This is Bob Jensen's Answer File to the
Introductory SFAS 133 Questions
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Key Web Sites
Bob Jensen's Helpers and Links to Key Web Sites
Question 01
Yahoo Finance is Bob Jensen's Favorite Place to learn more about the mechanics and widespread use of derivative financial instruments. That web site, however, will not help much with respect to accounting for such instruments under SFAS 133
Financial instruments derivatives are contracts that derive their value from outside indices such as interest rates, foreign exchange rates, commodity prices, and most any other time series variable with an uncertain future. Derivatives may be used for speculation, but they are more commonly used to hedge financial risks. The problem in many instances is that multiple derivative contracts often become so complex that even experts have a difficult time evaluating overall risk across many contingencies. SFAS 133 elaborates on the definition of a derivative instrument on Pages 132-138, Paragraphs 248-266.
Derivatives are typically written up in terms of a "notional" amount and a rate that is applied to that notional amount. The notional amount is not delivered and is only used as a basis for what is delivered.
The traditional derivative contracts are as follows:
An exchange-traded contract between a buyer or seller and the clearinghouse of a futures exchange to buy or sell a standard quantity and quality of a commodity, financial instrument, or index at a specified future date and price. Futures contracts commonly require daily settlement payments (known as the variation margin) for changes in the market price of the contract and often permit or require a final net cash settlement, rather than an actual purchase or sale of the underlying asset. Not all futures contracts are financial instruments derivatives. Futures on commodities, for example, are not necessarily financial instruments related unless qualifying as hedges of anticipated transactions.
Futures contracts are traded in block amounts such as $100,000 each for interest rate futures on U.S. Treasury notes. Trading markets may be very thin (in terms of numbers of traders and frequency of trades) for certain types of futures contracts.
Forward Transaction or Forward Contract
These are agreements to deliver cash, foreign currency, or some other item at a contracted date in the future. The key distinction between futures versus forward contracts is that forward contracts are customized and are not traded in organized markets. Unlike with futures contracts, it is very simple to specify exact terms such as the exact notional amount and rate to be applied. In the case of a futures contract, it may be difficult or impossible to find the needed combinations traded in markets. However, since forward contracts are not traded in markets, their value is often very difficult to estimate.
Since forward contracts are individually contracted, often through third party investment banks or brokers, the transactions costs of a forward contract can be high relative to futures contracts. Matters of settlement assurances must be contracted since they do not carry the settlement guarantees of futures contracts.
Swaps are agreements to barter items in question. For example, a company having no credit rating in a Japan may entice a Japanese investor to borrow the money and then swap interest payments with the company. Since notional (loan principals) are not swapped, there may be less credit risk than traditional lendings of principal plus interest to foreign borrowers.
With derivatives investments aggregating to nearly the $1 trillion level in notional amounts, well over half are interest rate swaps around the world. There are, of course, other types of swaps such as foreign currency swaps.
What makes options different from futures and forwards contracts is that the buyer (not the writer) of the option pays for the option up front and has no further obligation or risk of losing more than the initial purchase price of that option.
A contract that gives the purchaser the right to buy or sell an asset (such as a unit of foreign currency) at a specified price within a specified time period. A call option gives the holder the right to buy the underlying asset; a put option gives the holder the right to sell it. An option is "in the money" if the holder would benefit from exercising it now. A call option is in the money if the strike price (the exercise price) is below the current market price of the underlying asset; a put option is in the money if the strike price is above the market price. An option is "out of the money" if the holder would not benefit from exercising it now. A call option is out of the money if the strike price is above the current market price of the underlying asset; a put option is out of the money if the strike price is below the market price.
Option contracts may be obtained from organized exchange markets or they may be custom contracts between two or more parties. There are two types of contracting parties. The "writer" of an option who produces a "written option" takes on the obligation for future performance. For example the writer of a put option has an obligation to sell the contracted item or deliver the cash equivalent to a future purchase price. The writer of a call agrees to buy the item instead of selling at a future date. However, unless the option is "in the money," the writer will not be called upon to perform. A "covered" put from the writer’s standpoint means that the writer of the option actually owns the item in question and will not have to gamble on buying it in the future in order to make good on the option.
As indicated earlier, the buyer of the option is not obligated to perform in the future and stands only to lose the initial price of the option. Options are often purchased by speculators seeking buying/selling leverages with minimal capital at risk. Options are often written or sold by speculators who gamble that the option has little chance of becoming "in the money" during the contract period.
