Presented by Bill Brown
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Presented by Bill Brown
Accounting for Interest Rate Swaps
2009 Telergee CFO Conference
Newcastle, New HampshireOctober 15, 2009
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Relationship of Audience Attention Span to Number of Accounting Standards References
Uninteresting professional standard references
Minutes
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It’s all about the Hedging
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Definitions
• Interest rate swap• Derivative• Hedge• Hedge Accounting• Fair Value Hedge• Cash Flow Hedge
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Disclaimer on 15 Minute Primer
• Discussion of important practical considerations, not a structured study of the complex derivative accounting rules
• Accounting Standards Codification - 815 Derivatives and Hedging
• fka FAS 133 and 149
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Executive Summary
• Cash settlements paid or received (quarterly) are recorded as an increase or decrease to interest expense
• The contract must be recorded at fair value, which is typically zero at inception
• Changes in fair value are recorded in earnings unless you can apply hedge accounting, in which case they are recorded in Other Comprehensive Income (equity)
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2 Step Process to Apply Hedge Accounting
• Qualifying as a hedge (initial assessment)
• Assessing effectiveness/measuring ineffectiveness (ongoing)
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Qualifying as a Hedge
• Documentation– Risk being hedged
– Reason for undertaking
– Method for assessing effectiveness
– Method for measuring ineffectiveness
• Expectation of highly effective– When financials prepared/at least every 3 months
– Prospective and retrospective
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Highly Effective
• 80-125% correlation between cash flows associated with hedged risk and cash flows of the swap
• This applies to expected future cash flows as well as historical
• Regression analysis is sometimes used to make this assessment
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Measuring Ineffectiveness
• Standards discuss 3 methods:
– Change in variable cash flows method
– Hypothetical derivative method
– Change-in-fair-value method
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Shortcut Method
• Criteria for no ineffectiveness– Notional amount of swap matches principal amount
– Fair value of the swap at inception is zero.
– Formula for computing net settlements under the interest rate swap is the same for each net settlement. (fixed rate same throughout term and variable rate is based on same index.)
– Debt not pre-payable separately or without penalty. Other terms in the debt or swaps typical of those instruments and do not invalidate the assumption of no ineffectiveness.
–
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Shortcut Method
• Criteria for no ineffectiveness (continued)– All interest payments on the variable-rate liability during
the term of the interest rate swap are designated as hedged
– If there is a floor or cap, it is comparable to the floor or cap on the variable rate liability
– Repricing dates for swap and underlying debt occur on same date and are calculated the same
– Quarterly assessments not required– Specific to interest rate swaps
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Match of Critical Terms
• Permits an assumption of a highly effective relationship
• General – applies to different types of hedges
• Needs to be assessed on an ongoing basis
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Disclosure
• Don’t forget that footnote disclosure is required
– Why
– How
– How much
– Where
– When
– Terms
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Madness
Madness does not always howl.
Sometimes, it is the quiet voice at the end of the day saying,
"Hey, is there room in your head for one more?"
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Enjoy New Hampshire!