A Presentation by Professor Linsmeier
as Videotaped by Bob Jensen

Bob Jensen at Trinity University

Caveat: . I am grateful to Professor Linsmeier for allowing me to videotape his inspiring presentation. The quotations from Professor Linsmeier that appear at various points in this document have never been edited by him or modified from a transcript of a presentation that I videotaped at a conference. My videotape was transcribed by my secretary, Debbie Bowling. The transcription was modified by me only when Debbie failed to understand certain terminology.  I prefer to minimize changes in the transcription so that what is read remains as close as possible to what the audience listened to at the conference. None of us speak with the formalized vocabulary and grammar used in our writing. Also we cannot edit what we said in the same manner that we can edit what we wrote.  Bob Jensen added notes in red text.

Bob Jensen
Trinity University
Glosaary:  http://WWW.Trinity.edu/rjensen/133glosf.htm

Financial Reporting for Derivatives and Risk Management Activities


Thomas J. Linsmeier
The University of Illinois

American Accounting Association

Continuing Education Program Workshop in New Orleans

August 16, 1998

Table of Contents


Definition of a derivative

Common types of derivatives

Risk management activities

New financial reporting standards

Illustrative examples

Example 1(Fair Value Hedge)

Introduction to Example 1
Firm Commitment
Fair Value Hedge Criteria
Hedgeable Items
Data and Journal Entries

Example 2 (Cash Flow Hedge)

Introduction to Example 2
Hedgeable Items
Cash Flow Earnings Recognition
Example 2 Data and Journal Entries

Advanced Topics in SFAS 133

Evaluation of SFAS 133

Look to the Future

Closing Remarks


Bob Jensen's SFAS 133 Glossary and Transcriptions of Experts

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Understanding everything that has to go on, especially with SFAS 133. See mine's getting a little dog-eared. This document is about as complex as anything I've seen the FASB issue. And what I'd like to do today is give you an introduction to derivatives, then introduce to you in an overview the new financial reporting standards related to derivatives. There are two and the one we are going to concentrate on today is Statement 133 (SFAS 133) from the FASB.  The other one (SEC Financial Reporting Release 48) comprises the disclosure rules from the SEC.

If you want to know more about the disclosure rules that the SEC issued in the last year's time period, you can attend a session tomorrow morning, at 10:30, at which I and some of my colleagues are speaking about the SEC market risk disclosure rules and outlining a research program that I've developed as a consequence in being involved with market risk in the SEC. So we will bypass that today, Financial Reporting #48, but, if you are interested in that there is a full session tomorrow on that topic.

You'll find that after I give you verbal summary of SFAS 133, you won't be very comfortable. So it's going to be important to give you some in the beginning a lot of examples as to what might be happening in the accounting for cash flow hedge and a fair value hedge. And we will spend some time going through simplified two basic examples of that accounting.

And finally, I'll give you an evaluation of what I think the strengths and weaknesses of SFAS 133 are in conclusion. That's the road map for today.

I can get going pretty much on derivatives. People tell me I have to be quiet at times. What I want is to serve you. I can stand up here and talk at you for a long time. But, I don't know what level of expertise I have in the room. I assume it varies from people that don't understand derivatives much at all to people that have some penetrating questions. I'd like you to interrupt me throughout this session. I thought very hard trying to make this an active learning session. But there's so much background that by the time you can actively learn, or move forward on this, it would've been me for three-quarters of the hour anyhow and  then I would've been out of time. So I want you to be able to intervene and ask questions whenever you feel it's necessary.

To start, you each should have a copy of the slides, and before you ask, it's on my last slide. And before you ask if you want this in electronic form, I've got an e-mail address on the very last slide, so that at the end, you can send it to me next week and I'm more than willing to share it with those slides.

Part of my objective of putting this together was to provide materials for you to bring it to the classroom. So, if you want those slides, they're free for the taking.

Definition of a Derivative


A generic term used to describe a wide variety of financial and commodity instruments whose value depends on or is derived from the value of an underlying asset/liability, reference rate, or index.

Jensen Note:  Paragraph 252 on Page 134 of SFAS 133 mentions that the FASB considered expanding the underlying to include all derivatives based on physical varialbes such as rainfall levels, sports scores, physical condition of an asset, etc., but this was rejected unless the derivative itself is exchange traded.  For example, a swap payment based upon a football score is not subject to SFAS 133 rules.  An option that pays damages based upon the bushels of corn damaged by hail is subject to insurance accounting rules (SFAS 60) rather than SFAS 133.  A option or swap payment based upon market prices or interest rates must be accounted for by SFAS 133 rules.  However, if derivative itself is exchange traded, then it is covered by SFAS 133 even if it is based on a physical variable that becomes exchange traded.

Let's start with what are derivatives? This is not the FASB's definition of what a derivative is. The FASBs definition in SFAS 133 goes on for about six or seven pages and has three appendices describing the definition. So just to start more generically, what is a generic definition for a derivative? It is it's a word used to describe a wide variety of primarily financial and commodity instruments. We'll find other sorts of instruments also as a underlying. They are financial and commodity instruments whose values are derived from an underlying rate, price, index those sorts of things. Now if you are not very familiar with derivatives, that might not help you.

That might not give you a very good picture of what a derivative is. So let's go through and talk about what some of the common derivatives are, and talk about their key characteristics.

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Common Types of Derivatives

Forwards / Futures



Hybrids / Embedded derivatives

Common derivatives include forwards and futures. These are basically the same things --- it depends on whether they're exchange traded or not --- whether they are called a forward (non-exchange traded) or a future (exchange traded).

So those two contracts (forward vs futures) are going to differ primarily on dimensions of liquidity risk and credit risk. By being exchange traded, the movements in underlying rate are priced at what would cause one party to lose, and another party to win, when it's traded on the exchange. You have to, as the losing party in a price change that gets big enough has to on a daily basis, put up the loss in cash (in a futures transaction).   (Futures contracts) minimize credit risk problems, the risk of somebody defaulting, and (forward contracts) minimize liquidity risk. The cash that is available to the party that's going to win but that's the only difference in concept and obviously and I'll talk about this more. One of the reasons why you have a forward contract, versus a futures contract, is how unique the contract is. (Forward contracts can be customized.)  We'll talk about that a little bit more.  A unique contract is not going to be traded on an exchange, because other people are not going to want to participate, are not going to want to participate, in that trade. So you can have forwards or futures.

We'll also talk about options. And I'll want to convince you by the end, that the option is the underlying fundamental derivative. Everything else is a combination of options (or forwards or futures).

So you would think of options as the basic derivative. Swaps, we are going to see, are a series of forward contracts, and we move to hybrid or embedded derivatives and if anybody followed some of the catastrophic loss 94 or 95, there are some pretty weird derivatives out there. Things like wedding band derivatives. Now what's that going to be? We got some very complex derivatives, but all they are, they're basic forms of derivatives, options, forwards or futures embedded in something else and sometimes being leveraged.

What do I mean by leveraged? If the price changes and underlying interest rate index changes by 100 basis points, the "put" the term, the term in the contract that says as the change in the underlying flows are leveraged by a factor of 103. So 103 times the change is what the effect is on the cash flows.

That's what happened to Proctor and Gamble when they lost $57 million dollars on one contract. They had a leveraged derivative that took a minor change, and blew up on them.

So those are the common derivatives, at least an introduction in words. Let's look at them in more detail through some graphical representations. A forward or future is a lot like what we do in normal cash market. A forward and futures contract obligates one party to buy and another party to sell an underlying instrument, that's a key term in derivatives, an underlying. But it doesn't have to be imposing, an underlying instrument or commodity at a future date and price.

Just think about buying an automobile. That's really a derivative contract, because most of the time we don't go in and buy that day. We go when we decide instead of price with that automobile dealership where there might be time that goes elapsed between the time you buy it and the time it's delivered.

And there is a price risk, isn't there in that time period? You contracted to buy that automobile several days in the future. And yet if the price did change in that time period, if it went up, the buyer wins. If it went down, the buyer loses, and the seller wins.

That's not unlike what a forward or a future contract is. So we can think of first the normal cash market, when we buy or exchange in cash now and get the product back now; as their normal exchange mechanism and now let's introduce some derivatives' terms. The party that's going to get what's being contracted for is going to be long in that item. And those that are going to give up the automobile, the dealer is going to be short in that item. But in the normal contract in a cash market, it's going to happen today.

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All that happens in a forward or a future setting is that we agree to the terms today to do the same thing sometimes in the future. It's a forward or future contract. Now, you are all familiar with the very common forward on futures contract. It's called a variable rate mortgage. Now what's true and what we are going to see in these particular settings, what's true about a forward contract?

If you set it at the money; that is if we contract to buy something in the future at the price we think it's going to be at the future. Taking the present value out of that amount, weren't neither party in the exchange to a forward or future is going to exchange cash up front. Because we've gotten equal expectations and we're equally likely to win on that contract as to lose on that contract. And that's the key distinguishing features I want you to pick up about a forward and futures. No particular up-front premium. There will be a transaction cost for writing the contract, but no other premium up-front if it's purchased at the money.

Jensen Note:  This makes most forwards and futures contracts different from many options such as puts and calls where a premium is paid up front for the contractual rights to exercise the option in the future.  It is possible, however, to add a contractual up-front premium to a forward contract or a swap contract, but this is not common.  It is common with options contracts.

Suppose we think that gold will still be worth $400 an ounce several days from now, ok, several days or months from now, when we have a forecasted values.  (e.g., I predict one value and you predict another value.)  We decide to do a future's contract on gold; neither of us are going to have to provide cash to each other. Because we are going to be in agreement that that's the reasonable transaction price for that. And each of us can win and lose. So, no transaction, no premium, ok, in this contract. Both parties have the opportunity to win and lose.

