Overview and Expected Impact of FAS133
Summary based on
"A Guide to Accounting for Derivative: A Instruments and Hedging Activities"
Preparations and Presentation by:
School of Accountancy
University of Hawaii at Manoa
Monday, October 26, 1998
Table of Contents
Recognition and Measurement
Fair Value Hedge Illustration
Cash Flow Hedge Illustration
Foreign Currency Fair Value Hedge Illustration
Qualifying Criteria for Hedges
Bob Jensen's SFAS 133 Glossary and Transcriptions of Experts
SFAS 133 Issued in June 1998 based on four fundamental conclusions:
1) Derivative instruments represent rights or obligations that meet the definitions of assets or liabilities and should be reported in financial statements.
2) Fair value is the most relevant measure for financial instruments and the only relevant measure for derivative instruments. Derivative instruments should be measured at fair value, and adjustments to the carrying amount of hedged items should reflect changes in their fair value (that is, gains or losses) that are attributable to the risk being hedged and that arise while the hedge is in effect.
3) Only items that are assets or liabilities should be reported as such in financial statements. Gains/losses from derivatives should not be separated from assets/liabilities and must be represented as part of fair market value for assets/liabilities.
4) Special accounting for items designated as being hedged should be provided only for qualifying items. One aspect of qualification should be an assessment of the expectation of effective changes in fair values or cash flows during the term of the hedge for the risk being hedged. Companies are therefore required to assess whether the hedging instrument is highly effective in offsetting changes in the fair value or cash flows of the hedged item that are attributable to the hedged risk.
SFAS 133 Standardizes the Accounting for Derivative Instruments Requiring that All Entities Recognize Them as Assets and in the Statement of Financial Position and Subsequently Measure at Fair Value.
A derivative instrument is defined in paragraphs 6-11 of FAS 133 as a financial instrument or other contract that possesses all of the three characteristics:
It has (1) one or more underlyings and (2) one or more amounts or payment provisions or both. Those terms determine the amount of the settlement or settlements, and in some cases, whether or not a settlement is required.
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.
Its terms require or permit net settlement, it can readily be settled by a 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.
FAS 133 defines a derivative instrument as a contract that does not require an initial net investment that is equal to the notional amount (or the notional amount plus a premium or minus a discount) or that is determined by applying the notional amount to the underlying. The holder or writer of a derivative instrument, therefore, does not have to invest or receive the notional amount of the derivative instrument at the inception or maturity of the contract.
FAS 133's scope includes derivatives that are embedded in "other contracts." The "other contract" without the embedded derivative is referred to as the "host" contract. The combined contract (i.e., the host contract and the embedded derivative) is referred to as a "hybrid instrument". For example, a structured note that pays interest based on changes in the S&P 500 index would be the hybrid instrument; the component of the contract to pay interest based on changes in the S&P 500 index would be the embedded derivative; and the component of the contract to repay the principal amount would be the host contract.
Under FAS 133, an embedded derivative instrument must be separated from the host contract and accounted for separately as a derivative instrument if, and only if, all of the following criteria of paragraph 12 are met:
a) The economic characteristics and risks of the embedded derivative instrument are not clearly and closely related to the economic characteristics and risks of the host contract. Additional guidance on applying this criterion to various contracts containing embedded derivative instruments is included in Appendix A (of FAS 133).
b) The contract ("the hybrid instrument") that embodies both the embedded derivative instrument and the host contract is not remeasured at fair value under otherwise applicable generally accepted accounting principles with changes in fair value reported in earnings as they occur.
c) A separate instrument with the same terms as the embedded derivative instrument would, pursuant to paragraphs 6-11, be a derivative instrument subject to the requirements (of FAS 133). (The initial net investment for the hybrid instrument shall not be considered to be the initial net investment for the embedded derivative.)
Accounting for Hybrid Instruments, if an embedded derivative were to be separated from its host contract, the host contract would be accounted for based on the accounting standards that are applicable to instruments of that type. The bifurcated derivative, of course, would be accounted for as a derivative instrument under FAS 133. The analysis of whether bifurcation is required under FAS 133 must be performed at the date the hybrid instrument is issued or acquired.
