No. 2014-03
30 January 2014
Technical Line
FASB — final guidance
Certain private companies can now
use simplified hedge accounting
In this issue:
Overview ....................................... 1
Scope ............................................ 2
Requirements and application
of the approach ........................ 2
Disclosure, transition and
other considerations ................. 6
Appendix: Example of formal
hedge documentation ............... 8
What you need to know
• The FASB has issued final guidance that makes it easier for certain private companies to
qualify for hedge accounting for interest rate swaps used to convert variable-rate debt
into fixed-rate debt.
• An eligible private company can assume that a hedging relationship is perfectly effective
if the swap and the debt meet certain conditions.
• The guidance permits companies to recognize swaps at their settlement value rather
than their fair value and to complete formal hedge documentation up until the date on
which the company’s annual financial statements are available to be issued.
• The final guidance is effective for annual periods beginning after 15 December 2014.
Early adoption is permitted, and calendar year-end companies that haven’t yet made
their 2013 financial statements available to be issued can use it for qualifying swaps in
effect in 2013.
Overview
The Financial Accounting Standards Board (FASB or Board) has issued final guidance1 that
makes it easier for certain private companies to qualify for hedge accounting for interest rate
swaps used to economically convert variable-rate debt to fixed-rate debt.
Under this simplified hedge accounting approach, an eligible private company can assume
that a hedging relationship is perfectly effective if the swap and the debt meet certain
qualitative conditions. This allows a company to use hedge accounting to reduce earnings
volatility without having to perform periodic calculations to measure hedge ineffectiveness.
EY AccountingLink | www.ey.com/us/accountinglink
The new approach also allows companies to record swaps at their “settlement value,” rather
than at fair value. Settlement value is easier to calculate than fair value because it doesn’t
require an adjustment for nonperformance risk (i.e., risk that an entity or its counterparty will
not perform on their respective obligations).
Companies can use the new approach to hedge interest rate indexes such as the prime rate
that cannot otherwise be designated as benchmark interest rates for hedging in US GAAP.
The new approach provides flexibility on hedge documentation as well. Eligible private
companies have until the date on which their annual financial statements are available to be
issued to complete their hedge documentation. Other hedge accounting approaches require
that documentation be completed at inception of the hedging relationship.
The guidance was developed by the Private Company Council (PCC), which makes
recommendations to the FASB about how to simplify private company accounting while still
providing users of the financial statements with the information they need. The PCC took up
the hedge accounting issue because stakeholders said many private companies lack the
expertise to comply with the hedge accounting requirements of US GAAP,2 due to limited
resources and the complexity of the guidance.
This publication discusses which companies are eligible to use the new approach, the
conditions that have to be met, the application of the approach to common products such as
“you-pick-’em” debt and forward-starting swaps, and the disclosure requirements. Other
provisions of the hedge accounting guidance in Accounting Standards Codification (ASC) 815
continue to apply to a company that uses the new approach. The appendix to this publication
includes an example of how a company might document a hedge under the new approach.
The new approach
provides a practical
expedient for
Scope
eligible companies The simplified hedge accounting approach can be elected by companies that are not (1) public
business entities, as now defined in the Master Glossary of the Codification, or (2) financial
to apply hedge
institutions, as described in ASC 942-320-50-1. The approach also cannot be applied by
employee benefit plans within the scope of ASC 960 through 965 or not-for-profit entities.
accounting.
Before applying the simplified hedge accounting approach, a company should make sure it is
not a public business entity.3 The new definition, which the FASB issued recently, is broader
than previous definitions of a public entity. As a result, some private companies will be
considered public business entities and will not be eligible to apply this standard.
Only swaps that a company uses to economically convert forecasted interest payments or
forecasted issuance of variable-rate debt to fixed-rate debt qualify for the simplified
approach. This approach cannot be used for hedges of floating-rate assets or the forecasted
issuance of fixed-rate debt.
