Cash Flow Hedges AICPABAI Conference Chicago, Illinois May 4, 2000

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a
U.S. GAAP Accounting
Derivatives and Hedging
November 6, 2000 FEI CFRI Conference New York,
New York
John E. Stewart Arthur Andersen LLP
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Statement 133 Down to Implementation

• Scope
• Valuation
• Qualification
• Complexities
• Transition

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Cornerstones of Statement 133

• Derivatives are assets or liabilities
• Fair value is the measure
• High hurdle for hedge accounting
• Designation and effectiveness are key

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Statement 133 Tools

• DIG - FASB Staff implementation guidance (100
  issues)
• FASB Staff training course
• Accounting firm presentations
• Accounting firm interpretations
• Communication is key
• Senior management
• Audit committees
• Board of Directors

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Natural State of Derivatives

• Report derivatives at fair value
• Report all changes in value currently in earnings
• Hedge accounting criteria provide only exception

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Universe of Statement 133 Hedges
Fixed-Rate Assets Fixed-Rate Liabilities Firm
Commitments
Floating-Rate Assets Floating-Rate
Liabilities Forecasted Transactions
Cash Flow Hedges
Fair Value Hedges
Foreign Currency Hedges
FX-Denominated Forecasted Transactions (Third
Party or Intercompany) Certain FX-Denominated Rece
ivables and Payables
FX-Denominated AFS Securities or Firm
Commitments Certain FX-Denominated Receivables
and Payables
Net Investments in Foreign Operations
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Statement 133 Down to Implementation

• November
• December
• Statement 133 is effective for all fiscal
  quarters
• of all fiscal years beginning after June 15, 2000
• (January 1 for calendar-year fiscal years)
• To achieve hedge accounting, need
  contemporaneous, formal documentation

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Statement 133 Statement 138

• Statement 133 amended in June 2000 by Statement
  138 in four primary areas
• Scope of commodity contracts
• Interest rate hedging
• Foreign currency payables and receivables
• Intercompany foreign currency transactions
• Ideas turned down
• Partial term hedging
• Special accounting for option time value

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Statement 133 Down to Implementation

• Scope
• Valuation
• Qualification
• Complexities
• Transition

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Scope

• Always Ask Two Questions
• 1. Is the contract a derivative?
• 2. If not, is the contract embedded with a
  derivative?
• Be sure to read the DIG issues
• - Definition
• - Whether and how to bifurcate

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Is the Contract a Derivative? Yes

• Interest rate swaps
• Interest rate caps
• Interest rate floors
• Treasury locks and other forward rate
  agreements
• Forward sales commitments on loans and securities
• Foreign currency interest-rate swaps
• Foreign currency forward contracts
• Foreign currency swaps

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Is the Contract a Derivative? No

• Normal purchases or normal sales
• Certain insurance contracts
• Certain financial guarantees
• Contracts in shareholders equity
• Stock compensation
• Contingent consideration
• Weather derivatives
• Contingent rent
• Regular-way securities trades
• Derivatives that kill sale accounting

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Is the Contract a Derivative?

• Credit derivatives
• Contracts on companys own equity
• Beneficial interests in securitized assets
• Energy contracts
• Loan commitments (creditor and debtor accounting)
• Insurance contracts
• Foreign currency derivatives in purchase orders
  and leases
• Equity warrants

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Is the Contract Embedded with a Derivative?

• Hybrid Contract
• Contracts that contain derivative-like features
  but that are not derivatives themselves
• Embedded Features
• Features in a Hybrid Contract affecting cash
  flows or value of other exchanges similar to that
  of a derivative
• Host Contract
• What would be left if the Embedded Features were
  not in the Hybrid Contract

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Is the Contract Embedded with a Derivative?

• Hybrid Contract Convertible Debt
• Contracts that contain derivative-like features
  but that are not derivatives themselves
• Embedded Features Call Option on Equity
• Features in a Hybrid Contract affecting cash
  flows or value of other exchanges similar to that
  of a derivative
• Host Contract Plain Vanilla Debt
• What would be left if the Embedded Features were
  not in the Hybrid Contract

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Is the Contract Embedded with a Derivative?

• Are features clearly and closely related?
• Convertible debt securities held
• Embedded, purchased equity call option (holder
  perspective)
• Issuer and investor accounting can differ
• Credit features
• Debt indexed to appreciated equity securities

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Statement 133 Down to Implementation

• Scope
• Valuation
• What
• When
• Who
• Qualification
• Complexities
• Transition

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Valuation What Needs to Be Valued?

• Each freestanding derivative
• Each embedded derivative
• Each host contract upon bifurcation
• Each item hedged in a fair value hedge
• Cash flows in a cash flow hedge
• Intrinsic value and time value

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Valuation When Are Values Needed?

• Hedge inception to establish hedge effectiveness
  expectations
• On transition (resulting in transition
  adjustments)
• Each quarter end to support compliance with each
  recognition, measurement, and disclosure
  requirement

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Valuation Who Will Value?

• Accounting firms? Sorry, not for audit clients
• Counterparty? Maybe, but is a party to the
  transaction
• Third Party? Maybe, but demand and risk aversion
  may prevent
• Client? Probably, but requires controlled process
  and reliable data

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Statement 133 Down to Implementation

• Scope
• Valuation
• Qualification
• Complexities
• Transition

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Qualification

• Contemporaneous, formal documentation required at
  hedge at inception
• Objectives and strategy
• Hedged item
• Hedging instrument
• Risk being hedged
• How effectiveness will be assessed
• SEC has required restatement for improper
  documentation
• All criteria for hedge accounting must be met -
  no materiality
• Be sure to read the DIG issues

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Qualification

• Effectiveness Methodology
• 1. Expecting high effectiveness at hedge
  inception
• 2. Observing whether high effectiveness has
  occurred
• 3. Expecting effectiveness prospectively each
  quarter
• 4. Measure ineffectiveness to be reported in
  earnings

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Statement 133 Down to Implementation

• Scope
• Valuation
• Qualification
• Complexities
• Transition

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Complexities - A sampler!

• Scope
• Shortcut qualification
• Hedging the benchmark rate (methods 2 and 3)
• Forward points in forward currency hedges
• Purchased and complex options
• Basis risk for nonfinancial assets
• Aggregating (e.g. commercial paper programs)
• Tracking OCI

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Complexities - A sampler, continued!

• Mortgage servicing rights
• Net investment hedges
• Call monetization
• Prohibitions
• Calculation of transition adjustments
• Be sure to read the DIG issues!

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Statement 133 Down to Implementation

• Scope
• Valuation
• Qualification
• Complexities
• Transition

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Transition

• Bifurcate hybrid instruments
• Make any Statement 115 or Statement 125
  reclassifications to the extent permitted
• Recognize all freestanding and bifurcated
  derivatives at fair value
• Designate and document all hedges anew
• Determine and record transition adjustments based
  on any pre-existing qualifying hedging
  relationship
• Pre-adoption disclosures

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Other Considerations

• Impact on EITF guidance
• Impact of Statement 138 on FASB staff
  implementation guidance
• Statement 125 amendments
• DIG meeting scheduled for December
• New implementation issues weekly