Types of Financial Assets

The term “financial assets” encompasses a wide range of instruments including, but not limited to

An unconditional contractual obligation whose economic benefit or sacrifice is to be the receipt or delivery of a financial instrument other than cash is to be considered a financial instrument. For example, a note that is payable in US Treasury bonds gives an issuer the contractual obligation to deliver and gives a holder the contractual right to receive bonds, not cash. But because the bonds represent obligations of the U.S. Treasury to pay cash, they are considered financial instruments. Therefore, the note is also a financial instrument to both the holder of the note and the issuer of the note.

Another type of financial instrument is one that gives an entity the contractual right or obligation to exchange other financial instruments on potentially favorable or unfavorable terms. An example of this type of financial instrument would be a call option to purchase a specific U.S. Treasury note for $100,000 in six months. The option holder has a contractual right, but not obligation, to exchange the financial instrument on potentially favorable terms. Six months later, if the fair value of the note exceeds $100,000, the holder will exercise the option because the terms are favorable (the option is now “in the money”). The writer of the call option has a contractual obligation to exchange financial instruments on potentially unfavorable terms if the holder exercises the option. The writer is normally compensated for accepting this obligation by being paid a premium, which it keeps whether or not the option is exercised.

A put option to sell a Treasury note has similar effects, although the change in fair values making it worthwhile to exercise the option will be a decline, rather than an increase. The holder of the put option, as with the call option, effectively has an unlimited profit potential and no risk of loss (the only sunk cost is the premium paid), whereas the writer of the option has unlimited risk of loss and only a fixed amount of income.

Options, such as those discussed here, are derivative financial instruments because their value is derived from the value of the underlying. A bank's commitment to lend $100,000 to a customer at a fixed rate of 10% any time during the next six months at the customer's option is also a derivative financial instrument, since its value would vary as market interest rates change. It is an option, with the potential borrower being the holder and the bank being the writer (the parties are collectively referred to as the “counterparties”).

An interest rate swap is a series of forward contracts to exchange, for example, fixed cash payments for variable cash receipts. The cash receipts are computed by multiplying a specified floating-rate market index by a notional amount of principal. An interest rate swap is both a contractual right and a contractual obligation of both counterparties.

Exclusions

Excluded from financial instrument classification are options and contracts that contain the right or obligation to exchange a financial instrument for a physical asset, such as bushels of wheat. For example, two entities enter a sale-purchase contract in which the purchaser agrees to take delivery of wheat or gold six months later and pay the seller $100,000 at the time of delivery. The contract is not a financial instrument because it requires the delivery of wheat or gold, which are not financial instruments.

Also excluded from financial instrument classification are contingent items that may ultimately require the payment of cash but that are not contractual. An example would be a contingent liability for tort judgments payable. However, when such an obligation becomes enforceable and is reduced to a fixed payment schedule, it then would be considered to be a financial instrument.

Underlying Principles

There are four key principles underlying ASC 815:

1. Derivative instruments are assets and liabilities and must be recognized on the financial statements.
2. Report derivatives are to be reported at fair value.
3. Gains and losses from derivative instruments are to be reported immediately in income.
4. Only designated qualifying items that are effectively offset by changes in fair value or cash flows during the term of the hedge are eligible to use the special accounting for hedging. Gains and losses on hedges are reported based on the type of hedge.

Derivative instruments represent rights and obligations, and these must be reported as assets and liabilities at fair value (which reflects the current cash equivalent). Gains and losses on derivative instruments not designated as hedges are recognized in earnings (or as a change in net assets, in the case of not-for-profit enterprises). The ability to apply hedge accounting requires that specified criteria be met, because of its elective nature and because of its reliance on management intent. Strategic risk hedges do not meet the qualifying criteria. Thus, hedge accounting is limited to relationships involving derivative instruments and certain foreign currency-denominated instruments that are designated as hedges and meet the qualifying criteria.

Private Company Alternative

ASC 815 allows for a simplified hedging accounting approach for private companies. This alternative does not apply to public business entities, not-for-profit entities, employee benefit plans within the scope of Topics 960-965 on plan accounting, and financial institutions. It allows private companies to apply a simplified hedge accounting method to hedging relationships. Certain criteria must be met and the relationships must involve variable-rate debt and a pay-fixed, receive-floating interest rate swap. The new approach assumes no hedge ineffectiveness in the hedging relationship. This results in an income statement impact similar to what could have occurred had the company simply entered into a fixed-rate borrowing. The approach also allows private companies to measure the hedging interest rate swap at its settlement value, rather than at fair value, and gives private companies more time to put hedge documentation in place. Also included in the guidance are provisions that allow certain private companies with relief from fair value measurement disclosure requirements.

Example of Embedded Instruments Which are Separately Accounted For

Assuming that the host contract is a debt instrument, the following are considered not to be clearly and closely related and would normally have to be separated out as embedded derivatives:

1. Interest rate indexes, floors, caps, and collars not meeting the criteria for exclusion (see number 2 in the next set of examples);
2. Leveraged inflation-indexed interest payments or rentals;
3. Calls and puts that do not accelerate repayment of the principal but require a cash settlement equal to the option price at date of exercise. Subsequently added options that cause one party to be exposed to performance or default risk by different parties for the embedded option than for the host contract;
4. Term extending options where there is no reset of interest rates;
5. Equity-indexed interest payments;
6. Commodity-indexed interest or principal payments;
7. A convertible debt conversion option for the investor if it qualifies as a derivative instrument (readily convertible to cash, etc.); and
8. A convertible preferred stock conversion option if the terms of the preferred stock (not the conversion option) are more similar to debt (a cumulative fixed rate with a mandatory redemption feature) than to equity (cumulative, participating, perpetual).

Example of Embedded Instruments Which are not Separately Accounted For

Assuming that the host contract is a debt instrument, the following are considered to be clearly and closely related and would not normally have to be separated out as embedded derivative instruments:

1. Interest rate indexes (see below)
2. Interest rate floors, caps and collars, if at issuance:
   1. The cap is at or above the current market price (or rate), and/or
   2. The floor is at or below the current market price (or rate)
3. Nonleveraged inflation-indexed interest payments or rentals
4. Credit-sensitive payments (interest rate resets for debtor creditworthiness)
5. “Plain-vanilla” servicing rights not containing a separate embedded derivative instrument
6. Calls and puts that can accelerate repayment of principal unless:
   1. The debt involves substantial premium or discount (zero coupon), and
   2. The call or put is only contingently exercisable (not exercisable unless default occurs) and is indexed only to credit risk or interest rates
7. Term-extending options if the interest rate is concurrently reset to approximately the current market rate for the extended term and the host contract had no initial significant discount
8. Contingent rentals based on a variable interest rate.

