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The forward contract was not a FAS 133-allowed cash flow hedge even though it was an economic hedge.  The reason goes back to Paragraph 29d on Page 20 of SFAS 130.

For this same reason, a trading security (not subject to APB 15 equity method accounting and as defined in SFAS 115) cannot be a FAS 133 hedged item.  That is because SFAS 115 requires that trading securities be revalued (like gold) with unrealized holding gains and losses being booked to current earnings.  Conversely, Paragraphs 4c on Page 2, 38 on Page 24, and 479 on Page 209 of FAS 133 state that a forecasted purchase of an available-for-sale security can be a hedged item, because available-for-sale securities revalued under SFAS 115 have holding gains and losses accounted for in comprehensive income rather than current earnings.  Unlike trading securities, available-for-sale securities can be FAS 133-allowed hedge items.   Mention of available-for sale is made in Paragraphs 4, 18, 23, 36, 38, 49, 52-55, 123, 479-480, and 534 of FAS 133.  Held-to-maturity securities can also be FAS 133-allowed hedge items.

Held-to-maturity securities may not be hedged for cash flow risk according to Paragraphs 426-431 beginning on Page 190 of FAS 133.  See held-to-maturity.  Suppose a firm has a forecasted transaction to purchase a held-to-maturity bond investment denominated in a foreign currency.  Under SFAS 115, the bond will eventually, after the bond purchase, be adjusted to fair value on each reporting date.  As a result, any hedge of the foreign currency risk exposure to cash flows cannot receive favorable cash flow hedge accounting under FAS 133 rules (as is illustrated in Examples 6 beginning on Page 265 of the Derivatives and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998).   Before the bond is purchased, its forecasted transaction is not allowed to be a hedged item under Paragraph 29d on Page 20 of FAS 133 since, upon execution of the transaction, the bond "will subsequently be remeasured with changes in fair value ...."  Also see Paragraph 36 on Page 23 of FAS 133.

Even more confusing is Paragraph 29e that requires the cash flow hedge to be on prices or interest rates rather than credit worthiness.  For example, a forecasted sale of a specific asset at a specific price can be hedged for spot price changes under Paragraph 29e.  The forecasted sale's cash flows may not be hedged for the credit worthiness of the intended buyer or buyers.  Example 24 in Paragraph 190 on Page 99 of FAS 133 discusses a credit-sensitive bond.  Because the bond's coupon payments were indexed to credit rating rather than interest rates, the embedded derivative could not be isolated and accounted for as a cash flow hedge.  See also credit risk swaps.

A  swaption can be a cash flow hedge.   See swaption.

Paragraph 21c on Page 14 and Paragraph 29f on Page 20 of FAS 133 prohibits forecasted cash flows from minority interests in a consolidated subsidiary from being designated as a hedged item in a cash flow hedge.  Reasons are given in Paragraph 472 beginning on Page 206 of FAS 133.  See minority interest.

Cash flow hedges are accounted for in a similar manner but not identical manner in both FAS 133 and IAS 39 (other than the fact that none of the IAS 39 standards define comprehensive income or require that changes in fair value not yet posted to current earnings be classified under comprehensive income in the equity section of a balance sheet):

To the extent that the cash flow hedge is effective, the portion of the gain or loss on the hedging instrument is recognized initially in equity. Subsequently, that amount is included in net profit or loss in the same period or periods during which the hedged item affects net profit or loss (for example, through cost of sales, depreciation, or amortization).

Paul Pacter states the following at http://www.iasc.org.uk/news/cen8_142.htm (emphasis added):

IAS 39 Cash Flow Hedge Accounting:  For a hedge of a forecasted asset and liability acquisition, the gain or loss on the hedging instrument will adjust the basis (carrying amount) of the acquired asset or liability. The gain or loss on the hedging instrument that is included in the initial measurement of the asset or liability is subsequently included in net profit or loss when the asset or liability affects net profit or loss (such as in the periods that depreciation expense, interest income or expense, or cost of sales is recognised).

FAS 133 Cash Flow Hedge Accounting:  For a hedge of a forecasted asset and liability acquisition, the gain or loss on the hedging instrument will remain in equity when the asset or liability is acquired. That gain or loss will subsequently included in net profit or loss in the same period as the asset or liability affects net profit or loss (such as in the periods that depreciation expense, interest income or expense, or cost of sales is recognised). Thus, net profit or loss will be the same under IAS and FASB Standards, but the balance sheet presentation will be net under IAS and gross under FASB.

 

DIG issues at http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issuindex.html  Section G: Cash Flow Hedges *Issue G1—Hedging an SAR Obligation (Cleared 02/17/99) *Issue G2—Hedged Transactions That Arise from Gross Settlement of a Derivative ("All in One" Hedges) (Cleared 03/31/99) *Issue G3—Discontinuation of a Cash Flow Hedge (Cleared 03/31/99) *Issue G4—Hedging Voluntary Increases in Interest Credited on an Insurance Contract Liability (Cleared 07/28/99) *Issue G5—Hedging the Variable Price Component (Cleared 11/23/99) Issue G6—Impact of Implementation Issue E1 on Cash Flow Hedges of Market Interest Rate Risk (Released 11/99) Issue G7—Measuring the Ineffectiveness of a Cash Flow Hedge of Interest Rate Risk under Paragraph 30(b) When the Shortcut Method is Not Applied (Released 11/99) Issue G8—Hedging Interest Rate Risk of Foreign-Currency-Denominated Floating-Rate Debt (Released 11/99)

 

CBOE =

Chicago Board Options Exchange.  See http://www.cboe.com/    Also see CBOT and CME.

You can find some great tutorials at http://www.cboe.com/education/   For the best educational materials at CBOE, you have to download the Authorware player. But that is free and easy to download.

CBOT =

Chicago Board of Trade.  See http://www.cbot.com/   For some good tutorials, go to http://www.cbot.com/ourproducts/index.html.  Also see CBOE and CME.

Circus =

a hedging combination that entails both an interest rate swap and a foreign currency swap.   As a   single-contract derivative, the circus swap runs into trouble in FAS 133 because it simultaneously hedges a price (or interest rate) risk and foreign currency risk.   Suppose a U.S. company has a trading or available-for-sale portfolio containing a variable rate note receivable in Brazilian reals.   Suppose the company enters into a circus swap that hedges both interest rate and foreign currency risks.  Since SFAS 115 requires that the hedged item (the Brazilian note) be remeasured to fair value at each interest rate date (with foreign currency gains and losses being accounted for under SFAS 52), Paragraph 21c on Page 14 and Paragraph 36 on Page 23 of FAS 133 prohibit the Brazilian note for being the basis of a cash flow hedge.  Paragraph 18 on the top of Page 10 prohibits "separating a compound derivative into components representing different risks .... "  Example 14 beginning on Page 271 illustrates the same problem with a note payable illustration in Derivatives and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998. 

If the Brazilian note was instead classified as held-to-maturity, the booked value is not remeasured to fair value on each balance sheet date.  That overcomes the Paragraph 21c revaluation objection on Page 14 of FAS 133.  Since the note is not an equity investment, other barriers in Paragraph 21c do not apply.  However, held-to-maturity securities may not be hedged for cash flow risk according to Paragraphs 426-431 beginning on Page 190 of FAS 133.  And Paragraph 18 on Page 10 looms as a lingering barrier.

To circumvent the Paragraph 18 problem of having compound risk hedges in a single contract, the U.S. company could enter into to separate derivative contracts such as an interest rate swap accompanied by an independent forward contract that hedges the foreign currency risk.  Then the issue for a cash flow hedging combination is whether the Brazilian note qualifies as a hedging instrument qualifies under Paragraph 29 rules beginning on Page 20 of FAS 133.  Paragraph 20e bans interest rate hedging if the note is declared held-to-maturity.   Paragraph 20d bans interest rate hedging for a note declared as a trading security under SFAS 115.  Conversely, Paragraphs 4c on Page 2, 38 on Page 24, and 479 on Page 209 of FAS 133 state that a forecasted purchase of an available-for-sale security can be a hedged item, because available-for-sale securities revalued under SFAS 115 have holding gains and losses accounted for in comprehensive income rather than current earnings.  Unlike trading securities, available-for-sale securities can be FAS 133-allowed hedge items.   Mention of available-for sale is made in Paragraphs 4, 18, 23, 36, 38, 49, 52-55, 123, 479-480, and 534 of FAS 133.  Even if this results in accounting for the two derivatives as a cash flow hedge of the Brazilian note, the same cannot be said for a fair value hedge since the forward contract hedging foreign currency risk must be carried at fair value.  Somewhat similar conclusions arise for a foreign currency note payable illustration in Example 15 on Page 272 of Derivatives and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998.

One of my students wrote the following case just prior to the issuance of FAS 133:

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 .  He states the following:

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. (prior to FAS 133).

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.

Clearly-and-Closely Related Criteria (or Clearly and Closely Related) =

criteria that determine when and when not to treat an embedded derivative as a freestanding contract apart from its host contract.  An embedded derivative that is both deemed to be free standing and is not clearly-and-closely related" must be accounted for separately rather than remain buried in the accounting for the host contract.  Relevant sections of FAS 133 include Paragraphs 304-311 in Pages 150-153 and Paragraphs 443-450 in Pages 196-198.  The FASB reversed its ED 162-B position on compound derivatives.   Examples 12-34 beginning in Paragraph 176 on Page 93 illustrate clearly-and-closely-related criteria in embedded hybrid derivative instruments.  For example, a call option cannot be accounted for separately if it is clearly-and-closely related to to a hybrid instrument that is clearly an equity instrument on a freestanding basis and, thereby, is not subject to FAS 133 rules.  If a prepayment option on a in a variable rate mortgage is based upon an interest rate index, the option is clearly-and-closely related to the host contract and cannot be accounted for separate from its host.  On the other hand, if the option is instead based upon a stock price index such as the Standard and Poors 500 index. the option is no longer clearly-and-closely related to to the host contract.  See hedge.

For example suppose a bond receivable has a variable interest rate with an embedded range floater derivative that specifies a collar of 4% to 8% based upon LIBOR.  The bond holder receives no interest payments in any period where the average LIBOR is outside the collar.  In this case, the range floater embedded option cannot be isolated and accounted for apart from the host bond contract.  The reason is that the option is "clearly-and-closely related" to the interest payments under the host contract (i.e., it can adjust the interest rate).  See Paragraph 12 beginning on Page 7 of FAS 133.

Some debt has a combination of fixed and floating components.  For example, a "fixed-to-floating" rate bond is one that starts out at a fixed rate and at some point (pre-determined or contingent) changes to a variable rate.   This type of bond has a embedded derivative (i.e., a forward component for the variable rate component that adjusts the interest rate in later periods.   Since the forward component is  "clearly-and-closely related"adjustment of interest of the host contract, it cannot be accounted for separately according to Paragraph 12a on Page 7 of FAS 133 (unless conditions in Paragraph 13 apply). 

Illustrations are provided under cap and floater.

See DIG Issue B5 under embedded derivatives.

CME =

Chicago Mercantile Exchange.  See http://www.cme.com   Also see CBOE and CBOT.

Collar=

a hedge that confines risk to a particular range. For example, one form of collar entails buying a call option and selling a put option in such a manner that extreme price variations are hedged from both sides. In Paragraph 181 on Page 95 of FAS 133, a timing collar is discussed.  A collar combines a cap and a floor.  Another example is given in Paragraph 182 beginning on Page 95 of FAS 133. Also see cap and  floater.

Collateralized Mortgage Obligation CMO =

a priority claim against collateral used to back mortgage debt. This is considered a derivative financial instrument, because the value is derived from another asset whose value, in turn, varies with global and economic circumstances.

Combination Option = see compound derivatives and option.

Commercial Paper Hedging Message

Hi Bob,
Re the commercial paper problem:  The difficulty is articulating the 
criteria for the test that is sufficiently liberal to ensure that you 
qualify for hedge accounting - which is the problem everyone faces for a 
cross hedge.  It's easier for cash flow hedges, as opposed to fair value 
hedges, however, as there is no concern about the "aging" of the security. 
 That is, for fair value hedges, I believe you have to worry about the fact 
that the hedged item's maturity is declining over the accounting period. 
 You don't have this concern for cash flow hedges.

I'm handling just this type of concern for a major bank.

Ira
Kawaller & Company, LLC
(718) 694-6270
kawaller@idt.net
www.kawaller.com 

Commitment Exposure =

economic exposure arising from the effects of foreign currency fluctuations on the cost curves of competitors. See firm commitment and hedge.

Commodity-Indexed Embedded Derivative =

a derivative embedded in a contract such as an interest bearing note that changes the amount of the payments according to movements of a commodity price index.  When a contract has such a provision, the embedded portion must be separated from the host contract and be accounted for as a derivative according to Paragraph 61i on Page 43 of FAS 133.   This makes embedded commodity indexed derivative accounting different than credit indexed and   inflation indexed embedded derivative accounting rules that do not allow separation from the host contract.  In this regard, credit indexed embedded derivative accounting is more like equity indexed accounting. See index, equity-indexed, derivative financial instrument and embedded derivatives. 

In my viewpoint, not all commodity indexed derivatives fail the Paragraph 61i test.  See my Mexcobre Case.

Competitive Exposure =

economic exposure arising from the effects of foreign currency fluctuations on the cost curves of competitors.

Compound Derivatives  =

derivatives that encompass more than one contractual provision such that different risk exposures are hedged in the compound derivative contract.  Paragraph 18 on Pages 9-10 prohibits separation of a compound derivative into components to designate different risks and then use only one or a subset of components as a hedging instrument.  FAS 133, Pages 167-168, Paragraphs 360-361 discusses how the FASB clung to its position on pro rata decomposition in FAS 133 vis-à-vis the earlier Exposure Draft 162-B that also did not allow pro rata decomposition. Further discussion is given in Paragraphs 523-524.  See circus, derivative, embedded derivatives, and option.

Closely related are synthetic instruments arising when multiple financial instruments are synthetically combined into a single instrument, possibly to meet hedge criteria under FAS 133. FAS 133 does not allow synthetic instrument accounting. See Paragraphs 349-350 on Page 164 of FAS 133.  Examples 12-34 beginning in Paragraph 176 on Page 93 illustrate clearly-and-closely-related criteria in embedded hybrid derivative instruments.  These criteria are discussed under hedge.  For a case illustration of a synthetic instrument hedging situation see D.C. Cerf and F.J. Elmy, "Accounting for Derivatives:  The Case Study of a Currency Swap Used to Hedge Foreign Exchange Rate Exposure," Issues in Accounting Education, November 1999, 931-956.

In summary, for hedging purposes, a compound grouping of multiple derivatives (e.g., a portfolio of options or futures or forward contracts or any combination thereof) is prohibited from "separating a derivative into either separate proportions or separate portions and designating any component as a hedging instrument or designating different components as hedges of different exposures."   See Paragraphs 360-362 beginning on Page 167 of FAS 133.  Paragraphs dealing with compound derivative issues include the following:

• Paragraph 18 beginning on Page 9,

• Footnote 13 on Page 29,

• Paragraphs 360-362 beginning on Page 167,

• Paragraph 413 on Page 186,

• Paragraphs 523-524 beginning on Page 225.

Section c(4) of Paragraph 4 on Page 2 of FAS 133 makes an exception to Paragraph 29a on Page 20 for portfolios of dissimilar assets and liabilities. It allows hedging under "net investment" criteria under Paragraph 20 of SFAS 52.  The gain or loss is reported in other comprehensive income as part of the cumulative translation adjustment. Reasons are given in Paragraph 477 on Page 208 of FAS 133:

The net investment in a foreign operation can be viewed as a portfolio of dissimilar assets and liabilities that would not meet the criterion in this Statement that the hedged item be a single item or a group of similar items. Alternatively, it can be viewed as part of the fair value of the parent's investment account. Under either view, without a specific exception, the net investment in a foreign operation would not qualify for hedging under this Statement. The Board decided, however, that it was acceptable to retain the current provisions of Statement 52 in that area. The Board also notes that, unlike other hedges of portfolios of dissimilar items, hedge accounting for the net investment in a foreign operation has been explicitly permitted by the authoritative literature.

For a derivative not designated as a hedging instrument, the gain or loss is recognized in earnings in the period of change.  Section 4(c) of Paragraph 4 of FAS 133 amends SFAS 52 on Foreign Currency Translation, to permit special accounting for a hedge of a foreign currency forecasted transaction with a derivative.  For more detail see foreign currency hedge.