The Board considered allowing public entities to use this approach but decided against doing
so because it plans to consider ways to simplify hedge accounting for all entities as part of its
broader project on hedging.
Requirements and application of the approach
Companies can apply the simplified hedge accounting approach on a swap-by-swap basis to a
receive-variable, pay-fixed interest rate swap that meets all of the following conditions:
•
The variable rate on the swap and the variable-rate borrowing are based on the same
index and reset period (e.g., one-month London Interbank Offered Rate or LIBOR). In
complying with this condition, an entity is not limited to benchmark interest rates
described in ASC 815-20-25-6A.
2 | Technical Line Certain private companies can now use simplified hedge accounting 30 January 2014
EY AccountingLink | www.ey.com/us/accountinglink
•
The terms of the swap are typical (i.e., the swap is what is generally considered to be a
“plain-vanilla” swap), and there is no floor or cap on the variable interest rate of the swap
unless the borrowing has a comparable floor or cap.
•
The repricing and settlement dates for the swap and the borrowing match or differ by no
more than a few days.
•
The swap’s fair value at inception (that is, at the time the derivative was executed to
hedge the interest rate risk of the borrowing) is at or near zero.
•
The notional amount of the swap matches the principal amount of the borrowing being
hedged. The amount of the borrowing being hedged may be less than the total principal
amount of the borrowing.
•
All interest payments on the variable-rate borrowing during the term of the swap (or the
effective term of the swap underlying a forward-starting swap) are designated as hedged
whether in total or in proportion to the principal amount of the borrowing being hedged.
If all of these conditions are met, a company may assume that there is no ineffectiveness and
may recognize all of the changes in either the fair value or settlement value of the derivative
in accumulated other comprehensive income (AOCI). The concept of settlement value is
described later.
A company that elects to apply the simplified hedge accounting approach will have to follow all
of ASC 815’s other requirements, including determining in each period that it is probable that
the forecasted cash flows (i.e., interest payments) will occur and assessing whether there have
been adverse developments regarding the risk of counterparty default. We understand that,
consistent with the requirements of ASC 815, companies generally should use the simplified
hedge accounting approach for all eligible swaps in similar relationships (e.g., eligible
prime-based swaps) for which they elect hedge accounting.
If any of the conditions cease to be met or the relationship otherwise ceases to qualify for
hedge accounting, the amounts in AOCI would be reclassified to earnings in accordance with
ASC 815-30-40-1 through 40-6. For example, if variable-rate debt is prepaid and is not to be
replaced with other debt, the amount in AOCI would be reclassified to earnings immediately.
If the interest rate swap is terminated and the debt remains, however, the amounts in AOCI
would be reclassified into earnings in the period or periods during which interest payments
will be made.
How we see it
Unlike other hedge accounting approaches described in US GAAP, the new approach
allows eligible private companies to designate non-benchmark interest rate indexes
(e.g., the prime rate, SIFMA) for interest rate hedges. The new approach requires the
repricing dates for the variable-rate debt and the swap to differ by no more than a “few
days.” While the FASB has not provided additional guidance, we believe that as many as
three to seven days would generally be considered appropriate.
Future refinancing
The simplified hedge accounting approach would continue to apply if debt that is refinanced
(as variable-rate bank loans typically are) continues to meet all of the applicable conditions.
Consider an eligible private company that enters into a five-year variable-rate bank loan
indexed to three-month LIBOR, then hedges the forecasted LIBOR payments using a five-year
receive-variable, pay-fixed interest rate swap and determines that the hedging relationship
qualifies for the simplified hedge accounting approach.
3 | Technical Line Certain private companies can now use simplified hedge accounting 30 January 2014
EY AccountingLink | www.ey.com/us/accountinglink
If the company refinances the loan in year three and enters into another five-year variable-rate
bank loan that is also indexed to three-month LIBOR and the reset dates continue to match
those of the interest rate swap, we understand that the company could continue to apply the
simplified hedge accounting approach for the remaining term of the original swap. However, if
the hedge no longer meets the required conditions as a result of the refinancing, the company
would not be able to prospectively apply the simplified hedge accounting approach and would
have to dedesignate the hedging relationship.
