a comprehensive guide derivatives and hedging · with derivatives instruments, including the...

Financial reporting developments A comprehensive guide

Derivatives and hedging (before the adoption of ASU 2017-12) January 2019

To our clients and other friends

The accounting for derivative instruments is considered by many to be one of the more challenging

areas within US GAAP. In the years since originally issuing FASB Statement No. 133, the Financial

Accounting Standards Board (FASB) has amended this standard numerous times and issued more than

170 implementation interpretations (also known as DIG Issues) to address various practice issues

associated the application of this standard.

As a result, the derivatives literature codified in Accounting Standards Codification (ASC) Topic 815

remains intimidating to many because of both its breadth and complexity. Our Financial reporting

developments (FRD) publication includes excerpts from and references to the Codification, interpretive

guidance and examples and is intended to help you understand the financial reporting issues associated

with derivatives instruments, including the special (or hedge) accounting permitted by ASC 815 when

specific requirements are met.

In response to criticism that the hedge accounting guidance in ASC 815 is overly restrictive and complex,

the FASB issued Accounting Standards Update (ASU) 2017-12, Targeted Improvements to Accounting

for Hedging Activities, in August 2017. The ASU makes a number of targeted amendments that enable

entities to more clearly portray the economics of their risk management activities in the financial

statements and ease the application of hedge accounting in certain situations.

ASU 2017-12 is effective for annual periods beginning after 15 December 2018, and interim periods

within those years, for public business entities. For all other entities, it is effective for annual periods

beginning after 15 December 2019, and interim periods the following year. However, the standard

permits early adoption in any interim period or fiscal year before the effective date.

This edition of our publication does not address the amendments made to the hedge accounting guidance

by ASU 2017-12 and therefore should be used by those entities that have not yet adopted the ASU. This

publication has been updated from our prior edition to reflect other updates to accounting standards that

affect ASC 815. (Refer to Appendix F for additional details on these updates.)

Entities that have adopted ASU 2017-12 should refer to our Technical Line publication, A closer look at

the FASB’s new hedge accounting standard (last updated in October 2018), and our soon-to-be-issued

Financial reporting developments publication, Derivatives and hedging (post adoption of ASU 2017-12).

As always, EY professionals are prepared to assist you in your understanding and are ready to discuss

your particular concerns and questions.

January 2019

Financial reporting developments Derivatives and hedging | i

Contents

1 Overview ................................................................................................................... 1

1.1 Historical timeline for primary components of ASC 815 ........................................................... 1

1.2 Problems addressed by Statement 133 ................................................................................... 4

1.3 Fundamental concepts ........................................................................................................... 5

1.4 Scope .................................................................................................................................... 6

1.5 Hedgeable risks and types of hedges ....................................................................................... 7

1.6 Hedge criteria ........................................................................................................................ 9

1.7 Accounting treatment .......................................................................................................... 10

1.8 Disclosure ........................................................................................................................... 11

1.9 Key management considerations .......................................................................................... 11

2 Scope and definition ................................................................................................. 12

2.1 General scope provisions — who is and is not affected ............................................................ 12

2.2 Viewing two or more contracts as a unit in applying the scope of ASC 815 .............................. 13

2.3 What is a derivative? ............................................................................................................ 14

2.4 The characteristics of a derivative ........................................................................................ 14

2.4.1 The underlying ............................................................................................................ 15

2.4.2 Notional amount or payment provision ......................................................................... 16

2.4.2.1 Lack of a specified notional amount ................................................................. 17

2.4.3 No (or smaller) initial net investment ............................................................................ 18

2.4.3.1 Certain derivatives with initial net investments greater than zero ...................... 20

2.4.3.2 Derivatives containing other-than-insignificant financing elements .................... 22

2.4.4 Net settlement ............................................................................................................ 23

2.4.4.1 Contractual net settlement ............................................................................. 23

2.4.4.2 Existence of a market mechanism ................................................................... 26

2.4.4.3 Readily convertible to cash ............................................................................. 29

2.5 Instruments that are not subject to ASC 815 ......................................................................... 32

2.5.1 Regular-way security trades ........................................................................................ 34

2.5.1.1 Existing securities .......................................................................................... 35

2.5.1.2 “When-issued” or “to-be-announced” securities or other securities that do not yet exist ....................................................................................... 35

2.5.2 “Normal” purchases and “normal” sales (updated October 2017) .................................. 36

2.5.2.1 What constitutes “normal”? ............................................................................ 38

2.5.2.2 Must not settle net and will result in physical delivery ....................................... 39

2.5.2.3 Formal documentation required ...................................................................... 41

2.5.2.4 Forward contracts with price adjustment features ............................................ 43

2.5.2.5 Freestanding option contracts ........................................................................ 44

2.5.2.6 Forward contracts with optionality features ..................................................... 44

2.5.2.7 Power purchase or sale agreements ................................................................ 47

2.5.2.8 Application of the scope exception to certain power contracts in nodal markets ................................................................................................ 49

2.5.2.9 Energy contract (non-trading) analysis ............................................................ 50

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2.5.3 Certain insurance contracts ......................................................................................... 51

2.5.4 Certain financial guarantee contracts ........................................................................... 52

2.5.5 Certain non-exchange-traded contracts ........................................................................ 54

2.5.5.1 Climatic, geological or other physical variables ................................................. 55

2.5.5.2 Nonfinancial assets or liabilities ....................................................................... 56

2.5.5.3 Specified volumes of sales or service revenues ................................................. 57

2.5.6 Impediments to sales accounting ................................................................................. 57

2.5.7 Investments in life insurance ........................................................................................ 58

2.5.8 Certain investment contracts held by benefit plans ....................................................... 58

2.5.9 Certain loan origination commitments .......................................................................... 59

2.5.10 Certain contracts indexed to a company’s own stock and classified in stockholders’ equity .................................................................................................... 60

2.5.10.1 The “road map” (updated October 2017) ......................................................... 61

2.5.11 Stock-based compensation .......................................................................................... 63

2.5.12 Contracts between an acquirer and a seller to enter into a business combination at a future date ........................................................................................ 64

2.5.13 Physically settled forward contracts on a fixed number of an entity’s own shares ................................................................................................................. 65

2.5.14 Registration payment arrangements ............................................................................ 65

2.6 Special situations ................................................................................................................. 66

2.6.1 Short sales.................................................................................................................. 66

2.6.2 Repurchase agreements and “wash sales” (involving transfers of assets accounted for as sales under ASC 860) ........................................................................ 66

2.6.3 Overallotment provisions (or “greenshoes”) ................................................................. 66

2.6.3.1 Overview and background .............................................................................. 66

2.6.3.2 Analysis ........................................................................................................ 68