Paragraph 42 on Page 26 reads as follows:

.A derivative instrument or a nonderivative financial instrument that may give rise to a foreign currency transaction gain or loss under Statement 52 can be designated as hedging the foreign currency exposure of a net investment in a foreign operation. The gain or loss on a hedging derivative instrument (or the foreign currency transaction gain or loss on the nonderivative hedging instrument) that is designated as, and is effective as, an economic hedge of the net investment in a foreign operation shall be reported in the same manner as a translation adjustment to the extent it is effective as a hedge. The hedged net investment shall be accounted for consistent with Statement 52; the provisions of this Statement for recognizing the gain or loss on assets designated as being hedged in a fair value hedge do not apply to the hedge of a net investment in a foreign operation. 

These Section c(4) confusions in Paragraph 4 are illustrated in Examples 11-13 beginning on Page 270 of the Derivatives and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998.

Paragraph 18 at the top of  Page 10 does allow a single derivative to be divided into components  but never with partitioning of  "different risks and designating each component as a hedging instrument."   An example using Dutch guilders versus French francs is given under cash flow hedge.  The problem is troublesome in circuses.

Compound derivative rules do not always apply to compound options such as a combination of put and call options.  Paragraph 28c on Page 19 of FAS 133 highlights these exceptions for written compound options or a combination of a written option and a purchased option.  The test is that for all changes in the underlying, the hedging outcome provides positive cash flows that are never less than the unfavorable cash flows.  See Example 16 beginning on Page 273 of of the Derivatives and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998.

Comprehensive Income or Other Comprehensive Income (OCI) =

the change in equity of a business entity during a period from transactions and other events and circumstances from nonowner sources.   Paragraph 5 40 on Page 243 of FAS 133 defines it as follows:

The change in equity of a business enterprise during a period from transactions and other events and circumstances from nonowner sources.   It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners (FASB Concepts Statement No. 6, Elements of Financial Statements, paragraph 70).

Comprehensive income includes all changes in equity during a period except those resulting from investments by owners and distributions to owners (FASB Concepts Statement No. 6, Elements of Financial Statements paragraph 70). The FASB’s ED 162-A proposed a standard on comprehensive income accounting that eventually became a standard in SFAS 130. FAS 133 sought to book financial instrument derivatives without changing net earnings levels prior to issuance of FAS 133. Accordingly, booking of derivative hedgings at fair market value, especially cash flow hedges, entails deferral of earnings in Other Comprehensive Income until cash settlements transpire. Comprehensive income is discussed at various points in FAS 133, notably Paragraphs 46-47, 18c, 127-130, 131-139, 140-143, 144-152, 162-164, 165-172, 173-177, and 338-344.  The acronym AOCI is sometimes used to depict accumulated other comprehensive income. 

The International Accounting Standards Committee (IASC) has not yet defined or required comprehensive statements or the Other Comprehensive Income (OCI) account.  This is especially important since it causes important reproted earnings differences  between IAS 39 versus FAS 133.  Under FAS 133, the OCI account is used for cash flow hedges.  OCI is not used under IAS 39.

See also struggle statement.

Click here to view where Rashad calls OCI the FASB's garbage can.

Contango Swap = the following according to one of my students:

A contango swap is a commodity curve swap, which enables the user to lock in a positive spread between the forward price and the spot price. A producer of a commodity, for example, might pay an amount equal to the 6-month futures contract and receive a floating payment equal to the daily price plus a spread. This enables the commodity producer to lock-in the positive spread and hedge against anticipated backwardation.    Her project on such a swap is as follows:

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 .  She states the following:

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.

The term "contango" is also used in futures trading.  It refers to situations in which the spot price is higher than the futures price and converges toward  zero from above the futures price.  In contrast, backwardation arises when the spot price is lower than the futures price, thereby yielding an upward convergence as maturity draws near.  See basis.

Contingent Consideration =

outcomes that have maturities or payouts that depend upon the outcome of a a contingency such as a civil lawsuit.  Contingent consideration in a business combination as defined in Paragraph 78 of APB 16 are excluded (for the issuer) from the scope of FAS 133 under Paragraph 11c on Page 7.  Accounting for this type of transaction remains as originally required for the issuer in APB 16.  Contingent lease rentals based on related sales volume, inflation indexed rentals, and contingent rentals based upon a variable interest rate are also excluded from FAS 133 in Paragraph 61j on Page 43.

Convertible Debt =

a debt contract that has an embedded derivative such as an option to convert the instrument debt into common stock must be viewed as having an embedded option.  When a contract has such a provision, the embedded portion must be separated from the host contract and be accounted for as a derivative according to Paragraph 61k on Page 43 of FAS 133.   See derivative financial instrument and embedded option.

Convexity = 

the rate of change of duration as yields change. For all option-free bonds, duration increases as yields decline. An option-free bond is said to have positive convexity.  See yield curve.

Covered Call and Covered Put  =

simultaneous writing (selling) of a call option coupled with ownership (long position) of the underlying asset.  The written call option is a short position that exposes the call option writer to upside risk.  A covered call transfers upside potential of the long position to the buyer of the call and, thereby, may create more upside price risk than downside price expected benefit.    Paragraph 399 on Page 180 does not allow hedge accounting for covered calls, because the upside potential must be equal to or greater than the downside potential.   In the case of a covered call, the upside risk may exceed the downside potential..   

A covered put entails writing (selling) a put option (long position) coupled with having a short position (e.g., a short sale contract) on the underlying asset.  In the case of a covered put, the downside risk may exceed the downside potential.

Paragraph 399 on Page 180 of FAS 133 does not allow covered call strategies that permit an entity to write an option on an asset that it owns.   In a covered call the combined position of the hedged item and the derivative option is asymmetrical in that exposure to losses is always greater than potential gains.  The option premium, however, is set so that the option writer certainly does not expect those "remotely possible" losses to occur.  Only when the potential gains are at least equal to potential cash flow losses will Paragraph 28c on Page 19 of FAS 133 kick in to allow a cash flow hedge under FAS 133.  Also see Paragraph 20c on Page 12.

Also see option and written option.

Credit Risk Swap =

a form of insurance against default by means of a swap. See Paragraphs 190 and 411d of FAS 133. See Risks.

Somewhat confusing is Paragraph 29e on Page 20 of FAS 133 that requires any cash flow hedge to be on prices or interest rates rather than credit worthiness.  For example, a forecasted sale of a specific asset at a specific price can be hedged for spot price changes under Paragraph 29e.  The forecasted sale's cash flows may not be hedged for the credit worthiness of the intended buyer or buyers.  Example 24 in Paragraph 190 on Page 99 of FAS 133 discusses a credit-sensitive bond.  Because the bond's coupon payments were indexed to credit rating rather than interest rates, the embedded derivative could not be isolated and accounted for as a cash flow hedge.

One of my students wrote the following case just prior to the issuance of FAS 133:.  John D. Payne's case and case solution entitled A Case Study of Accounting for an Interest Rate Swap and a Credit Derivative appear at http://www.resnet.trinity.edu/users/jpayne/coverpag.htm .  He states the following:

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.

A good site on credit risk is at http://www.numa.com/ref/volatili.htm   

Example 24 in Paragraph 190 on Page 99 of FAS 133 discusses a credit-sensitive bond.

You can read more about credit derivatives at http://www.intltreasurer.com/corpcder.htm 

Credit Sensitive Payments =

payments on a debt instrument that vary under an embedded option that adjusts the interest rate on the basis of changed credit rating of the borrower.  Paragraph 61c on Page 41 of FAS 133 defines these payments as clearly-and-closely related such that the embedded derivative cannot be accounted for separately under Paragraph 12 on Page 7.  This makes embedded credit derivative accounting different than commodity indexed and equity indexed embedded derivative accounting rules that require separation from the host contract such as commodity indexed, equity indexed, and inflation indexed embedded derivatives.  In this regard, credit indexed embedded derivative accounting is more like inflation indexed accounting.  See derivative financial instrument and embedded derivatives.

Cross Hedge = See cross rate and foreign currency hedge.

Cross-Currency Hedge = see foreign currency hedge.

Cross Rate =

the exchange rate between two currencies other than the dollar, calculated using the dollar exchange rates of those currencies.  A cross rate is a rate / price implied by two or more component prices / rates.  Cross-hedging entails a hedge that has basis risk because the derivative and the hedged item are referenced to indexes whose changes are imperfectly correlated.  See basis risk.

Crude Oil Knock-in Note = 

a bond that has upside potential on the principal payback contingent upon prices in the crude oil market.  Such a note is illustrated in Example 21 in Paragraph 187 of FAS 133.

CTA = a term with alternate meanings.

Commodity Trading Advisor - One who provides advice on investing in currencies as a separate asset class. Some also act in a separate function as overlay managers, advising on hedging the currency risk in international asset portfolios.

Cumulative Translation Adjustment - An entry in a translated balance sheet in which gains and losses from transactions have been accumulated over a period of years.

Cumulative Dollar Offset = see ineffectiveness.

Currency Swap =

a transaction in which two counterparties exchange specific amounts of two different currencies at the outset and repay over time at a predetermined rate that reflects interest payments and possibly amortization of the principal as well. The payment flows are based on fixed interest rates in each currency.    An example of a currency swap in FAS 133 appears in Example 5 Paragraphs 131-139 on Pages 72-76.

Current Rate =

The exchange rate in effect at the relevant-financial-statement date.

D-Terms

Dedesignation =

a change in status of a designated hedge such that all or a portion of the hedged amounts must be taken into current earnings rather being deferred.  Dedesignation for cash flow hedges is discussed in Paragraph 30 on Page 21 of FAS 133.  If a cash forecasted transaction becomes a firm commitment, its corresponding cash flow hedge must be dedesignated.  Controversies between the FASB's distinction between forecasted transactions versus firm commitments are discussed in Paragraphs 324-325 on Page 157 of FAS 133.

An illustration of dedesignation. is given in Example 10 in Paragraphs 165-172 of FAS 133.  Example 10 illustrates a forward contract cash flow hedge of a forecasted series of transactions in a foreign currency.  When the forecasted transactions become accounts receivable, a portion of the value changes in the futures contract must be taken into current earnings rather than other comprehensive income.  Another illustration of dedesignation. is in Example 7 of FAS 133, pp. 79-80, Paragraphs 144-152.  See derecognition and  hedge.

Paul Pacter states the following at http://www.iasc.org.uk/news/cen8_142.htm 

IAS 39 A financial asset is derecognised if the transferee has the right to sell or pledge the asset; and the transferor does not have the right to reacquire the transferred assets. (However, such a right does not prevent derecognition if either the asset is readily obtainable in the market or the reacquisition price is fair value at the time of reacquisition.)

FAS 133 In addition to those criteria, FASB requires that the transferred assets be legally isolated from the transferor even in the event of the transferor’s bankruptcy.

 

Defeasance =

the early extinguishment of debt by depositing, in risk-free securities, the present value of the interest and principal payments in an irrevocable trust such that the earnings from the trust will service the debt and have sufficient funds to eventually extinguish the debt.  Exxon invented the concept in the 1970s.  In one instance Exxon captured $132 million of unrealized gain on $515 million of long-term debt acquired when interest rates were high.  The trust must be entirely under the control of an independent trustee. Defeasance was sometimes used to remove debt and capture gains when recalling the bonds had relatively high transaction costs.   The FASB allowed defeasance to capture gains and remove debt from the balance sheet in SFAS 76.  However, this  was rescinded in SFAS 125.  Defeasance can no longer remove debt from the balance sheet or be used to capture unrecognized gains due to interest rate increases.  See derecognition.

Defined-Benefit-Plan = see not-for-profit.

Delivered Floater = see floater.

DELTA = see ineffectivness.

Derecognition =

the opposite of recognizing an asset or liability on the balance sheet.  Assets are derecognized when they are sold or abandoned.   Liabilities are derecognized when they are paid or forgiven.  Derecognition, however, can be a more complex issue when rights or obligations are changed in other ways.   Paragraph 26 on Page 17 and Paragraph 491 on Page 213of FAS 133 require that the fair value of a firm commitment be derecognized when the hedged item no no longer meets the Paragraph 22 criteria.  The concept appears again in Paragraph 49.  See dedesignation.

Paul Pacter states the following at http://www.iasc.org.uk/news/cen8_142.htm 

IAS 39 A financial asset is derecognised if the transferee has the right to sell or pledge the asset; and the transferor does not have the right to reacquire the transferred assets. (However, such a right does not prevent derecognition if either the asset is readily obtainable in the market or the reacquisition price is fair value at the time of reacquisition.)

FAS 133 In addition to those criteria, FASB requires that the transferred assets be legally isolated from the transferor even in the event of the transferor’s bankruptcy.

 

IAS 39 Guidance in IAS 39 includes the following example. A bank transfers a loan to another bank, but to preserve the relationship of the transferor bank with its customer, the acquiring bank is not allowed to sell or pledge the loan. Although the inability to sell or pledge would suggest that the transferee has not obtained control, in this instance the transfer is a sale provided that the transferor does not have the right or ability to reacquire the transferred asset.

FAS 133 While a similar example is not included in FASB Standards, FASB Standards might be interpreting as prohibiting derecognition by the transferor bank.

 

Derivative =

A financial instrument whose value is derived from changes in the value of some underlying asset such as a commodity, a share of stock, a debt instrument, or a unit of currency.  A nice review appears in Myron Scholes' Nobel lecture that is reprinted as "Derivatives in a Dynamic Environment," American Economic Review, June 1998, 350-370.  For further elaboration, see derivative financial instrument.    Especially note the terms hedge and disclosure.

A great listing of links on options, derivatives, futures and commodities --- http://www.investingsites.com/options_derivatives.htm 
Not much about FAS 133 in this site.

Also see CBOE, CBOT, and CME for some great tutorials on derivatives investing and hedging.

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. 

 The FASB provides a free 95-page document that defines derivatives in greater detail and provides summaries of various types of derivatives.  The document can be downloaded from "Summary of Derivatives Types from FASB" at http://www.rutgers.edu/Accounting/raw/fasb/derivsum.exe.  A somewhat simpler definition is given at http://www.finpipe.com/derivatives.htm (I recommend visiting that website to learn more about derivatives and how they are used.)

A derivative financial product is a contrived instrument, the value of which depends indirectly on the price of a cash instrument. The price of the cash instrument is referred to as the "underlying" price, quite often. Examples of cash instruments include actual shares in a company, physical stocks of commodities, cash foreign exchange, etc.

Why use derivatives and not just cash instruments? Derivatives exist to solve specific positioning, accounting and regulatory problems.

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

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

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

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

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

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

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

Recommended Tutorials on FAS 133

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

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

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

• Summary of Derivatives Types from FASB at http://www.rutgers.edu/Accounting/raw/fasb/derivsum.exe 
  
  

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

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

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

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

Recommended Glossaries

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

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

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

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

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

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

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 that hedge 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)

Also see other DIG issues under net settlement.

Paul Pacter states the following at http://www.iasc.org.uk/news/cen8_142.htm 

IAS 39 A derivative is a financial instrument— (a) - whose value changes in response to the change in a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, a credit rating or credit index, or similar variable (sometimes called the ‘underlying’); (b) - that requires no initial net investment or little initial net investment relative to other types of contracts that have a similar response to changes in market conditions; and (c) - that is settled at a future date.

FAS 133 (a) – same as IAS 39 (b) – same as IAS 39 (c) – FASB definition requires that the terms of the derivative contract require or permit net settlement.

FAS 133 Paragraph 408 reads as follows:

The Board recognizes that entities are commonly exposed to a variety of risks in the course of their activities, including interest rate, foreign exchange, market price, credit, liquidity, theft, weather, health, catastrophe, competitive, and business cycle risks. The Exposure Draft did not propose detailed guidance on what risks could be designated as being hedged, other than to note in the basis for conclusions that special hedge accounting for certain risk management transactions, such as hedges of strategic risk, would be precluded. In redeliberating the issue of risk, the Board reaffirmed that hedge accounting cannot be provided for all possible risks and decided to be more specific about the risks for which hedge accounting is available.

Various exceptions are dealt with in Paragraph 58 of FAS 133.  For example, Paragraph 58c reads as follows:

Certain contracts that are not traded on an exchange. A contract that is not traded on an exchange is not subject to the requirements of this Statement if the underlying is:

(1) A climatic or geological variable or other physical variable. Climatic, geological, and other physical variables include things like the number of inches of rainfall or snow in a particular area and the severity of an earthquake as measured by the Richter scale.