Recognition and Measurement
If certain conditions are met, entities may elect to designate a derivative instrument as one of the following:
a) Fair Value hedge - a hedge of the exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment.
b) Cash-Flow hedge - a hedge of the exposure to variability in the cash flows of a recognized asset or liability or a forecasted transaction. Cash-flow changes are caused by the variable terms of the asset, liability, or forecasted transaction; for example, a variable-rate asset or a forecasted purchase of inventory at market prices.
c) A foreign-currency hedge - a fair-value or cash flow hedge of the foreign-currency exposure of (1) an unrecognized firm commitment, (2) an available-for-sale security, (3) a forecasted transaction, or a hedge of a net investment in a foreign operation.
Fair Value Hedges
For a qualifying fair-value hedge, the gain or loss on the hedging instrument (i.e., the derivative instrument), as well as the related loss or gain on the hedged item, should be recognized currently in earnings in the same accounting period. Generally, the gain or loss on the hedging instrument and that of the hedged item (attributable to the hedged risk) will be equal and offsetting. The following example illustrates some of the basic fair-value hedge concepts (for simplicity, income-tax consideration are ignored):
An entity issues $10 million of five-year, 8-percent interest-only nonprepayable debt. It wishes to change the interest rate on the debt from fixed to variable and, therefore, enters into a five-year, receive-fixed pay-variable, $10 million (notional amount) interest-rate swap with settlement dates that match the interest payment dates on the debt. Assume that the following holds true at the end of the first year:
Interest rates have declined significantly. The entity receives $120,000 as the annual settlement under the swap contract. Based on dealer quotes, the swap has a fair value of $400,000 gain (excluding the annual settlement). The entity determines that the fair value of the debt (attributable to changes in interest rates) has adversely changed by $400,000. At the end of the first year, the entity would record the following entries to apply fair-value hedge accounting under FAS 133:
1. Interest expense 800,000
(To record a payment of 8% interest on the debt)
2. Cash 120,000
Interest expense 120,000
(To record the receipt of the swap settlement as a reduction of interest expense)
3. Swap contract 400,000
Gain on hedging activity 400,000
(To record the change in the fair value of the swap contract)
4. Loss on hedging activity 400,000
(To record the change in the fair value of the debit that is due to the interest-rate risk being hedged)
The entity's balance sheet at the end of the first year would show a swap asset of $400,000 and a debt liability of $10,400,000. The net of these two amounts would be $10,000,000, which is equal to the initial principal amount of the debt. The application of FAS 133 results in a "grossing up" of the balance sheet to reflect the swap at fair value. Under old GAAP, interest-rate swaps generally were not recorded on the balance sheet. To the extent that the hedge relationship is 100% effective (as in this example), there will be no impact on the income statement, since the gain or loss on the derivative instrument is completely offset by the loss or gain on the change in the fair value of the debt. The net interest expense ($680,000) is lower than that at the fixed rate of 8%, because interest rates have declined and the entity effectively has changed the debt's interest rate from fixed to variable (i.e., by receiving at a fixed rate and paying a variable rate on the swap, the debt's rate is converted from fixed to variable).
Cash Flow Hedges
For a qualifying cash-flow hedge, the derivative's gain or loss, to the extent that it is offset by the losses or gains on (1) the forecasted transaction or (2) the cash flows of the asset or liability being hedged, will be deferred and reported as a component of other comprehensive income (outside of earnings). The gains and losses accumulated in other comprehensive income will then be reclassified to earnings in the same period or periods in which the hedged forecasted transaction or cash flows affect earnings (e.g., when inventory that is purchased as part of a forecasted transaction is subsequently sold). Any gains or losses on the derivative that are not offset by the cash-flow losses and gains on the hedged forecasted transaction, asset, or liability are recognized currently in earnings. The following example illustrates some of the basic cash-flow hedge concepts (for simplicity, income-tax considerations are ignored):
In January 2001, an entity anticipates that in June 2001 it will purchase 1,000 metric tons of aluminum. The actual cost of the aluminum will depend on the aluminum spot price in June 2001. In January 2001, the entity enters into an aluminum futures contract to purchase aluminum at the June futures price of $1,625 per metric ton. The entity designated the futures contract as a hedge of the anticipated purchase of aluminum in June. The entity assesses hedge effectiveness by comparing the entire change in the fair value of the futures contract to changes in the cash flows of the forecasted transaction.
