This example pertains only to the use of a swap contract in a cash flow hedging situation.
The starting point for determining journal entries and disclosure values for interest rate swap positions is a swaps pricing model. Such models require an underlying set of forward interest rates. These forward interest rates are generally determined with reference to observed market data, but some analytical manipulations are typically required. Derivative valuations require summing discounted values of all prospective cash flows expected under the contract.
Critical Values for Journal Entries and Disclosures
Balance sheet carrying value of the derivative as of the hedge designation date. (Equals zero for a new, at-market swap contract or forward contract.)
Balance sheet carrying value of the derivative as of the prior accounting period-end. Should reflect credit quality considerations.
Balance sheet carrying value of the derivative at the current accounting period-end. Should reflect credit quality considerations.
Sum of all settlements received (+) or paid (-) during the current accounting period
The portion of the most immediate swap settlement (following the current accounting period-end) that is associated with the just-completed accounting period.
Balance sheet carrying value of AOCI as of the prior accounting period-end.
Expected 12-Month Reclassification to Earnings
Estimate of the amount that will be reclassified out of AOCI to earnings in the 12-month period following the end of the current accounting period.
If hedges are recognized as being imperfect (i.e., the critical terms of the derivative do not perfectly correspond with the risk being hedged), the pricing model would have to be employed two times for each hedge relationship – once in connection with the actual derivative, and a second time in connection with a hypothetical derivative. The hypothetical derivative is a theoretical construct of a derivative that would perfectly offset the risk being hedged. Critical values would have to be found for both the Actual Derivative and the Hypothetical Derivative.
Amounts to be Derived
OCI Allocation due to Effective Hedge Results
For perfect hedges, this amount is the current period gain or loss, inclusive of the change in the derivative’s present value plus (minus) any settlements received (paid) during the period. For imperfect hedges this allocation requires following a two-step process: (1) Calculate the Cumulative Effective Hedge Results, which is the smaller gain or smaller loss, when comparing cumulative gains or losses of the actual derivative with those of a hypothetical. (2) The Current Effective Hedge Result is simply the current period change of this Cumulative Effective Hedge Result.
Amount Reclassified from AOCI to Earnings
For perfect hedges, the amount reclassified to Earnings is the swap’s settlements paid (received) in the current accounting period, adjusted for accruals. For imperfect hedges, the amount reclassified to earnings is an amount that serves to assure that the AOCI amount relates only to forthcoming periods.
Ineffective Hedge Results Recognized in Earnings
The current Ineffective Hedge Result is zero for a perfect hedge. For an imperfect hedge, this amount is any excess (if any) of the derivative’s gain or loss in the current period, relative to the Current Effective Hedge Results, or otherwise, zero.
Type in all the critical values, and the required calculations and journal entries will be generated. Caution: Garbage-in-garbage-out. If you lack the capability to calculate the required inputs or disclosures correctly, Kawaller & Company can assist in generating these values.