Derivatives Implementation Group

Statement 133 Implementation Issue No. G20

QUESTIONS

When designating a purchased option (including a combination of options that comprise either a net purchased option or a zero-cost collar) as hedging the exposure to variability in expected future cash flows attributable to a particular rate or price beyond a specified level (or levels), an entity documents that the assessment of effectiveness will be based on total changes in the option's cash flows (that is, the assessment will include the hedging instrument's entire change in fair value—its entire gain or loss), rather than documenting that the assessment of effectiveness will be based on only the changes in the hedging instrument's intrinsic value as permitted by paragraph 63(a).

1. For a cash flow hedging relationship documented as described above, can an entity focus on the hedging instrument's terminal value (that is, its expected future pay-off amount at its maturity date) in determining under paragraph 28(b) of Statement 133 whether the hedging relationship is expected to be highly effective in achieving offsetting cash flows attributable to the hedged risk during the term of the hedge?

2. For a cash flow hedging relationship documented as described above, how should an entity calculate the amount of ineffectiveness to be recognized in earnings for that hedging relationship in applying paragraph 30(b) of Statement 133?

3. When should the portion of the hedging instrument's gain or loss that is reported in accumulated other comprehensive income (OCI) be reclassified out of accumulated OCI into earnings?

BACKGROUND

Paragraph 28 of Statement 133 states, in part:

    An entity may designate a derivative instrument as hedging the exposure to variability in expected future cash flows that is attributable to a particular risk. That exposure may be associated with an existing recognized asset or liability (such as all or certain future interest payments on variable-rate debt) or a forecasted transaction (such as a forecasted purchase or sale)....

2. Both at inception of the hedge and on an ongoing basis, the hedging relationship is expected to be highly effective in achieving offsetting cash flows attributable to the hedged risk during the term of the hedge....If the hedging instrument, such as an at-the-money option contract, provides only one-sided offset against the hedged risk, the cash inflows (outflows) from the hedging instrument must be expected to be highly effective in offsetting the corresponding change in the cash outflows or inflows of the hedged transaction. All assessments of effectiveness shall be consistent with the originally documented risk management strategy for that particular hedging relationship.
   

Paragraph 30 states, in part:

    The effective portion of the gain or loss on a derivative designated as a cash flow hedge is reported in other comprehensive income, and the ineffective portion is reported in earnings. More specifically, a qualifying cash flow hedge shall be accounted for as follows: ...

2. Accumulated other comprehensive income associated with the hedged transaction shall be adjusted to a balance that reflects the lesser of the following (in absolute amounts):

   (1)  The cumulative gain or loss on the derivative from inception of the hedge less (a) the excluded component discussed in paragraph 30(a) above and (b) the derivative's gains or losses previously reclassified from accumulated other comprehensive income into earnings pursuant to paragraph 31

   (2)  The portion of the cumulative gain or loss on the derivative necessary to offset the cumulative change in expected future cash flows on the hedged transaction from inception of the hedge less the derivative's gains or losses previously reclassified from accumulated other comprehensive income into earnings pursuant to paragraph 31.

   That adjustment of accumulated other comprehensive income shall incorporate recognition in other comprehensive income of part or all of the gain or loss on the hedging derivative, as necessary.

3. A gain or loss shall be recognized in earnings, as necessary, for any remaining gain or loss on the hedging derivative or to adjust other comprehensive income to the balance specified in paragraph 30(b) above.

Paragraph 63 states, in part:

    In defining how hedge effectiveness will be assessed, an entity must specify whether it will include in that assessment all of the gain or loss on a hedging instrument. This Statement permits (but does not require) an entity to exclude all or a part of the hedging instrument's time value from the assessment of hedge effectiveness....

Example

A company forecasts that 1 year later it will purchase 1,000 ounces of gold at then current market prices for use in its operations. The company wishes to protect itself against increases in the cost of gold above the current market price of $275 per ounce. The company purchases a 1-year cash-settled at-the-money gold option on 1,000 ounces of gold, paying a premium of $10,000. If the price of gold is above $275 at the maturity (settlement) date, the counterparty will pay the company 1,000 times the difference. If the price of gold is $275 or below at the maturity date, the contract expires worthless. The option cannot be exercised prior to its contractual maturity date. The company designates the purchased option contract as a hedge of the variability in the purchase price (cash outflow) of the 1,000 ounces of gold for prices above $275 per ounce.

