Q: My company has a term loan with a financial institution for $25 million for five years at London Interbank Offered Rate (LIBOR) plus 175 basis points. To protect the company from future increases in interest rate hikes, a swap was entered into, requiring us to pay fixed (9 percent) and receive variable (LIBOR). The notional amount of the swap is $10 million, but all of the other terms of the perfectly match the terms of the loan.
Is it correct to treat this swap agreement as a cash flow hedge?
A: You’re in luck. Assuming all the documentation requirements have been satisfied, the situation you describe qualifies for cashflow hedge accounting. To get it, however, you’ll need to specify that the “hedged item” is the interest rate risk associated with only a portion of your debt — specifically, $10 million. If you’ve accurately represented this hedging relationship, you probably also have the benefit of qualifying for the “shortcut treatment.” (You’ll want to confirm that all of the criteria spelled out in paragraphs 68 and 69 are satisfied, before this treatment is applied, however.) If so, life is sweet. You will be exempt from having to provide any analytic justification for believing that the hedge will be highly effective, which would be required, otherwise. Moreover, all mark-to-market effects of the swap will be deferred through Other Comprehensive Income, such that only by the accruals of the loan and the swap — and nothing else – will affect earnings.
Everyone should have it as easy as you do!
President, Kawaller & Co. LLC
Member, FASB Derivatives Implementation Group
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