Qualifications
Effectiveness
Transitions
Disclosure
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OVERVIEW
Motivated by the FASB's intent to provide greater transparency, FAS
133 makes a dramatic departure from past accounting practice by
requiring derivative contracts to be marked-to-market and recorded
as assets or liabilities on the balance sheet.
For speculative purposes, derivative
gains or losses must be marked-to-market and gains or losses are
realized in the current period's income.
When hedging exposures associated with
the price of an asset, liability, or a firm commitment, accounting
for the derivative is the same as it is for speculative uses. In
addition, however, the underlying exposure must also be
marked-to-market due to the risk being hedged; and these results
must flow through current income, as well. This treatment is called
a "fair value hedge."
A hedge of an upcoming, forecasted
event is a "cash flow hedge." For cash flow hedges, derivative
results must be evaluated, with a determination made as to how much
of the result is "effective" and how much is "ineffective." The
ineffective component of the hedge results must be realized in
current income, while the effective portion is initially posted to
"other comprehensive income" and later re-classified as income in
the same time frame in which the forecasted cash flow affects
earnings. Importantly, the FASB only recognizes hedges as being
ineffective for accounting purposes when the hedge effects exceed
the effects of the underlying forecasted cash flow, measured on a
cumulative basis.
Finally, the last category qualifying
for special accounting treatment is the hedge associated with the
currency exposure of a net investment in a foreign operation. Again,
the hedge must be marked-to-market. This time, the treatment
maintains the spirit of the current provisions of the FASB Statement
52, which require effective hedge results to be consolidated with
the translation adjustment in other comprehensive income.
Differences between total hedge results and the translation
adjustment being hedged flow through earnings.
QUALIFICATIONS Scope Cash
Flow Fair
Value Foreign
Operations Speculative Trades
Definition of a derivative under FAS 133
A qualifying derivative must satisfy
three criteria (Paragraphs 6-9):
- It has (1) one or more underlyings
and (2) one or more notional amounts or payment provisions or
both. These contractual terms determine the amount of the
settlement or settlements, and, in some cases, whether or not a
settlement is required.
- It requires no initial net
investment or an initial net investment that is smaller than would
be required for other types of contracts that would be expected to
have a similar response to changes in market factors.
- Its terms require or permit net
settlement, it can readily be settled net by a means outside the
contract, or it provides for delivery of an asset that puts the
recipient in a position not substantially different from net
settlement.
Complicating the process for assessing
whether or not any contractual arrangement qualifies as a derivative
is the fact the FASB has scoped out a host of situations that might
otherwise appear to satisfy the above definition.
Exemptions (Paragraphs 10
& 11):
- Regular-way securities trades, where
delivery occurs within the time frame of normal market
conventions.
- Normal purchases and normal sales
where instruments will be delivered in amounts expected to be used
within a reasonable period of time in the normal course of
business and where there is a high probability that the contracts
will result in physical deliver. Contracts that required periodic
cash settlements (e.g., futures contracts) do not qualify for this
exception.
- Certain insurance contracts which
generally fall under FAS 60, 07, and 113. Contracts are exempt
from FAS 133 if the payout compensates the insured for an
identifiable insurable event other than a change in price.
- Financial guarantee contracts that
reimburse for specific losses due to defaults of debtors.
- Off-exchange contracts where
settlement amounts are based on (a) climactic, geological, or
other physical variables; (b) prices of non-financial assets or
liabilities on either party to the contract, where the underlying
instrument is not readily convertible to cash; or (c) specific
volumes of sales or revenues of one of the parties to the
contract.
- Derivatives that serve as
impediments to sales accounting.
- Contracts (a) indexed to a companies
own stock and classified in stockholders' equity; (b) issued by
the reporting entity relating to stock-based compensation; or (c)
issued as a contingent consideration from a business combination.
