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Set 1 Quiz Questions With Answers
Last Updated on December 17, 1998
Bob Jensen at Trinity University
SFAS
133 Glossary and Transcriptions of Experts
Table of Contents and Links
In Class Introductory Quiz Questions
03.006007 What Is a Derivative Instrument?-Notional Amount or Payment Provision
04.006008 What Is a Derivative Instrument?-Initial Investment
06.010010 What Instruments or Contracts Are Excluded from SFAS 133?
Summary of Accounting for Derivative Instruments and Hedging Activities
Fair Value Risk Hedging Questions
Cash Flow Risk Hedging Questions
Foreign Currency Exposure Risk Questions
22.037037 Foreign-Currency-Denominated Firm Commitments and Fair Value Hedges
23.040040 Forecasted Foreign-Currency-Denominated Transactions and Cash Flow Hedges
FASB Financial Statement Disclosure Questions
SEC Financial Statement Disclosure Questions
Effective Date and Transition Questions
Helper Documents
Bob Jensen's SFAS 133 Glossary on Derivative Financial Instruments and
Hedging Activities
Also see a comprehensive risk and trading glossary at http://risk.ifci.ch/SiteMap.htm
Bob Jensen's Document on the Missing Parts of SFAS 133
ACCT 5341 International Accounting Theories Course Helpers
Yahoo Finance is Bob Jensen's Favorite Place to Find Good Web Sites on Derivative Instruments
Bob Jensen's Transcripts of Presentations by Experts
In Class Quiz Questions & Answers
01.006011
What Is a Derivative Instrument?-All Criteria (Paragraphs 6 through 11 of SFAS 133)
q01.01
ABC purchases an option for $100 that will expire in six months to acquire 1,000 shares of
XYZ's common stock at a fixed price. XYZ's shares are publicly traded and the option
provides for net cash settlement.
Q. Should ABC account for the purchased option as a derivative instrument pursuant to SFAS 133?
A. Yes. Paragraph 6 of SFAS 133 sets forth the definition of a derivative instrument. The purchased option has an underlying (XYZ's share price), a notional amount (1,000 XYZ shares), requires little or no investment at inception of the contract, and settles in net cash; therefore, ABC should account for the purchased option as a derivative instrument because it meets the definition of a derivative instrument pursuant to Paragraph 6 of SFAS 133 and is not explicitly excluded from the scope by Paragraphs 10 and 11 of SFAS 133.
q01.02
A wheat farmer enters into a futures contract to deliver 80,000 bushels of wheat in two
months at a specified price per bushel. A market mechanism exists to settle the contract
on a net basis.
Q. Should the wheat farmer account for the futures contract as a derivative instrument pursuant to SFAS 133?
a01.02
A. Yes. The futures contract has an underlying (price of wheat), a notional amount (80,000 bushels), requires little or no initial investment at inception of the contract, and is settled net; therefore, the wheat farmer should account for the wheat futures contract as a derivative instrument because it meets the definition of a derivative instrument pursuant to Paragraph 6 of SFAS 133 and is not explicitly excluded from the scope by Paragraphs 10 or of SFAS 133.15
q01.03
Securitization of fixed-rate receivables often are structured such that variable-rate
payments are passed on to investors in the debt instruments issued by the securitization
trust. By altering the payments on the debt instruments from a fixed rate to a variable
rate of interest, the transferor has entered into an interest rate swap (i.e., the
transferor will receive a fixed rate of interest from the assets that have been
securitized and will pass on a variable rate of interest to the investors in the
securitization).
Q. Should this interest rate swap be accounted for as a derivative instrument pursuant to SFAS 133?
A. Yes. This interest rate swap represents a derivative instrument created in a securitization. I believe this interest rate swap would be accounted for in a manner similar to interest rate swaps not associated with a securitization. An interest rate swap has an underlying (the variable interest rate), a notional amount (the principal amount of the debt instrument), requires little or no investment at inception of the contract, and settles net in cash; therefore, I believe interest rate swaps associated with a securitization should be accounted for as derivative instruments because they meet the definition of a derivative instrument pursuant to Paragraph 6 of SFAS 133 and are not explicitly excluded from the scope by Paragraphs 10 and 11 of SFAS 133.
02.006007
What Is a Derivative Instrument?-Underlying (Paragraphs 6(a) and 7 of SFAS 133)
q02.04
LAB Corp. enters into a six-month forward contract to purchase 10,000 ounces of gold. The
contract may be settled in net cash, net gold, or through delivery of a unique metal. LAB
pays a small premium to enter into this contract.
Q. What is the underlying in this contract?
A. Paragraphs 6(a) and (7) of SFAS 133 set forth the characteristics of an underlying. Because the value of and amount of settlement in this contract is determined by the price of gold, I believe the underlying in this contract is the price of gold. The fact that a unique metal may be delivered in lieu of cash or gold only affects the manner in which the contract will be settled, not the value or amount of the settlement.
03.006007
What Is a Derivative Instrument?-Notional Amount or Payment Provision
(Paragraphs 6(a) and 7 of SFAS 133)
q03.05
ABC has purchased a financial instrument for $250,000 that provides for $5,000,000 to be
paid to ABC if LIBOR exceeds 10 percent during the next two years. Assume the $250,000
initial payment is smaller than would be required for other types of contracts that would
have a similar response to an increase in LIBOR over 10 percent.
Q. Does the financial instrument meet the requirements of Paragraph 6(a) of SFAS 133 to qualify as a derivative instrument pursuant to SFAS 133?
a03.05
A. Yes. Paragraph 6 of SFAS 133 sets forth the definition of a derivative instrument. Paragraph 6(a) of SFAS 133 requires the instrument or contract to have, "one or more notional amounts or payment provisions or both" (emphasis added). While the instrument does not have a notional amount, it does include a payment provision (as defined by SFAS 133). As such, I believe the financial instrument meets the requirements of Paragraph 6(a) of SFAS 133 for a derivative instrument. Note that this type of instrument is viewed similarly to a purchased option that pays if LIBOR exceeds 10 percent. If LIBOR does not exceed 10 percent, the option does not pay and would expire worthless.
04.006008
What Is a Derivative Instrument?-Initial Investment (Paragraphs 6(b) and 8 of SFAS 133)
q04.06
DEF enters into an interest rate swap with XYZ Bank. The terms of the interest rate swap
require DEF to receive a fixed rate of interest at 8.5 percent and pay a variable rate of
interest at LIBOR plus 1 percent on a notional amount of $50,000,000 for a five-year term.
The terms of the interest rate swap also require DEF to receive $10,000 at the inception
of the transaction. Assume the $10,000 payment made to DEF represents compensation for the
fact that the interest rate swap is "off-market" in that DEF is only receiving a
fixed rate of 8.5 percent whereas an interest rate swap with comparable terms would be
receiving a fixed rate of 8.55 percent in today's market.
Q. Does the interest rate swap meet the little or no initial investment criterion of Paragraph 6(b) of SFAS 133 to qualify as a derivative instrument pursuant to SFAS 133?
a04.06
A. Yes. Paragraph 6 of SFAS 133 sets forth the definition of a derivative instrument. Paragraph 8 of SFAS 133, which expands on the little or no initial investment criterion of Paragraph 6(b) of SFAS 133, states that many derivative instruments will require an initial investment to compensate for terms that are more or less favorable than market conditions and that, "a derivative instrument does not require an initial net investment in the contract that is equal to the notional amount (or the notional amount plus a premium or minus a discount)." Because the initial investment on the interest rate swap was not equal to the notional amount (or the notional amount plus a premium or minus a discount), I believe the interest rate swap meets the little or no initial investment criterion of a derivative instrument specified in Paragraph 6(b) of SFAS 133.
q04.07
A foreign currency swap is an agreement that generally requires the exchange of principal
amounts denominated in two different currencies at the inception of the contract at the
current (spot) rate and an agreement to re-exchange the currencies at a specified future
date at an agreed-upon rate.
Q. Does a foreign currency swap meet the little or no initial investment criterion of Paragraph 6(b) of SFAS 133 to qualify as a derivative instrument pursuant to SFAS 133?
a04.07
A. Yes. While the requirement to exchange notional amounts at the inception of the contract would, on the surface, appear to exclude these instruments as derivative instruments under SFAS 133, the Board specifically permitted the definition of a derivative instrument pursuant to Paragraph 6 of SFAS 133 to include currency swaps. It is the Board's observation that the initial exchange of currencies does not constitute an initial investment equal to the notional amount of the contract, but is instead the exchange of one kind of cash for another kind of cash. The forward contract that obligates and entitles both parties to exchange specified currencies, on specified dates, at specified prices is a derivative instrument if it meets the definition in Paragraph 6 of SFAS 133.Because the foreign currency swap requires no initial investment, I believe a foreign currency swap meets the little or no initial investment criterion of a derivative instrument pursuant to Paragraph 6(b) of SFAS 133.
q04.08
Company A owns 1,000 shares of Company B that it plans to sell at the end of a one-month
restriction period. These shares of Company B cost Company A $10 per share and they are
now trading at $20 per share. Company A is concerned that Company B's share price will
decline in the coming month and wants to hedge this exposure. To do so, Company A borrows
1,000 shares of Company B from Bank A for a one-month period. Company A immediately sells
these shares in the open market for $20 per share. At the end of the month, Company A
satisfies its obligation to Bank A using the 1,000 shares of Company B that it owns.
Q. Does the arrangement between Bank A and Company A (i.e., the borrowing of Company B shares for one month) meet the little or no initial investment criterion of Paragraph 6(b) of SFAS 133 to qualify as a derivative instrument pursuant to SFAS 133?
a04.08
A. No. The seller (Company A) is required to receive the 1,000 shares of Company B at the inception of the contract, which is the notional amount; therefore, I believe this arrangement does not meet the little or no initial investment criterion pursuant to Paragraph 6(b) of SFAS 133 and, as such, does not meet the definition of a derivative instrument pursuant to Paragraph 6 of SFAS 133.Company A's arrangement with Bank A is a short sale arrangement. As stated in Paragraph 290 of SFAS 133, the Board intentionally did not address whether short sales arrangements would always (or never) meet the definition of a derivative instrument pursuant to Paragraph 6 of SFAS 133 because the terms and related customary practices of the contracts vary. Instead, the specific terms of the contract must be evaluated to determine whether it meets SFAS 133's definition of a derivative instrument. (¶290)
Paragraph 59(d) of SFAS 133 addresses this specific situation. Paragraph 59(d) of SFAS 133 also addresses other activities typically involved in a short sale arrangement such as (1) the short seller selling a security to the purchaser, (2) the short seller delivering a borrowed security to the purchaser, and (3) the short seller purchasing a security from the market, all of which the Board indicates do not generally involve derivative instruments. Paragraph 59(d) of SFAS 133 does state, however, that if a forward purchase or sale is involved, and the contract does not qualify for the exception of Paragraph 10(a) of SFAS 133, it is subject to the provisions of SFAS 133. (¶59(d))
05.006009
What Is a Derivative Instrument?-Net Settlement (Paragraphs 6(c) and 9 of SFAS 133)
q05.09
ABC purchases an option that will expire in six months to acquire 1,000 shares of XYZ's
common stock at a fixed price. XYZ's shares are publicly traded and the option settles
through delivery of XYZ's shares. XYZ's shares are actively traded. The average trading
volume 30 days prior to purchasing the option is well in excess of 1,000,000 shares.
Q(a). Does the purchased option meet the net settlement criterion of Paragraph 6(c) of SFAS 133 to qualify as a derivative instrument pursuant to SFAS 133?
A(a). Yes. Paragraph 6 of SFAS 133 sets forth the definition of a derivative instrument. Paragraphs 6(c) and 9 require that, in order to meet the definition of a derivative instrument pursuant to SFAS 133, settlement of the contract must be (1) net, (2) in an asset that is neither associated with the underlying nor in a denomination that is equal to the notional amount (or the notional amount plus a premium or minus a discount), (3) in an asset that is readily convertible to cash, or (4) a market mechanism exists to facilitate net settlement. Although the asset being delivered as settlement of this contract is associated with the underlying and in a denomination equal to the notional amount, XYZ's shares are readily convertible to cash. As such, I believe the purchased option meets the net settlement criterion pursuant to Paragraph 6(c) of SFAS 133. Q(b). If the average trading volume 30 days prior to the purchasing of the option was below 10,000, would the net settlement criterion of Paragraph 6(c) of SFAS 133 be met?
a05.09b
A(b). No. As stated in Paragraph 9.14 herein, I believe that if the shares or units underlying an instrument represent more than 10 percent of the average daily trading volume for that security, the security would not be readily convertible to cash. The asset being delivered as settlement of this contract (XYZ shares) is associated with the underlying and in a denomination equal to the notional amount and XYZ's shares are not readily convertible to cash (i.e., amount of the 1,000 share settlement exceeds 10 percent of the average trading volume); therefore, I believe this contract does not meet the net settlement criterion pursuant to Paragraph 6(c) of SFAS 133 and, as such, does not meet the definition of a derivative instrument pursuant to Paragraph 6 of SFAS 133.
q05.10
Tarheel Co. has a commitment to purchase raw material inventory at £30,000 in three
months. Tarheel Co.'s functional currency is the U.S. dollar. In order to have adequate
British pounds on hand for the purchase, Tarheel Co. enters into a forward contract with
Hurricane Co. to acquire £30,000 in three months at a rate of US$1.60/£1.00.
Q. Is the forward contract a derivative instrument pursuant to SFAS 133?
a05.10
A. Yes. Because the contract is settled in an asset that, while being associated with the underlying and in a denomination equal to the notional amount (£30,000), is readily convertible to cash, I believe the foreign currency forward contract meets the net settlement criterion pursuant to Paragraph 6(c) of SFAS 133.
q05.11
ABC enters into a loan commitment with XYZ bank paying a 50 basis point fee to lock into a
7 percent rate today for a loan that will be made in three months.
Q. Does the loan commitment meet the net settlement criterion of Paragraph 6(c) of SFAS 133 to qualify as a derivative instrument pursuant to SFAS 133?
a05.11
A. No. The contract settles through delivery of a promissory note (in exchange for making the loan (i.e., cash) that is equal to the notional amount and is neither readily convertible to cash nor does a market mechanism exist to facilitate net settlement. For this reason, I believe the loan commitment does not meet the net settlement criterion pursuant to Paragraph 6(c) of SFAS 133 and, as such, does not meet the definition of a derivative instrument pursuant to Paragraph 6 of SFAS 133.
q05.12
XYZ Bank commits to sell at par a $1,000,000 pool of conforming 1-4 family conventional
mortgage loans (debt security) with a weighted average rate of 6.5 percent.
Q. Does the commitment to a sell a pool of mortgage loans (debt security) meet the net settlement criterion of Paragraph 6(c) of SFAS 133 to qualify as a derivative instrument pursuant to SFAS 133?
a05.12
A. Yes. Because the contract is settled with assets that, while being associated with both the underlying and in a denomination equal to the notional amount, are readily convertible to cash (i.e., there is a liquid market for conforming 1-4 family conventional mortgage loans). For this reason, I believe the net settlement criterion pursuant to Paragraph 6(c) of SFAS 133 has been met.
q05.13
In conjunction with the issuance of debt, ABC a non-public company, issues an
option that allows XYZ to acquire 100 shares of ABC's stock at a specified price for a
period of two years. The option requires physical settlement; (that is, if the options are
exercised, settlement is accomplished through physical delivery of the full stated amount
of the shares (i.e., not net shares or cash)).
