, Year 1 to document the
existence of the hedging relationship. There is no entry for the foreign currency
forward because the contract is at market rates (i.e. fair value is zero).
Hedging 576
7. Hedging foreign currency exposures

Journal entries – March 31, Year 1

Debit Credit
Forward contract1 1,703
OCI 1,703
To record change in fair value of foreign currency
forward contract.
Note:
CHF100,000 × (change in forward rates (0.6793 - 0.6614)) = $1,790 discounted to
March 31 at an appropriate rate.

Journal entries – June 30, Year 1

Debit Credit
OCI1 526
Forward contract 526
To record change in fair value of foreign currency
forward contract.
Note:
Current quarter fair value of $1,177 - prior quarter fair value of $1,703. Current quarter
fair value is calculated as CHF100,000 × (change in forward rates (0.6734 - 0.6614)) =
$1,200 discounted to June 30 at an appropriate rate.

Journal entries – July 15, Year 1

Debit Credit
Inventory 67,610
Accounts payable 67,610
To record purchase of inventory at spot rate of
CHF1 = $0.6761.
Forward contract1 293
OCI 293
To record change in fair value of foreign currency
forward contract.
Cash 1,470
Forward contract 1,470
To record payment received by ABC to settle gain
on foreign currency forward contract.
Note:
Current quarter fair value of $1,470 - prior quarter fair value of $1,177. Current quarter
fair value is calculated as CHF100,000 × (change in forward rates (0.6761 - 0.6614)) =
$1,470.

ABC recorded inventory of $67,610 (based on the July 15, Year 1 spot rate).
The amount at July 15, Year 1 in AOCI of $1,470 will remain in AOCI until the
inventory is sold. At that time, it will be reclassified to cost of sales resulting in
Hedging 577
7. Hedging foreign currency exposures

a net cost of $66,140, which is equivalent to the forward rate of $0.6614 =

CHF1 that ABC locked in at January 14, Year 1.

Example 7.7.40
Cash flow hedge of recognized FCD payable with a
forward contract
ABC Corp.’s functional currency is the US dollar. On January 1, Year 1 ABC
purchases inventory on credit for 100,000 Swiss francs (CHF). The payment is
due April 30, Year 1. ABC enters into a forward contract to purchase
CHF100,000 at CHF1 = $0.6614. ABC designates a cash flow hedge of the
functional currency equivalent cash flows through the payment date of April 30,
Year 1.
Hedge effectiveness. ABC expects this hedging relationship to be perfectly
effective because the critical terms of the FCD payable match the foreign
currency forward contract. ABC assesses effectiveness by verifying and
documenting that the critical terms have not changed during the review period.
ABC will recognize the spot-forward premium (cost) of $390 on the forward
contract based on the implicit interest rate of the forward contract recognized
on a pro rata basis over the hedging relationship.
The spot and forward rates for $/CHF over the life of the hedge are as follows.

Spot rate April 30 forward rate

January 1 0.6575 0.6614
March 31 0.6757 0.6793
April 30 0.6761 N/A

Journal entries – January 1, Year 1

ABC makes a memorandum entry on January 1, Year 1 to document the
existence of the hedging relationship. There is no entry for the foreign currency
forward because the contract is at market rates (i.e. fair value is zero).

Debit Credit
Inventory 65,750
Accounts payable 65,750
To record purchase of inventory at spot rate of
CHF1 = $0.6565

Journal entries – March 31, Year 1

Debit Credit
Other income/expense1 1,820
Accounts payable 1,820
To record spot remeasurement of accounts
payable to functional currency.
Hedging 578
7. Hedging foreign currency exposures

Debit Credit
Forward contract2 1,780
OCI 1,780
To record change in fair value of foreign currency
forward contract.
AOCI 1,820
Other income/expense 1,820
To reclassify amount out of AOCI to offset spot
remeasurement adjustment.
Other income/expense3 292
AOCI 292
To reclassify portion of forward premium on
foreign currency forward contract attributable to
hedging period (rounded).
Notes:
CHF100,000 × (change in spot rates (0.6757 - 0.6575)).
CHF100,000 × (change in forward rates (0.6793 - 0.6614)) = $1,790 discounted to
March 31 at an appropriate rate.
$390 premium × 90/120 days.

Journal entries – April 30, Year 1

Debit Credit
Other income/expense1 40
Accounts payable 40
To record spot remeasurement of accounts
payable to functional currency.
OCI2 310
Forward 310
To record change in fair value of foreign currency
forward contract.
AOCI 40
Other income/expense 40
To reclassify amount out of AOCI to offset spot
remeasurement adjustment.
Other income/expense3 98
AOCI 98
To reclassify portion of forward premium on
foreign currency forward contract attributable to
the hedging period (rounded).
Hedging 579
7. Hedging foreign currency exposures

Debit Credit
Cash 1,470
Forward contract 1,470
To record payment received by ABC to settle gain
on foreign currency forward contract.
Accounts payable 67,610
Cash 67,610
To record payment of FCD payable at spot rate.
Notes:
CHF100,000 × (change in spot rates (0.6761 - 0.6757)).
April 30 fair value of $1,470 - March 31 fair value of $1,780 = $310.
$390 premium × 30/120 days.

ABC is able to lock in its functional currency payable at the January 1, Year 1
forward rate of CHF1 = $0.6614. It initially records the CHF100,000 payable at
$65,750 and settles it on April 30, Year 1 at the spot rate of CHF1 = $0.6761
($67,610). This amount is offset by a $1,470 gain on the forward contract.
Absent the forward contract, ABC would have realized a foreign exchange loss
of $1,860 on the CHF100,000 payable. The difference of $390 ($1,860 - $1,470)
represents the spot-forward premium incurred by ABC.

Example 7.7.50
Single cash flow hedge with a foreign currency
purchased option
ABC Corp.’s functional currency is the US dollar. On December 31, Year 1, ABC
forecasts the sale of inventory on credit for 10,000,000 Australian dollars (A$)
on February 15, Year 2 with settlement of the receivable on April 15, Year 2.
ABC purchases a foreign currency European style put option that gives it the
right to sell A$10,000,000 on April 15, Year 2, for $5,000,000. The terms of the
purchased put option are as follows.

Contract amount A$10,000,000

Expiration date April 15, Year 2
Put option strike price A$2 = $1
Spot rate A$2 = $1
Premium $20,000

Because the option is purchased at the money, the premium on December 31,
Year 1 reflects the option's time value only. The option can be exercised only on
its expiration date. It is designated as a single cash flow hedge that
encompasses the variability of functional currency equivalent cash flows
attributable to foreign currency exchange risk related to:
— forecasted sale of inventory on credit on February 15, Year 2; and
Hedging 580
7. Hedging foreign currency exposures

— settlement of the resulting FCD receivable on April 15, Year 2.

ABC defines its foreign currency risk as being in one direction because it
wishes to preserve its functional currency equivalent cash flows when the
exchange rate increases above A$2.00 = $1 – that is, the option will be
exercised if the A$/$ rate increases above the strike price of A$2.00 = $1.
Specifically, as the functional currency equivalent cash flows of $5,000,000
decrease, the pay-off amount of the option will compensate ABC for the
difference.
ABC ascertains that the conditions in paragraph 815-20-25-129 have been met
such that the hedging relationship is considered perfectly effective (see
section 9.7.20).
The assumed spot exchange rates and fair value of the option are as follows.

Spot rate Change in fair

(A$/$) Fair value value
December 31, Year 1 2.00 $ 20,000 $ -
January 31, Year 1 2.10 253,095 233,095
February 15, Year 2 2.05 133,951 (119,144)
March 31, Year 2 1.90 3,000 (130,951)
April 15, Year 2 2.30 652,174 649,174

Journal entries – December 31, Year 1

Debit Credit
Purchased put option 20,000
Cash 20,000
To record purchase of put option at fair value.

Journal entries – January 31, Year 2

Debit Credit
Purchased put option 233,095
OCI 233,095
To record change in fair value of put option.

Journal entries – February 15, Year 2

Debit Credit
OCI 119,144
Purchased put option 119,144
To record change in fair value of put option.
Hedging 581
7. Hedging foreign currency exposures

Debit Credit
Accounts receivable 4,878,049
Revenue 4,878,049
To record sale of inventory on credit at spot rate
of A$2.05 = $1 (rounded).
AOCI1 121,951
Revenue 121,951
To reclassify amount out of AOCI for portion of
change in fair value of put option to effectively
lock in the hedge level (rounded).
Revenue2 8,762
AOCI 8,762
To reclassify portion of put option premium
attributable to forecast period (rounded).
Notes:
(A$10,000,000 ÷ A$2.00) - (A$10,000,000 ÷ A$2.05).
Put option premium of $20,000 × (46 day forecast period ÷ 105 day option term).

Journal entries – March 31, Year 2

Debit Credit
OCI 130,951
Purchased put option 130,951
To record change in fair value of put option.
Accounts receivable1 385,109
Other income/expense 385,109
To record spot remeasurement of accounts
receivable to functional currency (rounded).
Other income/expense2 121,951
AOCI 121,951
To reclassify amount out of AOCI for portion of
change in fair value of put option to offset spot
remeasurement adjustment. Amount limited to
defined hedge exchange rate of A$2.00 = $1
(rounded).
Other income/expense3 8,381
AOCI 8,381
To reclassify portion of put option premium
attributable to period of recognized receivable
(rounded).
Notes:
(A$10,000,000 ÷ A$1.90) - (A$10,000,000 ÷ A$2.05).
Hedging 582
7. Hedging foreign currency exposures

Debit Credit
(A$10,000,000 ÷ A$2.05) - (A$10,000,000 ÷ A$2.00). This amount is limited to the
defined hedged exchange rate of A$2.00 = $1 because ABC is only hedging against
an increase in the rate – i.e. if the rate exceeds A$2.00. Because the exchange rate
changes from A$2.05 = $1 to A$1.90 = $1, this adjustment only offsets the
movement from A$2.05 to A$2.00 per $1.
Put option premium of $20,000 × (44 days ÷ 105 day option term).

Journal entries – April 15, Year 2

Debit Credit
Purchased put option 649,174
OCI 649,174
To record change in fair value of put option.
Other income/expense1 915,332
Accounts receivable 915,332
To record spot remeasurement of accounts
receivable to functional currency (rounded).
AOCI2 652,174
Other income/expense 652,174
To reclassify amount out of AOCI for portion of
change in fair value of put option to offset spot
remeasurement adjustment.
Other income/expense3 2,857
AOCI 2,857
To reclassify portion of put option premium
attributable to period of recognized receivable
(rounded).
Cash 4,347,826
Accounts receivable 4,347,826
To record settlement of FCD receivable at spot
rate of A$2.30 = $1.
Cash 652,174
Purchased put option 652,174
To record cash receipt on exercise of put option
by ABC.
Notes:
(A$10,000,000 ÷ A$2.30) - (A$10,000,000 ÷ A$1.90).
(A$10,000,000 ÷ A$2.30) - (A$10,000,000 ÷ A$2.00). This amount is limited to the
increase above the defined hedged exchange rate of A$2.00 = $1 because ABC is
only hedging against an increase in the rate. Even though the rate changed from
A$1.90 = $1 to A$2.30 = $1, the change in the fair value of the put option that is
considered effective is the change from A$2.00 to A$2.30 per $1.
Put option premium of $20,000 × (15 days ÷ 105 day option term).
Hedging 583
7. Hedging foreign currency exposures

A single cash flow hedge of a forecasted sale on credit hedges two items: the
forecasted sale until the date of sale, and the FCD receivable until settlement.
Therefore, the gain or loss on the put option is recognized in revenue during the
forecast period and in other income/expense when the FCD receivable is
outstanding.
Upon sale of the inventory, ABC records revenue of $4,878,049 (based on the
February 15, Year 1 spot rate) and reclassifies $121,951 from AOCI to revenue,
resulting in net revenue on this sale of $5,000,000. Part of the option premium
of $20,000 attributable to the forecasted period is also recognized in earnings at
this time.
The net effect in ABC’s income statement for this sale in Australian dollars,
collection of the Australian dollar-denominated receivable and related hedging
option is $4,980,000. This amount is based on the put option's exchange rate of
A$2.00 = $1, which fixes the functional currency amount of the A$10,000,000
sale and collection at $5,000,000 less the option's premium of $20,000. ABC is
not exposed to the increase in the A$/$ exchange rate above A$2.00 = $1
because it effectively hedged its exposure.

Excerpt from ASC 815-30

>> Example 11: Cash Flow Hedge of the Foreign Currency Exposure in a
Royalty Arrangement

55-67 This Example illustrates the application of the guidance in Subtopic 815-
20 and this Subtopic to a hedging relationship involving a single hedging
derivative and three separate forecasted transactions. The three transactions
occur on three separate dates, but the payment on receivables related to all
three occurs on the same date. The settlement of the hedging derivative will
occur on the date the receivable is paid. For simplicity, commissions and most
other transaction costs, initial margin, and income taxes are ignored unless
otherwise stated. Assume that there are no changes in creditworthiness that
would alter the effectiveness of the hedging relationship.
55-68 Entity DEF's functional currency is the U.S. dollar (USD). Entity ZYX's
functional currency is the euro (EUR). Effective January 1, 20X1, Entity DEF
enters into a royalty agreement with Entity ZYX that gives Entity ZYX the right
to use Entity DEF's technology in manufacturing Product X. On April 30, 20X1,
Entity ZYX will pay Entity DEF a royalty of EUR 1 million for each unit of
Product X sold by that date. Entity DEF expects Entity ZYX to sell one unit of
Product X on January 31, one on February 28, and one on March 31. The
forecasted royalty is probable because Entity ZYX has identified a demand for
Product X and no other supplier has the capacity to fill that demand.
55-69 Also on January 1, 20X1, Entity DEF enters into a forward contract to sell
EUR 3 million on April 30, 20X1, for a price equal to the forward price of USD
0.6057 per EUR. Entity DEF designates the forward contract as a hedge of the
risk of changes in its functional-currency-equivalent cash flows attributable to
changes in the EUR-USD exchange rates related to the forecasted receipt of
EUR 3 million from the royalty agreement. The spot price and forward price of
Hedging 584
7. Hedging foreign currency exposures

EUR at January 1, 20X1, and the USD equivalent of EUR 3 million at those
prices are assumed to be as follows.
USD Equivalent of
Prices at January 1, 20X1 USD per EUR EUR 3 Million
Spot price USD 0.6019 USD 1,805,700
4-month forward price 0.6057 1,817,100

55-70 Entity DEF will exclude from its assessment of effectiveness the portion
of the fair value of the forward contract attributable to the spot-forward
difference (the difference between the spot exchange rate and the forward
exchange rate). Entity DEF elects to recognize changes in that portion of the
derivative instrument's fair value currently in earnings in accordance with
paragraph 815-20-25-83B. Entity DEF will estimate the cash flows on the
forecasted transactions based on the current spot exchange rate and will
discount that amount. Thus, Entity DEF will assess effectiveness by comparing
the following amounts:
a. Changes in the fair value of the forward contract attributable to changes in
the USD spot price of EUR
b. Changes in the present value of the forecasted cash flows based on the
current spot exchange rate.
55-71 Those two changes will exactly offset because the currency and the
notional amount of the forward contract match the currency and the total of
the expected foreign currency amounts of the forecasted transactions. Thus, if
Entity DEF dedesignates a proportion of the forward contract each time a
royalty is recognized (as described in the following paragraph), the hedging
relationship will meet the highly effective criterion.
55-72 As each royalty is recognized, Entity DEF recognizes a receivable and
royalty income. The forecasted transaction (the recognition of royalty income)
has occurred. The receivable is an asset, not a forecasted transaction, and
would separately be eligible to be designated as a fair value hedge of foreign
exchange risk or continue to be eligible as a cash flow hedge of foreign
exchange risk. Consequently, if the variability of the functional currency cash
flows related to the royalty receivable is not being hedged, Entity DEF will
dedesignate a proportion of the hedging instrument in the original hedging
relationship with respect to the proportion of the forward contract
corresponding to the recognized royalty. As the royalty is recognized in
earnings and each proportion of the derivative instrument is dedesignated, the
related derivative instrument gain or loss in accumulated other comprehensive
income is reclassified into earnings and presented in the same income
statement line item as the earnings effect of the hedged item. After that date,
any gain or loss on the dedesignated proportion of the derivative instrument
and any transaction loss or gain on the royalty receivable will be recognized in
earnings and may substantially offset each other.
55-73 Subtopic 830-20 requires immediate recognition in earnings of any
foreign currency transaction gain or loss on a foreign-currency-denominated
receivable that is not designated as a hedging instrument. Therefore, the effect
of changes in spot prices on the royalty receivable must be recognized
immediately in earnings.
Hedging 585
7. Hedging foreign currency exposures

55-74 The spot prices and forward prices for settlement on April 30, 20X1, in
effect at inception of the hedge (January 1, 20X1) and at the end of each
month between inception and April 30, 20X1, are assumed to be as follows.
USD per EUR
Forward Price for
Spot Price Settlement on 4/30/X1
January 1 USD 0.6019 USD 0.6057
January 31 0.5970 0.6000
February 28 0.5909 0.5926
March 31 0.5847 0.5855
April 30 0.5729 0.5729

55-75 The changes in fair value of the forward contract that are recognized
each month in earnings and other comprehensive income are shown in the
following table. Amounts reclassified from accumulated other comprehensive
income to earnings and amounts excluded from the assessment of hedge
effectiveness are presented in the same income statement line item as the
earnings effect of the hedged item. The fair value of the forward is the present
value of the difference between the USD to be received on the forward (USD
1,817,100) and the USD equivalent of EUR 3 million based on the current
forward rate. A 6 percent discount rate is used in this Example.
Debit (Credit)

Other
Forward Comprehensive
Contract Earnings Income
Fair value on January 1 $ -
Period ended January 31:
Change in spot-forward difference 2,364 $ (2,364)
Change in fair value of dedesignated
proportion - -
Change in fair value of designated
proportion 14,482 $ (14,482)
Reclassification of gain - (4,827) 4,827
Fair value on January 31 16,846

Period ended February 28:

Change in spot-forward difference 3,873 (3,873)
Change in fair value of dedesignated
proportion 6,063 (6,063)
Change in fair value of designated
proportion 12,127 (12,127)
Reclassification of gain - (10,891) 10,891
Fair value on February 28 38,909

Period ended March 31:

Change in spot-forward difference 2,718 (2,718)
Change in fair value of dedesignated
proportion 12,448 (12,448)
Change in fair value of designated
proportion 6,223 (6,223)
Reclassification of gain - (17,114) 17,114
Fair value on March 31 60,298

Period ended April 30:

Change in spot-forward difference 2,445 (2,445)
Hedging 586
7. Hedging foreign currency exposures

Change in fair value of dedesignated

proportion 35,657 (35,657)
Change in fair value of designated
proportion - -
Fair value on April 30 $ 98,400
Cumulative effect $ (98,400) -

55-76 The effect on earnings of the royalty agreement and hedging relationship
illustrated in this Example is summarized by month in the following table.
Amounts Recognized in Earnings Related to

Receivable Forward Contract

Amount
Attributable
Amount to the
USD Foreign Attributable Reclassifications Difference Total
Equivalent of Currency to the from Other between the Amount
EUR 1 Million Transaction Dedesignated Comprehensive Spot and Reported in
Period Ended Royalty Gain (Loss) Proportion Income Forward rates Earnings
January 31 $ 597,000 $ - $ - $ 4,827 $ 2,364 $ 604,191
February 28 590,900 (6,100) 6,063 10,891 3,873 605,627
March 31 584,700 (12,400) 12,458 17,104 2,718 604,580
April 30 - (35,400) 35,657 - 2,445 2,702

$ 1,772,600 $ (53,900) $ 54,178 $ 38,822 $ 11,400 $ 1,817,100

$98,400

Excerpt from ASC 815-30

>> Example 13: Cash Flow Hedge of a Fixed-Rate Foreign-Currency-

Denominated Loan Eliminating Variability in the Functional-Currency-
Equivalent Cash Flows (Fixed-to-Fixed Scenario)

55-81 This Example illustrates the application of the guidance in Subtopic 815-
20 and this Subtopic to accounting for a cash flow hedge of a fixed-rate
foreign-currency-denominated debt in which all of the variability in the
functional-currency-equivalent cash flows are eliminated by the effect of the
hedge.
55-82 On July 1, 20X1, Entity DEF, a U.S. dollar (USD) functional currency
entity, issues a zero-coupon debt instrument with a notional amount of FC
154,766.79 for FC 96,098.00. The interest rate implicit in the debt is 10
percent. The debt will mature on June 30, 20X6. Entity DEF enters into a
forward contract to buy FC 154,766.79 in 5 years at the forward rate of
1.090148194 (USD 168,718.74) and designates the forward contract as a
hedge of the variability of the USD functional currency equivalent cash flows
on the debt. Because the currency, notional amount, and maturity of the debt
and the forward contract match, the entity concludes that the hedging
relationship will achieve perfect offset. The USD interest rate implicit in the
Hedging 587
7. Hedging foreign currency exposures

forward contract is 11.028 percent. The market data, period end balances, and
journal entries from cash flow hedge accounting are as follows.
Spot Rate Forward Rate
USD/ USD/ Foreign
Functional Functional Forward Rate Currency USD Spot USD Debt Fair Value
Period Currency Currency Difference Present Value Amounts (@11.028%) Forward USD

0 1.040604383 1.090148194 0 $ 96,098.00 $100,000.00 $100,000.00 $ -

1 1.1 1.184985966 0.094837771 105,707.80 116,278.58 111.028.04 9,327.97
2 1.1 1.163142906 0.072994712 116,278.58 127,906.44 123,272.25 8,041.09
3 1.1 1.141702484 0.051554290 127,906.44 140,697.08 136,866.76 6,360.72
4 1.1 1.120657277 0.030509083 140,697.08 154,766.79 151,960.48 4,215.89
5 1.1 1.1 0.009851806 154,766.79 170,243.47 168,718.74 1,524.73
Other
Comprehen- Interest Transaction
Cash Forward Debt sive Income Expense Loss
7/1/20X1 Borrow money $ 100,000.00 $(100,000.00)
6/30/20X2 Accrue interest on
debt (10,570.78) $ 10,570.78
6/30/20X2 Mark debt to spot (5,707.80) $ (5,707.80)
6/30/20X2 Mark forward to fair
value $ 9,327.97 $ (4,077.43) 457.26 (5,707.80)
6/30/20X2 Balances 100,000.00 9,327.97 (116,278.58) (4,077.43) 11,028.04 -

6/30/20X3 Accrue interest on

debt (11,627.86) 11,627.86
6/30/20X3 Mark forward to fair
value (1,286.88) 670.53 616.35
6/30/20X3 Balances 100,000.00 8,041.08 (127,906.44) (3,406.90) 23,272.25

6/30/20X4 Accrue interest on

debt (12,790.64) 12,790.64 -
6/30/20X4 Mark forward to fair
value (1,680.37) 876.50 803.87
6/30/20X4 Balances 100,000.00 6,360.71 (140,697.08) (2,530.40) 36,866.76

6/30/20X5 Accrue interest on

debt (14,069.71) 14,069.71
6/30/20X5 Mark forward to fair
value (2,144.94) 1,120.83 1,024.01
6/30/20X5 Balances 100,000.00 4,215.98 (154,766.79) (1,409.57) 51,960.48

6/30/20X6 Accrue interest on

debt (15,476.68) 15,476.68
6/30/20X6 Mark forward to fair
value (2,691.15) 1,409.57 1,281.58
6/30/20X6 Balances $ 100,000.00 $ 1,524.72 $(170,243.47) $ - $ 68,718.74 -

55-83 Following are journal entries at inception of the loan and at the end of
the first year.

7/1//20X1 Debit Credit

Cash $ 100,000.00
Functional currency debt at spot $ 100,000.00
To record FC borrowing in USD.
6/30/20X2 Debit Credit
Interest expense $ 10,570.78
Debt $ 10,570.78
To accrue interest. Period and spot rate used for simplicity.
Transaction loss $ 5,707.80
Debt $ 5,707.80
To record a transaction loss on the debt.
Derivative asset $ 9,327.97
Hedging 588
7. Hedging foreign currency exposures

Other comprehensive income $ 9,327.97

To record a derivative instrument at fair value and record the gain on the
derivative in other comprehensive income.
Other comprehensive income $ 5,250.54
Interest expense 457.26
Transaction gain/loss $ 5,707.80
To reclassify an amount out of accumulated other comprehensive income to do both of
the following:
a. To increase interest expense to the USD yield of 11.028 percent.
b. To offset the transaction loss on the debt.
55-84 Journal entries for the remaining four years are not displayed.
55-85 This Example would also be relevant for a non-interest-bearing foreign-
currency-denominated receivable or payable instrument. An amount based on
the rate implicit in the forward contract would be reported in earnings each
period. Given the short maturities of many receivables and payables, the
amount reported in earnings each period may be small.

Excerpt from ASC 815-20

>> Example 15: Portions of a Foreign-Currency-Denominated Financial

Asset or Liability as Hedged Item

55-141 The following Cases illustrate the application of paragraph 815-20-25-41

to fixed-rate and variable-rate foreign-currency-denominated debt:
a. Foreign-currency-denominated fixed-rate debt (Case A)
b. Foreign-currency-denominated variable-rate debt (Case B).
55-142 Specifically, for each of the eight situations presented collectively in
Cases A (see paragraph 815-20-55-143) and B (see paragraph 815-20-55-153),
an entity can use cash flow hedge accounting to hedge the variability in the
specific principal repayments, interest cash flows, or both by applying the
guidance in paragraph 815-30-35-3(d) to the specifically identified hedged cash
flows. Only an amount that would offset the transaction gain or loss arising
from the remeasurement of a hedged cash flow would be reclassified each
period from other comprehensive income to earnings. Also, the change in the
fair value of the forward points (time value) attributable to the hedged future
cash flows would be reported in other comprehensive income, while the
change in the fair value of the forward points (time value) attributable to the
unhedged future cash flows would be reported in earnings.
>>> Case A: Foreign-Currency-Denominated Fixed-Rate Debt
55-143 Entity ABC, a U.S. dollar (USD) functional entity, issues a five-year
foreign-currency-denominated fixed-rate debt obligation that requires interest
payments and partial principal payments annually in the foreign currency with
the remaining principal due at the end of five years (maturity) in the foreign
currency. More specifically, Entity ABC issues an FC 45 million debt obligation
Hedging 589
7. Hedging foreign currency exposures

on December 31, 20X0, with FC 5 million due on December 31 of each of the

next 4 years and FC 25 million due on December 31, 20X5. Interest payments
at 10 percent are paid annually.
55-144 In this Case, Entity ABC can use cash flow hedge accounting to hedge
the variability in its functional-currency-equivalent cash flows associated with
any of the following:
a. All of the payments of both principal and interest of the debt
b. All of the payments of principal of the debt
c. All or a fixed portion of selected payments of either principal or interest of
the debt (such as either principal or interest payments on December 31,
2001, and December 31, 2003)
d. Selected payments of both principal and interest of the debt (such as
principal and interest payments on December 31, 2001, and December 31,
2003).
55-145 For instance, Entity ABC could use a receive-fixed-rate, pay-fixed rate
cross-currency interest rate swap or a series of forward contracts to eliminate
variability attributable to foreign exchange rates.
55-146 The following illustrates the second option, hedging the variability in all
principal cash flows attributable to foreign exchange risk.
55-147 Entity ABC enters into the following five forward contracts to hedge all
principal cash flows:
a. Forward contract to purchase FC 5,000 on December 31, 20X1, at a
forward rate of 1.05061019
b. Forward contract to purchase FC 5,000 on December 31, 20X2, at a
forward rate of 1.06061601
c. Forward contract to purchase FC 5,000 on December 31, 20X3, at a
forward rate of 1.07066924
d. Forward contract to purchase FC 5,000 on December 31, 20X4, at a
forward rate of 1.08076989
e. Forward contract to purchase FC 25,000 December 31, 20X5, at a forward
rate of 1.090871.
55-148 Exchange rates are as follows.
12/31/X1 12/31/X2 12/31/X3 12/31/X4 12/31/X5
Period Spot Forward Forward Forward Forward Forward
12/31/X0 1.04060438 1.05061019 1.06061601 1.07066924 1.08076989 1.090871
12/31/X1 1.1 1.12125604 1.14271548 1.16448149 1.18655697
12/31/X2 1.1 1.12125604 1.14272548 1.16448149
12/31/X3 1.1 1.12125604 1.14272548
12/31/X4 1.1 1.12125604
12/31/X5 1.1

55-149 Entity ABC would make the following journal entries.

Debit (Credit)

Accum. Other
Forward Income or Comprehensive
Cash Contracts Note Payable Expense Income

Inception 12/31/X0 46,827 (46,827)

December 31, 20X1 entries:
Hedging 590
7. Hedging foreign currency exposures

Repayment of principal (5,500) 5,203 297

Payment of interest (4,950) 4,950
Transaction loss on note
payable (2,376) 2,376
Fair value of forward contract
#1 247 (247)
Settlement of forward #1 247 (247)
Offset $247 of loss on principal
($50 related to cost of hedge
remains in earnings) (247) 247
Debit (Credit)

Accum. Other
Forward Income or Comprehensive
Cash Contracts Note Payable Expense Income

Fair value of forward contracts

#2-5 (based on 6% discount
rate) 2,853 (2,853)
Paragraph 815-30-35-3(d)
adjustment—offset the
transaction loss related to
principal (1,734) 1,734
Paragraph 815-30-35-3(d)
adjustment—effect of hedge 396 (396)

December 31, 20X2 entries:

Repayment of principal (5,500) 5,203 297
Payment of interest (4,400) 4,400
Fair value of forward contract
#2 (89) 89
Settlement of forward #2 197 (197)
Offset $197 of loss on principal
($100 related to cost of hedge
remains in earnings) (197) 197
Fair value of forward contracts
#3-5 (based on 6% discount
rate) (507) 507
Paragraph 815-30-35-3(d)
adjustment—effect of hedge 299 (299)
Change in time value related to
principal goes to other
comprehensive income or
change in time value related to
interest goes to earnings(a) 297 (180) (117)

December 31, 20X3 entries:

Repayment of principal (5,500) 5,203 297
Payment of interest (3,850) (3,850)
Fair value of forward contract
#3 (92) 92
Settlement of forward #3 147 (147)
Offset $147 of loss on principal
($150 related to cost of hedge
remains in earnings) (147) 147
Fair value of forward contracts
#4-5 (based on 6% discount
rate) (477) 477
Paragraph 815-30-35-3(d)
adjustment—effect of hedge 202 (202)
Change in time value related to
principal goes to other
comprehensive income or
change in time value related to
interest goes to earnings 297 (168) (129)

December 31, 20X4 entries:

Repayment of principal (5,500) 5,203 297
Payment of interest (3,300) 3,300
Hedging 591
7. Hedging foreign currency exposures

Fair value of forward contract

#4 (95) 95
Settlement of forward #4 96 (96)
Offset $96 of loss on principal
($201 related to cost of hedge
remains in earnings) (96) 96
Fair value of forward contract
#5 (based on 6% discount rate) (437) 437
Paragraph 815-30-35-3(d)
adjustment—effect of hedge 104 (104)
Debit (Credit)

Accum. Other
Forward Income or Comprehensive
Cash Contracts Note Payable Expense Income

Change in time value related to

principal goes to other
comprehensive income or
change in time value related to
interest goes to earnings 297 (154) (143)

December 31, 20X5 entries:

Repayment of principal (27,500) 26,015 1,485
Payment of interest (2,750) 2,750
Fair value of forward contract
#5 (488) 488
Settlement of forward #5 228 (228)
Offset $228 of loss on principal (228) 228
Paragraph 815-30-35-3(d)
adjustment—effect of hedge 1,485 (1,001) (484)
Change in time value related to
principal goes to other
comprehensive income or
change in time value related to
interest goes to earnings (140) (140)
(21,008) - - (b) -
a. The entry recording the $297 gain for the period ended December 31, 20X2, results from the spot
exchange rate remaining unchanged from December 31, 20X1, and one less period remaining on the loan
payable. The $117 principal portion of the gain goes to other comprehensive income because only principal
is being hedged. The $180 interest portion of the gain goes to earnings because interest is not being
hedged.
b. See Schedule 3 (paragraph 815-20-55-152) for income or expense for each period.

55-150 The following schedules support the preceding entries.

Functional Functional
Currency at Currency at
Foreign 12/31/X0 Current Spot Transaction
Schedule 1 Currency Spot Rate (1) Rate (2) Gain or Loss (2) – (1) Change in Time Value
12/31/X0
Principal 30,976(a) 32,234
Interest 14,024(a) 14,593
Loan value 45,000 46,827

12/31/X1
Principal 29,192 30,377 32,111 1,734
Interest 10,808 11,247 11,889 642
Loan value 40,000 41,624 44,000

12/31/X2
Principal 27,222 28,328 29,945 1,617 117 = (1,734 – 1,617)
Interest 7,778 8,093 8,555 462 180 = (642 – 462)
Loan value 35,000 36,421 38,500

12/31/X3
Principal 25,048 26,065 27,553 1,488 129 = (1,617 – 1,488)
Hedging 592
7. Hedging foreign currency exposures

Interest 4,952 5,153 5,447 294 168 = (462 – 294)

Loan value 30,000 31,218 33,000

12/31/X4
Principal 22,649 23,568 24,913 1,345 143
Interest 2,351 2,447 2,586 140 154
Loan value 25,000 26,015 27,500

12/31/X5 (before final principal payment is made)

Functional Functional
Currency at Currency at
Foreign 12/31/X0 Current Spot Transaction
Schedule 1 Currency Spot Rate (1) Rate (2) Gain or Loss (2) – (1) Change in Time Value
Principal 25,000 26,015 27,500 1,485 (140)
Interest - - - 140
Loan value 25,000 26,015 27,500

(a) The value ascribed to the principal portion was determined by discounting the future principal
payments at an annual rate of 10% compounded quarterly. The value ascribed to the interest
portion was determined by discounting future quarterly interest accruals at an annual rate
of 10%.

55-151 Schedule 2 provides the amount of cost attributed to each period for
each forward contract. Each period’s cost is determined based on applying the
interest method to each forward contract.
Forward Forward Forward Forward Forward
Schedule 2 Contract #1 Contract #2 Contract #3 Contract #4 Contract #5 Total

12/31/X1 $ 50.03 $ 49.79 $ 49.63 $ 49.50 $ 246.61 $ 445.56

12/31/X2 50.27 50.11 49.97 248.95 399.30
12/31/X3 50.59 50.44 251.31 352.34
12/31/X4 50.92 253.69 304.61
12/31/X5 256.11 256.11
Total $ 50.03 $ 100.06 $ 150.33 $ 200.83 $1,256.67 $1,757.92

55-152 Schedule 3 provides a breakdown for each year-end reporting period.

Schedule 3
12/31/X1
$ 4,950 Interest expense
446 Cost of hedge (396 + (297 – 247))
642 Transaction loss related to unhedged interest (2,376 – 1,734)
$ 6,038 Total expense

12/31/X2
$ 4,400 Interest expense
399 Cost of hedge (299 + (297 – 197))
(180) Time value related to unhedged interest
$ 4,619 Total expense

12/31/X3
$ 3,850 Interest expense
352 Cost of hedge (202 + (297 – 147))
(168) Time value related to unhedged interest
Hedging 593
7. Hedging foreign currency exposures

$ 4,034 Total expense

12/31/X4
$ 3,300 Interest expense
305 Cost of hedge (104 + (297 – 96))
(154) Time value related to unhedged interest
$ 3,451 Total expense

12/31/X5
$ 2,750 Interest expense
256 Cost of hedge (1,485 – (1,001 + 228))
(140) Time value related to unhedged interest
$ 2,866 Total expense

>>> Case B: Foreign-Currency-Denominated Variable-Rate Debt

55-153 Entity XYZ, a U.S. dollar (USD) functional entity issues a five-year
foreign-currency-denominated variable-rate debt obligation that requires
interest payments and partial principal payments annually in the foreign
currency with the remaining principal due at the end of five years (maturity) in
the foreign currency. More specifically, Entity XYZ issues an FC 45 million debt
obligation on December 31, 20X0, with FC 5 million due on December 31 of
each of the next 4 years and FC 25 million due on December 31, 20X5. Interest
payments are paid annually based on LIBOR.
55-154 In this Case the guidance in paragraph 815-20-25-41 provides that
Entity XYZ can use cash flow hedge accounting to hedge the variability in its
functional-currency-equivalent cash flows associated with any the following:
a. All of the payments of both principal and interest of the debt
b. All of the payments of principal of the debt
c. All or a fixed portion of selected payments of either principal or interest of
the debt
d. Selected payments of both principal and interest of the debt (such as
principal and interest payments on December 31, 2001, and December 31,
2003).
55-155 An entity could use a receive-variable-rate, pay-fixed-rate cross-currency
interest rate swap to eliminate variability attributable to interest rates and
foreign exchange rates. In cash flow hedges of recognized foreign-currency-
denominated assets and liabilities, the entity must assess whether the
changes in cash flows attributable to the risk being hedged are expected to
offset at the inception of the hedging relationship and on an ongoing basis. In a
manner similar to that described beginning in paragraph 815-30-35-25, the
entity would assess the effectiveness of the hedge using the hypothetical
derivative method. After the initial quantitative assessment of hedge
effectiveness, the entity may elect to assess hedge effectiveness on a
qualitative or quantitative basis.
Hedging 594
7. Hedging foreign currency exposures

12/31/X5
$ 2,750 Interest expense
256 Cost of hedge (1,485 – (1,001 + 228))
(140) Time value related to unhedged interest
$ 2,866 Total expense

>>> Case B: Foreign-Currency-Denominated Variable-Rate Debt

8. Net investment hedges

Detailed contents
8.1 How the standard works
8.2 Qualifying criteria for net investment hedges
8.2.10 Overview
8.2.20 Redesignation of the hedged item
Questions
8.2.10 Can foreign currency risk related to a forecasted equity
method investment be hedged?
8.2.20 Can the ending or average balance be designated as the
hedged item in a net investment hedge?
Example
8.2.10 Hedging a foreign net investment with a FCD liability of
another subsidiary
8.3 Hedging instruments
8.3.10 Overview
8.3.20 Counterparty to hedging instrument
8.3.30 Tandem currency hedges
8.3.40 Ineligible hedging instruments
Questions
8.3.10 Does the use of proceeds affect whether a FCD
nonderivative debt obligation can be used as the hedging
instrument in a net investment hedge?
8.3.20 Can FCD variable-rate debt that is the hedging instrument
in a net investment hedge be the hedged item in a cash
flow hedge of interest rate risk?
Example
8.3.10 Eligibility of financial instruments as hedging instruments
8.4 Assessing effectiveness
8.4.10 Overview
8.4.20 Spot method
8.4.30 Forward method
8.4.40 Changing the effectiveness assessment method
8.4.50 Counterparty credit risk and entity’s own nonperformance
risk
Questions
8.4.10 Does a change in tax rates affect effectiveness when it is
assessed on an after-tax basis?

8.4.20 Can the cross-currency basis spread be an excluded

component when a cross-currency interest rate swap is
used in a net investment hedge?
8.4.30 Where is the effect of the excluded components presented
in earnings?
8.4.40 What interest rate curves are considered comparable?
8.4.50 Can a hedging relationship be perfectly effective if a
derivative hedging instrument has a non-zero fair value at
designation?
8.4.60 What is the effect on a hedging relationship if the interest
rates in a qualifying cross-currency interest rate swap are
higher than normal market rates and the forward method is
used?
8.4.70 Has leverage been added to coupon rates in a qualifying
cross-currency interest rate swap that is designated in a
hedge after its initial recognition?
8.4.80 Is an entity permitted to change the method it uses to
assess effectiveness of a net investment hedge?
8.4.90 What does an entity consider in changing its method of
assessing effectiveness for a net investment hedge?
8.4.100 What does an entity consider when it dedesignates and
redesignates a net investment hedge?
Examples
8.4.10 Adjusting the notional of the hedging instrument when
hedging on an after-tax basis
8.4.20 Using the spot method when FCD debt is used to hedge a
net investment
8.4.30 Using the forward method when using a foreign currency
forward to hedge a net investment
8.5 Accounting for net investment hedges
8.5.10 Overview
8.5.20 Subsequent accounting for amounts in CTA
8.5.30 Assessing impairment
8.5.40 Discontinuing hedge accounting
Question
8.5.10 Is hedge accounting applied through the date an event
causes a hedging relationship to no longer be effective as
an economic hedge?
Example
8.5.10 Recognizing amounts in CTA

8.1 How the standard works

Throughout this chapter, FCD means foreign currency denominated.
A net investment hedge is a hedge of the exposure to foreign currency risk of
a net investment in a foreign operation.
When the comprehensive hedge accounting model in Topic 815 was
developed, the FASB did not reconsider the accounting for foreign currency
translation. As a result, the FASB decided to continue to permit hedge
accounting for net investment hedges, including that these hedging
relationships would continue to be subject to only certain hedging criteria.
Net investment hedges are subject only to the following hedging criteria.

General qualifying — Hedging instrument. The entity with the foreign

criteria for all foreign currency exposure needs to be a party to the hedging
currency hedges instrument (section 7.3.20).
(Section 7.3) — Hedged item or transaction. The hedged net
investment needs to be denominated in a currency
other than the entity’s functional currency
(section 7.3.30).

Hedge effectiveness — The hedging instrument must be both designated and

(Section 8.4) effective as an economic hedge of the net
investment.
— The entity assesses effectiveness at least quarterly
and whenever financial statements or earnings are
reported.

Formal The entity formally documents the hedging relationship.

documentation
(Section 2.9)

In general, the net investment hedge accounting model works as follows.

The following diagram shows the general accounting and presentation for a net
investment hedging relationship (assuming there are no excluded components).

Hedging instrument Hedged item – Net investment

(derivative or nonderivative) in foreign operation

Entire change in fair value

of derivative (or transaction Apply Topic 830, including
gain or loss of nonderivative) recording translation gains
hedging instrument or losses in CTA
recorded in CTA

Reclassified when hedged Reclassified when hedged

net investment is sold, net investment is sold,
exchanged or liquidated exchanged or liquidated

Record in the same income statement line item1

Note:
In certain situations, a portion of the translation gain or loss should be reclassified from
CTA to noncontrolling interest (see section 8.5.20).

8.2 Qualifying criteria for net investment hedges

8.2.10 Overview
The objective of a net investment hedge is to reduce or eliminate the exposure
to foreign currency risk of a net investment in a foreign operation.
A net investment in a foreign operation includes incorporated and
unincorporated business structures such as subsidiaries, divisions, branches,
joint ventures, consolidated variable interest entities and equity method
investments.
Topic 830 (foreign currency matters) provides accounting guidance on foreign
currency transactions and the translation of financial statements. Before the
comprehensive hedge accounting model in Topic 815 was established, the
foreign currency accounting guidance permitted hedge accounting for net
investments and practice in this area was well-established. When the
comprehensive hedge accounting model was developed, the FASB did not
reconsider the accounting for foreign currency translation. As a result, the FASB
decided to continue to permit hedge accounting for net investment hedges,
including that these hedging relationships would only be subject to certain
hedging criteria. [FAS 133.BC475–.478]
Designation of a net investment in a foreign operation as a hedged item is
permitted even though it is considered the same as designating a group of
dissimilar assets and liabilities as the hedged item, which is not permitted for a
fair value hedge or cash flow hedge.
Net investment hedges are subject only to the following hedging criteria:
— The operating unit with the foreign currency exposure needs to be a party
to the hedging instrument (see section 7.3.20). [815-20-25-30(a)]
— The hedged net investment needs to be denominated in a currency other
than the entity’s functional currency (see section 7.3.30). [815-20-25-30(b)]
— The entity needs to formally document the hedging relationship. The
documentation requirements for net investment hedges are the same as
those for other hedging relationships (see section 2.9). [815-20-25-3(b)]
— The entity needs to assess effectiveness at least quarterly and whenever
financial statements or earnings are reported (see sections 8.2.20 and 8.4).
[815-35-35-27]

— The hedging instrument must be designated and effective as an economic

hedge of the net investment (see section 8.4). [815-20-25-26(e), 830-20-35-3]
As highlighted above, the operating unit that has the foreign currency
exposure must be a party to the hedging instrument. However, as explained in
section 7.3.20, another member of the consolidated group that has the same
functional currency as the operating unit may instead be a party to the hedging
instrument if there is no intervening subsidiary with a different functional
currency. [815-20-25-23, 25-24, 25-30(a)]

Question 8.2.10
Can foreign currency risk related to a forecasted
equity method investment be hedged?
Background: ABC Corp.’s functional currency is the US dollar. ABC anticipates
acquiring a 35% equity interest in a Korean car manufacturer. ABC has signed a
purchase contract and has publicly announced the terms of the acquisition,
which include a fixed price of 10 billion Korean won (₩). The expected
consummation date is July 1, Year 1.
Once it is acquired, ABC will account for the investment using the equity
method. ABC forecasts that ₩500 million of net income will be earned related
to the investment in the year after the acquisition.
Scenario 1: ABC wants to hedge the foreign currency risk related to the
forecasted purchase of the equity method investee
Interpretive response: No. As explained in section 2.5.20, cash flow hedges of
transactions relating to investments accounted for by the equity method are not
permitted. Because ABC will account for the investment using the equity
method, it cannot designate the forecasted transaction as the hedged item in a
cash flow hedge. [815-20-25-43(b)(1)]
Scenario 2: ABC wants to hedge the foreign currency risk related to
forecasted earnings of the investment after the acquisition
Interpretive response: No. Although ABC may designate the recognized equity
method investee as the hedged item in a net investment of a foreign operation,
forecasted earnings cannot be hedged. This is because net income represents
the netting of many dissimilar transactions, rather than a series of individual but
similar transactions sharing the same risk exposure. Additionally, dividends from
an equity method investment may not be designated as the hedged item.
[FAS 133.BC485, 815-20-25-39(c)]

Example 8.2.10
Hedging a foreign net investment with a FCD liability
of another subsidiary
Parent’s functional currency is the US dollar. Parent has two subsidiaries: Sub
NZ in New Zealand and Sub J in Japan. The functional currency of Sub J is its
local currency (Japanese yen).
Scenario 1: Sub NZ’s functional currency is its local currency (NZ dollar)
Sub NZ issues yen-denominated notes. Parent is not permitted to designate the
yen-denominated notes issued by Sub NZ as the hedging instrument in a hedge
of its net investment in Sub J. This is because Sub NZ is not part of the
operating unit that has the foreign currency exposure and Sub NZ has a
functional currency different from that of the Parent.
Scenario 2: Sub NZ’s functional currency is the US dollar
Sub NZ issues yen-denominated notes and Parent designates those notes
payable as the hedging instrument in its hedge of its net investment in Sub J.

This is permissible because Sub NZ has the same functional currency as Parent
and there are no intervening subsidiaries with a different functional currency.
On a consolidated basis, Parent translates Sub J’s financial statements from its
functional currency into US dollars. Any foreign currency translation gains or
losses are recorded in CTA in AOCI.
In its stand-alone financial statements, Sub NZ’s yen-denominated notes are
remeasured at spot through earnings to its functional currency (the US dollar) at
period-end because the hedging relationship and related hedge accounting exist
only in the context of Parent’s consolidated financial statements.
However, if Sub NZ’s yen-denominated notes are effective at hedging the
exchange gains or losses arising on translation of Sub J’s financial statements
from yen to US dollars, the gain or loss in Sub NZ’s stand-alone financial
statements related to remeasuring the yen-denominated notes to US dollars is
reclassified in consolidation to CTA in AOCI (i.e. in Parent’s consolidated
financial statements).

8.2.20 Redesignation of the hedged item

Excerpt from Subtopic 815-35

> Redesignation
35-27 If an entity documents that the effectiveness of its hedge of the net
investment in a foreign operation will be assessed based on the beginning
balance of its net investment and the entity’s net investment changes during
the year, the entity shall consider the need to redesignate the hedging
relationship (to indicate what the hedging instrument is and what numerical
portion of the current net investment is the hedged portion) whenever financial
statements or earnings are reported, and at least every three months. An entity
is not required to redesignate the hedging relationship more frequently even
when a significant transaction (for example, a dividend) occurs during the
interim period. Example 1 (see paragraph 815-35-55-1) illustrates the
application of this guidance.

Determining the amount of the net investment to hedge presents a challenge

because the net investment balance is constantly changing as the foreign
operation generates profits and losses. In practice, an entity designates the
beginning balance (or a specified amount of it) as the hedged item (see
Question 8.2.20). [815-35-35-27]
An entity is required to consider the need to prospectively redesignate the
hedging relationship whenever financial statements or earnings are reported,
and at least every three months. [815-35-35-27]
An entity is not required to redesignate the hedging relationship more
frequently even when a significant transaction (e.g. a dividend or additional
investment) occurs during the interim period. However, an entity may wish to
do so to avoid volatility in the CTA in AOCI related to the net investment. [815-35-
35-27]

This is because when the beginning balance of the net investment is

designated as the hedged item, the hedging instrument is also designated
based on that beginning balance (see Question 8.2.20). However, the ending
balance of the net investment is translated in consolidation. As a result, when
significant transactions occur during the interim period and the hedge is not
redesignated, the translation of the net investment’s ending balance (which is
recorded in CTA in AOCI) may not be exactly offset by the remeasurement of
the hedging instrument that is recognized in CTA in AOCI. Redesignating the
hedging relationship more frequently may reduce the volatility resulting from
this lack of offset. [815-35-35-27]

Question 8.2.20
Can the ending or average balance be designated as
the hedged item in a net investment hedge?
Interpretive response: No. We believe using the ending or average balance
would be equivalent to hedging the foreign currency exposure associated
with the future earnings (loss) of a foreign operation. As discussed in
Question 8.2.10, it is not permitted to hedge the future earnings of a foreign
operation.
Instead, we believe an entity should assess the effectiveness of the hedging
relationship based on the beginning balance of the net investment.
An entity that expects its net investment in a foreign operation to decrease
during the quarter may want to consider redesignating the hedged amount at
the beginning of each month to mitigate the amount of volatility that would
otherwise be included in the CTA in AOCI. This may be preferable if the entity
expects significant decreases during a quarter.

FASB Example: Frequency of designation of hedged net

investment
Subtopic 815-35’s Example 1 (paragraph 815-35-35-1) illustrates assessing the
effectiveness of a hedge of the foreign currency exposure of a net investment
when the balance changes.
— In the first scenario (paragraph 815-35-55-1(a)), the entity could enter into an
additional forward contract to hedge the net investment balance exceeding
the original forward contract’s notional amount.
— In both scenarios (paragraphs 815-35-55-1(a) and 55-1(b)), the full change in
the fair value of the foreign currency forward contract would be recorded in
the CTA in AOCI for the quarter then ended.

Excerpt from Subtopic 815-35

>> Example 1: Frequency of Designation of Hedged Net Investment

55-1 This Example illustrates the application of paragraph 815-35-35-27.

Assume that an entity enters into a foreign currency forward contract that has
a notional amount equal to the beginning balance of its investment in a
foreign operation (for example, 100,000 foreign currency units [FC]). This
foreign currency forward contract is immediately designated as a hedge of the
entire beginning balance of the net investment at the inception of the hedge.
As the net investment changes, the entity would periodically assess the
original hedging relationship and decide whether it needs to remove (that is,
dedesignate) that original relationship and designate a new hedging
relationship for the following assessment period. The following presents one
method of such redesignation in those circumstances in which the entity
chooses not to obtain a new derivative instrument:
a. If the net investment had increased (for example, to FC 120,000), the
entire forward contract would be designated prospectively as hedging only
a portion of the beginning balance of the net investment in that foreign
operation. The hedged portion would be the ratio of the net investment at
the inception of the hedge to the net investment at the beginning of the
new assessment period (for example, five-sixths of the FC 120,000).
b. If the net investment had decreased (for example, to FC 90,000), only a
proportion of the forward contract would be designated prospectively as
hedging the entire beginning balance of the net investment in that foreign
operation. The proportion of the forward contract designated prospectively
as the hedging instrument would be the ratio of the net investment at the
beginning of the new assessment period to the net investment at the
inception of the hedge (for example, nine-tenths of the forward contract).
The proportion of the forward contract not designated prospectively as the
hedging instrument in the net investment hedge could be designated as a
hedging instrument in a different hedging relationship or simply reported at
fair value with its gain or loss after the dedesignation date recognized
currently in earnings pursuant to paragraph 815-20-35-1(a).

8.3 Hedging instruments

8.3.10 Overview

Excerpt from Subtopic 815-20

>>> Hedging Instruments in Net Investment Hedges

25-66 A derivative instrument or a nonderivative financial instrument that may
give rise to a foreign currency transaction gain or loss under Subtopic 830-20
can be designated as hedging the foreign currency exposure of a net

investment in a foreign operation provided the conditions in paragraph 815-20-

25-30 are met. A nonderivative financial instrument that is reported at fair value
does not give rise to a foreign currency transaction gain or loss under Subtopic
830-20 and, thus, cannot be designated as hedging the foreign currency
exposure of a net investment in a foreign operation.
>>>> Foreign-Currency-Denominated Debt Instrument as both Hedging
Instrument and Hedged Item
55-38 A foreign-currency-denominated debt instrument that is designated as
the hedging instrument in a net investment hedge may also be designated as
the hedged item in a fair value hedge of interest rate risk. The two hedging
relationships address separate risk types that are permitted to be hedged
individually under this Subtopic. Example 10 (see paragraph 815-20-55-127)
illustrates this circumstance.

An entity may designate a derivative instrument or a FCD nonderivative financial

liability as a hedge of the foreign currency exposure inherent in a net
investment in a foreign operation, consistent with Topic 830 (foreign currency
matters). [815-20-25-66]
To be used as a hedging instrument, a FCD nonderivative is required to be a
financial liability that gives rise to a foreign currency transaction gain or loss
under Topic 830. A FCD nonderivative that is reported at fair value (e.g. an
instrument to which an entity has chosen to apply the fair value option under
Topic 825 (financial instruments)) cannot be used as a hedging instrument
because it does not give rise to a foreign currency transaction gain or loss under
Topic 830. [815-20-25-66]
A FCD fixed-rate debt instrument designated as the hedging instrument in a net
investment hedge may also be designated as the hedged item in a fair value
hedge of interest rate risk. The two hedging relationships address separate
types of risk, which can be hedged individually.
As a result of applying fair value hedge accounting, the debt’s carrying amount
will be adjusted to reflect changes in its FCD fair value attributable to interest
rate risk. As a result, the notional amount of the debt designated to hedge the
net investment amount will change over time, which may cause an entity to
adjust the amount of the hedged net investment as discussed in section 8.2.20.
For an example of using a FCD fixed-rate debt instrument as a hedging
instrument and a hedged item in a fair value hedge of interest rate risk, see
Subtopic 815-20’s Example 10 (reproduced in this section). [815-20-55-38, 55-129]
Cross-currency interest rate swaps that have either two fixed-rate legs or two
variable-rate legs are eligible as hedging instruments. However, Topic 815
prohibits using compound derivatives as hedging instruments. As a result, cross-
currency interest rate swaps with one fixed-rate and one variable-rate are not
eligible as hedging instruments. Topic 815 also prohibits using a combination of
hedging instruments (i.e. a single synthetic instrument) as a hedging
instrument. For further discussion, see section 8.3.40. [815-20-25-67 – 25-68]
The hedging instrument’s gain or loss included in the effectiveness assessment
is reported in CTA, consistent with the accounting for the net investment.
[815-35-35-1 – 35-2]

Question 8.3.10
Does the use of proceeds affect whether a FCD
nonderivative debt obligation can be used as the
hedging instrument in a net investment hedge?
Background: Parent’s functional currency is the US dollar. Parent has a UK
subsidiary and its functional currency is the pound sterling. Parent issues a debt
obligation denominated in pound sterling to a third party and uses the proceeds
to finance its US operations. Parent did not elect the fair value option for the
debt obligation.
Interpretive response: No. A FCD nonderivative financial liability is eligible to
be used as the hedging instrument in a hedge of a net investment in a foreign
operation without regard to how the proceeds are used, provided it gives rise to
a transaction gain or loss under Topic 830.
Because Parent’s debt obligation is denominated in pound sterling, its
remeasurement each period to the Parent’s functional currency (US dollar) will
give rise to a transaction gain or loss. As a result, Parent may designate the
debt obligation as a hedging instrument in a net investment hedge of its net
investment in the UK subsidiary. [815-20-25-66]

Question 8.3.20
Can FCD variable-rate debt that is the hedging
instrument in a net investment hedge be the
hedged item in a cash flow hedge of interest rate
risk?
Interpretive response: Yes, we believe a FCD variable-rate debt instrument
may be designated as the hedging instrument in a net investment hedge and
also be the hedged item in a cash flow hedge of interest rate risk.
The cash flow hedge accounting model does not result in adjusting the notional
amount of the debt, so the quarterly redesignation (discussed in section 8.2.20)
would focus on changes of the net investment balance in assessing the
prospective hedged amount.

FASB Example: FCD debt instrument as both hedging

instrument and hedged item

Excerpt from Subtopic 815-20

>> Example 10: Foreign-Currency-Denominated Debt Instrument as both

Hedging Instrument and Hedged Item

55-127 This Example illustrates the application of paragraph 815-20-55-38.

55-128 A U.S. parent entity (Parent A) with a U.S. dollar (USD) functional
currency has a German subsidiary that has the Euro (EUR) as its functional
currency. On January 1, 2001, Parent A issues a five-year, fixed-rate EUR-
denominated debt instrument and designates that EUR-denominated debt
instrument as a hedge of its net investment in the German subsidiary. On the
same date, Parent A enters into a five-year EUR-denominated receive-fixed,
pay-Euribor-interest rate swap. Parent A designates the interest rate swap as a
hedge of the foreign-currency-denominated fair value of the fixed-rate EUR-
denominated debt instrument attributable to changes in Euribor interest rates,
which is considered the benchmark interest rate for a hedge of the EUR-
denominated fair value of that instrument.
55-129 As permitted by paragraph 815-20-55-38, Parent A may designate the
EUR-denominated debt instrument as a hedge of its net investment in the
German subsidiary and also as the hedged item in a fair value hedge of the
debt instrument’s foreign-currency-denominated fair value attributable to
changes in the designated benchmark interest rate. As a result of applying fair
value hedge accounting, the debt’s carrying amount will be adjusted to reflect
changes in its foreign-currency-denominated fair value attributable to interest
rate risk. The notional amount of the debt that is designated as the hedging
instrument in the net investment hedge will change over time such that it may
not match the notional amount of the hedged net investment. The entity then
applies the net investment hedge guidance in Subtopic 815-35 and the fair
value hedge guidance in Subtopic 815-25. As discussed in paragraphs 815-35-
35-13 through 35-14, because the notional amount of the nonderivative
instrument designated as a hedge of the net investment does not match the
portion of the net investment designated as being hedged, hedge
effectiveness is assessed by comparing the following two values:
a. The foreign currency transaction gain or loss based on the spot rate change
(after tax effects, if appropriate) of that nonderivative hedging instrument
b. The transaction gain or loss based on the spot rate change (after tax
effects, if appropriate) that would result from the appropriate hypothetical
nonderivative instrument that has a notional amount that matches the
portion of the net investment being hedged. The hypothetical nonderivative
instrument also would have a maturity that matches the maturity of the
actual nonderivative instrument designated as the net investment hedge.

8.3.20 Counterparty to hedging instrument

A derivative or nonderivative hedging instrument can be with either an
unrelated third party or with a related party.
However, an internal derivative cannot be considered a hedging instrument in
the consolidated financial statements unless the risk acquired through the
internal derivative has been offset with an unrelated third-party derivative
contract. That is, the counterparty to the internal derivative (usually a treasury
center) is required to enter into an offsetting contract with a third party.
This is because internal derivatives do not offset foreign currency exposure on a
consolidated basis. Instead, they merely transfer the exposure from one party
to another and may alter the form of the exposure if the functional currencies of
the two entities are different. Unless an internal derivative is offset by a

contract that transfers the exposure to an unrelated third party, the consolidated
exposure has not been offset.
Similarly, an intercompany FCD liability cannot be considered a hedging
instrument in the consolidated financial statements unless the counterparty to
the FCD liability has entered into an unrelated third-party nonderivative financial
instrument that offsets the foreign currency exposure. This requirement is the
same as the requirement when using a FCD nonderivative as the hedging
instrument to hedge the risk of changes in fair value attributable to changes in a
foreign currency exchange rate associated with an unrecognized firm
commitment. For further discussion, see section 7.4.60, including
Question 7.4.40.

8.3.30 Tandem currency hedges

Excerpt from Subtopic 815-20

>>> Hedging Instruments in Net Investment Hedges

25-69 To designate a derivative instrument as a hedge of a net investment, an
entity shall have an expectation that the derivative instrument will be effective
as an economic hedge of foreign exchange risk associated with the hedged net
investment. Accordingly, if any difference in notional amount, currencies, or
underlyings is present, the entity shall establish an expectation that the actual
derivative instrument designated as the hedging instrument will be effective as
an economic hedge.
25-70 For example, if an entity designates a derivative instrument that has an
underlying exchange rate involving a currency other than the functional
currency of the net investment, that exchange rate shall be expected to move
in tandem with the exchange rate between the functional currency of the
hedged net investment and the investor’s functional currency. Use of a
currency different from the exposed currency is not limited to cases in which it
is not practical or feasible to hedge in the exposed currency if all other
qualifying criteria are met.

As discussed in section 7.3.40 (tandem or cross-currency hedging), an entity is

not required to use a derivative instrument denominated in the same foreign
currency as the hedged item. Instead, a hedging transaction can involve
‘tandem’ currencies – i.e. currencies from two different countries that are highly
correlated. This is permitted as long as the hedging relationship is expected to
be effective as an economic hedge. [815-20-25-33, 815-35-25-69 – 25-70]
See Subtopic 815-20’s Example 10 (reproduced in section 8.3.10) for an
example of a tandem currency hedge.

8.3.40 Ineligible hedging instruments

Excerpt from Subtopic 815-20

>> Instruments Specifically Ineligible for Designation as Hedging

Instruments
25-71 Besides those hedging instruments that fail to meet the specified
eligibility criteria, none of the following shall be designated as a hedging
instrument for the respective hedges:
d. With respect to net investment hedges only:
1. A compound derivative instrument that has multiple underlyings—one
based on foreign exchange risk and one or more not based on foreign
exchange (for example, the price of gold or the price of an S&P 500
contract), except as indicated in paragraph 815-20-25-67 for certain
cross-currency interest rate swaps
2. A derivative instrument and a cash instrument in combination as a
single hedging instrument (that is, an entity shall not consider a
separate derivative instrument and a cash instrument as a single
synthetic instrument for accounting purposes)

Topic 815 prohibits using a compound derivative or a combined hedging

instrument (i.e. a single synthetic instrument) as a hedging instrument. [815-20-
25-71(d)]

Compound derivatives

Excerpt from Subtopic 815-20

>>> Hedging Instruments in Net Investment Hedges

25-67 Hedging instruments that are eligible for designation in a net investment
hedge include, among others, both of the following:
a. A receive-variable-rate, pay-variable-rate cross-currency interest rate swap,
provided both of the following conditions are met:
1. The interest rates are based on the same currencies contained in the
swap.
2. Both legs of the swap have the same repricing intervals and dates.
b. A receive-fixed-rate, pay-fixed-rate cross-currency interest rate swap. A
cross-currency interest rate swap that has two fixed legs is not a
compound derivative instrument and, therefore, is not subject to the
criteria in (a).
25-68 A cross-currency interest rate swap that has either two variable legs or
two fixed legs has a fair value that is primarily driven by changes in foreign
exchange rates rather than changes in interest rates. Therefore, foreign
exchange risk, rather than interest rate risk, is the dominant risk exposure in
such a swap.

25-68A Under the guidance in paragraph 815-20-25-71(d)(1), a cross-currency

interest rate swap with one fixed-rate leg and one floating-rate leg cannot be
designated as the hedging instrument in a net investment hedge.

An entity may not use a compound derivative that has multiple underlyings –
one based on foreign currency risk and one or more not based on foreign
currency risk (e.g. interest rate index, Standard & Poor’s 500) – as the hedging
instrument in a net investment hedge. [815-20-25-71(d)(1)]
Topic 815 provides the following guidance regarding whether different types of
cross-currency interest rate swaps may be used as hedging instruments in a
net investment hedge.

Two variable A receive-variable, pay-variable cross-currency interest rate swap

legs or two can be designated as the hedging instrument in a net investment
fixed legs hedge if:
[815-20-25-67, — the interest rates are based on the same currencies
25-68] contained in the swap; and
— both legs of the swap have the same repricing intervals and
dates.
A receive-fixed, pay-fixed cross-currency interest rate swap is not
a compound derivative and may be designated as the hedging
instrument in a net investment hedge. This type of derivative
reacts very similarly to a foreign currency forward contract.
These cross-currency interest rate swaps may be used because
their fair value is primarily driven by changes in foreign exchange
rates rather than changes in interest rates. Therefore, foreign
currency risk – rather than interest rate risk – is the dominant risk
exposure in such swaps.

One fixed and A cross-currency interest rate swap with one fixed-rate leg and
one variable leg one variable-rate leg may not be designated as the hedging
instrument in a net investment hedge.
[815-20-25-68A]

Synthetic hedging instruments

Excerpt from Subtopic 815-20

>>> Synthetic Foreign Currency Borrowing Ineligible as a Hedging

Instrument
55-49 A debt instrument denominated in the investor’s functional currency and
a cross-currency interest rate swap cannot be accounted for as synthetically
created foreign-currency-denominated debt to be designated as a hedge of the
entity’s net investment in a foreign operation.
55-50 For example, a parent entity that has the U.S. dollar (USD) as its
functional and reporting currency has a net investment in a Japanese yen-
(JPY-) functional-currency subsidiary. The parent borrows in euros (EUR) on a
fixed-rate basis and simultaneously enters into a receive-EUR, pay-Japanese
yen currency swap (for all interest and principal payments) to synthetically

convert the borrowing into a yen-denominated borrowing. The parent entity

cannot designate the EUR-denominated borrowing and the currency swap in
combination as a hedging instrument for its net investment in the JPY-
functional-currency subsidiary.
55-51 An approach that would involve measuring a derivative instrument and a
cash instrument as a single unit at the current spot rate (which is used in the
translation of the hedged net investment) violates the requirements of
Subtopic 830-20 for translation of foreign-currency-denominated borrowings at
the spot rate relevant to the currency of the borrowing. It also violates the
requirements of Subtopic 815-10 for measurement of all derivative instruments
at fair value. Accordingly, combining the EUR-denominated borrowing and the
currency swap for designation as a single hedging instrument—a JPY-
denominated borrowing—in a net investment hedge is not permitted.
55-52 In contrast, an entity could designate a foreign currency derivative
instrument and a foreign-currency-denominated cash instrument individually as
hedging different portions of its net investment in a foreign operation provided
the derivative instrument and the cash instrument each individually qualified as
a hedging instrument.
55-53 For example, a JPY-USD forward contract and a JPY-denominated cash
instrument could each be designated as the hedging instrument in a hedge of
different portions of the net investment in a JPY-functional-currency subsidiary
(that is, two separate hedging relationships would be designated).

Topic 815 prohibits considering a separate derivative and a nonderivative

financial instrument as a combined hedging instrument (i.e. single synthetic
instrument) for hedge accounting purposes. [815-20-25-71(d)(2), 55-49]
This approach is prohibited because it would result in measuring a derivative
and a financial instrument as a single unit at the current spot rate (synthetic
accounting). This violates the requirements of Topic 830 for remeasurement of
FCD debt at the spot rate relevant to the currency of the borrowing. It also
violates the requirements of Topic 815 to measure all derivatives at fair value.
[815-20-55-51]

However, an entity may designate a foreign currency derivative and a FCD

nonderivative financial liability individually as hedging instruments that are
hedging different portions of its net investment in a foreign operation. This is
permitted if each of the instruments qualifies individually as a hedging
instrument. [815-20-55-52]

Example 8.3.10
Eligibility of financial instruments as hedging
instruments
The following example is based on paragraphs 815-20-55-50 and 55-3.
Parent has the US dollar as both its functional currency and its reporting
currency. It has a net investment in a Japanese subsidiary (Sub J), which has
Japanese yen as its functional currency.

Scenario 1: Synthetic fixed-rate, yen-denominated borrowing

Parent has both of the following financial instruments:
— fixed-rate, euro-denominated debt; and
— receive-euros, pay-yen currency swap (for all interest and principal
payments on the euro-denominated debt).
As a result of the combination of these financial instruments, Parent has
synthetically converted its borrowing into a fixed-rate, yen-denominated
borrowing.
Parent is not permitted to designate the synthetic fixed-rate, yen-denominated
borrowing as a hedging instrument for its net investment in Sub J.
Scenario 2: Separate forward contract and yen-denominated financial
liability
Parent has both of the following:
— yen-US dollar forward contract; and
— yen-denominated nonderivative financial liability.
Each of these financial instruments could be designated as the hedging
instrument in a hedge of different portions of the net investment in Sub J (i.e.
two separate hedging relationships would be designated), as long as each
qualifies individually as a hedging instrument.

8.4 Assessing effectiveness

8.4.10 Overview

Excerpt from Subtopic 815-35

> Assessing Hedge Effectiveness and Measuring Hedge Results

35-4 If a derivative instrument is used as the hedging instrument, an entity
may assess the effectiveness of a net investment hedge using either a
method based on changes in spot exchange rates (as specified in
paragraphs 815-35-35-5 through 35-15) or a method based on changes in
forward exchange rates (as specified in paragraphs 815-35-35-17 through 35-
26). This guidance can also be applied to purchased options used as hedging
instruments in a net investment hedge. However, an entity shall consistently
use the same method for all its net investment hedges in which the hedging
instrument is a derivative instrument; use of the spot method for some net
investment hedges and the forward method for other net investment hedges
is not permitted. An entity may change the method that it chooses to assess
the effectiveness of its net investment hedges in accordance with
paragraphs 815-20-55-55 through 55-56A.
35-4A Hedge effectiveness shall be assessed on a quantitative basis at hedge
inception in accordance with paragraph 815-20-25-3(b)(2)(iv)(01) unless one of
the exceptions in that paragraph applies. Subsequent assessments of hedge

effectiveness may be performed either on a quantitative basis or on a

qualitative basis in accordance with paragraphs 815-20-35-2 through 35-2F.

To designate a derivative or FCD nonderivative as a hedging instrument in a net

investment hedge, the relationship must be expected to be – and actually be –
effective as an economic hedge of foreign currency risk associated with the
hedged net investment. The entity is required to assess effectiveness of a net
investment hedge at least quarterly and whenever financial statements or
earnings are reported. [815-20-25-26(e), 815-35-35-27]
At inception, an entity is required to assess effectiveness quantitatively,
unless the conditions that will result in perfect effectiveness are met (see
sections 8.4.20 and 8.4.30). [815-20-25-3(b)(2)(iv), 815-35-35-5, 35-12]
Subsequently, an entity may assess effectiveness quantitatively, or qualitatively
if certain conditions are met. See Questions 9.2.50 regarding whether a
quantitative or qualitative method is used when the conditions that will result in
perfect effectiveness are met; and section 9.5 for a discussion of the qualitative
method. [815-35-35-4A]
Depending on the hedging instrument, an entity may assess effectiveness on a
quantitative basis using a method based on either changes in spot exchange
rates (the spot method) or changes in forward exchange rates (the forward
method). [815-35-35-4]
The following table summarizes these methods as relevant for the categories of
hedging instruments.

Hedging instrument category Effectiveness assessment method(s)

Derivative instrument — Spot method (i.e. intrinsic value

E.g. a cross-currency interest rate swap, method for purchased options)
a foreign currency forward contract, — Forward method (i.e. total value for
purchased option purchased options)
— While either method is appropriate,
the same method is required to be
used for all net investment hedges
using derivative hedging
instruments.
[815-35-35-4]

Nonderivative financial instrument Spot method [815-35-35-14]

E.g. FCD debt obligation

Topic 815 permits hedging foreign currency risk on an after-tax basis, provided
that the documentation of the hedge at inception indicated that the assessment
of effectiveness will be on an after-tax basis (rather than on a pre-tax basis).
[815-20-25-3(b)(2)(vi)]

If an entity has elected to hedge foreign currency risk on an after-tax basis, it

must adjust the notional amount of its hedging instrument appropriately to
reflect the effect of tax rates. In that case, the hypothetical derivative contract
used to assess effectiveness when a hedging relationship is not perfectly
effective should have a notional amount that has been appropriately adjusted

(pursuant to the documentation at inception) to reflect the effect of the after-tax

approach. [815-35-35-26]

Question 8.4.10
Does a change in tax rates affect effectiveness
when it is assessed on an after-tax basis?
Interpretive response: Yes. When effectiveness is assessed on an after-tax
basis, the notional amount of the hedging instrument must be adjusted to
appropriately reflect the effect of tax rates. If tax rates change, the notional
amount of a hedging instrument that would result in perfect effectiveness is
affected by the change in tax rates.
As a result, if an entity has a hedging relationship that is perfectly effective and
tax rates change, the hedging relationship will no longer be perfectly effective
unless the entity redesignates the hedging relationship taking into consideration
the effect of the changed tax rates.

Example 8.4.10
Adjusting the notional of the hedging instrument
when hedging on an after-tax basis
Parent’s functional currency is the US dollar. Parent has a wholly owned
subsidiary, Sub, whose functional currency is the euro (€). As of January 1,
Year 1, Parent has a net investment in Sub of €100 million.
Parent asserts indefinite reinvestment of Sub’s foreign earnings and therefore
does not provide deferred taxes on its outside basis difference. It does provide
deferred taxes on the derivative’s unrealized gains and losses because those
amounts are not taxable or deductible until realized.
When designating its hedging relationship as of January 1, Year 1, Parent
considered its enacted tax rate of 21% and designated a forward contract with
a notional amount of €126.6 million [€100 million ÷ (1 - 21%)] to perfectly offset
(on an after-tax basis) the foreign currency changes in its €100 million net
investment in Sub.

8.4.20 Spot method

An entity may elect to assess effectiveness based on spot rates when the
hedging instrument is a derivative. Additionally, this method is used when the
hedging instrument is a FCD nonderivative.

Derivative hedging instrument

Excerpt from Subtopic 815-35

>>> Hedging Instrument Is a Derivative Instrument

35-5 The change in the fair value of the derivative instrument attributable to
changes in the difference between the forward rate and spot rate would be
excluded from the assessment of hedge effectiveness if all of the following
conditions are met:
a. The notional amount of the derivative instrument designated as a hedge
of a net investment in a foreign operation matches (that is, equals) the
portion of the net investment designated as being hedged.
b. The derivative instrument's underlying exchange rate is the exchange rate
between the functional currency of the hedged net investment and the
investor’s functional currency.
c. When the hedging derivative instrument is a cross-currency interest rate
swap, it is eligible for designation in a net investment hedge in accordance
with paragraph 815-20-25-67.
In that circumstance, the hedging relationship would be considered perfectly
effective, and no quantitative effectiveness assessment is required at hedge
inception. (See paragraph 815-20-25-3(b)(2)(iv)(01).)
35-5A An entity shall recognize in earnings the initial value of the component
excluded from the assessment of effectiveness using a systematic and rational
method over the life of the hedging instrument. Any difference between the
change in fair value of the excluded component and amounts recognized in
earnings under that systematic and rational method shall be recognized in the
same manner as a translation adjustment (that is, reported in the cumulative
translation adjustment section of other comprehensive income).
35-5B An entity alternatively may elect to record changes in the fair value of
the excluded component currently in earnings. This election shall be applied
consistently to similar hedges in accordance with paragraph 815-20-25-81.
35-6 The interest accrual (periodic cash settlement) components of qualifying
receive-variable-rate, pay-variable-rate and receive-fixed rate, pay-fixed-rate
cross-currency interest rate swaps shall also be reported directly in earnings.
35-7 The change in fair value of the derivative instrument attributable to
changes in the spot rate shall be reported in the same manner as a translation
adjustment (that is, reported in the cumulative translation adjustment section
of other comprehensive income).
35-8 The spot-to-spot changes in value reported in the cumulative translation
adjustment section of other comprehensive income shall not be discounted.
35-9 The hedging relationship would not be considered perfectly effective, and
the guidance in paragraph 815-35-35-10 shall be applied if any of the following
conditions exist:
a. The notional amount of the derivative instrument does not match the
portion of the net investment designated as being hedged.

b. The derivative instrument's underlying exchange rate is not the exchange

rate between the functional currency of the hedged net investment and
the investor’s functional currency.
c. When the hedging derivative instrument is a cross-currency interest rate
swap eligible for designation in a net investment hedge in accordance with
paragraph 815-20-25-67, both legs are not based on comparable interest
rate curves (for example, pay foreign currency based on the three-month
London Interbank Offered Rate [LIBOR], receive functional currency based
on three-month commercial paper rates).
35-10 If any of the conditions in paragraph 815-35-35-9 exist, the change in fair
value of the hypothetical derivative instrument that does not incorporate those
differences shall be compared with the change in fair value of the actual
derivative instrument in assessing hedge effectiveness.
35-11 The hypothetical derivative instrument used to assess hedge
effectiveness also shall have a maturity and repricing and payment frequencies
for any interim payments that match the maturity and repricing and payment
frequencies for any interim payments of the actual derivative instrument
designated as the hedging instrument in the net investment hedge.

When a derivative instrument is designated as the hedging instrument in a net

investment hedge under the spot method, an entity may assume the hedging
relationship is perfectly effective if certain conditions are met.

Conditions that — The notional amount1 of the derivative hedging instrument

will result in matches (i.e. equals) the portion of the net investment
perfect designated as being hedged.
effectiveness — The derivative’s underlying exchange rate is the exchange
[815-35-35-5, 35-9] rate between the functional currency of the hedged net
investment and the investor’s functional currency.
— When using the spot method, a non-zero fair value
derivative designated as a hedging instrument may be
assumed to not affect hedge effectiveness. This approach
is consistent with the guidance in 815-35-35-17A to 35-18
regarding net investment hedging relationships that are
considered perfectly effective. That is, those paragraphs do
not require the derivative hedging instrument to have a zero
fair value at hedge designation for the relationship to be
perfectly effective. 2
— If the derivative is a qualifying receive-variable, pay-variable
cross-currency interest rate swap, both legs are based on
comparable interest rate curves.3
How — If the conditions that will result in perfect effectiveness
effectiveness is (above) are not met, an entity must perform initial and
assessed if the subsequent hedge effectiveness assessments using the
conditions that hypothetical derivative method (see section 9.7.30).
will result in — Under this method, the following are compared:
perfect
effectiveness are
— the change in fair value of the actual hedging
not met instrument; and
— the change in fair value of a PEH derivative.4
[815-35-35-10 –
35-11]

Notes:
1. The notional amount is adjusted to reflect the effect of tax rates if effectiveness is
assessed and hedge results are measured on an after-tax basis. [815-35-35-26]
2. As discussed in Question 8.4.100, a non-zero fair value due to the derivative hedging
instrument being off-market at designation creates some complexity when
determining the value of the excluded component (such as when an entity changes
from the forward method to the spot method). When an amortization approach is
used to recognize the excluded component, any systematic and rational approach that
results in the off-market nature being reduced to zero at the end of the hedging
relationship generally is acceptable. Nonetheless, an approach designed specifically to
take advantage of structuring opportunities to achieve a desired accounting result
would not meet the spirit of a systematic and rational approach.
3. See Question 8.4.40 regarding what interest rate curves are considered ‘comparable’.
4. The PEH derivative is one that meets conditions for the relationship to be perfectly
effective and also has a maturity date, repricing dates and payment frequencies for
any interim payments that match the actual derivative hedging instrument. [815-35-35-
10 – 35-11]

Topic 815 permits an entity to exclude forward points of a forward contract (i.e.
the spot-forward difference) or time value of an option from its effectiveness
assessments when using a derivative as the hedging instrument in a net
investment hedge (see also section 9.2.70). In these situations, an entity
recognizes the initial value of the excluded component in earnings using either
an amortization approach or a mark-to-market approach. [815-35-35-5A – 35-5B]
— Amortization approach. The initial value of the excluded component is
amortized into earnings using a systematic and rational method over the life
of the hedging instrument. The difference between the amortized amount
and the change in the excluded component’s fair value is recognized in CTA
for the period.
— Mark-to-market approach. The entire change in fair value of the excluded
component is immediately recognized in earnings.
The interest accrual/periodic cash settlement components of qualifying cross-
currency interest rate swaps (i.e. the periodic amortization in a cross-currency
interest rate swap whose terms are at-market) are reported directly in earnings.
[815-35-35-6]

When a hedging relationship is effective as an economic hedge, the change in

fair value of the derivative hedging instrument attributable to changes in the
spot rate is reported in the same manner as a translation adjustment (i.e.
reported in CTA in AOCI). The spot-to-spot changes in value reported in CTA in
AOCI should not be discounted. [815-35-35-7 – 35-8]

Question 8.4.20
Can the cross-currency basis spread be an excluded
component when a cross-currency interest rate
swap is used in a net investment hedge?
Interpretive response: No. While an entity is permitted to exclude the portion
of the change in fair value of a currency swap attributable to a cross-currency

basis spread in a cash flow or fair value hedge, it cannot be the excluded
component for a net investment hedge. [815-20-25-82]
For a cross-currency interest rate swap used in a net investment hedge, only
the change in the fair value of the derivative instrument attributable to changes
in the difference between the forward rate and the spot rate (spot-forward
difference) can be excluded from the assessment of hedge effectiveness.
[815-35-35-5]

Question 8.4.30
Where is the effect of the excluded components
presented in earnings?
Interpretive response: For net investment hedges, Topic 815 does not specify
a required presentation in earnings for excluded components. [815-20-45-1C]
For fair value and cash flow hedges, Topic 815 requires that excluded
components be presented in the same income statement line item in which the
earnings effect of the hedged item is presented.
However, the FASB decided not to provide similar guidance for net investment
hedges. This is because amounts in CTA related to a hedged net investment
are not reclassified into earnings until the hedged net investment is sold,
exchanged or liquidated (see section 8.5.20). In contrast, the initial value of the
excluded component is recognized in earnings over the life of the hedging
instrument (using either an amortization or mark-to-market approach). As a
result, requiring the excluded components to be presented together with the
earnings effect of the hedged item could result in presentation in an income
statement line item such as ‘gain or loss on sale of subsidiary’ even when that
subsidiary has not or will not be sold. [ASU 2017-12.BC131]
Regardless of whether the entity chooses the amortization or mark-to-market
approach, we believe an entity should develop a policy for income statement
line item presentation for excluded components and apply that policy
consistently for all applicable net investment hedges.
For example, many entities present the excluded component for net investment
hedges in interest expense.

Nonderivative hedging instrument

Excerpt from Subtopic 815-35

>>> Hedging Instrument Is Not a Derivative Instrument

35-12 The translation gain or loss determined under Subtopic 830-30 by
reference to the spot exchange rate between the transaction currency of the
debt and the functional currency of the investor (after tax effects, if
appropriate) shall be reported in the same manner as the translation
adjustment associated with the hedged net investment (that is, reported in the

cumulative translation adjustment section of other comprehensive income) if

both of the following conditions are met:
a. The notional amount of the nonderivative instrument matches the portion
of the net investment designated as being hedged.
b. The nonderivative instrument is denominated in the functional currency of
the hedged net investment.
In that circumstance, the hedging relationship would be considered perfectly
effective, and no prospective quantitative effectiveness assessment is required
at hedge inception (see paragraph 815-20-25-3(b)(2)(iv)(01)).
35-13 The hedging relationship would not be perfectly effective if either of the
following conditions is met:
a. The notional amount of the nonderivative instrument does not match the
portion of the net investment designated as being hedged.
b. The nonderivative instrument is denominated in a currency other than the
functional currency of the hedged net investment.
35-14 Effectiveness shall be assessed by comparing the following two values:
a. The foreign currency transaction gain or loss based on the spot rate change
(after tax effects, if appropriate) of that nonderivative instrument
b. The transaction gain or loss based on the spot rate change (after tax
effects, if appropriate) that would result from the appropriate hypothetical
nonderivative instrument that does not incorporate those differences. The
hypothetical nonderivative instrument shall also have a maturity that
matches the maturity of the actual nonderivative instrument designated as
the net investment hedge.

When a nonderivative instrument is designated as the hedging instrument in a

net investment hedge under the spot method, an entity may assume the
hedging relationship is perfectly effective if certain conditions are met.

