• Explanation

An interest rate (IR) swap is a derivative Financial contracts that derive their value from the performance of some underlying asset such as a share of stock, a commodity, or a currency. contract that allows two parties to exchange a stream of variable IR payments with fixed-rate payments. IR swaps allow companies to hedge A risk management strategy employed to offset losses in investments by taking an opposite position in a related asset. exposure to changes in IR. A company can use an IR swap as a cash flow hedgeA derivative contract used to reduce exposure to variability in the expected future cash flows of recognized assets and liabilities or any unrecognized forecasted transactions. Changes in valuation are reported in other comprehensive income. to convert its variable-rate financing into a fixed rate.

Due to a lack of resources or expertise with derivatives, compliance with hedge accountingAccounting that combines the entries to adjust a security's fair value and hedge position to reduce the volatility created by repeated fair value adjustments on the financial statements. rules can be difficult for smaller private companies. FASB made the following changes to simplify hedge accounting for private companies:

• Election can be done on a swap-by-swap basis, and swaps are assumed to be perfectly effective A hedge position in which a position's changes in value and cash flows are eliminated by the hedge position..
• Swaps are reported at the settlement amount, not the fair value.
• Swap documentation doesn't have to be in place until financial statements are issued.

To qualify for the simplified approach:

• The variable rate on the debt and the variable rate on the IR swap must be linked to the same index (ie, London Interbank Offered Rate). There is no need to cap the rate on the IR swap in relation to the debt (Choice C).
• An IR swap's fair value at inception must be close or equal to zero (Choice B).
• A swap's notional The nominal (ie, face) amount used to calculate payments on a derivative contract. amount (ie, face value) must be less than or equal to the debt's principal balance (Choice A).

Things to remember:
To qualify for simplified hedge accounting rules for interest rate (IR) swaps, the variable rate on the swap and original debt must be linked to the same index, the IR swap's fair value at inception must be close or equal to zero, and the notional amount must be less than or equal to the debt's principal balance.

Lecture References :

• FAR 4.02 : Derivatives & Hedge Accounting: Fair Value vs. Cash Flow Hedge