FAS 133 As Amended and DIGed:
Introduction to FAS 138 Amendments and Some Key DIG Issues
Accounting for Derivative Financial Instruments and Hedging Activities

This document was prepared for my
KPMG Workshops on
October 12 (Chicago), November 1 (NYC), and November 30 (Las Vegas)

Bob Jensen at Trinity University

Table of Contents

Introduction and Summary

Interest Rate Hedges as Amended and DIGed

Cross-Currency Compound Hedges as Amended and DIGed

Two Board Members Dissent from Issuance of FAS 138

Intercompany FX Hedges as Amended and DIGed

Other FAS 138 Amendments

DIG Issues Incorporated Into FAS 138

What the FASB Refused to Amend in FAS 138

Issues of Booking Out and Normal Purchases Normal Sales (NPNS)

Bob Jensen’s Introduction to FAS 133 and FAS 39 (with audio clips of leading experts)

Bob Jensen's Online FAS 133 and IAS 39 Glossary

Bob Jensen's free online cases are at http://www.trinity.edu/rjensen/caseans/000index.htm

Resource Links

Introduction and Overview

In 1998, the Financial Accounting Standards Board (FASB) issued Financial Accounting Standard 133 (FAS 133) on Accounting for Derivative Financial Instruments and Hedging Activities.  The standard was so confusing and costly to implement that the FASB later extended the implementation deadline to January 1, 2001 for calendar-year companies.

In the meantime, the FASB formed the FAS 133 Derivatives Implementation Group (DIG) to help resolve particular implementation questions, especially in areas where the standard is not clear or allegedly onerous.  The FASB's DIG website (that contains its mission and pronouncements) is at http://www.rutgers.edu/Accounting/raw/fasb/derivatives/digmain.html.  DIG issues are also summarized (in red borders) at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#0000Begin.

A number of important issues that surfaced in the DIG have resulted in a new standard FAS 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities an amendment of FASB Statement No. 133, Released June 15, 2000 --- http://www.rutgers.edu/Accounting/raw/fasb/public/index.html

A nice summary of FAS 138 and its impact on FAS 133 implementation is provided by CFO.com on July 1, 2000 at http://www.cfo.com/printarticle/1,4580,3|17|AD|880,00.html

The FASB provides some new examples illustrating the FAS 138 Amendments to FAS 133 at http://www.rutgers.edu/Accounting/raw/fasb/derivatives/examplespg.html

The purpose of this document is to highlight some of the more important FAS 138 amendments and to comment on some of the DIG issues that were not amended.  FAS 133 as “amended and DIGed” remains the most confusing and arguably the most controversial accounting standard ever issued in the history of U.S. accounting rules and regulations.

FAS 133 requires that all derivative financial instruments (with only a few defined exceptions) be booked and adjusted to fair value at least quarterly.  This is a huge departure from earlier standards and accounting traditions.  Financial instruments, except in a few defined exceptions, are accounted for at historical (amortized) cost.  Hence there is now a distinction between derivative financial instruments (at fair value) versus financial instruments (amortized cost). 

Complications arise in particular when a derivative financial instrument (the hedge) is used to hedge a financial instrument (the hedged item).  If the hedge does not meet the FAS 133 requirements for special hedge accounting of cash flow, fair value, or foreign exchange (FX) hedges.  Firms complained to the FASB and the DIG that some common and “natural” hedges had to be adjusted repeatedly to fair value but did not qualify for FAS 133 hedge accounting to mitigate the impact of the fair value adjustments on current earnings and balance sheet items.

 

Interest Rate Hedges as Amended and DIGed

FAS 138 Introduces Benchmarking

FAS 138 Amendments expand the eligibility of many derivative instrument hedges to qualify FAS 133/138 hedge. Such qualifications in accounting treatment that reduces earnings volatility when the derivatives are adjusted for fair value. 

It is very popular in practice to have a hedging instrument and the hedged item be based upon two different indices.  In particular, the hedged item may be impacted by credit factors.  For example, interest rates commonly viewed as having three components noted below:

·        Risk-free risk that the level of interest rates in risk-free financial instruments such as U.S. treasury T-bill rates will vary system-side over time.

·        Credit sector spread risk that interest rates for particular economic sectors will vary over and above the risk-free interest rate movements.  For example, when automobiles replaced horses as the primary means of open road transportation, the horse industry’s credit worthiness suffered independently of other sectors of the economy.  In more recent times, the dot.com sector’s sector spread has suffered some setbacks.

·        Unsystematic spread risk of a particular borrower that varies over and above risk-free and credit sector spreads.  The credit of a particular firm may move independently of more system-wide (systematic) risk-free rates and sector spreads.

Suppose that a hedge only pays at the T-Bill rate for hedged item based on some variable index having credit components.  FAS 133 prohibited “treasury locks” that hedged only the risk-free rates but not credit-sector spreads or unsystematic risk.  This was upsetting many firms that commonly hedge with treasury locks.  There is a market for treasury lock derivatives that is available, whereas hedges for entire interest rate risk are more difficult to obtain in practice.  It is also common to hedge with London’s LIBOR that has a spread apart from a risk-free component.

The DIG confused the issue by allowing both risk-free and credit sector spread to receive hedge accounting in its DIG Issue E1 ruling.  Paragraph 14 of FAS 138 states the following:

Comments received by the Board on Implementation Issue E1 indicated (a) that the concept of market interest rate risk as set forth in Statement 133 differed from the common understanding of interest rate risk by market participants, (b) that the guidance in the Implementation Issue was inconsistent with present hedging activities, and (c) that measuring the change in fair value of the hedged item attributable to changes in credit sector spreads would be difficult because consistent sector spread data are not readily available in the market. 

In FAS 138, the board sought to reduce confusion by reducing all components risk into just two components called “interest rate risk” and “credit risk.”  Credit risk includes all risk other than the “benchmarked” component in a hedged item’s index.  A benchmark index can include somewhat more than movements in risk-free rates.  FAS 138 allows the popular LIBOR hedging rate that is not viewed as being entirely a risk-free rate.  Paragraph 16 introduces the concept of “benchmark interest rate” as follows:

Because the Board decided to permit a rate that is not fully risk-free to be the designated risk in a hedge of interest rate risk, it developed the general notion of benchmark interest rate to encompass both risk-free rates and rates based on the LIBOR swap curve in the United States.

FAS 133 thus allows benchmarking on LIBOR.  It is not possible to benchmark on such rates as commercial paper rates, Fed Fund rates, or FNMA par mortgage rates.

Readers might then ask what the big deal is since some of the FAS 133 examples (e.g., Example 5 beginning in Paragraph 133) hedged on the basis of LIBOR.  It is important to note that in those original examples, the hedging instrument (e.g., a swap) and the hedged item (e.g., a bond) both used LIBOR in defining a variable rate?  If the hedging instrument used LIBOR and the hedged item interest rate was based upon an index poorly correlated with LIBOR, the hedge would not qualify (prior to FAS 138) for FAS 133 hedge accounting treatment even though the derivative itself would have to be adjusted for fair value each quarter.  Recall that LIBOR is a short-term European rate that may not correlate with various interest indices in the U.S.  FAS 133 now allows a properly benchmarked hedge (e.g., a swap rate based on LIBOR or T-bills) to hedge an item having non-benchmarked components.