Hedge documentation requirement
The guidance allows private companies to complete their formal hedge documentation up until
the date on which their first annual financial statements after hedge inception are available to
be issued.4 This is a significant change. The other hedge accounting approaches in ASC 815
require hedge documentation to be completed at the inception of the hedge relationship.
For example, this means that a company with a calendar year-end that entered into a
qualifying hedging relationship on 1 January 2014 but doesn’t make its financial statements
available to be issued until 30 April 2015 would have until 30 April 2015 to complete its
hedge documentation. While the Board acknowledged that management would have time to
look back on the performance of the derivative before deciding whether to apply hedge
accounting, it said private companies need this flexibility because most do not consider
accounting requirements until year-end.
The approach
can be applied to
forward-starting
swaps.
How we see it
A company should carefully review the terms of the interest rate swap and the variable-rate
debt to make sure the swap qualifies for the new approach. If a company doesn’t complete
the formal documentation at inception of the hedge because it expects to use the simplified
method but later determines that the swap doesn’t meet the required conditions, it would
not be able to apply another hedge accounting method retroactively. Moreover, because
the derivative will not have a fair value of zero, additional ineffectiveness may need to be
recognized, or the swap may fail to qualify for hedge accounting prospectively.
Application to ‘you-pick-’em’ debt
Variable-rate debt that allows borrowers to pick the interest rate index used in resets
(e.g., LIBOR, the prime rate) and/or the frequency at which the rate is reset (e.g., monthly,
quarterly) may qualify for the simplified hedge accounting approach, if both the interest rate
index and the reset period match those of the interest rate swap at the swap’s inception. This
debt is commonly called “you-pick-’em” debt.
The new approach simplifies the documentation required for hedges involving this type of debt
and gives companies that use it more flexibility than other approaches. A company that applies
the simplified hedge accounting approach has to specify in its formal hedge documentation
both the index it is electing to hedge and the reset frequency and state that those terms match
the terms of the interest rate swap. Other approaches require that the documentation also
include an assertion that the company won’t exercise its right to change those terms.
Because the terms of the swap typically don’t provide the same flexibility (e.g., selecting a
different index and/or frequency), changing the index or rate frequency on the variable-rate
debt would generally result in the terms of the interest rate swap and the variable-rate debt no
longer matching. As a result, the hedge would no longer qualify for the simplified approach.
We understand that, consistent with the cash flow hedge provisions of ASC 815, a company in
this situation would have to measure and record ineffectiveness.
4 | Technical Line Certain private companies can now use simplified hedge accounting 30 January 2014
EY AccountingLink | www.ey.com/us/accountinglink
How we see it
A company should keep in mind that, if it repeatedly determines that the terms of hedged
forecasted interest payments no longer meet the criteria to apply the simplified approach,
this pattern would call into question both the company’s ability to accurately predict
forecasted interest payments and the propriety of using the simplified hedge accounting
approach in the future. This result would be similar to what happens when entities miss
cash flow forecasts under ASC 815-30-40-5.
Application to forward-starting swaps
While the FASB initially proposed excluding forward-starting swaps, the final guidance applies
to forward-starting receive-variable, pay-fixed swaps used to hedge future interest payments
associated with variable-rate debt (e.g., payments in years three through five of five-year
debt for a swap entered into at the beginning of year one).
Given that the repricing and settlement dates for the swap and the borrowing have to either
match or differ by no more than a few days, a company that is trying to hedge debt it plans to
issue in the future would have to be fairly certain of the timing to qualify for the simplified
hedge accounting approach. If the reset date on which the variable-rate debt is issued differs
by more than a “few days” from the reset dates of the forward-starting swap, the company
would no longer qualify for the simplified hedge accounting approach.
