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The U.S. economy has been improving steadily forthe past seven years, and interest rates haveremained at historical lows. Nevertheless, therewill be an economic slowdown at some point in

the future, and the economy will be better positioned ifinterest rates are relatively high when the downturn starts.In December 2015, the Federal Reserve raised its bench-mark key interest rate by 0.25% for the first time in nearlyten years. Comments by chairwoman Janet Yellen indi-cated that interest rates might rise gradually for the remain-

der of the current up-cycle; however, it appears that theFederal Reserve intends to proceed cautiously on this mat-ter, and as a result, it has introduced a certain level ofuncertainty into the financial markets.

In June 2017, the Federal Reserve raised its bench-mark key interest rate by a quarter-point for the thirdtime since its first rate increase in December 2015. Thislatest increase, which brings the federal funds rate tobetween 1% and 1.25%, was highly anticipated by themarkets. The rate hike “reflects the progress the econ-

Simplified Accounting for a Perfect Fair Value HedgeInterest Rate Swaps By Josef Rashty

DEPARTMENTS I AccountingDEPT

omy has made and is expected to maketoward maximum employment andprice stability,” Yellen said in a pressconference, arguing that a gradual pathof rate increases was the best way toavoid a more damaging scenario for theeconomy (Ana Swanson, “Fed RaisesInterest Rate, Signaling Confidence inthe Economy,” Washington Post, June14, 2017, http:// wapo.st/ 2uQKeyC).

Companies routinely utilize interestrate swaps to reduce their exposure tochanges in the fair value of assets andliabilities or cash flows due to fluctua-tions in interest rates. This article pro-vides a background on interest rate swapprograms and fair value hedging. It dis-cusses the benefits and limitations of dif-ferent methods of hedging programs andprovides guidance for the use of theshortcut method on perfect fair valuehedge contracts.

Hedge ProgramsHedging is a risk management strategy

that companies use to limit or offset theprobability of any losses in fluctuation ofprices in commodities, currencies, securi-ties, or interest rates. Companies must rec-ognize their derivative instruments at fairvalue on their balance sheets. If a deriva-tive does not meet the criteria for hedgeaccounting, any fluctuations in its fairvalue will be reflected in earnings.

Accounting Standards Codification(ASC) Topic 815, “Derivatives andHedging,” specifies three different types ofhedges:■ Fair value hedges, which hedge theexposure to changes in fair value of rec-ognized assets, liabilities, or any recog-nized firm commitment■ Cash flow hedges, which hedge theexposure to variability in expected futurecash flows of recognized assets, liabilities,or any unrecognized forecasted transactions■ Hedges of net investment in foreignoperations, which hedge the translationexposure to changes in foreign exchange

rates in other comprehensive income. Fair value and cash flow hedges are the

most prominent and complex hedge types.Companies use fair value or cash flowhedge interest rate swap contracts to mit-igate risks associated with changes ininterest rates. A company can implementfair value hedges for its existing fixed-ratedebt using a “pay-floating/receive-fixed”interest rate swap contract. The swap con-tract converts the fixed-rate payments intofloating rates. The floating rates, whichare market rates for the debt instrument,protect the instrument against fluctuations

in its fair value. The use of an interest rateswap unlocks the fixed interest expenseassociated with the debt and results invariable interest rate expense that fluctu-ates with the market rate (i.e., the compa-ny benefits if the market interest ratedeclines and vice versa).

In contrast to fair value hedges, cashflow hedges for interest rate swap con-tracts address risks that arise due to interest

rates that are variable, either by contractor because they may be entered into atinterest rates that would be in effect at afuture date. Cash flow hedges allow com-panies to manage their risks by locking inor eliminating the variability of the interestrate in their debt, changing variable inter-est expense into a fixed interest expense.The fixed interest rate is immune fromsubsequent market rate fluctuations.

Hedgeable RisksHedgeable risks differ from one com-

pany to another and for financial instru-ment-related exposures and nonfinancialexposures (ASC 815-20-25-12).

