2.5 Hedge Effectiveness | DART – Deloitte Accounting Research Tool (2024)

The dollar-offset method is the simplest assessment method to apply, but it is mostly used for retrospective effectiveness assessments that take into account data over the life of the hedging relationship. Under the dollar-offset method, an entity compares the change in the fair value of the derivative to the change in the fair value or cash flows of the hedged item that is attributable to changes in the designated risk.

Before the issuance of ASU 2017-12, entities had to measure and recognize the ineffectiveness of qualifying hedging relationships, so the use of the dollar-offset method was a bit more common than we expect it will be after the adoption of ASU 2017-12.

When using the dollar-offset method, an entity must choose to determine the dollar-offset on the basis of either (1) changes in the fair values (or cash flows) for the period under evaluation (a period-by-period approach) or (2) the cumulative changes that have occurred since the inception of the hedging relationship. The entity should note which approach it elects in the hedge designation documentation it prepares at hedge inception.

If an entity elects to apply a period-by-period approach, the evaluation period cannot exceed three months. Under such an approach, patterns of changes in the fair values (or cash flows) of the hedging instrument or the hedged item (or hedged transaction) that occurred in periods before the assessment period are not relevant.

For example, assume that an entity uses a derivative to hedge the fair value of a debt instrument. The table below illustrates the changes in the fair values of a derivative and a hedged item that are attributable to the hedged risk and the hedge effectiveness dollar-offset ratios under both a period-by-period assessment and a cumulative assessment. (The numbers in green indicate that the percent offset is within the acceptable range of 80 to 125 percent and the hedge is highly effective; the numbers in red mean that the percent offset is outside the acceptable range and the hedge is not highly effective.)

As illustrated above, if an entity applies the dollar-offset method to assess hedge effectiveness, its election to use the period-by-period approach instead of the cumulative approach may affect whether the hedging relationship is considered highly effective and can qualify for hedge accounting for the current assessment period. If the entity elected to use the period-by-period approach, the hedging relationship would not be highly effective for the quarters ended December 31, 20X0, and March 31, 20X1. If the entity elected to use the cumulative approach, the hedging relationship would not be highly effective only for the quarter ended March 31, 20X1.

Regression analysis is a technique for predicting the extent to which the change in one variable (the independent variable) will result in a change in another variable (the dependent variable). In assessing hedge effectiveness, an entity regresses the data related to the derivative and the hedged item against each other and evaluates the results of the regression analysis to determine whether the hedge is expected to be highly effective (prospective) or has been highly effective (retrospective), or both. For example, if an entity wants to use forward contracts to purchase crude oil to hedge forecasted jet fuel purchases, it might use historical price changes for jet fuel as the dependent variable and historical price changes for crude oil as the independent variable. In fact, some entities use regression analysis to determine their risk mitigation strategies regardless of whether they intend to apply hedge accounting.

As indicated in ASC 815-20-35-3, if, at the inception of a hedging relationship, an entity elects to use the same regression analysis approach for both prospective and retrospective effectiveness assessments, those regression analysis calculations should generally incorporate the same number of data points during the term of that hedging relationship. An entity should use enough data points, but not an inappropriately excessive number, to create a statistically sound analysis. Use of at least 30 data points is recommended. The entity also must periodically update its regression (or other statistical) analysis.

For a hedging relationship to be considered highly effective under a regression analysis, (1) R2 should be equal to or greater than 0.8, (2) the slope should be between negative 0.8 and negative 1.25,10 and (3) the F and t statistics should be evaluated at a 95 percent confidence level. These terms are defined below.

The table below discusses how to evaluate the validity of a linear regression.

Note that statistical problems with data (e.g., serial correlation or nonconstant variance of the error terms) may result in inaccurate estimates of t, F, and R2. When this occurs, consultation with statistical analysis experts is often advisable.

Entities should challenge all statistical model assumptions to ensure that they remain valid under current market and business conditions. Even if an entity does not elect the dollar-offset method as one of its methods of assessing hedge effectiveness, it still may need to be aware of the dollar-offset results; this is because a continued “failure” of that method (i.e., if the dollar offset indicates that the effectiveness of the hedging relationship was not in the 80–125 percent range) would call into question the reliability of the results produced by the statistical models. This periodic “reality check” is necessary because a statistical analysis, such as regression, inherently smooths historical data and may not appropriately reflect current market or business conditions. One way of challenging the validity of the model’s assumptions is to monitor the results of dollar offset. Another potential alternative would be to analyze the data points used as inputs in the regression analysis to identify whether the relationship between the most recent data points indicates that current market or business conditions are inconsistent with historical trends. In that case, the entity might then perform dollar-offset tests.