2.6.3.2.1 Freestanding or embedded ..................................................................... 68

2.6.3.2.2 Evaluating greenshoes as ASC 480 liabilities ........................................... 68

2.6.3.2.3 Evaluating greenshoes as derivatives ...................................................... 68

2.6.3.2.4 Exceptions available for greenshoes meeting the definition of a derivative ....................................................................................... 69

2.6.3.2.5 Accounting for greenshoes determined to be derivatives .......................... 69

2.6.3.2.6 Application of the SEC’s long-standing view on written options ................................................................................................. 70

2.7 Application of definition to common contracts ....................................................................... 70

2.8 Illustration of key “scope and definition” concepts and accompanying analysis ........................ 73

2.9 Pre-Codification Statement 133 implementation issues ......................................................... 79

3 Embedded and compound derivatives ....................................................................... 82

3.1 Overview ............................................................................................................................. 82

3.2 What is an embedded derivative? ......................................................................................... 82

3.2.1 Exceptions .................................................................................................................. 83

3.3 Criteria for bifurcation of embedded derivatives .................................................................... 84

3.3.1 Criterion #1 — “Clearly and closely related” .................................................................. 85

3.3.1.1 Illustration of the double/double test ............................................................... 88

3.3.2 Criterion #2 — Hybrid instrument is already remeasured at fair value through earnings ........................................................................................................ 89

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3.3.3 Criterion #3 — Embedded derivative has characteristics of “freestanding derivative” .................................................................................................................. 90

3.3.3.1 Evaluating exceptions for embedded derivatives .............................................. 90

3.3.4 Unit of analysis ........................................................................................................... 92

3.4 Embedded derivative reassessment ...................................................................................... 93

3.5 Embedded derivatives that cannot be identified and measured ............................................... 94

3.6 Non-option embedded derivatives ......................................................................................... 95

3.7 Embedded option derivatives................................................................................................ 97

3.8 Host contracts ..................................................................................................................... 98

3.8.1 Determining the nature of a host contract related to a hybrid financial instrument issued in the form of a share (updated October 2017) ............................... 100

3.8.1.1 Defining the host contract ............................................................................ 101

3.8.1.1.1 Weighing terms and features ................................................................ 101

3.9 Illustrations of the application of the clearly and closely related criterion .............................. 105

3.10 Special embedded derivative situations ............................................................................... 111

3.10.1 Structured notes containing embedded derivatives ..................................................... 111

3.10.2 Foreign currency embedded derivatives ..................................................................... 112

3.10.3 Purchase contracts with a selling price subject to a cap and a floor .............................. 113

3.10.4 Calls and puts in debt instruments .............................................................................. 114

3.10.4.1 Freestanding calls and puts ........................................................................... 114

3.10.4.2 Embedded calls and puts .............................................................................. 114

3.10.5 Contingent interest features ...................................................................................... 117

3.10.6 Embedded features not bifurcated from the host debt instrument ............................... 119

3.10.7 Convertible debt and other convertible instruments — high-level overview .................... 119

3.10.7.1 Issuer’s accounting ...................................................................................... 120

3.10.7.2 Investor’s accounting ................................................................................... 120

3.10.8 Convertible debt and other convertible instruments — detailed overview of issuer accounting ...................................................................................................... 121

3.10.8.1 Criterion 1: “Indexed to its own stock” (updated October 2017) ...................... 121

3.10.8.2 Criterion 2: “Classified in stockholders’ equity in its statement of financial position” ........................................................................................ 123

3.10.8.3 “Time value make-whole” features ................................................................ 127

3.10.8.4 Interest make-whole features ........................................................................ 129

3.11 Compound embedded derivatives ....................................................................................... 130

3.12 Evaluating interests in securitized financial assets for bifurcation ......................................... 130

3.12.1 Historical overview .................................................................................................... 130

3.12.2 The bifurcation model for interests in securitized financial assets ................................ 134

3.12.2.1 Exception for interest-only and principal-only strips ........................................ 135

3.12.2.2 Exception for concentrations of credit risk ..................................................... 136

3.12.2.3 “Clearly and closely related” principles and rules ............................................ 136

3.13 The fair value election for hybrid financial instruments ........................................................ 140

3.14 Pre-Codification Statement 133 implementation issues ....................................................... 143

4 Hedge criteria and hedge effectiveness ................................................................... 146

4.1 Three types of hedges ........................................................................................................ 146

4.2 Hedge criteria .................................................................................................................... 147

4.2.1 Documentation requirement ...................................................................................... 147

4.2.2 Permissible hedging strategy requirement .................................................................. 147

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4.2.3 Effectiveness requirement ......................................................................................... 150

4.3 Consequences of not meeting hedge criteria ....................................................................... 151

4.4 Formal hedge documentation ............................................................................................. 152

4.4.1 Additional requirements for documenting cash flow hedges ........................................ 154

4.4.2 Additional requirements for documenting fair value hedges ........................................ 157

4.4.3 Changing hedge designations .................................................................................... 157

4.4.4 Rollover hedging strategies ....................................................................................... 158

4.5 Permissible hedging strategies limitation on hedging instruments......................................... 159

4.5.1 Hedge limitations involving written options ................................................................. 160

4.5.1.1 Collars ........................................................................................................ 161

4.5.1.2 Call monetization ......................................................................................... 163

4.6 Permissible hedging strategy limitations on hedged items .................................................... 164

4.6.1 The hedged item could affect earnings ....................................................................... 164

4.6.2 Hedged forecasted transaction must be with an external third party ............................ 165

4.6.3 The hedged item cannot be remeasured through earnings .......................................... 166

4.6.4 Hedged risk component is permissible: financial items ................................................. 167

4.6.4.1 Hedging the benchmark interest rate ............................................................. 168

4.6.5 Hedged risk component is permissible: nonfinancial items ........................................... 171

4.6.6 Forecasted transaction is “probable” in a cash flow hedge ........................................... 173

4.6.7 Hedging portions of items .......................................................................................... 177

4.6.8 Partial-term fair value hedges .................................................................................... 178

4.6.9 Portfolio hedging ...................................................................................................... 179

4.6.9.1 Fair value portfolio hedges ........................................................................... 179

4.6.9.2 Cash flow portfolio hedges ............................................................................ 182

4.6.10 Other exclusions ....................................................................................................... 184

4.7 Preexisting hedge relationships under ASC 815 ................................................................... 187

4.8 Hedge effectiveness ........................................................................................................... 187

4.8.1 What is “highly effective”? ......................................................................................... 187

4.8.1.1 Over what period does the hedge have to be highly effective? ......................... 189

4.8.1.2 Effectiveness assessment contrasted with measurement and bookkeeping of ineffectiveness ....................................................................... 189

