Bob Jensen's Document on FAS 133 Hedge Accounting Ineffectiveness Issues

This document was specially prepared for my Year 2000 KPMG Workshops in Chicago October 12-13, New York City November 2-3, and Las Vegas November 30-December 1.

I added some cases on hedge ineffectiveness testing and measurement. Most of these cases are extensions of FAS 133 and FAS 138 examples, although one is an extension of a KPMG foreign currency hedging example. In most instances, you must download the accompanying Excel workbooks to really understand the cases.

Selected FAS 133 Appendix B Illustrations That Avoid Ineffectiveness Testing
Introduction (Including Several Extended FAS 133 Appendix B Examples) B Example 7 B Example 9 B Example 10 Rules for Defining Effectiveness are Not Set in Stone

Selected FAS 133 Appendix A Extended Illustrations of Hedge Effectiveness Analysis
A Example 01	Fair Value Hedge of Natural Gas Inventory with Futures Contracts
A Example 07	Cash Flow Hedge--Forecasted Purchase of Inventory with a Forward Contract
A Example 08	Cash Flow Hedge with a Basis Swap
A Example 09	Cash Flow Hedge of Forecasted Sale with a Forward Contract
A Example 10	Attempted Hedge of a Forecasted Sale with a Written Call Option

A FAS 138 Benchmarking Case That Features Ineffectiveness Testing
FAS 138 Benchmark Interest Value-Locked Debt Accounting Case The above benchmark case is my longest and most complete case involving ineffectiveness testing.

Ineffectiveness is the degree ex ante to which a hedge fails to meet its goals in protecting against risk (i.e., degree to which the hedge fails to perfectly offset underlying value changes or forecasted transaction prices). According to Paragraphs 20 on Page 11 and 30 on Page 21 of FAS 133, ineffectiveness is to be defined ex ante at the time the hedge is undertaken. Hedging strategy and ineffectiveness definition with respect to a given hedge defines the extent to which interim adjustments affect interim earnings. Hedge effectiveness requirements and accounting are summarized in Paragraphs 62-103 beginning on Page 44 of FAS 133. An illustration of intrinsic value versus time value accounting is given in Example 9 of FAS 133, Pages 84-86, Paragraphs 162-164. In Example 9, the definition of ineffectiveness in terms of changes in intrinsic value of a call option results in changes in intrinsic value being posted to other comprehensive income rather than earnings. In Examples 1-8 in Paragraphs 104-161, designations as to fair value versus cash flow hedging affects the journal entries.

One means of documenting hedge effectiveness is to compare the cumulative dollar offset defined as the cumulative value over a succession of periods (e.g., quarters) in which the cumulative gains and losses of the derivative instrument are compared with the cumulative gains and losses in value of the hedged item. In assessing the effectiveness of a hedge, an enterprise will generally need to consider the time value of money according to FAS 133 Paragraph 64 and IAS 39 Paragraph 152.

Neither the FASB nor the IASC specify a single method for either assessing whether a hedge is expected to be highly effective or measuring hedge ineffectiveness. Tests of hedge effectiveness should be conducted at least quarterly and on financial statement dates. The appropriateness of a given method can depend on the nature of the risk being hedged and the type of hedging instrument used. See FAS 133 Appendix A, Paragraph 62 and IAS 39 Paragraph 151.

Prospective Steps	Regression	$ Offset
Establish expectation of effectiveness Ongoing Reaffirmation of expectations of effectiveness	Yes Yes	Yes Yes
Retrospective Steps Proving effectiveness has been achieved Measuring ineffectiveness in earnings/equity	Yes No	Yes Yes

FAS 133 allows some discretion in how hedge ineffectiveness will be assessed. It must, however, pre-define some means of testing for ineffectiveness and then charge the ineffectiveness to current earnings (as opposed to, say OCI in a cash flow or FX hedge). Different methods can be specified for different hedges, but for a given contract the testing must be consistent throughout the life of the contract.

Three Types of Exclusions from Effectiveness Testing
Only in three instances can a portion of the hedge's change in value be excluded from effectiveness tests. Paragraph 63 in FAS 133 reads as follows:

Effectiveness testing in value lock hedges are less troublesome in this regard since there is no partitioning of value changes between OCI and current earnings. In a value lock hedge, all changes in value are posted to current earnings.

