Derivatives Implementation Group

Statement 133 Implementation Issue No. G7

QUESTION

How should paragraph 30(b)(2) of Statement 133 be applied to calculate the amount of ineffectiveness to be recognized in earnings for a cash flow hedge that does not meet the requirements for use of the shortcut method and that involves either (a) a receive-floating, pay-fixed interest rate swap designated as a hedge of the variable interest payments on an existing floating-rate liability or (b) a receive-fixed, pay-floating interest rate swap designated as a hedge of the variable interest receipts on an existing floating-rate asset?

BACKGROUND

When the requirements for the shortcut method in paragraph 68 of Statement 133 are not satisfied, it cannot be assumed that the hedge results in zero ineffectiveness, thereby resulting in reporting the entire change in fair value of the derivative designated as the hedging instrument in a cash flow hedge in other comprehensive income (OCI). In those situations, the requirements of paragraph 30 must be applied. Paragraph 30 requires that the effective portion of the gain or loss on a derivative designated as a cash flow hedge be reported in OCI and the ineffective portion be reported in earnings. To determine the adjustment to accumulated OCI for changes in value of a derivative designated as a cash flow hedge, paragraph 30(b) requires the comparison of the following:

1. The cumulative gain or loss on the derivative from inception of the hedge (less any excluded components and any gains or losses previously reclassified from accumulated OCI into earnings)

    

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 the inception of the hedge (less any gains or losses previously reclassified from accumulated OCI into earnings).

Accumulated OCI associated with the hedged transaction should be adjusted to a balance that reflects the lesser of the two foregoing amounts (in absolute amounts).

Depending on the interest rate index (or indices) involved and the expected effectiveness of the hedging swap, the hedging relationships covered by the question above encompass (a) hedges of interest rate risk (pursuant to paragraph 29(h)(2)) or (b) hedges of the risk of overall changes in the hedged cash flows related to the asset or liability (pursuant to paragraph 29(h)(1)). An example of a hedge of interest rate risk that would be covered by the scope of this issue is a hedging relationship that does not qualify for the shortcut method that involves an interest rate swap with its floating-rate index based on the LIBOR swap rate (a benchmark interest rate) designated as a hedge of a variable-rate asset or liability with an interest-rate index also based on the LIBOR swap rate. An example of a hedge of the risk of overall changes in the hedged cash flows related to the asset or liability that would be covered by this issue is a hedging relationship involving an interest-rate swap with its floating-rate index based on a bank's Prime rate designated as a hedge of a variable-rate asset or liability with an interest-rate index also based on the same Prime rate. That hedging relationship may not qualify for the shortcut method because the shortcut method applies only to hedges of interest rate risk, and the designated floating-rate index giving rise to variability in cash flows is not a benchmark interest rate as defined by Statement 133, as amended.

RESPONSE

Three methods for calculating the ineffectiveness of a cash flow hedge that involves either (a) a receive-floating, pay-fixed interest rate swap designated as a hedge of the variable interest payments on an existing floating-rate liability or (b) a receive-fixed, pay-floating interest rate swap designated as a hedge of the variable interest receipts on an existing floating-rate asset are discussed below. As noted in the last section of the response, Method 1 (Change in Variable Cash Flows Method) may not be used in certain circumstances. Under all three methods, an entity must consider the risk of default by counterparties that are obligors with respect to the hedging instrument (the swap) or hedged transaction, pursuant to the guidance in Statement 133 Implementation Issue No. G10, "Need to Consider Possibility of Default by the Counterparty to the Hedging Derivative." An underlying assumption in this Response is that the likelihood of the obligor not defaulting is assessed as being probable.

Method 1: Change in Variable Cash Flows Method

For the types of cash flow hedges described in the question section, the measurement of hedge ineffectiveness may be based on a comparison of the floating-rate leg of the swap and the hedged floating-rate cash flows on the asset or liability (herein referred to as the "change in variable cash flows" method). The change in variable cash flows method is consistent with the cash flow hedge objective of effectively offsetting the changes in the hedged cash flows attributable to the hedged risk. The method is based on the premise that only the floating-rate component of the swap provides the cash flow hedge, and any change in the swap's fair value attributable to the fixed-rate leg is not relevant to the variability of the hedged interest payments (receipts) on the floating-rate liability (asset).

