FAS 133 IAS 30 CICA 13

1
Accounting for Derivative Financial Instruments
and Hedging Transactions

• FAS 133 IAS 30 CICA 13
• Bob Jensens Free Tutorials, Glossaries,
  and Cases are at http//www.trinity.edu/rjensen
  /caseans/000index.htm

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ACCOUNTING FOR DERIVATIVES

• Presentation by
• Bob JensenTrinity University San Antonio, TX
  78212rjensen_at_trinity.edu
• http//www.trinity.edu/rjensen/

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REASONS FOR NEW STANDARDS
Undisclosed Assets and LiabilitiesUnbooked
Assets and LiabilitiesMeaningless Measures of
Value Risk Rise in Scandals in the 1980s
1990sComplex Frauds --- Partnoys
Fiasco Explosion of Swap Contracts Evolution
Toward Fair Value Accounting
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PROBLEMS WITH NEW STANDARDS
Complex Contracts Technical Jargon Complex
Scoping of Coverage --- NPNS Complex Hedge
Accounting RulesMany Derivatives Are Difficult
to Value Difficult to Find Embedded
DerivativesComplex Effectiveness Testing
Rules Continuous Stream --- DIG,
Amendments Implementation Failures --- Freddie
Mac, etc. Held-to-Maturity Interim
DistortionsHedge Acctg. Denied to Most Macro
Hedges
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Differences Between StandardsFAS 133 vs. IAS 39
vs. CICA 13
Differences are relatively minor IAS 39 Macro
Hedging Pending Amendment Listing of Major
Differences http//www.trinity.edu/rjensen/caseans
/canada.htm .
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Hedge Accounting Section Objectives

• After completing this section, you should be able
  to
• Determine whether a contract is scoped into the
  standards and, if so, whether it is
• Qualified for Hedge Accounting
• Treated as a cash flow, fair value, or FX hedge
• Understand the basic journal entries
• Cry out loud if forced to implement the standards

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FOUR CORNERSTONES

• Derivatives are contracts that create rights and
  obligations that meet the definitions of assets
  and liabilities
• Fair value is the only relevant measure for
  derivatives
• Value risk can be hedged into cash flow risk, and
  cash flow risk can be hedged into value risk, but
  both risks cannot simultaneously be eliminated.
• Hedge effectiveness tests can be varied with the
  type of risk being hedged.

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KEY ASPECTS OF THE STANDARDS

• Most derivatives are reported at fair value on
  balance sheet
• Changes in fair value for derivatives not
  designated and qualifying in a hedging
  relationship are recorded in earnings
• Hedge accounting is provided for the change in
  value of derivatives designated and qualifying
  as
• Fair value hedges
• Cash flow hedges
• Foreign currency hedges
• Hedge effectiveness tests may be tough hurdles
  over time

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DERIVATIVES IMPLEMENTATIONGROUP (DIG)

• DIG is made up of FASB staff members, Big 5
  members and Industry professionals. Active DIG
  observers include the SEC and certain regulators.
• DIGs mandate is to assist the FASB in answering
  implementation questions by identifying practice
  issues that arise from applying Statement 133 and
  to advise the FASB staff on how to resolve the
  issues.
• Issues are discussed by DIG, tentatively
  concluded by the FASB staff and posted on the
  FASB website (www.fasb.org) for two months before
  being presented to the Board for negative
  clearance.
• DIG Site http//www.fasb.org/derivatives/

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Bob Jensens Flow Charthttp//www.trinity.edu/rje
nsen/acct5341/speakers/133flow.htm

• Flow chart for deciding whether derivative is
  scoped into FAS 133
• Flow chart for deciding how to account for a
  derivative financial instrument qualified for
  hedge accounting.Cash Flow Hedge (booked item
  vs. forecasted transact.)Fair Value Hedge
  (booked item vs. firm commitment)Foreign
  Currency (FX) Hedge (fair value vs. cash flow)

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DERIVATIVE DEFINITION 616

• The definition is based on distinguishing
  characteristics
• A derivative instrument is a contract with all
  three of the following characteristics (6)
• Underlying and either a notional amount or a
  payment provision or both
• Relatively small initial net investment
• Net settlement or its equivalent (excludes most
  short sales Take-Or-Pays, but see FAS 133
  Paragraph 290)
• Definition includes freestanding as well as
  embedded derivative instruments
• A number of exclusions exist

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FREESTANDING DERIVATIVESOverview

• Statement 133 created a new definition of the
  term derivative
• Some instruments that are not usually considered
  derivatives are included (e.g. certain
  purchase/sales contracts)
• The definition is based on certain distinguishing
  characteristics.
• Certain scope exceptions exist not everything
  that meets the definition of a derivative is
  subject to the requirements of Statement 133.