American options can be settled at any time during the option’s contractual period. Purchasers of European options must wait until the closing date of the contract. Asian options use an averaging settlement formula. An Asian option's pay-off is based on the difference between the contracted strike price and the average foreign exchange rate over a specified period of time. A case on accounting for Asian options is given by one of my students as follows just prior to the issuance of SFAS 133:
Brandon J. Lamb For his case and case solution on Case Study on Asian Options click on http://www.resnet.trinity.edu/users/blamb/5341/cover.htm
The objective of this case is to illustrate the implementation of a derivative financial instrument to hedge against a particular risk. Students are shown how to account for a derivative transaction used by Texas Electronics Company (TEC) to hedge foreign exchange rate exposure. The case is designed to help students identify and solve derivatives problems and to present current accounting standards related to derivatives.Many, actually most, options are not financial instruments derivatives. Options to purchase stocks and commodities become derivatives only when financial instruments are involved. For example, an employee stock option to purchase shares in his or her employer’s company is not a derivative per se. However, an option to that locks in the price of an anticipated transaction to purchase inventory is a derivative.
A case on options accounting was provided by one of my students as follows just prior to the issuance of SFAS 133:
Manisha Shah For her case and case solution on Accounting For Options and Futures in the Gas Industry click on http://www.resnet.trinity.edu/users/mshah/5341/cover.htm
The objective of this case is to provide students with an opportunity to prepare and evaluate accounting for a derivative transaction used by Burns Energy Associates as a means of managing risk. The case is designed to expose the student to commodity derivatives and its place in the energy industry. Also, the case focuses on enhancing students' ability to analyze a series of transactions while introducing current standards to effectively account for them. In 1997, Burns contracted Smithers Investment Group to recommend a hedging strategy that would protect it from adverse price movements in the natural gas market. As a result, the company entered into a natural gas futures option to hedge against the possibility of falling prices in the marketplace. Attaching option packages such as caps, floors, and collars further complicate this case.
Another student writes on put options as follows:
Willie J. Roberts For his case and case solution entitled Interest Rate Caps Using Put Options: A Case Analysis click on http://www.resnet.trinity.edu/users/wroberts/title.htm
The following is a case analysis for an Accounting Theory Project for Robert J. Jensen. It entails a fictional company in need of capital to fund a project. The following case will look at accounting issues involved in the case, as the company uses an interest rate cap by way of a put option to hedge against interest rate risk. A proposed method for measuring risk designed to meet the SEC rule of "quantitative" in "forward-looking information, which includes these quantitative and qualitative disclosures outside the financial statements."
Combinations and Specialized Hedging Contracts
There is a complex array of alternatives that have a terminology known only to specialists and experts. Certain combinations of derivatives that simultaneously hedge both interest rates and foreign currency risks are known as "circuses." One of my students wrote a case just prior to SFAS 133 on circuses as described below:
Brian T. Simmons For his case and case solution entitled ACCOUNTING FOR CIRCUS SWAPS: AN INSTRUCTIONAL CASE click on http://www.resnet.trinity.edu/users/bsimmons/circus/framecase.htm
This case examines a basic circus swap which involves not only the exchange of floating interest rate for fixed, but also one currency for another. Separation of the effects from both interest rate and foreign currency fluctuations is no simple matter. In fact, no formal accounting pronouncements specifically address this issue.
The introduction first reviews the history and reasoning of pronouncements leading up to Exposure Draft 162-B. For years, institutions have relied on settlement accounting to record their derivative instruments. With growing concern over the risk of these instruments, however, the SEC and FASB have attempted to increase the detail of disclosure regarding the value and risk of their derivative portfolio. The case provides an example of a hybrid instrument in the form of a circus swap. The case questions review the accounting for these types of instruments under the current settlement accounting guidelines as well as the new fair-value method. Additionally, a simplistic measure of Risk Per Contract (RPC) is developed. By using information that is easy for management to obtain, the likelihood of the benefits of RPC outweighing the costs is greatly enhanced.
