Published on February 5, 2014
The Substance of the Standard TM MAYER HOFFMAN MCCANN P.C. – AN INDEPENDENT CPA FIRM A publication of the Professional Standards Group February 2014 Changes to the Accounting for Interest Rate Swaps Used in Hedging Relationships for Private Companies The Financial Accounting Standards Board (FASB) has endorsed the alternative proposed by the Private Company Council (PCC) in PCC Issue 13-03A through the issuance of Accounting Standards Update ASU 2014-03 Derivatives and Hedging (Topic 815): Accounting for Certain Receive – Variable, Pay – Fixed Interest Rate Swaps (ASU 2014-03). Accounting for Certain Interest Rate Swaps ASU 2014-03 permits an entity that is not a public business entity (see MHM Messenger 2014-03), not-for-profit entity, employee benefit plan, or financial institution to elect to account for a qualifying receive-variable, pay-fixed interest rate swap under a simplified hedge accounting approach. The election to account for a swap using the Contents Accounting for Certain Interest Rate Swaps................... 1 Qualifying Receive-Variable, Pay-Fixed Interest Rate Swaps.................................. 2 Required Documentation.... 3 Measurement, Precision and Disclosure........................... 3 Transition............................. 3 Implementation Steps......... 4 Appendix: Summary of Significant Changes............ 5 our roots run deep TM In summary: ASU 2014-03 was issued on January 16, 2014 and its provisions may be elected by entities that are not public business entities, not-for-profit entities, employee benefit plans or financial institutions. Through the early adoption provision, entities may elect to use the simplified hedging method on qualifying interest rate swaps as soon as their December 31, 2013 financial statements (for calendar year companies), as long as those financial statements have not been made available for issuance prior to January 16, 2014. See the Summary of Significant Changes for the key differences under ASU 2014-03. simplified hedge accounting approach is made on a swap by swap basis. A receive-variable, pay-fixed interest rate swap is a derivative contract that is often used to mitigate the risk that interest rates will change on an entity’s outstanding variable rate debt. If designed appropriately, the interest payments received or paid as a result of the swap terms offset the changes in interest payments on the variable rate debt, resulting in a fixed rate that is equial to the fixed leg of the swap. ASU 2014-03 represents a project undertaken by the PCC to reduce the complexities and ultimately the cost of applying hedge accounting to a cash flow hedge using a plain vanilla interest rate swap. The accounting alternative reduces the complexity by simplifying the criteria that must be met to qualify for hedge accounting, and simplifies the requirement to continue the application of hedge accounting to the qualifying hedging transaction. The reduced cost of compliance is obtained by providing additional time to prepare the hedge documentation, removal of the requirement to compute hedge ineffectiveness, as well as an alternative to fair value measurement and disclosure. Qualifying Cash Flow Hedge Example: A private company obtains a 10 year loan for the principal balance of $10 million with an interest rate of LIBOR plus 2 percent, which is reset monthly. At the date the debt is entered into, LIBOR plus 2 percent is equal to 4.5 percent. The Substance of the Standard TM • © 2014 Mayer Hoffman McCann P.C. 877- 887-1090 • w w w.mhmcpa.com • All rights reserved. PAG E 1
In order to protect itself from changes in the interest payments as a result of changes in the LIBOR rate the entity also obtains a receive-variable, pay-fixed interest rate swap which states that the entity will receive an amount equal to LIBOR plus 2 percent interest computed based on a notional amount of $10 million and will pay a fixed rate of 5.25% based on the same notional. The difference between the variable amount of prime plus 2 percent and the fixed amount of 5.25% computed on $10 million is net settled monthly. The economic result is that the entity pays interest of 5.25% for the term of the swap rather than a variable interest amount. The notional on the swap can be an amount equal to, or less than, the outstanding balance of the loan, however, the notional amount should not exceed the outstanding balance of the loan. If the entity does not elect hedge accounting, then the interest rate swap is measured at fair value for each reporting period and the changes in the fair value of the swap are recorded directly in the income statement as a gain or loss. If the transaction qualifies for hedge accounting, then the swap is measured at fair value, however, changes in the fair value of the swap, minus ineffectiveness, if any, is recorded as a component of other comprehensive income. Thus, under hedge accounting, pretax income would reflect interest expense of $450,000 per year which would match the economics the entity expects to pay by entering into the hedge. If the entity did not apply hedge accounting, it would reflect $450,000 of net interest expense plus the change, measured at fair value, of the interest rate swap, which may result in period expense greater or less than $450,000. Qualifying Receive-Variable, Pay-Fixed Interest Rate Swaps For an interest rate swap to qualify for the simplified hedge accounting approach, the hedging relationship must meet six criteria. The criteria, at left, for a qualifying hedge transaction are interpreted strictly and require a swap and the hedged cash flow to