Introduction to FAS 133, FAS 138, and IAS 39
Accounting for Derivative Financial Instruments and Hedging Activities

This document was prepared for my
General Electric Train the Trainer Workshops on June 21 and 29, 2000

Bob Jensen at Trinity University

Introduction

Definitions

My free online cases are at http://www.trinity.edu/rjensen/caseans/000index.htm 

Recognition and Measurement of Derivatives

• Introduction

• Hedge Accounting

• Fair Value Hedges

• Cash Flow Hedges

• Foreign Currency Hedges

• Assessing Hedge Effectiveness

• Discontinuance of Hedge Accounting

• Disclosures

• Effective Date and Transition

Common Risk Management Strategies Under FAS 133

A Decision Flowchart for FAS 133 

Unfortunate Consequences of FAS 133 and IAS 39

A Condensed Outline Overview With Audio from Experts

Bob Jensen's Online FAS 133 and IAS 39 Glossary

My free online cases are at http://www.trinity.edu/rjensen/caseans/000index.htm 

Introduction

It may be best to take a look at a flowchart just to know that it is always there and can be viewed at any time.  The link is at http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm.  
Or the relative link is133flow.htm.

In 1998, the Financial Accounting Standards Board (FASB) issued Financial Accounting Standard 133 (FAS 133) on Accounting for Derivative Financial Instruments and Hedging Activities.  This was followed in 1999 by International Accounting Standard 39 (IAS 39) from the International Accounting Standards Committee (IASC).  Although less detailed and complex than FAS 133, IAS 39 accounting rules are virtually in accordance with FAS 133.  Differences are noted (in green) in Bob Jensen's Glossary at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm.  Paul Pacter itemized the major differences at http://www.iasc.org.uk/news/cen8_142.htm 

New Fair Value Exposure Draft
FAS 133 is arguably the most complex, controversial, and tentative standard ever issued by the FASB.  It is not tentative in terms of required implementation, but it may fade in prominence if and when the FASB issues its proposed fair value standard for all financial instruments.  The first exposure draft on this even more controversial proposal is given in Exposure Draft 204-B entitled Reporting Financial Instruments and Certain Related Assets and Liabilities at Fair Value at http://www.rutgers.edu/Accounting/raw/fasb/draft/draftpg.html 

The DIG
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 sumwarized (in red borders) at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#0000Begin.

The international equivalent of the DIG arose when the International Accounting Standards Committee issued  proposed Questions and Answers about IAS 39 on accounting derivative financial instruments recognition, measurement, and hedging activities --- http://www.iasc.org.uk/docs/0005qa39.pdf 

 FAS 138 Amendments to FAS 133
The more 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 

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

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 

Resources

The Financial Executives Institute (FEI) has some PowerPoint presentations available (from Arthur Andersen experts) on FAS 133.  Faculty and practitioners may find these useful --- http://www.fei.org/download/fas133.cfm 

Definitions

The FASB's FAS 133 and IASC's IAS 39 were badly needed standards in spite of strong opposition from the corporate world, especially from the banking community.  Many types of contracts included in the scope of these standards (e.g. swaps and forwards contracts) had no prior rules for accounting measurement or disclosure.  Settlement accounting failed to disclose or measure assets, liabilities, and risks of these contracts.  Some contracts had prior standards (e.g., FAS 80 covered futures contracts on commodities but not derivative financial instruments) that were inconsistent and incomplete.  Some corporations had enormous financial risks in derivative instruments that were not disclosed.

Initially the FASB and the IASC wanted very simple (apart from difficulties in measuring fair value) accounting standards that required all derivative instruments to be maintained at fair value with gains and losses due to changes in value being posted to current earnings.  Due to immense political pressures (that came down largely from financial institutions and their friends in government), special exceptions were granted for certain types of contracts.  As a result, the hoped-for simple fair value accounting standards turned into the most complex nightmares ever issued by either the FASB or the IASC.  Read about and listen to the experts complaining in http://www.cs.trinity.edu/~rjensen/000overview/wav/133sumw.htm.

A FAS 133 and IAS 39 Glossary is available at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm.  Complaints about both standards may be overshadowed by complaints about more recent movements by the FASB and the IASC to require fair value accounting for all financial instruments rather than just derivative instruments.  You can read about this and find links to the current exposure drafts for new standards requiring such fair value accounting.  Look up "Fair Value" at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#F-Terms.  If those new fair value standards are enacted, both FAS 133 and IAS 39 fade in importance.  Until then, however, implementation of FAS 133 and IAS 39 has become the most difficult and costly implementation of any accounting standards in history.  There are many complex and controversial issues with discovery of embedded derivatives, value estimation, and effectiveness testing of hedges being the most problematic issues.

Note especially that Appendix A beginning in Paragraph 57 of FAS 133 provides implementation guidance.  Section 2 of Appendix A beginning with Paragraph 62 deals with assessment of hedge effectiveness.

Derivative Financial Instrument

a financial instrument that by its terms, at inception or upon the occurrence of a specified event, provides the holder (or writer) with the right (or obligation) to participate in some or all of the price changes of an underlying (that is, one or more referenced financial instruments, commodities, or other assets, or other specific items to which a rate, an index of prices, or another market indicator is applied) and does not require that the holder or writer own or deliver the underlying.  A contract that requires ownership or delivery of the underlying is a derivative financial instrument if (a) the underlying is another derivative, (b) a mechanism exists in the market (such as an organized exchange) to enter into a closing contract with only a net cash settlement, or (c) the contract is customarily settled with only a net cash payment based on changes in the price of the underlying.  What is most noteworthy about derivative financial instruments is that in the past two decades, the global use of derivatives has exploded exponentially to where the trading in notional amounts is in trillions of dollars.  Unlike FAS 133, IAS 39 makes explicit reference also to an insurance index or catastrophe loss index and a climatic or geological condition.  

Tutorial:  Financial Derivatives in Plain English --- 
http://www.iol.ie/~aibtreas/derivs-pe/ 
There are some good examples of hedging and speculating strategies.  I did not, however, see anything on accounting for derivatives under FAS 133 or IAS 39.

A nonderivative financial instrument fails one or more of the above tests to qualify as a derivative in FAS 133.  Nonderivatives do not necessarily have to be adjusted to fair value like derivative instruments.  However, they may be used for economic hedges even though they do not qualify for special hedge accounting under FAS 133.  Exceptions in FAS 133 that afford special hedge accounting treatment for nonderivative instruments include hedges of foreign currency fair value and/or hedge foreign currency exposures of net investment in a foreign operation.  See FAS Paragraphs 6c, 17d, 18d, 20c, 28d, 37, 39, 40, 42, 44, 45, 246, 247, 255, 264, 293-304, 476, 477, and 479.  Also see foreign currency hedge.

It is important to note that all derivatives in finance may not fall under the FAS 133 definition.  In FAS 133, a derivative must have a notional, an underlying, and net settlement.  There are other requirements such as a zero or minimal initial investment as specified in Paragraph 6b and Appendix A Paragraph 57b of FAS 133 and Paragraph 10b of IAS 39.  Examples of derivatives that are explicitly excluded are discussed in Paragraph 252 on Page 134 of FAS 133.  Paragraph 10c of IAS 39 also addresses net settlement.  IASC does not require a net settlement provision in the definition of a derivative.  To meet the criteria for being a derivative under FAS 133, there must be a net settlement provision.  

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

There must also be zero or small net investment to meet the definition of a derivative financial instrument  (FAS 133 Paragraphs 6b and Appendix A Paragraph 57b.  Also see IAS 39 IAS 39: Paragraph 10b).

Key to this definition are the concepts of "underlying," "notional amount," and "payment provision."  An "underlying" in a derivative is a specified interest rate, security price, commodity price, foreign-exchange rate, or some other variable.  An underlying may be a price or rate of an asset or liability but is not the asset or liability itself.  Accordingly, the underlying generally will be the referenced index that determines whether or not the derivative has a positive or negative value.