Under this method, the interest rate swap designated as the hedging instrument would be recorded at fair value on the balance sheet. The calculation of ineffectiveness involves a comparison of the present value of the cumulative change in the expected future cash flows on the variable leg of the swap and the present value of the cumulative change in the expected future interest cash flows on the floating-rate asset or liability. (Because the focus of a cash flow hedge is on whether the hedging relationship achieves offsetting changes in cash flows, if the variability of the hedged cash flows of the floating-rate asset or liability is based solely on changes in a floating-rate index, the present value of the cumulative changes in expected future cash flows on both the floating-rate leg of the swap and the floating-rate asset or liability should be calculated using the discount rates applicable to determining the fair value of the swap.) If hedge ineffectiveness exists, accumulated OCI would be adjusted to a balance that reflects the difference between the overall change in fair value of the swap since the inception of the hedging relationship and the amount of ineffectiveness that must be recorded in earnings.

The change in variable cash flows method will result in no ineffectiveness being recognized in earnings if the following conditions are met: (1) the floating-rate leg of the swap and the hedged variable cash flows of the asset or liability are based on the same interest rate index (for example, three-month LIBOR), (2) the interest rate reset dates applicable to the floating-rate leg of the swap and to the hedged variable cash flows of the asset or liability are the same, (3) the hedging relationship does not contain any other basis differences (for example, ineffectiveness could be created if the variable leg of the swap contains a cap and the floating-rate asset or liability does not), and (4) the likelihood of the obligor not defaulting is assessed as being probable. However, ineffectiveness would be expected to result if any basis differences existed. For example, ineffectiveness would be expected to result from a difference in the indices used to determine cash flows on the variable leg of the swap (for example, the three-month Treasury rate) and the hedged variable cash flows of the asset or liability (for example, three-month LIBOR) or a mismatch between the interest rate reset dates applicable to the variable leg of the swap and the hedged variable cash flows of the hedged asset or liability.

To demonstrate the application of the change in variable cash flows method to an example hedging relationship, an entity designates a receive-floating, pay-fixed interest rate swap with a zero fair value as a hedge of variable interest rate payments on a debt instrument. The variable leg of the swap is based on the three-month Treasury rate and the variable cash flows of the debt are based on three-month LIBOR. Assume that the overall change in fair value of the swap from inception of the hedge is $16,300, the present value of the cumulative change in the cash flow on the variable leg of the swap is a gain (increased cash inflow) of $16,596, and the present value of the cumulative change in the expected future interest cash flows on the floating-rate liability due to changes in the cash flows expected for the remainder of the hedge term is a loss (increased cash outflow) of $16,396. (The cumulative changes in expected future cash flows on both the variable leg of the swap and the floating-rate debt are discounted using the rates applicable to determining the fair value of the derivative.) The entity would report in earnings a gain of $200 as ineffectiveness, representing the amount by which the present value of the cumulative change in the cash flows on the variable leg of the swap exceeds the present value of the cumulative change in the expected cash flows on the floating-rate debt. The swap would be recorded at fair value on the balance sheet (asset of $16,300) and the balance in accumulated OCI would be adjusted to a credit of $16,100. In accordance with the requirements of paragraph 30(b), there is no reported ineffectiveness when the present value of the cumulative change in the future expected cash flows on the floating-rate debt exceeds the present value of the cumulative change in the future cash flows on the variable leg of the swap.