In accordance with the documentation requirements of ASC 815 and as an appropriate risk management practice, entities should establish policies and procedures that address the possibility that a statistical method, such as regression, could indicate that a hedging relationship is, or is expected to be, highly effective while a dollar-offset analysis (i.e., the determination of the actual offset) indicates that the relationship has not been highly effective. Such policies may dictate that falling below a certain level of offset, as indicated by a dollar-offset analysis, for a specified period will trigger reassessment by an appropriate level of management of the validity of the inputs used in the statistical model. That reassessment would need to take into account current market and business conditions. In some instances, consultation with statistical analysis experts may be advisable. An entity’s process for challenging the validity of a regression analysis should be well documented and consistently applied.

Generally speaking, regression analysis is the most common type of statistical analysis used by entities to determine the level of effectiveness of a hedging relationship. The dollar-offset method and regression analysis are both specifically mentioned in ASC 815, but broader reference is also made to “other statistical analysis.” Other analyses may involve simulations (e.g., Monte Carlo simulation), which may be necessary in scenarios in which there is not enough historical information available to provide a statistically valid regression analysis. For example, a new market may develop for a product or a derivative market may develop in connection with a specific underlying. In these cases, entities should consider consulting with relevant experts to develop the proper parameters for an analysis that would validate whether a hedging relationship is expected to be or has been highly effective.

Time value is a component of the fair value of derivative instruments, and it can be a source of ineffectiveness in a hedging relationship if there is no corresponding time value component in the hedged item’s fair value or expected cash flows. ASC 815 gives entities the option to exclude components of a derivative’s fair value (and the resulting changes in the components’ fair value) from the assessment of hedge effectiveness. Depending on the type of derivative used, different components of a derivative’s fair value may be excluded. The following table illustrates, by type of derivative, the alternatives available for excluded components:

An entity’s decision to exclude changes in the fair values of certain components of a derivative is part of its overall method of assessing hedge effectiveness. Since an entity should assess the effectiveness of similar hedges in a consistent manner (see Section 2.5.3), the entity should apply its decision to exclude certain components (or no components) to all similar hedging relationships.

As indicated in ASC 815-20-25-83A, the default method of accounting for an excluded component is the “systematic and rational amortization method.” An entity that prefers to recognize changes in the fair value of the excluded component in earnings as they occur should document that election. Similar hedges should be accounted for similarly.

Note that if an entity uses a purchased option that meets the definition of a derivative under ASC 815 in a hedge, it can amortize the time value of the option over its life by (1) designating the option as the hedging instrument in a qualifying hedging relationship and (2) electing to exclude the time value from the hedge effectiveness assessment.

The fair value of an option has two components: intrinsic value and time value. Intrinsic value is calculated by comparing the strike price (or strike rate) of the option with the market price (or market rate) of the underlying exposure. An option will have intrinsic value only if its strike price is favorable compared with the current market price. Time value is equal to the option’s fair value minus its intrinsic value. The premium paid to enter into an option generally represents the option’s time value since most options are issued at-the-money or out-of-the-money.

ASC 815 requires all derivatives to be recorded at fair value. Under ASC 815-20-25-82, when designating an option as a hedging instrument in a qualifying hedging relationship, an entity can exclude the option’s time value from the assessment of the hedging relationship’s effectiveness if the entity documents that it is using the change in the option’s intrinsic value to hedge the exposure. In such a case, the entity recognizes the initial value of the excluded time value component as an adjustment to earnings over the life of the hedging instrument (i.e., the option) by using a systematic and rational method. Any difference between the change in the fair value of the excluded component (i.e., the time value) and the amount recognized currently in earnings under the amortization approach is recorded in OCI (for net investment hedges, this amount should be in the CTA within OCI).

Alternatively, an entity may elect to record the changes in the fair value of the excluded time value component currently in earnings (albeit this election must be consistently applied to similar hedges). In accordance with ASC 815-20-25-129, the time value of an option can be an effective portion of the hedging relationship if the “terminal value” method is applied and certain criteria are met (see Sections 2.5.2.1.2.2 and 2.5.2.2.3).

Hedging with options is different from hedging with forwards or swaps because the payoff profile of an option is asymmetrical. Regardless of whether an entity hedges with a single option or a combination of options (like a collar), there is an unhedged element in the hedged transaction. If an entity is seeking to eliminate a risk exposure, it can enter into a forward contract; however, when it enters into an option, it is hedging only the underlying risk beyond a certain desired threshold (or thresholds). Accordingly, the hedge effectiveness assessment should not focus solely on the risk being hedged but also on the level of that risk.