Q. From XYZ's perspective, does the purchased option meet the net settlement criterion of Paragraph 6(c) of SFAS 133 to qualify as a derivative instrument pursuant to SFAS 133?
A. No. This contract requires physical settlement; that is, the asset being delivered in settlement of the contract (ABC shares) is associated with both the underlying and in a denomination equal to the notional amount. Because ABC's shares are not publicly traded, the stock is not considered to be readily convertible to cash. In addition, there is no market mechanism that permits net settlement of the contract; therefore, I believe the contract does not meet the net settlement criterion of Paragraph 6(c) of SFAS 133 and, as such, the contract does not meet the definition of a derivative instrument pursuant to Paragraph 6 of SFAS 133.
q05.14
ABC enters into a contract to purchase 100 units of a unique metal in 60 days at a fixed
price. The contract requires physical settlement.
Q(a). Does the contract meet the net settlement criterion of Paragraph 6(c) of SFAS 133 to qualify as a derivative instrument pursuant to SFAS 133?
a05.14a
A(a).No. Settlement of the contract is through delivery of an asset that is associated with the underlying and denominated in an amount equal to the notional amount. Furthermore, the asset being delivered in settlement of the contract (unique metal) is not readily convertible to cash. Finally, there is no market mechanism to facilitate net settlement of the contract. Thus, I do not believe the contract meets the net settlement criterion of Paragraph 6(c) of SFAS 133 and, as such, does not meet the definition of a derivative instrument pursuant to Paragraph 6 of SFAS 133.Q(b). Would the same contract (for 100 units of a unique metal) meet the net settlement criterion of Paragraph 6(c) of SFAS 133 if settlement of the contract was for the delivery of gold instead of a unique metal?
a05.14b
A(b). Yes. Because the contract can be settled with the physical delivery of gold, I believe such a contract meets the net settlement criterion of Paragraph 6(c) of SFAS 133. Specifically, the contract settles in an asset that is neither associated with the underlying nor in a denomination equal to the notional amount.
06.010010
What Instruments or Contracts Are Excluded from SFAS 133? (Paragraph 10 of SFAS 133)
q06.15
Brokerage, Inc. has executed a trade for the forward purchase of a mortgage-backed
security. This forward purchase contract will settle in 30 days and that settlement is the
shortest settlement available.
Q. Should Brokerage, Inc. account for the forward purchase contract as a derivative instrument pursuant to SFAS 133?
a06.15
A. No. Paragraph 10 of SFAS 133 addresses contracts that are excluded from the scope of SFAS 133. Paragraph 10(a) of SFAS 133 addresses "regular-way" security trades that are readily convertible to cash and provide for delivery of the security within the time generally established by regulations or conventions in the marketplace or exchange in which the transaction is being executed. Furthermore, "regular-way" security trades are contracts with no net settlement provisions and have no market mechanism to facilitate net settlement. Because security trades involving mortgage-backed securities customarily settle in 30 days, I believe this transaction meets the "regular-way" exclusion of Paragraph 10(a) of SFAS 133 and, therefore, is explicitly excluded from the scope of SFAS 133. As such, Brokerage, Inc. should not account for the forward purchase contract as a derivative instrument pursuant to SFAS 133.
q06.16
TGK Corporation enters into a three-day forward to acquire 30,000 shares of Z Company
stock (Z Company is a high-volume, publicly traded company). TGK Corporation pays a small
commission to enter into this contract. The contract settles through physical delivery of
Z Company stock.
Q(a). Should TGK Corporation account for the forward purchase contract as a derivative instrument pursuant to SFAS 133?
a06.16a
No. Paragraph 10(a) of SFAS 133 specifically excludes "regular-way" security trades from the scope of SFAS 133. Because this contract does not provide for net settlement, nor does a market mechanism exist to facilitate net settlement, and because security trades involving equity securities are readily convertible to cash and customarily settle in three days, I believe this transaction meets the "regular-way" exclusion of Paragraph 10(a) of SFAS 133 and, therefore, is explicitly excluded from the scope of SFAS 133. As such, TGK Corporation should not account for the forward purchase contract as a derivative instrument pursuant to SFAS 133.q06.16b
Q(b). If the contract instead permitted settlement in an equivalent value of Company Y stock, which is a public equity investee of Company Z with high-volume trading (the forward would continue to be valued based on Company Z stock). Should TGK Corporation account for the forward purchase contract as a derivative instrument pursuant to SFAS 133?
a06.16b
A(b). Yes. A "regular-way" security trade arises from the trade of a specified security, which is settled through physical delivery of that specified security. SFAS 133's scope exclusion in Paragraph 10(a) relating to "regular-way" security trades refers only to securities delivered that are readily convertible to cash. Despite the fact that the contract may be settled in three days, it is not for the security specified in the contract (i.e., Company Z stock). The contract has an underlying (Company Z stock), a notional amount (30,000 shares), requires little or no investment at inception of the contract (small premium), and is settled in Company Y stock (an asset that is associated with neither the underlying nor in a denomination equal to the notional amount); therefore, I believe TGK Corporation should account for the contract as a derivative instrument because it meets the definition of a derivative instrument pursuant to Paragraph 6 of SFAS 133 and is not explicitly excluded from the scope of SFAS 133 by Paragraphs 10 or 11 of SFAS 133.
q06.17
ABC enters into a one-year contract to purchase 34,000 gallons of fuel oil at a fixed
price from an oil company to satisfy its normal requirements for fuel oil. The contract
provides that as an alternative to taking physical delivery of fuel oil, during any given
month, either party may elect to settle the contract net cash for the difference between
the fixed price in the contract and the market price of the fuel oil.
Q. Should ABC account for the contract as a derivative instrument pursuant to SFAS 133?
a06.17
A. Yes. Paragraph 10(b) of SFAS 133 specifically excludes from the scope of SFAS 133 normal purchases and normal sales arrangements with no net settlement provisions and no market mechanism to facilitate net settlement. Although this contract covers the forward purchase of oil in quantities that will be used over a reasonable period in the normal course of business, I do not believe it meets the requirements for exclusion as a derivative instrument under Paragraph 10(b) because it provides for net cash settlement. The contract has an underlying (fuel oil price), a notional amount (34,000 gallons), little or no initial investment at inception of the contract, and provides for net cash settlement; therefore, I believe ABC should account for this contract as a derivative instrument because it meets the definition of a derivative instrument pursuant to Paragraph 6 of SFAS 133 and is not explicitly excluded from the scope by Paragraphs 10 or 11 of SFAS 133.
q06.18
Bank A has a two-year, $50 million, 15 percent fixed-rate loan with Company Z and wants to
hedge its credit exposure on this loan. To hedge the credit exposure associated with this
loan, Bank A enters into an arrangement with Bank B. The terms of the arrangement provide
that Bank A will pay Bank B all principal and interest collected from Company Z on the
loan. In return, Bank B will pay Bank A interest at an annual rate of 9 percent (on a
notional amount of $50 million) plus a $50 million payment in two years. This contract
settles on a net basis at the end of each of the next two years. At the end of year two,
Bank A transfers legal title on the loan to Bank B.
Q. Should Bank A account for the arrangement as a derivative instrument pursuant to SFAS 133?
a06.18
A. No. Paragraph 10(d) of SFAS 133 specifically excludes financial guarantees from the scope of SFAS 133 because they represent payments to reimburse a loss that has been incurred by one of the parties to the contract. I believe this contract is in substance a financial guarantee contract because, no matter how Company Z performs on the loan, Bank A will receive the principal plus a 9 percent return. However, if Company Z does not perform on the loan, Bank B receives zero. As such, I believe this arrangement is explicitly excluded from the scope of SFAS 133 pursuant to Paragraph 10(d) of SFAS 133 and Bank A should not account for this contract as a derivative instrument pursuant to SFAS 133.
q06.19
LAK Co. enters into a contract that is an option to purchase a piece of artwork owned by
ALB Co. for a specified price in six months. LAK Co. pays ALB Co. a premium for this
purchased option.
Q. Should LAK Co. account for the arrangement as a derivative instrument pursuant to SFAS 133?
a06.19
A. No. Paragraph 10(e) of SFAS 133 specifically excludes from the scope of SFAS 133 contracts that are not exchange-traded in which payments are provided in response to an underlying that is based on the price or value of a nonfinancial asset of one of the parties to the contract that is not readily convertible to cash. This arrangement represents an option to purchase a piece of art work owned by ALB Co., which is a nonfinancial asset of one of the parties to the contract that is not readily convertible to cash; therefore, I believe this arrangement is explicitly excluded from the scope of Standard by Paragraph 10(e) of SFAS 133. As such, LAK should not account for the arrangement as a derivative instrument pursuant to SFAS 133.
07.011011
Other Exclusions (Paragraph 11 of SFAS 133)
q07.20
MG Corp. enters into a contract to sell 10,000 shares of MG Corp. stock at $350 per
share to Rascal Co. in six months. The contract may be settled through physical settlement
(i.e., delivery of MG Corp. stock) or in net cash at the option of Rascal Co.
Q(a). Should MG Corp. account for the contract as a derivative instrument pursuant to SFAS 133?
a07.20a
A(a). Yes. Paragraph 11 of SFAS 133 addresses contracts that are excluded from the scope of SFAS 133. Paragraph 11(a) of SFAS 133 specifically excludes contracts that are issued or held by that reporting entity that are both (1) indexed to its own stock and (2) classified in its stockholders' equity. EITF Issue 96-13 sets forth the accounting for financial instruments indexed to and potentially settled in a company's own stock. Pursuant to EITF Issue 96-13, this contract would be accounted for as an asset or liability because its settlement in cash is at the option of Rascal Co. Thus, the contract would not be included in stockholders' equity of MG Corp.The contract has an underlying (the price of MG Corp. stock), a notional amount (10,000 shares of MG Corp. stock), requires little or no initial investment at inception of the contract, and is settled in cash or MG Corp. stock, which is readily convertible to cash; therefore, I believe MG Corp. should account for the arrangement as a derivative instrument because it meets the definition of a derivative instrument pursuant to Paragraph 6 of SFAS 133 and is not explicitly excluded from the scope by Paragraphs 10 or 11 of SFAS 133.
Q(b). Should MG Corp. account for the contract as a derivative instrument pursuant to SFAS 133 if it permitted settlement through physical settlement or net cash at the option of MG Corp.?
a07.20b
A(b). No. If the contract permitted settlement in cash or physical settlement at the option of MG Corp., it would be deemed an equity instrument pursuant to EITF Issue 96-13 with classification of such instruments in MG Corp.'s equity. Because such a contract is both (1) indexed to the MG Corp.'s own stock and (2) classified in MG Corp.'s in stockholders' equity, I believe the contract would be explicitly excluded as a derivative instrument pursuant to Paragraph 11(a) of SFAS 133 and, as such, MG Corp. should not account for the arrangement as a derivative instrument pursuant to SFAS 133. Note, however, that Rascal Co. would account for the instrument as a derivative instrument.
q07.21
In connection with a purchase business combination JEE Co. issues a certificate to selling
shareholders. The value of the certificate is indexed to the acquired company's earnings
over the next five years.
Q. Should JEE Co. account for the certificate as a derivative instrument pursuant to SFAS 133?
a07.21
A. No. Paragraph 11(c) of SFAS 133 specifically excludes from the scope of SFAS 133 contracts issued by an entity as contingent consideration from a business combination. This certificate represents a contingent consideration arrangement in a business combination and is explicitly excluded from the scope of SFAS 133 by Paragraph 11(c) and, as such, JEE Co. should not account for this arrangement as a derivative instrument pursuant to SFAS 133. However, the seller of the business (and holder of the agreement) is not explicitly excluded from SFAS 133 by Paragraph 11(a) and would be subject to the provisions of SFAS 133 if the agreement meets the definition of a derivative instrument pursuant to Paragraph 6 of SFAS 133.
08.012015
Embedded Derivative Instruments (Paragraphs 12 through 15 of SFAS 133)
q08.22
KAG purchases a bond at market with a coupon rate dependent on LIBOR. If LIBOR stays
within a pre-established range of 4 to 7 percent, the bond pays LIBOR plus 2 percent. If
LIBOR does not stay within the pre-established collar of 4 to 7 percent, the bond pays
zero. This instrument is commonly referred to as a range floater.
Q. Does this instrument contain an embedded derivative component that is required to be accounted for separately as a derivative instrument pursuant to SFAS 133?
a08.22
A. No. Paragraph 12 of SFAS 133 sets forth the conditions that need to be present for an embedded derivative instrument to be separated from the host contract and accounted for as a derivative instrument pursuant to SFAS 133. Specifically, the embedded derivative component must (1) not be clearly and closely related to the host contract (Paragraph 12(a) of SFAS 133), (2) the hybrid instrument must not be measured at fair value (Paragraph 12(b) of SFAS 133), and (3) a separate instrument with the same terms as the embedded derivative component must meet the definition of a derivative instrument pursuant to Paragraph 6 of SFAS 133 (Paragraph 12(c) of SFAS 133).This hybrid instrument contains an embedded derivative component that is referenced to an interest rate index (LIBOR, in this example) altering the net interest payments that otherwise would be paid by the debtor or received by the investor on an interest-bearing host contract (bond). Because the embedded derivative component is an adjustment to interest, it is considered to be clearly and closely related to the host contract (a debt instrument) as described in Paragraph 12(a) of this Standard; therefore, I believe the embedded derivative component should not be accounted for separately from the host contract.
However, the clearly and closely related condition specified in Paragraph 12(a) of SFAS 133 does not apply if the conditions specified in Paragraph 13 of SFAS 133 exist. The conditions in Paragraph 13 of SFAS 133 include that (1) the hybrid instrument can contractually be settled in such a way that the investor would not recover substantially all of its initial recorded investment or (2) the embedded derivative component could at least double the investor's initial rate of return and could result in a return that is twice what a similar contract including a debtor with similar credit risk would return on the market. If either of the two conditions specified in Paragraph 13 of SFAS 133 have the potential of occurring at any time throughout the life of the instrument or contract, the embedded derivative component is not deemed to be clearly and closely related to the host contract and, as such, should be accounted for separately from the host contract if it meets the definition of a derivative instrument pursuant to Paragraph 6 of SFAS 133.
In this instance, if KAG purchases the bond at a premium that exceeds 10 percent of the settlement amount, I believe this embedded derivative component would not be considered clearly and closely related to the host contract. The reasoning is the potential exists that LIBOR could fall outside the pro-established collar and KAG would receive zero in interest and only the par amount of principal and, therefore, not receive substantially all of the initial investment (even if the probability of LIBOR falling outside of the preestablished collar is remote). Thus, the embedded derivative component would be accounted for separately from the host contract if it met the definition of a derivative instrument pursuant to Paragraph 6 of SFAS 133. (¶181)
q08.23
JRE Co. enters into a debt instrument with a coupon rate equal to the average three-month
LIBOR rate plus 50 basis points. JRE Co. pays par for the instrument. Over the term of the
instrument, the calculated coupon rate may not exceed 7.25 percent (interest cap).
Furthermore, the coupon rate for each period could not fall below the effective coupon
rate for the previous period plus 25 basis point (interest floor). The instrument is
commonly referred to as a ratchet floater.
