FASB Fair Value Hedges Interaction of Statement 133 and Statement 114

FASB: Fair Value Hedges: Interaction of Statement 133 and Statement 114

Derivatives Implementation Group

Statement 133 Implementation Issue No. F4

Title: Fair Value Hedges: Interaction of Statement 133 and Statement 114
Paragraph references: 18, 27
Date cleared by Board: November 23, 1999
Affected by: FASB Statement No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities
(Revised September 25, 2000)

QUESTION

Because fair value hedge accounting under Statement 133 requires the carrying amount of a hedged loan to be adjusted for changes in fair value attributable to the hedged risk, does Statement 133 implicitly affect the measurement of impairment under Statement 114 by requiring the present value of expected future cash flows to be discounted by the new effective rate (based on the adjusted recorded investment) rather than by the old effective rate?

BACKGROUND

Company A formally documents a qualifying fair value hedge (for fair value changes attributable to changes in the designated benchmark interest rate) between a fixed-rate loan receivable from Company B and an interest rate swap. The 5-year, fixed-rate loan to Company B has a principal amount of $1,000,000 payable at maturity and interest payable annually at a 10 percent rate. One year after inception of the hedging relationship, the change in the hedged item's fair value attributable to changes in the LIBOR swap rate (the designated benchmark interest rate) is a gain of $16,022. (Refer to Row B in the following Exhibit, which presents calculations-at the end of the first year of the loan's term-of the present value of contractual cash flows based on the loan's original effective interest rate adjusted for a 50 basis point decrease in the LIBOR swap rate.) In addition, one year after inception of the hedging relationship, (1) the market interest rates for debtors of Company B's original credit sector have decreased to 9.2 percent (50 basis points related to changes in the LIBOR swap rate and 30 basis points related to changes in sector spread) and (2) there has been an adverse change to Company B's creditworthiness.

Assume that the repayment of the loan is not dependent on the underlying collateral. In applying the requirements of Statement 114 to the loan, Company A determines that the loan is impaired and that the present value of expected future cash flows discounted at the loan's effective interest rate at inception of the loan is $930,000. (Refer to Row C in the following Exhibit, which presents calculations-at the end of the first year of the loan's term-of the net present value of current estimates of expected future cash flows based on the loan's original effective interest rate.)

Paragraph 27 of Statement 133 states:

     An asset or liability that has been designated as being hedged and accounted for pursuant to paragraphs 22-24 remains subject to the applicable requirements in generally accepted accounting principles for assessing impairment for that type of asset or for recognizing an increased obligation for that type of liability. Those impairment requirements shall be applied after hedge accounting has been applied for the period and the carrying amount of the hedged asset or liability has been adjusted pursuant to paragraph 22 of this Statement.

Statement 133 gives an entity flexibility in deciding when to begin the amortization to earnings of the adjustments of the loan's carrying amount arising from fair value hedge accounting. Paragraph 24 states, in part:

     An adjustment of the carrying amount of a hedged interest-bearing financial instrument shall be amortized to earnings; amortization shall begin no later than when the hedged item ceases to be adjusted for changes in its fair value attributable to the risk being hedged.

RESPONSE

Yes. Statement 133 has implicitly affected the measurement of impairment under Statement 114 by requiring the present value of expected future cash flows to be discounted by the new effective rate based on the adjusted recorded investment in a hedged loan. When the recorded investment of a loan has been adjusted under fair value hedge accounting, the effective rate is the discount rate that equates the present value of the loan's future cash flows with that adjusted recorded investment. The adjustment under fair value hedge accounting of the loan's carrying amount for changes in fair value attributable to the hedged risk under Statement 133 should be considered to be an adjustment of the loan's recorded investment.

The loan's original effective interest rate becomes irrelevant once the recorded amount of the loan is adjusted for any changes in its fair value. Since paragraph 27 requires that the loan's carrying amount be adjusted for hedge accounting before the impairment requirements of Statement 114 are applied, Statement 133 implicitly supports using the new effective rate and the adjusted recorded investment.

After adjusting the carrying amount of the hedged loan by $16,022 (pursuant to paragraph 22 of Statement 133) for the increase in the hedged item's fair value attributable to changes in the benchmark interest rate, Company A should apply the requirements of paragraph 13 of Statement 114 by:

  1. Comparing the recorded investment of the loan after the effect of the fair value hedge, or $1,016,022, to the $944,901 present value of expected future cash flows discounted using the rate that reflects the rate of return implicit in the loan after adjusting the carrying amount of the hedged loan pursuant to paragraph 22 of Statement 133 (that is, 9.5 percent), then

  2. Recognizing an impairment by creating a valuation allowance (with the offsetting entry charged to expense) for the difference of $71,121 ($1,016,022 - $944,901).

The above guidance applies to all entities applying Statement 114 to financial assets that are hedged items in a fair value hedge, regardless whether those entities have delayed amortizing to earnings the adjustments of the loan's carrying amount arising from fair value hedge accounting until the hedging relationship is dedesignated. The guidance in this Issue on recalculating the effective rate is not intended to be applied to all other circumstances that result in an adjustment of a loan's carrying amount.

EXHIBIT

Following are calculations (at the end of the first year of the loan's term) of the net present value of the contractual cash flows and the creditor's best estimate of expected future cash flows based on the loan's original effective interest rate and the new implicit rate.

NPV at End

Assumed Cash Flow in Year

Rate

of Year 1

2

3

4

5

A.

Original Cash Flows and Original Effective Rate

10.0%

$1,000,000

$100,000

$100,000

$100,000

$1,100,000

B.

Original Cash Flows and New Implicit Rate

9.5%

$1,016,022

$100,000

$100,000

$100,000

$1,100,000

C.

Expected future Cash Flows and Original Effective Rate

10.0%

$930,000

$93,000

$93,000

$93,000

$1,023,000

D.

Expected future Cash Flows and New Implicit Rate

9.5%

$944,901

$93,000

$93,000

$93,000

$1,023,000

The above response has been authored by the FASB staff and represents the staff's views, although the Board has discussed the above response at a public meeting and chosen not to object to dissemination of that response. Official positions of the FASB are determined only after extensive due process and deliberation.