Derivatives Implementation Group

Statement 133 Implementation Issue No. J8

QUESTION

In determining the transition adjustment for a fair-value-type hedge of interest rate risk that existed prior to the initial adoption of Statement 133, should the adjustment of the hedged item's carrying amount be based on its overall unrecognized changes in fair value or on its unrecognized changes in fair value attributable only to changes in the designated benchmark interest rate during the pre-existing fair-value-type hedge? Should that transition adjustment be based on only the changes in the hedged item's fair value that occurred during the period of the pre-existing fair-value-type hedge?

RESPONSE

In determining the transition adjustment for a fair-value-type hedge of interest rate risk that existed prior to the initial adoption of Statement 133, the adjustment of the hedged item's carrying amount should be based on either (1) the overall gain or loss on the hedged item determined as the difference between the hedged item's fair value and its carrying amount on the date of initial application (that is, not limited to the portion attributable to the hedged risk nor limited to the gain or loss occurring during the period of the pre-existing hedging relationship) (referred to as Method 1 in this Issue) or (2) the gain or loss on the hedged item attributable to changes in the designated benchmark interest rate during the period of the pre-existing hedging relationship (referred to as Method 2 in this Issue). The adjustment of the hedged item's carrying amount under Method 1 is based on the difference between the hedged item's fair value at the date of initial adoption and its carrying amount at that date, regardless of whether that difference is attributable to changes in the designated benchmark interest rate, changes in other unhedged risks, or changes in fair value arising prior to the designation of the pre-existing fair-value-type hedge. The adjustment of the hedged item's carrying amount under Method 2 is limited to the hedged risks that can be designated under paragraph 21 of Statement 133. An entity is permitted to use either of those two methods for each individual pre-existing fair-value-type hedge. An entity is not required to use the same method for similar hedges. This guidance is consistent with the amendment of paragraph 52 by FASB Statement No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities.

Paragraph 52 (as amended) indicates that the difference between the derivative's previous carrying amount and its fair value at the date of initial adoption would be included in the transition adjustment and recorded as a cumulative-effect-type adjustment of other comprehensive income (OCI) for derivatives previously designated in a cash-flow-type hedging relationship and as a cumulative-effect-type adjustment of net income for those previously designated in a fair-value-type hedging relationship. In addition, for a fair-value-type hedging relationship, an adjustment to the hedged item's carrying amount (based on either Method 1 or Method 2) is made, but only to the extent of an offsetting transition adjustment for the derivative. The adjustment to the hedged item's carrying amount under Method 1 is not limited to the changes in the hedged item's fair value attributable only to the hedged risk. Even though fair value hedge accounting under Statement 133 is based on a bifurcation-by-risk approach (that is, considering only the changes in the hedged item's fair value attributable to the hedged risk), under the transition provisions for a fair-value-type hedge that existed prior to the initial adoption of Statement 133, an entity may elect to focus on overall unrecognized changes in fair value that are not based on a bifurcation-by-risk approach.

Additionally, the adjustment to the hedged item's carrying amount under Method 1 is not limited to the changes in the hedged item's fair value that occurred during the hedge period that existed prior to the initial adoption of Statement 133. A portion of that change in fair value could have occurred prior to the designation of the original, pre-existing fair-value-type hedge of interest rate risk. In contrast, the adjustment to the hedged item's carrying amount under Method 2 is limited to the changes in the hedged item's fair value (attributable to the hedged risk) that occurred during the period that the fair-value-type hedging relationship existed prior to the initial adoption of Statement 133.

In the following examples, assume that prior to the initial adoption of Statement 133, an entity had acquired an interest-bearing asset for $100 and, after its fair value had fallen to $95 (a change in fair value considered temporary), designated an interest rate swap (whose fair value was zero) as hedging the fair value exposure of that asset. The examples demonstrate the application of only Method 1.

1. Example 1. The hedged item is an interest-bearing asset measured at amortized cost. If prior to the adoption of Statement 133, the hedged asset's fair value had increased by $9 to $104 and the swap's fair value had decreased by $10, the transition adjustment for that pre-existing fair-value-type hedging relationship would be a net $6 cumulative-effect-type reduction of net income, representing the $10 loss from recognizing the swap as a $10 liability and the $4 gain from adjusting the hedged asset's carrying amount from its $100 cost-based carrying amount to its $104 fair value.

    

2. Example 2. The hedged item is an interest-bearing asset measured at amortized cost. If prior to the adoption of Statement 133, the hedged asset's fair value had decreased by $9 to $86 and the swap's fair value had increased by $10, the transition adjustment for that pre-existing fair-value-type hedging relationship would be a net zero cumulative-effect-type adjustment of net income, representing the $10 gain from recognizing the swap as a $10 asset and the $10 loss from adjusting the hedged asset's carrying amount to $90 fair value. (Even though the difference between the hedged item's $86 fair value at the date of initial adoption and its $100 carrying amount was $14, the transition adjustment is limited to the extent of the offsetting $10 transition adjustment for the hedging swap.)

    

3. Example 3. The hedged item is an interest-bearing available-for-sale debt security measured at fair value with changes in fair value recognized in a separate component of OCI. Assume that the same fair value changes for the hedged item and the swap had occurred as in Example 1, with the changes in the swap's fair value also recognized in a separate component of OCI, pursuant to paragraph 115 of FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities. Upon adoption of Statement 133, both the $10 loss on the swap and the $4 unrealized holding gain on the hedged security would be reclassified into earnings as a cumulative-effect-type adjustment of both net income and accumulated OCI.

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.