As expected, the entity purchases 1,000 tons of aluminum in June at what is then the current aluminum spot price of $1,635 per metric ton, $10,000 ($1625 x 1,000 tons).
The entry would record the following journal entries to apply cash-flow hedge accounting under FAS 133.
January 2001 DR CR
No entry is recorded, since the margin deposit for the futures contract is ignored for purposesof this example.
1. Aluminum inventory 1,635,000
To record the purchase of aluminum at the spot rate of $1,635 per metric ton
2. Futures contract 10,000
Other comprehensive income 10,000
To record the change in the fair value of the futures contract
3. Cash 10,000
Futures contract 10,000
To record the net cash settlement of the futures contract (futures contracts are settled daily, for illustrative purposes, we have shown one settlement in June)
The entity fixed its inventory cost at the June aluminum futures price of $1,625 through the use of a futures contract ($1,635,000 actual purchase price based on the spot price in June 2001 less the $10,000 gain on the futures contract). The gain on the futures contract that is accumulated in other comprehensive income will be reclassified to earnings at a later date, when the inventory is sold and earnings are impacted.
Foreign-Currency Fair-Value and Cash-Flow Hedges
For qualifying foreign-currency hedges, the accounting is as follows:
1. In a fair-value hedge of a foreign-currency-denominated firm commitment, the gain or loss on the derivative (or nonderivative hedging instrument) and the offsetting loss or gain on the hedged firm commitment attributable to foreign-currency exchange rates are recognized currently in earnings in the same accounting period.
2. In a fair-value hedge of an available-for-sale security, the gain or loss on the hedging derivative and the offsetting loss or gain attributable to the hedged foreign-currency risk in the available-for-sale security are recognized currently in earnings in the same accounting period.
3. In a cash-flow hedge of a forecasted foreign-currency-denominated transaction, the effective portion of the gain or loss on the hedging derivative (i.e., the portion of the gain or loss on the derivative that is offset by the exchange-rate loss or gain on the forecasted transaction) is reported as a component of other comprehensive income and will be reclassified into earnings in the same period or periods during which the hedged forecasted transaction affects earnings. Any remaining gain or loss on the hedging instrument is recognized currently in earnings.
4. In a hedge of a net investment in a foreign operation, the effective portion of the gain or loss on the hedging instrument is reported in other comprehensive income (outside of earnings) as part of the cumulative translation adjustment. Any remaining gain or loss on the hedging instrument is recognized currently in earnings.
The following example illustrates some of the basic foreign-currency hedge concepts (for simplicity, income-tax considerations are ignored):
In January 2001, an entity anticipates that it will import raw materials from the UK in June 2001 at a cost of approximately £100,000. The actual dollar cost of the raw materials will depend on the spot exchange rate in June 2001. In January 2001, the entity enters into a forward-exchange contract to receive £100,000 and pay $170,000 in June 2001. The forward contract is designated by the entity as a hedge of the anticipated obligation to pay £100,000 in June. The entity assesses hedge effectiveness by comparing the entire change in the fair value of the forward contract to changes in the cash flows of the forecasted transaction.
As expected, the entity purchases the raw materials in June 2001 and incurs an obligation to pay £100,000. Assume that the spot exchange rate in June 2001 (when the forward contract is settled) is £1 = U.S. $1.80 and, accordingly, the forward contract has a gain of $10,000.
