Derivatives Implementation Group

Statement 133 Implementation Issue No. G13

QUESTION

Company A and Company B both make to their respective customers LIBOR-indexed floating-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 companies determine that they will each always have at least $100 million of those LIBOR-indexed floating-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.

1. Company A wishes to hedge its interest rate exposure to changes in the quarterly interest receipts on $100 million principal of those LIBOR-indexed floating-rate loans by entering into a 3-year interest rate swap that provides for quarterly net settlements based on Company A receiving a fixed interest rate on a $100 million notional amount and paying a floating LIBOR-based rate on a $100 million notional amount. In identifying the hedged forecasted transactions in cash flow hedges of interest rate risk, can Company A designate the hedging relationships as hedging the risk of changes (attributable to interest rate risk) in Company A's first LIBOR-based interest payments received 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 interest payments on $100 million principal of its then existing LIBOR-indexed floating-rate loans?

    

2. Company B wishes to hedge its interest rate exposure to changes in the quarterly interest receipts on $100 million principal of those LIBOR-indexed floating-rate loans by entering into a 3-year interest rate swap that provides for quarterly net settlements based on Company B receiving a fixed interest rate on a $100 million notional amount and paying a floating LIBOR-based rate on a $100 million notional amount. If Company 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 floating-rate loans aggregating $100 million principal but then some of those loans (a) experience prepayments, (b) are sold, or (c) experience credit difficulties, can 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 floating-rate interest-bearing loans?
   

This Issue 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 29(h)(1).

BACKGROUND

Paragraph 28(a) of Statement 133 states, in part:

   At inception of the hedge, there is formal documentation of the hedging relationship and the entity's risk management objective and strategy for undertaking the hedge, including identification of the hedging instrument, the hedged transaction, the nature of the risk being hedged, and how the hedging instrument's effectiveness in hedging the exposure to the hedged transaction's variability in cash flows attributable to the hedged risk will be assessed. There must be a reasonable basis for how the entity plans to assess the hedging instrument's effectiveness....

2. Documentation shall include all relevant details, including the date on or period within which the forecasted transaction is expected to occur, the specific nature of asset or liability involved (if any), and the expected currency amount or quantity of the forecasted transaction.
   
   1. The phrase expected currency amount refers to hedges of foreign currency exchange risk and requires specification of the exact amount of foreign currency being hedged.
      
   2. The phrase expected...quantity refers to hedges of other risks and requires specification of the physical quantity (that is, the number of items or units of measure) encompassed by the hedged forecasted transaction. If a forecasted sale or purchase is being hedged for price risk, the hedged transaction cannot be specified solely in terms of expected currency amounts, nor can it be specified as a percentage of sales or purchases during a period. The current price of a forecasted transaction also should be identified to satisfy the criterion in paragraph 28(b) for offsetting cash flows.

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, the 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).

Paragraph 28(b) of Statement 133 states, "Both at inception of the hedge and on an ongoing basis, 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...."

Paragraph 29 of Statement 133 (as amended) states, in part:

1. The forecasted transaction is specifically identified as a single transaction or a group of individual transactions. If the hedged transaction is a group of individual transactions, those individual transactions must share the same risk exposure for which they are designated as being hedged....

    

2. The occurrence of the forecasted transaction is probable....

8. In a cash flow hedge of a variable-rate financial asset or liability, either existing or forecasted, the designated risk being hedged cannot be the risk of changes in its cash flows attributable to changes in the specifically identified benchmark interest rate if the cash flows of the hedged transaction are explicitly based on a different index, for example, based on a specific bank's prime rate, which cannot qualify as the benchmark interest rate.

Paragraphs 459-462 in the basis for conclusions of Statement 133 state, in part:

   The Board decided to require 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. 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, the Board does not consider it necessary to 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 to prevent such after-the-fact designation.

   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.

   The Board understands that 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. The Board decided that an entity should be permitted to aggregate individual forecasted transactions for hedging purposes in some circumstances. As for a hedge of a single forecasted transaction, an entity must identify the hedged transactions with sufficient specificity that it is possible to determine which transactions are hedged transactions when they occur. 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.

   To qualify for hedging as a group rather than individually, the aggregated transactions must share the risk exposure for which they are being hedged. If a forecasted transaction does not share the risk exposure for which the group of items is being hedged, it should not be part of the group being hedged. The Board considers that requirement to be necessary to ensure that a single derivative will be effective as a hedge of the aggregated transactions. To illustrate, under the guidance in this Statement, a single derivative of appropriate size could be designated as hedging a given amount of aggregated forecasted transactions such as the…forecasted interest payments on several variable-rate debt instruments within a specified time period. However, the transactions…must share the risk exposure for which they are being hedged. For example, the interest payments…must vary with the same index to qualify for hedging with a single derivative.

Paragraph 29(a) of Statement 133 requires that:

   The forecasted transaction is specifically identified as a single transaction or a group of individual transactions. If the hedged transaction is a group of individual transactions, those individual transactions must share the same risk exposure for which they are designated as being hedged. Thus, a forecasted purchase and a forecasted sale cannot both be included in the same group of individual transactions that constitute the hedged transaction.