As noted above, if a swap no longer qualifies for the simplified hedge accounting approach, a
company would have to dedesignate and measure and record ineffectiveness in accordance
with the general cash flow hedge provisions of ASC 815.
How we see it
Companies that want to hedge debt they plan to issue in the future may not want to use
the simplified hedging approach if they are unsure of the timing of the issuance and they
are hedging benchmark interest risk. Other hedge accounting approaches available under
ASC 815 allow companies to continue to qualify for hedge accounting if the timing
changes and the hedge is still highly effective. The simplified hedge accounting approach
does not provide this flexibility.
Settlement value
To address concerns about the cost and complexity of estimating fair value, the new guidance
gives companies the option of measuring the designated swap at settlement value. The PCC
and the Board have said they believe the primary difference between settlement value and
fair value is that nonperformance risk is not considered in determining settlement value.
In this context, nonperformance risk relates to the credit risk of both the reporting entity and
the counterparty to the swap. The standard notes that an acceptable approach for estimating
a swap’s settlement value is to perform a present value calculation of the swap’s remaining
estimated cash flows using a valuation technique that is not adjusted for nonperformance
risk. If the hedging relationship ceases to qualify for hedge accounting, the swap would have
to be measured at fair value prospectively. We understand that companies can elect to use
settlement value on a swap-by-swap basis as long as the swap is designated and qualifies as a
hedge under the simplified approach.
5 | Technical Line Certain private companies can now use simplified hedge accounting 30 January 2014
EY AccountingLink | www.ey.com/us/accountinglink
Disclosure, transition and other considerations
Disclosures
The disclosure requirements in ASC 815 and ASC 8205 apply to swaps accounted for under
the new approach.
However, a company that elects to measure a swap at settlement value would substitute
amounts recorded at settlement value for fair value where applicable, and amounts disclosed
at settlement value should be disclosed separately from amounts disclosed at fair value. The
simplified hedge accounting approach also gives certain companies relief from the fair value
disclosure requirements under ASC 825.6 The guidance states explicitly that having an
interest rate swap that is accounted for under the new approach wouldn’t trigger these
disclosure requirements.
The standard also amended ASC 825 to exclude receive-variable, pay-fixed interest rate
swaps for which the simplified hedge accounting approach is applied from the requirement to
disclose fair value information about the instrument. As such, a private company that elects
to measure a swap at settlement value on the statement of financial position is not required to
separately disclose the swap’s fair value.
Transition
Companies can
choose to measure
swaps at settlement
value rather than
fair value.
The simplified hedge accounting approach is effective for the first annual period beginning after
15 December 2014 and interim periods within annual periods beginning after 15 December
2015. Early adoption is permitted. If a company chooses to early adopt the new guidance, it can
apply the simplified hedge accounting approach to eligible interest rate swaps that existed
during the year the new guidance is initially applied. For example, if a company had swaps
that existed at any point during 2013, the company can early adopt this standard and elect
to apply the simplified hedge accounting approach for these swaps.
For these existing swaps, the criterion that the swap’s fair value at inception is at or near zero
does not need to be considered as long as the swap’s fair value was at or near zero at the time
the swap was entered into.
Companies can apply either a modified retrospective approach or a full retrospective
approach upon adoption.
Other considerations
The FASB’s private company decision-making framework notes that the accounting
alternatives developed by the PCC may not be suitable for private companies that plan to go
public in the near term. If the FASB and the Securities and Exchange Commission do not
provide any transition guidance for this situation, companies that become public business
entities after electing to apply the simplified hedge accounting approach would have to
retrospectively apply the public entity accounting and reporting requirements to all prior
periods presented.
6 | Technical Line Certain private companies can now use simplified hedge accounting 30 January 2014
EY AccountingLink | www.ey.com/us/accountinglink
Endnotes:
_______________________
1
2
3
4
5
6
EY | Assurance | Tax | Transactions | Advisory
© 2014 Ernst & Young LLP.