Appendix B: Example 7 beginning in Paragraph 144 of FAS 133: Designation and Discontinuance of a Cash Flow Hedge of the Forecasted Purchase of Inventory
My Excel Workbook expansion of this example into a case can be viewed by downloading the 133ex07a.xls file at www.cs.trinity.edu/~rjensen.

145. On February 3, 20X1, JKL Company forecasts the purchase of 100,000 bushels of corn on May 20, 20X1. It expects to sell finished products produced from the corn on May 31, 20X1. On February 3, 20X1, JKL enters into 20 futures contracts, each for the purchase of 5,000 bushels of corn on May 20, 20X1 (100,000 in total) and immediately designates those contracts as a hedge of the forecasted purchase of corn.

146. JKL chooses to assess effectiveness by comparing the entire change in fair value of the futures contracts to changes in the cash flows on the forecasted transaction. JKL estimates its cash flows on the forecasted transaction based on the futures price of corn adjusted for the difference between the cost of corn delivered to Chicago and the cost of corn delivered to Minneapolis. JKL does not choose to use a tailing strategy (as described in paragraph 64). JKL expects changes in fair value of the futures contracts to be highly effective at offsetting changes in the expected cash outflows for the forecasted purchase of corn because (a) the futures contracts are for the same variety and grade of corn that JKL plans to purchase and (b) on May 20, 20X1, the futures price for delivery on May 20, 20X1 will be equal to the spot price (because futures prices and spot prices converge as the delivery date approaches). However, the hedge may not be perfectly effective. JKL will purchase corn for delivery to its production facilities in Minneapolis, but the price of the futures contracts is based on delivery of corn to Chicago. If the difference between the price of corn delivered to Chicago and the price of corn delivered to Minneapolis changes during the period of the hedge, the effect of that change will be included currently in earnings according to the provisions of paragraph 30 of this Statement.

147. On February 3, 20X1, the futures price of corn for delivery to Chicago on May 20, 20X1 is $2.6875 per bushel resulting in a total price of $268,750 for 100,000 bushels.

148. On May 1, 20X1, JKL dedesignates the related futures contracts and closes them out by entering into offsetting contracts on the same exchange. As of that date, JKL had recognized in accumulated other comprehensive income gains on the futures contracts of $26,250. JKL still plans to purchase 100,000 bushels of corn on May 20, 20X1. Consequently, the gains that occurred prior to dedesignation will remain in other comprehensive income until the finished product is sold. If JKL had not closed out the futures contracts when it dedesignated them, any further gains or losses would have been recognized in earnings.

149. On May 20, 20X1, JKL purchases 100,000 bushels of corn, and on May 31, 20X1, JKL sells the finished product.

Example 7 as illustrated in my B7 Case in my 133ex07a.xls file at www.cs.trinity.edu/~rjensen.
Hedged Item: Forecasted purchase cost of 100,000 bushels of Minneapolis corn on May 20.
Hedge Derivative: The ex post settlement value of Chicago futures contracts having a combined notional equal to the 100,000 bushels of Chicago corn.

Hedge Derivative's Carrying Value
W(0) = $0 since futures contracts have no value on the date of acquisition.
W(t) = ex ante forward value of the futures contracts discounted back to t.

Hedged Item's Account Receivable Carrying Value C(t) and Ineffectiveness
I(t) = hedged item's ex post commodity spot value at the end of Period t.
C(t) = C(t) + (W(t)-W(t-1) (the FASB assumed a zero discount rate in Example 7.)

Risk:
The risk is that the cash flow lock using the futures contracts may lock the company into February 3 corn prices when the corn prices plunge between February 3 and the futures contract settlement date. In an anticipation of a further drop in corn prices between May 1 and May 20 prompted the company to settle the futures contracts early on May 1.

I find Example 7 to be both deficient and misleading. This is what inspired me to write a more comprehensive case around Example 7. Reasons are listed below:

1. The FASB did not fully account for the entire scenario with spot prices in addition to the futures
prices. I added spot prices to Example 7.

