Accounting For Derivatives

Guidance to Identifying Common Derivative Transactions

Reporting entities and their auditors must properly identify derivatives and hedges to determine that management authorization is appropriate and, if applicable, that transactions are identified as hedges at their inception and accounted for properly. If hedge documentation is not appropriate and transactions are marked to market, an entity’s profitability could be materially and unexpectedly impacted. The author approaches accounting for derivatives and hedges in the same way they are normally encountered: from the beginning of a transaction. The author analyzes the accounting and reasoning behind six cases based on actual transactions where derivatives were used by nonfinancial entities.

The voluminous and complex rules for accounting for derivatives and hedges are presented in SFAS 133, Accounting for Derivative Instruments and Hedging Activities, as amended by SFASs 137 and 138 and interpreted by over 33 consensuses issued by the Emerging Issues Task Force (EITF) and over 160 issues of the FASB Derivatives Implementation Group. The rules themselves tend to be legalistic and occasionally emphasize form over substance.

One of the biggest problems in implementing derivative and hedge accounting rules is identifying a transaction as a derivative and, if applicable, a hedge. Derivatives are difficult to identify because, by definition, there are no significant expenditures or recording of assets or liabilities. The traditional means of identifying unrecorded transactions-reviewing the general ledger and cash journals for large transactions-will not uncover derivatives. The best way of identifying derivatives and hedges is to rely on the entity’s internal controls to flag such transactions. Derivatives and hedges potentially represent an important component of an entity’s risk management activities and would require authorization by an appropriate level of management. As a backup, analysis of the transactions that typically spawn derivatives and hedges would facilitate discovery for entities not regularly engaged in such trading.

Case 1: Interest Rate Swap

Construction Retail, LLC, a nonpublic company, was organized to construct and operate a shopping mall. In January 2002, Construction obtained a construction loan from National Bank, which provided up to $150 million in financing at an interest rate of one-month LIBOR plus 1.90% and a maturity date of September 15, 2006. If certain covenants were met, the agreement provided for a reduced interest rate of one-month LIBOR plus 1.75% and an extension of the maturity date for two years. In 2003, National increased the amount available under the loan to $160 million.

On February 1, 2002, Construction entered an interest rate swap agreement with National. The swap agreement covered the period from February 1, 2002, to September 15, 2006, and effectively fixed the interest rate at 7.0% on the first $150 million of borrowings. Interest accrued quarterly. Construction did not pay anything for the swap. This transaction reflects Construction’s bet that interest rates will go up and that interest costs at the fixed rate will be lower than those at the variable rate. (Construction may also be seeking a fixed interest expense for budgetary purposes.) National, however, is betting that interest rates will go down and it will receive more interest revenue at the fixed rate.

Identifying the instrument as a derivative. The first step is to determine whether Construction entered a derivative transaction. The best place to start is Construction’s internal controls. Because Construction did not pay anything for the swap, the agreement would not be recorded in the accounting records. If its internal processes fail, analysis that should ordinarily be performed on the construction loan agreement should identify the swap. The red flag for an interest rate swap is a fixed rate on a loan with a stated variable rate.

Having identified its existence, the second step is to determine whether the swap is a derivative as defined by SFAS 133 and its assorted amendments and interpretations. Interest rate swaps ordinarily meet the criteria for derivatives. SFAS 133, paragraph 6, defines a derivative as a financial instrument or other contract with all of the following characteristics: an underlying, a notional amount, an initial net investment smaller than that required for other types of contracts, and a required net settlement.

An underlying is the variable whose market movements cause the fair value or cash flows of an instrument to fluctuate. In this case, the underlying is the one-month LIBOR rate. Although Construction is swapping the LIBOR-based rate for a fixed rate, the value of the swap is based on LIBOR. For example, if LIBOR decreased to 4.0%, the original loan would require an interest rate of 5.9% (LIBOR plus the 1.90% risk factor), which is lower than the 7.0% fixed rate. In this case, Construction would record a liability (or reduction in an asset) reflecting its loss position (it is paying more interest than if it had not entered into the swap). If LIBOR increased to 6.0%, Construction would record an asset (or a decrease in the liability) reflecting its gain position (it is paying less interest than if it had not entered into the swap).