ASC 815 identifies the followinghedgeable risks for financial instrument-related exposures:

■ Market price risk■ Interest rate risk■ Foreign exchange risk■ Credit risk.

Fair Value Measurements and Hedge Effectiveness

ASC Topic 820, “Fair Value Measure-ment,” requires companies to reflectderivatives at fair value in their financialstatements. Gains or losses for instru-ments that qualify as fair value hedgesand the offsetting gains or losses on thehedged items attributable to the hedgedrisk are recognized in earnings in thesame period and offset each other as longas the hedge program qualifies as a “high-ly effective” hedge contract.

“Hedge effectiveness” refers to the extentthat changes in the fair value of hedgeinstrument (the notional amount) offsets

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If a derivative does notmeet the criteria forhedge accounting,

any fluctuations in its fair value will be

reflected in earnings.

Exhibit 1Application of the Shortcut Method

SemiannualPeriod Ended

Differencebetween Fixed

Rates

Variable RateApplicable on

Swap (Libor rate)

Sum of Rates

Debt’s PrincipalAmount

SemiannualInterest

Expense*

1/15/2016 1.0% 5.0% 6.0% $10,000 $300

7/15/2016 1.0% 6.5% 7.5% $10,000 $375

* (Principal Amount × Rate) ÷ 2

changes in the fair value of the hedgeditem. The measurement of hedge effective-ness must be consistent with company’srisk management strategies and the methodof assessing hedge effectiveness that com-pany has initially documented. Any inef-fectiveness in a fair value hedge programmay affect the earnings of the company.

Although there are no bright lines fordetermining whether a hedge is highlyeffective, FASB’s staff has informally stat-ed that the cumulative change in the valueof the derivative instrument, expressed asa ratio of the cumulative change in thefair value of the hedged item, must fallwithin the range of 80% to 125%.

Perfect HedgesIf an interest rate swap contract meets

certain criteria and its critical terms matchthe other conditions of ASC 815, thehedge contract may possibly be a perfecthedge and therefore qualify for adoptionof a simplified accounting method (i.e.,the “shortcut method”).

ASC 815-20-25-102 through 25-111and ASC 815-20-55-71 through 55-73provide detailed guidance as to when aninterest rate swap contract is perfectlyeffective; these criteria are referred to asthe “shortcut method.” The shortcutmethod simplifies hedge accounting forinterest rate swap contracts significantly.It still requires preparation of all the ini-tial formal hedge documentation at theinception date; however, it does not man-date any ongoing assessment of hedgeeffectiveness. The shortcut method forinterest rate swaps requires that hedgeprograms meet certain criteria in additionto initial formal hedge documentationcompleted at the inception of the hedgecontract. The following is a summary ofthese criteria:■ The notional amount of the swap mustmatch the principal amount of the inter-est-bearing liability being hedged [ASC815-20-25-104 (a)].

■ The fair value of an interest-bearingswap (with one exception that is beyondthe scope of this article) at the inceptionof the hedging relationship must be nil[ASC 815-20-25-104 (b)].■ The formula for computing net settle-ments under the interest rate swap agreementmust be the same for each net settlement[ASC 815-20-25-104 (d)]. That is, the fol-lowing two conditions must be met:■ The fixed rate remains the samethroughout the term of the contract.■ The floating rate is based on the sameindex and includes the same constantadjustment or no adjustment.

■ The interest-bearing liability must notbe prepayable; that is, either party havingthe ability to settle it before its scheduledmaturity ASC 815-20-25-104 (e)].■ The index for the variable leg of theswap must match the benchmark interestrate designated as the interest rate riskbeing hedged [ASC 815-20-25-104(f)].

Furthermore, fair value interest rateswaps must meet the following additionalcriteria:■ The expiration date of the swap mustmatch the maturity date of the interest-bearing liability [ASC 815-20-25-105(a)].■ There must not be any floor or ceilingon the variable interest rate of the swap[ASC 815-20-25-105(b)].■ The interval between repricings of thevariable leg of the swap must be frequent

enough to justify an assumption that thevariable payment or receipt is at a marketrate; six months or less is usually accept-able [ASC 815-20-25-105(c)].■ For fair value hedges of a proportionof the principal amount of the interest-bearing liability, the notional amount ofthe interest rate swap designated as thehedging instrument must match the por-tion of liability being hedged [ASC 815-20-25-105(e)].■ Finally, ASC 815-20-25-103 requirescompanies applying the shortcut methodto initially review and document the cred-itworthiness of their counterparties and onlyconsider the likelihood of the counterparty’scompliance on an ongoing basis subsequentto initiation of the hedge program.