2. The FASB assumed a zero discount rate. I allow readers to specify a rate.

	It is misleading for the FASB to assume a zero discount rate in its examples.
	The reason for this is that discounting is required under FAS 133. In particular,
	note Paragraphs 64 and 319.

	Other relevant paragraphs include 64, 94, 112, 117, 125, 171, and 220.

3. The FASB assumed zero ineffectiveness, which seems strange to me since Example 7 is devoted
to ineffectiveness of hedging Minneapolis corn prices with Chicago-based futures contracts.

	Since Paragraph 152 of Example 7 assumes changes in futures prices as the
	indicator of hedge ineffectiveness, I did not invoke the Paragraph 63(c) condition that
	applies to ineffectiveness based on spot rates rather than forward rates.

4. I allow for a sensitivity analysis on key parameters in this case.

5. I introduce an ineffectivenss materiality bound on the difference between Chicago and
Minneapolis futures contracts. When the observed difference exceeds the
materiality bound, I do not allow hedge accounting in the sense that the posting
to Other Comprehensive Income (OCI) is zero. When the difference is material
in any period, the company should also examine whether hedge accounting should
be disallowed in all future periods as well as the period where the material difference
arose

6. Futures contracts are typically settled daily. Balances exceeding a margin limit
may be withdrawn in cash. Shortages require additional cash deposits. The FASB
has never illustrated how to combine futures contract accounting with Margin Deposit
Accounts. This case illustrates such a combination.

	It is assumed in this case that the company has a policy of maintaining the Margin
	Deposit Account at the minimum required balance. This entails withdrawing excess
	cash daily and depositing cash shortages daily. In order to simplify the outcomes an
	avoid daily journal entries, such cash transactions are only illustrated on the dates
	featured in the original Example 7 beginning in Paragraph 144 in FAS 133.

Appendix B Example 9 beginning in Paragraph 162 of FAS 133: Accounting for a Derivative's Gain or Loss in a Cash Flow Hedge -- Effectiveness Based on Changes in Intrinsic Value
My Excel Workbook expansion of this example can be viewed by downloading the 133ex09a.xls file at www.cs.trinity.edu/~rjensen.

Example 9 illustrates the partitioning of value changes in the hedge derivative (a call option in Example 9) into intrinsic (Commodity X spot price minus the call option's strike price) and time value (call option's strike price minus the call option's forward value) components. In a cash flow hedge, only the changes in intrinsic value are deferred in OCI. Changes in time value are posted to current earnings. In effectiveness testing, the change in the time value is excluded from effectiveness measurements since time value is posted to earnings and does not affect OCI. If effectiveness is based on a minimum value of intrinsic value plus the effect of discounting, the change in the volatility value of the option is excluded in effectiveness tests (that is not illustrated in Example 9).

The main purpose of Example 9 is to illustrate how hedge effectiveness of an option is based only upon intrinsic value changes. My spreadsheet solution for Example 9 can be downloaded as the 133ex09a.xls file from the listing of files at www.cs.trinity.edu/~rjensen.

Example 9 as illustrated in my 133ex09a.xls file at www.cs.trinity.edu/~rjensen.
Hedged Item: Forecasted purchase price of a commodity at the end of Period 5
Hedge Derivative: The ex post intrinsic value (spot value price I(t) minus the strike value of $125) of an American call option purchased at t=0 for a premium of $9.25.

Hedge Derivative's Carrying Value
W(0) = $9.25 since the call option contract has a value equal to the premium at t=0.
W(t) = ex ante forward value of the call option at the end of Period t.
= [Ex post Intrinsic Value] + [Ex Ante Time Value].

Hedged Item's Account Receivable Carrying Value C(t) and Ineffectiveness
I(t)   = hedged item's ex post commodity spot value at the end of Period t
X(t) = the time value component of W(t) depicting the difference between the Period t ex post intrinsic value and the ex ante forward value of the call option.
C(t) = $0 since the purchase is only a forecasted transaction rather than a recognized firm commitment.
C(5)= I(5) + $9.25 - [I(5) - $125 Strike Price] = $115.75 if I(5)>$125 for a call option that is in-the-money
       = I(5) + $9.25 if I(5)<$125 for a call option that is out-of-the-money.