Jensen Note:  If we enter into futures contracts, we will both buy standardized contracts traded on a futures contract exchange market.   If we enter into a forward contract, we can enter into a customized contract with each other and avoid the costs and benefits of using a futures contract exchange market.   Benefits of a futures market include ease of finding parties to contract with and credit backing of the exchange itself to eliminate credit risk.  Costs of a futures exchange include brokerage fees, taxes, and other costs of exchange trading.

Let's go back to that variable rate mortgage. Remember we say that a derivative is an item that value is derived based on an underlying price rate or index? Think about the variable rate mortgage. The cash flow that you paid in a variable rate mortgage are derived based on underlying index that's specified in the contract. Now that could be called a derivative contract.

If we said that, and the bank and yourself in buying the home, set the mortgage rate in that index in that contract; if it was On Market, and if you look at an interest rate yield curve, interest rates are lowered short term, longer long-term for inflation effects. But you have a yield curve that's what mortgages contracted On-Market, there's no extra price paid by the mortgagor or the mortgagee in that process.

Now, the FASB is going to work real hard at deciding --- I can find a derivative in almost anything. The FASB members are going to work real hard in SFAS 133 to build tiny walls around what they think are going to be derivatives and needed to be contracted as a derivative versus those that are not (subject to SFAS 133). Because any normal purchases order is a forward contract. And if it's for normal items, if it's in a company, the FASB is going to say we already have accounting for normal operating items in a purchase contract and we don't want to get into derivatives in that area and they are going to divide those off. But that's a forward and a future contract. The forward futures contract you can either decide to buy the instrument at the specified price or you can decide to sell the instrument at the specified price at a future date.

Jensen Note:  Paragraph 10 on Page 5 of SFAS 133 specifially lists certain types of contracts that are not covered by SFAS 133.  These include regular-way secrurity trades, insurance contracts, and operations transactions such as normal purchases and sales of goods and services.


Question/Comment. What is a Chinese wall?

It's an artificial thing that you and I probably can punch through very easily, one of those paper-thin walls.

Options. Options are a different nature. Options provide the holder one of the parties, one of the sides of the contract the right but not the obligation to either buy or sell an underlying item, instrument or commodity at a pre-determined price in the contracted derivative terms that the "strike" price or at "exercise" price.


Options provide the holder the right, but not the obligation, to buy or sell the underlying instrument or commodity at a predetermined price called the "strike" or "exercise" price

Options normally are in the form of a "Call" or a "Put"

Calls - enable the holder to buy the underlying instrument or commodity at the strike price

Puts - enable the holder to sell the underlying instrument or commodity at the strike price

Require "up-front" payment or "premium"

Well, what should I pick up first in that definition? One party has the right either not to make any money, or to win. That's what we are going to see here in an option or in the writer of the --- that's the one that buys the option. The other one, the writer of the option, is either going to not lose any money or lose money--unsure of whole sentence.

Jensen Note:  Exposure Draft 162-B would not allow hedge accounting for written options.  SFAS 133 relaxed the rules for written options under certain circumstances explained in Paragraphs 396-401.  See option and covered call.

The two parties (buyer of the option versus the writer of the option) that contracted is pre-determined an option, one party could lose and one party can win, depending on the exercise price of the option. So let's think about that automobile again. Let's say I contracted to buy a Camaro for $25,000 on a forward (contract).  And the price went up and I have --- I am the holder of the right of the option to buy it for $25,000 (when the current price may be $26,000).

What happens in that setting if the price goes up in a production period, let's say 30 days, to $26,000.  I exercise my option to buy it at $25,000.  Now if it went down to $24,000, my option's useless. I'd be pretty stupid to buy it at $25,000 if I can get it at $24,000 on the regular market.

Jensen Note:  For some reason, Tom provided a forward contract illustration in the section on options.  If this were an option derivative contract, the car buyer most likely paid a premium for the option.  Suppose that when the Camero was $25,000, I purchase an option for $500 that will allow me to purchase the Camero for $25,000 over the next 30 days.  If the price of the Camero rises to $26,000, I exercise my option and ourchase the car for $25,000, thereby,  making my total cash outflow equal to $25,500.  Under the forward contract, my cash outflow was only $25,000 because there was no premium.  However, I might find it more difficult to find someone to write me the forward contract than it would be to purchase an option contract.  Tom was probably trying to stress that an option is a forward in spirit, but the attributes of the contracts are different in terms of premiums paid up-front and in terms of how they are acquired.  Forward contracts are usually custom contracts whereas option contracts, especially securities options such as puts and calls, are typically traded in exchange markets (and therefore cannot be customized as easily as forward contracts).

So your option's going to give you the right to win. The writer of the option is possibly going to lose. The buyer of the option is possibly going to win (although it is certain that the buyer will lose the premium paid for the option). Now obviously, in equilibrium we don't do that for any cost. If I have the right to win and you have the right to lose, we are going to have to agree on what the potential expected value that win or loss might be.

You know what this sounds like? Sounds to me like insurance. What do we do with insurance? We pay a premium up front and what is that premium based on? Based on in all actuality, what on average what we might expect to lose in that setting. And we buy that option, so that minimizes our outside loss. So we guarantee that loss to be the premium, don't we? Because we are giving that up.

Jensen Note:  However, insurance contracts are covered by other FASB standards (SFAS 60, 97, and 113) and options are covered by SFAS 133.  Paragraph 10 on Page 5 specifically bans insurance contracts from SFAS 133 coverage.  Also see paragraphs 277-283.

That's nature of what an option's like. Options are the form of a call. The "call" allow you to buy something, to gain the right. Or a "put", that's the right to sell something. So you can have a "call" option or a "put" option. Do you long in a position or short in a position? But in equilibrium, it's going to have an up-front payment for the expected value of the potential loss or gain is, in contract with the two parties.

And so the writers of the options are betting that they are not going to lose as much as we expected and the holder of the option is hoping that in the end that they are not over-paying --- that their losses in actuality would've been larger in that setting. But if there is no price change at all, if there's no price change at all in the underlying, the holder of the option threw away some money.   So there's a risk there for the person that buys the option. So that's an option.

Options have this common sort of hockey stick pay-off function. You were just looking at just purchased options, those that have by the options or the right to win or lose. A purchased-call option gives you the right to buy a commodity at that exercise price. So how are you going to win by holding that option? You are going to win if the price goes up and you get to buy it more cheaply. So that the pay-off arises and if you can buy it at the exercise price, rather than having to do it at the actual market price. That's the pay-off per purchase call when you're buying. No, if the actual price is below the exercise price, the value of that option is zero.

Opposite for purchase put. Purchase put gives you the right to sell something at the exercise price. So what's happening here is that you can sell them at this price and the actual price is below, you win in that option. If you can sell it at a higher price, no pay-off at the other side.

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Now, what I have up here is what we would see is the purchase of the holder of the right and the options pay-off function. What's going to be the writer of the options pay-off function? It's going to be the opposite, if that party wins this one's going to lose. There's going to be no loss of --- you can end up putting on the other side a different option that has this sort of features. But note if I put an option that has that sort of features, that line that goes together, if I put a written option and a purchase option's together, that line becomes something that you can win, lose at, both parties --- that becomes a forward contract.

So you put together a written option, with a purchase option, certain combinations and you can make a combination of options a forward.


Question/Comment. If you look at an option then as, really, it could be a hedge. If you don't want to play in that ball game, you don't want to expose yourself to the risk or you can look to have option that is speculation?

Tom. You can look at every derivative as both the hedge and speculation. I hope to convince you of that by the end of the day.

Question/Comment. Even those that have symmetrical returns?

Tom. Yes, yes, yes! Every derivative choice requires that you take a view. What are you doing? Let's say that you've got fixed-rate debt and you want to swap it to variable. Why do you swap it to variable? Because you think interest rates are going to go down. You are saying you are hedging your exposures against interest rates going down, because if it goes down in variable you pay less.

What if they go up? Means that you forward a contract. You lose. How is that any different than betting on interest rates? You have to take the view when you do a forward contract. Flip it around.

Question/Comment. Suppose that you have a variable and you don't want to expose yourself to something that changes in the interest rate so you swap it to the fixed. Isn't that a hedge?

Tom. It is also a hedge when taking a view. What happens if you switch the fix and you've got a debt? You win if it goes up, you lose if it goes down. It's the opposite direction every time, the opposite direction between a fair value hedge and a cash flow hedge.

Comment. I guess I must have meant the hedge is that --- I view the hedge as --- I just don't want to play in the ballpark. I'll give up the right to win and the right to lose. I just --- what do you do though, when you're trading a derivative? You're betting that the interest rates are going to go one way or the other to your advantage. No, as I think that in some cases you're not betting whether --- you're betting that it may change but the direction of the change is not as important to you as the fact that it may change.

I'm talking about the point of view of your foreign currency. Because we have a small company that just doesn't feel like they have the expertise to play in that ballpark. So they just abstract themselves from that [unsure]. Whether they win or lose depending on how the currency rates change; that they will win or lose.

Tom. But not your value of cash flow that are symmetric in foreign currencies. Translation gains and losses versus transactions gains and losses in an earnings setting. It will tell you, you are going to win or lose at every bet that you take.

Now it might be you don't want to put yourself ---

Comment. You don't want to expose yourself to the risk.

Tom. Well, what I want to convince you is you are always exposed to risk. If we got out of risk, we make companies treasure [bills--unsure] and I don't think any of us want to pay for the buying of treasury [bills--ditto].

There's going to be risk. In a derivatives [unsure] reshape the risk that you're exposed to, but you can win or lose. Whether you call it hedging or speculation. Almost any time.

Question/Comment. Tom would it be fair to say that when you are talking about winning or losing, it's almost relative to counterparty.

Tom. I think it's relative to a counterparty, but it's also relative with what your reasonable exposure was. And we will get to that in a moment. I've got some examples. It's going to change win or losing relative to what you have before the derivative. Yes.

Comment. Put has to be below the exercise price, before you made any money.