Another complex combination entails joining a swap with an option in a "swaption." One of my students wrote the following swaption case just prior to SFAS 133:
Suzanne M. Winegar For her case and case solution entitled Understanding swaptions: A case study click on http://www.resnet.trinity.edu/users/swinegar/swaption.htm
The objective of this case is to provide an example of a company that purchases an interest rate swaption in order to hedge the variability of its interest payments. Swaptions are a type of derivative financial instrument for which there are no accounting standards or guidelines. This case explains one method that could be used to account for swaptions and mark them to market. In order to mark the swaptions to market, this case uses the Black-Scholes Model to determine the fair value of the swaption. The case presents a series of questions dealing with valuation and accounting issues, and ends with a discussion of the risk involved in using swaption derivatives.To my knowledge the FASB has not yet taken up the complicated combination of an interest rate swap joined with a credit risk derivative. One of my students wrote a case on this as follows:
John D. Payne For his case and case solution entitiled A Case Study of Accounting for an Interest Rate Swap and a Credit Derivative click on http://www.resnet.trinity.edu/users/jpayne/coverpag.htm
The objective of this case is to provide students with an in-depth examination of a vanilla swap and to introduce students to the accounting for a unique hedging device--a credit derivative. The case is designed to induce students to become familiar with FASB Exposure Draft 162-B and to prepare students to account for a given derivative transaction from the perspective of all parties involved. In 1991, Vandalay Industries borrowed $500,000 from Putty Chemical Bank and simultaneously engaged in an interest rate swap with a counterparty. The goal of the swap was to hedge away the risk that variable rates would increase by agreeing to a fixed-payable, variable-receivable swap, thus hopefully obtaining a lower borrowing cost than if variable rates were used through the life of the loan. In 1992, Putty Chemical Bank entered into a credit derivative with Mr. Pitt Co. in order to eliminate the credit risk that Vandalay would default on repayment of its loan principal to Putty.Another one of my students wrote a case on a specialized derivative known as a "contango" as follows just prior to SFAS 133:
Debra W. Hutcheson For her case and case solution on Accounting for Commodity and Contango Swaps, click on http://www.resnet.trinity.edu/users/dhutches/project.htm
This case examines the interplay of a cotton consumer and a cotton producer, both participating in a commodity swap, one of the many commodity-based financial instruments available to users. Each party wants to protect itself from commodity price risk and the cotton swap allows each participating party to "lock-in" a price for 6 million pounds of cotton. One party might lose in the cotton swap and, therefore, must enter into some other derivative alternatives. Additionally, this case examines the requirements for accounting for these contracts under the FASB’s latest exposure draft on accounting for derivatives and the "forward-looking" disclosure required by the SEC.
Still another type of derivative is the "quanto" swap used in the following case:
Linda O. Norman For her case and case solution on Financial Derivatives and Foreign Currency Risk go to http://www.resnet.trinity.edu/users/lnorman/quantotc.htm
The rest of this paper is dedicated to providing the reader with an illustration of a foreign currency derivatives contract. The contract, a quanto swap, illustrates one combination of the standard derivative instruments. A quanto swap, also known as a diff swap, is a combination of the foreign currency swap and interest rate swap.
Recall that the currency swap usually involves the exchange of principal and interest payments of a local firm for that of a foreign entity. In an interest rate swap, both of the firms are local and only the interest payments are exchanged. Out of the intersection of the currency and interest rate swap comes the quanto swap. This contract involves the exchange of interest payments of a local firm for that of a foreign entity. The local firm will pay interest at the foreign interest rate, but its notional will be held in the local currency.
Yahoo Finance is Bob Jensen's Favorite Place to learn more about the mechanics and widespread use of derivative financial instruments. That web site, however, will not help much with respect to accounting for such instruments under SFAS 133
Question 02
What is the political history of
SFAS 133 arose from the derivatives instrument scandals of the1980s and 1990s. The best known is the derivatives trading activities that plunged Orange County (in California) into bankruptcy with over $1.6 billion in speculation losses caused by its treasurer named Rober Citron. Only a portion of these losses were recovered when the Merrill Lynch brokerage firm paid out $467 million in civil penalties and legal fees. Some major business corporations ended up with millions at stake in liabilities that were not booked. There were no accounting rules other than settlement (cash flow) accounting for the most popular types of derivatives such as interest rate swaps. The issue essentially revolves around accounting for an organization's financial risk exposures and risk management practices. A more detailed history of SFAS 133 is provided in Pages 119-122, Paragraphs 206-216. Incompleteness of hedge activity accounting is discussed in Paragraphs 235-237.
In the early 1990s the SEC increased disclosure requirements and brought pressure to bear upon the Financial Accounting Standards Board (FASB) to issue a standard requiring booking of all derivatives at fair market value. In June 1996, the FASB issued the controversial Exposure Draft ED 162-B that proposed fair market booking of derivative instruments and criteria for timing of recognition of changes in fair market value as
earnings. Changes in fair value were required to be closed into current earnings unless some controversial hedging criteria are met allowing for deferral as "other comprehensive income" under SFAS 130 for cash flow hedges and other means of deferral for value hedges.
ED 162-B unleashed a hailstorm of criticism from industry in general and especially the banking industry. In particular, criticisms were leveled at the FASB’s lack of guidance on how to measure fair market value and failure to allow for "macro hedging." Macro hedging would not require that a derivative instrument contract be tied to risk exposure of a particular asset or liability (or a grouping of such items having identical risk exposures." (See the discussion under the term "Hedge" in the Glossary.) Also see SFAS 133 Paragraphs 357-361 and 443-450. Another criticism that still remains focuses on the FASB's stance on pro rata accounting for compound derivatives. See Paragraphs 360-361 on Pages 167-168 of SFAS 133.
In 1996, SEC Chairman Arthur Levitt estimated that over $70 trillion in innovative financing instruments are not booked as assets or liabilities in balance sheets. Senator Phil Gramm (R-Texas) introduced a bill in the Senate to absolve banks from having to meet the forthcoming FASB standard. What is really irritating is that the title of the bill is "The Accurate Accounting Standards Certification Act of 1998." That bill on "accuracy" would have preserved off-balance sheet financing options for banks.