Risks and Benefits of Shortcut MethodAt the 2006 AICPA National

Conference on Current SEC and PCAOBDevelopments, Timothy Kviz, profession-al accounting fellow at the SEC’s Officeof the Chief Accountant, stated that thereis no “spirit” or “principle” to the shortcutmethod (http://bit.ly/2v0LIUq). The SECviews the shortcut method as a rule-basedexception to the ASC 815 framework andconsiders it subject to strict application ofASC 815 exception criteria. Improperapplication of the shortcut method mayresult in restatement; therefore, companiesmust carefully evaluate the application ofshortcut method criteria to ensure that theyare in compliance. In 2008, FASB pro-posed to eliminate the use of the shortcutmethod for fair value hedges of fixed ratedebt after their initial issuance; however,the proposal was never finalized.

Nevertheless, application of the shortcutmethod for fair value hedges has remainedappealing up to now despite the SEC’snegative views, due to the following:■ Periodic evaluation of hedge effective-ness is not required. ■ Changes in the fair value of hedgeditems are exactly the same as changes in

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DEPARTMENTS I AccountingDEPT

The shortcut method simplifies hedge

accounting for interestrate swap contracts

significantly.

45NOVEMBER 2017 / THE CPA JOURNAL

DEPARTMENTS I Accounting

the fair value of derivatives, and as a resultthere is no impact on earnings. ■ It does not require the existence of com-parable credit risk between derivatives andhedged items. ■ Accounting and related disclosures aregenerally more simplified.

IllustrationEntity A has a fixed-rate obligation and

enters into a “receive-fixed, pay-floating”interest rate swap, with the variable legof the swap set on the London InterbankOffered Rate (Libor), to avoid volatilityin earnings as a result of fluctuation infair value.

On July 15, 2015, Entity A issues a$10,000, non-callable, 6.5% fixed-ratenote at par. The note is due on July 15,2025, with semiannual payments interestpayments due each January 15 and July15 until maturity.

On the same day, Entity A enters intoan interest rate swap contract for $10,000notional amount. The swap receives inter-est at a fixed rate of 5.5% for the fixedleg of swap throughout the term of swapand pays interest at a variable rate equalto Libor plus 1% for the variable leg ofswap throughout the term of the swap,with semiannual settlements and interestrate reset days due each January 15 andJuly 15 until maturity.

The shortcut method does not require thatthe fixed rate on a hedged item match thefixed rate on a swap. Similarly, it does notrequire the variable rate of the hedged itemto match the rate of the variable leg of theswap (ASC 815-20-25-109). This is becausethe fixed and variable legs on a swap canbe changed without affecting the net settle-ment if both are changed by the same per-centage and amount. For example, a swapwith a payment based on Libor and a receiptwith a fixed rate of 6.5% has the same netsettlement and fair value as a swap with apayment based on Libor plus 1% and areceipt based on a 5.5% fixed rate.

Entity A has designated the swap as ahedge of the changes in fair value of thefixed-rate note due to changes in the des-ignated benchmark interest rate and Liboras the benchmark rate risk being hedged.

Therefore, Entity A qualifies to use theshortcut method. Since the critical terms(principal vs. notional amounts and matu-rity vs. expiration dates) of the debt andthe interest rate swap match and otherASC 815 criteria are met, the hedge isconsidered to be perfectly effective.

Application of the shortcut methodrequires the following (Exhibit 1):■ First, calculate the difference betweenthe fixed rate the company expects toreceive on the swap and the fixed rate itexpects to pay on the debt.■ Second, combine that difference withthe variable rate applicable on the swap.■ Third, compute and recognize the semian-

nual interest expense using the combined rateand the fixed-rate debt’s principal amount.