A "notional amount" is a number of currency units, shares, bushels, pounds, or other units specified in the contract.  The notional amount represents the second half of the equation that goes into determining the settlement amount or amounts under the derivative contract.  Accordingly, the settlement of a derivative is determined by the interaction of the notional amount with the underlying.  This interaction may consist of simple multiplication or it may involve a more complex formula.  A "payment provision" specifies a fixed or determinable settlement that is to be made if the underlying behaves in a specified manner (e.g., if the rainfall in San Francisco exceeds five inches in a given month, a payment of $1,000,000 would be made).

Most futures, forwards, swaps, and options will meet the FAS 133 definition of a derivative.  As a general matter, one's intuition of what is or is not a derivative will probably align with the Standard most of the time.  Regarding intuition, however, it would be prudent to follow the motto:  Trust, but verify.

Like most man-made things, the FAS 133 definition is not perfect.  It includes some things that the FASB wanted to exclude and excludes some things that the FASB wanted to include.  So there are some exclusions and add-ons to the Standard.  Among the more important exclusions are

• "regular-way" securities trades (e.g., the purchase of an equity security traded on the New York Stock Exchange, which is technically a forward contract on the trade date);
  

• "normal" purchases and sales of inventory items;
  

• contingent consideration from a business combination;
  

• certain insurance contacts (such as traditional life and property/casualty insurance contracts) and financial guarantees;
  

• employee compensation arrangements; and
  

• contracts that are indexed to an entity's own stock and classified as part of stockholders' equity.

The exclusion of "normal" purchases and sales of inventory items may have the most relevance for some companies.  Simply stated, if a forward contract for the purchase or sale of inventory or other goods that are not financial instruments cannot be settled net and represents a purchase or sale that occurs in the entity's normal course of business, it is not accounted for under FAS 133, even though technically it might meet the definition of a derivative.

One of the things that concerns accounting standard-setters when they are considering a new standard is the possibility that people might find a way around the rules.  In the case of derivatives, the FASB realized that it may not be all that difficult for financial engineers to "embed" derivatives into contracts that clearly are not derivatives.  In so doing, these so-called "embedded derivatives" could escape the new accounting rules that are intended for them.  This concern led to the inclusion of certain "embedded derivatives" in the Standard's scope.

Embedded Derivatives

Embedded derivatives are portions of contracts that meet the definition of a derivative when the entire nonderivative contract cannot be considered a financial instruments derivative. Types of embedded derivative  instruments are often indexed debt and investment contracts such as commodity indexed interest or principal payments, convertible debt, credit indexed contracts, equity indexed contracts, and inflation indexed contracts.  Embedded derivatives are discussed in FAS 133, pp. 7-9, Paragraphs 12-16.  Embedded derivatives such as commodity indexed and equity indexed contracts and convertible debt require separation of the derivative from the host contract in FAS 133 accounting.  In contrast, credit indexed and inflation indexed embedded derivatives are not separable from the host contract.   Also see FAS 133 Paragraphs 51, 60, 61, 176-178, and 293-311. The overall contract is sometimes referred to as a "hybrid" that contains one or more embedded derivatives.  Embedded derivatives within embedded derivatives generally meet the closely-and-clearly related test and cannot be accounted for as separate derivatives.  The concept of "closely related is also discussed in IAS 39  Paragraph 23a.  Rules for accounting for the host contract after an embedded derivative has be bifurcated are discussed in FAS 133 Paragraph 16.  If an embedded derivative should bifurcated but the firm cannot do so for some reason, FAS 133 Paragraph 16 requires that the entire contract be treated as a trading security that is adjusted to fair value at least quarterly with changes and fair value being charged to current earnings rather than OCI.  See FAS 133 Paragraph 16 and IAS 39 Paragraph 26.

Paragraph 10 notes that interest only strips and principal only strips are not subject to FAS 133 accounting rules under conditions noted in Paragraph 14. In Paragraph 15, it is noted that embedded foreign currency derivatives "shall not be separated from the host contract and considered a derivative instrument."   Prepayment options on mortgage loans also do not qualify for accounting under FAS 133 according to Paragraph 293 on Page 146.  See compound derivative and embedded option.

An example is a leveraged gold note that has the amount of note's principal vary with the price of gold. This type of note can be viewed as containing a series of embedded commodity (gold) option contracts.  These options can separated out and accounted for as derivatives apart from the host contract under Paragraph 12 on Page 7 of FAS 133 under the assumption that the price of gold is not "clearly-and-closely related" to interest rates. 

An equity-linked bear note is another example of a note with a series of embedded options that can be accounted for as separate derivative instruments under Paragraph 12 of FAS 133.  For example, suppose such a note has 5% coupon bonds that increase interest rates at certain levels of movement up or down of an index such the S&P stock price index.  The embedded condition that interest rates may move up based upon an index can qualify as an embedded derivative that can be separated according to Paragraph 12 on Page 7 of FAS 133 provided the derivative is not clearly-and-closely related.   The S&P index is an equity index that is not clearly-and-closely related, whereas an interest rate index such a LIBOR is a clearly-and-closely related index.  The host contract (hedged item)  must be an asset or liability that is not itself a derivative instrument.   In this example, the bonds are not derivatives, and the embedded derivatives can be separated from the host contract under FAS 133 rules.  See equity-indexed.

Derivatives cannot be embedded in other derivatives according to Paragraph 12c on the top of Page 8 of FAS 133.. For example, an index-amortizing interest rate swap cannot usually be accounted for as a derivative instrument (pursuant to FAS 133 under Paragraph 12 on Page 7 of FAS 133) when it is a derivative embedded in another derivative.  Suppose a company swaps a variable rate for a fixed rate on a notional of $10 million.  If an embedded derivative in the contract changes the notional to $8 million if LIBOR falls below 6% and $12 million if LIBOR rises above 8%, this index-amortizing embedded derivative cannot be separated under Paragraph 12 rules.  KPMG states that Paragraph 12 applies only "when a derivative is embedded in a nonderivative instrument and illustrates this with an index-amortizing Example 29 beginning on Page 75 of the Derivatives and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998.  The prior Example 28 and the subsequent Example 30 illustrate index-amortizing embedded derivatives that qualifies since, in each example, the derivative is embedded in a nonderivative instrument.

One of the major sources of difference between FAS 133 and IAS 39 concerns embedded derivatives.  These are less important in IAS 39 accounting that adjusts all financial instruments to fair value whether or not derivatives are embedded.  International:  IAS 39 differs in that it requires fair value adjustments of "all" financial instruments rather than just derivatives --- see IAS Paragraphs 1, 5, and 6.  There are some exceptions for hybrid instruments as discussed in  IAS 39  Paragraphs 23b and 23c;  Also see FAS 133  Paragraphs 12b and 12c.

In summary, bifurcation under FAS 133 is required in the following examples:

• Call/Put Debt Option --- If options alter maturity dates, they are clearly and closely related to a debt instrument that requires principal repayments unless both (1) the debt involves a substantial premium or discount and (2) the put/call option is only contingently exercisable.  See FAS 133 Paragraph 61d.  An example is given in FAS 133 Paragraph 186.  Also see IAS 39 Paragraph 24g.
  

• Put/Call Equity Option on Host Equity Instrument --- A put option should be separated from the host contract by the issuer of the equity instrument except in those cases in which the put option is not considered to be a derivative instrument pursuant to FAS 133 Paragraph 11(a), because it is classified in stockholders' equity.  A call option embedded in the related equity instrument would not be separated from the host contract by the issuer, but would be otherwise for the holder of the related equity instrument.
  See FAS 133 Paragraphs 11a and 61b;  IAS 39 Paragraphs 11a, 24a, and 25b. 
  

• Equity-indexed interest payments --- See FAS 133 Paragraph 61h and an example given in SFAS Paragraph 185.  Also see IAS Paragraph 24d.
  