The entity would record the following journal entries to apply cash-flow hedge accounting under FAS 133:
No entry is recorded, since the forward-exchange contract is at market.
1. Raw materials inventory 180,000
Accounts payable 180,000
To record the receipt of raw materials for £100,000 at the spot rate of £1 = U.S. 1.80
2. Forward exchange contract 10,000
Other comprehensive income 10,000
To record the change in the fair value of the forward contract
3. Cash 10,000
Forward exchange contract 10,000
To record the net cash settlement of the
The entity fixed its raw-materials cost at £1 = U.S. $1.70 ($180,000 actual purchase price less $10,000 gain on the forward-exchange contract). The gain on the forward contract that is accumulated in other comprehensive income will be reclassified to earnings at a later date, when the inventory is sold and earnings are impacted.
All Types of Hedges
Common Qualifying Criteria for the Derivative Hedging Instrument
Designation, Documentation, and Risk Management
At inception of the hedge, there is formal documentation of the hedging relationship and the entity's risk management objective and strategy for undertaking the hedge, including identification of the hedging instrument, the hedged item, the nature of the risk being hedged, and how the hedging instrument's effectiveness in offsetting the exposure to changes in the hedged item's fair value or variability in cash flows attributable to the hedged risk will be assessed. There must be a reasonable basis for how the entity plans to assess the hedging instrument's effectiveness.
1) For a fair value of a firm commitment, the entity's formal documentation at the inception of the hedge must include a reasonable method for recognizing in earnings the asset or liability representing the gain or loss on the hedged firm commitments.
2) An entity's defined risk management strategy for a particular hedging relationship may exclude certain components of a specific hedging derivative's change in fair value, such as time value, from the assessment of hedge effectiveness.
3) (In the case of a cash flow hedge), documentation shall include all relevant details, including the date on or period within which the forecasted transaction is expected to occur, the specific nature of asset or liability involved (if any), and the expected currency amount or quantity of the forecasted transaction.
The hedged forecasted transaction shall be described with sufficient specificity so that when a transaction occurs, it is clear whether that transaction is or is not the hedged transaction. Thus, the forecasted transaction could be identified as the sale of either the first 15,000 units of a specific product sold during a specified three-month period or the first 5,000 units of a specific product sold in each of three specific months, but it could not be identified as the sale of the last 15,000 units of that product sold during a three-month period (because the last 15,000 units cannot be identified when they occur, but only when the period has ended).
Both at inception of the hedge and on an ongoing basis, the hedging relationship is expected to be highly effective in achieving offsetting changes in fair value or cash inflows or outflows attributable to the hedged risk during the period that the hedge is designated. An assessment of effectiveness is required whenever financial statements or earnings are reported, and at least every three months. For qualifying hedge relationships, the applications of FAS 133's hedge-accounting rules would be applied prospectively (i.e., entities cannot designate hedge relationships retroactively).
High effectiveness must be achieved initially and on an ongoing basis in order for a hedge relationship to qualify for special/hedge accounting. if a hedge relationship ceases to be highly effective, hedge accounting must be discontinued prospectively. Where the hedge is highly effective but not perfectly effective (i.e., the hedge is between 80- and 125% effective, but it is not 100% effective), there will be some volatility in earnings due to the ineffective portion of the hedge. This is because FAS 133 requires that the ineffective portion of a hedge be recorded in earnings.
Common Qualifying Criteria for the Hedged Item
a) In the case of a fair value hedge, the hedged item presents an exposure to changes in fair value attributable to the hedged risk that could affect reported earnings. In the case of a cash flow hedge, the forecasted transaction is a transaction with a party external to the reporting entity (except as permitted by paragraph 40 [for intercompany foreign-currency hedge transaction]) and presents an exposure to variations in cash flows for the hedged risk that could affect reported earnings.