Method 2: Hypothetical Derivative Method

For the types of cash flow hedges described in the question section, the measurement of hedge ineffectiveness may be based on a comparison of the change in fair value of the actual swap designated as the hedging instrument and the change in fair value of a hypothetical swap (herein referred to as the "hypothetical derivative" method). That hypothetical swap would have terms that identically match the critical terms of the floating-rate asset or liability (that is, the same notional amount, same repricing dates, the index on which the hypothetical swap's variable rate is based matching the index on which the asset or liability's variable rate is based, mirror image caps and floors, and a zero fair value at the inception of the hedging relationship). Essentially, the hypothetical derivative would need to satisfy all of the applicable conditions in paragraph 68 (as amended) necessary to qualify for use of the shortcut method except criterion 68(dd). Thus, the hypothetical swap would be expected to perfectly offset the hedged cash flows. The change in the fair value of the "perfect" hypothetical swap can be regarded as a proxy for the present value of the cumulative change in expected future cash flows on the hedged transaction as described in paragraph 30(b)(2).

Under the hypothetical derivative method, the actual swap would be recorded at fair value on the balance sheet, and accumulated OCI would be adjusted to a balance that reflects the lesser of either the cumulative change in the fair value of the actual swap or the cumulative change in the fair value of a "perfect" hypothetical swap. The determination of the fair value of both the "perfect" hypothetical swap and the actual swap should use discount rates based on the relevant swap curves. The amount of ineffectiveness, if any, recorded in earnings would be equal to the excess of the cumulative change in the fair value of the actual swap over the cumulative change in the fair value of the "perfect" hypothetical swap. Paragraph 30(b) indicates that hedge ineffectiveness in a cash flow hedge occurs only if the cumulative gain or loss on the derivative hedging instrument exceeds the cumulative change in the expected future cash flows on the hedged transaction.

Method 3: Change in Fair Value Method

For the types of cash flow hedges described in the question section, the measurement of hedge ineffectiveness may be based on a calculation that compares the present value of the cumulative change in expected variable future interest cash flows that are designated as the hedged transactions and the cumulative change in the fair value of the swap designated as the hedging instrument (herein referred to as the "change in fair value" method). The discount rates applicable to determining the fair value of the swap designated as the hedging instrument should also be applied to the computation of present values of the cumulative changes in the hedged cash flows.

Application of the Methods

If, at the inception of the hedge, the fair value of the swap designated as the hedging instrument is zero or is somewhat near zero, any of the three methods discussed above may be applied. In contrast, if, at the inception of the hedge, the fair value of the swap is not somewhat near zero, the change in variable cash flows method (Method 1) may not be applied because that method does not require entities to recognize in income currently the ineffectiveness related to the interest element of the change in fair value of a hedging instrument that incorporates a financing element; instead, either the hypothetical derivative method (Method 2) or the change in fair value method (Method 3) should be applied. Those latter two methodologies require entities to recognize in income currently the ineffectiveness related to the interest element of the change in fair value of a hedging instrument that incorporates a financing element that is not somewhat near zero, such as when the swap has been structured to be significantly in-the-money at the inception of the hedge.

Statement 133 requires that an entity define and document, at the time it designates a hedging relationship, the method it will use to measure the hedge's effectiveness in achieving offsetting cash flows. It also requires that an entity use that defined method consistently throughout the hedge period to measure the ineffective part of the hedge. In addition, in deciding which of the above methods to use, an entity must comply with paragraph 62, which states, "Ordinarily, however, an entity should assess effectiveness for similar hedges in a similar manner; use of different methods for similar hedges should be justified."

Regardless of which method is used for the measurement of cash flow hedge effectiveness, an entity must meet the requirements of paragraph 28(b) of Statement 133 for designation of a cash flow hedging relationship. That is, in designating a cash flow hedging relationship, an entity must have the expectation, both at the inception of the hedge and ongoing, that the relationship will be highly effective at achieving offsetting changes in cash flows.

Although the question in this Implementation Issue addresses a cash flow hedge of the variable interest receipts on an existing floating-rate asset or liability, the guidance in this Implementation Issue also applies to cash flow hedges of the variability of future interest payments on interest-bearing assets to be acquired or interest-bearing liabilities to be incurred (such as the rollover of an entity's short-term debt as described in Example 8 in paragraphs 153-161).

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.