Off-Market Interest Rate Hedge Accounting for Variable Rate Debt
The updated guidance introduces a new way to deal with off-market hedging relationships. Companies with interest rate hedging programs hedging variable rate debt that are designated in off-market hedging relationships will be required to change the way they assess hedge effectiveness and measure and record any hedge ineffectiveness.
While the new guidance provides the opportunity to perform ongoing effectiveness assessments on a qualitative basis when there have been no changes in the hedging relationship, it isn’t clear how practice will develop for off-market hedging relationships. It’s likely that companies with off- market relationships will continue to perform quantitative effectiveness assessments. Quantitative effectiveness testing will continue to be required at inception of the hedging relationship.
The proposal will also require that all derivative gains and losses be deferred in other comprehensive income (OCI) for qualifying designated hedges, whether or not the hedging relationship is considered off-market. Those deferred gains and losses will then be reclassified from OCI into earnings during the period in which the hedged transactions affect earnings. Any inception value that may have previously been deferred in OCI will be reclassified to earnings on a systematic and rational basis over the period of time that the hedged transactions impact earnings.
In addition, companies will be required to record all changes in fair value in the same income statement line item as the item being hedged, thereby eliminating a company’s ability to choose where to present hedge ineffectiveness. This includes derivative gains and losses reclassified from OCI to earnings when the hedged transactions impact earnings. The only exception will be for amounts reclassified out of OCI when a missed forecasted transaction occurs, in which case a company would be permitted to select the income statement account to record those amounts.
When the short cut method is not used, current accounting guidance requires companies to assess hedge effectiveness and measure any ineffectiveness by comparing the company’s exposure against the hedging instrument. This is done by creating a hypothetical derivative that mirrors the company’s exposure and has an inception value of zero at the point of designation. Interest expense is then typically recognized on an ongoing basis based on the interest rate of the hypothetical derivative while the inception value of the actual derivative instrument is accounted for separately (potentially amortized if the instrument was in a prior hedging relationship). The effective portion of the hedge is allowed to be deferred in OCI, whereas any ineffective portion must be recognized in current period earnings. When companies reclassify deferred gains or losses from OCI to earnings, they are allowed the flexibility to determine the appropriate line item in which gains and losses should be recognized.
The new guidance introduces a new way to account for off-market hedging relationships. Practice has yet to develop around important areas including recognition patterns for inception values that were in prior hedging relationships, appropriateness of qualitative effectiveness assessments, and proper interest expense recognition for future cash settlements. Companies will need to assess their unique programs and determine the methodologies that are most appropriate.
Prepare for the new hedge accounting standard by learning about Chatham’s 8-Step Transition and Implementation Process.
Contact us today to learn more. CorpAcctgTeam@chathamfinancial.com