have many of the same terms. Thus, a qualifying swap will often be one that is negotiated in conjunction with a debt instrument at the time of obtaining the borrowing. Criteria a, b and c all require the terms of the swap and the hedged debt instrument to have comparable terms. The first term to compare is the benchmark for the variable interest rate. The variable rate on the debt and the swap must be based on the same index. For instance the interest rate on the variable portion of the swap and the debt in the above example are both based on movements in the LIBOR rate. Certain interest rate indexes, such as LIBOR, Criteria (excerpted from ASC 815-20-25-131D): a. Both the variable rate on the swap and the borrowing are based on the same index and reset period (for example, both the swap and borrowing are based on one-month London Interbank Offered Rate [LIBOR] or both the swap and borrowing are based on three-month LIBOR). In complying with this condition, an entity is not limited to benchmark interest rates described in paragraph 815-20-25-6A. b. The terms of the swap are typical (in other words, the swap is what is generally considered to be a “plain-vanilla” swap), and there is no floor or cap on the variable interest rate of the swap unless the borrowing has a comparable floor or cap. c. The repricing and settlement dates for the swap and the borrowing match or differ by no more than a few days. d. The swap’s fair value at inception (that is, at the time the derivative was executed to hedge the interest rate risk of the borrowing) is at or near zero. e. The notional amount of the swap matches the principal amount of the borrowing being hedged. In complying with this condition, the amount of the borrowing being hedged may be less than the total principal amount of the borrowing. f. All interest payments occurring on the borrowing during the term of the swap (or the effective term of the swap underlying the forward starting swap) are designated as hedged whether in total or in proportion to the principal amount of the borrowing being hedged. have many variations (i.e. 1-month, 3-month, 6-month, etc) and the same variant of the index should be used in both the swap and the debt. The second term that must be consistent is that the swap and debt have comparable floors or caps, if any. If a debt has an interest rate floor so that its interest rate is a prime rate plus 2%, but not less than 4%, a comparable swap could be stated as the prime rate, but not less than 2% (assuming prime was 2% on the date of the transaction). Lastly, in addition to the interest rate being comparable, the swap and debt should have interest due and the variable rate reset at nearly the same time. Therefore, when a debt borrowing has the interest payment due and interest rate reset on the last day of the month, the swap should have interest payments net settled and the rate reset on the same day or within a few days. The Substance of the Standard TM • © 2014 Mayer Hoffman McCann P.C. 877- 887-1090 • w w w.mhmcpa.com • All rights reserved. PAGE 2
Although a few days is not defined, the objective of the standard was to allow for administrative and practical application issues that would occur if the settlement and reset were required to occur at the same time for the debt and swap. For administrative reasons it is not unusual to have the swap settlement and reset occur two or three business days after the debt instruments interest due date. However, it is also common for interest rate reset provisions to vary by greater than a few days, such as quarterly versus monthly. In such instances, application of the simplified approach would not be appropriate. Criteria d establishes the requirement that the swap’s fair value should be at or near zero when it is entered into (inception). The fair value of an interest rate swap is generally measured by computing the present value, adjusted for the risk of nonperformance, of the future cash flows of the fixed interest rate payments over its term compared to the expected payments for the variable portion of the swap based on the forward yield curve for the applicable index. Most interest rate swaps are structured so that they have a fair value of near zero at the date of inception so that, with the exception of fees, neither party is required to make a payment to the other upon entering the swap. In a similar way to the criterias requiring that the swap and debt have comparable terms, criteria e requires that the notional amount of the swap be matched to the principal amount of the debt. For instance, if an entity intends to hedge a debt with a principal balance of $10 million the notional amount of the swap can be an amount that is equal to $10 million or less. If the notional amount of the swap were $7.5 million, then the swap would only hedge a portion of expected cash flows associated with the debt and the entity would be exposed to interest rate risk related to the remaining unhedged cash flows. The last criteria, criteria f, requires that all of the interest payments (cash flows) on the hedged debt that are made during the term of the swap be designated as the hedged items in the relationship. An entity is not permitted to enter into an interest rate swap and elect to hedge only a portion of the cash flows associated with the interest rate swap. Although an entity must designate all payments of interest as being hedged over the term of the swap, if the swap or debt instrument were changed such that criteria a through f were no longer met, an entity would be required to stop hedge accounting under the practical expedient despite the