Q. Does this instrument contain an embedded derivative component that is required to be accounted for separately as a derivative instrument pursuant to SFAS 133?
a08.23
A. No. A ratchet floater is a bond that pays a floating rate of interest and has an adjustable cap and floor that moves with each new reset rate. The instrument is viewed as having embedded purchased and written options that create changing caps and floors and, as such, does contain an embedded derivative component.The embedded derivative component is referenced to an interest rate index (LIBOR, in this example) altering the net interest payments that otherwise would be paid by the debtor or received by the investor on an interest-bearing host contract (bond). Because the embedded derivative component is an adjustment to interest, it is considered to be clearly and closely related to the host contract (a debt instrument) as described in Paragraph 12(a) of this Standard; therefore, I believe the embedded derivative component should not be accounted for separately from the host contract.
However, the clearly and closely related condition specified in Paragraph 12(a) of SFAS 133 does not apply if the conditions specified in Paragraph 13 of SFAS 133 exist. In this instance, it does not appear that either of the conditions in Paragraph 13 of SFAS 133 have the potential of occurring. (¶182)
q08.24
Company A purchases a bond at par that pays a fixed rate of interest in the first year and
a variable rate of interest based on the prime rate in all subsequent years. This
instrument is commonly referred to as a fixed-to-floating bond.
Q. Does this instrument contain an embedded derivative component that is required to be accounted for separately as a derivative instrument pursuant to SFAS 133?
a08.24
A. No. This fixed-to-floating bond contains an embedded derivative component (i.e., forward starting interest rate swap) that is referenced to an interest rate index (prime, in this example) altering the net interest payments that otherwise would be paid by the debtor or received by the investor on an interest-bearing host contract. Because the embedded derivative component is an adjustment to interest, it is considered to be clearly and closely related to the host contract (a debt instrument). As such, I believe the embedded derivative component should not be accounted for separately from the host contract.However, the clearly and closely related condition specified in Paragraph 12(a) of SFAS 133 does not apply if the conditions specified in Paragraph 13 of SFAS 133 exist. In this instance, it does not appear that either of the conditions in Paragraph 13 of SFAS 133 have the potential of occurring. (¶183
q08.25
ABC Co. purchases a bond in which the coupon rate is zero and the principal varies based
on the London Gold Index. This instrument is commonly referred to as a leveraged gold
note.
Q. Does this instrument contain an embedded derivative component that is required to be accounted for separately as a derivative instrument pursuant to SFAS 133?
a08.25
A. Yes. A leveraged gold note can be viewed as combining an interest-bearing instrument with a series of embedded commodity option contracts and is designed to incorporate a collar on gold whereby the investor buys a call and sells a put option in exchange for giving up the coupon. The entire coupon interest rate and the premiums from written options (in the form of caps on the appreciation in the value of gold that the investor would otherwise be entitled to) are used to purchase options that provide the investor with potential gains resulting from increases in gold prices. The embedded derivative components (the option contracts) are indexed to the price of gold, which I believe is not clearly and closely related to an investment in a fixed-interest-rate note. Thus, the embedded derivative component would qualify for separation from the host contract pursuant to Paragraph 12(a) of SFAS 133.The embedded derivative component has an underlying (price of gold), a notional amount (principal amount of note), requires little or no initial investment at inception of the contract, and settles in cash; therefore, I believe that a separate instrument with the same terms as the embedded derivative component meets the definition of a derivative instrument pursuant to Paragraph 6 of SFAS 133 and is not explicitly excluded from the scope by Paragraphs 10 or 11 of SFAS 133. As such, the embedded derivative component qualifies to be accounted for as a separate derivative instrument from the host contract in accordance with Paragraph 12 of SFAS 133. (¶188)
q08.26
DEF purchases a bond with a fixed 4 percent coupon rate and guaranteed principal with
upside potential if the S&P Index falls to a specified level. This instrument is
commonly referred to as an equity-linked bear note.
Q. Does this instrument contain an embedded derivative component that is required to be accounted for separately as a derivative instrument pursuant to SFAS 133?
a08.26
A. Yes. An equity-linked bear note can be viewed as combining an interest-bearing instrument with a series of embedded option contracts. A portion of the coupon interest rate is used to purchase put options that provide the investor with potential gains resulting from declines in the S&P 500. Because the option contracts are indexed to the S&P 500, and, therefore, the underlying is an equity index, I believe the embedded derivative component is not clearly and closely related to an investment that is typically interest-bearing. As such, the embedded derivative component would qualify for separation from the host contract pursuant to Paragraph 12(a) of SFAS 133.The embedded derivative component has an underlying (S&P 500 index), a notional amount (principal of bond), requires little or no initial investment at inception of the contract (issuing a debt obligation), and settles in cash, therefore, I believe that a separate instrument with the same terms as the embedded derivative component meets the definition of a derivative instrument pursuant to Paragraph 6 of SFAS 133 and is not explicitly excluded from the scope by Paragraphs 10 or 11 of SFAS 133. As such, the embedded derivative component qualifies to be accounted for as a separate derivative instrument from the host contract in accordance with Paragraph 12 of SFAS 133. (¶185)
q08.27
Company A originates a loan at an above-market interest rate to Company X. The functional
currency of both Company A and Company X is in the U.S. dollar. The loan is denominated in
U.S. dollars, but the borrower has the option to repay the loan in U.S. dollars or in a
fixed amount of a specified foreign currency.
Q. Does this instrument contain an embedded derivative component that is required to be accounted for separately as a derivative instrument pursuant to SFAS 133?
a08.27
A. Yes. This instrument can be viewed as a loan at prevailing market interest rates with an embedded foreign currency option. The lender has written a foreign currency option exposing it to changes in foreign currency exchange rates during the outstanding period of the loan. The premium for the option has been paid as part of the interest rate. I believe a foreign currency option is not clearly and closely related to issuing a loan, an interest-bearing instrument. Also, Paragraph 15 of SFAS 133 addresses foreign-currency-denominated interest or principal payments but does not apply to foreign currency options. As such, the embedded derivative component would qualify for separation from the host contract pursuant to Paragraph 12(a) of SFAS 133.The embedded derivative component has an underlying (foreign currency spot rate), a notional amount (principal of loan), requires little or no initial investment at inception of the contract, and settles in cash or in a foreign currency for which a market mechanism exists to permit net settlement or is readily convertible to cash; therefore, I believe that a separate instrument with the same terms as the embedded derivative component meets the definition of a derivative instrument pursuant to Paragraph 6 of SFAS 133 and is not explicitly excluded from the scope by Paragraphs 10 or 11 of SFAS 133. As such, the embedded derivative component qualifies to be accounted for as a separate derivative instrument from the host contract in accordance with Paragraph 12 of SFAS 133. (¶195)
q08.28
Company A owns 100,000 shares of Company B's common stock that are being accounted for as
available-for-sale securities pursuant to SFAS 115. To lock in some of the gains
associated with these shares, Company A issues a debt obligation whose return is indexed
to the market value of these 100,000 shares of Company B. This instrument is commonly
referred to as a specific equity-linked bond.
Q. Does this instrument contain an embedded derivative component that is required to be accounted for separately as a derivative instrument pursuant to SFAS 133?
a08.28
A. Yes. This equity-indexed debt obligation can be viewed as combining what is typically an interest-bearing instrument with a forward contract indexed to Company B's share price. I believe that a forward contract for which the underlying is an equity index is not clearly and closely related to an investment that is typically interest-bearing. As such, this embedded derivative component would qualify for separation from the host contract pursuant to Paragraph 12(a) of SFAS 133.The embedded derivative component has an underlying (price of Company B stock), a notional amount (100,000 shares of Company B stock), requires little or no initial investment at inception of the contract (issuing a debt obligation), and settles in cash; therefore, I believe that a separate instrument with the same terms as the embedded derivative component meets the definition of a derivative instrument pursuant to Paragraph 6 of SFAS 133 and is not explicitly excluded from the scope by Paragraphs 10 or 11 of SFAS 133. As such, the embedded derivative component qualifies to be accounted for as a separate derivative instrument from the host contract in accordance with Paragraph 12 of SFAS 133. (¶193)
q08.29
On January 1, 20X0, ABC Co. enters into a five-year, fixed rate interest rate swap with a
notional amount of $100 million. If the yield on four-year Treasuries falls below 6
percent on March 1, 20XI, the notional amount of the swap declines to $50 million for the
duration of the swap. This swap is commonly referred to as an index-amortizing swap.
Q. Does this instrument contain an embedded derivative component that is required to be accounted for separately as a derivative instrument pursuant to SFAS 133?
a08.29
A. No. An index-amortizing swap, viewed as a written option embedded within a swap contract, is an instrument that acts as a basic swap for an initial period. After this period the notional principal balance may be amortized based on certain conditions being met during the intervening period. While Paragraph 12 of SFAS 133 sets forth the conditions that need to be present for an embedded derivative instrument to be separated from the host contract and accounted for as a derivative instrument pursuant to SFAS 133, I believe those provisions only apply in instances when a derivative instrument is embedded in a nonderivative instrument. In instances where a derivative instrument is embedded in another derivative instrument, SFAS 133 prohibits separation of the instruments in applying hedge accounting. Specifically, in order to qualify for hedge accounting the entire derivative instrument would have to be designated as the hedging instrument. For example, this compound derivative could not be separated into two derivatives and have one qualify for hedge accounting and the other not qualify for hedge accounting.
q08.30
Company A, a public company, issues debt that is indexed to and settleable in shares of
Company B, which is a private company.
Q. Does this instrument contain an embedded derivative component that is required to be accounted for separately as a derivative instrument pursuant to SFAS 133?
a08.30
A. No. I believe interest rates on a debt instrument and the changes in the fair value of an equity index are not clearly and closely related to an investment that is typically interest-bearing. Thus, the embedded derivative component would qualify for separation from the host contract pursuant to Paragraph 12(a) of SFAS 133.However, despite the presence of an underlying (price of Company B stock), a notional amount (shares of Company B stock), and the fact that there is little or no initial investment at inception of the contract, the embedded derivative component settles in stock that is associated with the underlying and in a denomination equal to the notional amount. Furthermore, because Company B'5 stock is not publicly traded and, therefore, no active market exists, the stock is not considered to have a market mechanism that permits net settlement nor is it considered to be readily convertible to cash and thus does not meet the net settlement criterion pursuant to Paragraph 6(c) of SFAS 133. Thus, I believe that a separate instrument with the same terms as the embedded derivative component would not meet the definition of a derivative instrument pursuant to Paragraph 6 of SFAS 133 prohibiting the embedded derivative component from being accounted for as a separate derivative instrument from the host contract because it does not meet the requirements of Paragraph 12(c) of SFAS 133.
10.Exhibit3.01
Exhibit 3.1-Summary of Accounting for Derivative Instruments and Hedging Activities
Derivative Instrument Transaction |
Example |
Accounting for Derivative Instrument |
Accounting for Hedged Item |
Derivative instrument that does not qualify for hedge accounting |
Equity call options are written by a mutual fund manager to enhance the yield of a mutual fund. |
Derivative instrument recorded in the statement of financial position at fair value with changes in that fair value reported in earnings. |
Not applicable. |
Fair value hedge |
A purchased put option is used to hedge declines in the fair value of a fixed-rate loan receivable. |
Derivative instrument recorded in the statement of financial position at fair value with changes in that fair value reported in earnings. |
Recognize in earnings the gains or losses on the hedged item attributable to the hedged risk with the offset being recorded as an adjustment to the carrying amount of the hedged item.3 |
Cash flow hedge |
A bank enters into a receive-fixed, pay-variable interest rate swap used to hedge the cash flow exposure of its variable-rate loan receivable. |
Derivative instrument recorded in the statement of financial position at fair value with changes in that fair value allocated between OCI (effective portion) and earnings (ineffective portion). Amounts accumulated in AOCI are reclassified into earnings during the periods that the variability in cash flows associated with the loan (interest rate reset on the loan) impacts earnings. |
Existing GAAP. |
Fair value hedge of the foreign currency exposure inherent in a firm commitment or an available-for-sale security |
A foreign currency forward contract to sell foreign currency is used to hedge firmly committed sales revenue denominated in a foreign currency. |
Use the fair value hedge model previously discussed. |
Use the fair value hedge model previously discussed. |
Cash flow hedge of the foreign currency exposure inherent in a forecasted transaction (including certain intercompany transactions) |
A purchase put option in yen is used to hedge forecasted sales that are denominated in yen. |
Use the cash flow hedge model previously discussed. |
Use the cash flow hedge model previously discussed. |
Hedge of the foreign currency exposure inherent in a net investment in a foreign operation |
Debt denominated in Sterling is used to hedge the U.S. parent's investment in a U.K. subsidiary. |
Transaction gain or loss on the hedging instrument is accounted for as a translation adjustment (i.e., in OCI), to the extent it is considered effective. |
Translation gain or loss on the hedged net investment will continue to be recorded in OCI pursuant to SFAS 52. |
11.020020
Fair Value Risk Hedging Questions
Definition of a Fair Value Hedge (Paragraph 20 of SFAS 133)
q11.01
SWM owns 100 shares of Company B common stock. SWM is restricted from selling the common
stock for one more month. SWM is concerned that Company B's share price will decline in
the coming months and decides to hedge this exposure by entering into a short position in
Company B's stock. To do so, SWM borrows 100 shares of Company B from Bank X for a
one-month period. SWM immediately sells these shares in the open market at fair market
value. At the end of the month, SWM satisfies its obligation to Bank X using the 100
shares of Company B that it owns.
Q. Would SWM be permitted to designate the short position as a fair value hedge of its investment in Company B?
a11.01
A. No. Paragraph 20 of SFAS 133 generally prohibits nonderivative financial instruments from being designated as the derivative hedging instrument in a fair value hedge. Short positions generally do not meet the definition of a derivative instrument pursuant to Paragraphs 6(b) and 8 of SFAS 133 because they require an initial investment equal to the notional amount. In this instance, at inception of the contract SWM was required to purchase 100 shares of Company B, which is the notional amount. As a consequence, this transaction would not qualify as a fair value hedge.In Paragraph 290 of SFAS 133, the Board intentionally did not address whether short sales arrangements would always (or never) meet the definition of a derivative instrument pursuant to Paragraph 6 of SFAS 133 because the terms and customs of the contracts vary. Instead, the specific terms of the contract must be evaluated to determine whether it meets SFAS 133's definition of a derivative instrument.
q11.02
A swaption is an option on a swap. Swaptions
are usually interest rate options used to hedge long-term debt. When a company has
an interest rate swap, a swaption can be used to close out the swap. A swaption can
also be used to enter into an interest rate swap. The majority are European
options in terms of settlements.
Q. Can an instrument like a swaption, which is an option on a swap, qualify as 3 derivative hedging instrument in a fair value hedge for the writer of the option?
a11.02
A. Yes, in certain limited circumstances. Paragraph 20(c) of SFAS 133 states that a written option (or net written option) can qualify for hedge accounting of a recognized asset or liability if the combination of the hedged item and the written option (or net written option) provides at least as much potential for gains as a result of increases in the fair value of the combined instruments as exposure to losses from declines in their combined fair value. Paragraph 20(c)(1) states that a derivative that results from combining a written option and any other nonoption derivative is considered a written option. Thus, Paragraph 20(c) applies to a swaption.