b) For a fair value hedge, the hedged item is not 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). For a cash flow hedge, the forecasted transaction is not 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 (for example, the forecasted acquisition of a foreign-currency-denominated asset for which a foreign currency transaction gain or loss is recognized in earnings). However, forecasted sales on credit and the forecasted accrual of royalties on probable future sales on credit and the forecasted accrual of royalties on probable future sales by third-party licensees are not considered the forecasted acquisition of a receivable. If the forecasted transaction relates to a recognized asset or liability, the asset or liability is not remeasured with changes in the fair value attributable to the hedged risk reported currently in earnings. THESE items do not require special accounting, because the gains and losses are offset each period.
c) The hedged item is not (1) an investment accounted for by the equity method in accordance with the requirements of APB Opinion No. 18, (2) a minority interest in one or more consolidated subsidiaries, (3) an equity investment in a consolidated subsidiary, (4) a firm commitment or a forecasted transaction either to enter into a business combination subject to the provisions of APB 16 or to acquire or dispose of a subsidiary, a minority interest in a consolidated subsidiary, or an equity investment, or (5) an equity instrument issued by the entity and classified in stockholders' equity in the statement of financial position.
d) If the hedged item is all or a portion of a debt security (or a portfolio of similar debt securities) that is classified as held-to-maturity in accordance with FASB Statement No. 115, the designated risk being hedged is the risk of changes in its fair value (or cash flows) attributable to default or changes in the obligor's creditworthiness or if the hedged item is an option component of a held-to-maturity security that permits its prepayment, the designated risk being hedged is the risk of changes in the entire fair value of that option component. (The designated hedged risk for a held-to-maturity security may not be the risk of changes in its fair value (or cash flows) attributable to changes in market interest rates or foreign exchange rates. If the hedged item is other than an option component that permits its prepayment, the designated-hedged risk also may not be the risk of changes in its overall fair value.)
e) If the hedged item is nonfinancial asset or liability (other than a recognized loan servicing right or a nonfinancial firm commitment with financial components), the designated risk being hedged is the risk of changes in the fair value or cash flows (i.e., the purchase or sales price) of the entire hedged asset or liability (reflecting its actual location if a physical asset). That is, the price risk of a similar asset in a different location or of a major ingredient may not be the hedged risk. Thus, in hedging the exposure to changes in the fair value of gasoline, an entity may not designate the risk of changes in the price of crude oil as the risk being hedged for purposes of determining effectiveness of the fair value hedge of gasoline. Further, in hedging the exposure to changes in the cash flows relating to the purchase of bronze bar inventory, an entity may not designate the risk of changes in the cash flows relating to purchasing the copper component in bronze as the risk being hedged. If the hedged transaction is the forecasted purchase or sale of a nonfinancial asset, the designated risk being hedged also can be the risk of changes in the functional-currency-equivalent cash flows attributable to changes in the related foreign-currency exchange rates.
f) if the hedge item is a financial asset or liability, a recognized loan servicing right, or a nonfinancial firm commitment with financial components, the designated risk being hedged is (1) the risk of changes in the overall fair value (or cash flows) of the entire hedged item, (2) the risk of changes in its fair value (or cash flows) attributable to changes in market interest rates, (3) the risk of changes in its fair value (or cash flows) attributable to changes in the related foreign currency exchange rates, or (4) the risk of changes in its fair value (or cash flows) attributable to changes in the obligor's creditworthiness. Of the risk designated as being hedged is not the risk in (1) above, two or more of the other risks (market interest rate risk, foreign currency exchange risk, and credit risk) may simultaneously be designated as being hedged. An entity may not simply designate prepayment risk as the risk being hedged for a financial asset. However, it can designate the option component of a prepayable instrument as the hedged item in a fair value hedge of the entity's exposure to changes in the fair value of that "prepayment" option, perhaps thereby achieving the objective of its desire to hedge prepayment risk. The effect of an embedded derivative of the same risk class must be considered in designating a hedge of an individual risk. For example, the effect of an embedded prepayment option must be considered in designating a hedge of market interest rate risk.
End of Presentation
Transcripts of Presentations of Experts
Bob Jensen's SFAS 133 Glossary and Transcriptions of Experts