Derivatives Implementation Group

Statement 133 Implementation Issue No. F6

QUESTION

An entity that is the issuer of fixed-rate debt enters into an interest rate swap (Swap 1) and designates it as a hedge of the fair value exposure of the debt to interest rate risk. The fair value hedge of the fixed-rate debt involving Swap 1 meets the required criteria in paragraphs 20 and 21 of Statement 133 to qualify for hedge accounting. The entity simultaneously enters into a second interest rate swap (Swap 2) with the same counterparty with the exact mirror terms as Swap 1 and does not designate Swap 2 as part of that hedging relationship. Is the entity required to view the two swaps as a unit, and is it, therefore, precluded from applying fair value hedge accounting to swap 1, by analogy to Statement 133 Implementation Issue No. K1, "Determining Whether Separate Transactions Should Be Viewed as a Unit"?

BACKGROUND

Implementation Issue K1 addresses situations in which individual transactions that do not meet the definition of a derivative should be combined and viewed as a unit in order to determine whether the combination of the transactions meets the definition of a derivative for purposes of applying Statement 133. The Response in Implementation Issue K1 states, in part:

   If two or more separate transactions may have been entered into in an attempt to circumvent the provisions of Statement 133, the following indicators should be considered in the aggregate and, if present, should cause the transactions to be viewed as a unit and not separately:

1. The transactions were entered into contemporaneously and in contemplation of one another
2. The transactions were executed with the same counterparty (or structured through an intermediary)
3. The transactions relate to the same risk
4. There is no apparent economic need nor substantive business purpose for structuring the transactions separately that could not also have been accomplished in a single transaction.

RESPONSE

Generally, no. Statement 133 is a transaction-based standard. It generally does not provide for the combination of separate financial instruments to be evaluated as a unit, unless two or more derivatives in combination are designated as a hedging instrument. The guidance in Implementation Issue K1 is an exception to the fundamental principle that Statement 133 is a transaction-based standard. However, the guidance in that issue is meant to be applied in circumstances in which there is an attempt to circumvent accounting for a derivative contract. In the example in the Question section, the swaps were not entered into to circumvent the definition of a derivative in Statement 133.

However, similar to the reasoning in Implementation Issue K1, if certain indicators are present, those indicators should be considered in determining whether the overall intent of a transaction is to circumvent generally accepted accounting principles. That is, if separate derivative contracts are entered into contemporaneously and in contemplation of one another, if they are entered into with the same counterparty, if they relate to the same risk, and if there is no substantive business purpose for structuring the transactions separately, judgment should be applied to determine whether the separate derivative contracts have been entered into in lieu of a structured transaction in an effort to circumvent generally accepted accounting principles. In instances where such a determination is made, the derivative contracts should be viewed as a unit.

In the example in the Question section (in which Swaps 1 and 2 were entered into contemporaneously with the same counterparty), if Swap 2 was entered into in contemplation of Swap 1 and the overall transaction was executed for the sole purpose of obtaining fair value accounting treatment for the debt, it should be concluded that the purpose of the transaction was not to enter into a bona fide hedging relationship involving Swap 1. In that case, the two swaps should be viewed as a unit and the entity would not be permitted to adjust the carrying value of the debt to reflect changes in fair value attributable to interest rate risk.

However, if Swap 2 was not entered into in contemplation of Swap 1 or there is a substantive business purpose for structuring the transactions separately, and if both Swap 1 and Swap 2 were entered into in arms-length transactions (that is, at market rates), then the swaps should not be viewed as a unit. For example, some entities have a policy that requires a centralized dealer subsidiary to enter into third-party derivative contracts on behalf of other subsidiaries within the organization to hedge the subsidiaries' interest rate risk exposures. The dealer subsidiary also enters into internal derivative contracts with those subsidiaries in order to operationally track those hedges within the organization. (In accordance with Statement 133 Implementation Issue No. J2, "Hedging with Intercompany Derivatives," internal derivatives do not qualify in consolidated financial statements as hedging instruments for risks other than foreign exchange risk.)

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.