4.8.2 The shortcut method for interest rate swaps .............................................................. 191

4.8.2.1 Applicability to interest rate swaps ................................................................ 191

4.8.2.2 Consideration of potential default by counterparty to the hedging derivative under the shortcut method ............................................................ 195

4.8.2.3 Prepayable instruments that qualify for the shortcut method .......................... 196

4.8.3 The “long haul method” ............................................................................................. 198

4.8.3.1 “Critical terms match” .................................................................................. 198

4.8.3.2 “Simplified hedge accounting approach” ........................................................ 204

4.9 Methods to assess hedge effectiveness ............................................................................... 205

4.9.1 The dollar-offset approach ......................................................................................... 207

4.9.2 Regression analysis or other statistical analysis approach ........................................... 208

4.9.2.1 Basic concepts of regression ......................................................................... 210

4.9.2.2 A warning about statistics ............................................................................ 215

4.9.2.3 Establishing the predictive validity of the regression analysis .......................... 216

4.9.2.4 Characteristics of valid and predictive regression analysis ............................... 218

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4.9.2.5 What alternatives exist if a regression analysis cannot be validated? ................................................................................................... 219

4.9.2.6 Use of regression analysis to assess effectiveness of fair value and cash flow hedges ......................................................................................... 220

4.9.3 Excluding the time value portion of the derivative from the effectiveness test .......................................................................................................................... 223

4.9.3.1 Spot vs. forward rate ................................................................................... 224

4.9.3.2 Options ....................................................................................................... 227

4.9.4 Derivatives with ineffectiveness present in hedge designs ........................................... 229

4.9.5 Overnight indexed swap rate (OIS) ............................................................................. 231

4.9.5.1 OIS discounting and fair value hedge accounting ............................................ 231

4.9.5.2 OIS discounting and cash flow hedge accounting ............................................ 231

4.9.5.3 OIS discounting and net investment hedge accounting .................................... 232

4.10 Practical considerations in approaching the requirement to assess hedge effectiveness ........................................................................................................... 232

4.10.1 Is the hedge eligible for shortcut treatment? .............................................................. 232

4.10.2 Can the hedge be assessed qualitatively as having no expectation of ineffectiveness (also known as the “critical terms match … for now”

approach)? ............................................................................................................... 232

4.10.3 If a quantitative method is necessary, is it appropriate (i.e., safe) to use the dollar-offset method of assessing effectiveness retrospectively? ........................... 233

4.10.4 Evaluate the appropriate statistical analysis approach (such as regression) for either prospective or retrospective (or both) evaluations of

hedge effectiveness ................................................................................................... 234

4.11 Credit risk in derivative contracts — accounting considerations ............................................. 234

4.11.1 Incorporating credit risk into the fair value of derivatives ............................................ 235

4.11.2 Cash flow hedges and the implications of credit valuation adjustments for hedge accounting ...................................................................................................... 236

4.11.2.1 Effect on the assessment of whether a hedge is “highly effective” and qualifies for hedge accounting ................................................................ 237

4.11.2.2 Effect on the measurement of hedge ineffectiveness for qualifying cash flow hedge relationships ....................................................................... 239

4.11.3 Fair value hedges and the implications of credit valuation adjustments for hedge accounting ...................................................................................................... 242

4.11.3.1 Effect on the assessment of whether a hedge is “highly effective” and qualifies for hedge accounting ................................................................ 243

4.11.3.2 Effect on the measurement of hedge ineffectiveness for qualifying fair value hedge relationships ....................................................................... 243

4.11.4 Allocation of credit valuation adjustment from portfolio-level determination to individual derivatives for purposes of assessing hedge

effectiveness of fair value hedges .............................................................................. 244

4.11.5 Considerations when counterparties are in financial distress, including novation ................................................................................................................... 246

4.11.5.1 Effect of novations on hedge relationships ..................................................... 249


5 Fair value hedges ................................................................................................... 254

5.1 What is a fair value hedge? ................................................................................................. 254

5.1.1 Firm commitment ..................................................................................................... 255

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5.2 The accounting treatment for a fair value hedge .................................................................. 256

5.3 Hedge ineffectiveness ........................................................................................................ 260

5.4 Examples of fair value hedges............................................................................................. 261

Example 1: Fair value hedge of a firm commitment using a forward contract (ineffectiveness present) ......................................................... 261

Example 2: Fair value hedge of a firm commitment using a futures contract (ineffectiveness present) ......................................................... 264

Example 3: Fair value hedge of fixed-rate debt using an interest rate swap (no ineffectiveness) ..................................................................... 267

Example 4: Fair value hedge of the LIBOR swap rate in a fixed-rate note (ineffectiveness present) ...................................................................... 270

Example 5: Fair value hedge of a commodity inventory using futures contracts ............................................................................................ 282

5.4.1 Unique situations ...................................................................................................... 286

5.4.1.1 Discontinuing a fair value hedge .................................................................... 286

Example 6: Fair value hedging relationship no longer qualifies as highly effective ............................................................................................. 288

Example 7: Discontinuation of a fair value hedge of fixed-rate debt .......................... 290

5.4.1.2 Amended firm commitments ......................................................................... 292

5.4.1.3 Hedge of inventory involving LIFO ................................................................. 293

Example 8: Hedging the fair value of LIFO inventory through the use of a forward contract ................................................................................. 294

5.4.1.4 Impairment (and lower of cost or market) ...................................................... 298

Example 9: Assessing impairment — fair value hedge of a fixed-rate loan receivable ........................................................................................... 298

5.4.1.5 Written options ............................................................................................ 301

Example 10: Sale of a written option to hedge an embedded purchased option ................................................................................................. 302

5.4.1.6 Hedge of benchmark interest rate component of convertible debt ................... 305


6 Cash flow hedges ................................................................................................... 310

6.1 What is a cash flow hedge? ................................................................................................. 310

6.2 Difference between a forecasted transaction and a firm commitment ................................... 311

6.2.1 Firm commitments that are also derivatives (all-in-one hedges) ................................... 312

6.2.2 Identification of forecasted transactions ..................................................................... 313

6.3 Foreign currency cash flow hedges ..................................................................................... 313

6.4 The accounting treatment for cash flow hedges ................................................................... 313

6.5 “Simplified hedge accounting approach” ............................................................................. 317

6.5.1 Scope ....................................................................................................................... 317

6.5.2 Requirements and application of the approach ........................................................... 318

6.6 Hedge ineffectiveness ........................................................................................................ 322

6.6.1 Pitfalls to using the “critical terms match” approach to assess hedge effectiveness and measure hedge ineffectiveness ....................................................... 324

