Two Teaching Notes

Two Teaching Notes (Revised March 4, 2008)
by
Robert E. Jensen
Emeritus Accounting Professor from Trinity University
190 Sunset Hill Road
SUGAR HILL, NH 03586
rjensen@trinity.edu

Teaching Note prepared by Smith and Kohlbeck for the following case:
     “Accounting for Derivatives and Hedging Activities Comparisons of Cash Flow Versus Fair Value Accounting,”
     by Pamela A. Smith and Mark J. Kohlbeck
     Issues in Accounting Education, Volume 23, Number 1, February 2008, pp. 103-118
     http://www.atypon-link.com/AAA/loi/tnae

I think there are huge advantages in comparing the Smith and Kohlbeck Teaching Note with the revised teaching note that I prepared. I don’t want to leave the impression that a few of what I take issue with outweighs much of the good in the carefully-crafted Teaching Note and discussion found in the Smith and Kohlbeck Teaching Note. I highly recommend that Issues in Accounting Education serve up both Teaching Notes.

Revised Teaching Note prepared by Robert E. Jensen for the following case:
     “Accounting for Derivatives and Hedging Activities Comparisons of Cash Flow Versus Fair Value Accounting,”
     by Pamela A. Smith and Mark J. Kohlbeck
     Issues in Accounting Education, Volume 23, Number 1, February 2008, pp. 103-118

The Smith and Kohlbeck Case and Teaching Note contain the following errors, misleading assumptions, and misleading wording.

Issue 1 (Misleading Wording)
The case never should’ve used the term “portfolio” at any point. It’s highly misleading to do so since for all practical purposes it is not possible to get hedge accounting for hedges of portfolios. In FAS 133, hedges of portfolios are called “macro hedges.” Firms commonly hedge portfolios when it is impractical to hedge each component of a portfolio such as when Fannie Mae hedges a portfolio of 10,000 individual homeowner mortgages for interest rate risk. Such a macro hedge is probably impractical in terms of each mortgage note. To be eligible for hedge accounting under FAS 133 Paragraphs 21(a)(1), 448, and 449 each mortgage in the portfolio must have the same interest rate and maturity date. It is not practical to create portfolios that are homogeneous to this extent. Nor is a possible to get hedge accounting treatment for a portfolio of shares in different companies. In other words, FAS 133 does not allow accounting hedge relief for macro hedges of portfolios that are not perfectly homogeneous. The International IAS 39 was amended to allow for slight relief in the case of interest rate hedges, but for most other types of portfolios hedge accounting is not allowed except when portfolios are perfectly homogeneous.

Hence it was misleading for the Smith and Kohlbeck Case to repeatedly use the term “portfolio.” They neither discussed macro hedging nor explained why FAS 133 for all practical purposes does not allow hedge accounting for the many, many macro hedges used in practice. Firms that do macro hedges must post changes in value of hedging derivatives to current earnings.

Issue 2 (Error)
The case applies cash flow hedge accounting to a hedged item in Exhibit 1 of the Teaching Note that has no cash flow risk. All that can be hedged in the Part A case is fair value as is accounted for in Exhibit 2. Exhibit 1 should be deleted from the Teaching Note or replaced with a short statement that students are supposed to recognize that cash flow hedges are not allowed in this part of the case. It might be a good learning exercise. Alternately, Exhibit 1 could be a summary of Example 9 of FAS 133 beginning in Paragraph 162. That is a great example of using options contracts for cash flow hedging.

Issue 3 (Incomplete Wording)
I think Exhibit 2 is based on a contrived example of a hedged item that performs a fair value hedge on a hedged item that has cash flow risk. This can be simply fixed up with a third party firm commitment contract as illustrated below. What is misleading about Exhibit 2 and the statements leading up to it is that the authors seem to imply that this is available-for-sale (AFS) hedge accounting for a fair value hedge. Actually, their Exhibit 2 is hedge accounting for any classification of security under FAS 115. From the start of the hedge to the hedge’s settlement or dedesignation this is the hedge accounting for AFS security hedges, trading security hedges, and held-to-maturity (HTM) hedged items in a fair value hedge.