(2) The price or value of (a) a nonfinancial asset of one of the parties to the contract unless that asset is readily convertible to cash or (b) a nonfinancial liability of one of the parties to the contract unless that liability requires delivery of an asset that is readily convertible to cash.

(3) Specified volumes of sales or service revenues by one of the parties. That exception is intended to apply to contracts with settlements based on the volume of items sold or services rendered, for example, royalty agreements. It is not intended to apply to contracts based on changes in sales or revenues due to changes in market prices.

If a contract's underlying is the combination of two or more variables, and one or more would not qualify for one of the exceptions above, the application of this Statement to that contract depends on the predominant characteristics of the combined variable. The contract is subject to the requirements of this Statement if the changes in its combined underlying are highly correlated with changes in one of the component variables that would not qualify for an exception.

Also see "regular-way" security trading exceptions in Paragraph 58a if FAS 133.  Also note the exception in DIG C1.  Some general DIG exceptions to the scope of FAS 133 are listed in the "C" category at http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issuindex.html 

DIG exceptions at http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issuindex.html  Section C: Scope Exceptions *Issue C1—Exception Related to Physical Variables (Cleared 02/17/99) *Issue C2—Application of the Exception to Contracts Classified in Temporary Equity (Cleared 02/17/99) *Issue C3—Exception Related to Stock-Based Compensation Arrangements (Cleared 02/17/99) *Issue C4—Interest-Only and Principal-Only Strips (Cleared 02/17/99) *Issue C5—Exception Related to a Nonfinancial Asset of One of the Parties (Cleared 02/17/99) *Issue C6—Derivative Instruments Related to Assets Transferred in Financing Transactions (Cleared 03/31/99) *Issue C7—Certain Financial Guarantee Contracts (Cleared 07/28/99) *Issue C8—Derivatives That Incorporate an Underlying on the Issuer's Equity Price (Released 10/99)

A nice review of the theory and application (aside from accounting) of derivative financial instruments appears in Myron Scholes' Nobel lecture that is reprinted as "Derivatives in a Dynamic Environment," American Economic Review, June 1998, 350-370.   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.  By "indexed" it is meant that an uncertain economic event that is measured by an economic index (e.g., a credit rating index, commodity price index, convertible debt, or inflation index) defined in the contract.  An equity index might be defined as a particular index derived from common stock price movements such as the Dow Industrial Index or the Standard and Poors 500 Index.   Derivative instruments may also be futures contracts, forward contracts, interest rate swaps, foreign currency derivatives, warrants, forward rate agreements, basis swaps,  and complex combinations of such contracts such as a circus combination.    Interest rate swaps are the most common form of derivatives in terms of notional amounts.  There are Paragraph 6b initial investment size limitations discussed under the term premium.

Derivatives that are covered by FAS 133 accounting rules must remeasured to fair value on each balance sheet date.  Paragraph 18 on Page 10 of FAS 133 outlines how to account gains and losses on derivative financial instruments designated for FAS 133 accounting.  See hedge accounting.

FAS 133 does not change the requirement banning the netting of assets and liabilities in the balance sheet (statement of financial position) unless there is a right of  setoff.  This rule goes back to APB 10, Omnibus Opinion.  Hence the aggregate of positive valued derivative financial instruments cannot be netted against those with negative values.  The only exception would be when there are contractual rights of offset.  FAS 133 is silent as to whether derivatives expiring in the very near future are cash equivalents in the cash flow statement.  KPMG argues against that in terms of SFAS 95 rules.  See Example 6 beginning on Page 347 of of the Derivatives and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998.

FAS 133 requires disclosures of hedging gains and losses by risk type.  Paragraph 45 on beginning on Page 27 does require that aggregate net amounts be reported by type of hedge.  Disclosure by market risk category is required by the SEC. 

In this FAS 133 Glossary, there are added conditions to become a qualified derivative financial instrument under FAS 133 rules.   In certain instances a nonfinancial derivative will also suffice for accounting under FAS 133 rules.  Unless noted otherwise it will be assumed that such instruments meet the FAS 133 criteria.  The formal definition of a derivative financial instrument for purposes of FAS 133 is given in Paragraph 249 on Page 133.  Such an instrument must have all three of the following attributes:

a. 
It has (1) one or more underlyings and (2) one or more notional amounts or payment provisions or both.

b.
It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.

c.
Its terms require or permit net settlement, it can readily be settled net by means outside the contract, or it provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.

Initial investment is an important criterion for distinguishing a derivative instrument from a nonderivative instrument.  See Paragraph 6b on Page 3 of FAS 133.  Paragraph 256 on Page 135 contains the following example:

A party that wishes to participate in the changes in the fair value of 10,000 shares of a specific marketable equity security can, of course, do so by purchasing 10,000 shares of that security.  Alternatively, the party may enter into a forward purchase contract with a notional amount of 10,000 shares of that security and an underlying that is the price of that security. Purchasing the shares would require an initial investment equal to the current price for 10,000 shares and would result in benefits such as the receipt of dividends (if any) and the ability to vote the shares. A simple forward contract entered into at the current forward price for 10,000 shares of the equity instrument would not require an initial investment equal to the notional amount but would offer the same opportunity to benefit or lose from changes in the price of that security.

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.  

In FAS 133, derivative financial instruments come in three basic types that are listed in Paragraph 4 on Page 2 of FAS 133:

Paragraph 4 on Page 2 of FAS 133.
This Statement standardizes the accounting for derivative instruments, including certain derivative instruments embedded in other contracts, by requiring that an entity recognize those items as assets or liabilities in the statement of financial position and measure them at fair value. If certain conditions are met, an entity may elect to designate a derivative instrument as follows:

a.
A hedge of the exposure to changes in the fair value of a recognized asset or liability, or of an unrecognized firm commitment, \2/ that are attributable to a particular risk (referred to as a fair value hedge)
==========================================================================
Footnote 2
\2/ An unrecognized firm commitment can be viewed as an executory contract that represents both a right and an obligation. When a previously unrecognized firm commitment that is designated as a hedged item is accounted for in accordance with this Statement, an asset or a liability is recognized and reported in the statement of financial position related to the recognition of the gain or loss on the firm commitment. Consequently, subsequent references to an asset or a liability in this Statement include a firm commitment.
==========================================================================

b.
A hedge of the exposure to variability in the cash flows of a recognized asset or liability, or of a forecasted transaction, that is attributable to a particular risk (referred to as a cash flow hedge)

c.
A hedge of the foreign currency exposure of

(1) an unrecognized firm commitment (a foreign currency fair value hedge), (

(2) an available-for-sale security (a foreign currency fair value hedge),

(3) a forecasted transaction (a foreign currency cash flow hedge), or

(4) a net investment in a foreign operation.

With respect to Section a above, a firm commitment cannot have a cash flow risk exposure because the gain or loss is already booked.  For example, a contract of 10,000 units per month at $200 per unit is unrecognized and has a cash flow risk exposure if the payments have not been made. If the payments have been prepaid, that prepayment is "recognized" and has no further cash flow risk exposure. The booked firm commitment, however, can have a fair value risk exposure.

With respect to Section c(1) above, firm commitments can have foreign currency risk exposures if the commitments are not already recognized.  See Paragraph 4 on Page 2 of FAS 133. If the firm commitment is recognized, it is by definition booked and its loss or gain is already accounted for. For example, a purchase contract for 10,000 units per month at 100DM Deutsche Marks per unit is unrecognized and has a foreign currency risk exposure if the payments have not been made. If the payments have been prepaid, that prepayment is "recognized" and has no further foreign currency risk exposure.  Similar reasoning applies to trading securities that are excluded in c(2) above since their gains and losses are already booked.  These gains have been deferred in comprehensive income for available-for-sale securities.

Cash flow hedges must have the possibility of affecting net earnings.  For example, Paragraph 485 on Page 211 of FAS 133 bans foreign currency risk hedges of forecasted dividends of foreign subsidiary.  The reason is that these dividends are a wash item and do not affect consolidated earnings.  For reasons and references, see equity method.

Section c(4) of Paragraph 4 on Page 2 of FAS 133 makes an exception to  Paragraph 29a on Page 20 for portfolios of dissimilar assets and liabilities. It allows hedging under "net investment" criteria under Paragraph 20 of SFAS 52. The gain or loss is reported in other comprehensive income as part of the cumulative translation adjustment. Reasons are given in Paragraph 477 on Page 208 of FAS 133:

The net investment in a foreign operation can be viewed as a portfolio of dissimilar assets and liabilities that would not meet the criterion in this Statement that the hedged item be a single item or a group of similar items. Alternatively, it can be viewed as part of the fair value of the parent's investment account. Under either view, without a specific exception, the net investment in a foreign operation would not qualify for hedging under this Statement. The Board decided, however, that it was acceptable to retain the current provisions of Statement 52 in that area. The Board also notes that, unlike other hedges of portfolios of dissimilar items, hedge accounting for the net investment in a foreign operation has been explicitly permitted by the authoritative literature.

For a derivative not designated as a hedging instrument, the gain or loss is recognized in earnings in the period of change.  Section 4(c) of Paragraph 4 of FAS 133 amends SFAS 52 on Foreign Currency Translation, to permit special accounting for a hedge of a foreign currency forecasted transaction with a derivative.  For more detail see foreign currency hedge.

Paragraph 42 on Page 26 reads as follows:

.A derivative instrument or a nonderivative financial instrument that may give rise to a foreign currency transaction gain or loss under Statement 52 can be designated as hedging the foreign currency exposure of a net investment in a foreign operation. The gain or loss on a hedging derivative instrument (or the foreign currency transaction gain or loss on the nonderivative hedging instrument) that is designated as, and is effective as, an economic hedge of the net investment in a foreign operation shall be reported in the same manner as a translation adjustment to the extent it is effective as a hedge. The hedged net investment shall be accounted for consistent with Statement 52; the provisions of this Statement for recognizing the gain or loss on assets designated as being hedged in a fair value hedge do not apply to the hedge of a net investment in a foreign operation. 

These Section c(4) confusions in Paragraph 4 are illustrated in Examples 11-13 beginning on Page 270 of the Derivatives and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998.

A more confusing, at least to me, portion of Paragraph 36 reads as follows:

The criterion in paragraph 21(c)(1) requires that a recognized asset or liability that may give rise to a foreign currency transaction gain or loss under Statement 52 (such as a foreign-currency-denominated receivable or payable) not be the hedged item in a foreign currency fair value or cash flow hedge because it is remeasured with the changes in the carrying amount attributable to what would be the hedged risk (an exchange rate change) reported currently in earnings.  Similarly, the criterion in paragraph 29(d) requires that the forecasted acquisition of an asset or the incurrence of a liability that may give rise to a foreign currency transaction gain or loss under Statement 52 not be the hedged item in a foreign currency cash flow hedge because, subsequent to acquisition or incurrence, the asset or liability will be remeasured with changes in the carrying amount attributable to what would be the hedged risk reported currently in earnings. A foreign currency derivative instrument that has been entered into with another member of a consolidated group can be a hedging instrument in the consolidated financial statements only if that other member has entered into an offsetting contract with an unrelated third party to hedge the exposure it acquired from issuing the derivative instrument to the affiliate that initiated the hedge.

Investments accounted for under the equity method cannot be hedged items under FAS 133 accounting for reasons explained under the term "equity method."   Recall that the magic percentage of equity ownership is 20% of more.  Lower ownership share accounted for under the cost as opposed to equity method can be hedged. 

In summary, the major exceptions under FAS 133 are discussed in the following FAS 133 Paragraphs:

• Business combinations APB Opinion No. 16 (FAS 133Paragraph 11c)

• Shareholders' equity (FAS 133 Paragraph 11a)

• Leases (FAS 133 Paragraph 10f)

• Employee benefits (SFAS 123 (Paragraph 11b)

• Insurance contracts (note exceptions in FAS 133 Paragraph 10c)

• Financial guarantees (note exceptions in FAS 133 Paragraph 10d)

• Physical indices (FAS 133 Paragraphs 10e, 58c)

• Regular-way trades (FAS 133 Paragraphs 10b, 58b)

Exceptions are not as important in IAS 39, because fair value adjustments are required of all financial instruments.  However, exceptions or special accounting for derivatives are discussed at various places in IAS 39:

• Business combinations )IAS 39 Paragraph 1g --- Also note  IAS 22 Paragraphs 65-76)

• Shareholders' equity IAS 39 Paragraph 1e)

• Leases IAS 39 Paragraph 1b)

• Employee benefits IAS 39 Paragraph 1c)

• Insurance contracts IAS 39 Paragraph 1d)

• Financial guarantees IAS 39 Paragraph 1f)

• Physical indices (IAS 39 Paragraph 1h)

• Regular-way trades (Not an explicit exception in IAS 39)

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

See hedge and financial instrument.

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 FAS 133 and IAS 39.  Also see CBOE, CBOT, and CME for some great tutorials on derivatives investing and hedging.

DIG = 

the Derivatives Implementation Group established by the FASB for purposes of helping firms implement FAS 133.  The web site is at http://www.rutgers.edu/Accounting/raw/fasb/derivatives/digmain.html . 

The Derivatives Implementation Group is a task force that was created to assist the FASB in answering questions that companies will face when they begin implementing Statement 133, Accounting for Derivative Instruments and Hedging Activities. The FASB’s objective in forming the group was to establish a mechanism to identify and resolve significant implementation questions in advance of the implementation of Statement 133 by many companies.

The role of the Derivatives Implementation Group is different from that of other task forces previously assembled by the FASB because it was established to address issues related to a new Statement that has not yet been implemented by most companies. The responsibilities of the Derivatives Implementation Group are to identify practice issues that arise from applying the requirements of Statement 133 and to advise the FASB on how to resolve those issues. In addition to members of the implementation group, any constituent or organization may submit questions to be debated by the group by sending a detailed letter to the group chairman, FASB Vice Chairman Jim Leisenring. The FASB staff also seeks input from the implementation group on selected technical inquiries that it resolves.

The model for the Derivatives Implementation Group is the Emerging Issues Task Force (EITF) with the key difference being that the Derivatives Implementation Group does not formally vote on issues to reach a consensus. Instead, it is the responsibility of the Chairman to identify an agreed-upon resolution that emerges based upon the group’s debate. Implementation group members are free submit written objections to any issue where the group reaches an agreed-upon resolution. In instances where no clear resolution of an issue emerges, the issue may be further discussed at a future meeting or handled by the FASB staff.

After each meeting of the Derivatives Implementation Group, the FASB staff has the responsibility of documenting tentative conclusions reached by the group. Those tentative conclusions are publicly available on the FASB web site approximately three weeks after a meeting of the Derivatives Implementation Group. Those conclusions will remain tentative until they are formally cleared by the FASB and become part of an FASB staff implementation guide (Q&A). The Board is typically not asked to formally clear the staff's tentative conclusions at a public Board meeting until those conclusions have been publicly available on the web site for at least one month. That delay provides constituents the opportunity to study those conclusions and submit any comments before the Board considers formal clearance.

Meetings of the Derivatives Implementation Group are held at the FASB offices in Norwalk, CT and are open to public observation. The group will meet bimonthly during 1998 and 1999 when companies are planning for transition to the new accounting requirements. The need for meetings of the group in the year 2000 will be assessed at a later date.

If you click on menu choices (Edit, Find) or the binoculars icon in your web browser, you can enter the search term DIG to find various DIG issues in this document.