Based on the foregoing, calls and puts embedded in equity instruments are normally accounted for as follows:

1. Investor—Both the call and the put are embedded derivative instruments.
2. Issuer—Only the put could be an embedded derivative instrument. The put and the call would not be embedded derivative instruments if they are both:
   1. Indexed to the issuing entity's own stock, and
   2. Classified in shareholders' equity.

The hybrid instrument is not required to be measured at fair value under GAAP with changes reported in earnings. For example, most unsettled foreign currency transactions are subject to ASC 830. Gains or losses are recognized in earnings and thus instruments of this nature are not considered embedded derivative instruments. Trading and available-for-sale securities that have cash flows denominated in a foreign currency also are not considered embedded derivative instruments.

A separate instrument with the same terms as the embedded derivative instrument would be accounted for as a derivative instrument. For this condition, the initial net investment of the hybrid instrument is not the same as that for the embedded derivative instrument.

To illustrate, a convertible debt conversion option for the issuer would not be an embedded derivative instrument since a separate option with the same terms would not be a derivative instrument because it is indexed to the issuer's own stock and would be classified in shareholders' equity.

To determine whether an instrument is indexed to an entity's own stock, the reporting entity is to use a two-step approach: Step 1 is to evaluate the instrument's contingent exercise provisions, if any; Step 2 is to evaluate the instrument's settlement provisions. An exercise contingency would not preclude an instrument (or embedded feature) from being considered indexed to an entity's own stock provided that it is not based on (1) an observable market, other than the market for the issuer's stock (if applicable), or (2) an observable index, other than an index calculated or measured solely by reference to the issuer's own operations (e.g., sales revenue of the issuer, EBITDA of the issuer, net income of the issuer, or total equity of the issuer). An instrument (or embedded feature) would be considered indexed to an entity's own stock if its settlement amount will equal the difference between the fair value of a fixed number of the entity's equity shares and a fixed monetary amount or a fixed amount of a debt instrument issued by the entity. An equity-linked financial instrument (or embedded feature) would not be considered indexed to the entity's own stock if the strike price is denominated in a currency other than the issuer's functional currency (including a conversion option embedded in a convertible debt instrument that is denominated in a currency other than the issuer's functional currency).

Freestanding financial instruments (and embedded features) for which the payoff to the counterparty is based, in whole or in part, on the stock of a consolidated subsidiary are not precluded from being considered indexed to the entity's own stock in the consolidated financial statements of the parent if the subsidiary is a substantive entity.

Another example of an embedded derivative determination situation would involve convertible preferred stock. A convertible preferred stock conversion option would not be an embedded derivative instrument if the terms of the preferred stock (not the conversion option) bear greater similarity to equity (e.g., cumulative, participating, perpetual) than to debt (i.e., a cumulative fixed rate with a mandatory redemption feature).

Interest-only strips and principal-only strips are specifically not subject to this standard assuming (1) the original financial instrument did not contain an embedded derivative instrument and (2) they don't incorporate any new terms from the original. In addition, foreign currency derivative instruments are specifically not separated from the host contract if (1) the currency of the primary economic environment is the functional currency of one of the parties, or (2) the good or service price is routinely denominated in that currency in international commerce.

If an embedded derivative instrument is separated from the host, the accounting is as follows:

1. The embedded derivative instrument is accounted for based on ASC 815, and
2. The host contract is accounted for based on GAAP for that instrument, without the embedded derivative instrument.

If the embedded derivative instrument cannot be reliably identified and measured separately, the contract cannot be designated as a hedging instrument, and the entire contract must be measured at fair value with the gain or loss recognized in income.

The SEC's position, as articulated in ASC 815-10-S99, is that in performing an evaluation of an embedded derivative feature, the consideration of the economic characteristics and risks of the host contract should be based on all of the stated or implied substantive terms and features of the hybrid financial instrument. In evaluating the stated and implied substantive terms and features, the existence or omission of any single term or feature is not necessarily determinative of the economic characteristics and risks of the host contract (i.e., whether the nature of the host contract is more akin to a debt instrument or more akin to an equity instrument). Although the consideration of an individual term or feature may be weighted more heavily in the evaluation, judgment is required based upon an evaluation of all the relevant terms and features.

Hybrid Financial Instruments

By definition, financial instruments that contain embedded derivatives are known as hybrid financial instruments. ASC 815-15-25 simplifies the accounting hybrid financial instruments such as interest-only and principal-only strips by permitting fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation under ASC 815. ASC 815-15-25 narrows the scope exception for interest-only and principal-only strips on debt instruments to include only such strips representing rights to receive a specified portion of the contractual interest or principal cash flows.

Per ASC 815, if an embedded instrument requires separation (because the close correlation criterion noted above is not met) from its host, but it cannot be reliably identified and measured, the entire contract must be measured at fair value. Upon recognition of a hybrid instrument that would otherwise require separation into a derivative and a host, the reporting entity may elect irrevocably to measure, on an instrument-by-instrument basis, the entire hybrid instrument at fair value. The changes in fair value are reported currently in earnings. Such an election must be supported either by concurrent documentation or by a preexisting documented policy supporting automatic election.

This fair value election is also available for remeasurement with respect to previously recognized financial instruments upon the occurrence of a business combination, a significant modification of debt, or other qualifying remeasurement event, where a new basis of accounting may be created.

Fair value measurements will often differ because they exclude transaction costs, which are included in many historical cost-based accounting entries. (For example, the fair value of stock just purchased on an exchange is lower than cost.) ASC 815 holds that any difference at inception of a recognized hybrid financial instrument for which the fair value election is applied and the transaction price is not to be included in current earnings (and thus is retained in the asset carrying amount) unless estimated fair value has been determined (1) from a quoted price in an active market, (2) from comparison to other observable current market transactions, or (3) using a valuation technique that incorporates observable market data.

According to ASC 815, the holder of an interest in securitized financial assets (other than holders of strips or related claims to cash flows) is to determine whether the interest is a freestanding derivative or contains an embedded derivative that would be required to be separated from the host contract and accounted for separately. That determination is to be based on an analysis of the contractual terms of the interest in securitized financial assets. This, in turn, requires understanding the nature and amount of assets, liabilities, and other financial instruments that constitute the complete securitization transaction. It is expected that the holder of an interest in securitized financial assets will obtain sufficient information about the payoff structure and the payment priority of the interest to make a determination about whether an embedded derivative exists.

Changes in cash flows that are attributable to changes in the creditworthiness of an interest resulting from securitized financial assets and liabilities (including derivative contracts) that represent the assets or liabilities that are held by the issuer are not to be considered an embedded derivative. The concentration of credit risk in the form of subordination of one financial instrument to another is also not to be considered an embedded derivative under the new standard.

ASC 815 requires statement of financial position segregation of those hybrid financial instruments that are being measured at fair value. This can be accomplished either by (1) the display of separate line items for fair value and non-fair value carrying amounts, or (2) parenthetical disclosure of fair value carrying amounts included in the aggregate of all carrying amounts. Also, disclosure must be made of the effect on earnings of changes in the fair value of recognized hybrid financial instruments.