FAS 133 does not allow hedge accounting for a hedged trading security. However, the Smith and Kohlbeck’s Exhibit 2 accounting passes everything through current earnings which is exactly what FAS 133 requires for trading securities. For a HTM hedged items, the financial instrument is normally carried at historical cost or at amortized historical cost in the case of some bonds and mortgages. For a fair value hedge that qualifies for hedge accounting, however, FAS 133 requires that the historical cost accounting be suspended and that the hedged item be carried at fair value from the start of the hedge until settlement of the hedge or dedesignation. Hedge accounting during the hedging period is exactly the same as the AFS approach illustrated in Smith and Kohlbeck’s Exhibit 2 during the hedging period.

I don’t care for the Smith and Kohlback Exhibit 2 approach when it comes to AFS securities. If the AFS security has been adjusted to fair value before the start of the hedge, there is a balance in other comprehensive income (OCI) that remains unchanged during the hedging period even though its balance is sadly out of date relative to the hedged item’s fair value. This is why I call this hedge accounting approach the “Dangling OCI” approach for fair value hedges.

In 1998, KPMG proposed a unique solution for AFS securities that keeps OCI up to date rather than dangling. This approach cannot be applied to trading or HTM hedged items, but it can be applied to AFS hedged items. I illustrate this solution below.

Issue 4 (Error)

The Smith and Kohlbeck solutions in Exhibit 5 and elsewhere are in error for taking a premature basis adjustment on January 31. Basis adjustment is explained in FAS 133 Paragraph 31. Smith and Kohlbeck should defer basis adjustment until the March 31 sale of the oil. This is a FAS 133 rule that differs in the international IAS 39 standard. IAS 39 requires basis adjustment when the hedging derivative is settled. FAS 133 requires basis adjustment when the hedged item is settled.

Issue 5 (Misleading Assumption)
Exhibits 5 and 6 ignore huge hedge ineffectiveness on every reset date. All Delta values are outside the 80%-125% limits. I show the problems and then tweak the forward and spot prices to achieve better hedging effectiveness.

Professors Smith and Kohlbeck wanted to simplify their case by not performing hedge effectiveness tests. This would be well and good except they did so with erroneous reasoning. They could have said that they were simply ignoring hedge effectiveness tests that in real life must be performed.

But instead they made the following incorrect statement on Page105:

In anticipation of this transaction, the treasurer has determined that Warfield will purchase

a futures contract at $39 per barrel (bbl) for 100,000 bbls with a maturity of January

31.2 The critical terms of the futures contract will match the anticipated transaction so the

hedge is 100 percent effective. The futures contract is at market rates, and the company

maintains a margin account with the broker; therefore, no cash will be exchanged at the

inception of the contract. The futures contract settles in cash for the difference between

the price stated on the contract and the spot price on January 31 (maturity).

The above argument is not allowed in FAS 133 or FAS 39. Indeed most hedging contracts are designed to be perfectly effective on a cumulative basis on the date of full maturity. Most tests of for hedging ineffectiveness at interim dates before maturity would thereby be unnecessary if the above statement by Smith and Kohlbeck were true. But the statement is true only for the very limiting hedging of interest risk using the Shortcut Method for interest rate swaps as explained in Paragraphs 114 and 132 of FAS 133. The Shortcut Method does not apply to any hedging contracts other than interest rate swaps --- http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#ShortcutMethod

For interest rate swaps the international standard IAS 39 does not even allow the Shortcut method. Hence, for hedging contracts such as oil futures and oil forward contracts hedge effectiveness must be tested at interim points between inception and settlement of the hedge. What’s worse is that it is extremely common for hedges that are assured to be perfectly effective at maturity to be ineffective at interim points in time. The reason mainly is that hedged items and derivative hedging contracts are traded in different markets. Hedged items (like oil purchase contracts and inventories) are traded by users of a commodity whereas derivative contracts (like forward, futures, option, and swap contracts) are traded heavily by speculators. The two markets are correlated by they are far from perfectly correlated.

As I said, Smith and Kohlbeck could have simply said they were not illustrating effectiveness tests. I would not object had that not given an erroneous justification for ignoring these tests. But I would’ve preferred under those circumstances that the hedges they illustrated be reasonably effective. Actually their hedges are all ineffective to a point where hedge accounting is not even allowed.