Conditions that — The principal amount1 of the nonderivative instrument

will result in matches the portion of the net investment designated as
perfect being hedged.
effectiveness
— The nonderivative instrument is denominated in the
[815-35-35-12 – 35-
functional currency of the hedged net investment.
13]

How — If the conditions that will result in perfect effectiveness

effectiveness is (above) are not met, an entity must perform initial and
assessed if the subsequent hedge effectiveness assessments by
conditions that comparing:
will result in
perfect
— the foreign currency transaction gain or loss of the
effectiveness are nonderivative instrument based on the spot rate
not met change (after tax effects, if appropriate); and
[815-35-35-14]
— the transaction gain or loss based on the spot rate
change (after tax effects, if appropriate) that would
result from the appropriate hypothetical nonderivative
instrument that does meet the conditions that would
result in perfect effectiveness and also has a maturity
that matches the maturity of the actual nonderivative
hedging instrument.

Note:
The principal amount is adjusted to reflect the effect of tax rates if effectiveness is
assessed and hedge results are measured on an after-tax basis. [815-35-35-26]

When a hedging relationship is effective as an economic hedge, the foreign

currency transaction gain or loss upon remeasurement at the spot rate (after tax
effects, if appropriate) is reported in the same manner as the translation
adjustment associated with the hedged net investment (i.e. in the CTA in
AOCI). [815-35-35-12]

Example 8.4.20
Using the spot method when FCD debt is used to
hedge a net investment
Parent’s functional currency is the US dollar. Parent has a wholly owned
subsidiary, Sub, whose functional currency is the euro (€). As of January 1,
Year 1, Parent has a net investment of €10,000,000.
Parent also has a €12,000,000 debt obligation that matures on June 30, Year 1.
Parent designates €10,000,000 of this debt obligation to hedge its €10,000,000
net investment.
Parent chooses to apply hedge accounting and formally designates and
documents the hedging relationship on January 1, Year 1.
The following additional facts are relevant.
— All criteria for hedge accounting have been met.
— Parent assesses effectiveness based on changes in spot rates and on the
balance of the net investment at the beginning of the hedging period.
Parent believes that because the hedged amount matches the designated
proportion of the debt obligation and the debt obligation is denominated in
euros, the hedging relationship will provide an economically effective hedge
of its net investment in Sub.
— The spot exchange rates for various dates and changes for remeasurement
at the spot rate are as follows.

Translation
gain/(loss) on Remeasurement
€10,000,000 net gain/(loss) on
investment €12,000,000 debt
1 2
Date Spot rate balance balance
January 1, Year 1 €1 = $0.90 $ - $ -
March 31, Year 1 €1 = $0.95 500,000 (600, 000)
June 30, Year 1 €1 = $0.85 (1,000,000) 1,200,000
Notes:
€10,000,000 × (Spot exchange rate at respective date - Spot exchange rate at
preceding measurement date).
€(12,000,000) × (Spot exchange rate at respective date - Spot exchange rate at
preceding measurement date).

— Parent’s net investment in Sub did not change during the hedging
relationship – i.e. Sub’s operations were break-even during the period.
— On April 1, Year 1, Parent redesignated this hedging relationship to be for
the balance of the net investment at April 1, Year 1 of €10,000,000.
For simplicity, this example ignores the effect of commissions and other
transaction costs, initial margins and income taxes.
Journal entries – January 1, Year 1
There is a memorandum entry made on January 1, Year 1 documenting the
existence of this hedging relationship.
Journal entries – March 31, Year 1
Parent records the following journal entries as of March 31, Year 1.

Debit Credit
Investment in Sub 500,000
CTA 500,000
To record change in carrying amount of net
investment in Sub due to changes in spot
exchange rates from January 1 to March 31.
CTA 500,000
Transaction gain / loss 100,000
Debt obligation 600,000
To record remeasurement of FCD debt obligation
to Parent’s functional currency at March 31 spot
rate.1
Note:
The total remeasurement of €12,000,000 is recorded as follows.
— The remeasurement of €10,000,000 of the debt obligation is recorded in CTA in
AOCI because it was designated as hedging the corresponding net investment
amount.
— The remeasurement of €2,000,000 of the debt obligation is recorded as a
transaction gain/loss.

Journal entries – June 30, Year 1

Parent records the following journal entries as of June 30, Year 1.

Debit Credit
CTA 1,000,000
Investment in Sub 1,000,000
To record change in carrying amount of net
investment in Sub due to changes in spot
exchange rates from April 1 to June 30.

Debit Credit
Debt obligation 1,200,000
CTA 1,000,000
Transaction gain / loss 200,000
To record remeasurement of FCD debt obligation
to Parent’s functional currency at June 30 spot
rate.1
Note:
The total remeasurement of €12,000,000 of the debt obligation is recorded as follows.
— The remeasurement of €10,000,000 of the debt obligation is recorded in CTA
because it was designated as hedging the corresponding net investment amount.
— The remeasurement of €2,000,000 of the debt obligation is recorded as a
transaction gain/loss.

Parent was concerned that the dollar would strengthen relative to the euro and
designated a euro-denominated debt obligation as a hedge of its net
investment.
As a result of entering into this hedge, Parent was able to offset translation
gains and losses on its net investment. This was achieved by recording the
Topic 830 remeasurement adjustment on the designated portion of the euro-
denominated debt obligation (€10,000,000) in CTA in AOCI to offset the
translation adjustment.
Without the designation of the euro-denominated debt obligation as a hedging
instrument, the remeasurement adjustment for the debt obligation would have
been recorded in earnings, creating foreign exchange volatility in Parent’s
earnings.
The undesignated portion of the debt obligation (€2,000,000) continued to be
remeasured at the spot rate through earnings.

8.4.30 Forward method

Excerpt from Subtopic 815-35

>> Method Based on Changes in Forward Exchange Rates

35-17 Under a method based on changes in forward exchange rates, an entity
shall report all changes in fair value of the derivative instrument in the same
manner as a translation adjustment (that is, reported in the cumulative
translation adjustment section of other comprehensive income), including the
following amounts:
a. The time value component of purchased options
b. The interest accrual/periodic cash settlement components of qualifying
receive-variable-rate, pay-variable-rate and receive-fixed-rate, pay-fixed-rate
cross-currency interest rate swaps.

>>> Assessment of Effectiveness

35-17A If the notional amount of the derivative instrument designated as a
hedge of a net investment in a foreign operation matches (that is, equals) the
portion of the net investment designated as being hedged and the derivative
instrument's underlying relates solely to the foreign exchange rate between
the functional currency of the hedged net investment and the investor’s
functional currency, the hedging relationship would be considered perfectly
effective, and no quantitative effectiveness assessment is required at hedge
inception (see paragraph 815-20-25-3(b)(2)(iv)(01)).
35-18 However, the hedging relationship would not be considered perfectly
effective if any of the following conditions exist:
a. The notional amount of the derivative instrument does not match the
portion of the net investment designated as being hedged.
b. The derivative instrument's underlying exchange rate is not the exchange
rate between the functional currency of the hedged net investment and
the investor’s functional currency.
c. When the hedging derivative instrument is a cross-currency interest rate
swap eligible for designation in a net investment hedge in accordance with
paragraph 815-20-25-67, both legs are not based on comparable interest
rate curves (for example, pay foreign currency based on three-month
LIBOR, receive functional currency based on three-month commercial
paper rates).
35-19 The assessment of hedge effectiveness due to such differences
between the hedging derivative instrument and the hedged net investment
considers the following:
a. Different notional amounts. If the notional amount of the derivative
instrument designated as a hedge of the net investment does not match
the portion of the net investment designated as being hedged, hedge
effectiveness shall be assessed by comparing the following two values:
1. The change in fair value of the actual derivative instrument designated
as the hedging instrument
2. The change in fair value of a hypothetical derivative instrument that has
a notional amount that matches the portion of the net investment being
hedged and a maturity that matches the maturity of the actual
derivative instrument designated as the net investment hedge. See
paragraph 815-35-35-26 for situations in which the hedge of a net
investment in a foreign operation is hedging foreign currency risk on an
after-tax basis, as permitted by paragraph 815-20-25-3(b)(2)(vi).
b. Different currencies. If the derivative instrument designated as the hedging
instrument has an underlying foreign exchange rate that is not the
exchange rate between the functional currency of the hedged net
investment and the investor’s functional currency (a tandem currency
hedge), hedge effectiveness shall be assessed by comparing the following
two values:
1. The change in fair value of the actual cross-currency hedging
instrument
2. The change in fair value of a hypothetical derivative instrument that has
as its underlying the foreign exchange rate between the functional
currency of the hedged net investment and the investor’s functional
currency and a maturity and repricing and payment frequencies for any

interim payments that match the maturity and repricing and payment
frequencies for any interim payments of the actual derivative
instrument designated as the net investment hedge.
c. Multiple underlyings. In accordance with paragraph 815-20-25-67(a), the
only derivative instruments with multiple underlyings permitted to be
designated as a hedge of a net investment are receive-variable-rate, pay-
variable-rate cross-currency interest rate swaps that meet certain criteria.
Paragraph 815-20-25-67(b) also permits receive-fixed-rate, pay-fixed-rate
cross-currency interest rate swaps to be designated as a hedge of a net
investment.
35-20 If a receive-variable-rate, pay-variable-rate cross-currency interest rate
swap is designated as the hedging instrument in a net investment hedge,
hedge effectiveness shall be assessed by comparing the following two values:
a. The change in fair value of the actual cross-currency interest rate swap
designated as the hedging instrument
b. The change in fair value of a hypothetical receive-variable-rate, pay-variable-
rate cross-currency interest rate swap in which the interest rates are based
on the same currencies contained in the hypothetical swap and both legs
of the hypothetical swap have the same repricing intervals and dates. The
hypothetical derivative instrument also shall have a maturity that matches
the maturity of the actual cross-currency interest rate swap designated as
the net investment hedge.
35-21 If a receive-fixed-rate, pay-fixed-rate cross-currency interest rate swap is
designated as the hedging instrument in a net investment hedge, hedge
effectiveness shall be assessed by comparing the following two values:
a. The change in fair value of the actual cross-currency interest rate swap
designated as the hedging instrument
b. The change in fair value of a hypothetical receive-fixed-rate, pay-fixed-rate
cross-currency interest rate swap in which the interest rates are based on
the same currencies contained in the hypothetical swap. The hypothetical
derivative instrument shall also have a maturity that matches the maturity
of the actual cross-currency interest rate swap designated as the net
investment hedge.
35-26 Paragraph 815-20-25-3(b)(2)(vi) permits hedging foreign currency risk on
an after-tax basis, provided that the documentation of the hedge at its
inception indicated that the assessment of effectiveness and measurement of
hedge results will be on an after-tax basis (rather than on a pretax basis). If an
entity has elected to hedge foreign currency risk on an after-tax basis, it shall
adjust the notional amount of its derivative instrument appropriately to reflect
the effect of tax rates. In that case, the hypothetical derivative instrument used
to assess effectiveness shall have a notional amount that has been
appropriately adjusted (pursuant to the documentation at inception) to reflect
the effect of the after-tax approach.

When a derivative instrument is designated as the hedging instrument in a net

investment hedge, an entity may elect to assess effectiveness based on
forward rates rather than spot rates.
When using the forward method, an entity may also assume the hedging
relationship is perfectly effective if certain conditions are met.

Conditions for — The hedging instrument is a derivative.

applying this
method
[815-35-35-17 –
35-26]

Conditions that — The notional amount2, 3 of the derivative hedging instrument

will result in matches (i.e. equals) the portion of the net investment
perfect designated as being hedged.
1
effectiveness
— The derivative’s underlying relates solely to the foreign
[815-35-35-17A – exchange rate between the functional currency of the
35-18]
hedged net investment and the investor’s functional
currency
— If the derivative is a qualifying receive-variable, pay-variable
cross-currency interest rate swap, both legs are based on
comparable interest rate curves.4
How — If the conditions that will result in perfect effectiveness
effectiveness is (above) are not met, an entity must perform initial and
assessed if the subsequent hedge effectiveness assessments using the
conditions that hypothetical derivative method (see section 9.7.30).
will result in
— Under this method, the following are compared:
perfect
effectiveness are — the change in fair value of the actual hedging
not met instrument.
[815-35-35-19] — the change in fair value of a PEH derivative. See below
for additional guidance for defining the PEH derivative.

Notes:
See Question 8.4.50 regarding whether a hedging relationship can be perfectly
effective if a derivative hedging instrument has a non-zero fair value at designation.
The notional amount is adjusted to reflect the effect of tax rates if effectiveness is
assessed and hedge results are measured on an after-tax basis. [815-35-35-26]
See Questions 8.4.60 and 8.4.70 regarding whether leverage has effectively increased
the notional amount of a cross-currency interest rate swap, resulting in the notional
amount of the derivative instrument not matching the hedged portion of the net
investment.
See Question 8.4.40 regarding what interest rate curves are considered ‘comparable’.

When the hedging relationship does not meet the conditions to be considered
perfectly effective, what is compared when assessing effectiveness depends
on the cause of the relationship not being perfectly effective. This is shown in
the following table. [815-35-35-19 – 35-21]

Different notional Compare:

amounts — the change in fair value of the actual hedging derivative;
[815-35-35-19(a), and
35-26]
— the change in fair value of a PEH derivative contract that
has a notional amount1,2 that matches the portion of the
net investment being hedged and that has a maturity that
matches that of the actual hedging derivative.
Notes:
The notional amount is adjusted to reflect the effect of tax
rates if effectiveness is assessed and hedge results are
measured on an after-tax basis. [815-35-35-26]
See Questions 8.4.60 and 8.4.70 regarding whether leverage
has effectively increased the notional amount of a cross-
currency interest rate swap, resulting in the notional amount
of the derivative instrument not matching the hedged portion
of the net investment.

Different Compare:
currencies — the change in fair value of the actual hedging derivative;
[815-35-35-19(b)] and
— the change in fair value of a hypothetical derivative
contract that has as its underlying the foreign exchange
rate between the functional currency of the hedged net
investment and the investor’s functional currency; and also
that has a maturity date, repricing dates and payment
frequencies for any interim payments that match the actual
hedging derivative.
For example, if a cross-currency interest rate swap with two
fixed legs is designated as the hedging derivative but the
hedge uses a tandem currency, effectiveness would be
assessed by comparing:
— the change in fair value of the actual cross-currency
interest rate swap; and
— the change in fair value of a hypothetical receive-fixed, pay-
fixed cross-currency interest rate swap based on the
functional currencies of the hedged net investment and
the investor, with the interest rates based on the same
currencies contained in the hypothetical swap. The
hypothetical derivative must also have a maturity that
matches the maturity of the actual hedging derivative.

Cross-currency The only derivative with multiple underlyings permitted to be

interest rate designated as a hedge of a net investment is a cross-currency
swaps with two interest rate swap with two variable legs (see section 8.3.40).
variable legs If a qualifying receive-variable, pay-variable cross-currency
(multiple interest rate swap is the hedging instrument, compare:
underlyings)
— the change in fair value of the actual cross-currency
[815-35-35-19(c) – interest rate swap; and
35-20]
— the change in fair value of a hypothetical receive-variable,
pay-variable cross-currency interest rate swap. The
hypothetical swap should be based on the functional
currencies of the hedged net investment and the investor,
with the interest rates based on the same currencies and

comparable interest rate curves, and both legs of the

hypothetical swap having the same repricing intervals and
dates. See Question 8.4.40 regarding which interest rate
curves are considered comparable.

Cross-currency A cross-currency interest rate swap with two fixed legs is not
interest rate considered a compound derivative (see section 8.3.40).
swap with two If a qualifying receive-fixed, pay-fixed cross-currency interest
fixed legs rate swap is the hedging instrument, compare:
[815-35-35-21] — the change in fair value of the actual cross-currency
interest rate swap; and
— the change in fair value of a hypothetical receive-fixed, pay-
fixed cross-currency interest rate swap in which the
interest rates are based on the same currencies contained
in the hypothetical swap and that has a maturity that
matches the maturity of the actual hedging derivative.

If the hedging relationship has multiple differences (i.e. different notional

amounts, currencies and underlyings), effectiveness can be assessed by a
single comparison of the actual hedging derivative to the appropriate
hypothetical derivative contract that does not incorporate those differences.

Question 8.4.40
What interest rate curves are considered
comparable?
Interpretive response: We believe ‘comparable interest rate curves’ means
comparable credit quality curves. Therefore, a US dollar LIBOR and euro LIBOR
index would be comparable, whereas the commercial paper rate and a LIBOR
index rate reflect different credit quality.

Question 8.4.50
Can a hedging relationship be perfectly effective if a
derivative hedging instrument has a non-zero fair
value at designation?
Interpretive response: It depends on the approach to assessing effectiveness.
We believe there are two acceptable approaches that an entity may take to
assess effectiveness if a derivative hedging instrument has a non-zero fair value
at hedge designation. An entity should adopt a policy and apply it on a
consistent basis for all hedges of net investments in foreign operations.
Approach 1: The non-zero fair value affects hedge effectiveness, similar to
the approach for fair value and cash flow hedges
Under this approach, the entity assesses effectiveness by comparing:
— the change in fair value of the actual hedging derivative; and

— the change in fair value of a hypothetical derivative with similar notional

amounts, currencies, and underlyings as the hedged net investment.
However in constructing the hypothetical derivative, the underlying rates
would be the current market rates at the date of designation such that the
hypothetical derivative would have a fair value of zero at the date of
designation. This approach would be consistent with the required
approaches when the fair value of a hedging instrument in a cash flow or
fair value hedging relationship is other than zero on the date of hedge
designation.
Approach 2: The non-zero fair value does not affect hedge effectiveness
Under this approach, the non-zero fair value is assumed to not affect hedge
effectiveness. This approach is consistent with the guidance in 815-35-35-17A
to 35-18 regarding net investment hedging relationships that are considered
perfectly effective. That is, those paragraphs do not require the derivative
hedging instrument to have a zero fair value at hedge designation for the
relationship to be perfectly effective.
In our experience, most entities apply Approach 2 in practice, because it is
consistent with the general theory that an entity is required to have an
expectation that the derivative will be effective as an economic hedge of
foreign currency risk associated with the hedged net investment.

Question 8.4.60
What is the effect on a hedging relationship if the
interest rates in a qualifying cross-currency interest
rate swap are higher than normal market rates and
the forward method is used?
Background: When a qualifying cross-currency interest rate swap (having
either two variable or two fixed legs) is designated as the hedging derivative in
a net investment hedge, sometimes the terms of the swap are such that the
coupons in the two currencies may be at levels higher than normal market
rates, but the fair value of the swap at inception is still zero.
For example, a US dollar functional currency entity has a euro-denominated
foreign operation and wants to hedge its euro (€) net investment using a €/$
pay-fixed, receive-fixed cross-currency interest rate swap for a notional amount
of €100 million/$113 million.
The normal market terms of the swap may have fixed coupons of 1.5% for euro
and 2% for US dollar. The entity may decide to increase the coupon on the
receive US dollar leg to 2.5%, and have the pay euro leg of the swap adjusted
to an amount higher than 1.5% so that the fair value of the swap at inception is
still zero.
Interpretive response: When leverage is added to the coupon rates of the
cross-currency swap, it effectively increases the notional amount of the swap. If
the swap’s notional amount matches the portion of the net investment being
hedged, it may appear that the swap meets all the criteria outlined for the
hedging relationship to be considered perfectly effective.

However, because the leverage has effectively increased the notional amount
of the swap, the notional amount of the derivative instrument does not match
the portion of the net investment designated as being hedged. As a result, the
relationship cannot be considered to be perfectly effective.

Question 8.4.70
Has leverage been added to coupon rates in a
qualifying cross-currency interest rate swap that is
designated in a hedge after its initial recognition?
Background: As discussed in Question 8.4.60, leverage may be added to the
coupon rates of a swap, resulting in a hedging relationship not being perfectly
effective due to having notional amounts that do not match.
Interpretive response: No, we generally do not consider leverage to have been
added to the coupon rates of the swap if the rates were market rates at the
swap’s inception and the swap was not subsequently modified. This is even if
the swap is later designated as a hedging derivative after market rates had
changed.

Example 8.4.30
Using the forward method when using a foreign
currency forward to hedge a net investment
Parent’s functional currency is the US dollar. Parent has a wholly owned
subsidiary, Sub, whose functional currency is the pound sterling (£). As of
January 1, Year 1, Parent has a net investment of £10,000,000.
Parent enters into a six-month forward contract to buy USD and sell the foreign
currency. The hedging derivative has the following terms.
— Contract amount: £10,000,000
— Trade date: January 1, Year 1
— Maturity date: June 30, Year 1
— Forward contract rate: £1= $1.50
The contract is at market, and therefore no cash is exchanged at inception.
Parent chooses to apply hedge accounting and formally designates and
documents the hedging relationship on January 1, Year 1.
The following additional facts are relevant.
— All criteria for hedge accounting have been met.
— Parent elects to assess effectiveness based on changes in the forward
rates and on the balance of the net investment at the beginning of the
hedging period. Accordingly, all changes in the fair value of the forward
contract will be reported in CTA in AOCI because the hedged amount
matches the notional amount of the forward contract and the underlying
currency of the forward matches Sub’s functional currency. For the same

reasons, Parent believes the foreign currency forward contract will provide
an economically effective hedge of its net investment in Sub.
— The spot and forward exchange rates for various dates, along with the fair
value and changes in fair value of the forward contract, are as follows.

Forward Changes in
1
Date Spot rate rate Fair value fair value
January 1, Year 1 £1 = $1.475 £1 = $1.50 $ -1 N/A
March 31, Year 1 £1 = $1.48 £1 = $1.55 (493,000) 1
$(493,000)
June 30, Year 1 £1 = $1.45 N/A 500,0002 993,000
Notes:
Determined using the change in forward rates discounted at an appropriate
discount rate.
£10,000,000 × ($1.50 - $1.45).

— Parent’s net investment in Sub was $14,750,000 as of January 1, Year 1

(£10,000,000 × $1.475 spot exchange rate).
— Parent’s net investment in Sub did not change during the hedging
relationship (i.e. Sub’s operations were break-even during the period).
— On April 1, Year 1, Parent redesignated this hedging relationship to be for
the balance of the net investment at April 1, Year 1 of £10,000,000.
— The foreign currency forward contract settles on June 30, Year 1 with
Parent receiving $500,000.
For simplicity, this example ignores the effect of commissions and other
transaction costs, initial margins and income taxes.
Journal entries – January 1, Year 1
There is a memorandum entry made on January 1, Year 1 documenting the
existence of this hedging relationship. The financial records of Parent are not
otherwise affected as of this date because the forward contract has a fair value
of zero at inception.
Journal entries – March 31, Year 1
Parent records the following journal entries as of March 31, Year 1.

Debit Credit
Investment in Sub1 50,000
CTA 50,000
To record change in carrying amount of net
investment in Sub due to changes in spot
exchange rates from January 1 to March 31.
CTA 493,000
Forward contract 493,000
To record change in fair value of foreign currency
forward contract. 2

Notes:
£10,000,000 × ($1.48 - $1.475).
The amount recorded represents the entire change in fair value of the foreign currency
forward contract.

Journal entries – June 30, Year 1

Parent records the following journal entries as of June 30, Year 1.

Debit Credit
CTA 300,000
Investment in Sub 1
300,000
To record change in carrying amount of net
investment in Sub due to changes in spot
exchange rates from April 1 to June 30.
Forward contract 993,000
CTA 993,000
To record change in fair value of foreign currency
forward contract. 2
Cash 500,000
Forward contract 500,000
To record settlement of foreign currency forward
contract.
Notes:
£10,000,000 × ($1.45 - $1.48).
The amount recorded represents the entire change in fair value of the foreign currency
forward contract.

Parent was concerned that the dollar would strengthen relative to the pound
sterling and entered into a foreign currency forward contract to hedge its net
pound sterling investment.
As a result of entering into this hedge, Parent locked in an exchange rate of £1
= $1.50. Because the spot exchange rate at the end of the hedge period was
£1 = $1.45, the counterparty paid Parent $500,000 [($1.50 - $1.45) ×
£10,000,000].
During the six months ended June 30, Year 1, Parent recorded a change in its
net investment in Sub of $250,000 and an offsetting change in the fair value of
the forward contract of $500,000 in CTA in AOCI.
The change in fair value of the forward contract exceeded the translation loss
by $250,000. This amount represents the spot-forward difference (forward
points) [($1.50 forward rate - $1.475 spot rate at January 1, Year 1) ×
£10,000,000].

8.4.40 Changing the effectiveness assessment method

An entity is permitted to change the method it uses to assess effectiveness of
its net investment hedges. Guidance for changing effectiveness assessment
methods is discussed in section 9.6.40. [815-35-35-4]

Question 8.4.80
Is an entity permitted to change the method it uses
to assess effectiveness of a net investment hedge?
Interpretive response: Yes. An entity using a derivative hedging instrument in
a net investment hedge may change from the forward method to the spot
method or vice versa, provided that the new method is an improved method for
assessing effectiveness (see Question 8.4.90). [815-35-35-4]
In addition, the entity is required to use the new method for all of its net
investment hedges. Changing methods involves dedesignating existing hedging
relationships and redesignating hedging relationships (see Question 8.4.100).
[815-20-55-56]

The ability to change methods is not applicable when a nonderivative hedging

instrument is used, because only the spot method is applicable to such hedging
relationships (see section 8.4.10).

Question 8.4.90
What does an entity consider in changing its
method of assessing effectiveness for a net
investment hedge?
Interpretive response: When changing the method of assessing effectiveness,
an entity should document its justification for the new method being an
improved method for assessing effectiveness.
When making the initial change, the entity establishes that the new method is
an improved method. Therefore, it is unlikely that the entity could later support
the original method as an improved method because this would contradict the
original analysis.
For example, an entity that uses the forward method to assess effectiveness
and wants to change to the spot method may be able to justify that the spot
method is an improved method. This is because:
— its risk management objective is to hedge the changes in the spot
exchange rates arising from the translation of its foreign operation(s); and
— it considers the excluded component as a ‘cost of the hedge’, which should
be recognized ratably in earnings over the term of the hedge.
However, if that same entity wishes to change back to the forward method at a
later date, it is unlikely that it could justify the change because this would
contradict its original justification.

Question 8.4.100
What does an entity consider when it dedesignates
and redesignates a net investment hedge?
Interpretive response: If an entity uses a derivative hedging instrument, it is
likely that the derivative hedging instrument will have a non-zero fair value (i.e.
be off-market) at redesignation. The non-zero fair value of the derivative
instrument creates some complexity when determining the value of the
excluded component at the time of redesignation.
If an entity changes from the forward method to the spot method, and it elects
to subsequently amortize the excluded component (the spot-forward difference)
using the amortization approach, it will have to develop an appropriate
methodology at the date of redesignation to determine the value of the
excluded component (the spot-forward difference) that subsequently is
amortized. [815-35-35-5 – 35-5A]
In a February 2018 FASB meeting, the FASB discussed appropriate
methodologies for amortizing the excluded component, including the off-market
element of a derivative instrument that could occur at the time of redesignation.
The FASB agreed that an appropriate amortization method would not violate the
guidance in paragraphs 815-35-35-6 to 35-7, meaning that at the end of the
hedging relationship only amounts of the derivative related to the changes in
spot exchange rates over the hedge term on the notional amount of the net
investment should remain in CTA in AOCI. Therefore any systematic and
rational approach that results in the off-market nature of the swap being
reduced to zero at the end of the hedging relationship is acceptable.
The FASB further clarified that any approach that is designed specifically to take
advantage of structuring opportunities to achieve a desired accounting result
does not meet the spirit of a systematic and rational approach. For example, if
an entity deliberately enters into an off-market derivative to amortize the off-
market amount into interest income to achieve a desired accounting result, the
entity would have to use the terms of an at-market derivative to determine the
appropriate amortization of the excluded component.

8.4.50 Counterparty credit risk and entity’s own

nonperformance risk
An entity is required to consider the effects of counterparty credit risk and the
entity’s own nonperformance risk when assessing hedging relationships.
The potential effect of counterparty credit risk (and an entity’s own
nonperformance risk) on a net investment hedging relationship’s effectiveness
as an economic hedge is ignored unless it is no longer probable that the
derivative counterparty or the entity itself will not default.
However, if non-default by either party is no longer probable, an entity will be
required to assess whether the hedging relationship has been and is expected
to continue to be effective as an economic hedge. If an entity continues to
expect the relationship to be effective as an economic hedge, strong evidence
supporting the expectation would be needed.

See further discussion of considerations related to counterparty credit (and an

entity’s own nonperformance) risk and related to credit risk adjustments
determined at a portfolio level in section 9.2.60.

8.5 Accounting for net investment hedges

8.5.10 Overview

Excerpt from Subtopic 815-20

35-1 Paragraph 815-10-35-2 states that the accounting for subsequent changes
in the fair value (that is, gains or losses) of a derivative instrument depends
on whether it has been designated and qualifies as part of a hedging
relationship and, if so, on the reason for holding it. Specifically, subsequent
gains and losses on derivative instruments shall be accounted for as follows:
…
d. Net investment hedge. The gain or loss on the hedging derivative or
nonderivative hedging instrument in a hedge of a net investment in a
foreign operation shall be reported in other comprehensive income (outside
earnings) as part of the cumulative translation adjustment, as provided in
paragraph 815-20-25-66. If an entity excludes a portion of the hedging
instrument from the assessment of hedge effectiveness in accordance
with paragraphs 815-35-35-5 through 35-5B, the initial value of the
excluded component shall be recognized in earnings using a systematic
and rational method over the life of the hedging instrument. Any difference
between the change in fair value of the excluded component and the
amounts recognized in earnings under that systematic and rational method
shall be recognized in the same manner as a translation adjustment (that is,
reported in the cumulative translation adjustment section of other
comprehensive income) in accordance with paragraph 815-35-35-5A. An
entity also may elect to recognize the excluded component of the gain or
loss currently in earnings in accordance with paragraph 815-35-35-5B.
> Income Statement Classification
45-1C For qualifying net investment hedges, an entity shall present in the same
income statement line item that is used to present the earnings effect of the
hedged net investment those amounts reclassified from accumulated other
comprehensive income to earnings. This Subtopic provides no guidance on the
required income statement classification of amounts excluded from the
assessment of effectiveness in net investment hedges.
45-1D While the Derivatives and Hedging Topic does not specify whether
certain income statement line items are either permitted or appropriate, the
other hedging-related Subtopics in this Topic do contain specific disclosure
requirements for those items. See Section 815-10-50 and Subtopics 815-25,
815-30, and 815-35.

> Statement of Cash Flows

45-2 For guidance on the classification of cash receipts and payments related
to hedging activities, see paragraph 230-10-45-27.

Excerpt from Subtopic 815-35

> Overall
35-1 The gain or loss on a hedging derivative instrument (or the foreign
currency transaction gain or loss on the nonderivative hedging instrument) that
is designated as, and is effective as, an economic hedge of the net investment
in a foreign operation shall be reported in the same manner as a translation
adjustment (that is, reported in the cumulative translation adjustment section
of other comprehensive income).
35-2 The hedged net investment shall be accounted for consistent with
Topic 830. The provisions of Subtopic 815-25 for recognizing the gain or loss
on assets designated as being hedged in a fair value hedge do not apply to
the hedge of a net investment in a foreign operation.
35-3 If an entity has designated and documented that it will assess
effectiveness and measure hedge results on an after-tax basis as permitted by
paragraph 815-20-25-3(b)(2)(vi), the portion of the gain or loss on the hedging
instrument that exceeded the loss or gain on the hedged item shall be included
as an offset to the related tax effects in the period in which those tax effects
are recognized.

When a net investment is translated into the entity’s reporting currency, the
effects of translation are recognized in CTA in AOCI. When the net investment
is designated in a hedge that is effective as an economic hedge, changes in the
fair value of a hedging derivative instrument (or foreign currency transaction
gains or losses of a FCD nonderivative hedging instrument) are also recognized
in CTA in AOCI (other than excluded components). [815-35-35-1 – 35-2]
When the hedging instrument is a derivative and the spot method is used, an
entity excludes forward points (i.e. the spot-forward difference) from its
effectiveness assessments. In these situations, an entity recognizes the
initial value of the excluded component in earnings using either an
amortization approach or a mark-to-market approach. See further discussion in
sections 8.4.20 (derivative hedging instruments) and 9.2.70. [815-35-35-5A – 35-5B]
When the forward method is used, changes in the hedging derivative
instrument’s fair value that are included in CTA in AOCI include the time value
component of purchased options or forwards, or the interest accrual/periodic
cash settlement components of qualifying cross-currency interest rate swaps.
[815-35-35-17]

If an entity elects to assess effectiveness on an after-tax basis, the portion of

the gain or loss on the hedging instrument that exceeds the loss or gain on the
hedged net investment is included as an offset to the related tax effects in the
period in which those tax effects are recognized. [815-35-35-3]

Amounts in CTA in AOCI – including amounts related to excluded components –

generally remain in CTA until the hedged foreign entity is sold, exchanged or
liquidated (see section 8.5.20). However, amounts in CTA are considered as
part of the carrying amount when assessing impairment of a foreign operation if
an entity has committed to a plan that will cause the CTA related to the foreign
operation to be reclassified into earnings (see section 8.5.30).

Example 8.5.10
Recognizing amounts in CTA
On January 1, Year 1, Parent enters into a six-month foreign currency forward
contract to sell FC1,000. This contract is designated as a hedge of the foreign
currency exposure in its net investment of Subsidiary. The net investment in
Sub balance at January 1, Year 1 is FC1,000.
At March 31, Year 1, the net investment balance has declined to FC800.
For the quarter ended March 31, Year 1, the entire change in fair value of the
foreign currency forward contract is reflected in CTA because the entire
contract was designated and deemed effective as a hedge of the beginning
balance of the net investment.

8.5.20 Subsequent accounting for amounts in CTA

Excerpt from Subtopic 830-30

> Sale or Liquidation of an Investment in a Foreign Entity

40-1 Upon sale or upon complete or substantially complete liquidation of an
investment in a foreign entity, the amount attributable to that entity and
accumulated in the translation adjustment component of equity shall be both:
a. Removed from the separate component of equity
b. Reported as part of the gain or loss on sale or liquidation of the investment
for the period during which the sale or liquidation occurs.
40-1A A sale shall include:
a. The loss of a controlling financial interest in an investment in a foreign
entity resulting from circumstances contemplated by Subtopic 810-10 (see
paragraph 810-10-55-4A for related implementation guidance)
b. An acquirer obtaining control of an acquiree in which it held an equity
interest, accounted for as an equity method investment that is a foreign
entity, immediately before the acquisition date in a business combination
achieved in stages (see paragraphs 805-10-25-9 through 25-10).
>> Partial Sale of Ownership Interest
40-2 If a reporting entity sells part of its ownership interest in an equity
method investment that is a foreign entity, a pro rata portion of the
accumulated translation adjustment component of equity attributable to that

equity method investment shall be recognized in measuring the gain or loss on

the sale. If the sale of part of an equity method investment that is a foreign
entity results in the loss of significant influence, see paragraphs 323-10-35-37
through 35-39 for guidance on how to account for the pro rata portion of the
accumulated translation adjustment component of equity attributable to the
remaining investment. For guidance if an entity sells a noncontrolling interest in
a consolidated foreign entity, but still retains a controlling financial interest in
the foreign entity, see paragraph 810-10-45-23 through 45-24.
40-3 Although partial liquidations by a parent of net assets held within a foreign
entity may be considered similar to a sale of part of an ownership interest in
the foreign entity if the liquidation proceeds are distributed to the parent,
extending pro rata recognition (release of the cumulative translation adjustment
into net income) to such partial liquidations would require that their substance
be distinguished from ordinary dividends. Such a distinction is neither possible
nor desirable. For those partial liquidations, no cumulative translation
adjustment is released into net income until the criteria in paragraph 830-30-40-
1 are met.
40-4 Under Subtopic 220-20, a gain or loss on disposal of part or all of a net
investment may be recognized in a period other than that in which actual sale
or liquidation occurs. Paragraph 830-30-40-1 does not alter the period in which
a gain or loss on sale or liquidation is recognized under existing generally
accepted accounting principles (GAAP).

Amounts recorded in CTA in AOCI as a result of applying net investment hedge

accounting are subsequently accounted for in the same manner as translation
adjustments. Those adjustments do not affect reporting currency cash flows
until the respective foreign entity is sold, exchanged or liquidated. They can be
viewed as unrealized gains or losses; therefore, they are not reported as part of
the results of operations – but rather in CTA – until realized on sale, exchange,
or liquidation of the foreign entity. [815-35-35-1, 830-30-40-1 – 40-3]
The following table summarizes the accounting for amounts in CTA in AOCI
upon sale, exchange or liquidation of a hedged net investment.

Nature of net Accounting for amounts recorded in CTA (including

investment in amounts related to the excluded component) upon sale,
foreign operation exchange or liquidation
Consolidated Complete sale or substantial liquidation of investment in
investment foreign entity
— Amount recorded in CTA is reported in the income
statement as part of the gain or loss on sale or liquidation
of the investment.
Sale of part of investment in foreign entity
— Controlling financial interest is retained. Sale is
accounted for as an equity transaction with a pro rata
portion of CTA related to the interest sold transferred to
noncontrolling interest.
— Controlling financial interest is not retained. Entire
amount recorded in CTA related to the investment is
reported in the income statement as part of the gain or
loss on sale, even if significant influence is retained.

Nature of net Accounting for amounts recorded in CTA (including

investment in amounts related to the excluded component) upon sale,
foreign operation exchange or liquidation
Other events leading to loss of control of investment in
foreign entity
— Entire amount recorded in CTA related to the investment
is reported in the income statement as part of the gain or
loss if the foreign entity (1) is a business and (2) is not in-
substance real estate.
1
Sale of foreign entity’s net assets
— Sale represents complete or substantially complete
liquidation. Entire amount recorded in CTA related to the
investment is reported in the income statement as part of
the gain or loss on sale.
— Sale does not represent complete or substantially
complete liquidation. No amount of CTA is released into
earnings.
Exchange of investments in foreign entities
— The transaction's specific facts and circumstances must
be evaluated to determine the appropriate accounting for
the amount recorded in CTA.

Equity method Complete sale or substantial liquidation

investment — Related portion of CTA is reported in the income
statement as part of the gain or loss on sale or liquidation
of the investment.
Sale of part of investment
— Pro rata portion of CTA related to the interest sold is
reported in the income statement as part of the gain or
loss on sale.
— If significant influence is not retained after the sale, the
pro rata portion of CTA related to the portion of
investment that is not sold is offset against the carrying
amount of the investment. To the extent the offset results
in a carrying amount less than zero (i.e. the remaining CTA
balance is a credit amount greater than the cost basis of
the investment)), the carrying amount is reduced to zero
and the remaining amount is recorded in earnings.
Exchange of investments in foreign entities
— The transaction's specific facts and circumstances must
be evaluated to determine the appropriate accounting for
the amount recorded in CTA.

Note:
For purposes of this discussion, the concept of net asset groups includes subsidiaries
but does not include subsidiaries or net assets that represent in-substance real estate
or oil- and gas-producing activities. For guidance on transactions related to subsidiaries
or net assets that represent in-substance real estate or oil- and gas-producing
activities, see Topics 360 (property, plant and equipment) and 932 (oil and gas),
respectively.

See paragraphs 4.036 to 4.054 in KPMG’s Handbook, Foreign Currency, for

additional guidance on the accounting for translation adjustments upon the sale,

exchange or liquidation of an investment in a foreign entity, including guidance

on how ‘substantial liquidation’ is interpreted.

8.5.30 Assessing impairment

Excerpt from Subtopic 830-30

>>> Consideration of Cumulative Translation Adjustment in Impairment

Tests
45-13 An entity that has committed to a plan that will cause the cumulative
translation adjustment for an equity method investment or a consolidated
investment in a foreign entity to be reclassified to earnings shall include the
cumulative translation adjustment as part of the carrying amount of the
investment when evaluating that investment for impairment. The scope of this
guidance includes an investment in a foreign entity that is either consolidated
by the reporting entity or accounted for by the reporting entity using the equity
method. This guidance does not address either of the following:
a. Whether the cumulative translation adjustment shall be included in the
carrying amount of the investment when assessing impairment for an
investment in a foreign entity when the reporting entity does not plan to
dispose of the investment (that is, the investment or related consolidated
assets are held for use)
b. Planned transactions involving foreign investments that, when
consummated, will not cause a reclassification of some amount of the
cumulative translation adjustment.
45-14 In both cases, paragraph 830-30-40-1 is clear that no basis exists to
include the cumulative translation adjustment in an impairment assessment if
that assessment does not contemplate a planned sale or liquidation that will
cause reclassification of some amount of the cumulative translation
adjustment. (If the reclassification will be a partial amount of the cumulative
translation adjustment, this guidance contemplates only the cumulative
translation adjustment amount subject to reclassification pursuant to
paragraphs 830-30-40-2 through 40-4.)
45-15 An entity shall include the portion of the cumulative translation
adjustment that represents a gain or loss from an effective hedge of the net
investment in a foreign operation as part of the carrying amount of the
investment when evaluating that investment for impairment.

When an entity has committed to a plan to dispose of a hedged foreign

operation that will cause the related CTA in AOCI attributable to that operation
to be reclassified to earnings, the entity should include the CTA as part of the
carrying amount of the investment when evaluating that investment for
impairment. This includes the portion of the CTA that resulted from applying
hedge accounting. [830-30-45-13 – 45-15]

See paragraph 4.035 in KPMG’s Handbook, Foreign Currency, for additional

guidance about accounting for translation adjustments when assessing
impairment.

8.5.40 Discontinuing hedge accounting

Excerpt from Subtopic 815-35

> Discontinuing Hedge Accounting

>> Amounts Excluded from the Assessment of Effectiveness under an
Amortization Approach
40-1 When applying the guidance in paragraph 815-35-35-5A and a hedge is
discontinued, any amounts that have not yet been recognized in earnings shall
remain in the cumulative translation adjustment section of accumulated other
comprehensive income until the hedged net investment is sold or liquidated in
accordance with paragraphs 830-30-40-1 through 40-1A.

Hedge accounting is discontinued prospectively if any one of the following

events occurs.

Change in — Hedged item no longer meets the eligibility criteria (see

eligibility or section 8.2).
critical terms of — Complete sale or substantial liquidation of foreign operation
hedged item (net (see section 8.5.20).
investment in
foreign — Other events leading to a loss of control of the investment
operation) in foreign entity (see section 8.5.20).
(section 2.10.20) — Partial sale of investment in foreign operation (see
section 8.5.20).
— Changes in the net investment balance should be
monitored to determine whether the hedging relationship
should be redesignated to reflect a revised balance (see
section 8.2.20).

Change in — Hedging instrument no longer meets the eligibility criteria

eligibility or (see section 8.3).
critical terms of
— Hedging instrument expires or is sold, terminated or
hedging
exercised.
instrument
(section 2.10.30)
— Modification of hedging instrument such that critical terms
of the original hedging relationship have changed.

Change in the — Change in the hedged risk. [815-20-55-56]

hedged risk
(section 2.10.40)

Change in hedge — Hedging relationship is no longer effective as an economic

effectiveness hedge (see below).
(section 2.10.50) — Change in the effectiveness assessment method, including
changing from forward method to spot method, or vice
versa (see section 8.4.40). [815-20-55-56]

Elective An entity may elect to discontinue the hedging relationship (see

dedesignation sections 8.2.20 and 2.10).

Amounts in CTA in AOCI related to a discontinued hedging relationship –

including amounts related to excluded components – remain in CTA until the
hedged net investment is sold, exchanged or liquidated (see section 8.5.20).
[815-35-35-1, 40-1]

Hedged net investment. When hedge accounting is discontinued, the entity

may designate prospectively the previously hedged net investment in a new
hedging relationship with a different hedging instrument as long as the hedging
criteria are met for the new relationship (see section 8.2.20).
Hedging instrument. The accounting for the hedging instrument after a
hedging relationship is discontinued depends on whether the instrument is a
derivative or nonderivative.
— Derivative hedging instrument. A derivative hedging instrument that
remains outstanding continues to be recorded in the balance sheet at fair
value. However, changes in its fair value (including changes in excluded
components) are reflected in earnings – rather than CTA – unless it is
designated as the hedging instrument in a new cash flow or net investment
hedge.
— Nonderivative hedging instrument. Foreign currency transaction gains or
losses on a FCD nonderivative financial instrument that is no longer
designated as a hedging instrument are recognized in earnings – rather than
CTA – unless it is designated as the hedging instrument in a new net
investment hedge.

Hedging relationship is no longer effective as an economic

hedge
If an entity’s hedge effectiveness assessment indicates that a hedging
relationship is no longer highly effective, the hedging relationship is
discontinued prospectively. In that case, generally no changes in the fair value
of a derivative hedging instrument (or transaction gains or losses of a
nonderivative hedging instrument) are recognized in CTA after the last date on
which effectiveness testing indicated the relationship was effective as an
economic hedge.

Question 8.5.10
Is hedge accounting applied through the date an
event causes a hedging relationship to no longer be
effective as an economic hedge?
Background: If in a fair value hedge an event or change in circumstances
results in the hedging relationship not being retrospectively highly effective for
the current period and the date that event or change in circumstances occurred
can be identified, the entity must apply fair value hedge accounting through that
date (see section 4.5.20). Topic 815 does not contain similar language for cash
flow or net investment hedges. [815-25-40-4]
Based on discussions with the FASB staff, we believe cash flow hedge
accounting should be applied through the date of such an event or change (see
Question 6.5.30).
Interpretive response: Yes. We believe that when a hedging relationship was
not effective as an economic hedge at the current assessment date, the entity
generally should discontinue hedge accounting and should not recognize
changes in the fair value of the hedging derivative (or remeasurement gains or
losses of a FCD liability) in CTA in AOCI for that assessment period.
However, if the entity is able to identify the event or change in circumstances
that resulted in the hedging relationship being discontinued, the entity must
apply hedge accounting up to the date of that event or change in
circumstances. All subsequent changes in fair value of the derivative (and
remeasurement gains or losses of a FCD liability) that occurred from that date
to the current assessment date are reported in earnings.

9. Hedge effectiveness
Detailed contents
9.1 How the standard works
9.2 General requirements for assessing effectiveness
9.2.10 Overview
9.2.20 Timing and nature of prospective and retrospective
effectiveness assessments
9.2.30 Aligning effectiveness assessments with the designated
hedged risk
9.2.40 Meaning of ‘highly effective’
9.2.50 Determining the period for assessing effectiveness
9.2.60 Considering counterparty credit risk and entity’s own non-
performance risk
9.2.70 Excluded components
9.2.80 Consistency of methods between hedging relationships
9.2.90 Additional considerations when using options as the
hedging instrument
9.2.100 Additional consideration for fair value hedges – prepayment
risk under the last-of-layer method
9.2.110 Additional consideration for cash flow hedges – time value
of money
Questions
9.2.10 Is an entity permitted to deliberately overhedge or
underhedge?
9.2.20 How is a hedging relationship affected when a physical
(nonfinancial) asset’s actual location is different from that of
the derivative’s underlying?
9.2.30 Is a quarterly hedge effectiveness assessment always
performed only quarterly?
9.2.40 May an entity use different methods for its prospective and
retrospective effectiveness assessments?
9.2.50 If an entity is not required to perform an initial prospective
assessment on a quantitative basis, on what basis are its
subsequent effectiveness assessments performed?
9.2.60 Why may an entity elect to perform subsequent
assessments on a qualitative – rather than a quantitative –
basis?
9.2.70 Does Topic 815 define highly effective?
Hedging 643
9. Hedge effectiveness

9.2.80 How does an entity determine the historical period when

initially assessing hedge effectiveness?
9.2.90 If a hedging instrument is in a liability (asset) position, can
changes in counterparty creditworthiness (its own
nonperformance risk) be ignored?
9.2.100 Must an entity allocate a portfolio-level credit risk
adjustment to individual hedging relationships when
assessing effectiveness?
9.2.110 Under what circumstances may an entity qualitatively
evaluate the effect of a portfolio-level credit risk adjustment
on individual fair value hedging relationships?
9.2.120 What methods may be used to quantitatively allocate a
portfolio-level credit risk adjustment to individual fair value
hedging relationships?
9.2.130 How does a financial instrument’s level in the fair value
hierarchy affect allocation of a portfolio-level credit risk
adjustment to individual hedging relationships?
9.2.140 Could an entity be required to quantitatively allocate a
portfolio-level credit risk adjustment for reasons other than
assessing effectiveness?
9.2.150 Are there circumstances where the time value does not
affect the assessment of effectiveness even though it is
not considered an excluded component?
9.2.160 What is a systematic and rational method to recognize an
excluded component?
9.2.170 Under the amortization approach, is the excluded
component recognized when the hedged transaction
affects earnings?
9.2.180 Is the caplet method acceptable for recognizing the initial
value of an excluded component?
9.2.190 How does an entity account for amounts included in AOCI
related to an excluded component if hedge accounting is
discontinued?
9.2.200 Are there situations in which an entity may use different
effectiveness assessment methods for similar hedges?
9.2.210 Must an entity use qualitative effectiveness assessments
for all similar hedges?
9.2.220 What effect does ASU 2017-12 have on the requirement to
assess effectiveness for similar hedges in a similar
manner?
9.2.230 What are the components of an option’s value?
9.2.240 How is the intrinsic value of an option measured?
9.2.250 How is the intrinsic value of a cap option that involves a
series of payments measured?
Hedging 644
9. Hedge effectiveness

9.2.260 How are portions of time value (passage of time, market

variables) measured?
9.2.270 Must an entity assess effectiveness for all periods that the
option has intrinsic value?
9.2.280 If the hedged risk is changes within a range and time value
is an excluded component, how are changes in the
underlying that do not cause a change in intrinsic value
accounted for?
9.2.290 If a zero-cost collar has different notional amounts, can the
hedged item be different proportions of the same asset
referenced in the collar?
9.2.300 How is the timing of cash flows considered in an
effectiveness assessment for a cash flow hedge?
9.2.310 Is discounting required when the spot method is used?
9.2.320 How does discounting affect a hedging relationship when a
forward contract does not settle on the date of the
forecasted transaction?
Examples
9.2.10 Consistency of effectiveness assessment with
documented risk management objective
9.2.20 Calculations of effectiveness
9.2.30 Qualitative analysis of whether allocation of portfolio-level
credit risk adjustment is required
9.2.40 Effect of time value on hedge effectiveness
9.2.50 Comparison of approaches to recognize the excluded
component for a cash flow hedge
9.2.60 Assessing effectiveness with an interest rate cap
9.2.70 Comparison of excluding spot-forward difference –
discounted vs. undiscounted
9.2.80 Measuring changes in cash flows – discounted vs.
undiscounted
9.3 Shortcut method for interest rate swaps
9.3.10 Overview
9.3.20 General requirements
9.3.30 Criterion 1: Swap’s notional amount matches the hedged
item’s principal amount
9.3.40 Criterion 2: Swap’s fair value at hedge inception is zero
9.3.50 Criterion 3: Swap has a consistent formula for computing
net settlements each period
9.3.60 Criterion 4: Hedged item is not prepayable, with limited
exceptions
Hedging 645
9. Hedge effectiveness

9.3.70 Criterion 5: All other terms are typical and do not invalidate
assumption of perfect effectiveness
9.3.80 Additional criteria for fair value hedges
9.3.90 Additional criteria for cash flow hedges
9.3.100 Counterparty credit risk
9.3.110 Discontinuing the shortcut method
Questions
9.3.10 Can the shortcut method be applied to a hedge of the
forecasted issuance or purchase of a financial instrument?
9.3.20 How does an entity determine whether the trade and
settlement dates of a firm commitment differ due to
market conventions?
9.3.30 Can a lessee or lessor apply the shortcut method to a cash
flow hedge of the variability in lease payments of an
interest rate indexed operating lease?
9.3.40 Can an entity replace the hedged item or transaction during
a shortcut method hedging relationship?
9.3.50 Are there documentation considerations that are specific to
the shortcut method?
9.3.60 Can the shortcut method be applied when a portion (i.e. a
percentage) of an interest-bearing asset or liability is
designated as the hedged item or transaction?
9.3.70 Can the shortcut method be applied when hedging a
portfolio of interest-bearing assets or liabilities or group of
forecasted transactions?
9.3.80 Can the shortcut method be applied to a hedging
relationship if the hedging instrument is a part of a
derivative instrument?
9.3.90 Are there exceptions to the requirement that an interest
rate swap’s fair value be zero at hedge inception?
9.3.100 How does an entity determine whether the interest rate
swap has a zero fair value if it includes a premium for an
embedded call or put option?
9.3.110 Can an interest rate swap that has an embedded financing
arrangement have a fair value of zero?
9.3.120 Can the shortcut method be applied if the hedging
instrument is a forward-starting interest rate swap?
9.3.130 Can the shortcut method be applied to a hedge if the swap
contains an initial stub period?
9.3.140 Can the shortcut method be applied to a hedge if the first
cash flow on the swap includes debt issuance fees?
9.3.150 What financial instruments does an entity consider
prepayable?
Hedging 646
9. Hedge effectiveness

9.3.160 Is a debt instrument that becomes prepayable on the

debtor’s credit deterioration considered prepayable when
applying the shortcut method?
9.3.170 Is a debt instrument that becomes prepayable on the
occurrence of an event beyond the control of the debtor or
creditor considered prepayable when applying the shortcut
method?
9.3.180 Are there exceptions to the requirement that a hedged item
or transaction not be prepayable?
9.3.190 How does a debt instrument’s carrying amount affect
whether the swap used to hedge the debt contains a
mirror-image call option?
9.3.200 Does the shortcut method require the fixed rate on the
swap to match the fixed rate on the hedged item or
transaction?
9.3.210 Can the shortcut method be applied to a hedge of a
convertible debt instrument?
9.3.220 Can the shortcut method be applied to a hedge of a debt
instrument issued by a trust preferred structure?
9.3.230 Can the shortcut method be applied if the hedging
instrument is a swap with a variable leg that reprices in
arrears?
9.3.240 Can the shortcut method be applied to a hedge of a fixed-
rate debt instrument with an interest rate that increases if
the issuer’s credit rating deteriorates?
9.3.250 Can the shortcut method be applied to a hedge of a zero-
coupon bond?
9.3.260 Can the shortcut method be applied to a partial-term fair
value hedge?
9.3.270 Can the shortcut method be applied to a fair value hedge if
the swap expires one day before or after the hedged item’s
maturity date or assumed maturity date?
9.3.280 Can the shortcut method be applied to a fair value hedge if
the swap’s variable leg is based on a tenor different from
the hedged risk?
9.3.290 Can the shortcut method be applied to a fair value hedge if
the variable interest rate of the swap has a cap or floor?
9.3.300 Can the shortcut method be applied to a cash flow hedge if
the swap’s variable leg is based on a tenor different from
the hedged risk?
9.3.310 Can the shortcut method be applied to a cash flow hedge if
the hedged item is a variable-rate debt that contains a cap
or floor?
Hedging 647
9. Hedge effectiveness

9.3.320 Can the shortcut method be applied to a cash flow hedge

of interest payments arising from variable-rate debt if the
debt matures after the swap expires?
9.3.330 Can the shortcut method be applied to a cash flow hedge if
the swap reprices in arrears, but the hedged forecasted
transaction does not?
9.3.340 Does an entity consider counterparty credit risk or its own
nonperformance risk when applying the shortcut method?
9.3.350 What happens if an entity does not document a quantitative
method that it would use if the shortcut method was not
(or no longer is) appropriate?
9.3.360 When the shortcut method is required to be discontinued,
as of what date(s) should an entity perform the quantitative
assessments?
9.3.370 What is the effect of performing quantitative assessments
once the shortcut method is discontinued?
Examples
9.3.10 Debt hedged on trade date
9.3.20 Day 1 fair value of a compound interest rate swap
9.3.30 Day 1 fair value of an interest rate swap with an embedded
financing arrangement
9.4. Critical terms match method
9.4.10 Overview
9.4.20 Criteria
9.4.30 Scope
9.4.40 Assessment
Questions
9.4.10 Can the critical terms match method be applied if the
hedging instrument has a non-zero fair value at hedge
inception?
9.4.20 Can the critical terms match method be applied to a
hedging relationship that uses an interest rate swap as the
hedging instrument?
9.4.30 Can the critical terms match method be applied if one
derivative instrument hedges multiple transactions over a
period of time?
9.4.40 Can the critical terms match method be applied to a
forecasted transaction that gives rise to a receivable or
payable that settles subsequently?
9.4.50 Can the critical terms match method be applied if the
hedging instrument is a cross-currency interest rate swap?
Hedging 648
9. Hedge effectiveness

9.4.60 Does an entity consider counterparty nonperformance risk

when evaluating whether it is probable that a forecasted
transaction will occur?
9.4.70 Can the critical terms match method be applied to an all-in-
one hedge?
9.4.80 If the critical terms cease to match after hedge inception, is
an entity required to discontinue hedge accounting?
9.4.90 How does an entity consider counterparty credit risk or its
own nonperformance risk when applying the critical terms
match method to a cash flow hedge?
9.5 Qualitative effectiveness assessments
9.5.10 Overview
9.5.20 Changes in facts and circumstances
Questions
9.5.10 When the hedging relationship does not have perfect
offset, how does an entity reasonably support its
expectation of high effectiveness on a qualitative basis in
subsequent periods?
9.5.20 Under what circumstances is a subsequent quantitative
assessment required if an entity initially elects to perform
qualitative assessments?
9.5.30 If required, for what periods are subsequent quantitative
assessments performed?
9.5.40 What is the consequence of failing to identify that an entity
could not reasonably support performing qualitative
assessments in a prior period?
9.5.50 May an entity performing quantitative effectiveness
assessments revert to qualitative effectiveness
assessments?
Example
9.5.10 Whether an expectation of high effectiveness can be
reasonably supported in subsequent periods
9.6 Quantitative methods of assessing effectiveness
9.6.10 Overview
9.6.20 Dollar-offset method
9.6.30 Regression analysis
9.6.40 Changing quantitative methods for assessing effectiveness
9.6.50 Illustrative examples of quantitative methods to assess
effectiveness
Hedging 649
9. Hedge effectiveness

Questions
9.6.10 Why might an entity elect to use a quantitative method,
even if the hedging relationship is eligible for a different
method?
9.6.20 Can an entity choose different effectiveness assessment
methods each period based on the expected outcome?
9.6.30 Which technique for assessing hedge effectiveness is
more prevalent?
9.6.40 What implications arise under the dollar-offset method
when changes in fair values during the period are small?
9.6.50 Which approach is more commonly applied when using the
dollar-offset method: cumulative or period-by-period?
9.6.60 What should be compared (regressed) in a regression
analysis?
9.6.70 Must an entity perform the actual regression calculation if it
is mathematically certain a cash flow hedge will be
perfectly effective?
9.6.80 What outputs of regression analysis should be evaluated?
9.6.90 Should an entity consider using specialists when it uses
statistical analysis to assess effectiveness?
9.6.100 Do quantitative effectiveness assessments require
judgment?
Examples
9.6.10 Dollar-offset method for retrospective test (fair value
hedge)
9.6.20 Hedging forecasted purchases of fuel using regression
analysis and the dollar-offset method
9.7 Cash flow hedges – Methods for measuring cash flows
9.7.10 Overview
9.7.20 Terminal value method for certain cash flow hedges using
an option as the hedging instrument
9.7.30 Hypothetical derivative method
9.7.40 Methods applicable when an interest rate swap is used in a
cash flow hedge of variability in interest receipts or
payments
9.7.50 Project future cash flows using forward price curves or
using recent sales or purchase orders
Questions
9.7.10 What should an entity consider when assessing hedge
effectiveness for a group of similar forecasted
transactions?
Hedging 650
9. Hedge effectiveness

9.7.20 May the terminal value method be used by the buyer when
the hedging instrument is a swaption?
9.7.30 Can the hypothetical derivative method result in perfect
effectiveness when the hedging instrument is not an
interest rate swap and the hedged risk is not variability in
interest receipts or payments?
9.7.40 How is the PEH derivative defined when a cross-currency
interest rate swap is used to hedge intercompany fixed-rate
debt in a cash flow hedge?
9.7.50 How is the PEH derivative defined when a deal contingent
swap is used to hedge a forecasted debt issuance
contingent on a business combination?
Examples
9.7.10 Terminal value method is not appropriate
9.7.20 Terminal value method for a hedge of a forecasted foreign
currency denominated sale with a purchased option
9.7.30 Using the caplet method to reclassify amounts from AOCI
into earnings
9.7.40 PEH swap in a hedge of variable-rate debt that contains a
floor
9.7.50 Projecting future cash flows using recent purchase orders
9.8 Examples of effectiveness assessment methods relevant to various
hedging instruments
9.9 Comparison of methods for assessing effectiveness
Hedging 651
9. Hedge effectiveness

9.1 How the standard works

Throughout this chapter, PEH means perfectively effective hypothetical
(derivative).

Criterion 1 Criterion 2 Criterion 3 Criterion 4

Eligibility of Eligibility of
Eligibility of Hedge
hedged items hedging
hedged risk(s) effectiveness
or transactions instruments

Criterion 5: Formal documentation

Hedge accounting is permitted only if the hedging relationship is highly

effective at managing the risk being hedged. Effectiveness assessments are
required to be performed prospectively at hedge inception and both
prospectively and retrospectively periodically thereafter (at least quarterly).
— For a prospective assessment, the entity evaluates whether the hedging
relationship is expected to be highly effective.
— For a retrospective assessment, the entity evaluates whether the hedging
relationship has actually been highly effective.
The following diagram summarizes how effectiveness is assessed.

Quantitative vs. qualitative. Topic 815 requires the initial (prospective)

assessment to be performed on a quantitative basis unless the hedging
relationship meets certain conditions. Subsequent assessments may be
performed on a quantitative basis, or on a qualitative basis if certain conditions
are met (see section 9.5).
Additionally, Topic 815 provides the three methods that allow an entity to
assume a hedging relationship is perfectly effective if certain conditions are
met:
— shortcut method (section 9.3);
— critical terms match method (section 9.4); and
— simplified hedge accounting approach, which is available for private
companies that are not financial institutions (section 10.2).
An entity is generally required to apply the same method for assessing
effectiveness to similar hedging relationships (see section 9.2.80).
This chapter discusses the general requirements for assessing hedge
effectiveness and the specific requirements for various assessment methods. It
also explains some additional considerations that affect the assessments,
including the following.
Hedging 652
9. Hedge effectiveness

— Excluded components. Improving hedge effectivess by excluding certain

components of the hedging instrument (e.g. the time value of an option)
from effectiveness assessments. Excluding a component improves hedge
effectiveness when the hedged item’s fair value (or hedged transaction’s
cash flows) is not affected by (or not affected to the same extent as) the
component (see section 9.2.70).
— The effects of counterparty credit risk and the entity’s own
nonperformance risk when assessing hedging relationships. These
considerations are different, depending on whether the hedging relationship
is a cash flow, fair value, or net investment hedge and on the method used
for assessing effectiveness (see section 9.2.60).
If a hedge was not highly effective in a period, hedge accounting is not applied
for that period. Additionally, if an entity can no longer support its expectation of
high effectiveness, hedge accounting is discontinued prospectively (see
section 2.10.50).
Hedging 653
9. Hedge effectiveness

9.2 General requirements for assessing effectiveness

9.2.10 Overview

Excerpt from ASC 815-20

> Hedge Effectiveness

25-73 Sections 815-25-55 and 815-30-55 illustrate some ways in which an
entity may assess hedge effectiveness for specific strategies. The Examples
are not intended to imply that other reasonable methods are precluded.
However, not all possible methods are reasonable or consistent with this
Subtopic. Those Sections also discuss some methods of assessing hedge
effectiveness that are not consistent with this Subtopic and thus may not be
used.
>> Hedge Effectiveness Criteria Applicable to both Fair Value Hedges and
Cash Flow Hedges
25-74 This guidance addresses hedge effectiveness criteria applicable to both
fair value hedges and cash flow hedges.
25-75 To qualify for hedge accounting, the hedging relationship, both at
inception of the hedge and on an ongoing basis, shall be expected to be highly
effective in achieving either of the following:
a. Offsetting changes in fair value attributable to the hedged risk during the
period that the hedge is designated (if a fair value hedge)
b. Offsetting cash flows attributable to the hedged risk during the term of the
hedge (if a cash flow hedge), except as indicated in paragraph 815-20-25-
50.
25-77 There would be a mismatch between the change in fair value or cash
flows of the hedging instrument and the change in fair value or cash flows of
the hedged item or hedged transaction in any of the following circumstances,
among others:
a. A difference between the basis of the hedging instrument and the hedged
item or hedged transaction, to the extent that those bases do not move in
tandem
b. Differences in critical terms of the hedging instrument and hedged item or
hedged transaction, such as differences in any of the following:
1. Notional amounts
2. Maturities
3. Quantity
4. Location (not applicable for hedging relationships in which the variability
in cash flows attributable to changes in a contractually specified
component is designated as the hedged risk)
5. Delivery dates.
c. A change in the counterparty’s creditworthiness
25-78 Paragraph 815-20-55-62 discusses basis differences in cash flow hedges
of interest rate risk.
Hedging 654
9. Hedge effectiveness

Assessing effectiveness means determining the degree to which the change in

fair value or cash flows of the hedged item attributable to the risk being hedged
has been and is expected to continue to be offset by the change in the fair
value or cash flows of the derivative hedging instrument that are included in the
assessment of effectiveness. This assessment can be expressed in terms of a
percentage of offset and the percentage should be within the range of 80%–
125% (see section 9.2.40). [815-20-25-75]
As discussed in section 2.8, hedge accounting is applied only if the hedging
relationship is expected to be (and actually is) highly effective. [815-20-25-75]

Fair value hedge Cash flow hedge

Gains or losses on the derivative Gains or losses on the derivative
hedging instrument that are included in hedging instrument that are included in
the assessment of effectiveness are the assessment of effectiveness are
expected to be – and actually are – expected to be – and actually are –
highly effective at offsetting changes highly effective at offsetting changes
in the fair value of the hedged item in the cash flows of the hedged
attributable to the designated hedged transaction attributable to the
risk. designated hedged risk.

For net investment hedges, hedge accounting is applied only if the hedging
relationship is effective as an economic hedge (see section 8.4).
Topic 815 does not prescribe methods that must be used for assessing hedge
effectiveness. Rather, it requires that the method used be reasonable and
consistent with the risk management strategy; this means that the assessment
is required to be performed in a manner that is consistent with the documented
risk management objective (see section 9.2.30). Moreover, it generally requires
an entity to assess effectiveness for similar hedges in a similar manner (see
section 9.2.80).
To determine if a hedging relationship is both expected to be (prospectively will
be) and actually is (retrospectively has been) highly effective, an entity performs
effectiveness assessments both at inception of the hedging relationship and
periodically thereafter (at least quarterly). The initial assessment is required to
be quantitative, unless certain conditions are met (see Question 9.2.50). The
subsequent assessments may be quantitative (see section 9.6) or qualitative if
certain conditions are met (see section 9.5).
The assessment process can be complex. For example, an entity is required to
consider the effect of counterparty credit risk (its own nonperformance risk) on
the hedging relationship (see section 9.2.60). Additionally, an entity must select
a period over which to assess effectiveness, which may result in an entity
assessing effectiveness more frequently than quarterly (see section 9.2.50).
Moreover, there are additional considerations:
— when using options as hedging instruments (see section 9.2.90);
— for fair value hedges related to prepayment risk under the last-of-layer
method (section 9.2.100); and
— for cash flow hedges related to time value of money (see section 9.2.110).
Topic 815 streamlines the assessment process for certain hedging relationships
by providing three methods that assume a hedging relationship is perfectly
effective, each of which has specific criteria that must be met:
Hedging 655
9. Hedge effectiveness

— shortcut method (see section 9.3)

— critical terms match method (see section 9.4)
— simplified hedge accounting approach, which is available for private
companies that are not financial institutions (see section 10.2).
Topic 815 also permits an entity to exclude some components of the hedging
instrument from the effectiveness assessment to increase the likelihood that
the hedging relationship will be highly effective (see section 9.2.70).

Hedging relationships that are not perfectly effective

Some hedging relationships are not designed to be perfectly effective but
nonetheless can be highly effective. A hedging relationship will not be perfectly
effective in any of the following situations – i.e. there will be a mismatch
between the change in fair value or cash flows of the hedging instrument and
the change in fair value or cash flows of the hedged item or transaction. [815-20-
25-77]

Basis difference A basis difference is a difference between the basis that

exists drives the variability in cash flows of the hedging instrument
[815-20-25-77(a)] and the hedged item or hedged transaction; for example, a
difference between a contractually specified interest rate in
existing variable-rate debt and the index on which cash
flows of the variable leg of an interest rate swap are
determined. [815-20-25-78, 55-62]
Interest rate risk. See also section 2.3.40 regarding
basis differences in cash flow hedges of interest rate risk.

Other critical terms Other critical terms do not match (i.e. the critical terms of
do not match the hedging instrument and the hedged item or transaction
[815-20-25-77(b)] do not match), including differences in notional amounts,
maturities, payment dates, quantity, location, and delivery
dates.
Cash flow hedge. The location is not a critical term in a
cash flow hedge of a contractually specified component.

Changes in See section 9.2.60 regarding consideration of a

creditworthiness counterparty’s credit risk and the entity’s own
[815-20-25-77(c)] nonperformance risk.
Fair value hedges. Changes in both counterparty credit risk
and an entity’s own nonperformance risk affect the
measurement of changes in the fair value of the derivative
hedging instrument. These changes likely have no offsetting
effect on changes in the measurement of the hedged item
attributable to the hedged risk.

Additional items — There are additional items that affect the measurement
affecting the of the hedging instrument’s fair value or cash flows that
measurement of the affect the hedged item or transaction differently (or not
hedging instrument at all).
— For example:
— In a fair value hedge, the effect of credit risk on the
measurement of fair value may be different
Hedging 656
9. Hedge effectiveness

between the hedged item and hedging instrument.

For example, in a hedge of the changes in fair
value of a recognized fixed-rate liability due to
changes in LIBOR (a benchmark interest rate), a
collateralized interest rate swap (hedging
instrument) could be discounted using the
overnight index swap (OIS) rate while the change
in the fair value of the liability attributable to LIBOR
is discounted using LIBOR.
— The time value of an option, forward points in a
forward or futures contract, or cross-currency basis
spread in a currency swap affect the fair value of
those hedging instruments unless they are
excluded components (see section 9.2.70).

Question 9.2.10
Is an entity permitted to deliberately overhedge or
underhedge?
Background: An overhedge occurs when the hedging instrument is expected
to provide cash flows in excess of the expected cash flows of the forecasted
transaction. For example, an entity has a $1,000,000 investment in a variable-
rate (three-month LIBOR) corporate debt security and enters into an interest
rate swap to hedge the variability in cash flows attributable to interest receipts
due on the debt security, but designates the entirety of a swap contract with a
$1,100,000 notional as the hedging instrument.
An underhedge occurs when the expected cash flows on the hedged
transaction exceed the expected cash flows on the derivative hedging
instrument. For example, an entity has a $1,000,000 investment in a variable-
rate (three-month LIBOR) corporate debt security and enters into an interest
rate swap contract to hedge the variability in cash flows attributable to interest
receipts due on the debt security, but the swap contract has a $900,000
notional.
Interpretive response: Yes. An entity is permitted to deliberately overhedge or
underhedge as long as the hedging relationship will still be highly effective.
[815-20-25-75]

Fair value hedge. The effects of a fair value overhedge or underhedge are
included in earnings immediately because the entire change in fair value of the
hedging instrument included in the assessment of effectiveness is included in
earnings.
Cash flow hedge. The effects of a cash flow overhedge or underhedge are
initially recognized in OCI. These amounts are recognized when the hedged
transaction affects earnings (see section 6.3).
Net investment hedge. The effects of a net investment overhedge or
underhedge are initially recognized in CTA within AOCI. These amounts are
recognized when the respective foreign entity is sold, exchanged, or liquidated
(see section 8.5.20).
Hedging 657
9. Hedge effectiveness

Question 9.2.20
How is a hedging relationship affected when a
physical (nonfinancial) asset’s actual location is
different from that of the derivative’s underlying?
Interpretive response: Unless the hedged risk is a contractually specified
component in a cash flow hedging relationship, an underlying of the hedged
item or transaction being in a different location from the underlying of the
derivative hedging instrument will cause a mismatch between changes in the
fair value or cash flows of the hedged item or transaction and changes in the
fair value or cash flows of the derivative hedging instrument. This would
preclude the entity from assuming that the hedging relationship is
perfectly effective.
This is because an entity is required to incorporate the location as one of a
physical (nonfinancial) asset’s characteristics, unless the hedged risk is a
contractually specified component in a cash flow hedging relationship.
Specifically, actual location must be incorporated when measuring changes in
the fair value of a physical asset that is the hedged item in a fair value hedge,
or changes in the expected future cash flows of a forecasted transaction that
involves a physical asset in a cash flow hedge. [815-20-25-12(e), 25-15(i)(2), 25-77]
For example, if an entity designates a Colombian coffee futures contract as the
hedging instrument in a fair value hedge of its coffee inventory that is stored in
Brazil, the entity may not assume the hedging relationship will be perfectly
effective. This is because of the location difference between the physical asset that
is the hedged item and location of the underlying of the hedging instrument.
If the hedged risk is a contractually specified component in a cash flow hedging
relationship, Topic 815 does not require an entity to incorporate location as one
of a physical (nonfinancial) asset’s characteristics. [815-20-25-15(i)(3), 25-77]

FASB examples
The following FASB examples are reproduced below.
Fair value hedges
— Fair value hedge of natural gas inventory with futures contracts
(Subtopic 815-25’s Example 1). Effectiveness is assessed using the spot
method and is affected by a location difference.
— Fair value hedge of tire inventory with a forward contract (Subtopic 815-25’s
Example 2). Effectiveness is assessed using the spot method and is
affected by a basis difference.
— Fair value hedge of growing wheat with futures contracts (Subtopic 815-
25’s Example 3). Effectiveness is affected by the futures contract being for
grown, harvested wheat while the inventory is not grown (or harvested).
Cash flow hedges
— Effectiveness of cash flow hedge with a basis swap (Subtopic 815-30’s
Example 2). Effectiveness is affected by timing differences between the
hedging instrument and forecasted transactions.
Hedging 658
9. Hedge effectiveness

Excerpt from ASC 815-25

>> Example 1: Fair Value Hedge of Natural Gas Inventory with Futures
Contracts

55-1 This Example illustrates the guidance in Sections 815-20-25, 815-20-35,

and 815-25-35 for how an entity may assess hedge effectiveness in a fair
value hedge of natural gas inventory with futures contracts. Assume that the
hedge satisfied all of the criteria for hedge accounting at inception.
55-2 Entity A has 20,000 million British thermal units of natural gas stored at its
location in West Texas. To hedge the fair value exposure of the natural gas,
Entity A sells the equivalent of 20,000 million British thermal units of natural
gas futures contracts on a national mercantile exchange. The futures contracts
prices are based on delivery of natural gas at the Henry Hub gas collection
point in Louisiana.
55-3 The price of Entity A’s natural gas inventory in West Texas and the price
of the natural gas that is the underlying for the futures contracts it sold will
differ as a result of regional factors (such as location, pipeline transmission
costs, and supply and demand). Entity A therefore may not automatically
assume that the hedge will be highly effective at achieving offsetting changes
in fair value, and it cannot assess effectiveness by looking solely to the change
in the price of natural gas delivered to the Henry Hub. The use of a hedging
instrument with a different underlying basis than the item or transaction being
hedged is generally referred to as a cross-hedge. The principles for cross-
hedges illustrated in this Example also apply to hedges involving other risks.
For example, the effectiveness of a hedge of interest rate risk in which one
interest rate is used as a surrogate for another interest rate would be evaluated
in the same way as the natural gas cross-hedge in this Example.
55-4 Both at inception of the hedge and on an ongoing basis, Entity A might
assess the hedge’s expected effectiveness on a quantitative basis based on
the extent of correlation in recent years for periods similar to the spot prices
term of the futures contracts between the spot prices of natural gas in West
Texas and at the Henry Hub. If those prices have been and are expected to
continue to be highly correlated, Entity A might reasonably expect the changes
in the fair value of the futures contracts attributable to changes in the spot
price of natural gas at the Henry Hub to be highly effective in offsetting the
changes in the fair value of its natural gas inventory. In assessing effectiveness
during the term of the hedge, Entity A must take into account actual changes
in spot prices in West Texas and at the Henry Hub. The period of time over
which correlation of prices should be assessed would be based on
management’s judgment in the particular circumstance.
55-5 Entity A may not assume that the change in the spot price of natural gas
located at Henry Hub, Louisiana, is the same as the change in fair value of its
West Texas inventory. The physical hedged item is natural gas in West Texas,
not natural gas at the Henry Hub. In identifying the price risk that is being
hedged, Entity A also may not assume that its natural gas in West Texas has a
Louisiana natural gas component. Use of a price for natural gas located
somewhere other than West Texas to assess the effectiveness of a fair value
Hedging 659
9. Hedge effectiveness

hedge of natural gas in West Texas would be inconsistent with this Subtopic
and could result in an assumption that a hedge was highly effective when it
was not. If the price of natural gas in West Texas is not readily available,
Entity A might use a price for natural gas located elsewhere as a base for
estimating the price of natural gas in West Texas. However, that base price
must be adjusted to reflect the effects of factors, such as location,
transmission costs, and supply and demand, that would cause the price of
natural gas in West Texas to differ from the base price.
55-6 Consistent with Entity A's method of assessing whether the hedge is
expected to be highly effective, the hedge would not be perfectly effective and
there would be a net earnings effect to the extent that the actual change in the
fair value of the futures contracts attributable to changes in the spot price of
natural gas at the Henry Hub did not offset the actual change in the spot price
of natural gas in West Texas per million British thermal units multiplied by
20,000.
55-7 That method excludes the change in the fair value of the futures contracts
attributable to changes in the difference between the spot price and the
forward price of natural gas at the Henry Hub in assessing effectiveness. The
excluded amount would be recognized in earnings through an amortization
approach in accordance with paragraph 815-20-25-83A or a mark-to-market
approach in accordance with paragraph 815-20-25-83B and presented in the
same income statement line item as the earnings effect of the hedged item in
accordance with paragraph 815-20-45-1A.

Excerpt from ASC 815-25

>> Example 2: Fair Value Hedge of Tire Inventory with a Forward Contract

55-8 This Example illustrates the guidance in Sections 815-20-25, 815-20-35,

and 815-25-35 for how an entity may assess hedge effectiveness in a fair value
hedge of tire inventory with a forward contract. Assume that the hedge
satisfied all of the criteria for hedge accounting at inception.
55-9 Entity B manufactures tires. The production of those tires incorporates a
variety of physical components, of which rubber and steel are the most
significant, as well as labor and overhead. Entity B hedges its exposure to
changes in the fair value of its inventory of 8,000 steel-belted radial tires by
entering into a forward contract to sell rubber at a fixed price.
55-10 Entity B decides to perform subsequent hedge effectiveness
assessments on a quantitative basis and bases its assessment on changes in
the fair value of the forward contract attributable to changes in the spot price
of rubber. To determine whether the forward contract is expected to be highly
effective at offsetting the change in fair value of the tire inventory, Entity B
could estimate and compare such changes in the fair value of the forward
contract and changes in the fair value of the tires (computed as the market
price per tire multiplied by 8,000 tires) for different rubber and tire prices.
Entity B also should consider the extent to which past changes in the spot
Hedging 660
9. Hedge effectiveness

prices of rubber and tires have been correlated. Because tires are a
nonfinancial asset and rubber is only an ingredient in manufacturing them,
Entity B may not assess hedge effectiveness by looking to the change in the
fair value of only the rubber component of the steel-belted radial tires (see
paragraph 815-20-25-12(e)). Both at inception of the hedge and during its term,
Entity B must base its assessment of hedge effectiveness on changes in the
market price of steel-belted radial tires and changes in the fair value of the
forward contract attributable to changes in the spot price of rubber.
55-11 It is unlikely that this transaction would be highly effective in achieving
offsetting changes in fair value. However, if Entity B concludes that the hedge
will be highly effective and the hedge otherwise qualifies for hedge accounting,
the hedge would have a net earnings effect to the extent that the actual
changes in the following amounts did not offset:
a. The fair value of the forward contract attributable to the change in the spot
price of rubber
b. The market price of steel-belted radials multiplied by the number of tires in
inventory.
55-12 Because Entity B bases its assessment of effectiveness on changes in
spot prices, the change in the fair value of the forward contract attributable to
changes in the difference between the spot and forward price of rubber would
be excluded from the assessment of effectiveness, recognized in earnings
through an amortization approach in accordance with paragraph 815-20-25-83A
or a mark-to-market approach in accordance with paragraph 815-20-25-83B,
and presented in the same income statement line item as the earnings effect
of the hedged item in accordance with paragraph 815-20-45-1A.

Excerpt from ASC 815-25

>> Example 3: Fair Value Hedge of Growing Wheat with Futures

Contracts

55-13 This Example illustrates the guidance in Sections 815-20-25, 815-20-35,

and 815-25-35 for how an entity may assess hedge effectiveness in a fair value
hedge of growing wheat with futures contracts. Assume that the hedge
satisfied all of the criteria for hedge accounting at inception.
55-14 Entity C has a tract of land on which it is growing wheat. Historically,
Entity C has harvested at least 40,000 bushels of wheat from that tract of land.
Two months before its expected harvest, Entity C sells 2-month futures
contracts for 40,000 bushels of wheat, which it wants to designate as a fair
value hedge of its growing wheat, rather than as a cash flow hedge of the
projected sale of the wheat after harvest.
55-15 Even though the futures contracts are for the same type of wheat that
Entity C expects to harvest in two months, the futures contracts and hedged
wheat have different bases because the futures contracts are based on fully
grown, harvested wheat, while the hedged item is unharvested wheat with
two months left in its growing cycle. Entity C therefore may not automatically
Hedging 661
9. Hedge effectiveness

assume that the hedge will be highly effective in achieving offsetting changes
in fair value.
55-16 To determine whether the futures contracts are expected to be highly
effective in providing offsetting changes in fair value for the growing wheat,
Entity C would need to estimate and compare the fair value of its growing
wheat and of the futures contracts for different levels of wheat prices. Entity C
may not base its estimate of the value of its growing wheat solely on the
current price of wheat because that price is for grown, harvested wheat.
Entity C might, however, use the current price of harvested wheat together
with other relevant factors, such as additional production and harvesting costs
and the physical condition of the growing wheat, to estimate the current fair
value of its growing wheat crop.
55-17 It is unlikely that wheat futures contracts would be highly effective in
offsetting the changes in value of growing wheat.

Excerpt from ASC 815-30

>> Example 2: Effectiveness of Cash Flow Hedge with a Basis Swap

55-9 This Example illustrates the application of the guidance in Subtopic 815-20
and this Subtopic to assessing effectiveness for a cash flow hedge with a basis
swap. Assume that the entity elects to perform subsequent hedge
effectiveness assessments on a quantitative basis and that all hedge
documentation requirements were satisfied at inception.
55-10 Entity H has a 5-year, $100,000 variable-rate asset and a 7-year,
$150,000 variable-rate liability. The interest on the asset is payable by the
counterparty at the end of each month based on the prime rate as of the first
of the month. The interest on the liability is payable by Entity H at the end of
each month based on London Interbank Offered Rate (LIBOR) as of the
tenth day of the month (the liability’s anniversary date). The reference rates for
both the asset and the liability are contractually specified. Entity H enters into a
5-year interest rate swap to pay interest at the prime rate and receive interest
at LIBOR at the end of each month based on a notional amount of $100,000.
Both rates are determined as of the first of the month. Entity H designates the
interest rate swap as a hedge of 5 years of interest receipts on the $100,000
variable-rate asset and the first 5 years of interest payments on $100,000 of
the variable-rate liability. The hedged risk is the variability in the contractually
specified interest payments received on the asset and paid on the liability.
Assume the likelihood of credit default and the likelihood of principal
prepayments each is remote.
55-11 Entity H may not automatically assume that the hedge always will be
highly effective at achieving offsetting changes in cash flows because the
reset date on the receive leg of the interest rate swap differs from the reset
date on the corresponding variable-rate liability. Both at hedge inception and on
an ongoing basis, Entity H's assessment of expected effectiveness could be
based on the extent to which changes in LIBOR have occurred during
Hedging 662
9. Hedge effectiveness

comparable 10-day periods in the past. Entity H’s ongoing assessment of

effectiveness would be on a cumulative basis and would incorporate the actual
interest rate changes to date. There will be no perfect offset to the extent that
the cumulative change in cash flows on the prime leg of the interest rate swap
did not offset the cumulative change in expected cash flows on the asset, and
the cumulative change in cash flows on the LIBOR leg of the interest rate
swap did not offset the change in expected cash flows on the hedged portion
of the liability. The terms of the interest rate swap, the asset, and the portion
of the liability that is hedged are the same, with the exception of the reset
dates on the liability and the receive leg of the interest rate swap. Thus, there
will be no perfect offset in the hedging relationship if LIBOR has changed
between the first of the month (the reset date for the interest rate swap) and
the tenth of the month (the reset date for the liability).
55-12 See Topic 820 (including paragraph 820-10-55-13) for a discussion of
expected cash flows.