12.020020
Qualifying Hedge Criteria-Formal Documentation (Paragraph 20(a) of SFAS 133)
Q. What methodology does SFAS 133 prescribe for determining whether a hedging relationship is highly effective?
A. SFAS 133 does not specify a methodology that is required to be used in determining whether a hedging relationship is highly effective. Rather, Paragraph 20 of SFAS 133 requires an entity, at the inception of a hedge, to define how it will assess a derivative hedging instrument's effectiveness in achieving offsetting changes in the hedged item's fair value attributable to the risk being hedged. SFAS 133 requires that the methodology used be reasonable. SFAS 133 also requires that the assessment of hedge effectiveness be used in a consistent manner throughout the hedge period and also to be used for similar types of hedges. If the critical terms of the derivative hedging instrument and hedged item are the same, it is reasonable to assume that hedge effectiveness is achieved and ongoing assessment is not necessary. On the other hand, if the critical terms of the derivative hedging instrument and hedged item are not the same, initial and ongoing assessment of hedge effectiveness is required (see Paragraph A4.08 in Appendix A).
13.021021
Eligibility Requirements of Hedged Item-All Criteria (Paragraph 21 of SFAS 133)
q13.04
LDB, an investment advisor, is the general partner of ABC Investment Co. LDB owns 20
percent of ABC Investment Co. and is considered to have significant influence over the
affairs of ABC Investment Co. Thus, LDB uses the equity method of accounting for its
investment in ABC. ABC Investment Co. invests in various equity securities with the
objective of replicating the S&P 500. LDB believes the S&P 500 will fall in the
coming year and purchases a put option on the S&P 500 to hedge the exposure inherent
in its investment in ABC Investment Co.
Q. Will this put option qualify as a fair value hedge of LDB's investment in ABC Investment Co.?
A. No. Paragraph 21(c)(2) of SFAS 133 prohibits investments accounted for using the equity method of accounting from being designated as hedged items. Accordingly, a hedge of LDB's investment in ABC Investment Co. would not qualify for fair value hedge accounting.
Q. Can a chocolate manufacturer designate a cocoa forward contract as a hedge of the cocoa component of its chocolate inventory?
A. No. Paragraph 21(e) of SFAS 133 prohibits a major ingredient of a nonfinancial asset or liability from being designated as the hedged item. Rather, the entire nonfinancial asset or liability must be designated as the hedged item. Accordingly, the chocolate manufacturer only would be permitted to use the cocoa forward as a hedge of its chocolate inventory if it could establish that the forward was highly effective in achieving offsetting changes in the entire fair value of the chocolate inventory.
q13.06
SMS has entered into a contract to sell its wholly owned subsidiary to Company X at a
fixed price in one year.
Q. Would SMS be able to hedge the fair value of its wholly owned subsidiary as a fair value hedge?
A. No. This transaction would not qualify as a fair value hedge because Paragraph 21(c)(4) of SFAS 133 prohibits an equity investment in a consolidated subsidiary from being designated as the hedged item in a fair value hedge.
q13.07
MJW enters into a contract to sell 100,000 bushels of wheat to EWT at fair value in one
month. This transaction is considered a normal sale as defined in Paragraph 10(b)
of SFAS 133. If MJW cancels this contract it will be required to pay a $50,000 penalty to
EWT.
Q. Can MJW designate this contract to sell as a hedged item in a fair value hedge'?
A. No. The definition of a firm commitment, as provided in Appendix F to SFAS 133, states, among other things, that all significant terms of the exchange are to be specified in the agreement. The price of the item to be purchased or sold is considered a significant term. Because this contract provides for the sale of wheat to EWT at fair value as opposed to a fixed price, it would not qualify as a firm commitment. However, this contract may qualify as a cash flow hedge of a forecasted transaction.
q13.08
Bilcox owns 5 percent of CMM, a nonpublic company, and wants to enter into a derivative
instrument to hedge this investment. Bilcox accounts for this investment using the cost
method of accounting.
Q. Would Bilcox be permitted to hedge changes in the fair value of its investment in CMM?
A. Yes, assuming Bilcox was able to find a derivative instrument that would be highly effective in hedging the exposure to changes in the fair value of this investment.
q13.09
LAB has a portfolio of credit card loans that are yielding a fixed rate of 18 percent.
This portfolio is being funded by variable-rate liabilities. To reduce its exposure to
rising interest rates, LAB wants to enter into an interest rate swap that converts these
fixed-rate credit card loans to variable rate.
Q.
Would LAB be permitted to designate a five-year interest rate swap as a fair value hedge of its credit card portfolio?
A. No. A five-year interest rate swap is not likely to be effective at hedging changes in fair value of the existing credit card receivables because the receivables have expected maturities that are much shorter than five years. I believe only short-term interest rate swaps or interest rate futures are likely to be effective at hedging changes in the fair value of the existing credit card receivables. In addition, as discussed in Paragraph 18 of SFAS 133, a portion of a derivative instrument cannot be designated as a hedging instrument. Thus, LAB cannot designate a short-term portion of the swap as a derivative hedging instrument. I also do not believe that the anticipated origination of future credit card receivables presents a fair value exposure because those originations do not qualify as firm commitments. Moreover, I do not believe the anticipated origination of future credit card receivables qualifies for cash flow hedge accounting because future cash flows from these credit card receivables generally do not fluctuate with market rates.
q13.10
An entity owns a fixed-rate loan receivable that is held-for-sale and measured at the
lower of cost or market ("LOCOM").
Q. Can this entity designate the changes in fair value of the loan attributable to changes in interest rates as the hedged risk?
a13.10
A. Yes. Paragraph 21(c)(1) of SFAS 133 prohibits designating as a hedged item an asset or liability that is remeasured with changes in fair value attributable to the hedged risk reported currently in earnings. Because a fixed-rate loan receivable that is held-for-sale and measured at LOCOM is carried at market only if market declines below cost, I do not believe the prohibition of Paragraph 21(c)(1) applies. Moreover, I do not believe the Board intended assets accounted for at LOCOM to be prohibited from being designated as a hedged item.
q13.11
An entity enters into a firm commitment to purchase a security that will be classified in
the entity's trading portfolio.
Q. Can the firm commitment be designated as the hedged item in a fair value hedge?
a13.11
q13.12
One of the characteristics of a firm commitment, as defined in Appendix F to SFAS 133, is
that the agreement includes a disincentive for nonperformance that is sufficiently large
to make performance probable.
Q. Can the disincentive for nonperformance be in the form of "opportunity cost?" For example, can a disincentive exist when a manufacturer's commitment to purchase certain raw materials from one supplier is considered probable because to purchase the same raw materials from other suppliers would be significantly more expensive? Can the disincentive for nonperformance be in the form of potential write-off? For example significant amount of capitalized assets related to an in-process project can be considered worthless if certain materials needed to complete a project are not purchased from a particular supplier?
a13.12
A. No. Paragraph 540 of SFAS 133 states that a firm commitment is an agreement that includes, among other things, a disincentive for nonperformance that is sufficiently large to make performance probable. The disincentives above are not included in any agreements. Thus, I believe the agreements are not firm commitments.
Q. Is an entity permitted to designate a portion of a nonfinancial asset or liability (other than a recognized loan servicing right or a nonfinancial firm commitment with financial components) as the hedged item in a fair value hedge?
A. No. Paragraph 21(a)(2) of SFAS 133 permits a specific portion of an asset or liability to be the hedged item in a fair value hedge. However, Paragraph 21(e) of SFAS 133 requires that if a nonfinancial asset or liability (other than a recognized loan servicing right or a nonfinancial firm commitment with financial components) is the hedged item, the designated risk being hedged is the risk of changes in the fair value of the entire hedged asset or liability. Consequently, to meet the requirement of Paragraph 21(e), an entity would be unable to designate only a portion of the nonfinancial asset or liability as the hedged item.
14.022022
Accounting for a Fair Value Hedge (Paragraph 22 of SFAS 133)
q14.14
ALB purchased 10,000 units of widget inventory three months ago for $100,000. Since that
time, the widgets have increased in value to $150,000. Because ALB carries its inventory
at the lower of cost or market, ALB has not recognized the $50,000 appreciation in this
inventory. To hedge the fair value of these 10,000 units of widget inventory, ALB
purchases a put option to sell 10,000 widgets at a price of $15 each. ALB measures
effectiveness using the option's intrinsic value.
Q. If, as of the next reporting date (i.e., one month later), the intrinsic value of the option has increased by $20,000 and the fair value of the inventory has declined by $20,000, at what amount would ALB carry this inventory on its books?
A. ALB would carry the inventory at $80,000, which represents the carrying amount of the inventory at inception of the hedge ($100,000) less the change in its fair value during the hedge period ($20,000). Under SFAS 133, preexisting gains and losses on the hedged item at the inception of the hedge would not be recognized in the statement of financial position, except when a fair value type hedge relationship exists at adoption of SFAS 133 (see Chapter 9 for transition guidance). Thus, even though the fair value of the hedged inventory is $130,000, application of the fair value hedge accounting requirements results in this inventory being carried at an amount below its fair value. In essence, if the hedge is effective, the fair value hedge accounting approach has the effect of locking in the gain or loss that existed at the beginning of the hedge.
Q. Could an entity decide to exclude the premium of an interest rate futures or forward contract from its assessment of hedge effectiveness?
A. Yes. SFAS 133 does permit the forward premium to be excluded on an interest rate futures or forward contract. Paragraph 63 of SFAS 133 permits the exclusion of all or a part of the derivative hedging instrument's time value from the assessment of hedge effectiveness. See SFAS Paragraph 65c on Page 45 of SFAS 133.
q14.16
At inception of a hedging relationship, on January 1, 20XI, an entity formally documented
that the hedging relationship is expected to be highly effective in achieving offsetting
changes in fair value attributable to the hedged risk during the period that the hedge is
designated. The entity also documented that its established policy for the range of what
is considered highly effective is 80 to 125 percent. Assume the changes in fair
value of the derivative hedging instrument and the hedged item attributable to the hedged
risk during the three months ended March 31, 20XI were $(50,000) and $45,000,
respectively.
Q. Because the hedging relationship was highly effective during the three months ended March 31, 20X1 in achieving offsetting changes in fair value attributable to the hedged risk (i.e., $45,000/$50,000 = 90 percent effective) is the entity required to record in earnings the $5,000 which represents the loss on the derivative hedging instrument in excess of the gain on the hedged item?
A. Yes. Paragraph 22 of SFAS 133 states that the gain or loss on the hedging instrument shall be recognized currently in earnings. In addition, the gain or loss on the hedged item attributable to the hedged risk shall adjust the carrying amount of the hedged item and be recognized currently in earnings. Thus, even though the hedge performed as intended, the amount of ineffectiveness still must be recorded currently in earnings.
15.025025
Discontinuation of Hedge Accounting (Paragraph 25 of SFAS 133)
q15.17
JEB designated an interest rate swap (receive LIBOR and pay 8 percent) as a fair value
hedge of a pool of fixed-rate loans that earn 8 percent.
Q. Would JEB be permitted to replenish the designated hedged pool when loans within the pool prepay?
A. Yes. I believe it would be permissible for the excess derivative position to be redesignated as a hedge of the new loans put into the hedged pool as long as all hedge criteria were satisfied. In situations where the notional amount of a derivative instrument exceeds the hedged item, the excess would be treated as a speculative derivative instrument. Alternatively, the excess portion of the derivative instrument could be redesignated as a hedging instrument in a fair value or cash flow hedge.
16.027027
Assessing Impairment (Paragraph 27 of SFAS 133)
q16.18
To hedge the fair value exposure attributable to interest rate risk inherent in a
$1,000,000 five-year, 10 percent commercial loan, AJC enters into an interest rate swap
with the same critical terms (see Paragraph A4.04 of Appendix A to this
chapter for a discussion of critical terms for swaps) as the loan. At the end of the first
reporting period, AJC has recognized an increase in the fair value of the hedged loan
attributable to changes in interest rates and a decrease in the fair value of the interest
rate swap of $100,000 each.
Q. If, based on its impairment assessment pursuant to SFAS 114, AJC concludes that the present value of expected future cash flows discounted at the loan's effective interest rate at the inception of the loan is $950,000, how much of an impairment loss should be recognized?
A. Paragraph 27 of SFAS 133 requires that an asset designated as the hedged item in a fair value hedge remain subject to any impairment literature applicable to that type of item and be assessed after hedge accounting is applied. Accordingly, I would expect AJC to recognize an impairment loss of $150,000 which represents the carrying amount of the commercial loan ($1,100,000) less the estimated recovery ($950,000). Because the derivative hedging instrument (i.e., the interest rate swap) is recognized separately as an asset or liability, its fair value or expected cash flows would not be considered in assessing impairment.
17.028028
Cash Flow Risk Hedging Questions
Qualifying Hedge Criteria (Paragraph 28 of SFAS 133)
q17.01
Goldco sells gold watches and gold pens. Goldco does not know specifically how many units
of each will be sold in the coming months. The sales prices of these products are affected
directly by changes in the market price of gold. Assume Goldco could demonstrate that a
gold forward contract would be effective in achieving offsetting changes in cash flows
relating to all changes in sales price of the products.
Q. Would Goldco qualify for hedge accounting for the forecasted sale of the products with a gold forward contract?
a17.01
A. No. Paragraph 28(a) requires the formal documentation of the hedging relationship to be sufficiently specific so that it can determine whether the forecasted transaction has occurred. In this instance, Goldco does not know how many units of gold watches and pens will be sold and cannot easily determine whether the forecasted transaction has occurred. Thus, in order for the forecasted sale to qualify for hedge accounting, I believe Goldco must be able to estimate the number of units of each that will be sold and the estimated timing of the sales.
q17.02
Knight expects to issue a fixed-rate debt obligation three months from today. Until the
date of issuance, Knight is exposed to variability in cash flows attributable to interest
rate risk. This interest rate risk arises to the extent the fixed rate available to Knight
changes from the rate it would currently pay to the rate it will be required to pay once
the terms of the debt issuance are determined. To hedge this exposure to cash flows,
Knight enters into a forward starting interest rate swap that will require it to pay
interest at a fixed rate and receive interest at a variable rate. It plans to terminate
the swap once the debt obligation is issued.
Q. How should Knight account for the forward starting interest rate swap?
a17.02
A. Until the date of issuance of the fixed-rate debt obligation (i.e., when the interest rate on the debt obligation is determined), the forward starting interest rate swap is hedging a cash flow exposure. Thus, Knight should report all changes in the fair value of the forward starting swap attributable to the hedged risk in OCI. The amount in AOCI should be reclassified into earnings as the forecasted transaction impacts earnings (in this case, amortized over the life of the debt obligation).
Q. Can an instrument that contains an embedded written option (e.g., a swaption) qualify as a hedging instrument in a cash flow hedge?