The short-cut method of relieving hedge ineffectiveness testing may no longer be available.  Paragraph 23 of FAS 138 states the following:

For cash flow hedges of an existing variable-rate financial asset or liability, the designated risk being hedged cannot be the risk of changes in its cash flows attributable to changes in the benchmark interest rate if the cash flows of the hedged item are explicitly based on a different index.  In those situations, because the risk of changes in the benchmark interest rate (that is, interest rate risk) cannot be the designated risk being hedged, the shortcut method cannot be applied.  The Board’s decision to require that the index on which the variable leg of the swap is based match the benchmark interest rate designated as the interest rate risk being hedged for the hedging relationship also ensures that the shortcut method is applied only to interest rate risk hedges.  The Board’s decision precludes use of the shortcut method in situations in which the cash flows of the hedged item and the hedging instrument are based on the same index but that index is not the designated benchmark interest rate.  The Board noted, however, that in some of those situations, an entity easily could determine that the hedge is perfectly effective.  The shortcut method would be permitted for cash flow hedges in situations in which the cash flows of the hedged item and the hedging instrument are based on the same index and that index is the designated benchmark interest rate.

In other words, any hedge item that is not based upon only a benchmarked component will force hedge effectiveness testing at least quarterly.  Thus FAS 138 broadened the scope of qualifying hedges, but it made the accounting more difficult by forcing more frequent effectiveness testing.

FAS 138 also permits the hedge derivative to have more risk than the hedged item.  For example, a LIBOR-based interest rate swap might be used to hedge an AAA corporate bond or even a note rate based upon T-Bills.

There are restrictions noted in Paragraph 24 of FAS 138:

This Statement provides limited guidance on how the change in a hedged item’s fair value attributable to changes in the designated benchmark interest rate should be determined.  The Board decided that in calculating the change in the hedged item’s fair value attributable to changes in the designated benchmark interest rate, the estimated cash flows used must be based on all of the contractual cash flows of the entire hedged item.  That guidance does not mandate the use of any one method, but it precludes the use of a method that excludes some of the hedged item’s contractual cash flows (such as the portion of interest payments attributable to the obligor’s credit risk above the benchmark rate) from the calculation.  The Board concluded that excluding some of the hedged item’s contractual cash flows would introduce a new approach to bifurcation of a hedged item that does not currently exist in the Statement 133 hedging model.

The FASB provides some new examples illustrating the FAS 138 Amendments to FAS 133 at http://www.rutgers.edu/Accounting/raw/fasb/derivatives/examplespg.html
Example 1 on interest rate benchmarking begins as follows:

Example: Fair Value Hedge of the LIBOR Swap Rate in a $100 Million A1-Quality 5-Year Fixed-Rate Noncallable Debt On April 3, 20X0, Global Tech issues at par a $100 million A1-quality 5-year fixed-rate noncallable debt instrument with an annual 8 percent interest coupon payable semiannually. On that date, Global Tech enters into a 5-year interest rate swap based on the LIBOR swap rate and designates it as the hedging instrument in a fair value hedge of the $100 million liability. Under the terms of the swap, Global Tech will receive a fixed interest rate at 8 percent and pay variable interest at LIBOR plus 78.5 basis points (current LIBOR 6.29%) on a notional amount of $101,970,000 (semiannual settlement and interest reset dates). A duration-weighted hedge ratio was used to calculate the notional amount of the swap necessary to offset the debt's fair value changes attributable to changes in the LIBOR swap rate.

An extensive analysis of the above illustration is provided at http://www.cs.trinity.edu/~rjensen/000overview/138bench.htm

Some DIG Issues Affecting Interest Rate Hedging

Issue E1—Hedging the Risk-Free Interest Rate
http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issuee1.html
(Cleared 02/17/99)
Issue E1 heavily influenced FAS 138 as noted above.

*Issue G6—Impact of Implementation Issue E1 on Cash Flow Hedges of Market Interest Rate Risk
(Cleared 5/17/00)

With regard to a cash flow hedge of the variability in interest payments on an existing floating-rate financial asset or liability, the distinction in Issue E1 between the risk-free interest rate and credit sector spreads over the base Treasury rate is not necessarily directly relevant to assessing whether the cash flow hedging relationship is effective in achieving offsetting cash flows attributable to the hedged risk. The effectiveness of a cash flow hedge of the variability in interest payments on an existing floating-rate financial asset or liability is affected by the interest rate index on which that variability is based and the extent to which the hedging instrument provides offsetting cash flows.

If the variability of the hedged cash flows of the existing floating-rate financial asset or liability is based solely on changes in a floating interest rate index (for example, LIBOR, Fed Funds, Treasury Bill rates), any changes in credit sector spreads over that interest rate index for the issuer's particular credit sector should not be considered in the assessment and measurement of hedge effectiveness. In addition, any changes in credit sector spreads inherent in the interest rate index itself do not impact the assessment and measurement of hedge effectiveness if the cash flows on both the hedging instrument and the hedged cash flows of the existing floating-rate financial asset or liability are based on the same index. However, if the cash flows on the hedging instrument and the hedged cash flows of the existing floating-rate financial asset or liability are based on different indices, the basis difference between those indices would impact the assessment and measurement of hedge effectiveness.

*Issue E6—The Shortcut Method and the Provisions That Permit the Debtor or Creditor to Require Prepayment 
http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issueg6.html
(Cleared 5/17/00)

An interest-bearing asset or liability should be considered prepayable under the provisions of paragraph 68(d) when one party to the contract has the right to cause the payment of principal prior to the scheduled payment dates unless (1) the debtor has the right to cause settlement of the entire contract before its stated maturity at an amount that is always greater than the then fair value of the contract absent that right or (2) the creditor has the right to cause settlement of the entire contract before its stated maturity at an amount that is always less than the then fair value of the contract absent that right. A right to cause a contract to be prepaid at its then fair value would not cause the interest-bearing asset or liability to be considered prepayable under paragraph 68(d) since that right would have a fair value of zero at all times and essentially would provide only liquidity to the holder. Notwithstanding the above, any term, clause, or other provision in a debt instrument that gives the debtor or creditor the right to cause prepayment of the debt contingent upon the occurrence of a specific event related to the debtor's credit deterioration or other change in the debtor's credit risk (for example, the debtor's failure to make timely payment, thus making it delinquent; its failure to meet specific covenant ratios; its disposition of specific significant assets (such as a factory); a declaration of cross-default; or a restructuring by the debtor) should not be considered a prepayment provision under the provisions of paragraph 68(d). Application of this guidance to specific debt instruments is provided below.

