Simplified hedge accounting approach

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1 No April 3, 2014 What s inside: Overview... 1 Background... 1 Key provisions... 2 Applicability of simplified hedge accounting approach... 2 Recognition... 3 Hedge documentation requirements... 5 Initial measurement... 7 Subsequent measurement... 7 Discontinuance of hedge accounting... 8 Disclosure... 9 What s next... 9 Appendix Simplified hedge accounting approach New private company accounting alternative for certain interest rate swaps Overview On January 16, 2014, the FASB issued ASU No , Accounting for Certain Receive-Variable, Pay-Fixed Interest Rate Swaps Simplified Hedge Accounting Approach. This standard provides private companies, other than financial institutions, not-for-profit entities, and employee benefit plans with an accounting alternative intended to make it easier for certain interest rate swaps to qualify for hedge accounting. Under the simplified hedge accounting approach, an eligible private company would be able to apply hedge accounting to its receive-variable, pay-fixed interest rate swaps as long as certain conditions are met. Existing guidance would be simplified in that a company electing this alternative would be able to (1) assume the cash flow hedge has no ineffectiveness, (2) delay completing its necessary hedge documentation, and (3) recognize the interest rate swap at its settlement value, which excludes non-performance risk, instead of at its fair value. The standard is effective for annual periods beginning after December 15, 2014, and interim periods within annual periods beginning after December 15, Early adoption is permitted, which means that this alternative can be applied to calendar year 2013 financial statements, as long as those financial statements were not made available for issuance prior to the release of the final standard. The Appendix to this Dataline provides examples of the application of this guidance upon initial adoption of the ASU. Background.1 The ability of many private companies to borrow funds at a fixed rate of interest is often limited in the market. As a result, these companies will typically borrow on a floating rate basis, and at the same time, enter into an interest rate swap to economically convert the borrowing into fixed rate debt..2 Under existing U.S. GAAP, an interest rate swap is a derivative instrument and is recognized on the balance sheet at its fair value, as either an asset or a liability. If the interest rate swap is designated as a hedge of variability in cash flows and meets the criteria for hedge accounting, changes in its fair value are initially recognized in other National Professional Services Group CFOdirect Network Dataline 1

2 comprehensive income. Changes in the fair value for the ineffective portion of a designated interest rate swap are reported in current earnings..3 For an interest rate swap to be accounted for as a cash flow hedge, a company is required to document its election and assess the effectiveness of the hedging relationship at inception. If a company does not contemporaneously document the hedging relationship, including the effectiveness assessment, the interest rate swap would not qualify for hedge accounting. When an interest rate swap does not qualify for hedge accounting, or is not designated as a hedge, the changes in its fair value are reported in current earnings, typically as a charge to interest expense..4 Due to limited resources and/or the complexity of hedge accounting, private companies may lack the expertise to comply with the requirements to qualify for hedge accounting or the resources to prepare the necessary documentation and estimate the fair value of the interest rate swap each reporting period. Under the new guidance, qualifying for hedge accounting is simpler, and the measurement of the instrument is less complex. Key provisions Applicability of the simplified hedge accounting approach.5 The simplified hedge accounting approach may be applied by companies that are not financial institutions, not-for-profit-entities, employee benefit plans or public business entities, as defined in ASU , Definition of a Public Business Entity. Eligible private companies may also continue to follow the provisions of ASC 815, Derivatives and Hedging, rather than adopting the simplified approach..6 If an entity meets the definition of a public business entity solely because its financial statements are included in another entity s SEC filings, the entity is only a public business entity for purposes of the financial statements filed with the SEC. PwC observation: Before adopting the private company alternative, an eligible private company should carefully weigh both the impact of applying the standard on its key financial metrics, and the potential cost of unwinding the accounting and reapplying the existing hedge accounting requirements if its reporting requirements change because it no longer meets the definition of a private company. A company that is private today could later meet the definition of a public business entity, for example, by becoming: a public company through an initial public offering of its debt or equity securities, a conduit bond obligor through the issuance of industrial development bonds through a municipal financing agency, or a significant subsidiary for SEC filing purposes through its acquisition by a public company. Once a company meets the definition of a public business entity, it may no longer apply the simplified approach. Additionally, if upon becoming a public business entity, it is subject to SEC regulation, it will need to retrospectively adjust its historical financial statements to remove the effect of applying the simplified hedge accounting approach for all prior periods. This could prove to be a time consuming and costly exercise for the private company that is about to become a public business entity. National Professional Services Group CFOdirect Network Dataline 2