9.2.20 Timing and nature of prospective and retrospective

effectiveness assessments

Excerpt from ASC 815-20

>> Hedge Effectiveness Criteria Applicable to both Fair Value Hedges and
Cash Flow Hedges
25-79 An entity shall consider hedge effectiveness in two different ways—in
prospective considerations and in retrospective evaluations:
a. Prospective considerations. The entity's expectation that the relationship
will be highly effective over future periods in achieving offsetting changes
in fair value or cash flows, which is forward looking, must be assessed on
a quantitative basis at hedge inception unless one of the exceptions in
paragraph 815-20-25-3(b)(2)(iv)(01) is met. Prospective assessments shall
be subsequently performed whenever financial statements or earnings are
reported and at least every three months. The entity shall elect at hedge
inception in accordance with paragraph 815-20-25-3(b)(2)(iv)(03) whether to
perform subsequent assessments on a quantitative or qualitative basis.
See paragraphs 815-20-35-2A through 35-2F for additional guidance on
qualitative assessments of hedge effectiveness. A quantitative
assessment can be based on regression or other statistical analysis of past
changes in fair values or cash flows as well as on other relevant
information. The quantitative prospective assessment of hedge
effectiveness shall consider all reasonably possible changes in fair value (if
a fair value hedge) or in fair value or cash flows (if a cash flow hedge) of
the derivative instrument and the hedged items for the period used to
assess whether the requirement for expectation of highly effective offset
is satisfied. The quantitative prospective assessment may not be limited
only to the likely or expected changes in fair value (if a fair value hedge) or
in fair value or cash flows (if a cash flow hedge) of the derivative
instrument or the hedged items. Generally, the process of formulating an
Hedging 663
9. Hedge effectiveness

expectation regarding the effectiveness of a proposed hedging relationship

involves a probability-weighted analysis of the possible changes in fair
value (if a fair value hedge) or in fair value or cash flows (if a cash flow
hedge) of the derivative instrument and the hedged items for the hedge
period. Therefore, a probable future change in fair value will be more
heavily weighted than a reasonably possible future change. That calculation
technique is consistent with the definition of the term expected cash flow
in FASB Concepts Statement No. 7, Using Cash Flow Information and
Present Value in Accounting Measurements.
b. Retrospective evaluations. An assessment of effectiveness may be
performed on a quantitative or qualitative basis on the basis of the entity’s
election at hedge inception in accordance with paragraph 815-20-25-
3(b)(2)(iv)(03). That assessment shall be performed whenever financial
statements or earnings are reported, and at least every three months. See
paragraphs 815-20-35-2 through 35-4 for further guidance. At inception of
the hedge, an entity electing a dollar-offset approach to perform
retrospective evaluations on a quantitative basis may choose either a
period-by-period approach or a cumulative approach in designating how
effectiveness of a fair value hedge or of a cash flow hedge will be
assessed retrospectively under that approach, depending on the nature of
the hedge documented in accordance with paragraph 815-20-25-3. For
example, an entity may decide that the cumulative approach is generally
preferred, yet may wish to use the period-by-period approach in certain
circumstances. See paragraphs 815-20-35-5 through 35-6 for further
guidance.
25-79A See paragraphs 815-20-25-139 through 25-142 about the timing of
hedge effectiveness assessments required by paragraph 815-20-25-79 for a
private company that is not a financial institution or a not-for-profit entity
(except for a not-for-profit entity that has issued, or is a conduit bond obligor
for, securities that are traded, listed, or quoted on an exchange or an over-the-
counter market).

Topic 815 requires effectiveness assessments to be performed and

documented both at inception of a hedging relationship and periodically
thereafter. These subsequent effectiveness assessments are also referred to
as ‘quarterly hedge effectiveness assessments’ because they are required to
be performed at least quarterly. More specifically, they are required to be
performed whenever financial statements or earnings are reported and at least
every three months. [815-20-25-79]
Effectiveness assessments are required to be performed consistently with the
initially documented method for assessing effectiveness (see section 2.9).
[815-20-25-79(b), 55-68 – 55-69]

Two types of effectiveness assessments are required to be performed. [815-20-

25-79, 35-2]

Description Frequency Results

Prospective assessment
A forward-looking — At hedge If this assessment does not
assessment of whether inception. support an expectation of high
gains or losses on the — Whenever effectiveness, hedge
derivative hedging financial accounting is discontinued
Hedging 664
9. Hedge effectiveness

Description Frequency Results

instrument that are statements or prospectively (see
included in the earnings are section 2.10.50).
assessment of reported and at
effectiveness are least every three
expected to be highly months. In
effective at offsetting practice, this
changes in the fair value assessment is
(cash flows) of the usually supported
hedged item (forecasted by periodic
transaction). retrospective
This generally involves a assessments (see
probability-weighed Question 9.2.30).
analysis of possible
changes and is required to
consider all reasonably
possible scenarios.
Retrospective assessment
Focuses on actual Whenever financial If this assessment
performance – i.e. statements or earnings demonstrates that the hedge
whether gains or losses are reported and at was not highly effective,
on the derivative hedging least every hedge accounting is not
instrument that are three months. applied for the period being
included in the assessed.
assessment of Additionally, this may result in
effectiveness actually an entity concluding that the
have been highly effective hedging relationship is not
at offsetting changes in expected to be highly effective
the fair value (cash flows) in the future (prospectively),
of the hedged item resulting in the hedging
(forecasted transaction). relationship being discontinued
See also section 9.6.20 (see section 2.10.50).
regarding choosing a
cumulative or period-by-
period approach when the
dollar-offset method is
used to assess
effectiveness
quantitatively.

The initial prospective assessment is required to be quantitative, unless certain

conditions are met (see conditions in the table in Question 9.2.50).
Subsequent effectiveness assessments (both prospective and retrospective)
may be either qualitative or quantitative, depending on whether certain
conditions are met (see conditions in section 9.5.10).
Additionally, there are three assessment methods that assume the hedging
relationship is perfectly effective:
— the shortcut method (see section 9.3);
— the critical terms match method (see section 9.4); and
— the simplified hedge accounting approach, which is available for private
companies that are not financial institutions (see section 10.2).
Hedging 665
9. Hedge effectiveness

If a hedging relationship qualifies for one of these three assessment methods

and the entity elects that method, subsequent effectiveness assessments
under that method are primarily qualitative in nature.
When the initial effectiveness assessment is required to be quantitative, an
entity has until the earliest of several dates to perform and document the initial
quantitative effectiveness assessment, the latest of which is three months after
hedge designation (see section 2.9.40). [815-20-25-3(b)(2)(iv)(01-02)]
Certain private companies and certain not-for-profit entities have additional time
to perform and document their initial and subsequent quarterly effectiveness
assessments (see chapter 10). [815-20-25-79A]

Question 9.2.30
Is a quarterly hedge effectiveness assessment
always performed only quarterly?
Interpretive response: No. Although the periodic effectiveness assessments
that are required subsequent to hedge inception are commonly referred to as
quarterly hedge effectiveness assessments, they are required to be performed
whenever financial statements or earnings are reported and at least every three
months. [815-20-25-79]
Further, if the hedging relationship is shorter than three months, the
effectiveness assessment is required to be performed to match the hedge
period; for example, daily or weekly, such as when a dynamic hedging strategy
is used as described in section 9.2.50. In other words, if the hedge period is
daily, the effectiveness assessment is required to be performed daily based on
daily changes in fair value (cash flows) of the derivative and portfolio of hedged
items (forecasted transactions).

Question 9.2.40
May an entity use different methods for its
prospective and retrospective effectiveness
assessments?
Interpretive response: Yes. Topic 815 permits an entity to use different
methods for its prospective and retrospective effectiveness assessments,
provided that it documents the different methods in its hedge documentation
and consistently uses those methods during the hedge period. [815-20-55-68 –
55-70]

However, in practice, most entities use the same method for both their
prospective and retrospective assessments to reduce the administrative burden
of applying hedge accounting and because unusual results may occur
otherwise. Unusual results include the following.
— If an entity’s prospective assessment does not support an expectation that
the hedging relationship will be highly effective, the hedging relationship
must be discontinued even if the entity’s retrospective assessment
indicates that the hedging relationship was (1) highly effective, and (2)
Hedging 666
9. Hedge effectiveness

would, if used as the prospective method, support an expectation of high

effectiveness.
— If an entity’s retrospective assessment indicates that the hedging
relationship was not highly effective, hedge accounting cannot be applied
for the period assessed even if the entity’s prospective assessment (1)
supports an expectation of high effectiveness, and (2) would have, if used
as the retrospective method, indicated that the hedging relationship was
highly effective in the period assessed.

Initial effectiveness assessments

The following flowchart summarizes considerations related to whether an entity
performs an initial hedge effectiveness assessment on a quantitative basis.

Is the entity required to

perform an initial prospective
hedge effectiveness
assessment on a
quantitative basis? Yes
[815-20-25-3(b)(2)(iv)(01)]
Perform initial hedge
No effectiveness assessment
on a quantitative basis
(section 9.6)
Has the entity elected to
perform an initial prospective
hedge assessment on a Yes
quantitative basis?

Does the initial quantitative

assessment support a
Initial hedge effectiveness
prospective assessment
assessment not performed
that the hedging relationship
on a quantitative basis
will be highly effective?
(section 9.2.40)

Yes
Hedge accounting Do not apply
may be elected hedge accounting
Hedging 667
9. Hedge effectiveness

Subsequent effectiveness assessments

The following flowchart summarizes considerations related to whether an entity
performs subsequent effectiveness assessments on a quantitative or qualitative
basis.

Does the entity elect to apply one of the Perform subsequent effectiveness
following approaches (if the hedging assessments using applicable guidance
relationship is eligible)? — Shortcut method (section 9.3)
— Shortcut method — Critical terms match method
— Critical terms match method Yes (section 9.4)
— Simplified hedge accounting — Simplified hedge accounting
approach approach (section 10.2)

Based on its initial assessment, can

the entity reasonably support an No
expectation of high effectiveness on a
qualitative basis in subsequent periods?
(section 9.5.10) Perform subsequent hedge
effectiveness assessment
Yes on a quantitative basis
(section 9.6)

Does the entity elect to perform

subsequent effectiveness assessments
using the qualitative method?
No
(section 9.5)

Yes

Perform subsequent
effectiveness assessments using
a qualitative method
(section 9.5)

Question 9.2.50
If an entity is not required to perform an initial
prospective assessment on a quantitative basis, on
what basis are its subsequent effectiveness
assessments performed?

Interpretive response: It depends on the reason the initial prospective

assessment is not required to be performed on a quantitative basis.
There are eight situations in which an initial quantitative assessment is not
required (see also section 2.9.30 for formal documentation requirements). The
following table summarizes those situations. In all cases, the critical terms are
required to match. [815-20-25-3(b)(2)(iv)(01)]
Hedging 668
9. Hedge effectiveness

Description Reference
Fair value or cash flow hedges
(A) Shortcut method: Interest rate swap is used to hedge Section 9.3
interest rate risk related to recognized assets or liabilities and
certain conditions are met. [815-20-25-102 – 25-117]
Cash flow hedges
1
(B) Critical terms match method : A forward or option is used Section 9.4
and the critical terms of the hedging instrument and hedged item
match. [815-20-25-84 – 25-85, 35-9 – 35-12]
(C) Terminal value method: A purchased option, net purchased Section 9.7.20
option or zero-cost collar is used and certain conditions are met.
[815-20-25-126, 25-129 – 25-129A]

(D) Simplified hedge accounting approach: An interest rate Section 10.2

swap is used to hedge interest rate risk of variable-rate
borrowings and certain conditions are met. This approach is
available to private companies that are not financial institutions.
[815-20-25-133 – 25-138]

(E) Change-in-variable-cash-flows method: An interest rate Section 9.7.40

swap is used to hedge variability in interest receipts or payments
and certain conditions are met. [815-30-35-16 – 35-24]
(F) Hypothetical derivative method: A derivative instrument is Sections 9.7.30
used to hedge any eligible risk (an interest rate swap is used to and 9.7.40
hedge variability in interest receipts or payments) and the critical
terms of the hedging instrument and hedged transaction match.
[815-30-35-25 – 35-29]

Note:
We believe the critical terms match method is precluded for fair value hedging
relationships in the vast majority of circumstances (see section 9.4.20).

Net investment hedges

(G) Changes in spot rate method: Certain conditions are met, Section 8.4.20
depending on whether the hedging instrument is a derivative or a
nonderivative. [815-35-35-5, 35-12]
(H) Changes in forward rate method: Certain conditions are Section 8.4.30
met. [815-35-35-17A]

Shortcut method (A), critical terms match method (B), or simplified hedge
accounting approach (D)
If the entity is applying one of these methods, it applies the specific guidance
applicable to that method. The subsequent effectiveness assessments under
these methods are primarily qualitative in nature.
Other situations (C, E to H)
In these situations, Topic 815 indicates that the hedging relationships will be
perfectly effective if all conditions are met. However, it does not specify
whether the subsequent effectiveness assessments are to be performed using
the guidance for quantitative or qualitative assessments. As a result, we believe
an entity may choose to perform its quarterly hedge effectiveness assessments
on a quantitative or qualitative basis.
Hedging 669
9. Hedge effectiveness

Question 9.2.60
Why may an entity elect to perform subsequent
assessments on a qualitative – rather than a
quantitative – basis?

Background: As discussed in Question 9.2.50, an initial prospective

assessment is not required to be performed on a quantitative basis in eight
situations. In five of these situations (the ‘other situations’ referenced in
Question 9.2.50), Topic 815 does not provide specific guidance regarding
subsequent assessments. When an entity has applied one of these other
qualitative approaches in its initial effectiveness assessment, we believe it may
choose to perform its subsequent hedge effectiveness assessments on a
quantitative or qualitative basis.
Interpretive response: In the other situations referenced in Question 9.2.50,
the subsequent ongoing assessments will be largely similar regardless of
whether an entity documents that it is applying a quantitative or a qualitative
assessment as long as the critical terms of the hedging instrument and hedged
item or transaction match. However, we believe electing to perform
subsequent effectiveness assessments on a qualitative basis – rather than on a
quantitative basis – may provide an entity with more flexibility should the critical
terms of the hedging relationship cease to match (or other conditions cease to
be met, if applicable).
This is because when the critical terms cease to match (or other conditions
cease to be met), it may be possible for an entity to revert to performing
qualitative assessments after performing a quantitative assessment if it can
reasonably support an expectation of high effectiveness on a qualitative basis
for subsequent periods.
This is explained further in the following table.

Scenario 1: In this scenario, an entity’s quarterly hedge effectiveness

Critical terms assessment focuses on confirming and documenting the fact
continue to that the critical terms continue to match (and other conditions
match (and continue to be met, if applicable), whether the assessment is
other conditions on a quantitative or qualitative basis.
continue to be Additionally, the entity is required to include in its initial hedge
met, if documentation a quantitative method, even if it elects to
applicable) perform subsequent assessments on a qualitative basis (see
throughout the discusson of formal documentation in section 2.9.30). This
hedging method is required to be the same as that used to support the
relationship entity’s initial prospective hedge effectiveness assessment.
Further, when an entity will perform its subsequent
effectiveness assessments on a quantitative basis, we
believe that an entity is not required to perform the actual
calculation when the results of the quantitative test are known
with mathematical certainty without performing the full
calculation (see Question 9.6.80).
Hedging 670
9. Hedge effectiveness

Scenario 2: In this scenario, the subsequent assessment requirements

Critical terms differ depending on whether the entity chose to perform
cease to match subsequent assessments on a quantitative or qualitative basis.
(and/or other — Quantitative basis. If the entity documented that it will
conditions cease perform quantitative (rather than qualitative) assessments
to be met, if each period, it will be required to perform quantitative
applicable) assessments in all periods – i.e. dollar-offset or statistical
during the analysis, as selected in the initial documentation.
hedging
relationship — Qualitative basis. If the entity documented that it will
perform qualitative assessments, it is required to use its
judgment in determining whether there has been a change
in facts and circumstances such that it can no longer
assert qualitatively that the hedging relationship was and
continues to be highly effective (as discussed in
section 9.5.20). We believe the entity would apply
judgment when the critical terms of the hedging
instrument and hedged item or transaction cease to
match.
— The entity is permitted to perform a quantitative
assessment in any reporting period to validate
whether qualitative assessments of hedge
effectiveness remain appropriate. [815-20-35-2D]
— If the entity was required or elected to perform
quantitative effectiveness assessments, it is
permitted to revert to qualitative effectiveness
assessments if it can reasonably support an
expectation of high effectiveness on a qualitative basis
for subsequent periods (see Question 9.5.50).
As a result, an entity may conclude that continued
qualitative assessments are appropriate (e.g. if the
degree to which the critical terms cease to match is
minimal) and/or may perform a quantitative
assessment in one period to validate its assertion that
continued qualitative assessments are appropriate in
future periods.

9.2.30 Aligning effectiveness assessments with the

designated hedged risk

Excerpt from ASC 815-20

>> Hedge Effectiveness Criteria Applicable to both Fair Value Hedges and
Cash Flow Hedges
25-76 If the hedging instrument (such as an at-the-money option contract)
provides only one-sided offset of the hedged risk, either of the following
conditions shall be met:
a. The increases (or decreases) in the fair value of the hedging instrument are
expected to be highly effective in offsetting the decreases (or increases) in
the fair value of the hedged item (if a fair value hedge).
Hedging 671
9. Hedge effectiveness

b. The cash inflows (outflows) from the hedging instrument are expected to
be highly effective in offsetting the corresponding change in the cash
outflows or inflows of the hedged transaction (if a cash flow hedge).
>>> Hedge Effectiveness When Hedged Exposure Is More Limited Than
Hedging Instrument
25-100 An entity may designate as the hedging instrument in a fair value
hedge or cash flow hedge a derivative instrument that does not have a limited
exposure comparable to the limited exposure of the hedged item to the risk
being hedged. However, to make that designation, in accordance with
paragraph 815-20-25-75, the entity shall establish that the hedging relationship
is expected to be highly effective in achieving offsetting changes in fair value
or cash flows attributable to the hedged risk during the period that the hedge is
designated. See paragraph 815-20-25-79(a) for additional guidance on
prospective considerations of hedge effectiveness in this circumstance.

Effectiveness assessments are required to be performed in a manner that is

consistent with the documented risk management objective. That is, when
assessing effectiveness, the change in the fair value or cash flows of the
hedged item or forecasted transaction should consider only the risks that are
being hedged. That change should be compared with the extent of offset
provided by the derivative hedging instrument’s total change in fair value or
cash flows (other than excluded components). [815-20-25-75]
Topic 815 provides flexibility in designating the hedged risk, including that the
hedged risk is not always required to be the entire change in the fair value or
cash flows of the hedged item or forecasted transaction (see section 2.2.20).
Similarly, Topic 815 permits using a variety of hedging instruments (see
section 2.6), and permits excluding certain components of the hedging
instrument from effectiveness assessments (see section 9.2.70). However, in
all cases, an entity is required to select a derivative hedging instrument for
which the change in fair value or cash flows (other than excluded components)
is expected to be highly effective at offsetting changes in fair value or cash
flows attributable to the hedged risk. [815-20-25-75]
The following are examples of designating the hedged risk and selecting a
hedging instrument in the context of assessing effectiveness.

Hedged risk is For example, an entity may hedge only an increase in the
one-sided benchmark (or contractually specified) interest rate when
hedging existing fixed-rate (or variable-rate) debt.
It may be necessary for the entity to select a hedging
instrument that provides one-sided offset when the hedged
risk is one-sided to achieve a highly effective hedging
relationship. Typically, an option is used because of its one-
sided nature. [815-20-25-76]
See also section 9.2.70 regarding excluded components, and
section 9.2.90 regarding using options as hedging instruments.
Hedging 672
9. Hedge effectiveness

Hedged For example, an entity may hedge fixed-rate debt that is

exposure is prepayable in a fair value hedge with a hedging instrument that
limited but does not have a mirror prepayment feature. Or, an entity may
hedging hedge variable-rate debt that has a floor of zero on the interest
instrument’s rate in a cash flow hedge with a hedging instrument that does
exposure is not have a floor. The entity is required to demonstrate that the
not hedging instrument in each case is expected to be highly
effective at offsetting changes in fair value or cash flows
attributable to the hedged risk, including consideration of the
mismatch of exposures between the hedging instrument and
hedged item. [815-20-25-100, 55-193 – 55-197]
This type of relationship may be highly effective in some
circumstances. For example, an entity enters into a cash flow
hedge of variable-rate debt that has a cap on the interest rate
with a hedging instrument that does not. Although the
effectiveness assessment must consider all reasonably
possible changes in cash flows (rather than only likely or
expected changes) the assessment involves a probability-
weighted analysis.
This means that probable changes are more heavily weighted
than reasonably possible changes. As a result, if it is unlikely
that interest rates will fall below the level in the floor, they will
not have a significant effect on the expected cash flows of the
hedging instrument and the hedging relationship may be highly
(although not perfectly) effective. [815-20-25-79(a), 55-197]
See also Subtopic 815-20’s Example 22 reproduced below.

Hedged risk is For example, an entity may wish to hedge against changes in
within a range the benchmark (or contractually specified) interest rate on
and the existing fixed-rate (or variable-rate) debt only within a certain
hedging range of interest rates. In this situation, the entity may
instrument is a designate as the hedging instrument a combination of options
net purchased (deemed to be a net purchased option) and assess
option effectiveness based only on changes in the underlying that
cause a change in the intrinsic value of that net purchased
option. [815-20-25-130 – 25-131]
See section 9.2.70 regarding excluded components, and
section 9.2.90 regarding using options as hedging instruments
(including Example 9.2.60).

If the hedged risk is basis risk, each leg of the basis swap is required to be
linked to a designated item with the same underlying. For a discussion of the
special rule for basis swaps, see section 5.5.10. [815-20-25-50 – 25-51]

Examples
The following examples demonstrate effectiveness assessments that are
consistent with the documented risk management objective.
— Consistency of effectiveness assessment with documented risk
management objective (Example 9.2.10).
— Cesignation if hedged exposure is limited but derivative instrument
exposure is not (Subtopic 815-20’s Example 22).
Hedging 673
9. Hedge effectiveness

Example 9.2.10
Consistency of effectiveness assessment with
documented risk management objective
ABC Corp.’s documented hedged risk objective includes hedging only the
change in fair value (or cash flows) related to interest payments on debt due to
an increase in the benchmark rate above 7%.
Therefore, the change in fair value of the hedged item (or change in cash flows
of the forecasted transaction) that is included in the effectiveness assessment
is limited to the extent of the change in fair value (or change in cash flows) of
the debt resulting from increases in the benchmark interest rate over 7%.

Excerpt from ASC 815-20

>> Example 22: Designation If Hedged Exposure Is Limited but Derivative

Instrument Exposure Is Not

55-193 The following Cases illustrate the application of paragraph 815-20-25-

100 to situations in which the hedged item or hedged forecasted transaction
may have a risk exposure that is limited, but the derivative instrument that the
entity desires to designate as a hedging instrument does not have comparable
limits:
a. Fair value hedge (Case A)
b. Cash flow hedge (Case B).
55-194 For the purposes of both Cases A and B, it is assumed that the
shortcut method may not be applied.
>>> Case A: Fair Value Hedge
55-195 Entity A issues 10-year fixed-rate debt that is callable at the end of the
fifth year. It decides to convert the interest payments on the bond from fixed-
rate to variable-rate by entering into a 10-year receive-fixed, pay-variable
interest rate swap. The interest rate swap is not cancelable at the end of the
fifth year. From Entity A’s perspective, if interest rates increase, there is a gain
on the debt (the liability’s fair value decreases) and a loss on the swap (fair
value either decreases as an asset or increases as a liability). If interest rates
decrease, there is a loss on the debt (the liability’s fair value increases) and a
gain on the swap (fair value either increases as an asset or decreases as a
liability). However, during the first five years, if interest rates decrease, the gain
on the swap will exceed the loss on the debt because the debt’s fair value
change will consider the impact of the call feature, which is in the money when
interest rates fall below the stated rate on the debt. Entity A wishes to
designate the interest rate swap as the hedging instrument in a fair value
hedge of interest rate risk of the fixed-rate debt. The conclusions for Case A
and Case B are discussed in paragraph 815-20-55-197.
Hedging 674
9. Hedge effectiveness

>>> Case B: Cash Flow Hedge

55-196 Entity B issues 10-year, variable-rate debt that reprices based on
6-month LIBOR. The interest rate on the debt is capped at 9 percent. Entity B
decides to convert the interest payments on the debt from variable-rate to
fixed-rate by entering into a receive-variable, pay-fixed interest rate swap.
There is no cap on the variable-rate leg of the interest rate swap. From Entity
B’s perspective, if interest rates decrease, there will be a cumulative reduction
in the expected future cash outflows on the debt and a cumulative reduction in
the expected future cash inflows on the swap. If interest rates increase, there
will be a cumulative increase in the expected future cash outflows on the debt
and a cumulative increase in the expected future cash inflows on the swap.
However, if interest rates increase such that the variable rate on the swap
would be greater than 9 percent, the cumulative increase in the expected
future cash inflows on the swap will exceed the cumulative increase in the
expected future cash outflows on the debt because of the interest rate cap on
the debt, which is in the money if interest rates increase such that the variable
rate on the debt would exceed 9 percent. Entity B wishes to designate the
interest rate swap as the hedging instrument in a cash flow hedge of interest
rate risk of the variable-rate debt.
55-197 In both Cases A and B, the entity must assess, based on an appropriate
methodology, whether the changes in fair value or cash flows of the interest
rate swap could be expected to be highly effective in offsetting changes in fair
value or cash flows of the debt attributable to interest rate risk taking into
account the effect of the embedded call option (Case A) or the effect of the
interest rate cap (Case B). As required by paragraph 815-20-25-6, the effect of
an embedded derivative of the same risk class must be considered in
designating a hedge of an individual risk. Therefore, if the options in Cases A
and B are expected to be out of the money based on a probability-weighted
analysis of the range of possible changes in interest rates, then those options
would be expected to have a minimal effect on changes in fair value or cash
flows of the debt, and the hedging relationships could meet the requirement
for an expectation of high effectiveness. In the case of a fair value hedge of
callable debt discussed in Case A, in accordance with paragraph 815-20-25-6B,
Entity A may assess hedge effectiveness on the basis of whether the debt will
be called at the end of the fifth year because of expected changes in
benchmark interest rates, but not because of other factors potentially affecting
the exercise of the call feature. Entity A intends to assess hedge effectiveness
on this basis.

9.2.40 Meaning of ‘highly effective’

Entities commonly think of a highly effective hedging relationship from an
economic point of view – i.e. whether the derivative provides the desired risk
management effect. Often, that view is consistent with Topic 815’s notion that
high effectiveness is achieved when the changes in the fair value or cash flows
of a derivative hedging instrument are highly effective at offsetting changes in
the fair value or cash flows of the hedged item or hedged transaction
attributable to the hedged risk. However, the distinction between an effective
economic hedge and a hedge that is permitted under Topic 815 is significant
Hedging 675
9. Hedge effectiveness

because hedge accounting is permitted only if the specific criterion of high

effectiveness and other eligibility criteria are met.
Hedge effectiveness is measured using the following formula.
Percentage of
offset
Absolute value of change Absolute value of change
To be highly
in fair value or cash flows in fair value or cash flows
effective, should be
of hedging instrument of hedged item or
within the range of
(other than excluded transaction due to hedged
80%–125%
components) risk
(see Question
9.2.70)

Question 9.2.70
Does Topic 815 define highly effective?

Interpretive response: No. Topic 815 does not define ‘highly effective’.
When the term was initially introduced in FASB Statement No. 133 (now
Topic 815), the FASB intended it to have essentially the same meaning as the
notion of ‘high correlation’ used in FASB Statement No. 80 (futures contracts).
As a result, we believe that ‘highly effective’ describes a relationship in which
the change in the fair value or cash flows of the derivative hedging instrument
is within 80% to 125% of the opposite change in the fair value or cash flows of
the hedged item or cash flows attributable to the hedged risk.
Additionally, the FASB has acknowledged that practice has interpreted highly
effective to mean an 80%–125% offset. [ASU 2017-12.BC165]

Example 9.2.20
Calculations of effectiveness
The following scenarios show how the extent of effectiveness of a hedging
relationship is computed.

Increase
(decrease)
Scenario 1: Fair value hedge – 80% effective
Change in fair value of derivative hedging instrument included in the
assessment of effectiveness $80
Change in fair value of hedged item attributable to the hedged risk $(100)
Effectiveness1 80%
Scenario 2: Scenario 1: Fair value hedge – 125% effective
Change in fair value of derivative hedging instrument included in the
assessment of effectiveness $100
Change in fair value of hedged item attributable to the hedged risk $(80)
Effectiveness1 125%
Hedging 676
9. Hedge effectiveness

Increase
(decrease)
Scenario 3: Cash flow hedge – 80% effective
Change in cash flows of derivative hedging instrument included in
the assessment of effectiveness $80
Change in cash flows of hedged transaction item attributable to the
hedged risk $(100)
Effectiveness 1
80%
Scenario 4: Cash flow hedge – 125% effective
Change in cash flows of derivative hedging instrument included in
the assessment of effectiveness $100
Change in cash flows of hedged transaction item attributable to the
hedged risk $(80)
Effectiveness1 125%
Note:
Calculated as:
— Absolute value of the change in fair value (or cash flows) of derivative
hedging instrument included in the assessment of effectiveness
÷
— Absolute value of the change in fair value of hedged item (or cash flows of
hedged transaction) attributable to the hedged risk

9.2.50 Determining the period for assessing effectiveness

Excerpt from ASC 815-20

>>> Hedge Effectiveness during Designated Hedge Period

25-101 It is inappropriate under this Subtopic for an entity to designate a
derivative instrument as the hedging instrument if the entity expects that the
derivative instrument will not be highly effective in achieving offsetting
changes in fair value or cash flows attributable to the hedged risk during the
period that the hedge is designated, unless the entity has documented
undertaking a dynamic hedging strategy in which it has committed itself to an
ongoing repositioning strategy for its hedging relationship.

It is not appropriate for an entity to designate a derivative as the hedging

instrument when it expects that the derivative will not be highly effective in
achieving offsetting changes in fair value or cash flows attributable to the
hedged risk during the period over which effectiveness will be assessed. [815-20-
25-101]

However, an entity is not required to assess effectiveness using an assessment

period that is as long as the term of the hedging instrument. Instead, an entity
may undertake a dynamic hedging strategy in which it commits itself to an
Hedging 677
9. Hedge effectiveness

ongoing repositioning strategy for its hedging relationship and to an assessment

period that is shorter than the term of the hedging instrument. When an entity
does this, effectiveness is expected over that assessment period. [815-20-25-101]
The following are examples of dynamic hedging strategies.

Delta-neutral In a delta-neutral dynamic hedging strategy for a fair value

dynamic hedge, an entity may commit to constant monitoring of the ratio
hedging of changes in the option’s price to changes in the price of the
strategy hedged item (referred to as the option’s delta).
As the ratio changes, the entity rebalances the portfolio of options
(i.e. buy or sell options) so that the change in the fair value of all
of the options held can be expected to counterbalance or offset
the next change in the value of the hedged item.
In this situation, the hedging instrument is constantly being
changed and the assessment of effectiveness considers only the
change in fair value to the next rebalancing date.
See also Question 2.10.60 regarding whether a rebalancing of
hedging derivatives when such a strategy is used requires
discontinuation of the hedging relationship.

Tailing strategy In a tailing strategy with futures contracts in a cash flow hedge,
an entity adjusts the size or contract amount of futures contracts
used in a hedge so that earnings (or expense) from reinvestment
(or funding) of daily settlement gains (or losses) on the futures
contracts do not distort the results of the hedge.
To assess the offset of cash flows, an entity could include the
time value of money, perhaps by comparing the present value of
the hedged forecasted cash flow with the results of the hedging
instrument.
In this situation, an entity is required to document that it is
undertaking a dynamic hedging strategy in which it commits itself
to an ongoing repositioning strategy for the hedging relationship
and believes it is probable that the forecasted transactions will
occur. [815-20-25-121]
See also section 9.2.110 for a discussion of the time value of
money and Question 2.10.60 regarding whether a rebalancing of
hedging derivatives when such a strategy is used requires
discontinuation of the hedging relationship.

Additionally, Topic 815 does not prescribe the historical period that should be
used when assessing whether a hedging instrument is expected to be (or has
been) highly effective at offsetting the hedged risk (see Question 9.2.80).

Question 9.2.80
How does an entity determine the historical period
when initially assessing hedge effectiveness?
Interpretive response: Regardless of the technique used to assess hedge
effectiveness, we believe an entity should document the historical relationship
between changes in fair values of the hedged item (or cash flows of the
Hedging 678
9. Hedge effectiveness

forecasted transaction) and changes in the fair value (or cash flows) of the
derivative hedging instrument over an appropriate period.
Judgment is required in determining the appropriate period to be used.
However, an entity should consider that the objective of the prospective
effectiveness assessment is to conclude that the hedging relationship is
expected to be highly effective. As a result, an entity should consider a
historical period for which the potential changes are reasonably expected to
reflect those expected over the documented hedge period.
For example, if an entity is considering a two-year foreign currency hedging
relationship involving US dollars and euros (€), its prospective effectiveness
assessment should not be limited to changes in the $/€ exchange rate for the
last month. The changes for the last month may not be indicative of the
potential changes in the exchange rate that are reasonably expected to occur
over the next two years.
Once an entity has initially assessed hedge effectiveness, the historical period
to be used when performing subsequent effectiveness assessments depends
on the method used to assess effectiveness. For discussion of the information
to be used when performing quantitative effectiveness assessments using
dollar-offset method and regression analysis, see sections 9.6.20 and 9.6.30,
respectively.

Special criterion for fair value hedges only

Excerpt from ASC 815-20

> > Hedge Effectiveness Criterion Applicable to Fair Value Hedges Only
25-118 In documenting its risk management strategy for a fair value hedge, an
entity may specify an intent to consider the possible changes (that is, not
limited to the likely or expected changes) in value of the hedging derivative
instrument and the hedged item only over a shorter period than the derivative
instrument's remaining life in formulating its expectation that the hedging
relationship will be highly effective in achieving offsetting changes in fair value
for the risk being hedged. The entity does not need to contemplate the
offsetting effect for the entire term of the hedging instrument.

When designating a fair value hedging relationship, an entity can specify an

intent to consider changes in the values of the hedging instrument and hedged
item over a period shorter than the hedging instrument’s remaining life when
assessing effectiveness. To do so, the entity needs to consider the possible
changes in these values, not only the likely or expected changes. Therefore, the
entity does not need to contemplate the offsetting effect of the derivative
hedging instrument for the entire term of the hedging instrument and/or
hedging relationship. [815-20-25-118]
This approach may be useful when a hedged item’s risk exposure is limited, but
the risk exposure of the hedging derivative is not. Subtopic 815-20’s
Example 22 (reproduced in section 9.2.30) demonstrates a situation in which an
entity hedges 10-year debt that is callable after five years with a 10-year interest
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9. Hedge effectiveness

rate swap that is not cancelable. In that situation, an entity may choose to
assess effectiveness by considering the possible changes in the fair value of
the derivative hedging instrument for a period shorter than the derivative’s life,
such as the next three months.

Interest rate risk. Alternatively, an entity may choose to use a partial-term

hedging strategy when the hedged risk is interest rate risk or a combination of
interest rate risk and foreign currency risk, which is discussed in section 3.3.80.
Under this strategy, an entity measures the change in the hedged item’s fair
value attributable to interest rate risk using an assumed term that reflects only
the designated cash flows and assumes that the principal payment occurs at
the end of the hedge term. This strategy may result in a hedge that is more
likely to be highly effective, as explained in Question 3.3.210.

FASB Example: Hedge effectiveness horizon in a fair value

hedge when effectiveness is assessed on a quantitative basis

Excerpt from ASC 815-20

>> Example 25: Hedge Effectiveness Horizon in a Fair Value Hedge When
Effectiveness Is Assessed on a Quantitative Basis

55-204 This Example illustrates the application of paragraph 815-20-25-118.

Under the guidance in that paragraph, if a derivative instrument with a five-year
term is designated as the hedging instrument in a fair value hedge of a financial
asset that also has a five-year term, an entity may base its expectation that the
hedging relationship will be highly effective in achieving offsetting changes in
fair value for the risk being hedged by considering the possible changes in
value occurring only over a shorter period than the life of the derivative
instrument, such as over only the first three months of the derivative
instrument's five-year life. For example, an entity may specify, in documenting
its risk management strategy, that every three months it will do both of the
following:
a. It will assess the effectiveness of the existing hedging relationship for the
past three-month period.
b. It intends to consider possible changes in value of the hedging derivative
and the hedged item over the next three months in deciding whether it has
an expectation that the hedging relationship will continue to be highly
effective at achieving offsetting changes in fair value.
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9. Hedge effectiveness

9.2.60 Considering counterparty credit risk and entity’s

own non-performance risk

Excerpt from ASC 815-20

>>> Consideration of Counterparty Credit Risk

25-122 For a cash flow hedge, an entity shall consider the likelihood of the
counterparty’s compliance with the contractual terms of the hedging derivative
instrument that require the counterparty to make payments to the entity.
Paragraph 815-20-35-14 states that, for an entity to conclude on an ongoing
basis that a cash flow hedging relationship is expected to be highly effective in
achieving offsetting changes in cash flows, the entity shall not ignore whether
it will collect the payments it would be owed under the contractual provisions
of the derivative instrument. See paragraphs 815-20-35-14 through 35-18 for
further guidance.
> Possibility of Default by the Counterparty to Hedging Derivative
35-14 For an entity to conclude on an ongoing basis that the hedging
relationship is expected to be highly effective in achieving offsetting changes in
cash flows, the entity shall not ignore whether it will collect the payments it
would be owed under the contractual provisions of the derivative instrument.
In complying with the requirements of paragraph 815-20-25-75(b), the entity
shall assess the possibility of whether the counterparty to the derivative
instrument will default by failing to make any contractually required payments
to the entity as scheduled in the derivative instrument. In making that
assessment, the entity shall also consider the effect of any related
collateralization or financial guarantees. The entity shall be aware of the
counterparty’s creditworthiness (and changes therein) in determining the fair
value of the derivative instrument. Although a change in the counterparty’s
creditworthiness would not necessarily indicate that the counterparty would
default on its obligations, such a change shall warrant further evaluation.
35-15 If the likelihood that the counterparty will not default ceases to be
probable, an entity would be unable to conclude that the hedging relationship
in a cash flow hedge is expected to be highly effective in achieving offsetting
cash flows.
35-16 In contrast, a change in the creditworthiness of the derivative
instrument's counterparty in a fair value hedge would have an immediate
effect because that change in creditworthiness would affect the change in the
derivative instrument's fair value, which would immediately affect both of the
following:
a. The assessment of whether the relationship qualifies for hedge accounting
b. The amount of mismatch between the change in the fair value of the
hedging instrument and the hedged item attributable to the hedged risk
recognized in earnings under fair value hedge accounting.
35-18 Paragraph 815-20-25-103 states that, in applying the shortcut method, an
entity shall consider the likelihood of the counterparty’s compliance with the
contractual terms of the hedging derivative that require the counterparty to
make payments to the entity. That paragraph explains that implicit in the
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9. Hedge effectiveness

criteria for the shortcut method is the requirement that a basis exist for
concluding on an ongoing basis that the hedging relationship is expected to be
highly effective in achieving offsetting changes in fair values or cash flows.

Topic 815 – in combination with Topic 820 (fair value) – requires an entity to
consider the effects of counterparty credit risk and the entity’s own
nonperformance risk when assessing the effectiveness of hedging
relationships. These considerations are different for fair value versus cash flow
hedges, and also differ depending on the effectiveness assessment method, as
follows.

Fair value hedge — Changes in both counterparty credit risk and an entity’s
[815-20-35-16, 35-18] own nonperformance risk affect the measurement of
changes in the fair value of the derivative hedging
instrument. These changes likely have no offsetting effect
on changes in the measurement of the hedged item
attributable to the hedged risk.
— As a result, changes in counterparty credit risk and the
entity’s own nonperformance risk will result in a hedge not
being perfectly effective and such changes have an
immediate effect on the assessment of effectiveness.
— However, if the shortcut method is used (see section 9.3),
the potential effect of these differences on the hedging
relationship’s effectiveness is ignored unless it is no longer
probable that the derivative counterparty or the entity itself
will not default. If non-default by either party is no longer
probable, the shortcut method is required to be
discontinued.

Cash flow hedge — Changes in both counterparty credit risk and an entity’s
[815-20-25-122, 35-14 own nonperformance risk affect the measurement of
– 35-15] changes in the fair value of the derivative hedging
instrument – and therefore the derivative gains or losses
recognized in OCI.
— The effectiveness assessment may also be affected by
changes in counterparty credit risk and an entity’s own
nonperformance risk even if effectiveness is not assessed
based on a method that uses the derivative hedging
instrument’s fair value change.
— The potential effect on the hedging relationship’s
effectiveness of these changes is ignored. However, if it is
no longer probable that the derivative counterparty or the
entity itself will not default, an entity will be unable to
conclude that the hedging relationship is expected to be
highly effective and will therefore be required to
discontinue the hedging relationship.
— In addition, an entity is required to consider the credit risk
of the counterparty to the hedged transaction to determine
the likelihood that it will occur, particularly if the hedged
transaction involves payments under a contractual
obligation.
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9. Hedge effectiveness

Net investment — An entity is required to consider the effects of

hedge counterparty credit risk and the entity’s own
nonperformance risk when assessing hedging
relationships.
— Changes in both counterparty credit risk and an entity’s
own nonperformance risk affect the measurement of
changes in the fair value of a derivative hedging
instrument, and therefore the derivative gains or losses
recognized in CTA within AOCI.
— The potential effect of these differences on a net
investment hedging relationship’s effectiveness as an
economic hedge is ignored unless it is no longer probable
that the derivative counterparty or the entity itself will not
default. If the forward method is used and meets the
conditions to be perfectly effective, the total changes in
the fair value of the derivative instrument are included in
CTA within AOCI.
— However, if non-default by either party is no longer
probable, an entity will be required to assess whether the
hedging relationship has been and is expected to continue
to be effective as an economic hedge. If an entity
continues to expect the relationship to be effective as an
economic hedge, strong evidence supporting the
expectation would be needed.

hedging instrument is in an asset position, the entity typically should

discontinue the hedging relationship even if the hedging derivative is in a liability
position. That is, the possibility that a change in the underlying could cause the
derivative to move into an asset position before settlement or maturity typically
would cause the hedging relationship to be not highly effective on a prospective
basis.
Similarly, an entity cannot ignore the effect of its own nonperformance risk if a
derivative hedging instrument is in an asset position. Because the derivative
could move into a liability position before its settlement or maturity, an entity
must consider the effect its own nonperformance risk would have on the
hedging relationship in the same way that the entity must consider the
counterparty’s credit risk when the derivative is in a liability position.
See also KPMG’s Q&A: Fair value measurement, including Section O,
Application issues: Derivatives and hedging. In particular, see Question O20,
which provides information about how credit valuation adjustments (CVA) for
counterparty credit risk and debit valuation adjustments (DVA) for an entity’s
own nonperformance risk are determined in measuring derivatives at fair value.

Consideration of credit risk adjustments determined at a

portfolio level for hedging instruments
Derivative instruments are measured on the balance sheet at fair value. The fair
values of derivative instruments are typically determined on an individual basis.
However, if certain conditions are met, an entity is permitted to measure the
fair value of a group of financial assets and liabilities based on a price that would
be received to sell or paid to transfer the net risk position (referred to as a
‘portfolio measurement exception’). [820-10-35-18D – 35-18E]
If an entity has a group of derivative assets and liabilities with a particular
counterparty and applies the portfolio measurement exception to that
counterparty’s credit risk, the effect on the entity’s net exposure to the credit
risk of that counterparty (or on the counterparty’s net exposure to the entity’s
own nonperformance risk) may result in a portfolio-level credit risk adjustment
when measuring fair value to be recognized on the entity’s balance sheet.
Even though the credit risk adjustment may be determined at a portfolio level
under the portfolio measurement exception, hedge effectiveness is assessed
on an individual hedging relationship basis. This means that an entity is required
to consider the effect of counterparty credit risk (or its own nonperformance
risk) on each individual hedging relationship when assessing hedge
effectiveness. As a result, it may be necessary to allocate a portfolio-level credit
risk adjustment to individual hedging relationships, as explained in
Questions 9.2.90 and 9.2.100.
Because the effect of a portfolio-level credit risk adjustment is part of an
entity’s effectiveness assessments, an entity needs to determine the
adjustment as frequently as it performs the hedge effectiveness assessments
(whether daily, weekly, monthly, quarterly or other frequency).
Additionally, an entity may be required to allocate a portfolio-level credit risk
adjustment to individual hedging derivatives to properly account for the
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9. Hedge effectiveness

derivatives, even if such an allocation is not necessary for assessing

effectiveness (see Question 9.2.140).
See also KPMG’s Q&A: Fair value measurement. In particular, see:
— Section L, Portfolio measurement exception, which addresses the
circumstances under which it is appropriate to apply the portfolio
measurement exception and related issues.
— Section O, Application issues: Derivatives and hedging, including
Question O70, which discusses how the requirements to include
counterparty credit risk and an entity’s own nonperformance risk in
measuring the fair values of derivative instruments affect hedging
relationships.
The flowchart below summarizes considerations when evaluating whether a
portfolio-level credit risk adjustment (that results from applying the portfolio
measurement exception when measuring the fair value to be recognized on the
balance sheet for a group of derivatives) is required to be allocated to individual
derivative instruments either for purposes of assessing effectiveness of
hedging relationships or for other purposes.
Hedging 685
9. Hedge effectiveness

What is the type of hedging relationship?

— Cash flow hedge;

— Fair value hedge – shortcut Fair value hedge – effectiveness
method is used to assess is assessed using a method other
effectiveness; or than the shortcut method
— Net investment hedge.

Continue Continue

Is it appropriate for the entity to

qualitatively evaluate the effect of a
Is it probable the counterparty portfolio-level credit risk adjustment
to the hedging instrument on individual fair value hedging
will not default? relationships?
(see Question 9.2.110 and
Example 9.2.30)

No Yes Yes No

The hedging relationship is

A quantitative allocation of the
discontinued, so there is no
portfolio-level credit adjustment is
longer a hedging relationship to
required to assess effectiveness.
which to make a quantitative
(see Question 9.2.120)
allocation of the portfolio-level
credit risk adjustment.
(see Question 9.2.100)

A quantitative allocation of the portfolio-level credit risk adjustment is

not required for purposes of assessing hedge effectiveness. Continue
(see Question 9.2.100)
Continue

Continue

An allocation of the portfolio-level credit risk adjustment may be

necessary for accounting purposes.
(see Question 9.2.140)

Question 9.2.100
Must an entity allocate a portfolio-level credit risk
adjustment to individual hedging relationships
when assessing effectiveness?
Interpretive response: Generally, yes. When assessing hedge effectiveness,
an entity generally is required to determine the individual credit risk adjustments
to arrive at the fair values of the individual hedging derivatives or the appropriate
credit risk adjustment for a group of derivatives that have been designated
together as the hedging instrument in a single hedging relationship.
However, it may not be necessary to make such an allocation, depending on
the type of hedging relationship and the method used to assess effectiveness,
as explained in the following table.
Hedging 686
9. Hedge effectiveness

Fair value Under the shortcut method, a hedge is assumed to be perfectly

and cash flow effective – with changes in fair value of the hedging derivative
hedges – serving as a proxy for changes in the fair value of the hedged item –
shortcut when it is probable that the interest rate swap’s counterparty or the
method entity itself will not default.
[815-20-35-18] In this situation, an entity may conclude that the hedging
relationship is highly effective without allocating the portfolio-level
credit risk adjustment.
If it is not probable that the counterparty or the entity itself will not
default, the shortcut method is required to be discontinued and there
is no longer a hedging relationship to which to make an allocation.

Fair value For all fair value hedges other than those using the shortcut
hedges – method, changes in the fair value of a derivative – including those
long-haul related to counterparty credit risk and an entity’s own
methods nonperformance risk – have an immediate effect on the assessment
[815-20-35-16] of effectiveness. Normally, this results in a requirement to allocate a
portfolio-level credit risk adjustment to the individual hedging
instruments.
However, in some situations, it may be possible for an entity to
qualitatively evaluate whether it is necessary to allocate the
portfolio-level credit risk adjustment to individual fair value hedging
relationships (see Question 9.2.110).

Cash flow An entity is permitted to ignore the effects of changes in both

hedges – all counterparty credit risk and an entity’s own nonperformance risk for
methods a cash flow hedge if it is probable that the counterparty to the
other than derivative instrument and the entity itself will not default.
shortcut In this situation, an entity may conclude that the hedging
[815-20-25-122, relationship is highly effective without performing an allocation of
35-14 – 35-15] the portfolio-level credit risk adjustment.
Additionally, if it is not probable that the counterparty or the entity
itself will not default, an entity will be unable to conclude that the
hedging relationship is expected to be highly effective and must
discontinue the hedge. If the hedge is discontinued, there is no
longer a hedging relationship in which to make an allocation.

Net An entity is permitted to ignore the effects of changes in both

investment counterparty credit risk and an entity’s own nonperformance risk for
hedges a net investment hedge if it is probable that the counterparty to the
derivative instrument and the entity itself will not default. In this
situation, an entity may conclude that the hedging relationship is
effective as an economic hedge without performing an allocation of
the portfolio-level credit risk adjustment.
If it is not probable that the counterparty or the entity itself will not
default, an entity will frequently conclude that the hedging relationship
is no longer expected to be effective as an economic hedge and
discontinue the hedge. If the hedge is discontinued, there is no longer
a hedging relationship in which to make an allocation. If the entity
concludes that the hedging relationship continues to be expected to
be effective as an economic hedge, the entity is required to allocate
the portfolio-level credit risk adjustment to the individual hedging
relationships when assessing effectiveness.
Hedging 687
9. Hedge effectiveness

Question 9.2.110
Under what circumstances may an entity
qualitatively evaluate the effect of a portfolio-level
credit risk adjustment on individual fair value
hedging relationships?
Interpretive response: The SEC staff will not object to using a qualitative
analysis to conclude that it is not necessary to allocate the portfolio-level credit
risk adjustment to the individual fair value hedging relationships when
assessing effectiveness, provided the qualitative analysis results in a reasonable
conclusion, based on the specific facts and circumstances.
An entity should use reasonable judgment in performing a qualitative analysis. A
conclusion that it is probable that the counterparty and the entity itself will not
default is not, in isolation, a sufficient qualitative analysis. Instead, the
qualitative analysis should consider all relevant facts and circumstances,
including:
— the size of the portfolio-level credit risk adjustment;
— the hedging relationships’ degree of effectiveness without considering the
portfolio-level credit risk adjustment;
— the creditworthiness of the counterparty and the entity itself;
— the probability of default by either party; and
— the method used to assess effectiveness.
Further, if an entity is unable to conclude it is probable that the counterparty or
the entity itself will not default, a solely qualitative analysis is not appropriate.
Additionally, if the shortcut method is used to assess effectiveness, the
hedging relationship is required to be discontinued.
When a reasonable conclusion that the hedging relationships, including
derivative instruments subject to the portfolio-level credit risk adjustment,
would be highly effective cannot be reached solely through a qualitative
analysis, a quantitative analysis is necessary.

Example 9.2.30
Qualitative analysis of whether allocation of
portfolio-level credit risk adjustment is required
ABC Corp. applies the portfolio measurement exception to its derivative assets
and liabilities with DEF Counterparty and applies the portfolio measurement
exception to DEF’s credit risk, resulting in a portfolio-level credit risk
adjustment.
The net position of ABC’s derivative instruments with DEF is a $10 billion
liability position and the portfolio-level credit risk adjustment is $1 million. The
derivative instruments are part of fair value hedging relationships for which ABC
uses regression analysis (a long-haul method) for assessing effectiveness.
Both ABC and DEF are AA-rated and the likelihood of either party not defaulting
is deemed probable.
Hedging 688
9. Hedge effectiveness

Other causes of the relationship not being perfectly effective are minimal, such
that the hedging relationships are at least 95% effective without consideration
of the portfolio-level credit risk adjustment.
Based on these facts, ABC may conclude that a qualitative analysis is sufficient
for determining an allocation of the portfolio-level credit adjustment when
assessing effectiveness.
However, ABC may be required to allocate the portfolio-level credit
adjustment for reasons other than assessing effectiveness, as explained in
Question 9.2.140.

Question 9.2.120
What methods may be used to quantitatively
allocate a portfolio-level credit risk adjustment to
individual fair value hedging relationships?
Interpretive response: When measuring the fair values of individual hedging
insturments to assess effectiveness, we believe an entity should adopt a
reasonable and consistently applied methodology for allocating credit risk
adjustments determined at a portfolio level to individual derivative instruments.
In our experience, the following allocation methods generally are used for credit
risk adjustments.
— Relative fair value method. The portfolio-level credit risk adjustment is
allocated to the individual instruments in the portfolio based on their relative
fair values. There are two methods that are used in practice.
— Allocate the adjustment to all instruments in the portfolio based on their
relative fair values.
— Allocate the adjustment only to those instruments that are in the same
position (asset or liability) as the net position with the counterparty,
based on their relative fair values. For example, if the net position is an
asset, the portfolio-level credit risk adjustment is allocated only to the
financial assets in the portfolio based on their relative fair values.
— Relative credit adjustment method. The portfolio-level credit risk
adjustment is allocated to the individual instruments in the portfolio based
on their relative stand-alone credit risk adjustments. Applying this method
requires the entity to calculate the credit risk adjustment both on a gross
basis (assuming that the portfolio measurement exception is not applied)
and on a net basis.
The appropriate allocation method is affected by the fair value hierarchy of the
financial instruments within the portfolio (see Question 9.2.130).
See also KPMG’s Q&A: Fair value measurement. In particular, see:
— Section L, Portfolio measurement exception, including Question L60, which
addresses allocations of a net portfolio basis adjustment to individual
financial assets and liabilities that make up the portfolio.
— Section O, Application issues: Derivatives and hedging, including
Question O70, which discusses how the requirements to include
Hedging 689
9. Hedge effectiveness

counterparty credit risk and an entity’s own nonperformance risk in

measuring the fair values of derivative instruments affect hedging
relationships.

Question 9.2.130
How does a financial instrument’s level in the fair
value hierarchy affect allocation of a portfolio-level
credit risk adjustment to individual hedging
relationships?
Interpretive response: We understand from conversations with the FASB staff
that they believe the fair value allocated to financial instruments within the
portfolio categorized in Level 1 of the fair value hierarchy should be determined
using the instrument price times the quantity (i.e. P×Q), which is consistent
with the guidance in Topic 820 for Level 1 inputs. The FASB staff indicated that
the net portfolio measurement exception allows an entity to estimate the fair
value of financial instruments at levels different from the unit of account
prescribed by other Topics, but does not provide an exception to the other
conclusions and concepts of fair value measurement under Topic 820.
We believe this guidance is unlikely to apply in many circumstances because
the portfolios to which portfolio-level credit risk adjustments would apply
frequently do not contain Level 1 derivative instruments.
See also KPMG’s Q&A: Fair value measurement, including Question L60, which
addresses allocations of a net portfolio basis adjustment to individual financial
assets and liabilities that make up the portfolio.

Question 9.2.140
Could an entity be required to quantitatively
allocate a portfolio-level credit risk adjustment for
reasons other than assessing effectiveness?
Interpretive response: Yes. Even if an entity is not required to quantitatively
allocate a portfolio-level credit risk adjustment to the individual derivative assets
and liabilities within the group for which the portfolio measurement exception is
applied when assessing effectiveness (see Questions 9.2.90 and 9.2.100), such
an allocation frequently is necessary for other purposes.
The following are examples of when a quantitative allocation might be
necessary for reasons other than assessing effectiveness.
Hedging 690
9. Hedge effectiveness

Derivatives in It is necessary to allocate a portfolio-level credit risk adjustment

the group are to the individual hedging instruments. This is because the
used in fair change in fair value of a hedging instrument in a fair value hedge
value, cash flow is recorded immediately in earnings while the change in a cash
and net flow or net investment hedge is recorded in OCI (or CTA in
investment AOCI).
hedging
relationships

Derivatives in If the changes in fair value of the derivatives in the group are
the group are recorded in different income statement line items, it is
used in fair value necessary to allocate a portfolio-level credit risk adjustment
hedges of between income statement line items.
different types of
risk

Derivatives in — When the shortcut method is used to assess effectiveness

the group are for a fair value hedge of interest rate risk, the change in fair
used in fair value value of the hedging instrument is used as a proxy for the
hedges that use change in fair value of the hedged item (i.e. the basis
the shortcut adjustment).
method– basis — It may be necessary to allocate a portfolio-level credit risk
adjustments adjustment to determine the hedged item’s amortized cost
basis (which includes the basis adjustment) for purposes of
applying other applicable GAAP, including impairment (see
section 4.3.30).

Derivatives in — In these situations, it is necessary to allocate a portfolio-

the group are level credit risk adjustment to the individual hedging
used in cash instruments. This is because the net derivative gain or loss
flow hedges of is reclassified from AOCI into earnings when the hedged
different types of transaction affects earnings and is presented in the same
risk and/or to line item as the effect of the hedged transaction (see
hedge forecasted section 6.3).
transactions that — If the hedged risk varies for the derivatives in the group, the
affect earnings in income statement line items in which the allocated credit
different periods risk should be recorded when reclassified into earnings may
vary.
— If the timing of the hedged transaction affecting earnings
varies, the timing of reclassifications from AOCI will also
vary.
— Additionally, certain other circumstances also may result
in reclassifying amounts from AOCI, as discussed in
section 6.4.
Hedging 691
9. Hedge effectiveness

9.2.70 Excluded components

Excerpt from ASC 815-20

>> Hedge Effectiveness Criteria Applicable to both Fair Value Hedges and
Cash Flow Hedges
25-82 In defining how hedge effectiveness will be assessed, an entity shall
specify whether it will include in that assessment all of the gain or loss on a
hedging instrument. An entity may exclude all or a part of the hedging
instrument’s time value from the assessment of hedge effectiveness, as
follows:
a. If the effectiveness of a hedge with an option is assessed based on
changes in the option’s intrinsic value, the change in the time value of the
option would be excluded from the assessment of hedge effectiveness.
b. If the effectiveness of a hedge with an option is assessed based on
changes in the option’s minimum value, that is, its intrinsic value plus the
effect of discounting, the change in the volatility value of the contract shall
be excluded from the assessment of hedge effectiveness.
c. An entity may exclude any of the following components of the change in
an option’s time value from the assessment of hedge effectiveness:
1. The portion of the change in time value attributable to the passage of
time (theta)
2. The portion of the change in time value attributable to changes due to
volatility (vega)
3. The portion of the change in time value attributable to changes due to
interest rates (rho).
d. If the effectiveness of a hedge with a forward contract or futures contract
is assessed based on changes in fair value attributable to changes in spot
prices, the change in the fair value of the contract related to the changes in
the difference between the spot price and the forward or futures price
shall be excluded from the assessment of hedge effectiveness.
e. An entity may exclude the portion of the change in fair value of a currency
swap attributable to a cross-currency basis spread.
25-83 No other components of a gain or loss on the designated hedging
instrument shall be excluded from the assessment of hedge effectiveness nor
shall an entity exclude any aspect of a change in an option's value from the
assessment of hedge effectiveness that is not one of the permissible
components of the change in an option's time value. For example, an entity
shall not exclude from the assessment of hedge effectiveness the portion of
the change in time value attributable to changes in other market variables (that
is, other than rho and vega).
>>> Components of Option Time Value
55-57 This guidance discusses implementation of paragraph 815-20-25-82.
55-58 Some entities may wish to assess hedge effectiveness based on the
change in an option’s value excluding a certain aspect of the change in the
option’s time value. For example, some entities may wish to exclude the
change in time value attributable to the passage of time (theta) from the
assessment of hedge effectiveness, while assessing hedge effectiveness
Hedging 692
9. Hedge effectiveness

based on the remaining components of changes in an option’s value. As an

illustration, if out-of-the-money options are designated as hedging instruments,
changes in value of the option are primarily driven by the change, if any, in the
value of the underlying (delta). If the price of the underlying asset changes, in
effective hedging strategies involving out-of-the-money options, the hedge gain
or loss due to delta would offset the change in value of the hedged item;
however, if the price of the underlying does not change, there is no change in
fair value attributable to changes in delta. In that case, the only change in the
option’s value is attributable to the passage of time (theta), or to changes in
other market variables such as volatilities or interest rates. Accordingly, for
those hedging relationships to qualify for hedge accounting, an entity may
need to exclude the change in value attributable to theta from the assessment
of hedge effectiveness.
55-59 Other entities may wish to exclude changes in time value attributable to
certain market variables—volatility (vega) or interest rates (rho)—from the
assessment of hedge effectiveness. An entity may wish to exclude changes in
time value attributable to volatility (vega) from the assessment of hedge
effectiveness because the fair value measurement of the hedged item does
not incorporate a measure of implied volatility.
55-60 Similarly, an entity may seek to exclude changes in time value
attributable to interest rates (rho) from the assessment of hedge effectiveness.
For example, in a foreign currency hedge involving a country in which interest
rates are volatile, a substantial portion of the change in value of the option may
be attributable to fluctuations in those interest rates, while the fair value of the
hedged item is not affected correspondingly. Accordingly, for these hedging
relationships to qualify for hedge accounting, an entity may need to exclude
the change in value attributable to the relevant market variable from the
assessment of hedge effectiveness.
55-61 In summary, the exclusion of a certain aspect of the change in an
option’s time value from the assessment of hedge effectiveness is driven by
the fact that, in certain circumstances, the measurement of changes in fair
value of the hedged item or changes in the cash flows of the hedged
transaction does not depend on or incorporate that aspect. Option valuation
models are capable of isolating the various aspects of changes in an option’s
time value.

Topic 815 permits entities to exclude some components of a derivative hedging

instrument’s changes in fair value (i.e. cash flows) from the effectiveness
assessment. [815-20-25-82 – 25-83]
Hedge effectiveness is improved by excluding a component when the hedged
item’s fair value (or hedged transaction’s cash flows) is not affected by (or not
affected to the same extent as) the component. As a result, the ability to
exclude certain components from effectiveness assessments is important
because it improves effectiveness, which increases the likelihood of being able
to apply hedge accounting. [815-20-55-57 – 55-61]
Including all gains and losses on the derivative hedging instrument may result in
reduced levels of effectiveness if the fair value or cash flows of the hedged
item or transaction is not affected by (or to the same extent as) the excluded
components (e.g. time value).
Hedging 693
9. Hedge effectiveness

The following components of a hedging instrument’s fair value or cash flows

may be excluded from the effectiveness assessment. [815-20-25-82]

Hedging instrument Excluded component

Cash flow, fair value and net investment hedges
Options Excluded component depends on the method used to
assess effectiveness.
— Changes in intrinsic value. All changes in time value or
changes in time value attributable to either passage of
time (rho), volatility (theta) or interest rates (vega) may be
excluded.
— Changes in minimum value (i.e. intrinsic value after the
effect of discounting). Volatility value may be excluded.

Forward or futures Spot-forward difference – i.e. the difference between the

contract spot price and the forward or futures price (referred to as
forward points). This method is referred to as the spot
method.
Cash flow and fair value hedges
Currency swap Cross-currency basis spread – this represents a charge to
convert one currency to another; its initial cost is embedded
in the coupon payments that an entity has agreed to pay the
counterparty.

For additional considerations when using options (or combinations of options)

as a hedging instrument, see section 9.2.90.
No components (or portions of components) other than those specified in
Topic 815 may be excluded. [815-20-25-83]

Example 9.2.40
Effect of time value on hedge effectiveness
ABC Corp. purchases wheat to be used in its production of cereal. ABC enters
into a firm commitment to purchase wheat in six months at a fixed price from
DEF; this purchase is considered a ‘normal’ purchase.
ABC is concerned that the price of wheat will fall during the coming months. A
decline in wheat prices would decrease the value of the purchase commitment.
This is because ABC will be required to pay the fixed price in the firm
commitment even if the market value for the wheat is less than that six months
from now.
To hedge this exposure, ABC enters into a futures contract, which settles net in
cash, to sell wheat in six months at a fixed price. If the price of wheat
decreases, the fair value of the futures contract will increase while the fair value
of the firm commitment will decrease. Conversely, if the price of wheat
increases, the fair value of the futures contract will decrease while the fair value
of the firm commitment will increase.
ABC will assess the effectiveness of this hedging relationship by comparing the
changes in the fair value of the firm commitment to purchase wheat to changes
Hedging 694
9. Hedge effectiveness

in the entire fair value of the wheat futures contract – i.e. time value is not an
excluded component). Including all gains and losses of the derivative hedging
instrument improves effectiveness if the time value element of the futures
contract changes in amounts similar to (but in amounts opposite from) the time
value of the firm commitment.
In contrast, if ABC was hedging the fair value of its wheat inventory, the time
value element of the wheat futures contract would likely reduce the
effectiveness of the hedging relationship. This is because there is no time value
associated with the fair value of recognized inventory.

Question 9.2.150
Are there circumstances where the time value does
not affect the assessment of effectiveness even
though it is not considered an excluded
component?
Interpretive response: Yes, but only when the terminal value method is used.
When the hedging instrument is a purchased option or combination of options
resulting in a net purchased option or zero-cost collar, generally the option’s
premium (time value) does not offset hedged changes in cash flows. This
generally results in the time value affecting the hedging relationship’s
effectiveness unless time value is excluded from the assessment.
However, the time value component does not affect hedge effectiveness when
the terminal value method is used, even though time value is not an excluded
component under that approach (see section 9.7.20). This is because the
terminal value method focuses on the option’s terminal value (i.e. the expected
pay-off at its maturity date) in determining whether the hedging relationship is
expected to be highly effective.

Recognizing excluded components

Excerpt from ASC 815-20

>> Hedge Effectiveness Criteria Applicable to both Fair Value Hedges and
Cash Flow Hedges
25-83A For fair value and cash flow hedges, the initial value of the component
excluded from the assessment of effectiveness shall be recognized in earnings
using a systematic and rational method over the life of the hedging instrument.
Any difference between the change in fair value of the excluded component
and amounts recognized in earnings under that systematic and rational method
shall be recognized in other comprehensive income. Example 31 beginning in
paragraph 815-20-55-235 illustrates this approach for a cash flow hedge in
which the hedging instrument is an option and the entire time value is
excluded from the assessment of effectiveness.
Hedging 695
9. Hedge effectiveness

25-83B For fair value and cash flow hedges, an entity alternatively may elect to
record changes in the fair value of the excluded component currently in
earnings. This election shall be applied consistently to similar hedges in
accordance with paragraph 815-20-25-81 and shall be disclosed in accordance
with paragraph 815-10-50-4EEEE.
> Income Statement Classification
45-1A For qualifying fair value and cash flow hedges, an entity shall present
both of the following in earnings in the same income statement line item that
is used to present the earnings effect of the hedged item:
a. The change in the fair value of the hedging instrument that is included in
the assessment of hedge effectiveness
b. Amounts excluded from the assessment of hedge effectiveness in
accordance with paragraphs 815-20-25-83A through 25-83B.
See paragraphs 815-20-55-79W through 55-79AD for related implementation
guidance.
45-1B For cash flow hedges in which the hedged forecasted transaction is
probable of not occurring in accordance with paragraph 815-30-40-5, this
Subtopic provides no guidance on the required income statement classification
of amounts reclassified from accumulated other comprehensive income to
earnings.
45-1D While the Derivatives and Hedging Topic does not specify whether
certain income statement line items are either permitted or appropriate, the
other hedging-related Subtopics in this Topic do contain specific disclosure
requirements for those items. See Section 815-10-50 and Subtopics 815-25,
815-30, and 815-35..

If an entity has excluded components from its assessment of hedge

effectiveness, it can recognize the initial value of the excluded components in
earnings using either of the following approaches. [815-20-25-83A – 25-83B]
— Amortization approach. A systematic and rational method over the life of
the hedging instrument.
— Mark-to-market approach. A method that recognizes all fair value changes
of the excluded components currently in earnings.
When using the amortization approach, any difference between the change in
fair value of the excluded component and the amounts recognized in earnings
are included in AOCI (or CTA in AOCI). This election is applied consistently to
similar hedges, as discussed in section 9.2.80. If an entity elects the mark-to-
market approach, that election is disclosed. [815-10-50-4EEEE, 815-20-25-83A – 25-83B]
An entity presents amounts related to excluded components that are
recognized in earnings in the same income statement line item that is used to
present the earnings effect of the hedged item. [815-20-45-1A]
Hedging 696
9. Hedge effectiveness

Question 9.2.160
What is a systematic and rational method to
recognize an excluded component?
Interpretive response: The FASB did not prescribe a specific methodology to
satisfy the requirement that the excluded component be recognized in earnings
using a systematic and rational method over the life of the hedging instrument.
However, one method that an entity may consider to be systematic and rational
is the straight-line method. [815-20-55-237]
Additionally, the FASB noted that, similar to forward points (or the spot-forward
difference), cross-currency basis spreads reduce to zero by the time the
derivative matures. In the FASB’s view, recognizing the cross-currency basis
spread in earnings through the swap accrual is a systematic and rational
method for recognizing the cost of the cross-currency basis spread in earnings.
[ASU 2017-12.BC162–BC163]

When an entity elects to consider a cross-currency basis spread as an excluded

component and to recognize it through the swap accrual (an amortization
approach), the change in fair value of the swap attributable to the cross-
currency basis spread incorporated in the discount rates used to value the swap
is included in AOCI. It is not necessary to manually amortize any amounts when
their effect on the swap discounting reverses to zero in AOCI because the
swap matures. [ASU 2017-12.BC164]

Question 9.2.170
Under the amortization approach, is the excluded
component recognized when the hedged
transaction affects earnings?
Interpretive response: Not necessarily. The excluded component can be
viewed as the ‘cost of the hedge’. The amortization approach allows that cost
to be recognized over the term of the hedging relationship and could be viewed
as smoothing the effect of the excluded component in earnings. However, if
the forecasted transaction(s) will only affect earnings at the end of the hedging
relationship, the excluded component (cost of the hedge) will be recognized
earlier than when the hedged item actually affects earnings.
For example, an entity purchases an option to hedge its price exposure on the
anticipated sale of a nonfinancial item and decides to exclude the time value
from the assessment of hedge effectiveness. In that case, the effect of time
value is recognized over the period of the hedge, which is before the
anticipated sales revenue is recognized in earnings.
Hedging 697
9. Hedge effectiveness

Question 9.2.180
Is the caplet method acceptable for recognizing the
initial value of an excluded component?

Background: The caplet method involves associating the initial fair value of an
interest rate cap with each caplet within the rate cap, and reclassifying the
amount of each caplet from AOCI to earnings when the respective forecasted
interest payment occurs. [815-30-35-41B]
Interpretive response: No. The initial value of excluded components is
required to be recognized in earnings using either an amortization approach or
the mark-to-market approach, both of which result in the initial fair value of the
excluded component being recognized in earnings over the life of the hedging
instrument.
In contrast, the caplet method recognizes amounts when the hedged
transactions are reported in earnings. This may not occur during each period of
the hedging instrument’s life. For example, the hedged transaction may be
sales that occur in only certain periods or occur after the life of the hedging
instrument.
As a result, we believe that the caplet method is not an acceptable method for
recognizing the initial value of an excluded component.

Question 9.2.190
How does an entity account for amounts included
in AOCI related to an excluded component if hedge
accounting is discontinued?
Interpretive response: These amounts should be recognized in earnings
consistent with existing guidance for discontinued fair value or cash flow
hedges.
Fair value hedges
Any amounts associated with the excluded component remaining in AOCI
when a fair value hedge is discontinued are recorded in earnings in the same
manner as other components (e.g. the basis adjustment) of the carrying amount
of the hedged asset or liability when the hedged item continues to exist. [815-25-
40-7]

When the hedged item is derecognized, the amounts remaining in AOCI are
recognized in earnings immediately. [815-25-40-7]
For further guidance on the discontinuation of fair value hedge accounting, see
section 4.5.10.
Cash flow hedges
Any amounts associated with the excluded component remaining in AOCI
when a cash flow hedge is discontinued are recognized in earnings when the
hedged transaction affects earnings (see section 6.5.10). [815-30-40-6A]
Hedging 698
9. Hedge effectiveness

If the cash flow hedge relates to a forecasted transaction that it is probable will
not occur (i.e. a missed forecast), any amounts associated with the excluded
component remaining in AOCI are recognized currently in earnings. See also
section 6.5.20, including Question 6.5.100 related to income statement
presentation in such situations.
Net investment hedges
Any amounts remaining in the cumulative translation adjustment (CTA) in AOCI
related to a discontinued hedging relationhip – including amounts related to
excluded components – remain in CTA until the hedged net investment is sold,
exchanged or liquidated (see sections 8.5.20 and 8.5.40). For guidance on the
income statement presentation of excluded components, see Question 8.4.30.
[815-35-35-1(c), 40-1]

Examples
The following are examples that demonstrate the amortization and mark-to-
market approaches.
— Option time value excluded from the assessment of effectiveness in a cash
flow hedge and recorded in earnings under an amortization approach
(Subtopic 815-20’s Example 31).
— Comparison of approaches to recognize the excluded component for a cash
flow hedge (Example 9.2.50).
See sections 4.2.20 and 6.2.20 for additional examples of approaches to
recognize the excluded component for fair value and cash flow hedges,
respectively.

Excerpt from Subtopic 815-20

>> Example 31: Option Time Value Excluded from the Assessment of
Effectiveness in a Cash Flow Hedge and Recorded in Earnings under an
Amortization Approach

55-235 This Example illustrates the application of paragraph 815-20-25-83A.

55-236 On December 31, 20X0, an entity intends to purchase 1,000 barrels of
crude oil in December 20X4. The entity decides to hedge changes in the price
of the crude oil by purchasing an at-the-money call option on 1,000 barrels of
crude oil. The entity purchases the option on December 31, 20X0, with an
initial premium of $9,250, a strike price of $75, and a maturity date of
December 31, 20X4. The entity designates the option as the hedging
instrument in a cash flow hedge of a forecasted purchase of crude oil.
55-237 The entity elects to exclude the time value of the option from the
assessment of effectiveness in accordance with paragraph 815-20-25-82 and
applies the amortization approach for recognizing excluded components in
accordance with paragraph 815-20-25-83A. The entity applies a straight-line
amortization method and, based on the initial option premium of $9,250, the
Hedging 699
9. Hedge effectiveness

entity determines an annual amortization amount of $2,313. The entity records

all changes in fair value over the term of the derivative in other comprehensive
income and records amortization in earnings each period with an offsetting
entry to other comprehensive income. The changes in value of the option over
the life of the hedging relationship are as follows.

12/31/20X1 12/31/20X2 12/31/20X3 12/31/20X4

Ending market price of crude
oil $ 77 $ 76 $ 74 $ 81
Ending fair value of option:
Time value 7,500 5,500 3,000 -
Intrinsic value 2,000 1,000 - 6,000
Total $ 9,500 $ 6,500 $ 3,000 $ 6,000

Change in time value $ (1,750) $ (2,000) $ (2,500) $ (3,000)

Change in intrinsic value 2,000 (1,000) (1,000) 6,000
Total current-period gain
(loss) on derivative $ 250 $ (3,000) $ (3,500) $ 3,000

55-238 On December 31, 20X4, the entity purchases 1,000 barrels of crude oil,
and the option expires with an intrinsic value of $6,000. This amount will
remain in accumulated other comprehensive income until the commodity is
sold in 20X5. The journal entries over the life of the hedging relationship are as
follows.

December 31, 20X0

Derivative asset $ 9,250
Cash $ 9,250
To record the derivative asset based on the initial premium.

December 31, 20X1

Derivative asset $ 250
Other comprehensive income $ 250
To record the change in value of the derivative in other comprehensive income.

Cost of goods sold $ 2,313

Other comprehensive income $ 2,313
To record amortization of the excluded amount.

December 31, 20X2

Other comprehensive income $ 3,000
Derivative asset $ 3,000
To record the change in value of the derivative in other comprehensive income.

Cost of goods sold $ 2,313

Other comprehensive income $ 2,313
To record amortization of the excluded amount.
Hedging 700
9. Hedge effectiveness

December 31, 20X3

Other comprehensive income $ 3,500
Derivative asset $ 3,500
To record the change in value of the derivative in other comprehensive income.

Cost of goods sold $ 2,313

Other comprehensive income $ 2,313
To record amortization of the excluded amount.

December 31, 20X4

Derivative asset $ 3,000
Other comprehensive income $ 3,000
To record the change in value of the derivative in other comprehensive income.

Cost of goods sold $ 2,311(a)

Other comprehensive income $ 2,311(a)
To record amortization of the excluded amount.

July 1, 20X5
Accumulated other comprehensive income $ 6,000
Cost of goods sold $ 6,000
Upon sale of commodity, to record intrinsic value to cost of goods sold.

(a) $2 rounding adjustment

Example 9.2.50
Comparison of approaches to recognize the
excluded component for a cash flow hedge
Using the fact pattern in Subtopic 815-20’s Example 31, the following shows
the effect on earnings if the entity has elected to recognize the change in the
excluded component currently in earnings (mark-to-market approach).

December 31
Year 0 Year 1 Year 2 Year 3 Year 4
Ending fair value
of the option:
Time value $9,250 $7,500 $5,500 $3,000 $ -
Intrinsic value - 2,000 1,000 - 6,000

Total $9,250 $9,500 $6,500 $3,000 $6,000

Hedging 701
9. Hedge effectiveness

December 31
Year 0 Year 1 Year 2 Year 3 Year 4
Change in time
value $(1,750) $(2,000) $(2,500) $(3,000)
Change in intrinsic
value 2,000 (1,000) (1,000) 6,000
Total current-
period gain (loss)
on derivative $ 250 $(3,000) $(3,500) $3,000

The following journal entry recognizes the purchase of the derivative.

Debit Credit
Derivative asset (option) 9,250
Cash 9,250
To record derivative asset based on initial
premium paid.

The following journal entry recognizes the change in the fair value of the
derivative for Year 1.

Debit Credit
Cost of goods sold 1
1,750
Derivative asset (option) 1,750
To record change in time value.
Derivative asset (option)2 2,000
AOCI 2,000
To record change in intrinsic value.
Notes:
Beginning time value of $9,250 - ending time value of $7,500.
Beginning intrinsic value of $0 - ending intrinsic value of $2,000.

The following journal entry recognizes the change in the fair value of the
derivative for Year 2.

Debit Credit
Cost of goods sold 1
2,000
Derivative asset (option) 2,000
To record change in time value.
AOCI2 1,000
Derivative asset (option) 1,000
To record change in intrinsic value.
Hedging 702
9. Hedge effectiveness

Notes:
Beginning time value of $7,500 - ending time value of $5,500.
Beginning intrinsic value of $2,000 - ending intrinsic value of $1,000.

The following journal entry recognizes the change in the fair value of the
derivative for Year 3.

Debit Credit
Cost of goods sold1 2,500
Derivative asset (option) 2,500
To record change in time value.
AOCI2 1,000
Derivative asset (option) 1.000
To record change in intrinsic value.
Notes:
Beginning time value of $5,500 - ending time value of $3,000.
Beginning intrinsic value of $1,000 - ending intrinsic value of $0.

The following journal entry recognizes the change in the fair value of the
derivative for Year 4.

Debit Credit
Cost of goods sold1 3,000
Derivative asset (option) 3,000
To record change in time value.
Derivative asset (option)2 6,000
AOCI 6,000
To record change in intrinsic value.
Notes:
Beginning time value of $3,000 - ending time value of $0.
Beginning intrinsic value of $0 - ending intrinsic value of $6,000.

The following table compares the earnings effect of the excluded component
under the two methods:
— amortization approach (Subtopic 815-20’s Example 31); and
— mark-to-market approach (KPMG example).

December 31
Approach Year 1 Year 2 Year 3 Year 4 Total
Amortization $2,313 $2,313 $2,313 $2,311 $9,250
Mark-to-market 1,750 2,000 2,500 3,000 9,250
Difference $ 563 $ 313 $ (187) $ (689) $ -
Hedging 703
9. Hedge effectiveness

9.2.80 Consistency of methods between hedging

relationships

Excerpt from ASC 815-20

>> Hedge Effectiveness Criteria Applicable to both Fair Value Hedges and
Cash Flow Hedges
25-81 This Subtopic does not specify a single method for assessing whether a
hedge is expected to be highly effective. The method of assessing
effectiveness shall be reasonable. The appropriateness of a given method of
assessing hedge effectiveness depends on the nature of the risk being hedged
and the type of hedging instrument used. Ordinarily, an entity shall assess
effectiveness for similar hedges in a similar manner, including whether a
component of the gain or loss on a derivative instrument is excluded in
assessing effectiveness for similar hedges. Use of different methods for
similar hedges shall be justified. The mechanics of isolating the change in time
value of an option discussed beginning in paragraph 815-20-25-98 also shall
be applied consistently.

An entity should assess effectiveness for similar hedges in a similar manner,

and is required to justify using different methods for similar hedges. This
includes whether a component of a hedging instrument is an excluded
component for similar hedges, how the change in time value in an option is
isolated, and the method that will be used to recognize excluded components
(see section 9.2.70). [815-20-25-81]

Question 9.2.200
Are there situations in which an entity may use
different effectiveness assessment methods for
similar hedges?
Interpretive response: Yes. Topic 815 permits an entity to use different
effectiveness assessment methods when the entity can justify doing so. We
believe that judgment may be used when determining whether using different
methods is justified. For example, we believe an entity may be justified in using
different methods between autonomous business units when those business
units individually manage risk.

Question 9.2.210
Must an entity use qualitative effectiveness
assessments for all similar hedges?
Interpretive response: No. Topic 815 ordinarily requires an entity to justify
using different methods for assessing the effectiveness of similar hedges.
However, the FASB observed that requiring an entity to perform qualitative
Hedging 704
9. Hedge effectiveness

assessments for all similar hedges may have unintended consequences.

Instead, it decided to allow the election to be made on a hedge-by-hedge basis
to be consistent with its intent to provide more flexibility and relieve operational
burden. As a result, an entity is permitted to elect to perform subsequent
qualitative effectiveness assessments on a hedge-by-hedge basis. [815-20-25-81,
35-2B, ASU 2017-12.BC207]

However, an entity still needs to justify using different quantitative methods for
similar hedges. Unless using different quantitative methods is justified, an
entity is expected to specify in its initial hedge documentation the same
quantitative method to be used for assessing effectiveness for similar hedges,
both for the initial prospective effectiveness assessment, and in the event that
the entity is required to perform a quantitative test subsequently (see
Question 9.5.20). [815-20-25-81, 35-2B, ASU 2017-12.BC207]

Question 9.2.220
What effect does ASU 2017-12 have on the
requirement to assess effectiveness for similar
hedges in a similar manner?

Excerpt from ASC 815-20

> Transition Related to Accounting Standards Update No. 2017-12,

relationships executed after the date of adoption for which an

amortization approach is elected in accordance with paragraph 815-20-
25-83A.

Interpretive response: Due to operational concerns, the FASB provided relief

for entities from the requirement to assess effectiveness for similar hedges in a
similar manner. In the situations specified in the following table, an entity is not
required to comply with the requirement.