The notional amount is the fixed amount of currency or property units specified in the derivative instrument. In this case, the notional amount is the $150 million principal amount of the original loan covered by the swap agreement. SFAS 133 also requires an initial net investment smaller than what would be required for similar types of contracts. The swap agreement meets this criterion because the initial net investment is zero; neither party makes a payment. The net settlement criterion is met when the party in the loss position pays the party in the gain position. In the example above, if the variable contractual interest rate were 5.9% and the fixed rate 7.0%, Construction would pay the 5.9% in accordance with its contractual obligation and an additional 1.1% as a net settlement reflecting its loss position arising from the swap agreement.

Designating the swap as a hedge. Interest rate swaps can be classified as freestanding derivatives or, if specific criteria are met, as either fair value or cash flow hedges. Each classification entails different accounting and income recognition rules. If the swap were classified as a freestanding derivative, Construction would record it at fair value at the transaction’s inception and charge any subsequent changes in fair value to income at the end of each reporting period.

Construction could elect to designate the swap as either a fair value hedge or cash flow hedge. (A third type, the foreign currency hedge, does not apply here.) A fair value hedge is a hedge of the exposure to changes in the fair value of a recognized asset or liability or of an unrecognized firm commitment attributable to a particular risk. Like freestanding derivatives, fair value hedges are always recorded at fair value and changes in that fair value are recognized in current earnings. Changes in the fair value of the hedged item (i.e., the construction loan) are also recognized in current earnings and the carrying amount of the hedged item is adjusted to fair value. If the hedged item is perfectly matched to the loan agreement, the net effect on earnings would be zero. A cash flow hedge is a hedging relationship where the variability of the hedged transaction’s cash flows is offset by the cash flow of the hedging instrument. The cash flow hedge itself (i.e., the swap) is recorded at fair value and changes in that fair value are recorded in other comprehensive income (OCI).

To classify the swap as a hedge, Construction must, at the transaction’s inception, prepare documentation describing the hedging relationship and its risk management objective and strategy. The documentation should identify the hedging instrument, the hedged transaction, the nature of the hedged risk, and how the hedging instrument’s effectiveness will be assessed. The documentation should also designate the hedge as a cash flow, fair value, or foreign currency hedge.

A current practice of assessing hedge effectiveness (not specifically required by FASB) is the 80/125 criterion, which assumes hedge effectiveness if the interest rate obtained in the swap falls within a corridor defined by 80% to 125% of the original rate. In the example above, if the one-month LIBOR rate at the date of assessment is 5.0%, then the effective corridor would be from 4.0% to 6.25%. The hedged fixed rate would be 5.1% (7.0% minus the 1.9% risk factor), which is well within this corridor. Hence, the hedge is construed as effective.

A second method of assessing the effectiveness of a hedge is to apply the 80/125 criterion to the ratio of the changes in the fair value of the hedge and the changes in fair value of the hedged item. For example, if the change in the fair value of the swap is $16,230 and the change in fair value of the loan agreement is $20,000, the ratio would be 81.15%, and the hedge would be considered effective.

Construction should assess hedge effectiveness at least quarterly, even if Construction does not issue quarterly financial statements. For an ineffective hedge, losses are recognized from the period beginning from the date when the hedge was last determined to be
effective. Once a hedge is deemed ineffective, it must be accounted for as a freestanding derivative and can not be classified as a hedge during its remaining term.

Construction could avoid determining hedge effectiveness by using the shortcut method, which, under specified circumstances, assumes hedge effectiveness. The shortcut method is available for interest rate swaps designated as either fair value or cash flow hedges. The shortcut method, which saves a considerable amount of work, assumes that the hedge is perfectly effective in specified circumstances and, accordingly, the assessment of hedge effectiveness is not required. Exhibit 1 presents the criteria for applying the shortcut method.

Construction’s interest rate swap meets the criteria presented in Exhibit 1. Some of these criteria need explanation. The notional amount of the swap matched the principal amount of the debt (Item 1) at the inception of the swap (February 1, 2002); for purposes of hedge accounting, the additional $10 million made available in 2003 is considered an additional loan. The fair value of the swap at the inception of the hedge is zero (Item 2), as neither party paid for the swap.