3 Recognition.7 An eligible private company may apply the simplified hedge accounting approach to its receive-variable, pay-fixed interest rate swaps provided certain criteria are met. Interest rate swaps entered into by a private company that relate to investing or other speculative activities are not within the scope of the standard. The criteria to be met are as follows. Each is described in more detail in paragraphs a) The variable rate on both the swap and the borrowing are based on the same index and reset period (for example, both the swap and borrowing are based on six-month LIBOR with interest rate resets every six months) b) The terms of the swap are typical (i.e., plain-vanilla ) and do not contain a floor or cap on the variable interest rate, 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 (i.e., at the time the swap was executed to hedge the borrowing) is at or near zero e) The notional amount of the swap matches the principal amount of the borrowing being hedged, which may be less than the total principal on the borrowing f) All interest payments occurring on the borrowing during the term of the swap are designated as hedged whether in total or in proportion to the principal amount of the borrowing being hedged.8 If all of the above criteria are satisfied, the company may assume there is no hedge ineffectiveness in the cash flow hedging relationship, and the swap would qualify for hedge accounting. Index and reset period.9 Certain borrowing arrangements provide the borrower with the option to periodically select the interest rate index and reset period (what is commonly referred to as you pick em debt ). For example, the interest rate on a borrowing may reset every three months and, at each reset date, the entity has the ability to designate the interest rate index as three-month LIBOR, six-month LIBOR or the Prime rate. The existence of such an option will not preclude a company from applying the simplified hedge accounting approach as long as the interest rate index and reset period on the swap and the borrowing match (i.e., in this example, the entity elects three-month LIBOR as the interest rate for the borrowing at inception of the hedge, and the swap is based on threemonth LIBOR)..10 If the company subsequently elects to change the interest rate or reset period such that the rate on the swap no longer matches the borrowing (for example, if the entity subsequently resets the interest on the borrowing to Prime), the relationship will no longer qualify for the simplified hedge accounting approach. At that time, the company would have to dedesignate the hedging relationship and discontinue hedge accounting under the simplified approach. It would, however, be able to designate a new hedging relationship using the long haul method (i.e., apply the full hedge accounting provisions in ASC 815), assuming all of the qualifying criteria are met. Terms of the swap.11 The use of other than plain vanilla interest rate swaps may reflect more sophisticated structured financing arrangements for which the simplified approach would not be appropriate. A typical plain vanilla interest rate swap exchanges a fixed National Professional Services Group CFOdirect Network Dataline 3

4 interest rate for a floating interest rate based on a specified interest rate index, such as LIBOR. The swap is based on a specified notional amount for a defined time period, with periodic settlement dates. This type of swap would ordinarily be considered plainvanilla, as long as there are no unusual or non-standard features. However, there is one non-standard feature that is acceptable under the simplified approach. A swap may have an interest rate cap or floor as long as there is a comparable feature in the borrowing..12 A company may enter into a forward starting interest rate swap to hedge variablerate interest payments on future debt issuances. If the qualifying criteria are met, forward starting interest rate swaps may also be accounted for using the simplified hedge accounting approach. The following example illustrates the application of the simplified hedge accounting approach to forward starting interest rate swaps and related accounting considerations. Example: Forward-starting receive-variable, pay-fixed swap Entity A, a private company, expects to issue a 10-year $5 million variable rate borrowing in one year. Entity A enters into a forward-starting receive-variable, payfixed interest rate swap with a 10-year effective term and an effective date commencing one year after the swap s inception. Entity A designates the swap as a cash flow hedge of the interest payments on this 10-year variable-rate borrowing forecasted to be issued one year after the swap s inception. All interest payments occurring on the borrowing during the effective tem of the swap are designated as hedged. In this case, Entity A could apply the simplified hedge accounting approach assuming all of the qualifying criteria are met. PwC observation: Companies should be cautious when electing the simplified hedge accounting approach for forward starting interest rate swaps if there is uncertainty regarding the timing and final terms of the debt issuance. If, in the above example, Entity A decided to delay its debt issuance for another six months, it would no longer qualify for simplified hedge accounting and would need to dedesignate the hedging relationship. Repricing and settlement dates.13 The new guidance allows private companies a few days latitude in repricing and settlement dates to address administrative and other practicability concerns. The additional flexibility was provided because such a difference is unlikely to give rise to any significant amount of ineffectiveness in the hedging relationship. PwC observation: The basis for conclusion of the ASU explains that the Private Company Council (PCC) did not want to specify any bright-line threshold as to what qualifies as a few days. The intent was not to provide a blanket time period extension. Instead, the PCC preferred to let practice determine the appropriate application of this criterion. We believe that no more than one week would generally represent a reasonable time period. Fair value at inception.14 A swap s fair value must be at or near zero at inception of the hedging relationship. Similar to the latitude given to the repricing and settlement dates, the PCC decided to National Professional Services Group CFOdirect Network Dataline 4