Overview

While the standard requires that all derivatives be reported at fair value in the statement of financial position, the changes in fair value are reported in different ways depending on the nature and effectiveness of the hedging activities to which they are related, if held for hedging purposes. ASC 815 identifies changes in the fair values of derivatives as being the result of

1. effective hedging,
2. ineffective hedging, or
3. unrelated to hedging.

Furthermore, the hedging itself can be related to the fair value of an existing asset or liability or of a firm commitment, the cash flow associated with forecasted transactions, or foreign currency exposures.

After meeting specified conditions, a qualified derivative may be specifically designated as a total or partial (expressed as a percentage where the risk exposure profile is the same as that in the whole derivative) hedge of:

1. Changes in the fair value of:
   1. A recognized asset or liability, or
   2. An unrecognized firm commitment.

   In a fair value hedge, all gains and losses (of both the derivative instrument and the hedged item) are recognized in earnings in the period of change.

2. Variable cash flows of a forecasted transaction.

   In a cash flow hedge, the effective portion of the hedge is reported in other comprehensive income and is reclassified into earnings when the forecasted transaction affects earnings.

3. Foreign currency exposure of:
   1. A net investment in a foreign operation

      In a foreign currency net investment hedge, the gain or loss is reported in other comprehensive income as part of the cumulative translation adjustment to the extent that it is effective.

   2. An unrecognized firm commitment

      In a foreign currency unrecognized firm commitment hedge, the gain or loss is reported in the same way as a fair value hedge (see category 1).

   3. An available-for-sale security

      In a foreign currency available-for-sale security hedge, the gain or loss is reported in the same way as a fair value hedge (see category 1).

   4. A foreign currency-denominated forecasted transaction.

      In a foreign currency-denominated forecasted transaction hedge, the gain or loss is reported in the same way as a cash flow hedge (see category 2).

Hedge portions that are not effective are reported in earnings immediately.

A nonderivative financial instrument cannot generally be designated as a hedge. One exception, however, occurs when that instrument is denominated in a foreign currency and is designated as a hedge under 3a or 3b above. Not-for-profit enterprises cannot use hedge accounting for forecasted transactions.

Effectiveness—General Observations

The method used for assessing the effective and ineffective portions of a hedge must be defined at the time of designation, must be used throughout the hedge period, and must be consistent with the approach used for managing risk. Similar hedges should usually be assessed for effectiveness in a similar manner unless a different method can be justified. If an improved method is identified and is to be applied prospectively to an existing hedge, that hedge must be discontinued. The new method can then be designated and a new hedge relationship can be established.

Factors to be included in the effectiveness assessment must be specified at inception. The effect of all excluded factors and ineffective amounts are to be included in earnings. For example, if an option contract hedge is assessed for effectiveness based on changes in the option's intrinsic value, the change due to the time value of the contract would be excluded from the effectiveness assessment, and that amount would be included in earnings. As another example, differences in key terms between the hedged item and the hedging instrument such as notional amounts, maturities, quantities, location, or delivery dates would cause ineffectiveness and that amount would be included in earnings.

Qualifications

To qualify as a fair value hedge, both the hedged items and the designated hedging instruments must meet all of the following criteria:

1. At the hedge's inception, formal documentation exists of the:
   1. Hedging relationship;
   2. Risk management objectives;
   3. Strategy for undertaking the hedge;
   4. Identification of the hedged item, the hedging instrument, the nature of the risk being hedged, the method of assessing effectiveness and the components (if any) that are excluded (such as time value) from the effectiveness assessment; and the
   5. Reasonable method to be used in recognizing in earnings the asset or liability representing the gain or loss in the case of a hedged firm commitment.
2. The hedging relationship is expected to be highly effective in producing offsetting fair value changes throughout the hedge period. This relationship must be assessed at least every three months and each time financial statements or earnings are reported.
3. If hedging with a written option, the combination must provide as much potential for gains from positive fair value changes as potential for losses from negative fair value changes. If a net premium is received, a combination of options is considered a written option. The combination of a written option and some other nonoption derivative is also considered a written option.

According to ASC 815, an asset or liability will be eligible for designation as a hedged item in a fair value hedge if the hedged item:

1. is specifically identified as all or a specific portion of a recognized asset or liability, or an unrecognized firm commitment;
2. is exposed to fair value changes that are attributable to the hedged risk such that earnings would be affected; and
3. is not either remeasured at fair value for financial reporting purposes, or an equity-method investment, or an equity method or minority interest in a consolidated subsidiary, a firm commitment related to the foregoing, or an equity instrument issued by the entity.

Other limitations also apply, affecting held-to-maturity debt securities and nonfinancial assets.

More specifically, to be eligible for designation as a hedged item, an asset or liability must meet all of the following criteria:

1. The single item (or portfolio of similar items) must be specifically identified as hedging all or a specific portion.
   1. If similar items are aggregated and hedged, each item has to share the risk exposure that is being hedged (i.e. each individual item must respond in a generally proportionate manner to the change in fair value).
      1. (1) A specific portion must be one of the following:
      2. (2) A percentage of the total asset, liability, or portfolio;
      3. (3) One or more selected contractual cash flows: for instance, the present value of the interest payments due in the first two years of a four-year debt instrument;
      4. (4) An embedded put, call, cap, or floor that does not qualify as an embedded derivative in an existing asset or liability; or
      5. (5) Residual value in a lessor's net investment in a sales-type or direct financing lease.
2. The item has an exposure to fair value changes that could affect earnings (this does not apply to not-for-profit enterprises).
3. The item is not:
   1. Remeasured with changes reported currently in earnings; for example, a foreign currency-denominated item;
   2. An ASC 323 equity-method investment or an equity investment in a consolidated subsidiary;
   3. A minority interest;
   4. A firm commitment to enter into a business combination or to acquire or dispose of:
      1. (1) A subsidiary;
      2. (2) A minority interest; or
      3. (3) An equity method investee; or
   5. An entity-issued equity interest classified in stockholders' equity.
4. The item is not a held-to-maturity debt security (or similar portfolio) unless the hedged risk is for something other than for fair value changes in market interest rates or foreign exchange rates; examples include hedges of fair value due to changes in the obligor's creditworthiness, and hedges of fair value due to changes in a prepayment option component.
5. If the item is a nonfinancial asset or liability (other than a recognized loan servicing right or a nonfinancial firm commitment with financial components), the designated hedged risk is the fair value change of the total hedged item (at its actual location, if applicable); ASC 815 stipulates that the price of a major ingredient cannot be used, and the price of a similar item at a different location cannot be used without adjustment.
6. If the item is a financial asset or liability, a recognized loan servicing right or a nonfinancial firm commitment with financial components, the designated hedge risk is the risk of changes in fair value from fair value changes in:
   1. The total hedged item;
   2. Market interest rates;
   3. Related foreign currency rates;
   4. The obligor's creditworthiness; or
   5. Two or more of the above, other than a.

