Derivatives Implementation Group

Statement 133 Implementation Issue No. G17

Title:	Cash Flow Hedges: Impact on Accumulated Other Comprehensive Income of Issuing Debt with a Term That Is Shorter Than Originally Forecasted
Paragraph references:	29a, 29b, 33, 156
Date cleared by Board:	March 21, 2001
Date posted to website:	April 10, 2001

QUESTION

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 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 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 issues debt. However, due to market conditions, the entity 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. 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 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

No. When the entity decides that the term of the debt to be issued will differ from the term of the debt originally expected to be issued, the entity should not immediately reclassify into earnings the entire net gain or loss in accumulated other comprehensive income related to the derivative contract. Instead, the entity must first apply the requirements of paragraph 30 using its originally documented hedging strategy and the newly revised best estimate of the cash flows¹.

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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.

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). At the time that the entity decides that the term of the fixed-rate debt to be issued will be changed from 10 years to 5 years, the impact of that decision on the cumulative change in the hedged future interest payments from the inception of the hedge will be reflected in the application of paragraph 30(b). (When the entity performs its semi-monthly 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 28(b) 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 case, the hedging relationship is terminated and the requirements of paragraph 30 must be applied.) 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 by the date (or within the time period) originally specified or within an additional two-month period of time thereafter (refer to paragraph 33 as amended).

In the example case, when the entity 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 the example case, the entity terminates the hedging relationship no later than on the date it issues the five-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. Since the entity issued a five-year debt instrument, the entity would determine that it is probable that the first 20 forecasted transactions would occur since they are now contractual obligations. The entity must determine that it is not probable that any of the last 20 forecasted transactions will not occur in order to continue reporting the net derivative gain or loss related to these forecasted transaction 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, the entity must apply paragraph 30 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. If the entity 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 (refer to 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-occurring" forecasted transactions. That amount should be equivalent to the portion of 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.

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 transactions 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.