Risk:
The risk is that the cash flow lock using an option may force the company to lose its $9.25 premium paid on the call option. Unlike futures contracts, however, the call option does afford an opportunity for the XYZ Company to take advantage of a decline in the price of the commodity between t=0 and t=4. Futures contracts would deny this opportunity, but options contracts do not destroy the opportunity value of price declines in forecasted purchases.

Example 10 beginning in Paragraph 165 of FAS 133: Cash Flow Hedge of the Foreign Currency Exposure in a Royalty Arrangement
My Excel Workbook expansion of this example can be viewed by downloading the 133ex010a.xls file at www.cs.trinity.edu/~rjensen.

Example 10 illustrates FX cash flow effectiveness testing based upon a forward contract's change in spot prices. Example 10 assesses hedge effectiveness based upon changes in spot FX German mark prices.

One purpose of Example 10 is to illustrate how hedge ineffectiveness amounts exclude the FX spot minus derivative's forward prices. My spreadsheet solution for Example 10 can be downloaded as the 133ex10a.xls file from the listing of files at www.cs.trinity.edu/~rjensen.

Example 10 as illustrated in my 133ex10a.xls file at www.cs.trinity.edu/~rjensen.
Hedged Item: FX receivables of forecasted royalty payments in German marks in Periods 2, 3, and 4
Hedge Derivative: The I(4) spot value of a forward contract to sell DM3 million estimated as the sum of royalties accrued at the ends of Periods 2,3, and 4 (payment is received in Period 4). Accrued royalties are posted to earnings when earned rather than when paid. The proportion of the total royalty to be earned determines the proportion of the hedge's OCI accumulation that is transferred to current earnings.

Hedge Derivative's Carrying Value
W(0) = 0 since the forward contract has a zero starting value.
W(t) = ex ante forward value of the forward contract at the end of Period t.

Hedged Item's Account Receivable Carrying Value C(t) and Ineffectiveness
I(t) = hedged item's ex post spot value at the end of Period t
X(t) = component of W(t) depicting the difference between the Period t ex post spot value less the ex ante forward value.
C(0) = $0 since none of the royalty income has been earned at t=0.
C(t) = C(t-1)+(DM1 million)(ex post FX spot rate at the end of Period t).

Ineffectiveness = $0 and DELTA(t) = 1 for reasons explained in Paragraph 168 of FAS 133

Risk:
This FX lock forces the value of the account receivable to fluctuate with FX rate movements. The DEF Company, thereby, loses all opportunity of gaining from a weakening of the German mark against the dollar. However, it also will not lose from a strengthening of the German mark since the FX hedge locked in the exchange rate without any possibility of hedge ineffectiveness.

If it can be demonstrated in advance that a hedge will always be perfect, it is not necessary to perform hedge effectiveness tests. Paragraph 65 of FAS 133 provides some examples.

For example, an entity may assume that a hedge of a forecasted purchase of a commodity with a forward contract will be highly effective and that there will be no ineffectiveness to be recognized in earnings if:

Other situations where effectiveness need not be tested are provided in Paragraph 68-71 of FAS 133. Ineffectiveness testing in many other situations, however, can be exceedingly complex.

Just prior to Appendix A in FAS 138, the FASB states that "The provisions of this Statement need not be applied to immaterial items." This means that ineffectiveness can be ignored if it is deemed immaterial in amount. The ineffectiveness may still be charged to current earnings, but the firm does not lose hedge accounting privileges for ineffectiveness that is not material in amount.

For value lock hedges a popular test of ineffectiveness is the DELTA(t) or D ratio defined as follows:

The above ratio can be "significant" in terms of falling outside the effectiveness bounds when the amount of ineffectiveness is not material. The FASB has never discussed the combinations of alternatives, but presumably hedge accounting will be denied in any period for which the ineffectiveness of a value lock hedge is both significant and material. What is more ambiguous is what happens when the ineffectiveness is deemed insignificant because it falls within the 0.80-1.25 bounds but is material in amount. In this document, it will be assumed that hedge accounting will be permitted in such an instance unless management concedes that ineffectiveness will be significant and material in most future periods of the hedge.