• Option to Extend Debt Maturity --- Variable annuity instruments are generally not subject to FAS 133 accounting rules except for specific components such as equity-index-based interest annuity and accumulation period payments discussed in Paragraph 200.  Also see IAS Paragraph 24c.
  

• Credit-linked Debt --- These are not  to be separated from the host contract for debt instruments that have the interest rate reset in the event of (1) default, (2) a change in the debtor's published credit rating, or (3) a change in the debtor's creditworthiness indicated by a change in its spread over Treasury bond.   See Paragraph 61c of FAS 133.  An example is given in SFAS Paragraph 190.  Also see IAS 39 Paragraph 24h.
  

• Equity Conversion Feature --- If an option is indexed to the issuer's own stock, a separate instrument with the same terms would be classified in stockholders' equity in the statement of financial position, so that the written option is not considered a derivative instrument.  See FAS 133 Paragraph 11a.  If a debt instrument is convertible into a shares of the debtor's common equity stock or another company's common stock, the conversion option must be separated from the debt host contract.  That accounting applies only to the holder if the debt is convertible to the debtor's common stock.  See FAS 133 Paragraph 61k.  An example is provided in Paragraph 199 of FAS 133.  Also see IAS 39 Paragraph 24f.
  

• Commodity-linked Notes --- A commodity-related derivative embedded in a commodity-indexed debt instrument must be separated from the host contract under FAS 133 Paragraph 61i.  Examples are given in FAS 133  Paragraphs 187 and 188.  Also see IAS 39 Paragraph 24e.

Bifurcation under FAS 133 is not allowed in the following examples:

• Loan Prepayment Options --- these are not bifurcated.  See Paragraphs 14, 189, and 198 of FAS 133 and Paragraph 25e of IAS 39.  This also included prepayment options embedded in interest-only strips or principal-only strips that (1) initially resulted from separating the right to receive contractual cash flows of a financial instrument that, in and of itself, did not contain an embedded derivative and that (2) does not contain any terms not present in the original host debt contract (IAS Paragraph 25f).
  

• Contingent rentals --- these are not bifurcated.  Examples include Contingent rentals based upon variable interest rates (FAS 133 Paragraph 68j), related sales, inflation bonds (FAS 133 Paragraph 191).  There also is no bifurcation of a lease payment in foreign currency (FAS 133 Paragraph 196), although the derivative should be separated if the lease payments are specified in a currency unrelated to each party's functional currency.  Also see (FAS 133 Paragraph 197).  Also see IAS 39 Paragraph 25g.
  

• Embedded Cap/Floor --- See FAS 133 Paragraph 183 for reasons why embedded caps and floors are not bifurcated.  See IAS Paragraph 25b.  
  

• Indexed amortizing note --- See Paragraph 194 in FAS 133.  Also see IAS 39 Paragraph 25h.
  

• Inverse Floater --- See Paragraphs 178 and 179 of FAS 133.  Bifurcation depends upon certain circumstances.   Inverse floaters are separated if the embedded derivative could potentially result in the investor's not recovering substantially all of its initial recorded investment.  In addition, Levered inverse floaters must be separated if there is a possibility of the embedded derivative increasing the investor's rate of return on the host contract to an amount that is at least double the initial rate of return on the host contract.  Also see IAS 39 Paragraph 25a.
  

• Some Foreign Currency Embedded Derivatives --- Dual Currency Bond (FAS 133 Paragraph 194) and Short-Term Loan with a Foreign Currency Option (FAS 133 Paragraph 195) if both the principal payment and the interest payments on the loan had been payable only in a fixed amount of a specified foreign currency, in which case remeasurement will be done according to SFAS 52 (refer to paragraph 194).   However, foreign currency options not clearly and closely related to issuing a loan should be separated (refer to FAS 133 Paragraph 195.)  Also see IAS 39 Paragraph 25c.

Appendix E in FAS 133 beginning in Paragraph 539 provides a flowchart for detecting embedded derivatives that must be bifurcated and accounted for separately.

A FAS 133 flowchart developed by Ira Kawaller and John J. Ensminger is reproduced at http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm

Recognition and Measurement of Derivatives

Unlike financial instruments in general, derivative financial instruments must be measured at fair value on the balance sheet.  For example, fixed-rate bonds are measured at amortized historical cost, but a swap of that bond interest is a derivative financial instrument that must be maintained at fair value.  Or a forward contact intended to hedge the value of the bond must be maintained at fair value.  By definition, most derivatives (e.g., futures, forwards, and swaps) have no value at inception or a relatively low value (e.g., option contract premiums).  Since many such contracts are hedges of hedged items, the hedge contracts (unlike the hedged items) must be revalued at least quarterly.

Two major problems in adjusting to fair value (marking to market) are as follows:

• How to measure custom contract fair value such as forwards and swaps that are not traded in active markets.  The main guidance is given in FAS 107, but the guidance is very limited.  Also, FAS 107 has a "practicality exception" that does not extend to FAS 133.  It is impossible to measure hedge effectiveness without some estimate of fair value.  
  
  

• Whether to record changes in fair value as current earnings or as other comprehensive income (OCI) that came into being with FAS 133.  Outside the U.S., many nations do not define an OCI alternative.  However, in the international standard IAS 39, the International Accounting Standards Committee allows for a similar accounting using some equity account other than retained earnings.

The income-statement recognition of changes in the fair value of a derivative will depend on the intended use of the derivative.  If the derivative does not qualify as a hedging instrument or is not designated as such, the gain or loss on the derivative must be recognized currently in earnings.  If the derivative qualifies for special hedge accounting, the gain or loss on the derivative will either (1) also be recognized in income, along with an offsetting adjustment that is made to the basis of the item being hedged, or (2) be deferred in other comprehensive income (i.e., in equity).  To qualify for special hedge accounting, the derivative must qualify either as a "fair value hedge," "cash flow hedge," or "foreign currency hedge."   

It should be stressed that many derivative contracts are not hedges, especially all speculative derivative instruments.  Also some economic hedges cannot receive special hedge accounting treatment.  For example, a recall option embedded in a fixed-rate note payable is an economic hedge that allows the debtor to recall the bonds if interest rates plunge.  This is a hedge in the sense that it becomes possible to refinance at lower interest rates.  However, since the embedded recall provision does not have to be bifurcated and accounted for separately if it is considered "clearly-and-closely related," there is no special accounting provision for this economic hedge.

Hedge Accounting

In a hedging strategy, a choice must be made as to whether to hedge fair value or cash flow.  It is impossible to hedge both at the same time.  For example, if a company enters into a "firm commitment" (with a fixed quantity and fixed price) to purchase inventory at a future date, it is possible to hedge fair value but not cash flow.  If it is instead a "forecasted transaction (with a fixed quantity and an unknown price) it is possible to hedge the cash flow uncertainty due to the unknown price.  

As a second example, suppose a company owns a $1,000, 10% bond currently selling at a discount of $900 because new buyers are currently demanding more than a 10% return on the bond.  With some type of derivative instrument, the holder of such a bond may hedge against future value declines below $900, but the combined cash flow (from the bond and the hedge) must be variable such that the investor has given up cash flow certainty for value protection.  In the inverse situation, an investor in a variable rate bond has no fair value risk (by definition of a variable rate bond that moves up and down with market interest rate changes).  Such an investor can enter into a hedge of unknown cash flows, but to do so requires giving up the certainty that fair value is not at risk.

Fair Value Hedges

A fair value hedge represents the hedge of an exposure to changes in the fair value of an asset, liability, or an unrecognized firm commitment that is attributable to a particular risk.  Some common examples of fair value hedges include:

• the use of an interest-rate swap to change-fixed rate debt into floating-rate debt;
  

• the use of futures contracts to hedge the fair value of copper or other types of inventory; and
  

• the use of a derivative to hedge the fair value of a firm commitment (e.g., to sell crude oil at a fixed price).

