Dataline A look at current financial reporting issues

Hedge accounting Applying the shortcut method to "late" hedges

At a glance
An issuer of debt or investor in an asset may seek to hedge the change in fair value of the instrument due to changes in interest rates at a point in time after issuance of the instrument (as opposed to concurrently with issuance). Issuers and investors may undertake such a strategy for a number of reasons, including attractive interest rate swap rates or the decision to gain more floating rate exposure. This is commonly referred to as a "late" hedge. Questions have arisen regarding whether it is appropriate to use the shortcut method of hedge accounting for such hedging relationships. An entity that seeks to apply the shortcut method for a late hedge under the fair value hedging model should consider performing an analysis to demonstrate that the terms of the late hedge do not invalidate the assumption of no ineffectiveness that is required to apply the shortcut method of hedge accounting. This Dataline discusses certain considerations in the application of the shortcut method of hedge accounting to a late hedge.

No. 2011-22 June 2, 2011 Whats inside: At a glance ....................... 1 The main details .............. 1 Questions .........................4

The main details

.1 The derivatives and hedging guidance provides for a simplified approach to hedge accounting, commonly referred to as the shortcut method. The shortcut method allows an entity to assume that a hedging relationship is perfectly effective provided that it meets specified criteria. This allows the entity to avoid testing the effectiveness of the hedging relationship on a prospective and retrospective basis, which is required for hedging relationships accounted for using the long-haul method of hedge accounting. In addition, the shortcut method allows the entity to assume (for a fair value hedge) that the periodic change in fair value of the hedged instrument due to changes in interest rates is equal and offsetting to the periodic change in fair value of the interest rate swap, resulting in no hedge ineffectiveness recorded in earnings.
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ASC 815, Broad TransactionsDerivatives and Hedging

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PwC observation: The shortcut method was designed to provide for simplicity in the application of hedge accounting in a limited number of plain-vanilla hedging relationships. Given the potential for not recognizing any hedge ineffectiveness in earnings, the application of the shortcut method is narrow in scope by design, and the regulators have strictly (and literally) interpreted its requirements. .2 All fair value hedges of interest rate risk, even those qualifying for the shortcut method, have some amount of ineffectiveness. The guidance requires that an entity use the total contractual cash flows when determining the change in fair value of the hedged item attributable to the hedged risk. As such, there will always be some ineffectiveness in earnings when a fixed rate interest-bearing asset or liability with a credit spread is being hedged for changes in the benchmark interest rate. This is due to the difference between the interest coupon and the benchmark rate at inception of the hedging relationship, which is not economically reflected in the terms of the interest rate swap. The only way to avoid recognizing some amount of ineffectiveness in a fair value hedge of the benchmark interest rate is to qualify for the shortcut method. .3 ASC 815-20-25-104 and ASC 815-20-25-105 list the conditions that must be met for a fair value hedging relationship to qualify for the shortcut method of hedge accounting. All conditions in the guidance, without exception, must be met in order to qualify. One of these conditions is that terms of the hedged instrument and the interest rate swap must comply with both of the following: a. The terms are typical of those instruments

b. The terms do not invalidate the assumption of no ineffectiveness .4 Some have questioned whether a late hedge, designated subsequent to issuance, contains terms that invalidate the assumption of no ineffectiveness, and thus does not meet the above criteria and cannot be accounted for using the shortcut method. The primary concern is that the duration, or interest rate sensitivity, of the hedged instrument and interest rate swap in a late hedge will differ from the duration of the hedged instrument and the interest rate swap that would have been executed at issuance. .5 This duration difference may lead to increased ineffectiveness in the late hedging relationship in comparison to the hedging relationship that would have qualified for the shortcut method at the issuance date. However, in other cases, a late hedge may not be significantly less effective (and could be more effective) than a hedging relationship that would have qualified for the shortcut method at the issuance date. .6 Consider an entity that enters into an interest rate swap and designates it as a fair value hedge of a debt instrument that was issued a number of years ago. When the debt was issued (and the debt coupon was established), benchmark interest rates were 10%. In the current interest rate environment, benchmark interest rates are 1%. Assuming the swap is transacted such that it has a fair value of zero at inception, the fair value of the swap will be more sensitive to interest rate movements than the debt instrument.