Prepayment risk for a financial asset cannot be hedged, but an option component of a prepayable instrument can be designated as the hedged item in a fair value hedge. Embedded derivatives have to be considered also in designating hedges. For instance, in a hedge of interest rates, the effect of an embedded prepayment option must be considered in the designation of the hedge.

Reporting Gains and Losses from Fair Value Hedges

The accounting for qualifying fair value hedges' gains and losses is as follows:

• On the hedging instrument, gains and losses are recognized in earnings.
• On the hedged item, gains and losses are recognized in earnings, even if they would normally be included in other comprehensive income if not hedged. For example, gains and losses on an available-for-sale security would be taken into income, if this is being hedged. The carrying amount of the hedged item is adjusted by the gains and losses resulting from the hedged risk.

Differences between the gains and losses on the hedged item and the hedging instrument are either due to amounts excluded from the assessment of hedging effectiveness, or are due to ineffectiveness. These gains and losses are to be recognized currently in earnings.

Measuring the Effectiveness of Fair Value Hedges

Although there are specific conditions applicable to the hedge type (fair value or cash flow), in general, the assumption of no ineffectiveness in a hedging relationship between an interest-bearing financial instrument and an interest rate swap (or a compound hedging instrument composed of an interest rate swap and a mirror-image call or put option) can be made if all of the following conditions are met:

1. The principal amount of the interest-bearing asset or liability being hedged and the notional amount of the swap match.
2. The fair value of the swap is zero at inception, if the hedging instrument is solely an interest rate swap. If the hedging instrument is a compound derivative containing the swap and a mirror-image call or put, the premium for the option must be paid or received in the same manner as the premium on the option embedded in the hedged item, and further conditions must be met depending on whether the premium on the option element of the hedged item was paid upon inception or over the life of the instrument.
3. The net settlements under the swap are computed the same way on each settlement date.
4. The financial instrument is not prepayable, but this criterion does not apply to an interest-bearing asset or liability that is prepayable only due to an embedded call option when the hedging instrument is a compound derivative composed of a swap and a mirror-image call option.
5. The terms are typical for those instruments and don't invalidate the assumption of effectiveness.
6. The maturity date of the instrument and the expiration date of the swap match.
7. No floor or ceiling on the variable interest rate of the swap exists.
8. The interval (three to six months or less) between repricings is frequent enough to assume the variable rate is a market rate.

The fixed rate on the hedged item is not required to exactly match the fixed rate on the swap. The fixed and variable rates on the swap can be changed by the same amount. As an example, a swap payment based on LIBOR and a swap receipt based on a fixed rate of 5% can be changed to a payment based on LIBOR plus 1% and a receipt based on 6%.

ASC 815 permits a “shortcut method” to compute fair value adjustments, which produces the same reporting results as when the method illustrated above has been applied. This shortcut is only appropriate for a fair value hedge of a fixed-rate asset or liability using an interest rate swap and only with the assumption of no ineffectiveness is appropriate (i.e., if the criteria above have been met). The FASB's decision to redefine interest rate risk (by permitting “benchmark rate” hedging in ASC 815-20-25) necessitated that it also address the effect on the shortcut method for fair value hedges and cash flow hedges. The steps in the shortcut method are as follows:

1. Determine the difference between the fixed rate to be received on the swap and the fixed rate to be paid on the bonds.
2. Combine that difference with the variable rate to be paid on the swap.
3. Compute and recognize interest expense using that combined rate and the fixed-rate liability's principal amount. (Amortization of any purchase premium or discount on the liability also must be considered, although that complication is not incorporated in this example.)
4. Determine the fair value of the interest rate swap.
5. Adjust the carrying amount of the swap to its fair value and adjust the carrying amount of the liability by an offsetting amount.

For fair value hedges, an assumption of no ineffectiveness is invalidated when the interest rate index embodied in the variable leg of the interest rate swap is different from the benchmark interest rate being hedged. In situations in which the interest rate index embodied in the variable leg of the swap has greater credit risk than that embodied in the benchmark interest rate, the effect of the change in the swap's credit sector spread over that in the benchmark interest rate would represent hedge ineffectiveness because it relates to an unhedged risk (credit risk) rather than to the hedged risk (interest rate risk).

In situations in which the interest rate index embodied in the variable leg of the swap has less credit risk than that embodied in the benchmark interest rate, the effect of the change in a certain portion of the hedged item's spread over the swap interest rate would also represent hedge ineffectiveness. For an entity to comply with an assumption of no ineffectiveness, the index on which the variable leg of the swap is based must match the benchmark interest rate designated as the interest rate risk being hedged for the hedging relationship.

Discontinuance of a Fair Value Hedge

The accounting for a fair value hedge should not continue if any of the events below occur:

1. The criteria are no longer met;
2. The derivative instruments expire or are sold, terminated, or exercised; or
3. The designation is removed.

If the fair value hedge is discontinued, a new hedging relationship may be designated with a different hedging instrument and/or a different hedged item, as long as the criteria established in ASC 815 are met.

Ineffectiveness of a Fair Value Hedge

Unless the shortcut method is applicable, the reporting entity must assess the hedge's effectiveness at the inception of the hedge and at least every three months thereafter. In addition, ASC 815 requires that at the inception of the hedge the method to be used to assess hedge effectiveness must be identified. To comply, the reporting entity should decide which changes in the derivative's fair value will be considered in assessing the effectiveness of the hedge, and the method to be used to assess hedge effectiveness. Regarding the former, some derivative instruments (options) have two components: intrinsic value and time value. The intrinsic value of a call option is the excess, if any, of the market price over the strike or exercise price; the intrinsic value of an option recognizes that the price of the underlying item may move above the strike price (for a call) or below the strike price (for a put) during the exercise period. The enterprise elects to measure effectiveness either including or excluding time value; it must do so consistently once the designation is made.

Hedge effectiveness must be assessed in two different ways—in prospective considerations and in retrospective evaluations. ASC 815 provides flexibility in selecting the method the entity will use in assessing hedge effectiveness, but an entity should assess effectiveness for similar hedges in a similar manner and that the use of different methods for similar hedges should be justified.

Prospectively, the entity must, at both inception and on an ongoing basis, be able to justify an expectation that the relationship will he highly effective in achieving offsetting changes in fair value over future periods. That expectation can be based upon regression or other statistical analysis of past changes in fair values or on other relevant information. Retrospectively, the entity must, at least quarterly, determine whether the hedging relationship has been highly effective in having achieved offsetting changes in fair value through the date of periodic assessment. That assessment can also be based upon regression or other statistical analysis of past changes in fair values, as well as on other relevant information. If at inception the entity elects to use the same regression analysis approach for both prospective and retrospective effectiveness evaluations, then during the term of that hedging relationship those regression analysis calculations should generally incorporate the same number of data points. As an alternative to using regression or other statistical analysis, an entity could use the dollar-offset method to perform the retrospective evaluations of assessing hedge effectiveness.