Embedded derivative
instruments
Embedded derivatives are components of
contractual arrangements that, by themselves (i.e. on a stand-alone
basis), would satisfy the criteria in the definition of a
derivative. Embedded derivatives are often present in structured
note contracts and other debt obligations, but they may also be
found in such contracts such as leases, purchase agreements,
insurance contracts, guarantees, and other tailored arrangements.
Embedded derivatives reside in "host"
contracts; and the combined instrument (i.e., the host and the
embedded derivative) is referred to as the "hybrid instrument."
In general, embedded derivatives must
be separated from the host contract for accounting purposes.
Provided they meet the qualifying criteria for being a derivative
under FAS 133, embedded derivatives must be accounted for as if they
were free standing derivatives, unless (a) the characteristics and
risks of the embedded derivative are clearly and closely related to
those of the host, or (b) the hybrid instrument is remeasured at
fair value with changes reported in earnings.
Even in cases where the embedded
derivative is clearly and closely related to the host, if the
embedded derivative incorporates a leverage factor or if an investor
may not recover substantially all of the initial recorded
investment, the embedded derivative may be required to be accounted
for separately from the host. (Paragraph 13)
Interest-only and principal-only strips
are specifically exempted from FAS 133, provided (a) the original
securities from which these derivatives were constructed have no
embedded derivatives that would otherwise be covered under FAS 133,
and (b) the strips do not contain any features that were not
initially a part of the original instrument. (Paragraph 14)
Embedded foreign currency derivatives
are exempt from FAS 133 if (a) the host is not a financial
instrument and settlements are required in the functional currency
of any substantial party to the contract, or (b) the settlements are
denominated in the currency of the price that is routinely used for
international commerce of the underlying good or service. (Paragraph
15)
Cash Flow Accounting
Treatment
A hedge of an upcoming, forecasted
event is a "cash flow hedge." To qualify for cash flow hedge
treatment, a key requirement is that exposure involves the risk of
an uncertain (i.e., variable) cash flow. Derivative results must be
evaluated, with a determination made as to how much of the result is
"effective" and how much is "ineffective." The ineffective component
of the hedge results must be realized in current income, while the
effective portion is initially posted to "other comprehensive
income" (OCI) and later re-classified to income in the same time
frame in which the forecasted cash flow affects earnings.
For purposes of determining the amount
that is appropriate to be posted to OCI, this assessment must be
made on a cumulative basis. Contributions to earnings are required
only if the derivative results exceed the cash flow effects of the
hedged items. (Paragraph 30b)
Cash flow hedge accounting is not
automatic. Specific criteria must be satisfied both at the inception
of the hedge and on an ongoing basis. If, after initially qualifying
for cash flow accounting, the criteria for hedge accounting stop
being satisfied, hedge accounting is no longer appropriate. With the
discontinuation of hedge accounting, any accumulated OCI would
remain there, unless (except in extenuating circumstances) it is
probable that the forecasted transaction will not occur by the end
of the originally specified time period or within an additional
two-month period of time thereafter. (Paragraph 33)
Reporting entities have complete
discretion to un-designate cash flow hedge relationships at will and
later re-designate them, assuming all hedge criteria are again (or
still) satisfied. (Paragraph 32c)
Examples of exposures that
qualify for cash flow hedge accounting:
- Interest rate exposures that relate
to a variable or floating interest rates
- Planned purchases or sales of assets
- Planned issuances of debt or
deposits
- Planned purchases or sales of
foreign currencies
- Currency risk associated with
prospective cashflows that are not denominated in the functional
currency
Eligible risks (Paragraphs
29g and 29h):
-
Currency risk associated with (a) a
forecasted transaction in a currency other than the functional
currency, (b) an unrecognized firm commitment, or (c) a recognized
foreign-currency denominated debt instrument.
-
The entire price risk associated
with purchases or sales of non-financial goods. That is, unless
the purchase or sale specifically relates to buying or selling
individual components, the full price of the good in question must
be viewed as the hedged item.