Other Areas of Recommended Improvement of the Smith and Kohlbeck case

The case needs a better glossary or at least reference to a glossary such as http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#FirmCommitment

The case really needs to explain the difference between economic hedging and hedge accounting for both cash flow hedges and fair value hedges. The authors might then reference key examples in FAS 133 that illustrate fair value hedging versus cash flow hedging.

There needs to be more precise definitions of intrinsic versus time value and an elaboration about why time value is normally excluded from hedge effectiveness tests for hedges that use options contracts.

The authors really never define a forecasted transaction and what is necessary for a forecasted transaction as a hedged item, i.e. a specified notional, specified transaction date and an underlying based upon future spot rates. It should then be explained how a firm commitment differs from a forecasted transaction in that a forecasted transaction becomes a firm commitment when the underlying is contractually specified in place of the spot rate.

The authors throw out the account “Firm Commitment” invented by the FASB for purposes of hedging firm commitments without adequately explaining that the term “Firm Commitment” has two different meanings that must be taken in context. One alternative is that a firm commitment is hedged item that with a specified notional, transaction date, and underlying. The other one is that a Firm Commitment account is simply an artificial account used in hedge accounting for firm commitments. This account, however, is not a “firm commitment” which is why the FASB never should’ve used such a name for such an account --- http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#FirmCommitment

Actually the authors do not adequately define and contrast cash flow hedges versus fair value hedges. Most certainly they do not make it clear that a cash flow hedge creates fair value risk and a fair value hedge creates cash flow risk They should make it clear that it is totally naïve to make a statement about “hedging risk” without pointing out that it’s impossible to simultaneously hedge cash flow and fair value risk.

Most students are confused as to why anybody would create cash flow risk by entering into a contract to hedge fair value. A few examples here might help. For example, why would a company with fixed-rate bonds payable (with fair value risk and no cash flow risk) ever hedge these bonds for fair value (thereby creating cash flow risk)? One answer is that the company may feel that interest rates are going to decline and it may be smart to buy the bonds payable back in the market after interest rates for new debt go down. But if the company does not hedge the value of those fixed rate bonds, the bonds will be increasingly expensive to buy back or call back if interest rates plunge.

It might help to explain the advantages and disadvantages of certain types of hedges. For example, one of the great things about a purchased option is that risk is capped even in speculations. However, options are lousy as hedges if the company wants hedge accounting, because options seldom meet effectiveness tests, especially for changes in time value. It might help to discuss the relative advantages and drawbacks of futures versus forwards, at least on a basic level.

Revised Exhibit 1 Solutions in the Smith and Kohlbeck Teaching Notes
Actually there should be no Exhibit 1 illustration because Smith and Kohlbeck provide a cash flow hedging illustration to a transaction that has no cash flow risk. There is no cash flow risk because the hedged item (100,000 shares of Smith Company) was purchased for cash on October 31 and has no subsequent cash flow risk. It does have value risk, but this is addressed in the Exhibit 2 solution.

It was misleading to even make mention of a bond sinking fund since a put option on Smith Company shares cannot be used under FAS 133 to hedge a sinking fund cash flow need that either has no cash flow risk (if cash flows are contractually fixed) or has a cash flow risk based upon interest rate or credit risk, neither of which can be hedged under FAS 133 rules by Smith Company equity shares or a put option on those shares.

The FASB provides an excellent illustration of cash flow hedging with options. See Example 9 beginning in Paragraph 162 of FAS 133.
Also see the Excel Workbook solutions in the 133ex09a.xls file at http://www.cs.trinity.edu/~rjensen/
Also see the PowerPoint illustrations in the 05options.ppt file at http://www.cs.trinity.edu/~rjensen/Calgary/CD/JensenPowerPoint/

Revised Exhibit 2 Solutions in the Smith and Kohlbeck Teaching Notes
In the following journal entries I compare the original Smith and Kohlbeck Table Exhibit 2 Dangling OCI solutions with the Jensen and KPMG revised Exhibit 2 solutions. FAS 133 provides some discretion with respect to hedging AFS Securities. Both solutions lead to a correct result, although the Smith and Kohlbeck solutions leave a “Dangling OCI” balance that is out of date during the hedging period relative to the fair value-adjusted AFS hedged item.