ASC 815-20-25 addresses documentation of the method that is used to measure hedge ineffectiveness under ASC 815. ASC 815 implies that an entity must document, at inception of a hedge, the method that will be used to measure hedge ineffectiveness (in addition to the method to be used to assess effectiveness) in order to meet the documentation requirements of the standard. The FASB has stated that formal documentation is required, at the inception of a hedge, of the hedging relationship and the entity's risk management objective and strategy for undertaking the hedge, including identification of:

1. The hedging instrument,
2. The hedged item or transaction,
3. The nature of the risk being hedged,
4. The method that will be used to retrospectively and prospectively assess the hedging instrument's effectiveness, and
5. The method that will be used to measure hedge ineffectiveness.

Impairment Considerations for Hedging and Hedged Items

All assets or liabilities designated as fair value hedges are subject to the normal GAAP requirements for impairment assessment and, as needed, accounting adjustment. Those requirements are to be applied, however, only after the carrying amounts have been adjusted for the period's hedge accounting. Since the hedging instrument is a separate asset or liability, its fair value is not considered in applying the impairment criteria to the hedged item.

The hedged item is also, of course, subject to the requirement for impairment assessment. A fair value measurement represents the price at which a transaction would occur between market participants in an orderly transaction at the measurement date. The fair value is determined, as set forth by ASC 820-10, by using one of the following methods:

• Utilizing quoted prices in an active market (Level 1)
• Utilizing relevant observable inputs (Level 2)
• Utilizing significant unobservable inputs (Level 3).

ASC 820 stipulates that fair value represents the price at which an orderly transaction would take place between market participants. An orderly transaction is one that would not be characterized as a forced liquidation or distress sale. Thus, notwithstanding that there may be little or no market activity for an asset at the measurement date, the objective of determining fair value remains the identification of an exit price for the asset in question. Under reduced market activity conditions it would neither be appropriate to conclude that all market activity represents forced liquidations or distress sales, nor that any given transaction price is determinative of fair value.

Put another way, this admonition suggests that, in such circumstances, there may be a need to apply Level 3 measurements as described in ASC 820, if Level 1 (quoted prices) are absent or unreliable and Level 2 measures are similarly sparse or absent or no longer relevant. There would thus be a greater need to employ management's internal assumptions concerning future cash flows discounted at an appropriate risk-adjusted interest rate. When some Level 2 (observable) data is available but requires significant adjustment based on unobservable data, these should be considered to be Level 3 fair value measurements.

Qualifications

To qualify as a cash flow hedge, both the hedged items and the designated hedging instruments must meet all of the following criteria:

1. At the hedge's origin, formal documentation exists of the:
   1. Hedging relationship;
   2. Risk management objectives;
   3. Strategy for undertaking the hedge; and
   4. Identification of the hedged transaction, the hedging instrument, the nature of the hedged risk, the method of assessing effectiveness, and the components (if any) that are excluded (such as time value) from the effectiveness assessment.
2. Documentation must include:
   1. All relevant details;
   2. The specific nature of any asset or liability involved;
   3. When (date on or period within) a forecasted transaction is expected to occur; and
   4. The expected currency amount (exact amount of foreign currency being hedged) or expected quantity (specific physical quantities such as number of items, weight, etc.) of a forecasted transaction. If a price risk is being hedged in a forecasted sale or purchase, the hedged transaction cannot:
      1. (1) Be specified solely in terms of expected currency amounts, or
      2. (2) Be specified as a percentage of sales or purchases.

   The current price of the transaction should be identified and the transaction should be described so that it is evident that a given transaction is or is not the hedged transaction. For instance, a forecasted sale of the first 2,000 units in January is proper, but the forecasted sale of the last 2,000 units is not because they cannot be identified when they occur—the month has to end before the last units sold can be identified.

3. The hedging relationship is expected to be highly effective in producing offsetting cash flows throughout the hedge period. This relationship must be assessed at least every three months and each time financial statements or earnings are reported.
4. If hedging with a written option, the combination must provide at least as much potential for positive cash flow changes as exposure to negative cash flow changes. A derivative that results from the combination of a written option and another nonoption derivative is also considered a written option.
5. A link must be used to modify interest receipts or payments of a recognized financial asset or liability from one variable rate to another variable rate. It has to be between a designated asset (or group of similar assets) and a designated liability (or group of similar liabilities) and it has to be highly effective. A link occurs when the basis of one leg of an interest rate swap is the same as the basis of the interest rate receipt of a designated asset and the basis of the other leg of the swap is the same as the basis of the interest payments for a designated liability.

A nonderivative instrument cannot be designated as a hedging instrument for a cash flow hedge.

In addition to the above, to be eligible for designation as a cash flow hedge, a forecasted transaction must meet all of the following criteria:

1. The single transaction (or group of individual transactions) must be specifically identified. If individual transactions are grouped and hedged, each has to share the same risk exposure that is being hedged (i.e. each individual transaction must respond in a proportionate manner to the change in cash flow). Thus, a forecasted sale and a forecasted purchase cannot both be included in the same group of transactions.
2. The occurrence is probable.
3. It is a transaction with an external party (unless a foreign currency cash flow hedge) and it has an exposure to cash flow changes that could affect earnings.
4. The transaction is not to be remeasured under GAAP with changes reported in earnings; for example, foreign currency-denominated items would be excluded for this reason. Forecasted sales on credit and forecasted accrual of royalties on probable future sales are not considered the forecasted acquisition of a receivable. Also, if related to a recognized asset or liability, the asset or liability is not remeasured under GAAP with changes in fair value resulting from the hedged risk reported in earnings.
5. The item is not a held-to-maturity debt security (or similar portfolio) unless the hedged risk is for something other than for cash flow changes in market interest rates, as for example, in a hedge of cash flow changes due to an obligor's creditworthiness or default.
6. It does not involve:
   1. A business combination;
   2. A parent company's interest in consolidated subsidiaries;
   3. A minority interest;
   4. An equity-method investment; or
   5. An entity-issued equity interest classified in stockholders' equity.
7. If it involves a purchase or sale of a nonfinancial asset, the hedged risk is:
   1. The change in the functional-currency-equivalent cash flows resulting from changes in the related foreign currency rates; or
   2. The change in cash flows relating to the total hedged purchase or sales price (at its actual location, if applicable); for example, the price of a similar item at a different location cannot be used.
8. If it involves a purchase or sale of a financial asset or liability or the variable cash flow of an existing financial asset or liability, the hedged risk is the risk of changes in cash flow of:
   1. The total hedged item;
   2. Market interest rates;
   3. Related foreign currency rates;
   4. Obligor's creditworthiness or default; or
   5. Two or more of the above, other than a.