5 provide this accommodation to address administrative and practicability concerns. The ineffectiveness associated with the interest element inherent in an off-market interest rate swap is unlikely to be significant if it has a small fair value at the inception of the hedging relationship. PwC observation: The ASU does not define "at or near zero." We believe it should be interpreted similar to the guidance for the "somewhat near zero" limitation for the variable cash flows method in ASC and evaluated in terms of the potential ineffectiveness that may arise from the interest element in the interest rate swap. Therefore, if a private company (1) enters into an interest rate swap with terms that do not reflect the prevailing market rates and pays or receives a significant premium, or (2) designates an existing interest rate swap with a significant fair value at the inception of the hedging relationship, the simplified hedge accounting approach cannot be applied. This situation may also arise if, for example, a private company acquires another private company that was applying the simplified approach. Because the date the acquisition is consummated is considered the inception of the hedging relationship for the acquirer, and the interest rate swap will likely have a fair value other than "at or near zero" at that date, the simplified approach cannot be continued by the acquirer in its consolidated financial statements. Notional amount and interest payments.15 The notional amount of the interest rate swap must match the principal amount of the borrowing being hedged, and all interest payments on the principal amount of the borrowing being hedged during the term of the swap must be designated as hedged. The principal amount of the borrowing being hedged may be less than the total principal amount of the borrowing. Hedge documentation requirements.16 The simplified hedge accounting approach relaxes the ASC 815 requirement for contemporaneous hedge accounting documentation to be prepared at hedge inception. Under the private company alternative, hedge accounting documentation must be completed by the date on which the first annual financial statements are available to be issued after hedge inception. For example, if a calendar year end company enters into an interest rate swap on January 1, 2013, and the company has until March 31, 2014 to issue the annual financial statements, the company would have until the financial statements are available to be issued (i.e., on or before March 31, 2014) to complete the required hedge documentation..17 Although the simplified hedge accounting approach allows some latitude, private companies should exercise caution in waiting to complete the hedge accounting documentation. If a company later determines that the interest rate swap does not meet one of the requisite conditions to qualify for this alternative, the company would not be able to retroactively apply the long haul method as the documentation was not contemporaneously completed at hedge inception. While the company would be able to designate a new hedge relationship prospectively at that time, it will be more difficult, as the interest rate swap s fair value will likely have changed which gives rise to more ineffectiveness..18 All of the formal hedge documentation requirements outlined in ASC are still applicable. Although there is some relief with respect to timing, the documentation requirements are still extensive and include the following: National Professional Services Group CFOdirect Network Dataline 5