For instance, in Example 2-20, Golden Age was only concerned about its exposure to rising gold prices, so it purchased an at-the-money option with a strike price of $1,320 per ounce of gold. If it performed an assessment of hedge effectiveness for scenarios in which the price of gold declined, the forecasted cash flows related to the purchase of gold would be decreasing (lowering the ultimate cost of sales), with no offsetting change in ultimate cash flows from the option (it would expire unexercised). Therefore, the hedge effectiveness assessment should actually focus on those scenarios in which the price of an ounce of gold increases above the option’s strike price (i.e., $1,320). Golden Age should document that it is hedging the risk of changes in its overall cash flows related to its purchases that are attributable to an increase in the price of gold above $1,320 per ounce. A hedging relationship that is documented in this manner would qualify for hedge accounting if the option is highly effective at offsetting the increased costs of the forecasted purchase of gold at prices above that threshold.

The type of hedge may dictate which components of the change in the option’s fair value the entity will designate as part of its hedge effectiveness assessment. For options that hedge a net investment in foreign operations, ASC 815-35-35-5 describes the “spot method” of assessing hedge effectiveness in which the only excludable component is the change in fair value that is attributable to changes in the difference between the forward exchange rates and the spot exchange rate. For options in a fair value hedging relationship, all of the time value components discussed in Section 2.5.2.1.2.1 may be excluded (i.e., time value, volatility value, theta, vega, and rho). However, for options in cash flow hedging relationships, there is another alternative, as described below.

In summary, the following methods of calculating intrinsic value are available for options in hedging relationships:

In addition, DIG Issue G20 introduced an assessment method (and a measurement method until ASU 2017-12 eliminated it) called the “terminal value” method for cash flow hedging strategies that involve certain options.

Under the terminal value method of assessing hedge effectiveness, an entity compares the ultimate settlement amount of the option with the change in the cash flows of the hedged transaction that is attributable to the hedged risk. This approach requires the entity to apply the hypothetical-derivative method of hedge effectiveness assessment (see Section 2.5.2.1.2.4) and even specifies the criteria for making a qualitative assessment (see Section 2.5.2.2.3). Understanding the theoretical underpinnings of DIG Issue G20 requires a bit of intellectual flexibility. An entity that applies the terminal value method establishes the “perfect” hypothetical derivative as an option whose terms match the hedged transaction, which allows the entity to essentially exclude the erosion of the initial time value from the hedge effectiveness assessment. Because the entity is able to focus on the option’s terminal value when assessing hedge effectiveness, it can “account” for this excluded component differently from other excluded components in hedging relationships. In fact, when the entity applies the terminal value method, it does not even acknowledge that time value is an excluded component. Accordingly, if the hedging relationship is highly effective, the entire change in the option’s fair value is recognized in OCI (including all of the initial time value) and reclassified into earnings when the hedged item affects earnings. Section 4.1.3 provides more details on the accounting for cash flow hedges that use the terminal value method.

In a qualifying fair value hedging relationship, an entity will remeasure the hedged item in each reporting period for changes in its fair value that are attributable to changes in the designated risk. There is substantial guidance on how to measure such changes in the context of accounting for qualifying fair value hedges (see the discussion of measurement principles for fair value hedges in Chapter 3). That guidance is equally relevant for determining the inputs for the hedged item that are used in a quantitative hedge effectiveness assessment model because the purpose of such an assessment for a fair value hedge is to determine whether the changes in the hedging instrument’s fair value are highly effective at offsetting the changes in the hedged item’s fair value that are attributable to changes in the designated risk. Accordingly, the method that an entity uses to calculate the changes in the hedged item’s fair value that are attributable to the changes in the designated risk in a quantitative effectiveness assessment should be consistent with the method that the entity uses to calculate such changes when remeasuring the hedged item in a qualifying fair value hedge. Furthermore, a change in the method of measuring such changes would also be considered a change in the method of assessing hedge effectiveness for those fair value hedges.

DIG Issue G7 introduced three general methods for determining the change in the hedged item in a cash flow hedge effectiveness assessment.

DIG Issue G7 specifically addressed how to assess and measure ineffectiveness in an interest rate swap that hedges a variable-rate debt instrument (including forecasted issuances of debt) for a hedging relationship that did not qualify for the shortcut method because (1) the terms of the swap did not perfectly match the terms of the debt, (2) the entity wanted to hedge the total change in cash flows (not just interest rate risk), or (3) the entity was hedging interest rate risk related to forecasted debt.

If, at the inception of a hedge, the fair value of the swap that was designated as the hedging instrument is zero or near zero, an entity may apply any of the three methods listed above. By contrast, if, at the inception of the hedge, the fair value of the swap is not at or near zero, an entity cannot apply the change-in-variable-cash-flows method.