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Dataline

PwC Observation: The question of late hedging was raised to the Financial Accounting Standards Board (FASB) who began deliberations on a Derivative Implementation Group issue that would have addressed this issue. However, this effort was not completed, primarily due to a larger project that the FASB had begun to amend the hedge accounting standard. To date, all of the FASB's proposals to amend the hedge accounting standard include provisions that would eliminate the shortcut method of accounting. .7 We believe that it would be prudent for an entity that seeks to apply the shortcut method to a late hedge to ensure, at a minimum, that the hedging relationship is highly effective and does not invalidate the assumption of no ineffectiveness. One way this could be achieved is by performing a prospective effectiveness analysis on both the late hedging relationship and a hypothetical hedging relationship that would have met the requirements for the shortcut method at the issuance date of the instrument (i.e., one that is not a "late" hedge). .8 In this analysis, the terms of the interest rate swap in the hypothetical "at issuance" hedging relationship would mirror the terms of the interest rate swap executed in the late hedge, except that the coupon on the fixed rate leg of the interest rate swap would be adjusted so that it would have been "at market" at the issuance date of the instrument. The entity would then compare the amount of ineffectiveness in the late hedging relationship with the amount of ineffectiveness in the hypothetical "at issuance" hedging relationship. If the analysis demonstrates that the late hedging relationship is as effective as the hypothetical hedging relationship, this would indicate that the late hedge does not introduce additional ineffectiveness. .9 Another approach to demonstrate that the late hedge does not introduce additional ineffectiveness is by reference to the fair value of the hedged instrument. If the fair value of the instrument being hedged is at or near par, the entity may be able to conclude that the hedging relationship is no more ineffective than it would have been at the issuance date. .10 If the entity's analysis demonstrates that the late hedge produces hedge ineffectiveness that does invalidate the assumption of no ineffectiveness, then the longhaul method of hedge effectiveness testing and documentation should be used. .11 There are various methods for assessing hedge effectiveness. Chapter DH 8 of PwC's Guide to Accounting for Derivative Instruments and Hedging Activities discusses effectiveness assessments. .12 Robust contemporaneous documentation that includes how the criteria were met and the quantitative evidence to demonstrate "no ineffectiveness" should be prepared to clearly demonstrate how this conclusion was reached. PwC observation: The issue addressed in this Dataline refers to hedging after issuance of an instrument. It does not refer to hedging after execution of the swap. That is a different matter. The fair value of an interest rate swap designated in a hedging relationship under the shortcut method must always be zero at inception. Therefore, it is highly unlikely that a hedging relationship could qualify for the shortcut method unless the designation is made at inception of the swap. Any designation after that point, even one day later, would likely result in the swap having a fair value other than zero because of market movements in interest rates and the passage of time.

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Dataline

Questions
.13 PwC clients who have questions about this Dataline should contact their engagement partner. Engagement teams that have questions should contact the Financial Instruments team in the National Professional Services Group (1-973-236-7803).

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Dataline

Authored by:
Chip Currie Partner Phone: 1-973-236-5331 Email: frederick.currie@us.pwc.com Maria Constantinou Director Phone: 1-973-236-4957 Email: maria.constantinou@us.pwc.com

Datalines address current financial-reporting issues and are prepared by the National Professional Services Group of PwC. This publication has been prepared for general information on matters of interest only, and does not constitute professional advice on facts and circumstances specific to any person or entity. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication. The information contained in this material was not intended or written to be used, and cannot be used, for purposes of avoiding penalties or sanctions imposed by any government or other regulatory body. PwC, its members, employees and agents shall not be responsible for any loss sustained by any person or entity who relies on this publication. 2011 PwC. All rights reserved. "PwC" refers to PricewaterhouseCoopers LLP, a Delaware limited liability partnership, which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity. To access additional content on reporting issues, register for CFOdirect Network (www.cfodirect.pwc.com), PwCs online resource for financial executives.