Prepayment risk for a financial asset cannot be hedged.

Gains and Losses from Cash Flow Hedges

The accounting for qualifying cash flow hedges' gains and losses is as follows:

1. The effective portion of the gain or loss on the derivative instrument is reported in other comprehensive income.
2. The ineffective portion of the gain or loss on the derivative instrument is reported in earnings.
3. Any component excluded from the computation of the effectiveness of the derivative instrument is reported in earnings.
4. Accumulated other comprehensive income from the hedged transaction should be adjusted to the lesser (in absolute amounts) of the following:
   1. The cumulative gain or loss on the derivative from the creation of the hedge minus any component excluded from the determination of hedge effectiveness and minus any amounts reclassified from accumulated other comprehensive income into earnings;
   2. The portion of the cumulative gain or loss on the derivative needed to offset the cumulative change in expected future cash flow on the transaction from the creation of the hedge minus any amounts reclassified from accumulated other comprehensive income into earnings.

   The adjustment of accumulated other comprehensive income should recognize in other comprehensive income either a part or all of the gain or loss on the adjustment of the derivative instrument to fair value.

5. Any remaining gain or loss is reported in earnings.

Reclassifications to Earnings

In the period that the hedged forecasted transaction affects earnings, amounts in accumulated other comprehensive income should be reclassified into earnings. If the transaction results in an asset or liability, amounts in accumulated other comprehensive income should be reclassified into earnings when the asset or liability affects earnings through cost of sales, depreciation, interest expense, and the like. Any time that a net loss on the combined derivative instrument and the hedged transaction is expected, the amount that isn't expected to be recovered should immediately be reclassified into earnings.

Effectiveness of Cash Flow Hedges

The assumption of no ineffectiveness in a cash flow hedge between an interest-bearing financial instrument and an interest rate swap can be assumed if all of the following conditions are met:

1. The principal amount and the notional amount of the swap match;
2. The fair value of the swap is zero at origin;
3. The net settlements under the swap are computed the same way on each settlement date;
4. The financial instrument is not prepayable; and
5. The terms are typical for those instruments and don't invalidate the assumption of effectiveness.
6. All variable rate interest payments or receipts on the instrument during the swap term are designated as hedged and none beyond that term;
7. No floor or cap on the variable rate of the swap exists unless the variable rate instrument has one. If the instrument does, the swap must have a comparable (not necessarily equal) one;
8. Repricing dates match; and
9. The index base for the variable rates match.

The variable rate on the instrument is not required to exactly match the variable rate on the swap. The fixed and variable rates on the swap can be changed by the same amount.

Discontinuance of a Cash Flow Hedge

The accounting for a cash flow hedge should not continue if any of the events below occur:

1. The criteria are no longer met;
2. The derivative instrument expires or is sold, terminated or exercised, or
3. The designation is removed by management.

The net gain or loss in accumulated other comprehensive income should remain there until it is properly reclassified when the hedged transaction affects earnings. If it is probable that the original forecasted transactions won't occur, the net gain or loss in accumulated other comprehensive income should immediately be reclassified into earnings.

If the cash flow hedge is discontinued, a new hedging relationship may be designated with a different hedging instrument and/or a different hedged item, as long as the criteria established in ASC 815 are met.

Ineffectiveness of a Cash Flow Hedge

In assessing the effectiveness of a cash flow hedge, the time value of money generally will need to be considered, if significant in the circumstances. Doing so becomes especially important if the hedging instrument involves periodic cash settlements. For example, a tailing strategy with futures contracts is a situation in which an entity likely would reflect the time value of money. When employing such a strategy, the entity adjusts the size or contract amount of futures contracts used in a hedge so that earnings (or expense) from reinvestment (or funding) of daily settlement gains (or losses) on the futures do not distort the results of the hedge. To assess offset of expected cash flows when a tailing strategy has been used, an entity could reflect the time value of money, possibly comparing the present value of the hedged forecasted cash flow with the results of the hedging instrument.

Impairment

All assets or liabilities designated as cash flow hedges are subject to normal GAAP requirements for impairment. Those requirements are to be applied, however, after hedge accounting has been applied for the period. Since the hedging instrument is a separate asset or liability, its expected cash flow or fair value is not considered in applying the impairment criteria to the hedged item. If an impairment loss or recovery on a hedged forecasting asset or liability is recognized, any offsetting amount should be immediately reclassified from accumulated other comprehensive income into earnings.

Expanded Application of Interest Rate Hedging

ASC 815 also permits the use of hedge accounting where the interest rate being hedged is the “benchmark interest rate.” As used in the standard, this rate will be either the risk-free rate (i.e., that applicable to direct Treasury borrowings—UST), the LIBOR swap rate, or the OIS. LIBOR-based swaps are the most commonly employed interest rate hedging vehicles.

The FASB has concluded that, with respect to the separation of interest rate risk and credit risk, the risk of changes in credit sector spread and any credit spread attributable to a specific borrower should be encompassed in credit risk rather than interest rate risk. Under such an approach, an entity would be permitted to designate the risk of changes in the risk-free rate as the hedged risk, and any spread above that rate would be deemed to reflect credit risk.

ASC 815 requires that all contractual cash flows be used in determining the changes in fair value of the hedged item when benchmark interest rates are being employed. In other words, cash flows pertaining to the portion of interest payments which is related to the entity's credit risk (the risk premium over the benchmark rate) cannot be excluded from the computation.

The accounting for an interest rate hedge using a benchmark rate is very similar to that illustrated previously in this chapter. However, the variable rate used, rather than reflecting the credit riskiness of the party doing the hedging (which was prime + 1/2% in that illustration), would instead be the benchmark rate (e.g., the rate on Treasury five-year notes). Since changes in the benchmark rate might not exactly track the changes in the underlying instrument (due to changes in the “credit spread” which are a reflection of changes in the underlying party's perceived credit risk), the hedge will likely be imperfect, such that a net gain or loss will be reflected in periodic earnings.

Foreign Currency Net Investment Hedge

Either a derivative instrument or a nonderivative financial instrument (that can result in a foreign currency transaction gain or loss under ASC 830) can be designated as a hedge of a foreign currency exposure of a net investment in a foreign operation. The gain or loss from the designated instrument to the extent that it is effective is reported as a translation adjustment. The hedged net investment is accounted for under ASC 830.

Foreign Currency Unrecognized Firm Commitment Hedge

Either a derivative instrument or a nonderivative financial instrument (that can result in a foreign currency transaction gain or loss under ASC 830) can be designated as a fair value hedge of an unrecognized firm commitment (or a specific portion) attributable to foreign currency. If the criteria are met, this hedging relationship is accounted for as a fair value hedge.