earlier designation. The simplified hedge accounting approach is permitted for forward swaps if the forecasted interest payments of the underlying forecasted debt are probable. A forward swap is a swap that is entered into at a point in time, for example today, but for which payments (net settlement) of interest does not begin until some point in the future, for example one year from today. This is effective for fixing an interest rate (fixed leg of the swap) at the current rate rather than a future rate. Required Documentation Under the requirements for hedge accounting without the election of ASU 2014-03 hedge accounting may not be applied to a qualifying relationship until the documentation is complete (i.e. contemporaneous). The documentation requirement includes documenting the hedging instrument and hedged item or transaction, the risk being hedged, and the effectiveness of the hedge, including defining the method of assessment. In addition the hedge should be expected to be highly effective and the entity is required to assess effectiveness at least quarterly and measure ineffectiveness to be reported into current earnings (see also ASC 815-20-25-3). With the election of ASU 2014-03 an entity’s documentation requirements are reduced because it is assumed that the swap is effective, thus relieving what is often the most burdensome aspect of the existing hedge requirements. In addition, the documentation which designates the hedge can be completed at any point up until the financial statements for the period the swap is entered into are available for issuance, thus eliminating the need to prepare documentation concurrently when entering into the interest rate swap. Measurement, Presentation and Disclosure As with any recognized derivative asset or liability when electing the simplified hedge accounting approach an entity measures the value of the swap at the end of reporting period; however under ASU 2014-03 the entity may elect to measure a qualifying swap used in a hedging relationship at its settlement value rather than its fair value. The primary difference between settlement value and fair value for a swap is that the former removes the need to factor in the risk of non-performance in the projected cash flows used to estimate fair value. As a result, the settlement value is based on the discounted cash flows associated with the forward curve (for the variable leg) and the fixed contractual cash flows. The difference between the fair value (settlement value) of the swap and the carrying amount of the swap (the gain or loss) is recorded in other comprehensive income. The Substance of the Standard TM • © 2014 Mayer Hoffman McCann P.C. 877- 887-1090 • w w w.mhmcpa.com • All rights reserved. PAGE 3
If the qualifying swap ceases to qualify as a result of a change in the relationship between the swap and the debt — which may be caused by early settlement of the swap or prepayment of the debt — the gain or loss on the swap recorded in accumulated other comprehensive income is either recognized into income (if the projected cash flows are no longer probable), or remains in accumulated other comprehensive income until such time as the hedged cash flows are incurred. If the debt is repaid, and the swap reamins outstanding, the swap is remeasured at fair value with the changes in fair value recognized in income. Once a swap no longer qualifies for the simplified hedge accounting approach the election to record the swap at settlement value is not permitted and therefore the fair value, and not the settlement value, must be used. In addition to permitting the measurement of the qualifying swaps at settlement value, the disclosures required under ASC 815 Derivatives and Hedging may be made at the settlement value instead of fair value. Also, an entity whose only derivatives are interest rate swaps that are being accounted for under the simplified hedge accounting approach are exempted from the fair value disclosures under ASC 825 Financial Instruments. Transition The effective date for ASU 2014-03 is for periods beginning after December 15, 2014, which for calendar year entities is the year ended December 31, 2015. Early adoption is permitted; therefore a qualifying entity may adopt the standard for any financial statements that have not been made available for issuance as of January 16, 2014. The determination of which swaps qualify for the simplified hedge accounting approach is made by evaluating the swaps at the date they were entered into, therefore the simplified hedge accounting approach may be adopted for existing swaps at the date of adoption even if their fair value is not near zero at the date of adoption, as long as the fair value of the swap was near zero at the date the swap was entered into. When adopting this standard an entity is able to elect the simplified hedge accounting approach on a swap by swap basis. In the year of adoption, if the simplified hedge accounting approach is applied to an existing swap, an entity may use either the full or modified retrospective approach. The full retrospective approach requires that the financial statements for each period be adjusted to reflect the period specific effects of having applied the simplified hedge accounting approach. The retained earnings and accumu- lated other comprehensive income for the earliest period presented would be adjusted for the gain or loss on the fair value or settlement value of the swap. Under the modified retrospective approach the adjustment to the opening balance of accumulated other comprehensive income and retained earnings is presented at the beginning of the financial