-
For financial instruments,
hedgeable exposures include cash flow effects to (a) changes in
the full price of the instrument in question, (b) changes the
benchmark rate of interest (i.e., the risk-free rate of interest
or the rate associated with LIBOR-based swaps), (c) changes
associated with the hedged item's credit spread relative to the
interest rate bench mark (d) changes in cash flows associated with
default or the obligors' creditworthiness, and (e) changes in
currency exchange rates. (Paragraph 29h)
Prerequisite requirements to
qualify for cash flow accounting treatment
- Hedges must be documented at the
inception of the hedge, with the objective and strategy stated,
along with an explicit description of the methodology used to
assess hedge effectiveness. (Paragraph 28a)
- Dates (or periods) for the expected
forecasted events and the nature of the exposure involved
(including quantitative measures of the size of the exposure) must
be explicitly documented. (Paragraph 28a)
- The hedge must be expected to be
"highly effective," both at the inception of the hedge and on an
ongoing basis. Effectiveness measures must relate the gains or
losses of the derivative to changes in the cash flows associated
with the hedged item. (Paragraph 28b)
The forecasted
transaction must be probable. (Paragraph 29b) The forecasted
transaction must be made with a different counterparty than the
reporting entity. (Paragraph 29c)
Dis-allowed situations (i.e., when
cash flow accounting may not be applied)
- In general, written options may not
serve as hedging instruments. An exception to this prohibition
(i.e., when a written option may qualify for cash flow accounting
treatment) is when the hedged item is a long option. (Paragraph
28c)
- In general, basis swaps do not
qualify for cash flow accounting treatment unless both of the
variables of the basis swap are linked to two distinct variables
associated with two distinct cash flow exposures. (Paragraph 28d)
- Cross currency interest rate swaps
do not qualify for cash flow hedge accounting treatment if the
combined position results in exposure to a variable rate of
interest in the functional currency. This hedge would qualify,
however, as a fair value hedge.
- With held-to-maturity fixed income
securities under Statement 115, interest rate risk may not be
designated as the risk exposure in a cash flow relationship.
(Paragraph 29e)
- The forecasted transaction may not
involve a business combination subject to Opinion 16 and does not
involve (a) a parent's interest in consolidated subsidiaries, (b)
a minority interest in a consolidated subsidiary, (c) an
equity-method investment, or (d) an entity's own equity
instruments. (Paragraph 29f)
- Prepayment risk may not be
designated as the hedged item. (Paragraph 29h)
- The interest rate risk to be hedged
in a cash flow hedge may not be identified as a benchmark interest
rate, if a different variable interest rate is the specified
exposure -- e.g., if the exposure is the risk of a higher prime
rate, LIBOR may not be designated as the risk being hedged.
(Paragraph 29h)
Internal derivatives contracts
- Except in the case when currency
derivatives are used in cashflow hedges, derivatives between
members of a consolidated group (i.e., internal derivatives)
cannot qualify as hedging instruments in the consolidated
statement, unless offsetting contracts have been arranged with
unrelated third parties on a one-off basis. (Paragraph 36)
- For an internal currency derivative
to qualify as a hedging instrument in a consolidated statement, it
must be used as a cashflow hedge only for a foreign currency
forecasted borrowing, a purchase or sale, or an unrecognized firm
commitment, but the exposurefollowing conditions apply:
- The non-hedging counterpart to the
internal derivative must offset its net currency exposure with a
third party within 3 days of the internal contract's hedge
designation date. (Paragraph 40)
- The third-party derivative must
mature within 31 days of the internal derivative's maturity
date. (Paragraph 40)
Fair Value
Accounting Treatment
When hedging exposures associated with
the price of an asset, liability, or a firm commitment, the total
gain or loss on the derivative is recorded in earnings. In addition,
the underlying exposure due to the risk being hedged must also be
marked-to-market to the extent of the change due to the risk being
hedged; and these results flow through current income, as well. This
treatment is called a "fair value hedge." Hedgers may elect to hedge
all or a specific identified portion of any potential hedged item.