I actually prefer the AFS Securities hedging approach recommended in Derivatives and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998. Although we do not generally use the OCI account for fair value hedges under FAS 133 rules, an exception can be made for AFS securities since FAS 115 requires use of OCI to mark the AFS securities to market with an offset to OCI.

You can read more about hedge accounting in general at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#HedgeAccounting

Date

Revised Exhibit 2

Dangling OCI Solution

Jensen and KPMG Unique AFS Solution

Date	Ledger Account	Debit	Credit	Balance	Ledger Account	Debit	Credit	Balance
10/31	AFS securities	4,000,000		$4,000,000	AFS securities	4,000,000		$4,000,000
	Cash		4.000,000	($4,000,000)	Cash		4,000,000	($4,000,000)
	-Purchase of 100,000 shares				-Purchase of 100,000 shares

11/30	AFS securities	500,000		$4,500,000	AFS securities	500,000		$4,500,000
	Unrealized G/L (OCI)		500,000	($500,000)	Unrealized G/L (OCI)		500,000	($500,000)
	-FAS 115 &130 entry required to mark AFS securities to market				-FAS 115/130 entry required to mark AFS securities to market

11/30	Put option	300,000		$300,000	Put option	300,000		$300,000
	Cash		300,000	($4,300,000)	Cash		300,000	($4,300,000)
	-Purchased put option for a $300,000 premium				-Purchased put option for a $300,000 premium

12/31	Unrealized G/L (IS)	100,000		$100,000	Unrealized G/L (OCI)	100,000		($400,000)
	AFS securities		100,000	$4,400,000	AFS securities		100,000	$4,400,000
	-Entry to mark the AFS securities to market				-FAS 115/130 entry required to mark AFS securities to market
12/31	Unrealized G/L (IS)	140,000		$240,000	Unrealized G/L (IS)	140,000		$140,000
	Put option		140,000	$160,000	Put option		140,000	$160,000
	-Entry to charge the loss in time value to current earnings				-Entry to charge the loss in time value to current earnings
12/31	Put option	100,000		$260,000	Put option	100,000		$260,000
	Unrealized G/L (IS)		100,000	140,000	Unrealized G/L (OCI)		100,000	($500,000)
	-Entry to credit the increase in intrinsic value to current earnings				-Entry to credit the increase in intrinsic value to OCI because this is an AFS security

01/31	Unrealized G/L (IS)	100,000		$240,000	Unrealized G/L (OCI)	100,000		($400,000)
	AFS securities		100,000	$4,300,000	AFS securities		100,000	$4,300,000
	-Entry to mark the AFS securities to market				-FAS 115/130 entry required to mark AFS securities to market

1/31	Unrealized G/L (IS)	160,000		$300,000	Unrealized G/L (IS)	160,000		$300,000
	Put option		160,000	$100,000	Put option		160,000	$100,000
	-Entry to charge the loss in time value to current earnings				-Entry to charge the loss in time value to current earnings
1/31	Put option	100,000		$200,000	Put option	100,000		$200,000
	Unrealized G/L (IS)		100,000	$200,000	Unrealized G/L (OCI)		100,000	($500,000)
	-Entry to credit the increase in intrinsic value to current earnings				-Entry to credit the increase in intrinsic value to OCI because this is an AFS security

1/31	Cash	4,300,000		$0	Cash	4,300,000		$0
	AFS Security		4,300,000	$0	AFS Security		4,300,000	$0
	-To record sale of AFS securities				-To record sale of AFS securities

1/31	Cash	200,000		$200,000	Cash	200,000		$200,000
	Put option		200,000	$0	Put option		200,000	$0
	-To record settlement of the put option				-To record settlement of the put option

1/31	Unrealized G/L (OCI)	500,000		$0	Unrealized G/L (OCI)	500,000		$0
	Unrealized G/L (IS)		500,000	$200,000	Unrealized G/L (IS)		500,000	$200,000
	-To close out a dangling OCI balance from October 31				-To basis adjust on the date of the sale of all shares.

$300,000 = gain without a put option hedge = $4,300,000 on January 31- $4,000,000 invested on October 31.

$200,000 = gain with a put option hedge = $4,300,000 - $4,000,000 -$300,000 put option premium + $200,000 put option settlement

On November 30, the spot rate for December 31 was unknown, and Warfield Company elected to hedge against a plunge in share prices.
In retrospect, Warfield Company lost an opportunity value but it also eliminated the possibility of a huge loss of the Smith Company shares had they fallen way below $42 per share = $45 strike price - $3 premium per share of the put option.