The international equivalent of the DIG arose when the International Accounting Standards Committee (IASC)  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 

Disclosure =

the disclosures of key information in footnotes, special schedules, or other parts of financial reports. FAS 133 deals with disclosure at various points, especially in Paragraphs 502-513 on Pages 216-221.  An entity that holds or issues derivative instruments (or nonderivative instruments that are designated and qualify as hedging instruments pursuant to /FAS 133 Paragraphs 37 and 42) shall disclose its objectives for holding or issuing those instruments, the context needed to understand those objectives, and its strategies for achieving those objectives.  The description shall distinguish between derivative instruments (and nonderivative instruments) designated as fair value hedging instruments, derivative instruments designated as cash flow hedging instruments, derivative (and nonderivative) instruments designated as hedging instruments for hedges of the foreign currency exposure of a net investment in a foreign operation, and all other derivatives
(FAS 133 Paragraph 44)

Under IASC international disclosure rulings, financial statements should include all of the disclosures required by IAS 32, except that the requirements in IAS 32 for supplementary disclosure of fair values (IAS 39 Paragraphs 77 and 88) are not applicable to those financial assets and financial liabilities carried at fair value (Paragraph 166).  The following should be included in the disclosures of the enterprise's accounting policies as part of the disclosure required by IAS 32 Paragraph 47b:

(1) the methods and significant assumptions applied in estimating fair values of financial assets and financial liabilities that are carried at fair value, separately for significant classes of financial assets (see IAS 39 Paragraph 46)

2) whether gains and losses arising from changes in the fair value of those available-for-sale financial assets that are measured at fair value subsequent to initial recognition are included in net profit or loss for the period or are recognized directly in equity until the financial asset is disposed of; and

3) for each of the four categories of financial assets defined in paragraph 10, whether 'regular way' purchases of financial assets are accounted for at trade date or settlement date (see paragraph 30)
(IAS Paragraph 167)

In applying the above paragraph, an enterprise will disclose prepayment rates, rtes of estimated credit losses, and interest or discount rates
(paragraph 168)

The SEC has more controversial disclosure requirements for derivatives, especially requirements for quantification of risk. The required disclosures about accounting policies are specified in new Rule 4-08(n) of Regulation S-X and Item 310 of Regulation S-B. The required disclosures about market risk exposures are specified in new Item 305 of Regulation S-K and Item 9A of Form 20-F.   See http://www.sec.gov/rules/othern/derivfaq.htm

Some SEC rules, which amend Regulation S-X and Regulation S-K, require the following new market risk disclosures (unless a business is deemed a small business not subject to market risk disclosure rules and/or unless the market risks apply to trade accounts recievable or trade accounts payable):

• detailed disclosures of registrants' accounting policies for derivative financial instruments and derivative commodity instruments;
  

• quantitative and qualitative disclosures outside the financial statements about market risk information of derivatives and other financial instruments. 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.
  

• forward-looking information, which includes these quantitative and qualitative disclosures outside the financial statements.;
  

• disclosures about the effects of derivatives on other positions.
  

The Rules allow registrants to select one of the following methods to make their quantitative disclosures for market risk sensitive instruments:

• a tabular format --- a presentation of the terms, fair value, expected principal or transaction cash flows, and other information, with instruments grouped within risk exposure categories based on common characteristics;
  

• a sensitivity analysis --- the hypothetical loss in earnings, fair values, or cash; (the minumum percentage change seems to be 10% in Item 3.A of the Instructions to Paragraphs 305a and 305b.)
  

• flows resulting from hypothetical changes in rates or prices;
  

• value-at-risk --- a measure of the potential loss in earnings, fair values, or cash;
  

• flows from changes in rates or prices.

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.

For a reference on SEC disclosure rules, see T.J. Linsmeier and N.D. Pearson, "Quantitative Disclosures of Market Risk in the SEC Release," Accounting Horizons, March 1997, 107-135. 

Click here to view a nice commentary on the SEC financial risk disclosure choices.

One of my student's projects is summarized below: 

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.

Roger Debreceny wrote the following message on July 31, 1998:

Further to previous discussion on derivatives:

KPMG Derivatives and Hedging Handbook Offers Guidance on New Accounting Standards for Derivatives NEW YORK, July 27 /PRNewswire/ -- A comprehensive Derivatives and Hedging Handbook was published today by KPMG Peat Marwick LLP, the accounting, tax and consulting firm, in response to the new accounting standard for derivative instruments and hedging activities issued on June 15, 1998 by the Financial Accounting Standards Board (FASB).

The FASB issued the new standard (Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities) to replace the rules that had been in effect since 1984.

"The estimated worldwide amount of derivative instruments is well above $60 trillion," said Michael A. Conway, partner-in-charge, KPMG Department of Professional Practice." We developed this handbook because the new standard is so complex and the potential impact on commercial companies and financial institutions is enormous.

"Implementing this standard may require changes in hedging strategies and accounting systems, with possible significant effects on financial statements," said Conway. "Therefore, we believe it’s important for organizations to immediately begin evaluating the impact of the standard on their operations and financial reporting. This handbook is designed to make that assessment easier."

The primary author of the handbook, Stephen Swad, KPMG partner, Department of Professional Practice, said that companies must consider several key issues, including recognizing all derivative instruments as either assets or liabilities measured at fair value; designating all hedging relationships anew; measuring transition adjustments that will affect earnings; and modifying accounting, risk management objectives and strategies, and information systems to comply with the requirements of the standard. The 425-page publication, the second in KPMG’s handbook series, provides over 100 examples illustrating some of the complex areas of the standard, and answers possible questions that might arise during implementation.

KPMG’s Web site is: http://www.us.kpmg.com.

DIG Issue I1—Interaction of the Disclosure Requirements of Statement 133 and Statement 47 (Released 11/99)

Discount = see premium.

Disincentives for nonperformance = see firm commitment.

Dollar Offset Method =

a computation of the cumulative derivative hedging gain or loss on the basis of multiple period historical changes in fair value of the hedging instrument vis-a-vis changes in the fair value of the underlying.   The dollar offset period change ratio is the ratio of the dollar gain or loss of the hedging instrument divided by the dollar gain or loss of the hedged item.  The cumulative dollar change ratio is the sum of the gains and losses of the hedging instrument divided by the sum of the gains and losses of the hedged item.  See net settlement.

Dynamic Portfolio Management =

a technique of assessing the risk and managing a portfolio or group of assets and liabilities. Dynamic management is characterized by continuous assessment and periodic adjustment of the portfolio components.  See the discussion of macro hedges under hedge.  Also see compound derivatives.  Also see value at risk (VAR).  Also see my summary of key paragraphs in FAS 133 on portfolio/macro hedging.

E-Terms

Effectiveness =  see ineffectiveness.

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.

Embedded Option =

an option that is an inseparable part of another instrument. Most embedded options are conversion features granted to the buyer or early termination options reserved by the issuer of a security. A call provision of a bond or note that contractually allows for early extinguishment is an example of an embedded option.   See embedded derivatives and option.

Convertible debt can be viewed as a debt instrument with a call option on equity securities of the issuer.  Interest rates on that option are not clearly-and-closely related.  Hence, the embedded option might be accounted for separately under Paragraph 6 on Page 3 of FAS 133.

Also see compound derivative.

Eonia = See Euribor.

Equity-Indexed Embedded Derivative =

a contract with payments derived from a common stock price index such as the Dow Industrial Price Index or the Standard and Poors 500 Index.  For example,when a note's interest payment has an embedded derivative (e.g., a common stock price option on a particular stock or a stock index) pegged to equity prices, the embedded portion must be separated from the host contract and be accounted for as a derivative according to Paragraph 61h on Pages 42-43 of FAS 133.  This makes equity  indexed derivative accounting different than credit indexed and   inflation indexed embedded derivative accounting rules that do not allow separation from the host contract.  In this regard, credit-indexed embedded derivative accounting is more like commodity-indexed accounting.  An illustration is provided beginning in Paragraph 185 on Page 97 of FAS 133.  Also see Paragraph 250 on Page 133 of FAS 133.  FAS 133 does not cover derivatives in which the equity index is tied only to the firm's on common stock according to Paragraph 11a beginning on Page 6 of FAS 133.  Also see index-amortizing, derivative financial instrument and embedded derivative.

See DIG Issue B10 under embedded derivatives.

Equity-Linked Bear Note = see embedded derivatives.

Equity Method =

a naughty word for hedge accounting under FAS 133.  See Paragraph 29f on Page 20 of FAS 133.  Risks of cash flows, fair value and foreign currency cannot be hedged for securities accounted for under the equity method under SFAS 115 except under confusing net investment hedges discussed below.  For equity method accounting, ownership must constitute at least 20% of the outstanding voting (equity) shares of the security in question. Under the equity method the investment is adjusted for the owner's share of net earnings irrespective of cash dividends.  Since dividends do not affect earnings, the FASB does not allow cash flow hedges of forecasted dividends under equity method accounting.  

Cash flow hedges must have the possibility of affecting net earnings.  For example, Paragraph 485 on Page 211 of FAS 133 bans foreign currency risk hedges of forecasted dividends of foreign subsidiary.  The reason is that these dividends are a wash item and do not affect consolidated earnings.

Not allowing equity method investments to be hedged items is controversial.  The FASB defends its decision in Paragraph 455 beginning on Page 200 of FAS 133.  This reads as follows:

The Board decided to retain the prohibition in the Exposure Draft from designating an investment accounted for by the equity method as a hedged item to avoid conflicts with the existing accounting requirements for that item. Providing fair value hedge accounting for an equity method investment conflicts with the notion underlying APB Opinion No. 18, The Equity Method of Accounting for Investments in Common Stock. Opinion 18 requires an investor in common stock and corporate joint ventures to apply the equity method of accounting when the investor has the ability to exercise significant influence over the operating and financial policies of the investee. Under the equity method of accounting, the investor generally records its share of the investee’s earnings or losses from its investment. It does not account for changes in the price of the common stock, which would become part of the basis of an equity method investment under fair value hedge accounting. Changes in the earnings of an equity method investee presumably would affect the fair value of its common stock. Applying fair value hedge accounting to an equity method investment thus could result in some amount of double counting of the investor’s share of the investee’s earnings. The Board believes that result would be inappropriate. In addition to those conceptual issues, the Board was concerned that it would be difficult to develop a method of implementing fair value hedge accounting, including measuring hedge ineffectiveness, for equity method investments and that the results of any method would be difficult to understand. For similar reasons, this Statement also prohibits fair value hedge accounting for an unrecognized firm commitment to acquire or dispose of an investment accounted for by the equity method.

Section c(4) of Paragraph 4 is probably the most confusing condition mentioned in Paragraph 4. It allows hedging under "net investment" criteria under Paragraph 20 of SFAS 52.  The gain or loss is reported in other comprehensive income as part of the cumulative translation adjustment. Reasons are given in Paragraph 477 on Page 208 of FAS 133:

The net investment in a foreign operation can be viewed as a portfolio of dissimilar assets and liabilities that would not meet the criterion in this Statement that the hedged item be a single item or a group of similar items. Alternatively, it can be viewed as part of the fair value of the parent's investment account. Under either view, without a specific exception, the net investment in a foreign operation would not qualify for hedging under this Statement. The Board decided, however, that it was acceptable to retain the current provisions of Statement 52 in that area. The Board also notes that, unlike other hedges of portfolios of dissimilar items, hedge accounting for the net investment in a foreign operation has been explicitly permitted by the authoritative literature.

For a derivative not designated as a hedging instrument, the gain or loss is recognized in earnings in the period of change.  Section 4(c) of Paragraph 4 of FAS 133 amends SFAS 52 on Foreign Currency Translation, to permit special accounting for a hedge of a foreign currency forecasted transaction with a derivative.  For more detail see foreign currency hedge.

Paragraph 42 on Page 26 reads as follows:

.A derivative instrument or a nonderivative financial instrument that may give rise to a foreign currency transaction gain or loss under Statement 52 can be designated as hedging the foreign currency exposure of a net investment in a foreign operation. The gain or loss on a hedging derivative instrument (or the foreign currency transaction gain or loss on the nonderivative hedging instrument) that is designated as, and is effective as, an economic hedge of the net investment in a foreign operation shall be reported in the same manner as a translation adjustment to the extent it is effective as a hedge. The hedged net investment shall be accounted for consistent with Statement 52; the provisions of this Statement for recognizing the gain or loss on assets designated as being hedged in a fair value hedge do not apply to the hedge of a net investment in a foreign operation. 

These Section c(4) confusions in Paragraph 4 are illustrated in Examples 11-13 beginning on Page 270 of the Derivatives and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998.

A more confusing, at least to me, portion of Paragraph 36 reads as follows:

The criterion in paragraph 21(c)(1) requires that a recognized asset or liability that may give rise to a foreign currency transaction gain or loss under Statement 52 (such as a foreign-currency-denominated receivable or payable) not be the hedged item in a foreign currency fair value or cash flow hedge because it is remeasured with the changes in the carrying amount attributable to what would be the hedged risk (an exchange rate change) reported currently in earnings.  Similarly, the criterion in paragraph 29(d) requires that the forecasted acquisition of an asset or the incurrence of a liability that may give rise to a foreign currency transaction gain or loss under Statement 52 not be the hedged item in a foreign currency cash flow hedge because, subsequent to acquisition or incurrence, the asset or liability will be remeasured with changes in the carrying amount attributable to what would be the hedged risk reported currently in earnings. A foreign currency derivative instrument that has been entered into with another member of a consolidated group can be a hedging instrument in the consolidated financial statements only if that other member has entered into an offsetting contract with an unrelated third party to hedge the exposure it acquired from issuing the derivative instrument to the affiliate that initiated the hedge.

Equity Swap=

A swap with payments on one or both sides linked to the performance of equities or an equity index. Equity.  You can read the following at http://www.finpipe.com/equityswaps.htm 

Consider the Bulldog S&P 500 Mutual Fund that is a fund promising to deliver the return of the S&P 500 (less administrative and managerial costs). How do they do it?

One way would be to buy the 500 stocks that comprise the index in their exact proportions. However, the execution of this would be cumbersome, particularly if the level of funds in the Bulldog S&P 500 Mutual Fund were to fluctuate as people put more money to work or as they withdraw from the fund.

Another way would be to participate in the S&P 500 through the futures market by using the mutual fund's money to purchase S&P 500 Futures. The Futures contract would have to be rolled on a quarterly basis. There would be complex administration with the Futures Exchange.

There is a third alternative: the equity swap. The investment manager at Bulldog calls up First Derivatives bank and asks for an S&P 500 swap in which the fund pays First Derivatives some money market return in exchange for receiving the return on the S&P 500 index for a period of five years with monthly payments. The return on the S&P 500 index consists of capital gains as well as income distributions.

The structure is easy for the passive investment manager to implement administratively. And it fully accomplishes the goal with very little costs. Index trading funds typically have much lower costs associated with them.

There are also tax advantages or ownership advantages associated with equity swaps.

Let's say that you own $100 million of stock in Acme Tool & Die. The stock has gone up 50% in the past year and you want to take profit but you do not want to forfeit the shares. You just want someone to give you some money today for the capital gains and income distributions of that Acme Stock for the next five years. So you enter into an equity swap.

Paragraph 250 of FAS 133 explicitly provides for an underlying to be an equity index.  FAS 133 does not allow cash flow hedges based upon a firm's own equity.  Paragraph 472 reads as follows:

This Statement prohibits cash flow hedge accounting for forecasted transactions involving (a) an entity's interests in consolidated subsidiaries, (b) minority interests in consolidated subsidiaries, (c) investments accounted for by the equity method, or (d) an entity's own equity instruments classified in stockholders' equity.

See Equity Indexed Embedded Derivatives for specifics embedded derivatives entailing an equity index.

Euribor and Eonia=

money market reference rates for the European Union.  At the beginning of 1999 Europe adopted a new currency: 11 countries of the European Union will adopt the Euro. A new financial market was created which needed its own benchmarks. The benchmarks for the money and capital markets in the euro zone is Euribor and Eonia.  You can read the following definitions at the homepage of the Banking Federation of the Euorpean Union at http://www.euribor.org/ 

Euribor

(Euro Interbank Offered Rate) will be the rate at which euro interbank term deposits within the euro zone are offered by one prime bank to another prime bank.

Eonia

(Euro OverNight Index Average) will be an effective overnight rate computed as a weighted average of all overnight unsecured lending transactions in the interbank market, initiated within the euro area by the contributing panel banks.

These rates will benefit from:

• a large domestic market with a single currency;

• an impressive panel of quoting banks of first class credit standing;

• a solid code of conduct setting out strict rules for the panel banks;

• an independent Steering Committee of market experts which will oversee the application of the code.

The conditions are therefore in place to enable Euribor and Eonia to establish themselves as the benchmarks in the new euro market.

Exposed Net Asset Position =

the excess of assets that are measured or denominated in foreign currency and translated at the current rate over liabilities that are measured or denominated in foreign currency and translated at the current rate.

Exposure Draft 162-B =

a part of history in the Financial Accounting Standards Board leading up to FAS 133. See the Background Information section in FAS 133, pp. 119-127, Paragraphs 206-231. Especially note Paragraphs 214, 360-384, and 422-194.  See FAS 133.