A. Yes, in certain circumstances. SFAS 133 provides that a derivative instrument that results from combining a net written option and any other nonoption derivative instrument shall be considered a net written option. As a written swaption fits this description, the entity would need to consider the net written option criteria of Paragraph 28(c) to determine whether hedge accounting is appropriate. A swaption qualifies for cash flow hedge accounting only if the combination of the hedged item (which must be a recognized asset or liability) and the swaption (or net written option) provides at least as much potential for favorable cash flows as exposure to unfavorable cash flows. The test is met if a percentage favorable change in the underlying would provide at least as much favorable cash flows as the unfavorable cash flows that would be incurred from an unfavorable change in the underlying of the same percentage. I believe these situations will be rare for cash flow hedges.In addition, when a derivative instrument is embedded in another derivative instrument, the entire instrument must qualify for hedge accounting in order for the derivative instrument to qualify for hedge accounting. For example, an entity may not separate a compound derivative instrument into two derivative instruments such that one would qualify for hedge accounting, while the other would not.
q17.04
MFG forecasts the sale of 1,000 widgets in six months for the then market price. Widgets
currently are selling for $100 per unit. To enhance the cash proceeds from the sale of
these widgets, MFG writes a call option that gives a third party the ability to purchase
these widgets for $100 per widget. MFG receives a premium of $10,000 for writing this
option. MFG plans to use the premium to enhance the proceeds expected to be received from
the widgets or to offset any decrease in future cash inflows associated with the
forecasted sale that would occur if the market price of widgets decreases below $100. As
the intrinsic value of the written call is zero, the premium represents solely the time
value of the option.
Q. Can MFG designate the written call option as the derivative hedging instrument in the cash flow hedge of a forecasted sale of widgets?
A. No. Paragraph 28(c) prescribes the criteria for designating a written option as a hedging instrument in a cash flow hedge. One criterion for hedge accounting using a written option is that a written option only may be designated as a hedge of the variability in cash flows for a recognized asset or liability. The forecasted sale of widgets is not a recognized asset or liability. Therefore, that criterion has not been met. Another criterion is that the combination of the hedged item and the written option provides at least as much potential for favorable cash flows as exposure to unfavorable cash flows. In this circumstance, if the sales price of the widgets decreased to $50 per widget (50 percent decline in fair value) and MFG sold 1,000 widgets, it would sustain a loss in cash flows on the combination of the written option and the hedged forecasted sale of $40,000 ($50,000 loss on the forecasted sale less $10,000 premium received on the written option); however, if the sales price of the widgets increased to $150 per unit (50 percent increase in the fair value) and Company A sold 1,000 widgets, it would only realize a gain in cash flows of $10,000 ($50,000 gain on the forecasted sale plus $10,000 premium received on written option less $50,000 loss on the written option) on the combined instruments. Therefore, the criterion requiring as much potential for favorable cash flows as exposure to unfavorable cash flows has not been met.
q17.05
SWM owns 100 shares of Company B common stock. SWM is restricted from selling the common
stock for one more month but expects to sell the common stock at that time. SWM is
concerned that Company B's share price will decline in the coming month and decides to
hedge this exposure by entering into a short position in Company B's stock. To do so, SWM
borrows 100 shares of Company B from Bank X for a one-month period. SWM immediately sells
these shares in the open market at fair market value. At the end of the month, SWM
satisfies its obligation to Bank X using the 100 shares of Company B that it owns.
Q. Would SWM be permitted to designate the short position as a cash flow hedge of its investment in Company B?
A. No. Paragraph 28 of SFAS 133 generally prohibits nonderivative financial instruments from being designated as the derivative hedging instrument in a cash flow hedge. Short positions generally do not meet the definition of a derivative instrument pursuant to Paragraphs 6(b) and 8 of SFAS 133 because they require an initial investment equal to the notional amount. In this instance, SWM was required to purchase at inception of the contract 100 shares of Company B, which is the notional amount. As a consequence, this transaction would not qualify as a fair value hedge. In Paragraph 290 of SFAS 133, the Board intentionally did not address whether short sales arrangements would always (or never) meet the definition of a derivative instrument pursuant to Paragraph 6 of SFAS 133 because the terms and customs of the contracts vary. Instead, the specific terms of the contract must be evaluated to determine whether it meets SFAS 133's definition of a derivative instrument.
q17.06
Mark Co. purchased an option three months ago. Mark intends to use the option to hedge a
qualifying forecasted purchase expected to occur nine months from today.
Q. Can Mark Co. document and designate the hedging relationship today such that the hedge accounting would be applied retroactively from the date the option was purchased?
A. No. Paragraph 28 of SFAS 133 requires that the hedging relationship be formally documented at the inception of the hedge. Mark Co., therefore, may not designate and document the hedge today and retroactively qualify for hedge accounting. Mark Co., however, may formally document the existence of a qualifying hedge today and apply hedge accounting prospectively.
18.029029
Eligibility Requirements of the Forecasted Transaction (Paragraph 29 of SFAS 133)
q18.07
International Bank has a pool of variable-rate commercial mortgages. The interest rates on
these mortgages are based on U.S. Treasury, Canadian Treasury, or UK LIBOR. A historical
analysis of the movement in these rates indicates that they are highly correlated (i.e.,
their R-squared exceeds .80).
Q. Can International Bank designate the pool of variable-rate commercial mortgages as the hedged item in a cash flow hedge even though the mortgages are not based on the same index?
A. No. Paragraph 29(a) of SFAS 133 states that if the hedged transaction is a group of individual transactions, those transactions must share the same risk exposure for which they are designated as being hedged. Further, Paragraph 462 of SFAS 133 includes an example such that the Board concluded that forecasted interest payments on several variable-rate debt instruments must vary with the same index to qualify for hedge accounting with a single derivative instrument. Thus, I believe that International Bank cannot designate the pool of commercial mortgages with interest rates based on multiple indices as the hedged item in a cash flow hedge.
q18.08
Widget Inc. has always been a producer of consumer goods called Widgets. Although the CEO
recently has decided to expand its operations to include the manufacturing of equipment
used to produce widgets, the Board must approve this change in business strategy. This
change will require Widget Inc. to purchase, among other things, steel to manufacture the
equipment. It has never purchased steel in the past. Although Widget Inc. has not entered
into a firm commitment to purchase steel from Steelco, it expects a transaction to be
completed with them within six months. Steelco is one of several possible suppliers.
Widget Inc. wants to lock in the purchase price of steel.
Q. Can Widget Inc. designate the transaction as a hedged item in a cash flow hedge?
A. The answer to this question depends on specific facts and circumstances. In these circumstances, I believe Widget Inc. cannot designate the transaction as hedged item in a cash flow hedge. Paragraph 29(b) requires that forecasted transactions be probable. Paragraphs 463 - 465 of the Basis for Conclusion provides guidance on determining whether a forecasted transaction is probable. Paragraph 464 states that probable is the area within a range where the future event is likely to occur. Paragraph 463 of SFAS 133 states that the likelihood of a transaction occurring can be supported by information or evidence such as i) frequency of similar past transactions (none, in the case of Widget Inc.); ii) the financial ability and operational ability of the entity to carry out the transaction (uncertain until the Board gives their approval for the change in business strategy); the extent of loss of disruption of operations that could result if the transaction does not occur (unknown); and the likelihood that transactions with substantially different characteristics might be used to achieve the same business purpose (moderate, given that Steelco is one of several suppliers). Given the facts as described above, I believe that the transaction does not meet the probable criterion. Thus, Widget Inc. may not designate the expected steel purchase as the hedged item in a cash flow hedge.
q18.09
Mannah is a cereal producer. The primary ingredient in the Company's hottest selling
product is wheat.
Q. Can Mannah designate a wheat futures contract as a hedge of the forecasted sale of its wheat-based cereal?
A. Yes. In a hedge of a forecasted sale or purchase of a nonfinancial asset, Paragraph 29(g) requires the designated risk to be the risk of changes in the cash flows relating to all changes in the purchase price or sales price of the asset (reflecting its actual location if a physical asset). Thus, I believe that Mannah could qualify for hedge accounting if it uses a wheat futures contract to hedge the risk of changes in cash flows relating to all changes in the sales price of the wheat-based cereal. The cereal manufacturer must establish that this futures contract is highly effective at achieving offsetting changes in the cash flows of the wheat-based cereal inventory relating to all changes in the sales price of the cereal. The cereal manufacturer would be required to recognize hedge ineffectiveness to the extent that the cumulative gain or loss on the wheat futures contract does not move in tandem with the cumulative change in the expected future cash flows attributable to the forecasted sale of wheat-based cereal inventory. The cereal manufacturer, however, is precluded from designating the wheat futures contract as a cash flow hedging instrument of the wheat ingredient of its cereal.
q18.10
GCF expects to purchase an equity security three months from today. To reduce the
variability in cash flows associated with price movements in that security, GCF
simultaneously enters into a forward contract to purchase the same security. GCF wishes to
designate the forward contract as a hedge of its forecasted purchase.
Q. What methodology should GCF use for determining whether the cash flow hedging relationship is highly effective?
A. SFAS 133 does not specify a methodology that must be used to determine whether a hedging relationship is highly effective. Rather, at inception of a hedge, an entity is required to define how it will assess a hedge's effectiveness in achieving offsetting changes in cash flows attributable to the risk being hedged. Paragraph 386 of SFAS 133 outlines the Board's requirement that the methodology used be reasonable and used consistently throughout the hedge period. Paragraph 386 of SFAS 133 also requires an entity to assess effectiveness for similar hedges in a similar manner. Thus, the use of different methods for similar hedges should be justified. In addition, if an entity identifies an improved method for assessing effectiveness, it must discontinue the existing hedging relationship and designate the relationship anew using the improved method (see Paragraph A5.10 of Appendix A to this chapter.)
q18.11
Bank A designates an interest rate swap to receive interest at a fixed rate of 8 percent
and to pay interest at variable rates as a cash flow hedge of the variable-rate cash
inflows on a pool of variable-rate assets.
Q. Would Bank A be permitted to replenish the pool in instances when assets within the pool are prepaid?
A. The answer to this question depends on the specific facts and circumstances. For example, in a cash flow hedge where the hedged item is a pool of variable-rate mortgage-backed securities (MBS), the hedged item is not a specific asset. Instead, the hedged item is the pool of cash flows with particular characteristics. In this instance, Bank A's objective is to convert a pool of variable-rate MBS to a pool of 8 percent fixed-rate MBS. Therefore, if MBS in the pool prepay, Bank A could replenish the pool with similar MBS (same interest rate, term, credit quality, remaining term to maturity, etc.).
q18.12
Dee would like to acquire 10 percent of the stock of Cee, a publicly traded company three
months from now. The Company would account for its investment in Cee as a trading security
under SFAS 115. Alternatively, Dee is considering entering into a derivative instrument
three months from today whose value is indexed to the market price of Cee's common stock
(assume the derivative instrument meets the definition of a derivative instrument under
SFAS 133).
Q. Can either the forecasted acquisition of the SFAS 115 trading security or the forecasted acquisition of the derivative instrument be designated as a hedged item?
A. No. Neither item would qualify as a hedged item in a cash flow hedge. Paragraph 29(d) prohibits designating as a hedged item a forecasted acquisition of assets or liabilities that are reported in the statement of financial position at fair value with subsequent changes in fair value reported currently in earnings. As trading securities and derivative instruments are reported in the statement of financial position at fair value with subsequent changes in fair value being reported currently in earnings, I believe that neither item would qualify as a hedged item in a cash flow hedge. If, however, the SFAS 115 security was classified as an available-for-sale security, it could be designated as the hedged item in a cash flow hedge.
q18.13
On January 1, 20XI, Doe Inc. issued a 15-year, variable-rate debt obligation.
Simultaneously, Doe entered into a ten-year interest rate swap to receive interest at a
variable-rate and to pay interest at a fixed rate.
Q. Can the ten-year interest rate swap be used to hedge the variability in cash flows during the first ten years of the 15-year variable-rate debt obligation?
A. Yes. Assuming all the criteria in Paragraphs 28 and 29 of SFAS 133 are satisfied, I believe an entity would be permitted to hedge the variability in cash flows during the first ten years of a 15-year variable-rate debt obligation using a ten-year interest rate swap. Paragraph 20 of SFAS 133 permits entities to identify a specific portion of an unrecognized firm commitment as the hedged item in a fair value hedge. Although the criteria specified in Paragraph 28(a) of SFAS 133 do not address whether a portion of a single forecasted transaction may be identified as a hedged item, I believe that the portion principles discussed in the fair value hedging model also apply to forecasted transactions.
q18.14
On January 1, 20XI, Doe Inc. issued a ten-year variable-rate debt obligation.
Simultaneously, Doe entered into a 15-year interest rate swap to receive interest at a
variable-rate and to pay interest at a fixed rate.
Q. Can the first ten years of the 15-year interest rate swap be used to hedge the variability in cash flows associated with the ten-year variable-rate debt obligation?
A. No. Paragraph 18 of SFAS 133 permits entities to designate either all or a proportion of a derivative instrument as a hedging instrument, but prohibits separating a derivative instrument into components representing different risks and designating any such component as the hedging instrument. I believe separating a derivative instrument into different segments based on the timing of interest payments or receipts would result in one portion of the contract having different risks than those attributable to the entire derivative contract. Thus, I believe Doe would be precluded from hedging the variability in cash flows of the ten-year variable-rate debt obligation using the first ten years of the 15-year interest rate swap because the first ten years of the swap represents a portion of the entire derivative instrument.
q18.15
On January 1, 20X0, Doe issued a 15-year variable-rate debt obligation. On January 1,
20X5, Doe entered into a ten-year interest rate swap to receive interest at a
variable-rate and to pay interest at a fixed rate.
Q. Can the ten-year interest rate swap be used to hedge the variability in cash flows during the last ten years of the 15-year, variable-rate debt obligation (i.e., the swap is entered into at the beginning of the sixth year of the variable-rate debt obligation)?
A. Yes. Assuming all the criteria in Paragraphs 28 and 29 of SFAS 133 are satisfied, I believe an entity would be permitted to hedge the variability in cash flows during the last ten years of a 15-year variable-rate debt obligation with a swap entered into at the beginning of the sixth year of the variable-rate debt obligation.
q18.16
Jas Co. owns 50 percent of a joint venture, JV. Jas Co. uses the equity method of
accounting to account for its investment in JV. JV has a $10,000,000 LIBOR-rate debt
obligation. Jas Co. is concerned that fluctuations in LIBOR may adversely impact the
earnings of JV, and thereby impact its share of the earnings. To mitigate this risk, Jas
Co. enters into a pay-fixed, receive-LIBOR interest rate swap to lock in the cost of JV's
debt obligation.
Q. Is Jas Co. permitted to use cash flow hedge accounting for the interest rate swap used to hedge the variability in cash flows associated with JV's debt obligation?
A. No. Paragraph 29(c) of SFAS 133 requires the forecasted transaction in a cash flow hedge to be i) a transaction and ii) to present an exposure to cash flows for the hedged risk that could affect reported earnings. The impact of changes in LIBOR on Jas Co.'s income statement is not a transaction from Jas Co.'s perspective. In addition, neither Jas Co. nor any of its consolidated subsidiaries have any direct exposure to variability in cash flows attributable to its interest in the JV. Thus, I believe Jas Co. may not use cash flow hedge accounting in this instance.
q18.17
Bank A has a wholly owned trust subsidiary that has issued mandatorily redeemable
preferred securities to the public. The dividends on the preferred securities are based on
LIBOR, but may be deferred at the option of the trust subsidiary. The preferred securities
are presented as minority interest in Bank A's consolidated financial statements. Bank A
enters into a pay-fixed, receive-LIBOR interest rate swap to lock in the amount of
dividends to be paid.