Shortcut method ASU 2017-12 permits an entity to document a quantitative

method to be used if the shortcut method was not or no longer
is appropriate (see section 11.4.60).
An entity may document a quantitative effectiveness method for
new shortcut method hedging relationships executed after the
date of adoption of ASU 2017-12 regardless of whether the
entity modifies its hedge documentation to include a quantitative
effectiveness method for hedges existing at the date of
adoption. [815-20-65-3(i)(1), ASU 2017-12.BC261]

Contractually ASU 2017-12 added as a new hedging strategy the ability to

specified designate a contractually specified component or interest rate as
component or the hedged risk in a cash flow hedge (see section 11.4.40).
interest rate An entity may continue designating the variability in total cash
flows as the hedged risk for hedging relationships that existed
on the date of adoption, and designate the hedged risk as the
variability in the contractually specified component or
contractually specified interest rate for hedging relationships
executed after the date of adoption. [815-20-65-3(i)(2)]

Method for Before ASU 2017-12, entities were required to use the mark-to-
recognizing market approach for recognizing excluded components. ASU
excluded 2017-12 permits an entity to use the mark-to-mark approach or
components an amortization approach (see section 11.4.50).
An entity may continue recognizing excluded components using
a mark-to-market approach for hedging relationships that existed
on the date of adoption, and elect an amortization approach for
hedging relationships executed after the date of adoption.
[815-20-65-3(i)(3)]

9.2.90 Additional considerations when using options as the

hedging instrument

Excerpt from ASC 815-20

>>> Additional Considerations for Options in Cash Flow Hedges

25-123 When an entity has documented that the effectiveness of a cash flow
hedge will be assessed based on changes in the hedging option’s intrinsic
value pursuant to paragraph 815-20-25-82(a), that assessment (and the related
cash flow hedge accounting) shall be performed for all changes in intrinsic
Hedging 706
9. Hedge effectiveness

value—that is, for all periods of time when the option has an intrinsic value,
such as when the underlying is above the strike price of the call option.
25-124 When a purchased option is designated as a hedging instrument in a
cash flow hedge, an entity shall not define only limited parameters for the risk
exposure designated as being hedged that would include the time value
component of that option. An entity cannot arbitrarily exclude some portion of
an option’s intrinsic value from the hedge effectiveness assessment simply
through an articulation of the risk exposure definition. It is inappropriate to
assert that only limited risk exposures are being hedged (for example,
exposures related only to currency-exchange-rate changes above $1.65 per
pound sterling as illustrated in Example 26 [see paragraph 815-20-55-205]).
25-125 If an option is designated as the hedging instrument in a cash flow
hedge, an entity may assess hedge effectiveness based on a measure of the
difference, as of the end of the period used for assessing hedge effectiveness,
between the strike price and forward price of the underlying, undiscounted.
Although assessment of cash flow hedge effectiveness with respect to an
option designated as the hedging instrument in a cash flow hedge shall be
performed by comparing the changes in present value of the expected future
cash flows of the forecasted transaction to the change in fair value of the
derivative instrument (aside from any excluded component under paragraph
815-20-25-82), that measure of changes in the expected future cash flows of
the forecasted transaction based on forward rates, undiscounted, is not
prohibited. With respect to an option designated as the hedging instrument in a
cash flow hedge, assessing hedge effectiveness based on a similar measure
with respect to the hedging instrument eliminates any difference that the
effect of discounting may have on the hedging instrument and the hedged
transaction. Pursuant to paragraph 815-20-25-3(b)(2)(iv), entities shall document
the measure of intrinsic value that will be used in the assessment of hedge
effectiveness. As discussed in paragraph 815-20-25-80, that measure must be
used consistently for each period following designation of the hedging
relationship.

An entity can exclude time value (or certain portions of time value) from its
effectiveness assessments when the hedging instrument is an option (see
section 9.2.70).
When time value is excluded, effectiveness is assessed based on the option’s
intrinsic value. In those situations, effectiveness is assessed during those
periods when the option has intrinsic value – such as when the underlying is
above the strike price of a call option. [815-20-25-123]
In addition to the considerations in this section, an entity using an option
contract, a combination of option contracts, or a combination of an option
contract with a non-option derivative as a hedging instrument is required to
consider whether the option or combination is a net written option. This is
because there is a special rule for written options (see sections 2.7.50
and 2.7.60).
Hedging 707
9. Hedge effectiveness

Question 9.2.230
What are the components of an option’s value?

Interpretive response: An option’s total value at any point in time comprises

the following.

Component Description
Time value The value of the time to the end of the exercise period,
which is affected by volatility of the price of the underlying,
the remaining option term, and other economic factors.
Intrinsic value The amount by which the value of the underlying exceeds
(call option) or is less than (put option) an option’s strike
price.
This is commonly characterized by the term ‘in the money’ or
‘out of the money.’ In either case, intrinsic value normally can
only be a positive amount (i.e. an option cannot have an
intrinsic value less than zero from the holder’s perspective),
even when it is out of the money.

As a result, time value may be viewed as the portion of an option’s total value
that is not represented by intrinsic value (see Question 9.2.240).

Question 9.2.240
How is the intrinsic value of an option measured?

Interpretive response: The following table presents the methods that market
convention considers to be measures of intrinsic value, and whether those
methods may be used for fair value, cash flow or net investment hedging
relationships that use the intrinsic value method to assess effectiveness – i.e.
that exclude time value from the effectiveness assessment.

Method for measuring intrinsic value Hedging relationships that may use it
The difference between the strike price Fair value, cash flow or net investment
and the spot price of the underlying asset
The present value of the difference Fair value or cash flow
between the strike price (i.e. contractual
price) and the forward price (i.e. forward
rate in the market on the measurement
date) of the underlying asset
The difference between the strike price Cash flow only [815-20-25-125]
(i.e. contractual price) and the forward This method is available for cash flow
price (i.e. forward rate in the market on hedges due to the greater flexibility
the measurement date) of the underlying, provided in measuring the change in
undiscounted value of the hedged cash flow
Hedging 708
9. Hedge effectiveness

As part of the overall documentation for each hedging relationship, entities

must document the measure of intrinsic value that will be used in the
assessment of hedge effectiveness. That measure must be used consistently
for each period following designation of the hedging relationship. [815-20-25-125]

Question 9.2.250
How is the intrinsic value of a cap option that
involves a series of payments measured?

Background: An entity may purchase an option that involves a series of

payments. For example, an entity may purchase an interest rate cap (option)
that it designates as the hedging instrument in a cash flow hedge of changes in
the cash flows of forecasted interest payments that are attributable to changes
in a referenced interest rate when it exceeds a specified level (e.g. 8%).
Interpretive response: Topic 815 does not specify how to measure the
intrinsic value of a cap option if the option involves a series of payments. We
believe that the following are two acceptable methods.
— Estimate the intrinsic value of the cap assuming the referenced interest
rate remains constant for the remaining term of the hedge. In the
background example, the intrinsic value for all future periods would be
assumed to be 1% if the referenced interest rate is 9% at the valuation
date (9% referenced interest rate less 8% specified level in the interest
rate cap). Under this method, the effect of the forward yield curve is
excluded from the intrinsic value and instead is included in other
components (e.g. time value).
— Estimate the intrinsic value of the cap for each period based on the
market’s expectations of movements in the referenced interest rate using
the forward yield curve for that interest period.

Question 9.2.260
How are portions of time value (passage of time,
market variables) measured?

Excerpt from ASC 815-20

>>>> Computing Changes in an Option's Time Value

25-98 In computing the changes in an option's time value that would be
excluded from the assessment of hedge effectiveness, an entity shall use a
technique that appropriately isolates those aspects of the change in time value.
Generally, to allocate the total change in an option's time value to its different
aspects—the passage of time and the market variables—the change in time
value attributable to the first aspect to be isolated is determined by holding all
other aspects constant as of the beginning of the period. Each remaining
Hedging 709
9. Hedge effectiveness

aspect of the change in time value is then determined in turn in a specified

order based on the ending values of the previously isolated aspects.
25-99 Based on that general methodology, if only one aspect of the change in
time value is excluded from the assessment of hedge effectiveness (for
example, theta), that aspect shall be the first aspect for which the change in
time value is computed and would be determined by holding all other
parameters constant for the period used for assessing hedge effectiveness.
However, if more than one aspect of the change in time value is excluded from
the assessment of hedge effectiveness (for example, theta and vega), an entity
shall determine the amount of that change in time value by isolating each of
those two aspects in turn in a prespecified order (one first, the other second).
The second aspect to be isolated would be based on the ending value of the
first isolated aspect and the beginning values of the remaining aspects. The
portion of the change in time value that is included in the assessment of
effectiveness shall be determined by deducting from the total change in time
value the portion of the change in time value attributable to excluded
components.

Interpretive response: To measure portions of the changes in an option’s time

value that may be excluded from the effectiveness assessment, an entity uses
a technique that appropriately isolates those components of the change in time
value. [815-20-25-98]
Generally, to allocate the total change in an option’s time value to its different
aspects (i.e. the passage of time versus market variables), the change in time
value attributable to the first component to be isolated is determined by holding
all other components constant as of the beginning of the period. Each
remaining component is then determined in turn in a specified order based on
the ending values of the previously isolated components. [815-20-25-99]
— Only one component of the change in time value is excluded. Using
theta as the example component that is excluded, the change in time value
for theta is measured first. Its value would be determined by holding all
other parameters constant for the period used to assess hedge
effectiveness.
— More than one component is excluded. Using theta and vega as the
example components that are excluded, the entity determines the amount
of that change in time value by isolating each of those two components in a
pre-specified order (e.g. theta first and vega second). Vega is isolated based
on the ending value theta and the beginning values of the remaining
components that are not excluded.
The portion of the change in time value that is not an excluded component (i.e.
the portion that is included in the effectiveness assessment) is determined by
deducting from the total change in time value the portion that is attributable to
excluded components. [815-20-25-99]
Hedging 710
9. Hedge effectiveness

Question 9.2.270
Must an entity assess effectiveness for all periods
that the option has intrinsic value?

Interpretive response: Yes. Regardless of the method selected for measuring

an option’s intrinsic value, the effectiveness assessment (and related hedge
accounting) must be performed for all changes in the intrinsic value – i.e. for all
periods of time in which the option has an intrinsic value. An entity cannot
arbitrarily exclude some portion of the option’s intrinsic value from the
effectiveness assessment simply through an articulation of the risk exposure
definition. See also Subtopic 815-20’s Example 26 reproduced below. [815-20-
25-124]

However, an entity may be able to use the terminal value method when
assessing effectiveness. This approach includes the time value component of
the option in the assessment of effectiveness, but focuses on the hedging
instrument’s terminal value (i.e. the expected pay-off at its maturity date) in
determining whether the hedging relationship is expected to be highly effective
at achieving offsetting cash flows that are attributable to the hedged risk during
the term of the hedge (see section 9.7.20).

FASB Example: Defining the risk exposure for hedging

relationships involving an option contract as the hedging
instrument

Excerpt from ASC 815-20

>> Example 26: Defining the Risk Exposure for Hedging Relationships
Involving an Option Contract as the Hedging Instrument

55-205 This Example illustrates the application of paragraph 815-20-25-124.

55-206 Entity XYZ, a U.S. dollar (USD) functional currency entity forecasts the
purchase of goods with the payment denominated in pounds sterling (GBP). To
hedge the foreign currency exposure from the forecasted purchase, Entity XYZ
purchases an at-the-money call option on GBP. The notional amount of the
option equals the forecasted value of goods to be purchased, and the option
exercise date is the date the purchase consummates. At inception of the
hedging relationship the strike price and the forward market exchange rate for
GBP 1 are both USD 1.50. The time value component on the option is USD
0.15 per GBP. The foreign currency option in this Example could be effective
as a hedging instrument only if effectiveness for that hedging relationship were
based solely on either of the following:
a. Changes in the option’s intrinsic value
b. Changes in the option’s entire fair value.
Hedging 711
9. Hedge effectiveness

55-207 As stated in paragraph 815-20-25-124, it is inappropriate to assert that

only limited risk exposures are being hedged, such as exposures related only
to currency-exchange-rate changes above USD 1.65 per GBP.

Using a net-purchased combination of options as the hedging

instrument (assessing effectiveness only when intrinsic value
changes)

Excerpt from ASC 815-20

>>>> Hedge Effectiveness of a Net-Purchased Combination of Options

25-130 The guidance in the following paragraph addresses a cash flow hedging
relationship that meets both of the following conditions:
a. A combination of options (deemed to be a net purchased option) is
designated as the hedging instrument.
b. The effectiveness of the hedge is assessed based only on changes in
intrinsic value of the hedging instrument (the combination of options).
25-131 The assessment of effectiveness of a cash flow hedging relationship
meeting the conditions in the preceding paragraph may be based only on
changes in the underlying that cause a change in the intrinsic value of the
hedging instrument (the combination of options). Thus, the assessment can
exclude ranges of changes in the underlying for which there is no change in
the hedging instrument’s intrinsic value.

If a combination of options is deemed to be a net-purchased option (see

section 2.7.60), it may qualify for hedge accounting even if it offers protection
only within various ranges of changes in the underlying – instead of in all ranges
of change.
In this situation, effectiveness is assessed based only on changes in the
underlying that cause a change in the intrinsic value of the hedging
instrument(s). Effectiveness assessment excludes ranges of changes in the
underlying for which there is no change in the hedging instrument’s intrinsic
value. [815-20-25-130 – 25-131]
See Subtopic 815-20’s Example 28 reproduced below.

Question 9.2.280
If the hedged risk is changes within a range and
time value is an excluded component, how are
changes in the underlying that do not cause a
change in intrinsic value accounted for?
Interpretive response: When the hedged risk is changes within a range and
time value is an excluded component, the effectiveness assessment is based
only on changes in the underlying that cause a change in the intrinsic value of
Hedging 712
9. Hedge effectiveness

the hedging instrument. Under this method, the changes in the hedging
instrument’s underlying that occur outside of the various ranges not covered in
the hedging strategy are part of the excluded component. The related changes
in the fair value of the combination of options for the excluded components are
recognized using either the amortization or mark-to-market approach discussed
in section 9.2.70.
Cash flow hedges. However, for cash flow hedges we believe an entity may
use the terminal value method when assessing effectiveness if the conditions
for that approach are met (see section 9.7.20).

Question 9.2.290
If a zero-cost collar has different notional amounts,
can the hedged item be different proportions of the
same asset referenced in the collar?

Excerpt from ASC 815-20

>>> Different Proportions of the Same Asset as a Hedged Item

25-10 In a hedging relationship in which a collar that is comprised of a
purchased option and a written option that have different notional amounts is
designated as the hedging instrument and the hedge’s effectiveness is
assessed based on changes in the collar’s intrinsic value, the hedged item may
be specified as two different proportions of the same asset referenced in the
collar, based on the upper and lower price ranges specified in the two options
that make up the collar. That is, the quantities of the asset designated as being
hedged may be different based on those price ranges in which the collar’s
intrinsic value is other than zero. This guidance shall be applied only to collars
that are a combination of a single written option and a single purchased option
for which the underlying in both options is the same. This guidance shall not be
applied by analogy to other derivative instruments designated as hedging
instruments. Although the quantities of the asset designated as being hedged
may be different based on the upper and lower price ranges in the collar, the
actual assets that are the subject of the hedging relationship may not change.
The quantities that are designated as hedged for a specific price or rate change
shall be specified at the inception of the hedging relationship and shall not be
changed unless the hedging relationship is dedesignated and a new hedging
relationship is redesignated. Since the hedge’s effectiveness is based on
changes in the collar’s intrinsic value, the assessment of hedge effectiveness
shall compare the actual change in intrinsic value of the collar to the change in
value of the prespecified quantity of the hedged asset that occurred during the
hedge period.

Interpretive response: Yes. If a hedging relationship in which a zero-cost collar

that comprises a single purchased option and single written option that have
different notional amounts is designated as the hedging instrument, the hedged
item may be specified as two different proportions of the same asset
Hedging 713
9. Hedge effectiveness

referenced in the collar – based on the upper and lower price ranges specified
in the two options that comprise the collar. In this situation, hedge
effectiveness is assessed based on changes in the collar’s intrinsic value.
Specifically, the quantities of the forecasted transaction that are designated as
being hedged may differ based on the price ranges in which the collar’s intrinsic
value is other than zero. This strategy is used when an entity seeks full
protection of downside risk while partially paying for this protection by selling
some of the upside potential.
See Subtopic 815-20’s Example 9 reproduced below.
We believe this approach may also be used when the notional amounts in the
zero-cost collar are the same but the strike prices are different.
Cash flow hedges. We also believe that the terminal value method may be
used for cash flow hedges if the conditions for its use are met (see
section 9.7.20).
Fair value hedges. We do not believe an entity may designate a series of
possible percentages of servicing right assets (prohibition of preset hedge
coverage ratios) that each correspond to a specified independent variable, such
as an interest rate (see section 3.3.60).

Examples
The following are examples that demonstrate using a net-purchased
combination of options as the hedging instrument (assessing effectiveness only
when intrinsic value changes).
— Assessing effectiveness with an interest rate cap (Example 9.2.60)
— Effectiveness of a combination of options involving one written option and
two purchased options (Subtopic 815-20’s Example 28).
— Definition of hedged item when using a zero-cost collar with different
notional amounts (Subtopic 815-20’s Example 9).

Example 9.2.60
Assessing effectiveness with an interest rate cap
ABC Corp. issues floating-rate debt (indexed to three-month LIBOR, a
contractually specified component) and wishes to hedge its risk to variability in
cash flows due to three-month LIBOR changes when three-month LIBOR is
greater than 7%. ABC purchases an interest rate cap with a notional amount
equal to the principal of the debt and a strike price of 7% that includes a knock-
out provision (a written call) that nullifies the cap when three-month LIBOR
reaches 12%.
If the interest rate cap represents a net purchased option (see section 2.7.60),
ABC can designate the hedged risk as the risk of variability in cash flows due to
changes in a contractually specified component (i.e. three-month LIBOR) when
it exceeds 7% but is below 12%.
Hedging 714
9. Hedge effectiveness

Excerpt from ASC 815-20

>> Example 28: Effectiveness of a Combination of Options Involving One

Written Option and Two Purchased Options

55-212 This Example illustrates the application of paragraph 815-20-25-131.

55-213 Entity JPN is a Japanese subsidiary of a U.S. entity. Entity JPN's
functional currency is the Japanese yen (JPY). Entity JPN has forecasted
inventory purchases to be paid in U.S. dollars (USD). As a result, Entity JPN is
exposed to changes in the JPY-USD exchange rate: its functional currency
cash outflows will increase (loss) if JPY weakens versus USD and decrease
(gain) if JPY strengthens versus USD.
55-214 Entity JPN would like to hedge the foreign currency exposure related to
the forecasted transaction by entering into a combination of foreign-currency-
denominated option contracts designated as a single hedging instrument.
55-215 For purposes of this discussion, assume all of the following:
a. Entity JPN has met the qualifying criteria regarding forecasted transactions
eligible for designation as hedged transactions pursuant to paragraph 815-
20-25-15 and the options are entered into contemporaneously with the
same counterparty and can be transferred independently of each other.
b. The combination of foreign currency option contracts meets all of the
conditions in paragraphs 815-20-25-89 through 25-90 to be considered a
net purchased option (that is, considered not to be a net written option
subject to the requirements of paragraph 815-20-25-94).
55-216 Entity JPN employs the following hedging strategy:
a. The forecasted transaction is estimated at USD 150,000,000. The at-the-
money forward rate is JPY 120 per USD 1.
b. Entity JPN's documented hedge objective is to offset the foreign exchange
risk to the functional currency equivalent cash flows at levels above JPY
125/USD 1 and in the range from JPY 113/USD 1 to JPY 108/USD 1. In the
range JPY 113/USD 1 to JPY 125/USD 1 and at levels below JPY 108/USD
1, Entity JPN chooses not to offset the foreign exchange risk to the
functional currency equivalent cash flows.
c. To implement this hedge objective, Entity JPN enters into all three of the
following option contracts and jointly designates them as the hedging
instrument:
1. Option 1. One purchased option that gives Entity JPN the right to
purchase USD 150,000,000 at an exchange rate of JPY 125/USD 1.
Premium paid: USD 1,536,885.
2. Option 2. One sold (written) option that, if exercised, obligates Entity
JPN to purchase USD 150,000,000 at an exchange rate of JPY
113/USD 1. Premium received: USD 1,536,885.
3. Option 3. One purchased option that gives Entity JPN the right to sell
USD 150,000,000 at an exchange rate of JPY 108/USD 1. Premium
paid: USD 737,705.
Hedging 715
9. Hedge effectiveness

55-217 The time value of the combination of options is to be excluded from the
assessment of effectiveness and, therefore, effectiveness is based only on
changes in intrinsic value related to the combination of options.
55-218 The purpose of Option 1 is to protect Entity JPN when the JPY-USD
exchange rate increases above JPY 125/USD 1. As the JPY-USD exchange rate
increases, Entity JPN will be required to purchase the USD 150,000,000
inventory at a greater JPY-equivalent cost. As the JPY-USD exchange rate
increases above JPY 125/USD 1, the intrinsic value of the option increases as
the option is increasingly in the money. That increase in the option’s intrinsic
value is expected to offset the increase in the JPY-equivalent expenditure on
the forecasted transaction.
55-219 Entity JPN also writes an option (Option 2) that obligates Entity JPN to
purchase USD from the counterparty at an exchange rate of JPY 113/USD 1.
The counterparty will exercise the option whenever the JPY-USD exchange
rate is below JPY 113/USD 1. As the JPY-USD exchange rate decreases, Entity
JPN will be required to purchase the USD 150,000,000 inventory at a lesser
JPY-equivalent cost. As the JPY-USD exchange rate decreases below JPY
113/USD 1, Entity JPN's losses related to increases in the intrinsic value of the
written option are expected to offset the decrease in the JPY-equivalent
expenditure on the forecasted transaction.
55-220 Entity JPN also purchases an option to sell USD (Option 3) for a
notional amount equal to the notional of the written option (Option 2) with a
strike price of JPY 108/USD 1. Entity JPN will exercise Option 3 whenever the
JPY-USD exchange rate is below JPY 108/USD 1. When the exchange rate is
below JPY 108/USD 1, although Entity JPN will be obligated to make a
payment in relation to Option 2, it will also receive a payment in relation to
Option 3. As a result of purchasing Option 3, Entity JPN will be exposed to
exchange rate fluctuations on Option 2 only when the exchange rate is
between JPY 113/USD 1 and JPY 108/USD 1. Hence, with Options 2 and 3,
Entity JPN has effectively limited its hedge offset to changes in cash flows on
the forecasted item to levels between JPY 113/USD 1 and JPY 108/USD 1.
Changes in the exchange rate below JPY 108/USD 1 result in no change in the
intrinsic value of the combination of options because the change in Option 2
offsets the change in Option 3. However, when the exchange rate is below
JPY 108/USD 1, the combination of options has an intrinsic value other than
zero.
55-221 In summary, potential changes in intrinsic value related to this
combination option hedge construct (Options 1, 2, and 3) would limit the hedge
offset to corresponding changes in functional currency cash flows on the
forecasted transaction only at levels above JPY 125/USD 1 and in the range
JPY 108/USD 1 to JPY 113/USD 1, consistent with Entity JPN's documented
hedge objective.
55-222 The cash flow hedging relationship in this Example involving a
combination of options may be considered effective at offsetting the change in
cash flows due to foreign currency exchange rate movements related to the
forecasted transaction. Specifically, Entity JPN may assess the effectiveness
of the hedge based only on changes in the underlying that cause a change in
the intrinsic value of the combination of options. Thus, in that case, Entity
JPN would assess effectiveness of the hedge only when the JPY-USD
exchange rate is above JPY 125/USD 1 and between JPY 113/USD 1 and
Hedging 716
9. Hedge effectiveness

JPY 108/USD 1. Likewise, Entity JPN's assessment would exclude changes in

the JPY-USD exchange rate between JPY 113/USD 1 and JPY 125/USD 1 and
below JPY 108/USD 1.
55-223 The combination of options used by Entity JPN as a hedging instrument
is deemed to be a net purchased option based on the provisions of this
Subtopic. Therefore, the hedging relationship avoids being subject to the
hedge effectiveness test for written options in paragraph 815-20-25-94.
55-224 In particular, as it relates to paragraph 815-20-25-89(a), the aggregate
premium (that is, the time values) for the three options comprising the hedging
instrument results in Entity JPN paying a net premium.
55-225 The evaluation of whether a net premium has been received under
paragraph 815-20-25-89(a) must include consideration of only the time value
components of the options designated as the hedging instrument. That
evaluation must not include the intrinsic value, if any, of the options.

Excerpt from ASC 815-20

>> Example 9: Definition of Hedged Item When Using a Zero-Cost Collar

with Different Notional Amounts

55-117 The following Example illustrates the application of paragraph 815-20-

25-10 to a currency collar.
>>> Case B: Currency Collar
55-123 Entity B forecasts that it will purchase inventory that will cost
100 million foreign currency (FC) units. Entity B’s functional currency is the
U.S. dollar (USD). To limit the variability in USD-equivalent cash flows
associated with changes in the USD-FC exchange rate, Entity B constructs a
currency collar as follows:
a. A purchased call option providing Entity B the right to purchase FC
100 million at an exchange rate of USD 0.885 per FC 1.
b. A written put option obligating Entity B to purchase FC 50 million at an
exchange rate of USD 0.80 per FC 1.
55-124 The purchased call option provides Entity B with protection when the
USD-FC exchange rate increases above USD 0.885 per FC 1. The written put
option partially offsets the cost of the purchased call option and obligates
Entity B to give up some of the foreign currency gain related to the forecasted
inventory purchase as the USD-FC exchange rate decreases below USD 0.80
per FC 1. (For both options, the underlying is the same—the USD-FC exchange
rate.) Assuming that a net premium was not received for the combination of
options and all the other criteria in paragraphs 815-20-25-89 through 25-90 have
been met, if Entity B chooses to use the combination of options as a hedging
instrument, it is not required to comply with the provisions contained in
paragraph 815-20-25-94 related to written options.
Hedging 717
9. Hedge effectiveness

55-125 Entity B would like to designate the combination of options as a hedge

of the variability in USD-equivalent cash flows of its forecasted purchase of
inventory denominated in FC. Assume Entity B specifies in the hedge
effectiveness documentation that the collar’s time value would be excluded
from the assessment of hedge effectiveness.
55-126 The hedging relationship involving the currency collar designated as a
hedge of the effect of fluctuations in the USD-FC exchange rate qualifies for
cash flow hedge accounting. In that example, the hedged risk is the risk of
changes in USD-equivalent cash flows attributable to foreign currency risk
(specifically, the risk of fluctuations in the USD-FC exchange rate). The foreign
currency collar is hedging the variability in USD-equivalent cash flows for
100 percent of the forecasted FC 100 million purchase price of inventory for
USD-FC exchange rate movements above USD 0.885 per FC 1 and variability in
USD-equivalent cash flows for 50 percent of the forecasted FC 100 million
purchase price of inventory for USD-FC exchange rate movements below USD
0.80 per FC 1. Cash flow hedge effectiveness will be determined based on
changes in the underlying (the USD-FC exchange rate) that cause changes in
the collar’s intrinsic value (that is, changes below USD 0.80 per FC 1 and above
USD 0.885 per FC 1). Because the hedge’s effectiveness is based on changes
in the collar’s intrinsic value, hedge effectiveness must be assessed based on
the actual exchange rate changes by comparing the change in intrinsic value of
the collar to the change in the specified quantity of the forecasted transaction
for those changes in the underlying.

9.2.100 Additional consideration for fair value hedges –

prepayment risk under the last-of-layer method

Excerpt from ASC 815-20

>>>> Fair Value Hedges of Interest Rate Risk in Which the Hedged Item
Can Be Settled before Its Scheduled Maturity
25-6B An entity may designate a fair value hedge of interest rate risk in which
the hedged item is a prepayable instrument in accordance with paragraph 815-
20-25-6. The entity may consider only how changes in the benchmark interest
rate affect the decision to settle the hedged item before its scheduled maturity
(for example, an entity may consider only how changes in the benchmark
interest rate affect an obligor’s decision to call a debt instrument when it has
the right to do so). The entity need not consider other factors that would affect
this decision (for example, credit risk) when assessing hedge effectiveness.
Paragraph 815-25-35-13A discusses the measurement of the hedged item.
>>> Consideration of Prepayment Risk Using the Last-of-Layer Method
25-118A In a fair value hedge of interest rate risk designated under the last-of-
layer method in accordance with paragraph 815-20-25-12A, an entity may
exclude prepayment risk when measuring the change in fair value of the
hedged item attributable to interest rate risk.
Hedging 718
9. Hedge effectiveness

An entity is prohibited from hedging prepayment risk (see Question 2.3.20).

However, it generally is required to consider prepayment risk when assessing
hedge effectiveness and measuring the change in fair value of the hedged item
attributable to interest rate risk. Two exceptions and an election apply in some
instances to simplify the assessment process regarding prepayment risk.
— As exceptions. If an entity uses the following fair value hedges of interest
rate risk, it does not consider prepayment risk for assessing hedge
effectiveness and measuring the change in fair value of the hedged item:
— partial-term hedges, when the assumed term ends before (or on) the
initial date a financial instrument can be prepaid (see section 3.3.80);
and
— last-of-layer method (see section 3.3.100). [815-20-25-118A]
— As an election. Topic 815 allows an entity to consider only the effect of
changes in the benchmark interest rate on the decision to prepay a financial
instrument. If an entity elects this approach, it does not consider in its
assessment of hedge effectiveness how other factors (e.g. credit risk)
might affect the decision to prepay the financial instrument. [815-20-25-6B]
For further discussion of hedging interest rate risk on prepayable financial
instruments, see section 3.4.10.

9.2.110 Additional consideration for cash flow hedges – time

value of money

Excerpt from ASC 815-20

>>> Consideration of the Time Value of Money

25-120 In assessing the effectiveness of a cash flow hedge, an entity generally
shall consider the time value of money, especially if the hedging instrument
involves periodic cash settlements.
25-121 An example of a situation in which an entity likely would reflect the
time value of money is a tailing strategy with futures contracts. When using a
tailing strategy, an entity adjusts the size or contract amount of futures
contracts used in a hedge so that earnings (or expense) from reinvestment (or
funding) of daily settlement gains (or losses) on the futures do not distort the
results of the hedge. To assess offset of expected cash flows when a tailing
strategy has been used, an entity could reflect the time value of money,
perhaps by comparing the present value of the hedged forecasted cash flow
with the results of the hedging instrument.

Because the focus of the effectiveness of a cash flow hedging relationship is on

cash flows, the timing of the respective cash flows must be considered in
assessing effectiveness. This is especially important if the hedging instrument
involves periodic cash settlements. However, Topic 815 does not prescribe a
required method for measuring the changes in the derivative hedging
instrument’s cash flows or the changes in the hedged transaction’s cash flows
attributable to the hedged risk. [815-20-25-120]
Hedging 719
9. Hedge effectiveness

An example of a situation in which an entity likely would reflect the time value
of money is a tailing strategy with futures contracts, which is discussed in
section 9.2.50. To assess the offset of cash flows when using this strategy, an
entity could include the time value of money, perhaps by comparing the present
value of the hedged forecasted cash flow with the results of the hedging
instrument. [815-20-25-121]

Question 9.2.300
How is the timing of cash flows considered in an
effectiveness assessment for a cash flow hedge?
Interpretive response: We believe a present value methodology generally
should be used to consider the timing of cash flows of both the hedging
instrument and the forecasted transaction attributable to the hedged risk. The
discount rates to be used when determining the change in cash flows for
purposes of assessing effectiveness are summarized as follows.

Rate for discounting derivative Rate for discounting cash flows of the
hedging instrument’s cash flows hedged transaction attributable to the
hedged risk
Discount rate used to determine the fair Discount rate applicable to the cash
value of the instrument. flows to arrive at fair value (i.e. the
relevant curve for those cash flows) as if
the cash flows were related to an
instrument that has cash flows identical
to those of the hedged transaction.

The discount rates may differ between the derivative hedging instrument and
the hedged transaction as a result of the timing of the respective cash flows,
the credit risk of the counterparty to the derivative, the entity’s own
nonperformance risk and other relevant factors.
However, because cash flow hedging relationships are focused on the changes
in cash flows of the derivative hedging instrument and the hedged transaction,
credit risk (or the entity’s own nonperformance risk) has no effect on hedge
effectiveness under certain assessment methods, as long it is probable that the
counterparty to the derivative or the entity will not default.
— Hypothetical derivative method (section 9.7.30) and change-in-variable-
cash-flow method (section 9.7.40). An entity is permitted to use the same
credit risk adjustment that is used to determine the fair value of the
derivative when measuring the change in the cash flows of the hedged
transaction, as long it is probable that the counterparty to the derivative or
the entity will not default. As a result, credit risk (or the entity’s own
nonperformance risk) and changes therein do not affect hedge
effectiveness.
— Change-in-fair-value method (section 9.7.40). Even though the same
discount rate is used under the change-in-fair-value method when
measuring the swap and the present value of the cumulative change in
expected cash flows of the hedged transaction, the mechanics of applying
Hedging 720
9. Hedge effectiveness

this method may cause effectiveness to be affected in periods that

creditworthiness changes.
However, if it is not probable that an entity will not default, a cash flow hedging
relationship should be discontinued (see section 9.2.60).

Question 9.2.310
Is discounting required when the spot method is
used?
Interpretive response: No. One exception to Topic 815’s guidance that
discounting should generally be incorporated when assessing effectiveness is
when an entity uses the spot method – i.e. uses a forward contract as the
hedging instrument and chooses to exclude the spot-forward difference from
the effectiveness assessment.
In these circumstances, the entity chooses one of the following methods.
— Cash flows are discounted. The expected cash flows of the derivative
hedging instrument and the hedged transaction are discounted to convert
them to current amounts based on the date the respective cash flows will
actually occur.
— Cash flows are not discounted. The expected cash flows of the derivative
hedging instrument and the hedged transaction are not discounted because
they are both assumed to occur at the reporting date. In effect, a critical
terms match approach could be used and perfect effectiveness would
result when the other terms, such as notional amount and underlying, are
the same.
Under both methods, the excluded component (changes in value of the spot-
forward difference) are recognized using either an amortization approach or a
mark-to-market approach (see section 9.2.70).
The choice of method for calculating the spot-forward difference is considered
an accounting policy election that should be applied consistently to all similar
hedging relationships.
These methods are illustrated in Example 9.2.70.

Question 9.2.320
How does discounting affect a hedging relationship
when a forward contract does not settle on the
date of the forecasted transaction?

Background: As discussed in section 9.2.50, Topic 815 requires that a hedging

relationship is expected to be highly effective in achieving offsetting cash flows
that are attributable to the hedged risk during the term of the hedging
relationship. However, it does not require that the hedging derivative expire or
terminate on the same date that the forecasted transaction is expected to occur
Hedging 721
9. Hedge effectiveness

or that the cash inflows (outflows) from the derivative occur at the same time
as the cash outflows (inflows) from the forecasted transaction.
Interpretive response: When the timing of the derivative differs from the
timing of the forecasted transaction, the hedging relationship will not be
perfectly effective in either of the following situations.
— The entity elects to include the entire change in the cash flows of the
derivative hedging instrument in assessing effectiveness rather than
excluding the spot-forward difference from the effectiveness assessment
(see discussion of excluded components in section 9.2.70).
— The entity elects to discount expected cash flows of the derivative hedging
instrument and forecasted transaction (see Question 9.2.310).
When the hedging relationship is not perfectly effective due to timing
differences between the derivative and the forecasted transaction, strategies
that an entity may implement to improve hedge effectiveness include the
following.
— The hedging relationship is rebalanced. The entity implements a hedging
strategy whereby the derivative instrument will be rebalanced. See
discussion of dynamic hedging strategies in section 9.2.50.
— The notional amounts of the derivative and hedged transaction do not
match. The entity implements a hedging strategy for which the notional
amount of the derivative instrument is different from the notional amount of
the hedged transaction; however, the changes in cash flows of the
derivative instrument offset the changes in cash flows of the forecasted
transaction so that the relationship is expected to be highly effective
throughout the term of the hedge.

Examples
The following KPMG examples demonstrate the effect of considering time
value of money in cash flow hedging relationships.
— Comparison of excluding spot-forward difference – discounted vs.
undiscounted (Example 9.2.70).
— Measuring changes in cash flows – discounted vs. undiscounted
(Example 9.2.80).

Example 9.2.70
Comparison of excluding spot-forward difference –
discounted vs. undiscounted
The following table summarizes the effects of excluding (or including) the spot-
forward difference and of discounting (or not discounting) expected cash flows
on hedge effectiveness in a forecasted sale of widgets that is expected to
occur on a different date than when the hedging derivative settles.
Hedging 722
9. Hedge effectiveness

Case A: Case B:
Derivative’s term is Derivative’s term is
longer than that of shorter than that of
forecasted transaction forecasted transaction
Assumptions
Hedge inception date July 1, Year 1 July 1, Year 1
Date forecasted sale of September 30, Year 1 November 30, Year 1
widgets is expected to
occur and settle in cash
Settlement date for November 30, Year 1 September 30, Year 1
hedging derivative
End of hedge term: earlier September 30, Year 1 September 30, Year 1
of the derivative’s or
forecasted transaction’s
settlement date
Scenario 1: Effectiveness is assessed using the forward rate (i.e. no excluded
components) and expected cash flows are discounted
Reasons the hedge will not Differences in forward Differences in forward
be perfectly effective: prices. The forward price prices. The forward price
of the sale is through of the derivative is
September 30 while the through September 30
forward price of the while the forward price of
derivative is through the sale is through
November 30. November 30.
Discounting the forward Discounting the forward
prices. There are different prices. There are different
discounting periods discounting periods
through the forecasted through the derivative’s
sale date (three months settlement date (three
to September 30) and the months to September 30)
derivative’s settlement and the forecasted sale
date (five months to date (five months to
November 30). November 30).
Scenario 2: Effectiveness is assessed using the spot rate (i.e. spot-forward
difference is excluded) and expected cash flows are discounted
Reasons the hedge will not Discounting the spot Discounting the spot
be perfectly effective: prices. There are different prices. There are different
discounting periods discounting periods
through the forecasted through the derivative’s
sale date (three months settlement date (three
to September 30) and the months to September 30)
derivative’s settlement and the forecasted sale
date (five months to date (five months to
November 30). November 30).

This example summarizes potential effects in a hedging relationship involving a

single settlement date for each of the forecasted sale and the hedging
derivative. Similar effects occur if an entity designates a derivative with multiple
settlements as the hedging instrument in a relationship involving a series of
forecasted transactions. That is, differences between the hedging derivative’s
Hedging 723
9. Hedge effectiveness

settlement dates and the dates of the forecasted transactions may cause the
relationship to lack perfect effectiveness.

Example 9.2.80
Measuring changes in cash flows – discounted vs.
undiscounted
ABC Corp. is a manufacturer with the US dollar as its functional currency. On
January 1, Year 1, ABC forecasts the sale of 1,000,000 worth of goods
denominated in foreign currency (FC) to a foreign country on August 31, Year 1
(eight months from the date of hedge inception). ABC does not have any firm
contracts yet, but based on historical experience and its forecasts, it concludes
that these sales are probable.
ABC is exposed to changes in the $/FC exchange rates and enters into a six-
month forward contract to buy US dollars and sell the foreign currency. The
hedging derivative has the following terms:
— Contract amount: FC1,000,000;
— Trade date: January 1, Year 1;
— Maturity date: June 30, Year 1; and
— Forward contract rate: FC1 = $1.20.
ABC chooses to apply hedge accounting and formally designates and
documents the hedging relationship on January 1, Year 1. ABC elects to
exclude the spot-forward difference and recognize changes in the excluded
component using the mark-to-market approach.
The following additional facts are relevant.
— The spot and forward exchange rates for various dates as applicable to the
actual hedging derivative are in the following table.

Spot rate Forward rate

January 1, Year 1 $1.11 = FC1 $1.20 = FC1
March 31, Year 1 $1.13 = FC1 $1.23 = FC1
June 30, Year 1 $1.14 = FC1 -

— The fair value of the actual hedging derivative as of March 31, Year 1 is
$(29,851) – i.e. a liability position to the entity. This is based on changes in
forward rates discounted over three months (because it matures on June
30, Year 1) at an assumed discount rate of 2% – i.e. it is the present value
of $30,000 [FC1,000,000 x ($1.20 - $1.23)] discounted at 2%.
— The spot and forward exchange rates for various dates as applicable to the
hedged forecasted sale are in the following table.

Spot rate Forward rate

January 1, Year 1 $1.11 = FC1 $1.25 = FC1
March 31, Year 1 $1.13 = FC1 $1.28 = FC1
June 30, Year 1 $1.15 = FC1 -
Hedging 724
9. Hedge effectiveness

— On March 31, Year 1, ABC calculates the amounts to be reflected in the

financial statements.
Scenario 1: Changes in cash flows due to changes in spot prices are not
discounted
In this scenario, the entity does not discount changes in cash flows due to
changes in spot prices when assessing hedge effectiveness. The changes in
fair value of the forward contract and changes in cash flows of the hedged
transaction are as shown in the table below.

Change in fair Change in cash

value of flows of the
forward hedged
contract forecasted sale
gain (loss) gain (loss)
Total change in fair value $(29,851) $ -
Change in cash flows due to changes in spot
rates (20,000)1 20,0002
Change due to spot-forward difference
(excluded component recognized in earnings) (9,851)3 -
Notes:
FC1,000,000 × ($1.11 - $1.13)
FC1,000,000 × ($1.13 - $1.11)
$(29,851) - $(20,000)

This approach results in perfect effectiveness, as the change in fair value of the
forward exchange contract and changes in cash flows of the hedged anticipated
sale due to changes in the spot rate will be equal.
Scenario 2: Changes in cash flows due to changes in spot prices are
discounted
In this scenario, the entity discounts changes in cash flows due to changes in
spot prices when assessing hedge effectiveness.
— The projected cash flows of the forward contract are discounted over three
months because it matures on June 30, Year 1. The discount rate is
assumed to be 2%.
— The projected cash flows of the anticipated sale are discounted over five
months because it is forecasted to occur on August 31, Year 1. The
discount rate is assumed to be 2.05%.
The changes in fair value of the forward contract and changes in cash flows of
the hedged transaction are shown in the table below.

Change in fair Change in cash

value of flows of the
forward hedged
contract forecasted sale
gain (loss) gain (loss)
Total change in fair value $(29,851) $ -
Change in cash flows due to changes in spot
rates (19,900)1 19,8302
Change due to spot-forward difference
(excluded component recognized in earnings) (9,951)3 -
Hedging 725
9. Hedge effectiveness

Notes:
Present value of $20,000 [FC1,000,000 × ($1.11 - $1.13)] discounted over three
months at 2%.
Present value of $20,000 [FC1,000,000 × ($1.11 - $1.13)] discounted over five months
at 2.05%.
$(29,851) - $(19,900)

This approach results in the hedge not being perfectly effective, as the change
in fair value of the forward exchange contract is $70 different from the change
in cash flows of the hedged anticipated sale ($19,900 - $19,830).

9.3 Shortcut method for interest rate swaps

9.3.10 Overview

Excerpt from ASC 815-20

>>> Assuming Perfect Hedge Effectiveness in a Hedge with an Interest

Rate Swap (the Shortcut Method)
25-102 The conditions for the shortcut method do not determine which
hedging relationships qualify for hedge accounting; rather, those conditions
determine which hedging relationships qualify for a shortcut version of hedge
accounting that assumes perfect hedge effectiveness. If all of the applicable
conditions in the list in paragraph 815-20-25-104 are met, an entity may
assume perfect effectiveness in a hedging relationship of interest rate risk
involving a recognized interest-bearing asset or liability (or a firm commitment
arising on the trade [pricing] date to purchase or issue an interest-bearing asset
or liability) and an interest rate swap (or a compound hedging instrument
composed of an interest rate swap and a mirror-image call or put option as
discussed in paragraph 815-20-25-104[e]) provided that, in the case of a firm
commitment, the trade date of the asset or liability differs from its settlement
date due to generally established conventions in the marketplace in which the
transaction is executed. The shortcut method's application shall be limited to
hedging relationships that meet each and every applicable condition. That is,
all the conditions applicable to fair value hedges shall be met to apply the
shortcut method to a fair value hedge, and all the conditions applicable to cash
flow hedges shall be met to apply the shortcut method to a cash flow hedge.
A hedging relationship cannot qualify for application of the shortcut method
based on an assumption of perfect effectiveness justified by applying other
criteria. The verb match is used in the specified conditions in the list to mean
be exactly the same or correspond exactly.
>>>> Application of the Shortcut Method to a Portfolio of Hedged Items
25-116 Portfolio hedging cannot be used to circumvent the application of the
shortcut method criteria beginning in paragraph 815-20-25-102 to a fair value
hedge of an individual interest-bearing asset or liability. A portfolio of interest-
bearing assets or interest-bearing liabilities cannot qualify for the shortcut
Hedging 726
9. Hedge effectiveness

method if it contains an interest-bearing asset or liability that individually cannot

qualify for the shortcut method.
25-117 The fair value hedge requirements of paragraph 815-20-25-12(b)(1)
ensure that the individual items in a portfolio share the same risk exposure and
have fair value changes attributable to the hedged risk that are expected to
respond in a generally proportionate manner to the overall fair value changes of
the entire portfolio. That requirement restricts the types of portfolios that can
qualify for portfolio hedging; however, it also permits the existence of a
mismatch between the change in the fair value of the individual hedged items
and the change in the fair value of the hedged portfolio attributable to the
hedged risk in portfolios that do qualify. As a result, the assumption of perfect
effectiveness required for the shortcut method generally is inappropriate for
portfolio hedges of similar assets or liabilities that are not also nearly identical
(except for their notional amounts). Application of the shortcut method to
portfolios that meet the requirements of paragraph 815-20-25-12(b)(1) is
appropriate only if the assets or liabilities in the portfolio meet the same
stringent criteria in paragraphs 815-20-25-104(e), 815-20-25-104(g), and 815-20-
25-105(a) as required for hedges of individual assets and liabilities.
>>> Applicability of the Shortcut Method
55-71 Given the conditions in paragraph 815-20-25-104, the shortcut method
cannot be applied, for example, to any of the following hedging relationships:
a. Those hedging interest rate risk that involve hedging instruments other
than interest rate swaps.
b. For fair value hedges, those that involve hedged risks other than the risk of
changes in fair value attributable to changes in the designated benchmark
interest rate.
bb. For cash flow hedges, those that involve hedging relationships in which the
contractually specified interest rate of a recognized interest-bearing asset
or liability does not match the interest rate index of the variable leg of the
interest rate swap.
c. Those that do not involve a recognized interest-bearing asset or liability.
55-72 Based on (c) in the preceding paragraph, the shortcut method cannot be
applied in a cash flow hedge of a forecasted transaction, even if an entity
determines that all critical terms of the hedging instrument and the hedged
forecasted transaction are matched. .

The shortcut method is an elective method that greatly simplifies the hedge
effectiveness assessment for a hedge of interest rate risk. If a hedging
relationship meets the criteria for this method, the entity can assume that the
hedging relationship is perfectly effective. Therefore, the method simplifies the
hedge effectiveness assessment by eliminating the initial and ongoing
quantitative aspect of the assessment. [815-20-25-102]
Fair value hedges. For shortcut method fair value hedges, the hedged item’s
change in fair value attributable to the hedged risk is the inverse of the hedging
instrument’s change in the fair value. For example, if the hedging instrument’s
fair value increases by $100, the entity assumes that the hedged item’s change
in fair value attributable to the hedged risk has decreased by $100.
Hedging 727
9. Hedge effectiveness

Cash flow hedges. For shortcut method cash flow hedges, an entity records
the change in fair value of the hedging instrument in AOCI. An entity accounts
for all cash flow hedges in this manner. However, if an entity does not apply the
shortcut method, it will need to perform initial and ongoing effectiveness
assessments. [815-20-25-102, 35-1(c)]

Criteria for applying shortcut method

Hedged item or transaction Hedging Shortcut

instrument method
Recognized interest-bearing
asset or liability or a firm Assume
Interest rate
commitment that meets perfect
Interest rate swap
certain conditions effectiveness
risk

The shortcut method applies only to hedges of interest rate risk, and then only
if general requirements and specific criteria are met. It is narrow in scope by
design and cannot be applied by analogy. Specifically, the SEC staff has
indicated that the circumstances in which an entity can apply the shortcut
method are limited to those where the specific criteria are met. The staff does
not believe the shortcut method criteria have a spirit or principle that an entity
can meet without strictly complying with the stated requirements. [815-20-25-102,
2006 AICPA Conf]

The general requirements are discussed in section 9.3.20. The specific criteria
are summarized here and discussed in the referenced sections.

General criteria for both fair value hedges and cash flow hedges

Criterion 1 Swap’s notional amount matches the hedged item’s principal

(section 9.3.30) amount [815-20-25-104(a)]

Criterion 2 Swap’s fair value at hedge inception is zero [815-20-25-104(b),

(section 9.3.40) 25-104(c))]

Criterion 3 Swap has a consistent formula for computing net settlements each
(section 9.3.50) period [815-20-25-104(d)]

Criterion 4
Hedged item is not prepayable [815-20-25-104(e)]
(section 9.3.60)

Criterion 5 All other terms are typical and do not invalidate assumption of
(section 9.3.70) perfect effectiveness [815-20-25-104(g)]

Additional shortcut criteria for fair value hedges (section 9.3.80)

The maturity dates of the swap and hedged item(s) match. [815-20-25-105(a)]

The variable interest rate of the swap has no cap or floor. [815-20-25-105(b)]

The repricing intervals on the swap’s variable rate are frequent enough to assume that
the variable rate is a market rate. [815-20-25-105(c)]
Hedging 728
9. Hedge effectiveness

Additional shortcut criteria for fair value hedges (section 9.3.80)

The index on which the variable leg of the swap is based matches the benchmark
interest rate designated as the hedged interest rate. [815-20-25-105(f)]

Additional shortcut criteria for cash flow hedges (section 9.3.90)

All of the hedged transaction’s interest payments during the swap’s term are hedged,
and none of its interest payments beyond the swap’s term are hedged. [815-20-25-106(a),
25-106(b)]

Either the swap has no cap or floor, or if the hedged transaction has a cap or floor, the
swap has a comparable cap or floor. [815-20-25-106(c)]

The repricing dates of the swap and the hedged transaction match. [815-20-25-106(d)]

The index on which the variable leg of the swap is based matches the contractually
specified interest rate designated as the hedged interest rate. [815-20-25-106(g)]

9.3.20 General requirements

There are general requirements regarding the nature of the hedged item or
transaction, hedging instrument and hedged risk that must be met before an
entity can determine whether a hedging relationship meets the specific criteria
to be assessed under the shortcut method.

Interest rate risk. First, the hedging relationship needs to hedge interest
rate risk as follows. [815-20-25-102, 55-71]

Fair value hedge Cash flow hedge

The hedged risk is a benchmark The hedged risk is the interest rate index
interest rate. contractually specified in the interest-
bearing asset or liability.

Additional requirements for the hedged item or transaction and hedging

instrument are as follows.

Hedging — a simple interest rate swap without embedded options; or

instrument — a compound hedging instrument comprising an interest rate
needs to be: swap and an embedded call or put option that mirrors the call or
put option embedded in the hedged item. [815-20-25-102]

Hedged item — a recognized interest-bearing asset (e.g. a debt instrument

or transaction classified as AFS);
needs to be: — a recognized interest-bearing liability (e.g. fixed-rate debt
issued); or
— a firm commitment arising from a difference between the trade
date and settlement date relating to a purchase of an interest-
bearing asset or issuance of an interest-bearing liability. [815-20-
25-102]
Hedging 729
9. Hedge effectiveness

For a portfolio of interest-bearing assets or interest-bearing liabilities to qualify

for the shortcut method, each asset or liability in the portfolio must individually
qualify for the shortcut method. [815-20-25-116]

Question 9.3.10
Can the shortcut method be applied to a hedge of
the forecasted issuance or purchase of a financial
instrument?
Interpretive response: Generally an entity cannot apply the shortcut method to
the hedge of a forecasted purchase of an asset or issuance of a liability – e.g.
the variability in interest payments on the forecasted issuance of fixed rate
debt. This is because a forecasted purchase is not a recognized interest-bearing
asset or interest-bearing liability. This is true even if the critical terms of the
interest rate swap match the forecasted purchase or issuance. [815-20-25-102, 55-
71, 55-72]

However, an entity could apply the shortcut method to a firm commitment that
arises on the trade date if the difference between the trade and settlement
dates is due to generally established conventions in the marketplace in which
the transaction is executed (see Question 9.3.20). [815-20-25-102]

Question 9.3.20
How does an entity determine whether the trade
and settlement dates of a firm commitment differ
due to market conventions?
Background: An entity may designate a firm commitment as the hedged item
in a shortcut method hedge if: [815-20-25-102]
— the firm commitment arises on the trade date to purchase or issue an
interest-bearing asset or liability; and
— the reason for the difference between the trade date of the firm
commitment and settlement date of the interest-bearing asset or liability is
due to generally established conventions in the marketplace in which the
transaction is executed.
Interpretive response: An entity applies judgment when determining whether
the trade and settlement dates of a firm commitment to purchase or issue an
interest-bearing asset or liability differ due to established market conventions. It
considers the facts and circumstances of the specific transaction and the
market in which the transaction is executed.
Hedging 730
9. Hedge effectiveness

Example 9.3.10
Debt hedged on trade date
Debt issued and hedged with an interest rate swap
ABC Corp. issues a fixed-rate debt instrument. On the same day, ABC enters
into an interest rate swap whereby it will receive a fixed rate and pay a variable
rate.
The fixed-rate debt will settle five days after its trade date (i.e. date issued).
ABC determines that the reason for the five-day difference between the trade
and settlement dates is due to established market conventions. ABC applies
the shortcut method.
Fair value hedge designation

Hedged item Fixed-rate debt issued

Hedging Receive fixed, pay variable interest rate swap
instrument
Hedged risk Three-month LIBOR

Fair value hedge accounting – shortcut method

Trade date The interest rate swap and a firm commitment representing the
debt that will settle in five days both have fair values of zero.
Trade date to ABC applies the shortcut method. Therefore, it records the
settlement date change in fair value of the interest rate swap and an equal and
offsetting change in fair value of the firm commitment in
earnings. In addition, ABC adjusts the carrying amount of the
interest rate swap to its fair value and adjusts the carrying
amount of the firm commitment in an equal and offsetting
amount.
Settlement date ABC recognizes the debt instrument and incorporates the prior
carrying amount of the firm commitment into the amount it
recognizes.
After settlement ABC continues to apply the shortcut method.
date

What if the debt had a variable interest rate?

If ABC had issued variable-rate debt, it would have been exposed to cash flow
variability beginning on the debt’s trade date. ABC could have designated the
hedging relationship as a cash flow hedge and applied the shortcut method. All
changes in the fair value of the interest rate swap would have been recorded in
AOCI and are reclassified to earnings as the hedged item affects earnings. On
settlement date, ABC would have recognized the variable-rate debt instrument.
Hedging 731
9. Hedge effectiveness

Question 9.3.30
Can a lessee or lessor apply the shortcut method to
a cash flow hedge of the variability in lease
payments of an interest rate indexed operating
lease?
Interpretive response: No. Neither the lessee nor the lessor may apply the
shortcut method to a cash flow hedge of the variability in lease payments for
an interest-rate-indexed operating lease. The lease is neither an interest-bearing
asset or liability, nor a firm commitment to purchase or issue an interest-bearing
asset or liability with a settlement date that differs from its trade date due to
established market conventions. [815-20-25-102, 55-71]

Question 9.3.40
Can an entity replace the hedged item or
transaction during a shortcut method hedging
relationship?
Interpretive response: No. An entity must identify and document the specific
hedged item or transaction at the inception of the specific interest-bearing asset
or liability. Therefore, an entity is not permitted to replace the hedged item or
transaction during the hedging relationship. If the entity derecognizes the
hedged item or transaction that was designated in its original hedge
documentation, the hedging relationship would be terminated. [815-20-25-3]
The hedge of a firm commitment and subsequent recognition and continued
hedge of the related interest-bearing asset or liability is not considered a
replacement of the hedged item or transaction.

Question 9.3.50
Are there documentation considerations that are
specific to the shortcut method?
Interpretive response: Yes. We believe that at hedge inception, an entity
should formally document how each of the applicable shortcut criteria are
met.
In addition, an entity may want to consider documenting at hedge inception a
quantitative method it would use to assess hedge effectiveness if it
subsequently determines the shortcut method was not or no longer is
appropriate (see section 9.3.110). [815-20-25-117A]
Hedging 732
9. Hedge effectiveness

Question 9.3.60
Can the shortcut method be applied when a portion
(i.e. a percentage) of an interest-bearing asset or
liability is designated as the hedged item or
transaction?
Interpretive response: Yes. An entity may designate a portion (i.e. a
percentage) of an interest-bearing asset or liability as the hedged item (or
interest payments on a portion of the principal amount of an interest-bearing
asset or liability as the hedged transaction) in a shortcut method hedge.
However, the notional amount of the interest rate swap and the principal
amount of the hedged item or transaction must match (see section 9.3.30).
[815-20-25-105(d), 25-106(e)]

For guidance on designating a portion (or percentage) of a hedged item in a fair

value hedge, see section 3.3.60. For guidance on specifically identifying a
forecasted transaction in a cash flow hedge, see section 5.3.30.

Question 9.3.70
Can the shortcut method be applied when hedging
a portfolio of interest-bearing assets or liabilities or
group of forecasted transactions?
Interpretive response: Yes. An entity may designate a portfolio of similar
interest-bearing assets or liabilities (or proportions thereof) as the hedged item
or a group of forecasted transactions as the hedged transaction in a shortcut
method hedge as long as: [815-20-25-105(e), 25-106(f), 25-116]
— the notional amount of the interest rate swap and the aggregate notional
amount of the designated portfolio or group of forecasted transactions
match (see section 9.3.30); and
— each individual item in the portfolio or group meets all applicable shortcut
criteria.
As a practical matter, these criteria result in the need for the characteristics of
the individual items in the portfolio or group to be the same except for their
notional amounts. Therefore, opportunities for hedging a portfolio of items or
group of transactions using the shortcut method are limited.
For guidance on designating a portfolio of similar assets or liabilities in a fair
value hedge, see section 3.3.40. For guidance on designating a group of similar
forecasted transactions, see section 5.3.60.
Hedging 733
9. Hedge effectiveness

9.3.30 Criterion 1: Swap’s notional amount matches the

hedged item’s principal amount

Excerpt from ASC 815-20

>>> Assuming Perfect Hedge Effectiveness in a Hedge with an Interest

Rate Swap (the Shortcut Method)
25-104 All of the following conditions apply to both fair value hedges and cash
flow hedges:
a. The notional amount of the interest rate swap matches the principal
amount of the interest-bearing asset or liability being hedged.
25-105 All of the following incremental conditions apply to fair value hedges
only: …
d. For fair value hedges of a proportion of the principal amount of the interest-
bearing asset or liability, the notional amount of the interest rate swap
designated as the hedging instrument (see (a) in paragraph 815-20-25-104)
matches the portion of the asset or liability being hedged.
e. For fair value hedges of portfolios (or proportions thereof) of similar
interest-bearing assets or liabilities, both of the following criteria are met:
1. The notional amount of the interest rate swap designated as the
hedging instrument matches the aggregate notional amount of the
hedged item (whether it is all or a proportion of the total portfolio).
2. The remaining criteria for the shortcut method are met with respect to
the interest rate swap and the individual assets or liabilities in the
portfolio.
25-106 All of the following incremental conditions apply to cash flow hedges
only: …
e. For cash flow hedges of the interest payments on only a portion of the
principal amount of the interest-bearing asset or liability, the notional
amount of the interest rate swap designated as the hedging instrument
(see paragraph 815-20-25-104(a)) matches the principal amount of the
portion of the asset or liability on which the hedged interest payments are
based.
f. For a cash flow hedge in which the hedged forecasted transaction is a
group of individual transactions (as permitted by paragraph 815-20-25-
15(a)), if both of the following criteria are met:
1. The notional amount of the interest rate swap designated as the
hedging instrument (see paragraph 815-20-25-104(a)) matches the
notional amount of the aggregate group of hedged transactions.
2. The remaining criteria for the shortcut method are met with respect to
the interest rate swap and the individual transactions that make up the
group. For example, the interest rate repricing dates for the variable-
rate assets or liabilities whose interest payments are included in the
group of forecasted transactions shall match (that is, be exactly the
same as) the reset dates for the interest rate swap.
Hedging 734
9. Hedge effectiveness

When the hedged item or transaction is an entire financial asset or financial

liability, the shortcut method’s first criterion requires the notional amount of the
interest rate swap to match the principal amount of the hedged item or
transaction. [815-20-25-104(a)]

Hedged item or transaction Hedging instrument

Principal amount of interest- Notional amount of interest

bearing asset or liability rate swap

This criterion is met for portions and portfolios or groups of hedged items or
transactions as follows.

Fair value hedge Cash flow hedge

If hedged item or The interest rate swap The interest rate swap
transaction is a notional amount must notional amount must
portion (i.e. match the principal match the principal amount
percentage) of the amount of the portion (i.e. of the portion of the asset
principal amount … a percentage) of the or liability on which hedged
interest-bearing asset or interest payments are
liability. [815-20-25-105(d)] based. [815-20-25-106(e)]

If hedged item or The interest rate swap The interest rate swap
transaction is a notional amount must notional amount must
portfolio or group match the aggregate match the principal amount
of similar interest- principal amount of the of the aggregate group of
bearing assets or hedged portfolio. [815-20- hedged transactions.
liabilities (or 25-105(e)] [815-20-25-106(f)]
portion thereof) …

Question 9.3.80
Can the shortcut method be applied to a hedging
relationship if the hedging instrument is a part of a
derivative instrument?
Interpretive response: Yes, an entity may designate a proportion of an interest
rate swap as the hedging instrument in a shortcut method hedge if the swap’s
notional amount and the hedged item’s principal amount match. For example,
an entity could hedge $50 million notional of a $100 million notional. [815-20-25-
104(a)]
Hedging 735
9. Hedge effectiveness

9.3.40 Criterion 2: Swap’s fair value at hedge inception is

zero

Excerpt from ASC 815-20

>>> Assuming Perfect Hedge Effectiveness in a Hedge with an Interest

Rate Swap (the Shortcut Method)
25-104 All of the following conditions apply to both fair value hedges and cash
flow hedges: …
b. If the hedging instrument is solely an interest rate swap, the fair value of
that interest rate swap at the inception of the hedging relationship must be
zero, with one exception. The fair value of the swap may be other than
zero at the inception of the hedging relationship only if the swap was
entered into at the relationship’s inception, the transaction price of the
swap was zero in the entity’s principal market (or most advantageous
market), and the difference between transaction price and fair value is
attributable solely to differing prices within the bid-ask spread between the
entry transaction and a hypothetical exit transaction. The guidance in the
preceding sentence is applicable only to transactions considered at market
(that is, transaction price is zero exclusive of commissions and other
transaction costs, as discussed in paragraph 820-10-35-9B). If the hedging
instrument is solely an interest rate swap that at the inception of the
hedging relationship has a positive or negative fair value, but does not
meet the one exception specified in this paragraph, the shortcut method
shall not be used even if all the other conditions are met.
c. If the hedging instrument is a compound derivative composed of an
interest rate swap and mirror-image call or put option as discussed in (e),
the premium for the mirror-image call or put option shall be paid or
received in the same manner as the premium on the call or put option
embedded in the hedged item based on the following:
1. If the implicit premium for the call or put option embedded in the
hedged item is being paid principally over the life of the hedged item
(through an adjustment of the interest rate), the fair value of the
hedging instrument at the inception of the hedging relationship shall be
zero (except as discussed previously in (b) regarding differing prices
due to the existence of a bid-ask spread).
2. If the implicit premium for the call or put option embedded in the
hedged item was principally paid at inception-acquisition (through an
original issue discount or premium), the fair value of the hedging
instrument at the inception of the hedging relationship shall be equal to
the fair value of the mirror-image call or put option.

The shortcut method’s second criterion requires the following.

If the hedged instrument is:

Solely an interest rate swap The fair value of that interest rate swap at hedge
inception must be zero, with the exception of bid-
ask spreads. [815-20-25-104(b)]
Hedging 736
9. Hedge effectiveness

If the hedged instrument is:

A compound derivative The entity must pay or receive the premium for the
composed of an interest rate mirror-image call or put option and the premium for
swap with an embedded the call or put option embedded in the hedged
mirror-image call option item or transaction in the same manner. [815-20-25-
104(c)]

Because of the requirement that the fair value of the interest rate swap be zero
at hedge inception, it is highly unlikely that a hedging relationship could qualify
for the shortcut method unless an entity designates the hedging relationship at
the swap’s trade date. Immediately thereafter, the swap will very likely have a
fair value of other than zero because of the movement in both market interest
rates and the passage of time.

Question 9.3.90
Are there exceptions to the requirement that an
interest rate swap’s fair value be zero at hedge
inception?
Interpretive response: The shortcut method generally requires that the fair
value of the interest rate swap be zero at hedge inception. However, the
swap’s fair value may be other than zero if: [815-20-25-104(b)]
— the entity enters into the swap at hedge inception;
— the swap’s transaction price is zero (excluding commissions and other
transaction costs described in Subtopic 820-10) in the entity’s principal or
most advantageous market as applicable; and
— the difference between the swap’s transaction price and its fair value is
attributable solely to differing prices within the bid-ask spread between the
entry transaction and a hypothetical exit transaction.
In addition, a compound derivative comprising an interest rate swap and a call
or put option that mirrors the call or put option embedded in the hedged item or
transaction may have a non-zero fair value.

Question 9.3.100
How does an entity determine whether the interest
rate swap has a zero fair value if it includes a
premium for an embedded call or put option?
Background: An entity may hedge an interest-bearing asset or liability that has
an embedded call or put option for interest rate risk with an interest rate swap
containing a mirror-image call or put option. Typically, parties to both the asset
or liability and the swap will pay or receive a premium for the options. [815-20-
25-102]

Interpretive response: The shortcut method requires an entity to pay or

receive the premium for the mirror-image option contained in the interest rate
Hedging 737
9. Hedge effectiveness

swap in the same manner as it receives or pays the premium on the call or put
option embedded in the hedged item or transaction. [815-20-25-104(c)]
Therefore, an entity determines whether the implicit premium for the call or put
option embedded in the hedged item or transaction was paid at inception
(through an original issue discount or premium) or is being paid over the life of
hedged item or transaction (through an interest rate adjustment). An entity
makes this determination by comparing the hedged item or transaction with the
embedded option to an instrument without such an embedded option, but
equivalent to the hedged item or transaction in all other respects. [815-20-25-
104(c)]

If the premium for a call or put option embedded in the hedged item or
transaction is paid over the life of the hedged item or transaction, the fair value
of the hedging instrument at hedge inception must be zero. However, if such a
premium is paid at inception of the hedged item or transaction, the fair value of
the hedging instrument at hedge inception must equal the fair value of the
mirror-image call or put option. [815-20-25-104(c)]

Premium for call or put option To apply the shortcut method, the
embedded in the hedged item or fair value of the hedging instrument
transaction is paid: at hedge inception must equal:
Over the life of the hedged item or Zero [815-20-25-104(c)]
transaction
At inception of the hedged item or The fair value of the mirror-image call or
transaction put option [815-20-25-104(c)]

When applying the shortcut method, an entity does not perform the written
option effectiveness test if the options embedded in the hedging instrument
and hedged item have terms that mirror one another. This is because an entity
assumes that the written option effectiveness test would be met if a hedging
relationship also meets the requirements for application of the shortcut method.

Example 9.3.20
Day 1 fair value of a compound interest rate swap
ABC Corp. issues a callable debt instrument with a fixed rate of 5.5% and
designates the following in a shortcut method fair value hedge.

Hedged item Callable debt with a fixed rate of 5.5%.

Hedging An interest rate swap, whereby ABC receives 5.5% and pays
instrument three-month LIBOR, that contains a written embedded call option
that mirrors the call option in the debt.

If the swap did not contain the mirror option, ABC would not be able to apply
the shortcut method.
Does ABC pay for the debt’s premium and receive the swap’s premium in
the same manner?
ABC determines that the interest rate it is paying over the life of the debt
instrument includes a premium of 50 basis points for its purchased call option.
Hedging 738
9. Hedge effectiveness

That is, if the bond that ABC issued had been non-callable, its interest rate
would have been 5%. ABC also determines that an interest rate swap with
terms that match the debt and has a fair value of zero at inception would have a
fixed leg that pays 5%.
Because the swap that ABC designated as the hedging instrument has a fixed-
rate leg of 5.5%, it has a fair value of other than zero. However, this value is
offset by the value of the written option’s premium embedded in the swap.
Therefore, the net fair value of the compound derivative is zero at inception
of the hedging relationship. In this situation, ABC is receiving a premium of
50 basis points for the swap’s mirror-image written call option over the swap’s
life as part of the swap’s fixed interest rate. Therefore, this hedging relationship
meets the second criterion for the shortcut method because ABC pays for the
premium on the debt and receives the premium on the swap in the same
manner.
What if the debt had a fixed rate of 5%?
If ABC had instead issued debt with a fixed rate of 5% (i.e. a discount to yield
5.5%), it would pay a premium for the embedded call option at inception
through an original issue discount.
However, assume the terms of the interest rate swap are the same as
described above (i.e. ABC receives 5.5% and pays three-month LIBOR). In that
case, ABC receives a premium of 50 basis points for the swap’s mirror-image
written call option over the swap’s life as part of the swap’s fixed interest rate.
In this situation, ABC does not pay for the premium on the debt and receive the
premium on the swap in the same manner. Therefore, ABC cannot apply the
shortcut method.

Question 9.3.110
Can an interest rate swap that has an embedded
financing arrangement have a fair value of zero?

Interpretive response: Yes, in some cases. For example, a zero coupon swap
discussed in Question 9.3.250 has an embedded financing arrangement, but it
may be structured to have a zero fair value at inception. In other cases, an
interest rate swap that has an embedded financing arrangement may not have a
zero fair value at hedge inception because its fair value reflects the financing
component. In any case, an interest rate swap with an embedded financing
arrangement would not qualify for the shortcut method. This is because the
swap would fail the criterion requiring it to have a consistent formula for
computing net settlements each period. The swap would also fail the criterion
requiring its terms to be typical for a swap and to not invalidate the assumption
of perfect effectiveness. [815-20-25-14(b), 25-104(d), 25-104(g)]
Hedging 739
9. Hedge effectiveness

Example 9.3.30
Day 1 fair value of an interest rate swap with an
embedded financing arrangement
Bank accepts certificates of deposits acquired through Broker (i.e. brokered
CDs). It designates a brokered CD as the hedged item in a shortcut method fair
value hedge.
Broker charges a commission for providing the CDs to Bank. However, Bank
does not pay the commission to Broker directly. Instead, Bank enters into an
interest rate swap arrangement with Counterparty and designates the swap as
the hedging instrument. Counterparty pays Broker the commission on behalf of
Bank. Under the swap arrangement, Bank then reimburses Counterparty over
time through its payments to Counterparty under the swap. That is, Bank pays
Counterparty a rate that is 0.2% more than it would have if Counterparty had
not financed the broker commissions.
The interest rate swap has an embedded financing arrangement. Its initial fair
value is equal to Broker’s commission that Counterparty has financed. Because
the fair value of the swap is not zero at hedge inception (due to the embedded
financing arrangement), the swap does not qualify for the shortcut method.
When evaluating whether such a transaction qualifies for the shortcut method,
an entity considers all unstated rights and privileges that may have been
considered in negotiating the terms of the swap.

Continued use of shortcut method following a business

combination

Excerpt from ASC 815-20

>> Example 24: No Continuation of the Shortcut Method Following a

Purchase Business Combination

55-199 This Example addresses whether the shortcut method in paragraph

815-20-25-102 can be applied in the circumstances illustrated. This Example
has the following assumptions:
a. Entity A acquires Entity B in a business combination. A business
combination is accounted for as the acquisition of one entity by another
entity. The acquiring entity, Entity A, records the assets acquired and
liabilities assumed at fair value.
b. Subparagraph superseded by Accounting Standards Update No. 2017-12.
c. At the date of the business combination, Entity A and Entity B both have
certain hedging relationships that have met the requirements as discussed
beginning in paragraph 815-20-25-102 and that are being accounted for by
the respective entities under the shortcut method of accounting.
d. At the date of the business combination, the fair value of the hedging
swaps in Entity B’s hedging relationships is other than zero.
Hedging 740
9. Hedge effectiveness

55-200 Unless the applicable hedging relationships meet the requirements in

paragraph 815-20-25-102 at the date of the business combination (which would
be highly unlikely because the swap’s fair value would rarely be zero at that
date) and the combined entity chooses to designate the swaps and the hedged
items as hedging relationships to be accounted for under the shortcut method,
the acquiror cannot continue to use the shortcut method of accounting for the
hedging relationships of the acquiree that were being accounted for by the
acquiree under the shortcut method of accounting at the date of the business
combination.
55-201 Entity A is acquiring the individual assets and liabilities of Entity B at the
date of the business combination and accordingly any preexisting hedging
relationships of old Entity B must be designated anew by the combined entity
at the date of the business combination in accordance with the relevant
requirements of this Subtopic.
55-202 In part, this Example entails a determination of whether the business
combination results in a new inception date for the combined entity for
hedging relationships entered into by the acquiree before the consummation of
the business combination that remain ongoing at the date of the business
combination. The concept of acquisition accounting follows the accounting for
acquisitions of individual assets and liabilities. That is, the combined entity
should account for the assets and liabilities acquired in the business
combination consistent with how it would be required to account for those
assets and liabilities if they were acquired individually in separate transactions.
The acquisition method is based on the premise that in an acquisition, the
acquired entity (Entity B) ceases to exist and only the acquiring entity (Entity A)
survives. Thus, the postacquisition hedging relationship designated by Entity A
is a new relationship that has a new inception date.
55-203 Even in the unlikely circumstance that the new hedging relationship
qualifies for the shortcut method, there would be no continuation of the
shortcut method of accounting that had been applied by the acquired entity.

The acquiree in a business combination may have existing hedging relationships

to which it has applied the shortcut method. Any post-combination designation
of the existing hedging relationship by the acquirer would be considered a new
hedging relationship. [815-20-55-202]
After a business combination, the acquirer may not use the shortcut method for
a hedge that acquiree accounted for using the shortcut method before the
business combination unless: [815-20-55-200]
— the applicable hedging relationship meets the shortcut criteria at the date of
the business combination. This would be highly unlikely because the
interest rate swap’s fair value rarely would be zero at that date; and
— the combined entity chooses to designate the swap and the hedged item or
transaction as a hedging relationship to be accounted for under the shortcut
method.
Hedging 741
9. Hedge effectiveness

9.3.50 Criterion 3: Swap has a consistent formula for

computing net settlements each period

Excerpt from ASC 815-20

>>> Assuming Perfect Hedge Effectiveness in a Hedge with an Interest

Rate Swap (the Shortcut Method)
25-104 All of the following conditions apply to both fair value hedges and cash
flow hedges:
d. The formula for computing net settlements under the interest rate swap is
the same for each net settlement. That is, both of the following conditions
are met:
1. The fixed rate is the same throughout the term.
2. The variable rate is based on the same index and includes the same
constant adjustment or no adjustment. The existence of a stub period
and stub rate is not a violation of the criterion in (d) that would
preclude application of the shortcut method if the stub rate is the
variable rate that corresponds to the length of the stub period.

The shortcut method’s third criterion requires that the formula for computing
the net settlements of the interest rate swap to be the same for each net
settlement. This means that throughout its term, the swap’s: [815-20-25-104(d)]
— fixed rate does not change; and
— variable rate is based on the same index and includes no or a constant fixed
spread.

Question 9.3.120
Can the shortcut method be applied if the hedging
instrument is a forward-starting interest rate swap?
Interpretive response: No, an entity cannot apply the shortcut method to a
hedging relationship that involves a forward-starting interest rate swap. [815-20-
55-71, 25-102]

The FASB staff has noted that a forward-starting interest rate swap is not
considered to have a consistent formula for computing net settlements. This is
because settlements occur only after the effective date and not between the
trade date and effective date.

Question 9.3.130
Can the shortcut method be applied to a hedge if
the swap contains an initial stub period?
Background: The variable leg of an interest rate swap often resets every three
or six months. However, entities frequently enter into interest rate swaps on
Hedging 742
9. Hedge effectiveness

dates other than a swap reset date. An interest rate swap that resets quarterly
may have a first payment period that is shorter than a full quarter, referred to as
a ‘stub period.’ That stub period is the period that begins on the date that
coupon payments begin to accrue and ends on the first payment date. The
floating rate set for that shorter period is the ‘stub rate’.
Interpretive response: Yes, an interest rate swap containing an initial stub
period does not violate the shortcut method requirement that the swap have a
consistent formula for calculating net settlements if the stub rate corresponds
to the length of the stub period. A stub period is simply a market convention
necessary to determine the prices of interest rate swaps that are traded on
dates that do not coincide with swap reset dates. [815-20-25-104(d)(2)]

Question 9.3.140
Can the shortcut method be applied to a hedge if
the first cash flow on the swap includes debt
issuance fees?
Interpretive response: No. If the first cash flow on the interest rate swap
includes debt issuance fees, the swap is not eligible for the shortcut method.
To qualify for the shortcut method, the interest rate swap must have a
consistent formula for computing net settlements each period. Therefore, if the
first cash flow on the swap includes debt issuance fees, it is not eligible
because the formula for each net settlement is not the same. This transaction
would also not meet the second criterion for the shortcut method because the
interest rate swap would not have a zero fair value at inception (see
section 9.3.40). [815-20-25-104(b), 25-104(d)]

9.3.60 Criterion 4: Hedged item is not prepayable, with

limited exceptions

Excerpt from ASC 815-20

>>> Assuming Perfect Hedge Effectiveness in a Hedge with an Interest

Rate Swap (the Shortcut Method)
25-104 All of the following conditions apply to both fair value hedges and cash
flow hedges:
e. The interest-bearing asset or liability is not prepayable, that is, able to be
settled by either party before its scheduled maturity or the assumed
maturity date if the hedged item is measured in accordance with paragraph
815-25-35-13B, with the following qualifications:
1. This criterion does not apply to an interest-bearing asset or liability that
is prepayable solely due to an embedded call option (put option) if the
hedging instrument is a compound derivative composed of an interest
rate swap and a mirror-image call option (put option).
Hedging 743
9. Hedge effectiveness

2. The call option embedded in the interest rate swap is considered a

mirror image of the call option embedded in the hedged item if all of
the following conditions are met:
i. The terms of the two call options match exactly, including all of
the following:
01. Maturities
02. Strike price (that is, the actual amount for which the debt
instrument could be called) and there is no termination
payment equal to the deferred debt issuance costs that remain
unamortized on the date the debt is called
03. Related notional amounts
04. Timing and frequency of payments
05. Dates on which the instruments may be called.
ii. The entity is the writer of one call option and the holder (purchaser)
of the other call option.
25-108 Any discount or premium in the hedged debt's carrying amount
(including any related deferred issuance costs) is irrelevant to and has no
direct impact on the determination of whether an interest rate swap contains a
mirror-image call option under paragraph 815-20-25-104(e). Typically, the call
price is greater than the par or face amount of the debt instrument. The
carrying amount of the debt is economically unrelated to the amount the issuer
would be required to pay to exercise the call embedded in the debt.
>>>> Application of Prepayable Criterion
25-112 An interest-bearing asset or liability shall be considered prepayable
under the provisions of paragraph 815-20-25-104(e) if one party to the contract
has the right to cause the payment of principal before the scheduled payment
dates unless either of the following conditions is met:
a. The debtor has the right to cause settlement of the entire contract before
its stated maturity at an amount that is always greater than the then fair
value of the contract absent that right.
b. The creditor has the right to cause settlement of the entire contract before
its stated maturity at an amount that is always less than the then fair value
of the contract absent that right.
25-113 However, none of the following shall be considered a prepayment
provision:
a. Any term, clause, or other provision in a debt instrument that gives the
debtor or creditor the right to cause prepayment of the debt contingent upon
the occurrence of a specific event related to the debtor’s credit deterioration
or other change in the debtor’s credit risk, such as any of the following:
1. The debtor’s failure to make timely payment, thus making it delinquent
2. The debtor's failure to meet specific covenant ratios
3. The debtor's disposition of specific significant assets (such as a factory)
4. A declaration of cross-default
5. A restructuring by the debtor.
b. Any term, clause, or other provision in a debt instrument that gives the
debtor or creditor the right to cause prepayment of the debt contingent
upon the occurrence of a specific event that meets all of the following
conditions:
1. It is not probable at the time of debt issuance.
Hedging 744
9. Hedge effectiveness

2. It is unrelated to changes in benchmark interest rates, contractually

specified interest rates, or any other market variable.
3. It is related either to the debtor’s or creditor’s death or to regulatory
actions, legislative actions, or other similar events that are beyond the
control of the debtor or creditor.
c. Contingent acceleration clauses that permit the debtor to accelerate the
maturity of an outstanding note only upon the occurrence of a specified
event that meets all of the following conditions:
1. It is not probable at the time of debt issuance.
2. It is unrelated to changes in benchmark interest rates, contractually
specified interest rates, or any other market variable.
3. It is related to regulatory actions, legislative actions, or other similar
events that are beyond the control of the debtor or creditor.
25-114 Furthermore, a right to cause a contract to be prepaid at its then fair
value would not cause the interest-bearing asset or liability to be considered
prepayable because that right would have a fair value of zero at all times and
essentially would provide only liquidity to the holder.
25-115 Application of this guidance to specific debt instruments is illustrated in
paragraph 815-20-55-75.

The shortcut method’s fourth criterion requires that the hedged item or
transaction not be prepayable, except in limited situations described in
Question 9.3.150. [815-20-25-104(e)]

Question 9.3.150
What financial instruments does an entity consider
prepayable?
Interpretive response:
Prepayment amount always equals instrument’s fair value
An entity generally considers an interest-bearing asset or liability prepayable
when one party can prepay or require the other party to prepay the principal
amount before its scheduled payment date; or in the case of a partial-term
hedge, the assumed maturity date of the hedged item.
However, it does not consider an interest-bearing asset or liability to be
prepayable for purposes of applying the shortcut method if: [815-20-25-104(e),
25-112, 25-113]

The debtor has the right to: The creditor has the right to:
Cause settlement of the entire Cause settlement of the entire
instrument before its stated maturity Or instrument before its stated maturity
at an amount that is always greater at an amount that is always less than
than the current fair value of the the current fair value of the contract
contract without that right. without that right.

An entity does not consider a hedged item or transaction prepayable if the right
to prepay always results in a prepayment amount equal to the instrument’s
Hedging 745
9. Hedge effectiveness

current fair value. This is because that right would have a fair value of zero at all
times and essentially would provide only liquidity to the creditor. [815-20-25-114]
An entity should not assume that a variable-rate instrument always has a fair
value equal to its par value when the interest rate resets to the applicable
interest rate index. Other conditions (e.g. changes in credit risk) may affect the
fair value of the variable-rate debt instrument. For example, variable-rate debt
callable for par is not callable for fair value because its par value and fair value
may differ due to changes in variables other than interest rates. [815-20-25-104(e)]
Prepayment feature cannot be exercised during hedge term
An entity does not consider a hedged item or transaction to be prepayable
during the hedge term if the item has a prepayment feature (e.g. a call or put
option) that cannot be exercised during the hedge term. This occurs in a partial-
term hedge – i.e. a hedge in which an entity designates only a part of the
instrument’s term.
Other instruments not considered prepayable
Other debt instruments may not be considered prepayable for purposes of
applying the shortcut method depending on whether certain conditions are met.
These include certain debt instruments that become prepayable: [815-20-25-113]
— on the occurrence of an event related to the debtor’s credit deterioration
(see Question 9.3.160);
— on the occurrence of an event related to the debtor’s or creditor’s death, or
to regulatory or legislative actions that are beyond the control of the debtor
or creditor (see Question 9.3.170); and
— due to a contingent acceleration clause that permits the debtor to
accelerate the maturity of an outstanding note only on the occurrence of
one or more events that are beyond the control of the debtor or creditor
(see Question 9.3.170).