A hedge is normally regarded as highly effective if, at inception and throughout the life of the hedge, the enterprise can expect changes in the fair value or cash flows of the hedged item to be almost fully offset by the changes in the fair value or cash flows of the hedging instrument, and actual results are within a range of 80-125% (SFAS 39 Paragraph 146). The FASB requires that an entity define at the time it designates a hedging relationship the method it will use to assess the hedge's effectiveness in achieving offsetting changes in fair value or offsetting cash flows attributable to the risk being hedged (FAS 133 Paragraph 62). In defining how hedge effectiveness will be assessed, an entity must specify whether it will include in that assessment all of the gain or loss on a hedging instrument. The Statement permits (but does not require) an entity to exclude all or a part of the hedging instrument's time value from the assessment of hedge effectiveness. (FAS 133 Paragraph 63).

Hedge ineffectiveness would result from the following circumstances, among others:

Appendix A Example 1 Beginning in Paragraph 73 of FAS 133: Fair Value Hedge of Natural Gas Inventory with Futures Contracts
(Assessing ineffectiveness based upon spot rates rather than forward rates. Hence the company will exclude the change in the fair value of the forward contract attributable to changes in the difference between the forward rate and spot rate from the measure of hedge ineffectiveness and report it directly in earnings.)

73. Company A has 20,000 MMBTU's of natural gas stored at its location in West Texas. To hedge the fair value exposure of the natural gas, the company sells the equivalent of 20,000 MMBTU's of natural gas futures contracts on a national mercantile exchange. The futures prices are based on delivery of natural gas at the Henry Hub gas collection point in Louisiana.

Hedged Item: Inventory spot value of 20,000 MMBTU's of Texas natural gas
Hedge Derivative: Ex post spot value of futures contracts on Louisiana natural gas assuming
the contracts are sold at t=0 to lock in the hedged item value.

Hedge Derivative's Carrying Value
W(0) = 0 since futures contracts have zero starting value.
W(t) = ex ante forward values of futures contracts at the end of Period t.

Hedged Item's Carrying Value C(t) and Ineffectiveness
I(t) = hedged item's ex post spot value at the end of Period t.
X(t) = component of W(t) depicting the difference between the Period t spot and forward values of Henry Hub futures contracts (which might be viewed as a time value difference).
C(0) = inventory carrying cost at t=0.

If the company designates that it will exclude from tests of effectiveness any portion of the change in W(t)-W(t-1) forward value attributable to the X(t)-X(t-1) differences between ex post spot rates and ex ante forward rates. The carrying value becomes the following:

C(t) = C(t-1)+[I(t)-I(t-1)] - [X(t)-X(t-1)] if hedge accounting is allowed in Period t.
= C(t-1) if ineffectiveness is deemed both significant and material in amount.

Ineffectiveness = [W(t) -X(t) -W(t-1)+X(t-1)]-[I(t-1)-I(t)]

If the company designates that it will base effectiveness on the entire W(t)-W(t-1) forward value changes in the hedging derivative, the carrying value becomes the following:

C(t) = C(t-1)+[I(t)-I(t-1)] if hedge accounting is allowed in Period t.
= C(t-1) if ineffectiveness is deemed both significant and material in amount.

Ineffectiveness = [W(t) -W(t-1)]-[I(t-1)-I(t)]

Risk:
This value lock forces cash flow risk to the extent that the hedge is ineffective. The hedge also precludes taking advantage of increases in spot prices of the natural gas.

The above Example 1 in Appendix A is not so simple as Example 1 of Appendix B. In the Appendix B version it is stated in Paragraph 105 that it is assumed that the derivative hedges "have no time value." It is stressed in that Paragraph 105 that this is an unrealistic assumption in Example 1.

74. The price of Company A's natural gas inventory in West Texas and the price of the natural gas that is the underlying for the futures it sold will differ as a result of regional factors (such as location, pipeline transmission costs, and supply and demand). \19/ Company A therefore may not automatically assume that the hedge will be highly effective at achieving offsetting changes in fair value, and it cannot assess effectiveness by looking solely to the change in the price of natural gas delivered to the Henry Hub.