Several criteria must be met for a hedging relationship to qualify as a fair value hedge.  These criteria pertain to both the hedging instrument and the hedged item and are very prescriptive.  The excruciating level of detail in some of them illustrates quite well what many people believe to be a rather unfortunate state of affairs in U.S. generally accepted accounting principles today -- we seem to need a specific rule for every conceivable situation, plus a few extra rules to boot.  The more important (general) criteria that must be met if a hedging relationship is to qualify as a fair value hedge are as follows:

1. At the inception of the hedge, there is formal documentation of the hedging relationship and the entity's risk-management objective and strategy for undertaking the hedge.  This should include identification of the hedging instrument, the hedged item, the nature of the risk that is being hedged, and how the hedging instrument's effectiveness will be assessed.  There must be a reasonable basis for how the entity plans to assess the hedging instrument's effectiveness.  In short, the entity must clearly state what it is doing.
   

2. Both at the inception of the hedge and on an ongoing basis, the hedging relationship is expected to be highly effective in achieving the offset of changes in fair value that are attributable to the hedged risk during the period that the hedge is designated.  An assessment of effectiveness is required whenever financial statements or earnings are reported, and at least every three months.  In short, the entity must believe and regularly assess that its strategy will be effective.
   

3. The hedged item is a single asset, liability, or firm commitment, or is a specific portion thereof, or is a portfolio of similar items.  The FASB's interpretation of "similar" assets or liabilities in FAS 133 if very narrow -- when it says "similar," it means very similar.
   

4. The hedged item presents an exposure to changes in fair value that are attributable to a hedged risk that could affect reported earnings.  For example, this criterion precludes hedge accounting for transactions related to an entity's equity accounts (e.g., treasury stock), since earnings would not be affected.
   

5. If the hedged item is a nonfinancial asset or liability, the designated risk that is being hedged is the risk of changes in the fair value of the entire hedged asset or liability (reflecting its actual location, if it's a physical asset).  That is, the price risk of a similar asset in a different location or of a major ingredient may not be the hedged risk.  For example, if a derivative were used to hedge the exposure to changes in the fair value of tires held in inventory, the entity could not designate the market price of rubber as the hedged risk, even though rubber is a major component of the tires.
   

6. If the hedged item is a financial asset or liability, the designated risk that is being hedged can be the risk of (a) changes in the overall fair value of the entire hedged item or (b) changes that are attributable to changes in market interest rates, foreign currency exchange rates, or the obligor's creditworthiness.
   

7. The hedging instrument must be a derivative.  A nonderivative instrument, such as a treasury note, cannot be designated as a hedging instrument.

For a qualifying fair value hedge, the gain or loss on the hedging instrument (i.e., the derivative) is recognized currently in earnings.  The gain or loss (i.e., the change in fair value) on the hedged item attributable to the hedged risk also is recognized currently in earnings and adjusts the carrying amount (or "basis") of the hedged item.  This means that an asset or liability related to a firm commitment will appear on the balance sheet if the commitment is the subject of a fair value hedge.  Where the hedge is highly effective, the gains and losses generally will be equal and offsetting.  Earnings will be affected only to the extent that the hedge is not 100-percent effective.  The adjustment of the carrying amount of the hedged asset or liability is accounted for in the same manner as the other components of the carrying amount of the asset or liability.  For example, adjustments to hedged gasoline inventory would remain part of the gasoline inventory balance until the inventory is sold.  With respect to interest-bearing financial instruments, the adjustment is amortized to earnings beginning no later than when the hedged item ceases to be adjusted for changes in its fair value that are attributable to the risk that is being hedged.

Cash Flow Hedges

When observing the hedging strategies of different entities, the FASB noticed that risk to some entities is the risk of a change in fair value, whereas to other entities it is the risk of a change in cash flows.  For example, fixed-rate debt issued by an entity subjects the entity to a potential change in the fair value of the debt, but the interest cash flows are not subject to variation.  Floating-rate debt, on the other hand, is not subject to changes in its fair value as market interest rates change, but the interest cash flows may vary.  Thus was born the notion of a cash flow hedge.

A cash flow hedge is a hedge of an exposure to variability in cash flows that is attributable to a particular risk.  That exposure may be associated with an existing recognized asset or liability or a forecasted transaction (such as a forecasted purchase or sale).  Some common examples include

• the hedge of a forecasted sale or purchase of natural gas (or another commodity) with futures contracts; or
  

• the hedge of variable interest payments using an interest-rate swap to convert the variable payments into fixed payments.

As with fair value hedges, there are numerous prescriptive criteria that must be met in order for a hedging relationship to qualify as a cash flow hedge.  They are similar to the qualifying criteria for fair value hedges, the more important of which are as follows.

1. At the inception of the hedge, there is formal documentation of the hedging relationship and the entity's risk-management objective and strategy for undertaking the hedge, including identification of the hedging instrument, the hedged cash flow transaction, the nature of the risk that is being hedged, and how the hedging instrument's effectiveness will be assessed.  There must be a reasonable basis for how the entity plans to assess the hedging instrument's effectiveness.
   

2. Both at the inception of the hedge and on an ongoing basis, the hedging relationship is expected to be highly effective in offsetting the variability of cash flows that are attributable to the hedged risk during the term of the hedge.  An assessment of effectiveness is required whenever financial statements or earnings are reported, and at least every three months.
   

3. The forecasted transaction is specifically identified as a single transaction or a series of individual transactions.  If aggregated, the individual transactions must share the same risk exposure for which they are designated as being hedged.
   

4. The occurrence of the forecasted transaction is probable.
   

5. The forecasted transaction presents an exposure to variations in cash flow for the hedged risk, which could affect reported earnings.
   

6. If the hedged transaction is the forecasted purchase or sale of a nonfinancial asset, the designated risk that is being hedged is the risk of changes in the cash flows relating to all changes in the purchase price or sales price of the asset (reflecting its actual location, if it's a physical asset), not the risk of changes in the cash flows relating to the purchase or sale of a similar asset in a different location or of a major ingredient.
   

7. If the hedged transaction is the forecasted purchase or sale of a financial asset or liability, or, the variable cash flows of an existing financial asset or liability, the designated risk that is being hedged can be the risk of changes in the cash flows of the entire asset or liability, or, those changes in cash flows that are attributable to changes in market interest rates, foreign currency exchange rates, or the obligor's creditworthiness (or default).
   

8. The hedging instrument must be a derivative.

One of the legacies of double-entry bookkeeping (articulated by Luca Pacioli in the 15th Century)  is that debits must equal credits.  Generally, this means that the balance sheet articulates the income statement.  Sometimes, though, there is a tension between what is perceived as good for the balance sheet versus what is perceived as good for the income statement.  (For example, the LIFO method of inventory costing is usually viewed as meaningful for the income statement but of dubious merit for the balance sheet.)  The FASB admits to a balance sheet priority in setting many of its standards in the past two decades.  One of the main reasons is concern over understated liabilities and off-balance-sheet financing.  FAS 133 is one of the many standards where improved balance sheets result in volatile and confusing income statements.  In fact, earnings volatility resulting from FAS 133 and IAS 39 is the main reason for complaints raised by financial institutions and other corporations.

From time to time, accounting standard-setters have resolved this tension by allowing changes in balance-sheet assets and liabilities to bypass the income statement and go directly to equity.  As recently required by the FASB, such items are now included in other comprehensive income.  Prior to FAS 133, U.S. GAAP provided for three such items: foreign currency translation adjustments, unrealized gains and losses on available-for-sale debt and equity securities, and minimum pension liabilities.  The FASB has now added a fourth item resulting from cash flow hedge accounting.

