Derivatives Implementation Group

Statement 133 Implementation Issue No. E22

Title:	Hedging—General: Accounting for the Discontinuance of Hedging Relationships Arising from Changes in Consolidation Practices Related to Applying FASB Interpretation No. 46 or 46(R)
Paragraph references:	31, 32, 68
Date cleared by Board:	November 5, 2003
Date posted to website:	November 10, 2003
Date latest revision posted to website:	February 10, 2004 (Revised February 10, 2004)

QUESTION

If upon the initial application of FASB Interpretation No. 46, Consolidation of Variable Interest Entities, or No. 46 (revised December 2003), Consolidation of Variable Interest Entities, an entity is required to consolidate another entity (or remove an entity from its consolidated financial statements) and consequently must discontinue a pre-existing hedging relationship, what adjustments are made with respect to the previous hedge accounting?

BACKGROUND

Transition Provisions in Interpretation 46(R)

Paragraph 37 of Interpretation 46(R) states, in part:

    If initial application of the requirements of this Interpretation results in initial consolidation of an entity created before December 31, 2003, the consolidating enterprise shall initially measure the assets, liabilities, and noncontrolling interests of the variable interest entity at their carrying amounts at the date the requirements of this Interpretation first apply. In this context, carrying amounts refers to the amounts at which the assets, liabilities, and noncontrolling interests would have been carried in the consolidated financial statements if this Interpretation had been effective when the enterprise first met the conditions to be the primary beneficiary.

The transition provisions in paragraph 28 of Interpretation 46 mirror the above except that the provisions in paragraph 28 pertain to entities created before February 1, 2003.

Selected Provisions in Statement 133

Paragraph 25 for fair value hedges and paragraph 32 for cash flow hedges require that a hedging relationship be discontinued when any criterion for fair value hedge accounting (in paragraphs 20 and 21) or for cash flow hedge accounting (in paragraphs 28 and 29) is no longer met. Consequently, a pre-existing hedging relationship may need to be discontinued when a change in consolidation practices causes either (a) a hedged transaction with a third party to become an intercompany transaction that is not eligible for cash flow hedge accounting in the consolidated financial statements or (b) a hedged item to cease being an asset or liability of the consolidated entity.

Paragraphs 31–33 discuss the accounting for the net derivative gain or loss that is initially reported in accumulated other comprehensive income (OCI). Paragraph 33, as amended, states:

    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, except as indicated in the following sentence. In rare cases, the existence of extenuating circumstances that are related to the nature of the forecasted transaction and are outside the control or influence of the reporting entity may cause the forecasted transaction to be probable of occurring on a date that is beyond the additional two-month period of time, in which case the net derivative gain or loss related to the discontinued cash flow hedge shall continue to be reported in accumulated other comprehensive income until it is reclassified into earnings pursuant to paragraph 31. 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 the preceding sentence, that derivative gain or loss reported in accumulated other comprehensive income shall be reclassified into earnings immediately.

Statement 133 does not permit retroactive designation of hedging relationships to achieve hedge accounting for fair value changes occurring prior to the designation and documentation of those hedging relationships.

Example 1—Discontinued Cash Flow Hedge Arising from Consolidation

A special purpose leasing entity is established based on a $3,000 equity contribution by an independent equity participant. The leasing entity borrows $97,000 with LIBOR-based interest payable quarterly and principal repayable as a lump sum at maturity and purchases a $100,000 asset. Company A leases the asset for a variable quarterly lease payment equal to the sum of (a) the leasing entity’s LIBOR-based quarterly interest payment, (b) a fixed return to the equity participant that is paid quarterly, and (c) a fixed amount to cover the leasing entity’s insurance, maintenance, and other costs. Assume that the due dates for the quarterly interest payments and the quarterly lease payments are the same. Company A enters into a receive-LIBOR, pay-fixed interest rate swap (with a notional amount not exceeding $97,000) and designates the swap as a cash flow hedge of all or a portion of its exposure to the variability of its LIBOR-based cash outflows under the lease. Prior to the initial application of Interpretation 46 or 46(R), Company A had not been consolidating the special-purpose leasing entity.

Upon initial application of Interpretation 46 or 46(R), the special-purpose leasing entity is considered a variable interest entity; assume that it must be consolidated by Company A. The original cash flow hedge must be discontinued because the hedged forecasted transactions (the LIBOR-based lease payments) are no longer eligible forecasted transactions of the consolidated entity with a third party (because they are now intercompany transactions that are eliminated in consolidation). Assume that upon consolidation of the variable interest (leasing) entity, the noncontrolling interest in the newly consolidated leasing entity will be reported as equity (minority interest).