F-Terms

Fair Value =

the estimated best disposal (exit, liquidation) value in any sale other than a forced sale.  It is defined as follows in Paragraph 540 on Page 243 of FAS 133:

The amount at which an asset (liability) could be bought (incurred) or sold (settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale. Quoted market prices in active markets are the best evidence of fair value and should be used as the basis for the measurement, if available. If a quoted market price is available, the fair value is the product of the number of trading units times that market price. If a quoted market price is not available, the estimate of fair value should be based on the best information available in the circumstances. The estimate of fair value should consider prices for similar assets or similar liabilities and the results of valuation techniques to the extent available in the circumstances. Examples of valuation techniques include the present value of estimated expected future cash flows using discount rates commensurate with the risks involved, option- pricing models, matrix pricing, option-adjusted spread models, and fundamental analysis.  Valuation techniques for measuring assets and liabilities should be consistent with the objective of measuring fair value. Those techniques should incorporate assumptions that market participants would use in their estimates of values, future revenues, and future expenses, including assumptions about interest rates, default, prepayment, and volatility. In measuring forward contracts, such as foreign currency forward contracts, at fair value by discounting estimated future cash flows, an entity should base the estimate of future cash flows on the changes in the forward rate (rather than the spot rate). In measuring financial liabilities and nonfinancial derivatives that are liabilities at fair value by discounting estimated future cash flows (or equivalent outflows of other assets), an objective is to use discount rates at which those liabilities could be settled in an arm's-length transaction.

The Financial Accounting Standards Board (FASB) requires estimation of fair value for many types of financial instruments, including derivative financial instruments. The main guidelines are spelled out in SFAS 107 and FAS 133 Appendix F Paragraph 540.  If a range is estimated for either the amount or the timing of possible cash flows, the likelihood of possible outcomes shall be considered in determining the best estimate of future cash flows according to FAS 133 Paragraph 17.  For related matters under international standards, see IAS 39 Paragraphs 1,5,6, 95-100, and 165.  According to the FASB, fair value is the amount at which an asset (liability) could be bought (incurred) or sold (settled) in a current transaction between willing parties, that is, other than in a forced or liquidation sale. Quoted market prices in active markets are the best evidence of fair value and should be used as the basis for the measurement, if available. If a quoted market price is available, the fair value is the product of the number of trading units times that market price. 

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 

There are some exceptions for hybrid instruments as discussed in  IAS 39  Paragraph 23c and FAS 133  Paragraph 12b.  There are also exceptions where value estimates are unreliable such as in the case of unlisted equity securities (see IAS 39 Paragraphs 69, 93, and 95).   

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

Paul Pacter states the following at http://www.iasc.org.uk/news/cen8_142.htm 

IAS 39 All debt securities, equity securities, and other financial assets that are not held for trading but nonetheless are available for sale – except those unquoted equity securities whose fair value cannot be measured reliably by another means are measured at cost subject to an impairment test.

SFAF 133 All debt securities, equity securities, and other financial assets that are not held for trading but nonetheless are available for sale – except all unquoted equity securities are measured at cost subject to an impairment test. FASB requires fair value measurement for all derivatives, including those linked to unquoted equity instruments if they are to be settled in cash but not those to be settled by delivery, which are outside the scope of 133

 

Paragraph 28 beginning on Page 18 of FAS 133 requires that the hedge be formally documented from the start such that prior contracts such as options or futures contracts cannot later be declared hedges. Under international accounting rules, a hedged item can be a recognized asset or liability, an unrecognized firm commitment, or a forecasted transaction (IAS 39  Paragraph 127). 

If quoted market prices are not available, the estimate of fair value should be based on the best information available in the circumstances. The estimate of fair value should consider prices for similar assets and liabilities and the results of valuation techniques to the extent available in the circumstances. Examples of valuation techniques include the present value of estimated expected future cash flows using a discount rate commensurate with the risks involved, option-pricing models, matrix pricing, option-adjusted spread models, and fundamental analysis. Valuation techniques for measuring assets and liabilities should be consistent with the objective of measuring fair value. Those techniques should incorporate assumptions that market participants would use in their estimates of values, future revenues, and future expenses, including assumptions about interest rates, default, prepayment, and volatility.

Under IAS 39 Paragraph 100, under circumstances when a quoted market price is not available, estimation techniques may be used --- which include reference to the current market value of another instrument that is substantially the same, discounted cash flow analysis, and option pricing models.  When an enterprise has matching asset and liability positions, it may use mid-market prices according to IAS 39 Paragraph 99.

In reality, the FASB in FAS 133 and the IASC in IAS 39 require continual adjustments of financial instruments derivatives to fair value without giving much guidance about such matters when the instruments are not traded on exchange markets or are traded in markets that are too thin to rely upon for value estimation.  Unfortunately, over half of the financial instruments derivative contracts around the world are customized contracts for which there are no markets for valuation estimation purposes.  The most difficult instruments to value are forward contracts and interest rate and foreign currency swaps.  In my Working Paper 231 I discuss various approaches for valuation of interest rate swaps.  See http://www.trinity.edu/rjensen/231wp/231wp.htm .

The fair value of foreign currency forward contracts should be based on the change in the forward rate and should consider the time value of money. In measuring liabilities at fair value by discounting estimated future cash flows, an objective is to use discount rates at which those liabilities could be settled in an arm's-length transaction. Although the FASB  does not give very explicit guidance on estimation of a derivative’s fair market value, this topic appears at many points in FAS 133. See Paragraphs 312-319 and 432-457.See blockage factor and yield curve.

Paragraphs 216 on Page 122 and 220-231 beginning on Page 123 of FAS 133 leave little doubt that the FASB feels "fair value is the most relevant measure for financial instrument and the only relevant measure for derivative instruments."  This can be disputed, especially when unrealized gains and value hide operating losses. The December 1998 issue of the Journal of Accountancy provides an interesting contrast on fair value accounting.  On Pages 12-13 you will find a speech by SEC Chairman Arthur Levitt bemoaning the increasingly common practice of auditors to allow earnings management.  On Page 20 you will find a review of an Eighth Circuit Court of Appeals case in which a firm prevented the reporting of net losses for 1988 and 1989 by persuading its auditor to allow reclassification of a large a large hotel as being "for sale" so that it could revalue historical cost book value to current exit value and record the gain as current income.  Back issues of the Journal of Accountancy are now online at http://www.aicpa.org/pubs/jofa/joaiss.htm .

The FASB intends eventually to book all financial instruments at fair value. Jim Leisingring comments about " first shot in a religious war" in my tape31.htm. The IASC also is moving closer and closer to fair value accounting for all financial instruments for virtually all nations, although it too is taking that big step in stages.  Click here to view Paul Pacter's commentary on this matter.

See DIG Issue B6 under embedded derivatives.

At the moment, accounting standards dictate fair value accounting for derivative financial instruments but not all financial instruments.  However, the entire state of fair value accounting is in a state of change at the moment with respect to both U.S. and international accounting standards.

If a purchased item is viewed as an inventory holding, the basis of accounting is the lower of cost or market for most firms unless they are classified as securities dealers.  In other words, the inventory balance on the balance sheet does not rise if expected net realization rises above cost, but this balance is written down if the expected net realization falls below cost.  The one exception, where inventory balances are marked-to-market for upside and well as downside price movements, arises when the item in inventory qualifies as a "precious" commodity (such as gold or platinum) having a readily-determinable market value.    Such commodities as pork bellies, corn, copper, and crude oil, are not "precious" commodities and must be maintained in inventory at lower-of-cost-or market. 

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

• Financial Instruments: Issues Relating to Banks (strongly argues for fair value adjustments of financial instruments). The issue date is August 31, 1999.
  Trinity University students may view this paper at J:\courses\acct5341\iasc\jwgbaaug.pdf.  
  
  
• Accounting for financial Instruments for Banks (concludes that a modified form of historical cost is optimal for bank accounting). The issue date is October 4, 1999.
  Trinity University students may view this paper at J:\courses\acct5341\iasc\jwgfinal.pdf 
  
  

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

Fair Value Hedge =

a hedge that bases its periodic settlements on changes in value of an asset or liability. This type of hedge is most often used for forecasted purchases or sales. See FAS 133 Paragraphs 20-27,104-110, 111-120, 186, 191-193, 199, 362-370, 422-425, 431-457, and 489-491. The FASB intends to incrementally move towards fair value accounting for all financial instruments, but the FASB feels that it is too much of a shock for constituents to abruptly shift to fair value accounting for all such instruments.  See Paragraph 247 on Page 132, Paragraph 331 on Page 159, Paragraph 335 on Page 160, and Paragraph 321 on Page 156.  The IASC adopted the same definition of a fair value hedge except that the hedge has also to affect reported net income (See IAS 39 Paragraph 137a)

Held-to-maturity securities may not be hedged for fair value risk according to Paragraphs 426-431 beginning on Page 190 of FAS 133.  See held-to-maturity.

In FAS 133, derivative financial instruments come in three basic types that are listed in Paragraph 4 on Page 2 of FAS 133.  One of these types is described in Section a and Footnote 2 below:

Paragraph 4 on Page 2 of FAS 133.
This Statement standardizes the accounting for derivative instruments, including certain derivative instruments embedded in other contracts, by requiring that an entity recognize those items as assets or liabilities in the statement of financial position and measure them at fair value. If certain conditions are met, an entity may elect to designate a derivative instrument as follows:

a.
A hedge of the exposure to changes in the fair value of a recognized asset or liability, or of an unrecognized firm commitment, \2/ that are attributable to a particular risk (referred to as a fair value hedge)
==========================================================================
Footnote 2
\2/ An unrecognized firm commitment can be viewed as an executory contract that represents both a right and an obligation. When a previously unrecognized firm commitment that is designated as a hedged item is accounted for in accordance with this Statement, an asset or a liability is recognized and reported in the statement of financial position related to the recognition of the gain or loss on the firm commitment. Consequently, subsequent references to an asset or a liability in this Statement include a firm commitment.
==========================================================================

With respect to Section a above, a firm commitment cannot have a cash flow risk exposure because the gain or loss is already booked.  For example, a contract of 10,000 units per month at $200 per unit is unrecognized and has a cash flow risk exposure if the payments have not been made. If the payments have been prepaid, that prepayment is "recognized" and has no further cash flow risk exposure. The booked firm commitment, however, can have a fair value risk exposure.

Generally assets and liabilities must be carried on the books at cost (or not be carried at all as unrecognized firm commitments) in order to host fair value hedges.  The hedged item may not be revalued according to Paragraph 21c on Page 14 of SFAS 113.  However, since GAAP prescribes lower-of-cost-or market write downs (LCM) for certain types of assets such as inventories and receivables, it makes little sense if LCM assets cannot also host fair value hedges. Paragraph 336 on Page 160 does not discuss LCM.  It is worth noting, however, that Paragraph 336 on Page 160 does not support fair value adjustments of hedged items at the inception of a hedge.

The hedging instrument (e.g., a forecasted transaction or firm commitment) must meet the stringent criteria for being defined as a derivative financial instrument under FAS 133.   This includes the tests for being clearly-and-closely related.  It also includes strict tests of Paragraphs 21 beginning on Page 13 , 29 beginning on Page 20, and Paragraph 56 on Page 33 of FAS 133 with respect to the host contracts that are being hedged.  Those tests state that if the forecasted "transaction" is in reality a group or portfolio of individual transactions, all transactions in the group must bear the same risk exposure within a 10% range discussed in Paragraph 21.   Also see Footnote 9 on Page 13 of FAS 133.  The grouping tests are elaborated upon in the following Paragraphs:

• Paragraph 21 on Page 13,

• Paragraph 29 beginning on Page 20,

• Paragraph 241 on Page 130,

• Paragraph317 on Page 155,

• Paragraphs 333-334 beginning on Page 159,

• Paragraph 432 on Page 192,

• Paragraph 435 on Page 193,

• Paragraph 443-450 beginning on Page 196

• Paragraph 462 on Page 202,

• Paragraph 477 on Page 208.

For example, a group of variable rate notes indexed in the same way upon LIBOR might qualify, whereas having different indices such as LIBOR and U.S. Prime rate underlyings will not qualify.    Also, anticipated purchases cannot be combined with anticipated sales in the same grouping designated as a forecasted transaction even if they have the same underlying.   Paragraph 477 on Page 208 of FAS 133 makes an exception for a portfolio of differing risk exposures for financial instruments designated in foreign currencies so not to conflict with Paragraph 20 of SFAS 52.   For more detail see cash flow hedge and foreign currency hedge.

Those tests also state that a compound grouping of multiple derivatives (e.g., a portfolio of options or futures or forward contracts or any combination thereof) is prohibited from "separating a derivative into either separate proportions or separate portions and designating any component as a hedging instrument or designating different components as hedges of different exposures."   See Paragraphs 360-362 beginning on Page 167 of FAS 133.  Paragraphs dealing with compound derivative issues include the following:

• Paragraph 18 beginning on Page 9,

• Footnote 13 on Page 29,

• Paragraphs 360-362 beginning on Page 167,

• Paragraph 413 on Page 186,

• Paragraphs 523-524 beginning on Page 225.

Paragraph 18 on Page 10 does allow a single derivative to be divided into components provided but never with partitioning of   "different risks and designating each component as a hedging instrument."   An example using Dutch guilders versus French francs is given under cash flow hedge.

One question that arises is whether a hedged item and its hedge may have different maturity dates.  Paragraph 18 beginning on Page 9 of FAS 133 rules out hedges such as interest rate swaps from having a longer maturity than the hedged item such as a variable rate loan or receivable.  On the other hand, having a shorter maturity is feasible according to KPMG's Example 13 beginning on Page 225 of the Derivatives and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998) states the following.  A portion of that example reads as follows:

Although the criteria specified in paragraph 28(a) of the Standard do not address whether a portion of a single transaction may be identified as a hedged item, we believer that the proportion principles discussed in fair value hedging model also apply to forecasted transactions.

The difference between a forward exchange rate and a spot rate is not excluded from a fair value hedging relationship for firm commitments measured in forward rates.  However Footnote 22 on Page 68 of FAS 133 reads as follows:

If the hedged item were a foreign-currency-denominated available-for-sale security instead of a firm commitment, Statement 52 would have required its carrying value to be measured using the spot exchange rate. Therefore, the spot-forward difference would have been recognized immediately in earnings either because it represented ineffectiveness or because it was excluded from the assessment of effectiveness.

Paragraph 399 on Page 180 of FAS 133 does not allow covered call strategies that permit an entity to write an option on an asset that it owns.  See written option.

Fair value hedges are accounted for in a similar manner in both FAS 133 and IAS 39.  Paul Pacter states the following at http://www.iasc.org.uk/news/cen8_142.htm 

IAS 39 Fair Value Hedge Definition:  a hedge of the exposure to changes in the fair value of a recognised asset or liability (such as a hedge of exposure to changes in the fair value of fixed rate debt as a result of changes in interest rates). However, a hedge of an unrecognised firm commitment to buy or sell an asset at a fixed price in the enterprise’s reporting currency is accounted for as a cash flow hedge IAS 39 Fair Value Hedge Accounting: To the extent that the hedge is effective, the gain or loss from remeasuring the hedging instrument at fair value is recognised immediately in net profit or loss. At the same time, the corresponding gain or loss on the hedged item adjusts the carrying amount of the hedged item and is recognised immediately in net profit or loss.

FAS 133 Fair Value Hedge Definition: Same as IAS 39 ...except that a hedge of an unrecognised firm commitment to buy or sell an asset at a fixed price in the enterprise’s reporting currency is accounted for as a fair value hedge or a cash flow hedge. SFAS Fair Value Hedge Accounting: Same as IAS 39

 

a. The gain or loss from remeasuring the hedging instrument at fair value should be recognized immediately in earnings; and

b. The gain or loss on the hedged item attributable to the hedged risk should adjust the carrying amount of the hedged item and be recognized immediately in earnings.

c. This applies even if a hedged item is otherwise measured at fair value with changes in fair value recognized directly  in equity under paragraph 103b.  It also applies if the hedged item is otherwise measured at cost. 
(IAS 39 Paragraph 153)
See IAS 39 Paragraph 154 for example.

Also see hedge and hedge accounting.

 

DIG issues on fair value at http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issuindex.html  Section F: Fair Value Hedges *Issue F1—Stratification of Servicing Assets (Cleared 02/17/99) *Issue F2—Partial-Term Hedging (Cleared 07/28/99) *Issue F3—Firm Commitments—Statutory Remedies for Default Constituting a Disincentive for Nonperformance (Cleared 11/23/99) *Issue F4—Interaction of Statement 133 and Statement 114 (Cleared 11/23/99) *Issue F5—Basing the Expectation of Highly Effective Offset on a Shorter Period Than the Life of the Derivative (Cleared 11/23/99)

FAS 133 and FAS 138  = See SFAS 133

FASB = See Financial Accounting Standards Board (FASB)

Financial Accounting Standards Board (FASB) =

Financial Accounting Standards Board, P.O. Box 5116, Norwalk, CT 06856-5116. Phone: 203-847-0700 and Fax: 203-849-9714.  The web site is at http://www.rutgers.edu/Accounting/raw/fasb/ .  See FAS 133.