\Footnote 19/ The use of a hedging instrument with a different underlying basis than the item or transaction being hedged is generally referred to as a cross-hedge. The principles for cross-hedges illustrated in this example also apply to hedges involving other risks. For example, the effectiveness of a hedge of market interest rate risk in which one interest rate is used as a surrogate for another interest rate would be evaluated in the same way as the natural gas cross-hedge in this example.

75. Both at inception of the hedge and on an ongoing basis, Company A might assess the hedge's expected effectiveness based on the extent of correlation in recent years for periods similar to the spot prices term of the futures contracts between the spot prices of natural gas in West Texas and at the Henry Hub. \20/ If those prices have been and are expected to continue to be highly correlated, Company A might reasonably expect the changes in the fair value of the futures contracts attributable to changes in the spot price of natural gas at the Henry Hub to be highly effective in offsetting the changes in the fair value of its natural gas inventory. In assessing effectiveness during the term of the hedge, Company A must take into account actual changes in spot prices in West Texas and at the Henry Hub.

\Footnote 20/ The period of time over which correlation of prices should be assessed would be based on management's judgment in the particular circumstance.

76. Company A may not assume that the change in the spot price of natural gas located at Henry Hub, Louisiana, is the same as the change in fair value of its West Texas inventory. The physical hedged item is natural gas in West Texas, not natural gas at the Henry Hub. In identifying the price risk that is being hedged, the company also may not assume that its natural gas in West Texas has a Louisiana natural gas "component." Use of a price for natural gas located somewhere other than West Texas to assess the effectiveness of a fair value hedge of natural gas in West Texas would be inconsistent with this Statement and could result in an assumption that a hedge was highly effective when it was not. If the price of natural gas in West Texas is not readily available, Company A might use a price for natural gas located elsewhere as a base for estimating the price of natural gas in West Texas. However, that base price must be adjusted to reflect the effects of factors, such as location, transmission costs, and supply and demand, that would cause the price of natural gas in West Texas to differ from the base price.

77. Consistent with the company's method of assessing whether the hedge is expected to be highly effective, the hedge would be ineffective to the extent that (a) the actual change in the fair value of the futures contracts attributable to changes in the spot price of natural gas at the Henry Hub did not offset (b) the actual change in the spot price of natural gas in West Texas per MMBTU multiplied by 20,000. That method excludes the change in the fair value of the futures contracts attributable to changes in the difference between the spot price and the forward price of natural gas at the Henry Hub in determining ineffectiveness. The excluded amount would be reported directly in earnings.

Appendix A Example 7 Beginning in Paragraph 93 of FAS 133: Cash Flow Hedge of a Forecasted Purchase of Inventory with a Forward Contract
My Excel Workbook expansion of this example into a case can be viewed by downloading the 133ex07a.xls file at www.cs.trinity.edu/~rjensen.

93. Company G forecasts the purchase of 500,000 pounds of Brazilian coffee for U.S. dollars in 6 months. It wants to hedge the cash flow exposure associated with changes in the U.S. dollar price of Brazilian coffee. Rather than acquire a derivative based on Brazilian coffee, the company enters into a 6-month forward contract to purchase 500,000 pounds of Colombian coffee for U.S. dollars and designates the forward contract as a cash flow hedge of its forecasted purchase of Brazilian coffee. All other terms of the forward contract and the forecasted purchase, such as delivery locations, are the same.

94. Company G bases its assessment of hedge effectiveness and measure of ineffectiveness on changes in forward prices, with the resulting gain or loss discounted to reflect the time value of money. Because of the difference in the bases of the forecasted transaction (Brazilian coffee) and forward contract (Colombian coffee), Company G may not assume that the hedge will automatically be highly effective in achieving offsetting cash flows. Both at inception and on an ongoing basis, Company G could assess the effectiveness of the hedge by comparing changes in the expected cash flows from the Colombian coffee forward contract with the expected net change in cash outflows for purchasing the Brazilian coffee for different market prices. (A simpler method that should produce the same results would consider the expected future correlation of the prices of Brazilian and Colombian coffee, based on the correlation of those prices over past six-month periods.)

95. In assessing hedge effectiveness on an ongoing basis, Company G also must consider the extent of offset between the change in expected cash flows on its Colombian coffee contract and the change in expected cash flows for the forecasted purchase of Brazilian coffee. Both changes would be measured on a cumulative basis for actual changes in the forward price of the respective coffees during the hedge period.

