How to Apply the Simplified Hedge Accounting Approach

Hedge accounting allows companies to align the financial reporting of a hedging instrument with the item being hedged, which can reduce volatility in reported earnings. Standard hedge accounting rules under U.S. Generally Accepted Accounting Principles (GAAP) can be operationally complex, so the Financial Accounting Standards Board (FASB) introduced a simplified approach to ease the burden for specific transactions.

This alternative is a practical expedient for qualifying scenarios, not a full replacement for standard hedge accounting. It primarily targets the hedging of variable interest rate risk using interest rate swaps. The goal is to allow the gains or losses on the swap to be recognized in the same period as the interest expense on the related debt, creating a smoother earnings profile and reducing the extensive effectiveness testing standard hedge accounting demands.

Eligibility Criteria for the Simplified Approach

Entity-Level Criteria

The simplified hedge accounting approach is not available to all entities. Its use is restricted to organizations that are not classified as public business entities, making it accessible to private companies and most not-for-profit organizations. Financial institutions, even if privately held, are excluded from using this simplified method. This limitation exists because the simplification is intended for entities with fewer resources to dedicate to complex accounting requirements, while public companies are expected to follow more rigorous standard guidance.

Transaction-Level Criteria

Beyond the entity-level requirements, the specific financial instruments involved must meet a strict set of conditions. The debt being hedged must have a variable interest rate tied to a benchmark rate, such as the Secured Overnight Financing Rate (SOFR). The hedging instrument must be a “plain-vanilla” interest rate swap, where the entity receives a variable rate based on the same benchmark and pays a fixed rate. The terms of the swap and the debt must also be closely aligned:

• The notional amount of the swap must match the principal of the hedged debt.
• The swap’s fair value at the time of designation must be at or near zero.
• The swap agreement cannot contain complex features like floors, caps, or options unless they are immaterial.
• The settlement dates for the swap and the interest payment dates on the debt should match or be very close.
• The maturity date of the swap must align with the maturity of the hedged debt, and the debt cannot be prepayable.

Required Documentation and Initial Assessments

Formal Hedge Designation Document

Formal documentation is required before using this method. A company must prepare a formal hedge designation document, which must be completed by the date the first annual financial statements are available to be issued after the hedge is initiated. This timeline provides private companies more time than is required under standard hedge accounting. The document must identify the hedging instrument, the hedged transaction, the nature of the risk being hedged, and the hedge’s effective date.

Initial Qualitative Assessment

The initial documentation must include a qualitative assessment of hedge effectiveness. This involves documenting how the terms of the interest rate swap and the hedged debt align, based on the transaction-level criteria. The company must record its conclusion that the hedge is expected to be highly effective. This qualitative approach allows the company to assume effectiveness without performing the complex quantitative analysis required by standard hedge accounting.

Applying the Simplified Method to an Interest Rate Swap

Initial Recognition

At the inception of the hedge, the interest rate swap is recorded on the balance sheet at its fair value. An eligibility criterion for the simplified approach is that the swap’s fair value at inception must be at or near zero. Therefore, the initial journal entry often involves a debit to “Interest Rate Swap” and a credit to “Cash” for a negligible amount, or no entry at all if the fair value is precisely zero. This initial measurement establishes the swap as an asset or liability on the company’s books.

Subsequent Measurement

In each subsequent reporting period, the accounting reflects the activity of both the debt and the swap. First, the company records the interest expense on its variable-rate debt as it normally would. For example, if the interest payment is $12,000, the entry is a debit to “Interest Expense” and a credit to “Cash.” Next, the net cash settlement on the swap is recorded as an adjustment to interest expense.

If the fixed payment owed is $10,000 and the variable payment received is $12,000, the company receives a net $2,000. This settlement is recorded with a debit to “Cash” and a credit to “Interest Expense,” reducing the total interest cost.

Finally, the swap is adjusted to its current fair value at the end of the reporting period. Any change in the swap’s fair value is also recorded directly to interest expense. If the swap’s fair value increases by $5,000, the entry is a debit to “Interest Rate Swap” and a credit to “Interest Expense.”

Financial Statement Presentation

On the balance sheet, the interest rate swap is reported as either an asset or a liability, depending on its fair value at the reporting date. On the income statement, the impact is consolidated within interest expense. The original interest expense from the debt is adjusted by both the net cash settlement and the change in the swap’s fair value. This process results in the company’s net interest expense reflecting the fixed rate paid on the swap, smoothing fluctuations from the variable-rate debt.

Ongoing Accounting and Reporting Requirements

Subsequent Assessments

A company must perform ongoing assessments to ensure the hedging relationship continues to qualify for the simplified approach. These assessments are done on a quarterly basis and, like the initial assessment, can be qualitative. The purpose is to verify that the terms of the hedge have not changed and that the relationship remains effective. If any term changes, or if the company can no longer assert that the hedge is effective, the simplified accounting treatment must be discontinued.

Accounting for De-designation

If a hedge is terminated or no longer qualifies for the simplified approach, the special accounting treatment ceases in a process known as de-designation. The accounting then reverts to the standard rules for a terminated cash flow hedge. Upon de-designation, the cumulative gain or loss on the swap is recognized in earnings. From that point forward, the interest rate swap is treated as a standalone derivative. It continues to be marked-to-market on the balance sheet, but subsequent adjustments to its fair value are recorded directly in earnings, which can reintroduce the earnings volatility the hedge was intended to prevent.