6.6.2 Measurement of hedge ineffectiveness ...................................................................... 326

6.7 Measuring the ineffectiveness of a cash flow hedge ............................................................. 330

6.7.1 Method 1: Change in variable cash flows method ........................................................ 331

6.7.2 Method 2: Hypothetical derivative method ................................................................. 333

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6.7.3 Method 3: Change in fair value method ...................................................................... 335

6.8 Purchased options used in cash flow hedges ........................................................................ 336

6.8.1 Measuring ineffectiveness for purchased option cash flow hedge strategies ................................................................................................................. 337

6.8.2 Reclassifications out of other comprehensive income .................................................. 339

6.8.3 Other guidance involving options ............................................................................... 340

6.9 Cash flow hedges of existing or forecasted variable-rate financial assets and liabilities ...................................................................................................................... 341

6.9.1 The ability to hedge the benchmark interest rate in a cash flow hedge ......................... 341

6.9.2 The “first-payments-received” technique .................................................................... 344

6.10 Discontinuing a cash flow hedge ......................................................................................... 345

6.10.1 Change in hedge designation ..................................................................................... 349

6.11 Other structures affecting hedge accounting ....................................................................... 350

6.11.1 ‘Deal contingent’ interest rate swaps and associated hedge ineffectiveness .......................................................................................................... 350

6.11.2 Hedge designations involving interest rate swaps and debt with embedded interest rate reset options ......................................................................................... 353

6.12 Examples of cash flow hedges ............................................................................................ 357

Example 1: Cash flow hedge of variable-rate debt using an interest rate swap (no ineffectiveness) ..................................................................... 357

Example 2: Cash flow hedge of anticipated issuances (rollovers) of commercial paper using an interest rate swap (with

ineffectiveness) ................................................................................... 361

Example 3: Cash flow hedge of a forecasted purchase using futures contracts ............................................................................................ 368

Example 4: Cash flow hedging relationship no longer qualifies as highly effective ............................................................................................. 373

Example 5: Cash flow hedge of a forecasted transaction, but the forecast changes ................................................................................. 375

Example 6: Cash flow hedge of a forecasted issuance of fixed-rate debt with a forward-starting interest rate swap — expected cash

flow timing changes ............................................................................. 377

Example 7: Hedging a variable-rate guaranteed investment contract with an interest rate cap (excludes time value from

effectiveness assessment).................................................................... 390

Example 8: Hedging a variable-rate guaranteed investment contract with an interest rate cap (“hedge effectiveness based on an

option’s terminal value” approach) ........................................................ 394

Example 9: Cash flow hedge of variable-rate debt using an interest rate swap (using “simplified hedge accounting approach”; can be

applied only by certain private companies) ............................................ 401

6.13 Other special situations ...................................................................................................... 402

6.13.1 Situations in which designating a cash flow hedge may be more desirable than the fair value hedge alternative .......................................................................... 402

6.13.2 Basis swaps .............................................................................................................. 403

Example 10: Using a basis swap to hedge the basis difference between a variable-rate asset and a variable-rate liability ....................................... 404

6.13.3 Impairment considerations ........................................................................................ 409

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Example 11: Cash flow hedge of inventory sales, but inventory becomes impaired ............................................................................................. 410

6.13.4 Forecasted borrowings with timing changes ............................................................... 414

Example 12: Cash flow hedge of forecasted borrowings using a forward-starting interest rate swap but timing changes (illustration of

each ineffectiveness measurement method under ASC 815-

30-35-10 through 35-32 (formerly Implementation Issue

G7)).................................................................................................... 414

6.14 Comparison of the impact of ineffectiveness on cash flow and fair value hedges.................... 425


7 Foreign currency hedges ........................................................................................ 428

7.1 What is a foreign currency hedge? ...................................................................................... 428

7.2 General foreign currency hedge criteria (updated October 2017) ......................................... 429

7.2.1 Tandem currency hedges .......................................................................................... 430

7.3 Foreign currency cash flow hedges ..................................................................................... 431

7.3.1 Qualifying criteria specific to foreign currency cash flow hedges .................................. 431

7.3.2 Operating unit that has the foreign currency exposure has to be a party to the hedging instrument ............................................................................................. 432

7.3.3 Hedging all of the variability in the cash flows ............................................................. 434

7.4 Accounting treatment of foreign currency cash flow hedges ................................................ 435

7.4.1 Intercompany transactions ........................................................................................ 436

7.4.2 Hedging of anticipated intercompany royalty income .................................................. 436

7.5 Examples of foreign currency cash flow hedges ................................................................... 436

Example 1: Anticipated sales hedged with a forward contract using the forward method .................................................................................. 437

Example 2: Anticipated intercompany sales hedged with a forward contract using the forward method ....................................................... 439

Example 3: Anticipated intercompany royalties hedged with a forward contract using the spot method ............................................................ 440

Example 4: Anticipated sales hedged with an option contract ................................... 443

7.6 Intercompany derivative contracts — general principles ........................................................ 446

Example 5: Hedge accounting in the consolidated financial statements applied to internal derivatives that are offset on a net basis

by third-party contracts ....................................................................... 451

7.7 Foreign currency fair value hedges ..................................................................................... 458

7.7.1 Qualifying criteria specific to foreign currency fair value hedges .................................. 458

7.7.1.1 Unrecognized firm commitments .................................................................. 459

7.7.1.2 Available-for-sale debt securities ................................................................... 461

7.8 Additional examples of foreign currency fair value hedges ................................................... 462

Example 6: Firm commitment hedged using a forward contract ................................ 462

7.9 Hedges of recognized foreign-currency-denominated assets and liabilities ............................ 465

7.9.1 General principles ..................................................................................................... 465

7.9.2 Types of hedges to be considered .............................................................................. 467

7.9.2.1 Fair value hedges ......................................................................................... 467

7.9.2.2 Cash flow hedges ......................................................................................... 467

7.9.2.3 Hedging a forecasted transaction and the resulting asset or liability ........................................................................................................ 468

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7.9.2.4 Summary of hedge types .............................................................................. 469

7.10 Examples of foreign currency hedges of foreign-currency-denominated assets and liabilities ...................................................................................................................... 469

Example 7: Fair value hedge of a fixed-rate, foreign-currency-denominated loan converted into a variable-rate, functional

currency loan using a cross-currency interest rate swap

(based on FASB example) ..................................................................... 470

Example 8: Cash flow hedge of a fixed-rate, foreign-currency-denominated loan converted into a fixed-rate, functional

currency loan using a cross-currency swap (based on FASB

example) ............................................................................................. 473

Example 9: Cash flow hedge of a fixed-rate, foreign-currency-denominated zero-coupon note converted into a fixed-rate,

functional currency note using a forward contract ................................. 478