Accounting for the interest rate swap. Construction designates the hedge as a cash flow hedge because the swap is hedging the variability of future cash flows (interest expense paid) attributable to changes in interest rates. This allows changes in the swap’s fair value to be recorded in OCI rather than current earnings. The swap should meet the criteria in SFAS 133, paragraphs 28 and 29, to be classified as a cash flow hedge. The accounting for the swap is presented in Exhibit 2.

Case 2: Interest Capitalization and Interest Rate Swaps

Case 2 assumes the same facts as Case 1. However, because the loan was acquired for the express purpose of financing the construction of the shopping mall, Construction intends to capitalize the related interest cost, in accordance with SFAS 34, Capitalization of Interest Cost.

Accounting for interest costs. EITF Issue No. 99-9, Effective Derivative Gains and Losses on the Capitalization of Interest, requires interest costs be capitalized when hedged. As discussed in Case 1, gains or losses are not applicable because they are included in OCI.

Construction should capitalize the interest rate acquired in the swap (7.0%), as it is the effective rate of the loan. Thus, for the first quarter (ending April 30, 2002), Construction would capitalize $350,000, the interest cost based on 7.0% (see Exhibit 2). If Construction had multiple loans covering multiple construction projects, it would have to determine a capitalization rate, which would be applied to the average amount of accumulated expenditures. In this case, Construction should use the 7.0% fixed rate as the capitalization rate.

Should gains or losses related to the swap be capitalized as project costs, pursuant to paragraph 7 of SFAS 67, Accounting for Costs and Initial Rental Operations of Real Estate Projects? The author believes that the interest rate swaps, which are clearly part of the project financing, should be classified as direct project costs only if the swap is not designated as a hedge. If the swap is designated as a cash flow hedge, gains and losses included in OCI should be amorized over the life of the asst (i.e., the shopping mall).

Case 3: Embedded Derivative

Construction’s loan agreement provided for a reduced interest rate (from one-month LIBOR plus 1.90% to one-month LIBOR plus 1.75%) and an extension of the maturity date for two years if certain covenants are met. Hedge accounting is permissible if those covenants are based on matters which can be controlled by management, such as construction progress or budgetary limits. On the other hand, if the more favorable terms arise because of outside events, such as changes in the S&P rates, the loan modification would be classified as an embedded derivative, which is always classified as a freestanding derivative. Accordingly, the interest rate swap could not be classified as a cash flow hedge. A freestanding derivative is recorded as an asset or liability with changes in fair value charged to current income. This case illustrates the importance of obtaining a full understanding of the entire transaction and its context, including conditions that cause a change in the instrument’s terms.

Case 4: Interest Rate Caps

On May 8, 2002, Manufacturing Corporation obtained a loan from Commercial Bank based on the one-month LIBOR rate with a maturity date of November 1, 2005. At the same time, Manufacturing obtained an interest rate cap at 6.5% for $20,000 expiring on November 1, 2005, from another institution, Financial Products Company. The question is whether this interest rate cap is a derivative or an embedded derivative and whether, in either case, it can be classified as a hedge.

Accounting for the interest rate cap. The interest rate cap is a derivative, as defined by SFAS 133, because it has an underlying (the one-month LIBOR); a notional amount (the principal amount of the outstanding loan); an initial net investment ($20,000) that is smaller than what would be required for other types of contracts; and a net settlement payable when the variable rate exceeds the cap rate of 6.5%. Because the loan is a variable rate loan, the interest rate cap could be classified as a cash flow hedge if the SFAS 133 criteria are met. The interest rate cap would be accounted for in a manner similar to the interest rate swap presented in Case 1.

Avoiding derivative accounting. In an example of the legalistic nature of the accounting rules, Manufacturing could have avoided derivative accounting entirely if the loan and interest rate cap were structured differently. SFAS 133 excludes from its scope certain interest rate caps, floors, and collars that cannot be classified as either a derivative or an embedded derivative. Manufacturing could have embedded the interest rate cap in the loan while failing to meet the criteria of an embedded derivative.