Issue E10—Application of the Shortcut Method to Hedges of a Portion of an Interest-Bearing Asset or Liability (or its Related Interest) or a Portfolio of Similar Interest-Bearing Assets or Liabilities   http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issuee10.html
(Released 4/00)

1.        May the shortcut method be applied to fair value hedges of a proportion of the principal amount of the interest-bearing asset or liability if the notional amount of the interest rate swap designated as the hedging instrument matches the portion of the asset or liability being hedged, and all other criteria for applying the shortcut method are satisfied? May the shortcut method similarly be applied to cash flow hedges of the interest payments on only a portion of the principal amount of the interest-bearing asset or liability if the notional amount of the interest rate swap designated as the hedging instrument matches the principal amount of the portion of the asset or liability on which the hedged interest payments are based? [Generally yes was the DIG’s answer.}

2.        May the shortcut method be applied to fair value hedges of portfolios (or proportions thereof) of similar interest-bearing assets or liabilities if the notional amount of the interest rate swap designated as the hedging instrument matches the notional amount of the aggregate portfolio? May the shortcut method be applied to a cash flow hedge in which the hedged forecasted transaction is a group of individual transactions if the notional amount of the interest rate swap designated as the hedging instrument matches the notional amount of the aggregate group that comprises the hedged transaction?  [Generally no was the DIG’s answer.}

*Issue F2—Partial-Term Hedging  http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issuef2.html
(Cleared 07/28/99)

A company may not designate a 3-year interest rate swap with a notional amount equal to the principal amount of its nonamortizing debt as the hedging instrument in a hedge of the exposure to changes in fair value, attributable to changes in market interest rates, of the company’s obligation to make interest payments during the first 3 years of its 10-year fixed-rate debt instrument. There would be no basis for expecting that the change in that swap’s fair value would be highly effective in offsetting the change in fair value of the liability for only the interest payments to be made during the first three years. Even though under certain circumstances a partial-term fair value hedge can qualify for hedge accounting under Statement 133, the provisions of that Statement do not result in reporting a fixed-rate 10-year borrowing as having been effectively converted into a 3-year floating-rate and 7-year fixed-rate borrowing as was previously accomplished under synthetic instrument accounting prior to Statement 133. Synthetic instrument accounting is no longer acceptable under Statement 133, as discussed in paragraphs 349 and 350.

*Issue G7—Measuring the Ineffectiveness of a Cash Flow Hedge under Paragraph 30(b) When the Shortcut Method is Not Applied
http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issueg7.html
(Cleared 5/17/00)

Three methods for calculating the ineffectiveness of a cash flow hedge that involves either (a) a receive-floating, pay-fixed interest rate swap designated as a hedge of the variable interest payments on an existing floating-rate liability or (b) a receive-fixed, pay-floating interest rate swap designated as a hedge of the variable interest receipts on an existing floating-rate asset are discussed below. As noted in the last section of the response, Method 1 (Change in Variable Cash Flows Method) may not be used in certain circumstances. Under all three methods, an entity must consider the risk of default by counterparties that are obligors with respect to the hedging instrument (the swap) or hedged transaction, pursuant to the guidance in Statement 133 Implementation Issue No. G10, "Need to Consider Possibility of Default by the Counterparty to the Hedging Derivative." An underlying assumption in this Response is that the likelihood of the obligor not defaulting is assessed as being probable.

Other DIG issues can be viewed at http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issuindex.html

Cross-Currency Compound Hedges as Amended and DIGed

FAS 138 Makes Compound Hedging Possible

Prior to FAS 138, the scope of foreign currency hedging that qualified for hedge accounting under FAS 133 (even though the hedges themselves probably had to be accounted for at current fair value) was limited to the following for foreign currency denominated (FCD) items:

·        Fair Value Hedge of Unrecognized FCD Firm Commitments

·        Cash Flow Hedge of Forecasted FCD Transactions

·        Net Investment in FCD Foreign Operations

FAS 138 widened the net of qualified FX hedges as follows:

·        Foreign-currency-denominated (FCD) assets or liabilities can be hedged in fair value or cash flow hedgings.  However, cash flow hedging of a recognized FCD asset or liability is permitted only when all the variability in the hedged item's functional currency equivalent cash flows is reduced to zero.

·        Unrecognized FCD firm commitments also can be hedged in fair value or cash flow hedge.

Much of FAS 52 remains in effect.  For example, marking-to-spot the asset or liability under SFAS 52 is still in effect while marking-to-market the derivative under SFAS 133 rules.

One of the more important concessions granted by the FASB in FAS 138 is to allow joint hedging of interest rate risk and FX risk in one compound hedge --- the so-called cross-currency hedge (CCH) of fair value.  A CCH hedge of fair value was not allowed in FAS 133 prior to the FAS 138 Amendments.  However, it was possible with more cost and trouble to hedge each risk separately.  Paragraph 29 of FAS 138 reads as follows:

The Board’s decision to permit fair value hedge accounting for assets and liabilities denominated in a foreign currency relates to the ability of an entity to designate a compound derivative as a hedging instrument in a hedge of both interest rate risk and foreign exchange rate risk.  An entity’s ability to use a compound derivative would achieve the same result that would be achieved prior to this amendment with the use of an interest rate derivative as a qualifying hedging instrument to hedge interest rate risk and an undesignated foreign currency derivative to hedge exchange rate risk.  Permitting use of a compound derivative in a fair value hedge of interest rate risk and foreign exchange risk would result in the value of the foreign currency asset or liability being adjusted for changes in fair value attributable to changes in foreign interest rates before remeasurement at the spot exchange rate. The ability to adjust the foreign currency asset or liability for changes in foreign interest rates effectively eliminates any difference recognized currently in earnings related to the use of different measurement criteria for the hedged item and the hedging instrument.  The Board concluded that in the situations in which fair value hedges would be used, remeasurement of the foreign-currency-denominated asset or liability based on the spot exchange rate would result in the same functional currency value that would result if the instrument was remeasured based on the forward exchange rate.

For example, FCD items (e.g., a fixed-rate bond in German marks) is subject to fair value risk both in terms of changes in interest rates (that change the bond prices in German marks) and changes in the FX rates (that change the U.S. dollars needed to pay make interest coupon payments in German marks).  Before being amended, the debtor would first have to hedge interest rates in some way such as with a vanilla swap in which FCD variable interest is received and FCD fixed interest is paid, thereby locking in the combined value (bond + swap value) at a fixed amount in German marks.  Then another derivative contract would have to be entered into to hedge the combined FCD value for FX risk.  For example, a forward contract could be entered into to hedge a downward spiral of the German mark’s value against the dollar. 

After being amended by FAS 138, it is now possible to acquire a single compound derivative to hedge the joint fair value risk of interest rate and FX movements.  One such derivative is a cross currency interest swap (receive fixed interest rate in German marks, pay variable interest rate in US$).  The combined value (bond + swap) will, thereby, remain locked in at a fixed rate.  Of course locking in value must result in creation of cash flow risk.  The amount of US$ needed for each swap payment varies jointly with interest rate and FX movements.