Foreign Currency Available-for-Sale Security Hedge

Only a derivative instrument can be designated as a fair value hedge of an available-for-sale debt security (or a specific portion) attributable to foreign currency. If the criteria are met, this hedging relationship is accounted for as a fair value hedge. For an available-for-sale equity security to be accounted for as a fair value hedge, it must meet all of the fair value hedge criteria and the following two requirements:

1. The security cannot be traded on an exchange (or similar marketplace) denominated in the investor's functional currency, and
2. Dividends (or other cash flows) to the holders must be denominated in the same foreign currency as that expected to be received upon the sale of the security.

If the available-for-sale equity security qualifies as a foreign currency hedge, the change in fair value from foreign exchange risk is reported in earnings and not in other comprehensive income.

Any gain or loss on a designated nonderivative hedging instrument from foreign currency risk is determined under ASC 830 (as the increase or decrease in functional currency cash flows produced by the change in spot exchange rates) and is reported in earnings along with the change in the carrying amount of the hedged firm commitment.

Foreign Currency-Denominated Forecasted Transaction

Only a derivative instrument can be designated as a cash flow hedge of a foreign currency-denominated forecasted transaction. The parties to this transaction can either be external or intercompany. To qualify for hedge accounting, all of the following criteria must be met:

1. An operating unit with foreign currency exposure is a party to the derivative instrument;
2. The transaction is denominated in a currency that is not the functional currency;
3. All of the criteria for a cash flow hedge are met (with the possible exception of allowing a qualifying intercompany transaction); and
4. If a group of individual transactions is involved, both an inflow and an outflow of foreign currency cannot be included in the same group.

If the foregoing criteria are met, this hedging relationship is accounted for as a cash flow hedge.

Using Certain Intercompany Derivatives as Hedging Instruments in Cash Flow Hedges of Foreign Currency Risk in the Consolidated Financial Statements

ASC 815 permits the use of intercompany derivatives as the hedging instruments in cash flow hedges of foreign currency risk in the consolidated financial statements, if those intercompany derivatives are offset by unrelated third-party contracts on a net basis. The new standard defines an “internal derivative” as a foreign currency derivative contract that has been entered into with another member of a consolidated group and that can be a hedging instrument in a foreign currency cash flow hedge of a forecasted borrowing, purchase, or sale or an unrecognized firm commitment in the consolidated financial statements only if the following two conditions are satisfied. First, from the perspective of the member of the consolidated group using the derivative as a hedging instrument, specific criteria for foreign currency cash flow hedge accounting are satisfied. Second, the members of the consolidated group who are not using the derivative as a hedging instrument must either (1) enter into a derivative contract with an unrelated third party to offset the exposure that results from that internal derivative, or (2) if certain defined conditions are met, enter into derivative contracts with unrelated third parties that would offset, on a net basis for each foreign currency, the foreign exchange risk arising from multiple internal derivative contracts.

Other Guidance on Accounting for Financial Instruments

ASC 932-330-55 is directed at the accounting for derivative contracts held for trading purposes and contracts involved in energy trading and risk management activities. It concluded that energy contracts should not be marked to fair value. It determined, as well, that the common practice of carrying energy physical inventories at fair value had no basis under GAAP. Furthermore, net presentation of gains and losses derived from derivatives is required under ASC 815, even if physical settlement occurs, if the derivatives are held for trading purposes (as that term is defined in ASC 320). It was also decided that a derivative held for trading purposes may be designated as a hedging instrument, if the ASC 815 criteria are all met, on a prospective basis (i.e., from date of the consensus), notwithstanding the ASC 815 prohibition on designation of derivative instruments held for trading as “hedges.”

Accounting for Contracts Held or Issued by the Reporting Entity that are Indexed to its Own Stock

ASC 815-10-15 provides that the reporting entity is not to consider contracts issued or held by that reporting entity that are both (1) indexed to its own stock, and (2) classified in stockholders' equity in its statement of financial position to be derivative instruments for purposes of that topic. ASC 718-10-60-1B offers extensive examples to clarify the circumstances where the first part of this particular exemption (i.e., indexed to the entity's own stock) would apply. It applies to any freestanding financial instrument or embedded feature that has all the characteristics of a derivative in ASC 815-10-15, for purposes of determining whether that instrument or embedded feature qualifies for the first part of the scope exception in ASC 815-10-15-74. It also applies to any freestanding financial instrument that is potentially settled in an entity's own stock, regardless of whether the instrument has all the characteristics of a derivative in ASC 815-10-15, for purposes of determining whether the instrument is within the scope of ASC 815-40.

It is required that an evaluation be made of whether an equity-linked financial instrument (or embedded feature), using the following two-step approach:

• Step 1 is to evaluate the instrument's contingent exercise provisions, if any;
• Step 2 is to evaluate the instrument's settlement provisions.

An exercise contingency would not preclude an instrument (or embedded feature) from being considered indexed to an entity's own stock provided that it is not based on (1) an observable market, other than the market for the issuer's stock (if applicable), or (2) an observable index, other than an index calculated or measured solely by reference to the issuer's own operations. If the evaluation of Step 1 does not preclude an instrument from being considered indexed to the entity's own stock, the analysis would proceed to Step 2. An exercise contingency is a provision that entitles the entity, or counterparty, to exercise an equity-linked financial instrument (or embedded feature) based on changes in an underlying, including the occurrence (or nonoccurrence) of a specified event. Provisions that accelerate the timing of the entity's, or counterparty's, ability to exercise an instrument, and provisions that extend the length of time that an instrument is exercisable, are examples of exercise contingencies.

An instrument (or embedded feature) would be considered indexed to an entity's own stock if its settlement amount will equal the difference between the fair value of a fixed number of the entity's shares and a fixed monetary amount or a fixed amount of a debt instrument issued by the entity.

A number of examples of the application of this guidance are provided in the topic. For example, warrants that become exercisable upon an initial public offering (IPO), at a fixed price, would meet the criteria for being deemed indexed to the entity's stock, measured by the difference between fair value and the fixed exercise price. On the other hand, if conditioned on the change in some external index (such as the Dow Industrials) over some defined period, the warrants would not be deemed linked to the entity's stock.

