Considering an Interest Rate Swap? – Robert Bell, Auditor, CPA

Over the past several years we have seen many of our clients enter into interest rate swap agreements in an effort to stabilize interest expense. An interest rate swap is a forward contract in which one stream of future interest payments are exchanged for another based on a specified principal amount. The most common type of swap agreement that we see are referred to as “vanilla” or “plain vanilla” swaps, where a variable interest rate is traded for a fixed interest rate.

Interest rate swaps contain three basic components:

1. Underlying amount
2. Notional amount
3. Payment provision

The underlying amount is the specified interest rates in the agreement—variable and fixed. The notional amount is the amount that the underlying interest rates will be multiplied by to figure the payments. And the payment provision states how frequently payments will be made—monthly, quarterly or annually.

If you have entered into an interest rate swap with the intent of mitigating interest rate volatility, the next step is accounting for the swap. Vanilla swaps are accounted for in accordance with ASC 815, Derivatives and Hedging, under U.S. GAAP.

The first step to accounting for an interest rate swap is to assess the effectiveness. Some of the defining characteristics of an ineffective interest rate swap are: differences in the notional amount versus the underlying debt, different maturity dates between the swap agreement and the loan and differences in interest indexes.

The swap agreement must be marked to fair market value and recorded on the balance sheet, typically as a long-term asset or liability. If you have deemed your interest rate swap to be effective, the changes in fair market value will be recorded through other comprehensive income and will not have an impact on your bottom line. Whereas ineffective interest rate swaps will run through earnings.

The second part to accounting for interest rate swaps is documentation. At the inception of the swap, a documentation requirement exists, where certain aspects of the agreement need to be formally recorded. Some items that should be permanently documented and retained include: the underlying interest rates, the notional amount, payment provision, risk management objective, how effectiveness of the swap will be measured and frequency of assessment.

Interest rate swaps may continue to gain popularity in our current interest rate environment, and it is paramount to understand the accounting implications of entering into these agreements.