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FREESTANDING DERIVATIVES Three Characteristics
69 and 57

• A derivative instrument is a contract with all
  three of the following characteristics
• 1. Underlying and either a notional amount or a
  payment provision or both
• 2. No initial net investment or smaller initial
  net investment than contracts with similar
  responses to changes in market factors
• 3. Net settlement or its equivalent

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FREESTANDING DERIVATIVES Characteristic
1Underlying 7 and 57(a)

• An underlying is a variable, such as
• An interest rate (e.g., LIBOR)
• The price of a security or commodity (e.g., price
  of a share of ABC stock or a bushel of wheat)
• A foreign exchange rate (e.g., Euro/U.S. spot
  rate)
• A measure of creditworthiness (e.g., Moodys)
• An index on any of above or other (e.g., SP 500,
  CPI)
• Other specific items

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FREESTANDING DERIVATIVES Characteristic
1Notional Amount 7

• A notional amount is a number of
• Currency units
• Shares
• Bushels
• Pounds
• Other units
• Notional amount is used to determine the
  settlement amount (for example, a price x a
  number of shares)

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FREESTANDING DERIVATIVES Characteristic
1Examples of Underlyings and Notional Amounts

• Derivative Underlying Notional
  Amount
• - Stock option - Stock price - Number
  of shares
• - Currency forward - Exchange rate - Number of
  currency units
• - Commodity future - Commodity price - Number
  of commodity units
• - Interest rate swap - Interest index - Dollar
  amount

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FREESTANDING DERIVATIVES Characteristic
1Payment Provision 7

• A payment provision specifies a fixed or
  determinable settlement if the underlying behaves
  in a specified way.
• For example
• if interest rates increase by say 300
  basis points then payment of an
  applicable amount would be required

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FREESTANDING DERIVATIVES Characteristic
2Initial Net Investment 8 and 57(b)

• A derivative requires either
• No initial net investment
• A smaller initial net investment than other types
  of contracts that have a similar response to
  changes in market factors
• A derivative does not require an initial net
  investment of
• the notional amount
• An exchange of currencies is not a net investment

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FREESTANDING DERIVATIVES Characteristic 3Net
Settlement 9 and 57(c)

• There are 3 ways to meet the net settlement
  requirement
• 1. Net settlement explicitly required or
  permitted by the contract (transfer of cash or
  other assets)
• 2. Net settlement by a market mechanism outside
  the contract (e.g., futures exchange)
• 3. Delivery of a derivative or an asset that is
  readily convertible to cash

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FREESTANDING DERIVATIVES Characteristic
3Readily Convertible to Known Amounts of Cash
9 and 57(c)

• Readily convertible assets have
• Interchangeable (fungible) units
• Quoted prices available in an active market that
  can rapidly absorb the quantity held by the
  entity without significantly affecting the price
• For example
• Public securities, commodities, and foreign
  currencies

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FREESTANDING DERIVATIVES Exceptions 10 and 58

• The following are not subject to Statement 133
• Regular-way security trades
• Normal purchases and normal sales
• Traditional insurance contracts
• Most financial guarantee contracts
• OTC contracts with certain underlyings
• Derivatives that are an impediment to sales
  accounting

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FAS 138Scope-Excluded Contracts

• Normal purchase/sale exception expanded to
  include
• Contracts that permit net settlement (9a)
• Contracts that have a market mechanism to
  facilitate net settlement (but note FAS 138)

• As long as it is probable contracts will not
  settle net and will result in physical delivery
  (but note FAS 138 and FAS 149)

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FAS 138 Scope-Excluded Contracts (Contd)
Net settlement of similar contracts should be
rare Excluded from exception Contracts that
require cash settlement or otherwise settle
periodically Contracts that have price based
on underlying unrelated to asset sold or
purchased(1) Contracts denominated in foreign
currency not meeting embedded derivative
separation exception rules of paragraphs 15(a)
and 15(b) (1)


(1) May be considered compound derivatives
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FREESTANDING DERIVATIVES Exceptions OTC
Contracts with Certain Underlyings 10(e) and
58(c)

• Climatic variables
• Temperature
• Rain or snowfall totals
• Wind speed
• Geological variables
• Earthquake severity (Richter scale)
• Other physical variables

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FREESTANDING DERIVATIVES ExceptionsOTC
Contracts with Certain Underlyings 10(e) and
58(c)

• The price or value of nonfinancial assets of one
  of the parties that is not readily convertible to
  cash or the price or value of nonfinancial
  liabilities of one of the parties that does not
  require delivery of readily convertible assets
• Option to purchase or sell real estate owned by
  one party (even if it can be net settled)
• Firm commitment to sell machinery (if
  unique)owned by one party (even if it can be net
  settled)