Tom. Right, the purchase price --- when the purchase price is below the exercise price you can make money, when you're the holder of the "put" option.


Swaps. Basis "swaps". Here two parties are exchanging cash flow payments. If you think that any of you know about swaps, you're switching variable rate interest payments for fixed rate interest payments, right? The common sort of stock that you hear about, two parties are exchanging recurring payments.


Two parties exchange recurring payments

Similar to series of forward contracts

Interest-rate swaps most common

In a sense, it's a series of forward contracts. Because that's every, let's say interest payment day, depending on how floating rates changed vis-a-vis the fixed rate. One party's going to win, one party's going to lose. And if you set the swap on the yield curve in an interest rate environment, the up-front premium is zero again.

So a swap just happens to be a similar to a series of forward contracts. Interest rate swaps are the ones that are the most common. So look at the structure of plain vanilla interest rate swap, why call it plain vanilla? Because there's no embedded thing in there to blow up on you.

Here the structure. I don't know about these labels as being definitive. The fixed ratepayer or the fixed rate receiver could be the variable ratepayer or the fixed rate receiver; you could change things around. Well, we've got two parties in the contract. And one of the parties is going to be paying the other party a cash flow similar to interest and a fixed rate.

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Now let's say that the contractual fixed rate for interest over this term-structure, this term to maturity is 6.75%. We call that multiplied by a notional principal. That's a terminology in derivatives that's different. It's not --- a notional principal is a principal that's really not going to exchange hands. You think about debt, a real principal is somebody who lends you the actual cash and there's interest rate payment of the principal.

On a notional principal, it's the defining amount that helps you define the amount of the underlying --- of the cash flow in the contract but it never changes hands. It's just a definitional term in terms of how you come up with the magnitude of the cash flow.

We've got a fixed-rate payer, paying the receiver of the fixed-rate, a fixed-rate on equivalent principle. And we have the other person paying a variable rate in return. Most common variable rate, a common variable rate is called LIBOR, which is The London Inter-Bank Offer Rate the rate at which banks are willing to exchange to money. Inter-bank offer rate, ok, at that price.

And so we have that sort of contract. This is a series of forward contracts. This party's going to win and if interest rates go down, because they are going to have the higher fixed-rate from the start of the contract. This party's going to win if interest rates go up, because they are going to be getting that higher variable rate. And what we are starting at is an equilibrium that the fixed and variables are equilibrium in the term structure and so nobody's going to win or lose [unsure of word]. It'll depend on how interest rates change over time. Series of forward contracts.

Now what is the importance of forwards, futures, swaps and options? First of all there is instruments that involve in the exchange of cash flows. They can be used to alter existing cash flows and because of that, very easily by the way, because of that they are going to comprise what we are going to call the basic risk management tools.

Importance of Forwards, Futures
Swaps and Options

Instruments that involve the exchange of cash flows

Can be used to alter existing cash flows

Comprise the basic risk management tools

They arose; they started --- we started seeing many more derivatives after Nixon took us off the Brentwood Accord. And if you look at a time series history of volatility in interest rates, foreign currency exchange rates and commodity rates; what we'll see if this is past time and this is the future, and this is early 1970's, it was taken off. When we went off, when the Brentwood Accord were broken and there was no longer a [pegged--unsure] exchange rate to the US dollar, you'll see volatility going like this; very tight, and then start bouncing around in all of those particular rates.

Now the Brentwood Accord would explain currency rates and interest rates. It won't explain commodity prices but remember we had OPEC in the mid-1970's, so that kind of dampened the variability and that broke apart when the oil prices started really getting volatile.

And so what we saw was in the mid-1970's is that underlying fundamental changes in the economics in our world economy. We no longer had to be experts in just our operating risks, but there were other sorts of risk that begun to explode. And that change in the variability and the dawning of the Black ScholesOption Pricing Model, that actually allowed us to price those changes caused us in combination to see an explosion in derivative instruments. To manage the cash flow variability that arises or fair value variability that arose that affected business ability to make money.


Question/Comment. I think I understand better that some of the entries.  It can clearly see that with cash flows that the transactions a conventional kind of hedging planning. Do I have to considered any other entries at any other time with these derivatives? Or do I simply then rely on the FASB's pronouncement that at the end that I simply [tape faded].

Tom. So let's think about cash flows and fair values. The way I learned to think about that is that all that cash flow risk is [unclear] fair value. What is fair value? It's the present value of a series of cash flows today. So it takes account for all the cash flows. And the cash flow risk is not all the cash flows, it's the ---

Comment. Wait just a second. I don't have to worry about any data entries?

Tom. What we are going to see is a fundamental building block of entries.    The fundamental statement of SFAS 133 is get derivatives on the balance sheet at fair value, which represents the present value of future cash flow.

Question/Comment. So no matter what kind of [unclear], I just wait until the end of the year and take advantage of [unclear]?

Tom. No.

Question continued. Other than the cash [unclear]?

Tom. What we are going to end up seeing is there's going to be a lot of work that’s going to go on if we say that derivatives meets very constructive and tight rules to say that it's related to something else. And you are going to have to do a lot of things during the year. And we will talk about all the things you've got to do. It's not just disclosure; one of the huge costs will be documentation. And we will get to that as soon as we start describing SFAS 133.


Hybrid instruments are embedded derivatives. I want you to realize that these are --- that simple derivatives are the fundamental building blocks of these complex structures. So when you see something called a structure note; all it is, is a note with an embedded option or swap in it. So the fundamental derivatives we talked about are the ones that comprise all other more complex derivatives.

A complex swap is a plain vanilla swap with an embedded option or leverage feature. And that is what happened with Proctor and Gamble. They wrote a swap that said that the worry was on the part of Banker's Trust that wrote that swap --- was that the yield curve was going --- the short-term was going to go up faster than the long-term. And so they wrote a swap that said we will have a normal swap, but in fact if there's a twist in the yield curve, we don't want to be held accountable for that on the Banker's Trust side. You are going to be accountable and that twist times 103 or times 97, I can't remember exactly what the leverage feature is; what's going to define the change in interest rates.

And it's exactly what happened in a very short time period after that swap was written. And people could say, what's the likelihood of that? Well I would suggest to you that Banker's Trust thought that the likelihood was pretty high, you can write that into the contract. And so people anticipated that and so they had an embedded sort of leverage feature in that contract that caused it to be an exploding problem swap for Proctor and Gamble.

So let's talk about managing risk with derivatives. We are going to find in SFAS 133 that there's this magical belief that the only way you can manage risk is with derivatives. The only way you can hedge accounting is with derivatives. But think about it. If you've got fixed-rate assets, debt securities as assets; how can you assure you're not going to be interest rate sensitive in a fixed rate exposure? They're the identical fixed rate liability over there.

When interest rates go up [on one--unsure], when they go up on the fixed rate --- you're going to lose on the asset or gain on the liability. That's going to be a perfect hedge of the fair value differences. And we are not going to see that we are going to be using anything but derivatives in that hedging process. And that's a little bit problematic for me for SFAS 133. It gets us thinking that the only way that you can manage risk is with derivatives.

But when we manage risk with derivatives, why use derivatives? They are low cost, they are very easy to get into, and you can transact them at very speedily. So they are going to be very easy things to get into. A forward or future contract, what's it going to cost you up front? The transaction cost to write the contract. No premium up front, because you [unsure] to likely to win or lose. It's not going to be costly to you. So it's going to be low cost and you can do it relatively quickly. If it's a futures contract, it's exchange traded. A future's contract is one in which you are going to have a lot of people interested in that contract so you can get to be on the exchange; corn futures, gold futures, those sort of things.

But if you want to write a forward contract on buying a pink polka-dotted Cadillac, you're probably not going to find a lot of demand on that on the outside market. You are going to have to do that privately. And that contract is not going to trade, that will be a forward rather than a future. But what you can do here is --- manage risks very quickly.

Managing Risk With Derivatives

Low cost, ease, and speed of transacting make derivatives attractive for managing risk

Different derivatives provide means of adjusting the timing, amount, and variability of cash flows / fair values

Ideal for both hedging and speculation

Different derivative products provide means of adjusting either the timing, the amount, or the variability of cash flows or fair values. When I was talking to Charlie, I look at those two as a continual. Cash flows is just isolating on the cash flows in a short term period, where fair values is the cash flows over the whole contract that we think about in a present value sort of sense. These are going to be ideal for both hedging and speculation.


Question/Comment. That's the leverage [unclear for rest of question].

Tom. It's a good question, isn't it? She asked why would any company want leveraged features in their derivatives? What Proctor and Gamble --- what had some effect on Proctor and Gamble, was they went out and wanted to lower their cost of financing by at least 50-60 basis points. Kathy, do you remember --- some amount --- 50-60 basis points, ok?

And how do you get that? How do you get a lower cost of financing in a equilibrium market? You take away some of the risk of the person that's lending to you. And so, to take on the risk of getting a lower 50-60 basis points decrease in their funding cost, by the way, the treasurer was receiving bonuses in lowering their basis points in their borrowing. They take on some risks.

Now they took on a risk that was huge. That the effective interest rates went from a normal amount to way HUGE and we are talking about way down [unclear]. I can't remember, but we're talking HUGE, ok? 119%, something like that. Some unbelievable amount if they would've continued in the contract. They settled out at a 56-57 million-dollar loss before taxes.

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Risk Management Activities

So how are derivatives used? They're used for risk management in the FASBs terminology we are going to call that hedging; and they're also used as speculative instruments. And as I will try to convince you some over time the line between those two categories for me is rather fuzzy, as to what is one and what is the other.


How Are Derivatives Used?

Risk management (hedging)

  • Commodity price risk
  • Interest rate risk
  • Foreign currency price risk


I'm going to go through three ways in which derivatives can be used to manage original risk exposure. To sort of build off of what Tom is concerned was to [enlighten that a little more--unsure of phrase]. I'm going to go through a commodity risk example, an interest rate risk example, and a foreign currency price risk example. Those are good examples because derivatives are commonly in those rates or prices. And they're the key sorts of risks that are embedded with SFAS 133. Yes.

Question/Comment. Getting back to this fuzziness between hedging and speculation. Simply, does this statement continue the old practice in allowing management to contract the derivative [unclear] and not to designate it as a hedge, creating a speculative contract?

Tom. We'll see when we get to there, the basic fundamental issues. You put the derivatives on the balance sheet at fair value, with changes in those fair values going into earnings. Earnings is just a key term to me, that's not comprehensive income, earnings. Unless they meet very special criterion and then they can have special accounting. Not for the derivative, per se; not in a balance sheet; but for either a hedged item or what we do with the income in the income statement in certain derivatives.

Question continued. That's all the management option designated that as.

Tom. Well, say more than designation. Meet the criterion, have it be deemed a qualifying hedge. You are going to see a lot of criterion here.

How are derivatives used? Let's look at a commodity price risk example. Let's say we've got a cost of mining gold at $350 per ounce, so we've to gold in the ground, it's not mined yet. But we think it's going to cost us $350 per ounce to mine it from past history. The current spot price is $400 per ounce. So that's what we expect to be able to sell it at today, that means we expect a $50 profit today. We have a lot of gold reserves. There's no doubt that we will be able to sell gold in the future. You've got ten years worth of reserves in the ground.

Commodity Price Risk

Cost of mining gold: $350 per pounce

Current gold spot price: $400 per ounce

Gold reserves sufficient for ten years of production

Company exposed to risk of decreases in future prices of gold

Cash flow exposure (forecasted transaction)

The company at this point in time is exposed to a decrease in the future rates of gold prices. They're going to lose if those go down, before they get it out of the ground and sell it. In the FASB's terminology, SFAS 133 terminology, this is a cash flow exposure. What is the cash flow and this could be the [trouble--unsure]. Why is it this [equal--unsure] fair value exposure to inventory? We don't have inventory. We don't have it in sellable form. This is a cash flow exposure, which suggests that the revenues, the future cash flows of revenues, are at risk. That's a cash flow exposure of what they are going to call a forecasted transaction. A transacted, the expected sale of gold in the future.

So we get back to that notion when we get into 133, hopefully that will help you a little bit. Tom, here's your original exposures. What's the original exposure of this company? Gold price of 400, with an expected production price of 350, their profit is 50. They have an exposure if the gold price goes down. If it goes down, that profit's going to go down. So there's down side risk from this point down on the curve.

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There's upside potential if the gold price goes up. So right now they're exposure. Their original exposure is exposed to both up-price movements and down-price movements. Downward they are gong to lose, upward they are going to win, but they've got a full complete exposure to both sides of the movement. Yes.

Question/Comment. If they had --- if they entered into a contract to provide gold at a fixed price, a fixed amount and a fixed price; then do we change it to a fair value?

Tom. No, no it's always going to be a cash flow hedge if you don't have a hedged item on the balance sheet to have fair value. That's the distinction. Right now we don't have gold inventory on the balance sheet. We have gold reserves.

Question/Comment. Even though we have a firm commitment?

Tom. We don't have a firm commitment here to sell it. There's no contracting party that's willing to buy it.

Question/Comment. So whether you have a contract or not…

Tom. Sure, then you can go the other way, exactly. But, no what happens there, it becomes a fixed contract if you have price, day, time. You have a price, ok. You're no longer exposed to this upward and downward movement. Cash flow hedge, here you are. And that's the difference in what we would see in the original exposure. The original exposure would look different on a fair value versus a cash flow hedge.

Question/Comment. Instead of taking the value of the future gold, why not hedge the value of the gold deposit?

Tom. Because it's very hard to write a derivatives' contract that would be effective for the gold deposit. Because you don't really know how much it's really going to cost to get it out. And that's why the FASB will not allow you, doesn't think in SFAS 133 that you can hedge the value of the gold in the ground. Because you are not going to be able to find the derivatives contract who's underlying changes very well. With that actual gold, until it's in more common form to know what the price is…

Question/Comment. [Too faded to understand]

Tom. Yes, but it's very much more mined-specific than ounce-common, and that's the issue. There's a forecasted transaction we expect to be happening in the future with the sales price is in sellable form. Now, I'm not tell you…

Question continued. There's a fine line there [again, too faded to understand]

Tom. There may be a fine dividing line, but the FASB also addressed it in SFAS 133 that oil in the ground is not something your problems' going to have an effective hedge on.

Question/Comment. [Faded] is that contracts on book or is that unrecognized firm commitment?

Tom. When you use the word firm commitment, it's unrecognized. Synonymous to being unrecognized. So you can also have a fair value hedge of an exiting asset or liability.

Now what might they do on this setting? They might want to make sure that they get the $50 profit. What would be the easiest way to do that? What are they worried about here? They are worried about price going down. It's the only thing they're worried about. Price going down, they want to at least --- they want to get to 50.

And their view might be going into this derivative's contract; we're worried that prices are going to go down. If they are worried that the price is going up, it would be really stupid to do anything. Because even if you did an option in that setting, you'd be paying the premium that would be negative cash out flow. So if you think for sure prices are going up, you want to stay with the original exposure.

But here they have a view that prices might go down, and to protect themselves in that view at that least cost, they go under a forwards or futures contract. Because there is no up-front [cost for that--unsure]. What do they do? They go under a forward contract that allows them to sell short, sell gold at $400 in the future. So price goes down and they only sell at the real gold that comes out of the ground, they sell it at $375; but they're guaranteed to be able to sell it at $400. They make themselves whole because the derivatives contract is going to be worth $25.

So they sell the gold forward short, which says that if the price of the gold goes below $400, they are going to get a pay-off dollar for dollar below that $400 amount. But if price goes up, they just lost by doing this. Did they take a view? Yes, they took a view. Because this contract is a pretty stupid contract if prices go up. Because they capped that up-size potential. Yes, they are hedging the right to downsize exposure, but they've created risk of not being able to participate in up-side price movement.


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And that's not much different than going into a normal derivative contract, or a normal investment of any type. You might win; you might lose. And they are changing their win and lose position by getting into this short forward contract. What happened to the short forward contract? We put the two series of cash flow diagrams together, they cross very nicely and in that position they locked into a $50 profit on any gold they sold forward.

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Interest Rate Risk;

Interest Rate Risk

Company issued a $100 million floating rate note with interest payments based on LIBOR

Interest expense: LIBOR X $100 Million

LIBOR currently is 7%

Company exposed to risk of increases in LIBOR

Cash flow exposure

let's say a company issued a $100 million floating rate so there's no fair value exposure is there, in a floating rate note? It's always coming back to the principle. They've got a company issued on $100 million floating rate note with interest rate based --- interest payments based on LIBOR. It's going to be LIBOR times $100 million in their interest payment in the floating rate note. It's the note payable. LIBOR is currently 7%. LIBOR goes up, not a good thing for this company. Got to pay higher interest.

So the company is exposed to risk in the increases in LIBOR. And this is the cash flow exposure. Because there's no change in fair value ever on a variable rate note. Because as that changes, the discount rate changes and you get back to the principle amount all the time.

So this is a cash flow exposure that your actual interest cash flows are going to change based on LIBOR. By definition they will change based on LIBOR, and in the SFAS 133 terminology, that's a cash flow exposure of an existing liability. We are going to see those cash flow exposures of forecasted transactions in existing liabilities as an existing liability. And I wanted to put this one up here because most of you will read 133, they say almost say, everything's a forecasted transaction.

They sort of gloss over the fact, they don't emphasize that there's cash flow exposures of existing liabilities. Because when they tell you forecasted transactions unlike my response to firm commitment, firm commitments are guaranteed to be unrecognized. They sort of try to scoop in cash flow exposures of existing liabilities and assets as if they are just like forecasted transactions. They don't maintain the definition's as nicely. So watch that when you read the 270-page ton called SFAS 133.

What's the exposure at each interest payment date? Well here, right now, LIBOR was 7%, so their interest is $7 million on this particular $100 million contract. What's the exposure? If LIBOR goes up there's a risk of increase in interest payments; LIBOR goes down, they win. Looks sort of like a forward contract, doesn't it? The original exposure looks like a forward contract. Things go one way we win, things go the other way, and we lose.

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But what we might be worried about is this risk of increase. And so we don't want to be exposed to variable rate increase, so what we could use to hedge that exposure is a swap. An interest rate swap that has the same notional principal amount as the debt of $100 million. Note what happens in this. Here's the company with the exposure; they want to become a fixed-rate payer. They are a variable ratepayer right now, aren't they? They are paying variable out.

How am I going to make myself a fixed-rate payer? I'm paying variable out; the swap would work to have them paid variable to me. That would net me back to zero, right? And I would have to pay fixed-out on the swap. So one leg of the contract of this swap, the received floating rate to this company with the exposure negates what they are already doing on the cash outflow for interest and the [pay-leg--unsure] at fixed-rate, swaps changes the variable rate to a fixed-rate contract. And that's how they are going to hedge the exposure.

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Question/Comment. In this case Tom, does the fixed-rate receiver, do they generally work on a transaction cost basis for their --- they attempt to be brokered…

Tom. The banker or any other mediator can make money two ways. One way they can make money is jump on the transaction [cost--unsure] to swap which is really low for a [pay-leg--unsure of phrase] swap, but they can make money on writing that contract. But if all they wanted to do was make money on writing that contract, they are going to have to negate their risks in this setting. Or they could make money by leaving themselves [bare--unsure] on this contract and really this person, the fixed-rate payer is believing interest rates are going to go up, the banker could be believing that interest rates are going down. And if the yield curves an equilibrium that's likely can go either way.

So they are going to make money on transactions cost and the banker and the mediator are going to have to decide whether they leave themselves bare there. If they are going to take it back, they are going to speculate themselves or they are going to have to go out and do their contracts that hedge that exposure. And a lot of times people ask questions where did the other side go in Proctor and Gamble, or in Orange County, etc… How come we didn't see it some place else? Because the bank and other intermediaries laid off their risks all over the economy. The only conversation that I was part of about Proctor and Gamble they would've taken them hundreds of millions of dollars of contracts to be able to undo what was happening there. But Banker's Trust probably hedged some of their risks there and so that loss or gain was spread over many parts in the process.

Question/Comment. Did you ever finance transaction? Is it the case where the [unclear] variable rates contract and turn them around [unclear]?

Tom. It can depend on their view, whenever they need protection. A lot of times companies will --- if you look at really borrowing almost all of them are fixed rate. Because for some reason there's lower transaction cost in fixed-rates. But if you really want a variable, what you do is issue fixed and you go right away to variable.

But others sometimes companies can lay this on at other instances. The problem that we have in the process here is that if you entered an option in a swap, you write the option; in other words, you are giving someone the right to [unclear] benefits and you get an up-front premium on that. The way we have accounting now, people can buy income that way. Because the swap accounting didn't disentangle the option and so there were representation fellows the FCC by sellers of derivatives that half-of the swap market --- and the swap market at the something like 20-30 trillion level was by up-front income. The earnings managed were buying swaps.

So that timing differences is going --- that timing issue couldn't go away now. So we may end up seeing that when they lay on swaps, it would be different than they are now. Because if it were for earnings management purposes to bring yourself into whatever your target is, it would be more frequent that it wouldn't be at the start than at other times.

Now that was just a representation of somebody who after the fact; when I talked to [Moore--unsure of spelling], he said that was pretty stupid of me to say that at the SEC wasn't it? Yes, it seemed kind of dumb to be saying that and I would suspect that he was exaggerating at the 50% level. But if it's even 10%, that's a lot, that's a lot. Yes, Bill.

Question/Comment. Question is that they enter into a fixed rate transaction costs or [lower--unsure]. And then enter into a swap.

Tom. To get to the variable.

Question/Comment. Would that work just because the swap involved notional amounts?

Tom. I don't know why the transaction costs and swaps are lower, but they really --- in competition got to be like 1 or 2 basis points. That's about ---

Questions continued. Because I was thinking on that well --- is if your transaction costs meaning you couldn't conceivably have [greater--unsure] transaction costs because you were entering into two transactions.

Tom. Well, obviously it would not make sense I know unless the net was less.

Question/Comment. The only thing I can think if is because the swap involves a notional amount is that the [guarantee--unsure] of the party is not providing the cash, it's just ---

Tom. I don't know the answer but it's going to involve [equity--unsure of spelling] risk, credit risk, a whole bunch of different risk factors that must be different in that setting. And so you might be right. But I don't know, but I have not empirical evidence as to what it is that causes the swaps to be cheaper than that fixed-rate --- variable rate debt originally.

Comment. But on the face of it, it looks like an irrational transaction.

Tom. So what are we going to do in this setting? If we're worried about movement, we already talked about the swap; here's what one of the cash flows in the swap will look like. Remember we --- just showed you the original exposure that told you that the outflows would go up if rates went up.

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So if rates went up here in this setting in the swap setting; you are going to have outflows from the swap if the rates go down. Because you are going to become a fixed-rate payer at what was it, 7%, right at 7%, when the other persons' --- the leg you are going to get is less than 7% you [end--unsure] that outflows. You are going to settle that swap at an outflow to you.

But if prices go --- if interests rates go up, the net on the swap is --- you are going to have a net inflow. That's going to lower your outflows. And I had to draw this graph this way because my first original exposure graph was what the outflow was. So that's why this graph is depicted as it is.

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What's the net position? After laying on the swap, here's the original exposure. Interest rate is going up. [IRA--unsure] payments haven't been paid. By swapping from variable to fixed, I'm going to lower that when we go above 7%. The net is, as you know, that we're paying a fixed interest rate.

Now is that hedging? Is that speculation? What is the outcome of the activity? The idea was, to think about reducing funding costs. Let's think about that more. Reducing funding costs of derivatives. Swapping from floating to fix like we just saw, reduced funding costs only if rates increase. If rates decrease, you're stuck at 7, not the lower rate.

Reduce Funding Costs With Derivatives

Swapping floating-rate cash flows to fixed-rate reduces funding costs only if rates increase

Swapping fixed-rate cash flows to floating-rate reduces funding costs if rates decrease

Funding costs reduced by "expressing a view" (i.e., by betting on movements in future interest rates)

Swapping from fixed to floating reduces funding cost if rates decrease. So by being either in a variable rate exposure or a fixed-rate exposure, you changed your original exposure, Tom, that was direction, from one or the other. But the move that you want to be here, the decision that you're going to do is, you're betting on changes what directions interest rates are going to change in doing that hedging strategy. When you use a forward or a future in that setting, you're betting that it makes sense. That interest rates are going to go one way and it's going to do the right thing for you.

If they go the other way, you've made a bad move. That sounds to me almost like speculating. What do you do with speculating? You buy an instrument; you hope it goes up. If not, if it goes down you made a bad choice. It's fuzzy to me as to what we're saying is the difference between risk management and speculation. That's why I think of everything as taking a view; in changing your original exposure to a different exposure.

Question/Comment. Would you explain to me [several years ago--not sure] that one motivation for borrowing [total--unsure] then swapping fixed, is it because of the [legitimacy--unsure] in capital [unclear]? You could borrow floating [unclear].

Tom. Which has to suggest that there is some sort of friction in the market or that you can arbitrage away that difference, right? You should be able to do it. I just don't know what the friction is that would suggest that we're equilibrium and it makes sense in costs. I do know though, that the more I thought about derivatives, the more there are underlying issues that cause those instruments not to be the same. And we have to start thinking about what those risks are, and they may not be market risks. They may not be changes --- exposure to market rates or prices. But they might be equity risks, they might be credit risks, they might be legal risks. There's a whole cornucopia of risks that we ought to think about and people are expert at writing derivatives' contracts to reflect those risks.

You know I haven't thought about this setting enough or have convinced myself what it is. But there is possible in a lot of settings that when you say cheese you know, there's an opportunity for arbitrage here there's a miss-pricing going on --- then there might not be a miss-pricing. There might be. But we've seen instances of where there's miss-pricing across the world derivatives' markets, that people get very good at making money on that really rapidly. So people are picking up on the abilities. If there are some frictions, they are not risk-based or not equilibrium correct, making some up. Obviously there should be some contracts out there where that isn't obvious, and yet people haven't exploited it.

But the one area I'd be pretty convinced that people would've thought about is borrowing and swapping. When that happens enough times and I think there was an arbitrage opportunity, people would've done that.

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Foreign currency price risk;

Suppose a company commits to purchase machinery from a manufacturer --- a French manufacturer, sometimes in the future. The payment is for 10 million French Francs to be made six months from now. So it's something in the future. Currently you can get a US Dollar --- the US Dollar-French Franc exchange rate is 20 cents US Dollar for every French Franc.

Foreign Currency Price Risk

US Company commits to purchase machinery from a French manufacturer

Payment of 10 million French francs (FF) to be made six months from now

Currently $US/FF exchange rate $.20 per FF

US Company is exposed to risk of increases in the $US price of a FF

Fair value exposure (firm commitment)

So right now the contract says we buy this machine in dollars at 10 million dollars. That's what we expect there. The company's exposed to risk of increases in the price of a US Dollar for French Franc. Exchange rate goes up above 20; they are going to have to pay more six months from now. So that's their price exposure.

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In SFAS 133 notion is a fair value exposure of a firm commitment, assuming that his purchase --- you know the contract, you know the quantity, you know the amount, you know the timing. Its all there in my description. And there's a legal and forcible contract available through the firm commitment.

But this is a fair value exposure of a firm commitment. It’s a firm commitment because it's not an existing asset or liability yet. It will become one. It's a fully executory contract that we don't recognize that asset yet until some party performs, normally. So there's the commitment, you've got a contract to buy the asset in the future, but we don't normally put that on the books when you've got a contract. So that's why this is a firm commitment. I'll buy this six months from now for you.

When do we recognize an asset?

Comment. Nothing's been delivered.

Tom. Nothing's been delivered and you haven't paid anything. You've just got a contract to agree to buy something in the future.

Comment. To agree --- to only agreed to buy ---

Tom. To agree to buy; that's good, the impression's good because we need to make that clear what this is. We just agreed that six months from now that we are willing to buy this thing at that price.

Question/Comment. [Too faint]

Tom. Six months from now and the six months from now are also [unclear]. Yes.

Question/Comment. What is the fair value [too faint]?

Tom. You ask --- well what is the cash flow [--- revenue or --unclear]. What is the fair value? The total amount of the present value of the effected cash flows. What are we going to do in accounting when we buy this thing? Put it on the books as an asset. What's our exposure? That asset, the fair value of that asset's going to change from 20 to 2 million dollars.

Comment. [Too faint]

Tom. Yes it is definitional but this is a fair value hedge. You fair value the asset liability, not cash. And I know cash is an asset.

Comment. You say fair value represents future cash flows. In here is everything in this contract is already determined [unclear] cash flow hedge ---

Tom. And this gets back to what I said to Charlie. Before I think the difference between [cash-book--unsure] and fair value if you look [unclear] bookkeeping, if we hedge the value all of the cash flows --- fair value. And if you're only doing a part of it, for a certain period of time and there's more, [hence it be more--not sure] like cash flows.

Now I don't know if that --- I'm not that all [sure--unclear] as whether that's definitive for everything, but I think that works. Here we're doing all of it.

Question/Comment. Isn't this Tom, based on FASBs decision to recognize certain executive [not sure] contracts when there are derivatives involved?

Tom. Yes, we are going to find out that this non-recognition that we don't normally see.

Comment. The other things are forecasted transactions [unclear] contracts.

Tom. Remember there is a distinction, but there is also a cash flow hedge of existing assets or liabilities too. So all cash flow hedges aren't forecasted transactions. So that's the difference I think, what you choose to call your hedge. What you decide to hedge. You can make your choice. In some respects, you can make your choice whether it's the total present value of the sum or it's part of it.

Question/Comment. I do have a question about that one swap having a [unclear]. Seems to me that would be fair value [unclear].

Tom. Well, no because think about the fair value of the variable rate note [on bond--unclear]. Does that ever change with rate change? There's no cash flow --- there is no fair value to support that because it's fixed.

Comment. Fair value never changes.

Tom. That's right. But principal counter-acts to get the same total fair value at all time.

Comment. That's kind of a special case having some liability that cannot [be of--unsure] fair value.

Tom. Cannot be a fair value hedge. Cannot be because there's no fair value exposure there. So we really have to get to the essence. No, every time I start to hear [as I cover an--unsure] original exposure and I drew on the diagram what are exposures. You know outside the potential [unclear] where is the variability? And some instruments can be both cash flows in fair value [depending on whether you're looking at--unclear] or hold. Otherwise, it's not possible at all. Either of fair value or cash flow. That's truly one or the other. Fixed rate debt is fair value exposed. Variable rate debt, cash flows.

Question/Comment. If the main product goes down because the exchange rates different, that would be a cash flow exposure, wouldn't it?

Tom. Yes, now they actually talk about this on 133. So [it's in the right implication for--unclear] changes in foreign currency rates on ---

Question/Comment. [Too faint to understand]

Tom. That's right and they will talk about that, that it's very difficult to say that a derivative can hedge that effectively. Because there's too many links in the channel to know how that change in foreign currency exchange rates really flow through your operating activities. But we know that the US Dollar - Japanese Yen exchange rate changes that's going to add implications for the ability to Japanese automakers to sell automobiles here. Probably not much on our ability because we don't get into that. But you know there will be some implications [unclear] in their operating, in their ability to supply demand here. But the linkage between the changes in the rating and what's going to happen there are so far reaching and there's so many steps for it, they suggest that you can't hedge that for the derivatives. You can get special accounting, you can hedge it with a derivative by choice, but you have to treat that as if it's an unhedged position for accounting book.

Comment. [Too faint]

Tom. No. And we are going to end up seeing that they worked real hard on putting the Chinese wall up that I'm talking about around what is a derivative and what is the exposure that you can have. They limit both. That's what makes this very complicated.

Question/Comment. [Too faint]

Tom. Here's our exposure. Right now the exchange rate is $ .20 --- US price of a French Franc is $ .20. If that goes up, you will have to pay more six months from now, because we didn't set the price. We set the price in Francs but not in Dollars. So you have to pay more in dollars to get this thing. Obviously if it goes down, we win.

What's this company's thinking about; this company is going to be a little bit more sophisticated. They are not going to wipe out this whole exposure. They are going to say, let's think about these strategic issues. The company believes the price of the French Franc might go down, it might go down. They actually think that's a possibility. They are not just worried about it going up, they think it might go down and they don't want to take out the possibility of the gain, the lower cost, if it goes down.

So they are not going to use a forward or a future. And they are not all that concerned about having to pay 2.5 million for this asset. They are concerned if they have to pay more. So they are not worried about all increases, just increases above a certain amount. Sounds like they are going to buy insurance, right? They buy an option; their hedging instrument is going to be an option.

That option says it's going to be a call option, which says that they can buy that machine --- they can buy it. Not the machine, they can buy the French Francs at $ .25, guaranteed you can buy it at $ .25, per French Francs. And so if it goes above $ .25, for every cent it goes up, they are going to get a cent back, which will negate that increase. But there's the hockey stick pay-off function for that particular contract.

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It's going to be the net cost of the machinery in this setting. It's going to be a little bit more complicated. Remember our original exposure was they paid the price whatever it was per French Franc, up and down. The pay-off function on the option is, I just inverted it. Remember this was an outflow and the hockey stick, the upper, was the inflow we got. So I ended up coming over here at $ .25 and here's the inflow that counter-acts the outflow and so what they are going to pay is --- if price goes down, they are going to receive all the benefits of the price going down. But if it goes up above $ .25 per French Franc, it's capped.

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But where is the risk now here? It's not the downward price movements it's great. It's not the upper price movement, above $ .25. The risk [unclear]. The risk is that it stays at 20 or 21 or 22, 23 or 24. Because what did they do in that setting? If they didn't change their exposure there but they paid an up-front premium for the cost of the expected exposure change. And so where they are going to lose or make a bad decision is in that little range. They changed their original exposure.

Question/Comment. Cost of premium is that capitalized on the after --- [unclear]

Tom. Up-front it's the time value; we are going to call it the time value of the option. But it's going to go on the option account. That's going to be the up-front cost of the option.

Question/Comment. So why do you say it's a bad decision only in that little range? Isn't it a bad decision anytime the price falls?

Tom. No.

Question continued. Well, it [unclear] of the option.

Tom. That's true, you're right. You're absolutely right, you're absolutely right.

Speculation with derivatives, speculation primarily the domain of the viewers and sophisticated traders is what the idea was. It's primarily their domain that's where we think speculation occurs. I would venture to guess a lot of the corporate that got caught in 1994 we very, very seriously think about some of their options --- some of their derivatives they invested in as also being speculative.

Speculation With Derivatives

Speculation primarily domain of dealers and sophisticated traders

Speculative trading based on investors’ views of future market movements

Using interest rate swaps to reduce funding costs also requires "expressing a view" (i.e. form of speculation)

Query: Is risk management much different from speculation?

Comment. I have a comment as to what you think their motives are at the CEO level for these speculative derivatives.

Tom. Well for a lot of the catastrophic losses that we saw in '94 and '95, the CEO had no idea that is was going on. There was not a good set of risk management policies and procedures or what was being represented to them as we were in very plain vanilla instruments. So a lot of what has happened is some internal controls have been placed within companies that define what the risk management policies and procedures are and many corporate now have a rule--plain vanilla. None of this embedded sort of stuff.

So, it's not clear to me that the CEO knew, or the CEO understood. Even if they knew, that they understood what was going on. And some of the comments in the press were, if the CEO really knew what was happening, understood, this would not have happened.

Question/Comment. But that was the CEO talking, wasn't it?

Tom. No, I think this was others talking, others talking. Obviously they CEO's that got caught are not good people to [go--unclear] get truthful responses as to their level of knowledge. So there has been some internal control developments that has been going on in setting what they wanted to be doing. But I told you that Proctor and Gamble's motivation for the treasurer was to reduce funding costs because the compensations --- his compensation contract was tied to that.

Question/Comment. You think that was a fairly typical background [too faded]?

Tom. It was --- there were --- that was not a-typical at that time period. I think people realized that there was a really perverse incentive placed on that person that got companies in trouble and I don't --- I'm pretty sure that things have been re-contracted over time.

Question/Comment. Do you think placement of stock in that [unclear] top-level executives trying to pretend to be better than they are by ---

Tom. Oh, I place a lot of theory in the notion that derivatives can be used for earnings management purposes and for helping managers with their compensation by getting them in perfect --- in ranges that makes sense. There's a whole series of theories as to why firms getting into derivatives I'll be talking about at 10:30 tomorrow. But the only empirical evidence solid is while compensation contracts and maybe hedging your investments are indeed activities. You try to deal with internal financing rather than with external financing.

But there is not a lot of empirical evidence other than maybe managers using these internally for their own compensation benefits. The question on the outside is does the investor want them to do that? Does the investor want a company to be in derivatives? Why wouldn't the investor invest in their own derivatives and hedge their own risks in the portfolio? Yes.

Question/Comment. What would the answer be on that last question about the machine? What would be the cost on the machine?

Tom. It depends on whatever the dollar price for French Franc was when it came out. In the accounting you're talking about?

Question/Comment. Yes, you capitalize [that it comes out a difference. We are going to capitalize in there--unsure of whole phrase]

Tom. You are going to capitalize at $ .22. Whatever the fair value of that machine is. The machine's going out on that fair value. You are going to also end up having some counter accounting for that particular transaction in the derivative's contract that will settle things out. So that the net implications for the company in cash flow is to cap it at 25. But the machine is going out at fair value.

Question/Comment. It's going to affect [unclear] derivatives?

Tom. That's right.

Question/Comment. I want to go back to [debits and credits here--unsure]. When you record that machine's purchase ---

Tom. Let's save the debits and credits until I get some examples where I've got debits and credits for you. Right now all I want you to think about is exposures and what could be managed and what's happening in those exposures. I'd --- we could end up doing those entries and there will be a series of entries over a series of dates and we've got some examples later. Not on this exact study, but you'll see how on a fair value hedge things work out [unclear].

Question/Comment. [Unclear] payable [unclear] cash flow.

Tom. Remember this is a commitment, so you are not going to record the machine until it's purchased. And you are going to record it at fair value. In the [acquired--unsure] time period, you've got the derivatives on the books. With this price going up and down, as the price changes and as you net that out, the cash flows' going to be capped at 25 --- at $ .25.

Question/Comment. [Unclear] about the options ---

Tom. You are going to record the option in your derivative contract. And you are going to settle the derivative at the purchase date. So when you settle it, it's going to be in the money or out of the money. If it's in the money, you're going to end up taking it off at value. And ending up having a gain that ends up a lot --- you're going to take it off. And is going to --- well it depends if its an asset or a liability. What position --- well it can only be an asset. It can only be an asset if it's not.

Question/Comment. Let me attach a number to this. Suppose you purchase the price of the French Franc is $ .30. [Unclear] you are going to have a $500,000 gain or option. Would you recognize the earnings immediately? [Unclear]. Isn't it --- recognized ---?

Tom. Because it's a fair value hedge, you are not going to --- one of the key things when you get to SFAS 133 is we don't end up basis adjusting anything. We don't end up taking the implications of a value change in the derivative and putting it into the attached contract. We view this as a company purchasing machine, a comparability basis; you want the machine to go on at what it was worth when you purchased it. Whether or not you have the derivative and have the derivative implication in the derivatives account.

So we are not going to end up having basis adjustment any longer. Now that was possible in the past. But there's a work here to say what measurement attribute are you recording these things at? And whether we can make it more consistent. We're still going to have problems with that and I'll talk about that later.

Question/Comment. [Unclear] derivatives are an integral part [unclear].

Tom. Well, that's right, and we're no longer thinking about that. We're going back to more what we think about is, separate transactions are counted for separately and we [aggregate--unclear] them through into the income statement; their implications separately. But the net effects are all there in the income statement and separately in the balance sheet.

We are not tying them together and doing any aggregation and linkage together on the face and one line account. We are doing them separately.

Question/Comment. What if the French Franc price of the machine drops? Are the value of the French Franc [unclear]. Are you still going to be recording the machine at fair value?

Tom. Absolutely.

Question/Comment. Would the original amount be Francs [unclear]?

Tom. Yes.

Question/Comment. Even if the French manufacturers install the machine as opposed to the now [unclear] for only 900,000 Francs ---

Tom. You already have a firm commitment for the price. You don't get to re-contract that.

Question/Comment. That's historical that cost based on current fair value of Francs. That's not the fair value of the machine. If you bought the machine now for 900,000 Francs, $ .30 equals $7 million dollars, not $3 million dollars.

Tom. The fair value of the transaction price is what it is you pay for it when you agree to pay for it. It's what you're willing to contract it at, to exchange it for. Yes. There are impairment issues. You can still have impairment tests after the fact. But the transaction price is what we account for.

Question/Comment. I guess I'm probably still in 52, but if the value went up to 30 million based on the exchange price and we had a firm commitment to buy it at 22 ---

Tom. We don't have a firm commitment to buy it at 22. We have a firm commitment to buy it for 10 million Francs. That's the firm commitment. That price can change because we are going to have to do it in Dollars because our functional currency is Dollars. The 10 million is not changing. The firm commitment is for amount, quantity, and timing.

Question/Comment. Then we're not going to off-set the ---

Tom. No.

Question/Comment. Increased depreciation we are going to take that ---

Tom. We are going to end up recognizing that ---

Question/Comment. In earnings is the fair value.

Tom. With the fair value hedge, you are going to recognize it in the settlement of the contract as the contract's settled. So that net cash implications are you bought it for whatever the net was, cash implication. The machinery is going to be on the books at its fair value. And its transaction price, if we want to move from risks in changes on that amount. We'll see that as we move on.

Speculation, we've already talked about that. The domain of dealers and sophisticated traders speculative trading based on investor's views of future market rates or movement, using interest rate swaps. The hedge or risk in a debt is also expressing a view in market rates movements. The question I ask you is, is risk management much different from speculation?

It's going to come down to this fundamental issue, one of the four cornerstones of SFAS 133 is, we should have special accounting in a risk management setting. And I think we ought to step back and think about whether this is really uniquely different than speculation. We're working really hard at special accounting here. And we're putting together about as complex a statement as I've ever seen. This thing's, what, 200 and something pages long, and they put it on thin pages to fool us. It's not normal thickness pages for the FASB. To make it look smaller.

Do we need to work that hard at coming up with special accounting, if really what it is, is not much different than speculation, it's just changing your exposures. Should we work so hard and make our heads hurt so much as to how things are going to be tied together in this process? I don't know. I'm not answering that question, but we're working awful hard at coming up with a specialized model.

No, a company --- manufacturing company can speculate with derivatives. Here this manufacturing company anticipates that a certain commodity will soon drop in price. This business has nothing to do with the commodity --- nothing to do with this commodity. They are not in business with this commodity. But they think it's going to drop in price. They think they have an expertise in guessing at gold price movements.

Speculating With Derivatives

A manufacturing company anticipates that a certain commodity will soon drop in price.

To exploit this belief, the company sells the commodity for forward (or future) delivery at a price reflecting the current market consensus

If the price does decline, the company can buy the commodity in the spot market and deliver it against the forward contract

Profit = Forward price - spot price

So what they do, they decide --- they decide they are going to try to make some money on that knowledge. So they go out and exploit this [lead--not sure]; the company sells the commodity forward for future delivery at a price reflecting the current market consensus. They thing it's going to sell for 400. The market thinks it's going to sell for 400 and they think it's going to go down. So they buy it and decide to sell it forward for 400. If the price does decline and the company goes out on a [date at that time--unsure of phrase] and buys the products at 350; it turns around and sells it for 400 and makes $50 with the difference between the forward and the spot rates. Companies can do that.

You might actually want the company to do that if we think that they have some comparative advantage of being able to know about these markets. I certainly like to know that when I buy the company. That they're not only doing their operating risks but they're doing these sorts of things so that's the way you can speculate.

But is that much difference from the gold example I just told you? If gold now is their business, if they had to decide whether they wanted a $50 profit margin or not, is it much different? I think for sure that we would say that's speculation. If they're Sears & Roebuck and they're going into commodity gold futures, I don't know. What I want to leave you with as we go to break, and after break we will come back, we'll do SFAS 133.

Bob Jensen's Home Page Bob Jensen's Helpers Mexcobre Case Table of Contents

New Financial Reporting Standards

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What we are going to do for the rest of the time here is talk about FASB's SFAS 133. Give you an overview of its guidance, and then go through some examples and give you an evaluation. The compass there is so to say that this is something there that we might need some steering through.

Why do we have a change? Why the change in SFAS 133? Well first of all, the quantity and variety of derivatives is increasing. If you go from 1990 to 1997, the number of [OTC--unsure] contracts sent --- we increased 10 times the amount and the notional amounts of [OTC--ditto] contracts and derivatives in '97 projected were 30 trillion dollars. This is not a small market. So the amount and variety of derivatives is increasing greatly.

SFAS 133:  Why the Change?

Quantity and variety of derivatives is increasing

Accounting conventions and standards are outdated, incomplete, and inconsistent

The resulting financial statements are not transparent

Going into SFAS 133, the accounting model for derivatives was inconsistent, incomplete, and outdated. Inconsistent in that it didn't address all types of derivatives. Inconsistent also in that 180 said; look at enterprise risk reduction. 52 looked at a transaction's basis level. We had a lot of inconsistencies across the two primary Documents 52 and 80. Or even the same sort of derivative instruments, and it was incomplete. Didn't address also a derivative instrument. So when I was at the SEC, it became bloody obvious that by analogy, people can do almost anything. Unless it was exactly a future's contract under 80, or it was exactly something in 52. People, even people trying to do a good job had difficulty.

And then we know that there are incentives not to try to do a good job. And so we have broken accounting models that made the results of a derivative in the financial statements not transparent. And the example that I just wanted to give that related to what we were taking about previously, previously in 52 you actually took the derivative gain or loss and did a basis adjustment on that asset that we were buying. And so the implications of making the choice to hedge it was not transparent to anybody on the outside. And the same company making the wrong call all the time, nobody knew the right call. There was no separation, there's no idea of getting any notion as to how well these risk management activities or these speculative activities are for a company in terms of ascertaining whether you want the [unclear]. We had little or no transparency; derivatives are not on the balance sheet prior to 133. Except maybe an option premium. And they are not in all settings.

What are the four cornerstone decisions of SFAS 133? And I think these are --- this is the place to start if you want to try and understand this statement. These are where the board started from there are four fundamental decision, the cornerstone decisions.

SFAS 133:  Four Cornerstone Decisions

Derivatives are contracts that create rights and obligations that meet the definition of assets and liabilities

Fair value is the only relevant measure for derivatives

Only assets & liabilities should be on balance sheet

Special hedge accounting should be provided, but should be limited to transactions involving offsetting changes in fair values or cash flows for the risk being hedged

First of all, derivatives are contracts that create rights or obligations that meet the definition of an asset or a liability in Concept 6, and therefore should be recognized on the financial statements. Now the problems with that statement is that it might have already been true, but if we did it at an historical cost measurement attribute, what would you put a forward or a future on it to contract it? [Day--unsure] zero.

And so that leads to the second fundamental cornerstone, fair value is the only reasonable measurement attribute for derivatives. The risk or loss of gain or loss isn't there at the start on a forward or a future, it arises at the rate of price changes occur over time. And if we are going to pick up with consequences [of those are--unsure of phrase], we need a fair value derivatives or there's not going to be on a financial statement on the face of the balance sheet. So that's the second one.

Thirdly, they will say we only want assets and liabilities on the balance sheets. Remember the old concepts under --- what was it --- 52 or 80 that we could defer a gain or loss and call it an asset or liability. The board decided that really stunk. That's not something we want to be doing, is deferring gain or loss. For a loss, you call it an asset. How could a loss possibly be an asset? How can a gain be a liability, in a deferral notion? They decided when we go about setting up this accounting model; we are not going to have anything that is just a deferred gain or loss on the balance sheets.

Now that doesn't mean that certain measurement attributes and [assets--unsure] like a firm commitment, that the deferred gain or loss is not going to be the amount that we put the asset or liability in the book. But they say a firm commitment is a potential asset or liability. So they're kind of [unsure] here. They say they don't want a deferred gain or loss. They are really very special with today, that they don't want any assets or liabilities. But they're still going to fall back in this compromise to come up with this complicated model; that we want a firm commitment saying we are going to measure the firm commitment in a deferred gain or loss. Amount.

Finally they did decide; and remember I was trying to set you up here to wonder should we really have special accounting? Should we really have hedge accounting? Because of its nature, what's the difference between speculation and risk management? But they did decide that special accounting should be provided. Frankly, they had no political ability to get rid of it. We are going to see that they'd like to get rid of cash flows exposures and they had not political ability to get rid of cash flows hedges.