Of course a reverse process can be used to hedge cash flow risk of variable-rate FCD items.  For example, if a variable rate bond is denominated in German marks, it is possible to jointly hedge interest rate and FX cash flow risk by entering into a cross currency interest swap (receive variable interest rate in German marks, pay fixed interest rate in US$).  This will lock in the cash flow in US$, but the combined value (bond + swap) will vary with both interest rate and FX movements.

The FASB provides two FX hedging examples illustrating the FAS 138 Amendments to FAS 133 at http://www.rutgers.edu/Accounting/raw/fasb/derivatives/examplespg.html

Some DIG Issues Affecting Foreign Currency Hedging

Issue G8—Hedging Interest Rate Risk of Foreign-Currency-Denominated Floating-Rate Debt
http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issueg8.html
(Cleared 5/17/00)

After entering into a currency swap to "hedge" the foreign exchange risk of the foreign-currency-denominated debt instrument (that is, without designating the currency swap as a hedge under Statement 133), an entity may not designate a cash flow hedging relationship in which the hedging instrument is a receive-floating, pay-fixed interest rate swap denominated in the entity's functional currency. That hedging relationship would involve designation of a hedged transaction that is not permitted under Statement 133. Specifically, the hedged transaction may not be expressed as the net flows after consideration of the effect of the currency swap that is economically hedging the foreign currency risk of the floating-rate foreign-currency-denominated debt because that would be applying the notion of synthetic instrument accounting, which is not permitted by Statement 133. The floating-rate cash flow exposure from the interest payments on the debt exists only with respect to interest payments actually made in the currency in which the debt is denominated—not with respect to the synthetic interest payments in the entity's functional currency. Therefore, an interest rate swap denominated in the entity's functional currency could not be expected to be highly effective in mitigating the variability of the floating interest payments denominated in a foreign currency. Similarly, the floating-rate interest flows that represent the leg of the currency swap matching the functional currency of the entity may not be designated as the hedged transaction. Statement 133 does not permit variable cash flows from a derivative to be the hedged transaction in a cash flow hedge because the currency swap is a derivative that is measured at fair value with changes in fair value reported currently in earnings.

Paragraph 425 of Statement 133 contemplated that only an interest rate derivative that is denominated in the same currency as the interest rate exposure would qualify for hedge accounting treatment. Therefore, if an entity employs a strategy of first entering into a foreign-currency-denominated interest rate swap to hedge the interest rate risk inherent in the foreign-currency-denominated floating-rate debt, the entity may designate that interest rate swap as a cash flow hedge of the variability of the foreign-currency-denominated floating-rate interest payments. Under that strategy, the entity could then enter into a currency swap if it desired to economically hedge the foreign exchange risk of the foreign-currency-denominated fixed-rate interest flows (the net cash flows arising from the debt and the interest rate swap). The currency swap may not be designated as a cash flow hedge of the synthetic foreign-currency-denominated fixed-rate interest payments; however, the currency swap could function as an economic hedge of the foreign currency risk because some income statement offset would be achieved by recognizing both the change in fair value of the undesignated currency swap and the remeasurement of the debt into the entity's functional currency concurrently in earnings. That strategy achieves the objective of simultaneously hedging foreign currency and interest rate risk but utilizes derivative products different from those described in the strategy presented in the question section.

All DIG Section H issues and several Section J issues deal with FX matters.  There are too many issues to discuss here.  The issues can be viewed at http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issuindex.html

Two Board Members Dissent from Issuance of FAS 138

Two of the seven FASB members dissented from issuing FAS 138 primarily due to the above amendments to partial hedging of interest rate risk and compound hedging of joint interest rate and FX risks.  You can read the following beginning on Page 25 of FAS 138 regarding the dissents of Messr.s Foster and Leisenring:

While Statement 133 gave wide latitude to management in determining the method for measuring effectiveness, it is clear that the hedged risk is limited to (a) the risk of changes in the entire hedged item, (b) the risk attributable to changes in market interest rates, (c) the risk attributable to changes in foreign currency exchange rates, and (d) the risk attributable to changes in the obligor’s creditworthiness.  Those limitations were designed to limit an entity’s ability to define the risk being hedged in such a manner as to eliminate or minimize ineffectiveness for accounting purposes.  The effect of the provisions in this amendment relating to (1) the interest rate that is permitted to be designated as the hedged risk and (2) permitting the foreign currency risk of foreign-currency-denominated assets and liabilities to be designated as hedges will be to substantially reduce or, in some circumstances, eliminate the amount of hedge ineffectiveness that would otherwise be reflected in earnings.  For example, permitting an entity to designate the risk of changes in the LIBOR swap rate curve as the risk being hedged in a fair value hedge when the interest rate of the instrument being hedged is not based on the LIBOR swap rate curve ignores certain effects of basis risk, which, prior to this amendment, would have been appropriately required to be recognized in earnings.  Messrs. Foster and Leisenring believe that retreat from Statement 133 is a modification to the basic model of Statement 133, which requires that ineffectiveness of hedging relationships be measured and reported in earnings. 

Intercompany FX Hedges as Amended and DIGed

The Confusing Intercompany FX Amendments

In this particular section of FAS 138, a whole lot of words are spent to give away very little in real benefits.  The added accounting difficulties of the central treasury of the consolidated group of companies might discourage making use of these intercompany FX amendments (see Paragraphs 30-36) of FAS 138.  Paragraph 30 sets the stage:

Paragraph 36 of Statement 133 permits a derivative instrument entered into with another member of the consolidated group to qualify as a foreign currency hedging instrument in the consolidated financial statements only if the member of the consolidated group has entered into an individual offsetting derivative contract with an unrelated third party.  Constituents requested that Statement 133 be amended to permit derivative instruments entered into with a member of the consolidated group to qualify as hedging instruments in the consolidated financial statements if those internal derivatives are offset by unrelated third-party contracts on a net basis. 

The constituents essentially got their wish, but this is an illustration of the old warning “watch what you ask for before you ask.”  Consider the accounting (and auditing) requirements imposed by FAS 138:

·        Central treasury must act as a pass-through entity by entering into third-party contracts to offset, on a net basis, for each foreign currency.  The foreign exchange risk arising from multiple internal derivatives AND the derivative contract with the unrelated third party must general equal or closely approximating gains and losses when compared with the aggregate or net losses and gains generated by the intercompany derivative contracts.

·        Due to concerns regarding macro-hedging, accountants must track exposures and document linkage of all derivatives.  Central treasury cannot alter or terminate third-party contracts unless the hedging affiliate initiates action.  Accountants must reassess compliance with all requirements if the internal derivative is modified or de-designated as a hedge.