On another front, Congressman Richard Baker (R-La) introduced legislation to delay the forthcoming FASB standard on booking of derivatives in all corporations. Derivative financial instruments are especially popular in global deals involving interest rate swaps, foreign currency swaps, forward rate agreements, options, and futures contracts in financial instruments.
In June of 1998, the FASB fended off industry and political pressure and unanimously passed on the issuance of a SFAS 133 that is only slightly modified from its controversial ED 162-B predecessor. A bulletin from the AICPA reads as follows:
"Highlights: Damn the Torpedoes --- Full Speed Ahead," Journal of Accountancy, July 1998, Page 4
The FASB derivatives project has caused so much controversy that many observers doubted it would be issued at all. But last month, the FASB unanimously approved it as Statement no. 133. To give companies time to study its complex provisions, FASB made it effective for fiscal years beginning after June 15, 1999.
For corporate America and its accounting firms, the new statement means highly technical financial accounting rules. And for the CPA profession in general, the project is a political challenge as business and other groups petition Congress to end a long tradition of private standard-setting.
The new law of the land
FASB said it built the statement on four pillars: Derivatives are assets and liabilities that should be reported, fair value is the most relevant measure, only assets and liabilities should be reported as such (gains and losses should not be reported as assets and liabilities) and special accounting should be limited to qualifying hedge transactions. According to the FASB, "Gains or losses resulting from changes in the values of derivatives would be accounted for depending on the use of a derivative and whether it qualified for hedge accounting."
FASB made a number of modifications during the exposure period, such as: (1) several changes will reduce volatility in earnings, (2) revised criteria for qualification as a hedged asset or liability will allow companies to apply hedge accounting in most risk management strategies and (3) the common practice of rollover hedging strategies is eligible for hedge accounting.
The political problems may prove harder to resolve than the accounting ones. FASB Chairman Edmund Jenkins continues to say the new standard is key to helping investors make informed decisions. Nevertheless, corporate complaints led to congressional hearings in October 1997. Two separate bills—HR 3165 and S 1560--would rein in some of FASB’s power. Jenkins has strongly opposed any government interference in FASB’s process. The Journal asked Jenkins why he thought so many companies had objected. "The objection seems to be coming from those who trade or sell derivative instruments. They’re concerned the new statement will affect the market for them negatively. I think many companies have stopped using derivatives because there have been no standards. The new statement gives some certainty to derivatives—I can see more companies using them."
Jenkins pointed to many supporters of the derivatives statement and the FASB’s standard setting process generally. For example, several members of Congress who are or have been CPAs wrote to their congressional colleagues urging them to support FASB.
Jenkins also emphasized the approximately 140 public meetings FASB has held over a six-year period to allow every party to air its views.
Many remain unconvinced. "It’s fatally flawed," said Donna Fisher, CPA, the American Bankers Association’s director of tax and accounting, in an interview with the Journal. "We believe the FASB should have taken a broad look at market value accounting. Also, the statement focuses on individual hedging transactions rather than on macro hedging. Hedge accounting is not permitted for macro hedging—and we think that’s the direction in which corporations are going." The ABA believes the FASB should have tried to make macro hedging workable. In discussing implementation, she said, "Entities already using derivatives will find this statement complicated; others unfortunately may decide to avoid derivatives altogether. I don’t think the accounting results are logical." She said the ABA had involved itself deeply in the FASB’s process, sending representatives to many meetings. "We support Representative Baker’s bill—HR 3165. We think it will improve FASB’s process."
Commentaries that provide useful information are given in the transcriptions of experts at http://WWW.Trinity.edu/rjensen/acct5341/speakers/133glosf.htm
Question 03
What major accounting rules applied to derivatives before the FASB’s SFAS 133?
What FASB standards were superseded by SFAS 133? Discuss in terms of each types of derivative listed in your
answer to Question 1.
Prior to SFAS 133, accounting for derivatives was largely settlement (cash basis) accounting falling into the category of off balance sheet financing (OBSF). The SEC and the FASB tightened up disclosure rules. FASB 119 belatedly issued on disclosure requirements was admittedly only an interim disclosure standard that awaited booking rules in the subsequent SFAS 133. The SEC issued more controversial disclosure standards that will be addressed in another question.
Prior to the disclosure standards mentioned above that emerged in after 1995, there was virtually no information regarding millions of dollars in derivative investments and financial obligations. It was virtually impossible to analyze risk measurement practices of management in this regard. Transactions were sometimes so complex, experts within the companies themselves often did not fully comprehend the risk exposures from derivatives.