Contracts not meeting the definition of a derivative may contain embedded derivative instruments. SFAS 133 indicates that contracts may contain implicit or explicit terms affecting some or all of cash flows or other values in a manner similar to a derivative. These terms, classified as embedded derivatives, should be separated from the original (host) contract and accounted for separately as a freestanding derivative if the instrument meets all three conditions presented in SFAS 133, paragraph 12, and if it is transferable separately of the host contract.
The guidance pertaining to the transferability of the interest rate cap is not included in SFAS 133, but rather in interpretative guidance. Derivatives Implementation Group (DIG) Issue K2, “Miscellaneous: Are Transferable Options Freestanding or Embedded?,” and DIG Issue K3, “Miscellaneous: Determination of Whether Combinations of Options with the Same Terms Must Be Viewed as Separate Option Contracts or as a Single Forward Contract,” state that any derivative that is separable and transferable from the host contract is not, by definition, an embedded derivative. Transferable interest rate caps are considered freestanding derivatives.

The first step in avoiding derivative accounting is to overcome the strong presumption that the cap is transferable. This can be accomplished by writing the interest rate cap directly into the loan agreement with Commercial and by explicitly stating that the cap is not transferable. The terms of the interest cap provisions should be consistent with the debt instrument, e.g., mature at the same date. In Case 4, the fact that Manufacturing signed a separate interest rate cap agreement with another financial institution (Financial) means that, for purposes of applying SFAS 133, the cap is transferable. Even signing a separate agreement with the primary lending institution (Commercial) is not sufficient to overcome the presumption that the instrument is transferable. Neither is management intent. Only an explicit provision within the original debt agreement can overcome the presumption of transferability.

The second step is to structure the interest rate cap agreement to fail at least one test in paragraph 12 of SFAS 133. This agreement fails the criteria in paragraph 12a because it is clearly and closely related to the economic characteristics and risks of the host contract. According to paragraph 13, embedded derivatives in which the underlying is an interest rate cap (among other instruments) are clearly and closely related to the economic characteristics and risks of the host contract (and therefore do not meet the criteria presented in paragraph 12a) unless one of two additional specified conditions are met. The loan and interest rate cap do not meet either of the conditions. In addition, the instrument must meet the criteria discussed in paragraph 61f, which states that an interest rate cap, floor, or collar is clearly and closely related to the economic characteristics and risks of the host contract if the cap is at or above the current market rate (one month LIBOR, in this case).

Thus, by structuring the interest cap differently, Manufacturing could avoid derivative accounting completely. Of course, it would have to cooperate with Commercial on terms within the loan agreement that would make economic sense.

Case 5: Interest Rate Swap Involving a Capital Lease

Real Estate LLP has a land lease classified as a capital lease. Real Estate shares the lease obligation with an affiliate and is liable for 75% of the total lease obligation. Real Estate’s lease payments are limited to its allocable share of the lessor’s debt service payments through 2020. The lessor’s debt has a variable interest rate. Real Estate entered a swap agreement for the period ending June 1, 2004, that effectively fixes the interest rate at 6%.
Real Estate would account for the swap in a manner similar to Case 1. The indirect nature of this transaction does not affect the fact that the swap agreement contains all the characteristics described in SFAS 133, paragraph 6. As in Case 1, the swap may be eligible for the shortcut method. The capital lease swap meets all of the criteria in Exhibit 1. One criterion (Item 4) requires further explanation: the requirement that the lease agreement not be prepayable. A prepayment of the capital lease based on undiscounted future rents represents settlement in excess of the swap’s fair value, which results in the instrument not being considered prepayable, according to DIG Issue E6, “The Shortcut Method and the Provisions That Permit the Debtor or Creditor to Require Prepayment.”

Case 6: Derivatives and Hedges on the Income Tax Basis

Certain reporting entities preparing financial statements on the income tax basis also enter derivative and hedgin transactions. FASB has not issued any rules on income tax basis financial statements, but Interpretation 14 of SAS 62, Special Reports, requires disclosure of items that would ordinarily be disclosed in financial statements prepared in conformity with GAAP. Thus, entities preparing income tax basis financial statements and entering into derivative and hedging transactions should disclose the essence of the transaction, but, pursuant to current income tax laws and regulations, would not record the fair value of the derivative or recognize any charges to income. The disclosure of the fair value of the derivative is not required, but, in the author’s opinion, should be disclosed if readily available.