·        Offsetting net third-party contract must offset the aggregate or net exposure to that currency.  Exposures from internal contracts must mature within the same 31-day period and be entered into within 3 business days after the designation of internal contracts as hedging instruments

All I can say on this one is that the cost of accounting and auditing may far outweigh the benefits unless the notional amounts involved are enormous.

The FASB provides a complicated example illustrating internal derivatives FAS 138 Amendments to FAS 133 at http://www.rutgers.edu/Accounting/raw/fasb/derivatives/examplespg.html

A DIG Issue on Intercompany Derivatives

*Issue E3—Hedging with Intercompany Derivatives http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issuee3.html
(Cleared 03/31/99)

Whether an intercompany derivative can be designated as a hedging instrument in consolidated financial statements depends on the risk being hedged. If the hedged risk is either the risk of changes in fair value or cash flows attributable to changes in a foreign currency exchange rate or the foreign exchange risk for a net investment in a foreign operation, then an intercompany derivative can be designated as the hedging instrument provided that the counterparty (that is, the other member of the consolidated group) has entered into a contract with an unrelated third party that offsets the intercompany derivative completely, thereby hedging the exposure it acquired from issuing the intercompany derivative instrument to the affiliate that designated the hedge. For example, if a parent company’s central treasury function enters into an intercompany derivative with a subsidiary for the subsidiary’s use in hedging its foreign currency risk, the central treasury function must also enter into an offsetting matched foreign currency derivative contract with a third party (or an offsetting contract of at least the same magnitude). In contrast, if the central treasury function chooses to enter into a contract with a third party for only its net foreign currency exposure from all intercompany derivatives, that action would be insufficient to enable all of the related counterparties (such as subsidiaries) to designate those intercompany derivatives as qualifying hedging instruments in consolidated financial statements. The Board decided to permit the designation of intercompany derivatives as hedging instruments for hedges of foreign exchange risk to enable companies to continue using a central treasury function for derivative contracts with third parties and still comply with the requirement in paragraph 40(a) that the operating unit with the foreign currency exposure be a party to the hedging instrument. (As used in this response, the term subsidiary refers only to a consolidated subsidiary. The response should not be applied directly or by analogy to an equity-method investee.)

In contrast, an intercompany derivative cannot be designated as the hedging instrument if the hedged risk is (1) the risk of changes in the overall fair value or cash flows of the entire hedged item or transaction, (2) the risk of changes in its fair value or cash flows attributable to changes in market interest rates, or (3) the risk of changes in its fair value or cash flows attributable to changes in the obligor’s creditworthiness or nonperformance. Similarly, an intracompany derivative (that is, a derivative instrument contract between operating units within a single legal entity) cannot be designated as the hedging instrument in a hedge of those risks. Only a derivative instrument with an unrelated third party can be designated as the hedging instrument in a hedge of those risks in consolidated financial statements.

There is no requirement in Statement 133 that the operating unit with the interest rate, market price, or credit risk exposure be a party to the hedging instrument. Thus, for example, a parent company’s central treasury function can enter into a derivative contract with a third party and designate it as the hedging instrument in a hedge of a subsidiary’s interest rate risk for purposes of the consolidated financial statements. However, if the subsidiary wishes to qualify for hedge accounting of the interest rate exposure in its separate-company financial statements, the subsidiary (as the reporting entity) must be a party to the hedging instrument, which can be an intercompany derivative obtained from the central treasury function. Thus, an intercompany derivative for interest rate risk can qualify for designation as the hedging instrument in separate company financial statements but not in consolidated financial statements.

Other DIG issues in Sections H and J will not be reviewed here.  These can be viewed at http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issuindex.html

Other FAS 138 Amendments

The other amendments are not so controversial.  I will list them without further comment:

·        Amendment Related to Normal Purchases and Normal Sales (NPNS)

For a message from an industry expert who says NPNS is important, click here.

·        Amendments for Certain Interpretations of Statement 133 Cleared by the Board Relating to the Derivatives Implementation Group Process

·        Amendments to Implement Guidance in Implementation Issue No. G3, “Discontinuation of a Cash Flow Hedge”

·        Amendments to Implement Guidance in Implementation Issue No. H1, “Hedging at the Operating Unit Level”

·        Amendments to Implement Guidance in Implementation Issue No. H2, “Requirement That the Unit with the Exposure Must Be a Party to the Hedge”

·        Amendments to the Transition Guidance, the Implementation Guidance in Appendix A of Statement 133, and the Examples in Appendix B of Statement 133

·        Amendments to the Glossary of Statement 133

DIG Issues Incorporated Into FAS 138

DIG Issue G3, "Discontinuation of a Cash Flow Hedge":  Gain or loss continues to be reported in OCI unless it is probable that the forecasted transaction will not occur by the originally specified time period or within an additional two month period.  Extenuating circumstances resulting in the continued reporting in OCI beyond that two-month period must be rare and beyond control of the reporting entity.

DIG Issue H2, "Requirements That the Unit With the Exposure Must Be Party to the Hedge":  For consolidated financial statements, either:

DIG Issue H5, "Hedging a Firm Commitment or a Fixed-Price Agreement Denominated in a Foreign Currency":  Unrecognized foreign-currency-denominated firm commitment can be designated in either a fair value or a cash flow hedge.  The DIG’s earlier position reaching the same conclusion for payments due under an available-for-sale (AFS under FAS 115) debt security is explicitly permitted by SFAS 138.

What the FASB Refused to Amend in FAS 138

Except for the confusing and highly limited amendments on intercompany intercompany derivative contracts, FAS 138 does not change the FASB’s stand against portfolio (macro) hedging.  In order to qualify as a FAS 133/138 hedge, the hedge must, except in unrealistic circumstances, relate to a particular hedged item in a portfolio rather than a subset of items.  The only exception is where subsets of items having identical terms and are virtually fungible.  Drilling down to matches of individual hedges against individual hedged items (see Paragraph 21 in FAS 133) not only magnifies the accounting costs, it runs contrary to the way many firms view economic hedges.  As a result, FAS 133 allegedly forces companies to change hedging strategies and risk management practices. 

 

The FASB did not replace FAS 52 and, thereby, left a great deal of confusion when applying both standards simultaneously.  FAS 138 did a great deal to reduce differences between spot versus forward rate adjustments, but in the end we are still left with a certain amount of confusion in reconciling the two standards.