Probably the best example of bad accounting was in the area of interest rate swaps and foreign currency swaps. In effect there were no rules, which is possibly why nearly 80% of the trillions of dollars in swaps world wide were off balance sheet and not reported until cash settlements transpired. The only FASB documents that applied to Swaps were as follows:
EITF Issue 84-07 on Termination of Interest Rate Swaps
EITF Issue 84-36 on Interest Rate Swap Transactions
EITF Issue 88-08 on Mortgage Swaps
By analogy using SFAS 80 & SFAS 52
(SFAS 80 is superseded by SFAS 133)
The most explicit accounting rules for derivatives were the rules that covered futures contracts in SFAS 80. Forward Contract and Option contracts were mainly covered only by analogy using SFAS 80 and an AICPA 86-2 document. Futures were covered by SFAS 80, but that standard did not cover the hedging specifics in SFAS 133.
Foreign currency documents prior to SFAS 133 included the following:
SFAS 52 on Foreign Exchange Translation
EITF Issue 90-17 on Hedging Foreign Risk with Purchased Options Contracts
EITF Issue 91-04 Hedging Foreign Currency Risks with Complex Options, etc.
However, none of the above documents covered foreign currency Swaps.
The following standards were entirely superseded by SFAS 133:
- SFAS 80 (Accounting for Futures Contracts);
- SFAS 105 (Disclosure of Information about Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk);
- SFAS 119 (Disclosure about Derivative Financial Instruments and Fair Value of Financial Inatruments).
Ammendments to existing pronouncements are Found in SFAS 133, Appendix D, Paragraphs 525-538
Question 04
What are the controversial disclosure rules required by the SEC for derivatives?
Issues Regarding FASB Derivatives Disclosures
SFAS 119 encouraged, but does not require, quantitative information about market risks of derivative financial instruments, and also of other assets and liabilities, that is consistent with the way the entity manages or adjusts risks and that is useful for comparing the results of applying the entity's strategies to its objectives for holding or issuing the derivative financial instruments. SFAS 133 supercedes SFAS 105 and 119.
SFAS 119 amended Statement 105 to require disaggregation of information about financial instruments with off-balance-sheet risk of accounting loss by class, business activity, risk, or other category that is consistent with the entity's management of those instruments. SFAS 133 supercedes SFAS 105 and 119.
SFAS 119 amended Statement 107 to require that fair value information be presented without combining, aggregating, or netting the fair value of derivative financial instruments with the fair value of nonderivative financial instruments and be presented together with the related carrying amounts in the body of the financial statements, a single footnote, or a summary table in a form that makes it clear whether the amounts represent assets or liabilities. SFAS 133 supercedes SFAS 105 and 119.
SFAS 133 deals with disclosure at various points, especially in Paragraphs 502-513 on Pages 216-221.
Issues Regarding SEC Derivatives Disclosures
The new Rules, which amend Regulation S-X and Regulation S-K, require the following new disclosures:
The required information includes the fair values of the instruments and contract terms needed to determine expected cash flows for each of the next five years and aggregate cash flows thereafter. This information should be categorized by expected maturity dates. The information should be grouped based on whether the instruments are held for trading or for other purposes and summarized by market risk category, subdivided by specific characteristics within a risk category, such as US dollar/German mark and US dollar/Japanese yen foreign currency exchange risk. The subdivision based on characteristics should be made to the extent it better reflects the market risk for a group of instruments.
A registrant that holds nonderivative financial instruments that have material amounts of market risk, such as investments, loans, and deposits, is required to make the qualitative and quantitative disclosures of market risk, even though the registrant may hold no derivatives.
The new Rules are effective for filings that include financial statements for fiscal periods ending after June 15, 1997. However, for registrants that are not banks or thrifts and that have a market capitalization of $2.5 billion or less on January 28, 1997, the effective date for the quantitative and qualitative disclosures outside the financial statements about market risk is delayed one year.
Registrants are required to provide summarized quantitative market risk information for the preceding fiscal year. They should explain the reasons for material quantitative changes in market risk exposures between the current and preceding fiscal years in sufficient detail to enable investors to determine trends in market risk information.
One of my students wrote a case on risk aggregation as follows:
Joseph F. Zullo For his relational database project in Microsoft Access that disaggregates and then aggregates various types of risk on interest rate swaps, click on http://www.resnet.trinity.edu/users/jzullo/title.htm
The heart of this project is a relational database. The term project topic was "suggested aids for using emerging technologies in measuring and evaluating investment risk." To that end, I created a relational database that is able to track the use of derivative instruments and assign risk to individual contracts. The creation of the database is an attempt at dissaggregated reporting. Theoretically, an investor could access the database through the Internet and compute custom reports and evaluate individual measures of risk associated with each derivative. The benefit of dissaggregated reporting lies in the investor’s ability to perform the aggregation of relevant data. In today’s environment, investors have to rely on annual financial statements of a company to acquire relevant information. The financial statements of a company do not always provide a complete picture of the financial condition of the company. Notably, off-balance sheet items such as derivative financial instruments do not appear in the body of the financial statements. The FASB and the SEC have made strides to overcome this reporting deficiency with pronouncements that require more informational disclosures in the financial statements.