Q. Is Bank A permitted to use cash flow hedge accounting for the interest rate swap used to hedge the variability in cash flows associated with the trust subsidiary's redeemable preferred securities?
A. No. Paragraph 29(f) of SFAS 133 prohibits forecasted cash flows associated with minority interest in a consolidated subsidiary from being designated as a hedged item in a cash flow hedge. Because the preferred securities are classified as minority interest, it is precluded from designating the swap as a hedge of the variability in cash flows attributable to the preferred dividends.
q18.18
LAP Co. wishes to hedge a forecasted sale of a product to a third party. The terms of the
forecasted sale are such that the sales price is fixed because the buyer has agreed to
purchase 100 units of the product for $100 on March 31, 20XI. The sales agreement does not
include any disincentive for nonperformance.
Q. Can LAP Co. hedge the future sale in a cash flow hedge?
A. No. Paragraph 29(c) of SFAS 133 requires that, in addition to being with a party external to the reporting entity, the hedged forecasted transaction in a cash flow hedge must present an exposure to variations in cash flows that could affect reported earnings. LAP Co.'s future sale of the product does not expose the entity to variations in cash flows because the sales price of the units to be sold is fixed at $100. In addition, the future sale is not a firm commitment and cannot be hedged under the fair value hedge model. If the sales price was such that it had been the market price on March 31, 20XI, the forecasted transaction would qualify for designation as a cash flow hedged item.
19.030031
Accounting for the Cash Flow Hedge (Paragraphs 30 and 31 of SFAS 133)
q19.19
Company SGP enters into a hedge of the forecasted purchase of 1,000 shares of
available-for-sale equity securities. Shortly thereafter, the hedged available-for-sale
securities appreciate in value and Company SGP reports a $1,000,000 net gain in AOCI
related to the derivative hedging instrument.
Q. When should the $1,000,000 net gain be reclassified into earnings?
A. Paragraph 31 of SFAS 133 states that the net gain in AOCI related to a forecasted transaction should be reclassified into earnings when the hedged forecasted transaction affects earnings (i.e., when the available-for-sale equity securities are sold). In addition, the amount in AOCI should be reclassified in earnings if:Paragraph 33); or
it becomes probable that the forecasted purchase of the available-for-sale equity securities will not occur (
Paragraph 35). In this circumstance, any offsetting net gain related to the transaction should be reclassified into earnings immediately. For example, if Company SGP' recorded an other-than-temporary impairment of $750,000 because of a decline in the fair value of these available-for-sale equity securities, $750,000 of the $1,000,000 gain in AOCI would be reclassified into earnings to offset the impairment loss recognized on the available-for-sale securities. there is an other-than-temporary impairment of the available-for-sale equity securities that is included in earnings (
If the other-than-temporary impairment was $750,000 and Company SGP had reported in AOCI a net loss of $1,000,000 on account of the derivative hedging instrument, in addition to recording the $750,000 impairment loss on the available-for-sale securities, Company SGP would reclassify the $1,000,000 net loss into earnings immediately as the amount is not expected to be recovered when the forecasted transaction impacts earnings.
q19.20
Company X has reported a net gain of $5,000,000 in AOCI that resulted from the hedge of a
forecasted purchase of 10,000 units of inventory. In the subsequent
year, Company X expects to sell 20,000 units of inventory.
Q. Does Company X have latitude in determining when to recognize the $5,000,000 net gain?
A. No. Similar to the accounting for the sales of inventory, I believe that Company X, as part of its formal documentation of this hedging relationship, would have to establish a cost flow assumption (e.g., LIFO, FIFO or Average Cost) for reclassifying from AOCI into earnings the net gains or losses on derivative hedging instruments.
20.034035
Discontinuance of Cash Flow Hedge Accounting (Paragraphs 34 and 35 of SFAS 133)
q20.21
On January 1, 20X1, Henry Co. purchased a call option to hedge the
forecasted purchase of 10,000 units of inventory, which is expected to occur in six months. At June 30, 20XI, a $5,000,000 gain on the call option remains in AOCI. On July 1, 20X1, Henry Co. enters into a firm
commitment to acquire the 10,000 units of inventory in six months, thereby transforming
the forecasted transaction into a firm commitment. Henry Co. elects to designate prospectively the call option to the firm commitment
(as a fair value hedge).
Q. How should Henry Co. account for $5,000,000 gain in AOCI?
a20.21
A. When the hedged forecasted transaction becomes a firm commitment, it no longer qualifies as a cash flow hedge because there is no variability in expected future cash flows. Thus, pursuant to Paragraph 32 of SFAS 133, Henry Co. would discontinue prospectively the application of cash flow hedge accounting to the forecasted transaction/call option hedging relationship. Paragraph 29 of SFAS 133 requires any gains or losses on the hedging instrument reported in AOCI to the date that the hedge is discontinued to continue to be reported in AOCI until the date the hedged forecasted transaction impacts earnings. Thus, in this circumstance, the $5,000,000 gain in AOCI would be reclassified into earnings when the hedged inventory is sold.
21.034035
Accounting for Impairment of Hedged Item (Paragraphs 34 and 35 of SFAS 133)
q21.22
During this past year, Company A hedged the forecasted purchase of 10,000 units of its
inventory. Prior to today, Company A expected to be able to sell
these units for $16,000,000. Due to a recent influx of imported
units resulting in an oversupply of units in the market, Company A now expects the sales
price for the units to erode. As of today, the following is true:
Q. Is Company A required to recognize an impairment loss at December 31, 20X1?Sales value of units $11,000,000
Cost of units $10,000,000
AOCI (Loss) $ 3,000,000
Company A expects the sales price to remain at $11,000,000 for the next six months.
A. Yes. Paragraph 31 of SFAS 133 requires that if an entity expects at any time that continued reporting of a loss in AOCI would lead to recognizing a net loss on the combined hedging instrument and hedged transaction in one or more periods, the loss currently reported in AOCI should be reclassified immediately into earnings for the amount that is not expected to be recovered. Thus, Company A would reclassify $2,000,000 of the $3,000,000 loss in AOCI because this amount is not expected to be recovered when the forecasted transaction impacts earnings (the remaining $1,000,000 loss will be recovered through futures sales).
22.037037
Foreign Currency Risk Exposure Hedging
Foreign-Currency-Denominated Firm Commitments and Fair Value Hedges (Paragraph 37 of SFAS
133)
q22.01a
Empire Inc. is a manufacturing company. Its
functional currency is the U.S. dollar. A
major component in its manufacturing process (CPUs) comes from Asia Corp., an unrelated
Japanese supplier. No other supplier has a product that meets
Empire's specifications. In order to ensure CPU availability, Empire
Inc. enters into a contract with Asia Corp. to
purchase a minimum of 1,000 CPUs each month for the next 12 months. The
cost of each CPU is 10,000 yen. There are significant penalties if
the contract is broken.
Q22.01(a).
Does Empire have a foreign-currency-denominated firm commitment that it can designate as the hedged item?
A(a). Yes. The definition of a firm commitment is set forth in Appendix F to SFAS 133. It requires that the commitment have, among other things, a fixed price and quantity, that the timing of the transaction be known, and that the agreement include a sufficiently large disincentive for nonperformance to make performance probable. The fixed price may be expressed as a specific amount of an entity's functional currency or of a foreign currency. Empire's commitment has all of these features. The fixed price has been specified in yen, a currency other than Empire's functional currency.
Q(b). Could Empire designate the hedged item as being the foreign currency exposure associated with any 500 units being acquired each month?
A(b). No. Paragraph 21(a) of SFAS 133 states that the hedged item must be all or a specific portion of a recognized asset or liability or of an unrecognized firm commitment. In this instance, Empire has not identified a specific portion as the hedged item. The proposed hedged item could be any 500 units acquired during the month. Without knowing specifically which units are being hedged, Empire cannot properly adjust the basis of those units when applying the fair value hedge accounting model.
Q(c). Could Empire hedge the foreign currency exposure associated with the first 500 units being acquired each month?
A(c). Yes. In this instance Empire has identified a specific portion of the unrecognized firm commitment and, therefore, there is no uncertainty as to which units acquired should include the effects of any accounting adjustments required under the fair value hedge accounting model.
q22.02
Liberty Inc.'s functional currency is the U.S. dollar.
Liberty pays royalties on each of the two products it sells. For
one of its products, Liberty pays Samurai Corp. royalties of 10
percent of sales revenue on all U.S. sales. The
royalty payments are made on January 15 and July 15 each year in yen at an exchange rate
agreed at the start of the fiscal year. Liberty has a very stable sales history and has consistently achieved its stated budgets. Liberty expects to make royalty payments of the yen equivalent (at the
agreed rate) of $5,000,000 on each of January 15 and July 15.
For Liberty's second product, it pays Queen PLC royalties on all Liberty sales in the United Kingdom of a product licensed from Queen. The royalties are paid in pounds sterling and equal £200,000 per quarter plus two percent of the quarterly sales revenue in excess of £5,000,000. The royalties are due 10 business days after the quarter-end. Liberty expects to pay Queen £300,000 per quarter.
In both instances, Liberty is subject to an enforceable contract with a third party and can estimate the quantity/price and timing of the payments with a high level of precision.
Q. Do the payments made pursuant to the royalty agreements meet the definition of a firm commitment?
A. The first agreement with Samurai is not a firm commitment. The definition of a firm commitment is set forth in Appendix F to SFAS 133. It requires that the commitment have, among other things, a fixed price and quantity to be exchanged. The royalty payments due under this contract depend solely on sales levels. Those sales levels are not determinable in advance and the royalty agreement does not include contractual minimums. Therefore, the fixed price and quantity requirements for a firm commitment have not been satisfied. This contract may, however, qualify as a designated item in a cash flow hedge because the anticipated payments due under the contract may qualify as forecasted transactions.
The second arrangement with Queen is a firm commitment because there is a £200,000 minimum contractual payment. That amount is not variable and is due to Queen regardless of the level of sale revenues. The remaining amounts (i.e. any royalty payable over £200,000) should be considered in the same manner as the agreement with Samurai.
q22.03
ABC is a manufacturing company. Its functional currency is the U.S. dollar. ABC has entered into a contract with a
foreign customer to sell them 10,000 units of product each month. The
price of the product is denominated in a foreign currency and is determined as the market
price on the date of shipment. There are significant economic
penalties resulting from breaking the contract.
Historically, the price of the product has ranged from FC80 to FC90 per unit. ABC wishes to hedge the currency exposure as a hedge of a firm commitment and has proposed hedging the first FC50 on each of its fixed quantity of units to be sold. ABC contends that sales below FC50 per unit are remote, therefore, effectively, at least this amount (FC500,000) is fixed.
Q. Could ABC designate the first FC50 on each unit sold as the hedged item in a fair value hedge?
A. No. The definition of a firm commitment set forth in Appendix F to SFAS 133 states, among other things, that there must be a fixed price. In this instance, the price is the market price at the time of shipment and therefore it is not fixed until the time of shipment. However, the transaction could be structured as a cash flow hedge if ABC's transaction met the requirements for a forecasted transaction. This likely would be the case if ABC designated, say, the first 5,900 units of product to be shipped as the hedged item. Based on a forecasted price of FC85 per unit, the foreign currency hedge would cover sales of FC501,500. To be able to designate the forecasted sales as the hedged item in a cash flow hedge, ABC should be able to accurately estimate the expected currency amount of the sales. Given stable prices in the past and no expectation for significant change in the future, ABC would be able to specify the exact amount of foreign currency being hedged.
q22.04
ERM Inc. is a manufacturing company. Its
functional currency is the U.S. dollar. A
major component of ERM’s manufacturing process (CPUs) is purchased from Asia Corp.,
an unrelated Japanese supplier. CPUs are readily available from a
number of suppliers and there is little cost associated with switching suppliers. In order to ensure CPU availability, ERM has signed a letter of intent
with Asia Corp. that specifies its likely CPU requirements. The letter of intent includes a fixed price.
Q. Does ERM have a foreign-currency-denominated firm commitment that it can designate as the hedged item?
A. No. The definition of a firm commitment set forth in Appendix F to SFAS 133 states, among other things, that the agreement must include a disincentive for nonperformance that is sufficiently large to make performance probable. ERM does not have a binding agreement and there is not a sufficiently large economic disincentive restricting ERM from changing suppliers.
23.040040
Forecasted Foreign-Currency-Denominated Transactions and Cash Flow Hedges (Paragraph
40 of SFAS 133)
q23.05
ABC's functional currency is the U.S. dollar. ABC
owns 1,000 shares of common stock of DMM, which it classifies as available for sale under
SFAS 115. DMM stock is listed on a foreign stock exchange and does
not trade on any exchanges or markets where trades are executed in U.S. dollars.
Historically, DMM has paid a semi-annual dividend of FC1 a share on July 15th and January 15th of each year. When announcing its results for the six months ended June 30, 20X0, DMM stated that it expects to maintain future dividends at historical rates.
Q. Can ABC designate the expected future dividend income from its investment in DMM as the hedged item in a cash flow hedge?
A. Yes. The forecasted dividend income can be designated as the hedged item in a cash flow hedge. Paragraph 29(d) prohibits a forecasted transaction from being designated as a hedged item if it relates to a recognized asset that is remeasured to fair value with changes in fair value attributable to the hedged risk reported currently in earnings. In the instant case, although the available-for-sale securities are recognized in the statement of financial position at fair value, any changes in that value are recognized in OCI, rather than currently through earnings. Thus, I believe the foreign currency exposure inherent in the forecasted dividend income from DMM may be designated as a hedged item.
q23.06a
XYZ has forecasted an acquisition of a pound sterling debt security with a three-year
maturity. The debt security entitles XYZ to receive interest at a
fixed rate of 8 percent.
Q(a). If XYZ classifies this debt security as held to maturity under SFAS 115, can the foreign currency exposure inherent in the forecasted acquisition of the debt security be designated as the hedged item in a cash flow hedge?
a23.06a
A(a). No. Paragraph 36 prohibits a forecasted acquisition of an asset that will be remeasured at fair value with changes in fair value attributable to the hedged risk being recognized currently through earnings from being designated as a hedged item. A foreign-currency-denominated held-to-maturity debt security is accounted for in this manner and, therefore, the foreign currency exposure inherent in XYZ’s forecasted acquisition cannot be designated as the hedged item in a cash flow hedge.
Q(b). If XYZ intends to classify this debt security in the available-for-sale category after acquisition can the foreign currency exposure inherent in the forecasted acquisition of the debt security be designated as the hedged item in a cash flow hedge?
A(b). Yes. Paragraph 36 prohibits a forecasted acquisition of an asset that will be remeasured at fair value with changes in fair value attributable to the hedged risk being hedged recognized currently through earnings from being designated as a hedged item. If the security will be held in the available-for-sale category under SFAS 115 the currency risk inherent in the security may be hedged because future changes in fair value of the security attributable to exchange rate movements will be recorded through OCI (rather than earnings).
Q(c). If, subsequent to acquisition, the security is classified in the available-for-sale category and is the hedged item in a fair value hedge of foreign currency exposure, can XYZ hedge the interest rate risk associated with future interest receipts?
A(c). Yes. Paragraph 21(f) of SFAS 133 permits more than one risk to be hedged if the appropriate criteria are met and the risk of changes in the entire fair value is not one of the designated risks being hedged.