All Rights Reserved.
SCORE No. BB2693
ey.com/us/accountinglink
Accounting Standards Update (ASU) 2014-03, Accounting for Certain Receive-Variable, Pay-Fixed Interest Rate
Swaps — Simplified Hedge Accounting Approach.
ASC 815, Derivatives and Hedging.
ASU 2013-12, Definition of a Public Business Entity, defines a public business entity as a business entity meeting
any one of the criteria below. Neither a not-for-profit entity nor an employee benefit plan is a business entity.
a. It is required by the U.S. Securities and Exchange Commission (SEC) to file or furnish financial statements,
or does file or furnish financial statements (including voluntary filers), with the SEC (including other entities
whose financial statements or financial information are required to be or are included in a filing).
b. It is required by the Securities Exchange Act of 1934 (the Act), as amended, or rules or regulations
promulgated under the Act, to file or furnish financial statements with a regulatory agency other than the SEC.
c. It is required to file or furnish financial statements with a foreign or domestic regulatory agency in
preparation for the sale of or for purposes of issuing securities that are not subject to contractual
restrictions on transfer.
d. It has issued, or is a conduit bond obligor for, securities that are traded, listed, or quoted on an exchange or
an over-the-counter market.
e. It has one or more securities that are not subject to contractual restrictions on transfer, and it is required by
law, contract, or regulation to prepare U.S. GAAP financial statements (including footnotes) and make them
publicly available on a periodic basis (for example, interim or annual periods). An entity must meet both of
these conditions to meet this criterion.
An entity may meet the definition of a public business entity solely because its financial statements or financial
information is included in another entity’s filing with the SEC. In that case, the entity is only a public business
entity for purposes of financial statements that are filed or furnished with the SEC.
Financial statements are considered available to be issued when they are complete in a form and format that
complies with US GAAP and all approvals necessary for issuance have been obtained, for example, from
management, the board of directors and/or significant shareholders. The process involved in creating and
distributing the financial statements will vary depending on an entity’s management and corporate governance
structure as well as statutory and regulatory requirements.
ASC 820, Fair Value Measurement.
ASC 825, Financial Instruments.
About EY
EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the
capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing,
we play a critical role in building a better working world for our people, for our clients and for our communities.
EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal
entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization,
please visit ey.com.
Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited operating in the US.
This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice.
7 | Technical Line Certain private companies can now use simplified hedge accounting 30 January 2014
EY AccountingLink | www.ey.com/us/accountinglink
Appendix: Example of formal hedge documentation
On 1 January 20X1, private company A enters into a borrowing arrangement with Bank B for a 10-year, $10,000,000
variable-rate note payable, due 20Y1, at three-month LIBOR plus 1%. Interest payment dates and interest rate reset dates
occur on 1 January, 1 April, 1 July and 1 October until maturity. The principal is due at maturity. Also on 1 January 20X1, the
company enters into a 10-year interest rate swap with a notional amount of $10,000,000 from which it will receive periodic
payments at the three-month LIBOR rate and make periodic payments at a fixed rate of 9%, with settlement and rate reset
dates every 1 January, 1 April, 1 July and 1 October. The fair value of the swap is zero at inception.
On 1 January 20X1, the three-month LIBOR is 8%. This position locks the interest rate for the note at 10% (the 9% fixed pay
rate of the swap, plus the 1% differential between the variable-rate of the note (LIBOR plus 1%) and the variable-rate of the
swap (LIBOR)). Private company A’s financial statements will be available to be issued on 30 April 20X2. The documentation of
the hedging relationship under the simplified hedge accounting approach is as follows:
Formal hedge designation documentation
Risk management objective
and nature of risk being
hedged
The objective of the hedge is to eliminate the variability of cash flows in the interest
payments associated with $10,000,000 of variable-rate debt. Changes in the cash flows of
the interest rate swap are expected to exactly offset the changes in cash flows
(i.e., changes in interest rate payments) attributable to fluctuations in the three-month
LIBOR interest rate on the first interest payments associated with $10,000,000 of
variable-rate debt.