Exhibit 2 reflects the six-month bench-mark Libor rates and the swap and debtcorresponding fair values.

Below are sample journal entriesreflecting the above fact pattern: July 15, 2015, Journal Entry1. Entity A makes the following journalentry at the initiation of the debt:Cash $10,000

Debt $10,000January 15, 2016, Journal Entries2. Entity A makes the following journalentries for interest payable. It accruessemiannual interest in the debt at anaffixed rate of 6.5% [(6.5% × $10,000) ÷2] and pays the balance.Interest expense $325

Accrued interest payable $325Accrued interest payable $325

Cash $3253. Entity A records the settlement of thesemiannual swap-amount receivable at5.5%, less the amount payable at LIBORplus 1% at 5%, a decrease adjustment tothe interest rate [((5.5% − 5.0%) ×$10,000) ÷ 2]: Cash $25

Interest expense $25In this scenario, Entity A has benefited

from the execution of the swap, since theinterest rate has declined.4. Entity A records changes in the debt’sfair value that are attributable to changesin the benchmark interest rate:Debt $1,500

Gain on hedge activity $1,500

Date Six-Month BenchmarkLibor Rate

Swap Fair Value Asset(liability)

Debt Carrying Value

7/15/2015 5.0% $– $10,000

1/15/2016 6.5% (1,500) 8,500

7/15/2016 4.0% 1,000 11,000

Exhibit 2Benchmark Rate and Fair Value Changes

Improper application ofthe shortcut method may

result in restatement;companies must carefullyevaluate the application of shortcut method criteria

to ensure they are in compliance.

NOVEMBER 2017 / THE CPA JOURNAL46

5. Entity A records any changes in the fairvalue of the swap: Loss on hedge activity $1,500

Swap contract $1,500Note that Entry 4 offsets Entry 5.

Because Libor increased on January 15,2016, it caused a decline in the fair valueof the debt.July 15, 2016, Journal Entries6. Entity A makes the following journalentries for interest payable. It accrues semi-annual interest at an affixed rate of 6.5%[(6.5% × $10,000) ÷ 2] and pays the balance.Interest expense $325

Accrued interest payable $325Accrued interest payable $325

Cash $3257. Entity A records the settlement of thesemiannual swap-amount receivable at5.5%, less the amount payable at Liborplus 1% at 6.5%, an increase adjustmentto the interest rate [((6.5% − 5.5%) ×$10,000) ÷ 2]: Interest expense $50

Cash $50In this scenario, Entity A has not ben-

efited from the execution of the swap,since the interest rate has increased.8. Entity A records changes in the debt’sfair value that is attributable to changesin the benchmark interest rate:Loss on hedge activity $2,500

Debt $2,5009. Entity A records any changes in the fairvalue of the swap:Swap contract $2,500

Gain on hedge activity $2,500Note that Entry 8 offsets Entry 9.

Libor declined on July 15, 2016 andcaused an increase in the fair value ofthe debt.

DisclosuresASC 815-10-50 requires that the notes

to financial statements discuss how andwhy a company uses derivatives, howderivatives are accounted for, and theirimpact on the financial position of the

company (including the results of opera-tions and cash flows). These discussionsshould include the underlying risks (e.g.,interest rates), their accounting designation(e.g., fair value hedges), and the levels ofderivative activities.

Centene Corporation uses the shortcutmethod in its fair value interest rate swapprogram and made the following note dis-closure in its Form 10-K for the fiscal yearended December 31, 2016:

The Company uses interest rate swapagreements to convert a portion of itsinterest rate exposure from fixed rates

to floating rates to more closely aligninterest expense with interest incomereceived on its cash equivalent and vari-able rate investment balances. TheCompany has $2,100 million of notionalamount of interest rate swap agreementsconsisting of: $600 million, expiring onFebruary 15, 2021; $500 million, expir-ing on May 15, 2022; and $1 billionexpiring on February 15, 2024. Underthe Swap Agreements, the Companyreceives a fixed rate of interest and paysan average variable rate of the three-month LIBOR plus 3.92% adjustedquarterly. At December 31, 2016, theweighted average rate was 4.83%.