ASC 815-40 reached a number of conclusions. These are summarized as follows:

1. Basis of settlement. Initial statement of financial position classification is to be guided by the principle that contracts that require net cash settlements are assets or liabilities, and those that require settlement in shares are equity instruments. If the reporting entity has the choice of settlement modes, settlement in shares is to be assumed; if the counterparty has the option, net cash settlement is presumed. An exception occurs if the two settlement alternatives are not of equal value, in which case the economic substance should govern.
2. Measurement. Initial measurement should be at fair value. Contracts classed as equity are accounted for in permanent equity, with value changes being ignored, unless settlement expectations change. For publicly held companies, under defined circumstances, guidance is provided by analogy from Accounting Series Release (ASR) 268. All other contracts would be classified as assets or liabilities, to be measured continuously at fair value. If settlement in shares ultimately occurs, already recognized gains or losses are left in earnings, not reclassified or reversed.
3. Contract reclassification. Events may necessitate reclassification of contracts from assets/liabilities to equity. If a contract first classed as equity is later reclassified to assets/liabilities, any value change to the date of reclassification will be included in equity, not earnings. Thereafter, value changes will be reported in earnings. If partial net share settlement is permitted, the portion that can be so settled remains in equity. Appropriate disclosure under ASC 235 may be required, if more than one contract exists and different methods are applied to them.
4. Equity classification criteria. All the following conditions must be satisfied in order to classify a contract in equity:
   1. The contract permits settlement in unregistered shares (the assumption being that the issuer cannot effectively control the conditions for registration, making cash settlement likely unless unregistered shares can be delivered);
   2. There are sufficient authorized, unissued shares to settle the contact, after considering all other outstanding commitments;
   3. The contract contains an explicit limit on the number of shares to be issued;
   4. There are no required cash payments to the counterparty based on the issuer's failure to make timely SEC filings;
   5. There are no “make whole” provisions to compensate the holder after he sells the shares issued in the market at a price below some defined threshold value;
   6. Requirements for net cash settlement are accompanied by similar requirements for existing shareholders;
   7. There are no provisions that indicate that the counterparties have rights greater than those of the actual shareholders; and
   8. There is no requirement for any collateral posting for any reason.
5. Hedge accounting applicability. Contracts that are subject to this consensus cannot qualify for hedge accounting.
6. Multiple settlement alternatives. Contracts offering multiple settlement alternatives that require the company to receive cash when the contract is in a gain position but pay either stock or cash at the company's option when in a loss position are to be accounted for as equity. Also, such contracts requiring payment of cash when in a loss position but receipt of either cash or stock at the company's option when in a gain position must be accounted for as assets/liabilities.
7. EPS calculations. For EPS computation purposes, for those contracts that provide the company with a choice of settlement methods, settlement in shares is to be assumed, although this can be overcome based on past experience or stated policy. If the counterparty controls the choice, however, the more dilutive assumption must be made, irrespective of past experience or policy.

Freestanding Derivatives Indexed to, and Potentially Settled in, Stock of a Consolidated Subsidiary

ASC 815-40 cited above, establishes a framework for accounting for freestanding derivative instruments that are indexed to, and potentially settled in, a company's own stock. The ASC does not, however, provide guidance on how to account for freestanding derivative instruments that are indexed to, and potentially settled in, a subsidiary's stock. ASC 810-10 deals with how such contracts should be classified and measured in the consolidated financial statements.

Stock of a subsidiary is not equity of the parent; therefore, derivatives indexed to and to be settled in stock of a subsidiary do not meet ASC 815-10-15's exclusion criteria. If derivatives meet the criteria (e.g., for net settlement, etc.), they must be accounted for under the provisions of ASC 815-25 through 815-35, and not of ASC 815-40. The ASC also discusses a number of exceptions based on the criteria set forth in ASC 815.

Option or forward strike prices and premiums could be indicative of impairments of the parent's investment in subsidiaries. A parent's contract to purchase a subsidiary's (minority held) common stock should not be recorded until settled; during the period of the contract, income should continue to be allocated to the minority interest. A contract to sell shares in a subsidiary, likewise, should be recorded when settled; until that time, income would not be allocated to outside interests (counterparties to the derivative).

ASC 815-40 applies to freestanding derivatives only—similar embedded derivatives are not covered. Also not covered are derivatives which are issued to compensate employees or to acquire goods and services from nonemployees, when performance has yet to occur. It does apply, however, to derivatives issued to acquire goods and services from nonemployees, when performance has occurred.

FASB clarified whether a financial instrument for which the payoff to the counterparty is based, in whole or in part, on the stock of an entity's consolidated subsidiary is indexed to the reporting entity's own stock. It holds that freestanding financial instruments (and embedded features) for which the payoff to the counterparty is based, in whole or in part, on the stock of a consolidated subsidiary are not precluded from being considered indexed to the entity's own stock in the consolidated financial statements of the parent if the subsidiary is a substantive entity. If the subsidiary is not a substantive entity, however, the instrument or embedded feature would not be considered indexed to the entity's own stock. The fair value of an outstanding instrument that was previously classified as an asset or liability is to be its net carrying amount at that date (that is, the current fair value). The net carrying amount is then to be reclassified to noncontrolling interest. Gains or losses recorded during the periods that the instrument was classified as an asset or liability are not to be reversed.

Structured Notes

Structured notes are debt obligations that are coupled with derivatives, most often related to interest rates or foreign currency exchange rates, such that a prescribed increase or decrease in the reference rate will have a large impact on some defined attribute of the debt obligation, such as its interest rate, maturity value, or maturity date. In some instances, two or more such instruments may be acquired, having essentially opposite characteristics, such that, for example, a change in a reference interest rate will cause the fair value on one holding to increase and the other to decrease, by equal amounts. In some instances, this may have been arranged in order to be able to achieve a recognizable loss on the one (losing) investment by selling it, while holding the other (winning) one as an AFS security with unrealized gains reported in other comprehensive income. ASC 320 effectively ends this practice by requiring that the related investments be accounted for as a unit while held, but if one is sold the (joint) carrying amount must be allocated based on relative fair values as of the date of sale, consistent with guidance in ASC 860. The consequence is that neither gain nor loss, recognized or included in stockholders' equity, will result from such transactions.

Accounting for Freestanding Derivative Financial Instruments Indexed to, and Potentially Settled in, the Stock of a Consolidated Subsidiary

ASC 815 contains a framework for accounting for freestanding derivative instruments that are indexed to, and potentially settled in, a company's own stock. It does not, however, provide guidance on the accounting for freestanding derivative instruments that are indexed to, and potentially settled in, a subsidiary's stock. ASC 810 addresses how such contracts should be classified and measured in the consolidated financial statements.

The stock of a subsidiary is not equity of the parent; therefore, derivatives indexed to and to be settled in stock of a subsidiary do not meet ASC 815's exclusion criteria. If derivatives meet the criteria of ASC 815 (e.g., for net settlement, etc.), these must be accounted for under the provisions of ASC 815. The consensus also discusses a number of exceptions based on the criteria set forth in ASC 815.

Option or forward strike prices and premiums could be indicative of impairments of the parent's investment in subsidiaries—which would need to be assessed using ASC 360. A parent's contract to purchase a subsidiary's (minority held) common stock is not recorded until settled; during the period of the contract, income continues to be allocated to the minority interest. A contract to sell shares in a subsidiary, likewise, is recorded when settled; until that time, income would not be allocated to outside interests (counterparties to the derivative).