 

The FASB requires fair value adjustments but provides very little guidance on how to measure fair value of custom derivatives such as swaps and forwards that are not traded in markets or are not traded in sufficiently deep and wide markets.  Example 5 in Appendix B of FAS 133 that begins in Paragraph 131 contains some errors and confusions that were not cleaned up by FAS 138 or any other FASB announcements.  In particular, there is no FASB guidance on how swap values were derived in Examples 2 or 5.  Corrections and derivation discussions are discussed in the following two documents:

 

·        ”The Receive Fixed/Pay Variable Interest-Rate Swap in SFAS 133, Example 2, Needs An Explanation:  Here It Is,” by Carl M. Hubbard and Robert E. Jensen, Derivatives Report, November 1999, pp. 6-11.
http://www.trinity.edu/rjensen/caseans/294wp.doc 
The Excel workbook is at http://www.cs.trinity.edu/~rjensen/133ex02a.xls 

·        ”An Explanation of Example 5, Cash Flow Hedge of Variable-Rate Interest Bearing Asset in SFAS 133,” by Carl M. Hubbard and Robert E. Jensen, Derivatives Report, Aprils 2000, pp. 8-13.
http://www.trinity.edu/rjensen/caseans/133ex05.htm 
The Excel workbook is at http://www.cs.trinity.edu/~rjensen/133ex05a.xls 

 

Derivative instruments cannot be designated as held-to-maturity items that are not subject to fair value adjustment.  For certain derivatives, this can cause income volatility that is entirely artificial and will ultimately, at maturity, have all previously recognized fair value gains wash out against fair value losses.  Economic hedges of hedged items (e.g., bond investments) designated as held-to-maturity cannot receive hedge accounting under FAS 133 even though the hedges must be booked at fair value.  The reason, as given in Paragraph 29e, is that this hedge is a credit hedge.  Fair value hedging of fixed-rate debt makes little sense since the item will be held to maturity.  Cash flow hedging of variable interest payments will wash out each other unless the interest payments cease in contract default.  The reasons for not allowing such hedges to receive FAS 133 hedge accounting treatment are clear.  However, what is not clear is why the hedges have to be booked to market value if they also will be held to maturity.

 

FAS 138 did very little to reduce the complexity of FAS 133 and the enormous confusions that exist among financial managers, accountants, and auditors.  Effectiveness testing remains a nightmare.  It is virtually impossible to write general software packages that can deal with the thousands of unique types of derivative instruments contracts used worldwide.

 

Some of the issues considered by the FASB that were either included or excluded in FAS 133 are summarized with thumbs-up and thumbs-down symbols in a Deloitte and Touche document http://www.us.deloitte.com/PUB/HEADSUP/7-1/feb07-01.htm.  The thumbs down topics that were considered and rejected by the FASB were as follows:

 

 

Topic

Perceived Problem

FASB Leaning

Accounting for Time Value in Purchased Options

Under today’s accounting, the time value of purchased options that qualify as hedges are recognized in expense ratably. Under FAS 133, the time value is recognized based on changes in fair value, leading to volatility in earnings.

The FASB will not consider the issue for a possible amendment.

Partial-Term Fair Value Hedges

Today, hedge accounting permits a hedger to swap to floating the first two years of interest on fixed-rate,  ten-year debt (other conditions need to be met). FAS 133 precludes fair value hedging for this strategy because the changes in fair value of the debt and the derivative won’t closely offset.

The FASB will not consider the issue for a possible amendment.

 

 

Hopefully, readers will give me feedback on both typos and issues of substance.  My email address is shown below:

 

Bob Jensen at email address rjensen@trinity.edu

 

A message concerning Normal Purchases and Normal Sales (NPNS)

I received a very long message and received permission to quote the message below regarding the Normal Purchases and Normal Sales (NPNS) amendment in FAS 138::

Hello Professor Jensen,

Great website! However, I have to disagree with your comment regarding the issue of NPNS.

I work for the Bonneville Power Administration (Bonneville), a federal based Electric Wholesale Power Marketer, we sell the output from the 29 federally owned dams on the Columbia and Snake River system in the Pacific Northwest.  I am the project manager for Bonneville responsible for implementing FAS 133.  More on Bonneville at the end of this email - postscript.

 

 Regarding the NPNS issue:    This issue is of big concern to the Energy industry as it relates to our normal sales and purchases activities.  I am most familiar with the Electric Utility  industry and the sales and delivery practices that are prevalent throughout the industry.  I would argue that Bonneville was much better off under the original statement para 10 (b) because the statement was silent on the practice I describe below referred to as "Bookouts".

 

Specifically, in the electric utility industry it is necessary and is considered best utility and business practice to perform a type of transaction called a "Bookout" whereby several transactions with the same Counterparty in the same month - a purchase and a sale - are offset and not scheduled for physical delivery.  For example, Bonneville may sell forward 200 MWs for the month of August 2000 in January 2000 based on our most current hydro forecasts and subsequently in May 2000 our most current forecasts now show a deficit and we have to purchase 200 MWs for the same month to cover our obligations.  We may from time to time find ourselves with both purchases and sales with the same counterparty in the same month at the same delivery location.  Just prior to delivery, we look at our schedule and try and match up transactions --- the "Bookout" procedure.

 

This "Bookout" procedure is common in the electric utility industry as a scheduling convenience when two utilities happen to have offsetting transactions. If this procedure is not used, both counterparties incur transmission costs in order to make deliveries to each other. The Bookout procedure avoids the energy scheduling process (an administrative burden as well) which would trigger payment of transmission costs.  We do not plan for this event or know in advance what we will bookout and we do not "Bookout" to capture a margin.  Rather, we find ourselves in this situation because of our inventory management constraints, maintenance schedules, and dependency on factors outside our control such as the weather and streamflows or environmental constraints placed upon us by other federal agencies or federal courts. 

 

We  lobbied the FASB and the DIG to clarify and revise the NPNS language to allow for this practice, but the FASB position was very restrictive -- if you do not deliver then it is considered net settled.   It seems to me and other industry participants that bookouts do not fit into the net settlement definition as it was described and intended in FAS 133. Rather it is a utility best practice that results in no physical delivery.  In addition, when we bookout the cash settling is done at the agreed upon contract prices - not at the market pricing.  We would argue that the Board's original intent was to capture net settlement mechanisms that require "market" settlement.   Unfortunately, the FASB made their decision about a practice without doing more homework on the nature of the transaction.  I understand the pressures the FASB was under to get the statement amended and implemented.  Unfortunately, the industry participants and practitioners are left to deal with the Board's end product.   The final 138 was not clear in its guidance either as it relates to these types of transactions and what this meant to our "similar" contracts that we want to qualify for NPNS.  I continue, along with our auditors, to hold discussions with FASB staff. 

 

What I am afraid may happen is that because of the "One size fits all approach by the FASB",  Bonneville and other regulated utilities will be forced into adopting a FV accounting approach on transactions that are simple sales and purchases.  Applying mark to market treatment to these transactions is more misleading to the financial statement reader not clearer - the original intent of 133.  I believe the interpretation of the final written words by individuals unfamiliar with the Energy industry is driving us into misleading and confusing presentation.

 

Any advice or encouragement you can provide would be appreciated.  We adopt October 1 and I have a deadline to meet and I still do not have final clear and convincing guidance.  I am ahead of most folks on this issue since we do have an earlier adoption date than most utilities.  Thanks for your time.  This is a complex issue and I apologize for the length of this email and I imagine I still have not described the issues in the most succinct and clear fashion.