Financial Accounting Standards Board, P.O. Box 5116, Norwalk, CT 06856-5116. Phone: 203-847-0700 and Fax: 203-849-9714.  The web site is at http://www.rutgers.edu/Accounting/raw/fasb/ .  See FAS 133.

For matters pertaining to FAS 133 and FAS 138, see SFAS 133.

Also see International Accounting Standards Committee (IASC) and FAS 133.

Financial Instrument =

cash, evidence of an ownership interest in an entity, or a contract that both:

Firm Commitment =

an agreement with an unrelated party, usually legally enforceable, under which performance is probable because of a sufficiently large disincentive for nonperformance.  For example, even though a company expects future dividends from an investment to continue at a fixed rate, future dividends are not firm commitments unless there are disincentives for failure to declare dividends.   There might be such disincentives in the case of preferred dividends, but there are no such disincentives for common stock dividends.  Disincentives for nonperformance may not be indirect opportunity gains or losses according to Paragraph 540 beginning on Page 243 of FAS 133.  Paragraph 540 on Page 244 defines a firm commitment as follows:

An agreement with an unrelated party, binding on both parties and usually legally enforceable, with the following characteristics:

a. The agreement specifies all significant terms, including the quantity to be exchanged, the fixed price, and the timing of the transaction. The fixed price may be expressed as a specified amount of an entity's functional currency or of a foreign currency. It may also be expressed as a specified interest rate or specified effective yield.

b. The agreement includes a disincentive for nonperformance that is sufficiently large to make performance probable.

Section b above is judgmental.  The best way to meet this condition is to spell out the penalties for nonperformance in the contract.  But there are many situations where legal recourse is implicit as a matter of statute or tradition.  Must the "agreement disincentives"  be spelled out in each contract?  Clearly there are many situations in which disincentives are implicit in the law.  There are many others in which it is not so much legal as it is economic disincentives requiring laying off of workers, closing down of plants, negative publicity, etc.  Economic disincentives, however, are far more difficult to use in distinguishing firm commitments from forecasted transactions.

To my students I like to relate firm commitments and forecasted transactions to purchase commitments or sales contracts that call for future delivery.  If the contract specifies an exact quantity at a fixed (firm) price, the commitment is deemed a "firm commitment."   Cash flow is never in doubt with a firm (fixed-price) commitments and, therefore, a firm commitment cannot be hedged by a cash flow hedge.  For example, suppose Company A enters into a purchase contract to purchase 10,000 tons of a commodity for $600 per ton in three months time.  This a firm commitment without any doubt about the cash flows.  However, if the price is contracted at "spot price" in three months, the commitment is no longer a "firm" commitment.  The clause "spot price" makes this a forecasted transaction for 10,000 at a future price that can can move up or down from its current level.  It is possible to enter into a cash flow hedge with a derivative instrument that will lock in price of a forecasted transaction.  In the case of a firm commitment there is no need for a cash flow hedge.

In the case of a firm commitment the cash flow is fixed but the value can vary with spot prices.  For example, in three months time the firm commitment cash flow may be ($600)($10,000) = $6,000,000.  If the spot price moves to $500, the cash flow is more than the value of the commodity at the time of purchase.  It is possible, however, to use a derivative financial instrument to hedge the value at a given level (called a fair value hedge) such that if the spot rate falls to $500, the hedge will pay ($600-$500)(10,000 tons) =  $1,000,000.

In the case of a forecasted transaction at spot rates, the value stays fixed at ($ spot rate)(10,000 tons).  However, the cash flow accordingly varies.  It is possible to enter into a cash flow hedge using a derivative financial instrument, however, such that the cash flow is fixed a desired level.  In summary either cash flows are fixed and values vary (i.e., a fixed commitment) or cash flows vary and values are fixed (forecasted transaction).  If hedging takes place, firm commitments are only hedged with respect to value, whereas forecasted transactions are only hedged as to cash flow.  

I think the FASB really intends that the disincentives or penalties must be legally specified for each firm commitment to a point where these specifications will invoke very serious damages after a court in case for any breach of contract.   Section b is probably best interpreted in terms of its main purpose.  The main purpose, I surmise, is to distinguish a firm commitment from both a forecasted transaction and a common form of purchase contract that is easily broken with few if any penalties.  For example, a newspaper's 80-year agreement to purchase newsprint from a paper manufacturer might be broken with relatively small damages if the trees needed for the newsprint have not even been planted.  That type of purchase agreement is not a firm commitment.  It would seem, however, that Section b must be a matter of judgment regarding degrees of "firmness." rather than the mere writing in of any form of penalty for breach of contract.

See DIG Implementation Issue A5 under net settlement.

Differences between firm commitments versus forecasted transactions are elaborated upon in Paragraphs 320-326 beginning on Page 157 of FAS 133.  Respondents did not necessarily agree that the differences are important.   The FASB argues that they are important.  As a result,  firm commitments do not need cash flow hedges unless there is foreign currency risk.  They may   need fair value hedging since values may vary from committed prices.   According to Paragraph 325, forecasted transactions have fewer rights and obligations vis-a-vis firm commitments.  All significant terms of the exchange should be specified in the agreement, including the quantity to be exchanged and the fixed price.  A forecasted transaction has no contractual rights and obligations.  Firm commitments differ from long-term purchase commitments. Generally long-term purchase agreements such as agreements to purchase timber of trees not yet planted or oil not yet pumped from the ground can usually be broken with a relatively small amount of penalty equal to damages sustained in the breaking of a contract. A firm commitment usually entails damage awards equal to or more than the contractual commitment. Hence they are less likely to be broken than purchase commitments. Firm commitments are discussed at various points in FAS 133.  See Paragraphs 37, 362, 370, 437-442, and 458-462.

Firm commitments can have fair value hedges even though they cannot have cash flow hedges other than cash flow hedges of foreign currency risk exposures --- see Paragraph 20 on Page 11 and Paragraph 37 on Page 24 of FAS 133.  They can be contracted in terms of a currency other than the designated functinal currency.   Gains and losses on fair value hedges of firm commitments are accounted for in current earnings following guidance in Paragraph 39 on Page 25 of FAS 133.  If the firm commitment is recognized, it is by definition booked and its loss or gain is already accounted for. For example, a purchase contract for 10,000 units per month at 100DM Deutsche Marks per unit is unrecognized and has a foreign currency risk exposure if the payments have not been made. If the payments have been prepaid, that prepayment is "recognized" and has no further foreign currency risk exposure.  See derivative financial instrument.

In Paragraph 440 beginning on Page 195 of FAS 133, the definition of a firm commitment reads the same as is does in Paragraph 540:

An agreement with an unrelated party, binding on both parties and usually legally enforceable, with the following characteristics:

a. The agreement specifies all significant terms, including the quantity to be exchanged, the fixed price, and the timing of the transaction. The fixed price may be expressed as a specified amount of an entity's functional currency or of a foreign
currency. It also may be expressed as a specified interest rate or specified effective yield.

b. The agreement includes a disincentive for nonperformance that is
sufficiently large to make performance probable.

That definition is based on the definition of a firm commitment in
Statements 52 and 80.

Paragraph 324 on Page 157 also declares that firm commitments must be fixed-price contracts. Also see Paragraphs 370, 416, and 432 of FAS 133.  Contracts not having fixed prices are generally not allowed to host fair value hedges.   An illustration of a fair value hedge of a firm commitment begins in Paragraph 121 on Page 67 of FAS 133.  Disincentives for nonperformance can be direct penalties, but they may not be indirect opportunity gains or losses according to Paragraph 540 beginning on Page 243 of FAS 133.

Some firm commitments are not booked at the time of the contract.  For example, purchase contracts for raw materials are not booked until title changes hands or prepayment takes place.  Unrecognized firm commitments, unlike recognized firm commitment, are not booked as assets or liabilities.  Footnote 2 on Page 2 of SFAS reads as follows:

An unrecognized firm commitment can be viewed as an executory contract that represents both a right and an obligation. When a previously unrecognized firm commitment that is designated as a hedged item is accounted for in accordance with this Statement, an asset or a liability is recognized and reported in the statement of financial position related to the recognition of the gain or loss on the firm commitment. Consequently, subsequent references to an asset or a liability in this Statement include a firm commitment

Footnote 8 on Page 13 of FAS 133 notes how commitments sometimes do and sometimes do not qualify for accounting as firm commitments for hedges:

A firm commitment that represents an asset or liability that a specific accounting standard prohibits recognizing (such as a noncancellable operating lease or an unrecognized mortgage servicing right) may nevertheless be designated as the hedged item in a fair value hedge. A mortgage banker's unrecognized "interest rate lock commitment" (IRLC) does not qualify as a firm commitment (because as an option it does not obligate both parties) and thus is not eligible for fair value hedge accounting as the hedged item.  (However, a mortgage banker's "forward sale commitments," which are derivatives that lock in the prices at which the mortgage loans will be sold to investors, may qualify as hedging instruments in cash flow hedges of the forecasted sales of mortgage loans.)

Sometimes even a firm commitment is not eligible for hedge accounting.  For example, a a firm commitment to acquire equity investment in a consolidated subsidiary is not eligible under Paragraph 456 on Page 201 of FAS 133.  Under international rules, a hedged item can be a recognized asset or liability, an unrecognized firm commitment, or a forecasted transaction (IAS 39 Paragraph 127).  Also see FAS 133 Paragraph 21a.

A firm commitment must meet the stringent criteria for being defined as a derivative financial instrument under FAS 133.  This includes the tests for being clearly-and-closely related.  It also includes strict tests of Paragraphs 21 beginning on Page 13 , 29 beginning on Page 20, and Paragraph 56 on Page 33 of FAS 133 with respect to the host contracts that are being hedged.  Those tests state that if the firm "commitment" is in reality a group or portfolio of individual transactions, all transactions in the group must bear the same risk exposure within a 10% range discussed in Paragraph 21.   Also see Footnote 9 on Page 13 of FAS 133.  The grouping tests are elaborated upon in the following Paragraphs:

• Paragraph 21 on Page 13,

• Paragraph 29 beginning on Page 20,

• Paragraph 241 on Page 130,

• Paragraph317 on Page 155,

• Paragraphs 333-334 beginning on Page 159,

• Paragraph 432 on Page 192,

• Paragraph 435 on Page 193,

• Paragraph 443-450 beginning on Page 196

• Paragraph 462 on Page 202,

• Paragraph 477 on Page 208.

For example, a group of variable rate notes indexed in the same way upon LIBOR might qualify, whereas having different indices such as LIBOR and U.S. Prime rate underlyings will not qualify.    Also, anticipated purchases cannot be combined with anticipated sales in the same grouping designated as a forecasted transaction even if they have the same underlying.   Paragraph 477 on Page 208 of FAS 133 makes an exception for a portfolio of differing risk exposures for financial instruments designated in foreign currencies so not to conflict with Paragraph 20 of SFAS 52.  It allows hedging under "net investment" criteria under Paragraph 20 of SFAS 52.  For more detail see foreign currency hedge.

Paul Pacter states the following at http://www.iasc.org.uk/news/cen8_142.htm 

IAS 39 Fair value hedge definition: a hedge of the exposure to changes in the fair value of a recognised asset or liability (such as a hedge of exposure to changes in the fair value of fixed rate debt as a result of changes in interest rates). However, a hedge of an unrecognised firm commitment to buy or sell an asset at a fixed price in the enterprise’s reporting currency is accounted for as a cash flow hedge

FAS 133 Same... ...except that a hedge of an unrecognised firm commitment to buy or sell an asset at a fixed price in the enterprise’s reporting currency is accounted for as a fair value hedge or a cash flow hedge.

Also see forecasted transaction and hedge accounting.

Fixed-to-Floating = see floater.

Floater =

a variable coupon (nominal) rate that determines the interim cash flows on bond debt and bond investments.   Example 12 in FAS 133 Paragraph 178 illustrates an inverse floater where the coupon rate varies with changes in an interest rate index such as the prime rate or LIBOR.  Example 13 in Paragraph 179 illustrates a levered inverse floater that varies indirectly rather than directly with an index.  Example 14 in Paragraph 180 illustrates a delivered floater that has a lagged relation to an index.   Example 15 in Paragraph 15 illustrates a range floater with a cash payment based upon the number of days that the referent index stays with a a pre-established collar (range).  Example 16 illustrates a ratchet floater that has an adjustable cap and floor that move in relation to a referent index such as LIBOR.  Example 17 in Paragraph 183 illustrates a fixed-to-floating floater varies between fixed rate periods versus floating rate periods. 

Much of the concern in FAS 133 accounting focuses on whether a floater-based embedded option can be separated from its host.  For example suppose a bond receivable has a variable interest rate with an embedded range floater derivative that specifies a collar of 4% to 8% based upon LIBOR.  The bond holder receives no interest payments in any period where the average LIBOR is outside the collar.  In this case, the range floater embedded option cannot be isolated and accounted for apart from the host bond contract.  The reason is that the option is clearly and closely related to the interest payments under the host contract (i.e., it can adjust the interest rate).  See Paragraph 12 beginning on Page 7 of FAS 133.   An example of a range floater is provided beginning in Paragraph 181 on Page 95 of FAS 133.

A ratchet floater pays a floating interest rate with an adjustable cap and an adjustable floor.  The embedded derivatives must be accounted for separately under Paragraph 12.  An example is provided in Paragraph 182 beginning on Page 95 of FAS 133.

Some debt has a combination of fixed and floating components.  For example, a "fixed-to-floating" rate bond is one that starts out at a fixed rate and at some point (pre-determined or contingent) changes to a variable rate.   This type of bond has a embedded derivative (i.e., a forward component for the variable rate component that adjusts the interest rate in later periods.   Since the forward component is  "clearly-and-closely related"adjustment of interest of the host contract, it cannot be accounted for separately according to Paragraph 12a on Page 7 of FAS 133 (unless conditions in Paragraph 13 apply).  See also Paragraph 21a(2) on Page 14 of FAS 133.  An example of a fixed-to-floating rate debt is provided beginning in Paragraph 183 on Page 196 of FAS 133.

Floor = see cap.

Forecasted Transaction =

a transaction that is expected, with high probability, to occur but as to which there has been no firm commitment. Particularly important is the absence penalties for breach of contract.  Paragraph 540 on Page 245 of FAS 133 defines it as follows:

A transaction that is expected to occur for which there is no firm commitment. Because no transaction or event has yet occurred and the transaction or event when it occurs will be at the prevailing market price, a forecasted transaction does not give an entity any present rights to future benefits or a present obligation for future sacrifices

To my students I like to relate firm commitments and forecasted transactions to purchase commitments or sales contracts that call for future delivery.  If the contract specifies an exact quantity at a fixed (firm) price, the commitment is deemed a "firm commitment."   Cash flow is never in doubt with a firm (fixed-price) commitments and, therefore, a firm commitment cannot be hedged by a cash flow hedge.  For example, suppose Company A enters into a purchase contract to purchase 10,000 tons of a commodity for $600 per ton in three months time.  This a firm commitment without any doubt about the cash flows.  However, if the price is contracted at "spot price" in three months, the commitment is no longer a "firm" commitment.  The clause "spot price" makes this a forecasted transaction for 10,000 at a future price that can can move up or down from its current level.  It is possible to enter into a cash flow hedge with a derivative instrument that will lock in price of a forecasted transaction.  In the case of a firm commitment there is no need for a cash flow hedge.

In the case of a firm commitment the cash flow is fixed but the value can vary with spot prices.  For example, in three months time the firm commitment cash flow may be ($600)($10,000) = $6,000,000.  If the spot price moves to $500, the cash flow is more than the value of the commodity at the time of purchase.  It is possible, however, to use a derivative financial instrument to hedge the value at a given level (called a fair value hedge) such that if the spot rate falls to $500, the hedge will pay ($600-$500)(10,000 tons) =  $1,000,000.

In the case of a forecasted transaction at spot rates, the value stays fixed at ($ spot rate)(10,000 tons).  However, the cash flow accordingly varies.  It is possible to enter into a cash flow hedge using a derivative financial instrument, however, such that the cash flow is fixed a desired level.  In summary either cash flows are fixed and values vary (i.e., a fixed commitment) or cash flows vary and values are fixed (forecasted transaction).  If hedging takes place, firm commitments are only hedged with respect to value, whereas forecasted transactions are only hedged as to cash flow. 

