Accounting for Interest-Bearing Instruments as Derivatives and Hedges

By Robert A. Dyson

In brief

Guidance to Identifying Common Derivative Transactions

Reporting entities and their auditors must properly identify derivatives and hedges to determine that management authorization is appropriate and, if applicable, that transactions are identified as hedges at their inception and accounted for properly. If hedge documentation is not appropriate and transactions are marked to market, an entity's profitability could be materially and unexpectedly impacted. The author approaches accounting for derivatives and hedges in the same way they are normally encountered: from the beginning of a transaction. The author analyzes the accounting and reasoning behind six cases based on actual transactions where derivatives were used by nonfinancial entities.

The voluminous and complex rules for accounting for derivatives and hedges are presented in SFAS 133, Accounting for Derivative Instruments and Hedging Activities, as amended by SFASs 137 and 138 and interpreted by over 33 consensuses issued by the Emerging Issues Task Force (EITF) and over 160 issues of the FASB Derivatives Implementation Group. The rules themselves tend to be legalistic and occasionally emphasize form over substance.

One of the biggest problems in implementing derivative and hedge accounting rules is identifying a transaction as a derivative and, if applicable, a hedge. Derivatives are difficult to identify because, by definition, there are no significant expenditures or recording of assets or liabilities. The traditional means of identifying unrecorded transactions-reviewing the general ledger and cash journals for large transactions-will not uncover derivatives. The best way of identifying derivatives and hedges is to rely on the entity's internal controls to flag such transactions. Derivatives and hedges potentially represent an important component of an entity's risk management activities and would require authorization by an appropriate level of management. As a backup, analysis of the transactions that typically spawn derivatives and hedges would facilitate discovery for entities not regularly engaged in such trading.

Case 1: Interest Rate Swap

Construction Retail, LLC, a nonpublic company, was organized to construct and operate a shopping mall. In January 2002, Construction obtained a construction loan from National Bank, which provided up to $150 million in financing at an interest rate of one-month LIBOR plus 1.90% and a maturity date of September 15, 2006. If certain covenants were met, the agreement provided for a reduced interest rate of one-month LIBOR plus 1.75% and an extension of the maturity date for two years. In 2003, National increased the amount available under the loan to $160 million.

On February 1, 2002, Construction entered an interest rate swap agreement with National. The swap agreement covered the period from February 1, 2002, to September 15, 2006, and effectively fixed the interest rate at 7.0% on the first $150 million of borrowings. Interest accrued quarterly. Construction did not pay anything for the swap. This transaction reflects Construction's bet that interest rates will go up and that interest costs at the fixed rate will be lower than those at the variable rate. (Construction may also be seeking a fixed interest expense for budgetary purposes.) National, however, is betting that interest rates will go down and it will receive more interest revenue at the fixed rate.

Identifying the instrument as a derivative. The first step is to determine whether Construction entered a derivative transaction. The best place to start is Construction's internal controls. Because Construction did not pay anything for the swap, the agreement would not be recorded in the accounting records. If its internal processes fail, analysis that should ordinarily be performed on the construction loan agreement should identify the swap. The red flag for an interest rate swap is a fixed rate on a loan with a stated variable rate.

Having identified its existence, the second step is to determine whether the swap is a derivative as defined by SFAS 133 and its assorted amendments and interpretations. Interest rate swaps ordinarily meet the criteria for derivatives. SFAS 133, paragraph 6, defines a derivative as a financial instrument or other contract with all of the following characteristics: an underlying, a notional amount, an initial net investment smaller than that required for other types of contracts, and a required net settlement.

An underlying is the variable whose market movements cause the fair value or cash flows of an instrument to fluctuate. In this case, the underlying is the one-month LIBOR rate. Although Construction is swapping the LIBOR-based rate for a fixed rate, the value of the swap is based on LIBOR. For example, if LIBOR decreased to 4.0%, the original loan would require an interest rate of 5.9% (LIBOR plus the 1.90% risk factor), which is lower than the 7.0% fixed rate. In this case, Construction would record a liability (or reduction in an asset) reflecting its loss position (it is paying more interest than if it had not entered into the swap). If LIBOR increased to 6.0%, Construction would record an asset (or a decrease in the liability) reflecting its gain position (it is paying less interest than if it had not entered into the swap).

The notional amount is the fixed amount of currency or property units specified in the derivative instrument. In this case, the notional amount is the $150 million principal amount of the original loan covered by the swap agreement. SFAS 133 also requires an initial net investment smaller than what would be required for similar types of contracts. The swap agreement meets this criterion because the initial net investment is zero; neither party makes a payment. The net settlement criterion is met when the party in the loss position pays the party in the gain position. In the example above, if the variable contractual interest rate were 5.9% and the fixed rate 7.0%, Construction would pay the 5.9% in accordance with its contractual obligation and an additional 1.1% as a net settlement reflecting its loss position arising from the swap agreement.

Designating the swap as a hedge. Interest rate swaps can be classified as freestanding derivatives or, if specific criteria are met, as either fair value or cash flow hedges. Each classification entails different accounting and income recognition rules. If the swap were classified as a freestanding derivative, Construction would record it at fair value at the transaction's inception and charge any subsequent changes in fair value to income at the end of each reporting period.

Construction could elect to designate the swap as either a fair value hedge or cash flow hedge. (A third type, the foreign currency hedge, does not apply here.) A fair value hedge is a hedge of the exposure to changes in the fair value of a recognized asset or liability or of an unrecognized firm commitment attributable to a particular risk. Like freestanding derivatives, fair value hedges are always recorded at fair value and changes in that fair value are recognized in current earnings. Changes in the fair value of the hedged item (i.e., the construction loan) are also recognized in current earnings and the carrying amount of the hedged item is adjusted to fair value. If the hedged item is perfectly matched to the loan agreement, the net effect on earnings would be zero. A cash flow hedge is a hedging relationship where the variability of the hedged transaction's cash flows is offset by the cash flow of the hedging instrument. The cash flow hedge itself (i.e., the swap) is recorded at fair value and changes in that fair value are recorded in other comprehensive income (OCI).

To classify the swap as a hedge, Construction must, at the transaction's inception, prepare documentation describing the hedging relationship and its risk management objective and strategy. The documentation should identify the hedging instrument, the hedged transaction, the nature of the hedged risk, and how the hedging instrument's effectiveness will be assessed. The documentation should also designate the hedge as a cash flow, fair value, or foreign currency hedge.

A current practice of assessing hedge effectiveness (not specifically required by FASB) is the 80/125 criterion, which assumes hedge effectiveness if the interest rate obtained in the swap falls within a corridor defined by 80% to 125% of the original rate. In the example above, if the one-month LIBOR rate at the date of assessment is 5.0%, then the effective corridor would be from 4.0% to 6.25%. The hedged fixed rate would be 5.1% (7.0% minus the 1.9% risk factor), which is well within this corridor. Hence, the hedge is construed as effective.

A second method of assessing the effectiveness of a hedge is to apply the 80/125 criterion to the ratio of the changes in the fair value of the hedge and the changes in fair value of the hedged item. For example, if the change in the fair value of the swap is $16,230 and the change in fair value of the loan agreement is $20,000, the ratio would be 81.15%, and the hedge would be considered effective.

Construction should assess hedge effectiveness at least quarterly, even if Construction does not issue quarterly financial statements. For an ineffective hedge, losses are recognized from the period beginning from the date when the hedge was last determined to be
effective. Once a hedge is deemed ineffective, it must be accounted for as a freestanding derivative and can not be classified as a hedge during its remaining term.

Construction could avoid determining hedge effectiveness by using the shortcut method, which, under specified circumstances, assumes hedge effectiveness. The shortcut method is available for interest rate swaps designated as either fair value or cash flow hedges. The shortcut method, which saves a considerable amount of work, assumes that the hedge is perfectly effective in specified circumstances and, accordingly, the assessment of hedge effectiveness is not required. Exhibit 1 presents the criteria for applying the shortcut method.

Construction's interest rate swap meets the criteria presented in Exhibit 1. Some of these criteria need explanation. The notional amount of the swap matched the principal amount of the debt (Item 1) at the inception of the swap (February 1, 2002); for purposes of hedge accounting, the additional $10 million made available in 2003 is considered an additional loan. The fair value of the swap at the inception of the hedge is zero (Item 2), as neither party paid for the swap.

Accounting for the interest rate swap. Construction designates the hedge as a cash flow hedge because the swap is hedging the variability of future cash flows (interest expense paid) attributable to changes in interest rates. This allows changes in the swap's fair value to be recorded in OCI rather than current earnings. The swap should meet the criteria in SFAS 133, paragraphs 28 and 29, to be classified as a cash flow hedge. The accounting for the swap is presented in Exhibit 2.

Case 2: Interest Capitalization and Interest Rate Swaps

Case 2 assumes the same facts as Case 1. However, because the loan was acquired for the express purpose of financing the construction of the shopping mall, Construction intends to capitalize the related interest cost, in accordance with SFAS 34, Capitalization of Interest Cost.

Accounting for interest costs. EITF Issue No. 99-9, Effective Derivative Gains and Losses on the Capitalization of Interest, requires interest costs be capitalized when hedged. As discussed in Case 1, gains or losses are not applicable because they are included in OCI.

Construction should capitalize the interest rate acquired in the swap (7.0%), as it is the effective rate of the loan. Thus, for the first quarter (ending April 30, 2002), Construction would capitalize $350,000, the interest cost based on 7.0% (see Exhibit 2). If Construction had multiple loans covering multiple construction projects, it would have to determine a capitalization rate, which would be applied to the average amount of accumulated expenditures. In this case, Construction should use the 7.0% fixed rate as the capitalization rate.

Should gains or losses related to the swap be capitalized as project costs, pursuant to paragraph 7 of SFAS 67, Accounting for Costs and Initial Rental Operations of Real Estate Projects? The author believes that the interest rate swaps, which are clearly part of the project financing, should be classified as direct project costs only if the swap is not designated as a hedge. If the swap is designated as a cash flow hedge, gains and losses included in OCI should be amorized over the life of the asst (i.e., the shopping mall).

Case 3: Embedded Derivative

Construction's loan agreement provided for a reduced interest rate (from one-month LIBOR plus 1.90% to one-month LIBOR plus 1.75%) and an extension of the maturity date for two years if certain covenants are met. Hedge accounting is permissible if those covenants are based on matters which can be controlled by management, such as construction progress or budgetary limits. On the other hand, if the more favorable terms arise because of outside events, such as changes in the S&P rates, the loan modification would be classified as an embedded derivative, which is always classified as a freestanding derivative. Accordingly, the interest rate swap could not be classified as a cash flow hedge. A freestanding derivative is recorded as an asset or liability with changes in fair value charged to current income. This case illustrates the importance of obtaining a full understanding of the entire transaction and its context, including conditions that cause a change in the instrument's terms.

Case 4: Interest Rate Caps

On May 8, 2002, Manufacturing Corporation obtained a loan from Commercial Bank based on the one-month LIBOR rate with a maturity date of November 1, 2005. At the same time, Manufacturing obtained an interest rate cap at 6.5% for $20,000 expiring on November 1, 2005, from another institution, Financial Products Company. The question is whether this interest rate cap is a derivative or an embedded derivative and whether, in either case, it can be classified as a hedge.

Accounting for the interest rate cap. The interest rate cap is a derivative, as defined by SFAS 133, because it has an underlying (the one-month LIBOR); a notional amount (the principal amount of the outstanding loan); an initial net investment ($20,000) that is smaller than what would be required for other types of contracts; and a net settlement payable when the variable rate exceeds the cap rate of 6.5%. Because the loan is a variable rate loan, the interest rate cap could be classified as a cash flow hedge if the SFAS 133 criteria are met. The interest rate cap would be accounted for in a manner similar to the interest rate swap presented in Case 1.

Avoiding derivative accounting. In an example of the legalistic nature of the accounting rules, Manufacturing could have avoided derivative accounting entirely if the loan and interest rate cap were structured differently. SFAS 133 excludes from its scope certain interest rate caps, floors, and collars that cannot be classified as either a derivative or an embedded derivative. Manufacturing could have embedded the interest rate cap in the loan while failing to meet the criteria of an embedded derivative.

Contracts not meeting the definition of a derivative may contain embedded derivative instruments. SFAS 133 indicates that contracts may contain implicit or explicit terms affecting some or all of cash flows or other values in a manner similar to a derivative. These terms, classified as embedded derivatives, should be separated from the original (host) contract and accounted for separately as a freestanding derivative if the instrument meets all three conditions presented in SFAS 133, paragraph 12, and if it is transferable separately of the host contract.
The guidance pertaining to the transferability of the interest rate cap is not included in SFAS 133, but rather in interpretative guidance. Derivatives Implementation Group (DIG) Issue K2, "Miscellaneous: Are Transferable Options Freestanding or Embedded?," and DIG Issue K3, "Miscellaneous: Determination of Whether Combinations of Options with the Same Terms Must Be Viewed as Separate Option Contracts or as a Single Forward Contract," state that any derivative that is separable and transferable from the host contract is not, by definition, an embedded derivative. Transferable interest rate caps are considered freestanding derivatives.

The first step in avoiding derivative accounting is to overcome the strong presumption that the cap is transferable. This can be accomplished by writing the interest rate cap directly into the loan agreement with Commercial and by explicitly stating that the cap is not transferable. The terms of the interest cap provisions should be consistent with the debt instrument, e.g., mature at the same date. In Case 4, the fact that Manufacturing signed a separate interest rate cap agreement with another financial institution (Financial) means that, for purposes of applying SFAS 133, the cap is transferable. Even signing a separate agreement with the primary lending institution (Commercial) is not sufficient to overcome the presumption that the instrument is transferable. Neither is management intent. Only an explicit provision within the original debt agreement can overcome the presumption of transferability.

The second step is to structure the interest rate cap agreement to fail at least one test in paragraph 12 of SFAS 133. This agreement fails the criteria in paragraph 12a because it is clearly and closely related to the economic characteristics and risks of the host contract. According to paragraph 13, embedded derivatives in which the underlying is an interest rate cap (among other instruments) are clearly and closely related to the economic characteristics and risks of the host contract (and therefore do not meet the criteria presented in paragraph 12a) unless one of two additional specified conditions are met. The loan and interest rate cap do not meet either of the conditions. In addition, the instrument must meet the criteria discussed in paragraph 61f, which states that an interest rate cap, floor, or collar is clearly and closely related to the economic characteristics and risks of the host contract if the cap is at or above the current market rate (one month LIBOR, in this case).

Thus, by structuring the interest cap differently, Manufacturing could avoid derivative accounting completely. Of course, it would have to cooperate with Commercial on terms within the loan agreement that would make economic sense.

Case 5: Interest Rate Swap Involving a Capital Lease

Real Estate LLP has a land lease classified as a capital lease. Real Estate shares the lease obligation with an affiliate and is liable for 75% of the total lease obligation. Real Estate's lease payments are limited to its allocable share of the lessor's debt service payments through 2020. The lessor's debt has a variable interest rate. Real Estate entered a swap agreement for the period ending June 1, 2004, that effectively fixes the interest rate at 6%.
Real Estate would account for the swap in a manner similar to Case 1. The indirect nature of this transaction does not affect the fact that the swap agreement contains all the characteristics described in SFAS 133, paragraph 6. As in Case 1, the swap may be eligible for the shortcut method. The capital lease swap meets all of the criteria in Exhibit 1. One criterion (Item 4) requires further explanation: the requirement that the lease agreement not be prepayable. A prepayment of the capital lease based on undiscounted future rents represents settlement in excess of the swap's fair value, which results in the instrument not being considered prepayable, according to DIG Issue E6, "The Shortcut Method and the Provisions That Permit the Debtor or Creditor to Require Prepayment."

Case 6: Derivatives and Hedges on the Income Tax Basis

Certain reporting entities preparing financial statements on the income tax basis also enter derivative and hedgin transactions. FASB has not issued any rules on income tax basis financial statements, but Interpretation 14 of SAS 62, Special Reports, requires disclosure of items that would ordinarily be disclosed in financial statements prepared in conformity with GAAP. Thus, entities preparing income tax basis financial statements and entering into derivative and hedging transactions should disclose the essence of the transaction, but, pursuant to current income tax laws and regulations, would not record the fair value of the derivative or recognize any charges to income. The disclosure of the fair value of the derivative is not required, but, in the author's opinion, should be disclosed if readily available. Sample footnote disclosures on derivatives in income tax basis financial statements are presented in Exhibit 3.

Robert A. Dyson, MS, CPA, is a director of quality control at Friedman Alpren & Green LLP and a member of the NYSSCPA Financial Accounting Standards Committee. He can be reached at He would like to acknowledge the assistance of Roseanne Farley, CPA, a fellow member of the Financial Accounting Standards Committee, in preparing this article.

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