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Accounting for Interest Rate Caps

Dec 21, 2022

In March 2022, in an effort to fight inflation, the Federal Reserve raised its federal funds benchmark rate for the first time since 2018. Rate hikes have continued throughout the year rising from around 0% in the beginning of 2022 to almost 4% in November, a level which the U.S. has not seen in nearly 15 years. This means it is now more expensive to borrow money than it was a year ago, as borrowers will have to pay higher interest rates. Also, any borrower with preexisting debt that carries a variable interest rate based on underlying indexes will be affected by these rate hikes. However, interest rate caps are one way for companies to protect themselves from rising interest rates when holding variable rate debt.

An interest rate cap is an agreement that allows the borrower to negotiate a pre-determined cap on a variable interest rate. In other words, an interest rate cap is an insurance policy a borrower can take out against interest rate increases. These caps are purchased by the borrower, usually in conjunction with obtaining variable rate debt, and require a single upfront premium payment. The cost of this premium is dependent on a number of factors, but three key variables influencing the price are the notional, the term, and the strike rate. The notional is the amount of debt being hedged by the cap, typically a larger notional will cost more to cap the interest than a smaller one. The term is the length of time the cap will be effective, shorter terms will cost less than longer terms. The strike rate is the maximum interest rate the borrower will be responsible for paying and the rate at which the provider of the cap will start making payments to the borrower. While other external factors, like current market rate volatility, will also influence cap premiums, these factors play a crucial role in how much an interest rate cap will cost. But how do companies account for these interest rate cap contracts?

Accounting for interest rate caps 

When entering into an interest rate cap, the first step when determining the appropriate accounting treatment is to determine if the cap meets the criteria of a derivative. Under ASC 815, a derivative has all three of the following distinguishing characteristics:

  • The settlement amount is determined by an underlying (the referenced rate) and a notional amount (the debt amount);
  • The initial investment, the premium in the case of an interest rate cap, is either zero or smaller than the notional amount or the amount obtained by applying the notional amount to the underlying; and
  • Net settlement is permitted or required, a market mechanism exists for net settlement (like market rates exceeding the strike rate), or the asset to be delivered is readily convertible to cash.

Based on the key terms associated with interest rate caps discussed previously, these will likely meet these three criteria of a derivative. Once that determination is made, the next step will be to determine if the interest rate cap qualifies for hedge accounting and if the company wants to elect hedge accounting. Derivatives are recorded at fair value on the balance sheet and without hedge accounting, changes in fair value of the cap would be recorded through earnings in each reporting period. However, the implementation of hedge accounting is optional and is an election a company can make.

Hedge accounting involves the designation of a derivative as a hedging instrument and designating the hedge item, either a recognized asset or liability that is not remeasured at fair value, an unrecognized firm commitment, or a forecasted transaction (variable interest on debt). ASC 815-20-25 discusses the often-complex criteria that must be met for transactions to qualify for hedge accounting, which include the following:               

  1. Formal designation and documentation at hedge inception.
  2. Eligibility of hedged items and transactions.
  3. Eligibility of hedging instruments.
  4. Hedge effectiveness.

While a company will have to perform a complex analysis to determine if its derivatives meet each of the criteria to qualify for hedge accounting, in many cases, interest rate caps will qualify for hedge accounting as they hedge the increase of interest payments, a forecasted transaction, protecting the borrower from exposure to increased interest rates.

As mentioned above, ASC 815 requires all derivatives to be recognized at fair value on the balance sheet. However, the accounting for changes in the fair value of a derivative that qualifies for hedge accounting will depend on the type of hedge it is. Some of the common types of hedges include cash flow hedges, fair value hedges, foreign currency hedges, and net investment hedges. An interest rate cap would fall under the definition of a cash flow hedge, which is a hedge of the exposure to variability in the cash flows of a forecasted transaction. As such, the recognition of changes in the fair value of an interest rate cap are recorded in other comprehensive income (OCI) until the hedged transaction impacts earnings, which in this case is when the strike rate is exceeded and the provider of the cap starts making payments to the borrower, at which time a portion of the amounts reported in OCI will be reclassified to earnings.

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