FAS 52
(Financial Accounting Standards Board Statement No. 52, Foreign Currency Translation)

Application of this Statement will affect financial reporting of most companies operating in foreign countries. The differing operating and economic characteristics of varied types of foreign operations will be distinguished in accounting for them. Adjustments for currency exchange rate changes are excluded from net income for those fluctuations that do not impact cash flows and are included for those that do. The requirements reflect these general conclusions:

The economic effects of an exchange rate change on an operation that is relatively self-contained and integrated within a foreign country relate to the net investment in that operation. Translation adjustments that arise from consolidating that foreign operation do not impact cash flows and are not included in net income.

The economic effects of an exchange rate change on a foreign operation that is an extension of the parent’s domestic operations relate to individual assets and liabilities and impact the parent’s cash flows directly. Accordingly, the exchange gains and losses in such an operation are included in net income.

Contracts, transactions, or balances that are, in fact, effective hedges of foreign exchange risk will be accounted for as hedges without regard to their form.

More specifically, this Statement presents standards for foreign currency translation that are designed to (1) provide information that is generally compatible with the expected economic effects of a rate change on an enterprise’s cash flows and equity and (2) reflect in consolidated statements the financial results and relationships as measured in the primary currency in which each entity conducts its business (referred to as its “functional currency”).

An entity’s functional currency is the currency of the primary economic environment in which that entity operates. The functional currency can be the dollar or a foreign currency depending on the facts. Normally, it will be the currency of the economic environment in which cash is generated and expended by the entity. An entity can be any form of operation, including a subsidiary, division, branch, or joint venture. The Statement provides guidance for this key determination in which management’s judgment is essential in assessing the facts.

A currency in a highly inflationary environment (3-year inflation rate of approximately 100 percent or more) is not considered stable enough to serve as a functional currency and the more stable currency of the reporting parent is to be used instead.

The functional currency translation approach adopted in this Statement encompasses:

1. Identifying the functional currency of the entity’s economic environment
2. Measuring all elements of the financial statements in the functional currency
3. Using the current exchange rate for translation from the functional currency to the reporting currency, if they are different
4. Distinguishing the economic impact of changes in exchange rates on a net investment from the impact of such changes on individual assets and liabilities that are receivable or payable in currencies other than the functional currency

Translation adjustments are an inherent result of the process of translating a foreign entity’s financial statements from the functional currency to U.S. dollars. Translation adjustments are not included in determining net income for the period but are disclosed and accumulated in a separate component of consolidated equity until sale or until complete or substantially complete liquidation of the net investment in the foreign entity takes place.

Transaction gains and losses are a result of the effect of exchange rate changes on transactions denominated in currencies other than the functional currency (for example, a U.S. company may borrow Swiss francs or a French subsidiary may have a receivable denominated in kroner from a Danish customer). Gains and losses on those foreign currency transactions are generally included in determining net income for the period in which exchange rates change unless the transaction hedges a foreign currency commitment or a net investment in a foreign entity. Intercompany transactions of a long-term investment nature are considered part of a parent’s net investment and hence do not give rise to gains or losses.

What is FAS 133?

Statement 133 (FAS 133 or SFAS 133) establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities. Released in June 1998, FAS 133 represents the culmination of the US Financial Accounting Standards Board’s nearly decade-long effort to develop a comprehensive framework for derivatives and hedge accounting. The Financial Accounting Standards Board establishes generally accepted accounting principles for most companies operating in the United States or requiring financial statements meeting US GAAP (see FASB site for more).