Fair value hedge accounting is not
automatic. Specific criteria must be satisfied both at the inception
of the hedge and on an ongoing basis. If, after initially qualifying
for fair value accounting, the criteria for hedge accounting stop
being satisfied, hedge accounting is no longer appropriate. With the
discontinuation of hedge accounting, gains or losses of the
derivative will continue to be recorded in earnings, but no further
basis adjustments to the original hedged item would be made.
(Paragraph 26)
Reporting entities have complete
discretion to de-designate fair value hedge relationships at will
and later re-designate them, assuming all hedge criteria remain.
(Paragraph 24)
Examples of exposures that
qualify for fair value hedge accounting
- Interest exposures associated with
the opportunity cost of fixed rate debt
- Price exposures for fixed rate
assets
- Price exposures for firm commitments
associated with prospective purchases or sales
- Price exposures associated with the
market value of inventory items
- Price exposures on
available-for-sale securities
Eligible risks (Paragraph 21f and
36)
- The risk of the change in the
overall fair value
- The risk of changes in fair value
due to changes in the benchmark interest rates (i.e., the
risk-free rate of interest or the rate associated with LIBOR-based
swaps), foreign exchange rates, credit worthiness, or the spread
over the benchmark interest rate relevant to the hedged item's
credit risk.
- Currency risk associated with (a) an
unrecognized firm commitment, (b) a recognized
foreign-currency-denominated debt instrument, or (c) an
available-for-sale security
Prerequisite requirements to
qualify for fair value accounting treatment
- Hedges must be documented at the
inception of the hedge, with the objective and strategy stated,
along with an explicit description of the methodology used to
assess hedge effectiveness. (Paragraph 28a)
- The hedge must be expected to be
"highly effective," both at the inception of the hedge and on an
ongoing basis. Effectiveness measures must relate the gains or
losses of the derivative to those changes in the fair value of the
hedged item that are due to the risk being hedged. (Paragraph 20b)
- If the hedged item is a portfolio of
similar assets or liabilities, each component must share the risk
exposure, and each item is expected to respond to the risk factor
in comparable proportions. (Paragraph 21a)
- Portions of a portfolio may be
hedged if they are (a) a percentage of the portfolio; (b) one or
more selected cash flows; (c) an embedded option (provided it is
not accounted for as a stand-alone option); (d) the residual value
in a lessor's net investment in a direct financing or sale-type
lease. (Paragraph 21a2 and 21f)
- A change in the fair value of the
hedged item must present an exposure to the earnings of the
reporting entity. (Paragraph 21b)
- Fair value hedge accounting is
permitted when cross currency interest rate swaps result in the
entity being exposed to a variable rate of interest in the
functional currency
Dis-allowed situations (i.e., when
fair value accounting may not be applied)
- In general, written options may not
serve as hedging instruments. An exception to this prohibition
(i.e., when a written option may qualify for cash flow accounting
treatment) is when the hedged item is a long option. FAS 133 also
defines any combinations that include a written option and
involves the net receipt of premium -- either at the inception or
over the life of the hedge -- as a written option position.
(Paragraph 20c)
- Assets or liabilities that are
remeasured with changes in value attributable to the hedged risk
reported in earnings -- e.g., non-financial assets or liabilities
that are denominated in a currency other than the functional
currency -- do not qualify for hedge accounting. The prohibition
does not apply to foreign-currency-denominated debt instruments
that require remeasurement of the carrying value at spot exchange
rates. (Paragraph 21c, 29d, and 36)
- Investments accounted for by the
equity method do not qualify for hedge accounting. (Paragraph 21c)
- Equity investments in consolidated
subsidiaries are not eligible for hedge accounting. (Paragraph
21c)
- Firm commitments to enter into
business combinations or to acquire or dispose of a subsidiary, a
minority interest or an equity method investee are not eligible
for hedge accounting. (Paragraph 21c)
- A reporting entity's own equity is
are not eligible for hedge accounting. (Paragraph 21c)
- For held-to-maturity debt securities
the risk of a change in fair value due to interest rate changes is
not eligible for hedge accounting. Fair value hedge accounting may
be applied to a prepayment option that is embedded in a
held-to-maturity security, however, if the entire fair value of
the option is designated as the exposure. (Paragraph 21d)
- Prepayment risk may not be
designated as the risk being hedged for a financial asset.