24.040040
Intercompany Cash Flow Hedging Transactions (Paragraph 40 of SFAS 133)
q24.07
Q. Parent's functional currency is the U.S. dollar. ABC is a subsidiary of Parent. ABC's functional currency is the FC. ABC intends
to declare dividends of FC100,000 to Parent. Can Parent hedge the
exchange risk associated with the future cash flow?
A. No. Paragraph 485 of the Basis for Conclusions states that intercompany dividends do not affect earnings; therefore, a forecasted intercompany dividend cannot qualify as a hedgeable forecasted transaction.
q24.08
Foreign subsidiary ABC has a forecasted foreign-currency-denominated transaction it wishes
to designate as the hedged item in a cash flow hedge. ABC does not
have any treasury function or significant banking relationships. Parent
wishes to hedge the exposure on the subsidiary's behalf.
Q. Can Parent hedge the foreign currency cash flow exposure related to the forecasted foreign-currency-denominated transaction on ABC's behalf?
A. No. Paragraph 40(a) of SFAS 133 requires that the entity that has the foreign currency exposure (in this case ABC) be a party to the hedging instrument. However, ABC could enter into a hedging transaction with either Parent or a third party. If ABC were to enter into a derivative hedging instrument with Parent, ABC could use hedge accounting in its stand-alone financial statements because it entered into a derivative hedging instrument with a party external to the reporting entity. Pursuant to Paragraph 36 of SFAS 133, to qualify for cash flow hedge accounting at the consolidated level, Parent must offset the risk acquired through the intercompany derivative contract by entering into an offsetting contract with an unrelated party. (¶¶471 and 487)
q24.09a
Finance Co.'s functional currency is the U.S. dollar.
It acts as the central treasury function for all entities within its consolidated
group, including Bath Co. and Tokyo Co. Bath's
functional currency is the pound sterling (£). Tokyo's functional
currency is the yen.
Bath has a forecasted transaction in which it expects to receive U.S.$100 in three months. To hedge this exposure it enters into a foreign currency forward contract with Finance to sell U.S.$100 and buy £75 in three months. Tokyo has a forecasted transaction in which it will pay U.S.$100 in three months. To hedge its exposure, it enters into a foreign currency forward contract with Finance to buy U.S.$100 and sell 10,000 yen in three months.
As a result of these intercompany derivative contracts, Finance has a net position to buy £75 and sell Yen 10,000 in three months and therefore has an exposure to both fluctuations in the U.S.$/£ exchange rate and the U.S.$/yen exchange rate. Finance offsets these two exposures by entering into a foreign currency forward contract with Bank A, an unrelated third party, to sell £75 and buy 10,000 yen in three months.
Q(a). Can Bath and Tokyo apply cash flow hedge accounting in their stand-alone financial statements?
A(a). Yes. SFAS 133 requires that to qualify for cash flow hedge accounting the operating unit that has the foreign currency exposure must be a party to the hedging transaction. Paragraph 41(a) of SFAS 133 clarifies that a derivative instrument used in a cash flow hedge may be between a parent and its subsidiary. On a stand-alone basis, both Bath and Tokyo have entered into a derivative instrument which will be effective in hedging their foreign currency cash flow exposure. (¶¶471 and 487)
Q(b). Can Finance apply hedge accounting in its stand-alone financial statements?
A(b). No. The risks acquired from the subsidiaries by Finance were acquired in the form of derivative instruments. The Board does not permit items that are recorded at fair value (or spot rates for recognized assets and liabilities) with their changes in fair value (spot value) recognized currently through earnings to be designated as hedged items. The derivative contracts entered into by Finance with Bath and Tokyo will be remeasured at fair value through earnings. Thus, they cannot be designated as hedged items. The derivative contract entered into with Bank A to offset the risks acquired in the derivative contracts with the subsidiaries will be accounted for as speculative (i.e., mark-to-market). The changes in the fair value of all three of these derivative contracts will offset in earnings.
Q(c). Can the consolidated group apply cash flow hedge accounting?
A(c). No. When considering whether the derivative instrument and hedged item qualify for hedge accounting in consolidation, it is necessary to look through the intercompany derivative transaction and consider Finance's derivative contract with Bank A and the two foreign currency exposures at the subsidiary level. The consolidated group has two foreign currency exposures and chose to "hedge" them using only one "hedging" derivative instrument. In these circumstances, to qualify as a hedged item, the two foreign currency exposures at the subsidiary level must be hedged as a group. Paragraph 29(a) of SFAS 133 requires that individual transactions included in a group (i.e., the exposures at the subsidiary level) must share the same risk exposure in order to qualify as a hedged item. On a consolidated basis, the risks being hedged are a U.S.$/£ risk and a U.S.$/yen risk. These are not the same and, therefore, cannot be grouped together as a hedged item.
Additionally, Paragraph 40(d) of SFAS 133 specifically states that if the hedged transaction is a group of individual forecasted foreign-currency-denominated transactions, a forecasted inflow of foreign currency and a forecasted outflow of foreign currency cannot be included in the same group. In this instance, the risks being hedged are a forecasted inflow of U.S. dollars in a £ environment and a forecasted outflow of U.S. dollars in a yen environment.
q24.10
Same facts as example 9, except that Finance wishes to hedge the two foreign currency
exposures individually. Finance considers two scenarios:
a) Finance enters into a single foreign currency forward contract with Bank A, an unrelated third party, to sell £75 and buy 10,000 yen in three months and designates one leg of the forward contract against the exposure acquired from Bath and the other against the exposure acquired from Tokyo.
b) Finance enters into two foreign currency forward contracts with Bank A. The first is to buy U.S.$100 and sell £75 in three months and the second is to sell U.S. $100 and buy 10,000 yen in three months. The contracts are individually designated as hedges of the foreign currency exposures acquired from Bath and Tokyo.
Q. Will either of these scenarios permit hedge accounting to be adopted in the consolidated financial statements?
A. As in question 9, when considering whether the derivative instrument and hedged item qualify for hedge accounting in consolidation, it is necessary to look through the intercompany derivative transaction and consider Finance's derivative contract with Bank A and the two foreign currency exposures at the subsidiary level.Scenario a) would not result in hedge accounting in the consolidated financial statements. Paragraph 18 of SFAS 133 requires that either "all or a proportion" of a derivative instrument be designated as the hedging instrument. It prohibits separating a derivative instrument into components representing different risks and designating those components as a hedge. Thus, in this case, Finance would be prohibited from using hedge accounting because it cannot split the £/yen forward contract into two components and designate each component as a hedging instrument in cash flow hedges of different transactions.
Scenario b) would result in hedge accounting in the consolidated financial statements. Finance has specifically offset, in a contract with an unrelated third party, each of the exposures it acquired through the intercompany derivative contracts. Therefore, on a consolidated basis, the original exposures have been hedged in accordance with the provisions of Paragraph 36 of SFAS 133 and hedge accounting is permitted in consolidation.
25.042042
Hedging a Net Investment in a Foreign Operation (Paragraph 42 of SFAS 133)
q25.11
Investor Inc.'s functional currency is the U.S. dollar.
Investor anticipates acquiring a 35 percent equity interest in a Korean car
manufacturer. Investor Inc. has signed a
purchase contract and has publicly announced the terms of the acquisition, which include a
fixed price of 10 billion Korean won. The expected consummation date
is July 1, 20X0. Post acquisition, Investor plans on accounting for
the investment using the equity method of accounting.
Q. Can Investor Inc. enter into a derivative contract and designate it as the hedging instrument in a cash flow hedge of the U.S.$ value of its investment?
A. No. Paragraph 29(f)(3) of SFAS 133 prohibits cash flow hedges relating to investments accounted for by the equity method. Because Investor will account for the investment using the equity method it cannot designate the forecasted transaction as the hedged item in a cash flow hedge.
q25.12
Same facts as example 11 above except that Investor Inc. wishes, at
consummation, to hedge its recognized 10 billion Korean won investment, as well as the
forecasted 500 million won net income forecasted to be earned over the next six months. Investor Inc. believes that the hedge of net
income will provide stability in earnings in its U.S. dollar
consolidated financial statements.
Q.
Can Investor designate the investment and the future net income as the hedged item in a foreign-currency hedge?
A. Investor may designate the recognized net investment as a hedged item. Paragraph 42 permits hedging an existing net investment in a foreign operation with either a derivative financial instrument or a nonderivative financial instrument. Therefore, at consummation, Investor may hedge the recognized W billion Korean won investment. Investor cannot designate the forecasted net income as a hedged item. Paragraph 485 of the Basis for Conclusions states that hedges of future earnings are not permitted. The prohibition exists because net income represents the netting of many dissimilar transactions, rather than a series of individual but similar transactions sharing the same risk exposure (see Paragraph 40(d)). Therefore, the expected future net income of 500 million won, although it may be accurately estimable and probable, is not eligible to be designated as a hedged item. Moreover, Paragraph 29(f) of SFAS 133 prohibits a forecasted dividend involving an equity-method investment from being designated as a hedged item.
q25.13
Parent's functional currency is the U.S. dollar. Parent
has a UK subsidiary and its functional currency is the pound sterling (£).
Parent issues a debt obligation denominated in £ and uses the proceeds to finance
its U.S. operations.
Q.
Can Parent designate the £ debt obligation payable to third parties as a hedge of the net investment in the UK operation?
A. Yes. Paragraph 42 of SFAS 133 permits a nonderivative financial instrument to be used as the hedging instrument in a hedge of a net investment in a foreign operation.
26.018018
Compound Derivative Instruments (Paragraph 18 of SFAS 133)
q26.14a
Miami Inc.'s functional currency is the U.S. dollar. Miami
intends to issue a Swiss franc 10,000,000 (SWF) debt obligation. The
debt obligation will have a term of five years. The debt obligation
requires Miami to pay interest semi-annually at a variable interest rate equal to LIBOR.
Miami prefers a fixed interest rate over a variable interest rate. It also prefers U.S. dollar-denominated debt obligations over debt obligations denominated in foreign currencies. Concurrent with issuing the debt obligation, Miami intends to enter into a foreign currency interest rate swap. The swap contract requires Miami to lend SWF10,000,000 to Bank A (on which it will receive a variable rate of interest equal to LIBOR) and to borrow $20,000,000 from Bank A (on which it will pay a fixed interest rate of 6 percent). The payment terms and maturity of the foreign currency interest rate swap match the SWF debt obligation.
Q(a). Can the foreign currency interest rate swap be designated as a hedging instrument to hedge foreign currency exposures arising from the SWF debt obligation?
A. No. The SWF debt obligation is a liability that will be remeasured at spot exchange rates with changes in its value attributable to movements in spot rates being recognized currently through earnings (i.e., the debt obligation gives rise to foreign currency transaction gains and losses under SFAS 52). Paragraph 36 specifically prohibits transactions that result in such assets and liabilities from being designated as hedged items. However, Miami could get a partial earnings offset by entering into a separate interest rate hedging instrument and a foreign currency derivative instrument. The debt obligation and the foreign-currency derivative instrument will be remeasured for changes in exchange rates (using spot and forward rates, respectively), and although the remeasurement basis is different, there likely will be a significant degree of foreign currency gains and losses offset in earnings.q26.14b
Q(b). Can the foreign currency interest rate swap be designated as a hedging instrument to hedge the variable-rate interest exposure arising from the SWF debt obligation?
A. No. As noted previously, the foreign currency interest rate swap cannot be used to hedge the foreign currency exposure inherent in the SWF debt obligation. Therefore, in order to use the swap as a hedge of just the interest rate exposures, it would be necessary to separate the swap into components. Those components would be the foreign currency component and the interest rate component. One component (the interest rate component) would then be designated as a hedging instrument. Paragraph 18 of SFAS 133 prohibits separating derivatives into components representing different risks and designating the components as hedging instruments.
Q(c). Can Miami designate the entire foreign currency interest rate swap as the hedging instrument to hedge both the foreign currency exposure and the interest rate exposure?
a26.14c
A(c). No. The SWF debt obligation does not qualify as a hedged item and the foreign currency interest rate swap cannot be separated into components representing different risks and have the components designated as hedging instruments.
q26.15a
Rose Inc's functional currency is the U.S. dollar. Rose
intends to issue a Swiss franc 10,000,000 (SWF) debt obligation. The
debt obligation will have a term of five years. The debt obligation requires Rose to pay
interest semi-annually at a variable interest rate equal to LIBOR.
Rose prefers a fixed interest rate over a variable interest rate. It also prefers U.S. dollar-denominated debt obligations over debt obligations denominated in foreign currencies. Concurrent with issuing the debt obligation, Rose intends to enter into a five-year interest rate swap with a notional amount of SWF10,000,000 to receive interest at a variable rate equal to LIBOR and to pay interest at a fixed interest rate of 6 percent. In a separate transaction, it will also enter into a forward contract to offset any changes in the U.S. dollar value of the SWF obligation.
Q(a). Will the interest rate swap qualify as a derivative hedging instrument in a cash flow hedge of the variable cash flows resulting from the variable-rate SWF debt obligation?
A(a). Yes. The SWF debt obligation will not be remeasured to fair value for changes in interest rates and, therefore, cash flows of the debt obligation presenting an interest rate exposure may qualify as a hedged item. In this instance the interest rate swap is denominated in the same currency as the debt obligation, therefore, there is no need to separate the derivative instrument into components (the previous example illustrates that the separation of a compound derivative would preclude hedge accounting).q26.15b
Q(b). Will the foreign currency forward contract qualify as a hedging instrument in a fair value hedge of the SWF debt obligation?
A(b). No. Paragraph 36 of SFAS 133 prohibits assets or liabilities that are, or will be, remeasured at spot exchange rates with changes in its value attributable to movements in spot rates being recognized currently through earnings, from qualifying as hedged items in a fair value or cash flow hedge.Therefore, Rose also would account for the forward contract at fair value (based on changes in the forward rate) with changes in fair value recognized through earnings. Rose will remeasure the SWF debt obligation at spot exchange rates with any change in carrying value from the previous remeasurement being recognized through earnings. Although, the forward contract and the debt obligation are being remeasured on different bases (fair value versus spot rates) there likely will be a degree of offset in earnings.
27.018018
Combination Options (Paragraph 18 of SFAS 133)
q27.16
Ryan Inc’s functional currency is the U.S. dollar.
Ryan has entered into a forecasted transaction to acquire inventory from Australia. The purchase price is denominated in Australian dollars (A$). Ryan wishes to hedge its exposure to foreign currency risk arising from
changes in the U.S. dollar/A$ exchange rate.
Ryan entered into a combination option whereby it purchased a call option to buy the A$ and at the same time sold (wrote) a put option against the AS. The strike prices are different, however, all other terms are the same. The exchange risk associated with the forecasted transactions could have been hedged with just the purchased calls, however, Ryan decided to write the put options in order to receive an option premium that would offset the option premium paid when purchasing the call options. There is a net zero premium on the combined options.
Q. Can Ryan designate the option contracts as the hedging instrument in a cash flow hedge of the forecasted inventory acquisition?
A. Yes. The special rules for using written options as a hedging instrument in a cash flow hedge as set forth in Paragraph 28(c) of SFAS 133 (which refers to Paragraph 20(c)), allow combination options to be designated as a hedging instrument unless either at inception or over the life of the contracts a net premium is received in cash or as a favorable rate or other term. In this instance, Ryan's combination of option contracts results in a zero net premium and no other favorable terms, therefore, the specific written option test in Paragraph 28(c) does not apply.