The debt provides the company an option for selecting the interest rate reset index
(e.g., LIBOR, US Treasury, prime or an “Alternate Base Rate” defined in the debt
agreement) and/or the periodic interest rate reset frequency (e.g., monthly, quarterly,
semiannually), sometimes referred to as “you-pick-’em” debt. The company will elect to pay
interest on the debt based on the three-month LIBOR interest rate. This is a cash flow
hedge of interest rate risk designated under the simplified hedge accounting approach
permitted for certain private companies.
Date of designation
1 January 20X1
Hedge documentation
completion date
20 March 20X2
Date first annual financial
statements are available to
be issued
30 April 20X2
Hedging instrument and
measurement objective
$10,000,000 notional amount, receive-variable (three-month LIBOR) and pay-fixed (9%)
interest rate swap, expiring 1 January 20Y1, with settlement and reset dates every
1 January, 1 April, 1 July and 1 October. The terms of the swap are considered typical
(“plain vanilla”).
The company has elected to measure the swap at its settlement value.
Hedged transactions
Each of the first quarterly variable-rate interest payments associated with $10,000,000
three-month LIBOR-based note payable due 1 January 20Y1, or replacement thereof, with
payments and reset dates every 1 January, 1 April, 1 July and 1 October.
8 | Technical Line Certain private companies can now use simplified hedge accounting 30 January 2014
EY AccountingLink | www.ey.com/us/accountinglink
How hedge effectiveness will
be assessed
This hedge will be assessed under the simplified hedge accounting approach. Because the
terms of the swap and hedged item meet all of the conditions to apply the simplified hedge
accounting approach outlined in ASC 815-20-25-131D, the hedge is considered perfectly
effective. There is no need to periodically assess effectiveness during the term of the
hedge as long as the conditions in 815-20-25-131D continue to be met. On an ongoing
basis, the company will consider the likelihood of the swap counterparty’s compliance with
its contractual obligations under the swap in applying the simplified hedge accounting
approach.
How hedge ineffectiveness
will be measured
As permitted by the simplified hedge accounting approach, the entire change in settlement
value of the derivative will be recorded in other comprehensive income and reclassified to
earnings in accordance with paragraphs 815-30-40-1 through 40-6. There is no
ineffectiveness to be recorded as long as the hedge relationship continues to meet all the
conditions of paragraph 815-20-25-131D. However, if there is a change and the conditions
in paragraph 815-20-25-131D are no longer met or a counterparty’s ability to honor its
obligation under the swap changes, the hedge relationship must be dedesignated, the swap
must be re-measured at fair value, and ineffectiveness must be measured. The hypothetical
derivative method from paragraph 815-30-35-16 through 35-24 will be used to measure
the effectiveness of the hedging relationship upon a dedesignation of the simplified hedge
accounting approach. That measurement will be based on fair value and not settlement
value.
Because this hedge qualifies for the simplified hedge accounting approach, the company will continually adjust the swap to its
settlement value with an offsetting adjustment to other comprehensive income. As interest expense is accrued on the debt,
gains or losses on the swap deferred in AOCI are reclassified and reported as interest expense each period. The net effect of
the AOCI reclassification causes the company to recognize interest expense on the debt at the fixed rate of 10% (even though
three-month LIBOR plus 1% will fluctuate). ASU 2013-02, Comprehensive Income, and ASC 815-10-50-4C require disclosures
of amounts reclassified from AOCI to interest expense each period. See Chapter 8 of our Financial reporting developments
publication Derivatives and Hedging (SCORE No. BB0977) for the disclosure requirements related to AOCI.
9 | Technical Line Certain private companies can now use simplified hedge accounting 30 January 2014