6 the hedging relationship the entity s risk management objective and strategy for undertaking the hedge, including identification of all of the following: o the hedging instrument o the hedged item or transaction o the nature of the risk being hedged o the method that will be used to retrospectively and prospectively assess the hedging instrument s effectiveness in offsetting the exposure to the hedged transaction s variability in cash flows attributable to the hedged risk o the method that will be used to measure hedge ineffectiveness.19 Even though the simplified hedge accounting approach allows a company to assume no ineffectiveness in the cash flow hedging relationship, the company must still choose a method of measuring ineffectiveness. The method selected must be included in the initial hedge documentation. If at any point the hedging relationship no longer qualifies for the alternative, the method included in the initial documentation must be used to measure ineffectiveness at the time of hedge dedesignation. PwC observation: Care should be taken when documenting the hedging relationship, especially with respect to the description of the hedged item or transaction. For example, an entity may designate the hedged item as either the interest payments of a specific borrowing or the interest payments for borrowings associated with a specific interest rate index. This documentation is critical to the determination of whether and when a hedging relationship must be discontinued, as well as the subsequent accounting for amounts in other comprehensive income should hedge accounting be lost. We believe hedge documentation should be specific enough such that when the transaction occurs, it is clear that it was the hedged transaction. However, the more specific the designation, the more likely changes in the terms of the hedged item or transaction could result in the termination of the hedging relationship and the potential release of accumulated other comprehensive income because the hedged transaction, as defined, will not occur. Therefore, the entity should not be more specific than is necessary to comply with the requirements of ASC 815. Example: Debt refinancing Entity A, a private company, enters into a $5 million, 10-year variable-rate interest only, non-prepayable borrowing indexed to 6-month LIBOR on January 1, It concurrently enters into an at-market 10-year receive-variable, pay-fixed interest rate swap to economically convert the debt s variable rate to a fixed rate. All criteria to qualify for the simplified hedge accounting approach are met. Entity A is eligible to apply the simplified hedge accounting approach and designates the interest rate swap as a cash flow hedge. In year five, Entity A decides to refinance the loan with a new lender. Entity A enters into another 10-year variable-rate interest only, non-prepayable borrowing indexed to 6-month LIBOR for a principal amount of $5 million. The reset periods and settlement dates continue to match the original interest rate swap. As the company borrowed money from a new lender, this is treated as an extinguishment of the old borrowing for accounting purposes. Entity A s ability to continue to apply the simplified hedge accounting approach for the remaining term of the interest rate swap will depend on its initial hedge National Professional Services Group CFOdirect Network Dataline 6

7 documentation. If Entity A defined the hedged transaction as forecasted interest payments on the specific $5 million loan entered into on January 1, 2013, the company would no longer be able to prospectively apply the simplified hedge accounting approach, as the debt was extinguished for accounting purposes, and therefore, the hedged transaction will no longer occur. Conversely, if Entity A defined the hedged transaction as forecasted interest payments indexed to 6-month LIBOR on the first $5 million of principal on variable-rate debt, then the simplified hedge accounting approach could continue to be applied, as the forecasted transaction (as defined) will still occur. Therefore, it is not a foregone conclusion that a refinancing with similar terms to the interest rate swap and the original borrowing will continue to qualify for the simplified hedge accounting approach. The initial hedge documentation must support the continuation of the simplified approach subsequent to a refinancing. Initial measurement Settlement value versus fair value.20 Under the simplified hedge accounting approach, an eligible private company can elect to recognize the interest rate swap at its settlement value instead of fair value. The primary difference between settlement value and fair value is that non-performance risk is not considered in the measurement of settlement value. Non-performance risk is defined in the ASC Glossary as the risk that an entity will not fulfill an obligation (including credit risk for both the company and the swap counterparty). PwC observation: Companies often receive periodic statements of an interest rate swap s value from the swap counterparty. The value provided from the counterparty would typically be expected to reflect a settlement value consistent with the ASU s guidance. However, if a private company wishes to use this approach, it should gain an understanding of the valuation techniques employed by the swap counterparty to ensure the value provided is representative of settlement value as defined. As an alternative, a private company may estimate the settlement value on its own. The new ASU indicates that an acceptable approach to measuring settlement value is a present value calculation of the swap s remaining estimated future cash flows using a recognized valuation technique that is not adjusted for non-performance risk. We believe that the discount rate used in the present value calculation may either be the current market rate of interest adjusted for credit risk, or the appropriate current risk free / benchmark rate. In practice, we expect the settlement value to be typically based on the estimated future cash flows discounted at LIBOR for uncollateralized swaps and may be discounted at the overnight indexed swap rate (OIS) for collateralized swaps..21 Use of settlement value is optional under the simplified approach; a company may choose to continue reporting qualifying swaps at fair value. Settlement value is provided as a practical expedient and can be elected on a swap-by-swap basis. As such, settlement value does not need to be used for all similar hedge relationships. Subsequent measurement.22 The change in settlement value or fair value of an interest rate swap designated as a cash flow hedge under the simplified hedge accounting approach will be recorded in other comprehensive income (OCI). No ineffectiveness is measured or recorded as the hedge relationship is assumed to be perfectly effective. As a result, the income statement National Professional Services Group CFOdirect Network Dataline 7

