Financial Accounting Standards Board

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Financial Accounting Standards Board

• Derivatives Hedging
• Accounting for Energy Derivatives Seminar
• September 25-26, 2008
• Kevin Stoklosa

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Disclaimer

• The views expressed in this presentation are my
  own and do not represent positions of the
  Financial Accounting Standards Board.
• Positions of the FASB Board are arrived at only
  after extensive due process and deliberations.

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Derivatives and Hedging

• Derivatives Disclosures Statement 161
• Disclosures about Credit Derivatives
• Hedging Project

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Derivatives Disclosures S161Background

• Statement 133 has been criticized by constituents
  for lacking transparent disclosures. Sources of
  criticism include
• November 2004 Fitch Ratings Report
• Berkshire Hathaways 2002 Annual Report
• Numerous published articles
• Comments from Constituents
• The Board agreed to add a project to its agenda
  at the March 9, 2005 Board meeting
• Exposure Draft was issued on December 8, 2006
• Final Statement issued March 2008

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Derivatives Disclosures S161Objectives

• The Board decided that the disclosure
  objectives are to provide an enhanced
  understanding of
• How and why an entity uses derivatives
• How derivatives and related hedged items are
  accounted for under Statement 133 and its related
  interpretations, and
• How derivatives affect an entitys financial
  position, results of operations, and cash flows.
  

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Derivatives Disclosures S161Scope

• The scope of the final Statement is limited to
  all derivatives and all related hedged items
  accounted for under Statement 133.
• The Board decided not to add a fourth objective
  to require information about an entitys risk
  exposures and strategy for mitigating those risks
  
• The Board decided not to expand the scope to
  include all financial instruments.

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Derivatives Disclosures S161Tabular
Disclosures

• Final Statement requires 2 tables
• Those 2 tables focus on (1) where in balance
  sheet derivatives are located and what is the
  fair value (balance sheet table) and (2) where in
  income statement change in fair value is located
  and what is the change in fair value (income
  statement table)
• Information on hedged items is required but does
  not have to be part of the tabular format

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Derivatives Disclosures S161Other Required
Disclosures

• Final Statement requires disclosure of the
  existence and nature of credit-risk-related
  contingent features embedded in derivative
  instruments
• Disclosure must include the aggregate fair value
  of derivative instruments that contain those
  features
• Disclosure must include the aggregate fair value
  of assets posted as collateral, the aggregate
  fair value of additional assets that would be
  required to be posted as collateral and/or needed
  to settle the instrument if the contingent
  features were triggered
• Final Statement requires entities to
  qualitatively discuss, by underlying risk, its
  objectives for holding or issuing derivative
  instruments
• Final Statement requires entities to provide
  information that would enable users to understand
  its volume of derivative activity

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Derivatives DisclosuresEffective Date

• The effective date for the final Statement is for
  interim periods beginning after November 15, 2008
  and fiscal years that include those interim
  periods
• In the first fiscal year this Statement is
  applied, information related to interim periods
  that began on or prior to November 15, 2008 may
  be omitted. Periods covered must be identified
• For example, March 31 fiscal year entity must
  provide disclosures for its 4th Qtr interim
  period ending 3/31/09 in its 2009 annual
  financial statements

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Disclosures about Credit DerivativesBackground

• There is a current focus on credit default swaps
  given turmoil in credit markets
• 62 trillion estimated notional amount of
  outstanding CDS
• On actively traded names CDS volume is
  substantially greater than outstanding debt
  making it difficult to settle contracts
• When Delphi defaulted - 28 billion outstanding
  CDS against 5.2 billion of bonds

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Disclosures about Credit DerivativesObjectives

• Improve disclosures about credit derivatives and
  guarantees to help users better understand their
  impact on an entitys financial position,
  financial performance, and cash flows
• Close the gap in GAAP
• Align recognition/measurement and disclosures in
  same standards

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Disclosures about Credit DerivativesGap in GAAP

• FIN 45 requires disclosures by guarantors for
  guarantees within its scope, which includes some,
  but not all, credit derivatives
• S133 CDS for which the party purchasing the
  protection owns the referenced obligation are
  within the scope of FIN 45s disclosure
  requirements
• S133 CDS for which the party purchasing the
  protection does not own the referenced obligation
  are not within the scope of FIN 45s disclosure
  requirements
• Project would amend S133 and FIN 45 to result in
  the disclosure requirements for all S133 credit
  derivatives being included in S133

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Disclosures about Credit DerivativesScope

• Credit derivatives within Statement 133
• Hybrid instruments that have embedded credit
  derivatives
• Credit derivative is a derivative in which one or
  more of its underlyings (1) is related to the
  credit risk of a specified entity (or a group of
  entities) or an index on a group of entities (2)
  exposes the seller to potential loss from credit
  risk-related events specified in the contract
• Derivatives such as credit default swaps, credit
  spread options included
• Derivatives such as plain vanilla interest rate
  swap not included
• Guarantees within FIN 45

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Disclosures about Credit DerivativesProposed
Disclosures

• Disclosures for Sellers of Credit Derivatives
• The nature of the credit derivative, including
  the approximate term of the credit derivative,
  the events or circumstances that would require
  the seller to perform under the credit
  derivative, and the current status of the credit
  derivative (for example, the current credit risk
  of the referenced obligation).
• The maximum potential amount of future payments
  (undiscounted) the seller could be required to
  make under the credit derivative. That maximum
  potential amount of future payments shall not be
  reduced by the effect of any amounts that may
  possibly be recovered under recourse or
  collateralization provisions in the credit
  derivative (which are addressed below). If the
  terms of the credit derivative provide for no
  limitation to the maximum potential future
  payments under the credit derivative, that fact
  shall be disclosed. If the seller is unable to
  develop an estimate of the maximum potential
  amount of future payments under the credit
  derivative, the seller shall disclose the reasons
  why it cannot estimate the maximum potential
  amount.