RESPONSE

Question 1

Yes. In a cash flow hedge of interest rate risk, Company A may identify the hedged forecasted transactions as the first LIBOR-based interest payments received by Company 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 floating-rate loans. The LIBOR-based interest payments received by Company A after it has received payments on $100 million aggregate principal would be unhedged interest payments for that quarter.

The hedged forecasted transactions for Company A in the above scenario are described with sufficient specificity so that when a transaction occurs, it is clear whether that transaction is or is not the hedged transaction. Because Company A has designated the hedging relationship as hedging the risk of changes attributable to changes in the LIBOR benchmark interest rate in Company A's first LIBOR-based interest payments received, any prepayment, sale, or credit difficulties related to an individual LIBOR-indexed floating-rate loan would not affect the designated hedging relationship. Provided Company 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 floating-rate loans, Company A can conclude that the hedged forecasted transactions in the documented cash flow hedging relationships are probable of occurring.

An entity may not assume no ineffectiveness in such a hedging relationship as described in paragraph 68 of Statement 133 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, Company A must consider the timing of the hedged cash flows vis-à-vis the swap's cash flows when assessing effectiveness and calculating ineffectiveness.

Question 2

No. Company 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 floating-rate interest-bearing loans. Paragraph 29(a) of Statement 133 requires that for a cash flow hedge, the forecasted transaction should 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 benchmark-interest-rate-based floating-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 Company B specifically related to that loan are now no longer probable of occurring. Pursuant to paragraph 32, Company 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 Question 1, 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 impact on the application of Statement 133.

Changing the composition of the specified individual loans within the group of floating-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 floating-rate interest-bearing loans. Consequently, the hedging relationships for future interest payments that are no longer probable of occurring must be terminated. Paragraph 33 of Statement 133 (as amended) states that "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 [that paragraph], that derivative gain or loss reported in accumulated other comprehensive income shall be reclassified into earnings immediately." (Note that the provisions related to immediately reclassifying a derivative'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.) Subsequent to the discontinuation of the hedging relationships for interest payments related to the individual loans removed from the group of floating-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 (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 494 warns that "a pattern of determining that hedged forecasted transactions probably will not occur would call into question both entity's ability to accurately predict forecasted transactions and the propriety of using hedge accounting in the future for similar forecasted transactions."

The guidance on Question 2 above does not conflict with the guidance to Example 8 in paragraphs 153-161. In Example 8, MNO Company plans to borrow $5 million for an overall period of 5 years and, because MNO Company does not plan to initially enter into a 5-year fixed-rate debt obligation, the interest payments over that 5-year period have variability. In Example 8, MNO Company obtains a LIBOR-based interest rate swap to hedge the variability in the quarterly interest payments on the 5-year borrowing program attributable to changes in the LIBOR benchmark rate. Initially, MNO Company plans to accomplish its 5-year borrowing program by sequentially issuing 90-day notes over the total period, though it is aware that changes in market conditions may prompt it to accomplish its 5-year borrowing program by other means, such as a fixed-rate borrowing for the remainder of the 5-year period.

In Scenario 1 of Example 8, MNO Company discontinues at the end of the second year its practice of issuing 90-day notes and instead issues a 3-year, fixed-rate $5 million note. Paragraph 156 notes that in Scenario 1, "The variability of the payments has been eliminated, but it still is probable that they will occur." This is true because MNO Company has still continued its 5-year borrowing program with a mechanism that still requires quarterly interest payments on a $5 million debt. Scenario 1 illustrates the provisions of paragraphs 32 and 33. The hedging relationships for the future hedged quarterly interest payments must be discontinued under paragraph 32 because the variability has ceased. Paragraph 156 clarifies paragraph 154 and indicates that the originally designated hedged transactions are the future interest payments under MNO Company's 5-year borrowing program. In other words, MNO Company originally documented that it was hedging its interest rate risk exposure to changes in the quarterly interest payments on its $5 million borrowing over the next 5 years. Because MNO Company will continue to be obligated to make quarterly interest payments on its $5 million borrowing for the remainder of the 5-year period, no immediate reclassification of amounts from OCI into earnings is required (or permitted) under paragraph 33.¹

In contrast, in the example in Question 2, the hedged quarterly interest payments were directly linked to Company 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 Company B). Consequently, the hedging relationships for those future quarterly interest payments fail to meet the criterion in paragraph 29(b) and must be discontinued under paragraph 32. 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 net gain or loss in OCI must be immediately reclassified into earnings pursuant to paragraph 33.

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¹How 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. In the cash flow hedge in Example 8, 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 those future debt issuances would cause the related derivative net gain or loss in OCI to be immediately reclassified into earnings pursuant to paragraph 33 because it would have been probable that the hedged forecasted transactions would not occur. Furthermore, that failure, if part of a pattern of having hedged forecasted transactions cease being probable of 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, pursuant to paragraph 494.

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.