Question 9.3.160
Is a debt instrument that becomes prepayable on
the debtor’s credit deterioration considered
prepayable when applying the shortcut method?
Interpretive response: No. A debt instrument that gives the debtor (creditor)
the right to prepay (require the other party to prepay) the debt instrument on
the occurrence of a specific event related to the debtor’s credit deterioration or
other change in the debtor’s credit risk is not considered prepayable for the
purpose of applying the shortcut method. [815-20-25-113(a)]
The following are examples of such provisions:
— the debtor’s failure to make timely payment, thereby making it delinquent;
— the debtor’s failure to meet specific covenant ratios;
— the debtor’s disposal of specific significant assets;
— cross-default; and
— a restructuring by the debtor.
Hedging 746
9. Hedge effectiveness

Question 9.3.170
Is a debt instrument that becomes prepayable on
the occurrence of an event beyond the control of
the debtor or creditor considered prepayable when
applying the shortcut method?
Interpretive response: It depends. A debt instrument is not considered
prepayable if it gives the debtor or creditor the right to prepay or require the
other party to prepay the debt instrument on the occurrence of an event that:
[815-20-25-113(b)]

— is not probable at the time of debt issuance;

— is unrelated to changes in benchmark interest rates, contractually specified
rates, or any other market variable; and
— is related either to the debtor’s or creditor’s death, or to regulatory or
legislative actions, or other similar events that are beyond the control of the
debtor or creditor.
In addition, an outstanding note is not considered prepayable if it permits the
debtor to accelerate its maturity only on the occurrence of an event that: [815-20-
25-113(c)]

— is not probable at the time of debt issuance;

— is unrelated to changes in benchmark interest rates, contractually specified
rates, or any other market variable; and
— is related to regulatory or legislative actions, or other similar events that are
beyond the control of the debtor or creditor.
See Illustrative debt instrument 7 in paragraph 815-20-55-75 (reproduced in the
FASB example that follows) for an example of a debt instrument that meets the
above criteria.

Question 9.3.180
Are there exceptions to the requirement that a
hedged item or transaction not be prepayable?
Interpretive response: Yes. As an exception, a hedged item or transaction that
is prepayable may qualify for the shortcut method if the hedging instrument is a
compound derivative comprising an interest rate swap and an option that is the
mirror image of the option embedded in the hedged item or transaction. [815-20-
25-104(e)(1)]

The following diagram illustrates when an option is considered a mirror image

of the option embedded in the hedged item or transaction. [815-20-25-104(e)(2)]
Hedging 747
9. Hedge effectiveness

Option is mirror image of embedded option if:

(all characteristics must be included)

Entity is the writer of one option and holder of other option

Terms of the two call options need to match exactly

Each of these terms of the two call options need to match exactly:
— maturities;
— strike prices;
— notional amounts;
— notification/election dates (the option notification date partially defines the
term of the option, which is a key factor in determining its fair value);
— how premiums are paid;
— style of option;
— timing and frequency of payments; and
— call dates.

Question 9.3.190
How does a debt instrument’s carrying amount
affect whether the swap used to hedge the debt
contains a mirror-image call option?
Background: Before entering into a hedge, a debt instrument’s carrying
amount may differ from its redemption amount at maturity. This difference may
be due to an issuance premium or discount or deferred debt issuance costs. In
addition, if the debt instrument is callable, the carrying amount often differs
from the call option’s strike price.
Interpretive response: The carrying amount of the debt is economically
unrelated to the amount the issuer would be required to pay to exercise the call
embedded in the debt. Any discount or premium in the hedged debt’s carrying
amount (including any related deferred issuance costs) is therefore irrelevant to
determining whether an interest rate swap contains a mirror-image call option.
Typically, the call price is greater than the par amount of the debt instrument.
The carrying amount of the debt is economically unrelated to the amount the
issuer would be required to pay to exercise the call embedded in the debt.
Therefore, for example, an interest rate swap is not permitted to contain a
termination payment equal to the debt issuance costs that remain unamortized
on the date the option is exercised if the shortcut method is to be applied.
[815-20-25-108]
Hedging 748
9. Hedge effectiveness

FASB Example: Applying the prepayable criterion under the

shortcut method

Excerpt from ASC 815-20

>>> Application of the Prepayable Criterion under the Shortcut Method

55-74 This implementation guidance discusses the application of the
prepayable criterion in paragraph 815-20-25-104(e) and related guidance
beginning in paragraph 815-20-25-112.
55-75 A debt instrument may contain various terms and provisions that permit
either the debtor or the creditor to cause prepayment of the debt (that is,
cause the payment of principal before the scheduled payment dates), including
the terms in the following illustrative instruments:
a. Illustrative debt instrument 1. Some fixed-rate debt instruments include a
typical call option that permits the debt instrument to be called for
prepayment by the debtor at a fixed amount, for example, at par or at a
specified premium over par. In some instruments, the prepayment amount
varies based on when the call option is exercised. Fixed-rate debt
instruments that provide the borrower with the option to prepay at a fixed
amount are considered prepayable under paragraph 815-20-25-104(e),
because those contracts permit settlement at an amount that is potentially
below the contract’s fair value (absent the effect of the call provision) as of
the date of settlement. Such clauses can be exercised based on an
economic advantage related to changes in the designated benchmark
interest rate.
b. Illustrative debt instrument 2. Some debt instruments include contingent
acceleration clauses that permit the lender to accelerate the maturity of an
outstanding note only if a specified event related to the debtor’s credit
deterioration or other change in the debtor’s credit risk occurs (for
example, the debtor’s failure to make timely payment, thus making it
delinquent; its failure to meet specific covenant ratios; its disposition of
specific significant assets, such as a factory; a declaration of cross-default;
or a restructuring by the debtor). A common example is a clause in a
mortgage note secured by certain property that permits the lender to
accelerate the maturity of the note if the borrower sells the property. Debt
instruments that include contingent acceleration clauses that permit the
lender to accelerate the maturity of an outstanding note only upon the
occurrence of a specified event related to the debtor’s credit deterioration
or other changes in the debtor’s credit risk are not considered prepayable
under paragraph 815-20-25-104(e).
c. Illustrative debt instrument 3. Some fixed-rate debt instruments include a
call option that permits the debtor to repurchase the debt instrument from
the creditor at an amount equal to its then fair value. Fixed-rate debt
instruments that provide the debtor with the option to repurchase from the
creditor the debt at an amount equal to the then fair value of the contract
are not considered prepayable under paragraph 815-20-25-104(e), because
that right would have a fair value of zero at all times. Such clauses, which
provide the debtor with the discretionary opportunity to settle its obligation
before maturity, are not exercised based on an economic advantage
Hedging 749
9. Hedge effectiveness

related to changes in the designated benchmark interest rate because the

repurchases are done at fair value.
d. Illustrative debt instrument 4. Some fixed-rate debt instruments, typically
issued in private markets, include a make-whole provision. A make-whole
provision differs from a typical call option, which enables the issuer to
benefit by prepaying the debt if market interest rates decline. In a declining
interest rate market, the settlement amount of a typical call option is less
than what the fair value of the debt would have been absent the call
option. In contrast, a make-whole provision involves settlement at a
variable amount typically determined by discounting the debt’s remaining
contractual cash flows at a specified small spread over the current
Treasury rate. That calculation results in a settlement amount significantly
above the debt’s current fair value based on the issuer’s current spread
over the current Treasury rate. The make-whole provision contains a
premium settlement amount to penalize the debtor for prepaying the debt
and to compensate the investor (that is, to approximately make the
investor whole) for its being forced to recognize a taxable gain on the
settlement of the debt investment. In some debt instruments, the
prepayment option under a make-whole provision will not be exercisable
during an initial lock-out period. (For example, Private Entity A borrows
from Insurance Entity B under a 10-year loan with fixed periodic coupon
payments. The spread over the Treasury rate for Entity A at issuance of the
debt is 275 basis points. The loan agreement contains a make-whole
provision that if Entity A prepays the debt, it will pay Insurance Entity B an
amount equal to all the future contractual cash flows discounted at the
current Treasury rate plus 50 basis points.) Fixed-rate debt instruments that
include a make-whole provision (as previously described) are not
considered prepayable under paragraph 815-20-25-104(e), because it
involves settlement of the entire contract by the debtor before its stated
maturity at an amount greater than (rather than an amount less than) the
then fair value of the contract.
e. Illustrative debt instrument 5. Some variable-rate debt instruments include
a call option that permits the debtor to repurchase the debt instrument
from the creditor at each interest reset date at an amount equal to par.
Although illustrative debt instrument 5, a variable-rate debt instrument,
does have a fair value exposure between the date of a change in the
contractually specified interest rate and the reset date, a swap would not
be an appropriate hedging instrument to hedge that fair value exposure.
Thus, a fair value hedge of illustrative debt instrument 5 could not qualify
for the shortcut method discussed in paragraph 815-20-25-102, which
requires the hedging instrument to be an interest rate swap. In cash flow
hedges, if the reset provisions always result in the instrument’s par
amount being equal to its fair value at a reset date, then an option for the
debtor to prepay the variable-rate debt instrument at par at that reset date
would not be considered prepayable under paragraph 815-20-25-104(e).
However, if the reset provisions can result in the instrument’s par amount
not being equal to its fair value at those reset dates, then an option for the
debtor to prepay the variable-rate debt instrument at par at a reset date
would be considered prepayable under that paragraph. (Because the reset
provisions typically do not adjust the variable interest rate for changes in
credit sector spreads and changes in the debtor’s creditworthiness, the
variable-rate debt instrument’s par amount could seldom be expected to be
equal to its fair value at each reset date.) Furthermore, to qualify for cash
Hedging 750
9. Hedge effectiveness

flow hedge accounting, the hedging relationship must meet the applicable
conditions in this Subtopic and the entity designating the hedge (that is,
the debtor or creditor) must conclude it is probable that future interest
payments will be made during the term of the interest rate swap. If the
creditor’s counterparty (that is, the debtor) on a recognized variable-rate
asset related to the hedged forecasted interest payments can cause that
asset to be prepaid, then that creditor would likely be unable to conclude
that all the forecasted interest payments on its recognized interest-bearing
asset are probable and, thus, the cash flow hedging relationship would not
qualify for the shortcut method. (Even though the creditor believes it could
immediately obtain a replacement variable-rate asset if prepayment occurs
and thus could conclude that the forecasted variable interest inflows are
probable, the only hedged forecasted interest inflows that are eligible for
application of the shortcut method are those related to a recognized
interest-bearing asset at the inception of the hedge.) However,
paragraph 815-20-25-104(e) indicates that its criterion that prohibits a
prepayment option in the interest-bearing asset or liability does not apply to
a hedging relationship if the hedging interest rate swap contains an
embedded mirror-image option. In that latter case, if both the prepayment
option and the mirror-image option in the swap were exercised, there
would be no future hedged interest cash flows related to the recognized
interest-bearing asset or liability and no future cash flows under the swap
and, thus, the existence of the prepayment option would not preclude the
use of the shortcut method.
f. Illustrative debt instrument 6. Some fixed-rate debt instruments include
both a call option as described in illustrative debt instrument 1 and a
contingent acceleration clause as described in illustrative debt
instrument 2. The same conclusions reached relative to illustrative debt
instrument 1 also apply to illustrative debt instrument 6.
g. Illustrative debt instrument 7. Some debt instruments contain an investor
protection clause (which is standard in substantially all debt issued in
Europe) that provides that, in the event of a change in tax law that would
subject the investor to additional incremental taxation by tax jurisdictions
other than those entitled to tax the investor at the time of debt issuance,
the coupon interest rate of the debt increases so that the investor’s yield,
net of the incremental taxation effect, is equal to the investor’s yield before
the tax law change. The debt issuance also contains an issuer protection
clause (which is standard in substantially all debt issued in Europe) that
provides that, in the event of a tax law change that triggers an increase in
the coupon interest rate, the issuer has the right to call the debt obligation
at par. There would be no market for the debt were it not for the
prepayment and interest rate adjustment clauses that protect the issuer
and investors. Illustrative debt instrument 7 is not considered prepayable
under paragraph 815-20-25-104(e) because it meets the exclusion criteria
under paragraph 815-20-25-113(c).
55-76 An entity is not precluded from applying the shortcut method to a fair
value hedging relationship of interest rate risk involving illustrative debt
instruments 1 and 6 that are prepayable due to an embedded purchased call
option if the hedging interest rate swap contains an embedded mirror-image
written call option.
Hedging 751
9. Hedge effectiveness

55-77 In addition, an entity is not precluded from applying the shortcut method
to a fair value hedging relationship of interest rate risk involving illustrative debt
instruments 2, 3, 4, and 7 that are not considered prepayable if the hedging
interest rate swap does not contain an embedded purchased or written call
option related to changes in the designated benchmark interest rate.
55-78 However, an entity would likely be precluded from applying the shortcut
method to a cash flow hedging relationship of interest rate risk involving
illustrative debt instrument 5 because the entity would likely be unable to
conclude that all the forecasted interest payments on the recognized interest-
bearing asset or liability are probable.
>>> Determining Whether a Mirror-Image Call Provision Exists in
Application of the Shortcut Method
55-79 This implementation guidance addresses the application of
paragraph 815-20-25-104(e). It is common to quote the call prices (strike
prices) on debt as a percentage of par value. In contrast, the strike prices of
options embedded in interest rate swaps are generally quoted as a rate or
current yield (the current fixed-rate coupon on a noncallable-nonputtable swap
having zero fair value at inception). One means of determining whether these
strike prices are the same would be to:
a. Impute the yield to maturity at a price equal to the call price for a
noncallable-nonputtable debt instrument that is otherwise identical to the
hedged debt instrument.
b. Compare that yield to the call or put yield embedded in the swap.

Financial instruments that are considered prepayable for purposes of the

shortcut method may differ from the financial instruments that are considered
prepayable for purpose of the last-of-layer method and for the purposes of
applying paragraph 815-20-25-6B. For a discussion of what is considered
prepayable for the purpose of applying the last-of-layer method and
paragraph 815-20-25-6B, see Question 3.4.30.

9.3.70 Criterion 5: All other terms are typical and do not

invalidate assumption of perfect effectiveness

Excerpt from ASC 815-20

>>> Assuming Perfect Hedge Effectiveness in a Hedge with an Interest

Rate Swap (the Shortcut Method)
25-104 All of the following conditions apply to both fair value hedges and cash
flow hedges: …
g. Any other terms in the interest-bearing financial instruments or interest
rate swaps meet both of the following conditions:
1. The terms are typical of those instruments.
2. The terms do not invalidate the assumption of perfect effectiveness.
Hedging 752
9. Hedge effectiveness

25-107 The shortcut method may be applied to a hedging relationship that

involves the use of an interest rate swap-in-arrears provided all of the
applicable conditions are met.
25-109 The fixed interest rate on a hedged item need not exactly match the
fixed interest rate on an interest rate swap designated as a fair value hedge.
Nor does the variable interest rate on an interest-bearing asset or liability need
to be the same as the variable interest rate on an interest rate swap
designated as a cash flow hedge. An interest rate swap’s fair value comes
from its net settlements. The fixed and variable interest rates on an interest
rate swap can be changed without affecting the net settlement if both are
changed by the same amount. That is, an interest rate swap with a payment
based on LIBOR and a receipt based on a fixed rate of 5 percent has the same
net settlements and fair value as an interest rate swap with a payment based
on LIBOR plus 1 percent and a receipt based on a fixed rate of 6 percent.

The shortcut method’s fifth criterion requires that all of the ‘other’ terms of the
hedging instrument (i.e. terms other than those discussed in Criteria 1 – 4) be
typical of interest-bearing financial instruments or interest rate swaps.
Moreover, none of these ‘other’ terms can invalidate the assumption of perfect
effectiveness. The FASB included this criterion to ensure that all terms of the
hedging relationship are considered in evaluating the appropriateness of the
shortcut method. [815-20-25-104(g)]
This criterion suggests that a highly structured interest rate swap would not
meet this criterion. However, whether a feature is typical is a matter of
judgment on a case-by-case basis.
In general, to not invalidate the assumption of effectiveness, the terms of the
hedged item or transaction and hedging instrument must match. This includes
notional amounts, dates, day count conventions, calendar adjustments for
business days for payments and fixing variable rates, interest calculation
periods, interest rate fixing and payment conventions (in advance versus in
arrears).

Question 9.3.200
Does the shortcut method require the fixed rate on
the swap to match the fixed rate on the hedged
item or transaction?
Interpretive response: No, the shortcut method does not require the fixed rate
on the interest rate swap to match the fixed rate on the hedged item. The
difference between the swap’s fixed rate and the hedged item’s fixed rate
relates to the difference between the credit risk of the swap and the hedged
item. [815-20-25-109]
Because of the complication caused by the interaction of interest rate risk and
credit risk that are not easily separable, comparable creditworthiness is not
considered a necessary condition to assume no ineffectiveness in a hedge of
interest rate risk. [815-20-25-111]
Hedging 753
9. Hedge effectiveness

Question 9.3.210
Can the shortcut method be applied to a hedge of a
convertible debt instrument?
Interpretive response: No, a convertible debt instrument cannot be designated
as the hedged item or transaction in a shortcut method hedge. The FASB staff
has noted that the interaction between equity prices and interest rates on
convertible debt adds a level of complexity not envisioned by the FASB in the
shortcut method.

Question 9.3.220
Can the shortcut method be applied to a hedge of a
debt instrument issued by a trust preferred
structure?
Background: Banks sometimes issue securities known as trust preferred
securities through a trust structure. The bank establishes the trust that it funds
with debt. The bank then sells ownership interests in the trust (trust preferred
securities) to investors. These trust preferred securities are considered
preferred stock and pay dividends on a set schedule. However, because the
trust holds the bank's debt, the payments the investors receive qualify as
interest income for IRS purposes.
Interpretive response: No. We believe debt instruments with complex
features, such as interest deferral features in debt instruments issued by
financial institutions under trust preferred structures, cannot be designated as a
hedged item or transaction in a shortcut method hedge. These interest deferral
features allow the entity to defer the payment of interest at its option for a
period of time if the entity is not in default. The deferred amounts themselves
bear interest.
This feature would prohibit an entity from assuming perfect effectiveness,
unless the interest rate swap had a mirror feature. Even if the swap did have a
mirror feature, the hedging relationship would not meet the third criterion of the
shortcut method because the swap would not have a consistent formula for
computing net settlement (see section 9.3.50).

Question 9.3.230
Can the shortcut method be applied if the hedging
instrument is a swap with a variable leg that
reprices in arrears?
Background: In a plain vanilla interest rate swap, the swap’s variable interest
rate is determined (i.e. reset) at the beginning of each period and payment
generally occurs at the end of the period. In contrast, in an interest rate swap-in-
arrears, the swap’s variable interest rate reprices in arrears. This means the
swap’s variable rate is determined at the end of the period and is applied
retrospectively to calculate the swap settlement.
Hedging 754
9. Hedge effectiveness

Interpretive response: Yes. Topic 815 specifically permits the shortcut method
for hedging relationships that involve interest rate swaps-in-arrears as long as
other shortcut criteria are met. [815-20-25-107]

Question 9.3.240
Can the shortcut method be applied to a hedge of a
fixed-rate debt instrument with an interest rate that
increases if the issuer’s credit rating deteriorates?
Interpretive response: No, an entity may not apply the shortcut method when
the hedged item is a fixed-rate debt instrument with an interest rate that
increases if the issuer’s credit rating deteriorates.
The hedged item’s cash flows include the potential increased interest cash
flows due to a deterioration of the issuer’s credit rating. However, a swap that
would be appropriate for the shortcut method would not have cash flows with a
similar potential to increase. When the hedged item’s cash flows have this
potential to increase, the change in fair value of the swap is not expected to
fully offset the hedged item’s change in fair value attributable to interest rate
risk. Therefore, the hedging relationship would not meet the requirement that
all terms be typical and not invalidate the assumption of perfect effectiveness.
Even if the swap has a mirror-image feature (i.e. the fixed leg of the swap
increased as the interest rate on the debt increased), the shortcut method still
would not apply. This is because:
— the shortcut method can be used only when the risk being hedged is
interest rate risk, and in this case the hedging relationship would
incorporate both interest rate and credit risk; and
— the fixed rate on the swap is not the same throughout the term as required
by the third criterion– i.e. the swap must have a consistent formula for
computing net settlements each period (see section 9.3.50).

Question 9.3.250
Can the shortcut method be applied to a hedge of a
zero-coupon bond?
Background: A zero-coupon bond is a debt instrument that doesn’t pay interest
(a coupon), and as a result it sells at a deep discount. It renders its profit at
maturity when the investor redeems the bond for its face value.
For economic purposes, an entity may want to hedge a zero-coupon bond with
a zero-coupon swap. Typically, a zero-coupon swap has a fixed leg with one
lump sum payment at maturity and a floating leg that is tied to a floating rate
that resets and settles periodically. The following is an example.

Hedged item Five-year zero-coupon bond with a face value of $90 million that
was issued for $70 million (an imputed interest rate of 5.15%
compounded annually).
Hedging 755
9. Hedge effectiveness

Hedging A zero-coupon swap with a notional of $70 million that receives

instrument $20 million at maturity and pays three-month LIBOR every
three months.

Interpretive response: We believe an entity may not apply the shortcut

method to a hedging relationship where the hedged item is a zero-coupon bond
and the hedging instrument is a zero-coupon swap. Unlike a typical interest rate
swap, which has a fixed leg that pays a fixed rate periodically during the life of
the swap, a zero-coupon swap does not have a fixed leg that pays periodically.
It typically makes one lump payment at maturity.
This means the swap contains a financing element – i.e. the periodic payments
of the floating leg during the term of the swap finance the fixed payments of
the fixed leg of the swap. Therefore, we believe that a zero-coupon swap
violates the fifth criterion to qualify for the shortcut method, which requires all
other terms of the interest-bearing financial instrument or interest rate swap to
be typical for those instruments. In addition, the swap would also violate the
third criterion, which requires it to have a consistent formula for computing net
settlements each period (see section 9.3.50).

9.3.80 Additional criteria for fair value hedges

Excerpt from ASC 815-20

>>> Assuming Perfect Hedge Effectiveness in a Hedge with an Interest

Rate Swap (the Shortcut Method)
25-105 All of the following incremental conditions apply to fair value hedges
only:
a. The expiration date of the interest rate swap matches the maturity date of
the interest-bearing asset or liability or the assumed maturity date if the
hedged item is measured in accordance with paragraph 815-25-35-13B.
b. There is no floor or cap on the variable interest rate of the interest rate
swap.
c. The interval between repricings of the variable interest rate in the interest
rate swap is frequent enough to justify an assumption that the variable
payment or receipt is at a market rate (generally three to six months or
less).
…
f. The index on which the variable leg of the interest rate swap is based
matches the benchmark interest rate designated as the interest rate risk
being hedged for that hedging relationship.

In addition to the general requirements and the five specific criteria necessary
to apply the shortcut method to both fair value and cash flow hedges, fair value
hedges are required to meet the following additional criteria.
Hedging 756
9. Hedge effectiveness

Additional shortcut criteria for fair value hedges

The maturity dates of the swap and hedged item(s) match. [815-20-25-105(a)]

The variable interest rate of the swap has no cap or floor. [815-20-25-105(b)]

The repricing intervals on the swap’s variable rate are frequent enough to assume that
the variable rate is a market rate. [815-20-25-105(c)]

The index on which the variable leg of the swap is based matches the benchmark
interest rate designated as the hedged interest rate. [815-20-25-105(f)]

Question 9.3.260
Can the shortcut method be applied to a partial-
term fair value hedge?
Background: In a partial-term hedge, an entity designates only certain
consecutive interest payments of a financial instrument that represent an
assumed term (see section 3.3.80). An assumed term begins when the first
hedged cash flow begins to accrue and ends when the last hedged cash flow is
due and payable. [815-25-35-13B]
Interpretive response: The shortcut method may be used in a partial-term
hedge if the expiration date of the interest rate swap matches the assumed
maturity date of the hedged item and all the other shortcut method criteria are
met. [815-20-25-104(a)]

Question 9.3.270
Can the shortcut method be applied to a fair value
hedge if the swap expires one day before or after
the hedged item’s maturity date or assumed
maturity date?
Interpretive response: No. For an entity to apply the shortcut method, the
expiration date of the interest rate swap must exactly match the maturity date
of the hedged item, or the last day of the assumed term in the case of a partial-
term hedge. [815-20-25-102, 25-105(a), 815-25-35-13B]

Question 9.3.280
Can the shortcut method be applied to a fair value
hedge if the swap’s variable leg is based on a tenor
different from the hedged risk?
Interpretive response: No. To qualify for the shortcut method, the index on
which the variable leg of the interest rate swap is based must exactly match the
hedged risk. [815-20-25-105(f)]
Hedging 757
9. Hedge effectiveness

To meet this criterion, we believe the tenors must match exactly. For example,
the relationship would not qualify for the shortcut method if the variable leg of a
swap is indexed to 90-day LIBOR and the entity designates 60-day LIBOR as
the hedged risk.

Question 9.3.290
Can the shortcut method be applied to a fair value
hedge if the variable interest rate of the swap has a
cap or floor?
Interpretive response: No, an entity may not apply the shortcut method to a
hedging relationship where the variable interest rate of the swap has a cap or
floor. If an entity were to enter into an interest rate swap with a cap or floor,
changes in interest rates above the cap or below the floor would not affect the
fair value of the swap. This would be inconsistent with the assumption of
perfect effectiveness. [815-20-25-105(b)]

9.3.90 Additional criteria for cash flow hedges

Excerpt from ASC 815-20

>>> Assuming Perfect Hedge Effectiveness in a Hedge with an Interest

Rate Swap (the Shortcut Method)
25-106 All of the following incremental conditions apply to cash flow hedges
only:
a. All interest receipts or payments on the variable-rate asset or liability during
the term of the interest rate swap are designated as hedged.
b. No interest payments beyond the term of the interest rate swap are
designated as hedged.
c. Either of the following conditions is met:
1. There is no floor or cap on the variable interest rate of the interest rate
swap.
2. The variable-rate asset or liability has a floor or cap and the interest rate
swap has a floor or cap on the variable interest rate that is comparable
to the floor or cap on the variable-rate asset or liability. For purposes of
this paragraph, comparable does not necessarily mean equal. For
example, if an interest rate swap's variable rate is based on LIBOR and
an asset's variable rate is LIBOR plus 2 percent, a 10 percent cap on
the interest rate swap would be comparable to a 12 percent cap on the
asset.
d. The repricing dates of the variable-rate asset or liability and the hedging
instrument must occur on the same dates and be calculated the same way
(that is, both shall be either prospective or retrospective). If the repricing
dates of the hedged item occur on the same dates as the repricing dates
of the hedging instrument but the repricing calculation for the hedged item
Hedging 758
9. Hedge effectiveness

is prospective whereas the repricing calculation for the hedging instrument

is retrospective, those repricing dates do not match.
…
g. The index on which the variable leg of the interest rate swap is based
matches the contractually specified interest rate designated as the interest
rate being hedged for that hedging relationship.

In addition to the general requirements and the five specific criteria necessary
to apply the shortcut method to both fair value and cash flow hedges, cash flow
hedges are required to meet the following additional criteria.

Additional shortcut criteria for cash flow hedges

All of the hedged transasction’s interest payments during the swap’s term are hedged,
and none of its interest payments beyond the swap’s term are hedged. [815-20-25-106(a),
25-106(b)]

Either the swap has no cap or floor, or if the hedged transaction has a cap or floor, the
swap has a comparable cap or floor. [815-20-25-106(c)]

The repricing dates of the swap and the hedged transaction match. [815-20-25-106(d)]

The index on which the variable leg of the swap is based matches the contractually
specified interest rate designated as the hedged interest rate. [815-20-25-106(g)]

Question 9.3.300
Can the shortcut method be applied to a cash flow
hedge if the swap’s variable leg is based on a tenor
different from the hedged risk?
Interpretive response: No. To qualify for the shortcut method, the index on
which the variable leg of the interest rate swap is based must exactly match the
hedged risk. To meet this criterion, we believe the tenors must match exactly.
For example, the relationship would not qualify for the shortcut method if the
variable leg of a swap is indexed to 90-day LIBOR and the entity designates
60-day LIBOR as the hedged risk. [815-20-25-106(g)]

Question 9.3.310
Can the shortcut method be applied to a cash flow
hedge if the hedged item is a variable-rate debt that
contains a cap or floor?
Interpretive response: Yes, an entity may apply the shortcut method to a cash
flow hedging relationship where the hedged transaction is a variable-rate debt
instrument that contains a cap or floor. However, the interest rate swap that is
designated as the hedging instrument must contain a comparable cap or floor,
which does not necessarily mean an equal cap or floor. For example, if an
Hedging 759
9. Hedge effectiveness

interest rate swap's variable rate is based on LIBOR and an asset's variable rate
is LIBOR plus 2 percent, a 10 percent cap on the interest rate swap would be
comparable to a 12 percent cap on the asset. [815-20-25-106(c)]
It is important for an entity to understand how the interest rate terms are
defined in the legal documents for the hedged item and the swap – to
determine what could happen if the underlying referenced interest rate were to
become negative. If the hedged item or interest rate swap have terms that
would prevent the rate from becoming negative, such a feature would be
considered a floor.

Question 9.3.320
Can the shortcut method be applied to a cash flow
hedge of interest payments arising from variable-
rate debt if the debt matures after the swap
expires?
Interpretive response: Yes, an entity may apply the shortcut method to cash
flow hedges of the interest payments on only a portion of the term of the debt.
Therefore, an entity may apply the shortcut method to a variable-rate debt
instrument and an interest rate swap if the debt instrument matures after the
swap expires. [815-20-25-106(a), 25-106(b)]
In this case, the entity has hedged all interest receipts or payments on the
variable-rate asset or liability during the term of the swap. In addition, it has not
hedged any interest payments beyond the term of the swap. [815-20-25-106(a), 25-
106(b)]

Question 9.3.330
Can the shortcut method be applied to a cash flow
hedge if the swap reprices in arrears, but the
hedged forecasted transaction does not?
Interpretive response: No, an entity may not apply the shortcut method to an
interest rate swap that reprices in arrears and a forecasted transaction that does
not reprice in arrears. The term ‘match’ is defined narrowly and is intended to
mean “be exactly the same as or correspond exactly.” Therefore, if the swap
reprices in arrears, the hedged forecasted transaction also must reprice in
arrears. [815-20-25-102, 25-106(d)]
Hedging 760
9. Hedge effectiveness

9.3.100 Counterparty credit risk

Excerpt from ASC 815-20

>>> Assuming Perfect Hedge Effectiveness in a Hedge with an Interest

Rate Swap (the Shortcut Method)
25-103 Implicit in the conditions for the shortcut method is the requirement
that a basis exist for concluding on an ongoing basis that the hedging
relationship is expected to be highly effective in achieving offsetting changes in
fair values or cash flows. In applying the shortcut method, an entity shall
consider the likelihood of the counterparty’s compliance with the contractual
terms of the hedging derivative that require the counterparty to make
payments to the entity.
25-111 Comparable credit risk at inception is not a condition for assuming
perfect effectiveness even though actually achieving perfect offset would
require that the same discount rate be used to determine the fair value of the
swap and of the hedged item or hedged transaction. To justify using the same
discount rate, the credit risk related to both parties to the swap as well as to
the debtor on the hedged interest-bearing asset (in a fair value hedge) or the
variable-rate asset on which the interest payments are hedged (in a cash flow
hedge) would have to be the same. However, because that complication is
caused by the interaction of interest rate risk and credit risk, which are not
easily separable, comparable creditworthiness is not considered a necessary
condition for assuming perfect effectiveness in a hedge of interest rate risk.

Question 9.3.340
Does an entity consider counterparty credit risk or
its own nonperformance risk when applying the
shortcut method?
Interpretive response: Yes, counterparty credit risk and nonperformance risk
are considered when applying the shortcut method.
Fair value of the interest rate swap
An entity considers counterparty credit risk and its own nonperformance risk
when determining the fair value of the interest rate swap. This is the case
regardless of whether it applies the shortcut method. [820-10]
The counterparty credit risk of a derivative instrument that is acquired on a
regulated exchange is the credit risk of the exchange. [820-10]
See also KPMG’s Q&A: Fair value measurement, including:
— Section O, Application issues: Derivatives and hedging, including
Question O70, which provides additional information about whether (and
how) the requirements to include counterparty credit risk and an entity’s
own nonperformance risk in measuring the fair values of derivative
instruments affect hedging relationships.
Hedging 761
9. Hedge effectiveness

— Question C70, which addresses how to consider the existence of a

separate arrangement (such as a master netting agreement or credit
support agreement) that mitigates credit risk exposure in the event of
default when measuring the fair value of a financial instrument.
Hedge inception
Comparable credit risk between the hedging instrument and the hedged item or
transaction is not necessary to assume perfect effectiveness for accounting
purposes. The FASB allowed this accommodation as a practical matter even
though a perfect economic offset requires the interest rate swap and hedged
item or transaction to have the same credit risk. Nonetheless, an ongoing
expectation of high effectiveness is implicit in the shortcut method. Therefore,
when applying the shortcut method, an entity considers the likelihood of the
counterparty complying with the swap’s payment terms. We believe this
guidance should apply to the entity's own nonperformance risk as well. [815-20-
25-103, 25-111]

Changes in counterparty credit risk and own nonperformance risk

When using the shortcut method, an entity monitors hedges for changes in
counterparty credit risk and nonperformance risk. We believe an entity may
continue the shortcut method if the likelihood that the counterparty or the entity
will not default continues to be probable. However, if the likelihood that the
counterparty or the entity will not default is no longer probable, the entity
should discontinue hedge accounting altogether.
If the entity can identify the date on which the counterparty or the entity not
defaulting became less than probable, the entity stops hedge accounting
prospectively from that day forward. If the entity cannot identify that date, it
does not apply hedge accounting for the entire reporting period in which the
counterparty or the entity not defaulting became less than probable.

9.3.110 Discontinuing the shortcut method

Excerpt from ASC 815-20

>>>> Application of Whether the Shortcut Method Was Not or No Longer

Is Appropriate
25-117A In the period in which an entity determines that use of the shortcut
method was not or no longer is appropriate, the entity may use a quantitative
method to assess hedge effectiveness and measure hedge results without
dedesignating the hedging relationship if both of the following criteria are met:
a. The entity documented at hedge inception in accordance with paragraph
815-20-25-3(b)(2)(iv)(04) which quantitative method it would use to assess
hedge effectiveness and measure hedge results if the shortcut method
was not or no longer is appropriate during the life of the hedging
relationship.
b. The hedging relationship was highly effective on a prospective and
retrospective basis in achieving offsetting changes in fair value or cash
Hedging 762
9. Hedge effectiveness

flows attributable to the hedged risk for the periods in which the shortcut
method criteria were not met.
25-117B If the criterion in paragraph 815-20-25-117A(a) is not met, the hedging
relationship shall be considered invalid in the period in which the criteria for the
shortcut method were not met and in all subsequent periods. If the criterion in
paragraph 815-20-25-117A(a) is met, the hedging relationship shall be
considered invalid in all periods in which the criterion in paragraph 815-20-25-
117A(b) is not met.
25-117C If an entity cannot identify the date on which the shortcut criteria
ceased to be met, the entity shall perform the quantitative assessment of
effectiveness documented at hedge inception for all periods since hedge
inception.
25-117D The terms of the hedged item and hedging instrument used to assess
effectiveness, in accordance with paragraph 815-20-25-117A(b), shall be those
existing as of the date that the shortcut criteria ceased to be met. For cash
flow hedges, if the hypothetical derivative method is used as a proxy for the
hedged item, the value of the hypothetical derivative shall be set to zero as of
hedge inception.

The shortcut method is discontinued when:

— any of the applicable shortcut criteria are no longer met; or
— an entity determines that the shortcut method was inappropriately applied.
However, an entity may not need to dedesignate the hedging relationship if
certain criteria are met.

Hedging In the period in which an entity makes this determination, it may

relationship use a quantitative method to assess hedge effectiveness and
may continue measure hedge results without dedesignating the hedging
relationship if it: [815-20-25-117A]
— documented at hedge inception which quantitative method it
would use to assess hedge effectiveness if the shortcut
method becomes inappropriate; and
— determines that when that quantitative method is applied the
hedge was highly effective for the periods in which the
shortcut method criteria were not met.

Hedging If the above criteria are not met, the hedging relationship must be
relationship dedesignated.
must be For guidance on the accounting consequences when the shortcut
dedesignated method is misapplied, see Question 9.3.350.

When these criteria are met, the quantitative method is used to assess hedge
effectiveness in all periods for which the shortcut method was not appropriate.
Hedging 763
9. Hedge effectiveness

Question 9.3.350
What happens if an entity does not document a
quantitative method that it would use if the
shortcut method was not (or no longer is)
appropriate?
Interpretive response: If an entity applies the shortcut method and does not
document a quantitative effectiveness assessment method in the initial hedge
documentation, there is no consequence if the shortcut method remains
appropriate to use in all periods.
In contrast, there are accounting consequences when the shortcut method is
misapplied and the entity did not document a quantitative effectiveness
assessment method. In this event, an entity treats the misapplication as an
accounting error under Topic 250 in all periods in which the shortcut method
was misapplied. The amount of this accounting error usually will be greater than
the amount of the accounting error had a quantitative assessment method been
documented. This is because when no such method is documented, the
amount of the error does not consider whether the hedging relationship would
have been highly effective. Instead, it assumes that hedge accounting should
not have been applied in those periods.
When the shortcut method is misapplied, the entity also evaluates the severity
of any control deficiencies related to the failure to identify the inappropriate use
of the shortcut method.

Question 9.3.360
When the shortcut method is required to be
discontinued, as of what date(s) should an entity
perform the quantitative assessments?
Interpretive response: If a shortcut method hedge is required to be
discontinued, an entity should perform quantitative effectiveness assessments
beginning at the date the shortcut method was not (or no longer is) appropriate.
However, this assumes that the entity documented at hedge inception which
quantitative method it would use if the shortcut method was not or no longer is
appropriate.
The date(s) from which quantitative assessments should be performed depends
on when the shortcut method ceased to be appropriate. [815-20-25-117B – 25-117C,
ASU 2017-12.BC191 – BC192]

The criteria for applying the Quantitative assessments should be

shortcut method were not met at performed for all periods since hedge
hedge inception inception.

A term of the hedged item or Quantitative assessments should be

hedging instrument changed after performed for all periods since the date the
inception, causing the shortcut shortcut method criteria were no longer
method criteria to no longer be met met.
Hedging 764
9. Hedge effectiveness

The date at which the shortcut Quantitative assessments should be

method ceased to be appropriate performed for all periods since hedge
cannot be identified inception.

Question 9.3.370
What is the effect of performing quantitative
assessments once the shortcut method is
discontinued?
Interpretive response: If the shortcut method was applied during prior periods
when it was not appropriate, the guidance for accounting errors in Topic 250 is
followed. However, permitting an entity to retroactively apply a quantitative
method of assessing hedge criteria in this instance reduces the likelihood that
the error is material (thereby reducing the likelihood of restatement).
The determination of the error when an entity documented a quantitative
assessment method at hedge inception depends on whether the relationship
was highly effective in the prior period(s) affected.
— Not highly effective. In this situation, the amount of the error is the
difference between not applying hedge accounting and the results recorded
by applying the shortcut method.
— Highly effective. In this situation, whether there is an error (and if so, its
nature) depends on the type of hedge and also on whether the hedging
instrument is measured appropriately.
— Cash flow hedges. If the hedging instrument is measured properly,
there is no error. However, the hedging instrument may not have been
measured appropriately if its characteristics (including consideration of
credit risk) were not properly defined in the prior reporting periods –
e.g. because a changed term was not captured in its measurement.
This would result in the hedging instrument’s recorded amount and the
related amount recorded in AOCI being incorrect.
— Fair value hedges. Under the shortcut method, the change in fair
value of the hedging instrument is used as a proxy to measure the
change in the fair value of the hedged item with no effect on net
income. This approach for measuring the hedged item’s fair value is not
appropriate in periods when the shortcut method is not appropriate.
Because the hedged item was measured incorrectly in prior reporting
periods, an error will result. Additionally, the hedging instrument may
not have been measured appropriately if its characteristics (including
consideration of credit risk) were not properly defined in prior reporting
periods. Incorrect measurements would result in the recorded amounts
for the hedged item and/or the hedging instrument – along with the
related gains (losses) recognized in net income – being incorrect.
In both circumstances, the entity also evaluates the severity of any control
deficiencies related to the failure to identify the inappropriate use of the
shortcut method.
Hedging 765
9. Hedge effectiveness

9.4. Critical terms match method

9.4.10 Overview

Excerpt from ASC 815-20

>> Hedge Effectiveness Criteria Applicable to both Fair Value Hedges and
Cash Flow Hedges
25-84 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:
a. The forward contract is for 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 hedged risk and the
requirements in paragraphs 815-20-25-22A through 25-22B are met.
b. The fair value of the forward contract at inception is zero.
c. Either of the following criteria is met:
1. 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.
2. The change in expected cash flows on the forecasted transaction is
based on the forward price for the commodity.
25-84A 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.
25-85 If all of the criteria in paragraphs 815-20-25-84 through 25-84A are met,
an entity shall still perform and document an assessment of hedge
effectiveness at the inception of the hedging relationship and, as discussed
beginning in paragraph 815-20-35-9, on an ongoing basis throughout the hedge
period. No quantitative effectiveness assessment is required at hedge
inception if the criteria in paragraphs 815-20-25-84 through 25-84A are met
(see paragraph 815-20-25-3(b)(2)(iv)(01)).
>> Assessing Effectiveness Based on Whether the Critical Terms of the
Hedging Instrument and Hedged Item Match Relative Ease of Assessing
Effectiveness
35-9 If, at inception, the critical terms of the hedging instrument and the
hedged forecasted transaction are the same (see paragraphs 815-20-25-84
through 25-84A), the entity can conclude that changes in cash flows
attributable to the risk being hedged are expected to be completely offset by
Hedging 766
9. Hedge effectiveness

the hedging derivative. Therefore, subsequent assessments can be performed

by verifying and documenting whether the critical terms of the hedging
instrument and the forecasted transaction have changed during the period in
review.
35-10 Because the assessment of hedge effectiveness in a cash flow hedge
involves assessing the likelihood of the counterparty’s compliance with the
contractual terms of the derivative instrument designated as the hedging
instrument, the entity must also assess whether there have been adverse
developments regarding the risk of counterparty default, particularly if the
entity planned to obtain its cash flows by liquidating the derivative instrument
at its fair value.
35-11 If there are no such changes in the critical terms or adverse
developments regarding counterparty default, the entity may conclude that the
hedging relationship is perfectly effective. In that case, the change in fair value
of the derivative instrument can be viewed as a proxy for the present value of
the change in cash flows attributable to the risk being hedged.
35-12 However, the entity must assess whether the hedging relationship is
expected to continue to be highly effective using a quantitative assessment
method (either a dollar-offset test or a statistical method such as regression
analysis) if any of the following conditions exist:
a. The critical terms of the hedging instrument or the hedged forecasted
transaction have changed.
b. There have been adverse developments regarding the risk of counterparty
default.

The critical terms match method is elective and greatly simplifies the hedge
effectiveness assessment when the hedging instrument is a forward or futures
or option contract. [815-20-25-84 – 25-85]
If a hedging relationship meets the criteria for this method, the entity can
assume that the hedging relationship is perfectly effective. Therefore, the
method simplifies the hedge effectiveness assessment by eliminating the
quantitative aspect of the assessment. [815-20-25-84 – 25-85]
One of the criteria for applying this method is that the critical terms of the
hedging instrument and the hedged transaction are the same. When the critical
terms are the same, the change in the cash flows of the hedging instrument
(except for any amounts excluded from the assessment of effectiveness) can
be viewed as a proxy for the change in the cash flows of the hedged
transaction. [815-20-25-84]
This section discusses the application of the critical terms match method solely
in the context of cash flow hedges. While Topic 815 permits application of the
critical terms match method for fair value hedges, we believe the FASB
intended the method to apply only to hedging relationships that will be perfectly
effective. This has the practical effect of precluding the use of the critical terms
match method for fair value hedges in the vast majority of circumstances
because fair value hedges are rarely perfectly effective. There commonly is a
lack of perfect effectiveness in fair value hedges because changes in both
counterparty credit risk and an entity’s own nonperformance risk affect the
measurement of changes in the fair value of the derivative hedging instrument.
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9. Hedge effectiveness

These changes commonly have no offsetting effect on changes in the

measurement of the hedged item attributable to the hedged risk.

9.4.20 Criteria
The criteria for applying the critical terms match method are as follows.

Criterion 1 The hedging instrument (forward, futures or option contract) is

for the purchase of the same quantity of the same commodity at
the same time and location as the hedged transaction. [815-20-
25-84(a)]

Criterion 2 Forward or futures contract has a fair value of zero at hedge

inception. If the contract is an option it has an intrinsic value of
zero at hedge inception. [815-20-25-104(b), 25-104(c)]

These criteria can be illustrated through a hedging transaction involving the

forecasted sale of West Texas natural gas. If the hedging instrument is a
forward contract, the criteria for the critical terms match method are met if the
forward contract:
— has West Texas natural gas as its underlying;
— is for the same quantity of natural gas as the hedged transaction;
— settles at the same time and in the same location as the hedged
transaction; and
— has a fair value of zero at hedge inception.

Criterion 3 For forwards or futures contracts: [815-20-25-84(c)(1)]

— change in the spot-forward difference on the forward or
futures contract is excluded from the assessment of
effectiveness; or
— the change in the cash flows of the hedged transaction is
based on the commodity’s forward price.
For option contracts, the change in the time value of the option
is excluded from the assessment of effectiveness.

Question 9.4.10
Can the critical terms match method be applied if
the hedging instrument has a non-zero fair value at
hedge inception?
Background: The second criterion to apply the critical terms match method is
that the fair value of the hedging instrument at hedge inception is zero. [815-20-
25-84(b)]

Interpretive response: It depends. We believe an entity may apply the critical

terms match method to a hedging relationship that uses a hedging instrument
with a non-zero fair value at hedge inception. However, this is only the case if
the non-zero fair value is due solely to a bid-ask spread. All of the other criteria
for the critical terms match method must be met.
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9. Hedge effectiveness

FASB Example: Cash flow hedge of the forecasted sale of a

commodity when the critical terms match inventory

Excerpt from ASC 815-30

>> Example 5: Cash Flow Hedge of the Forecasted Sale of a Commodity

When the Critical Terms Match

55-20 This Example illustrates the application of the guidance in

paragraphs 815-20-25-84 through 25-85 and this Subtopic to the accounting for
a cash flow hedge of a forecasted sale of a commodity. The terms of the
hedging derivative have been negotiated to match the terms of the forecasted
transaction. Assume that there is no time value in the derivative instrument.
Entity ABC has chosen to hedge the variability of the cash flows from the
forecasted sale of the commodity instead of the changes in its fair value. For
simplicity, commissions and most other transaction costs, initial margin, and
income taxes are ignored unless otherwise stated. Assume that there are no
changes in creditworthiness that would alter the effectiveness of the hedging
relationship.
55-21 Because there is no contractually specified component, Entity ABC
hedges the risk of changes in its cash flows relating to changes in the sales
price of a forecasted sale of 100,000 bushels of Commodity A by entering into
a derivative instrument, Derivative Z. Entity ABC expects to sell the 100,000
bushels of Commodity A on the last day of Period 1. On the first day of
Period 1, Entity ABC enters into Derivative Z and designates it as a cash flow
hedge of the forecasted sale. Entity ABC neither pays nor receives a premium
on Derivative Z (that is, its fair value is zero). Entity ABC expects that there will
be perfect offset between the hedging instrument and the hedged item
because all of the following conditions exist:
a. The notional amount of Derivative Z is 100,000 bushels and the forecasted
sale is for 100,000 bushels.
b. The underlying of Derivative Z is the price of the same variety and grade of
Commodity A that Entity ABC expects to sell (assuming delivery to Entity
ABC’s selling point).
c. The settlement date of Derivative Z is the last day of Period 1 and the
forecasted sale is expected to occur on the last day of Period 1.
The entity need not perform an initial quantitative assessment of hedge
effectiveness in accordance with paragraph 815-20-25-3(b)(2)(iv)(01) because
the conditions in paragraphs 815-20-25-84 through 25-85 are met.
55-22 At inception of the hedge, the expected sales price of 100,000 bushels
of Commodity A is $1,100,000. On the last day of Period 1, the fair value of
Derivative Z has increased by $25,000, and the expected sales price of 100,000
bushels of Commodity A has decreased by $25,000. Both the sale of 100,000
bushels of Commodity A and the settlement of Derivative Z occur on the last
day of Period 1. The following table illustrates the accounting, including the net
effect on earnings and other comprehensive income, for the situation
described.
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9. Hedge effectiveness

Debit (Credit)

Other
Comprehensive
Cash Derivative Income Earnings

Recognize change in fair

value of derivative $ 25,000 $ (25,000)
Recognize revenue from
sale $ 1,075,000 $ (1,075,000)
Recognize settlement of
derivative 25,000 (25,000)
Reclassify change in fair
value of derivative to
earnings 25,000 (25,000)

Total $ 1,100,000 $ - $ - $ (1,100,000)

55-23 At the inception of the hedge, Entity ABC anticipated that it would
receive $1,100,000 from the sale of 100,000 bushels of Commodity A. This
Example illustrates that by hedging the risk of changes in its cash flows
relating to the forecasted sale of 100,000 bushels of Commodity A, Entity ABC
still received a total of $1,100,000 in cash flows even though the sales price of
Commodity A declined during the period.

9.4.30 Scope
This section addresses the types of hedging relationships that may be eligible
for the critical terms match method.

Question 9.4.20
Can the critical terms match method be applied to a
hedging relationship that uses an interest rate
swap as the hedging instrument?
Interpretive response: No. We believe the FASB intended that each general
type of hedging instrument be able to qualify for a less burdensome method of
documenting and assessing effectiveness. Therefore, we believe the critical
terms match method is not available for hedging relationships that use interest
rate swaps as the hedging instrument. This is the case even if the interest rate
swap is perfectly effective at hedging the interest rate risk.

Interest rate risk. When hedging interest rate risk with an interest rate
swap, an entity should apply the shortcut method (see section 9.3) or one of
the other assessment methods for interest rate risk (see section 9.8).
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9. Hedge effectiveness

Question 9.4.30
Can the critical terms match method be applied if
one derivative instrument hedges multiple
transactions over a period of time?
Interpretive response: Yes, an entity may designate one derivative instrument
as the hedging instrument for a hedge of a group of forecasted transactions.
The entity may assume that the timing in which the hedged transactions are
expected to occur and the maturity date of the hedging instrument match (as
required by paragraph 815-20-25-84(a)) if those forecasted transactions occur
and the derivative matures within the same 31-day period or fiscal month.
[815-20-25-84A]

Example 23 in Subtopic 815-30 illustrates how to apply the critical terms match
method to a group of forecasted transactions (reproduced below).

Excerpt from ASC 815-30

>> Example 23: Designation of a Cash Flow Hedge of a Forecasted

Purchase of Inventory for Which Commodity Exposure Is Managed
Centrally

Grade 1 Grade 2 Grade 3 Grade 4 Grade 5

Plant A JP + $0.14 JP + $0.11 JP + $0.09 JP + $0.05 JP – $0.02
Plant B JP + $0.16 JP + $0.12 JP + $0.07 JP + $0.06 JP – $0.03

Settlement Date Notional Amount Underlying Index

Jan forward January 30, 20X1 80,000 (lbs) JP
Jan forward January 30, 20X1 80,000 (lbs) JP
Feb forward February 28, 20X1 80,000 (lbs) JP
Mar forward March 30, 20X1 80,000 (lbs) JP
April forward April 30, 20X1 80,000 (lbs) JP
May forward May 30, 20X1 80,000 (lbs) JP
June forward June 30, 20X1 80,000 (lbs) JP
July forward July 30, 20X1 80,000 (lbs) JP
Aug forward August 30, 20X1 80,000 (lbs) JP
Sep forward September 30, 20X1 80,000 (lbs) JP
Oct forward October 30, 20X1 80,000 (lbs) JP
Nov forward November 30, 20X1 80,000 (lbs) JP
Dec forward December 30, 20X1 80,000 (lbs) JP

the hedging relationship and on an ongoing basis on the basis of the following
factors in accordance with paragraphs 815-20-25-84 through 25-85:
a. The hedging instrument’s underlying matches the index upon which plastic
purchases will be determined (that is, the JP Index).
b. The notional of the hedging instrument matches the forecasted quantity
designated as the hedged item.
c. The date on which the derivatives mature matches the timing in which the
forecasted purchases are expected to be made. That is, the quantity of the
hedged item, 80,000 pounds, is an aggregate amount expected to be
purchased over the course of the respective month (that is, the same
31-day period) in which the derivative matures.
d. Each hedging instrument was traded with at-market terms (that is, it has
an initial fair value of zero).
e. Assessment of effectiveness will be performed on the basis of the total
change in the fair value of the hedging instrument.
f. Although the amount of plastic being hedged each period is a cumulative
amount across multiple grades of plastic, the basis differentials between
grades of plastic and location are not required to be included in
assessments of effectiveness because Entity Q has designated the
variability in cash flows attributable to changes in the JP index (the
contractually specified component) as the hedged risk within its purchases
of plastics.

Question 9.4.40
Can the critical terms match method be applied to a
forecasted transaction that gives rise to a
receivable or payable that settles subsequently?
Background: A forecasted sale of goods expected to occur on a certain date
(e.g. September 30, Year 1) will give rise to an accounts receivable that will
settle later (e.g. October 31, Year 1). The company enters into a forward
contract that matures on September 30, Year 1 and hedges the cash flow
variability only up to the forecasted sale date.
Interpretive response: Yes, assuming all the criteria are met. The first criterion
of the critical terms match method requires that the forward or futures contact
settle at the same time as the hedged transaction. [815-20-25-84(a)]
In the background example, we believe this criterion is met because in effect
the forecasted sale transaction creates a cash inflow from the sale of the goods
and a simultaneous cash outflow for the financing of the sale on September 30,
Year 1. Therefore, a forward contract that hedges the forecasted sale
transaction and expires on September 30, Year 1 has the same cash settlement
date as the forecasted sale transaction.
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9. Hedge effectiveness

Question 9.4.50
Can the critical terms match method be applied if
the hedging instrument is a cross-currency interest
rate swap?
Background: A cross-currency interest rate swap (CCIRS) is a contractual
agreement between two parties to exchange fixed principal amounts of
currencies as well as periodic interest cash flows. For further discussion of
CCIRS, see section 2.6.20.
Interpretive response: We believe a receive-fixed, pay-fixed CCIRS designated
to hedge the foreign exchange risk in a fixed-rate foreign currency denominated
financial asset or liability is eligible for the critical terms match method for a
number of reasons.
— We believe the FASB intended that each general type of hedging
instrument be able to qualify for a less burdensome method of
documenting and assessing effectiveness – e.g. the shortcut method or the
critical terms match method. Because the shortcut method can only be
applied to interest rate swaps, it appears reasonable that a receive-fixed,
pay-fixed CCIRS is eligible for the critical terms match method.
— A CCIRS with two fixed legs has foreign exchange risk as the dominant risk
exposure and is not considered a compound derivative instrument. We
believe a compound derivative instrument (i.e. a derivative with more than
one underlying) is not eligible for the critical terms match method.
— The fair value of a CCIRS reacts to changes in currency rates similar to a
foreign currency forward contract. Therefore, economically a CCIRS is
similar to a foreign currency forward contract, which is eligible for the
critical terms match method.
We believe the following conditions should be met for the hedging relationship
to be eligible for the critical terms match method:
— the two currencies underlying the exchange rate of the CCIRS are the
entity’s functional currency and the currency in which the hedged foreign
currency financial asset or liability is denominated;
— the notional amount of the foreign currency leg of the CCIRS matches the
designated portion of the principal amount of the hedged transaction
throughout the term of the hedge;
— the interest payments on the foreign currency leg of the CCIRS match the
designated portion of the hedged interest payments (both timing and
amount);
— the maturity date of the CCIRS matches the final principal repayment date
of the hedged transaction; and
— the fair value of the CCIRS at hedge inception is zero.
Note: The principal amounts on the CCIRS will be exchanged at inception, but
the net effect of this exchange should be based on current spot rates and
therefore will be zero.
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9. Hedge effectiveness

Question 9.4.60
Does an entity consider counterparty
nonperformance risk when evaluating whether it is
probable that a forecasted transaction will occur?
Background: In order to apply cash flow hedge accounting, including the critical
terms match method, the hedged transaction has to be probable of occurring.
Interpretive response: Yes, an entity considers counterparty nonperformance
risk when evaluating whether it is probable that a forecasted transaction that is
part of a cash flow hedge will occur even if it uses the critical terms match
method. For further discussion of considering nonperformance credit risk, see
section 9.2.60. [815-20-35-10]

Question 9.4.70
Can the critical terms match method be applied to
an all-in-one hedge?
Background: In an all-in-one hedge, the hedged transaction and hedging
instrument are essentially the same (see section 5.3.90). In this hedging
relationship, a derivative 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.
Interpretive response: Yes, an entity can apply the critical terms match
method to an all in-one-hedge.
For example, Gas Co. enters into a forward contract (firm commitment) to
purchase natural gas for the daily purchase of 5,000 MMBTUs at a fixed price in
the month of January Year 10. The purchase contract does not qualify for the
normal purchases and normal sales scope exception and is accounted for as a
derivative. Gas Co. can document this transaction as an all-in-one hedge by
designating the forecasted purchase of 5,000 MMBTUs per day in January
Year 10 as the hedged transaction. The hedging instrument is the firm
commitment (i.e. the same transaction). Therefore, the critical terms of the
forecasted transaction and hedging instrument match.

9.4.40 Assessment
Applying the critical terms match method does not eliminate the requirement to
assess hedge effectiveness. However, it does eliminate the need to measure
hedge effectiveness quantitatively. [815-20-25-85]

Initial assessment
During the initial hedge effectiveness assessment, the entity determines
whether the critical terms of the hedging instrument and hedged transaction
match and that the other criteria for the critical terms match method are met.
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9. Hedge effectiveness

The entity documents its conclusion that the changes in the cash flows
attributable to the risk being hedged are expected to be completely offset by
changes in the cash flows of the hedging instrument. [815-20-25-85]
The extent of that assessment is based on judgment and varies depending on
the complexity of the derivative and hedged transaction. However, an entity
need not initially assess hedge effectiveness quantitatively. [815-20-25-85]

Subsequent assessments
An entity performs subsequent assessments by verifying and documenting that
the critical terms of the hedging instrument and the hedged transaction have
not changed during the assessment period. An entity also assesses whether
there have been adverse developments related to counterparty credit risk or the
entity’s own nonperformance risk related to the derivative hedging instrument.
The entity concludes and documents that the hedging relationship has been
perfectly effective if it determines that there have been no changes in: [815-20-25-
85, 35-10 – 35-11]

— critical terms; and

— creditworthiness of the counterparty to the derivative and the entity's own
nonperformance risk that would make the likelihood of the counterparty or
the entity not defaulting no longer probable.
In contrast, an entity discontinues the critical terms match method if: [815-20-
35-12]

— the critical terms of the hedging instrument or the hedged transaction no

longer match; or
— the likelihood that the counterparty or the entity will not default is no longer
probable.

Question 9.4.80
If the critical terms cease to match after hedge
inception, is an entity required to discontinue
hedge accounting?
Interpretive response: Not necessarily. If the critical terms of the hedging
instrument and the hedged transaction cease to match at any point, or if there
has been an adverse development regarding the risk of counterparty default, an
entity is required to assess whether the hedging relationship is expected to
continue to be highly effective using a quantitative assessment method. [815-20-
35-12]

If the hedging relationship is expected to continue to be highly effective based

on a quantitative effectiveness assessment, the hedging relationship may
continue with ongoing effectiveness assessments performed quantitatively.
The quantitative method may be selected when the criteria for the critical terms
match method is no longer met. It does not need to be preselected upon hedge
inception. See section 9.6.
Hedging 776
9. Hedge effectiveness

If the hedging relationship is not expected to continue to be highly effective

based on a quantitative effectiveness assessment, the hedging relationship is
required to be discontinued (see section 2.10.50). [815-20-35-12]

Question 9.4.90
How does an entity consider counterparty credit
risk or its own nonperformance risk when applying
the critical terms match method to a cash flow
hedge?
Interpretive response: Counterparty credit risk and the entity’s own
nonperformance risk are considered when applying the critical terms match
method to a cash flow hedge as follows.
Fair value of the forward or futures contract or option contract
An entity considers counterparty credit risk and its own nonperformance risk
when determining the fair value of the forward, futures or option contract. This
is the case regardless of whether it applies the critical terms match method.
[820-10]

The counterparty credit risk of an exchange-traded futures contract is generally

the credit risk of the futures exchange. [820-10]
See also KPMG’s Q&A: Fair value measurement, including:
— Section O, Application issues: Derivatives and hedging, including
Question O70, which provides additional information about whether (and
how) the requirements to include counterparty credit risk and an entity’s
own nonperformance risk in measuring the fair values of derivative
instruments affect hedging relationships.
— Question C70, which addresses how to consider the existence of a
separate arrangement (such as a master netting agreement or credit
support agreement) that mitigates credit risk exposure in the event of
default when measuring the fair value of a financial instrument.
Hedge inception
Comparable credit risk between the hedging instrument and the hedged
transaction is not necessary for a cash flow hedge to assume perfect
effectiveness for accounting purposes. The FASB allowed this accommodation
as a practical matter even though a perfect economic offset requires the
forward, futures or option contract and hedged transaction to have the same
credit risk.
Nonetheless, an ongoing expectation of high effectiveness is implicit in the
critical terms match method. Therefore, when applying this method, an entity
considers the likelihood of the counterparty complying with the hedging
instrument’s payment terms. [815-20-35-9]
We believe this guidance should also apply to the entity's own nonperformance
risk.
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9. Hedge effectiveness

Changes in counterparty credit risk and own nonperformance risk

When using the critical terms match method, an entity monitors hedges for
changes in counterparty credit risk and nonperformance risk. We believe an
entity may continue the critical terms match method if the likelihood that the
counterparty or the entity will not default continues to be probable. However, if
the likelihood that the counterparty or the entity will not default is no longer
probable, the entity should discontinue hedge accounting altogether. [815-20-35-
10 – 35-12]

If the entity can identify the date on which the counterparty or the entity not
defaulting became less than probable, the entity stops hedge accounting
prospectively from that day forward. If the entity cannot identify that date, it
does not apply hedge accounting for the entire reporting period in which the
counterparty or the entity not defaulting became less than probable.

9.5 Qualitative effectiveness assessments

9.5.10 Overview

Excerpt from ASC 815-20

>> Effectiveness Assessments on a Qualitative Basis

35-2A An entity may qualitatively assess hedge effectiveness if both of the
following criteria are met:
a. An entity performs an initial quantitative test of hedge effectiveness on a
prospective basis (that is, it is not assuming that the hedging relationship is
perfectly effective at hedge inception as described in paragraph 815-20-25-
3(b)(2)(iv)(01)(A) through (H)), and the results of that quantitative test
demonstrate highly effective offset.
b. At hedge inception, an entity can reasonably support an expectation of high
effectiveness on a qualitative basis in subsequent periods.
See paragraphs 815-20-55-79G through 55-79N for implementation guidance
on factors to consider when determining whether qualitative assessments of
effectiveness can be performed after hedge inception.
35-2B An entity may elect to qualitatively assess hedge effectiveness in
accordance with paragraph 815-20-35-2A on a hedge-by-hedge basis. If an
entity makes this qualitative assessment election, only the quantitative method
specified in an entity’s initial hedge documentation must comply with
paragraph 815-20-25-81.
>>> Eligibility of Hedging Relationships for Subsequent Qualitative
Effectiveness Assessments
55-79G An entity should use judgment in determining whether it can
reasonably support performing assessments of effectiveness after hedge
inception on a qualitative basis. That judgment should include careful
consideration of the following factors:
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9. Hedge effectiveness

a. Results of the quantitative assessment of effectiveness performed for the

hedging relationship.
b. Alignment of the critical terms of the hedging relationship. If one or more
of the critical terms of the hedging instrument and the hedged item are not
aligned, an entity should consider whether changes in market conditions
may cause the changes in fair values or cash flows of the hedging
instrument and hedged item or hedged forecasted transaction attributable
to the hedged risk to diverge as a result of those differences in terms.
1. In cases in which the underlyings of the hedged item and hedging
instrument are different, an entity should consider the extent and
consistency of the correlation exhibited between the changes in the
underlyings of the hedged item and hedging instrument.
i. This may inform the entity about whether expected changes in
market conditions could cause the changes in fair values or cash
flows of the hedging instrument and the hedged item or hedged
forecasted transaction attributable to the hedged risk to diverge.
Particularly in the context of reverting to qualitative assessments
of hedge effectiveness after being required to perform a
quantitative assessment (as discussed in paragraph 815-20-35-2D),
this may inform an entity about whether there is a reasonable
expectation that the hedging relationship is expected to remain
stable or whether that divergence is expected to continue or recur
in the future.
ii. A specific event or circumstance may cause a temporary
disruption to the market that results in an entity concluding that
the facts and circumstances of the hedging relationship have
changed such that it no longer can assert qualitatively that the
hedging relationship was and continues to be highly effective. In
those instances, if the results of the quantitative assessment of
effectiveness do not significantly diverge from the results of the
initial assessment of effectiveness, that market disruption should
not prevent the entity from returning to qualitative testing in
subsequent periods. If the results of the quantitative assessment
of effectiveness do significantly diverge from the results of the
initial assessment of effectiveness, the entity should continually
monitor whether the temporary market disruption has been
resolved when determining whether to return to qualitative testing
in subsequent periods.

Topic 815 permits an entity to perform its subsequent effectiveness

assessments on a qualitative (rather than quantitative) basis if certain criteria are
met.
To elect to perform quarterly effectiveness assessments qualitatively, both of
the following criteria must be met: [815-20-35-2A]

Criterion 1 An initial quantitative test of hedge effectiveness on a prospective

basis is performed and demonstrates highly effective offset.

Criterion 2 At hedge inception, the entity can reasonably support an

expectation of high effectiveness on a qualitative basis in
subsequent periods.
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9. Hedge effectiveness

An entity uses judgment to determine whether it can reasonably support an

expectation of high effectiveness on a qualitative basis after hedge inception.
Factors to consider include: [815-20-55-79G, ASU 2017-12.BC202]
— the results of the quantitative assessment of effectiveness performed for
the hedging relationship at hedge inception; and
— how well the critical terms of the hedging relationship are aligned.
When the critical terms are not aligned, an entity considers additional factors.
[815-20-55-79G]

Critical terms that are not Factor(s) to consider

aligned
Critical terms of the hedging — Whether changes in market conditions may
instrument and the hedged cause the changes in fair values or cash flows
item are not aligned – e.g. of the hedging instrument and hedged item or
underlyings, notional amounts, hedged transaction attributable to the hedged
maturities, quantities, risk to diverge as a result of those differences
locations, delivery dates in terms.
Underlyings of the hedged — The extent and consistency of the correlation
item and hedging instrument exhibited between the changes in the
are different. underlyings of the hedged item and hedging
instrument.
— As part of this evaluation, the entity considers
whether expected changes in market
conditions are anticipated to prevent the
hedging relationship from achieving highly
effective offset.

Formal documentation. When an entity elects qualitative effectiveness

assessments, its initial hedge documentation is required to specify a
quantitative method that will be used to assess effectiveness if facts and
circumstances change and the entity is required to assess effectiveness
quantitatively. This method is required to be the same as that used to support
the entity’s initial prospective hedge effectiveness assessment. See
section 2.9.30. [815-20-25-3(b)(2)(iv)(03)]
An entity is permitted to elect qualitative effectiveness assessments on a
hedge-by-hedge basis, rather than being required to assess all similar hedges
on a qualitative basis. However, if quantitative effectiveness assessments are
required due to changes in facts and circumstances, the same quantitative
method is required for similar hedges (see Question 9.2.210). [815-20-35-2B]

Question 9.5.10
When the hedging relationship does not have
perfect offset, how does an entity reasonably
support its expectation of high effectiveness on a
qualitative basis in subsequent periods?
Interpretive response: A hedging relationship may not achieve perfect offset
on a quantitative basis because some of the critical terms of the hedged item
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9. Hedge effectiveness

and the hedging instrument are not aligned – e.g. when the underlying of the
hedged item and hedging instrument are different.
In this circumstance, it may be more difficult for an entity to reasonably support
an expectation of high effectiveness on a qualitative basis at hedge inception
based on the factors the entity is required to consider under Topic 815.
Additionally, it may be more difficult to determine when it is no longer
appropriate to perform qualitative (rather than quantitative) assessments in
subsequent periods; see Question 9.5.20 for factors to consider to be able to
assert qualitatively that the hedge was and continues to be highly effective.
An entity should also consider the nature of its selected quantitative method for
assessing effectiveness when evaluating the effect of known changes in
relationships. For example, when the dollar-offset method is used, if the
hedging instrument and the hedged transaction involve small dollar amounts
but large percentages, small changes can result in the hedge not being
perfectly effective. Conversely, an unusual change in the relationship that
occurred during a period may not result in a lack of high effectiveness under
regression analysis (e.g. because many data points are regressed). Such an
unusual change may indicate that solely qualitative analyses are no longer
appropriate. Additionally, when they occur over periods of time, small changes
in each period may cumulatively cause the relationship between a hedging
instrument and hedged item or transaction to cease being highly effective,
regardless of the method used.
When evaluating whether the hedging relationship will be highly effective
prospectively, an entity is required to consider all reasonably possible scenarios.
[815-20-25-79(a)]

When some of the terms of the hedged item and the hedging instrument are
different (see section 9.2.10 for examples of terms that are not aligned), we
believe performing qualitative hedge effectiveness assessments includes
monitoring whether the conditions in the subsequent periods are consistent
with the conditions that were evaluated to support the initial determination that
a qualitative assessment approach was appropriate. We also believe all factors
that affect hedge effectiveness should be considered when evaluating whether
an assertion of high effectiveness in subsequent periods is reasonably
supported. For example, an entity is required to measure the fair value of both
the hedging instrument and the fair value of the hedged item attributable to the
hedged risk in a fair value hedge for purposes of accounting for the fair value
hedge (see chapter 4); an entity should not disregard information obtained for
this purpose when performing a qualitative hedge effectiveness assessment.
An entity may find it useful to include in its initial prospective assessment
hypothetical scenarios that simulate changes in factors that affect hedge
effectiveness to see whether the relationship still meets the highly effective
threshold in each of the hypothetical scenarios. For example, if the underlyings
in the hedged item and the hedging instrument are not aligned, identifying the
extent of movements in those underlyings (whether in the same or opposite
directions) that cause the relationship to cease being highly effective would
allow the entity to compare the movements in subsequent periods to those in
the hypothetical scenarios to demonstrate that those movements did not cause
the relationship to cease being highly effective.
Hedging 781
9. Hedge effectiveness

Formal documentation. We believe an entity should document its

consideration of factors considered in support of its assertion that it could
reasonably support its expectation of high effectiveness.

Examples
The following FASB examples (paragraphs 815-20-55-79H to 55-79N)
demonstrate when an expectation of high effectiveness can be reasonably
supported in subsequent periods. It is followed by Example 9.5.10, adapted in
part from the FASB examples to further illustrate when this expectation can be
reasonably supported.

Excerpt from ASC 815-20

>>> Eligibility of Hedging Relationships for Subsequent Qualitative

Effectiveness Assessments
55-79H In the following scenarios, assume that the entity is required to
perform a quantitative assessment of effectiveness at hedge inception in
accordance with paragraph 815-20-25-3(b)(2)(iv)(01). For each scenario, a
discussion of whether the entity could reasonably support performing
qualitative assessments of effectiveness is included in paragraphs 815-20-55-
79L through 55-79N.
>>>> Scenario A
79-I The following factors are present in the hedging relationship:
a. The results of the initial or most recent quantitative assessment of
effectiveness performed indicate that the hedging relationship is close to
achieving perfect offset.
b. All critical terms of the hedging relationship match except for the
underlyings of the hedged item and hedging instrument.
1. The changes in the underlyings of the hedged item and hedging
instrument have been consistently highly correlated such that expected
changes in market conditions are not anticipated to prevent the
hedging relationship from achieving highly effective offset.
>>>> Scenario B
55-79J The following factors are present in the hedging relationship:
a. The results of the initial or most recent quantitative assessment of
effectiveness performed indicate that the hedging relationship is close to
failing the effectiveness test.
b. All critical terms of the hedging relationship match except for the
underlyings of the hedged item and the hedging instrument.
1. The changes in the underlyings of the hedged item and the hedging
instrument have not been consistently highly correlated such that
expected changes in market conditions could prevent the hedging
relationship from achieving highly effective offset.
Hedging 782
9. Hedge effectiveness

>>>> Scenario C
55-79K The following factors are present in the hedging relationship:
a. The results of the initial or most recent quantitative assessment of
effectiveness performed indicate that the hedging relationship is neither
close to achieving perfect offset nor close to failing the effectiveness test.
b. All critical terms of the hedging relationship match except for the
underlyings of the hedged item and the hedging instrument.
1. The changes in the underlyings of the hedged item and the hedging
instrument have not been consistently highly correlated such that
expected changes in market conditions could prevent the hedging
relationship from achieving highly effective offset.
55-79L In Scenario A, the entity could reasonably support performing
qualitative assessments of effectiveness. The quantitative assessment of
effectiveness was close to achieving perfect offset and past observations of
changes in the underlyings of the hedged item and hedging instrument (that is,
the only critical term that did not match) consistently exhibited high correlation.
This indicates that the results of subsequent assessments of effectiveness
may not significantly differ from those observed from the assessment of
effectiveness performed at hedge inception.
55-79M In Scenario B, the entity could not reasonably support performing
qualitative assessments of effectiveness. The lack of consistent high
correlation exhibited between the changes in the underlyings of the hedged
item and the hedging instrument could prevent the entity from concluding that
the results of subsequent assessments of effectiveness will be similar to the
results observed from the initial assessment of effectiveness. Had the changes
in underlyings of the hedged item and the hedging instrument been
consistently highly correlated, the entity may conclude that it is still unable to
reasonably support performing subsequent assessments of effectiveness on a
qualitative basis. Because the hedging relationship is close to failing its
quantitative assessment, minimal changes in the relationship between the
hedged item and hedging instrument could result in the hedging relationship
not being highly effective.
55-79N In Scenario C, the entity could not reasonably support performing
qualitative assessments of effectiveness. Although this hedging relationship is
not close to failing the quantitative assessment of effectiveness as in Scenario B,
the lack of consistent high correlation exhibited between the changes in the
underlyings of the hedged item and the hedging instrument prevent the entity
from concluding that the results of subsequent assessments of effectiveness
will be similar to the results observed from the initial or most recent quantitative
assessment of effectiveness. Had the changes in value of the underlyings of the
hedged item and the hedging instrument consistently been highly correlated, the
entity may conclude that it could reasonably support performing subsequent
assessments of effectiveness on a qualitative basis.
Hedging 783
9. Hedge effectiveness

Example 9.5.10
Whether an expectation of high effectiveness can be
reasonably supported in subsequent periods
The following example is adapted in part from scenarios A to C in
paragraphs 815-20-55-79H to 55-79N.
ABC Corp. performs a quantitative assessment of effectiveness at hedge
inception for five hedging relationships (Hedges A – E). In each hedging
relationship, all critical terms match except the underlyings of the hedged item
and hedging instrument.
The following table summarizes each relationship and discusses whether an
expectation of high effectiveness in subsequent periods can be reasonably
supported.

Extent and
Results of consistency of
initial correlation Do initial testing results and
quantitative between evaluation of correlation indicate
effectiveness changes in the potential for an expectation of
assessment underlyings high effectiveness?
Hedge A Close to Changes have Yes. The high degree of offset
achieving been achieved and the high correlation
perfect consistently between changes in the underlyings
offset. highly indicate that the results of
correlated. subsequent quarterly hedge
effectiveness assessments may not
significantly differ from those
observed at hedge inception. [815-20-
55-79I, 55-79L]

Hedge B Close to Changes have No. The lack of consistent high

failing not been correlation between changes in the
effectiveness consistently underlyings precludes a conclusion
test. highly that subsequent quarterly hedge
correlated. effectiveness assessments will be
similar to the results observed at
hedge inception. [815-20-55-79J,
55-79M]

Hedge C Close to Changes have Maybe not. Although the changes in

failing been underlyings are consistently highly
effectiveness consistently correlated, the relationship is close to
test. highly failing, so minimal changes in the
correlated. relationship between the hedged item
and hedging instrument could result
in the hedging relationship not being
highly effective. [815-20-55-79J, 55-79M]
Hedge D Neither close Changes have No. The lack of consistent high
to achieving not been correlation between changes in the
perfect offset consistently underlyings precludes a conclusion
nor close to highly that subsequent quarterly hedge
failing correlated. effectiveness assessments will be
effectiveness similar to the results observed at
test. hedge inception. [815-20-55-79K,
55-79N]
Hedging 784
9. Hedge effectiveness

Extent and
Results of consistency of
initial correlation Do initial testing results and
quantitative between evaluation of correlation indicate
effectiveness changes in the potential for an expectation of
assessment underlyings high effectiveness?
Hedge E Neither close Changes have Yes. The high degree of offset
to achieving been achieved and the high correlation
perfect offset consistently between changes in the underlyings
nor close to highly indicate that the results of
failing correlated. subsequent quarterly hedge
effectiveness effectiveness assessments may not
test. significantly differ from those
observed at hedge inception. [815-20-
55-79K, 55-79N]

9.5.20 Changes in facts and circumstances

Excerpt from ASC 815-20

>> Effectiveness Assessments on a Qualitative Basis

35-2C When an entity performs qualitative assessments of hedge
effectiveness, it shall verify and document whenever financial statements or
earnings are reported and at least every three months that the facts and
circumstances related to the hedging relationship have not changed such that
it can assert qualitatively that the hedging relationship was and continues to be
highly effective. While not all-inclusive, the following is a list of indicators that
may, individually or in the aggregate, allow an entity to continue to assert
qualitatively that the hedging relationship is highly effective:
a. An assessment of the factors that enabled the entity to reasonably support
an expectation of high effectiveness on a qualitative basis has not changed
such that the entity can continue to assert qualitatively that the hedging
relationship was and continues to be highly effective. This shall include an
assessment of the guidance in paragraph 815-20-25-100 when applicable.
b. There have been no adverse developments regarding the risk of
counterparty default.
35-2D If an entity elects to assess hedge effectiveness on a qualitative basis
and then facts and circumstances change such that the entity no longer can
assert qualitatively that the hedging relationship was and continues to be highly
effective in achieving offsetting changes in fair values or cash flows, the entity
shall assess effectiveness of that hedging relationship on a quantitative basis in
subsequent periods. In addition, an entity may perform a quantitative
assessment of hedge effectiveness in any reporting period to validate whether
qualitative assessments of hedge effectiveness remain appropriate. In both
cases, the entity shall apply the quantitative method that it identified in its
initial hedge documentation in accordance with paragraph 815-20-25-
3(b)(2)(iv)(03).
Hedging 785
9. Hedge effectiveness

35-2E When an entity determines that facts and circumstances have changed
and it no longer can assert qualitatively that the hedging relationship was and
continues to be highly effective, the entity shall begin performing subsequent
quantitative assessments of hedge effectiveness as of the period that the facts
and circumstances changed. If there is no identifiable event that led to the
change in the facts and circumstances of the hedging relationship, the entity
may begin performing quantitative assessments of effectiveness in the current
period.
35-2F After performing a quantitative assessment of hedge effectiveness for
one or more reporting periods as discussed in paragraphs 815-20-35-2D
through 35-2E, an entity may revert to qualitative assessments of hedge
effectiveness if it can reasonably support an expectation of high effectiveness
on a qualitative basis for subsequent periods. See paragraphs 815-20-55-79G
through 55-79N for implementation guidance on factors to consider when
determining whether qualitative assessments of effectiveness can be
performed after hedge inception.

When an entity elects to perform quarterly hedge effectiveness assessments

on a qualitative basis, it may perform subsequent quarterly assessments on a
qualitative basis as long as it qualifies to do so (see section 9.2.20). Therefore,
during each quarterly assessment, an entity determines whether it qualifies to
perform the assessment on a qualitative basis under the current facts and
circumstances. [815-20-35-2C]
If facts and circumstances change, an entity may no longer be able to assert
qualitatively that the hedging relationship was and continues to be highly
effective. In that situation, the entity is required to assess effectiveness using
the quantitative method identified in the hedge documentation at inception (see
section 2.9.30). [815-20-35-2D]

Question 9.5.20
Under what circumstances is a subsequent
quantitative assessment required if an entity
initially elects to perform qualitative assessments?
Interpretive response: Determining whether the facts and circumstances have
changed such that an entity is required to perform a quarterly hedge
effectiveness assessment on a quantitative (rather than qualitative) basis
requires judgment. In making this determination, an entity should consider
whether: [815-20-35-2C, ASU 2017-12.BC203]
— the factors assessed at inception of the hedging relationship that enabled
the entity to reasonably support an expectation of high effectiveness on a
qualitative basis have changed; and
— there have been any adverse developments in the risk of counterparty
default.
Hedging 786
9. Hedge effectiveness

Question 9.5.30
If required, for what periods are subsequent
quantitative assessments performed?
Interpretive response: Quantitative assessments (if required) are performed
beginning as of the period in which facts and circumstances changed such that
the entity can no longer support qualitatively that the relationship is highly
effective.
— If there is an identifiable event that led to the change, the quantitative
assessments are performed beginning in the period that includes that
event.
— If there is no identifiable event that led to the change, the quantitative
assessments may begin in the current period.
Quantitative assessments are performed for each period thereafter unless it is
appropriate to revert to qualitative effectiveness assessments in a future period
(see Question 9.5.50). [815-20-35-2F]
See also Question 9.5.10 regarding how to support an expectation of high
effectiveness when a relationship does not have perfect offset and
Question 9.5.40 regarding the consequence of failing to timely identify that
such an expectation is not supported.

Question 9.5.40
What is the consequence of failing to identify that
an entity could not reasonably support performing
qualitative assessments in a prior period?
Interpretive response: If an entity fails to identify that it was not appropriate to
apply the qualitative method in a prior period(s), the quantitative assessment
approach documented at hedge inception is used to determine whether the
relationship was highly effective in that period(s).
The guidance in Topic 250 (accounting changes and errors) on accounting errors
is also applied, and the determination of the error depends on whether the
relationship was highly effective in the prior period(s) affected.
— Not highly effective. If the relationship was not highly effective in prior
reporting periods, the amount of the error is the difference between not
applying hedge accounting and the results recorded in the prior reporting
period. [ASU 2017-12.BC215]
— Highly effective. If the relationship was highly effective and the hedged
item (for a fair value hedge) and hedging instrument are measured properly,
there is no error. However, an error will result if either of these is measured
incorrectly. The nature of any error differs between cash flow and fair value
hedges.
Hedging 787
9. Hedge effectiveness

Fair value hedge Cash flow hedge

The hedged item and/or the hedging The hedging instrument may not have
instrument may not have been been measured appropriately if its
measured appropriately if their characteristics (including consideration
characteristics (including consideration of credit risk) were not properly defined
of credit risk) were not properly defined in the prior reporting periods. This would
in the prior reporting periods. This result in the hedging instrument’s
would result in the recorded amounts recorded amount and the related
for the hedged item and/or the hedging amount recorded in AOCI being
instrument – along with the related incorrect.
gains (losses) recognized in net income
– being incorrect.

In both circumstances, the entity also evaluates the severity of any control
deficiencies related to the failure to identify the inappropriate use of the
qualitative approach.
See KPMG’s ICFR reference guide for insights on assessing internal controls
over financial reporting, including evaluating deficiencies.