RESPONSE

Question 1

Yes. If (a) the hedging instrument in a cash flow hedge is a purchased option or a combination of only options that comprise either a net purchased option or a zero-cost collar, (b) the exposure being hedged is the variability in expected future cash flows attributed to a particular rate or price beyond (or within) a specified level (or levels), and (c) the assessment of effectiveness is documented as being based on total changes in the option's cash flows (that is, the assessment will include the hedging instrument's entire change in fair value, not just changes in intrinsic value), an entity may focus on the hedging instrument's terminal value (that is, its expected future pay-off amount at its maturity date) in determining under paragraph 28(b) of Statement 133 whether the hedging relationship is expected to be highly effective in achieving offsetting cash flows attributable to the hedged risk during the term of the hedge. At the onset of each cash flow hedging relationship, an entity must document how it will assess effectiveness, such as whether the assessment will be based on total changes in the option's cash flows (that is, the assessment will include the hedging instrument's entire change in fair value—its entire gain or loss) as discussed in paragraph 63 of Statement 133, rather than based, for example, on only the changes in the hedging instrument's intrinsic value. The documented method must be applied consistently when assessing effectiveness throughout the hedging relationship. An entity's focus on the hedging instrument's terminal value is not an impediment to the entity's subsequently deciding to dedesignate that cash flow hedge prior to the occurrence of the hedged transaction. (Refer to paragraph 494 of Statement 133 for potential consequences when an entity determines the original hedged transaction probably will not occur.)

If the hedging instrument is a purchased cap consisting of a series of purchased caplets that are each hedging an individual hedged transaction in a series of hedged transactions (such as caplets hedging a series of hedged interest payments at different monthly or quarterly dates), the entity may focus on the terminal value of each caplet (that is, the expected future pay-off amount at the maturity date of each caplet) in determining under paragraph 28(b) whether each of those hedging relationships is expected to be highly effective in achieving offsetting cash flows.

The above guidance applies to a purchased option regardless of whether at the inception of the cash flow hedging relationship it is at-the-money, in-the-money, or out-of-the-money.

In the example, in assessing the effectiveness of the cash flow hedge, the company would determine that since the change in the expected future pay-off amount of the purchased option completely offsets the change in the expected future cash flows on the purchase of 1,000 ounces of gold above $275 per ounce, the hedging relationship is expected to be highly effective under paragraph 28(b).

Question 2

For a cash flow hedge in which (a) the hedging instrument is a purchased option or a combination of only options that comprise either a net purchased option or a zero-cost collar, (b) the exposure being hedged is the variability in expected future cash flows attributed to a particular rate or price beyond (or within) a specified level (or levels), and (c) the assessment of effectiveness will be based on total changes in the option's cash flows (that is, the assessment will include the hedging instrument's entire change in fair value), the hedging relationship may be considered to be perfectly effective (resulting in recognizing no ineffectiveness in earnings) if the following conditions are met:

1. The critical terms of the hedging instrument (such as its notional amount, underlying, and maturity date, etc.) completely match the related terms of the hedged forecasted transaction (such as, the notional amount, the variable that determines the variability in cash flows, and the expected date of the hedged transaction, etc.)

2. The strike price (or prices) of the hedging option (or combination of options) matches the specified level (or levels) beyond (or within) which the entity's exposure is being hedged.

3. The hedging instrument's inflows (outflows) at its maturity date completely offset the change in the hedged transaction's cash flows for the risk being hedged

4. The hedging instrument can be exercised only on a single date—its contractual maturity date. (This condition is consistent with the entity's focus on the hedging instrument's terminal value, as discussed under Question 1. If the holder of the option chooses to pay for the ability to exercise the option at dates prior to the maturity date (for example, by acquiring an American-style option), the potential for recognizing ineffectiveness exists.)

If the entity concludes that the hedging relationship may be considered to be perfectly effective, the entity would simply record all changes in the hedging option's fair value (including changes in the option's time value) in OCI.

If those four conditions are not met, the entity must determine whether ineffectiveness must be recognized in earnings by comparing the change in fair value of the actual hedging instrument and the change in fair value of a "perfectly effective" hypothetical hedging instrument. That hypothetical hedging instrument should have terms that meet the four conditions listed above. The change in fair value of that hypothetical hedging instrument can be regarded as a proxy for the present value of the cumulative change in expected future cash flows on the hedged transaction(s) as described in paragraph 30(b)(2).

When ineffectiveness is required to be recognized, accumulated OCI would be adjusted to a balance that reflects the lesser of either the cumulative change in the fair value of the actual hedging instrument or the cumulative change in the fair value of the hypothetical derivative. (Consistent with paragraph 30(b)(1), that comparison excludes the effect of the hedging instrument's gains or losses previously reclassified from accumulated OCI into earnings pursuant to paragraph 31.) The amount of ineffectiveness, if any, recorded in earnings would be equal to the excess of the cumulative change in the fair value of the actual hedging derivative over the cumulative change in the fair value of the hypothetical derivative. Paragraph 30(b) indicates that hedge ineffectiveness in a cash flow hedge occurs only if the cumulative gain or loss on the derivative hedging instrument exceeds the cumulative change in the expected future cash flows on the hedged transactions.