Simplicity is not one of FAS 133’s strong suits. That’s partly because FAS 133 is a halfway house of sorts, falling short of full fair value accounting (the FASB’s ultimate goal) and maintaining some ‘old’ accounting that dates back to FAS 52. This complexity is largely the reason the FASB has set up a special committee to deliberate and explain how to apply FAS 133. This committee is known as the Derivatives Implementation Group (DIG). Despite the special efforts of the DIG, the FASB was forced to delay implementation for one year. And now, working with the DIG, the FASB is considering amendments that change significantly the impact on certain accounting aspects.
A careful reading of the Statement, put within the context of its ‘founding fathers” original intent, helps us collapse the lengthy document into key concepts:

(1) FAS 133 focuses on the hedge tools and not the sort of risk that’s being hedged.This is a fundamental change in hedge accounting. Instead of focusing on currency (FAS 52) or commodities (FAS 80), FAS 133 occupies itself with derivatives, no matter how they are used. The good news? If it’s not a derivative, it’s not scoped in. The bad news? The definition of a derivative is pretty wide and include several commercial contracts as well.

(2) FAS 133 is a compromise on fair value accounting. FAS 133 puts an end to deferral accounting as we know it. Ultimately, the Board would like to have all financial instruments on the balance sheet at fair value. Such a radical overhaul’ particularly for non-banks’would have created massive income statement effects. So instead, the Board compromised, offering hedgers (vs. traders of derivatives) a halfway house in the form of Other Comprehensive Income (OCI). OCI is a place to ‘park’ gains and losses on hedges until it is time to recognized them in current income. It’s part of the income statement, but not current earnings. This compromise solution, inevitably, creates inconsistency in the treatment of certain gains and losses.

(3) Volatility, volatility, volatility. Finally, much of the controversy surrounding FAS 133 has to do with the possibility that it will greatly increase income-statement volatility. Under the previous guidance, companies could ‘hide’ ineffective, imprecise and simply bad hedges in the CTA account’deferring the effects on their P/(L). FAS 133 exposes such hedges by forcing companies to deliberately measure and record (in income) all ineffectiveness; plus, it basically outlaws some common hedge practices such as marco and portfolio hedging, netting and synthetic accounting in its various incarnation. The result is a much greater chance that hedge mismatch will create volatile earnings’ sometimes for ‘good’ reasons, and often for technical reasons that do not necessarily reflect the economics of the hedging relationship.

For example, time value in options must be marked to market in income in most cases, so even if the option hedge is perfectly effective at limiting the company’s downside risk with respect to future cash flows, the cost of the hedge (which used to be amortized in a straight line fashion) can become a source of undue volatility.

This worrisome potential of earning volatility is the ‘trigger’ of various FAS 133-related trends. First, it will (and should) capture senior management attention. CFOs and CEOs don’t like earnings surprises, and neither does Wall Street. Second, bankers and risk management advisers are busy devising ways to limit the volatility of hedges by either changing strategies or inventing new hedge products. Hence much of the focus at the DIG level during 1999 on expanding the shortcut method (which basically allows hedgers to assume effectiveness, as long as the hedge and hedged item live up to a set of pretty strict criteria).
The three hedge relationships. Under FAS 133 (in order to qualify for hedge accounting) treasuries can define the relationship between a derivative and an exposure in one of three basic ways:

‘ Fair value hedges’Hedges of exposures to the changes in value of a recognized asset or liability, or unrecognized firm commitment.
‘ Cash flow hedges’Hedges of forecasted transactions, or the variability in the cash flow of a recognized asset or liability.
‘ Net investment hedges’Hedges of the net investment in a foreign operation.

While the accounting for these hedge relationships may vary, generally speaking:

‘ Fair value hedges’The derivatives are marked to market in earnings. The value of the hedge will be offset by changes in the value of the underlying exposure.

‘ Cash flow hedges’The derivatives are marked to market and carried at fair value. The effective portion is recorded in OCI. The ineffective portion goes into current income.

‘ Net investment hedges’The gain/losses in the hedge are recorded in OCI. Net investment hedges are only currency related and are a FAS 52 relic. Consequently, these hedges are inconsistent with much of the new derivatives accounting rule. For example, they allow treasury to hedge the ‘net’ exposure. They also allow companies to use nonderivatives (e.g. foreign currency borrowing) to cover their investment risk.

What’s a Derivative Anyway? While FAS 133 is aimed primarily at derivatives, it defines derivatives rather broadly, so it can affect the accounting for many transactions that some financial statement preparers would never think of as derivatives. Identifying these derivatives, including those embedded in non-derivative contracts is a difficult aspect of implementing proper accounting under FAS 133.