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Disclosures about Credit DerivativesProposed
Disclosures Cont

• Disclosures for Sellers of Credit Derivatives
  Cont
• The fair value of the credit derivative.
• The nature of (1) any recourse provisions that
  would enable the seller to recover from third
  parties any of the amounts paid under the credit
  derivative and (2) any assets held either as
  collateral or by third parties that, upon the
  occurrence of any specified pre-agreed event or
  condition under the credit derivative, the seller
  can obtain and liquidate to recover all or a
  portion of the amounts paid under the credit
  derivative. The seller shall indicate, if
  estimable, the approximate extent to which the
  proceeds from liquidation of those assets would
  be expected to cover the maximum potential amount
  of future payments under the credit derivative.
  In its estimate of potential recoveries, the
  seller of credit protection should consider the
  effect of any purchased credit protection with an
  identical underlying(s).

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Disclosures about Credit DerivativesTiming

• Exposure Draft of an FSP issued in May 2008 with
  30 day comment period.
• 16 comments letters received
• Redeliberations completed
• Final FSP expected to be issued in September 2008
• Effective for reporting periods (annual or
  interim) ending after November 15, 2008

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Hedging Project

• Project Objectives
• Simplify accounting for hedging activities
• Improve the financial reporting of hedging
  activities to make the accounting model and the
  associated disclosures easier to understand for
  financial statement users
• Resolve hedge accounting practice issues that
  have arisen under Statement No. 133
• Address differences in the accounting for
  derivative instruments and hedged items or
  transactions

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Hedging Project

• The hedge accounting approach would establish a
  fair value methodology to hedge accounting. The
  approach would eliminate many elements that exist
  under the current hedge accounting model,
  including bifurcation-by-risk, the shortcut
  method, critical terms match, and the requirement
  to quantitatively assess effectiveness in order
  to qualify for hedge accounting
• The items and transactions currently eligible for
  hedge accounting would continue to be eligible
  under this approach.

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Hedging ProjectMajor Changes

• Hedge Effectiveness
• Qualitative instead of Quantitative
• Reasonably effective
• No ongoing effectiveness testing unless
  circumstances suggest no longer reasonably
  effective
• No effectiveness testing at all was considered

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Hedging ProjectMajor Changes

• Dedesignation
• Discontinuation of hedge accounting only if
  hedging relationship is terminated
• Discontinuation of hedging relationship by merely
  dedesignating is not permitted

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Hedging ProjectMajor Changes

• Hedged Risk
• General model is that the designated hedged risk
  must be all changes in fair value or variability
  in cash flows (bifurcation-by-risk not permitted)
• Two exceptions
• Foreign exchange rate risk can be designated as
  the hedged risk
• Interest rate risk can be designated as the
  hedged risk in a hedge of an entitys own debt at
  inception of the debt

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Hedging ProjectMajor Changes

• Measurement of Hedged Item in Fair Value Hedges
• Hedged item and derivative hedging instrument
  must be independently measured for changes in
  fair value
• Not permitted to take the change in fair value of
  the derivative, change the sign and apply it to
  the hedged item
• All of contractual cash flows of the entire
  hedged item must be included in calculating the
  fair value
• Adjust the carrying value of hedged item for
  changes in fair value during the hedge period

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Hedging ProjectMajor Changes

• Measuring and Reporting Ineffectiveness in Cash
  Flow Hedges
• Compare change in fair value of the actual
  derivative and the present value of the
  cumulative change in expected future cash flows
  on the hedged transaction
• For example, an entity could compare the change
  in fair value of the actual derivative with the
  change in fair value of a derivative that would
  mature on the date of the forecasted transaction,
  be priced at market, and provide cash flows that
  would exactly offset the hedged cash flows
• The difference would be reported in earnings as
  ineffectiveness
• Nonperformance risk must be considered when
  calculating the fair value of the derivative
  hedging instrument
• Permitted to use the same credit adjustment in
  the derivative that would exactly offset the
  hedged cash flows as used in the actual derivative

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Hedging ProjectMajor Changes

• Measuring and Reporting Ineffectiveness in Cash
  Flow Hedges
• Hedging with purchased options
• When a purchased option contract is used as the
  hedging instrument to provide only one-sided
  protection, a purchased option derivative that
  would mature on the date of the forecasted
  transaction and provide cash flows that would
  exactly offset the one-sided change in the hedged
  cash flows could be used for calculating
  ineffectiveness.
• Ineffectiveness can be measured using all changes
  in the options cash flows

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Hedging ProjectMajor Changes

• Measuring and Reporting Ineffectiveness in Cash
  Flow Hedges
• Hedging groups of transactions first 100M in
  sales for January
• Compare actual derivative to derivative that
  settles within a reasonable period of time of
  cash flows on forecasted transactions
• Reasonable if the difference in forward rates
  between that derivative and derivative(s) that
  would exactly offset cash flows is minimal

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Hedging ProjectMajor Changes

• Disclosures
• For hedged items in fair value hedges - table
  showing amount reported in balance sheet,
  Statement 133 adjustment, Other fair value
  adjustments, amount excluding those adjustments
• Hedging interest rate risk in issued debt how
  hedging derivative(s) changes maturity and
  interest rate on debt

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QUESTIONS