ASC 815-20-25-3 and ASC 815-20-25-80 and 25-81 require an entity, at the time it designates a hedging relationship, to define and document the method it will use to assess a hedge’s effectiveness in achieving offsetting cash flows. The guidance also requires the entity to use that defined method consistently when evaluating effectiveness in subsequent periods. In addition, an entity should assess the effectiveness of similar hedges in a similar manner. If an entity uses different methods for similar hedges, it should justify such differences.

The three models are discussed in more detail later in this section, but the discussion below begins with the hypothetical-derivative method because it is the most broadly used, even outside of interest rate hedging. In fact, it is required in certain situations.

DIG Issue G7 extended the hypothetical derivative concept that previously existed in net investment hedging. Under that concept, an entity could assess effectiveness (and, until ASU 2017-12 was issued, measure ineffectiveness) by comparing the actual derivative in the hedging relationship with a derivative that would be deemed “perfectly effective.” Since the shortcut method requires the terms of an interest rate swap to perfectly match the relevant features of a debt instrument to qualify for an assumption of perfect effectiveness (see Section 2.5.2.2.1), the DIG believed that using those criteria as the yardstick for comparison when the actual swap used did not mirror the terms of the debt was an acceptable approach for assessing the effectiveness of a hedging relationship.

Under the hypothetical-derivative method, an entity uses the same discount rate to compare (1) the change in the fair value of the actual interest rate swap designated as the hedging instrument with (2) the change in the fair value of a hypothetical swap (one that would have qualified for the shortcut method). The hypothetical derivative should have the same critical terms as the floating rate asset or liability (hedged item) — including notional amount, repricing dates, index, caps, and floors — and have a fair value of zero at the inception of the hedging relationship. Thus, the hypothetical swap would be expected to perfectly offset the hedged cash flows. Under this method, the actual swap is recorded at fair value on the balance sheet, and an offsetting entry is recorded in OCI, as long as the hedging relationship is deemed highly effective. Amounts are reclassified out of AOCI when hedged transactions affect earnings.

In addition, the shortcut method criterion in ASC 815-20-25-104(e), under which an interest rate swap must mirror any prepayment features in the related debt, is not a required term of the hypothetical derivative under ASC 815-30-35-26 “[b]ecause the requirements of paragraph 815-20-25-104(e) were developed with an emphasis on fair value hedging relationships.” However, if the hedged debt is prepayable or is related to a future forecasted transaction, the entity still needs to assert that it is probable that those payments will either occur or be replaced by a sufficient amount of interest payments with the same key characteristics.

The hypothetical-derivative method may also be applied to hedges of interest payments for debt instruments that cannot be hedged under the shortcut method and could potentially achieve shortcut-like results. For example, the shortcut method cannot be applied to rollovers of fixed-rate debt or forecasted purchases or issuances of variable-rate debt, but the hypothetical-derivative method would be available.

The hypothetical-derivative method has also been applied in practice to many cash flow hedging relationships other than those involving interest rate swaps that hedge interest rate risk in debt instruments. Oftentimes, it is used as a proxy for determining the change in the hedged item’s estimated cash flows in cash flow hedges of forecasted transactions in commodities and foreign currencies. An entity that applies the hypothetical-derivative method by analogy to assess the effectiveness of non-interest-related hedges would construct the hypothetical “perfectly effective” derivative so that it satisfies all applicable conditions in ASC 815-20-25-84 and 25-84A for designation as the hedging derivative in a “critical-terms-match” relationship (see Section 2.5.2.2.2). This is because the conditions in ASC 815-30-35-25 and 35-26 are specific to interest rate swaps that hedge the interest payments of a recognized interest-bearing asset or liability, while ASC 815-20-25-84 and 25-84A describe scenarios in which a hedge of a forecasted transaction could be deemed perfectly effective.

Under the change-in-variable-cash-flows method, an entity compares the changes in the floating-rate leg of the swap that is designated as the hedging instrument with the changes in the floating-rate cash flows related to the hedged item. Both items would be discounted by using the relevant discount rate for valuing the swap. If the hedging relationship is deemed to be highly effective, the entire change in the swap’s fair value is recorded in OCI and will not affect the entity’s earnings until the hedged item affects earnings (which will trigger the reclassification out of AOCI).

Although it may seem counterintuitive, it is possible for a hedge to be deemed perfectly effective under the guidance in ASC 815-30-35-22 on the change-in-variable-cash-flows method even if the hedging relationship did not qualify for the application of the shortcut method. Before the issuance of ASU 2017-12, strategies that involved debt that was repriced on the basis of a nonbenchmark interest rate (e.g., prime rate) would not have qualified for application of the shortcut method even if the swap terms matched the hedged debt’s terms.