 

Regards,

Sanford Menashe

Project Manager, FAS 133

Bonneville Power Administration

phone:  503-230-3570

email:  smmenashe@bpa.gov

 

Postscript:

 

About Bonneville Power Administration:

 

Bonneville is a federal agency under the Department of Energy, which was established over 60 years ago to market power from 29 federal dams and one non-federal nuclear plant in the Pacific Northwest. BPA’s energy sales are governed by federal legislation (e.g. the Northwest Power Act) and other regional mandates to maintain the benefits of power sales for the Pacific Northwest region and to manage its environmental and safety obligations relative to operating the federal hydroelectric system. Its primary objective is to provide low-cost electricity to the region by offering cost-based rates for its power and transmission services to eligible publicly owned and investor-owned utilities in the Pacific Northwest (including Oregon, Washington, Idaho, western Montana and small parts of Wyoming, Nevada, Utah, California and eastern Montana).

 

Sanford Menashe, Manager, FAS 133 Project.
Project Manager, FAS 133
Bonneville Power Administration
phone:  503-230-3570
email:  smmenashe@bpa.gov

Email: smmenashe@bpa.gov

 

Update in September 2001:
The DIG addressed Mr. Menasche's concerns, especially in Dig Issue C16.  See the term "Net Settlement" at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm

 

 

----Original Message----- From: sajjad [mailto:lima@flash.net]  Sent: Monday, July 24, 2000 9:39 AM To: Jensen, Robert Subject: Re: Correction.noted

I had been busy, will look at your over(underhedging) case for swaps. Like I said before that situation should also exist on forwards also? What do you think? . I do want to respond to one of your readers addressing the issue of "Bookouts". That phenomenon is common in the commodity biz, specifically in the Gas and Commodity business and it has been addressed by DIG, Firstly 138 has expanded the Normal Purchase and Sales exceptions in a way that on the 9(a) and 9(b) criteria have been relaxed. Secondly in applying the interpretation language to the case of Bookouts, the issue is the existence of a market mechanism that facilitates Net settlement. And settlement process in turn requires a process that extinguishes the existence of rights and obligations that have otherwise been created by the contract. If there exists a series of transactions whereby offsetting contracts are created that tend to offset each other, but DO NOT actually eliminate the rights and obligations of each party under contract, then they DONOT meet the definition, since the rights and obligation DO EXIST under each contract. They are merely offsetting not eliminating. This is exactly the case in most Bookouts.

The only exception will be, if the offsetting contract ends up with the counterparty that was the originating party. In that case the terminating contract will have the cancellation characteristics of the original contract's rights and obligations.

You can share my response with the reader who asked you the question. Also if you can elaborate his question, or provide me complete excerpt, I might be able to address it better.

Sajjad Rizvi
Energy Risk Consulting

YES you can post my message as follows:

We were hoping in the industry that the question addressing both "Back to Back" contracts and "Bookouts arrangements" will be addressed under 138 and the industry practice be recongized as NPNS (normal purchase normal sales). However, it appears that such contractual arrangement go against one of the key cornerstone concepts of the 133 pronouncement, that recognizes the derivatives as rights and obligation that meet the definition of assets and liabilities. In case of net settlement process in the bookouts and Back to back contracts, the orignal rights and obligations of multiple counterparties within the loop remain in tact. They are merely offsetting not actually eliminating or releiving the orignating counterparty of its asset or liability. Thus DIG clearly came out and has explicity stated for the BOOKOUTS to be excluded from NPNS scope.

However the attempt to expand the scope of the 10-b provision to include certain contracts affected by 9-a and 9-c net settlement requirements has failed to make a clear determination for NPNS (normal purchase normal sales). In the sense they have failed to address the contracts that fall under 9-c (large amount of power generators and commodity producers have contracts that fall into that category.One thing that is interesting is the expansion of the scope by including the word "probable" in its language of defining the intent of the parties not to Net settle, even though the 9a, 9b criteria of Net settlement is being met. The recent meeting by EITF on Energy related contracts could have provided more guidance on some of these issues, but I am not aware of any major "breakthroughs".

Secondly, an issue might be a major one for the commodity industry to consider, in view of the scrutiny that will follow the 133 implementation process starting next year. That is the issue of dislosure of hidden physical optionality embedded in the commodity contracts. Having been exposed to the trading market place as a Risk manager, I see a very big chunk of hidden "embedded optionality" sitting on the books of major Gas and power companies. Take or pay contracts, Requirements contracts, Swing contracts, Keep Whole Arrangements etc. Historically comanies with less sophistication and resources have always looked at them as NPNS, and primarily hedged them without hedging the optionality component (OC). Since the contracts were on the books without OC, the hedge was also a straight swap or a forward based on the face value of the hedged item, and hence no apparent discrepancies. Would that be a disclosable item effective Jan 2000? Would the non disclosure of the embedded optionality be OK, as it could qualify for "clearly and closely related" definition? If the answer is yes, then it can lead to a further question of what will be the structure of the derivative that will be required to hedge it, leading to a whole new valuation scope. Might create scope for more OTC structuring. Thus IF there is ANY optionality language in a GAS or OIL or POWER purchase or sales contracts, SFAS 133 implementation can force the industry to PRICE it.

Sajjad Rizvi Energy/Financial Risk Consulting lima@flash.net

Note from Bob Jensen (as suggested to me by Roy Monarch:

From the Emerging Issues Task Force EITF 98-10

Booking Out (or Netting Out)--Booking out is a procedure for financially settling a contract for the physical delivery of energy. Booking out occurs when one party appears more than once in a contract path for the sale and purchase of energy. In that instance, the intervening counterparties may agree that they will not schedule or deliver physical energy that originates and ends with the same counterparty, but rather will settle in cash the amounts due to or from each intervening counterparty, thus booking out the transaction.

Example:

In March, Utility X sells electricity for delivery in June to Marketer A. Marketer A sells June electricity to B, B sells to C, C sells to D, D sells back to A and A sells to Utility Z. Marketer A appears twice in the contract path. Prior to June, Marketers A, B, C, and D agree to settle the amounts due to/from each other in cash and agree not to schedule the flow of physical electricity between them. Rather, Utility X schedules the flow of electricity to Marketer A, who in turn schedules delivery of the electricity to Utility Z.

Flash Title--Flash title is an instantaneous flow-through of title caused by purchases and sales of energy for delivery at the same time and location, resulting in no physical movement by the purchaser or seller of the energy (also known as physical bookout).

Capacity Contract--A capacity contract is an agreement by an owner of capacity to sell theright to that capacity to another party to satisfy its obligations. For example, in the electric industry, capacity (sometimes referred to as installed capacity) is the capability to deliver electric power to the electric transmission system of an operating control area. A control area is a portion of the electric grid that schedules, dispatches, and controls generating resources to serve area load (ultimate users of electricity) and coordinates scheduling of the flow of electric power over the transmission system to neighboring control areas. A control area requires entities that serve load within the control area to demonstrate ownership or contractual rights to capacity sufficient to serve that load at time of peak demand (usually annual) and to provide a reserve margin to protect the integrity of the system against potential generating unit outages in the control area.