(Paragraph 21f)
- Except for currency derivatives,
derivatives between members of a consolidated group cannot be
considered to be hedging instruments in the consolidated
statement, unless offsetting contracts have been arranged with
unrelated third parties on a one-off basis. (Paragraph 36)
Hedges
of Net Investments in Foreign Operations
Special hedge accounting is appropriate
for hedges of the currency exposure associated with net investments
in foreign operations, which give rise to translation gains or
losses under SFAS 52. Derivatives and non-derivatives (i.e.., assets
or liabilities denominated in the same currency as that of the net
investment) may be designated as hedges of these exposures.
Effective results of such hedges are recognized in the same manner
as a translation adjustment. Ineffective portions of hedge results
are recognized in earnings. (Paragraph 42)
Hedge accounting for net investments in
foreign operations is not automatic. Specific criteria must be
satisfied both at the inception of the hedge and on an ongoing
basis. If, after initially qualifying, the criteria for hedge
accounting stop being satisfied, hedge accounting is no longer
appropriate. With the discontinuation of hedge accounting, gains or
losses of the derivative will be recorded in earnings.
Reporting entities have complete
discretion to hedge relationships at will and later re-designate
them, assuming all hedge criteria remain satisfied.
Prerequisite requirements to
qualify for hedge accounting treatment
- Hedges must be documented at the
inception of the hedge, with the objective and strategy stated,
along with an explicit description of the methodology used to
assess hedge effectiveness. This documentation must include the
identification of the hedged item and the hedging instrument and
the nature of the risk being hedged. (Paragraph 20a)
- The hedge must be expected to be
"highly effective," both at the inception of the hedge and on an
ongoing basis. Effectiveness measures must relate the gains or
losses of the derivative to those changes in the fair value of the
hedged item that are due to the risk being hedged. (Paragraph 20b)
Speculative Trades (Not Qualifying for Hedge
Accounting)
The accounting treatment is the same
for derivatives intended for speculative purposes or for which the
prerequisite hedge criteria are not satisfied. Gains and losses of
the derivative are realized currently in earnings. The objective for
using the derivative contract(s) must still be disclosed.
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EFFECTIVENESS
Hedge Effectiveness
Methodologies
FAS 133 requires the method used to
assess hedge effectiveness to be defined at the time of hedge
designation; and this method must then be applied consistently -
both at the inception of the hedge and on an ongoing basis. If the
entity decides to improve upon this method, the original hedge must
be de-designated and a new hedge relationship needs to be
stipulated. If the same method is not applied to similar hedges, a
justification for using differing methods is required.
Entities may elect to exclude specific
components of hedge results from the hedge effectiveness assessment.
Allowable excluded items are (a) differences between spot and
forward (or futures prices), if the derivative is or contains a
forward or futures contract, or (b) the time value or the volatility
value of options, if the derivative is or contains an option
contract. (Paragraph 63) Hedge effectiveness may be assumed to be
perfect in two specific situations (Paragraph 68):
-
If the hedging instrument is a
forward contract that perfectly matches the intended forecasted
transaction, with the forward having a market value equal to zero
at the inception of the hedge.
-
If the hedging instrument is a
plain-vanilla interest rate swap (i.e., with no optionality) that
perfectly matches (in terms of notional amounts, tenors,
settlement frequencies, and payment dates) the hedged item to
which it is paired.
