Derivatives Implementation Group

Statement 133 Implementation Issue No. G16

Title:	Cash Flow Hedges: Designating the Hedged Forecasted Transaction When Its Timing Involves Some Uncertainty within a Range
Paragraph references:	28, 30, 33, 64, 65, 460
Date cleared by Board:	March 21, 2001
Date posted to website:	April 10, 2001

QUESTION

How should the requirements of paragraphs 28, 29, and 33 be applied to a forecasted transaction that is expected (probable) to occur on a specific date but whose timing involves some uncertainty within a range?

BACKGROUND

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 company 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 two. 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.

Paragraph 28(a)(2) states, in part, that the "documentation [of the hedged forecasted transaction] shall include all relevant details, including the date on or period within which the forecasted transaction is expected to occur….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."

Paragraph 33 (as amended) states:

The net derivative 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 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 paragraph 31.

Paragraph 30 states, in part:

    The effective portion of the gain or loss on a derivative designated as a cash flow hedge is reported in other comprehensive income, and the ineffective portion is reported in earnings. More specifically, a qualifying cash flow hedge shall be accounted for as follows: ...

2. Accumulated other comprehensive income associated with the hedged transaction shall be adjusted to a balance that reflects the lesser of the following (in absolute amounts):

   (1)   The cumulative gain or loss on the derivative from inception of the hedge less (a) the excluded component discussed in paragraph 30(a) above and (b) the derivative's gains or losses previously reclassified from accumulated other comprehensive income into earnings pursuant to paragraph 31

   (2)   The portion of the cumulative gain or loss on the derivative necessary to offset the cumulative change in expected future cash flows on the hedged transaction from inception of the hedge less the derivative's gains or losses previously reclassified from accumulated other comprehensive income into earnings pursuant to paragraph 31.

   That adjustment of accumulated other comprehensive income shall incorporate recognition in other comprehensive income of part or all of the gain or loss on the hedging derivative, as necessary.
   

3. A gain or loss shall be recognized in earnings, as necessary, for any remaining gain or loss on the hedging derivative or to adjust other comprehensive income to the balance specified in paragraph 30(b) above.

RESPONSE

Paragraph 28(a)(2) of Statement 133 requires that documentation of the cash flow hedging relationship and the entity's risk management objective and strategy for undertaking the hedge include documentation specifying either the date on or period within which the forecasted transaction is expected to occur.

For forecasted transactions whose timing involves some uncertainty within a range, that range could be documented as the "originally specified time period," provided that 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. That is, the general contractor could document (as required by paragraph 28(a)(2)) 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 paragraph 33). 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."

This response is consistent with the example provided in paragraph 460, which states:

    The following example illustrates the requirement for specific identification of the hedged transaction. Company 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 Company A is already committed but the precise timing of which has not yet been determined. To qualify for cash flow hedge accounting, Company 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.

Although documenting only the period within which the forecasted transaction will occur is sufficient to comply with the requirements of paragraph 28(a), compliance with paragraphs 28(b) and 30 requires that the best estimate of the forecasted transaction's timing be both documented and used in assessing hedge effectiveness. As explained in paragraphs 64 and 65, the time value of money is likely to be important in the assessment of cash flow hedge effectiveness, especially if Company A 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.

If the expected timing of the forecasted transaction changes, the contractor must first apply the requirements of paragraph 30 using its originally documented hedging strategy and the newly revised best estimate of the cash flows,¹ and then reevaluate whether continuing hedge accounting is appropriate, pursuant to the requirements of paragraph 32. If hedge accounting is discontinued prospectively, the derivative's gains or losses in other comprehensive income after the application of paragraph 30(b) should be accounted for pursuant to paragraph 31 (unless paragraph 33 requires reclassification into earnings).

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¹Note that paragraph 30 requires recognition of cumulative ineffectiveness for overhedges. This could result in an entity reporting a significant amount of ineffectiveness in income (in essence a catch-up adjustment) in the period that a change is made in the expected future cash flows on the hedged forecasted transaction from the inception of the hedge. That is, the final measurement under paragraph 30(b)(2) should 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. If 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.

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.