reporting period in which ASU 2014-03 was adopted. When adopted an entity is required to provide the disclosures of a change in accounting principal within the footnotes to its financial statements, including the nature of, and reason for, the change in accounting principal. In addition the entity should disclose the method of applying the change including a) a description of prior-period information that was retrospectively adjusted, b) the effect of the change on affected financial statement line items, subtotals and totals and c) the cumulated effect of the change on the components of equity. Implementation Steps Every implementation of ASU 2014-03 will be unique, however the following steps can be used to assist in designing an implementation plan: Step 1: Ensure the entity is a qualifying private company • An entity is only eligible to apply the practical expedi- ent if they do not meet the definition of a public business entity provided by ASU 2013-12. Additionally, the option is not available to not-for-profit entities, employee benefit plans, or financial institutions (including banks, credit unions, and finance companies). Step 2: Ensure the hedge transaction meets the criteria established in ASC 815-20-25-131D • ASC 815-20-25-131D provides six criteria, discussed above, that must be met in order to apply the simplified hedge accounting approach. The violation of any one of the six criteria would result in a prohibition of application of the accounting alternative. Consider establishing a procedure and standard documentation to document the six criteria for each swap. Step 3: Complete documentation of the hedging relationship • The documentation is required to be completed no later than the date the financial statements are available to be issued. Once the financial statements are available for issuance, the election is no longer avail- The Substance of the Standard TM • © 2014 Mayer Hoffman McCann P.C. 877- 887-1090 • w w w.mhmcpa.com • All rights reserved. PAGE 4
able. Documentation includes the hedging instrument and hedged item or transaction, and the risk being hedged. Further information on required documentation can be found at ASC 815-20-25-3. Step 4: Apply the transition requirements • Upon adoption, a private company may elect to either (1) not apply the practical expedient to any qualifying existing hedging relationships, or (2) apply the transition provisions to any individual, or all existing qualifying hedging relationships. If an election is made to apply the practical expedient to existing hedging relationships, the entity must apply either a modified or full retrospective approach. The full retrospective approach requires that all financial statements presented be restated to reflect the application of the practical expedient to the respective period’s financial statements. Step 5: Ensure accounting, presentation and disclosure for new transactions is appropriate • The reporting for each transaction is the same as that traditionally applied to a cash flow hedge, except the value of the derivative financial instrument may be recorded on the balance sheet at settlement value or fair value, with changes in value recorded in other comprehensive income. The reporting entity may assume no ineffectiveness. • The fair value disclosure requirements of ASC 815 and ASC 820 remain unchanged; however, the reporting entity may elect to report the value of the interest rate swap at settlement value in completing those disclosures. For more information If you have any specific questions or concerns regarding accounting for receive-variable, pay-fixed interest rate swaps, please contact James Comito of MHM’s Professional Standards Group or your MHM service professional. James can be reached at 858.795.2029 or email@example.com. The Substance of the Standard TM • © 2014 Mayer Hoffman McCann P.C. 877- 887-1090 • w w w.mhmcpa.com • All rights reserved. PAGE 5
Substance of the Standard 2014-02 Appendix: Changes to the Accounting for Interest Rate Swaps Summary of Significant Changes Without the election of ASU 2014-03 With the election of ASU 2014-03 Documentation In order to obtain hedge accounting concurrent documentation meeting the criteria of ASC 815-20-25-3 is required. Documentation of the hedging relationship following the guidance of ASC 815-20-25-3 may be completed anytime until the financial statements are available to be issued. An entity may assume the swap has no ineffectiveness, thus eliminating the required documentation related to hedge effectiveness. Measurement Fair value Fair value or settlement value Recognition If hedge accounting is elected the changes in fair value of the swap, net of ineffectiveness, are recorded in other comprehensive income. If hedge accounting is elected the changes in fair value or settlement value of the swap are accounted for in other comprehensive income. If hedge accounting is not elected then the changes in fair value of the swap If hedge accounting is not elected are recorded in income. then the changes in fair value of the swap are recorded in income. Disclosure Disclosure of the swap under ASC 815 Disclosure of the swap under ASC and ASC 820 are at fair value. 815 and ASC 820 are at fair value or settlement value. All required disclosures of ASC 825 Fair Value are required. If an entity’s only derivative instruments are swaps accounted for under ASU 2014-03 the disclosures of ASC 825 Fair Value are not required. The Substance of the Standard TM • © 2014 Mayer Hoffman McCann P.C. 877- 887-1090 • w w w.mhmcpa.com • All rights reserved. PAGE 6
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