96. Because the only difference between the forward contract and forecasted purchase relates to the type of coffee (Colombian versus Brazilian), Company G could consider the changes in the cash flows on a forward contract for Brazilian coffee to be a measure of perfectly offsetting changes in cash flows for its forecasted purchase of Brazilian coffee.

Example 7 as illustrated in the A7 Case in my 133ex07a.xls file at www.cs.trinity.edu/~rjensen.
Hedged Item: Forecasted purchase cost of 500,000 lbs of Brazilian coffee on May 20.
Hedge Derivative: The ex post settlement value of a Columbian coffee forward contract having a combined notional equal to the 500,000 lbs of Brazilian coffee.

Hedge Derivative's Carrying Value
W(0) = $0 since the forward contract has no value on the date of acquisition.
W(t) = ex ante forward value of the forward contract discounted back to t.

Hedged Item's Account Receivable Carrying Value C(t) and Ineffectiveness
I(t) = hedged item's ex post commodity spot value at the end of Period t
C(t) = C(t) + (W(t)-W(t-1) (the FASB assumed a zero discount rate in Example 7)

Ineffectiveness = The difference in W(t)-W(t-1) between Columbian and Brazilian forward contracts as explained in Paragraphs 96 and 97 of FAS 133.

Risk:
The risk is that the cash flow lock using the futures contracts may lock the company into the initial prices when the coffee prices plunge between between the start of the hedge and the maturity date six months later. The company loses the opportunity value of cheaper purchasing prices.

Example 8 Beginning in Paragraph 98 of FAS 133: Cash Flow Hedge with a Basis Swap

98. Company H has a 5-year, $100,000 variable-rate asset and a 7-year, $150,000 variable-rate liability. The interest on the asset is payable by the counterparty at the end of each month based on the prime rate as of the first of the month. The interest on the liability is payable by Company H at the end of each month based on LIBOR as of the tenth day of the month (the liability's anniversary date). The company enters into a 5-year interest rate swap to pay interest at the prime rate and receive interest at LIBOR at the end of each month based on a notional amount of $100,000. Both rates are determined as of the first of the month. Company H designates the swap as a hedge of 5 years of interest receipts on the $100,000 variable-rate asset and the first 5 years of interest payments on $100,000 of the variable-rate liability.

99. Company H may not automatically assume that the hedge always will be highly effective at achieving offsetting changes in cash flows because the reset date on the receive leg of the swap differs from the reset date on the corresponding variable- rate liability. Both at hedge inception and on an ongoing basis, the company's assessment of expected effectiveness could be based on the extent to which changes in LIBOR have occurred during comparable 10-day periods in the past. Company H's ongoing assessment of expected effectiveness and measurement of actual ineffectiveness would be on a cumulative basis and would incorporate the actual interest rate changes to date. The hedge would be ineffective to the extent that the cumulative change in cash flows on the prime leg of the swap did not offset the cumulative change in expected cash flows on the asset, and the cumulative change in cash flows on the LIBOR leg of the swap did not offset the change in expected cash flows on the hedged portion of the liability. The terms of the swap, the asset, and the portion of the liability that is hedged are the same, with the exception of the reset dates on the liability and the receive leg of the swap. Thus, the hedge will only be ineffective to the extent that LIBOR has changed between the first of the month (the reset date for the swap) and the tenth of the month (the reset date for the liability).

Example 9 Begining in Paragraph 101 of FAS 133: Cash Flow Hedge of Forecasted Sale with a Forward Contract
(Assessing ineffectiveness based upon spot rates rather than forward rates. Hence the company will exclude the change in the fair value of the forward contract attributable to changes in the difference between the forward rate and spot rate from the measure of hedge ineffectiveness and report it directly in earnings.)

100. Company I, a U.S. dollar functional currency company, forecasts the sale of 10,000 units of its principal product in 6 months to French customers for FF500,000 (French francs). The company wants to hedge the cash flow exposure of the French franc sale related to changes in the US$-FF exchange rate. It enters into a 6-month forward contract to exchange the FF500,000 it expects to receive in the forecasted sale for the U.S. dollar equivalent specified in the forward contract and designates the forward contract as a cash flow hedge of the forecasted sale.