ASU 2017-12 eliminated the requirement that to be eligible for the shortcut method, the interest rate index of variable-rate debt and a hedging interest rate swap must be a benchmark interest rate; instead the ASU introduced the notion of a “contractually specified interest rate.” As a result, this hedging strategy may now qualify for the shortcut method.

As noted above, the change-in-variable-cash-flows method cannot be applied if, at the inception of the hedge, the fair value of the swap is not at or near zero.

The use of the change-in-fair-value method is fairly limited. As discussed above, most entities that cannot apply the shortcut method elect to apply the hypothetical-derivative method. Under the change-in-fair-value method, the entity would use the same discount rate to compare (1) the cumulative change in the fair value of the interest rate swap that is designated as the hedging instrument with (2) the present value of the cumulative change in expected variable future interest cash flows that are designated as the hedged transactions. The discount rate used to calculate the fair value of the interest rate swap should also be used to calculate the present value of the cumulative change in expected variable future interest cash flows that are designated as the hedged transactions. If the hedging relationship is deemed to be highly effective, the entire change in the swap’s fair value is recorded in OCI and will not affect the entity’s earnings until the hedged item affects earnings (which will trigger the reclassification out of AOCI).

ASC 815 provides detailed guidance on assessing the effectiveness of net investment hedges. If the hedging instrument is a foreign-currency-denominated nonderivative instrument, the spot method is the only method that can be used to assess the effectiveness of the hedging relationship. By contrast, if the hedging instrument is a derivative instrument, the entity may choose between the “spot method” and the “forward method.” Generally speaking, the entity’s choice is largely based on the financial reporting differences between the methods, which we explain in further detail in Section 5.4.2.1. However, an entity must use the same method of assessing effectiveness for all of its net investment hedges that involve derivative instruments. A change in methods can only be made if the new method is considered an improved method of assessing hedge effectiveness (see Section 2.5.4).

Note that regardless of whether the hedging instruments is a derivate or nonderivative, if an entity elects to assess and measure the results of the net investment hedge on an after-tax basis (see Section 5.1.3), the assessment should reflect the after-tax notional amounts of the hedging instrument.

When assessing the effectiveness of a net investment hedge, an entity may be able to assume that the hedge is perfectly effective if certain conditions are satisfied (see Section 2.5.2.2.4); in such a case, the entity would make a qualitative assessment. If the conditions for a qualitative assessment are not met for the net investment hedging relationship, the entity should refer to the detailed quantitative assessment guidance in ASC 815-35. The mechanics of that quantitative assessment will vary, depending on (1) whether the hedging instrument is a derivative or a foreign-currency-denominated nonderivative instrument and (2) for derivatives, whether the spot method or the forward method is applied.

The fair value of a derivative is affected by the credit risk of both parties to the derivative contract (i.e., the entity and the counterparty to the derivative). The impact on fair value can be somewhat mitigated by collateral arrangements or master netting arrangements (for multiple derivatives between the same counterparties), but changes in credit risk are not typically eliminated by such arrangements. Changes in a hedging derivative’s fair value that are attributable to changes in credit risk are not generally offset by changes in the fair value (or cash flows) of the hedged item, since the hedged item may not have any credit risk (e.g., a nonfinancial asset) or it may have a different credit risk (e.g., debt only has credit risk related to the issuer).

The impact of changes in credit risk on the hedge effectiveness assessment depends on the type of hedging relationship and the method of assessment chosen by the entity. The table below briefly summarizes the impacts of credit risk changes. We divide the discussion between default risk (i.e., whether it is no longer probable that both parties will perform under the derivative) and general credit risk (changes in the credit spreads of either party to the arrangement that do not rise to the level of default risk). A more detailed discussion follows the table.

The first criterion that must be met for an entity to apply the shortcut method is that the notional amount of an interest rate swap designated as the hedging instrument must match the amount of the debt being hedged. If a proportion of a swap is designated as the hedging instrument in a hedging relationship, the designated notional amount of that swap needs to match the portion of the hedged asset or liability. If multiple swaps are designated as the hedging instrument in a single hedging relationship, the combined notional amount of the swaps needs to match the hedged item. Also, if multiple swaps are used in one hedging relationship, all of the swaps must have the same terms so that they all meet the other conditions for application of the shortcut method (e.g., the net settlements are calculated in the same manner and the maturity dates match).