8 impact for interest expense under this approach would approximate the amount that would have been recognized if a company directly entered into a fixed-rate borrowing. Consequently, the accounting treatment reflects the economics of the hedging strategy..23 Similar to the requirements of the critical-terms match approach described in ASC 815, entities must make an ongoing assessment that the terms of the hedge relationship have not been modified (i.e., that the critical terms have not changed during the period) and that the forecasted interest payments are probable of occurring. As part of this assessment, entities must evaluate the likelihood of the counterparty s compliance with the contractual terms of the swap..24 An entity must assess counterparty credit risk pursuant to ASC through 18 on at least a quarterly basis. If there have been adverse developments regarding counterparty credit risk such that it is no longer probable that the counterparty will not default, an entity can no longer apply the simplified hedge accounting approach. However, if there are no adverse developments regarding counterparty default risk and the terms of the swap continue to mirror the terms of the borrowing in accordance with the simplified hedge accounting approach criteria, an entity may continue to conclude there is no ineffectiveness to record. An ongoing assessment should be undertaken for each quarterly period, albeit with the documentation prepared no later than the date the annual financial statements are available to be issued. Discontinuance of hedge accounting.25 Hedge accounting must be discontinued prospectively if the hedging relationship no longer meets the qualifying criteria of the simplified hedge accounting approach or if the private company elects to discontinue hedge accounting. At the time of such disqualification or dedesignation, an entity must perform a final measurement of effectiveness of the hedge relationship based on the newly revised best estimate of cash flows and adjust OCI accordingly for any ineffectiveness. The final assessment shall be performed based on the fair value of the interest rate swap, rather than its settlement value. The assessment should follow the method of measuring ineffectiveness documented in the entity s initial hedge documentation..26 The difference between settlement value and fair value at the time of dedesignation will be reported in OCI to the extent of the effectiveness of the hedging relationship, and subsequent changes in the fair value of the swap will be reported in earnings. If the hedge is still considered to be highly effective, a company may redesignate a new hedge relationship prospectively under the long haul method..27 Upon dedesignation, treatment of the gains and losses previously deferred in accumulated other comprehensive income (AOCI) will depend on the cause of dedesignation and the original hedge documentation. For example, assume an eligible private company designates an interest rate swap indexed to three-month LIBOR as a cash flow hedge under the simplified approach to hedge exposure to variability in interest rate payments indexed to LIBOR for a specified principal amount of borrowings. If, during the term of the swap, the company resets its interest rate to the Prime rate, the hedge relationship will no longer qualify for the simplified hedge accounting approach and gains and losses on the swap in AOCI would be reclassified to earnings. This is because it is probable there will not be LIBOR indexed interest payments due to the switch to Prime..28 In contrast, if the entity changes its interest rate index on its borrowing from threemonth LIBOR to six-month LIBOR, the hedge relationship would no longer qualify under the simplified hedge accounting approach; however, the forecasted transaction (as defined) is still expected to occur as the company will continue to incur interest payments indexed to LIBOR. In this case, the entity would need to measure effectiveness of the hedging relationship as of the date of disqualification and record the interest rate National Professional Services Group CFOdirect Network Dataline 8