At issue is the accounting upon consolidation for the net gain or loss that had been reported in accumulated OCI related to that discontinued cash flow hedge.

Example 2—Discontinued Cash Flow Hedge Arising from Consolidation

A special-purpose leasing entity is established based on a $3,000 equity contribution by an independent equity participant whose terms are mandatorily redeemable for a fixed amount. The leasing entity borrows $97,000 with LIBOR-based interest payable quarterly and principal repayable as a lump sum at maturity and purchases a $100,000 asset. Company A leases the asset for a variable quarterly lease payment equal to the sum of (a) the leasing entity’s LIBOR-based quarterly interest payment, (b) a LIBOR-based return to the equity participant that is paid quarterly, and (c) a fixed amount to cover the leasing entity’s insurance, maintenance, and other costs. Company A enters into a receive-LIBOR, pay-fixed interest rate swap (with a $100,000 notional amount) and designates the swap as a cash flow hedge of all of its exposure to the variability of its LIBOR-based cash outflows under the lease. Prior to the initial application of Interpretation 46 or 46(R), Company A had not been consolidating the special-purpose leasing entity.

Upon initial application of Interpretation 46 or 46(R), the special-purpose leasing entity is considered a variable interest entity; assume that it must be consolidated by Company A. The original cash flow hedge must be discontinued because the hedged forecasted transactions (the LIBOR-based lease payments) are no longer eligible forecasted transactions of the consolidated entity with a third party (because they are now intercompany transactions that are eliminated in consolidation). Assume that upon consolidation of the variable interest (leasing) entity, the noncontrolling interest in the newly consolidated leasing entity will be reported as a liability in the consolidated financial statements.

At issue is the accounting upon consolidation for the net gain or loss that had been reported in accumulated OCI related to that discontinued cash flow hedge.

Example 3—Discontinued Fair Value Hedge Arising from Deconsolidation

Bank B establishes a special-purpose trust to issue preferred stock to investors. The preferred stock is mandatorily redeemable on a specified date and specifies a fixed periodic (such as quarterly or annual) dividend. The proceeds of the issuance are paid to Bank B and the bank records a liability to the trust. However, because Bank B consolidates the trust, the bank’s liability to the trust is eliminated in its consolidated financial statements. Assume that the trust’s mandatorily redeemable preferred stock is reported as a “trust preferred certificates” liability in the consolidated financial statements.

Bank B enters into a receive-fixed, pay-LIBOR interest rate swap (with a $100,000 notional amount) and designates the swap as a fair value hedge of its exposure to changes in the fair value of the liability for the trust preferred certificates. (Had the trust’s mandatorily redeemable preferred stock not been reported as a liability in the consolidated financial statements, the preferred stock could not have been designated as the hedged item in a fair value hedge under Statement 133.)

Assume that upon initial application of Interpretation 46 or 46(R), Bank B concludes that the special-purpose trust is a variable interest entity and that the bank is not the primary beneficiary of the trust; consequently, Bank B deconsolidates the trust, thereby excluding the trust preferred certificates from the consolidated financial statements. However, Bank B would report its liability to the trust in the consolidated financial statements. The original fair value hedge must be discontinued because the hedged item (that is, the liability for the trust preferred certificates) no longer exists as a liability in Bank B’s consolidated financial statements.

At issue is the accounting upon deconsolidation for the net effect of fair value hedge accounting adjustments on the carrying amount of the hedged item and whether that net effect on the date of deconsolidation can be reported as an adjustment of the carrying amount for the bank’s liability to the trust.

RESPONSE

If a reporting entity is required to discontinue a pre-existing hedging relationship upon the initial application of Interpretation 46 or 46(R) due to the required consolidation of another entity in (or the deconsolidation of that entity from) the reporting entity’s consolidated financial statements, the adjustments of the reporting entity’s financial statements must reflect the ongoing effect of the previous hedge accounting for those discontinued relationships in a manner consistent with the reporting entity’s risk management policy and the objectives of those discontinued hedging relationships. Reflecting that ongoing effect of those discontinued relationships will involve identification and designation of surrogate hedged items for discontinued fair value hedges and surrogate hedged forecasted transactions for discontinued cash flow hedges. The surrogate hedged items and hedged forecasted transactions would need to have met (on a retroactive basis) the qualifying criteria applicable to those items and transactions (other than the requirement for contemporaneous documentation).

The identification of surrogate hedged items and hedged transactions relates solely to reflecting the ongoing effect of the discontinued hedging relationships, that is, how the basis adjustments arising from fair value hedge accounting and the amounts in OCI arising from cash flow hedge accounting should affect earnings in future periods.