In order to qualify for hedge
accounting, gains or losses on the derivative must offset changes in
the fair value or changes in cash flows of the associated hedged
item. Put another way, the combined effect of the derivative and the
hedged item should result in a gain or loss that is constrained to
be a small fraction of the initial value of the exposed item, X,
with a high level of confidence, Y. It is left to the discretion of
the client, however, to specify parameter values for X and Y,
respectively.
Besides these determinations, the
client also needs to specify the time span from which the price data
are collected (e.g., two year's worth of data). Also, the span of
time for which price changes are measured will be dictated by the
hedging horizon (i.e., the time frame over which the hedge will be
maintained), with a maximum of a quarter of a year.
For instance, consider the case of a
fair value hedging relationship where the hedging entity constructs
a data set from the most recent three-years of daily price data,
resulting in approximately 1,000 paired observations of 91-day price
changes. Their objective, then, would be to assess whether hedges
have been effective in offsetting price changes of the hedged item
over quarter-year time horizons.
Assuming the client specified a maximum
price effect of 2% (i.e., X = 2%) with a confidence level of 95%
(i.e., Y = 95%), in order to qualify for hedge accounting, the
following condition would have to be satisfied in 95 percent of the
1,000 cases:
where E and D refer to the values
associated with the exposure (i.e., the hedged item) and the
derivative instrument, respectively.
For interest rate exposures, it is
critical to take the passage of time into consideration. That is, it
is inappropriate to measure changes in a constant maturity
instrument when the maturity of the instrument in question is
diminishing over time. For example, to assess the prospective
effectiveness of a five-year swap used to hedge of a five-year bond,
91-day value changes would be the calculated using rates for 4
¾-year securities at the end of the quarter versus 5-year securities
at the beginning of the quarter.
Warning: The FASB has not sanctioned
any particular methodology for assessing prospective hedge
effectiveness. And while the above discussion represents the
perspective of Kawaller & Company, hedging entities are
encouraged to discuss this -- or any alternative approach -- with
their external auditors before adopting it.
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TRANSITIONS
Special transition rules apply for the
first quarter in which FAS 133 accounting rules are adopted. Among
these provisions are the following:
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DISCLOSURE
Disclosure Requirements
The following must be disclosed by
all reporting entities that use derivative instruments (Paragraph
44)
- Objectives for using each
derivative, whether for hedging or for speculation.
- The context needed to understand
objectives.
- Qualitative disclosures are
encouraged.
The following must be
disclosed if derivatives are used in hedging relationships
(Paragraph 45)
- Risk management policies must be
specified, identifying exposures to be hedged and hedging
strategies for managing the associated risks.
- Identification of the type of
hedging relationship (i.e., fair value, cash flow, net investment
in foreign operation), if applicable.
- The hedged item must be explicitly
identified.
- Ineffective hedge results must be
disclosed.
- Any component of the derivatives'
results that is excluded from the hedge effectiveness assessment
must be disclosed.
Specific requirements for fair
value hedges (Paragraph 45a)
- The place on the income statement
where derivative gains or losses are reported must be disclosed.
- When a firm commitment no longer
qualifies as a hedged item, the net gain or loss recognized in
earnings must be disclosed.
Specific requirements for cash flow
hedges (Paragraph 45b)
- A description of the conditions that
will result in the reclassification of accumulated other
comprehensive income into earnings, and a schedule of the
estimated reclassification expected in the coming 12 months must
be disclosed.
- The maximum length of time over
which hedging is anticipated (except for variable interest rate
exposures) must be disclosed.
- Entities must disclose the amount
reclassified into earnings as a result of discontinued cash flow
hedges because the forecasted transaction is no longer probable.
- Specific requirements for hedges of
net investments in foreign operations (Paragraph 45c)
- Entities must disclose the amount of
the derivatives' results that is included in the cumulative
translation adjustment during the reporting period.
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