28.000000
FASB Financial Statement Disclosure Questions
Disclosure --- Income Statement
q28.01
When a cash flow hedge is discontinued because it is probable that the original hedged
forecasted transaction will not occur, Paragraph 32 of SFAS 133 requires the related net
gain or loss in AOCI to be reclassified immediately into earnings. Similarly, when a
hedged firm commitment no longer qualifies as a fair value hedge because it no longer
meets the definition of a firm commitment, Paragraph 26 of SFAS 133 requires the firm
commitment asset or liability to be derecognized and a corresponding loss or gain to be
recognized currently in earnings.
Q. Where should reclassified net gains or losses, and gains or losses on dereconized firm commitment assets or liabilities, be presented in the income statement? Can the gain or loss on the derecognized firm commitment be presented as an extraordinary item given the Board's belief that the circumstances under which derecognition would occur are rare?
a28.01
A. SFAS 133 requires that the reclassified net gains or losses and the gains or losses on derecognized firm commitments be disclosed, but it is silent on the issue of where the information should be presented.I believe net gains or losses arising in these circumstances should be presented as part of operating income because these amounts arise in the normal course of an entity's operations. Further, I believe that gains or losses recognized in earnings when a hedged firm commitment no longer qualifies as a firm commitment also should be presented as part of operating income. Although the Board has stated that it believes that the derecognition of a firm commitment will be rare, I believe the gain or loss does not meet the provisions of APB 30. Reporting the Results of Operations - Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions, and as such, should not be presented as an extraordinary item.
q28.02
Q. Where should changes in the fair
value (i.e., the gains and losses) of a nonhedging derivative instrument be presented in
the income statement (i.e., should they be presented as part of operating income (loss) or
no, operating/other income (expense))?
A. SFAS 133 does not prescribe where gains and losses on nonhedging derivative instruments should be presented in the income statement. To the extent that nonhedging derivative activities are part of the normal operations of the entity, I believe these gains and losses are generally best included in operating income, for example, as part of "trading activities."If, however, the nonhedging derivative activities are ancillary to an entity's operations, I believe the gains and losses on nonhedging derivative instruments may be presented in nonoperating income (loss).
29.000000
Disclosure --- Statement of Financial Position
q29.03
Q. For statement of financial position presentation purposes,
may an entity report on a net basis the aggregate fair value of all derivative
instruments?
a29.03
A. No. SFAS 133 has not changed the statement of financial position offsetting provisions for assets and liabilities as provided in APB Opinion No. 10, Omnibus Opinion - 1966, and FIN 39. Paragraph 8 of FIN 39 states that "unless [a right of setoff] exists, the fair value of contracts in a loss position should not be offset against the fair value of contracts in a gain position." Therefore, I believe derivative instrument assets and liabilities should not be offset unless the FIN 39 provisions have been met.
q29.04
Paragraph 12 of SFAS 133 requires certain embedded derivative instruments to be separated
from the host contract and accounted for as derivative instruments pursuant to SFAS 133.
Q. Must embedded derivative instruments be presented separately from the host contract in the statement of financial position?
a29.04
A. SFAS 133 does not specifically address the issue of whether the embedded derivative instrument is to be displayed separately from the host contract in the statement of financial instrument position.I expect that most entities will follow the legal form of the instrument to display the embedded derivative instrument such that the carrying amount of the hybrid instrument will reflect the aggregate carrying amount of the host contract (as determined by the accounting standards applicable to instruments of that type) and the fair value of the embedded derivative instrument. An alternative is to present the embedded derivative instrument separately from the host contract. Regardless of the presentation alternative chosen, the policy should be disclosed in the notes to the financial instrument statements.
30.000000
Disclosure --- Statement of Cash Flows
q29.05
Q. How should cash receipts and
payments arising from derivative activities be classified in the statement of cash flows?
a29.05
A. SFAS 133 is silent on this issue. I believe that the cash flows arising from derivative hedging instruments generally would be classified in the same category as the cash flows from the hedged item.Most derivative instruments are entered into with the objective that they be used to manage the risks attributable to an entity's operating activities (e.g., foreign currency options acquired to fix the price of a nondomestic input or pay-fixed, receive-floating interest rate swap to fix an expense stream). These types of activities are consistent with operating activities as described in Paragraphs 22 and 23 of FASB Statement No. 95, Statement of Cash Flows (SFAS 95).
To the extent that derivative instruments are used to managed the price risk attributable to purchases or sales of capital assets (e.g., property, plant, and equipment), the activities are consistent with investing activities as described in Paragraphs 15 to 17 of SFAS 95.
To the extent that derivative instruments are used to manage the price risk attributable to the issuance or purchase of nonderivative financial instruments (e.g., issuance of a fixed-rate debt obligation), the activities are consistent with financing activities as described in Paragraphs 18 to 20 of SFAS 95.
For cash flows associated with the issuance or purchase of nonhedging derivative instruments, I believe the guidance found in Paragraph 8 of SFAS 102 is applicable such that "cash receipts and cash payments resulting from purchases and sales of securities and other assets shall be classified as operating cash flows if those assets are acquired specifically for resale and are carried at market value in a trading account."
Changes in the fair value of derivative instruments that do not result in cash receipts or payments in the period of change are eliminated to determine cash from operating activities.
q29.06
Q. Can derivative instruments be considered cash equivalents for purposes of presentation in the statement of cash flows?
a29.06
A. No. SFAS 133 did not change the requirements of SFAS 95. I believe that the nature of derivative instruments is such that even if their original maturity is of three months or less, they are exposed to more than "an insignificant risk of change in value" and as such fail to meet the criterion listed in Paragraph 8(b) of SFAS 95. Accordingly, I believe that derivative instruments should not be considered cash equivalents for purposes of presentation in the statement of cash flows.
31.000000
Disclosure --- Interim Reporting
q31.07
Q. Must the qualitative
disclosures required by Paragraph 44 of SFAS 133 be included in interim period
information? Must the quantitative disclosures required by Paragraph 45 of SFAS 133 be
included in interim period information?
a31.07
A. No. The minimum disclosure requirements for summarized interim financial information issued by publicly traded entities are established by APB Opinion No. 28, Interim Financial Reporting (APB 28). SFAS 133 did not amend APB 28, therefore, qualitative information about derivative instruments and hedging activities need not be included in interim period information.Further, Paragraph 45 states that SFAS 133's quantitative disclosures are required only for complete sets of financial statements. Accordingly, interim period information that is not part of a complete set of financial statements is not required to include such disclosures (e.g., information contained in a Form 10-Q is not required to include the disclosures). The disclosures are required to be made in all complete sets of financial statements for interim periods (e.g., in conjunction with a securities registration statement).
SEC registrants should be aware that when a registrant adopts a standard in an interim period, the SEC staff requires the financial statements in that interim period to include all disclosures identified by the adopted standard, including those disclosures required only in annual financial statements.
32.000000
Disclosure --- General
q32.08
Q. Must an entity separately disclose
by hedged risk the net gains or losses arising from derivative instruments
designated as hedging instruments?
a32.08
A. No. Paragraph 45 of SFAS 133 requires the aggregate net gain or loss by type of hedge (i. e., fair value or cash flow) to be disclosed. Although net gains and losses arising in a fair value or cash flow hedge may be attributable to different risks (e.g., foreign currency risk, interest rate risk, risk of changes in creditworthiness, etc.), SFAS 133 does not include a requirement to present the net gain or loss categorized by hedged risk. Information by category of market risk exposure, however, is required by the SEC market risk disclosure rules and encouraged to be disclosed by SFAS 107, as amended by SFAS 133.
q32.09
Paragraph 45(b)(2) requires disclosure of the estimated net amount of existing gains or
losses reported in AOCI at the reporting date that is expected to be reclassified into
earnings within the next 12 months.
Q. Must the entity separately disclose the nature of the expected income statement impact (e.g., $X will be charged as depreciation expense and $X will be included in net interest expense)? Must this disclosure be updated in the financial statements of subsequent interim periods?
a32.09
A. There is no requirement to separately disclose the nature of the expected financial statement impact of estimated net amounts that will be reclassified into earnings within the next 12 months. Further, there is no requirement to update the disclosure in the financial statements of subsequent interim periods.
33.0000
SEC Financial Statement Disclosure Questions
SEC Rule --- Disclosure Scope
q33.10
Q. Are "small business issuer" that are banks or
thrifts, or otherwise have control over a nonpublic depository institution, subject to the
market risk disclosure requirements?
a33.10
A. No. Small business issuers, regardless of the nature of their operations, are not subject to the market risk disclosure requirements. This is true regardless of whether they use the Small Business forms to file their annual disclosure. However, they are subject to the enhanced accounting policy requirements.
q33.11
A Bank has a consolidated finance subsidiary trust. The Trust issued mandatorily
redeemable fixed-rate cumulative preferred shares to the public and invested the proceeds
from the issuance of the preferred shares in debt instruments of the Bank. The debt
instruments of the Bank are the Trust's only assets.
Q. Is the Bank required to provide Item 305 of Reg. S-K quantitative and qualitative market risk disclosures about the preferred shares?
A. I believe inclusion of the preferred shares in the quantitative and qualitative market risk disclosures is dependent on the Bank's presentation of the preferred shares in its consolidated financial statements. Item 305 of Reg. S-K is applicable to derivative and other financial instruments and derivative commodity instruments. Under Item 305, the term financial instruments has the same meaning as defined in SFAS 107. As such, Item 305 is applicable to, among other things, debt obligations, but excludes minority interests in consolidated enterprises. I believe if the preferred shares are presented as a debt obligation, the quantitative and qualitative market risk disclosures should include information about the preferred shares. However, if the preferred shares are presented as minority interests in the Bank's consolidated financial statements, I believe the preferred shares would be excluded from the scope of the Item 305 quantitative and qualitative market risk disclosure requirements because minority interests in consolidated enterprises are excluded from the SFAS 107 definition of a financial instrument.
q33.12
Q. If an entity sells a portfolio of
financial assets, such as credit card receivables, and retains the servicing rights, must
it include the sold credit card receivables in its market risk disclosures?
a33.12
A. No. If the securitization was accounted for as a sale under SFAS 125, the entity is not exposed to market risk associated with the credit card receivables after the sale. It may be exposed, however, to market risk to the extent of any retained financial instruments that fall with the scope of SFAS 107 are received as consideration in the sale.
q33.13
A registrant has an unconsolidated subsidiary (i.e., control is temporary).
Q. Is the registrant required to provide market risk disclosures about the market risk sensitive instruments held by the subsidiary?
a33.13
A. The scope of the market risk disclosures is based, in part, on the scope of SFAS 107. SFAS 107 does not apply to investments accounted for using the equity method of accounting. Because the equity method of accounting is used for an unconsolidated subsidiary, I do not believe that the market risk rule applies to market risk sensitive instruments held by unconsolidated entities in the SEC forms filed by the registrant.
q33.14
Item 3(c)(ii) of General Instructions to Paragraphs 305(a) and 305(b) permits the
exclusion of "trade accounts receivable and trade payables" from the definition
of "other financial instruments" when "their carrying amounts approximate
fair value."
Q. Can other short-term financial assets and liabilities with carrying amounts that approximate fair value be ignored for purposes of the SEC Rule?
A. No. I believe that short-term financial assets and liabilities other than trade accounts receivable and trade payables are subject to the SEC Rule regardless of whether their carrying amounts approximate fair value. This conclusion is based on the specificity of the exclusionary language.
34.000000
SEC Rule Sensitivity Analysis
q34.15
Q. In what circumstances should an entity consider a greater
than 10 percent change in end of period market rates or prices in calculating sensitivity
analysis disclosures?
Q. May a registrant calculate sensitivity analysis or value at risk disclosures on a net basis by taking into consideration anticipated transactions that are being hedged currently by market risk sensitive instruments?a34.15
A. Item 3.A of Instructions to Paragraph 305(a) states that "registrants should select hypothetical changes in market rates or prices that are expected to reasonably reflect reasonably possible near-term changes in those rates or prices. In this regard, absent economic justification for the selection of a different amount, registrants should use changes that are not less than 10 percent of end of the period market rates or prices" (emphasis added). I believe that, absent specific evidence to the contrary, the minimum hypothetical change in rates or prices to be selected should be the greater of i) 10 percent or ii) the actual change in the rates or prices experienced during the prior 12-month period. I believe the actual change experienced over the last year generally "reflects reasonably possible near-term changes in those rates prices."
A. Yes. Item 4 of General Instructions to Paragraphs 305(a) and 305(b) permits registrants to voluntarily include other market risk sensitive instruments, positions, and transactions within their quantitative disclosures about market risk under the sensitivity analysis or value at risk disclosure alternatives.
35.049049
Effective Date and Transition
Transition --- Exception for Available-for-Sale Securities (Paragraph 49 of SFAS 133)
q35.01
An entity is hedging the market value changes of a fixed-rate bond, classified as
available-for-sale, with a futures contract (i.e., a fair value type hedge). At adoption
of SFAS 133, the entity has recorded in AOCI an unrealized gain of $350 related to the
fixed-rate bond, and an unrealized loss of ($345) related to the futures contract. The
transition provision of Paragraph 52(b) of SFAS 133 requires the entity to recognize in
net income all of the ($345) loss related to the futures contract but only $345 of the
unrealized gain related to the fixed-rate bond (i.e., to the extent of an offsetting
adjustment for the derivative hedging instrument).
Q. Subsequent to adoption of SFAS 133, how should the entity account for the unrealized gain of $5 that remains in AOCI?
a35.01
A. The $5 should be accumulated with the entity's other non-hedged activities in AOCI and remain in AOCI until realized (i.e., through the sale or maturity of the fixed-rate bond).
36.049049
Transition --- SFAS 115 Securities (Paragraph 49 of SFAS 133)
a36.02
A. Generally, no. The provisions of Paragraphs 54 and 55 of SFAS 133 allow entities, at adoption of SFAS 133, to transfer securities into the trading category, however, SFAS 133 is silent with respect to transfers out of the trading category. Paragraph 15 of SFAS 115 prescribes that, given the nature of a trading security, transfers to or from the trading category should be rare. Practice has interpreted the word rare to be almost never. Therefore, I believe entities generally should not transfer securities from the trading category into the available-for-sale or held-to-maturity categories.
q36.03
Paragraph 54 of SFAS 133 permits an entity to transfer any held-to-maturity securities
into the available-for-sale category or the trading category without calling into question
an entity's intent to hold other debt securities to maturity in the future.
Q. May an entity sell the securities that were transferred out of the held-to-maturity category into the available-for-sale category, as permitted by Paragraph 54 of SFAS 133, within a short period of time after adopting SFAS 133?
a36.03
A. Yes. The SEC staff has indicated that an entity may sell such securities any time after the transfer is made upon adoption of SFAS 133. However, if the gain or loss resulting from sales of such securities occur within approximately 90 days of adopting SFAS 133, that gain or loss must be reported as a transition adjustment recorded in earnings (see Paragraph 52.01 of this chapter for "Reporting Transition Adjustments").
q36.04
Q.
A. No. Entities that want to early adopt Paragraph 54 of SFAS 133 must be prepared to implement the entire Standard at that time.