Example 1—Discontinued Cash Flow Hedge Arising from Consolidation

Because the hedged forecasted transactions (that is, the LIBOR-based lease payments to the special-purpose leasing entity) on the discontinued cash flow hedge were related to the LIBOR-based interest payments on the leasing entity’s LIBOR-based variable-rate debt, Company A should, upon consolidation of the variable interest (leasing) entity, designate the LIBOR-based interest payments on that newly consolidated debt as the surrogate hedged forecasted transactions for purposes of the subsequent accounting for the amounts in accumulated OCI related to the discontinued cash flow hedge at the date the hedge was discontinued.

Under that surrogate designation, the amounts in accumulated OCI related to the discontinued cash flow hedge would be reclassified into earnings in the same period or periods during which the hedged LIBOR-based interest payments on the newly consolidated debt affects earnings, pursuant to the provisions of paragraph 31 of Statement 133. The amounts in accumulated OCI related to the discontinued cash flow hedge would not be reclassified into earnings immediately upon consolidation.

The provisions of paragraph 28 of Interpretation 46 and paragraph 37 of Interpretation 46(R) do not specifically address the amounts in OCI because those paragraphs address the carrying amounts of only the assets, liabilities, and noncontrolling interests of the variable interest (leasing) entity. But the notion in those paragraphs about measurement in the consolidated financial statements being determined as if the Interpretation had been effective when the reporting entity first met the conditions to be the primary beneficiary is relevant to the subsequent accounting for the amounts in OCI related to the discontinued cash flow hedge. The accounting under Statement 133 should be based on the assumption that if the leasing entity had been consolidated, that entity’s receive-LIBOR, pay-fixed interest rate swap would have likely been designated as the hedging instrument in a cash flow hedge of all or a portion of the consolidated entity’s exposure to the variability of the LIBOR-based cash outflows related to the interest payments on the leasing entity’s debt.

Example 2—Discontinued Cash Flow Hedge Arising from Consolidation

Because the hedged forecasted transactions (that is, the LIBOR-based lease payments to the special-purpose leasing entity) on the discontinued cash flow hedge were related to (a) the quarterly LIBOR-based interest payments on the leasing entity’s LIBOR-based variable-rate debt and (b) the LIBOR-based return to the equity participant that is being paid quarterly, Company A should, upon consolidation of the variable interest (leasing) entity, designate both the quarterly LIBOR-based interest payments on that newly consolidated debt and the quarterly payments on the newly consolidated liability to the equity participant as the surrogate hedged forecasted transactions for purposes of the subsequent accounting for the amounts in accumulated OCI related to the discontinued cash flow hedge at the date the hedge was discontinued.

Under that surrogate designation, only 97 percent of the amounts in accumulated OCI related to the discontinued cash flow hedge would relate to the LIBOR-based interest payments (on that newly consolidated debt) that are being designated as the surrogate hedged forecasted transactions (for 97 percent of the hedging swap). Because the noncontrolling interest is reported as a liability, the remaining 3 percent of the amounts in accumulated OCI related to the discontinued cash flow hedge would relate to the LIBOR-based payments to that noncontrolling interest (the equity participant), which would be designated as the surrogate hedged forecasted transactions (for 3 percent of the hedging swap). (In contrast, if the noncontrolling interest would have been reported as equity (minority interest) in the consolidated financial statements, the LIBOR-based payments to that noncontrolling interest would not be eligible under paragraph 29(f) of Statement 133 for designation as the hedged forecasted transaction, in which case the remaining 3 percent of the amounts in accumulated OCI related to the discontinued cash flow hedge would be removed from accumulated OCI and recognized as part of the cumulative effect of an accounting change.) If any timing difference exists between the LIBOR-based lease payments to the special-purpose leasing entity (the original hedged transaction) and the LIBOR-based interest payments on the leasing entity’s variable-rate debt (the surrogate hedged transaction) that creates ineffectiveness with respect to the surrogate hedged transaction that would have been recognized under paragraph 30 of Statement 133, that ineffectiveness should be recognized as part of the cumulative effect of an accounting change and should adjust the 97 percent of the amounts in accumulated OCI related to the discontinued cash flow hedge.

For the 97 percent of the amounts in accumulated OCI related to the discontinued cash flow hedge, they would be reclassified into earnings in the same period or periods during which the LIBOR-based interest payments on the newly consolidated debt affect earnings, pursuant to the provisions of paragraph 31 of Statement 133. Similarly, for the remaining 3 percent of those amounts in accumulated OCI, they would be reclassified into earnings in the same period or periods during which the LIBOR-based payments on the liability to the equity participant affect earnings. The amounts in accumulated OCI related to the discontinued cash flow hedge would not all be reclassified into earnings immediately upon consolidation.