Example 10: Cash flow hedge of a non-interest-bearing liability (accounts payable) using a forward contract .......................................................... 481

Example 11: “Dual purpose” cash flow hedge of the ultimate settlement of a forecasted foreign-currency-denominated payable

resulting from a forecasted purchase on credit using a single

forward contract ................................................................................. 484

7.11 Net investment hedges ...................................................................................................... 488

7.11.1 What is a net investment hedge? ............................................................................... 488

7.11.2 Qualifying criteria specific to net investment hedges ................................................... 489

7.11.3 Accounting treatment for a net investment hedge ...................................................... 490

7.11.4 Instruments that qualify as hedging instruments in a net investment hedge, including complex hedging instruments ........................................................... 491

7.11.4.1 Hedging a net investment with a compound derivative that incorporates exposure to multiple risks .......................................................... 492

7.11.4.2 Hedging a net investment with a combination of a derivative and a cash instrument ........................................................................................... 492

7.11.5 Measuring the amount of ineffectiveness in a net investment hedge ............................ 493

7.11.5.1 Derivatives used as hedging instruments — ineffectiveness based on forward rates .......................................................................................... 493

7.11.5.2 Derivatives used as hedging instruments — ineffectiveness based on spot rates ............................................................................................... 495

7.11.5.3 Nonderivatives used as hedging instruments .................................................. 496

7.11.5.4 Changing nature of the net investment balance .............................................. 497

7.11.6 After-tax hedging of foreign currency risk .................................................................. 499

7.12 Examples of net investment hedges .................................................................................... 500

Example 12: Accounting for a net investment (no hedge accounting) ......................... 500

Example 13: Accounting for a net investment (with hedge accounting and no ineffectiveness) .............................................................................. 503

Example 14: Accounting for a net investment (with hedge accounting with ineffectiveness present) ................................................................ 505

Example 15: Accounting for a hedge of a net investment using a fixed rate-for-fixed rate cross-currency interest rate swap and

assessing effectiveness using the spot method ...................................... 507

7.13 Pre-Codification Statement 133 Implementation issues ....................................................... 520

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8 Disclosures and financial statement presentation .................................................... 521

8.1 Disclosure guidance ........................................................................................................... 521

8.2 Qualitative disclosure requirements .................................................................................... 522

8.2.1 Disclosure of objectives and strategies ....................................................................... 522

8.2.2 Disclosure of volume of derivative activity .................................................................. 525

8.3 Example qualitative disclosures .......................................................................................... 526

8.4 Quantitative disclosure requirements .................................................................................. 528

8.5 Statement of financial position tabular disclosures............................................................... 529

8.5.1 Disclosures about offsetting (netting) ......................................................................... 531

8.5.1.1 Scope ......................................................................................................... 532

8.5.1.2 Quantitative tabular disclosures .................................................................... 532

8.5.1.3 Other considerations .................................................................................... 533

8.5.1.3.1 Amounts offset in accordance with offsetting guidance .......................... 533

8.5.1.3.2 Limits on amounts disclosed for collateral not offset in the balance sheet ...................................................................................... 533

8.5.1.3.3 Disclosure of the net amounts presented on the balance sheet .................................................................................................. 533

8.6 Example statement of financial position tabular disclosures ................................................. 533

8.7 Statement of financial performance tabular disclosures ....................................................... 535

8.7.1 Fair value hedges ...................................................................................................... 536

8.7.2 Cash flow hedges ...................................................................................................... 537

8.7.3 Hedged items not designated in qualifying ASC 815 hedging relationships ................... 538

8.7.4 Other situations ........................................................................................................ 538

8.8 Example statement of financial performance tabular disclosures .......................................... 539

8.8.1 Trading exemption .................................................................................................... 541

8.9 Example statement of financial performance tabular disclosures using the trading exemption .............................................................................................................. 542

8.10 Additional quantitative disclosures specific to fair value hedges ............................................ 542

8.11 Additional quantitative disclosures specific to cash flow hedges ........................................... 544

8.12 Disclosure requirements of hybrid instruments .................................................................... 547

8.13 Other considerations related to quantitative disclosures ...................................................... 548

8.13.1 Credit-risk disclosures ............................................................................................... 548

8.13.1.1 Credit-risk-related contingent features .......................................................... 548

8.13.1.2 Concentrations of credit risk ......................................................................... 550

8.13.1.3 Credit derivatives ......................................................................................... 551

8.13.2 Other considerations ................................................................................................. 553

8.13.2.1 Accumulated other comprehensive income .................................................... 553

8.13.2.2 Disclosures of the effects of credit on the fair value of derivatives ................... 555

8.14 Financial statement presentation ........................................................................................ 556

8.15 General financial statement presentation ............................................................................ 556

8.15.1 Derivatives that are part of master netting arrangements ........................................... 557

8.15.2 Hybrid instruments ................................................................................................... 558

8.15.3 Centrally cleared derivative instruments (updated October 2017) ............................... 559

8.15.3.1 Hedge accounting implications ...................................................................... 560

8.15.3.2 Balance sheet presentation and netting ......................................................... 560

8.15.3.3 Income statement presentation..................................................................... 561

8.15.3.4 Statement of cash flows ............................................................................... 561

Contents

Financial reporting developments Derivatives and hedging | xi

8.15.3.5 Disclosures .................................................................................................. 561

8.16 Financial statement presentation for derivatives not used in ASC 815 hedges ....................... 561

8.16.1 Derivatives held for trading purposes ......................................................................... 562

8.16.2 Derivatives that are subject to ASC 815 but not held for trading purposes ................... 562

8.16.3 Derivatives that are used as economic hedges ............................................................ 563

8.17 General cash flow statement presentation ........................................................................... 564

A Derivatives and hedging primer................................................................................... 1

A.1 Introduction .......................................................................................................................... 1

A.2 Why do companies hedge? ..................................................................................................... 1

A.3 Does a company have to use derivatives to hedge its exposures? ............................................. 1

A.4 Does a company always want to hedge its exposures? ............................................................. 3

A.5 What are the most common hedged exposures and risks? ........................................................ 3

A.6 What are the most common types of derivatives? .................................................................... 4

A.7 What are some common derivatives-related hedge strategies? ................................................ 5

A.7.1 Interest rate risk ........................................................................................................... 5

A.7.2 Commodity price risk..................................................................................................... 6

A.7.3 Foreign currency risk..................................................................................................... 6

B Index of ASC references in this publication .................................................................. 1

C Implementation guidance relevant to insurers and insurance products .......................... 1

C.1 Non-traditional life products ................................................................................................... 2

C.1.1 Equity-indexed annuities ................................................................................................ 2

C.1.2 Benefit guarantees ........................................................................................................ 4

C.1.3 Synthetic GICs .............................................................................................................. 6