101. Company I chooses to assess hedge effectiveness at inception and during the term of the hedge based on (a) changes in the fair value of the forward contract attributable to changes in the US$-FF spot rate and (b) changes in the present value of the current U.S. dollar equivalent of the forecasted receipt of FF500,000. Because the critical terms of the forward contract and the forecasted transaction are the same, presumably there would be no ineffectiveness unless there is a reduction in the expected sales proceeds from the forecasted sales. Because Company I is assessing effectiveness based on spot rates, it would exclude the change in the fair value of the forward contract attributable to changes in the difference between the forward rate and spot rate from the measure of hedge ineffectiveness and report it directly in earnings.

Example 10 Beginning in Paragraph 102 of FAS 133: Attempted Hedge of a Forecasted Sale with a Written Call Option
(Hedge Accounting Denied.)

102. Company J forecasts the sale in 9 months of 100 units of product with a current market price of $95 per unit. The company's objective is to sell the upside potential associated with the forecasted sale by writing a call option for a premium. The company plans to use the premium from the call option as an offset to decreases in future cash inflows from the forecasted sale that will occur if the market price of the product decreases below $95. Accordingly, Company J sells an at-the- money call option on 100 units of product with a strike price of $95 for a premium. The premium represents only the time value of the option. The option is exercisable at any time within nine months.

103. Company J's objective of using the premium from the written call option as an offset to any decrease in future cash inflows would not meet the notion of effectiveness in this Statement. Future changes in the market price of the company's product will not affect the premium that Company J received, which is all related to time value in this example and thus is the maximum amount by which Company J can benefit. That is, the company could not expect the cash flows on the option to increase so that, at different price levels, a decrease in cash flows from the forecasted sale would be offset by an increase in cash flows on the option.

Example 1A in a KPMG book is a relatively simple example of hedging foreign currency risk in a forecasted purchase of equipment. Although the KPMG example mentions hedging ineffectiveness, the example really does not illustrate ineffectiveness testing since perfect hedge effectiveness is assumed. In my extensions of this example, I introduce examples of hedging ineffectiveness for both the case where ineffectiveness is immaterial and where it is material. This Case is given as the KPMG A! Case in my Excel Workbook file 133ex07a.xls file at www.cs.trinity.edu/~rjensen.

I am sharing my latest working draft of a case entitled FAS 138 Benchmark Interest Value-Locked Debt Accounting Case. This is accompanied by a rather complicated Excel workbook. The link to everything is now available at http://www.cs.trinity.edu/~rjensen/000overview/mp3/138bench.htm. However, the way I keep revising both the case and the worksheet, it is probably best to wait until I make an announcement that I am at last happy with my work (that I mistakenly posted before it made sense.)

One feature of the case is a focus on accounting for hedge ineffectiveness. In addition to the familiar 0.80-1.25 DELTA(t) Rule, I introduce a parameter for hedge amount ineffectiveness. Testing for ineffectiveness significance only on the 0.80-1.25 rule ignores hedge materiality. I propose a joint test for materiality and significance. If C(t) depicts the carrying value of the debt, A(t) depicts the current discount/premium amortization, and I(t) depicts the present value of the index rate present values as specified in FAS 138, most firms want economic hedges to qualify for FAS 138 hedge accounting in order to adjust carrying value of the debt by [I(t)-I(t-1)] to offset the booking of changes in hedge (e.g., swap) values required under FAS 133. Suppose -V(0) proceeds are received when the debt is issued for a market rate liability of V(0).

With No Qualifying Hedge or a Hedge that Combines Ineffectiveness Materiality and Significance in Terms of the 0.80-1.25 Rule for DELTA(t).

With A Qualifying Hedge or a Hedge that Combines Ineffectiveness Immateriality and Insignificance in Terms of the 0.80-1.25 Rule for DELTA(t).

One question never addressed by standard setters is what to do about hedge ineffectiveness that is material in amount but also has a DELTA(t) ratio falling within the 0.80-1.25 Rule bounds. In my case, I do not deny hedge accounting in those outcomes, although the reason has me staring at the wall and wondering why.