Requirements Contract--A requirements contract is a contract to serve the full needs of an end user of energy. For example, in the electric industry, an end user's electricity requirements consist of several components including:

o Installed capacity--the need to have generation owned or under contract which, if available, is sufficient to serve the expected peak demand of the customer plus reserves

o Load-following energy--energy provided when and as demanded by the end user, including adjusting the level of energy provided to reflect instantaneous changes in demand

o Transmission and ancillary services--those services necessary to deliver power from the generation source to the end user as well as the other services necessary to maintain the operational security and the integrity of the electric grid.

 

 

 

Some Resource Links

  • FAS 133 Copies  from the Financial Accounting Standards Board in the United States
    Publication Number 186-B, June 1998, Product Code S133
    FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities
    Web site http://www.rutgers.edu/Accounting/raw/fasb/public/index.html 
    For additional information about FASB subscriptions, please direct your inquiries as follows:
    Call: (800) 748-0659 (Weekdays 8:00am to 5:00pm EST)
    FAX: Attention FASB Subscriptions (203) 847-6045

·         FASB's FAS 138 Amendments to FAS 133
FAS 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities an amendment of FASB Statement No. 133 , Released June 15, 2000 --- http://www.rutgers.edu/Accounting/raw/fasb/public/index.html 

I have created a summary document called "FAS 133 As Amended and DIGed:
Introduction to FAS 138 Amendments and Some Key DIG Issues" at 
http://www.cs.trinity.edu/~rjensen/000overview/mp3/138intro.htm
 

·         One of the best documents the FASB generated for FAS 133 implementation is called "summary of Derivative Types."  This document also explains how to value certain types.  It can be downloaded free from at http://www.rutgers.edu/Accounting/raw/fasb/derivsum.exe

For a FAS 133 flow chart, go to http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm 

FASB's Exposure Draft for Fair Value Adjustments to all Financial Instruments
On December 14, 1999 the FASB issued Exposure Draft 204-B entitled Reporting Financial Instruments and Certain Related Assets and Liabilities at Fair Value.  This document can be downloaded from http://www.rutgers.edu/Accounting/raw/fasb/draft/draftpg.html 
(Trinity University students can find the document at J:\courses\acct5341\fasb\pvfvalu1.doc ).

If an item is viewed as a financial instrument rather than inventory, the accounting becomes more complicated under SFAS 115.  Traders in financial instruments adjust such instruments to fair value with all changes in value passing through current earnings.  Business firms who are not deemed to be traders must designate the instrument as either available-for-sale (AFS) or hold-to-maturity (HTM).  A HTM instrument is maintained at original cost.  An AFS financial instrument must be marked-to-market, but the changes in value pass through OCI rather than current earnings until the instrument is actually sold or otherwise expires.   Under international standards, the IASC requires fair value adjustments for most financial instruments.  This has led to strong reaction from businesses around the world, especially banks.  There are now two major working group debates.  In 1999 the Joint Working Group of the Banking Associations sharply rebuffed the IAS 39 fair value accounting in two white papers that can be downloaded from http://www.iasc.org.uk/frame/cen3_112.htm.

·         Financial Instruments:  Issues Relating to Banks (strongly argues for required fair value adjustments of financial instruments).  The issue date is August 31, 1999.  
Trinity University students may view this paper at J:\courses\acct5341\iasc\jwgbaaug.htm.  
Others may go to the IASC download site at http://www.iasc.org.uk/pix/banksjwg.pdf.

·         Accounting for financial Instruments for Banks (concludes that a modified form of historical cost is optimal for bank accounting).  The issue date is October 4, 1999
Trinity University students may view this paper at J:\courses\acct5341\iasc\jwgfinal.htm 
Others may go to the IASC download site at http://www.iasc.org.uk/pix/jwgfinal.pdf.

Recommended Tutorials on Derivative Financial Instruments (but not about FAS 133 or IAS 39)

·         You might start at http://www.finpipe.com/derivatives.htm.  

·         Then you can try Financial Derivatives in Plain English --- http://www.iol.ie/~aibtreas/derivs-pe/ 

·         For details on products and how they work in practice, I like the following tutorial/education websites:

CBOE --- http://www.cboe.com/education/ 

CBOT --- http://www.cbot.com/ourproducts/index.html 

CME --- http://www.cme.com/educational/index.html 

Recommended Tutorials on FAS 133

·         One of the best documents the FASB generated for FAS 133 implementation is called "summary of Derivative Types."  This document also explains how to value certain types.  It can be downloaded free from at http://www.rutgers.edu/Accounting/raw/fasb/derivsum.exe

·         The Appendix B examples in FAS 133.  You can also download Excel worksheet tutorials on the first 10 examples in files 133ex01a.xls through 133ex10.xls at http://www.cs.trinity.edu/~rjensen/ 
Instructions are given at http://www.cs.trinity.edu/~rjensen/13300tut.htm 

·         Bob Jensen's cases indexed at http://www.trinity.edu/rjensen/caseans/000index.htm 

·         The FASB's CD-ROM Self-Study CPE Training Course and Research Tool http://www.rutgers.edu/Accounting/raw/fasb/CDROM133.html 

·         The FASB provides some new examples illustrating the FAS 138 Amendments to FAS 133 at http://www.rutgers.edu/Accounting/raw/fasb/derivatives/examplespg.html

·         Implementation Guidelines on IAS 39 --- http://www.iasc.org.uk/frame/cen2_139.htm 

·         The excellent tutorials entitled Introductory Cases on Accounting for Derivative Instruments and Hedging Activities by Walter R. Teets and Robert Uhl available free from http://www.gonzaga.edu/faculty/teets/index0.html.

  • Accounting Firm Helpers
    • KPMG Book  Derivatives and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998). The book in hard copy or PDF versions can be ordered at http://www.us.kpmg.com/fs/publications/banking/deriv.html.
    • PwC Book that I cannot find an online reference to is the PricewaterhouseCoopers book entitled A Guide for Derivative Instruments and Hedging Activities.   PwC also has a book entitled FAS 133:  New Rules for Derivatives by Robert Sullivan and Lou Le Guyader. Another PwC book is entitled Derivatives and the Internal Auditor. You can order all PwC books and other risk publications at http://www.riskpublications.com/

Recommended Glossaries

Bob Jensen's FAS 133 Glossary on Derivative Financial Instruments and Hedging Activities

Also see comprehensive risk and trading glossaries such as the ones listed below that provide broader coverage of derivatives instruments terminology but almost nothing in terms of FAS 133, FAS 138, and IAS39:

·         http://risk.ifci.ch/SiteMap.htm

·         http://www.margrabe.com/Dictionary.html 

·         http://www.adtrading.com/glossary/glossary.htm

·         Related glossaries are listed at http://www.trinity.edu/rjensen/bookbus.htm