If the hedged item is (1) only a proportion of fixed-rate debt or (2) interest payments related to a proportion of variable-rate debt, the notional amount of the swap must match the amount of the hedged debt. Also, if the hedged item is a portfolio of fixed-rate debt or interest payments on a portfolio of variable-rate debt, the notional amount of the swap must match the principal amount of the debt portfolio. When such a portfolio is designated in a hedging relationship that is eligible for the shortcut method, each of the debt instruments in the portfolio must individually qualify to be the hedged item. Consequently, all of the other criteria for application of the shortcut method must be evaluated against each individual item in the portfolio (see ASC 815-20-25-116 and 25-117 for further discussion).

As discussed in Section 2.5.2.1.4, the designation of an off-market derivative in a hedging relationship results in a source of ineffectiveness related to the embedded financing component of that derivative. Thus, since the shortcut method is based on an assumption of perfect hedge effectiveness, it is only available for at-market swaps, with one exception for prepayable debt in certain circ*mstances. That is, if the hedged item is prepayable debt that was issued at a premium or discount on the basis of the value of the prepayment option, the swap’s fair value upon the inception of the hedge must be equal to and offset the fair value of the premium or discount on the debt related to that prepayment option. The prepayment option in most debt instruments is paid for by adjusting the coupons on the debt. For example, debt that may be called by the issuer carries a higher interest rate than debt that is not prepayable. Conversely, debt that is puttable by the investor carries a lower interest rate than debt that is not puttable. However, if an entity issued callable debt at a discount instead of structuring it to have a higher coupon rate, the fair value of the hedged interest rate swap should match that of the debt discount and that swap should be a liability for the issuer. In other words, the combination of the fair value of the swap and the proceeds from the debt (ignoring debt issuance costs with third parties) should equal the par amount of the debt if the discount or premium is solely attributable to the fair value of the prepayment option.

A swap is considered to be at-market as long as it is entered into for no consideration, exclusive of commissions and other transaction costs (see ASC 820-10-35-9B). If there is an initial fair value because there are differences in the bid-ask spread or the transactions occurred in markets that are not the entity’s primary market, the swap is not automatically ineligible for application of the shortcut method.

If the debt is prepayable during the term of the hedging relationship, the swap must have mirrored prepayment terms, as defined in ASC 815-20-25-104(e)(2), to qualify for application of the shortcut method. Because this criterion is applicable to debt that is prepayable during the hedging relationship, questions have arisen about the types of terms that would cause a debt instrument to be considered prepayable in the application of the shortcut method. Consequently, that subject was addressed in DIG Issue E6, which is codified in ASC 815-20-25-112 through 25-115 and the examples in ASC 815-20-55-75 through 55-78.

In addition, the definition of “prepayable” in the context of the shortcut method differs from the guidance in the ASC master glossary, which defines prepayable as “[a]ble to be settled by either party before its scheduled maturity.”

DIG Issue E6 stated that the definition of prepayable that is used in other areas of derivative and hedge accounting was too broad to incorporate into the criteria for the shortcut method. This is because a requirement that interest rate swaps mirror many typical prepayment options that may have little to no economic substance or would only be triggered in remote scenarios would be impractical to apply in practice. Accordingly, DIG Issue E6 carved out prepayment options that would have no theoretical economic value, which resulted in the guidance in ASC 815-20-25-112 and ASC 815-20-25-114. The following types of prepayment options are excluded from the definition of prepayable:

Finally, DIG Issue E6 established that contingent acceleration clauses that could be exercised by either the debtor or the creditor do not need to be mirrored in the interest rate swap if those prepayment options were triggered by events whose occurrence was not probable, depending on the nature of the triggering event. The following table highlights different types of triggering events that do and do not need to be mirrored in the interest rate swap:

DIG Issue E6 provided examples that illustrate whether certain terms in a debt instrument make the instrument prepayable in the assessment of eligibility for the shortcut method. These examples are codified in ASC 815-20-55-75 through 55-78. The table below summarizes the examples and conclusions in ASC 815-20-55-75.

When an entity designates a partial-term hedge (either a fair value or cash flow hedge), its analysis of whether the debt is prepayable in the assessment of shortcut method eligibility should take into account only those terms that are operable during the designated term of the hedging relationship. For example, assume that the entity wants to hedge a 10-year fixed-rate debt instrument that (1) is callable by the issuer at any time after the five-year anniversary and (2) has no other prepayment features. If the entity designates as the hedging instrument an interest rate swap that matures in five years and identifies the hedged item as the first five years of interest payments (see Section 2.2.2.1.1.2), the debt would not be considered prepayable in the analysis of shortcut method eligibility. This is because the call option cannot be exercised during the designated term of the hedge. The analysis of prepayment features in the debt should cover the entire period represented by the hedged interest payments.

In addition, the entity must be the writer of one option and the holder (purchaser) of the other option.