Accounting for cash flow hedges involves the notion of other comprehensive income (OCI).  The effective portion of a hedging instrument's gain or loss is initially reported as a component of other comprehensive income (outside of earnings) and reclassified as earnings in the same period or periods during which the hedged forecasted transaction affects earnings (for example, when a forecasted sale actually occurs).  If the hedged transaction were to result in the acquisition of an asset or the incurrence of a liability, the gains and losses that had accumulated in other comprehensive income would be reclassified as earnings in the same period or periods during which the asset acquired or the liability incurred affects earnings (such as in the periods in which depreciation expense, interest expense, or cost of sales are recognized).  This procedure ensures that the "earnings impact" in future periods is equal to the price or cost that the entity "fixed" or "locked in" by entering into the cash flow hedge.

Foreign Currency Hedges

A foreign currency hedge can be a hedge of the foreign currency exposure of

• an unrecognized firm commitment (a fair value hedge),
  

• an available-for-sale security (a fair value hedge),
  

• a foreign currency-denominated transaction.  Prior to the FAS 238 amendments, the hedge could only be a cash flow hedge.  FAS 133 extended this to cross-currency fair value hedge such as a hedge of the value of variable rate note denominated in a foreign currency.
  

• a net investment in a foreign operation.

Although an available-for-sale security cannot have a fair value hedge (since the hedged item is adjusted for value changes in its own currency), it can be hedged for foreign currency risk whether it is an inter-company investment or with a third party provided the following conditions are met:

• the security is not traded on an exchange based upon the investor's functional currency,
  
  

• dividends and sale proceeds are denominated in the same foreign currency.

The accounting for a foreign currency fair value hedge and a foreign currency cash flow hedge follows the same principles as those that apply to the accounting for non-foreign currency hedges.  In a hedge of a net investment in a foreign operation, the gain or loss on the hedging instrument is reported in other comprehensive income (outside of earnings) as part of the cumulative translation adjustment (as provided for in FAS 52, Foreign Currency Translation).

Except for available-for-sale securities, FAS 133 precludes a recognized foreign currency-denominated asset or liability from being a hedged item, because such an asset or liability is remeasured with the changes in carrying value (attributable to what would be the hedged risk -- i.e., an exchange-rate change) reported currently in earnings.  The FASB's rationale for prohibiting a foreign currency-denominated asset or liability from being a hedged item is that the transaction gains and losses on the asset or liability arising from changes in exchange rates would naturally be, to a great extent, offset in the income statement by the changes in the fair value of the derivative.

Generally, FAS 133 retains the hedge-accounting provisions currently in practice for foreign currency hedges.  To accommodate this, the Standard makes a couple of exceptions to its overall hedge-accounting model.  The two exceptions relate to permitting (1) hedge accounting for a net investment in a foreign operation and (2) the designation of nonderivative financial instruments denominated in a foreign currency (such as foreign currency debt) as part of a hedge of a firm commitment or of a net investment.  Both are continuations of practices permitted prior to FAS 133.

Two aspects of FAS 133 that mark a notable departure from previous practice in the foreign currency area are (1) an entity's ability to hedge forecasted transactions with foreign currency forward contracts or combination options and (2) an entity's ability to hedge with a tandem currency (provided that effectiveness can be demonstrated).

Assessing Hedge Effectiveness

Perhaps the key qualifying criterion for hedge accounting under FAS 133 is that the hedging relationship between the hedging instrument and the hedged item be highly effective in achieving the offset of changes in those fair values or cash flows that are attributable to the hedged risk, both at the inception of the hedge and on an ongoing basis.  An assessment of this effectiveness is required at least every three months and whenever financial statements or earnings are reported by the entity.  This requirement is meant to have the same meaning and application as the "high correlation" assessment required by current accounting rules.  It does not mean that there must be a "reduction of risk," as was required under the pre-FAS 133 hedge model.

FAS 133 requires that an entity, as part of the designation of a hedging relationship, define up front how it will assess a hedge's effectiveness in achieving the offset of changes in fair value or the offset of cash flows that are attributable to the risk that is being hedged.  In this regard, FAS 133 requires that, throughout the hedge period, an entity consistently use a defined method to (1) assess whether it expects the hedging relationship to be highly effective in achieving offset and (2) measure the ineffective part of the hedge.  The Standard does not limit an entity to specifying a single method for assessing effectiveness and provides entities with a reasonable amount of flexibility.  Generally, however, it would be expected than an entity would assess effectiveness for similar hedges in a similar manner.  Any changes that an entity might make to its method of assessing effectiveness would have to be justified and would be applied prospectively by there being a discontinuation of the existing hedging relationship and a new designation of the relationship through the use of the improved method.

Statistical techniques, such as regression analysis, and expectations about future changes based on various pricing models may often be used at the hedge's inception to assess the probable future effectiveness of a hedging relationship.  The test of actual past effectiveness (i.e., the ongoing effectiveness during the hedge period) should be measured based on the actual results of the hedge.  A common way of measuring the degree of ongoing effectiveness is to divide the cumulative price (or cash flows) change for the hedging instrument by the cumulative price (or cash flows) change of the hedged item that is attributable to the risk that is being hedged.  Although there is not precise guidelines, in order for a hedging relationship to qualify for ongoing "high effectiveness," the changes in the fair value or cash flows of the hedging instrument must, at a minimum, be between 80 percent and 125 percent on the inverse changes in the fair value or cash flows of the hedged item.  FAS 133 requires the termination of hedge accounting for hedging relationships that are no longer "highly effective."

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 correlate perfectly with the 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 sumwarized 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 each period 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.  When 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.  

Paragraph 63 of FAS 133 reads as follows:

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. This 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, as follows:

a. If the effectiveness of a hedge with an option contract is assessed based on changes in the option's intrinsic value, the change in the time value of the contract would be excluded from the assessment of hedge effectiveness.

b. If the effectiveness of a hedge with an option contract is assessed based on changes in the option's minimum value, that is, its intrinsic value plus the effect of discounting, the change in the volatility value of the contract would be excluded from the assessment of hedge effectiveness.

c. If the effectiveness of a hedge with a forward or futures contract is assessed based on changes in fair value attributable to changes in spot prices, the change in the fair value of the contract related to the changes in the difference between the spot price and the forward or futures price would be excluded from the assessment of hedge effectiveness.

Paragraph 69 of FAS 133 reads as follows [also see (IAS 39 Paragraph 152)]:

The fixed rate on a hedged item need not exactly match the fixed rate on a swap designated as a fair value hedge. Nor does the variable rate on an interest-bearing asset or liability need to be the same as the variable rate on a swap designated as a cash flow hedge. A swap's fair value comes from its net settlements. The fixed and variable rates on a swap can be changed without affecting the net settlement if both are changed by the same amount. That is, a swap with a payment based on LIBOR and a receipt based on a fixed rate of 5 percent has the same net settlements and fair value as a swap with a payment based on LIBOR plus 1 percent and a receipt based on a fixed rate of 6 percent.

Paragraph 10c of IAS 39 also addresses net settlement.  IASC does not require a net settlement provision in the definition of a derivative.  To meet the criteria for being a derivative under FAS 133, there must be a net settlement provision.  

The following Section c in Paragraph 65 on Page 45 is of interest with respect to a premium paid for a forward or futures contract:

c. Either the change in the discount or premium on the forward contract is excluded from the assessment of effectiveness and included directly in earnings pursuant to Paragraph 63 or the change in expected cash flows on the forecasted transaction is based on the forward price for the commodity.

Delta ratio D = (D option value)/ D hedged item value)
range [.80 < D < 1.25] or [80% < D% < 125%]      (FAS 133 Paragraph 85)
Delta-neutral strategies are discussed at various points (e.g., FAS 133 Paragraphs 85, 86, 87, and 89)

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:

a) difference between the basis of the hedging instrument and the hedged item or hedged transaction, to the extent that those bases do not move in tandem.

b) differences in critical terms of the hedging instrument and hedged item or hedged transaction, such as differences in notional amounts, maturities, quantity, location, or delivery dates.

c) part of the change in the fair value of a derivative is attributable to a change in the counterparty's creditworthiness (FAS 133 Paragraph 66).