C.1.4 Market-value adjusted annuity contract .......................................................................... 8

C.1.5 COLI/BOLI and stable value riders .................................................................................. 9

C.1.6 Multi-bucket annuities ................................................................................................. 10

C.1.7 Group pension participating and experience rated contracts .......................................... 11

C.1.8 ModCo reinsurance ..................................................................................................... 12

C.1.9 Actuarial funded products ........................................................................................... 14

C.2 Property/Casualty products ................................................................................................. 15

C.2.1 Dual trigger insurance contracts .................................................................................. 15

C.2.2 Dual-trigger financial guarantee contracts .................................................................... 16

C.2.3 Foreign currency elements of insurance contracts ........................................................ 16

C.3 Other matters affecting accounting for embedded derivatives ................................................ 16

C.3.1 DAC implications of embedded derivatives ................................................................... 16

D Pitfalls on designation of non-zero fair value derivatives in hedge relationships .............................................................................................................. 1

D.1 Commonplace scenarios......................................................................................................... 1

D.2 Redesignation requirements ................................................................................................... 3

D.2.1 Preclusion on use of the shortcut method, “critical terms match” approach, and “change in variable cash flows” method for assessing

effectiveness ................................................................................................................ 3

D.2.2 Evaluation at redesignation ........................................................................................... 4

D.2.3 Dollar-offset.................................................................................................................. 4

D.2.4 Impact on accumulated other comprehensive income ..................................................... 5

D.3 When is the non-zero value issue most likely to be a problem? .................................................. 5

Contents

Financial reporting developments Derivatives and hedging | xii

D.3.1 Derivative fair value ...................................................................................................... 5

D.3.2 Hypothetical derivative .................................................................................................. 6

D.3.3 Illustrative examples ..................................................................................................... 6

D.3.3.1 Off-market forward contract example ................................................................ 6

D.3.3.2 Off-market swap contract example .................................................................... 8

D.4 Comprehensive example: Redesignation of an existing interest rate swap following a business combination .......................................................................................... 10

D.5 Effect of non-zero fair value derivatives on fair value hedges ................................................. 15

E Abbreviations used in this publication ......................................................................... 1

F Summary of important changes .................................................................................. 1

Contents

Financial reporting developments Derivatives and hedging | xiii

Notice to readers:

This publication includes excerpts from and references to the FASB Accounting Standards Codification

(the Codification or ASC). The Codification uses a hierarchy that includes Topics, Subtopics, Sections

and Paragraphs. Each Topic includes an Overall Subtopic that generally includes pervasive guidance for

the topic and additional Subtopics, as needed, with incremental or unique guidance. Each Subtopic

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Topic (XXX), Subtopic (YY), Section (ZZ) and Paragraph (PP).

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numbers. References are also made to certain pre-Codification standards (and specific sections or

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Financial reporting developments Derivatives and hedging | 1

1 Overview

1.1 Historical timeline for primary components of ASC 815

In January 1992, the Financial Accounting Standards Board (FASB) began deliberating issues related to

derivatives and hedging transactions. After many years of controversy, the FASB issued Statement 133,

Accounting for Derivative Instruments and Hedging Activities, in June 1998. The Statement was required

to be applied for fiscal years beginning after 15 June 2000 (2001 for a calendar year end),1 although

companies could early adopt the Statement as of the beginning of any fiscal quarter. Statement 133

superseded FASB Statement 80, Accounting for Futures Contracts, FASB Statement 105, Disclosure of

Information about Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with

Concentrations of Credit Risk (Statement 105), and FASB Statement 119, Disclosures about Derivative

Financial Instruments and Fair Value of Financial Instruments (Statement 119), and amended the hedging

sections of FASB Statement 52, Foreign Currency Translation (Statement 52 (codified under ASC 830)). It

also amended FASB Statement 107, Disclosures about Fair Value of Financial Instruments (Statement 107

(codified in ASC 825-10)), to include from the now superseded Statement 105 its disclosure provisions

concerning concentrations of credit risk.

In June 2000, the FASB issued Statement 138, an amendment of Statement 133. It had to be adopted

concurrently with the date that an entity adopted Statement 133. An entity that adopted Statement 133

prior to 15 June 2000 had to adopt Statement 138 as of the first day of the first fiscal quarter beginning

after 15 June 2000.

In April 2003, the FASB issued Statement 149, another amendment of Statement 133. It was effective

for contracts entered into or modified after 30 June 2003, and hedging relationships designated after

30 June 2003. However, the provisions of Statement 149 that merely represented codification of

previous Derivatives Implementation Group decisions were already effective prior to the issuance of

Statement 149 and still followed their prior respective effective dates.

In February 2006, the FASB issued Statement 155, Accounting for Certain Hybrid Financial Instruments —

an Amendment of FASB Statements No. 133 and 140 (Statement 155). Statement 155 amended

Statement 133 to require evaluation of all interests in securitized financial assets, eliminating

a longstanding (but always intended to be temporary) exemption from Statement 133 for such financial

instruments. As a result of Statement 155 (codified under ASC 815-15), entities now have to determine

whether such interests may be (1) freestanding derivatives, (2) hybrid financial instruments containing

embedded derivatives requiring bifurcation or (3) hybrid financial instruments containing embedded

derivatives that do not require bifurcation. This guidance also permitted fair value remeasurement for

any hybrid instrument (on an instrument-by-instrument basis) that contained an embedded derivative

that would otherwise have to be bifurcated. ASC 815-15 (including former Statement 155) is addressed

primarily in a separate section of Chapter 3, “Embedded and Compound Derivatives.”

In September 2006, the FASB issued Statement 157, Fair Value Measurements (Statement 157).

Statement 157 established a framework for measuring fair value under US GAAP, clarified the definition of

fair value within that framework, and expanded disclosures about the use of fair value measurements.

1 In June 1999, the FASB issued Statement 137, Accounting for Derivative Instruments and Hedging Activities — Deferral of the Effective Date of FASB Statement No. 133 (Statement 137). This Statement deferred the required effective date of

Statement 133 until the first day of all fiscal years beginning after 15 June 2000.

1 Overview


Statement 157 became effective for derivatives for fiscal years beginning after 15 November 2007 (that is,

1 January 2008, for calendar year-end entities). To help address Statement 157 implementation issues,

the FASB formed the Valuation Resource Group (VRG), to provide input to the Board on such issues and

other valuation related items for which guidance is needed. As derivatives are required to be accounted for

at fair value by ASC 815, Statement 157 (codified under ASC 820) directly affected derivative accounting,

and therefore, hedge accounting. Certain paragraphs of Statement 133 were amended to conform to the

new ASC 820 definition of “fair value.” Among other things, ASC 820 may affect an entity’s assessment

of hedge effectiveness, nonperformance risk considerations in valuation methodologies, and the

recognition of Day 1 gains and losses. The impact of ASC 820 is addressed primarily in Chapter 4.