Because no transaction or event has yet occurred and the transaction or event when it occurs will be at the prevailing market price, a forecasted transaction does not give an entity any present rights to future benefits or obligations for future sacrifices.  Firm commitments differ from forecasted transactions in terms of legal rights and obligations.  A forecasted transaction has no contractual rights and obligations. Forecasted transactions are referred to at various points in FAS 133. For example, see FAS 133 Paragraphs 29-35, 93, 358, 463-465, 472-473, and 482-487. A forecasted transaction, unlike a firm commitment, may need a cash flow hedge.  

Paragraph 29b on Page 20 of FAS 133 requires that the forecasted transaction be probable.  Important in this criterion would be past sales and purchases transactions.  An on-going baking company, for example, must purchase flour.  It does not have to purchase materials for a plant renovation, however, until management decisions to renovate are firmed up.

Paragraph 325 on Page 157 of FAS 133 states that even though forecasted transactions may be highly probable, they lack the rights and obligations of a firm commitment, including unrecognized firm commitments that are not booked as assets and liabilities. 

Forecasted transactions differ from firm commitments in terms of enforcement rights and obligations. They do not differ in terms of the need for a specific notional and a specific underlying under Paragraph 440a on Page 195 of FAS 133.  Section a of that paragraph reads as follows:

a. The agreement specifies all significant terms, including the quantity to be exchanged, the fixed price, and the timing of the transaction. The fixed price may be expressed as a specified amount of an entity's functional currency or of a foreign
currency. It also may be expressed as a specified interest rate or specified effective yield.

In Paragraph 29c on Page 20 of FAS 133, the forecasted transaction cannot be with a related party such as a subsidiary or parent company if it is to qualify as the hedged transaction of a cash flow hedging derivative.  An exception is made in Paragraph 40 on Page 25 for forecasted intercompany foreign currency-denominated transactions if the conditions on Page 26 are satisfied. Also see Paragraphs 471 and 487.  Paragraph 40 beginning on Page 25 allows such cash flow hedging if the parent becomes a party to the hedged item itself, which can be a contract between the parent and its subsidiary under Paragraph 36b on Page 24 of FAS 133.  However, a consolidated group may not apply cash flow hedge accounting as stated in Paragraph 40d on Page 26. 

Cash flow hedges must have the possibility of affecting net earnings.  For example, Paragraph 485 on Page 211 of FAS 133 bans foreign currency risk hedges of forecasted dividends of foreign subsidiary.  The reason is that these dividends are a wash item and do not affect consolidated earnings.  For reasons and references, see equity method.

Suppose a company expects dividend income to continue at a fixed rate over the two years in a foreign currency.  Suppose the investment is adjusted to fair market value on each reporting date.  Forecasted dividends may not be firm commitments since there are not sufficient disincentives for failure to declare a dividend.  A cash flow hedge of the foreign currency risk exposure can be entered into under Paragraph 4b on Page 2 of FAS 133.  Whether or not gains and losses are posted to other comprehensive income, however, depends upon whether the securities are classified under SFAS 115 as available-for-sale or as trading securities.   There is no held-to-maturity alternative for equity securities.

One question that arises is whether a hedged item and its hedge may have different maturity dates.  Paragraph 18 beginning on Page 9 of FAS 133 rules out hedges such as interest rate swaps from having a longer maturity than the hedged item such as a variable rate loan or receivable.  On the other hand, having a shorter maturity is feasible according to KPMG's Example 13 beginning on Page 225 of the Derivatives and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998) states the following.  A portion of that example reads as follows:

Although the criteria specified in paragraph 28(a) of the Standard do not address whether a portion of a single transaction may be identified as a hedged item, we believer that the proportion principles discussed in fair value hedging model also apply to forecasted transactions.

Paragraph 29d precludes forecasted transactions from being the hedged items in cash flow hedges if those items, when the transaction is completed, will be remeasured on each reporting date at fair value with holding gains and losses taken directly into current earnings (as opposed to comprehensive income).  Also see Paragraph 36 on Page 23 of FAS 133.  Thus, a forecasted purchase of raw material inventory maintained at cost can be a hedged item, but the forecasted purchase of a trading security not subject to APB 15 equity method accounting and as defined in SFAS 115, cannot be a hedged item. That is because SFAS 115 requires that trading securities be revalued with unrealized holding gains and losses being booked to current earnings.  Conversely, the forecasted purchase of an available-for-sale security can be a hedged item, because available-for-sale securities revalued under SFAS 115 have holding gains and losses accounted for in comprehensive income rather than current earnings.

Even more confusing is Paragraph 29e that requires the cash flow hedge to be on prices rather than credit worthiness.  For example, a forecasted sale of a specific asset at a specific price can be hedged for spot price changes under Paragraph 29e.  The forecasted sale's cash flows may not be hedged for the credit worthiness of the intended buyer or buyers.  Example 24 in Paragraph 190 on Page 99 of FAS 133 discusses a credit-sensitive bond.  Because the bond's coupon payments were indexed to credit rating rather than interest rates, the embedded derivative could not be isolated and accounted for as a cash flow hedge.

A forecasted transaction must meet the stringent criteria for being defined as a derivative financial instrument under FAS 133.  This includes the tests for being clearly-and-closely related.  It also includes strict tests of Paragraphs 21 beginning on Page 13 , 29 beginning on Page 20, and Paragraph 56 on Page 33 of FAS 133 with respect to the host contracts that are being hedged.  Those tests state that if the forecasted "transaction" is in reality a group or portfolio of individual transactions, all transactions in the group must bear the same risk exposure within a 10% range discussed in Paragraph 21.    Also see Footnote 9 on Page 13 of FAS 133.  The grouping tests are elaborated upon in the following Paragraphs:

• Paragraph 21 on Page 13,

• Paragraph 29 beginning on Page 20,

• Paragraph 241 on Page 130,

• Paragraph317 on Page 155,

• Paragraphs 333-334 beginning on Page 159,

• Paragraph 432 on Page 192,

• Paragraph 435 on Page 193,

• Paragraph 443-450 beginning on Page 196

• Paragraph 462 on Page 202,

• Paragraph 477 on Page 208.

For example, a group of variable rate notes indexed in the same way upon LIBOR might qualify, whereas having different indices such as LIBOR and U.S. Prime rate underlyings will not qualify.    Also, anticipated purchases cannot be combined with anticipated sales in the same grouping designated as a forecasted transaction even if they have the same underlying.   Paragraph 477 on Page 208 of FAS 133 makes an exception for a portfolio of differing risk exposures for financial instruments designated in foreign currencies so not to conflict with Paragraph 20 of SFAS 52.  It allows hedging under "net investment" criteria under Paragraph 20 of SFAS 52.  For more detail see foreign currency hedge.

Merely meeting the tests of being a forecasted transaction or a firm commitment does not automatically qualify the item to be designated a hedge item in a hedging transaction.  For example, it cannot be a forecasted transaction cannot be hedged for cash flows if it is remeasured at fair value on reporting dates.  For example, trading securities under SFAS 115 are remeasured at fair value with unrealized gains and losses going directly into earnings. 

Paragraph 40 beginning on Page 25 bans a forecasted transaction of a subsidiary company from being a hedged item if the parent company wants to hedge the cash flow on the subsidiary's behalf.  However Paragraph 40a allows such cash flow hedging if the parent becomes a party to the hedged item itself, which can be a contract between the parent and its subsidiary under Paragraph 36b on Page 24 of FAS 133.  Also see Paragraphs 471 and 487.

Paragraph 21c on Page 14 and Paragraph 29f on Page 20 of FAS 133 prohibits forecasted cash flows from minority interests in a consolidated subsidiary from being designated as a hedged item in a cash flow hedge.   Reasons are given in Paragraph 472 beginning on Page 206 of FAS 133.  See minority interest.

Also see firm commitment. 

Foreign Currency Financial Statements =

financial statements that employ foreign currency as the unit of measure.

Foreign Currency Futures Options = see foreign currency hedge.

Foreign Currency Hedge =

a hedge that manages risks of variations in exchange rates for foreign currencies. For example, companies that have firm commitments to purchase or sell items priced in foreign currencies can hedge against exchange rate losses between the time of the commitment and the time of the transaction. Major sections of FAS 133 dealing with such hedges include Paragraphs 36-42, 121-126, 162-175, 194-197, and 474-487.  See currency swap, hedge, and hedge accounting.  The IASC retained the definition in IAS 21 Paragraph 137c.  Held-to-maturity investments carried at amortized cost may be effective hedging instruments with respect to risks from changes in foreign currency exchange rates (IAS 39 Paragraph 125).  A financial asset or liability whose fair value cannot be reliably measured cannot be a hedging instrument except in the case of a nonderivative instrument (a) that is denominated in a foreign currency, (b) that is designated as a hedge of foreign currency risk, and (c) whose foreign currency component is reliably measurable (IAS 39 Paragraph 126).  A nonderivative financial asset or liability may be designated as a hedging instrument, for hedge accounting purposes, only for a hedge of a foreign currency risk according to IAS 39 Paragraph 122.

Under IAS 39, foreign currency hedge accounting is similar to accountning for  cash flow hedges.

(a) the portion of the gain or loss on the hedging instrument that is determined to be an effective hedge (see IAS Paragraph 142) should be recognized directly in equity through the statement of changes in equity (see IAS 1, Paragraphs 86-88); and

(b) the ineffective portion should be reported:  (1) immediately in earnings if the hedging instrument is a derivative; or (2) in accordance with Paragraph 19 of IAS 21, in the limited circumstances in which the hedging instrument is not a derivative

The gain or loss on the hedging instrument relating to the effective portion of the hedge should be classified in the same manner as the foreign currency translation gain or loss
(IAS Paragraph 164)

One of the main differences in a foreign currency swap vis-a-vis other swaps is that the notional amounts are exchanged at inception and maturity in a foreign currency swap.  A common type of economic hedge in practice cannot receive hedge accounting treatment under FAS 133 is called a cross-currency swap.  This is a variant on the standard currency or interest rate swap in which the interest rate in one currency is fixed, and the interest rate in the other is floating. The only difference between a traditional interest rate swap and a currency coupon swap is the combination of the currency and interest rate features. But the DIG originally took a  hard position on cross-currency swaps that upsets corporations.  See http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issueh4.html.  Also listen to the audio file CERINO40.mp3 at http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issueh4.html. But the FASB softened its position in the FAS 138 Amendments to FAS 133.  Also see circus.

FAS 133 Paragraph 40 originally read as follows:

A nonderivative financial instrument shall not be designated as a hedging instrument in a foreign currency cash flow hedge. A derivative instrument designated as hedging the foreign currency exposure to variability in the functional-currency-equivalent cash flows associated with either a forecasted foreign-currency-denominated transaction (for example, a forecasted export sale to an unaffiliated entity with the price to be denominated in a foreign currency) or a forecasted intercompany foreign-currency-denominated transaction (for example, a forecasted sale to a foreign subsidiary or a forecasted royalty from a foreign subsidiary) qualifies for hedge accounting if all of the following criteria are met:

a. The operating unit that has the foreign currency exposure is a party to the hedging instrument (which can be an instrument between a parent company and its subsidiary -- refer to FAS 133 Paragraph 36).

b. The hedged transaction is denominated in a currency other than that unit's functional currency.

c. All of the criteria in FAS 133 Paragraphs 28 and 29 are met, except for the criterion in FAS 133 Paragraph 29c that requires that the forecasted transaction be with a party external to the reporting entity.

d. If the hedged transaction is a group of individual forecasted foreign currency denominated transactions, a forecasted inflow of a foreign currency and a forecasted outflow of the foreign currency cannot both be included in the same group.

In FAS 133, derivative financial instruments come in three basic types that are listed in Paragraph 4 on Page 2 of FAS 133.  One of the types is described in Section c below:

Paragraph 4 on Page 2 of FAS 133.
This Statement standardizes the accounting for derivative instruments, including certain derivative instruments embedded in other contracts, by requiring that an entity recognize those items as assets or liabilities in the statement of financial position and measure them at fair value. If certain conditions are met, an entity may elect to designate a derivative instrument as follows:

c.
A hedge of the foreign currency exposure of

(1) an unrecognized firm commitment (a foreign currency fair value hedge), (

(2) an available-for-sale security (a foreign currency fair value hedge),

(3) a forecasted transaction (a foreign currency cash flow hedge), or

(4) a net investment in a foreign operation.

With respect to Section c(1) above, firm commitments can have foreign currency risk exposures if the commitments are not already recognized.  See Paragraph 4 on Page 2 of FAS 133. If the firm commitment is recognized, it is by definition booked and its loss or gain is already accounted for. For example, a purchase contract for 10,000 units per month at 100DM Deutsche Marks per unit is unrecognized and has a foreign currency risk exposure if the payments have not been made. If the payments have been prepaid, that prepayment is "recognized" and has no further foreign currency risk exposure.  Similar reasoning applies to trading securities that are excluded in c(2) above since their gains and losses are already booked.  These gains have been deferred in comprehensive income for available-for-sale securities.

An example of a foreign currency hedge is a contract for foreign currency options on the Philadelphia Exchange.  On Page C23 of the Wall Street Journal on July 22, 1998, blocks of 62,500 Swiss franc European-style August call options required a payment of 3.58 or $0.0358 per franc plus a strike price of 63 or $0.6300 bringing the total price up to $0.6658 per franc.  Hence, spot price on July 22 was 66.23 or $0.6623 per franc.  Hence, the price need only rise by more than $0.0035 per franc to be in-the-money.  On the Philadelphia Exchange, options on Swiss francs can only be transacted in blocks of 62,500 francs.

It is also possible to buy options on foreign currency futures options.  A futures call option gives the owner the right (but not an obligation) to buy the underlying futures contract at the option contract's strike price.  The Chicago Board of Trade deals in foreign currency futures options.

If the hedged item is a specific portion of an asset/liability (or of a portfolio of similar assets/liabilities), the hedged item is one of the following:

(1) A percentage of the entire asset/liability

(2) One or more selected contractual cash flows

(3) A put option, a call option, an interest rate cap, or an interest rate floor embedded in an existing asset/liability that is not an embedded derivative accounted for separately pursuant to paragraph 12 of the Statement

(4) The residual value in a lessor's net investment in a direct financing or sales-type lease
If the entire asset/liability is an instrument with variable cash flows, the hedged item cannot be deemed to be an implicit fixed-to-variable swap perceived to be embedded in a host contract with fixed cash flows.  (FAS 133 Paragraph 21a(2))

The hedged item is not:

(1) an asset or liability that is remeasured with the changes in fair value attributable to the hedged risk reported currently in earnings (for example, if foreign exchange risk is hedged, a foreign-currency-denominated asset for which a foreign currency transaction gain or loss is recognized in earnings), (FAS 133 Paragraph 21c(1)).  Likewise, paragraph 29d prohibits the following transaction from being designated as the hedged forecasted transaction in a cash flow hedge: the acquisition of an asset or incurrence of a liability that will subsequently be remeasured with changes in fair value attributable to the hedged risk reported currently in earnings.  If the forecasted transaction relates to a recognized asset or liability, the asset or liability is not remeasured with changes in fair value attributable to the hedged risk reported currently in earnings.)

(2) an investment accounted for by the equity method in accordance with the requirements of APB Opinion No. 18.

(3) a minority interest in one or more consolidated subsidiaries.

(4) an equity instrument in a consolidated subsidiary.

(5) a firm commitment either to enter into a business combination or to acquire or dispose of a subsidiary, a minority interest or an equity method investee.

(6) an equity instrument issued by the entity and classified in stockholders' equity in the statement of financial position (FAS 133 Paragraph 21c).

The following cannot be designated as a hedged item in a foreign currency hedge:

(a) a recognized asset or liability that may give rise to a foreign currency transaction gain or loss under Statement 52 (such as a foreign-currency-denominated receivable or payable) either in a  fair value hedge or a cash flow hedge.

(b) the forecasted acquisition of an asset or the incurrence of a liability that may give rise to a foreign currency transaction gain or loss under Statement 52 in a cash flow hedge
(FAS 133 Paragraph 36).  An available-for-sale equity security can be hedged for changes in the fair value attributable to changes in foreign currency exchange rates if:

(a) the security is not traded on an exchange on which trades are denominated in the investor's functional currency.
(b) dividends or other cash flows to holders of the security are all denominated in the same foreign currency as the currency expected to be received upon sale of the security (FAS 133 Paragraph 38).