9 swap at fair value; however, only the amount of ineffectiveness would be reported in earnings at this time. The gains and losses on the interest rate swap deferred in AOCI will not be reclassified until earnings are impacted by the forecasted transaction. Future changes in the interest rate swap s fair value (subsequent to discontinuance of hedge accounting) are reported in earnings, unless the swap is redesignated in a qualifying hedge under another method pursuant to ASC 815. Disclosure.29 The current disclosure requirements in ASC 815 and ASC 820, Fair Value Measurement, continue to apply under the simplified hedge accounting approach. However, amounts recorded at settlement value must be specifically disclosed as settlement value in place of fair value in complying with the fair value disclosure requirements..30 An interest rate swap designated as a cash flow hedge under the simplified hedge accounting approach is not considered a derivative instrument for purposes of applying the guidance in ASC , Financial Instruments, which allows certain private companies an exemption from the fair value disclosure requirements if the specified conditions are met. What s next Effective date and transition.31 The simplified hedge accounting approach is effective for annual periods beginning after December 15, 2014 and for interim periods within annual periods beginning after December 15, Early adoption is permitted. Therefore, a calendar year-end company within the scope of the guidance could apply the simplified hedge accounting approach to its 2013 financial statements as long as the criteria are met and the hedge accounting documentation is completed prior to when the 2013 financial statements are available to be issued..32 Private companies with existing interest rate swaps that elect to apply the simplified hedge accounting approach may use one of the following two approaches upon initial adoption of the ASU: Modified retrospective approach: Under this approach, a company would adjust assets, liabilities and opening AOCI and retained earnings as of the beginning of the current reporting period to reflect the application of the simplified hedge accounting approach from the date of the swap s inception. Full retrospective approach: Under this approach, a company would retrospectively adjust prior period financial statements to reflect the periodspecific effects of the simplified hedge accounting approach from the date of the swap s inception. This includes adjusting assets, liabilities, opening AOCI and retained earnings as of the beginning of the earliest period presented..33 If a company adopts the ASU for an existing qualifying interest rate swap, the criteria for the swap s fair value to be at or near zero at inception applies to the initial inception of the swap, not the date of adoption of the simplified hedge accounting approach. The fact that the interest rate swap would no longer have a zero or near zero value as of the date of adoption does not preclude application of the approach for qualifying hedges as long as the swap s fair value was at or near zero when the company entered into the swap agreement. National Professional Services Group CFOdirect Network Dataline 9

10 Appendix The following example illustrates the application of the simplified hedge accounting approach. Implementation of simplified hedge accounting approach to existing plain vanilla receive-variable, pay-fixed interest rate swap Background/Facts On June 30, 2012, a private company (the Company) with high quality credit borrowed $10,000,000 of 3-year, variable-rate interest-only, non-prepayable debt at par with interest payments indexed to the 6-month U.S. LIBOR. The Company concurrently entered into a 3-year interest-rate swap with a bank to economically convert the debt s variable rate to a fixed rate. Under the swap contract, the Company pays interest at a fixed rate of 4.5% and receives interest at a variable rate indexed to the 6-month U.S. LIBOR, based on a notional amount of $10,000,000. Both the debt and the swap require that payments be made or received semiannually, on December 31 and June 30. The fair value of the swap at inception is zero. The 6-month U.S. LIBOR on each reset date of December 31 and June 30 determines the variable interest-rate on the debt and the swap for the following 6-month period. There is no floor or cap on the variable interest rate of the swap or debt. The Company was not able to contemporaneously prepare the initial hedge documentation and did not perform a hedge effectiveness test at inception and as such, the swap did not qualify as a cash-flow hedge. At December 31, 2012, the fair value of the swap was $1,000,000 (liability). The change in fair value and the periodic swap settlements were recognized in interest expense. The settlement value of the swap was $1,250,000 (liability). At December 31, 2013, the fair value of the swap is $1,500,000 (liability). The settlement value is $1,750,000 (liability). Question The Company is preparing its financial statements for December 31, 2013 and would like to early adopt the simplified hedge accounting approach for this existing interest rate swap and record the swap at settlement value with changes in the swap recorded in other comprehensive income. What steps are required in order for the Company to adopt this accounting alternative? Analysis/Discussion Assuming the Company does not meet the criteria to be a public business entity and is within the scope of the ASU, the Company must first determine if its interest rate swap meets the required criteria to apply the simplified hedge accounting approach outlined in ASC D. See below for analysis based on the fact pattern outlined above: 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 A. National Professional Services Group CFOdirect Network Dataline 10