The Swap Agreements are formallydesignated and qualify as fair valuehedges and are recorded at fair value inthe Consolidated Balance Sheets in

other assets and/or other liabilities. Gainsand losses due to changes in fair valueof the interest rate swap agreementscompletely offset changes in the fairvalue of the hedged portion of theunderlying debt. Therefore, no gain orloss has been recognized due to hedgeineffectiveness. Offsetting changes infair value of both the interest rate swapsand the hedged portion of the underlyingdebt both were recognized in interestexpense in the Consolidated Statementof Operations. The Company does nothold or issue any derivative instrumentfor trading or speculative purposes.

The fair values of the SwapAgreements as of December 31, 2016were assets of $4 million and liabilitiesof $62 million, and are included in otherlong-term assets and other long-term lia-bilities, respectively in the ConsolidatedBalance Sheet. The fair value of theSwap Agreements as of December 31,2015 were assets of $11 million and lia-bilities of $2 million, and are includedin other long term assets and other longterm liabilities, respectively in theConsolidated Balance Sheet. The fairvalue of the Swap Agreements excludesaccrued interest and takes into consid-eration current interest rates and currentlikelihood of the swap counterparties'compliance with its contractual obliga-tions (http://bit.ly/2tTI3Gt).

Latest DevelopmentsIn August 2017, FASB issued ASU

2017-12, Targeted Improvements toAccounting for Hedging Activities, toimprove the transparency and understand-ability of information conveyed to usersand to simplify the application of hedgeaccounting by preparers. This ASU iseffective for public business entities forfiscal years beginning after December 15,2018, and interim periods therein. For allother entities, this ASU is effective for fis-cal years beginning after December 15,

DEPARTMENTS I AccountingDEPT

ASU 2017-12 not onlyretains both the shortcut

method and critical-terms-match method, but alsoprovides additional relief

for entities applying thosemethods.

47NOVEMBER 2017 / THE CPA JOURNAL

2019, and interim periods within fiscalyears beginning after December 15, 2020.FASB permits early adoption of this ASUfor all entities.

This ASU does not change the “highlyeffective” threshold in hedge accountingthat this article discussed earlier. It neitherchanges the benchmark interest rate con-cept for fixed-rate financial instrumentsclassified as fair value hedges even thoughit eliminates it for variable-rate financialinstruments classified as cash flow hedges.Furthermore, this ASU not only retainsboth the shortcut method and critical-terms-match method, but also provides additionalrelief for entities applying those methods.Finally, this ASU adds new disclosurerequirements, for example, entities mustdisclose the carrying amounts and cumu-lative basis adjustments of items designat-

ed and qualifying as hedged items in fairvalue hedges.

Ensuring ComplianceFair value hedges address risks that arise

due to interest rates that are fixed. Forexample, a company may use a fair valuehedge (a “pay-floating/receive-fixed” inter-est rate swap) to hedge its fixed-rate debt.In this example, the use of an interest rateswap unlocks the fixed interest expenseassociated with the debt and creates interestrate expenses that vary with the marketrate (the company will benefit if the marketinterest rate declines). Companies may usethe shortcut method for their perfect hedgeprograms if certain criteria are met.

The SEC views use of the shortcutmethod as a rule-based exception to ASC815 framework and emphasizes strict

application of FASB’s exception criteria.Any material inappropriate application ofthe shortcut method may result in restate-ment of financial statements. Therefore,companies must carefully evaluate the cri-teria for application of the shortcut methodprior to its adoption to ensure that theymeet the requirements of the guidance.Nevertheless, use of the shortcut methodin fair value hedges has remained verypopular due its accounting simplicity andlower administrative burden. ❑

Josef Rashty, CPA, has held managerialpositions with several technology basedpublic business entities in Silicon Valleyand is an adjunct professor of accountingat Golden Gate University, SanFrancisco, Calif. He can be reached atj_rashty@yahoo.com.