Derivatives Implementation Group

Statement 133 Implementation Issue No. G9

QUESTION

In a cash flow hedge of a forecasted transaction (for example, a forecasted purchase or sale of a commodity), if the critical terms of the hedging instrument and of the hedged forecasted transaction are the same such that the entity may conclude, based on paragraph 65 of Statement 133, that the changes in cash flows attributable to the risk being hedged are expected to completely offset at the inception of the hedging relationship and on an ongoing basis, what type of assessment of hedge effectiveness must be performed and what are the documentation requirements for that assessment of hedge effectiveness?

BACKGROUND

Paragraph 65 of Statement 133 states:

     If the critical terms of the hedging instrument and of the entire hedged asset or liability (as opposed to selected cash flows) or hedged forecasted transaction are the same, the entity could conclude that changes in the 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 highly effective and that there will be no ineffectiveness to be recognized in earnings if:

1. 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.

    

2. The fair value of the forward contract at inception is zero.

    

3. Either the change in the discount or premium on the forward contract is excluded from the assessment of effectiveness and included directly in earnings pursuant to paragraph 63 or the change in expected cash flows on the forecasted transaction is based on the forward price for the commodity.

Example 4 in Appendix B (paragraphs 127-130) illustrates a cash flow hedge of the forecasted sale of a commodity inventory. Paragraph 127 states, in part: "The terms of the hedging derivative have been negotiated to match the terms of the forecasted transaction. Thus, there is no ineffectiveness." [Emphasis added.]

Paragraph 128 states:

     ABC Company decides to hedge the risk of changes in its cash flows relating to a forecasted sale of 100,000 bushels of Commodity A by entering into a derivative contract, Derivative Z. 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, ABC enters into Derivative Z and designates it as a cash flow hedge of the forecasted sale. ABC neither pays nor receives a premium on Derivative Z (that is, its fair value is zero). The hedging relationship qualifies for cash flow hedge accounting. ABC expects that there will be no ineffectiveness from the hedge because (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 ABC expects to sell (assuming delivery to ABC's selling point), and (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. [Emphasis added.]

RESPONSE

If the critical terms of the hedging instrument and of the hedged forecasted transaction are the same so that the changes in cash flows attributable to the risk being hedged are expected to completely offset at the inception of the hedging relationship and on an ongoing basis, an entity is still required to perform and document an assessment of hedge effectiveness at the inception of the hedging relationship and on an ongoing basis throughout the hedge period. The shortcut method may not 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. As indicated in Statement 133 Implementation Issue No. E4, "Application of the Shortcut Method," the shortcut method can be applied only if all of the applicable conditions in paragraph 68 are met and the hedging relationship involves only an interest rate swap.

However, based on the fact that, at inception, the critical terms of the hedging instrument and the hedged forecasted transaction are the same, the entity can conclude that changes in cash flows attributable to the risk being hedged are expected to be completely offset by the hedging derivative. Therefore, 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. 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 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 at its fair value. If there are no such changes in the critical terms or adverse developments regarding counterparty default, the entity may conclude that there is no ineffectiveness to be recorded. In that case, the change in fair value of the derivative can be viewed as a proxy for the present value of the change in cash flows attributable to the risk being hedged.

However, if the critical terms of the hedging instrument or the hedged forecasted transaction have changed or if there have been adverse developments regarding the risk of counterparty default, the entity must measure the amount of ineffectiveness that must be recorded currently in earnings pursuant to the guidance in Implementation Issue No. G7, "Measuring the Ineffectiveness of a Cash Flow Hedge under Paragraph 30(b) When the Shortcut Method Is Not Applied." In addition, the entity must assess whether the hedging relationship is expected to continue to be highly effective (using either a dollar-offset test or a statistical method such as regression analysis).

The above response has been authored by the FASB staff and represents the staff's views, although the Board has discussed the above response at a public meeting and chosen not to object to dissemination of that response. Official positions of the FASB are determined only after extensive due process and deliberation.