11 The index on both the debt and interest rate swap is 6-month U.S. LIBOR and rates reset on December 31 and June 30 for each instrument. As such, this criterion is met. 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. There is no floor or cap on the variable interest rate of the swap or debt, and there are no other atypical terms in the swap. As such, this criterion is met. c. The repricing and settlement dates for the swap and the borrowing match or differ by no more than a few days. The repricing dates of the interest rate swap match those of the variable-rate debt (i.e. both December 31 and June 30, for the following 6-month period). As such, this criterion is met. 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. The interest rate swap s fair value at inception was zero. As such, this criterion is met. 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. The notional amount of the interest rate swap is $10,000,000 which matches the principal amount of the variable-rate borrowing. As such, this criterion is met. 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. All interest payments on the variable-rate debt during the term of the interest rate swap are designated as hedged. The purpose of the interest rate swap is to economically convert a variable-rate borrowing to a fixed-rate borrowing and the payment dates for both instruments are the same. As such, this criterion is met. Based on the fact that the interest rate swap has met the criteria outlined in ASC D, the Company may adopt the simplified hedge accounting approach. The next step in applying the simplified approach is to record the impact of adopting the standard to its existing interest rate swap using either the modified retrospective or full retrospective approach. As the Company previously recorded the interest rate swap at fair value with changes through earnings and would like to record the interest rate swap at settlement value with changes through other comprehensive income, an analysis would need to be performed to assess the impact on the opening balance sheet. (Note for this example the modified retrospective approach will be used). See analysis below. National Professional Services Group CFOdirect Network Dataline 11

12 Amount Fair value of interest rate swap at 12/31/12 $1,000,000 (liability) Settlement value of interest rate swap at 12/31/12 1,250,000 (liability) Difference $250,000 (liability) This difference represents the additional liability needed to record the interest rate swap at settlement value at January 1, As the interest rate swap qualifies for hedge accounting using the simplified hedge accounting approach, this amount should be recorded in accumulated other comprehensive income (AOCI). See journal entry for the adjustment below. (Note that the effects of income taxes have been ignored in this example for simplicity). Journal entry #1 Dr. Accumulated other comprehensive income 250,000 Cr. Interest rate swap liability 250,000 As the modified retrospective approach is being applied, the liability and AOCI adjustments will be reflected as of the opening balance sheet date. There will be no impact on the December 31, 2012 closing balances. Next, opening retained earnings should be adjusted to remove the effect of recording the interest rate swap at fair value in earnings. See journal entry for the adjustment below. Journal entry #2 Dr. Accumulated other comprehensive income 1,000,000 Cr. Retained earnings 1,000,000 The net effect of these entries is a reduction in the aggregate opening equity of $250,000, relating to the difference between the interest rate swap s fair value and settlement value at December 31, See below for a sample presentation of the statement of changes in stockholders equity for the opening balance sheet adjustment to AOCI and retained earnings (note only retained earnings and AOCI are presented for purpose of this example presentation). Accumulated Other Retained Comprehensive Earnings Income Total Balance, December 31, 2012 $ 25,000,000 $ - $ 25,000,000 Cumulative effect of adoption of simplified hedge accounting 1,000,000 (1,250,000) (250,000) Beginning balance, January 1, 2013, as adjusted $ 26,000,000 $ (1,250,000) $ 24,750,000 National Professional Services Group CFOdirect Network Dataline 12

13 With the opening balance sheet adjusted to reflect the adoption of the simplified hedge accounting approach, the Company now should record the interest rate swap at settlement value as of December 31, See below for the calculation and journal entry for the current year adjustment. Amount Settlement value of interest rate swap at 12/31/12 $1,250,000 (liability) Settlement value of interest rate swap at 12/31/13 1,750,000 (liability) Difference $500,000 (liability) Journal entry #3 Dr. Other comprehensive income 500,000 Cr. Interest rate swap liability 500,000 The result of this series of journal entries is that the interest rate swap is recorded at its current settlement value of $1,750,000 (liability) and the cumulative change in the interest rate swap value is recorded in accumulated other comprehensive income at December 31, Finally, if not already documented previously, the Company must prepare the documentation required by ASC by the date on which the first annual financial statements are available to be issued after hedge inception (see PwC s Guide to Accounting for Derivative Instruments and Hedging Activities for examples of initial hedge documentation). Although the simplified hedge accounting approach is used, the Company is still required to document how hedge ineffectiveness will be measured if the swap no longer meets the criteria in ASC D. In addition, the Company must assess and document on a quarterly basis the swap counterparty s creditworthiness. Questions? PwC clients who have questions about this Dataline should contact their engagement partner. Engagement teams who have questions should contact the Financial Instruments team in the National Professional Services Group ( ). Authored by: John Althoff Partner Phone: [email protected] Michele Marino Manager Phone: [email protected] Dominick Kerr Senior Manager Phone: [email protected] 2014 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the United States member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors. To access additional content on financial reporting issues, visit PwC s online resource for financial executives.