In March 2008, the FASB issued Statement 161, Disclosures about Derivative Instruments and Hedging

Activities (Statement 161) in response to certain users of financial statements’ concerns about the lack of

transparency of an entity’s derivative and hedging activities. Statement 161 became effective for financial

statements issued for fiscal years and interim periods beginning after 15 November 2008 (i.e., first

quarter 2009 for calendar year-end companies). Statement 161 (codified as part of ASC 815-10-50)

required entities to provide more information about (1) how and why an entity uses derivative instruments,

(2) how derivative instruments and related hedged items are accounted for under ASC 815 and (3) how

derivative instruments affect an entity’s financial position, results of operations and cash flows. Upon the

adoption of Statement 161, the disclosures about concentrations in credit risk in ASC 825-10 were not

applicable to derivatives accounted for under ASC 815 as ASC 815-10-50 requires similar disclosures

about credit risk associated with derivative instruments, replacing the ASC 825-10 requirements. The

disclosure requirements introduced by Statement 161 are addressed in Chapter 8.

In July 2013, the FASB issued Accounting Standards Update (ASU) 2013-102, which permits the

Federal Funds Effective Swap Rate (which is the overnight index swap rate, or OIS rate, in the US) to be

designated as a benchmark interest rate for hedge accounting purposes under ASC 815. Previously, only

US Treasury rates and the London Interbank Offering Rate (LIBOR) could be used as benchmark interest

rates. Companies can designate the OIS benchmark rate on a prospective basis in new or redesignated

hedging relationships as of the issuance date of this final guidance (17 July 2013). Existing interest rate

swaps designated as benchmark interest rate hedges must be redesignated in new hedge relationships

with new hedge documentation if a company wants to change the hedged risk to OIS.

In January 2014, the FASB issued ASU 2014-033, allowing certain private companies to use a simplified

hedge accounting approach for interest rate swaps used to economically convert variable-rate debt to

fixed-rate debt. This approach will allow private companies entering into these swaps to assume that the

cash flow hedging relationship is perfectly effective when certain criteria are met.

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 ASC 815, due to limited resources and the complexity of the guidance. The

requirements to apply this approach are further discussed in Chapter 6.

2 ASU 2013-10, Derivatives and Hedging (Topic 815): Inclusion of the Fed Funds Effective Swap Rate (or Overnight Index Swap Rate) as a Benchmark Interest Rate for Hedge Accounting Purposes (a consensus of the FASB Emerging Issues Task Force).

3 ASU 2014-03, Derivatives and Hedging (Topic 815): Accounting for Certain Receive-Variable, Pay-Fixed Interest Rate Swaps —

Simplified Hedge Accounting Approach.

1 Overview


In November 2014, the FASB issued ASU 2014-16,4 which requires an entity (an issuer or an investor) to

consider all stated and implied substantive terms and features of a hybrid financial instrument issued in

the form of a share when determining whether the nature of the host contract is more akin to debt or to

equity, weighing each term and feature on the basis of relevant facts and circumstances. That is, an

entity should determine the nature of the host contract by considering the economic characteristics and

risks of the entire hybrid financial instrument, including the embedded derivative feature that is being

evaluated for separate accounting. This requirement is effective for public business entities for fiscal

years, and interim periods within those fiscal years, beginning after December 15, 2015. For all other

entities, the guidance is effective for fiscal years beginning after December 15, 2015, and interim periods

within fiscal years beginning after December 15, 2016. Early adoption is permitted. The requirements

regarding the bifurcation of embedded derivatives, including the determination of the host contract, is

discussed further in Chapter 3.

In August 2015, the FASB issued ASU 2015-13,5 specifying that entities are not precluded from applying

the normal purchases and normal sales (NPNS) exception to derivative accounting to certain forward

contracts that necessitate the transmission of electricity through, or delivery to a location within, a nodal

energy market. Physical delivery of the underlying is a key criterion to apply the NPNS scope exception.

The new guidance specifies that the use of locational marginal pricing (LMP) by an independent system

operator (ISO) to determine a transmission charge or credit in a nodal energy market does not constitute

a net settlement of a forward contract for the purchase or sale of electricity, even when legal title to the

electricity is conveyed to the ISO during transmission.

As a result, an ISO’s use of LMP to determine transmission charges or credits, in and of itself, does not

preclude certain forward contracts from meeting the physical delivery criterion to qualify for the NPNS

exception. However, to qualify for the NPNS exception, the contracts would still need to meet the other

requirements in ASC 815, including the criterion that physical settlement is either required by the

contract or is probable at contract inception and throughout the term of a contract. The requirements to

qualify for the NPNS scope exception to derivative accounting are further discussed in Chapter 2.

In March 2016, the FASB issued ASU 2016-056 to clarify that the novation of a derivative contract that

is part of a hedge accounting relationship does not automatically require a dedesignation of that hedge

relationship. The guidance amended ASC 815 to specify that a novation does not, in and of itself,

represent a termination of the original derivative instrument or a change in the critical terms of the

hedge relationship. As a result, the hedging relationship could continue uninterrupted if all of the other

hedge accounting criteria are met, including the expectation that the hedge will be highly effective when

the creditworthiness of the new counterparty to the derivative contract is considered. Derivative

novations, as well as the requirements regarding the evaluation of counterparty credit risk in hedging

relationships, are further discussed in Chapter 4.

In March 2016, the FASB also issued ASU 2016-067 to clarify that the assessment of whether an

embedded contingent put or call option is clearly and closely related to a debt host only requires an

analysis of the four-step decision sequence outlined in ASC 815-15-25-42. For contingently exercisable

put or call options, an entity does not have to assess whether the event that triggers the ability to exercise

a put or call option is related to interest rates or credit risk of the entity. The requirements regarding the

assessment of embedded call and put options in debt instruments are further discussed in Chapter 3.

4 ASU 2014-16, Derivatives and Hedging (Topic 815): Determining Whether the Host Contract in a Hybrid Financial Instrument Issued in the Form of a Share Is More Akin to Debt or to Equity.

5 ASU 2015-13, Derivatives and Hedging (Topic 815): Application of the Normal Purchases and Normal Sales Scope Exception to Certain Electricity Contracts within Nodal Energy Markets.

6 ASU 2016-05, Derivatives and Hedging (Topic 815): Effect of Derivative Contract Novations on Existing Hedge Accounting Relationships. 7 ASU 2016-06, Derivatives and Hedging (Topic 815): Contingent Put and Call Options in Debt Instruments.