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FREESTANDING DERIVATIVES Exceptions OTC
Contracts with Certain Underlyings 10(e) and
58(c)

• Exceptions include specified volumes of sales or
  service revenues of one of the parties.
• For example
• Leases based on sales of the lessee
• Royalty agreements

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FREESTANDING DERIVATIVES Contracts Not
Considered Derivativesfor Purposes of Statement
133, 11

• Instruments indexed to an entitys own stock and
  classified in stockholders equity
• Stock-based compensation covered by Statement 123
  (issuer only)
• Contingent consideration in a business
  combination covered by Opinion 16 (purchaser
  only)

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EMBEDDED DERIVATIVES Definition 12

• Embedded derivatives are implicit or explicit
  terms that affect the cash flows or value of
  other exchanges required by a contract in a
  manner similar to a derivative
• The combination of a host contract and an
  embedded derivative is referred to as a hybrid
  contract
• Examples of hybrid contracts are
• Structured notes
• Convertible securities
• Securities with caps, floors, or collars

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EMBEDDED DERIVATIVES When Does a Contract Have
an Embedded Derivative Subject to This Statement?
12
Would it be a derivative if it was freestanding?
Is the contract carried at fair value
through earnings?
Is it clearly and closely related to the
host contract?
No
Yes
No
Apply This Statement
Yes
No
Yes
Do Not Apply This Statement
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EMBEDDED DERIVATIVES Clearly and Closely
RelatedGeneral 12 and 6061

• Clearly and closely related refers to
• Economic characteristics
• Risks
• Factors to consider
• The type of host
• The underlying
• See Flow Chart http//www.trinity.edu/rjensen/acc
  t5341/speakers/133flow.htm

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EMBEDDED DERIVATIVES Clearly and Closely
RelatedUnderlyings

• Type of Host Underlying
• Debt Interest
• Inflation
• Creditworthiness
• Equity Price of share in entity
• Lease Inflation
• Interest

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EMBEDDED DERIVATIVESClearly and Closely Related

• Paragraph 61 provides guidance for determining
  whether the economic characteristics and risks of
  the embedded derivative are clearly and closely
  related to the economic characteristics and risks
  of the host contract.

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FAIR VALUE HEDGE 2022

• A fair value hedge is a hedge of the exposure to
  a change in fair value of a recognized asset or
  liability or of an unrecognized firm commitment
  attributable to a particular risk. Key aspects
• Hedged item is exposed to price risk
• For a highly effective hedge, there must be
  offsetting fair value changes for hedged item and
  hedging instrument
• Changes in fair value of hedged item and hedging
  instrument are recorded in earnings
• Basis of hedged item is adjusted by the change in
  value

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FAIR VALUE HEDGE ACCOUNTING

• Key concepts
• Derivatives are always adjusted on the balance
  sheet at fair value (i.e., marked-to-market)
  (17)
• In qualified hedge accounting, the offset to
  changes in the hedging derivative is OCI for cash
  flow hedges but not for fair value hedges.
• For a qualified fair value hedge, the offset is
  Firm Commitment for a purchase contract
  with a contracted price
  Hedged Item carrying value if the hedged item
  such as inventory is already on the
  books at historical cost PL current
  earnings if the hedged item such as
  inventory is already on the books at fair value

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FAIR VALUE HEDGE ACCOUNTINGFor Hedged Item
Booked at Historical Cost

• Measurement of Derivative

Change in Fair Value
EarningsChangesOffset(1)
Accounting Model
Measurement of Hedged Item
Offsetting Gain or Loss Attributable to Risk
Being Hedged
(1) Ineffectiveness affects net earnings
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CASH FLOW HEDGE 2931

• A cash flow hedge is a hedging relationship where
  the variability of the hedged items cash flows
  is offset by the cash flows of the hedging
  instrument. Key aspects
• Hedged item may be a forecasted transaction with
  no contracted future price (i.e., not a firm
  commit.)
• Effective portion of derivatives gain or loss
  reported in OCI
• Earnings recognition matches hedged transaction
• Ineffective gain or loss recorded in earnings

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CASH FLOW HEDGE ACCOUNTING

• Derivative instrument recorded at fair value,
  effective portion through OCI, ineffective
  through earnings
• Amounts in OCI recognized in earnings when hedged
  transaction impacts earnings under FAS 133 but
  not under IAS 39. In other words, IAS 39
  requires basis adjustment when the derivative
  expires whereas FAS 133 carries OCI forward until
  hedged item is disposed of in a transaction.

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CASH FLOW HEDGE ACCOUNTING
Measurement of Derivative
OCI Equity
Effective
Change in Fair Value
Accounting Model
(1)
Ineffective
Earnings
(1) Based on Timing of Earnings Impact of
Hedged Item (interest, cost of sales,
depreciation)
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FOREIGN CURRENCY HEDGE 3642 (as amended by FAS
138)

• The Board intended to increase the consistency of
  hedge accounting guidance by broadening the scope
  of eligible foreign currency hedges. At the same
  time, the Board chose to continue certain prior
  practices. Key aspects
• Includes hedges of cash flow, fair value, and net
  investments in foreign operations
• Carries forward the functional currency concept
  from Statement 52
• Permits limited use of nonderivative instruments
• Expands hedge accounting, particularly for
  forecasted transactions and tandem currency hedges

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Hedging Instruments

• For a fair value hedge of foreign exchange risk
  related to AFS securities or a recognized
  foreign-currency-denominated debt instrument, an
  entity can only use a derivative instrument
• For a fair value hedge of foreign exchange risk
  related to a firm commitment, an entity can use
  either a derivative or a non-derivative
  instrument
• For a cash flow hedge of a forecasted foreign
  currency denominated transaction (including
  forecasted intercompany transactions, recognized
  foreign-currency-denominated debt instruments and
  firm commitments accounted for as forecasted
  transactions), an entity can only use a
  derivative instrument
• For a hedge of a net investment in a foreign
  operation, an entity can use either a derivative
  or a non-derivative instrument

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OBJECTIVE OF HEDGE ACCOUNTING

• Timing of gain/loss recognition on hedging
  instrument and
• hedged item
• Hedged Item -0- (1) (20) (20)
• Derivative 20 (2) -0- 20
• 20 (20) -0-

Periods 1 2 Total
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Change to Forward/Futures PowerPoint ShowAnd
Compare Examples 1 and 4

• Go to 02ForFutCalgary.ppt
• End of Calgary Introduction

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CASE 1 Cash Flow Hedge of Forecasted Inventory
Sale

• ABC is hedging the risk of changes in cash flows
  related to a forecasted sale of 100,000 bushels
  of Commodity A to be sold at the end of period 1.
  The inventory carrying value is 1 million, and
  current market value is 1.1 million
• On the first day of period 1, ABC enters into
  Derivative Z to sell 100,000 bushels at 1.1
  million at the end of period
• At hedge inception, the derivative is
  at-the-money (fair value is 0)
• All terms of the commodity and the derivative
  match (i.e., no expected ineffectiveness)
• On last day of Period 1, fair value of Derivative
  Z increased by 25,000 and expected sales price
  of 100,000 bushels of Commodity A decreased
  25,000
• From Example 4, Appendix B of Standard

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CASE 1 Cash Flow Hedge of Forecasted Inventory
Sale

• Journal entries at end of period 1
• Derivative Z 25,000
• OCI 25,000
• To record Derivative Z at fair value
• Cash 25,000
• Derivative Z 25,000
• To record settlement of Derivative Z

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CASE 1 Cash Flow Hedge of Forecasted Inventory
Sale

• Journal entries at end of period 1
• Cash 1,075,000
• CGS 1,000,000
• Revenue 1,075,000
• Inventory 1,000,000
• To record inventory sale
• OCI 25,000
• Earnings 25,000
• To reclassify amount in OCI to earnings upon
  inventory sale

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CASE 1 Cash Flow Hedge of Forecasted Inventory
Sale

• Forecasted cash flows 1,100,000
• Actual cash flows
• Derivative 25,000
• Sale of inventory 1,075,000
• Total 1,100,000
• The variability of cash flows related to the
  forecasted inventory sale is offset by change in
  value of derivative.

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CASE 2Fair Value Hedge of Inventory

• ABC has 1,000 bushels of a Commodity with a fair
  value of 1.1 million and a carrying value of
  1.0 million
• ABC wants to hedge overall fair value of the
  Commodity
• On 1/1/X1, ABC enters into an at-the-money
  matching derivative to hedge the changes in
  fair value of the 1,000 bushels of the Commodity

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CASE 2 (Contd)Fair Value Hedge of Inventory

• Effectiveness will be assessed by comparing
  entire change in fair value of derivative to
  change in market price of inventory (time value
  will be ignored for illustration purposes only)
• On 1/31/X1, the fair value of the derivative has
  increased by 25,000 and the fair value of the
  inventory has decreased by 25,000

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CASE 2Fair Value Hedge of Inventory

• Journal entries at end of period
• Derivative 25,000
• Earnings 25,000
• To record derivative at fair value
• Earnings 25,000
• Inventory 25,000
• To record loss on hedged inventory