The shortcut method was developed to reduce the complexity of applying the hedge accounting model when entities want to use plain-vanilla interest rate swaps to hedge typical debt instruments for interest rate risk. In a typical interest rate swap, the settlement formula does not change during the life of the swap. In other words, the swap has the same indexed rate with a fixed (or no) basis adjustment on its variable leg and the same fixed rate on its fixed leg throughout its life. However, if the swap agreement calls for a change in the payment terms from one period to the next, the change in terms (i.e., moving partial payments from one period to the other) would essentially represent an embedded financing component in the swap, which would be inconsistent with the notion that a hedging relationship is perfectly effective and that no hedge effectiveness assessments are required. Therefore, a hedging relationship with a swap whose payment terms change during the swap term would not qualify for application of the shortcut method.

The existence of a stub period and a stub rate would not violate the criterion in ASC 815-20-25-104(d) as long as the stub rate is the variable rate that corresponds to the length of the stub period. For example, assume that (1) an entity issues fixed-rate debt with a term of 10 years and three months, (2) interest is due semiannually through the first 10 years, and (3) at maturity, the issuer must pay three months of interest and the principal amount. If the entity wants to hedge its interest rate risk for the entire term of the debt and apply the shortcut method, it should use a swap that is repriced and settled on each payment date. In such a case, all of the semiannual periods covered by the swap would be repriced on the basis of six-month benchmark rates; however, the repricing for the final stub period should be based on the three-month benchmark rates (the variable rate that corresponds to the length of the final stub period).

ASC 815-20-25-104(g) is commonly referred to as a “catch-all” criterion that prevents any hedges from qualifying for the shortcut method other than plain-vanilla hedging relationships in which “typical” interest rate swaps hedge the interest rate risk of “typical” debt. This criterion can be difficult to interpret because what is “typical” in accordance with ASC 815-20-25-104(g)(1) can change over time as market conventions evolve. Note that the shortcut method (1) allows an entity to assume that a hedging relationship is perfectly effective without having to perform any quantitative assessments of hedge effectiveness and (2) simplifies financial reporting. Consequently, in the evaluation of the criteria for the shortcut method, the determination of whether the catch-all provision has been satisfied should not be viewed as a simple check-the-box process. If either the swap or the debt is highly structured, the hedging relationship is not likely to meet this condition and therefore would not qualify for the shortcut method.

An interest rate swap and a debt instrument with different maturities would not be expected to react to changes in interest rates similarly, which would invalidate an assumption of perfect hedge effectiveness. Therefore, the expiration date of a swap must match the actual maturity date of the debt unless a partial-term hedging strategy is employed.

Before the issuance of ASU 2017-12, an entity could not apply the shortcut method to a partial-term fair value hedge. In fact, such a hedge was unlikely to be eligible for hedge accounting because of the potentially significant ineffectiveness. However, under ASC 815-25-35-13B, which was added by ASU 2017-12, if an entity hedges selected cash flows of an existing debt instrument, it can measure the change in fair value that is attributable to changes in interest rates by using an assumed maturity that occurs on the date on which the last hedged cash flow is due and payable. In addition, ASC 815-20-25-105(a) was amended to explicitly allow a partial-term fair value hedge to qualify for the shortcut method, provided that the other conditions for the shortcut method are also met. See further discussion of partial-term hedges in Section 3.2.1.1. Note that partial-term cash flow hedges already qualified for the shortcut method before the issuance of ASU 2017-12.

In addition, for an entity to assume that a hedge is perfectly effective, the terms of the variable leg of the swap must (1) match the designated benchmark interest rate, (2) not incorporate caps or floors, and (3)be repriced often enough that the rate at any given time is close to a market rate. In practice, this means that the swap must be repriced at least every six months. Note that the timing of the repricing and settlements of the swap does not need to match the timing of coupon payments on the fixed-rate debt.

It is not necessary for an entity to hedge all of the interest payments on variable-rate debt to qualify for the shortcut method; however, an entity cannot use a forward-starting swap in a qualifying shortcut method hedge (see Example 2-32).

The shortcut method allows an entity to qualitatively assess hedge effectiveness without recognizing ineffectiveness in the income statement. If a cash flow hedge is highly effective, all changes in fair value are already initially recorded in OCI. While ineffectiveness is not separately tracked and reported for a highly effective fair value hedge (see Chapter 3 for further discussion), any differences between the changes in the derivative’s fair value and changes in the hedged item’s fair value that are attributable to changes in the designated risk will affect the income statement. However, if the shortcut method is applied, entities may recognize an adjustment to the basis of the hedged debt that is equal to the changes in the derivative’s fair value. In that sense, the shortcut method is a simplified way of measuring changes in the debt’s fair value that are attributable to changes in the designated benchmark interest rate.