Example 3—Discontinued Fair Value Hedge Arising from Deconsolidation

Because the hedged item (that is, the liability for the trust preferred certificates) on the discontinued fair value hedge was related to Bank B’s liability to the trust, Bank B should, upon deconsolidation of the variable interest entity (the trust), designate its liability to the trust as the surrogate hedged item for purposes of removing the trust from the consolidated financial statements. The net basis adjustment of the liability for the trust preferred certificates made under fair value hedge accounting and remaining at the date the fair value hedge is discontinued should be used to adjust the carrying amount of Bank B’s liability to the trust. Although the classification of trust preferred certificates is addressed in FASB Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, at the time this Implementation Issue was cleared, the Board had deferred the effective date for aspects of the guidance in Statement 150 with respect to certain instruments, including certain trust preferred certificates. Refer to FASB Staff Position No. FAS 150-3, “Effective Date, Disclosures, and Transition for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests under FASB Statement No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.”

Special Application of the Shortcut Method

If the initial application of Interpretation 46 or 46(R) causes the discontinuance of a pre-existing hedging relationship for which effectiveness was being assessed under the shortcut method in paragraph 68 of Statement 133 and the company designates a new hedging relationship, the new hedging relationship can qualify for the shortcut method if the following criteria are met:

1. The new hedging relationship meets all conditions in paragraph 68 other than the condition in paragraph 68(b).
2. The designation of the new hedging relationship was completed at the same time that the pre-existing hedging relationship was discontinued.
3. The hedging derivative in the new hedging relationship is all or a proportion of the hedging derivative used in the discontinued pre-existing hedging relationship.
4. The hedged item or the hedged transaction in the new hedging relationship is the surrogate for the discontinued pre-existing hedging relationship.
5. The discontinued pre-existing hedging relationship had qualified for and had been accounted for under the shortcut method.

If an entity had already applied Interpretation 46 and had designated a new hedging relationship (that meets all of the above criteria) contemporaneous with the discontinuance of a pre-existing hedging relationship due to the change in consolidation practices, the entity is allowed to apply the shortcut method to that new hedging relationship even though the use of the shortcut method had not been documented at the inception of that new hedging relationship. That entity should report the accounting effects of initially applying the shortcut method to the new hedging relationship as a cumulative change in accounting principles in the first fiscal quarter that ends after November 10, 2003 (as discussed in the effective date and transition section below).

Application of This Guidance

The guidance in this Issue applies to the adjustments made with respect to the previous hedge accounting for a pre-existing hedging relationship that was discontinued because of the consolidation or deconsolidation of another entity due to the initial application of Interpretation 46 or 46(R). The guidance in this Issue should also be applied by analogy to situations in which the issuance of new authoritative guidance results in a reporting entity becoming a primary beneficiary under Interpretation 46(R) and, therefore, must consolidate the related VIE. The guidance does not address the discontinuance of hedging relationships attributable to the consolidation or deconsolidation of another entity due to a change in ownership, control, or other circumstances.

The guidance in this Issue does not affect the designation of new hedging relationships on or after the date of initial application of Interpretation 46 or 46(R). Such new hedging relationships need to comply with all applicable requirements of Statement 133 (as amended) except with respect to the special use of the shortcut method as previously discussed.

At its November 5, 2003 meeting, the Board reached the above answer. Absent that, the staff would not have been able to provide guidance that permits (a) the identification of a surrogate hedged item or hedged transaction that would impact the ongoing effect of the previous hedge accounting for those hedging relationships discontinued due to a change in consolidation practices related to application of Interpretation 46 or 46(R) and (b) the new hedging relationship to qualify for the shortcut method without meeting the conditions in paragraph 68(b) at the inception of that hedging relationship.

EFFECTIVE DATE(S) AND TRANSITION

The effective date(s) of the implementation guidance in this Issue for each reporting entity is the date of initial application of Interpretation 46 and/or 46(R). Consequently, the identification and designation of the surrogate hedged items and hedged transactions may need to be made retroactively as of that date(s). If an entity has already applied Interpretation 46 and issued financial statements for the period that reported the resulting change in accounting principle, that entity should report the accounting effects of initially applying the guidance in this Implementation Issue as a cumulative effect of an accounting change in its first fiscal quarter that ends after November 10, 2003, the date that the Board-cleared guidance was posted on the FASB website.

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.