Under Paragraph 42 on Page 26, a financial instrument that may give rise to foreign currency transaction gains or losses under SFAS 52 can be designated as a hedge against a net investment in a foreign operation (e.g., a subsidiary, branch, or joint venture).  However, such hedges are subject to Paragraph 20 of SFAS 52 criteria rather than FAS 133 criteria.  SFAS 52 dictates that that the gain or loss on the hedging instrument recorded in the SFAS 52-defined currency translation adjustment (CTA) cannot be greater than the offsetting CTA that arose by translating the foreign entity's financial statements into the investor's reporting currency.  It allows hedging under "net investment" criteria under Paragraph 20 of SFAS 52.  For more detail see cash flow hedge.

FAS 138 Makes Compound Hedging Possible

For example, FCD items (e.g., a fixed-rate bond in German marks) is subject to fair value risk both in terms of changes in interest rates (that change the bond prices in German marks) and changes in the FX rates (that change the U.S. dollars needed to pay make interest coupon payments in German marks).  Before being amended, the debtor would first have to hedge interest rates in some way such as with a vanilla swap in which FCD variable interest is received and FCD fixed interest is paid, thereby locking in the combined value (bond + swap value) at a fixed amount in German marks.  Then another derivative contract would have to be entered into to hedge the combined FCD value for FX risk.  For example, a forward contract could be entered into to hedge a downward spiral of the German mark’s value against the dollar.   After being amended by FAS 138, it is now possible to acquire a single compound derivative to hedge the joint fair value risk of interest rate and FX movements.  One such derivative is a cross currency interest swap (receive fixed interest rate in German marks, pay variable interest rate in US$).  The combined value (bond + swap) will, thereby, remain locked in at a fixed rate.  Of course locking in value must result in creation of cash flow risk.  The amount of US$ needed for each swap payment varies jointly with interest rate and FX movements. Of course a reverse process can be used to hedge cash flow risk of variable-rate FCD items.  For example, if a variable rate bond is denominated in German marks, it is possible to jointly hedge interest rate and FX cash flow risk by entering into a cross currency interest swap (receive variable interest rate in German marks, pay fixed interest rate in US$).  This will lock in the cash flow in US$, but the combined value (bond + swap) will vary with both interest rate and FX movements. The FASB provides two FX hedging examples illustrating the FAS 138 Amendments to FAS 133 at http://www.rutgers.edu/Accounting/raw/fasb/derivatives/examplespg.html You can read more about cross-currency swaps at  Sumitomo Bank Capital Markets’ Definition of a Cross-Currency Swap       http://www.sbcm.com/currency/currency.htm  Equity Analytics’ Explanation of a Cross-Currency Swap       http://www.adtrading.com/glossary/cross.htm  For an illustration of cross-currency hedging with an interest rate swap, see http://www.trinity.edu/rjensen/acct5341/speakers/ADTcross.htm

For an illustration of cross-currency hedging with an interest rate swap, see http://www.trinity.edu/rjensen/acct5341/speakers/ADTcross.htm 

DIG Issue H4 at http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issueh4.html  Statement 133 Implementation Issue No. H4 Title: Foreign Currency Hedges: Hedging Foreign-Currency Denominated Interest Payments   Paragraph references: 21, 29, 37, 40, 540   Date cleared by Board: July 28, 1999 QUESTION May a company treat foreign-currency-denominated fixed-rate interest coupon payments arising from an issuance of foreign-currency-denominated fixed rate debt as (a) an unrecognized firm commitment that may be designated as a hedged item in a foreign currency fair value hedge or (b) forecasted transactions that may be designated as hedged transactions in a foreign currency cash flow hedge? BACKGROUND A company whose functional currency is the U.S. dollar issues fixed-rate debt denominated in a foreign currency. The debt has a fixed interest coupon that is payable semi-annually in that foreign currency. The company wishes to lock in, in U.S. dollar functional currency terms, the future interest expense that will result from the debt and enters into a derivative instrument to hedge the foreign currency risk of the fixed foreign-currency-denominated interest coupon payments. For example, the company may enter into a foreign currency swap to receive an amount of the foreign currency required to satisfy the coupon obligation in exchange for U.S. dollars at each coupon date, or, alternatively, it may enter into a strip of foreign currency forward contracts that provide for receipt of an amount of foreign currency required to satisfy the interest coupon obligation in exchange for the payment of U.S. dollars at each coupon date. Paragraph 37 of Statement 133 states: A derivative instrument or a nonderivative financial instrument that may give rise to a foreign currency transaction gain or loss under Statement 52 can be designated as hedging changes in the fair value of an unrecognized firm commitment, or a specific portion thereof, attributable to foreign currency exchange rates. The designated hedging relationship qualifies for the accounting specified in paragraphs 22-27 if all the fair value hedge criteria in paragraphs 20 and 21 are met. [Footnote reference omitted.] Paragraph 40 of Statement 133 states, in part: A derivative instrument designated as hedging the foreign currency exposure to variability in the functional-currency-equivalent cash flows associated with either a forecasted foreign-currency-denominated transaction…or a forecasted intercompany foreign-currency-denominated transaction…qualifies for hedge accounting if all of the following criteria are met:   The operating unit that has the foreign currency exposure is a party to the hedging instrument (which can be an instrument between a parent company and its subsidiary—refer to paragraph 36).   The hedged transaction is denominated in a currency other than that unit's functional currency.   All of the criteria in paragraphs 28 and 29 are met, except for the criterion in paragraph 29(c) that requires that the forecasted transaction be with a party external to the reporting entity.   If the hedged transaction is a group of individual forecasted foreign-currency-denominated transactions, a forecasted inflow of a foreign currency and a forecasted outflow of a foreign currency cannot both be included in the same group.   Paragraph 540 of Statement 133 includes the following definitions: Firm commitment   An agreement with an unrelated party, binding on both parties and usually legally enforceable, with the following characteristics: The agreement specifies all significant terms, including the quantity to be exchanged, the fixed price, and the timing of the transaction. The fixed price may be expressed as a specified amount of an entity's functional currency or of a foreign currency. It may also be expressed as a specified interest rate or specified effective yield.   The agreement includes a disincentive for nonperformance that is sufficiently large to make performance probable.   Forecasted transaction A transaction that is expected to occur for which there is no firm commitment. Because no transaction or event has yet occurred and the transaction or event when it occurs will be at the prevailing market price, a forecasted transaction does not give an entity any present rights to future benefits or a present obligation for future sacrifices. RESPONSE No. A company may not treat foreign-currency-denominated fixed-rate interest coupon payments arising from an issuance of foreign-currency-denominated fixed-rate debt as either (a) an unrecognized firm commitment that may be designated as a hedged item in a foreign currency fair value hedge or (b) forecasted transactions that may be designated as hedged transactions in a foreign currency cash flow hedge. The foreign-currency exposure of the future interest payments would not meet Statement 133's definition of an unrecognized firm commitment because the obligation is recognized on the balance sheet—that is, the carrying amount of the foreign-currency-denominated fixed-rate debt incorporates the entity's obligation to make those future interest payments as well as the repayment of principal. In addition, paragraph 21(c) clarifies that if a foreign currency transaction gain or loss is recognized in earnings for a foreign-currency-denominated asset or liability, the prohibition against hedging foreign exchange risk applies to that foreign-currency-denominated asset or liability. Similarly, because the foreign-currency-denominated interest payments relate to a recognized liability that is remeasured with changes in fair value attributable to the hedged risk reported in current earnings, paragraph 29(d) would not permit those interest payments to be designated as the hedged item in a cash flow hedge. Accordingly, neither paragraph 21(c) nor paragraph 29(d) would permit those interest payments to be designated as the hedged item or the hedged transaction in a fair value hedge or a cash flow hedge, respectively, of foreign exchange risk. The above guidance also applies to dual-currency bonds that provide for repayment of principal in the functional currency and periodic interest payments denominated in a foreign currency. FASB Statement No. 52, Foreign Currency Translation, applies to dual-currency bonds and requires the present value of the interest payments denominated in a foreign currency to be remeasured and the transaction gain or loss recognized in earnings. Thus, those interest payments on a dual-currency bond cannot be designated as the hedged item or the hedged transaction in a fair value hedge or a cash flow hedge, respectively, of foreign exchange risk. Although hedge accounting, per se, is not permitted, an entity can mitigate its exposure with respect to a foreign-currency-denominated fixed-rate debt instrument for both the risk of changes in market interest rates and the risk of changes in foreign exchange rates. It may obtain (a) a qualifying interest-rate-based derivative to use in a fair value hedge of the changes in the debt's foreign-currency-denominated fair value due to changes in market interest rates (for example, if the debt is fixed-rate debt denominated in British sterling (GBP), the interest rate swap would be a receive-GBP-fixed, pay-GBP-floating swap) and (b) a foreign currency derivative that hedges the change in exchange rates. Statement 133 provides special hedge accounting for the qualifying fair value hedge using the interest-rate-based derivative, but it provides no special accounting for the foreign currency derivative. However, the change in the fair value of the foreign currency derivative (as a non-hedging instrument) would be recognized in earnings pursuant to Statement 133 and the foreign currency transaction gain or loss for the foreign-currency-denominated debt instrument would be recognized in earnings pursuant to Statement 52. The above response has been authored by the FASB staff and represents the staff’s views, although the Board has discussed the above response at a public meeting and chosen not to object to dissemination of that response. Official positions of the FASB are determined only after extensive due process and deliberation.

 

 

With respect to Paragraph 29a on Page 20 of FAS 133, KPMG notes that if the hedged item is a portfolio of assets or liabilities based on an index, the hedging instrument cannot use another index even though the two indices are highly correlated.  See Example 7 on Page 222 of the Derivatives and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998.

Cash flow hedges must have the possibility of affecting net earnings.  For example, Paragraph 485 on Page 211 of FAS 133 bans foreign currency risk hedges of forecasted dividends of foreign subsidiary.  The reason is that these dividends are a wash item and do not affect consolidated earnings.  For some complicating factors, however, see equity method.

Paragraph 399 on Page 180 of FAS 133 does not allow covered call strategies that permit an entity to write an option on an asset that it owns.   In a covered call the combined position of the hedged item and the derivative option is asymmetrical in that exposure to losses is always greater than potential gains.  The option premium, however, is set so that the option writer certainly does not expect those "remotely possible" losses to occur.  Only when the potential gains are at least equal to potential cash flow losses will Paragraph 28c on Page 19 of FAS 133 kick in to allow a cash flow hedge under FAS 133.  Also see Paragraph 20c on Page 12.  See written option.

Foreign currency hedges can be on the basis of after-tax risk.  See tax hedging.

In summary, a derivative instrument or a nonderivative financial instrument that may give rise to a foreign currency transaction gain or loss under SFAS 52 can be designated as hedging the foreign currency exposure of a net investment in a foreign operation (FAS 133 Paragraph 42).  A derivative instrument or a nonderivative financial instrument that may give rise to a foreign currency transaction gain or loss under SFAS 52 can be designated as hedging changes in the fair value of an unrecognized firm commitment, or a specific portion thereof, attributable to foreign currency exchange rates (FAS 133 Paragraph 37).  However, such an instrument cannot be classified as available-for-sale.  A derivative instrument can be designated as hedging the changes in the fair value of an available-for-sale debt security attributable to changes in foreign currency exchange rates.  (See FAS 133 Paragraph 38).  Unlike originated loans and receivables, a held-to-maturity investment cannot be a hedged item with respect to interest-rate risk because designation of an investment as held-to-maturity involves not accounting for associated changes in interest rates.  However, a held-to-maturity investment can be a hedged item with respect to risks from changes in foreign currency exchange rates and credit risk (IAS 39 Paragraph 127).

Paul Pacter states the following at http://www.iasc.org.uk/news/cen8_142.htm 

IAS 39 Use of noncash hedging instruments is restricted to exposure to hedges of any risk of gain or loss from changes in foreign currency exchange rates arising in fair value hedges, cash flow hedges, or hedges of a net investment in a foreign operation.

FAS 133 Use of noncash hedging instruments is restricted to exposure to hedges of risk of gain or loss from changes in foreign currency exchange rates arising in firm commitments or hedges of a net investment in a foreign operation.

Also see DIG Issue B4 under embedded derivatives.

 

DIG issues at http://www.rutgers.edu/Accounting/raw/fasb/derivatives/issuindex.html  Section H: Foreign Currency Hedges *Issue H1—Hedging at the Operating Unit Level (Cleared 02/17/99) *Issue H2—Requirement That the Operating Unit Must Be a Party to the Hedge (Cleared 02/17/99) *Issue H3—Hedging the Entire Fair Value of a Foreign-Currency-Denominated Asset or Liability (Cleared 07/28/99) *Issue H4—Hedging Foreign-Currency-Denominated Interest Payments (Cleared 07/28/99) *Issue H5—Hedging a Firm Commitment or Fixed-Price Agreement Denominated in a Foreign Currency (Cleared 07/28/99) *Issue H6—Accounting for Premium or Discount on a Forward Contract Used as the Hedging Instrument in a Net Investment Hedge (Cleared 11/23/99) *Issue H7—Frequency of Designation of Hedged Net Investment (Cleared 11/23/99) Issue H8—Measuring the Amount of Ineffectiveness in a Net Investment Hedge (Released 11/99) Issue H9—Hedging a Net Investment with a Compound Derivative That Incorporates Exposure to Multiple Risks (Released 11/99) Issue H10—Hedging Net Investment with the Combination of a Derivative and a Cash Instrument (Released 11/99)

Note:  Foreign currency hedging rules changed with the FAS 138 Amendments released on June 15, 2000.

Foreign Currency Transactions =

transactions (for example, sales or purchases of goods or services or loans payable or receivable) whose terms are stated in a currency other than the entity's functional currency. Foreign currency risks are discussed extensively in FAS 133. See for example, Paragraphs 71.

Also see DIG Issue B4 under embedded derivatives.

Foreign Currency Translation =

the process of expressing amounts denominated or measured in one currency in terms of another currency by use of the exchange rate between the two currencies.

Foreign Operation =

an operation whose financial statements are (1) combined or consolidated with or accounted for on an equity basis in the financial statements of the reporting enterprise and (2) prepared in a currency other than the reporting currency of the reporting enterprise.

Forward Contract or Forward Exchange Contract =

an agreement to exchange at a specified future date currencies of different countries at a specified rate (forward rate). An example of a forward contract appears in Example 3 Paragraphs 121-126 beginning on Page 67 of FAS 133. See forward transaction.

Forward Exchange Rate Agreement (FXA) =

a forward contract on exchange rates.  A FXA is a forward contract to buy/sell a notional amount of foreign currency forward at a contracted price.   See forward transaction and forward rate agreement (FRA).

Forward Rate =

the rate quoted today for delivery of a specific currency amount at a specific exchange rate on a specific future date.

Forward Rate Agreement (FRA) =

a forward contract on interest rates.   Loan principals are not exchanged and are used only as notionals to establish forward contract settlements.  These are customized contracts that allow borrowers to hedge future borrowing rates on anticipated loans in the future.  FRA contracts can also be purchased in foreign currencies, thereby affecting currency exchange and interest rate risk management strategies.  See forward transaction and forward exchange rate agreement (FXA).

Forward Transaction or Forward Contract =

an agreement 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.

See FAS 133 Paragraphs 59a, 93, and 100. An example of a forward contract in FAS 133 appears in Example 3 Paragraphs 121-126 and Example 10 Paragraphs 165-172.

By way of illustration, currency trading on July 22, 1998 showed the following exchange selling rates among banks in amounts of $1 million or more:

For example, the spot rate is such that in $1 million trades or higher, each British pound exchanges into $1.6435 U.S. dollars.  However, a forward exchange contract reduces that amount to $1.6271 if settled in six months.  In practice, forward contracts are tailor-made for the length or time and amounts to be exchanged.  The above rates serve only as guidelines for negotiation.  See futures contract.

FAS 133 leaves out the issue of trade date versus settlement date accounting and, thereby,  excluded forward contracts for regular-way security trades from the scope of FAS 133 (See Appendix C Paragraph 274).

See DIG Issue A1 under derivative financial instrument.
See DIG Issues A2 and A3 under net settlement.

Functional Currency =

the primary currency in which an entity conducts its operation and generates and expends cash. It is usually the currency of the country in which the entity is located and the currency in which the books of record are maintained.  See translation adjustment.

Futures Contract =

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.

By way of illustration, futures trading on July 29, 1998 showed the following exchange futures contract prices per stipulated contract amounts: