Changes to the Accounting for Interest Rate Swaps Used in Hedging Relationships for Private Companies

The Substance of the Standard

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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

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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.

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.

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-

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 jcomito@cbiz.com.

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.

PAGE 6

Changes to the Accounting for Interest Rate Swaps Used in Hedging Relationships for Private Companies

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