The method an enterprise adopts for assessing hedge effectiveness will depend on its risk management strategy.  In some cases, an enterprise will adopt different methods for different types of hedges.  For instance, an interest rate swap is likely to be an effective hedge if the notional and principal amounts, term, repricing dates, dates of interest and principal receipts and payments, and basis for measuring interest rates are the same for the hedging instrument and the hedge item (IAS 39 Paragraph 147).  Sometimes the hedging instrument will offset the hedged risk only partially.  For instance, a hedge would not be fully effective if the hedging instrument and hedged item are denominated in different currencies and the two do not move in tandem.
(IAS 39 Paragraph 148).

Especially note the section of Short-Cut Method for Interest Rate Swaps.

See further paragraphs 73-103 for illustrations of assessing effectiveness and measuring ineffectiveness:

Example 1: Fair Value Hedge of Natural Gas Inventory with Futures Contracts (FAS 133 Paragraphs 73-77)

Example 2: Fair Value Hedge of Tire Inventory with a Forward Contract
(FAS 133 Paragraphs 78-80)

Example 3: Fair Value Hedge of Growing Wheat with Futures Contracts
(FAS 133 Paragraphs 81-84)

Example 4: Fair Value Hedge of Equity Securities with Option Contracts
(FAS 133 Paragraphs 85-87)

Example 5: Fair Value Hedge of a Treasury Bond with a Put Option Contract
(FAS 133 Paragraphs 88-90)

Example 6: Fair Value Hedge of an Embedded Purchased Option with a Written Option
(FAS 133 Paragraphs 91-92)

Example 7: Cash Flow Hedge of a Forecasted Purchase of Inventory with a Forward Contract
(FAS 133 Paragraphs 93-97)

Example 8: Cash Flow Hedge with a Basis Swap
(FAS 133 Paragraphs 98-99)

Example 9: Cash Flow Hedge of Forecasted Sale with a Forward Contract
(FAS 133 Paragraphs 100-101)

Example 10: Attempted Hedge of a Forecasted Sale with a Written Call Option
(FAS 133 Paragraphs 102-103)

Note especially DIG Issue E7 at http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issuee7.html 

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

Discontinuance of Hedge Accounting

Under FAS 133, an entity would discontinue hedge accounting if (1) a hedge were to fail to meet any of the qualifying criteria of FAS 133 or (2) the derivative were to expire or be sold, terminated, exercised, or simply dedesignated as a hedging instrument.

The accounting for the discontinuance of a hedge depends on the reason for the discontinuance.  Generally, discontinuance will not have an immediate effect on earnings -- for either fair value hedges or cash flow hedges -- with two exceptions.  In a fair value hedge of a firm commitment, it is possible that the firm commitment will no longer qualify as such.  In this expected-to-be-rare situation, any asset or liability that had been recognized through cumulative mark-to-market adjustments of the firm commitment will be removed from the balance sheet, and a corresponding gain or loss will be recorded in earnings.  In a cash flow hedge of a forecasted transaction, it is possible that an entity may later determine that it is probable that the forecasted transaction will not occur.  In this situation, the gain or loss that had accumulated in other comprehensive income will be recognized immediately in earnings.  Note here a subtle but deliberate use of words by the FASB.  In order to preclude situations in which an entity might manipulate earnings by changing its estimate of probability (i.e., transferring gains deferred in other comprehensive income to earnings due solely to a change in the assessment of probability), the FASB decided to require earnings recognition of amounts accumulated in other comprehensive income only for those cases in which an entity determines that it is probable that the forecasted transaction will not occur, rather than when it is no longer probable, or reasonably possible, that the forecasted transaction will occur.

Disclosures

The disclosure requirements of FAS 133 are quite extensive.  The Standard requires certain general disclosures, quantitative disclosures for certain "failed" hedges, and some additional disclosures for cash flow hedges and hedges of a net investment in a foreign operation, as follows:

General disclosures:

• Qualitative information: The entity's objectives and strategies for holding and issuing derivatives, and a description of the items or transactions for which risks are hedged
  

• Quantitative information: The net gain or loss recognized in earnings for the period representing aggregate ineffectiveness for all hedges, and the components of the derivatives' gains or losses excluded from the assessment of hedge effectiveness

Disclosure of certain "failed" hedges: FAS 133 requires an entity to disclose the amount of gains and losses recognized in earnings as a result of (1) a previously hedged firm commitment that becomes no longer firm (for example, the commitment is canceled) or (2) a previously hedged forecasted transaction that becomes not probable of occurring.

     

Additional cash flow hedge disclosures:

• Qualitative information: A description of the forecasted transactions being hedged, the maximum period of time before the transactions are expected to occur, and the transactions or other events that will result in the recognition in earnings of gains and losses that have accumulated in other comprehensive income
  

• Quantitative information: An estimate of the amount of gains and losses included in other comprehensive income that will be recognized in earnings within the next twelve months
  

• Changes in the components of other comprehensive income: FAS 133 requires an entity to display within other comprehensive income the net gain or loss on derivative instruments that are both designated as and qualify as cash flow hedges.  In addition, beginning and ending accumulated derivative gains and losses, the related change associated with current-period transactions, and the amount of any reclassification as earnings are also required to be displayed pursuant to FAS 130, Reporting Comprehensive Income.

Additional net-investment hedge disclosures: FAS 133 requires disclosure of the hedging instrument  foreign currency-transaction gains or losses that are included in the cumulative translation adjustment for the period

SEC Market Risk Disclosures http://www.sec.gov/rules/othern/derivfaq.htm 

Effective Date and Transition

FAS 133 implementation deadlines were delayed by the FASB.  It is now effective for all fiscal quarters of fiscal years beginning after June 15, 2000 and January 1, 2001, for calendar-year entities).  The Standard can be implemented early, as of the beginning of any fiscal quarter subsequent to the Standard's issuance (i.e., as early as July 1, 1998), but it cannot be applied retroactively to financial statements of prior periods.

As might be expected, accounting for the transition to such a markedly different approach for derivatives and hedging is rather complex.  Upon adoption of the Standard, all derivatives must be recognized on the balance sheet at their then fair value.  Any stand-alone deferred gains and losses remaining on the balance sheet under previous hedge-accounting rules must be removed from the balance sheet, since the FASB determined that they don't meet the definition of an asset or liability.  All hedging relationships must be designated anew and documented pursuant to the new accounting rules.  In many cases, the designations will be consistent with the hedging purpose that had been previously in place.  However, in some cases, the hedge relationship may not qualify for hedge accounting under FAS 133.  The initial designation upon the adoption of the Standard will serve as the basis for the transition adjustments made in the financial statements (e.g., in a fair value hedge, the hedged item's carrying amount also will be adjusted as part of the transition).  In the period of adoption, the transition adjustments will include (1) a net effect on earnings, if the hedge relationship is designated as a fair value hedge and (2) a net effect on other comprehensive income, if the hedge relationship is designated as a cash flow hedge.

FAS 133's transition provisions permit, at the date of initial application, entities to reclassify any held-to-maturity security as either an "available-for-sale" or "trading" security so that, in the future, they may be able to designate such a security as the hedged item in a fair value hedge or designate its variable interest payments as the hedged item in a cash flow hedge.  Held-to-maturity securities generally cannot otherwise be hedged.  Any reclassification of held-to-maturity securities pursuant to the adoption of FAS 133 will not, however, call into question an entity's intent to hold other debt securities to their maturity in the future.