A commentary on SEC disclosure rules is given by Walter Teets at http://WWW.Trinity.edu/rjensen/acct5341/speakers/133teets.htm
Question 05
What is the IASC
planning for derivatives accounting?
On the heels of SFAS 133 in the U.S. the International Accounting Standards Committee (IASC) intends to issue its own standard for derivatives accounting and hedging activities. Initially, some representatives of the IASC implied that it intended to go along with the (then) anticipated SFAS 133. However, after a change of mind the IASC is conducting research and is expected to issue its own standard requiring booking of derivatives at fair market value. It will be part of a broader based document on financial instruments reporting. In reality, the IASC is moving more quickly than the FASB on requiring booking of fair market value changes in assets. The IASC has Exposure Draft 62 that is about to terminate with respect to a July 15 deadline. In December 1998, the IASC issued IAS 39 entitled "FINANCIAL INSTRUMENTS: RECOGNITION AND MEASUREMENT." See http://www.iasc.org.uk/frame/cen2_139.htm
A commentary on the IASC is given by Paul Pacter at http://WWW.Trinity.edu/rjensen/acct5341/speakers/pacter.htm
Question 06
Does the FASB require fair market value accounting for all financial instruments?
Will the IASC require fair market value accounting for all financial instruments?
Not yet! The FASB is headed in that direction, but SFAS 133 fell short of
requiring fair market value adjustments of all financial instruments. The discussion
is in Paragraphs 330-350 of SFAS 133. Note especially Paragraphs 330-334 on Pages
159-160.
The IASC has not yet adopted a fair market value standard, but in its ED 62 is is much
closer than the FASB in terms of requiring fair market value adjustments to all financial
instruments except in cases of extreme measurement difficulty. A stronger position
in a Discussion Paper that preceded ED 62 is given by Paul Pacter at http://WWW.Trinity.edu/rjensen/acct5341/speakers/pacter.htm#003.04
Question 07
How does the FASB justify the need for SFAS 133?
Paragraph 3 on Page 1 of SFAS 133 argues that the FASB concluded that derivative instruments meet the tests of rights and obligations under the concepts of assets and liabilities. They further argue that fair value is the proper accounting for derivatives with special exceptions for hedges.
Paragraphs 233-237 on Pages 128-129 of SFAS 133 assert the following:
Problems with Previous Accounting and Reporting Practices
233. The first step in considering whether the benefits
of a new accounting standard will justify the related costs is to identify
the problems in the existing accounting guidance that a new standard seeks
to resolve. The problems with previous accounting and reporting practices
for derivatives and hedging activities are discussed below.
234. The effects of derivatives were not
transparent in the basic financial statements. Under the varied
accounting practices that existed before the issuance of this Statement,
some derivatives were recognized in financial statements, others were not.
If recognized in financial statements, some realized and unrealized gains
and losses on derivatives were deferred from earnings recognition and
reported as part of the carrying amount (or "basis") of a related item or
as if they were freestanding assets and liabilities. Users of financial
statements found it difficult to determine what an entity had or had not
done with derivatives and the related effects because the basic financial
statements often did not report the rights or obligations associated with
derivative instruments.
235. The accounting guidance for derivative instruments
and hedging activities was incomplete. Before the issuance of this
Statement, accounting standards specifically addressed only a few types of
derivatives. Statement 52 addressed foreign exchange forward contracts,
and Statement 80 addressed exchange-traded futures contracts. Only those
two Statements specifically provided for "hedge accounting." That is, only
those Statements provided special accounting to permit a gain or loss on a
derivative to be deferred beyond the period in which it otherwise would be
recognized in earnings because it was designated as a hedging instrument.
The EITF addressed the accounting for some derivatives and for some hedging
activities not covered in either Statement 52 or Statement 80. However,
that effort was on an ad hoc basis and gaps remained in the authoritative
literature. Accounting practice filled some gaps on specific issues, such
as with "synthetic instrument accounting" as described in paragraph 349,
but without commonly understood limitations on the appropriate use of that
accounting. The result was that (a) many derivative instruments were carried "off-
balance-sheet" regardless of whether they were formally part of a hedging
strategy, (b) practices were inconsistent among entities, and (c) users of financial
reports had inadequate information.
236. The accounting guidance for derivative
instruments and hedging activities was inconsistent. Under previous
accounting guidance, the required accounting treatment differed depending
on the type of instrument used in a hedge and the type of risk being
hedged. For example, an instrument hedging an anticipated transaction may
have qualified for special accounting if it was a purchased option with
certain characteristics or an interest rate futures contract, but not if it
was a foreign currency forward or futures contract. Derivatives also were
measured differently under previous standards-futures contracts were
reported at fair value, foreign currency forward contracts were reported at
amounts that reflected changes in foreign exchange spot rates but not
changes in forward rates and that were not discounted for the time value of
money, and other derivatives often were unrecognized or were reported at
nominal amounts not closely related to the fair value of the derivatives
(for example, reported at the net cash due that period). Accounting
standards also were inconsistent on whether qualification for hedge
accounting was based on risk assessment at an entity-wide or an
individual-transaction level.