Question 9.5.50
May an entity performing quantitative effectiveness
assessments revert to qualitative effectiveness
assessments?
Interpretive response: Yes. An entity that initially elects to perform qualitative
effectiveness assessments may be required (or may elect) to perform a
quantitative effectiveness assessment in a subsequent period(s). In this case, it
may revert to performing qualitative effectiveness assessments once it can
reasonably support an expectation of high effectiveness on a qualitative basis
for subsequent periods. In making this determination, the entity considers the
same factors that it considered when making the initial election to perform
qualitative assessments (see section 9.5.10). [815-20-35-2E – 35-2F]
The FASB considered whether returning to qualitative effectiveness
assessments should be prohibited. However, it decided that not all
circumstances requiring an entity to perform quantitative assessments mean
that facts and circumstances have changed to such a degree that performing
qualitative assessments is no longer reliable. Rather, some changes in facts and
circumstances may be the result of a “temporary market disruption or an
anomalous or infrequent event that is not expected to recur.” As a result, the
FASB concluded that an entity may revert to performing qualitative
effectiveness assessments if it can reasonably support an expectation of high
effectiveness on a qualitative basis in subsequent periods. [815-20-35-2F, ASU 2017-
12.BC204–BC206]

FASB Examples
The following FASB examples (815-20-55-79P to 55-79V) demonstrate when it
may or may not be appropriate to revert to qualitative assessments after
performing quantitative assessments.
Hedging 788
9. Hedge effectiveness

Excerpt from ASC 815-20

>>> Change in Facts and Circumstances in Qualitative Effectiveness

Assessments
>>>> Scenario A
55-79P Entity B expects to purchase 10,000 metric tons of cottonseed meal
throughout April 20X3 based on the spot price of the cottonseed meal index on
the respective date of each purchase. Entity B wants to hedge the variability in
cash flows attributable to changes in the cottonseed meal index on the price
that it will pay for the cottonseed meal. It enters into a forward contract on
August 24, 20X1, with a notional of 10,000 metric tons, a maturity of April 1,
20X3, and an underlying of the soybean meal index because no market exists
for derivatives indexed to the cottonseed meal index. Concurrent with the
execution of the forward, Entity B designates the forward as the hedging
instrument in a hedging relationship in which the hedged item is documented
as the forecasted purchases of the first 10,000 metric tons of cottonseed meal
expected to be purchased during April 20X3 and the hedged risk is
documented as the variability in cash flows attributable to changes in the
contractually specified cottonseed meal index in the not-yet-existing contract.
On August 24, 20X1, Entity B determines that all requirements for cash flow
hedge accounting are met and that the requirements of paragraph 815-20-25-
22A will be met in the contract once executed in accordance with
paragraph 815-20-25-22B. Entity B also will assess whether the criteria in 815-
20-25-22A are met in the contract when it is executed.
55-79Q Because the hedged risk and forward contract are based on different
indexes, the hedging relationship does not qualify for one of the exemptions in
paragraph 815-20-25-3(b)(2)(iv)(01). Entity B performs an initial quantitative
hedge effectiveness assessment and determines that the hedging instrument
is highly effective at achieving offsetting cash flows associated with the
hedged item attributable to the hedged risk. In Entity B’s hedge
documentation, it elects to perform subsequent assessments of hedge
effectiveness on a qualitative basis. It makes this election based on the
following factors:
a. The results of the quantitative effectiveness assessment performed at
hedge inception indicate that the hedging relationship is close to achieving
perfect offset.
b. Changes in the value of the cottonseed meal index have been consistently
highly correlated with changes in value of the soybean meal index such
that expected changes in market conditions are not anticipated to prevent
the hedging relationship from achieving highly effective offset.
c. Although the underlyings of the hedging instrument and hedged item do
not match, the notional amount of the derivative and the expected quantity
to be purchased do match. Based on the quantitative effectiveness
assessment, Entity B also determined that the difference in timing
between the maturity date of the derivative and the dates on which the
group of forecasted purchases is expected to occur is insignificant.
55-79R During the fourth quarter of 20X1, a storm damages the soybean
harvest, which leads to a shortage in soybean meal supply and a sharp
Hedging 789
9. Hedge effectiveness

increase in the price of soybean meal based on the soybean meal index. The
cottonseed meal index has not experienced a similar increase because cotton
harvests were unaffected by the storm that damaged the soybean harvest.
Because the increase in the soybean meal index is not reflected in the
cottonseed meal index, Entity B concludes that a change in facts and
circumstance has occurred that prevents a qualitative assertion in subsequent
periods that the hedging relationship continues to be highly effective at
achieving offsetting cash flows. Thus, on the next subsequent effectiveness
assessment date (December 31, 20X1), the company begins performing
quantitative assessments of hedge effectiveness based on the method used to
perform the initial prospective assessment of effectiveness. In the
effectiveness assessment performed on December 31, 20X1, Entity B
determines that the hedging relationship remains highly effective but that it is
not close to achieving perfect offset.
55-79S Entity B returns to assessing effectiveness qualitatively as of June 30,
20X2, because the evaluation of the following criteria leads to the conclusion
that high effectiveness can be asserted prospectively on a qualitative basis:
a. Entity B determines that the event that caused the soybean meal index
and cottonseed meal index to experience a lack of correlation was
temporary, that it was an isolated weather event, and the effect of the
weather event has passed.
b. The changes in value of the soybean meal index and cottonseed meal
index reverted to levels of correlation that were consistent with those
before the storm.
c. The results of the June 30, 20X2 quantitative assessment of effectiveness
are in line with the results of the quantitative assessment of effectiveness
performed at hedge inception.
d. No further disruptions in supply are expected.
>>>> Scenario B
55-79T On August 17, 20X1, Entity C issues at par a $100 million 5-year fixed-
rate noncallable debt instrument with an annual 8 percent interest coupon. On
that date, Entity C enters into a 5-year interest rate swap with Financial
Institution D and designates it as the hedging instrument in a fair value hedge
of the LIBOR interest rate risk of the $100 million liability. Under the terms of
the interest rate swap, Entity C will receive fixed interest at 6 percent and pay
variable interest at LIBOR based on a notional amount of $100 million. The
variable leg of the interest rate swap resets at the end of each quarter for the
interest payment that is due at the end of the following quarter.
55-79U Entity C performs the initial quantitative and first subsequent hedge
effectiveness assessments on September 30 (the entity’s first quarterly testing
date after hedge inception) and determines that the hedging relationship is
highly effective at achieving offsetting changes in fair value attributable to
interest rate risk. Entity C also elects at hedge inception to subsequently
assess hedge effectiveness on a qualitative basis and documents how it would
carry out that qualitative assessment. In its quarterly effectiveness assessment
on December 31, the entity asserts that facts and circumstances related to the
hedging relationship have not changed and the hedging relationship was and
continues to be highly effective.
Hedging 790
9. Hedge effectiveness

55-79V However, in the first quarter of 20X2, Financial Institution D’s risk of
default significantly increases, which affects the valuation of the interest rate
swap with Entity C. Entity C notes that it no longer can qualitatively assert that
the hedging relationship was and continues to be highly effective at achieving
offsetting changes in fair value attributable to changes in benchmark interest
rates. Thus, on the next subsequent effectiveness assessment date
(March 31, 20X2), Entity C begins performing quantitative assessments of
effectiveness using the method documented at hedge inception. In
subsequent periods, Entity C does not return to qualitative effectiveness
assessments because it cannot reasonably support an expectation of high
effectiveness on a qualitative basis for the following reasons:
a. The significant risk of default of Financial Institution D has not reversed and
is not expected to be temporary.
b. The results of quantitative effectiveness tests performed indicate that the
hedging relationship is close to no longer being highly effective.

9.6 Quantitative methods of assessing effectiveness

9.6.10 Overview

Excerpt from ASC 815-20

>> Hedge Effectiveness—After Designation

35-2 If a fair value hedge or cash flow hedge initially qualifies for hedge
accounting, the entity would continue to assess whether the hedge meets the
effectiveness test on either a quantitative basis (using either a dollar-offset test
or a statistical method such as regression analysis) or a qualitative basis. See
paragraphs 815-20-35-2A through 35-2F for additional guidance on qualitative
assessments of effectiveness. If the hedge fails the effectiveness test at any
time (that is, if the entity does not expect the hedge to be highly effective at
achieving offsetting changes in fair values or cash flows), the hedge ceases to
qualify for hedge accounting. At least quarterly, the hedging entity shall
determine whether the hedging relationship has been highly effective in having
achieved offsetting changes in fair value or cash flows through the date of the
periodic assessment.
35-4 Electing to use a regression or other statistical analysis approach instead
of a dollar-offset approach to perform retrospective evaluations of assessing
hedge effectiveness may affect whether an entity can apply hedge accounting
for the current assessment period.
>>> Methodologies to Assess Effectiveness of Fair Value and Cash Flow
Hedges
55-68 As discussed in paragraph 815-20-25-80, if an entity assesses hedge
effectiveness on a quantitative basis and elects at the inception of a hedging
relationship to utilize a regression analysis approach for prospective
considerations of assessing effectiveness and the dollar-offset method to
perform retrospective evaluations of assessing effectiveness, then that entity
Hedging 791
9. Hedge effectiveness

must abide by the results of that methodology as long as that hedging

relationship remains designated. Thus, in its retrospective evaluation, an entity
might conclude that, under a dollar-offset approach, a designated hedging
relationship does not qualify for hedge accounting for the period just ended,
but that the hedging relationship may continue because, under a regression
analysis approach, there is an expectation that the relationship will be highly
effective in achieving offsetting changes in fair value or cash flows in future
periods. In its retrospective evaluation, if that entity concludes that, under a
dollar-offset approach, the hedging relationship has not been highly effective in
having achieved offsetting changes in fair value or cash flows, hedge
accounting may not be applied in the current period. Whenever a hedging
relationship fails to qualify for hedge accounting in a certain assessment
period, the overall change in fair value of the derivative instrument for that
current period is recognized in earnings (not reported in other comprehensive
income for a cash flow hedge) and the change in fair value of the hedged item
would not be recognized in earnings for that period (for a fair value hedge).

This section discusses the quantitative approach to assessing hedge

effectiveness by explaining the common methods used when that approach is
applied. Previous sections of this chapter discuss the other methods of
effectiveness testing, including:
— the qualitative approach (section 9.5);
— shortcut method (section 9.3); and
— critical terms match method (section 9.4).
Topic 815 does not prescribe which quantitative method should be used to
perform effectiveness assessments. Instead, Topic 815 provides an entity with
flexibility in determining the method to use for assessing hedge effectiveness,
provided the method is reasonable and is defined and documented at the
inception of the hedging relationship. In addition, the chosen quantitative
method needs to be consistent with the hedging strategy (see section 9.2.30).
Unlike the approaches listed above, there are no pre-conditions for electing a
quantitative approach, aside from the documentation requirements. Rather, it is
the fall-back approach when a hedging relationship does not qualify for any
other approach. But even when other approaches are allowable, an entity can
still elect to use the quantitative approach, and may even prefer to.
The two common quantitative methods are dollar-offset and statistical analysis,
with the most common statistical analysis being a regression analysis. Either of
these methods can be used in both the prospective and retrospective hedge
effectiveness assessments. Alternatively, an entity may use one method for the
prospective assessment and the other method for the retrospective
assessment (see Question 9.2.40).
Each of the dollar-offset and statistical analysis methods has advantages and
disadvantages. Moreover, each method may yield different results when
applied to the same hedging relationship. Therefore, because the results of
effectiveness assessments determine whether the entity can continue to apply
hedge accounting, the selection of the right method to assess effectiveness at
the inception of the hedging relationship should be carefully considered. [815-20-
35-4]
Hedging 792
9. Hedge effectiveness

The following diagram summarizes some main advantages and disadvantages

of selecting dollar-offset versus statistical analysis (e.g. regression).

Advantages Disadvantages

— Only considers data for the most

recent assessment period
— Limited elapsed time period may
increase the likelihood that an
unusual event or short-term
Dollar-offset Mathematically simple and volatility could result in a hedge
(section 9.6.20) easy to interpret results not being highly effective over a
short period
— Impact of ‘law of small numbers’
less likely to demonstrate hedge is
highly effective (see Question
9.6.40)

— Historical data can be used to

Statistical develop an assessment of
analysis effectiveness
Difficult to apply and interpret the
(e.g. — Using a longer timeframe results
regression) reduces the effect of short-
(section 9.6.30) term volatility or unusual
events

An entity chooses and documents a method at the inception of a hedging

relationship. It cannot switch from one method to another without
dedesignating the hedging relationship (see section 9.6.40).
The following guidance discussed in previous sections also applies for the
quantitative assessments of hedge effectiveness:
— An entity is permitted to exclude some components of a hedging
instrument from its effectiveness assessments (see section 9.2.70).
— An entity is required to use the same assessment method for similar
hedging relationships, including whether any components are excluded (see
section 9.2.80).
— An entity should consider the effect of counterparty credit risk (entity’s own
nonperformance risk) on hedging relationships (see section 9.2.60).
— An entity generally is required to discontinue a hedging relationship if the
results of retrospective testing indicate the relationship was not highly
effective (see section 2.10.50). However, if a hedging relationship was not
highly effective retrospectively, but is expected to be highly effective
prospectively, hedge accounting is not necessarily required to be
discontinued (see Question 2.10.90).
Formal documentation. Because Topic 815 provides for alternative methods
and those methods have various application possibilities, an entity is required to
document at the inception of a hedging relationship its decision about how it
will assess effectiveness both on a retrospective and prospective basis. See
section 2.9 for further discussion of the formal hedge documentation
requirements.
Hedging 793
9. Hedge effectiveness

Question 9.6.10
Why might an entity elect to use a quantitative
method, even if the hedging relationship is eligible
for a different method?
Interpretive response: Quantitative methods tend to be more complex to
apply in practice than other methods. However, an entity may choose to apply a
quantitative method – even if the hedging relationship is eligible for another
method – due to limitations of, or cost considerations related to, the other
effectiveness methods. For example:
— Using a quantitative method may mitigate the risk of being required to
discontinue hedge accounting and/or of misapplying other methods such as
the shortcut method or qualitative method.
— If an entity has a large number of hedging relationships, it may have
systems and processes in place that are capable of performing timely
quantitative tests for all hedges. In these situations, it may be more
efficient for an entity to apply quantitative methods to all of its hedging
relationships than the other available methods (e.g. the qualitative method
described in section 9.5).
— Practical implications of applying a qualitative approach, where the
assessment of effectiveness may not be easily determined qualitatively,
requires a level of judgment, and quarterly documentation of those
judgments, as well as additional processes and controls and monitoring
efforts.

Question 9.6.20
Can an entity choose different effectiveness
assessment methods each period based on the
expected outcome?
Interpretive response: No. An entity is required to document its planned
method of assessing hedge effectiveness at the inception of the hedging
relationship as part of its formal documentation (see requirements in
section 2.9). The documentation should be specific as to which method will
be used for retrospective and prospective effectiveness testing. Moreover, this
documented method must be used throughout the hedging relationship.
Additionally, an entity is not permitted to document that it will use a variety of
different techniques for the prospective assessment (or the retrospective
assessment), depending on the circumstances at the time of the testing.
For example, an entity may believe that the effectiveness of the hedging
relationship will significantly change if there are unexpected movements in the
fair value or cash flows of the hedged item or transaction or the hedging
instrument. However, it cannot devise and document a variety of effectiveness
tests whereby one method would be used in certain cases while another
method would be used in other cases.
Hedging 794
9. Hedge effectiveness

Question 9.6.30
Which technique for assessing hedge effectiveness
is more prevalent?

Interpretive response: It is our understanding that more entities choose to use

regression analysis in their retrospective and prospective hedge effectiveness
assessments.
While it is more difficult to apply and understand the results (see
Questions 9.6.80 and 9.6.90), regression analysis is generally regarded as
advantageous because it allows an entity to use historical data for periods
before the inception of the hedge for both the initial and subsequent
effectiveness assessments. In contrast, in applying the dollar-offset method for
the ongoing retrospective effectiveness assessment, only data from the hedge
period is considered.
For example, an entity is retrospectively assessing hedge effectiveness at the
end of the first reporting period after inception of a hedging relationship (i.e. one
quarter after inception) and the changes in the fair value or cash flows of the
hedging instrument during the period did not effectively offset the changes in
the fair value or cash flows of the hedged item or transaction.
— Dollar-offset. If the entity initially chose to use the dollar-offset method in
its retrospective assessment, it would be required to conclude that the
designated hedging relationship would not qualify for hedge accounting for
the period just ended.
— Statistical analysis (regression). If the entity initially chose to use a
statistical analysis based on a trailing 12-month period, which at the end of
the first quarter after hedge inception includes three months of the hedge
period and nine months before the hedge period, it may be able to conclude
that the designated hedging relationship qualifies for hedge accounting for
the period just ended. This is because the results of the nine months
preceding the hedge period may negate the unfavorable hedge results of
the most recent three months.
The hedge effectiveness testing results in this example – where one method
(statistical analysis) supports hedge accounting while another method (dollar-
offset) does not – is neither uncommon nor incorrect. Instead, it serves to
highlight the importance of the selection of a method.

9.6.20 Dollar-offset method

Excerpt from ASC 815-20

>> Quantitative Hedge Effectiveness Assessments after Hedge

Designation
35-5 In periodically (that is, at least quarterly) assessing retrospectively the
effectiveness of a fair value hedge (or a cash flow hedge) in having achieved
offsetting changes in fair values (or cash flows) under a dollar-offset approach,
Hedging 795
9. Hedge effectiveness

an entity shall use either a period-by-period approach or a cumulative approach

on individual fair value hedges (or cash flow hedges):
a. Period-by-period approach. The period-by-period approach involves
comparing the changes in the hedging instrument’s fair values (or cash
flows) that have occurred during the period being assessed to the changes
in the hedged item’s fair value (or hedged transaction’s cash flows)
attributable to the risk hedged that have occurred during the same period.
If an entity elects to base its comparison of changes in fair value (or cash
flows) on a period-by-period approach, the period cannot exceed three
months. Fair value (or cash flow) patterns of the hedging instrument or the
hedged item (or hedged transaction) in periods before the period being
assessed are not relevant
b. Cumulative approach. The cumulative approach involves comparing the
cumulative changes (to date from inception of the hedge) in the hedging
instrument’s fair values (or cash flows) to the cumulative changes in the
hedged item’s fair value (or hedged transaction’s cash flows) attributable to
the risk hedged.
35-6 If an entity elects at inception of a hedging relationship to base its
comparison of changes in fair value (or cash flows) on a cumulative approach,
then that entity must abide by the results of that methodology as long as that
hedging relationship remains designated. Electing to utilize a period-by-period
approach instead of a cumulative approach (or vice versa) to perform
retrospective evaluations of assessing hedge effectiveness under the dollar-
offset method may affect whether an entity can apply hedge accounting for
the current assessment period.

The dollar-offset method compares the dollar amount of the change in fair value
or cash flows of the hedging instrument with the dollar amount of the change in
fair value or cash flows of the hedged item or transaction for the risk being
hedged over the assessment period.
There are two approaches that may be used when applying the dollar-offset
method: the period-by-period approach and the cumulative approach. Either
approach can be elected to calculate the hedge effectiveness, which an entity
documents as part of its formal hedge documentation. An entity is not
permitted to switch from one approach to the other without dedesignating (and
redesignating) the hedging relationship (see section 9.6.40). [815-20-35-5]

Period-by-period Cumulative
The period-by-period approach involves The cumulative approach involves
comparing the changes in the hedging comparing the cumulative changes in
instrument’s fair values or cash flows the hedging instrument’s fair value or
during the period being assessed with cash flows to the cumulative changes in
the changes in the hedged item’s or the hedged item’s or transaction’s fair
transaction’s fair value or cash flows value or cash flows attributable to the
attributable to the hedged risk during hedged risk since inception of the
the same period. hedging relationship. [815-20-35-5(b)]
The period for this assessment can be
as short as an entity chooses (and
documents), but cannot exceed
three months. [815-20-35-5(a)]
Hedging 796
9. Hedge effectiveness

Question 9.6.40
What implications arise under the dollar-offset
method when changes in fair values during the
period are small?
Interpretive response: The dollar-offset method may be less likely to
demonstrate that the hedging relationship is highly effective when the change
in the fair value or cash flows of the hedging instrument and the hedged item or
transaction involve small dollar amounts but large percentages.
For example, if the fair value of a hedging instrument with a notional of
$1 million changed by $1,000 while the hedged item’s fair value changed by
$1,500, the dollar-offset method would indicate that the hedge was only 66%
effective ($1,000 ÷ $1,500), which is out of the highly effective range of 80% –
125% (see section 9.2.40). However, this change may be insignificant when
compared to the $1 million principal balance of the loan and $1 million notional
of the hedging instrument.
This is referred to as the ‘small dollar problem’ or the ‘law of small numbers’.

Question 9.6.50
Which approach is more commonly applied when
using the dollar-offset method: cumulative or
period-by-period?
Interpretive response: It is our understanding most entities that choose the
dollar-offset method for the retrospective assessment of effectiveness testing
elect the cumulative approach instead of the period-by-period approach.
This is because the cumulative approach provides more periods of data, which
may minimize the impact of short-term volatility or unusual events.

9.6.30 Regression analysis

Excerpt from ASC 815-20

>> Quantitative Hedge Effectiveness Assessments after Hedge

Designation
35-2G Quantitative assessments can be based on regression or other
statistical analysis of past changes in fair values or cash flows as well as on
other relevant information.
35-3 If an entity elects at the inception of a hedging relationship to use the
same regression analysis approach for both prospective considerations and
retrospective evaluations of assessing effectiveness, then during the term of
that hedging relationship both of the following conditions shall be met:
Hedging 797
9. Hedge effectiveness

a. Those regression analysis calculations shall generally incorporate the same

number of data points.
b. That entity must periodically update its regression analysis (or other
statistical analysis).
>>> Methodologies to Assess Effectiveness of Fair Value and Cash Flow
Hedges
55-69 As discussed in paragraph 815-20-35-3(b), if an entity assesses hedge
effectiveness on a quantitative basis and elects at the inception of a hedging
relationship to utilize a regression analysis (or other statistical analysis)
approach for either prospective considerations or retrospective evaluations of
assessing effectiveness, then that entity shall periodically update its regression
analysis (or other statistical analysis). As long as an entity reruns its regression
analysis and determines that the hedging relationship is still expected to be
highly effective, then it can continue to apply hedge accounting without
interruption.
55-70 The application of a regression or other statistical analysis approach to
assessing effectiveness is complex. Those methodologies require appropriate
interpretation and understanding of the statistical inferences.

Regression analysis is a statistical approach to measuring the effect that a

change in one variable (the independent variable) can have on another variable
(the dependent variable). In the case of hedging, a regression analysis could
determine the relationship between the hedged item or transaction and a
hedged instrument and whether it is expected to be – and actually has been –
highly effective.
While regression analysis and other statistical analysis methods can be used for
assessing effectiveness on a retrospective and/or prospective basis, applying
those methods to assess effectiveness is complex. Appropriate interpretation
and an understanding of the statistical inferences of statistical methods are
critical in applying those methods. [815-20-55-70]
To determine if a highly effective relationship exists, multiple data points need
to be evaluated. Topic 815 does not specify the number of data points (i.e. data
that represents the relationship of the independent and dependent variables
over time) that must be incorporated into a regression analysis.
As time progresses in the hedging relationship, the data points in the regression
analysis should be updated to include the current data. The entity should
generally incorporate the same number of data points in each analysis, as the
current data replaces the old data. This may help to further prove, or disprove,
the effectiveness of the hedging relationship. [815-20-35-3, 55-69]
A detailed discussion of regression analysis and other statistical methods for
assessing hedge effectiveness is beyond the scope of this publication.
Hedging 798
9. Hedge effectiveness

Question 9.6.60
What should be compared (regressed) in a
regression analysis?

Interpretive response: Generally regression analysis is applied to the changes

in two variables over time.
When using statistical analysis, such as regression analysis, the objective of the
assessment is to conclude that the hedging relationship has been or is
expected to be highly effective or both – i.e. that the change in the fair value or
cash flows of the derivative hedging instrument will be (and/or has been) highly
effective at offsetting changes in the fair value or cash flows of the hedged
item or transaction attributable to the hedged risk.
As a result, a regression analysis generally evaluates the relationship between
changes in the fair values or cash flows of the derivative and the hedged item
or transaction instead of the fair values or cash flows themselves.

Question 9.6.70
Must an entity perform the actual regression
calculation if it is mathematically certain a cash
flow hedge will be perfectly effective?
Interpretive guidance: No. In some circumstances, the variables to be
compared through regression may be known at inception to always be identical.
For example, if an entity is using the hypothetical derivative method in a cash
flow hedge and the terms of the actual hedging derivative exactly match those
of the perfectly effective hypothetical derivative (see section 9.7.30), the entity
knows with certainty that the changes in fair value or cash flows of the
hypothetical derivative will be identical to the changes in fair value or cash flows
of the actual hedging derivative. As a result, the entity knows with
mathematical certainty that the relationship will be 100% effective without
performing the actual quantitative calculation.
In those circumstances, we believe an entity is not required to perform the
actual calculation. This is because when the corresponding values to be
compared are identical, the results of the calculation are known with
mathematical certainty without performing the full calculation. Instead, we
believe an entity may satisfy the requirement to initially assess effectiveness by
documenting this fact.
Hedging 799
9. Hedge effectiveness

Question 9.6.80
What outputs of regression analysis should be
evaluated?

Interpretive guidance: The SEC staff has indicated that an entity must
consider all relevant outputs from a regression analysis used to determine
whether the hedging relationship has been and is expected to be highly
effective. [2003 AICPA Conf]
While that assessment will be determined based on the facts and
circumstances of the specific relationship, the SEC staff stated that at least the
following regression outputs should be considered.
— R2 statistic (coefficient of determination): the portion of variability in a
dependent variable that can be explained by variability in the independent
variable.
— Slope coefficient: the straight line that represents the ‘best fit’ of the
individual data points.
— F-statistic or t-statistic: statistics that aid in determining whether the
relationship between the variables is statistically valid.
Depending on the specifics of the hedging strategy, other regression outputs
may also need to be considered.

Question 9.6.90
Should an entity consider using specialists when it
uses statistical analysis to assess effectiveness?

Interpretive guidance: Yes. Applying statistical analysis (including regression)

is complex and an appropriate interpretation and understanding of the statistical
inferences of statistical methods are critical in applying those methods. As a
result, we believe an entity should ensure that it involves personnel with the
requisite knowledge to apply the methods properly.

Question 9.6.100
Do quantitative effectiveness assessments require
judgment?

Interpretive response: Yes. While they are quantitative in nature, judgment is

still involved in assessing effectiveness using quantitative methods. In
evaluating the overall effectiveness test of the given hedging relationship, the
overall understanding of the method selected and the inputs into the
quantitative methods are important considerations.
Hedging 800
9. Hedge effectiveness

The following are examples of inputs to a quantitative assessment that

frequently require the judgment.

Type of Inputs to
hedging quantitative
relationship assessment Example judgment
Fair value — Fair value of the — Estimating fair value of the hedged
hedged item item, unless the hedged risk is total
— Fair value of the changes in fair value and a quoted price
hedging for an identical item traded in an active
instrument market is available (i.e. Level 1 inputs).
— Estimating the fair value of the
derivative hedging instrument, unless
there are no excluded components and
a quoted price for an identical item
traded in an active market is available
(i.e. Level 1 inputs).

Cash flow — Cash flows of the — Estimating the amount and timing of the
hedged cash flows of the hedged forecasted
forecasted transaction, which may involve a
transaction probability-weighted assessment.
— Cash flows of the — Estimating the cash flows of the
derivative hedging derivative hedging instrument, unless
instrument there are no excluded components and
a quoted price for an identical item
traded in an active market is available
(i.e. Level 1 inputs).
Fair value — Selection of — Determination of data to include in the
and cash quantitative assessment (daily points, monthly, etc).
flow technique — Determining the number of data points
— Number of data to be used in a regression analysis.
points used in a — Determining the historical period to be
regression used in effectiveness assessments (see
analysis Question 9.2.80).
— Historical period
used
— Determination of
data to include in
the assessment
(daily points,
monthly, etc).

9.6.40 Changing quantitative methods for assessing

effectiveness

Excerpt from ASC 815-20

>> Hedge Effectiveness Criteria Applicable to both Fair Value Hedges and
Cash Flow Hedges

25-80 All assessments of effectiveness shall be consistent with the originally

documented risk management strategy for that particular hedging relationship.
An entity shall use the quantitative effectiveness assessment method defined
at hedge inception consistently for the periods that the entity either elects or is
required to assess hedge effectiveness on a quantitative basis.
>>>> Change in Hedge Effectiveness Method When Hedge Effectiveness
Is Assessed on a Quantitative Basis
35-19 If the entity identifies an improved method of assessing hedge
effectiveness in accordance with the guidance in paragraph 815-20-25-80 and
wants to apply that method prospectively, it shall do both of the following:
a. Discontinue the existing hedging relationship
b. Designate the relationship anew using the improved method.
35-20 The new method of assessing hedge effectiveness shall be applied
prospectively and shall also be applied to similar hedges unless the use of a
different method for similar hedges is justified. A change in the method of
assessing hedge effectiveness by an entity shall not be considered a change in
accounting principle as defined in Topic 250.
>>> Changes in Quantitative Assessment Methods
55-55 If an entity elects to or is required to assess hedge effectiveness on a
quantitative basis after the initial quantitative assessment of hedge
effectiveness, examples of changes in the types of methods an entity may use
in assessing hedge effectiveness (see paragraph 815-20-35-20) could include
the following:
a. A change from the dollar-offset method to the use of regression analysis or
vice versa
b. A change between any one of the three methods discussed beginning in
paragraph 815-30-35-10 (for example, a change from the change in variable
cash flows method to either the hypothetical derivative method or the
change in fair value method)
c. A change from excluding certain components of a derivative instrument
gain or loss to including such components or vice versa (for example, a
change from assessing effectiveness based on changes in intrinsic value to
the entire change in an option’s fair value)
d. A change from assessing hedge effectiveness on a period-by-period basis
to a cumulative basis or vice versa.
55-56 This Subtopic permits a hedging relationship to be dedesignated (that is,
discontinued) at any time. (See paragraphs 815-25-40-1(c) and 815-30-40-1(c).)
If an entity wishes to change any of the critical terms of the hedging
relationship (including the method designated for use in assessing hedge
Hedging 802
9. Hedge effectiveness

effectiveness), as documented at inception, the mechanism provided in this

Subtopic to accomplish that change is the dedesignation of the original hedging
relationship and the designation of a new hedging relationship that
incorporates the desired changes. However, as discussed in paragraph 815-30-
35-37A, a change to the hedged risk in a cash flow hedge of a forecasted
transaction does not result in an automatic dedesignation of the hedging
relationship if the hedging instrument continues to be highly effective at
achieving offsetting cash flows associated with the hedged item attributable to
the revised hedged risk. The dedesignation of an original hedging relationship
and the designation of a new hedging relationship represents the application of
this Subtopic and is not a change in accounting principle under Topic 250, even
though the new hedging relationship may differ from the original hedging
relationship only with respect to the method designated for use in assessing
the hedge effectiveness of that hedging relationship. Although paragraph 815-
20-35-19 refers to discontinuing an existing hedging relationship and then
designating and documenting a new hedging relationship using an improved
method for assessing effectiveness, that reference was not meant to imply
that the perceived improved method had to be justified as a preferable method
of applying an accounting principle under Topic 250.
55-56A For the purposes of applying the guidance in paragraph 815-20-55-56, a
change in the counterparty to a derivative instrument that has been designated
as the hedging instrument in an existing hedging relationship would not, in and
of itself, be considered a change in a critical term of the hedging relationship.

As discussed in section 2.9, an entity generally is required to define and

document the quantitative method it will use for assessing hedge effectiveness
at the time it designates a hedging relationship. That method must be applied
consistently throughout the period of the hedge. [815-20-25-3(b)(2), 25-80]
If an entity wishes to change the documented hedge effectiveness method –
i.e. because it has identified an improved method for assessing effectiveness –
it generally must discontinue the existing hedging relationship and designate a
new hedging relationship using the improved method. The new relationship
must meet all hedging criteria, including the formal documentation
requirements. [815-20-35-19]
The effect of discontinuing a hedging relationship is discussed in sections 4.5
(fair value hedges) and 6.5 (cash flow hedges).
The following are examples of changes in hedge effectiveness methods, and
whether dedesignation and redesignation of the hedging relationship is
required. [815-20-35-19, 55-55 – 55-56A]

Changes in hedge effectiveness Changes in hedge effectiveness

methods – dedesignation and methods – dedesignation and
redesignation required redesignation not required
— Change from the dollar-offset — An entity documents that it will use
method to regression analysis or the qualitative method for
vice versa (see sections 9.6.20 and subsequent effectiveness
9.6.30). assessments and later is required (or
— Change from period-by-period basis elects) to perform quantitative
to cumulative basis or vice versa effectiveness assessments using
(see section 9.6.20).
Hedging 803
9. Hedge effectiveness

Changes in hedge effectiveness Changes in hedge effectiveness

methods – dedesignation and methods – dedesignation and
redesignation required redesignation not required
— Change between any of the the method documented at hedge
following methods (see section 9.7) inception (see section 9.5.20).
— change-in-variable-cash-flows — Shortcut method is determined to
method not be or no longer be appropriate
— hypothetical derivative method and the entity had documented at
— change-in-fair-value method. hedge inception the quantitative
— Change from excluding to including method that would be used in such
certain components of a derivative circumstances (see section 9.3.110).
instrument’s gain or loss or vice — Critical terms cease to match
versa (see section 9.2.70). when an entity applies the critical
terms match method (see
Question 9.4.80).

Discontinuing a hedging relationship and designating a new hedging relationship

with a different effectiveness assessment method is not a change in an
accounting principle under Topic 250. As a result, no preferability letter is
necessary and the auditor’s report need not refer to this change. Nevertheless,
an entity that changes methods needs to: [815-20-35-20, 55-56]
— document its justification for the change, including why the new method is
an improvement;
— apply the new method to all similar hedges, unless facts and circumstances
support a different method (see section 9.2.80); and
— prepare documentation for the new hedging relationship (see section 2.9).

9.6.50 Illustrative examples of quantitative methods to

assess effectiveness
The following examples illustrate the quantitative hedge effectiveness testing
methods:
— Dollar-offset method for retrospective test (fair value hedge)
(Example 9.6.10).
— Assessing effectiveness of a cash flow hedge of a forecasted purchase of
inventory with a forward contract (contractually specified component)
(Subtopic 815-30’s Example 22).
— Hedging forecasted purchases of fuel using regression analysis and the
dollar-offset method (Example 9.6.20).

Example 9.6.10
Dollar-offset method for retrospective test (fair value
hedge)
At inception of the hedge, on March 31, Year 1, a hedging relationship was
expected to be highly effective in achieving offsetting changes in fair value
attributable to the hedged risk during the period that the hedge is expected to
be in place.
Hedging 804
9. Hedge effectiveness

Formal documentation
ABC Corp. documented that its retrospective assessment of hedge
effectiveness will be assessed based on changes in the fair value of the
derivative hedging instrument and changes in the fair value of the hedged item
attributable to the hedged risk on a cumulative basis.
Quarterly effectiveness testing – March 31, Year 2
The following is ABC’s documentation supporting its retrospective assessment
of hedge effectiveness using the cumulative dollar-offset method at March 31,
Year 2.

Derivative
hedging Hedged Period Cumulative
instrument item change change
Three months ended gain (loss) gain (loss) ratio ratio
March 31, Year 1 $100 $ (90) 111% 111%
June 30, Year 1 25 (21) 119% 113%
September 30, Year 1 (20) 24 83% 121%
December 31, Year 1 (5) 4 125% 120%
March 31, Year 2 25 (19) 132% 123%
Net gain (loss) to date $125 $(102)

To be highly effective, the extent of offset between the hedging instrument

and the hedged item or forecasted transaction should be 80%–125% (see
section 9.2.40).
ABC concludes that it cannot apply hedge accounting for the three months
ended March 31, Year 2 if it selects the period-by-period dollar-offset method
for its retrospective assessment of hedge effectiveness. This is because the
extent of offset under the period-to-period assessment was 132% – i.e. not
within a range of 80%–125%.
However, ABC is able to apply hedge accounting for the three months ended
March 31, Year 2 because its chosen method of retrospectively assessing
effectiveness is based on cumulative changes. As the table demonstrates, on a
cumulative basis, this relationship has been highly effective.

Excerpt from Subtopic 815-30

>> Example 22: Assessing Effectiveness of a Cash Flow Hedge of a

Forecasted Purchase of Inventory with a Forward Contract (Contractually
Specified Component)

55-134 This Example illustrates the application of the guidance in Subtopic 815-
20 and this Subtopic for assessing effectiveness for a cash flow hedge of a
forecasted purchase of inventory with a forward contract for which the hedged
risk is variability in cash flows attributable to changes in a contractually
Hedging 805
9. Hedge effectiveness

specified component. Assume the entity elects to perform subsequent

assessments of hedge effectiveness on a quantitative basis using a
cumulative-dollar-offset approach and all hedge documentation requirements
were satisfied at inception.
55-135 Entity J manufactures keys for door locks on buildings and cars. The
keys are cut from sheets of metal called key plates. Entity J primarily
purchases its key plates from Supplier 1 as needed. Supplier 1 and Entity J
have an outstanding agreement specifying that the per-unit cost of each key
plate will be determined by Supplier 1 on the first business day of each month
on the basis of the following pricing formula:
a. Spot price of COMEX Zinc per pound × 0.2 pounds, plus
b. Spot price of COMEX Copper per pound × 0.1 pounds, plus
c. The current cost of refining copper and zinc into key plates, plus
d. The current cost of transporting the key plates to Entity J.
55-136 In January 20X1, Entity J expects to purchase 100,000 key plates in
July 20X1, which requires 10,000 pounds of copper for the manufacturing
process. Entity J decides that it wishes to hedge only the change in value of
the price of COMEX Copper used to create the key plates being purchased in
July 20X1.
55-137 On January 15, 20X1, Entity J enters into a forward contract maturing
on July 1, 20X1 (that is, the date on which the price of copper used to
manufacture the key plates is fixed) to purchase 10,000 pounds of COMEX
Copper at $2.10 per pound. Any settlement amount on the forward contract
will be based on the difference between the contract price of $2.10 per pound
and the spot price of COMEX Copper on the maturity date (July 1, 20X1),
multiplied by the notional amount of 10,000 pounds.
55-138 Entity J designates a cash flow hedge in which the hedging instrument
is the forward contract, the hedged item is the forecasted purchase of key
plates in July 20X1, and the hedged risk is the variability in the purchase price
of the key plates attributable to changes in the COMEX Copper price index,
which is a contractually specified component within the frame agreement.
Entity J documents in its hedge documentation that the requirements to
designate variability in cash flows attributable to changes in a contractually
specified component as the hedged risk in paragraph 815-20-25-22A are met.
55-139 Entity J bases its assessment of hedge effectiveness on cumulative
changes in the fair value of the hedging instrument and the hedged item
attributable to changes in the hedged risk.
55-140 In assessing hedge effectiveness on an ongoing basis, Entity J must
consider the extent of offset between the change in expected cash flows on
the hedging instrument (the copper forward contract) and the hedged item
attributable to changes in the hedged risk (change in expected cash flows
associated with forecasted purchases of key plates attributable to changes in
the COMEX Copper price index). The table below illustrates the cumulative
changes in the hedging instrument and hedged item attributable to changes in
the hedged risk as of the first subsequent quarterly effectiveness assessment
date.
Hedging 806
9. Hedge effectiveness

Estimate of Change in Cash Flows

Hedged Item Due
Hedging to Fluctuation in
Instrument Hedged Risk
Forward price of copper (dollars per pound)
At hedge inception (Jan 15, 20X1) $ 2.10 $ 2.10
At first subsequent assessment date
(March 31, 20X1) $ 2.25 $ 2.25
Change in forward price of copper $ 0.15 $ 0.15

Cumulative change in copper (per pound)

x 10,000 pounds of copper $ 1,500.00 $ 1,500.00

55-141 Entity J could assess effectiveness as of March 31, 20X1, by

comparing the $1,500 change in the hedging instrument with the $1,500
change in the hedged item attributable to changes in the hedged risk because
the hedging instrument’s maturity date and the date on which the price of
copper will be fixed match (that is, July 1, 20X1).

Example 9.6.20
Hedging forecasted purchases of fuel using
regression analysis and the dollar-offset method
This is the continuation of Examples 2.9.50 and 5.3.30 involving forecasted
purchases of fuel when hedging price risk.
— Formal documentation of hedging relationship – except for hedge
effectiveness components, which are presented in this example (see
Example 2.9.50).
— Similarity assessment for forecasted transactions (see Example 5.3.30).
Freight Co. purchases both jet fuel and diesel fuel at various locations across
the US and internationally.
For ease of reference, details of the hedging relationships identified by Freight
are summarized below.

Nature of the Exposure to variability in the overall cash outflows (i.e. price risk)
risk being for the purchase of fuel due to changes in spot prices at various
hedged locations.

Groups of The hedged forecasted transaction is defined as the first

similar purchases of gallons of fuel over the 30-day period beginning on
forecasted the first day of the month in which the derivative contract
transactions matures/settles that:
— in aggregate represent the number of gallons (or equivalent
barrels) equal to the notional amount of the hedging
instrument; and
— are not currently being hedged by another derivative
instrument or were not previously identified in a relationship
Hedging 807
9. Hedge effectiveness

originally designated earlier in priority that has been

terminated for which amounts remain in AOCI.
Only individual forecasted purchases that are considered to be
similar with respect to the risk being hedged are included within
the same hedged group of forecasted transactions. Hedged
transactions within each of the following groups are considered
similar, based first by type of fuel and then more specifically by
location:
— Group 1: Jet fuel; NY Harbor, US Gulf Coast, LA
— Group 2: Jet fuel; Singapore, Rotterdam
— Group 3: Diesel fuel; NY Harbor, US Gulf Coast
— Group 4: Diesel fuel; LA

Hedging Futures or purchased options indexed to either:

instrument — the NYMEX Heating Oil or NY Harbor No. 2 index (generally
used for relationships involving forecasted purchases of jet
fuel); or
— the NYMEX West Texas Intermediate Crude Oil index
(generally used for relationships involving forecasted
purchases of diesel fuel).

The hedge period for individual relationships is typically three months.

Documentation of hedge effectiveness methods
The following illustrates how the methods chosen to assess effectiveness are
documented at the inception of the hedging relationships.
Hedge effectiveness at inception

Prospectively Freight will assess prospective effectiveness using a regression

analysis to demonstrate high correlation between:
— the cumulative changes in fair value of the hedging
instrument; and
— the cumulative changes in fair value of a PEH derivative (a
proxy for the change in the present value of the expected
future cash flows of the hedged forecasted purchases of
fuel).
Because the prospective assessment is intended to justify an
expectation that the relationship will be highly effective over
future periods in achieving offsetting changes in cash flows, the
regression analysis will demonstrate high correlation over a series
of 32 three-month periods.
The hedged forecasted transaction specified for each hedging
relationship is a group of individual forecasted purchases of fuel of
the same type but from differing locations. Therefore, Freight will
perform separate regression analyses (using 32 sets of data
points for each analysis) to demonstrate that the hedging
instrument is expected to be highly effective at hedging overall
price risk for purchases at each of the individual locations
identified within each group of hedged forecasted transactions.
For example, for an individual hedging relationship associated
with Group 1 above, three regression analyses would be prepared
to demonstrate that the derivative would be highly effective at
hedging forecasted purchases whose price varies upon (1) the NY
Harbor index, (2) the US Gulf Coast index and (3) the LA index.
Hedging 808
9. Hedge effectiveness

This analysis demonstrates that the hedging relationship would be

highly effective regardless of the ultimate composition of the
hedged group of forecasted transactions (e.g. if 100% of the
forecasted purchases were from any one of the identified
locations).

Each set of data points to be used in the regression analysis will be determined
as discussed below. The regression will encompass 32 such data points, each
based on the cumulative change in fair value over a three-month period for the
series of three-month periods beginning at the inception of the hedge and going
back a total of 32 three-month periods.

Cumulative The cumulative change in the fair value of the derivative over a
change in fair three-month period.
value of If historical prices for the hedging instrument do not exist, the fair
hedging values will be measured with inputs based on:
instrument
— the current spot price of the commodity underlying the
derivative;
— the derivative’s maturity/settlement date; and
— the applicable forward price curve for that particular date to
ensure that the valuations reflect the historical price curves
actually in place during each of the 32 three-month periods.
Freight believes that using changes in prices for the previous 32
three-month periods is reasonable for purposes of identifying
possible changes in prices over the next three months.
Cumulative The cumulative change in the fair value of the PEH derivative over
change in fair a three-month period.
value of PEH 1 — Futures contracts. For relationships involving futures
and PEH 2 contracts, PEH 1 is a futures contract (with a zero fair value at
inception of the hedging relationship) to purchase the type of
fuel being hedged (e.g. jet fuel or diesel fuel) at the location
within that group of forecasted transactions for which the
regression is being prepared.
— Purchased options. For relationships involving purchased
option contracts, PEH 2 is a European option contract to
purchase the type of fuel being hedged at the location within
that group of forecasted transactions for which the
regression is being prepared; Freight is assessing
effectiveness for option relationships based on total changes
in the option’s cash flows. The strike price on the option is
equal to the specified threshold over which the increase in
the overall market price of fuel (either jet fuel or diesel fuel) is
designated as the risk being hedged.

Settlement The settlement date of PEH 1 and PEH 2 is determined at the

date of PEH 1 inception of the hedge based on an analysis of the purchases
and PEH 2 made in the prior three-month period for each particular group of
hedged forecasted transactions.
For example, in March Freight designates an individual
relationship for the purchase of the first one million gallons of jet
fuel associated with Group 1 in June. There were no other
hedging relationships related to Group 1 previously designated for
forecasted purchases in June. Freight accumulates the purchase
data from the three-month period spanning December – February
to determine how many days it took to purchase one million
Hedging 809
9. Hedge effectiveness

gallons of Group 1’s fuel; this is from the beginning of December

because the hedged forecasted transaction is defined as the first
purchases.
Freight then computes a weighted-average number of days into
the three-month period and uses that weighted average to
determine the settlement date of PEH 1 and PEH 2. For example,
if the first two purchases during the three-month period were
500,000 gallons each, one purchase occurring on December 1,
and the second purchase occurring on January 31, the PEH
derivatives would have a settlement date of January 1.
However, if there was already a hedging relationship in place for
the first two million gallons of jet fuel purchased, the settlement
date for the PEHs for the next one million gallons purchased
would be based on the weighted-average number of days that it
took during the three-month period spanning December –
February to purchase gallons 2,000,001–3,000,000. The activity
for the previous three-month period is used because Freight
believes that recent historical information regarding the individual
groups is an appropriate basis on which to develop the best
estimate of future settlements.
Fair value of The fair value of each of PEH 1 and PEH 2 is measured with
PEH 1 and inputs based on the current spot price of the type of fuel and
PEH 2 applicable location (e.g. NYMEX New York Harbor Jet Kerosene,
NYMEX US Gulf Coast Low-Sulfur No. 2 Diesel Fuel) for which
the regression is being prepared and the applicable forward price
curve for that particular date to ensure that the valuation reflects
the historical price curves actually in place during each three-
month period. Freight believes that using changes in prices for
the previous 32 three-month periods is reasonable for purposes of
identifying possible changes in prices over the next three months.

Hedge effectiveness during the hedging relationship

Freight will update the regression analyses discussed above on a monthly basis,
continuously using the most current 32 data points.

Retrospectively The retrospective assessment is intended to determine whether

the relationship has been highly effective cumulatively to date.
Freight will assess retrospective effectiveness on a dollar-offset
basis. To support hedge accounting for all relationships within
each group for the previous period, the cumulative change in the
fair value of the actual derivatives will need to offset at least 80%,
and up to 125%, of the cumulative change in the fair value of the
associated PEH derivatives.
Prospectively Freight will determine whether it expects the hedging
relationships to continue to be highly effective based on the
updated regression analyses.
Hedging 810
9. Hedge effectiveness

9.7 Cash flow hedges – Methods for measuring cash

flows
9.7.10 Overview
Topic 815 does not prescribe a method for measuring the changes in the
derivative hedging instrument’s cash flows or the changes in the hedged
transaction’s cash flows attributable to the hedged risk. However, it describes
several methods for measuring cash flows in cash flow hedges, some of which
are only available for certain hedging strategies and/or when certain conditions
are met.

Terminal value method This method may be used for certain cash flow hedging
(section 9.7.20) relationships when the hedging instrument is an option.
 Change-in-variable- These methods are applicable to cash flow hedges of
cash-flows method variability in interest receipts or payments when the
 Hypothetical hedging instrument is an interest rate swap.
derivative method
 Change-in-fair-
value method
(section 9.7.30)

These methods may be used to measure the expected cash flows to be used
when performing quantitative tests (see section 9.6). Some of these methods
result in a hedge that is perfectly effective, depending on whether the critical
terms of the hedging instrument and hedged transaction match.
In many cases, Topic 815 does not prescribe methods that must be used for
assessing effectiveness for cash flow hedges. For example, Topic 815 does not
prescribe specific guidance in the following situations:
— the hedging relationship includes a basis difference, to the extent that
those bases do not move in tandem; this might occur, for example, when a
pound sterling-based hedging instrument is used to hedge a euro-based
forecasted transaction; and
— the critical terms do not match – e.g. when there is a difference between
the notional amounts, maturities, quantity, location or delivery dates of the
derivative hedging instrument and the hedged transaction.
In these situations, an entity is required to determine the changes in the
forecasted transaction’s cash flows attributable to the hedged risk and compare
these changes to the changes in cash flows of the derivative hedging
instrument. As a result, methods have developed in practice for situations when
Topic 815 does not prescribe how cash flows should be measured, including
the following.

Hypothetical derivative This method is described in Topic 815 as being relevant

method to certain hedges involving interest payments when the
(section 9.7.30) hedging instrument is an interest rate swap. Additionally,
FASB examples (e.g. Subtopic 815-30’s Example 1,
which is reproduced in section 9.7.30) demonstrate
using this method for other types of hedging
relationships. In practice, the PEH derivative instrument
Hedging 811
9. Hedge effectiveness

is used as a proxy for the change in expected cash flows

of the hedged transaction attributable to the hedged risk
for all types of cash flow hedging relationships.
Project future cash This method is used when hedging a forecasted sale or
flows using forward purchase of certain nonfinancial assets and a market is
price curves or using not available to help make estimates of their cash flows.
recent sales or purchase
orders
(section 9.7.50)

Question 9.7.10
What should an entity consider when assessing
hedge effectiveness for a group of similar
forecasted transactions?
Background: As discussed in section 5.3.60, a group of forecasted transactions
(rather than an individual transaction) may be designated as the hedged
transaction in a cash flow hedge, provided the transactions share the same risk
exposure and certain conditions are met.
Interpretive response: Although each item in a group of transactions may
share the same risk exposure, we believe an entity that identifies a group of
transactions as the hedged transaction in a cash flow hedging relationship
should consider additional factors when assessing whether the hedge is highly
effective. Therefore, a group of transactions could pass the similarity test but
the hedging relationship may not be highly effective.
The circumstances outlined below could result in a hedging relationship that is
not highly effective.

Timing of Regardless of the risk being hedged, the timing of the individual cash
cash flows flows of each transaction within a group of transactions will often not
be the same as the timing of the cash flow(s) of a single derivative
used as the hedging instrument.
Basis Basis differences occur when the underlying price/index, contractually
differences specified component or contractually specified interest rate of the
hedged transaction is different from the price, index or interest rate of
the hedging instrument.
For example, a hedged transaction varies based on 30-day LIBOR and
the hedging instrument varies based on 90-day LIBOR. For discussion
of similarity assessments related to contractually specified interest
rates, see Question 5.3.80.
Margin
When hedging price risk, margin variability may occur when each
variability
individual forecasted transaction in a group is based on the same
underlying price, index or rate, but the spread above that price, index
or rate may be different due to various factors.
This would not be a factor when hedging exposure to changes in a
contractually specified component or contractually specified interest
rate.
Hedging 812
9. Hedge effectiveness

If the hedging relationship for a group of similar transactions is not highly

effective, an entity may have the following alternatives:
— Changing the groupings of hedged transactions. Depending on the
circumstances, an entity may need to consider whether multiple hedging
relationships would be more appropriate. This could be different hedging
relationships for each individual transaction or more disaggregated groups
of similar forecasted transactions.
— Use a combination of hedging instruments. Alternatively, an entity could
use a dynamic hedging strategy that uses a combination of derivatives as
hedging instruments. As discussed in section 9.2.50, a dynamic hedging
strategy involves an entity committing itself to an ongoing repositioning
strategy for its hedging relationship and to an assessment period that is
shorter than the term of the hedging instrument.

9.7.20 Terminal value method for certain cash flow hedges

using an option as the hedging instrument

Excerpt from ASC 815-20

>>>> Assessing Hedge Effectiveness Based on an Option's Terminal Value

25-126 The guidance in paragraph 815-20-25-129 addresses a cash flow hedge
that meets all of the following conditions:
a. 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.
b. 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).
c. 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).
25-127 This guidance has no effect on the accounting for fair value hedging
relationships. In addition, in determining the accounting for seemingly similar
cash flow hedging relationships, it would be inappropriate to analogize to this
guidance.
25-128 For a hedging relationship that meets all of the conditions in
paragraph 815-20-25-126, an entity may focus on the hedging instrument’s
terminal value (that is, its expected future pay-off amount at its maturity date)
in determining whether the hedging relationship is expected to be highly
effective in achieving offsetting cash flows attributable to the hedged risk
during the term of the hedge. An entity’s focus on the hedging instrument’s
terminal value is not an impediment to the entity’s subsequently deciding to
dedesignate that cash flow hedge before the occurrence of the hedged
transaction. If the hedging instrument is a purchased cap consisting of a series
of purchased caplets that are each hedging an individual hedged transaction in
a series of hedged transactions (such as caplets hedging a series of hedged
Hedging 813
9. Hedge effectiveness

interest payments at different monthly or quarterly dates), the entity may focus
on the terminal value of each caplet (that is, the expected future pay-off
amount at the maturity date of each caplet) in determining whether each of
those hedging relationships is expected to be highly effective in achieving
offsetting cash flows. The guidance in this paragraph applies to a purchased
option regardless of whether at the inception of the cash flow hedging
relationship it is at the money, in the money, or out of the money.
25-129 A hedging relationship that meets all of the conditions in
paragraph 815-20-25-126 may be considered to be perfectly effective if all of
the following conditions are met:
a. 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, the expected date of
the hedged transaction, and so forth)
b. 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.
c. The hedging instrument’s inflows (outflows) at its maturity date completely
offset the change in the hedged transaction’s cash flows for the risk being
hedged.
d. The hedging instrument can be exercised only on a single date—its
contractual maturity date.
The condition in (d) is consistent with the entity’s focus on the hedging
instrument’s terminal value. If the holder of the option chooses to pay for the
ability to exercise the option at dates before the maturity date (for example, by
acquiring an American-style option), the hedging relationship would not be
perfectly effective.
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.

Excerpt from ASC 815-30

>> Hedging Relationship in Which Hedge Effectiveness Is Based on an

Option's Terminal Value
35-33 If an entity concludes under paragraphs 815-20-25-129 through 25-129A
that the hedging relationship may not be considered to be perfectly effective,
the entity shall assess hedge effectiveness by comparing the following
amounts:
a. The change in fair value of the actual hedging instrument
b. The change in fair value of a perfectly effective hypothetical hedging
instrument. That hypothetical hedging instrument shall have terms that
Hedging 814
9. Hedge effectiveness

meet the four conditions listed in paragraphs 815-20-25-129 through 25-

129A.
35-34 The change in fair value of the hypothetical hedging instrument can be
regarded as a proxy for the present value of the cumulative change in expected
future cash flows on the hedged transaction(s).

When an option is used as the derivative hedging instrument in a cash flow

hedging relationship, the total change in the option’s cash flows may not
perfectly offset the change in the forecasted transaction’s cash flows when the
option premium (or time value) is included in that calculation.
In these situations, an entity may elect to use the terminal value method. This
method includes the time value component of the option in the assessment of
effectiveness. However, it focuses on the hedging instrument’s terminal value
(i.e. the expected pay-off at its maturity date) in determining whether the
hedging relationship is expected to be highly effective at achieving offsetting
cash flows that are attributable to the hedged risk during the term of the hedge.
As a result, the terminal value method will result in higher effectiveness than an
approach that compares the total changes in the option’s cash flows with the
changes in the expected cash flows of the forecasted transaction.
The following table summarizes the terminal value method.

Conditions for — Hedging instrument. The hedging instrument is a purchased

applying this option or a combination of only options that comprise either a
method: net purchased option or a zero-cost collar (see sections 2.7.50
[815-20-25-126] and 2.7.60).
— Hedged risk. The hedged risk is variability in expected future
cash flows attributable to a particular rate or price beyond (or
within) a specified level (or levels).
— Hedge effectiveness. The effectiveness assessment is based
on total changes in the option’s cash flows – i.e. it includes
the hedging instrument’s entire change in fair value, not just
changes in intrinsic value.
Conditions — The critical terms of the hedging instrument completely match
that will the related terms of the hedged transaction (notional amount,
result in underlying, maturity and strike price). This includes that it is
perfect probable that the counterparty to the derivative and the entity
1
effectiveness : will not default.
[815-20-25-129 – — The strike prices of the hedging option (or combination of
25-129A] options) matches the specified level (or levels) beyond (or
within) which the entity’s exposure is being hedged.
— The hedging instrument’s inflows (outflows) at its maturity
date completely offset the outflows (inflows) from any
increase or decrease in the hedged transaction’s cash flows,
from the date of hedge designation, for the risk being hedged.
— The hedging instrument can be exercised only on a single
date, its contractual maturity date.
— See also Question 9.2.50 regarding whether subsequent
assessments are performed on a qualitative or quantitative
basis.
Hedging 815
9. Hedge effectiveness

What is This method involves comparing:

compared in — the option’s changes in the expected pay-off at its maturity;
assessing and
effectiveness:
— the changes in the expected cash flows of the forecasted
[815-30-35-33 –
transaction.
35-34]
However, if the conditions that will result in perfect effectiveness
(above) are not met, an entity must perform initial and subsequent
hedge effectiveness assessments by comparing the change in fair
values of:
— the actual hedging instrument; and
— the perfectly effective hypothetical derivative (see
section 9.7.30).

Note:
In determining whether these conditions are met, the entity may treat the timing of
the hedged transactions and the hedging instrument as matching, if the hedged
transactions occur and the hedging instrument matures within the same 31-day period
(or fiscal month). [815-20-25-129A]

The terminal value method is available only for cash flow hedges (not fair value
hedges) and cannot be used in cash flow hedges that do not meet the eligibility
requirements included in the above table. [815-20-25-127]
As an alternative to the terminal value method, an entity may exclude changes
in time value from its assessment of effectiveness (see section 9.2.70) to
improve the extent of offset when an option premium (or time value) is paid.
When time value is an excluded component, changes in time value are
recognized using either an amortization approach or a mark-to-market approach.
Either of these methods will result in the initial time value being recognized in
earnings over the term of the hedging relationship. See also Example 6.3.30,
which illustrates and compares the earnings effect of time value under each
method. [815-20-25-83A – 25-83B]

Question 9.7.20
May the terminal value method be used by the
buyer when the hedging instrument is a swaption?
Interpretive response: It depends on the hedged transaction.
The terminal value method focuses on the expected pay-off of the option at its
maturity date, not the potential cash flows on the interest rate swap. As a
result, the terminal value method would require an entity to focus on the
increase in cash flows to be received (in the form of cash or the fair value of the
swap) on expiration of the option portion of the interest rate swaption; this is
instead of the increase or decrease in cash flows to be exchanged during the
term of the interest rate swap. As a result, using a swaption as the hedging
instrument when the terminal value method is used to assess effectiveness
may be effective when the hedged transaction is proceeds from issuing a fixed-
rate debt instrument but may not be effective when hedging variability in
individual interest payments from a forecasted variable-rate debt issuance (see
Example 9.7.10).
Hedging 816
9. Hedge effectiveness

An interest rate swaption is an option to enter into a specified interest rate

swap at maturity of the option. In exchange for an option premium, the buyer
has the right (but not the obligation) to enter into a specified swap agreement;
or, in some cases, to receive cash proceeds for the fair value of that swap
agreement at the expiration of the option. In essence, if the buyer of the
swaption is in a gain position at the option’s maturity, it will exercise the option;
however, if the buyer is in a loss position at the option’s maturity, it will not
exercise the option.
We believe an interest rate swaption represents a purchased option from the
perspective of the buyer. As a result, the terminal value method may be used
by the buyer when the hedging instrument is an interest rate swaption in a cash
flow hedging relationship as long as the other eligibility requirements are met.
Additionally, the hedging relationship may be considered perfectly effective if
certain conditions are met.

Examples
The following are examples that demonstrate the terminal value method.
— Terminal value method is not appropriate (Example 9.7.10).
— Purchased option used in a cash flow hedge (Subtopic 815-20’s
Example 27).
— Terminal value method for hedge of forecasted foreign currency
denominated sale with a purchased option (Example 9.7.20).

Example 9.7.10
Terminal value method is not appropriate
ABC Corp. expects to issue $100 million of 10-year variable-rate debt in
six months. ABC will be exposed to variability in cash flows in the future
quarterly interest payments on the debt due to changes in the expected
contractually specified interest rate.
ABC enters into a swaption to hedge the variability in the 40 future quarterly
interest payments attributable to changes in the benchmark interest rate above
6% over the next 10 years related to its 10-year $100 million debt that begins in
six months.
The swaption provides ABC the right (but not the obligation) to enter into a
10-year, receive-three-month LIBOR, pay-fixed 6% interest rate swap with a
notional amount of $100 million and payment and receipt dates that coincide
with the payment dates on the debt instrument. When three-month LIBOR is
above 6%, ABC will exercise its option. When three-month LIBOR is below 6%,
ABC will allow its option to expire.
The conditions to apply the terminal value method are not met for the following
reasons.
— The hedging instrument for the first time period of the proposed hedging
relationship is a purchased option; however for the second time period it is
an interest rate swap.
Hedging 817
9. Hedge effectiveness

— The exposure being hedged for the first time period of the proposed
hedging relationship is variability in interest payments above 6%; however,
in the second time period, it is increases or decreases in three-month
LIBOR from 6%.

Excerpt from ASC 815-20

>> Example 27: Purchased Option Used in a Cash Flow Hedge

55-208 This Example illustrates the application of paragraph 815-20-25-126.

55-209 An entity forecasts that 1 year later it will purchase 1,000 ounces of
gold at then current market prices for use in its operations. The entity wishes
to protect itself against increases in the cost of gold above the current market
price of $275 per ounce. The entity purchases a 1-year cash-settled at-the-
money gold option on 1,000 ounces of gold, paying a premium of $10,000. If
the price of gold is above $275 at the maturity (settlement) date, the
counterparty will pay the entity 1,000 times the difference. If the price of gold
is $275 or below at the maturity date, the contract expires worthless. The
option cannot be exercised before its contractual maturity date. The entity
designates the purchased option contract as a hedge of the variability in the
purchase price (cash outflow) of the 1,000 ounces of gold for prices above
$275 per ounce.
55-210 In assessing the effectiveness of the cash flow hedge, the entity would
determine that because the change in the expected future pay-off amount of
the purchased option completely offsets the change in the expected future
cash flows on the purchase of 1,000 ounces of gold above $275 per ounce, the
hedging relationship is expected to be highly effective under paragraph 815-20-
25-75(b).
55-211 The entity would conclude there is perfect effectiveness because all of
the following conditions exist:
a. All the critical terms of the hedging derivative completely match the
hedged forecasted transaction.
b. The strike price of the hedging instrument matches the specified level
($275) beyond which the entity's exposure is being hedged.
c. The hedging derivative’s inflows at expiration completely offset the hedged
transaction’s outflows for any increase in the price of gold above $275 per
ounce.
d. The hedging option cannot be exercised before its contractual maturity date.
Hedging 818
9. Hedge effectiveness

Example 9.7.20
Terminal value method for a hedge of a forecasted
foreign currency denominated sale with a purchased
option
ABC Corp.’s functional currency is the US dollar.
On January 1, Year 1, ABC forecasts a sale on credit for 10,000,000 euros (€).
The sale is expected to occur on December 31, Year 1.
ABC purchases a European style put option for $442,000 for €10,000,000
notional amount with an exercise rate of €1 = $0.90.
ABC designates a cash flow hedge of the functional currency equivalent cash
flows due to a depreciation of the euro below $0.90 from the date the sale is
forecasted to be probable through the expected sale date.
The following additional facts are relevant.
— ABC expects this hedging relationship to be perfectly effective in hedging
against a depreciation of the euro below $0.90. This is because the critical
terms of the forecasted transaction match the critical terms of the put
option (notional amount, underlying, maturity and strike price of the
specified exposure level being hedged).
— ABC will assess effectiveness based on the terminal value method.
— The put option is expected to generate cash flows at maturity that
offset the change in cash flows of the hedged sale for the risk being
hedged.
— Based on these factors and the option’s single exercise date at
maturity, ABC will not record any portion of the option’s cost or change
in fair value in earnings until the forecasted sale affects earnings.
— The €/$ spot rate and fair value of the put option are as follows.

Change in
fair value of
Spot rate Fair value of put option
1
€/$ put option gain (loss)
January 1, Year 1 0.90 $442,000 N/A
March 31, Year 1 0.88 491,000 $49,000
June 30, Year 1 0.92 211,000 (280,000)
September 30, Year 1 0.89 261,000 50,000
December 31, Year 1 0.84 600,000 339,000
Note:
The fair value of the put option is based on an option pricing model.

— The put option settles on December 31, Year 1 with ABC receiving $600,000.
— Also on December 31, Year 1, the forecasted sale occurs.
Hedging 819
9. Hedge effectiveness

For simplicity, this example makes the following assumptions.

— It ignores the effect of commissions and other transaction costs, initial
margins and income taxes.
— The hedging relationship is perfectly effective.
Journal entry – January 1, Year 1
ABC records the following journal entries at January 1, Year 1.

Debit Credit
Put option 442,000
Cash 442,000
To record purchase of put option at fair value.

There would also be a memorandum entry made on January 1, Year 1

documenting the existence of this hedging relationship.
Journal entries – March 31, Year 1
ABC records the following journal entry.

Debit Credit
Put option 49,000
OCI – Gains (losses) on cash flow hedging
derivatives 49,000
To record change in fair value of derivative for
which hedge accounting is applied.

Journal entries – June 30, Year 1

ABC records the following journal entry.

Debit Credit
OCI – Gains (losses) on cash flow hedging
derivatives 280,000
Put option 280,000
To record change in fair value of derivative for
which hedge accounting is applied.

Journal entries – September 30, Year 1

ABC records the following journal entry.

Debit Credit
Put option 50,000
OCI – Gains (losses) on cash flow hedging
derivatives 50,000
To record change in fair value of derivative for
which hedge accounting is applied.
Hedging 820
9. Hedge effectiveness

Journal entries – December 31, Year 1

ABC records the following journal entries.

Debit Credit
Accounts receivable 8,400,000
Sales revenue 8,400,000
To record sale on credit. 1

Put option 339,000

OCI – Gains (losses) on cash flow hedging
derivatives 339,000
To record change in fair value of derivative for
which hedge accounting is applied.
Cash 600,000
Put option 600,000
To record cash received from settlement of put
option.
AOCI – Gains (losses) on cash flow hedging
derivatives 158,000
Sales revenue 158,000
To reclassify net derivative gain from AOCI into
earnings because hedged transaction (sale)
affected earnings. 2
Notes:
€10,000,000 sale price x €/$ spot rate of 0.84.
$600,000 settlement - purchase price $442,000.

Financial statement excerpts

At the end of each period, ABC’s financial statements reflect the following
related to this hedging relationship.

3 months 6 months 9 months Year

ended ended ended ended
Account Mar 31 Jun 30 Sep 30 Dec 31
Balance sheet – assets
Put option $491,000 $211,000 $261,000 -
Balance sheet – equity
AOCI – Gains
(losses) on cash flow
hedging derivatives $49,000 $(231,000) $(181,000) -
Income statement
Sales revenue - - - $8,558,000
Hedging 821
9. Hedge effectiveness

At December 31, Year 1, ABC records a sale of $8,400,000 along with a gain
on the put option of $158,000 for a total of $8,558,000 for the hedged
€10,000,000 sale.
The difference between the functional currency equivalent value of $9,000,000
at the forecast date (€10,000,000 × $0.90 spot rate at the forecast date) and the
net recorded amount of $8,558,000 is the cost of the put option ($442,000).
Absent this hedge, ABC would have recorded only the sale of $8,400,000 and
would have had an economic loss of $600,000 due to unhedged changes in the
foreign exchange rate from the forecasted date.
The put option was effective at hedging functional currency equivalent cash
flows for a depreciation of the euro below $0.90. As a result of the hedge,
ABC’s net effect on earnings attributable to changes in the foreign currency
exchange rate during the forecasted period was the cost of the put option
($442,000) rather than the full effect of depreciation in the euro during the
forecasted period ($600,000).

Options with periodic (multiple) settlements

Certain purchased option contracts comprise a series of contracts, each with a
potential cash flow, that are used to hedge a series of forecasted transactions.
For example, a purchased cap comprises a series of purchased caplets that may
be used to hedge a series of hedged transactions (such as caplets that hedge a
series of interest payments at different quarterly dates). When that type of
option is designated as the hedging instrument in a cash flow hedge, the entity
may focus on the terminal value of each caplet (i.e. the expected future pay-off
amount at the maturity date of each caplet) in determining whether each of
those hedging relationships is expected to be highly effective in achieving
offsetting cash flows. [815-20-25-128]
As with other cash flow hedging relationships, the net derivative gain or loss
that is reported in AOCI is reclassified into earnings when the hedged
transaction affects earnings when the terminal value method is used. When the
caplet method is used, because the amount in AOCI is a net amount that
comprises both derivative gains and derivative losses, the original allocated fair
value amount for an individual caplet that is reclassified out of AOCI into
earnings may be greater than the net amount in AOCI.
As discussed in section 6.3.20, Topic 815 provides guidance for accounting for
an initial non-zero fair value when a single derivative is used to hedge the
variability in multiple cash flows or periodic settlements (e.g. purchased caps).
In those situations, amounts in AOCI that are related to the initial fair value are
required to be reclassified to earnings on a systematic and rational basis over
the periods during which the hedged transactions affect earnings. One
acceptable method for reclassification is the caplet method (see
Question 6.3.50). [815-30-35-41A – 35-41B]
Hedging 822
9. Hedge effectiveness

Example 9.7.30
Using the caplet method to reclassify amounts from
AOCI into earnings
ABC Corp. documents a single interest rate cap as the hedging instrument in a
hedge of the interest rate risk on variable-rate debt with quarterly interest
payments over the next two years. ABC will use the terminal value method for
assessing effectiveness and the conditions that will result in perfect
effectiveness are met.
ABC allocates the fair value of the cap at the inception of the hedging
relationship to the respective caplets within the single cap on a fair value basis
at the inception of the hedging relationship. ABC reclassifies that original
allocated fair value amount out of AOCI into earnings when each of the
respective hedged transactions (the eight interest payments) affects earnings.
Because the amount in AOCI is a net amount that comprises both derivative
gains and derivative losses, the original allocated fair value amount for an
individual caplet that is reclassified out of AOCI into earnings may be greater
than the net amount in AOCI.
See also Scenario 3 of Example 6.3.30.

9.7.30 Hypothetical derivative method

As mentioned in section 9.7.10, the hypothetical derivative method is used in
practice for all types of cash flow hedges.
The following table summarizes the hypothetical derivative method.

Conditions that — The critical terms of the hedging instrument match the
will result in related terms of the hedged transaction (that is, the terms
perfect of the actual hedging instrument and the perfectly
effectiveness: effective hypothetical derivative are the same).
[815-20-25- — The fair value of a PEH derivative (when the hedging
3(b)(2)(iv)(01)(F)] instrument is a swap or a forward contract) is zero at
hedge inception.
— See also Question 9.2.50 regarding whether subsequent
assessments are performed on a qualitative or
quantitative basis.
What is compared
— The change in fair value of the actual hedging instrument.
in assessing
effectiveness: — The change in fair value for a hypothetical derivative that
would result in perfect offset (the PEH derivative).
[815-30-35-25]

The PEH derivative instrument is one whose terms identically match the terms
of the forecasted transaction. Therefore, the hypothetical derivative would be
expected to perfectly offset the hedged cash flows. The change in the fair value
of the PEH derivative can be regarded as a proxy for the present value of the
cumulative change in expected future cash flows on the hedged transaction
when assessing effectiveness.
Hedging 823
9. Hedge effectiveness

The fair values of both the PEH interest rate swap and the actual interest rate
swap should use discount rates based on the relevant interest rate swap
curves, as appropriate. As discussed in Question 9.2.300, under the
hypothetical derivative method, an entity is permitted to use the same credit
risk adjustment that is used to determine the fair value of the derivative when
calculating the change in the cash flows of the hedged transaction, as long it is
probable that the counterparty to the derivative or the entity will not default. As
a result, credit risk (or the entity’s own nonperformance risk) and changes
therein do not affect hedge effectiveness. [815-30-35-29]
If the original terms of the forecasted transaction change during the hedge
period, but the original transaction is still probable as described in the original
hedge documentation, the terms of the PEH derivative are changed to perfectly
offset the new terms of the transaction – i.e. the PEH derivative would be reset
to the new terms of the transaction with a start date equal to the original date
of the hedging relationship, and a fair value of zero if the hedging instrument is
a swap or forward contract.
This method is relatively operational because entities are likely to be able to
value cash flows that are identical to the variable-rate asset or liability being
hedged without difficulty.
See also section 9.7.40 for discussion of applying the PEH derivative method
when an interest rate swap is used in a cash flow hedge of variability in interest
receipts or payments.

Question 9.7.30
Can the hypothetical derivative method result in
perfect effectiveness when the hedging instrument
is not an interest rate swap and the hedged risk is
not variability in interest receipts or payments?
Interpretive response: Yes. Topic 815 only specifies that the hypothetical
derivative method may result in perfect effectiveness when an interest rate
swap is used in a cash flow hedge of variability in interest receipts or payments.
However, we believe the same result will occur for all types of cash flow
hedging relationships that use the hypothetical derivative method.
That is, when the critical terms of the actual hedging instrument match those of
the perfectly effective hypothetical derivative, the hedging relationship will be
perfectly effective.
In these situations, we believe the entity is not required to perform the actual
calculation. This is because when the variables to be compared are identical,
the results of the calculation are known with mathematical certainty without
performing the full calculation (see Question 9.6.80).
Hedging 824
9. Hedge effectiveness

Question 9.7.40
How is the PEH derivative defined when a cross-
currency interest rate swap is used to hedge
intercompany fixed-rate debt in a cash flow hedge?
Interpretive response: There are unique considerations when applying the
hypothetical derivative method for assessing effectiveness when a fixed-for-
fixed cross-currency interest rate swap is used to hedge intercompany fixed-
rate debt. This is because – under Topic 830 (foreign currency matters) – the
intercompany interest is eliminated in consolidation while the effect of foreign
currency exposure of the intercompany principal is not.
In a cash flow hedge of the foreign currency risk associated with foreign
currency denominated (FCD) debt issued by a third party where the hedging
instrument is a fixed-for-fixed cross-currency interest rate swap, the PEH
derivative has a zero fair value at inception of the hedging relationship and the
terms would match the terms of the hedged transactions.
However, judgment is required in defining the hypothetical derivative when the
FCD debt is intercompany.
We believe there are two acceptable approaches that an entity may consider
when determining the terms of the PEH derivative.
Approach 1: Define the hedged risk as solely the foreign currency risk
associated with the principal amount of the intercompany debt
Under this approach, the PEH derivative would be defined as a forward contract
that exactly matches the principal amount of the intercompany debt. In this
situation, the foreign currency risk inherent in that principal amount is a risk that
affects consolidated earnings during the life of the hedging relationship under
Topic 830, even though the debt and the interest payments on that debt are
eliminated in consolidation.
This approach does not include the foreign currency risk related to the interest
payments on the intercompany debt because they are eliminated in
consolidation. Accordingly, under Topic 830, foreign currency risk affects
consolidated earnings only when interest payments are accrued but unpaid.
Under this approach, the relationship may not be highly effective due to the
changes in fair value of the net coupon payments included in the hedging
instrument (i.e. the fixed-for-fixed cross-currency interest rate swap) that would
not be included in the hypothetical derivative.
Approach 2: Define the hedged risk as the foreign currency risk associated
with both (a) the principal amount of the intercompany debt and (b) the
forecasted interest payments on the intercompany debt
Under this approach, the PEH derivative is defined as a fixed-for-fixed cross-
currency interest rate swap that exactly matches the principal amount of the
intercompany debt and the forecasted interest payments of the intercompany
debt. In this situation, the foreign currency risk inherent in the principal amount
is a risk that under Topic 830 affects consolidated earnings during the life of the
hedging relationship and the foreign currency risk inherent in the forecasted
interest payments will eventually affect earnings as each interest payment is
accrued.
Hedging 825
9. Hedge effectiveness

While the foreign currency risk related to each interest payment does not affect
earnings until it is accrued, we believe this approach is acceptable by analogy to
paragraph 815-20-25-38(d) (reproduced in section 7.6.20). That paragraph
permits an entity to hedge the foreign currency risk related to the forecasted
sale to a foreign subsidiary or the forecasted royalty from a foreign subsidiary.
With the forecasted sale to or royalty from a foreign subsidiary, foreign currency
risk does not affect consolidated earnings until either the sale is recorded as a
payable/receivable or the royalty is earned and recorded as a payable/receivable.
When an entity uses this approach, we believe amounts should be reclassified
from AOCI into earnings in a pattern that is identical to the one that would be
used if the debt were issued to a third party (and interest payments were not
eliminated in consolidation). Reclassifying in this manner is necessary so that
the AOCI balance at the end of the hedged period for the hedging relationship
is zero.
However, these reclassifications will introduce volatility in consolidated earnings
because the interest payments will only affect consolidated earnings for the risk
being hedged (foreign currency risk) from the time they are accrued until the
time they are paid.

FASB Example: Effectiveness of cash flow hedge of a

forecasted purchase of inventory with a forward contract

Excerpt from Subtopic 815-30

>> Example 1: Effectiveness of Cash Flow Hedge of a Forecasted

Purchase of Inventory with a Forward Contract

55-1A This Example illustrates the application of the guidance in Subtopic 815-
20 and this Subtopic to assessing effectiveness for a cash flow hedge of a
forecasted purchase of inventory with a forward contract in which the forward
contract index differs from the index of the underlying hedged transaction.
Assume that the entity elected to perform subsequent quarterly hedge
effectiveness assessments on a quantitative basis and that all hedge
documentation requirements were satisfied at inception.
55-2 Entity G forecasts the purchase of 500,000 pounds of Brazilian coffee for
U.S. dollars in 6 months. The agreement outlining purchase terms between
Entity G and its supplier contains a contractually specified component
referencing a Brazilian coffee index denominated in U.S. dollars. Entity G
designates the variability in cash flows related to its forecasted purchase of
Brazilian coffee attributable to changes in the contractually specified
component (Brazilian coffee index) as the hedged risk. Rather than acquire a
derivative instrument based on Brazilian coffee, Entity G enters into a 6-
month forward contract to purchase 500,000 pounds of Colombian coffee for
U.S. dollars and designates the forward contract as a hedging instrument in a
cash flow hedge of the variability in cash flows attributable to changes in the
contractually specified Brazilian coffee index component of its forecasted
purchase of Brazilian coffee.
Hedging 826
9. Hedge effectiveness

55-3 Entity G bases its assessment of hedge effectiveness on changes in

forward prices, with the resulting gain or loss discounted to reflect the time
value of money. Both at inception and on an ongoing basis, Entity G could
assess the effectiveness of the hedge by comparing changes in the expected
cash flows from the Colombian coffee forward contract with the expected net
change in cash outflows attributable to changes in the contractually specified
component for purchasing the Brazilian coffee for different market prices. (A
simpler method that should produce the same results would consider the
expected future correlation of the prices of Brazilian and Colombian coffee,
based on the correlation of those prices over past six-month periods.)
55-4 In assessing hedge effectiveness on an ongoing basis, Entity G also must
consider the extent of offset between the change in expected cash flows on
its Colombian coffee forward contract and the expected net change in
expected cash flows for the forecasted purchase of Brazilian coffee attributable
to changes in the contractually specified component. Both changes would be
measured on a cumulative basis for actual changes in the forward price of the
respective coffees during the hedge period.
55-5 See Topic 820 (including paragraph 820-10-55-13) for a discussion of
expected cash flow.
55-6 Because the only difference between the forward contract and forecasted
purchase relates to the type of coffee (Colombian versus Brazilian), Entity G
could consider the changes in the cash flows on a forward contract for Brazilian
coffee to be a measure of perfectly offsetting changes in cash flows for its
forecasted purchase of Brazilian coffee. For example, for given changes in the
U.S. dollar prices of six-month and three-month Brazilian and Colombian
contracts, Entity G could compute the effect of a change in the price of coffee
on the expected cash flows of its forward contract on Colombian coffee and of
a forward contract for Brazilian coffee as follows.

Estimate of Change in Cash Flows

Hedging Instrument: Estimate of Forecasted
Forward Contract on Transaction: Forward
Colombian Coffee Contract on Brazilian
Coffee
Forward price of Colombian and
Brazilian coffee:
At hedge inception—6-month
price $ 2.54 $ 2.43
3 months later—3-month price 2.63 2.53
Cumulative change in price—gain $ 0.09 $ 0.10
x 500,000 pounds of coffee x 500,000 x 500,000
Estimate of change in cash flows $ 45,000 $ 50,000

55-7 See Topic 820 (including paragraph 820-10-55-13) for a discussion of

expected cash flows.
55-8 Using the amounts in paragraph 815-30-55-6, Entity G could evaluate
effectiveness 3 months into the hedge on its first subsequent quarterly
effectiveness assessment testing date by comparing the $45,000 change on
Hedging 827
9. Hedge effectiveness

its Colombian coffee contract with what would have been a perfectly offsetting
change in cash flow for its forecasted purchase—the $50,000 change on an
otherwise identical forward contract for Brazilian coffee. Entity G concludes
that the hedging relationship would be highly effective, and it would record the
$45,000 change in the fair value of the forward contract on Colombian coffee in
other comprehensive income. e.

9.7.40 Methods applicable when an interest rate swap is

used in a cash flow hedge of variability in interest
receipts or payments

Excerpt from ASC 815-30

>> Assessing Hedge Effectiveness in Certain Cash Flow Hedges Involving

Interest Rate Risk When Effectiveness Is Assessed on a Quantitative Basis
35-10 This guidance addresses the following three methods of assessing
effectiveness of certain cash flow hedges when hedge effectiveness is
assessed on a quantitative basis in accordance with paragraphs 815-20-25-
3(b)(2)(iv)(01) and 815-20-35-2 through 35-2F:
a. Change-in-variable-cash-flows method
b. Hypothetical-derivative method
c. Change-in-fair-value method
35-11 Those three methods relate to assessing the effectiveness of a cash
flow hedge that involves any of the following:
a. A receive-variable, pay-fixed interest rate swap designated as a hedge of
the variable interest payments on an existing floating-rate liability
b. A receive-fixed, pay-variable interest rate swap designated as a hedge of
the variable interest receipts on an existing variable-rate asset
c. Cash flow hedges of the variability of future interest payments on interest-
bearing assets to be acquired or interest-bearing liabilities to be incurred
(such as the rollover of an entity’s short-term debt as described in
Example 9 [see paragraph 815-30-55-52]).
35-12 The hedging relationships covered by this guidance encompass either of
the following:
a. Hedges of interest rate risk (pursuant to paragraph 815-20-25-15(j)(2)) that
do not qualify for the shortcut method
b. Hedges of the risk of overall changes in the hedged cash flows related to
the asset or liability (pursuant to paragraph 815-20-25-15(j)(1)).
35-13 If, at the inception of the hedge, the fair value of the interest rate swap
designated as the hedging instrument is zero or is somewhat near zero, any of
the three methods in paragraph 815-30-35-10 may be applied to assess hedge
effectiveness.
35-14 In contrast, if, at the inception of the hedge, the fair value of the interest
rate swap is not somewhat near zero, the change-in-variable-cash-flows
Hedging 828
9. Hedge effectiveness

method shall not be applied to assess hedge effectiveness because that

method does not require entities to consider the interest element of the
change in fair value of a hedging instrument that incorporates a financing
element; instead, either the hypothetical-derivative method or the change-in-
fair-value method shall be applied. Those latter two methods require entities to
consider the interest element of the change in fair value of a hedging
instrument that incorporates a financing element that is not somewhat near
zero, such as if the interest rate swap has been structured to be significantly in
the money at the inception of the hedging relationship.
35-15 Under all three methods, an entity shall consider the risk of default by
counterparties that are obligors with respect to the hedging instrument (the
interest rate swap) or hedged transaction, pursuant to the guidance in
paragraphs 815-20-25-122 and 815-20-25-16(a), respectively. An underlying
assumption in this guidance is that the likelihood of the obligor not defaulting is
assessed as being probable.
35-15A When assessing hedge effectiveness using any of the three methods
specified in paragraph 815-30-35-10, in addition to the guidance specific to
each method, an entity also shall apply the general guidance in paragraph 815-
20-25-79 on prospective considerations and retrospective evaluations of hedge
effectiveness.