Under the FAS 133 definition (paragraph 9)-
‘A derivative instrument is a financial instrument or other contract with all three of the following characteristics:

(a) It has (1) one or more underlyings and (2) one or more notional amounts (by any other name) or payment provisions or both. Those terms determine the amount of the settlement or settlements, and, in some cases, whether or not a settlement is required.

(b) It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.

(c) Its terms require or permit net settlement, it can readily be settled net by a means outside the contract, or it provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.’

Thus FAS 133 alters the risk management agenda by changing the performance yardsticks for many treasuries.

Accounting for Derivative Instruments and Hedging Activities (Issued 6/98)

This Statement establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, (collectively referred to as derivatives) and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. If certain conditions are met, a derivative may be specifically designated as (a) a hedge of the exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment, (b) a hedge of the exposure to variable cash flows of a forecasted transaction, or (c) a hedge of the foreign currency exposure of a net investment in a foreign operation, an unrecognized firm commitment, an available-for-sale security, or a foreign-currency-denominated forecasted transaction.

The accounting for changes in the fair value of a derivative (that is, gains and losses) depends on the intended use of the derivative and the resulting designation.

• For a derivative designated as hedging the exposure to changes in the fair value of a recognized asset or liability or a firm commitment (referred to as a fair value hedge), the gain or loss is recognized in earnings in the period of change together with the offsetting loss or gain on the hedged item attributable to the risk being hedged. The effect of that accounting is to reflect in earnings the extent to which the hedge is not effective in achieving offsetting changes in fair value.
• For a derivative designated as hedging the exposure to variable cash flows of a forecasted transaction (referred to as a cash flow hedge), the effective portion of the derivative’s gain or loss is initially reported as a component of other comprehensive income (outside earnings) and subsequently reclassified into earnings when the forecasted transaction affects earnings. The ineffective portion of the gain or loss is reported in earnings immediately.
• For a derivative designated as hedging the foreign currency exposure of a net investment in a foreign operation, the gain or loss is reported in other comprehensive income (outside earnings) as part of the cumulative translation adjustment. The accounting for a fair value hedge described above applies to a derivative designated as a hedge of the foreign currency exposure of an unrecognized firm commitment or an available-for-sale security. Similarly, the accounting for a cash flow hedge described above applies to a derivative designated as a hedge of the foreign currency exposure of a foreign-currency-denominated forecasted transaction.
• For a derivative not designated as a hedging instrument, the gain or loss is recognized in earnings in the period of change.

Under this Statement, an entity that elects to apply hedge accounting is required to establish at the inception of the hedge the method it will use for assessing the effectiveness of the hedging derivative and the measurement approach for determining the ineffective aspect of the hedge. Those methods must be consistent with the entity’s approach to managing risk.

This Statement applies to all entities. A not-for-profit organization should recognize the change in fair value of all derivatives as a change in net assets in the period of change. In a fair value hedge, the changes in the fair value of the hedged item attributable to the risk being hedged also are recognized. However, because of the format of their statement of financial performance, not-for-profit organizations are not permitted special hedge accounting for derivatives used to hedge forecasted transactions. This Statement does not address how a not-for-profit organization should determine the components of an operating measure if one is presented.

This Statement precludes designating a nonderivative financial instrument as a hedge of an asset, liability, unrecognized firm commitment, or forecasted transaction except that a nonderivative instrument denominated in a foreign currency may be designated as a hedge of the foreign currency exposure of an unrecognized firm commitment denominated in a foreign currency or a net investment in a foreign operation.

This Statement amends FASB Statement No. 52, Foreign Currency Translation, to permit special accounting for a hedge of a foreign currency forecasted transaction with a derivative. It supersedes FASB Statements No. 80, Accounting for Futures Contracts, No. 105, Disclosure of Information about Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk, and No. 119, Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments. It amends FASB Statement No. 107, Disclosures about Fair Value of Financial Instruments, to include in Statement 107 the disclosure provisions about concentrations of credit risk from Statement 105. This Statement also nullifies or modifies the consensuses reached in a number of issues addressed by the Emerging Issues Task Force.