In the example, since (1) all the critical terms of the hedging derivative completely match the hedged forecasted transaction, (2) the strike price of the hedging instrument matches the specified level ($275) beyond which the company's exposure is being hedged, (3) the hedging derivative's inflows at expiration completely offset the hedged transaction's outflows for any increase in the price of gold above $275 per ounce, and (4) the hedging option cannot be exercised prior to its contractual maturity date, the company would conclude there is no ineffectiveness to be recognized in earnings.

Question 3

The portion of the gain or loss that is reported in accumulated OCI would be reclassified out of OCI consistent with the provisions in paragraph 31. For example, the fair value of a single cap at the inception of a hedging relationship of interest rate risk on variable-rate debt with quarterly interest payments over the next two years for which the entity determines that the relationship will not result in any ineffectiveness should be allocated to the respective "caplets" within the single cap on a fair value basis at the inception of the hedging relationship. The change in each respective allocated fair value amount should be reclassified out of accumulated OCI into earnings when each of the hedged forecasted transactions (the eight interest payments) impacts earnings. Because the amount in accumulated OCI is a net amount composed of both derivative gains and derivative losses, the change in the respective allocated fair value amount for an individual caplet that is reclassified out of accumulated OCI into earnings may possibly be greater than the net amount in accumulated OCI.

In the example, the company would reclassify the purchased option's gain or loss that is reported in accumulated OCI in earnings when the cost of the gold affects earnings (such as being included in cost of goods sold).

The guidance in this Issue has no effect on the accounting for fair value hedging relationships. In addition, in determining the accounting for seemingly similar cash flow hedging relationships, it would be inappropriate to analogize to the above guidance.

General Observation

If an entity had designated any cash flow hedging relationship but had not documented the single basis on which effectiveness would be assessed, then the designation of that hedging relationship would have been incomplete and thus invalid, and no cash flow hedge accounting would be permitted under Statement 133 for the changes in the hedging derivative's fair value during the period that the documentation was incomplete. Similarly, no fair value hedge accounting would be permitted under Statement 133 for the changes in the hedged item's fair value during the period that the documentation was incomplete. The guidance on cash flow hedge accounting in this Issue does not apply to hedging relationships with incomplete documentation.

EFFECTIVE DATE

The effective date of implementation guidance in this Issue is the first day of the first fiscal quarter after August 10, 2001, the date that the Board-cleared guidance has been posted on the FASB website. Earlier application as of the first day of an earlier fiscal quarter (or the date that hedge documentation in accordance with hedging based on total changes in the option's cash flows is put in place, if later) for which financial statements have not been issued is permitted for cash flow hedging relationships in which the assessment of effectiveness was initially documented as being based on total changes in the option's cash flows (that is, the assessment will include the hedging instrument's entire change in fair value). (The guidance in this Issue does not apply to cash flow hedging relationships in which the assessment of effectiveness is documented as being based on only the changes in the hedging instrument's intrinsic value.)

If at the date of initial adoption of the guidance (the first day of a fiscal quarter) the reporting entity has any cash flow hedges for which the assessment of effectiveness was initially documented as being based on total changes in the hedging option's cash flows (that is, the assessment will include the hedging instrument's entire change in fair value), the reporting entity should report at the date of initial adoption cumulative-effect-type adjustments of net income and accumulated OCI for the amount (if any) needed to adjust accumulated OCI to a balance that reflects at that date the lesser of either the cumulative change in the fair value of the actual hedging instrument or the cumulative change in the fair value of the hypothetical derivative as well as any adjustments of accumulated OCI to conform with the guidance to Question 3 regarding the reclassification of derivative gains or losses into earnings.

For example, shortly after the tentative conclusions on this Issue were released on April 16, 2001, an entity with an April 30 fiscal quarter-end dedesignated some of its cash flow hedges in which the assessment of effectiveness was documented as being based on only the changes in intrinsic value and designated new cash flow hedges in which the assessment of effectiveness was documented as being based on total changes in the option's cash flows (that is, the assessment includes each hedging instrument's entire change in fair value). If those new hedging relationships do not qualify to be considered perfectly effective under the above guidance, the entity would recognize a cumulative-effect-type adjustment of accumulated OCI for the excess of (a) the cumulative change in the fair value of the actual hedging instrument over (b) the cumulative change in the fair value of the hypothetical derivative at the date of initial adoption. The offsetting entry is a cumulative-effect-type adjustment of net income.

If an entity dedesignated some of its cash flow hedges in which the assessment of effectiveness was documented as being based on only the changes in intrinsic value and designated new cash flow hedges on or after April 16, 2001 in an attempt to comply with the tentative conclusions on this Issue, those new cash flow hedges should be considered as having been documented as being based on total changes in the option's cash flows even though the actual documentation for that new cash flow hedge used language consistent with those tentative conclusions without explicitly referring to the assessment as "being based on total changes in the option's cash flows" or "including the hedging instrument's entire change in fair value." In that situation, the documentation for those new cash flow hedges should be revised to conform with the guidance in this Issue.

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.

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