237. The accounting guidance for derivatives and
hedging was difficult to apply. The lack of a single, comprehensive
approach to accounting for derivatives and hedging made the accounting
guidance difficult to apply. The incompleteness of FASB Statements on
derivatives and hedging forced entities to look to a variety of different
sources, including the numerous EITF issues and nonauthoritative
literature, to determine how to account for specific instruments or
transactions. Because there often was nothing directly on point, entities
analogized to other existing guidance. Different sources of analogy often
conflicted, and a wide range of answers sometimes was deemed supportable,
but those answers often were subject to later challenge.SFAS 133 Mitigates Those Problems
238. This Statement mitigates those four problems. It
increases the visibility, comparability, and understandability of the risks
associated with derivatives by requiring that all derivatives be reported
as assets or liabilities and measured at fair value. It reduces the
inconsistency, incompleteness, and difficulty of applying previous
accounting guidance and practice by providing comprehensive guidance for
all derivatives and hedging activities. The comprehensive guidance in this
Statement also eliminates some accounting practices, such as "synthetic
instrument accounting," that had evolved beyond the authoritative
literature.
239. In addition to mitigating the previous problems,
this Statement accommodates a range of hedge accounting practices by (a)
permitting hedge accounting for most derivative instruments, (b) permitting
hedge accounting for cash flow hedges of forecasted transactions for
specified risks, and (c) eliminating the requirement in Statement 80 that
an entity demonstrate risk reduction on an entity-wide basis to qualify for
hedge accounting. The combination of accommodating a range of hedge
accounting practices and removing the uncertainty about the accounting
requirements for certain strategies should facilitate, and may actually
increase, entities' use of derivatives to manage risks.
240. The benefits of improving financial reporting for
derivatives and hedging activities come at a cost. Even though much of the
information needed to implement this Statement is substantially the same as
was required for prior accounting standards for many hedges, and therefore
should be available, many entities will incur one-time costs for requisite
systems changes. But the benefits of more credible and more understandable
information will be ongoing.
241. The Board believes that accounting requirements
should be neutral and should not encourage or discourage the use of
particular types of contracts. That desire for neutrality must be balanced
with the need to reflect substantive economic differences between different
instruments. This Statement is the product of a series of many compromises
made by the Board to improve financial reporting for derivatives and
hedging activities while giving consideration to cost-benefit issues, as
well as current practice. The Board believes that most hedging strategies
for which hedge accounting is available in current practice have been
reasonably accommodated. The Board recognizes that this Statement does not
provide special accounting that accommodates some risk management
strategies that certain entities wish to use, such as hedging a portfolio
of dissimilar items. However, this Statement clarifies and accommodates
hedge accounting for more types of derivatives and different views of risk,
and provides more consistent accounting for hedges of forecasted
transactions than did the limited guidance that existed before this
Statement.
242. Some constituents have said that the requirements of
this Statement are more complex than existing guidance. The Board
disagrees. It believes that compliance with previous guidance was more
complex because the lack of a single, comprehensive framework forced
entities to analogize to different and often conflicting sources of
guidance. The Board also believes that some constituents' assertions about
increased complexity may have been influenced by some entities' relatively
lax compliance with previous guidance. For example, the Board understands
that not all entities complied with Statement 80's entity-wide risk
reduction criterion to qualify for hedge accounting, and that also may have
been true for requirements for hedging a portfolio of dissimilar items.
The Board also notes that some of the more complex requirements of this
Statement, such as reporting the gain or loss on a cash flow hedge in
earnings in the periods in which the hedged transaction affects earnings,
are a direct result of the Board's efforts to accommodate respondents'
wishes.
You may want to view the Jim Leisenring commentaries among the transcriptions of experts at http://WWW.Trinity.edu/rjensen/acct5341/speakers/133glosf.htm
Question 08
What are the major types of derivatives risk?
Bob Jensen's SFAS 133 Glossary defines risks as follows
the various types of financial risks, including market price risk, market interest rate risk, foreign exchange risk, and credit risk. These are discussed in SFAS 133, Paragraphs 411-415, Pages 184-186. SFAS 133 does not take up such things as tax rate swaps and credit swaps. Mention is given to nonfinancial assets and liabilities in Paragraphs 416-421. Other risks are mentioned in Paragraph 408.
A good site dealing with credit risk is at http://www.numa.com/ref/volatili.htm
SFAS 133, Paragraphs 411-415, Pages 184-186 lists the following types of risk:
a. Market price risk. A fair value hedge focuses on the
exposure to changes in the fair value of the entire hedged item.
