Derivatives Implementation Group

Statement 133 Implementation Issue No. G18

QUESTION

1. Assume that Company A expects to borrow $100 million over a 10-year period beginning in 6 months. Company 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, Company 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 prior to issuance. In order 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, the entity enters into a derivative contract (for example, a forward-starting interest rate swap) and 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. The entity documents that it will assess the effectiveness of the hedging relationship semi-monthly. Six months after inception of the hedging relationship, the entity decides to delay the issuance of the 10-year debt for three months. Should the entity immediately reclassify the entire net gain or loss related to the derivative contract in accumulated other comprehensive income into earnings?

    

2. Assume that Company B expects to issue $100 million of 10-year, 9 percent debt in 6 months. Because the debt will have a fixed interest rate of 9 percent, Company 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 prior to issuance. In order to hedge the risk of changes in the total proceeds attributable to changes in the benchmark interest rate, the entity enters into a derivative contract (for example, a short position in US Treasury note futures contracts) and 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. (Because the entity 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.) Six months after inception of the hedging relationship, the entity decides to delay the issuance of the debt for three months. Should the entity immediately reclassify the entire net gain or loss related to the derivative contract in accumulated other comprehensive income into earnings?

BACKGROUND

Paragraphs 29(a) and 29(b) state the forecasted transaction must be specifically identified and its occurrence must be probable.

Paragraph 33 (as amended) states, in part:

    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....

When using an interest rate swap to hedge the risk of changes in cash flows attributable to changes in the benchmark interest rate, paragraph 156 describes the effects of terminating this type of cash flow hedging relationship, even though the occurrence of the forecasted transactions remains probable. Specifically, it states that at termination of the hedging relationship any net gain or loss on the swap in accumulated other comprehensive income is not automatically 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. Even though the variability of future interest payments has been eliminated, the net gain or loss on the swap in accumulated other comprehensive income is reclassified to earnings in the same period or periods during which the hedged transaction affects earnings, as required by paragraph 31. The conclusions in paragraph 156 relate to an original hedging relationship involving a five-year swap being used to hedge the variable interest payments of the forecasted rollover of debt for five years. When three-year, fixed-rate debt is issued at the end of the second year, the variability of the future interest payments has been eliminated and the swap must be de-designated as the hedging instrument, thereby terminating the original hedging relationship. Although the original relationship related to five years of future interest payments, three years of the hedged future interest payments continue to remain. The net gain or loss in accumulated other comprehensive income relating to the terminated hedging relationship is not immediately reclassified into earnings because the remaining hedged future interest payments in the original forecasted transaction are now a contractual obligation and will continue to be probable of occurring). Footnote 25 to paragraph 156 states, "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."

RESPONSE

Question 1
No. When the entity decides to delay the issuance of the 10-year debt for 3 months, the entity should not immediately reclassify into earnings the entire net gain or loss in accumulated other comprehensive income related to the derivative contract. The entity'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, an entity 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 the entity 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 non-probable forecasted transactions (even if the forecasted transaction will occur within an additional two-month period of time after that originally specified date). (It 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, the entity must determine whether it is probable that any or all of those specific non-probable 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 paragraph 33 as amended). The entity should reclassify into earnings from accumulated other comprehensive income the amount of the net derivative gain or loss related to those specific non-probable forecasted transactions for which it is probable they will not occur. That amount should be equivalent to the present value of the derivative's cash flows intended to offset the changes in the original forecasted transactions for which the entity 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.

In the example case, when the entity 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 ten-year period. Since the entity did not issue the debt instrument as originally documented, the entity would determine that it is probable that the first forecasted transaction will not occur at the time forecasted; consequently, the entity must terminate the original hedging relationship with respect to that first forecasted transaction. However, the entity 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 non-probable first forecasted transaction, the entity must determine whether it is probable that specific non-probable first forecasted transaction will not occur by the forecasted date or within an additional two-month period of time thereafter. In the example, the entity 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 swap's net gain or loss equivalent to the present value of the cash flows from the swap intended to offset the changes in the first forecasted transaction that is probable not to occur.

Paragraph 494 of Statement 133 states:

    A pattern of determining that hedged forecasted transactions probably will not occur 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.

Thus, the nonoccurrence of one of the hedged forecasted transaction described in that example case could potentially jeopardize the entity's ability to use cash flow hedge accounting in the future for the situation described.

Question 2
Yes. 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, the entity must terminate the hedging relationship. After the hedging relationship is terminated, the entity must determine whether it is probable that the specific non-probable 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. Since in the example case the entity decided to delay the issuance of the debt for a three-month period of time, the entity 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, the entity should immediately reclassify into earnings the entire net gain or loss related to the derivative contract in accumulated other comprehensive income.

Paragraph 494 of Statement 133 states:

    A pattern of determining that hedged forecasted transactions probably will not occur 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.

Thus, the nonoccurrence of the hedged forecasted transaction described in that example case could potentially jeopardize the entity's ability to use cash flow hedge accounting in the future for the situation described.

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.