When a cash flow hedging relationship that involves an interest rate swap and
variability in interest receipts or payments is not eligible for (or the entity does
not elect) the shortcut method (see section 9.3), an entity is required to perform
periodic assessments of effectiveness.
Topic 815 describes three methods that may be elected for certain of those
hedging relationships, which are summarized in the following table.
Alternatively, an entity may choose to use methods that have developed in
practice, such as projecting cash flows based on forward price curves (see
section 9.7.50). [815-30-35-10 – 35-14, 815-20-25-15(j)(1) – 25-15(j)(2)]

Methods for assessing

Hedged risks Hedged transactions effectiveness
— An interest rate swap Methods described in
Interest rate risk
is used in a hedge of Topic 815:
(see sections 2.3.20 and variable interest — If the initial fair value
5.4) payments on an is zero (or somewhat
— Contractually specified existing variable-rate near zero):
interest rate on asset or liability
— Change-in-
existing variable-rate — A hedge of the
variable-cash-
financial instruments variability of future
flows method
or on forecasted interest payments on
— Hypothetical
issuances or interest-bearing
derivative
purchases of variable- assets to be acquired
method
rate financial or interest-bearing
— Change-in-fair-
instruments liabilities to be
value method
— Benchmark interest incurred such as the
rate on forecasted rollover of an entity’s — If the initial fair value
issuances or short-term debt as is not zero (or
purchases of fixed- described in somewhat near zero):
rate debt instruments Subtopic 815-30’s
Example 9
Hedging 829
9. Hedge effectiveness

Price risk – i.e. (reproduced in — Hypothetical

section 6.5.10) derivative
overall changes in the
— These hedged method
hedged cash flows (see
transactions are — Change-in-fair-
section 2.3.70)
referred to value method
collectively in this
section as ‘variability
in interest receipts or
payments’

Change-in-variable-cash-flows method

Excerpt from ASC 815-30

>>> Change-in-Variable-Cash-Flows Method

35-16 An entity shall assess hedge effectiveness under the change-in-variable-
cash-flows method by comparing the following items:
a. The variable leg of the interest rate swap
b. The hedged variable-rate cash flows on the asset or liability.
35-17 As noted in paragraph 815-30-35-14, the change-in-variable-cash-flows
method shall not be used in certain circumstances.
35-18 The change-in-variable-cash-flows method is consistent with the cash
flow hedge objective of effectively offsetting the changes in the hedged cash
flows attributable to the hedged risk. The method is based on the premise that
only the floating-rate component of the interest rate swap provides the cash
flow hedge, and any change in the interest rate swap’s fair value attributable to
the fixed-rate leg is not relevant to the variability of the hedged interest
payments (receipts) on the floating-rate liability (asset).
35-19 An entity shall assess hedge effectiveness under this method by
comparing the following amounts:
a. The present value of the cumulative change in the expected future cash
flows on the variable leg of the interest rate swap
b. The present value of the cumulative change in the expected future interest
cash flows on the variable-rate asset or liability.
35-20 Because the focus of a cash flow hedge is on whether the hedging
relationship achieves offsetting changes in cash flows, if the variability of the
hedged cash flows of the variable-rate asset or liability is based solely on
changes in a variable-rate index, the present value of the cumulative changes in
expected future cash flows on both the variable-rate leg of the interest rate
swap and the variable-rate asset or liability shall be calculated using the
discount rates applicable to determining the fair value of the interest rate swap.
35-22 The change-in-variable-cash-flows method will result in a perfectly
effective hedge if all of the following conditions are met:
a. The variable-rate leg of the interest rate swap and the hedged variable cash
flows of the asset or liability are based on the same interest rate index (for
example, three-month London Interbank Offered Rate (LIBOR) swap rate).
Hedging 830
9. Hedge effectiveness

b. The interest rate reset dates applicable to the variable-rate leg of the
interest rate swap and to the hedged variable cash flows of the asset or
liability are the same.
c. The hedging relationship does not contain any other basis differences (for
example, if the variable leg of the interest rate swap contains a cap and the
variable-rate asset or liability does not).
d. The likelihood of the obligor not defaulting is assessed as being probable.
35-23 However, a hedge would not be perfectly effective if any basis
differences existed. For example, this would be expected to result from either
of the following conditions, among others:
a. A difference in the indexes used to determine cash flows on the variable
leg of the interest rate swap (for example, the three-month U.S. Treasury
rate) and the hedged variable cash flows of the asset or liability (for
example, three-month LIBOR)
b. A mismatch between the interest rate reset dates applicable to the variable
leg of the interest rate swap and the hedged variable cash flows of the
hedged asset or liability.
35-24 Example 15 (see paragraph 815-30-55-91) illustrates the application of
the change-in-variable-cash-flows method.

The objective of a cash flow hedge is to offset the changes in the hedged cash
flows related to the hedged risk. The change-in-variable-cash-flows method is
most consistent with that objective. [815-30-35-18]
The following table summarizes the change-in-variable-cash-flows method.

Conditions for — This method may not be used if the fair value of the swap is
applying this not zero or somewhat near zero at inception of the hedge
method: since this method does not require an entity to consider the
[815-30-35-14, interest element of the change in fair value of a hedging
35-17] instrument that incorporates a financing element.
Conditions that — The variable-rate leg of the swap and the hedged variable
will result in cash flows of the asset or liability are based on the same
perfect interest rate index.
effectiveness: — The interest rate reset dates that apply to the variable-rate
[815-30-35-22] leg of the swap and to the hedged variable cash flows of the
asset or liability are the same.
— The payment dates on the swap and hedged variable cash
flows are the same.
— The hedging relationship does not contain any other basis
differences.
— The likelihood of the obligor not defaulting is assessed as
being probable.
— See also Question 9.2.50 regarding whether subsequent
assessments are performed on a qualitative or quantitative
basis.
Hedging 831
9. Hedge effectiveness

What is — The present value1 of the cumulative change in the expected

compared in future cash flows on the variable leg of the swap.
assessing — The present value1 of the cumulative change in the expected
effectiveness: future interest cash flows on the floating-rate asset or
[815-30-35-16, liability.
35-19]

Note:
When determining the present values, the discount rates should be the rates that
would be used to determine the fair value of the swap. [815-30-35-20]

The theory behind this methodology is that the cash flow hedge is
accomplished primarily through the variable leg of the interest rate swap.
Therefore, the hedge’s effectiveness should not be affected by the change in
fair value that is attributable to the fixed leg portion of the swap. Said
differently, only the floating-rate component of the swap provides the cash flow
hedge and any change in the swap’s fair value that is attributable to the fixed-
rate leg is not relevant to the variability of the hedged interest payments
(receipts) on the floating-rate liability (asset). [815-30-35-18]
Perfect effectiveness will not result if any of the conditions specified in the
table are not met. The following are examples.
— Any basis differences exist. For example, difference in the indices used to
determine cash flows on the variable leg of the swap (e.g. the three-month
Treasury rate) and the hedged variable cash flows of the asset or liability
(e.g. three-month LIBOR).
— There is a mismatch between the interest rate reset dates that apply to the
variable leg of the swap and the hedged variable cash flows of the hedged
asset or liability.

FASB Example: Change-in-variable-cash-flows method for

assessing hedge effectiveness

Excerpt from ASC 815-30

>>>> Example 15: Change-in-Variable-Cash-Flows Method for Assessing

Hedge Effectiveness

55-91 This Example demonstrates the application of the change-in-variable-

cash-flows method discussed in paragraph 815-30-35-16 to assess hedge
effectiveness.
55-92 An entity designates a receive-variable, pay-fixed interest rate swap
with a zero fair value as a hedge of variable interest rate payments on a debt
instrument. The variable leg of the interest rate swap is based on the three-
month U.S. Treasury rate, and the variable cash flows of the debt are based on
three-month LIBOR. Assume that the overall change in fair value of the interest
rate swap from inception of the hedge is $16,300, the present value of the
cumulative change in the cash flow on the variable leg of the interest rate
Hedging 832
9. Hedge effectiveness

swap is a gain (increased cash inflow) of $16,596, and the present value of the
cumulative change in the expected future interest cash flows on the variable-
rate liability due to changes in the cash flows expected for the remainder of the
hedge term is a loss (increased cash outflow) of $16,396. (The cumulative
changes in expected future cash flows on both the variable leg of the interest
rate swap and the variable-rate debt are discounted using the rates applicable
to determining the fair value of the derivative instrument.)
55-93A The entity assesses effectiveness by comparing the present value of
the cumulative change in the cash flow on the variable leg of the interest rate
swap of $16,596 with the present value of the cumulative change in the
expected future interest cash flows on the variable-rate liability of $16,396 and
concludes that the hedging relationship is highly effective. As a result, the
balance in accumulated other comprehensive income would reflect the
cumulative change in the fair value of the swap since hedge inception
($16,300).

Hypothetical derivative method

Excerpt from ASC 815-30

>>> Hypothetical-Derivative Method

35-25 An entity shall assess hedge effectiveness under the hypothetical-
derivative method by comparing the following amounts:
a. The change in fair value of the actual interest rate swap designated as the
hedging instrument
b. The change in fair value of a hypothetical interest rate swap having terms
that identically match the critical terms of the floating-rate asset or liability,
including all of the following:
1. The same notional amount
2. The same repricing dates
3. The same index (that is, the index on which the hypothetical interest
rate swap’s variable rate is based matches the index on which the
asset or liability’s variable rate is based)
4. Mirror image caps and floors
5. A zero fair value at the inception of the hedging relationship.
35-26 Essentially, the hypothetical derivative would need to satisfy all of the
applicable conditions in paragraphs 815-20-25-104 and 815-20-25-106
necessary to qualify for use of the shortcut method except the criterion in
paragraph 815-20-25-106(g) and the criterion in paragraph 815-20-25-104(e).
Thus, the hypothetical interest rate swap would be expected to perfectly offset
the hedged cash flows. Because the requirements of paragraph 815-20-25-
104(e) were developed with an emphasis on fair value hedging relationships,
they do not fit the more general principle that the hypothetical derivative in a
cash flow hedging relationship should be expected to perfectly offset the
hedged cash flows.
Hedging 833
9. Hedge effectiveness

35-27 The change in the fair value of the perfect hypothetical interest rate
swap can be regarded as a proxy for the present value of the cumulative
change in expected future cash flows on the hedged transaction.
35-29 The determination of the fair value of both the perfect hypothetical
interest rate swap and the actual interest rate swap shall use discount rates
based on the relevant interest rate swap curves.

Section 9.7.30 describes the hypothetical derivative method.

To use the hypothetical derivative method in cash flow hedges of variability in
interest receipts or payments, the terms of a PEH interest rate swap need to
match the critical terms of the variable-rate asset or liability. Specifically, the
following terms of the PEH swap need to identically match those of the hedged
transaction: [815-30-35-25]
— same notional amount;
— same repricing dates;
— the index on which the hypothetical swap’s variable rate is based matching
the index on which the asset or liability’s variable rate is based;
— mirror image caps and floors; and
— a zero fair value at the inception of the hedging relationship.
Essentially, the PEH derivative needs to satisfy all of the applicable conditions
for the shortcut method (see section 9.3), except that the PEH is not required to
include a mirror-image call or put option, as explained in Subtopic 815-20’s
Example 7 (reproduced below). If these terms match, the PEH swap is
expected to perfectly offset the hedged cash flows. As a result, the change in
the fair value of the PEH swap can be regarded as a proxy for the present value
of the cumulative change in expected future cash flows on the hedged
transaction. [815-30-35-26 – 35-27]
As discussed in Question 9.2.300, under the hypothetical derivative method, an
entity is permitted to use the same credit risk adjustment that is used to
determine the fair value of the derivative when calculating the change in the
cash flows of the hedged transaction, as long as it is probable that the
counterparty to the derivative or the entity will not default. As a result, credit
risk (or the entity’s own nonperformance risk) and changes therein do not affect
hedge effectiveness. [815-30-35-29]
If the actual hedging instrument meets the above conditions (i.e. if all of the
critical terms match), the hedging relationship will result in perfect
effectiveness. [815-20-25-3(b)(2)(iv)(01)(F)]

Question 9.7.50
How is the PEH derivative defined when a deal
contingent swap is used to hedge a forecasted debt
issuance contingent on a business combination?
Background: As discussed in Question 2.5.60, we believe it could be
acceptable to hedge the forecasted issuance of debt that is contingent on
consummation of a business combination if the forecasted transaction does not
directly affect the purchase price or the purchase accounting associated with
Hedging 834
9. Hedge effectiveness

the acquisition. An entity may wish to use a deal contingent forward-starting

interest rate swap as the hedging instrument in such a relationship.
Interpretive response: When an entity hedges a forecasted debt issuance that
is contingent on a business combination, we believe the PEH derivative is a
forward-starting interest rate swap whose critical terms match those of the
forecasted debt issuance and does not include a deal contingency.
Whether the entity will consummate a business combination is considered
when determining whether the forecasted debt issuance is probable, which is a
necessary condition for applying cash flow hedge accounting. Because the
terms of the debt, once issued, will not be contingent on the business
combination occurring, the PEH derivative should also not include a contingency
related to consummation of the business combination.
If the actual derivative hedging instrument includes a deal contingency, the
hedging relationship will not be perfectly effective because the deal
contingency will be considered when measuring the expected cash flows of the
actual derivative – but not when measuring the expected cash flows of the PEH
derivative.

Examples
Following are examples that demonstrate the hypothetical derivative method
when an interest rate swap is used to hedge variability in interest cash flows.
— PEH swap in a hedge of variable-rate debt that contains a floor
(Example 9.7.40).
— Determination of the appropriate hypothetical derivative for variable-rate
debt that is prepayable at par at each interest reset date (Subtopic 815-20’s
Example 7).

Example 9.7.40
PEH swap in a hedge of variable-rate debt that
contains a floor
ABC Corp. issues variable-rate debt that pays interest at the Prime rate (a
contractually specified interest rate) plus a fixed credit spread. The debt
agreement provides that the Prime rate can never be negative -- i.e. it has a
floor of zero. The floor was included in the debt agreement so that the lender
receives a minimum amount of interest (i.e. the initial credit spread) and never
has to make an interest payment to ABC.
ABC enters into an interest rate swap to hedge its exposure to variability in
interest cash flows caused by changes in the benchmark interest rate.
However, the variable leg of the interest rate swap does not have a matching
floor of zero. ABC documents the interest rate swap as a hedge of its exposure
to changes in the variable benchmark rate above the floor of zero.
Because the interest rate swap has no matching floor, ABC is precluded from
using the shortcut method, and the hedging relationship will not have perfect
offset. ABC documents that it will use the hypothetical derivative method to
assess effectiveness.
Hedging 835
9. Hedge effectiveness

The PEH swap incorporates terms that identically match the critical terms of the
debt instrument and have an initial fair value of zero. The PEH swap will have
the following differences from the actual hedging instrument.
— The PEH swap will incorporate a floor.
— As a result of the floor, the PEH swap will also likely have a different fixed
leg than the actual swap so that the PEH swap will have an initial fair value
of zero.
These differences from the actual swap are required to be considered when
assessing whether the hedging relationship is highly effective.
It is not necessary for the Prime rate to actually decline below zero for this
relationship to lack perfect offset. The mere potential for negative interest rates
results in a lack of perfect offset because the probability of a negative
benchmark rate is considered as part of determining the fair value of the PEH
swap that contains the floor.
See also Example 6.2.20 for an example of accounting for a cash flow hedge of
variable-rate debt when the hedging instrument (i.e. an interest rate swap) has a
cap and a floor but the hedged transaction (i.e. variable-rate debt) does not.

Excerpt from ASC 815-20

>> Example 7: Determination of the Appropriate Hypothetical Derivative

for Variable-Rate Debt That Is Prepayable at Par at Each Interest Reset
Date

55-106 This Example illustrates the application of paragraph 815-20-25-20.

55-107 Entity A issues variable-rate debt that is prepayable at par on each
interest rate reset date. The credit sector spread on the debt issuance is not
reset on the interest rate reset dates. Specifically, the debt bears interest at a
rate of LIBOR plus 100 basis points, with LIBOR reset every quarter. Entity A
also enters into a receive-variable, pay-fixed interest rate swap that is
designated as a hedge of the variability in the debt interest payments due to
changes in the contractually specified interest rate (LIBOR). During the term of
the hedging relationship (that is, the specific term of the interest rate swap),
Entity A expects to issue new variable-rate debt (in the event the original debt
is repaid before maturity) to maintain an aggregate debt principal balance equal
to or greater than the notional amount of the interest rate swap, and expects
the new debt (if any) to share the key characteristics of the original debt
issuance (specifically, quarterly repricing to the LIBOR index and no minimum,
maximum, or periodic constraints of the debt interest rate). The hedging
relationship meets all of the criteria for shortcut method accounting beginning
in paragraph 815-20-25-102 except for the criterion in paragraph 815-20-25-
104(e); the debt is prepayable and the interest rate swap does not contain a
mirror-image call option to match the call option embedded in the debt
instrument, as required by that paragraph.
Hedging 836
9. Hedge effectiveness

55-108 Entity A wishes to apply the hypothetical derivative method (as

described beginning in paragraph 815-30-35-25) for its initial and subsequent
quantitative assessments of hedge effectiveness. Because the actual interest
rate swap used in Entity A’s hedging relationship already meets all of the
criteria in paragraph 815-20-25-102 except the criterion in paragraph 815-20-25-
104(e), this guidance would seem to suggest that the hypothetical interest rate
swap would need to be the same as the actual interest rate swap except that a
mirror-image call option would need to be added to meet the criterion in that
paragraph and the guidance beginning in paragraph 815-30-35-10. However,
Entity A observes that because the hedged transactions are the variable
interest payments (on debt with a principal amount equal to the notional
amount of the swap) due to changes in the contractually specified interest rate
(LIBOR), and because the transaction had to be probable of occurring under
paragraph 815-20-25-15(b) for it to qualify for hedge accounting, the actual
swap would be expected to perfectly offset the hedged cash flows.
55-109 In this fact pattern, the hypothetical interest rate swap under the
guidance beginning paragraph 815-30-35-10 would be the same as the actual
interest rate swap described in this Example. Because Entity A has concluded
that if the original debt issuance is repaid before maturity, it is probable that a
sufficient principal amount of variable-rate debt with key characteristics that
match those of the original debt issuance (specifically quarterly repricing to the
LIBOR index and no minimum, maximum, or periodic constraints of the debt
interest rate) will be issued and remain outstanding during the term of the
hedging relationship (providing exposure to LIBOR-interest-rate-based variable
cash payments), the prepayment provisions of the debt instrument should not
be considered in determining the appropriate hypothetical derivative under that
guidance. The prepayment of the original variable-rate debt eliminates the
contractual obligation to make those interest payments; however, this Subtopic
permits replacing the hedged interest payments that are no longer
contractually obligated to be paid without triggering the dedesignation of the
original cash flow hedging relationship. Replacing the original debt issuance
with a new variable-rate debt issuance is permissible in a cash flow hedge of
interest rate risk and does not automatically result in the discontinuation of the
original cash flow hedging relationship.
55-110 Although the entity can terminate the debt at any interest rate reset
date for reasons that may be totally unrelated to changes in the contractually
specified interest rate (which is the hedged risk), it expects to be at risk for
variability in cash flows due to changes in the contractually specified interest
rate in an amount based on debt principal equal to or greater than the notional
amount of the swap during the specific term of the interest rate swap.
Therefore, the prepayment feature of the debt is not relevant for purposes of
determining the appropriate hypothetical swap under the guidance beginning in
paragraph 815-30-35-10 as long as the relevant conditions to qualify for cash
flow hedge accounting have been met with respect to the hedged transaction.
Hedging 837
9. Hedge effectiveness

Change-in-fair-value method

Excerpt from ASC 815-30

>>> Change-in-Fair-Value Method

35-31 An entity shall assess hedge effectiveness under the change-in-fair-value
method by comparing the following amounts:
a. The present value of the cumulative change in expected variable future
interest cash flows that are designated as the hedged transactions
b. The cumulative change in the fair value of the interest rate swap
designated as the hedging instrument.
35-32 The discount rates applicable to determining the fair value of the interest
rate swap designated as the hedging instrument shall also be applied to the
computation of present values of the cumulative changes in the hedged cash
flows.

The following table summarizes the change-in-fair-value method.

What is — The present value1 of the cumulative change in expected

compared in future cash flows related to the asset or liability being
assessing hedged
effectiveness: and
[815-30-35-31]
— The cumulative change in the fair value of the swap
designated as the hedging instrument
Note:
The discount rates for measuring the fair value of the swap are also applied to the
computation of present values of the cumulative changes in the hedged cash flows,
as long as it is probable that the counterparty to the swap or the entity will not default.
[815-30-35-32]

Even though the same discount rates are applied to the swap and the present
value of the cumulative change in expected cash flows of the hedged
transaction, this method appears to be the least desirable of the three
methodologies described in Topic 815 for cash flow hedges of variability in
interest receipts or payments because of the effect of fair valuing the fixed leg
of the interest rate swap.

9.7.50 Project future cash flows using forward price curves

or using recent sales or purchase orders
An entity may have the information available to use forward price curves to
determine changes in the expected future cash flows of the hedged
transaction. In these situations, that information can be used to estimate
changes in expected future cash flows by performing the following steps.
— At the end of each reporting period, use the appropriate current forward
price curve to determine the expected future cash flows for the remaining
term to maturity.
Hedging 838
9. Hedge effectiveness

— If the effectiveness technique requires a discounted value, discount those

expected future cash flows. Because Topic 815 does not specify the rate to
be used, an entity documents the discount rate it will use in its initial hedge
documentation. See also section 9.2.110 regarding consideration of the
time value of money for cash flow hedges.
— The difference between the amount calculated above (either discounted or
undiscounted, as appropriate) for the current reporting period and the
amount calculated at inception of the hedging relationship can be regarded
as a proxy for the present value of the cumulative change in expected
future cash flows on the hedged transaction.
When hedging a forecasted sale or purchase of certain nonfinancial assets, an
entity may be required to estimate future sales or purchase prices because a
market is not available to help make these estimates. An approach that would
remove some of the inherent limitations in the entity’s estimate involves basing
the estimates on recent sales orders or purchase orders with similar terms to
the terms of the hedged forecasted sale or purchase.

Example 9.7.50
Projecting future cash flows using recent purchase
orders
On January 1, Year 1, ABC Co. enters into a hedgeable forecasted transaction
to sell 10,000 widgets at the then-current market price one year into the future.
To lock in the sales price of the widgets, ABC enters into a forward contract to
sell 10,000 units for $95,000, which represents the current selling price of
widgets with terms that match the forecasted transaction ($100,000) less a
discount that represents the time value of money ($5,000). This implies a
current price for each widget on January 1, Year 1, of $10 ($100,000 ÷ 10,000).
On March 31, Year 1, ABC enters into purchase orders for widgets to be
delivered in nine months for a similar number of units at a sales price of $9.90
per unit. ABC could base its estimate of the cumulative change in cash flows of
the forecasted sale of 10,000 units using $1,000 (10,000 units × the difference
between the original implied price of $10 less the current price of $9.90).

9.8 Examples of effectiveness assessment methods

relevant to various hedging instruments
Type of hedging Method for
relationship / Hedged item or assessing
Reference transaction Hedged risk effectiveness Comments

Interest rate swaps (section 2.6.20)

Fair value Recognized Interest rate Shortcut method Assumes

(section 9.3) interest-bearing risk: Benchmark (if certain criteria perfect
asset or liability interest rate are met) effectiveness

Cash flow Variability in Interest rate Shortcut method Assumes

(section 9.3) interest receipts risk: (if certain criteria perfect
or payments on Contractually are met) effectiveness
Hedging 839
9. Hedge effectiveness

Type of hedging Method for

relationship / Hedged item or assessing
Reference transaction Hedged risk effectiveness Comments
recognized specified
interest-bearing interest rate
asset or liability

Cash flow Variability in Interest rate risk Change-in- If the initial fair
(section 9.7.40) interest receipts or variable-cash- value is not
or payments flows method zero (or
Overall changes somewhat
in the hedged near zero), this
cash flows (i.e. method may
price risk) not be used.
If certain
conditions are
met, this
method will
result in
perfect
effectiveness

Cash flow Variability in Interest rate risk Hypothetical If certain

(section 9.7.40) interest receipts or derivative conditions are
or payments method met, this
Overall changes method will
in the hedged result in
cash flows (i.e. perfect
price risk) effectiveness

Cash flow Variability in Interest rate risk Change-in-fair-

(section 9.7.40) interest receipts or value method
or payments
Overall changes
in the hedged
cash flows (i.e.
price risk)

Fair value Recognized Interest rate Other Effectiveness

(sections 9.5 or interest-bearing risk: Benchmark quantitative or may be
9.6) asset or liability interest rate qualitative assessed
(or a firm method based on all
commitment) (if shortcut contractual
method is not cash flows or
appropriate or on the
not selected) benchmark
interest rate
component of
contractual
cash flows

Cash flow Variability in Interest rate risk Quantitative

(sections 9.5 or interest receipts or method
9.6; 9.2.110) or payments
Overall changes
in the hedged
cash flows (i.e.
price risk)
Hedging 840
9. Hedge effectiveness

Type of hedging Method for

relationship / Hedged item or assessing
Reference transaction Hedged risk effectiveness Comments

Other swaps (e.g. commodity, equity and foreign currency) (section 2.6.20)

Cash flow – Fixed rate Foreign currency Critical terms Assumes

cross-currency foreign currency risk match perfect
interest rate swap denominated effectiveness
(section 9.4) financial asset or
liability

Net investment Net investment Foreign currency Spot method, If certain

hedge – eligible in a foreign risk forward method, conditions are
cross-currency operation or qualitative met, the spot
interest rate swap method or forward
(section 8.4) methods will
result in
perfect
effectiveness

Fair value or cash Any eligible Any eligible risk Other

flow hedged item or quantitative or
(sections 9.5 or transaction qualitative
9.6) method

Forwards /futures contracts (section 2.6.20)

Cash flow Any eligible Any eligible risk Critical terms Assumes
(section 9.4) forecasted match perfect
transaction effectiveness

Net investment Net investment Foreign currency Spot method, If certain

hedge in a foreign risk forward method, conditions are
(section 8.4) operation or qualitative met, the spot
method or forward
methods will
result in
perfect
effectiveness

Fair value or cash Any eligible Any eligible risk Other

flow hedged item or quantitative or
(sections 9.5 or transaction qualitative
9.6; 9.2.110) method

Options, combinations of options, or combination of an option contract with a non-option

derivative (for written options, section 2.7.50; for combinations of options, section 2.7.60)

Cash flow Any eligible Any eligible risk Terminal value If certain
(section 9.7.20) hedged method conditions are
transaction met, this
method will
result in
perfect
effectiveness

Cash flow Any eligible Any eligible risk Critical terms Assumes
(section 9.4) hedged match perfect
transaction effectiveness

Fair value or cash Any eligible Any eligible risk Other

flow hedged item or quantitative or
(sections 9.5 or transaction qualitative
9.6; 9.2.90; method
9.2.110)
Hedging 841
9. Hedge effectiveness

Type of hedging Method for

relationship / Hedged item or assessing
Reference transaction Hedged risk effectiveness Comments

Net investment Net investment Foreign currency Spot method, If certain

hedge in a foreign risk forward method, conditions are
(section 8.4) operation or qualitative met, the spot
method or forward
methods will
result in
perfect
effectiveness

9.9 Comparison of methods for assessing

effectiveness
Subsequent
Simplified qualitative
hedge assessment Quantitative
Shortcut Critical terms accounting approach methods
method match method approach (sections 8.4 (sections 8.4
(section 9.3) (section 9.4) (section 10.2) and 9.5) and 9.6)

Types of hedging relationships

Fair value or Cash flow1 Cash flow Fair value, Fair value,
cash flow cash flow or cash flow or
net net
investment investment
hedges hedges

Initial effectiveness assessment

Quantitative Quantitative testing Quantitative Quantitative Quantitative
testing not not required. testing not testing testing
required. required. required. required.

Nature of subsequent effectiveness assessments

If the shortcut Assessment of If the simplified Qualitative Quantitative.
method whether: hedge assessments
requirements — the critical accounting that consider
are met, the terms match requirements whether facts
entity evaluates are met, the and
whether the — there has been entity evaluates circumstances
credit risk of the an adverse whether the have changed
counterparty to development credit risk of such that the
the derivative or regarding the entity cannot
its own counterparty counterparty to assert
nonperformance credit risk or the derivative qualitatively
risk has changed the entity’s or its own non- that the
such that it is no own nonperformance hedging
longer probable performance risk has relationship
that the risk for the changed such was and
counterparty or hedging that it is no continues to be
it will not instrument longer probable highly effective.
default. If (see section that the This is an
neither party’s 9.2.60) counterparty or assessment
credit risk has — there has been it will not requiring the
changed in this an adverse default. If entity to apply
manner, no development neither party’s more judgment
further regarding credit risk has than the critical
credit risk of changed in this
Hedging 842
9. Hedge effectiveness

Subsequent
Simplified qualitative
hedge assessment Quantitative
Shortcut Critical terms accounting approach methods
method match method approach (sections 8.4 (sections 8.4
(section 9.3) (section 9.4) (section 10.2) and 9.5) and 9.6)
assessment is the manner, no terms match
required. counterparty further method.
to the hedged assessment is
transaction required.
(see section
9.2.60)

Timing of selection of quantitative method to be used if the respective approach is no

longer appropriate
Made at hedge Made at the time Not applicable. Required to be Not applicable.
designation, if the critical terms If this approach made at hedge
elected. change that cause is no longer designation.
this method to no appropriate, the
longer be hedging
appropriate. relationship is
discontinued.

Ability to revert to the approach after having to test quantitatively

Not available. Not available. Not available. Available. Not applicable.

Ability to deem settlement dates of hedged transactions and the hedging instrument as
being the same
No. Yes. Settlement Yes. The No. Terminal
dates of a group of repricing and value method
hedged settlement (see section
transactions and dates for the 9.7.20):
the hedging interest rate Settlement
instrument may be swap and the dates of a
deemed the same borrowing are group of
if they occur within deemed the hedged
the same 31-day same if they transactions
period (or fiscal differ by no and the
month). more than a hedging
few days. instrument
may be
deemed the
same if they
occur within
the same
31-day period
(or fiscal
month).
Other
methods: No.

Note:
We believe the critical terms match method is precluded for fair value hedging
relationships in the vast majority of circumstances (see section 9.4.20).
Hedging 843
10. Private companies

10. Private companies

Detailed contents
10.1 How the standard works
10.2 Simplified hedge accounting approach
10.2.10 Overview
10.2.20 Simplified hedge accounting criteria
10.2.30 Subsequent measurement
10.2.40 Discontinuation of simplified hedge accounting
10.2.50 Timing and extent of documentation
Questions
10.2.10 What types of entities can apply the simplified hedge
accounting approach?
10.2.20 Do all interest rate swaps qualify for simplified hedge
accounting?
10.2.30 Does simplified hedge accounting have to be applied to all
eligible swaps?
10.2.40 Why might a private company choose not to use simplified
hedge accounting?
10.2.50 What are the ongoing requirements when applying
simplified hedge accounting?
10.2.60 Can the hedged risk be a nonbenchmark interest rate risk?
10.2.70 What qualifies as a plain vanilla swap to be eligible for
simplified hedge accounting?
10.2.80 Can an entity hedge borrowings with embedded interest
rate caps or floors under simplified hedge accounting?
10.2.90 How should an entity evaluate the difference between the
repricing and settlement dates of the debt and the interest
rate swap?
10.2.100 How is the settlement value of an interest rate swap
different from fair value?
10.2.110 Can an entity voluntarily change from simplified hedge
accounting to general hedge accounting?
10.3 Additional relief for private companies when simplified hedge
accounting is not applied
10.3.10 Overview
10.3.20 Documentation requirements
10.3.30 Subsequent quarterly hedge effectiveness assessments

Questions
10.3.10 Which private companies and not-for-profit entities may
take advantage of the timing relief?
10.3.20 Are there downsides to delaying the quarterly hedge
effectiveness assessments?
10.3.30 Why are certain entities without quarterly reporting
requirements required to perform quarterly hedge
effectiveness assessments?
Examples
10.3.10 Timing of preparing initial hedge documentation
10.3.20 Timing of performing quarterly hedge effectiveness
assessments

10.1 How the standard works

Although hedge accounting can be an effective way to mitigate income
statement volatility from reporting derivative instruments at fair value, many
private companies historically have found the hedging requirements under the
general hedge accounting guidance to be onerous. It may be difficult for
smaller, less sophisticated companies to apply hedge accounting due to a lack
of resources, the extensive documentation requirements, the timing of those
documentation requirements, and required quarterly hedge effectiveness
testing.
The FASB’s outreach revealed that private companies often enter into receive-
variable, pay-fixed interest rate swaps to economically convert their variable-rate
borrowings into fixed-rate borrowings. While these interest rate swaps are
derivative instruments that are recorded at fair value on the balance sheet,
hedge accounting is often not applied and users of the financial statements
often see volatility in earnings.
To provide relief to private companies seeking to meet hedge accounting
requirements, the FASB developed a simplified hedge accounting approach for
private companies’ qualifying cash flow hedging relationships, as well as relief
in documentation requirements for private companies not adopting the
simplified hedge accounting approach and certain not-for-profit entities.
While the simplified hedge accounting approach may be beneficial in that it
makes it easier for private companies to apply hedge accounting, it is not as
beneficial for private companies that intend to become public business entities.
Private company accounting cannot be applied in filings with the SEC (see
Question 10.2.40 for further information).
In addition, there is additional relief in relation to the formal documentation and
the timing of hedge effectiveness assessments for private companies where
the simplified hedge accounting model is not applied. The additional time
granted to eligible private companies more closely aligns with these entities’
reporting cycles and is consistent with the FASB’s efforts to make hedge
accounting more operational. See section 10.3.

10.2 Simplified hedge accounting approach

Excerpt from ASC 815-20

> Hedge Accounting Provisions Applicable to Certain Private Companies

>> Assuming Perfect Hedge Effectiveness in a Cash Flow Hedge of a
Variable-Rate Borrowing with a Receive-Variable, Pay-Fixed Interest Rate
Swap Recorded under the Simplified Hedge Accounting Approach
25-133 Paragraphs 815-10-35-1A through 35-1C, 815-10-50-3, 815-20-25-3A,
815-20-25-119, 815-20-25-134 through 25-138, 815-20-55-79A through 55-79B,
825-10-50-3, and 825-10-50-8 provide guidance for an entity electing the
simplified hedge accounting approach.
25-134 The conditions for the simplified hedge accounting approach determine
which cash flow hedging relationships qualify for a simplified version of hedge
accounting. If all of the conditions in paragraphs 815-20-25-135 and 815-20-25-
137 are met, an entity may assume perfect effectiveness in a cash flow
hedging relationship involving a variable-rate borrowing and a receive-variable,
pay-fixed interest rate swap.
25-135 Provided all of the conditions in paragraph 815-20-25-137 are met, the
simplified hedge accounting approach may be applied by a private company
except for a financial institution as described in paragraph 942-320-50-1. An
entity may elect the simplified hedge accounting approach for any receive-
variable, pay-fixed interest rate swap, provided that all of the conditions for
applying the simplified hedge accounting approach specified in paragraph 815-
20-25-137 are met. Implementation guidance on the conditions set forth in
paragraph 815-20-25-137 is provided in paragraphs 815-20-55-79A through 55-
79B.
25-136 In applying the simplified hedge accounting approach, the
documentation required by paragraph 815-20-25-3 to qualify for hedge
accounting must be completed by the date on which the first annual financial
statements are available to be issued after hedge inception rather than
concurrently at hedge inception.
25-137 An eligible entity under paragraph 815-20-25-135 must meet all of the
following conditions to apply the simplified hedge accounting approach to a
cash flow hedge of a variable-rate borrowing with a receive-variable, pay-fixed
interest rate swap:
a. Both the variable rate on the swap and the borrowing are based on the
same index and reset period (for example, both the swap and borrowing
are based on one-month London Interbank Offered Rate [LIBOR] or both
the swap and borrowing are based on three-month LIBOR).
b. The terms of the swap are typical (in other words, the swap is what is
generally considered to be a “plain-vanilla” swap), and there is no floor or
cap on the variable interest rate of the swap unless the borrowing has a
comparable floor or cap.
c. The repricing and settlement dates for the swap and the borrowing match
or differ by no more than a few days.

d. The swap’s fair value at inception (that is, at the time the derivative was
executed to hedge the interest rate risk of the borrowing) is at or near zero.
e. The notional amount of the swap matches the principal amount of the
borrowing being hedged. In complying with this condition, the amount of
the borrowing being hedged may be less than the total principal amount of
the borrowing.
f. All interest payments occurring on the borrowing during the term of the
swap (or the effective term of the swap underlying the forward starting
swap) are designated as hedged whether in total or in proportion to the
principal amount of the borrowing being hedged.
>>> Simplified Hedge Accounting Approach
55-79A In complying with the condition in paragraph 815-20-25-137(b),
comparable does not necessarily mean equal. For example, if the swap’s
variable rate is the London Interbank Offered Rate (LIBOR) and the borrowing’s
variable rate is LIBOR plus 2 percent, a 10 percent cap on the swap would be
comparable to a 12 percent cap on the borrowing.
55-79B For a forward-starting swap, only the effective term of the receive-
variable, pay-fixed interest rate swap (that is, from its effective date through its
expiration date) shall be considered in complying with the condition in
paragraph 815-20-25-137(f). The period from the swap’s inception to the date
the swap is effective shall not be considered in complying with the condition in
paragraph 815-20-25-137(f) because the effective date of a forward-starting
swap occurs after the swap’s inception. For example, a forward-starting
receive-variable, pay-fixed, interest rate swap with a five-year effective term
and an effective date commencing one year after the swap’s inception would
meet the condition in paragraph 815-20-25-137(f) if designated as a hedge of a
five-year, variable-rate borrowing forecasted to be entered into one year after
the swap’s inception.
20 Glossary
Private Company – An entity other than a public business entity, a not-for-
profit entity, or an employee benefit plan within the scope of Topics 960
through 965 on plan accounting.

10.2.10 Overview
Topic 815 provides a simplified hedge accounting approach to account for
interest rate swaps that are used to hedge the variability in cash flows of
variable-rate borrowings. If the criteria to apply the simplified hedge accounting
approach are met (see section 10.2.20), a private company:

Hedge — may assume perfect hedge effectiveness for the qualifying

effectiveness cash flow hedging relationships; [815-20-25-134]
— is exempt from quarterly hedge effectiveness testing because
perfect effectiveness is assumed; [815-20-25-134]

Hedge — has additional time to prepare the required hedge

documentation documentation (see section 10.2.50); and [815-20-25-136]

Hedging — is allowed to measure the interest rate swap designated in the

instrument cash flow hedging relationship at settlement value instead of
fair value (see section 10.2.30). [815-10-35-1A]

Question 10.2.10
What types of entities can apply the simplified
hedge accounting approach?

Interpretive response: The simplified hedge accounting approach can be used

by any private company other than a financial institution. A private company is
any entity that is not a public business entity, a not-for-profit entity or an
employee benefit plan. A financial institution is a bank, savings and loan
association, savings bank, credit union, finance company or insurance entity.
[815-20-25-135, 815-20 Glossary, 942-320-50-1]

Financial institutions were excluded from the simplified hedge accounting

approach because they generally have greater exposure to financial instruments
and typically have quarterly reporting requirements. [ASU 2017-12.BC184]

Question 10.2.20
Do all interest rate swaps qualify for simplified
hedge accounting?

Interpretive response: No. Only a receive-variable, pay-fixed interest rate swap

that is designated in a cash flow hedge of a variable-rate borrowing, or a
forward-starting receive-variable, pay-fixed interest rate swap, qualifies for
simplified hedge accounting. To qualify for simplified hedge accounting, the
interest rate swap needs to meet the conditions specified in paragraph 815-20-
25-137 (see section 10.2.20). [815-20-25-134, 25-138]

Question 10.2.30
Does simplified hedge accounting have to be
applied to all eligible swaps?

Interpretive response: No. An eligible private company can elect to apply the
approach on a swap-by-swap basis, provided that all of the conditions of
applying simplified hedge accounting are met for each individual swap.
[ASU 2014-03.BC20]

If simplified hedge accounting is not elected, an eligible private company

wishing to apply hedge accounting may avail itself of the documentation relief
applicable to private companies (see section 10.3) or follow the general hedge
accounting guidance (see chapter 2).

Question 10.2.40
Why might a private company choose not to use
simplified hedge accounting?

Interpretive response: There are two common reasons why a private

company may decide not to apply simplified hedge accounting.
Entity may not qualify throughout the hedging relationship’s life
Before it adopts simplified hedge accounting, a private company may want to
consider if it will be eligible to apply the simplified approach throughout the life
of the hedging relationship. There may be costs due to the time and effort
associated with discontinuing simplified hedge accounting and redesignating a
new hedging relationship to apply the general hedge accounting guidance.
For example, a private company that becomes a public business entity will no
longer be eligible for simplified hedge accounting for existing hedges or
discontinued hedges that are included in the financial statements. In these
circumstances, the entity will be required to retrospectively adjust its financial
statements to remove the effects of the private company accounting guidance,
including the accounting effects under simplified hedge accounting (see
section 10.2.40). The entity will not be allowed to adopt the general hedge
accounting guidance from inception of the hedge, because the
contemporaneous documentation requirement and the additional qualifying
criteria will not have been met (see section 2.9).
Entity’s financial statements are incorporated into the financial
statements of an SEC registrant
A private company’s financial statements that are incorporated into a public
parent entity’s financial statements, as filed with the SEC, cannot incorporate
simplified hedge accounting.
This means that the private company could adopt simplified hedge accounting
for its stand-alone reporting, but not for consolidation by the public parent
entity. If the entity wanted to apply hedge accounting at the consolidated level,
it would have to comply with the general hedge accounting guidance.

Question 10.2.50
What are the ongoing requirements when applying
simplified hedge accounting?

Interpretive response: A private company that adopts simplified hedge

accounting is exempt from quarterly hedge effectiveness testing. However, a
private company should periodically verify that the criteria to apply simplified
hedge accounting are still met.
If the interest rate swap is a forward-starting swap, the company should
periodically reassess if the interest payments are still probable. If any of the
conditions to apply simplified hedge accounting subsequently cease to be met,

or the relationship otherwise ceases to qualify for hedge accounting, the

simplified approach is discontinued (see section 10.2.40).

10.2.20 Simplified hedge accounting criteria

The following conditions must be met before an entity applies simplified hedge
accounting. [815-20-25-137]

Hedged transaction Hedging instrument

Plain vanilla interest rate swap

Variable-rate borrowing
(receive-variable, pay-fixed)

— Swap and borrowing are based on the same index and reset
period1;
— The terms of the swap are typical and considered ‘plain vanilla’
(including forward starting swaps, see Question 10.2.70);
— Repricing and settlement dates match or differ by no more than
a few days (see Question 10.2.90);
— Swap’s fair value at inception is at or near zero;
— Notional amount of the swap is equal to or less than the principal
amount of the borrowing; and
— All interest payments on the borrowing during the term of the
swap are designated as hedged.

Simplified hedge accounting approach

Note:
1. This would Include borrowings where the borrower has an option to select the interest
rate index (you pick ‘em debt) as long as the interest rate of the swap and borrowing are
based on the same index at the inception of the swap and thereafter.

Question 10.2.60
Can the hedged risk be a nonbenchmark interest
rate risk?

Interpretive response: Yes. Although interest rate swaps are commonly based
on benchmark interest rates, simplified hedge accounting is not limited to
hedges of benchmark interest rates. Therefore, simplified hedge accounting
may be applied to borrowings that are not based on a benchmark interest rate
(e.g. prime rate) as long as all the conditions are met. In other words, both the
variable rate on the swap and the borrowing must be based on the same index

and reset period, but that index does not have to be a benchmark interest rate.
[815-20-25-137]

Question 10.2.70
What qualifies as a plain vanilla swap to be eligible
for simplified hedge accounting?

Interpretive response: The term ‘plain vanilla’ swap is not defined under US
GAAP; therefore, judgment is required to determine what types of swaps are
plain vanilla.
The FASB deliberated whether swaps other than plain vanilla swaps should be
allowed to be designated under simplified hedge accounting. It decided to limit
simplified hedge accounting to a narrow set of circumstances such that the
approach addresses the prevalent practice issue of a private company entering
into a plain vanilla receive-variable, pay-fixed interest rate swap for the purpose
of economically converting a variable-rate borrowing into a fixed-rate borrowing.
As such, the FASB observed that using of other than plain vanilla swaps may
reflect more sophisticated structured financing arrangements that would not
provide the sufficiently narrow set of circumstances to apply simplified hedge
accounting. [ASU 2014-03.BC9]
The FASB acknowledged that forward-starting interest rate swaps may qualify if
the occurrence of the hedged forecasted interest payments to be swapped is
probable and the required conditions to apply simplified hedge accounting are
met (see below, Forward-starting interest rate swaps). [ASU 2014-03.BC12]

Question 10.2.80
Can an entity hedge borrowings with embedded
interest rate caps or floors under simplified hedge
accounting?
Interpretive response: Yes. Borrowings with embedded interest rate caps or
floors may qualify for simplified hedge accounting if there is a comparable
feature in the swap. Topic 815 indicates that comparable does not necessarily
mean equal. For example, if the swap’s variable rate is the LIBOR and the
borrowing’s variable rate is LIBOR plus 2 percent, a 10 percent cap on the swap
is comparable to a 12 percent cap on the borrowing. [815-20-55-79A, ASU 2014-
03.BC11]

Question 10.2.90
How should an entity evaluate the difference
between the repricing and settlement dates of the
debt and the interest rate swap?
Interpretive response: Paragraph 815-20-25-137 indicates that the repricing
and settlement date of the swap and borrowing may differ by a few days but
does not provide additional guidance. The FASB observed that a ‘few days’ is
not intended to provide a blanket or extended period. Instead, it is provided only
as a means to address administrative or other practicability concerns. [ASU 2014-
03.BC15]

Forward-starting interest rate swaps

Excerpt from ASC 815-20

> Hedge Accounting Provisions Applicable to Certain Private Companies

>> Assuming Perfect Hedge Effectiveness in a Cash Flow Hedge of a
Variable-Rate Borrowing with a Receive-Variable, Pay-Fixed Interest Rate
Swap Recorded under the Simplified Hedge Accounting Approach
25-138 A cash flow hedge established through the use of a forward starting
receive-variable, pay-fixed interest rate swap may be permitted in applying the
simplified hedge accounting approach only if the occurrence of forecasted
interest payments to be swapped is probable. When forecasted interest
payments are no longer probable of occurring, a cash flow hedging relationship
will no longer qualify for the simplified hedge accounting approach and the
General Subsections of this Topic shall apply at the date of change and on a
prospective basis.
20 Glossary
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.

A forward-starting receive-variable, pay-fixed interest rate swap is an interest

rate swap with settlements that will begin at a later date. They can be used to
hedge interest payments associated with obligations that are expected to arise
in the future. For example, if an entity intends to obtain a construction loan in
two years, it could enter into a forward-starting interest rate swap with
settlements that begin at the time the construction loan is expected to be
entered into.
As the hedge is of future interest payments on a borrowing that is expected to
be issued at a future date, the entity has to demonstrate that the future interest
payments are probable. Probability is assessed at the same threshold level as
required for non-private companies as explained in section 5.3.40. If the interest

payments are no longer probable, the entity has to discontinue the cash flow
hedging relationship. [815-20-25-138]

Forecasted transactions
To verify that the probability assessment has not changed and the conditions to
apply the simplified approach are still met, the entity periodically reassesses if
the interest payments are still probable.
For further information on forecasted transactions, the eligibility criteria of
applying hedge accounting to forecasted transactions and the probability
assessment of forecasted transactions, see section 5.3.

10.2.30 Subsequent measurement

Excerpt from ASC 815-10

35-1A As a practical expedient, a receive-variable, pay-fixed interest rate swap

for which the simplified hedge accounting approach (see paragraphs 815-20-
25-131AB through 25-131E for scope) is applied may be measured
subsequently at settlement value instead of fair value.
35-1B The primary difference between settlement value and fair value is that
nonperformance risk is not considered in determining settlement value. One
approach for estimating the receive-variable, pay-fixed interest rate swap’s
settlement value is to perform a present value calculation of the swap’s
remaining estimated cash flows using a valuation technique that is not
adjusted for nonperformance risk.
50-3 If the simplified hedge accounting approach (see paragraphs 815-20-25-
133 through 25-138) is applied in accounting for a qualifying receive-variable,
pay-fixed interest rate swap, the settlement value of that swap may be used in
place of fair value when disclosing the information required by this Section or
in providing other fair value disclosures, such as those required under
Topic 820 on fair value. For the purposes of complying with these disclosure
requirements, amounts disclosed at settlement value will be subject to all of
the same disclosure requirements as amounts disclosed at fair value. Any
amounts disclosed at settlement value shall be clearly stated as such and
disclosed separately from amounts disclosed at fair value.

When applying the simplified hedge accounting approach, a private company

may elect to measure the interest rate swap at settlement value instead of at
fair value. However, any amounts disclosed at settlement value need to be
clearly stated as settlement values in the disclosures. The disclosure
requirements relating to fair value in Topic 815 and Topic 820 (fair value
measurement), apply regardless of whether the swap is measured at fair value
or settlement value. [815-10-35-1A, 50-3]

Question 10.2.100
How is the settlement value of an interest rate
swap different from fair value?

Interpretive response: The primary difference between settlement value and

fair value is that nonperformance risk is not considered in measuring settlement
value. [815-10-35-1B]
A private company may elect to record the settlement value of the swap on the
financial statements and in the required disclosures instead of recording the fair
value of the swap. If a company elects to use the settlement value, it should be
clearly stated.
Although a private company may choose to measure an interest rate swap at
settlement value under simplified hedge accounting, the FASB noted that the
guidance in Topic 815 requiring the consideration of counterparty credit risk still
applies. To initially and subsequently qualify for simplified hedge accounting, a
private company is required to satisfy the requirements of Topic 815 regarding
the consideration of counterparty credit risk and the possibility of default by the
counterparty to a hedging derivative. [ASU 2014-03.BC17, BC25]
If the likelihood that the counterparty to a hedging derivative will not default
ceases to be probable, a private company will be unable to conclude that the
cash flow hedging relationship is highly effective in offsetting cash flows. For
further discussion on assessing counterparty credit risk when qualifying for
cash flow hedge accounting, see section 9.2.60. [815-20-25-122, 35-14 – 35-15]

10.2.40 Discontinuation of simplified hedge accounting

Excerpt from ASC 815-10

35-1C If any of the conditions in paragraph 815-20-25-131D for applying the

simplified hedge accounting approach subsequently cease to be met or the
relationship otherwise ceases to qualify for hedge accounting, the General
Subsections of this Topic shall apply at the date of change and on a
prospective basis. For example, if the related variable-rate borrowing is prepaid
without terminating the receive-variable, pay-fixed interest rate swap, the gain
or loss on the swap in accumulated other comprehensive income shall be
reclassified to earnings in accordance with paragraphs 815-30-40-1 through 40-
6 with the swap measured at fair value on the date of change and subsequent
changes in fair value reported in earnings in accordance with paragraph 815-10-
35-2. Similarly, if the receive-variable, pay-fixed interest rate swap is terminated
early without the related variable-rate borrowing being prepaid, the gain or loss
on the swap in accumulated other comprehensive income shall be reclassified
to earnings in accordance with paragraphs 815-30-40-1 through 40-6.

If the criteria to qualify for simplified hedge accounting cease to be met, a

private company may no longer apply the approach. For example, a simplified

hedge accounting relationship involving a forecasted borrowing should be

discontinued if the forecasted borrowing is no longer probable.

The subsequent accounting for the gains/losses on the interest rate swap
depends on the reason for discontinuing the hedging relationship. For example,
if it is probable that the forecasted borrowing will not occur, the gain/loss on the
interest rate swap previously recognized in AOCI is reclassified into earnings
immediately. [815-30-40-5]
The following diagram depicts scenarios in which simplified hedge accounting is
discontinued and the related accounting effect.

Hedged transaction Hedging instrument

Hedging Variable rate
relationship Plain vanilla interest rate swap
Variable-rate borrowing
(receive-variable, pay-fixed)

Hedge designation
Probable that
Discontinue voluntarily Interest
Underlying forecasted
hedging removed, but rate swap
borrowing repaid transaction will not
relationship underlying debt terminated
occur
remains

Swap is remeasured at fair value, difference between settlement value and fair value is
Measurement
booked to AOCI and reclassified into earnings in the same manner as accounting treatment
of swap
noted below [815-10-35-1C]

Accounting Gain/loss in AOCI reclassified into Gain/loss in AOCI reclassified into earnings
treatment earnings when underlying interest immediately upon discontinuation of
payments are made hedge accounting treatment

Codification
[815-30-35-38 – 35-41, 815-30-40-1 – 40-6]
references

For a discussion of the subsequent accounting for discontinued hedges when

the hedged transactions are still probable, see section 6.5.
Redesignation. A private company that no longer meets the conditions to apply
the simplified hedge accounting approach may choose to redesignate the
interest rate swap in a new hedging relationship under the general hedge
accounting guidance if the hedge qualifying criteria are met (see
section 2.10.70).

Question 10.2.110
Can an entity voluntarily change from simplified
hedge accounting to general hedge accounting?

Interpretive response: Yes, but the entity will have to dedesignate the hedging
relationship and redesignate the hedging relationship taking into account the
general hedge accounting requirements (see section 2.10.70). However, the

swap may no longer have a zero fair value, which will impact the effectiveness
assessment of the hedging relationship under the general hedge accounting
guidance (see Question 2.10.120).
When an entity discontinues the simplified hedge accounting approach, the
interest rate swap is measured at fair value on the date of the discontinuance
and the difference between the fair value and settlement value is recognized in
AOCI. [815-10-35-1C]
In addition, as discussed above, the entity has to consider the timing of
reclassification of amounts recognized in AOCI related to the dedesignated
hedging relationship.

10.2.50 Timing and extent of documentation

While the general hedge designation requirements in paragraph 815-20-25-3
apply to simplified hedge accounting (see chapter 2), the simplified approach
extends the length of time a private company has to document its hedging
relationship.

Element of hedge documentation Timing

Simplified hedge accounting approach
All hedge designation documentation. By the date on which the first annual
[815-20-25-3] financial statements are available to be
issued after hedge inception. [815-20-25-
136]

The hedge documentation, including assessment of the qualifying criteria for

the simplified hedge accounting approach, should be completed with
information applicable at inception of the hedge.

10.3 Additional relief for private companies when

simplified hedge accounting is not applied

Excerpt from ASC 815-20

>> Timing of Hedge Documentation for Certain Private Companies If

Simplified Hedge Accounting Approach Is Not Applied
>>> Concurrent Hedge Documentation
25-139 Concurrent with hedge inception, a private company that is not a
financial institution as described in paragraph 942-320-50-1 shall document the
following:
a. The hedging relationship in accordance with paragraph 815-20-25-3(b)(1)
b. The hedging instrument in accordance with paragraph 815-20-25-3(b)(2)(i)

c. The hedged item in accordance with paragraph 815-20-25-3(b)(2)(ii),

including (if applicable) firm commitments or forecasted transactions in
paragraph 815-20-25-3(c) or (d)
d. The nature of the risk being hedged in accordance with paragraph 815-20-
25-3(b)(2)(iii).
25-140 A private company that is not a financial institution is not required to
perform or document the following items concurrent with hedge inception but
rather is required to perform or document them within the time periods
discussed in paragraph 815-20-25-142:
a. The method of assessing hedge effectiveness at inception and on an
ongoing basis in accordance with paragraph 815-20-25-3(b)(2)(iv) and (vi)
b. Initial hedge effectiveness assessments in accordance with paragraph 815-
20-25-3(b)(2)(iv)(01) through (04).
25-141 Example 1A beginning in paragraph 815-20-55-80A illustrates hedge
documentation when the critical terms of the hedging instrument and hedged
forecasted transaction match. Although that Example illustrates the
documentation of the method of assessing hedge effectiveness, private
companies that are not financial institutions may complete hedge
documentation requirements in accordance with paragraphs 815-20-25-139
through 25-140.
>>> Hedge Effectiveness Assessments
25-142 For a private company that is not a financial institution, the performance
and documentation of the items listed in paragraph 815-20-25-140, as well as
required subsequent quarterly hedge effectiveness assessments, may be
completed before the date on which the next interim (if applicable) or annual
financial statements are available to be issued. Even though the completion of
the initial and ongoing assessments of effectiveness may be deferred to the
date on which financial statements are available to be issued the
assessments shall be completed using information applicable as of hedge
inception and each subsequent quarterly assessment date when completing
this documentation on a deferred basis. Therefore, the assessment should be
performed to determine whether the hedge was highly effective at achieving
offsetting changes in fair values or cash flows at inception and in each
subsequent quarterly assessment period up to the reporting date.
> Hedge Accounting Provisions Applicable to Certain Not-for-Profit
Entities
25-143 Not-for-profit entities (except for not-for-profit entities that have issued,
or are a conduit bond obligor for, securities that are traded, listed, or quoted on
an exchange or an over-the-counter market) may apply the guidance on the
timing of hedge documentation in paragraphs 815-20-25-139 through 25-142.
Specifically, those entities shall document the items listed in paragraph 815-20-
25-139 concurrent with hedge inception, but they may perform and document
the items listed in paragraph 815-20-25-140 within the time periods discussed
in paragraph 815-20-25-142.

10.3.10 Overview
If a private company does not elect simplified hedge accounting for its cash
flow hedging relationships of interest rate risk, it may still take advantage of the
following relief for such hedging relationships, as well as other hedging
relationships:

Hedge — relaxed timing of documentation requirements (see

documentation section 10.3.20); and

Hedge — relaxed timing of initial and subsequent quarterly hedge

effectiveness effectiveness assessments (see section 10.3.30).

These relaxed requirements are also available to certain not-for-profit entities.

Although the FASB granted additional time to prepare or perform certain hedge
documentation and effectiveness assessments, they decided to continue
requiring these entities to document certain elements of the hedging
relationship at inception. This is because the FASB concluded that sound risk
management practices support such information being considered and
documented concurrently with derivative execution, and also to prevent
retroactive designation (or dedesignation) of hedging relationships to achieve
desired outcomes. [ASU 2017-12.BC179, BC186]

Question 10.3.10
Which private companies and not-for-profit entities
may take advantage of the timing relief?

Interpretive response: The following types of private companies and not-for-

profit entities may take advantage of the relaxed timing requirements discussed
in sections 10.3.20 and 10.3.30:
— private companies that are not financial institutions, as that term is
described in paragraph 942-320-50-1. A private company is an entity other
than a public business entity, a not-for-profit entity or an employee benefit
plan in the scope of Topics 960 through 965 on plan accounting. [815-20-25-
139 – 25-140, 815-20 Glossary]

— not-for-profit entities other than those that have issued (or are a conduit
bond obligor for) securities that are traded, listed or quoted on an exchange
or an over-the-counter market. [815-20-25-143]
For a discussion of the timing of documentation for a private company that
elects simplified hedge accounting, see section 10.2.50.

10.3.20 Documentation requirements

The documentation requirements for a private company not electing to apply
simplified hedge accounting are the same as for an entity applying the general
hedge accounting guidance. However, the timing of the preparation of

documentation is relaxed. This relaxed timing is also available to certain not-for-

profit entities (see Question 10.3.10).
The following table summarizes the required timing of the elements of initial
hedge documentation, including initial hedge effectiveness assessment.

Element of hedge Timing

documentation
Certain private
companies and certain Entities applying
not-for-profit entities general hedge
(not applying simplified accounting guidance
hedge accounting) (section 2.9)
Risk management Concurrent with hedge Concurrent with hedge
objective and strategy. designation. [815-20-25- designation. [815-20-25-3]
139, 25-143]
— The hedging relationship
— The hedging instrument
— The hedged item or
transaction
— The nature of the risk
being hedged
— Documentation
applicable to fair value
hedges only
— Documentation
applicable to cash flow
hedges only
[815-20-25-3(b)(1) – 25-3(b)(2)(iii),
25-3(c) – 25-3(d)]

Hedge effectiveness By the date on which the Concurrent with hedge

method. The method that next interim (if applicable) designation. [815-20-25-3]
will be used subsequently to or annual financial
retrospectively and statements are available
prospectively assess hedge to be issued. [815-20-25-
effectiveness. [815-20-25- 140, 25-142, 25-143]
3(b)(2)(iv)]
— If subsequent hedge
effectiveness
assessments will be
assessed qualitatively,
how it will be carried out
and which quantitative
method will be used if
required. The same
quantitative method is
required to be used for
the initial and
subsequent prospective
hedge effectiveness
assessments. [815-20-25-
3(b)(2)(iv)(03)]

— If the shortcut method

is applied and, if the
entity so elects, the
quantitative method that
will be used if it is later

Element of hedge Timing

Initial hedge effectiveness. By the date on which the Earlier of the following:
Initial prospective next interim (if applicable) [815-20-25-3(b)(2)(iv)]
assessment of hedge or annual financial — first quarterly hedge
effectiveness (if quantitative statements are available effectiveness
testing is required). [815-20- to be issued after hedge assessment date;
25-3(b)(2)(iv)] inception. [815-20-25-140, — date the financial
25-142, 25-143] statements that
include the hedged
transaction are
available to be
issued;
— date any hedge
accounting criterion
is no longer met;
— date the hedging
instrument expires or
is sold, terminated or
exercised;
— date the hedging
relationship is
dedesignated; or
— for a cash flow
hedge of a
forecasted
transaction (in
accordance with 815-
20-25-13(b)), the date
the forecasted
transaction occurs.
See also section 2.9.40.

Example 10.3.10
Timing of preparing initial hedge documentation
The following scenario illustrates the required timing for preparing initial hedge
documentation for a private company hedging relationship that is not eligible for
simplified hedge accounting. The example does not demonstrate the timing of
performing quarterly hedge effectiveness assessments, which is discussed in
section 10.3.30.

Fact pattern
PrivateCo is a private company that is not a financial institution, so it is not
required to document certain additional elements of the hedging relationship
until after hedge inception. PrivateCo does not prepare interim financial
statements.
Hedging relationship begins earlier in the quarterly period
PrivateCo enters into a cash flow hedging relationship on March 15, Year 1, in
which the hedged item is a forecasted transaction expected to occur in one year.
Date annual financial
Hedge statements are available
inception to be issued
March 15, Year 1 February 26, Year 2

A B

Hedged forecasted
transaction occurs
January 15, Year 2

On this date, the initial hedge documentation is required to include the

following: the hedging relationship, hedging instrument, hedged
A transaction and nature of risk being hedged, as well as other
documentation specifically applicable to a cash flow or fair value hedge,
as applicable.
By this date, the following are required to be performed/documented:
— the method that will be used subsequently to retrospectively and
B
prospectively assess hedge effectiveness; and
— the initial prospective quantitative effectiveness assessment.

10.3.30 Subsequent quarterly hedge effectiveness

assessments
An entity applying hedge accounting is generally required to perform a
prospective assessment at hedge inception to demonstrate that the hedging
relationship is expected to be highly effective. [815-20-25-79(a)]
Additionally, subsequent to inception, the entity is generally required to perform
both prospective and retrospective assessments of hedge effectiveness. These
are referred to as ‘quarterly hedge effectiveness assessments’. [815-20-25-79]
Certain private companies and not-for-profit entities (see Question 10.3.10) may
be eligible for the relief in the timing requirements relates to the ongoing hedge
effectiveness assessments. The following table summarizes the required timing
of the elements of the ongoing hedge effectiveness assessment.

Hedge accounting for private Entities applying general hedge

companies accounting guidance
Additional relief for private companies when simplified hedge accounting is not
applied
Hedge effectiveness. Quarterly hedge Hedge effectiveness testing performed
effectiveness assessments need not be on a quarterly basis (see section 9.2.20).
performed until the next interim or
annual financial statements are available
to be issued.

Although the timing of hedge effectiveness and quarterly effectiveness testing

is relaxed, the testing should be performed with information available at each
quarterly assessment date. [815-20-25-142]

Question 10.3.20
Are there downsides to delaying the quarterly
hedge effectiveness assessments?

Interpretive response: Yes. Although the relaxed timing for hedge

effectiveness assessments may initially seem advantageous, a private company
may run into problems if the hedge effectiveness testing is not performed
timely. For example, if the hedge is not highly effective throughout the entire
year, the private company will not be able to maintain the hedge accounting
treatment and will have to dedesignate the hedging relationship from the last
time period when it was highly effective.

Question 10.3.30
Why are certain entities without quarterly reporting
requirements required to perform quarterly hedge
effectiveness assessments?
Interpretive response: The FASB noted that Topic 815’s original intent was for
hedge effectiveness to be continuously monitored on an ongoing basis.
However, to make the model operable, the guidance required formal
effectiveness assessments every three months. [ASU 2017-12.BC184]
One reason the FASB decided to provide certain private companies (and certain
not-for-profit entities) with additional time to perform effectiveness
assessments is because many do not have quarterly reporting requirements.
However, the FASB decided not to reduce the minimum quarterly frequency of
effectiveness assessments. This is because if an entity only assesses
effectiveness once before its annual financial statements are available to be
issued and that assessment reveals the hedge to not be highly effective, it may
be more difficult to determine when the hedge ceased to be highly effective
than if effectiveness assessments were performed on a quarterly basis. [815-20-
25-142 – 25-143, ASU 2017-12.BC184]

Example 10.3.20
Timing of performing quarterly hedge effectiveness
assessments
The following scenarios illustrate the required timing for preparing quarterly
hedge effectiveness assessments by certain private companies (and certain
not-for-profit entities) for a hedging relationship that is not eligible for simplified
hedge accounting.
PrivateCo is a private company that is not a financial institution. The same fact
pattern as in Example 10.3.10 applies here.
The following additional assumptions are relevant to the given scenario.
— PrivateCo is required to perform an initial prospective effectiveness
assessment quantitatively and ongoing hedge effectiveness assessments.
— PrivateCo performs prospective and retrospective quarterly hedge
effectiveness assessments as of every three months on the last day of the
quarter, with the first date being March 31, Year 1.
— PrivateCo is permitted to perform its assessments at later times, but is
required to use information as of the quarterly hedge effectiveness
assessment dates. (Scenario 1 only)
In both scenarios, assume the next quarterly effectiveness assessment date is
March 31, Year 1.

Scenario 1: PrivateCo does not prepare interim financial statements

Date annual financial

Hedge statements are available
inception to be issued
March 15, Year 1 February 26, Year 2

Hedged forecasted
transaction occurs
January 15, Year 2

By the date PrivateCo’s annual financial statements are available to be

A issued, it is required to perform quarterly effectiveness assessments using
information applicable as of each quarter-end date.

Scenario 2: PrivateCo prepares interim financial statements

Date interim Date interim Date interim Date annual

financial financial financial financial
statements are statements are statements are statements are
Hedge available to be available to be available to be available to be
inception issued issued issued issued
March 15, April 30, July 30, October 30, February 26,
Year 1 Year 1 Year 1 Year 1 Year 2

A A A A

Quarterly hedge Quarterly hedge Quarterly hedge Quarterly hedge Hedged

effectiveness effectiveness effectiveness effectiveness forecasted
assessment assessment assessment assessment transaction occurs
March 31, June 30, September 30, December 31, January 15,
Year 1 Year 1 Year 1 Year 1 Year 2

By the date PrivateCo’s quarterly and annual financial statements are

available to be issued, it is required to perform quarterly effectiveness
A
assessments using information applicable as of the related quarter-end
date.

11. Effective dates and

transition
Detailed contents
11.1 How the standard works
Comparison to legacy US GAAP
Summary of changes
11.2 Effective dates
11.2.10 Overview
11.2.20 Early adoption considerations
Questions
11.2.10 Is an entity required to adopt ASU 2017-12 at a certain
point in time within an interim period?
11.2.20 If a public business entity early adopts ASU 2017-12 in an
interim period, what are the relevant considerations?
Example
11.2.10 Adopting ASU 2017-12 by retrospectively adjusting
previous interim periods
11.3 Required transition provisions
11.3.10 Modified retrospective transition approach
11.3.20 Income statement presentation and eliminating
ineffectiveness
11.3.30 New disclosure requirements
11.3.40 Disclosures for accounting changes under Topic 250
11.4 Elective transition principles
11.4.10 Overview
11.4.20 Transition elections for fair value hedges of interest rate
risk
11.4.30 Transition election to transfer securities from the HTM to
the AFS portfolio
11.4.40 Transition elections for cash flow hedges
11.4.50 Transition elections for recognition and presentation of
excluded components
11.4.60 Transition elections related to assessing hedge
effectiveness

Questions
11.4.10 What date is used to determine the cumulative basis
adjustment when modifying the measurement
methodology for a fair value hedge of interest rate risk?
11.4.20 What date is used to determine the benchmark rate if the
current hedging relationship was previously dedesignated
and redesignated?
11.4.30 When transitioning to measure a hedged item based on the
benchmark rate component of the coupon, can an entity
rebalance an existing hedging relationship?
11.4.40 What transition approach is required to apply the partial-
term hedging guidance?
11.4.50 On what date in the period of adoption can an entity
transfer securities from HTM to AFS?
11.4.60 Is there any restriction on selling AFS securities after
transferring them from the HTM category on adoption?
11.4.70 Will transferring securities from HTM to AFS affect an
entity’s pre-transition intent to hold the securities to
maturity?
11.4.80 Are there any disclosure requirements for securities
transferred from HTM to AFS?
11.4.90 What financial instruments are eligible to be transferred
from HTM to AFS?
11.4.100 What is the transition guidance for an existing hedging
relationship with a non-zero fair value derivative designated
at hedge inception?
11.4.110 Can the transition provision for excluding cross-currency
basis spreads in cross-currency swaps be applied to a cash
flow or a net investment hedge?
11.4.120 What transition approach is required to change from a long-
haul to the critical terms match method for an existing
hedging relationship?
11.4.130 What transition approach is required to change the method
used to assess effectiveness of a net investment hedge?
Examples
11.4.10 Dedesignating a portion of the hedged item
11.4.20 Hedged risk is changed to variability in contractually
specified component

11.1 How the standard works

Chapters 2 to 10 of this Handbook assume that an entity has adopted
ASU 2017-12.
This chapter discusses effective dates and transition guidance for applying
ASU 2017-12, which is summarized below.

Effective Public business entities: All other entities:

date: Annual and interim periods in — Annual periods in fiscal years
[815-20-65-3(a) – fiscal years beginning after beginning after December 15,
65-3(b)] December 15, 2018. 2019.
— Interim periods in fiscal years
beginning after December 15,
2020.

Early
adoption: Permitted in any annual or interim period.
[815-20-65-3(c)]

Date of — The date of adoption is the date an entity elects to first apply
adoption and the guidance in ASU 2017-12. This is the date used to
initial determine existing hedging relationships.
application
date: — The initial application date means the beginning of the fiscal
[815-20-65-3(c) – year of adoption. This is the date at which an entity records any
65-3(d)] transition adjustments.

Transition: — Modified retrospective basis applied to existing hedging

[815-20-65-3(d) – relationships as of the date of adoption, generally achieved
65-3(k)] through a cumulative-effect adjustment to AOCI with a
corresponding adjustment to opening retained earnings as of
the initial application date.
— Changes to income statement presentation and financial
statement disclosures are applied prospectively.
— Specific transition guidance provided for fair value hedges of
interest rate risk and risk component hedging.
— One-time transition elections are available to modify existing
hedge documentation.
— One-time ability to transfer certain securities from the HTM to
the AFS category. The securities must be eligible for the last-of-
layer method.

Comparison to legacy US GAAP

Summary of changes
The following table summarizes the key changes from legacy US GAAP related
to specific transition provisions discussed in this chapter.

Income While not changing the requirement to determine whether a hedge

statement is ‘highly effective’, the ASU eliminates the requirement to
presentation separately measure and disclose hedge ineffectiveness.
and

eliminating The ASU also updates income statement presentation for the
ineffectiveness following.
(section — The entire change in fair value of the hedging instrument is
11.3.20) included in the same income statement line item as the
earnings effect of the hedged item or transaction.
— For fair value and cash flow hedges, amounts related to
excluded components are recognized in earnings in the same
income statement line item as the earnings effect of the
hedged item or transaction.
Fair value The ASU provides opportunities for entities to apply fair value
hedges of hedge accounting to hedging strategies that are either not allowed
interest rate or impractical under legacy US GAAP. This includes the following.
risk — Benchmark interest rate component (section 3.3.70).
(sections — Interest rate risk hedges of prepayable financial instruments
11.4.20 and (section 3.4.10).
11.4.30)
— Last-of-layer method (section 3.3.100).
— Partial-term hedges (section 3.3.80).
In addition, the SIFMA Municipal Swap Rate was added as an
eligible benchmark interest rate (see section 2.3.30).
Cash flow The ASU provides new alternatives for applying hedge accounting
hedges to additional hedging strategies. The ASU amends legacy US GAAP
to permit an entity to apply hedge accounting for the following.
(section
11.4.40) — Contractually specified interest rate (section 2.3.40).
— Contractually specified component price risk for nonfinancial
transactions (section 5.4.10).

Recognition The ASU introduces the option to recognize permissible excluded

and components using a systematic and rational method (amortization
presentation approach) as an alternative to recognizing all fair value changes in
of excluded the excluded components in current earnings (mark-to-market
components approach).
(section The ASU also allows an entity to exclude the portion of the change
11.4.50) in fair value of a currency swap attributable to a cross-currency
basis spread for fair value and cash flow hedges.
Assessing The ASU makes targeted improvements to the hedge
hedge effectiveness assessment process. These improvements include:
effectiveness — Qualitative effectiveness assessments. Subsequent
(section quarterly effectiveness assessments (after an initial
11.4.60) quantitative assessment) may be performed on a qualitative
(rather than quantitative) basis if an entity can reasonably
support an expectation that the hedge is highly effective at
inception and in subsequent periods.
— Shortcut method. An entity that inappropriately applied the
‘shortcut method’ may continue to apply hedge accounting if
certain conditions are met.
— Critical terms match. The ’critical terms match’ method may
be applied to groups of forecasted transactions in which the
individual transactions occur, and the hedging derivative
matures, within the same 31-day period or fiscal month.

11.2 Effective dates

Excerpt from ASC 815-20

> Transition Related to Accounting Standards Update No. 2017-12,

11.2.10 Overview
If a calendar-year public business entity adopts ASU 2017-12 in accordance with
the mandatory effective date, then these are the relevant dates.

Beginning of earliest Effective date (date

period presented of adoption)
January 1, 2017 January 1, 2018 January 1, 2019 December 31, 2019

Comparative period Comparative period Current period

Legacy US GAAP Legacy US GAAP ASU 2017-12

Cumulative-
effect
adjustment

11.2.20 Early adoption considerations

If an entity early adopts ASU 2017-12 in an interim period, any cumulative-effect
adjustment for existing hedges should be reflected as of the beginning of the
fiscal year that includes the interim period (i.e. the initial application date).
[815-20-65-3(c)]

Question 11.2.10
Is an entity required to adopt ASU 2017-12 at a
certain point in time within an interim period?

Interpretive response: The ASU does not specify whether an entity is required
to adopt the amendments at a certain point in time within an interim period –
i.e. at the beginning or the end of a quarter, or on a date in between.
We believe an entity can elect to adopt the totality of these amendments on
any single date within an interim period before the mandatory effective date. In
other words, there cannot be different dates of adoption within an interim
period for different provisions of the ASU.

Question 11.2.20
If a public business entity early adopts ASU 2017-12
in an interim period, what are the relevant
considerations?
Background: For purposes of this Question, assume that a calendar year-end
public business entity early adopts ASU 2017-12 on July 1, 2018.
Interpretive response: ASU 2017-12 provides transition guidance that differs
from the general retrospective transition requirements of paragraphs 250-10-45-
5 to 45-8. However, it does not provide specific guidance on how adoption in an
interim period affects the results of the preceding interim periods in the fiscal
year of adoption – e.g. January 1, 2018 to June 30, 2018 in the background
example.
The general retrospective transition requirements in paragraphs 250-10-45-5 to
45-8 apply only when there are no transition requirements specific to a
particular Codification update. Therefore, we believe there are two acceptable
approaches for reporting changes to the preceding interim periods in the fiscal
year of adoption.
— Approach 1. Record the prior-period impact related to the adoption of
ASU 2017-12 in the interim period of adoption – e.g. the financial results for
the three months ended September 30, 2018; or
— Approach 2. Retrospectively apply ASU 2017-12 to preceding interim
periods, with the effect of any changes to those previous periods recorded
in the year-to-date results before adoption.
These approaches should only be applied to hedging relationships existing at
the date of adoption of July 1, 2018. An entity that early adopts ASU 2017-12 in
an interim period should disclose which of these transition approaches was
applied.
We believe an entity that early adopts in an interim period is not required to
amend previous Form 10-Q filings. An entity should include disclosures required
by paragraph 815-20-65-3(k) for the change in accounting principle in the interim
period of adoption, and in the annual financial statement period (see
section 11.3.40).

However, there are additional reporting considerations for an SEC filer that
elects to retrospectively apply ASU 2017-12 to the preceding interim periods
(Approach 2), including the following.
— The quarterly results of operations presented in the Form 10-K filed in the
year of adoption should reflect the retrospectively adjusted interim
amounts.
— In the year after adoption, comparative information and disclosures in the
Form 10-Q filings should reflect the retrospectively adjusted interim
amounts.

Example 11.2.10
Adopting ASU 2017-12 by retrospectively adjusting
previous interim periods
ABC Corp., a calendar year-end public business entity, early adopts the
guidance on July 1, 2018 – i.e. in its third quarter reporting period.
Interim reporting considerations in the year of adoption
ABC records a cumulative-effect adjustment as of January 1, 2018 (the initial
application date) in accordance with the transition requirements in ASU 2017-
12. It also retrospectively adjusts the interim period results between the initial
application date and the date of adoption to reflect the period-specific effects of
applying ASU 2017-12.
ABC elects to modify the recognition model for the excluded component from a
mark-to-market approach to an amortization approach. ABC elects the transition
provision that allows it to modify an existing hedging relationship without
dedesignating and redesignating the hedging relationship. Instead, ABC does
not dedesignate its existing hedging relationships at the date of adoption
(July 1, 2018), and it recognizes the cumulative-effect adjustment as of
January 1, 2018. For guidance on elective transition guidance for excluded
components, see section 11.4.50.
In the period between the initial application date and the date of adoption
(January 1, 2018 to June 30, 2018) ABC previously recognized the excluded
component using a mark-to-market approach. ABC calculates the effect of the
change to an amortization approach during this period, and adjusts amounts
previously recorded.
The adjusted amounts reflect what would have been recognized had the
amortization approach been adopted on January 1, 2018. The effect of any
changes from retrospectively adjusting the results of the previous interim
periods are reflected in the third quarter 2018 Form 10-Q, within the financial
results for the nine months ended September 30, 2018.

The graphic summarizes the interim reporting considerations for the third
quarter of 2018.
Initial application date Date of adoption
January 1, 2018 March 31, 2018 July 1, 2018 September 30, 2018

Adjusted for effect of change to ASU 2017-12 Apply ASU 2017-12

Cumulative-
effect
adjustment

Interim reporting considerations in the year after adoption

In its Form 10-Qs for the first and second quarters of 2019, ABC updates the
comparative amounts for the quarterly periods ended March 31, 2018 and
June 30, 2018 to reflect the retrospectively adjusted interim amounts.
Because the results of operations for periods presented have been adjusted
retroactively subsequent to the initial reporting of such period, ABC needs to
disclose the effect of the change. [S-X Rule 10-01(b)(7)]
Therefore, the Form 10-Qs for the first and second quarters of 2019 should
include information to explain the effect of any changes made to the quarterly
periods ended March 31, 2018 and June 30, 2018, from amounts previously
reported in the Form 10-Qs for the first and second quarters of 2018.

11.3 Required transition provisions

11.3.10 Modified retrospective transition approach

Excerpt from ASC 815-20

> Transition Related to Accounting Standards Update No. 2017-12,

An entity adopts ASU 2017-12 by applying a modified retrospective approach to

existing hedging relationships. Under this method, an entity records the
cumulative effect of applying certain amendments in ASU 2017-12 to the
opening balance of retained earnings as of the initial application date.
This modified retrospective approach includes eliminating the separate
measurement of ineffectiveness (see section 11.3.20), and other amendments
available for adoption with elected transition provisions (see section 11.4).

Existing hedging relationships

The modified retrospective transition method applies only to existing hedging
relationships as of the date of adoption.
The following table illustrates whether a cumulative-effect adjustment should
be recorded based on whether the hedging relationship existed on the initial
application date, the date of adoption or both.

Hedging relationship existed at the: Cumulative-effect adjustment

recorded as of the initial
Initial application date Date of adoption application date?
Yes Yes Yes
1
No Yes No
2
Yes No No
Notes:
1. For hedging relationships existing on the date of adoption, but not on the initial
application date, any impact on adoption should be recorded in the year-to-date
results. The impact should not be reflected in the cumulative-effect adjustment on the
initial application date because the hedging relationship did not exist then.
2. For hedging relationships that did not exist at the date of adoption, there is no
cumulative-effect adjustment. In addition, there is no retrospective adjustment to
preceding interim periods in the year of adoption.

11.3.20 Income statement presentation and eliminating

ineffectiveness

Excerpt from ASC 815-20

> Transition Related to Accounting Standards Update No. 2017-12,

1. Present the entire change in the fair value of the hedging instrument in
the same income statement line item as the earnings effect of the
hedged item when the hedged item affects earnings (with the
exception of amounts excluded from the assessment of hedge
effectiveness in a net investment hedge) in accordance with
paragraphs 815-20-45-1A and 815-20-45-1C.

ASU 2017-12 replaces existing guidance with specific income statement

requirements for the earnings effect of hedging instruments, and eliminates the
requirement under legacy US GAAP to separately measure and disclose hedge
ineffectiveness (see excluded components in section 11.4.50). The following
table summarizes the transition requirements related to these amendments.

Legacy US GAAP ASU 2017-12 Required transition

Cash — Effective portion — Entire change in Reverse any

flow is recognized in fair value of ineffectiveness
hedges AOCI and components previously recorded
(section reclassified into included in the in earnings on cash
6.2.10) earnings when effectiveness flow hedging
the hedged assessment is relationships existing
transaction recognized in on the date of
affects earnings. AOCI and adoption in the
Ineffective reclassified into cumulative-effect
portion is earnings when adjustment on the
recognized in the hedged initial application
earnings. [815-20- transaction date. [815-20-65-3(d)]
35-1(c), 815-30-35- affects earnings.
2 – 35-3] [815-20-35-1(c),
815-30-35-3]
— Ineffective
portion is — Ineffective
separately portion is not
measured and separately
disclosed. measured or
[815-10-50-4C(d), disclosed.
815-30-35-2 – 35-3]

Ineffective portion Entire change in fair Presentation

and excluded portion value (including any guidance is applied
can be presented in excluded portion) is prospectively. [815-20-
an income statement presented in the 65-3(j)]
line item different same income
from the effective statement line item
portion. [815-20-45-1] as the earnings effect
of the hedged
transaction. [815-20-
45-1A]

Legacy US GAAP ASU 2017-12 Required transition

Fair value — Entire change in — Entire change in For fair value hedging
hedges fair value is fair value of relationships existing
(section recognized in components on the date of
4.2.10) earnings. [815-25- included in the adoption, the entire
35-1 – 35-3] effectiveness change in the fair
assessment is value of the hedging
— Ineffective
recognized in instrument (including
portion is
earnings. [815-20- the ineffective
separately
35-1(b), 815-25- portion) has been
measured and 35-1] previously recorded
disclosed.
[815-10-50-4C, — Ineffective in earnings.
815-25-50-1(a)] portion is not Therefore, no
separately cumulative-effect
measured or adjustment is
disclosed. necessary on the
initial application
date.