Public companies that choose not to adopt FAS 133 early must follow the disclosure requirements of SEC Staff Accounting Bulletin No. 74, Disclosure of the Impact That Recently Issued Accounting Standards Will Have on the Financial Statements of the Registrant When Adopted in a Future Period.  Beginning with the first quarterly report issued after June 15, 1998, such disclosures should include

• a brief description of FAS 133, the date that adoption is required, and the date that the entity plans to adopt the Standard, if earlier;
  

• a discussion of the methods of adoption allowed by FAS 133 and the method expected to be utilized by the entity, if one has been determined;
  

• a discussion of the impact that the adoption of FAS 133 is expected to have on the financial statements of the entity, unless this is not known or reasonably estimable (in that case, a statement to that effect should be made); and
  

• disclosure of the potential impact of other significant matters that the entity believes might result from the adoption of FAS 133 (such as technical violations of debt covenant agreements, planned or intended changes in business practices, etc.) is encouraged.

Common Risk-Management Strategies Under FAS 133

Here are a number examples of common strategies and a brief analysis of how FAS 133 affects these strategies.

1. Identify all embedded dervatives and evaluate whether they have to be bifurcated under FAS 133 rules.  This entails an organized effort, sometimes worldwide, to have trained FAS 133 employees examine active financial contracts. It is especially troublesome in Asia where the business culture is one of trust rather than written documentation and contracting on paper.  
   
   

   Roger Pearson at Union Carbide CARBR10.WAV http://www.cs.trinity.edu/~rjensen/000overview/WAV/CARBR10.WAV

    

   Audio Clip on Costs of Detection and Documentation http://www.cs.trinity.edu/~rjensen/000overview/wav/133sumw.htm#Detection

   
   
   

2. Lock in or cap/floor an interest rate for a forecasted future borrowing/investing
   
   Interest rates on forecasted transactions can be hedged in a variety of ways.   Derivatives such as interest-rate options, futures, or forward contracts can accomplish this objective.   Example 9 beginning in Paragraph 153 illustrates use of a swap.   Under FAS 133, such a hedging strategy would constitute a cash flow hedge, provided that all requisite conditions of Paragraphs 28-29 are met.  The effective portion of the hedge is closed to OCI each time the derivative is marked to market (at least quarterly).  My CapIt and FloorIT Bank cases illustrate using Eurodollar options as hedges of interest rates on forecasted transactions.  See 
   http://www.trinity.edu/rjensen/acct5341/133cases/000index.htm .
   
   Note that cash flow hedge gains and losses are not automatically closed to OCI.  Effectiveness must be tested.  The ineffective portion due to over-hedging must be closed to current earnings.
   
   

   Martin Klein from Lehman Brothers http://www.cs.trinity.edu/~rjensen/000overview/WAV/KLEIN10.WAV

   
   

3. Convert variable-rate debt/investment into fixed-rate debt/investments by using an interest-rate swap
   
   This strategy illustrates one of the classic uses of interest-rate swaps as a cash flow hedge.  A company issues variable-rate debt (e.g., commercial paper) and, by entering into an interest-rate swap, it receives a payment based on a variable interest rate and makes a payment based on a fixed interest rate.  Or a company invests at a variable rate and hedges the variability of interest income.  Prior to FAS 133, accounting for these situations followed what became known as "synthetic-instrument accounting."  The effect was that the income statement was the same as if the company actually had issued fixed-rate debt or invested in a fixed rate note.  
   
   Under FAS 133, this technique should qualify as a cash flow hedge, with essentially the same income-statement effect as before.  The balance sheet, of course, will now be grossed up to reflect the swap's fair value and its changes in fair value that are deferred in other comprehensive income.  It is worth noting, however, that FAS 133 requires that a specific swap be designated as hedging a specific debt instrument or instruments (or portions thereof) to qualify for hedge accounting.  Previously, some companies took a broader view of things, designating a portfolio of swaps as being linked to a portfolio of debt instruments.
   
   It is important to note that if an interest rate swap satisfies effectiveness criteria for the shortcut method as illustrated in Paragraph 132 of FAS 133, then it is not necessary to test for effectiveness every quarter of the hedge.  The hedging of a variable interest investment is illustrated in Example 5 of FAS 133 beginning in Paragraph 131.  Jensen and Hubbard make some corrections in this example and elaborate upon how answers are derived at http://www.trinity.edu/rjensen/caseans/133ex05.htm.
   

4. Hedge foreign currency risk of debt/investment using an interest-rate swap
   
   This strategy illustrates one of the FAS 133 areas where effectiveness testing can destroy some of the OCI postings.  The problem is that FAS 52 uses spot rates and FAS 133 requires forward rates.  These two rates are often not sufficiently correlated to avoid ineffectiveness.
   
   

   Jin Chang from Lehman Brothers http://www.cs.trinity.edu/~rjensen/000overview/WAV/CHANG30.WAV

    

5. Convert nonprepayable fixed-rate debt into variable-rate debt by using an interest-rate swap
   
   This common technique is the mirror image of the one just described.  However it is a fair value hedge rather than a cash flow hedge.  A company issues fixed-rate debt and, by entering into an interest-rate swap whereby the company receives a payment based on a fixed interest rate and makes a payment based on a variable interest rate, synthetically creates variable-rate debt.  The popularity of both this and the previous technique comes from arbitrage opportunities in the various interest-rate markets, thus creating lower borrowing costs for companies.  Prior to FAS 133, synthetic-instrument accounting was followed, with the effect being that the income statement was the same as if the company actually had issued variable-rate debt.  
   
   Under FAS 133, this technique should qualify as a fair value hedge, with essentially the same income-statement effect as before.  However, unlike previous practice under the rather broad umbrella of synthetic-instrument accounting, hedge accounting for this technique may not be available for a plain-vanilla interest-rate swap if the underlying fixed-rate debt is prepayable or callable, because the changes in the debt's fair value may not be highly effective in offsetting the changes in the swap's fair value that are due to changes in market interest rates.
   
   An illustration of the use of a swap to hedge the fair value of an investment is illustrated in Example 2 of FAS 133 beginning in Paragraph 111.  Jensen and Hubbard elaborate on this illustration in http://www.trinity.edu/rjensen/caseans/133ex2.doc.
   

6. Monetize an embedded call option in existing callable fixed-rate debt
   
   As interest rates declined over the 1990s, companies increasingly entered into various transactions to monetize embedded call options in existing callable fixed-rate debt.  A typical situation involves a company that has outstanding callable fixed-rate debt.  Due to a decline in interest rates, it would be advantageous to the company to call the debt and refinance at lower interest rates.  However, the call provision is not exercisable until some contracted time in the future.  By writing a separate option that effectively neutralizes the purchased call option embedded in the debt, the company receives cash currently.  
   
   Prior to FAS 133, it was somewhat difficult to achieve hedge accounting for such transactions, due to the SEC staff position that hedge accounting was inappropriate for freestanding written options; companies had to resort to more complicated structures.  FAS 133 makes it easier to achieve hedge accounting for call monetizations because, assuming that all the conditions are met, a freestanding written option can qualify as a fair value hedge of an embedded purchased option.
   

7. Protect against the weakening of a foreign currency for anticipated export sales by a U.S. parent company
   
   One of the most common hedging strategies in the foreign currency area is to guarantee the dollar value of a U.S. parent company's expected future export sales that will be denominated in a foreign currency.  FAS 133, which treats such a forecasted transaction as a cash flow hedge, makes this process much easier than it was previously by allowing foreign currency forward contracts to be used and achieve hedge accounting.  Under prior rules and practice, only purchased options (which many companies viewed as too expensive) could qualify for hedge accounting with respect to these forecasted transactions.  Also, FAS 133 is more liberal than the previous rule in permitting a so-called "tandem currency" to be used in foreign currency hedging.  A tandem currency is one that is expected to move in tandem with the currency that represents the actual foreign currency exposure.
   