This Statement is effective for all fiscal quarters of fiscal years beginning after June 15, 1999. Initial application of this Statement should be as of the beginning of an entity’s fiscal quarter; on that date, hedging relationships must be designated anew and documented pursuant to the provisions of this Statement. Earlier application of all of the provisions of this Statement is encouraged, but it is permitted only as of the beginning of any fiscal quarter that begins after issuance of this Statement. This Statement should not be applied retroactively to financial statements of prior periods.

The new requirements will allow a company to designate a derivative as a hedge of the foreign currency exposure of–

* an unrecognized firm commitment (a foreign currency fair value hedge),

* an available-for-sale security (a foreign currency fair value hedge),

* a forecasted transaction (a foreign currency cash flow hedge), or

* a net investment of a foreign operation.

Fair value hedge accounting may be used for derivatives that are hedging the foreign currency exposure of an unrecognized firm commitment or available-for-sale security if all the fair value hedge criteria are met. Cash flow hedge accounting may be used for those derivatives hedging the foreign currency exposure of a forecasted transaction if all the cash flow hedge criteria are met and the hedging instrument hedges the foreign currency exposure to variability in the functional currency-equivalent cash flows associated with either a forecasted foreign currency-denominated transaction or a forecasted intercompany foreign currency-denominated transaction.

The foreign currency exposure of a net investment in a foreign operation results in translation gains and losses. These translation gains and losses are included in other comprehensive income (outside of earnings) and reported in equity. Losses and gains on derivatives and nonderivative instruments that hedge this foreign currency exposure are also included in other comprehensive income and reported in equity to the extent the hedging instrument is an effective economic hedge.

The entire change in the fair value of the derivative would be recognized in current earnings in the period of change along with the change in fair value of the hedged item attributable to the risk being hedged. The only risks that may be hedged are risk of changes in fair value due to–

* changes in market price of an item,

* changes in market interest rates,

* changes in foreign currency exchange rates, or

* credit (default) risk.

An interest rate swap could be entered into to hedge the fair value of a recognized liability. The fair value of fixed-rate debt will vary with changes in the market rate. Entering into a swap to receive fixed and pay variable interest would result in future cash flows varying with the market rate, and therefore hedge against changes in fair value due to market rate changes.

The derivative gain or loss is reported in other comprehensive income or in current earnings, as necessary, to adjust the balance in other comprehensive income to an amount that equals the lesser of a) the cumulative gain or loss on the derivative or b) the cumulative change in expected future cash flows on the hedged transaction. The result is that the excess cumulative gain or loss on the derivative is considered ineffective and recognized in earnings. The accumulated gains and losses are recognized in earnings in the same period(s) as the hedged asset, liability, or forecasted transaction affects earnings.

An interest rate swap could be entered into to hedge the cash flow associated with a recognized asset. A company holding variable-rate investments would have varied cash inflows as the market rate changes. To hedge these future cash inflows, the company could enter into an interest rate swap to receive a fixed flow of income and pay a variable rate of interest that would effectively convert the variable-rate investments to fixed-rate investments. The future cash inflows related to these investments would then be constant, and the swap would result in an effective cash flow hedge.

All derivatives are measured and reported at fair value as assets or liabilities in the statement of financial position. Reporting of the corresponding changes in fair value depends upon management’s purpose for holding the derivative. Special accounting treatment is allowed for derivatives designated and qualifying as 1) a hedge of a risk of change in fair value of a recognized asset or liability or an unrecognized firm commitment (fair value hedge), 2) a hedge of the risk of a change in the cash flows associated with a recognized asset or liability or associated with a forecasted transaction (cash flow hedge), or 3) a hedge of a foreign currency exposure of an unrecognized firm commitment, an available for sale security, a forecasted transaction, or a net investment in a foreign operation (foreign currency hedge). Changes in fair value of derivatives not specifically designated as one of the above hedges are included in current earnings. Interest rate swaps are used to illustrate the difference between a cash flow hedge and fair value hedge. Swaps that are currently accounted for similarly require different accounting methods depending on the purpose for holding the swap.