A hedge of a debt instrument’s interest rate risk already excludes credit risk from the hedging relationship, which means that changes in the debt issuer’s creditworthiness are not directly considered. However, under the cash flow hedging model, it must be probable that the hedged transaction will occur. Accordingly, for variable-rate debt to qualify for the application of hedge accounting, it must be probable that the interest payments (i.e., the hedged item) will occur; therefore, the hedging entity must be able to continually assert that it is probable that the hedged interest payments will be made. If the entity is hedging its own debt, it must assess its own performance risk. If the entity is hedging an asset, it must assess whether it is probable that the issuer or borrower will continue to make the payments being hedged. The entity must discontinue the use of hedge accounting, even under the shortcut method, if the entity concludes that it is no longer probable that hedged payments will be made on the debt instrument (see Section 4.1.5 for further discussion of discontinued cash flow hedges).

Although the creditworthiness of both parties to the derivative contract must also be monitored when the shortcut method is applied, the only real purpose of such monitoring is to assess the probability of default. ASC 815-20-25-111 acknowledges that “[c]omparable credit risk at inception is not a condition for assuming perfect effectiveness even though actually achieving perfect offset would require that the same discount rate be used to determine the fair value of the swap and of the hedged item or hedged transaction.” However, ASC 815-20-25-103 does note that “an entity shall consider the likelihood of the counterparty’s compliance with the contractual terms of the hedging derivative that require the counterparty to make payments to the entity.” While an entity is only explicitly required to consider the performance risk of the counterparty to the derivative, if either party to the hedging interest rate swap experiences a significant decline in its creditworthiness, that party’s ability to comply with the contractual provisions of the arrangement may be called into question. Consequently, the entity may be unable to assert that the hedging relationship is expected to be highly effective (i.e., because it is questionable whether either party to the arrangement will be able to fulfill its contractual obligations under the arrangement).

If there is a deterioration in the creditworthiness of either the entity itself or a counterparty, the impact on a hedging relationship that qualifies for the shortcut method depends on (1) the severity of the deterioration and (2) the likelihood of performance by both parties to the derivative. An expectation of “offset” is a prerequisite for all hedging relationships, and the effects of credit are a required element of that consideration.

Even if there is a deterioration in the creditworthiness of one of the parties to the interest rate swap, an entity may still be able to conclude that (1) it is probable that each counterparty will perform in accordance with the contractual provisions of the arrangement and (2) the hedging relationship continues to satisfy all of the requirements of the shortcut method. ASC 815 is clear that in such a case, the changes in creditworthiness that affect the fair value of the interest rate swap will not be recognized in income as hedge ineffectiveness.

ASC 815-20-35-18 addresses considerations of creditworthiness in the context of hedge effectiveness. Note that it does not change the overall guidance on measuring the fair value of the hedging derivative, such as the requirement that the change in the hedging instrument’s fair value include adjustments for nonperformance risk (as the term is defined in ASC 820).

According to the SEC staff, when an entity is assessing the materiality of an error that resulted from inappropriately applying the shortcut method, it is not acceptable to quantify the error as the amount of ineffectiveness that would have been recognized under a long-haul method unless the hedging relationship also meets all of the other criteria for long-haul hedge accounting in ASC 815 (e.g., prospective and retrospective testing of hedge effectiveness). If the hedging relationship had not complied with the long-haul criteria since the hedge’s inception, the error to be evaluated would be the difference between (1) the recorded amounts that resulted from applying the shortcut method and (2)the amounts that would have been reported if hedge accounting had not been used (i.e., if the derivative had been marked to fair value through earnings since inception). When evaluating an error related to fair value hedges, the entity must also consider the amount of the reversal of the basis adjustments that were made to the hedged item.

The shortcut method provides an exception to the overriding principle that an entity can only apply hedge accounting if it can (1) quantitatively establish, at inception, an expectation that the hedging relationship will be highly effective and then (2) continuously reassess the effectiveness both prospectively and retrospectively on an ongoing basis. If the rigorous conditions for eligibility are met and the shortcut method is applied, the effectiveness assessment will be qualitative and the financial reporting will also be simplified.

Consequently, the Board amended ASC 815 to permit entities to use a backup method of quantitatively assessing the effectiveness of a hedging relationship in cases in which application of the shortcut method was not or is no longer appropriate.

In light of these scenarios, it would be prudent for an entity that applies the shortcut method to specify a backup method for quantitatively assessing the effectiveness of the hedging relationship as part of the hedge designation documentation it prepares at the inception of the relationship. By providing such documentation, an entity would avoid scenario B above, in which the error correction guidance in ASC 250 must be applied if the entity determines that use of the shortcut method was not or no longer is appropriate regardless of whether the hedging relationship was highly effective.