1 Overview


In July 2017, the FASB issued ASU 2017-118 to simplify the accounting for equity contracts

(e.g., freestanding warrants) or equity-linked embedded features (e.g., conversion options in convertible

instruments) with down round features. Under this guidance, entities are no longer required to consider

down round features when determining whether these financial instruments containing a down round

feature are indexed to the issuer’s own stock pursuant to ASC 815-40. Being indexed to an entity’s own

stock is required for a freestanding financial instrument to be classified in shareholders’ equity and may

exempt an embedded feature from bifurcation and derivative accounting. The requirements for being

considered indexed to an entity’s own stock are discussed in Chapter 2 and Chapter 3.

In August 2017, the FASB issued ASU 2017-12 9, amending the hedge accounting model in ASC 815 to

enable entities to better portray the economics of their risk management activities in the financial

statements and enhance the transparency and understandability of hedge results. The amendments also

ease the application of hedge accounting in certain situations. Many of the amendments were made in

direct response to constituents’ feedback over the years that the current hedge accounting model was too

restrictive and complex. Some of the more significant amendments include eliminating the requirement to

separately measure and report hedge ineffectiveness, expanding component hedging for financial and

nonfinancial items, providing additional flexibility for measuring the change in fair value of the hedged

item in fair value hedges of interest rate risk and easing certain hedge documentation and assessment

requirements. This publication does not incorporate the amendments made by the new ASU, which

become effective in 2019 for calendar-year public business entities and in 2020 for all other calendar-

year companies. Companies considering early adoption, which is permitted in any interim or annual period

prior to the effective date, should stay alert for any additional application guidance provided by the FASB.

In October 2018, the FASB issued ASU 2018-1610 adding the overnight index swap rate based on the

Secured Overnight Financing Rate (SOFR) to the list of US benchmark interest rates in ASC 815 that are

eligible to be hedged. As a result, entities may designate changes in this rate as the hedged risk in new or

redesignated hedges of interest rate risk for fixed-rate financial instruments hedging relationships entered

into on or after the date the ASU is adopted. However, this guidance cannot be applied until an entity

adopts the new hedging guidance in ASU 2017-12.

1.2 Problems addressed by Statement 133

The FASB undertook Statement 133 to address the following perceived problems with the accounting

for derivatives:

• The effects of derivatives were not transparent in the basic financial statements. Prior to

Statement 133, some derivatives were recognized in the financial statements, while others were not.

• The accounting guidance for derivative instruments and hedging activities was incomplete. Though

Statements 52 and 80 addressed hedging of foreign currency and the accounting for futures contracts,

many other derivative instruments in use were not addressed by the authoritative literature.

The accounting guidance for derivative instruments and hedging activities was inconsistent. Prior to

Statement 133, the accounting treatment and recognition of derivatives, the measurement or valuation

of derivatives, and the requirements to qualify as a hedge all varied depending on the type of instrument

and risk involved.

8 ASU 2017-11, Earnings Per Share (Topic 260); Distinguishing Liabilities from Equity (Topic 480); Derivatives and Hedging (Topic 815): (Part I) Accounting for Certain Financial Instruments with Down Round Features, (Part II) Replacement of the Indefinite Deferral for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests with a Scope Exception,

9 ASU 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities. 10 ASU 2018-16, Derivatives and Hedging (Topic 815): Inclusion of the Secured Overnight Financing Rate (SOFR) Overnight Index

Swap (OIS) Rate as a Benchmark Interest Rate for Hedge Accounting Purposes.

1 Overview


How we see it

Arguably, the FASB successfully addressed the three perceived problems, but the requirements of

ASC 815 have significantly increased the complexity of accounting for derivatives. Many entities find

ASC 815 difficult to apply, particularly financial services entities with large volumes and a wide array

of derivatives, multinationals with centralized trading and hedging operations, companies that hedge

portions of items and companies that hedge commodities and cannot totally eliminate basis or location

risk. On the other hand, some companies find that ASC 815 provides more flexibility in the hedge

accounting rules applicable to foreign currency exposures because ASC 815 treats these exposures

consistently with similar interest rate or commodity exposures. In addition, when derivatives are not

perfectly effective in achieving offsetting changes in fair value or cash flows, the lack of perfection is

visible in the income statement — a significant change from the prior hedge accounting model.

In an unprecedented move, the FASB formed an advisory body, the Derivatives Implementation Group

(DIG), comprised of representatives from each of the then Big Five accounting firms as well as industry to

assist the FASB staff in developing answers to constituent questions that began arising prior to the

implementation of the Statement. The Securities and Exchange Commission (SEC) was also an influential

participant in the DIG meetings. The DIG met with the FASB staff on roughly a bimonthly basis between

August 1998 and March 2001. These discussions helped the FASB staff formulate their views regarding

a wide variety of implementation questions. Although there were no formal meetings of the DIG after

March 2001, the FASB staff continued to issue and update implementation guidance, which has been

codified along with the DIG Issues in ASC 815.

In each of the upcoming chapters, this publication discusses significant implementation guidance

relevant to that chapter topic that has been published by the FASB, with a summary listing at the

conclusion of each chapter, including pre- and post-Codification references. Companies should review

the related implementation guidance and illustrations under ASC 815 to determine whether they are

affected by industry-specific issues or other narrower issues that may not be discussed in this

publication, as well as guidance that is released after this publication date.

1.3 Fundamental concepts

The FASB considered various approaches to reconcile and extend the previous hedge accounting

guidelines in Statements 52 and 80. However, the FASB decided that such an approach was not practical

and instead decided to pursue a new approach to applying hedge accounting that would coexist with the

primary goal of making the effects of derivatives more transparent in the financial statements. The four

basic underlying premises of that approach are:

• Derivative instruments represent rights or obligations that meet the definitions of assets (expected

future cash inflows due from another party) or liabilities (expected future cash outflows owed to

another party) and should be reported in the financial statements.

• Fair value is the most relevant measure for financial instruments and the only relevant measure for

derivative instruments. ASC 820’s framework for determining fair value was required to be used

upon its adoption (1 January 2008 for calendar year-end companies).

• Only items that are assets or liabilities should be reported as such in the financial statements.

(The FASB believes gains and losses from hedging activities are not assets or liabilities and,

therefore, should not be deferred.)

• Special accounting for items designated as being hedged should be provided only for qualifying

transactions, and one aspect of qualification should be an assessment of the expectation of the

effectiveness of the hedge (i.e., offsetting changes in fair values or cash flows during the term of

the hedge for the risk being hedged).

1 Overview


The key changes to previous practice that were introduced by Statement 133 (issued in 1998) were:

• All derivatives are carried at fair value.

• The definition of a “derivative” is broader.

• Hedge accounti

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