8. Protect against the strengthening of a foreign currency when the U.S. parent company has a firm commitment to buy a fixed asset and the price is denominated in a foreign currency
   
   This is another classic example of foreign currency hedging.  Assume, for example, that a U.S. company has committed to buy a sophisticated piece of optical equipment from a German company and that the price is fixed in deutsche marks (or, perhaps, euros).  To lock in the dollar cost of the equipment, the U.S. company enters into a foreign currency forward contract to receive marks and pay dollars.  Consistent with current rules, such a transaction would qualify as a fair value hedge under FAS 133 (i.e., a foreign currency hedge of a firm commitment).  The income-statement effects would be largely unchanged from previous accounting practices.
   
   An illustration of this type of hedge is provided in Example 10 beginning in Paragraph 165 of FAS 133.
   

9. Protect against the weakening of a foreign currency for anticipated sales by a foreign subsidiary whose functional currency is not the foreign currency in which the sales will occur
   
   This is a convoluted way of addressing a situation in which, for example, a U.K. subsidiary, whose functional currency (an accounting term) is the pound, expects future sales in France that will be denominated in francs.  It is similar to the export-sale situation described in item (5) above, and the hedging strategy would be similar.
   
   However, FAS 133 introduces a requirement that could have significant practical implications for multinational entities that use centralized treasury centers (TCs) for hedging foreign currency risk.  In such a structure, the TC receives information about foreign currency exposures from a number of foreign subsidiaries.   The TC first attempts to offset these exposures within the consolidated group and then enters into hedging contracts for only the next exposure.  FAS 133 requires that, in order for these structures to qualify for hedge accounting, there must be (1) an intercompany hedging contract between the foreign subsidiary and the parent or TC and (2) another hedging contract between an independent third party and the parent or TC.  Essentially, the parent or TC must act as an intermediary between the foreign subsidiary and a third party, and the hedging gain or loss must be "pushed down" to the subsidiary.  The problem is that the new rules may restrict the ability of the TC to enter into a net contract by requiring that the parent or TC enter into contracts with third parties for "gross" amounts (that is, separate contracts for all long positions and short positions), without internal netting of currency exposures.  Accordingly, entities with centralized treasury operations may now have to incur additional transaction costs and increased counterparty risk.
   
   Relevant paragraphs in FAS 133 include Paragraphs 40 and 483.
   

10. Protect against the weakening of a foreign currency for a net investment in a foreign subsidiary
    
    The hedging strategy seeks to maintain the dollar value of a company's investment in one or more foreign subsidiaries whose functional currency is the local currency.  It sometimes is used as a surrogate for hedging anticipated dividends from a foreign subsidiary.  Foreign currency forward contracts, options, or nonderivative financial instruments, such as foreign currency debt, can all be used as the hedging vehicle.  
    
    This is one of only two areas (the other being the hedge of a foreign currency firm commitment) where FAS 133 permits nonderivatives to qualify as hedges.  The accounting for this hedging strategy is largely unchanged from that of previous practice.
    

11. Lock in the current price of a precious metal, such as gold, for anticipated sales of future production
    
    This hedging strategy often involves the use of forward contracts or option combinations that can be settled net.  Prior to FAS 133, there had been considerable uncertainty as to whether these types of transactions should be accounted for under the hedge-accounting rules or, rather, thought of simply as contracts for the sale of goods.  
    
    The forecasted purchase of lumber inventoried at cost can be a hedged item, but the forecasted purchase of gold or some other "precious" market commodity cannot qualify for OCI deferral as a hedged item.   The reason is that  "precious" items under GAAP are booked at maintained at market value.  For example, suppose a forward contract is entered into on January 1 when commodity's price is $300 per unit.  The "political issue" issue faced by the FASB is merely a matter of when gains and losses on the derivative contract are posted to current earnings.  If the price goes up to $400 per unit on July 1 when the commodity is actually purchased, there is a $100 per unit deferred gain on the forward contract that is transferred from OCI to current earnings if the commodity is lumber.  If the commodity is "precious" gold, however, there is no intervening credit to OCI because of Paragraph 29d on Page 20 of FAS 133. 
    

12. Lock in the current price of a commodity, such as lumber, for anticipated purchases/sales
    
    This strategy is similar to the previous one, except that it relates to qualifying cash flow hedges rather than precious commodities.  It can qualify as a cash flow hedge if it meets all the conditions in Paragraphs  29 and 30.  If the purchase is a firm commitment, however, it cannot be a cash flow hedge.   If it is not net settled it also cannot be a derivative.  FAS 133 clarifies this issue, generally requiring that such forecasted transactions can  be accounted for as derivatives.  The exception is for contracts that, by their terms, (a) require delivery of the asset subject to the contract, (b) are not traded on an exchange, (c) are for quantities that are reasonable in relation to the company's business activities, and (d) cannot be settled net.  Contracts that meet criteria (a) - (d) are considered normal sales and, thus, would be accounted for as such according to Paragraphs 271-272.  A derivative that is used to fix the price of anticipated future sales will be a cash flow hedge under FAS 133 if the derivative does not meet the aforementioned criteria and, thus, the specific exception for normal sales.

A Decision Flowchart for FAS 133

Appendix E in FAS 133 beginning in Paragraph 539 provides a flowchart for detecting embedded derivatives that must be bifurcated and accounted for separately.

A FAS 133 flowchart developed by ," Ira Kawaller and John J. Ensminger is reproduced at http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm

Unfortunate Consequences of FAS 133 and IAS 39

Probably the most unfortunate consequence is that firms that tend to hedge portfolios of financial assets and liabilities rather than individual components of the portfolio now must, except in unlikely circumstances, drill down to each component and link a hedge to each component rather than the portfolio as a whole.  The only exception is when all items in the portfolio are nearly identical in terms of risk and maturity dates.  Very few portfolios meet those conditions.

The consequence of having to change from portfolio hedging strategies to item hedging is only one of many unfortunate consequences of FAS 133 and IAS 39.

Other unfortunate consequences of FAS 133 and IAS 39 are the reactions of companies, security analysts, and investors to the fact of or efforts to mitigate the fact of earnings volatility and liability reporting.  Purportedly, some of our most prominent companies are sub-optimizing due to fears that better economic decisions (e.g., macro hedges) will adversely affect stock prices and volatility.  If you are reading this online and can play WAV files, click on the following examples of audio statements by some of the leading experts in the world.

• Wall Street is busily designing new derivative instruments to help customers comply with FAS 133 rules.
• Louis Le Guyader of PwC reports that foreign currency risk managers are changing strategies because of FAS 133.
• FAS 133 is causing some bad economic decisions in order have "better" accounting reports
  
  • Bob Jensen and the Equity Analyst Panel in NYC on December 14  Audio Clip PANEL01.WAV
  • Mike Koegler from Chase Bank Audio Clip KOEGLER80.WAV 
  • Martin Klein from Lehman Brothers Audio Clip KLEIN10.WAV  
  • Jin Chang from Lehman Bothers Audio Clip CHANG30.WAV  
  • Eileen Fahey from Duff & Phelps Audio Clip FAHEY06.WAV  

An unhappy executive at Chase Bank  
    Audio of Mike Koegler of Chase Bank  KOEGLER3.WAV
    Audio of Mike Koegler of Chase Bank  KOEGLER4.WAV

• The main issue is increased volatility from fair value adjustments 

• Audio of Mike Koegler of Chase Bank  KOEGLER5.WAV  
• Audio of a senior portfolio manger named Scott McGrossin  MCCROS01.WAV  
• Audio of equity analyst Gerard Cassidy  CASSIDY1.WAV  
• Audio of equity analyst Mark G. Brennan  BRENNAN1.WAV  

• The bottom line is crucial no matter how voluminous are the supplementary disclosures

• Audio from a panel of top financial analysts  PANEL02.WAV
• That unmentioned specter of compensation tied to earnings measures

However, in spite of all you heard above, there are also many, many companies who side with the FASB/IASC and go about implementing the standards with minimal complaints.  One such company is Union Carbide.

• Roger Pearson (Manager of Accounting Research at Union Carbide) CARBR30.WAV 

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Bob Jensen's Home page is at http://www.trinity.edu/rjensen/