The definition of fair value requires that the fair value of a
hedged item be based on a quoted market price in an active market,
if available. Similarly, a cash flow hedge focuses on variations in
cash flows, for example, the cash flows stemming from the purchase
or sale of an asset, which obviously are affected by changes in the
market price of the item. The Board therefore concluded that the
market price risk of the entire hedged item (that is, the risk of
changes in the fair value of the entire hedged item) should be
eligible for designation as the hedged risk in a fair value hedge.
Likewise, variable cash flows stemming from changes in the market
price of the entire item are eligible for designation as the hedged
risk in a cash flow hedge.
b. Market interest rate risk. For financial assets and
liabilities, changes in market interest rates may affect the right
to receive (or obligation to pay or transfer) cash or other
financial instruments in the future or the fair value of that right
(or obligation). The time value of money is a broadly accepted
concept that is incorporated in generally accepted accounting
principles (for example, in APB Opinion No. 21,
Interest on Receivables and Payables, and FASB Statement
No. 91, Accounting for Nonrefundable Fees and Costs
Associated with Originating or Acquiring Loans and Initial Direct
Costs of Leases). Because the marketplace has developed
techniques to delineate and extract interest rate risk from
financial instruments, the Board decided that the risk that changes
in market interest rates will affect the fair value or cash flows
of the hedged item warrants being identified as a risk that may be
designated as being hedged.
c. Foreign exchange risk. The fair value (expressed in the
entity's functional currency) of an asset such as a foreign debt or
equity security that is classified as available for sale, as well
as the fair value of the financial component of a firm commitment
that is denominated in a currency other than the entity's
functional currency, generally is exposed to changes in foreign
exchange rates. Similarly, the cash flows of a forecasted
transaction generally are exposed to changes in foreign exchange
rates if the transaction will be denominated in a foreign currency.
Statement 52 specifies special accounting for reflecting the
effects of changes in foreign exchange rates, and this Statement
continues much of that accounting. The Board therefore decided
that the risk of changes in foreign exchange rates on the fair
value of certain hedged items and on the cash flows of hedged
transactions warrants being identified as a risk that may be
designated as being hedged.
d. Default (credit) risk. A financial asset embodies a right to
receive cash or another financial instrument from a counterparty.
A financial asset thus embodies a risk that the counterparty will
fail to perform according to the terms of the contract; that risk
generally is referred to as credit risk. Because that risk affects
the fair value of a financial asset, as well as the related cash
flows, the Board decided that the risk of the counterparty's
default on its obligation is a risk that may be designated as being
hedged. Focusing on those four risks is consistent with the belief
that the largest amount of present hedging activity is aimed at
protecting against market price, credit, foreign exchange, or
interest rate risk. Those also were the risks generally
accommodated by special hedge accounting before this Statement.
Focusing on those four risks also is consistent with responses to
the Exposure Draft. Although the notice for recipients did not ask
respondents to comment on the type of risks that should be eligible
for hedge accounting, respondents generally discussed hedging
transactions in terms of those four risks.
There are added risks such as legal risks, security (fraud) risks, internal control risks and other risks that are not mentioned in SFAS 133.
Question 09
What derivative contracts are excluded from coverage
by SFAS 133?
Parts of a contract that do not pertain to an embedded derivative as described in Paragraphs 12-16 on Pages 8-9 of SFAS 133.
Regular-way security trades as discussed in Paragraph 10a on Page 5 of SFAS 133. Contracts that that have a delayed settlement due to trading traditions and technology limitations are excluded from SFAS 133 coverage if they meet the regular-way definition.
Normal purchases and normal sales of goods and services as discussed in Paragraph 10b on Page 5 of SFAS 133.
Certain insurance contracts under Paragraph 10c that are subject to SFAS 60 or SFAS 97.
Certain financial guarantee contracts under Paragraph 10d on Page 6 of SFAS 133. The test is whether the settlement is based upon credit risk failure or market risk failure of the underlying.
Certain contracts that are not traded on an exhange when settlements are based upon criteria listed in Paragraph 10e on Page 6 of SFAS 133. One of the key exclusions is when the settlement is not "readily convertible" into cash. Another exclusion arises from a settlement based upon a geological event such as $10 million times the official magnitude of an earthquake.
Derivative instruments that serve as impediments ot sales accounting as a call option to purchase back an item that is sold or a guarantee of the residual value of a leased asset by the lessor that prevents the lease from being a sales-type lease.
Contingent consideration in a business combination as defined in Paragraph 78 of APB 16 are excluded (for the issuer) from the scope of SFAS 133 under Paragraph 11c on Page 7. Accounting for this type of transaction remains as originally required for the issuer in APB 16. Contingent consideration outcomes by definition have maturities or payouts that depend upon the outcome of a a contingency such as a civil lawsuit.
Other assignment questions on derivatives accounting can be found at:
http://WWW.Trinity.edu/rjensen/acct5341/acct5341.htm#Assignment