Put another way, if the price of Smith Company shares tanked to zero, Warfield would’ve lost its entire $4 million investment without a hedge. With the hedge described in the case, the company locked in a minimum gain $2 per share or $200,000.

Revised Exhibits 5 Solutions in the Smith and Kohlbeck Teaching Notes

Fair Value Hedge Needs a Third-Party Firm Commitment Contract
In Part B Smith and Kohlbeck try to define a forward price of a futures contract as a fair value hedge. When one enters a futures contract there’s cash flow risk equal to what is called the basis equal to the spot price minus the forward price at any point in time --- http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#B-Terms
Basis risk is cash flow risk, and it’s impossible to define a fair value hedge on an hedge item that has cash flow risk. Fair value items must have no basis (cash flow) risk. Also FAS 133 does not allow hedge accounting for derivative hedges of derivative instruments.

What Smith and Kohlbeck needed to do in Part B was to have the Warfield Company enter into firm commitment contract (hedged item) that stands alone apart from the futures contract. A firm commitment contract must have a specified underlying (price), specified quantity (such as 100,000 shares if stock or 100,000 barrels of oil), and a specified purchase/sale date --- http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#FirmCommitment
This contract must exist apart from whatever contract is used to hedge the fair value.

The Smith and Kohlbeck Exhibit 5 solution is confusing because there is no contracted firm commitment price that we are hedging for fair value. The implied use of the October 31 forward price is confusing since most firms have relationships with suppliers and contract for something other than what they can get on the derivatives markets.. It’s best to find a third party who will possibly accept a forward price as a specified underlying, but more likely than not a third party outside the futures market will specify some price other than the forward price due to many factors impacting on that third party such as delivery costs, storage costs, interest returns, etc.

Actually the way fair value hedging typically works in practice is that users of commodities sign supply contracts with third-party suppliers for delivery at a plant such as a refinery in California. Oil and gas futures markets usually have specified delivery points in Chicago, Oklahoma, Louisiana, or Texas. The futures prices and spot rates are misleading for a market delivery point such as Louisiana. The California refinery must then add delivery, storage, and other costs to each spot price and each forward price in the futures market. This generally leads to hedging ineffectiveness such as the great Minneapolis versus Chicago Example 7 beginning in Paragraph 144 of FAS 133. That happens to be a cash flow hedge, but it could easily be converted into a fair value hedge by having JKL not just forecast the purchase of 100,000 bushels of corn but to sign a firm commitment from a supplier to buy the corn for delivery Bismarck, North Dakota for $2.93 per bushel. The Bismarck user of corn can then hedge the firm commitment using either Minneapolis or Chicago futures markets or both markets as illustrated in Example 7. A similar example appears for South American coffee beginning in Paragraph 93 of FAS 133.

One source of hedging ineffectiveness is the shift in delivery costs between the beginning and the ultimate settlement of a hedge. The forward and spot changes over several months in a CBOT exchange in Chicago may be different that the changes in prices in Bismarck if the delivery costs of corn have greatly changed during the hedging period.

Basis Adjustment Error
The Smith and Kohlbeck solution is in error for taking a premature basis adjustment on January 31 in Exhibit 5. Basis adjustment is standardized in FAS 133 Paragraph 31. Smith and Kohlbeck should defer basis adjustment until the March 31 sale of the oil. This is a FAS 133 rule that differs in the international IAS 39 standard. IAS 39 requires basis adjustment when the hedging derivative is settled. FAS 133 requires basis adjustment when the hedged item is settled.

You can read about Basis Adjustment at --- http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#BasisAdjustment
A PowerPoint illustration of Basis Adjustment is provided in the 03forfut.pps file at
http://www.cs.trinity.edu/~rjensen/Calgary/CD/JensenPowerPoint/
Especially note the example beginning on Slide 11.

Hedge Effectiveness Testing Misleading Assumptions
Professors Smith and Kohlbeck wanted to simplify their case by not performing hedge effectiveness tests. This would be well and good except they did so erroneously. They could have said that they were simply ignoring hedge effectiveness tests that in real life must be performed.