Ineffective portion or Entire change in fair Presentation

excluded portion can value (including any guidance is applied
be presented in an excluded portion) is prospectively. [815-20-
income statement presented in the 65-3(j)]
line item different same income
from the effective statement line item
portion. [815-20-45-1] used to present the
earnings effect of the
hedged item. [815-20-
45-1A]

Net — Effective portion Entire change in fair Reverse any

invest- is recognized in value of components ineffectiveness
ment CTA in AOCI and included in the previously recorded
hedges reclassified into effectiveness on net investment
(section earnings when assessment is hedging relationships
8.5) the foreign recognized in CTA in existing on the date
operation is sold AOCI and reclassified of adoption in the
or substantially into earnings when cumulative-effect
liquidated. [815- the foreign operation adjustment on the
20-35-1(d), 815-35- is sold or initial application
35-1] substantially date. [815-20-65-3(d)]
— Ineffective liquidated. [815-20-35-
1(d), 815-35-35-1]
portion is
recognized in
earnings. [815-35-
35-4, 35-13]

Ineffective portion is Ineffective portion is Presentation

separately measured not separately guidance is applied
and disclosed. measured or prospectively. [815-20-
[815-10-50-4C, 815-35- disclosed. 65-3(j)]
35-4, 35-13]

11.3.30 New disclosure requirements

Excerpt from ASC 815-20

> Transition Related to Accounting Standards Update No. 2017-12,

The disclosure guidance amended by ASU 2017-12 should be applied

prospectively for hedging relationships existing on the date of adoption. [815-20-
65-3(j)]

11.3.40 Disclosures for accounting changes under Topic 250

Excerpt from ASC 815-20

> Transition Related to Accounting Standards Update No. 2017-12,

In the interim and annual period of adoption, an entity should provide the
disclosures required by Topic 250 (accounting changes and error corrections),
which include: [815-20-65-3]
— the nature of and reason for the change in accounting principle; and
— the cumulative-effect adjustment for each affected component of equity or
net assets on the date of adoption.

11.4 Elective transition principles

11.4.10 Overview

Excerpt from ASC 815-20

> Transition Related to Accounting Standards Update No. 2017-12,

The transition provisions offer several elections that can provide relief when
applying the ASU 2017-12 amendments to existing hedging relationships. An
entity may apply each election on a stand-alone basis. [ASU 2017-12.BC246, BC259]
The following types of entities have until the first quarterly effectiveness
assessment date after the date of adoption to make these elections:
— public business entities;
— private companies that are financial institutions; and
— certain not-for-profit entities (that have issued, or are a conduit bond obligor
for, securities that are traded, listed, or quoted on an exchange or over-the-
counter market).
All other entities have until their next interim (if applicable) or annual financial
statements are available to be issued to make any of these elections. [815-20-65-
3(f) – 65-3(g)]

If an entity does not elect a transition provision within the allotted timeframe,
any hedging relationship existing at the date of adoption will not qualify for
transition relief. Instead, an entity will have to dedesignate and redesignate
existing hedging relationships to change the critical terms (see section 2.10).

11.4.20 Transition elections for fair value hedges of interest

rate risk

Excerpt from ASC 815-20

> Transition Related to Accounting Standards Update No. 2017-12,

Derivatives and Hedging (Topic 815): Targeted Improvements to
Accounting for Hedging Activities
65-3 The following represents the transition and effective date information
related to Accounting Standards Update No. 2017-12, Derivatives and Hedging
(Topic 815): Targeted Improvements to Accounting for Hedging Activities: …
e. An entity may elect any of the following items upon adoption of the
pending content that links to this paragraph:
1. For a fair value hedge of interest rate risk existing as of the date of
adoption, an entity may modify the measurement methodology for a
hedged item in accordance with either paragraph 815-20-25-6B or
paragraph 815-25-35-13 without dedesignation of the hedging
relationship. The cumulative basis adjustment carried forward shall be
adjusted to an amount that reflects what the cumulative basis
adjustment would have been at the date of adoption had the modified
measurement methodology been used in all past periods in which the
hedging relationship was outstanding. When making this election, the
benchmark rate component of the contractual coupon cash flows shall
be determined as of the hedging relationship’s original inception date.
The cumulative effect of applying this election shall be recognized as
an adjustment to the basis adjustment of the hedged item recognized
on the balance sheet with a corresponding adjustment to the opening
balance of retained earnings as of the initial application date.
2. For the fair value hedges of interest rate risk for which an entity
modifies the measurement methodology for the hedged item based on
the benchmark rate component of the contractual coupon cash flows in
accordance with (1) above, an entity may elect to dedesignate a portion
of the hedged item and reclassify the basis adjustment associated with
the portion of the hedged item dedesignated to the opening balance of
retained earnings as of the initial application date.
…
h. For fair value hedges existing as of the date of adoption in which the
hedged item is a tax-exempt financial instrument, the hedged risk may
be modified to interest rate risk related to the Securities Industry and
Financial Markets Association (SIFMA) Municipal Swap Rate. The
modification shall be considered a dedesignation and immediate
redesignation of the hedging relationship. In this situation, the cumulative
basis adjustment of the hedged item from the dedesignated hedging
relationship shall be amortized to earnings on a level-yield basis over a
period of time based on the applicable requirements in other Topics.

The following table summarizes the transition elections available for certain fair
value hedges of interest rate risk existing as of the date of adoption, as well as
a comparison of the changes from legacy US GAAP.

Legacy US GAAP ASU 2017-12 Required transition

Hedging Measure the change Measure the change — Change in

portions of in a hedged item’s in a hedged item’s measurement
financial fair value attributable fair value attributable methodology for
items: to changes in the to changes in the the hedged item
Benchmark benchmark interest benchmark interest does not require
interest rate rate based on the rate based on either a dedesignation
component entire contractual the hedged item’s: of the existing
(section coupon cash flows. [815-25-35-13] hedging
3.3.70) [815-25-35-13] — entire relationship.
contractual — The cumulative
coupon cash basis adjustment
flows; or included in the
— the benchmark amortized cost
rate component basis of the
of the hedged item is
contractual adjusted as of
coupon cash initial application
flows date based on
determined at the amount that
inception of the would have been
hedging recorded as if
relationship. the modified
measurement
methodology
had been used
since inception
of the hedging
relationship (see
Question
11.4.10).
— Benchmark
interest rate
component of
the hedged item
determined as of
the original
hedge inception
date.
— Dedesignate a
portion of the
hedged item and
reclassify the
basis adjustment
associated with
the portion of
the hedged item
dedesignated to
the opening
balance of
retained
earnings as of

Legacy US GAAP ASU 2017-12 Required transition

the initial
application date.
[815-20-65-3(e)(1) –
3(e)(2)]

Interest rate Consider the effect Option to consider — Change in

risk hedges of all factors (e.g. only the effect of measurement
of credit risk, liquidity, changes in the methodology for
prepayable interest rates) on the benchmark interest the hedged item
financial decision to prepay a rate on the decision does not require
instruments financial instrument. to prepay a financial a dedesignation
(section [815-20-25-6] instrument. [815-20- of the existing
3.4.10) 25-6B] hedging
relationship.
— The cumulative
basis adjustment
included in the
amortized cost
basis of the
hedged item is
adjusted as of
the initial
application date
based on the
amount that
would have been
recorded as if
the modified
measurement
methodology
had been used
since inception
of hedging
relationship (see
Question
11.4.10).
[815-20-65-3(e)(1)]

Interest rate In the United States, SIFMA Municipal To change the

risk: the following Swap Rate added as hedged risk to
Benchmark benchmark rates are eligible benchmark interest rate risk
interest rate eligible to be interest rate. related to the SIFMA
(section designated in a [815-20-25-6A] Municipal Swap
2.3.30) hedge: [815-20-25-6A] Rate:
— US treasury rate; — dedesignate and
— LIBOR swap immediately
rate; and redesignate the
hedging
— Fed funds
relationship if it
effective swap
is highly
rate (Overnight
effective; and
index swap rate).
— amortize the
basis adjustment
from the
dedesignated

Legacy US GAAP ASU 2017-12 Required transition

hedging
relationship into
earnings on a
level-yield basis
over a period
based on
applicable
requirements in
other Topics
(e.g. Subtopic
310-20 on
receivables –
nonrefundable
fees and other
costs).
[815-20-65-3(h)]

Question 11.4.10
What date is used to determine the cumulative
basis adjustment when modifying the
measurement methodology for a fair value hedge of
interest rate risk?
Interpretive response: Paragraph 815-20-65-3(e)(1) states that the cumulative
basis adjustment carried forward is “adjusted to an amount that reflects what
the cumulative basis adjustment would have been at the date of adoption had
the modified measurement methodology been used in all past periods in which
the hedging relationship was outstanding.”
This paragraph could be interpreted such that an entity calculates the basis
adjustment as of the date of adoption. However, we believe it was the FASB’s
intent for an entity to calculate the cumulative basis adjustment as of the initial
application date, not the date of adoption. This approach is consistent with the
modified retrospective transition approach used in other aspects of the
transition guidance.

Question 11.4.20
What date is used to determine the benchmark rate
if the current hedging relationship was previously
dedesignated and redesignated?
Interpretive response: An entity that elects to use the transition relief related
to the benchmark rate component is required to determine the benchmark rate
component as of the original hedge inception date. [815-20-65-3(e)(1)]
For previously dedesignated and redesignated hedging relationships existing at
the date of adoption, we believe the benchmark rate component should be
determined as of the most recent date of redesignation, not as of the date that

the original hedged item was designated in a hedging relationship for the first
time.

Question 11.4.30
When transitioning to measure a hedged item
based on the benchmark rate component of the
coupon, can an entity rebalance an existing hedging
relationship?
Background: Legacy US GAAP requires an entity to measure the change in fair
value of the hedged item in a fair value hedge based on the cash flows from the
entire contractual coupon. This requirement has caused income statement
volatility when an entity hedged interest rate risk with common hedging
instruments, such as interest rate swaps based on LIBOR. [815-25-35-13]
Historically, some entities limited this income statement volatility by
designating a hedge ratio of other than 1:1. In other words, an entity may have
designated a notional amount of the hedging instrument that was greater than
or less than the principal amount of the hedged item.
Under ASU 2017-12, an entity is allowed to measure the hedged item based on
the benchmark rate component of the coupon, which eliminates the need to
designate hedging relationships where the hedging instrument and the hedged
item have different notional/principal amounts solely to meet the highly
effective threshold. For existing hedging relationships with mismatched
notional/principal amounts, electing to measure the hedged item based on the
benchmark rate component of the coupon may cause the hedging relationship
to no longer meet the highly effective threshold. Additionally, an earnings
mismatch would be created because of the mismatched notional/principal
amounts.
Interpretive response: Yes. The transition relief allows an entity to rebalance
an existing hedging relationship that has different notional/principal amounts by
dedesignating a portion of the hedged item. The related basis adjustment is
recorded directly in retained earnings and therefore will not create earnings
volatility. [815-20-65-3(e)(2), ASU 2017-12.BC257]
The transition guidance does not explicitly state whether a similar adjustment
can be made to rebalance relationships by modifying the designated proportion
of the hedging instrument or increasing the designated portion of the
hedged item.
Based on discussions with the FASB staff, we believe an entity is allowed to
rebalance the hedging relationship by increasing or decreasing the hedging
instrument’s notional amount – or by increasing or decreasing the hedged
item’s principal amount – without dedesignating existing hedging relationships.
However, an entity may only designate an increased proportion of a hedging
instrument or an increased portion of a hedged item if the hedging instrument
or hedged item’s notional/principal was not fully designated at the inception of
the hedge. This means an entity may rebalance only by using the existing
hedged item or the existing hedging instrument and may not add new hedged
items or hedging instruments.

For example, an entity cannot replace the hedging instrument with a different
hedging instrument, modify the terms of the hedging instrument to increase the
notional amount, or increase the principal amount of the hedged item by including
additional debt instruments. In addition, a portion of the derivative could not have
been concurrently designated as part of another hedging relationship.

Example 11.4.10
Dedesignating a portion of the hedged item
ABC Corp. issues a 20-year, $100 million debt instrument with a 7% interest
coupon. On the same day it enters into a 20-year $100 million receive 3% fixed,
pay LIBOR interest rate swap that converts a portion of the fixed interest rate
on the debt instrument into a LIBOR-based floating interest rate.
Subsequently, on adopting ASU 2017-12, ABC decides to modify its
measurement methodology to calculate the change in fair value of the debt
instrument based on the benchmark rate component of the contractual coupon
cash flows.
Scenario 1: Previous hedge designation was 90% of the notional amount
of the swap
ABC previously designated 90% of the notional amount of the swap ($90
million notional) as a hedge of the $100 million debt to meet the highly effective
threshold.
On transition to ASU 2017-12, ABC records a cumulative-effect adjustment to
reflect the change in the measurement method of the hedged item on the basis
of the benchmark rate component of the contractual coupon cash flows.
[815-20-65-3(e)(1)]

In addition, ABC has two options for rebalancing the existing hedging
relationship.

Updated hedging Accounting considerations at transition

Rebalancing relationship specifically related to the rebalancing
Dedesignate Principal amount: The basis adjustment related to the $10 million
a portion of $90 million dedesignated portion is recorded directly in the
the debt1 Swap notional opening balance of retained earnings. [815-20-
amount: 65-3(e)(2)]
$90 million
Designate Principal amount: No incremental effect on the cumulative-effect
the full $100 million adjustment because the amount of the hedged
notional Swap notional item has not changed.
amount of amount: The incremental $10 million notional amount of
the existing $100 million the swap is included in the hedging relationship
swap at adoption.
Note:
1. This assumes the remaining 10% of the notional amount of the swap ($10 million
notional) is designated in a different hedging relationship.

Scenario 2: Previous hedge designation was 90% of principal amount of

debt
ABC previously designated 90% of the principal amount of the debt ($90 million
principal) against $100 million notional amount of the swap to meet the highly
effective threshold.
On transition to ASU 2017-12, ABC records a cumulative-effect adjustment to
reflect the change in the measurement method of the hedged item on the basis
of the benchmark rate component of the contractual coupon cash flows.
[815-20-65-3(e)(1)]

In addition, ABC has two options for rebalancing the existing hedging
relationship.

Updated hedging Accounting considerations at transition

Rebalancing relationship specifically related to the rebalancing
Dedesignate Principal amount: No incremental effect on the cumulative-effect
a portion of $90 million adjustment because the amount of the hedged
the notional Swap notional item has not changed.
amount of amount: $10 million of the notional amount of the swap
the swap $90 million will no longer be designated as part of this
hedging relationship; however, it may be
designated in a different hedging relationship.
Designate Principal amount: The $10 million principal amount of the debt is
the full $100 million included in the hedging relationship at adoption,
principal Swap notional and a cumulative basis adjustment is recorded
amount of amount: $100 as of the initial application date. This is based
the existing million on an assumption that the full principal amount
debt of the debt had been designated at the
inception of the hedging relationship.

Question 11.4.40
What transition approach is required to apply the
partial-term hedging guidance?

Interpretive response: Under ASU 2017-12, an entity may designate only

part of a financial instrument’s remaining term as the hedged item (see
section 3.3.80). There is no specific transition guidance for this new hedging
strategy.
We believe making this change to an existing hedging relationship on adoption
of ASU 2017-12 requires dedesignation and redesignation of the hedging
relationship. Therefore, there would be no cumulative-effect adjustment
recognized on transition.

11.4.30 Transition election to transfer securities from the

HTM to the AFS portfolio

Excerpt from ASC 815-20

> Transition Related to Accounting Standards Update No. 2017-12,

An entity may reclassify HTM securities that qualify to be hedged under the
last-of-layer method to the AFS category. Any unrealized gain or loss at the date
of the transfer is recorded in AOCI. [815-20-65-3(e)(7)]

Question 11.4.50
On what date in the period of adoption can an
entity transfer securities from HTM to AFS?

Interpretive response: Transition elections must be adopted within the

timeframe outlined in paragraphs 815-20-65-3(f) to 65-3(g) (see section 11.4.10).
This includes the transition election available for the transfer of eligible
securities from the HTM to the AFS category.
An entity may elect to transfer securities from HTM to AFS on a specific date
within the period of adoption. However, we believe all the transfers should be
recorded as if they occurred on the date of adoption of the ASU, with any
unrealized gain or loss – i.e. the difference between the fair value and the
amortized cost of the transferred securities – on that date recorded in AOCI.
For example, a calendar year-end public business entity adopts ASU 2017-12 on
January 1, 2019 and determines all of the transition elections it will apply on
March 1, 2019, which is before any quarterly effectiveness assessments. The
entity should record all transfers of securities and any related unrealized gains
or losses as of January 1, 2019 (the date of adoption).

Question 11.4.60
Is there any restriction on selling AFS securities
after transferring them from the HTM category on
adoption?
Interpretive response: No. We believe an entity is permitted to sell the
securities immediately after transferring them from the HTM to the AFS
category. There is no restriction requiring an entity to hold the AFS securities for
a period of time after they are transferred.

Question 11.4.70
Will transferring securities from HTM to AFS affect
an entity’s pre-transition intent to hold the
securities to maturity?
Interpretive response: No. We do not believe transferring securities from the
HTM to the AFS category affects management’s intent and ability to hold the
securities to maturity in the period before adopting ASU 2017-12. This is
because the transfer will be due to a one-time transition election available
through a new accounting standard. Management’s intention to sell the
securities after transferring them to AFS does not alter this conclusion.
For example, a calendar year-end entity elects to adopt ASU 2017-12 on
January 1, 2019 and transfers eligible securities from HTM to AFS. We believe
management’s intent to imminently adopt ASU 2017-12 and transfer the
securities to the AFS category does not affect the entity’s positive intent and
ability to hold the securities to maturity at December 31, 2018. On
December 31, 2018, the securities would remain eligible to be classified as
HTM and recorded at amortized cost, based on the entity’s positive intent and
ability to hold them to maturity.

Question 11.4.80
Are there any disclosure requirements for securities
transferred from HTM to AFS?

Interpretive response: There are no specific transition disclosure requirements

for securities transferred from the HTM to the AFS category. However, we
believe the SEC staff expects clear and transparent disclosures in the financial
statements to help users understand the effects of adopting ASU 2017-12.
Therefore, we believe an entity should make a materiality assessment and
determine what, if any, disclosures are needed in addition to those required by
paragraph 815-20-65-3(k) (see section 11.3.40).
We understand that the SEC staff expects disclosures similar to those required
by paragraph 320-10-50-10 for sales or transfers of HTM securities, which
include:
— the net carrying amount of the sold or transferred security;

— the related realized or unrealized gain or loss; and

— the circumstances leading to the decision to sell or transfer the security.

Question 11.4.90
What financial instruments are eligible to be
transferred from HTM to AFS?

Interpretive response: An entity may reclassify a debt security from the HTM
to the AFS category if the debt security is eligible to be hedged under the last-
of-layer method (see section 3.3.100). Only financial instruments that are
considered ‘prepayable’ can be included in the portfolio hedged under the last-
of-layer method (see Question 3.3.310). [815-20-25-12A, 65-3(e)(7)]
We believe a financial instrument is not required to be designated in a last-of-
layer hedge to be eligible for transfer from the HTM to the AFS category.
Therefore, a financial instrument that is eligible for the last-of-layer method but
is not designated in a hedge is eligible for transfer.

11.4.40 Transition elections for cash flow hedges

Excerpt from ASC 815-20

> Transition Related to Accounting Standards Update No. 2017-12,

The following table summarizes transition elections available for new hedging
strategies related to certain types of cash flow hedges existing as of the date of
adoption, as well as comparable guidance from legacy US GAAP.

Legacy US GAAP ASU 2017-12 Required transition

Interest rate For all financial — For variable-rate — An entity may

risk: instruments, interest financial modify the
Contractually rate risk relates to instruments or hedging
specified changes in the forecasted relationship to
interest rate benchmark interest issuances or specify the
for cash flow rate. [815-20-25- purchases of hedged risk as
hedges 15(j)(2)] variable-rate the variability in
(section debt the contractually
2.3.40) instruments, specified
interest rate risk interest rate,
relates to without
changes in a dedesignating
contractually the hedging
specified relationship.1
interest rate. — Terms of the
[815-20-25-15(j)(2), instrument used
25-19A]
to estimate
— For forecasted changes in value
issuances or of the hedged
purchases of transaction
fixed-rate debt, attributable to
interest rate risk the hedged risk
relates to when assessing
changes in the effectiveness
benchmark should be based
interest rate. on market data
[815-20-25-19A] as of the date of
hedge inception.
— Consider any
previously
recognized
ineffectiveness
as part of the
cumulative-
effect
adjustment
recorded as of
the initial
application date
(see section
11.3.20).
[815-20-65-3(e)(6)]

Contractually For nonfinancial For nonfinancial — An entity may

specified items, the following items, the following modify the
component risks are eligible to risks are eligible to hedging
price risk for be hedged: [815-20- be hedged: [815-20- relationship to
nonfinancial 25-15(i] 25-15(i] specify the
items — all changes in — all changes in hedged risk as
(section the purchase the purchase the variability in
5.4.10) price or sales price or sales the contractually

Legacy US GAAP ASU 2017-12 Required transition

price of the price of the specified
asset (i.e. price asset (i.e. price component,
risk) risk) without
— foreign currency — changes in a dedesignating
risk. contractually the hedging
specified relationship.1
component (i.e. — Terms of the
component price instrument used
risk) to estimate
— foreign currency changes in value
risk. of the hedged
item attributable
to the hedged
risk when
assessing
effectiveness
should be based
on market data
as of the date of
hedge inception.
— Consider any
previously
recognized
ineffectiveness
as part of the
cumulative-
effect
adjustment
recorded as of
the initial
application date
(see section
11.3.20).
[815-20-65-3(e)(6)]

Note:
As part of the transition relief, an entity does not need to assess effectiveness for
similar hedges in a similar manner. An entity may continue designating the variability in
total cash flows as the hedged risk for hedging relationships existing on the date of
adoption, and designate the hedged risk as the variability in the contractually specified
component or contractually specified interest rate for hedging relationships executed
after the date of adoption (see Question 9.2.220). [815-20-65-3(i)(2)]

Example 11.4.20
Hedged risk is changed to variability in contractually
specified component
Before adopting ASU 2017-12, Bakery purchased a contract to buy flour. The
contract specifies the total price to be paid as (per unit of measure) the price of
wheat index ABC, plus $1, plus transportation costs to Bakery's location.
Bakery also entered into a derivative contract with an underlying based on
wheat index ABC.

Hedge designation: legacy US GAAP

Bakery designated the derivative as a cash flow hedge of the variability in the
anticipated purchase price of flour (wheat index + $1 + transportation costs),
with the expectation that the hedging relationship will be highly effective.
Legacy US GAAP requires an entity to designate the risk of changes in cash
flows related to all changes in the purchase price of the asset reflecting its
actual location. [815-20-25-15(i)(2)]
Any ineffectiveness was previously recorded in earnings.
Hedge designation: at transition
Bakery elects to modify, without dedesignation, the existing hedging
relationship to specify the hedged risk as the variability in the contractually
specified wheat index ABC component.
Any ineffectiveness previously recognized is included as part of the cumulative-
effect adjustment to AOCI and opening retained earnings as of the initial
application date.
To assess effectiveness, Bakery creates the terms of the instrument used to
estimate changes in value of the hedged risk (e.g. a PEH derivative) using
market data for wheat index ABC at the original inception date of the hedge,
and compares to actual changes in the wheat index ABC derivative instrument.

Question 11.4.100
What is the transition guidance for an existing
hedging relationship with a non-zero fair value
derivative designated at hedge inception?
Interpretive response: There is no transition guidance in ASU 2017-12 for
existing cash flow hedging relationships where a non-zero fair value derivative
was designated as the hedging instrument at hedge inception.
Under legacy US GAAP, the initial non-zero fair value of the hedging derivative
may give rise to hedge ineffectiveness that is recorded in earnings throughout
the life of the hedging relationship – e.g. an interest rate swap with periodic
cash settlements and a non-zero fair value at hedge inception designated in a
cash flow hedge of forecasted variable interest payments.
In this situation, ASU 2017-12 requires the following. [815-30-35-41A]
— As long as the hedge is highly effective, the entire change in fair value of
the hedging instrument is included in OCI and subsequently reclassified
into earnings when the hedged transaction affects earnings – i.e. there is
no recognition of hedge ineffectiveness in earnings.
— The amounts related to the initial fair value that are recorded in OCI during
the hedging relationship are reclassified from AOCI into earnings on a
systematic and rational basis over the periods during which the hedged
forecasted transactions affect earnings. Section 6.3.20 provides guidance
on cash flow hedge accounting when a hedging instrument with periodic
settlements has a non-zero fair value at hedge inception.

On transition to ASU 2017-12, an entity is required to reverse any

ineffectiveness previously recognized through a cumulative-effect adjustment
recorded in AOCI and the opening balance of retained earnings as of the initial
application date.
As part of calculating the cumulative-effect adjustment, we believe an entity
is also required to consider the effect of the amounts related to the initial fair
value that would have been reclassified from AOCI into earnings for the period
from the original hedge inception date to the initial application date of
ASU 2017-12.

11.4.50 Transition elections for recognition and presentation

of excluded components

Excerpt from ASC 815-20

> Transition Related to Accounting Standards Update No. 2017-12,

The following table summarizes the transition elections related to recognizing

and presenting excluded components available for hedging relationships
existing on adoption, as well as a comparison of applicable changes from legacy
US GAAP.

Legacy US GAAP ASU 2017-12 Required transition

Recognizing Changes in excluded The initial value of An entity may:

excluded components are the excluded — modify the
components recognized currently component is recognition
(section in earnings, together recognized in model for the
9.2.70) with any earnings using excluded
ineffectiveness. either: [815-20-25-83A component
[815-20-25-83] – 25-83B, 815-35-35- from a mark-to-
5A – 35-5B]
market
— a systematic approach to an
and rational amortization
method over approach
the life of the without
hedging dedesignating
instrument the hedging
(amortization relationship;1
approach); or and
— currently in — recognize a
earnings (mark- cumulative-
to-market effect
approach). adjustment as
Under the of the initial
amortization application date.
approach, any [815-20-65-3(e)(4)]
difference between
the change in fair
value of the
excluded
component and the
amounts recognized
in income are
included in AOCI
(the CTA section of
AOCI for a net
investment hedge).
[815-20-25-83A, 815-
35-35-5A]
This election is
applied consistently
to similar hedges.
For fair value and
cash flow hedges, if
an entity elects to
record the amounts
currently in
earnings, that
election is disclosed.
[815-10-50-4EEEE,
815-20-25-83B, 815-35-
35-5B]

Legacy US GAAP ASU 2017-12 Required transition

Cross- An entity may An entity may Fair value hedges.

currency exclude: [815-20-25- exclude: [815-20-25- For fair value
basis 82] 82] hedges existing at
spreads in — time value of — time value of the date of adoption,
currency options options an entity:
swaps can modify
— forward points — forward points —
(section (spot-forward (spot-forward hedge
9.2.70) difference) in a difference) in a documentation
forward forward to exclude the
contract. contract cross-currency
basis spread
— cross-currency
component of a
basis spreads in
cross-currency
currency swaps
swap without
(for fair value
dedesignating
and cash flow
the hedging
hedges only).
relationship;
and
— recognize a
cumulative-
effect
adjustment as
of the initial
application date.
[815-20-65-3(e)(3)]

Note:
As part of the transition relief, an entity does not need to assess effectiveness for
similar hedges in a similar manner. An entity may continue recognizing excluded
components using a mark-to-market approach for hedging relationships existing on
the date of adoption, and elect an amortization approach for hedging relationships
executed after the date of adoption (see Question 9.2.220). [815-20-65-3(i)(3)]

Question 11.4.110
Can the transition provision for excluding cross-
currency basis spreads in cross-currency swaps be
applied to a cash flow or a net investment hedge?
Interpretive response: No. The FASB did not extend this transition provision to
cash flow or net investment hedges.
— Cash flow hedge. In a cash flow hedge, cross-currency basis spread
volatility does not affect earnings. All changes in fair value of the hedging
instrument are deferred in OCI.
— Net investment hedge. For a net investment hedge, the excluded
component model is different. If an entity has historically used cross-
currency interest rate swaps as the hedging instrument and elected to
assess effectiveness using the spot method, the hedging relationship
implicitly excludes the cross-currency basis spread (along with any other
component of the currency swap’s fair value excluded by the spot method

of assessing effectiveness) from the assessment of effectiveness. If an

entity determines that it now wishes to amortize the excluded component,
rather than marking it to market, it can do so through the transition
provision related to the recognition of excluded components. [ASU 2017-
12.BC251]

11.4.60 Transition elections related to assessing hedge

effectiveness

Excerpt from ASC 815-20

> Transition Related to Accounting Standards Update No. 2017-12,

The following table summarizes transition elections related to targeted

improvements to the hedge effectiveness assessment process for hedges
existing as of the date of adoption, as well as comparable guidance from legacy
US GAAP.

Legacy US GAAP ASU 2017-12 Required transition

Qualitative Subsequent Subsequent quarterly An entity is

effectiveness prospective and effectiveness permitted to amend
assessments retrospective assessments (after the hedge
(section 9.5) assessments of an initial quantitative documentation for
hedge effectiveness assessment) may be existing hedging
are required to be performed on a relationships to
quantitative, except qualitative (rather indicate that
for methods such as than quantitative) subsequent
’shortcut’ or ‘critical basis if an entity can assessments of
reasonably support effectiveness will be

Legacy US GAAP ASU 2017-12 Required transition

terms match’. an expectation that performed
[815-20-25-79] the hedge is highly qualitatively, without
effective at inception dedesignating the
and will continue to existing hedging
be in subsequent relationships. [815-20-
periods. [815-20-25- 65-3(e)(5)(i)]
79, 815-20-35-2A]

Shortcut An entity that An entity that An entity is

method determines it inappropriately permitted to amend
(section 9.3) inappropriately used applied the shortcut the hedge
the shortcut method method may documentation for
loses hedge continue to apply existing shortcut
accounting in all hedge accounting to method hedging
previous periods in previous periods if it: relationships without
which it had applied [815-20-25-117A] dedesignating the
the method. [2005 — documented at existing hedging
AICPA Conf] hedge inception relationships.1
which [815-20-65-3(e)(5)(ii)]
quantitative
method it would
use to assess
hedge
effectiveness in
the event that
the shortcut
method was no
longer
appropriate; and
— when the
quantitative
method was
identified as
being applied in
its hedge
documentation,
determines that
the hedge was
highly effective
for the periods
in which the
shortcut method
criteria were not
met.

Note:
As part of the transition relief, an entity does not need to assess effectiveness for
similar hedges in a similar manner. An entity may document a quantitative
effectiveness method for new shortcut method hedging relationships executed after
the date of adoption. This is regardless of whether an entity modifies its hedge
documentation to include a quantitative effectiveness method for hedges existing at
the date of adoption (see Question 9.2.220). [815-20-65-3(i)(1), ASU 2017-12.BC261]

Question 11.4.120
What transition approach is required to change
from a long-haul to the critical terms match method
for an existing hedging relationship?
Background: Under ASU 2017-12, the critical terms match method may be
applied to groups of forecasted transactions in which the individual transactions
occur, and the hedging derivative matures, within the same 31-day period or
fiscal month (see section 9.4). Under legacy US GAAP, an entity would have
applied a quantitative long-haul method instead of the critical terms match
method to such relationships.
Interpretive response: There is no specific transition guidance in ASU 2017-12
if an entity changes from a quantitative long-haul method to the critical terms
match method for an existing hedging relationship. Based on discussions with
the FASB staff, we understand it was the FASB’s intent to allow entities to
modify their documentation without dedesignating and redesignating an
existing hedging relationship to specify that the critical terms of the hedging
instrument and the hedged item match in accordance with paragraphs 815-20-
25-84 and 25-85.

Question 11.4.130
What transition approach is required to change the
method used to assess effectiveness of a net
investment hedge?
Background: The amendments in ASU 2017-12 allow an entity to change its
method of assessing the effectiveness of its net investment hedges – from
spot to forward, or vice versa (see section 8.4.40). Under legacy US GAAP, an
entity was prohibited from changing its method of assessing hedge
effectiveness. [815-35-35-4]
Interpretive response: The ASU does not provide transition guidance for
changing the method used to assess effectiveness of a net investment hedge.
We believe making this change to an existing hedging relationship on adoption
of ASU 2017-12 requires dedesignation and redesignation of the hedging
relationship. This is consistent with guidance for changing the effectiveness
assessment method for net investment hedges in section 8.4.40. [815-20-55-56]

Index of Q&As
2.
0B General hedging requirements
2.2.10 What is the difference between a firm commitment and a
forecasted transaction?

2.2.20 Must it be probable that variability in the hedged transaction will

actually occur and affect earnings?

2.3.10 Can a variable-rate debt instrument qualify to be designated in a

fair value hedge?

2.3.20 Can an entity hedge prepayment risk related to a financial

instrument?

2.3.30 Should prepayment risk be considered when assessing

effectiveness for a fair value hedge of interest rate risk?

2.3.40 Can other rates in the United States be used as benchmark

rates?

2.3.50 What rates can be used as benchmark rates outside the United
States?

2.3.60 Can an entity hedge the variability in a contractually specified

inflation index that is a component of an interest coupon?

2.3.70 Can a variable rate set via an auction process qualify as a

contractually specified interest rate?

2.3.80 Can interest rate risk or price risk related to the forecasted
purchase of a debt security that will be classified as HTM be
hedged in a cash flow hedge?

2.5.10 Can an entity apply hedge accounting to an item or transaction

of an equity method investee?

2.5.20 Can an entity hedge exposure to assets or liabilities of an

investee that is proportionately consolidated?

2.5.30 Are items classified in temporary or mezzanine equity eligible

for designation as a hedged item?

2.5.40 Can an entity hedge compensation expense related to stock

appreciation rights?

2.5.50 Can intercompany transactions be hedged for eligible risks at

the stand-alone financial statement level of a subsidiary?

2.5.60 Is an entity allowed to hedge a forecasted issuance of debt that

is contingent on a business combination?

2.5.70 Can an entity hedge total assets or liabilities of a disposal group

classified as held-for-sale?

2.5.80 Can assets measured at the lower of cost or market be

designated as hedged items?

2.6.10 What is the difference between a forward contract and a futures

contract?

2.6.20 Can an option with multiple underlyings be used as a hedging

instrument?

2.6.30 Can different proportions of the same derivative instrument be

designated in different hedging relationships?

2.6.40 Can the first 10 years of a 15-year interest rate swap be

designated as a portion of the hedging instrument?

2.6.50 Can additional derivative instruments be added to an existing

hedging relationship?

2.6.60 When should two freestanding derivatives be viewed as a single

derivative instrument?

2.7.10 Can a contract that meets the definition of a derivative after

acquisition by an entity qualify as a hedging instrument?

2.7.20 Is a subsidiary with exposure to the hedged risk required to be a

party to the hedging instrument to apply hedge accounting at
the consolidated level?

2.7.30 Is an intercompany derivative eligible to be designated as a

hedging instrument in the stand-alone financial statements of a
subsidiary?

2.7.40 Can a parent offset an intercompany derivative with a third-

party derivative and apply hedge accounting in the consolidated
financial statements?

2.7.50 Is an interest rate swaption a purchased option or a written

option?

2.7.60 How does an entity measure the potential gain or loss on the
combination of the written option (or net written option) and the
hedged item?

2.7.70 How often should the written option test be performed?

2.7.80 Is the written option test performed using the strike price
contained in the option contract or the current price of the
underlying?

2.7.90 Can a covered call strategy qualify for hedge accounting?

2.7.100 What is a collar?

2.7.110 Is the written option test required for a combination of a written

option and a non-option derivative?

2.7.120 When a hedging relationship is dedesignated and redesignated,

is a combination of options reassessed to determine if it is a net
written or net purchased option?

2.7.130 Are knock-out and knock-out/knock-in provisions considered

written options?

2.9.10 What is the level of detail needed to satisfy the hedge

documentation requirements?

2.10.10 If an entity concludes that some (but not all) forecasted

transactions are no longer probable, is it required to discontinue
a cash flow hedging relationship?

2.10.20 Does adding to or deleting from a portion of a hedged item or

transaction (or portfolio or group of hedged items or
transactions) require dedesignation of the hedging relationship?

2.10.30 Is a fair value hedging relationship required to be discontinued if

an entity repurchases and subsequently resells (reissues) some
of its own debt?

2.10.40 How does a decrease in the balance of the last of layer expected
to remain outstanding at the end of the hedge term affect a last-
of-layer hedging relationship?

2.10.50 How is hedge accounting discontinued for a hedged item that

no longer meets the definition of a firm commitment?

2.10.60 Is a hedging relationship required to be discontinued if the

hedging instrument is a combination of derivatives and the
combination is rebalanced?

2.10.70 Does modification of a hedging instrument’s collateral

requirements require a hedge to be discontinued?

2.10.80 Why would a derivative novation occur?

2.10.90 If a hedging relationship has not been highly effective

retrospectively, but is expected to be prospectively, is hedge
accounting required to be discontinued prospectively?

2.10.100 Under what conditions may an entity partially dedesignate a

hedging relationship?

2.10.110 How does an entity partially dedesignate a hedging instrument?

2.10.120 What should an entity consider when redesignating an existing

derivative instrument?

2.10.130 Is there a limit on the frequency of dedesignating and

redesignating a hedging relationship?

3. Qualifying criteria for fair value hedges

3.3.10 Can unrecognized assets or liabilities ever be hedged items in a
fair value hedge?

3.3.20 When hedging an unrecognized firm commitment, is the risk

related to changes in forward or spot prices?

3.3.30 Do loan commitments or interest rate locks meet the definition

of a firm commitment?

3.3.40 Can a price that varies with the market price of a fixed quantity
of an item qualify as a fixed price?

3.3.50 Can a price specified in a foreign currency be a fixed price?

3.3.60 Is there a requirement for the economic disincentive to be

explicitly stated in a contract?

3.3.70 Can the disincentive for nonperformance be in the form of

opportunity cost?

3.3.80 Can the disincentive for nonperformance be in the form of a

potential writeoff?

3.3.90 Can a firm commitment that is accounted for as a derivative

ever qualify as a hedging instrument?

3.3.100 Are there acceptable ranges when evaluating shared risk

exposure?

3.3.110 How often should the evaluation of the similarity of items

hedged in a portfolio be performed?

3.3.120 Are periodic similarity tests required to be performed on a

quantitative basis?

3.3.130 Should the similarity assessment for servicing rights use the
same risk characteristics as those used in the impairment
assessment under Topic 860?

3.3.140 Can a first cash flows received (paid) approach be used in a fair
value hedge?

3.3.150 Which key characteristics of a loan are considered when

evaluating whether individual loans share similar risk exposure?

3.3.160 Can an entity designate a portion or percentage of a

nonfinancial item as the hedged item?

3.3.170 Which benchmark interest rate may be used for measurement

purposes when hedging only the benchmark rate component?

3.3.180 May an entity separately designate the fixed rate subject to

inflation adjustments as a benchmark rate component?

3.3.190 Why would an entity designate only the benchmark rate

component?

3.3.200 If an entity uses the benchmark rate component to measure the

change in fair value of a hedged item, must it do so for all
similar hedging relationships?

3.3.210 When will a partial-term hedge improve effectiveness?

3.3.220 Can an entity designate a partial-term hedge using an assumed

term that ends on or before the initial date a financial instrument
can be prepaid?

3.3.230 Can the partial-term hedge guidance and the guidance for
hedging only the benchmark rate component be applied to the
same hedging relationship?

3.3.240 Must specific conditions be met to apply partial-term hedging in

a fair value hedge of interest rate risk?

3.3.250 Can an entity apply hedge accounting to more than one partial
term of a single instrument?

3.3.260 When multiple partial terms are hedged in separate hedging

relationships, do the terms need to be consecutive?

3.3.270 Can an entity hedge multiple risks when applying partial-term

hedging guidance?

3.3.280 Is an entity permitted to hedge the risk of changes in the fair

value of an embedded call option in an HTM security that is
prepayable?

3.3.290 Can an entity hedge the fair value exposure of options

embedded in contracts that qualify as firm commitments?

3.3.300 What is a ‘closed portfolio’?

3.3.310 What conditions must be met for a last-of-layer hedge to pass

the similarity test qualitatively?

3.3.320 What is needed to support the entity’s expectation that the last
of layer will remain outstanding at the end of the hedge term?

3.3.330 Must an entity assert it is ‘probable’ that the balance of the last
of layer will remain outstanding at the end of the hedge term?

3.3.340 What financial instruments can be included in the portfolio

under the last-of-layer method?

3.3.350 Can the last-of-layer method be applied to a portfolio of financial

liabilities?

3.3.360 Can an entity hedge multiple layers under the last-of-layer

method?

3.4.10 Why would an entity elect to consider only the effect of changes
in the benchmark interest rate on the decision to prepay the
financial instrument?

3.4.20 Is an entity required to consider only how changes in the

benchmark interest rate affect the decision to prepay?

3.4.30 What instruments are considered prepayable under

paragraph 815-20-25-6B?

3.4.40 How does paragraph 815-20-25-6B apply to nonconvertible debt

with an embedded contingent call or put option?

3.4.50 Does paragraph 815-20-25-6B apply to interest rate risk hedges

related to debt conversion options?

3.4.60 Does the election to consider only how changes in the

benchmark interest rate affect the decision to prepay a debt
instrument have to be applied to all prepayable hedged items?

4. Accounting for fair value hedges

4.2.10 Are changes in the fair value of a hedged AFS debt security
recognized in earnings?

4.3.10 May a basis adjustment be measured using a method different

from that used to assess effectiveness?

4.3.20 Is it appropriate to use the change in fair value of the hedging

instrument to measure the basis adjustment?

4.3.30 Do the principles of Topic 820 apply when measuring a basis

adjustment?

4.3.40 Does a basis adjustment result in the hedged item being

measured at its fair value?

4.3.50 When the hedged risk is overall changes in fair value, can any of
the contractual cash flows be excluded from the basis
adjustment measurement?

4.3.60 What discount rate should be applied when calculating the

change in fair value of the hedged item attributable to changes
in the benchmark rate?

4.3.70 When the hedged risk is the benchmark interest rate, are
changes in sector credit spreads, issuer credit risk or liquidity
spreads included in the measurement of the basis adjustment?

4.3.80 What is the benchmark rate component if the hedged item is a

nonprepayable financial instrument?

4.3.90 What is the benchmark rate component if the hedged item is a

prepayable financial instrument?

4.3.100 What is the benchmark rate component if the hedged item has a
premium or discount at hedge inception?

4.3.110 Can the benchmark rate component of the contractual coupon

be used if it is greater than the entire coupon?

4.3.120 Does Topic 815 prescribe a method to be used for measuring

the basis adjustment when the benchmark interest rate is
hedged?

4.3.130 When the last-of-layer method is used, is it necessary to allocate

the basis adjustment?

4.3.140 When assets in the portfolio from which the last of layer is
derived are sold during the hedge term, is the related basis
adjustment allocated to individual assets?

4.4.10 For firm commitments, what is the subsequent accounting for

assets (liabilities) recognized due to applying fair value hedge
accounting?

4.4.20 When is amortization of the basis adjustment for interest-

bearing financial instruments required to begin?

4.4.30 Over what period are basis adjustments of interest-bearing

financial instruments amortized?

4.4.40 Do basis adjustments for interest-bearing borrowings affect the

capitalization of interest?

4.5.10 Does amortization begin if a portfolio of hedged items that is

hedged by a combination of derivatives is rebalanced?

4.5.20 What is the accounting for a partially dedesignated fair value

hedging relationship?

4.5.30 How is the outstanding basis adjustment allocated to the

individual items in a portfolio on a full discontinuation?

5. Qualifying criteria for cash flow hedges

5.3.10 Can a contract that qualifies for the normal purchases and
normal sales scope exception qualify as a hedged transaction?

5.3.20 Does a change in the probability assessment of a hedged

transaction affect the ability to apply hedge accounting?

5.3.30 Does a change in the expected timing of a forecasted

transaction affect the ability to apply hedge accounting?

5.3.40 What is the difference between a ‘party external to the reporting

entity’ and an ‘unrelated party’?

5.3.50 Can both forecasted purchases and sales be included in a group

for hedge accounting?

5.3.60 How does an entity assess whether forecasted transactions of

nonfinancial assets or liabilities share similar risk exposure?

5.3.70 Can the first-payments-received (paid) approach be used to

hedge credit risk?

5.3.80 How does an entity assess whether the cash flows from
variable-rate financial instruments share the same risk
exposure?

5.3.90 How does an entity specifically identify the forecasted

transaction when using the layering approach for first-
payments-received (paid)?

5.3.100 If additional layers are added, or if existing layers are removed,

is an entity required to dedesignate and redesignate other
hedging relationships within the layers?

5.3.110 When does a hedging relationship move up the priority chain

into a vacated tranche of a discontinued hedging relationship?

5.3.120 Can a new or redesignated hedging relationship replace a

vacated tranche earlier in the priority chain?

5.3.130 If a hedging relationship within a priority chain is redesignated,

what happens to the hedging relationships later in the priority
chain?

5.3.140 Can a new hedging relationship be inserted earlier in the priority

chain than an active hedging relationship?

5.3.150 Which risks are eligible to be designated in an all-in-one hedge?

5.3.160 Is an all-in-one hedge assumed to be perfectly effective?

5.4.10 Can an entity hedge an index or rate that is not specified in the
contract?

5.4.20 If the contract price includes a variable basis spread, can an

entity hedge the contractually specified component?

5.4.30 Can an entity hedge a contractually specified component of a

forecasted purchase or sale of a nonfinancial asset in a spot
market transaction?

5.4.40 What conditions need to be met to designate a contractually

specified component as the hedged risk?

5.4.50 What are the requirements to meet the clearly and closely
related criteria?

5.4.60 What threshold is required to support an entity’s expectation

that the criteria to designate a contractually specified
component will be met?

5.4.70 How does an entity assess whether forecasted issuances or

purchases of short-term, fixed-rate debt in a rollover strategy
share similar interest rate risk exposure?

5.4.80 Should deposit/investment arrangements without contractually

stipulated maturity dates be characterized as rollovers of fixed-
rate instruments?

5.4.90 Does the ability to change the hedged risk also extend to the
hedged forecasted transaction?

5.5.10 How is the hedged forecasted transaction defined in a cash flow

hedging relationship involving a basis swap?

5.5.20 How does an entity assess whether a basis swap is highly

effective at offsetting changes in the net interest cash flows?

5.5.30 Can an entity hedge net interest cash flows from a group of
recognized assets or liabilities in a cash flow hedging
relationship involving a basis swap?

5.5.40 Can an entity apply the first-payments-received (paid) approach

when designating the net interest cash flows in a hedging
relationship involving a basis swap?

5.5.50 Is a cash flow hedge with a basis swap automatically

dedesignated if there is a change to the contractually specified
interest rate?

5.5.60 Can basis swaps other than those involving interest rates be
designated as a hedging instrument?

6. Accounting for cash flow hedges

6.3.10 What method is used to reclassify amounts in AOCI into
earnings?

6.3.20 When are amounts in AOCI related to specific borrowings

associated with assets under construction reclassified into
earnings?

6.3.30 Why is a loss in AOCI reclassified into earnings if the

combination of the hedging instrument and hedged transaction
would result in a future loss?

6.3.40 Can an impairment loss be recognized before a forecasted

transaction occurs?

6.3.50 What are acceptable methods to reclassify the initial non-zero

fair value of a hedging instrument with periodic cash
settlements?

6.3.60 What method is appropriate to reclassify amounts from AOCI

when an interest rate swap with scheduled increases in its fixed
leg is used to hedge interest payments on variable-rate debt?

6.3.70 What method is appropriate to reclassify amounts from AOCI

when multiple derivatives are used to hedge interest payments
on variable-rate debt?

6.4.10 Are the fair value or expected cash flows of a hedging

instrument ever considered when evaluating impairment of an
asset related to the hedged transaction?

6.4.20 Are net gains in AOCI reclassified if an impairment loss is

recognized on an existing asset to which a current or previous
hedged forecasted transaction relates?

6.5.10 If a hedging relationship has been retrospectively highly

effective, is hedge accounting required to be applied in the
previous period?

6.5.20 What is the accounting for amounts in AOCI related to a partially

dedesignated cash flow hedging relationship?

6.5.30 Is hedge accounting applied through the date an event causes a

hedging relationship to no longer be highly effective?

6.5.40 Is it appropriate to assume the last date of high effectiveness is

the date insolvency is declared or significant financial difficulties
are disclosed?

6.5.50 Can amounts be reclassified from AOCI when a hedge is

discontinued, even if the forecasted transaction is reasonably
possible?

6.5.60 Does an entity consider an additional two-month period when

deciding whether to discontinue hedge accounting?

6.5.70 May an entity ignore the additional two-month period when

deciding whether to immediately reclassify amounts from AOCI
into earnings?

6.5.80 How is the additional two-month period considered when an

entity has a series of hedging relationships?

6.5.90 How common are extenuating circumstances that extend the

additional two-month period?

6.5.100 Where are amounts reclassified from AOCI into earnings in

connection with a missed forecast presented in the income
statement?

6.5.110 What factors are considered when evaluating whether missed

forecasts represent a pattern?

7. Hedging foreign currency exposures

7.3.10 Can an entity hedge recognized FCD assets and liabilities?

7.3.20 What risk(s) may be hedged in FCD assets and liabilities?

7.3.30 Can a parent entity that has a functional currency different from
its subsidiary hedge the subsidiary’s foreign currency risk?

7.3.40 How is an operating unit evaluated when determining whether

foreign currency exposure can be hedged?

7.3.50 If a parent entity hedges its subsidiary’s foreign currency risk,

can the subsidiary recognize the effects of the hedge in its
stand-alone financial statements?

7.3.60 Can hedge accounting be applied if the hedged transaction is

denominated in the hedging entity’s functional currency but the
settlement amount is based on a foreign currency?

7.3.70 Are there limitations on hedging an intercompany FCD

transaction involving a recognized asset or liability?

7.3.80 Can an intercompany commitment be hedged?

7.3.90 If the hedged item affects more than one income statement line
item, where should the effect of the hedging instrument be
presented?

7.4.10 Can an entity hedge future interest payments of FCD debt as an

unrecognized firm commitment in a fair value hedge?

7.4.20 If a commitment to sell is based on the market price at the time

of shipment, can a portion of the price of each unit to be sold be
designated as the hedged item in a fair value hedge?

7.4.30 Can a nonderivative financial instrument be used to hedge an

unrecognized firm commitment?

7.4.40 In the consolidated financial statements, can an intercompany

nonderivative financial instrument be used to hedge an
unrecognized firm commitment?

7.4.50 What are the practical implications of using a nonderivative

instrument to hedge an unrecognized firm commitment?

7.5.10 What model will result in less earnings volatility when hedging
only the foreign currency exposure of a recognized financial
asset or liability?

7.5.20 Is a partial-term fair value hedge of foreign currency risk

permitted?

7.5.30 If a cross-currency interest rate swap is used to hedge only

foreign currency risk, what can be excluded from hedge
effectiveness?

7.6.10 Can a group of forecasted transactions be hedged in a single

cash flow hedge?

7.6.20 Can the foreign currency exposure in a forecasted issuance of

FCD debt be hedged?

Can the foreign currency exposure in forecasted earnings of a

7.6.30 foreign subsidiary be hedged?

Can forecasted intercompany dividends be hedged?

7.6.40
Can an intercompany FCD transaction be hedged for overall
7.6.50 changes in fair value or cash flows?

Can an entity apply hedge accounting once the forecasted

7.6.60 transaction to purchase a FCD nonfinancial asset has occurred?

Can an unrecognized FCD commitment with a related party be

7.6.70 hedged?

Can a commitment to sell in the future based on the market

7.6.80 price at the time of shipment be hedged in a cash flow hedge?

7.6.90 Does the requirement that all variability in cash flows be

eliminated mean that the hedging instrument needs to be
perfectly effective?

7.6.100 May the fixed-rate interest payments denominated in a foreign

currency in a dual-currency bond be designated as the hedged
transaction?

7.6.110 Can the treasury center enter into a third-party derivative with
neither leg being its functional currency?

7.6.120 How does an entity determine if third-party derivatives generate

closely approximating gains/ losses compared with the net
gains/losses generated by the internal derivatives?

7.6.130 Can internal derivatives that are not designated as hedging

instruments be included in determining the foreign currency
exposure to be offset on a net basis?

7.6.140 Does the linkage between each internal derivative and the
offsetting third-party derivative have to be documented at the
third-party derivative’s initiation?

7.6.150 Can the provisions for netting foreign currency risks be used to
offset exposures to FCD assets or liabilities or net investment
hedges?

7.6.160 If a forecasted transaction or firm commitment is being hedged

using an internal derivative, what is the effect when the
transaction or firm commitment occurs?

7.6.170 What is the effect of an issuing entity altering or modifying an

offsetting third-party derivative?

7.7.10 When are amounts in AOCI reclassified into earnings in a hedge

of a forecasted intercompany transaction?

7.7.20 How are gains and losses on a hedging instrument recognized if

an entity assesses effectiveness on an after-tax basis?

7.7.30 Is a partial-term cash flow hedge of foreign currency risk

permitted?

7.7.40 For non-option contracts, how are amounts reclassified from

AOCI when hedge effectiveness is based on a hedging
instrument’s total change in cash flows?

7.7.50 For option contracts, how are amounts reclassified from AOCI
when hedge effectiveness is based on a hedging instrument’s
total change in cash flows?

8. Net investment hedges

8.2.10 Can foreign currency risk related to a forecasted equity method
investment be hedged?

8.2.20 Can the ending or average balance be designated as the hedged

item in a net investment hedge?

8.3.10 Does the use of proceeds affect whether a FCD nonderivative

debt obligation can be used as the hedging instrument in a net
investment hedge?

8.3.20 Can FCD variable-rate debt that is the hedging instrument in a

net investment hedge be the hedged item in a cash flow hedge
of interest rate risk?

8.4.10 Does a change in tax rates affect effectiveness when it is

assessed on an after-tax basis?

8.4.20 Can the cross-currency basis spread be an excluded component

when a cross-currency interest rate swap is used in a net
investment hedge?

8.4.30 Where is the effect of the excluded components presented in

earnings?

8.4.40 What interest rate curves are considered comparable?

8.4.50 Can a hedging relationship be perfectly effective if a derivative

hedging instrument has a non-zero fair value at designation?

8.4.60 What is the effect on a hedging relationship if the interest rates

in a qualifying cross-currency interest rate swap are higher than
normal market rates and the forward method is used?

8.4.70 Has leverage been added to coupon rates in a qualifying cross-

currency interest rate swap that is designated in a hedge after its
initial recognition?

8.4.80 Is an entity permitted to change the method it uses to assess

effectiveness of a net investment hedge?

8.4.90 What does an entity consider in changing its method of

assessing effectiveness for a net investment hedge?

8.4.100 What does an entity consider when it dedesignates and

redesignates a net investment hedge?

8.5.10 Is hedge accounting applied through the date an event causes a

hedging relationship to no longer be effective as an economic
hedge?

9. Hedge effectiveness
9.2.10 Is an entity permitted to deliberately overhedge or underhedge?

9.2.20 How is a hedging relationship affected when a physical

(nonfinancial) asset’s actual location is different from that of the
derivative’s underlying?

9.2.30 Is a quarterly hedge effectiveness assessment always performed

only quarterly?

9.2.40 May an entity use different methods for its prospective and
retrospective effectiveness assessments?

9.2.50 If an entity is not required to perform an initial prospective

assessment on a quantitative basis, on what basis are its
subsequent effectiveness assessments performed?

9.2.60 Why may an entity elect to perform subsequent assessments on

a qualitative --- rather than a quantitative --- basis?

9.2.70 Does Topic 815 define highly effective?

9.2.80 How does an entity determine the historical period when initially
assessing hedge effectiveness?

9.2.90 If a hedging instrument is in a liability (asset) position, can

changes in counterparty creditworthiness (its own
nonperformance risk) be ignored?

9.2.100 Must an entity allocate a portfolio-level credit risk adjustment to

individual hedging relationships when assessing effectiveness?

9.2.110 Under what circumstances may an entity qualitatively evaluate

the effect of a portfolio-level credit risk adjustment on individual
fair value hedging relationships?

9.2.120 What methods may be used to quantitatively allocate a

portfolio-level credit risk adjustment to individual fair value
hedging relationships?

9.2.130 How does a financial instrument’s level in the fair value

hierarchy affect allocation of a portfolio-level credit risk
adjustment to individual hedging relationships?

9.2.140 Could an entity be required to quantitatively allocate a portfolio-

level credit risk adjustment for reasons other than assessing
effectiveness?

9.2.150 Are there circumstances where the time value does not affect
the assessment of effectiveness even though it is not considered
an excluded component?

9.2.160 What is a systematic and rational method to recognize an

excluded component?

9.2.170 Under the amortization approach, is the excluded component

recognized when the hedged transaction affects earnings?

9.2.180 Is the caplet method acceptable for recognizing the initial value
of an excluded component?

9.2.190 How does an entity account for amounts included in AOCI

related to an excluded component if hedge accounting is
discontinued?

9.2.200 Are there situations in which an entity may use different

effectiveness assessment methods for similar hedges?

9.2.210 Must an entity use qualitative effectiveness assessments for all

similar hedges?

9.2.220 What effect does ASU 2017-12 have on the requirement to

assess effectiveness for similar hedges in a similar manner?

9.2.230 What are the components of an option’s value?

9.2.240 How is the intrinsic value of an option measured?

9.2.250 How is the intrinsic value of a cap option that involves a series
of payments measured?

9.2.260 How are portions of time value (passage of time, market

variables) measured?

9.2.270 Must an entity assess effectiveness for all periods that the
option has intrinsic value?

9.2.280 If the hedged risk is changes within a range and time value is an
excluded component, how are changes in the underlying that do
not cause a change in intrinsic value accounted for?

9.2.290 If a zero-cost collar has different notional amounts, can the

hedged item be different proportions of the same asset
referenced in the collar?

9.2.300 How is the timing of cash flows considered in an effectiveness

assessment for a cash flow hedge?

9.2.310 Is discounting required when the spot method is used?

9.2.320 How does discounting affect a hedging relationship when a

forward contract does not settle on the date of the forecasted
transaction?

9.3.10 Can the shortcut method be applied to a hedge of the forecasted

issuance or purchase of a financial instrument?

9.3.20 How does an entity determine whether the trade and settlement
dates of a firm commitment differ due to market conventions?

9.3.30 Can a lessee or lessor apply the shortcut method to a cash flow
hedge of the variability in lease payments of an interest rate
indexed operating lease?

9.3.40 Can an entity replace the hedged item or transaction during a

shortcut method hedging relationship?

9.3.50 Are there documentation considerations that are specific to the

shortcut method?

9.3.60 Can the shortcut method be applied when a portion (i.e. a

percentage) of an interest-bearing asset or liability is designated
as the hedged item or transaction?

9.3.70 Can the shortcut method be applied when hedging a portfolio of

interest-bearing assets or liabilities or group of forecasted
transactions?

9.3.80 Can the shortcut method be applied to a hedging relationship if

the hedging instrument is a part of a derivative instrument?

9.3.90 Are there exceptions to the requirement that an interest rate

swap’s fair value be zero at hedge inception?

9.3.100 How does an entity determine whether the interest rate swap
has a zero fair value if it includes a premium for an embedded
call or put option?

9.3.110 Can an interest rate swap that has an embedded financing

arrangement have a fair value of zero?

9.3.120 Can the shortcut method be applied if the hedging instrument is

a forward-starting interest rate swap?

9.3.130 Can the shortcut method be applied to a hedge if the swap

contains an initial stub period?

9.3.140 Can the shortcut method be applied to a hedge if the first cash
flow on the swap includes debt issuance fees?

9.3.150 What financial instruments does an entity consider prepayable?

9.3.160 Is a debt instrument that becomes prepayable on the debtor’s

credit deterioration considered prepayable when applying the
shortcut method?

9.3.170 Is a debt instrument that becomes prepayable on the occurrence

of an event beyond the control of the debtor or creditor
considered prepayable when applying the shortcut method?

9.3.180 Are there exceptions to the requirement that a hedged item or

transaction not be prepayable?

9.3.190 How does a debt instrument’s carrying amount affect whether

the swap used to hedge the debt contains a mirror-image call
option?

9.3.200 Does the shortcut method require the fixed rate on the swap to
match the fixed rate on the hedged item or transaction?

9.3.210 Can the shortcut method be applied to a hedge of a convertible

debt instrument?

9.3.220 Can the shortcut method be applied to a hedge of a debt

instrument issued by a trust preferred structure?

9.3.230 Can the shortcut method be applied if the hedging instrument is

a swap with a variable leg that reprices in arrears?

9.3.240 Can the shortcut method be applied to a hedge of a fixed-rate

debt instrument with an interest rate that increases if the
issuer’s credit rating deteriorates?

9.3.250 Can the shortcut method be applied to a hedge of a zero-coupon

bond?

9.3.260 Can the shortcut method be applied to a partial-term fair value

hedge?

9.3.270 Can the shortcut method be applied to a fair value hedge if the
swap expires one day before or after the hedged item’s maturity
date or assumed maturity date?

9.3.280 Can the shortcut method be applied to a fair value hedge if the
swap’s variable leg is based on a tenor different from the
hedged risk?

9.3.290 Can the shortcut method be applied to a fair value hedge if the
variable interest rate of the swap has a cap or floor?

9.3.300 Can the shortcut method be applied to a cash flow hedge if the
swap’s variable leg is based on a tenor different from the
hedged risk?

9.3.310 Can the shortcut method be applied to a cash flow hedge if the
hedged item is a variable-rate debt that contains a cap or floor?

9.3.320 Can the shortcut method be applied to a cash flow hedge of

interest payments arising from variable-rate debt if the debt
matures after the swap expires?

9.3.330 Can the shortcut method be applied to a cash flow hedge if the
swap reprices in arrears, but the hedged forecasted transaction
does not?

9.3.340 Does an entity consider counterparty credit risk or its own

nonperformance risk when applying the shortcut method?

9.3.350 What happens if an entity does not document a quantitative

method that it would use if the shortcut method was not (or no
longer is) appropriate?

9.3.360 When the shortcut method is required to be discontinued, as of

what date(s) should an entity perform the quantitative
assessments?

9.3.370 What is the effect of performing quantitative assessments once

the shortcut method is discontinued?

9.4.10 Can the critical terms match method be applied if the hedging
instrument has a non-zero fair value at hedge inception?

9.4.20 Can the critical terms match method be applied to a hedging

relationship that uses an interest rate swap as the hedging
instrument?

9.4.30 Can the critical terms match method be applied if one derivative
instrument hedges multiple transactions over a period of time?

9.4.40 Can the critical terms match method be applied to a forecasted

transaction that gives rise to a receivable or payable that settles
subsequently?

9.4.50 Can the critical terms match method be applied if the hedging
instrument is a cross-currency interest rate swap?

9.4.60 Does an entity consider counterparty nonperformance risk when

evaluating whether it is probable that a forecasted transaction
will occur?

9.4.70 Can the critical terms match method be applied to an all-in-one

hedge?

9.4.80 If the critical terms cease to match after hedge inception, is an

entity required to discontinue hedge accounting?

9.4.90 How does an entity consider counterparty credit risk or its own
nonperformance risk when applying the critical terms match
method to a cash flow hedge?

9.5.10 When the hedging relationship does not have perfect offset,
how does an entity reasonably support its expectation of high
effectiveness on a qualitative basis in subsequent periods?

9.5.20 Under what circumstances is a subsequent quantitative

assessment required if an entity initially elects to perform
qualitative assessments?

9.5.30 If required, for what periods are subsequent quantitative

assessments performed?

9.5.40 What is the consequence of failing to identify that an entity

could not reasonably support performing qualitative
assessments in a prior period?

9.5.50 May an entity performing quantitative effectiveness

assessments revert to qualitative effectiveness assessments?

9.6.10 Why might an entity elect to use a quantitative method, even if

the hedging relationship is eligible for a different method?

9.6.20 Can an entity choose different effectiveness assessment

methods each period based on the expected outcome?

9.6.30 Which technique for assessing hedge effectiveness is more

prevalent?

9.6.40 What implications arise under the dollar-offset method when

changes in fair values during the period are small?

9.6.50 Which approach is more commonly applied when using the

dollar-offset method: cumulative or period-by-period?

9.6.60 What should be compared (regressed) in a regression analysis?

9.6.70 Must an entity perform the actual regression calculation if it is

mathematically certain a cash flow hedge will be perfectly
effective?

9.6.80 What outputs of regression analysis should be evaluated?

9.6.90 Should an entity consider using specialists when it uses

statistical analysis to assess effectiveness?

9.6.100 Do quantitative effectiveness assessments require judgment?

9.7.10 What should an entity consider when assessing hedge

effectiveness for a group of similar forecasted transactions?

9.7.20 May the terminal value method be used by the buyer when the
hedging instrument is a swaption?

9.7.30 Can the hypothetical derivative method result in perfect

effectiveness when the hedging instrument is not an interest
rate swap and the hedged risk is not variability in interest
receipts or payments?

9.7.40 How is the PEH derivative defined when a cross-currency

interest rate swap is used to hedge intercompany fixed-rate debt
in a cash flow hedge?

9.7.50 How is the PEH derivative defined when a deal contingent swap
is used to hedge a forecasted debt issuance contingent on a
business combination?

10. Private companies

10.2.10 What types of entities can apply the simplified hedge accounting
approach?

10.2.20 Do all interest rate swaps qualify for simplified hedge

accounting?

10.2.30 Does simplified hedge accounting have to be applied to all

eligible swaps?

10.2.40 Why might a private company choose not to use simplified

hedge accounting?

10.2.50 What are the ongoing requirements when applying simplified

hedge accounting?

10.2.60 Can the hedged risk be a nonbenchmark interest rate risk?

10.2.70 What qualifies as a plain vanilla swap to be eligible for

simplified hedge accounting?

10.2.80 Can an entity hedge borrowings with embedded interest rate

caps or floors under simplified hedge accounting?

10.2.90 How should an entity evaluate the difference between the

repricing and settlement dates of the debt and the interest rate
swap?

10.2.100 How is the settlement value of an interest rate swap different

from fair value?

10.2.110 Can an entity voluntarily change from simplified hedge

accounting to general hedge accounting?

10.3.10 Which private companies and not-for-profit entities may take

advantage of the timing relief?

10.3.20 Are there downsides to delaying the quarterly hedge

effectiveness assessments?

10.3.30 Why are certain entities without quarterly reporting

requirements required to perform quarterly hedge effectiveness
assessments?

11. Effective dates and transition

11.2.10 Is an entity required to adopt ASU 2017-12 at a certain point in
time within an interim period?

11.2.20 If a public business entity early adopts ASU 2017-12 in an

interim period, what are the relevant considerations?

11.4.10 What date is used to determine the cumulative basis adjustment

when modifying the measurement methodology for a fair value
hedge of interest rate risk?

11.4.20 What date is used to determine the benchmark rate if the current
hedging relationship was previously dedesignated and
redesignated?

11.4.30 When transitioning to measure a hedged item based on the

benchmark rate component of the coupon, can an entity
rebalance an existing hedging relationship?

11.4.40 What transition approach is required to apply the partial-term

hedging guidance?

11.4.50 On what date in the period of adoption can an entity transfer

securities from HTM to AFS?

11.4.60 Is there any restriction on selling AFS securities after

transferring them from the HTM category on adoption?

11.4.70 Will transferring securities from HTM to AFS affect an entity’s

pre-transition intent to hold the securities to maturity?

11.4.80 Are there any disclosure requirements for securities transferred

from HTM to AFS?

11.4.90 What financial instruments are eligible to be transferred from

HTM to AFS?

11.4.100 What is the transition guidance for an existing hedging

relationship with a non-zero fair value derivative designated at
hedge inception?

11.4.110 Can the transition provision for excluding cross-currency basis

spreads in cross-currency swaps be applied to a cash flow or a
net investment hedge?

11.4.120 What transition approach is required to change from a long-haul

to the critical terms match method for an existing hedging
relationship?

11.4.130 What transition approach is required to change the method used

to assess effectiveness of a net investment hedge?

Index of examples
2.
0B General hedging requirements
2.2.10 Future sale of inventory that does not create exposure to
variations in cash flows

2.3.10 Fair value hedge of changes in the benchmark interest rate for a
variable-rate debt obligation

2.3.20 Hedging more than one risk at a time

2.4.10 Comparison of cash flow hedges and fair value hedges of

inventory

2.4.20 Cash flow hedge of total price risk excluding the foreign
currency component

2.5.10 Forecasted transaction of an equity method investee

2.5.20 Contract to sell a wholly owned subsidiary

2.5.30 Forecasted transaction to purchase debt securities that will be

classified as trading under Topic 320

2.5.40 Forecasted transaction to purchase a derivative instrument

2.6.10 Hedging strategy using a fixed-for-floating interest rate swap

2.6.20 Hedging strategy using a purchased option

2.6.30 Separating an interest rate swap into components that represent

different risks

2.6.40 Interest rate swap to hedge a portion of a hedged item or

transaction

2.6.50 Combination of an interest rate swap and put option to hedge

fixed-rate debt with an embedded call option

2.6.60 Multiple instruments to hedge interest rate risk

2.6.70 Two concurrent swaps not viewed as a unit

2.7.10 Written option does not qualify for hedge accounting

2.7.20 Written option qualifying as a hedge of an embedded call option

in a debt obligation

2.7.30 Written option qualifying as a hedge of an embedded cap in a

long-term supply contract

2.7.40 Evaluation of whether a combination of options is a net written

option

2.7.50 Applying the net written option test to collar-based hedging

relationship

2.7.60 Indexed-amortizing swap considered to be a net written option

2.9.10 Importance of timing of formal documentation of the hedge

2.9.20 Timing requirements for initial hedge documentation

2.9.30 Formal documentation for a fair value hedge of a firm

commitment

2.9.40 Formal documentation for a cash flow hedge of a forecasted

transaction

2.9.50 Formal documentation of forecasted purchases of fuel when

hedging price risk

2.10.10 Discontinuance of hedging relationship when an unrelated party

is acquired

2.10.20 Hedge discontinuation because the hedging relationship is no

longer highly effective

2.10.30 Partial decrease of hedged item in a fair value hedge

2.10.40 Partial reduction of items in a group of hedged forecasted

transactions (cash flow hedge)

2.10.50 Partial termination of a hedging instrument

3.
S0B Qualifying criteria for fair value hedges
3.3.10 Letter of intent to purchase steel

3.3.20 Contract based on fair value at future date

3.3.30 Contract with fixed price specified in a currency other than the
entity’s functional currency

3.3.40 Payments made pursuant to royalty agreements

3.3.50 Firm commitment to purchase silver with a forward contract

3.3.60 Specific portion of a foreign currency denominated firm

commitment

3.3.70 Designating a fair value hedge of interest rate risk using the
partial-term approach

3.3.80 Hedging interest rate risk and foreign currency risk in a partial-
term hedge

3.4.10 Applying paragraph 815-20-25-6B to a callable bond

3.4.20 Applying paragraph 815-20-25-6B to a nonconvertible bond with

an embedded contingent put

3.4.30 Fair value hedge of gold watch inventory with a gold futures
contract

4. Accounting for fair value hedges

4.2.10 Accounting for a hedge that lacks perfect offset

4.2.20 Comparison of approaches to recognize excluded component

(time value) for a hedge of an AFS debt security with a put
option

4.3.10 Fair value hedge of inventory after initial recognition

4.3.20 Accounting for the hedge of long-term debt with an interest rate
swap (shortcut method)

4.3.30 Accounting for a fair value hedge of the LIBOR swap rate in a
fixed-rate noncallable note

4.3.40 Accounting for a hedge of a firm commitment to purchase silver

with a forward contract

4.3.50 Benchmark rate component for assessment and measurement

4.3.60 Change in fair value attributable to changes in LIBOR --- all

contractual cash flows included

4.5.10 Accounting for the termination of an interest rate swap hedging

fixed-rate debt

4.5.20 Identifying the date a hedging relationship ceased to be highly

effective

4.5.30 Discontinuation of a last-of-layer method hedge

5. Qualifying criteria for cash flow hedges

5.3.10 Probability of transaction to purchase steel

5.3.20 Assessing the probability of the forecasted acquisition of a

marketable debt security

5.3.30 Forecasted purchases of fuel when hedging price risk ---

similarity assessment

5.3.40 Group of variable-rate loans that do not share similar risk

exposure

5.3.50 Layering approach: Swap matures and related amounts

reclassified from AOCI

5.3.60 Layering approach: Swap terminated and related amounts not

reclassified from AOCI

5.3.70 Layering approach: Additional swap terminated and new swap

designated at end of priority chain

5.3.80 Layering approach: Swap terminated with interest payments on

a portion of principal remaining probable

5.3.90 Layering approach: Swap early in priority chain matures

subsequent to other swap terminations

5.3.100 Layering approach: Redesignation of swaps

5.3.110 All-in-one hedge of forecasted sales of gold

5.3.120 All-in-one hedge of forecasted sales of loans

5.4.10 Contractually specified component

5.4.20 Underlying index or price as a contractually specified

component

5.4.30 Contract not accounted for as derivative because normal

purchases and normal sales scope exception is met

5.4.40 Contractually specified component is not eligible to be the

hedged risk

5.4.50 Contract pricing with underlying that is clearly and closely

5.4.70 Forecasted issuance of fixed-rate debt

5.4.80 Forecasted issuance of debt when it is not known whether the

interest rate will be fixed or variable

5.4.90 Hedging interest rate risk on a group of individual transactions

related to a rollover strategy

5.4.100 Change in hedged risk for a contractually specified component

in not-yet-existing contracts

5.4.110 Defining hedged risk for a cash flow hedge of interest rate
payments of You Pick ‘Em debt

5.5.10 Basis swap that qualifies for cash flow hedge accounting

5.5.20 Basis swap that does not qualify for cash flow hedge accounting

5.5.30 First-payments-received (paid) approach with basis swap as the

hedging instrument

6. Accounting for cash flow hedges

6.2.10 Accounting for a cash flow hedge of a variable-rate loan with an
interest rate swap

6.2.20 Accounting for a cash flow hedge of a variable-rate debt

obligation with an interest rate swap that has a cap and a floor

6.2.30 Accounting for a cash flow hedge of a forecasted purchase of

inventory with a forward contract (critical terms match ---
forward value method)

6.2.40 Comparison of approaches to recognize the excluded

component for a cash flow hedge

6.2.50 Accounting for a cash flow hedge of forecasted purchase of

inventory with a call option (critical terms do not match ---
intrinsic value method)

6.3.10 Accounting for an all-in-one hedge of a forecasted equipment

purchase

6.3.20 Combination of loss reported in AOCI and hedged transaction

would give rise to a loss

6.3.30 Accounting for a cash flow hedge of a variable-rate, long-term

debt with an interest rate cap

6.4.10 Hedged asset is impaired and related amount in AOCI is a net

derivative loss

6.4.20 Hedged asset is impaired and related amount in AOCI is a net

derivative gain

6.5.10 Terminating an interest rate swap used in a cash flow hedge

6.5.20 Terminating a cash flow hedge when hedge designation is

removed

6.5.30 Accounting for amounts in AOCI when a hedged forecasted

transaction becomes a firm commitment

6.5.40 Dedesignation and redesignation of a hedging relationship due

to failing to qualify for cash flow hedge accounting in one period

6.5.50 Identification of the date credit deterioration caused a hedge to

cease being highly effective

6.5.60 Whether a delay in a forecasted transaction is due to

extenuating circumstances that extend the additional two-month
period

7. Hedging foreign currency exposures

7.3.10 Currency other than functional currency

7.3.20 Settlement of hedged transaction is based on a foreign currency

7.3.30 Forecasted purchase in foreign currency

7.4.10 Commitment to sell at fair value --- hedging a portion of the price
of each unit

7.4.20 Internal derivative with no offsetting third-party derivative

contract

7.4.30 Internal derivative with offsetting third-party derivative contract

7.5.10 Partial-term foreign currency fair value hedge

7.5.20 Fair value hedge of a firm FCD purchase commitment with a

forward contract

7.5.30 Fair value hedge of a FCD AFS debt security with a forward
contract

7.6.10 Forecasted cash inflows and outflows in foreign currency

7.6.20 Forecasted purchase in foreign currency

7.6.30 Applying the requirement to eliminate variability in all cash

flows

7.6.40 Hedging fixed-rate interest payments in a dual-currency bond

7.6.50 Hedging the net exposure from internal derivatives

7.7.10 Different maturities for hedged item and hedging instrument

7.7.20 Cash flow hedge of variable-rate FCD debt with a variable to

fixed cross-currency interest rate swap (variable-to-fixed
scenario)

7.7.30 Cash flow hedge of a forecasted FCD purchase with a forward

contract

7.7.40 Cash flow hedge of recognized FCD payable with a forward

contract

7.7.50 Single cash flow hedge with a foreign currency purchased

option

8. Net investment hedges

8.2.10 Hedging a foreign net investment with a FCD liability of another
subsidiary

8.3.10 Eligibility of financial instruments as hedging instruments

8.4.10 Adjusting the notional of the hedging instrument when hedging

on an after-tax basis

8.4.20 Using the spot method when FCD debt is used to hedge a net
investment

8.4.30 Using the forward method when using a foreign currency

forward to hedge a net investment

8.5.10 Recognizing amounts in CTA

9. Hedge effectiveness
9.2.10 Consistency of effectiveness assessment with documented risk
management objective

9.2.20 Calculations of effectiveness

9.2.30 Qualitative analysis of whether allocation of portfolio-level credit

risk adjustment is required

9.2.40 Effect of time value on hedge effectiveness

9.2.50 Comparison of approaches to recognize the excluded

component for a cash flow hedge

9.2.60 Assessing effectiveness with an interest rate cap

9.2.70 Comparison of excluding spot-forward difference --- discounted

vs. undiscounted

9.2.80 Measuring changes in cash flows --- discounted vs. undiscounted

9.3.10 Debt hedged on trade date

9.3.20 Day 1 fair value of a compound interest rate swap

9.3.30 Day 1 fair value of an interest rate swap with an embedded

financing arrangement

9.5.10 Whether an expectation of high effectiveness can be reasonably

supported in subsequent periods

9.6.10 Dollar-offset method for retrospective test (fair value hedge)

9.6.20 Hedging forecasted purchases of fuel using regression analysis

and the dollar-offset method

9.7.10 Terminal value method is not appropriate

9.7.20 Terminal value method for a hedge of a forecasted foreign

currency denominated sale with a purchased option

9.7.30 Using the caplet method to reclassify amounts from AOCI into
earnings

9.7.40 PEH swap in a hedge of variable-rate debt that contains a floor

9.7.50 Projecting future cash flows using recent purchase orders

10. Private companies

10.3.10 Timing of preparing initial hedge documentation

10.3.20 Timing of performing quarterly hedge effectiveness

assessments

11. Effective dates and transition

11.2.10 Adopting ASU 2017-12 by retrospectively adjusting previous
interim periods

11.4.10 Dedesignating a portion of the hedged item

11.4.20 Hedged risk is changed to variability in contractually specified

component

KPMG Financial
Reporting View
Insights for financial reporting professionals
As you evaluate the implications of new financial reporting standards on
your company, KPMG Financial Reporting View is ready to inform your
decision-making.
Visit kpmg.com/us/frv for accounting and financial reporting news and analysis
of significant decisions, proposals, and final standards and regulations.

US news Reference Newsletter

CPE
& views library sign-up

FRV focuses on major new standards (including revenue recognition, leases and
financial instruments) – and also covers existing US GAAP, IFRS, SEC matters,
broad transactions and more.

kpmg.com/us/frv
Insights for financial reporting professionals

Here are some of our other resources dealing with derivatives and hedging.

Handbook: Provides you with in-depth guidance on the scope of

Derivatives and ASC 815 (including the definition of a derivative) and
hedging embedded derivatives, before the adoption of ASU 2017-12.
(pre-ASU 2017-12)
Assists you in understanding the specific changes to hedge
Issues In-Depth accounting as a result of the issuance of ASU 2017-12.

Acknowledgments
This Handbook has been produced by the Department of Professional Practice
of KPMG LLP in the United States.

We would like to acknowledge the efforts of the main contributors to this

publication:
Sandy Bakaysa
Lindsey Freeman
Michael Gaiso
Danielle Imperiale
Mahesh Narayanasami
Mark Northan
Lisa Blackburn (contractor)

We would also like to acknowledge the significant contributions of the

following: Kimber Bascom, Shane Burak, Patrick Garguilo, Joan Rood,
Julie Santoro.

The FASB Accounting Standards Codification® material is copyrighted by the Financial Accounting Foundation, 401 Merritt 7,
Norwalk, CT 06856.

© 2018 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member
firms affiliated with KPMG International Cooperative ("KPMG International"), a Swiss entity. All rights reserved. The KPMG name and
logo are registered trademarks or trademarks of KPMG International.

The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual
or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is
accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information
without appropriate professional advice after a thorough examination of the particular situation.

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Hedging Handbook

Uploaded by

Hedging Handbook

Uploaded by

Hedging

As amended by ASU 2017-12

Kimber Bascom and Mark Northan

About this publication

Accounting literature and scope

Organization of the text

General qualifying criteria

Criterion 1 Criterion 2 Criterion 3 Criterion 4

Criterion 5: Formal documentation

Qualifying criteria for fair value hedges

Criterion 1: Items eligible for fair value hedges

Only recognized assets or liabilities, or unrecognized firm commitments, are

Individual recognized assets and

Portfolios of similar assets and liabilities

Portion (or percentage) of hedged item

Hedging only Partial-term

Criterion 2: Risks eligible for fair value hedges

Financial items Nonfinancial items

Interest  Changes in the Not applicable.

Credit Includes: Not applicable.

Foreign — Changes in the related — Changes in the related

Financial items Nonfinancial items

Criterion 3: Hedging instruments eligible for fair value hedges

There are no additional eligibility criteria or limitations specific to fair value

Accounting for fair value hedges

Hedging instrument Hedged item

Hedging instrument Hedged item

Changes in fair value

Gain or loss recognized Change in value attributable to

Income statement presentation

Recorded in the same income statement line item where the

Qualifying criteria for cash flow hedges

Criterion 1: Transactions eligible for cash flow hedges

Cash flows from existing recognized assets or liabilities or forecasted

Cash flows from existing recognized Forecasted transactions – e.g. forecasted

Group of similar forecasted

Criterion 2: Risks eligible for cash flow hedges

Financial assets and Nonfinancial assets and

Interest Either: Not applicable.

Financial assets and Nonfinancial assets and

Credit Includes: Not applicable.

Foreign — Changes in the related — Changes in the related

Price risk  Total change in the Either:

Criterion 3: Hedging instruments eligible for cash flow hedges

In addition to the general qualifying criteria and limitations of hedging

Cash flow hedge accounting

— The amounts in AOCI are recognized in earnings – in the same income

Hedging instrument Hedged transaction

Continue to apply otherwise

Reclassified from AOCI into

Offset of hedging instrum ent in sam e income statement

Hedging foreign currency exposures

— Hedged item or transaction. The hedged transaction needs to be

Foreign FCD asset or liability Derivative

Foreign FCD asset or liability Derivative

FCD forecasted transaction Derivative

Net investment hedges

General — Hedging instrument. The entity with the foreign currency

Hedge The hedging instrument must be both designated and effective

Formal The entity formally documents the hedging relationship.

In general, the net investment hedge accounting model works as follows.

Hedging instrument Hedged item – Net investment in

Entire change in fair value

Reclassified when hedged Reclassified when hedged

Record in the same income statement line item 1

Read more: chapter 8

The following diagram summarizes how effectiveness is assessed.

Quantitative vs. qualitative. Topic 815 requires the initial (prospective)

Simplified hedge accounting approach

Hedge — may assume perfect hedge effectiveness for the qualifying

Hedge — has additional time to prepare the required hedge

Hedging — is allowed to measure the interest rate swap designated in the

Additional relief when simplified hedge accounting is not

Hedge — relaxed timing of documentation requirements; and

Hedge — relaxed timing of initial and subsequent quarterly hedge

These relaxed requirements are also available to certain not-for-profit entities.