So they decided that special hedge accounting should be provided, but limited to transactions involving offsetting changes in either fair values of the derivative in the hedged item, or the cash flow exposure; offsetting changes in fair values or cash flows. And they are going to work real hard, they are going to work really hard that if the offset is ineffective, that the ineffective portion gets measured.

So we are not going to presume that it’s a perfect hedge. That the extent that it's not perfect, they are going to want to be able to try to make that flow through earnings. And they can almost do it until we came to the cash flow --- one of the cash flow hedge exposure anomalies, and I will talk about that in a bit. They couldn't get all the way there.

What are the key aspects? If I had to summarize 133 in a short presentation, I would say that. But you will see that, that doesn't have a lot of explanatory power. Overall that's what they decided on 133. All derivatives are at fair value on the balance sheet. And special accounting might arise, special accounting for the change in the value of the derivatives designated in a qualifying items, in either fair value hedges, cash flow hedges (most often thought of as in terms of forecasted transactions), and foreign currency hedges.


SFAS 133:  Key Aspects

All derivatives are at fair value on the balance sheet

Special accounting for the change in value of derivatives designated and qualifying in:

  • Fair value hedges
  • Cash flow (forecasted transaction) hedges
  • Foreign currency hedges

Don't be deceived that foreign currency hedges are different than cash flow or fair value hedges, they are not. They are examples of cash flow, fair value hedges. They put them separately because they didn't want to destroy Statement 52. We are going to find that every foreign currency hedge is an example of a fair value or a cash flow hedge, even a hedge of a net investment in a foreign sub, because that is going to be the fair value exposure in the transaction gain or loss.

So this is just a special category to help them in putting together the literature. They are going to deep 52 in place, 80's gone. But they are going to keep 52 as is; though there is not a lot said about hedge accounting in 52.

Why allow hedge accounting? Remember I told you the controversial choice is the fourth plane. Why allow it? You know, if we start thinking about all the problems in our accounting model, almost all of them that we struggle with now are either have to do with consolidating together entities or combinations, or certain recognition in measurement anomalies because we account for parts as parts, right? We account for line items; we don't look at it as a whole all the time.


Why Allow Hedge Accounting?

To resolve recognition and measurement anomalies

These anomalies cause earnings effects in different periods for hedging instrument and hedged item

And the effort is we are going to have some potential recognition in measurement anomalies. And what I mean by that is those anomalies in the balance sheet in terms of what we recognize and what we measure them. Since we're primarily an asset liability point of view; we are going to cause anomalies in the earnings effects as to when the earnings effects of hedged items in hedging instruments falter earnings.

Hedging instruments being the derivatives, hedged items being the items whose exposure are being hedged. And so there's a problem and most of this happens with the mixed, a mixed attribute model, where certain items are fair value if those changes in fair values currently going through earnings, where other items might be at different attributes; historical cost, lower cost, or market. Where the timing of those changes are not as contemporaneous and don't fall through earnings at the same time.

So all special accounting is, is an effort that if we think we can link together hedging items and hedged instruments. If we think we can link them together, that we are going to work to get the earnings is something that you want to listen to when I say earnings. That means our old net income. From that beyond earnings we have the other comprehensive income items to go to comprehensive income. We are going to make a distinction. And it's going to go to earnings together. To be able to have some of them go to earnings together, we are going to park the implications of the cash flow hedge in other comprehensive income until the hedged items effects [go up to--unsure] earnings. And then we are going to get the gain or loss on the hedging instrument earnings at the same time. That's how we are going to work at that.

So this is the resolve recognition and measurement anomaly. Why did I say recognition anomalies? What I just described is a measurement anomaly. The firm commitment notion is a recognition anomaly. People would actually say that a firm commitment in some respects is an asset or liability. We've just decided not to recognize it when it's fully executory or both parties' parts yet. Because an asset says future benefits under the control of the entity based on past transactions. That's true of all firm commitments. But we don't recognize it until one party --- one party does something on the side of the contract. The forward represents that as a recognition anomaly within SFAS 133.

Common Reporting Issues:   Qualifying Hedges

Documentation requirements

Effectiveness and ineffectiveness

General disclosure requirements

Specific accounting and disclosure rules

fair value, cash flow, foreign currency hedges

Hedge termination


If you want to understand 133, here are all the items that are dealt with in 133. Not just this bullet point about the accounting and disclosures rules, everything else that is built around this standard. You not only cover each of these documents --- documentation requirements. This is not disclosure. This is what system's development have to be underlined special accounting has had this happened. With a sort of internal documentation must be developed.

SFAS Paragraphs 20(a) and 28(a)  
Documation Requirements

Formal documentation is required at the inception of the hedge and must include:

  • Identification of the hedging instrument and the hedged item
  • The nature of the risk being hedged
  • The risk management objective/strategy
  • How effectiveness will be assessed

Then we'll talk about the extreme effort; they don't like special accounting but they are going to allow special accounting. But to be able to do that, they are going to not want, they are going to want to have the effective part of the hedge get special accounting and that ineffective, the extent that they don't fully offset fair value. [Exchange in--unsure] cash flow that ineffective portion is going to have to be disclosed. To allow people to ascertain exactly how well firms are doing in these positions.

Then, I'm going to talk about what the general disclosure requirements are for all sorts of hedges. There's this list of general disclosure requirements and then we are going to get into the specific types of hedges, fair value, cash flow, and foreign currency hedges. And we'll close with some tidying up issues. What happens when you start having hedge accounting, and you terminate the hedging relationship? Forecasted transactions no longer probable. You no longer see the relationship. How do we deal with terminations? And how do we deal with impairments? That hedged item is going to have to be checked for impairment issues. So we are going to be moving that up or down, that depending on fair value notions.

Documentation requirements, formal documentation is required at the inception of the hedge. It includes internally the identification of the hedging instrument in the hedged item. So after the fact, accounting is not going to be possible. From the start, they are going to have to tell you what the hedging instrument is, and what the hedged item is. If they don't have a record of that, then they are going to be in trouble in terms of documenting their special accounting. The nature of the risk being hedged and that might --- that's going to go beyond cash flow versus fair value. It could be cash flow or fair value, but it's also possible that we are going to be measuring certain portions of risks. Embedded options involving pre-payment sort of things might be a risk. But they are going to have to specify of the cornucopia of risks available for being hedged what it is.

The risk management or objective --- the risk management objective and strategy, what are they trying to achieve with this relationship? And how effectiveness will be assessed, more importantly, how will we measure ineffectiveness, which will be reported. Now I don't think that's a very clear --- it's not a very clear listing to understand, so let's give an example what might be the documentation.

On the first of the year, XYZ purchases a call option on a 5-year --- on 5-year treasury notes, as a hedging instrument in a cash flow hedge of a forecasted one hundred million dollar treasury note purchased --- to be purchased at 12/31/X1. That's what they are going to be doing. That's documenting the hedging instrument and the hedged item, and the nature of what it's going to be.

Required Documentation - Example of Cash Flow Hedge of Note Purchase

On 1/1/x1, XYZ purchases a call option on 5-year treasury notes as a hedging instrument in a cash flow hedge of a forecasted $100 million 5-year treasury note purchase at 12/31/x1

XYZ designates the decreases in cash flows related to decreasing interest rates as the hedged risk

For effectiveness measurement, the call premium is excluded from the test. The call option notional amount and forecasted note amount match.

XYZ designates that decreases in cash flows related to decreasing interest rates as the hedged risk. What is the exposure? You note that's what we were doing before break. What is the exposure? Then they have to tell you what the effectiveness [test is--unsure] going to be.

Paragraphs 20 & 28:  Effectiveness

Effectiveness is defined as the derivative instrument’s ability to generate offsetting changes in the fair value or cash flows of the the hedged item. Key aspects:

For both fair value and cash flow hedges, the hedge is expected to be highly effective

Effectiveness is measured at inception and must be assessed whenever earnings are reported (at least quarterly)

Effectiveness measures intended to be similar to "high correlation" in Statement 80

For effectiveness measurement, the call premium is excluded from the test. When they're measuring effectiveness, all changes in the value or the origination of value don't have to go in the effectiveness test. But if they are not in the effectiveness, any changes from that item go to earnings.

In a derivative, any change in the derivative item that's not part of the effective nature of the hedge, that's going to have to try to get to earnings directly. Right away, rather than being [matched--unsure] up. The call --- the call option notional amount and forecasted note amount are exactly the same. That's saying the portion of the risk, the intrinsic value in the option that's related to the treasury note, that portion looks like it's going to be a very effective hedge, but it's for the same notional amount as principal amount in the note. But that's the sort of detail and even beyond this that you're going to see within the documentation.

I should tell you that many of these slides were provided and allowed by use by the FASB [from their--unsure] course. I've been working with them on a lot of things. So this is --- some of these items are FASB materials that we're talking about here. So if you're thinking about being involved with that course, here's the courses, that thick, in terms of slides. But some of these are being provided to me [from the FASB--unsure].

Effectiveness; effectiveness is defined as a derivative instrument's ability to generate offsetting changes in fair values or cash flows of a hedged item. Remember we are not going to get special accounting, unless there's the appropriate offsets is going on in a relationship. If the derivatives move, we expect certain relationships with the hedged items or forecasted transaction.

Key aspects of this effectiveness notion, and this underlies what's trying to be accomplished with special accounting that was not there, that did not get worked at very hard in 52 and 80; coming up with what's effective and what is ineffective. For both fair value and cash flow hedges, the hedge is expected to be highly effective. Effectiveness is going to be measured not just at inception but we expect [unsure] to be the relationship between changes in rates or prices or indices, and the hedged item and the hedging instrument. What are going to have to be observed every time before reporting in the financial statement? And if hedge becomes ineffective, you've got to stop the special accounting.

Now what's effective or ineffective? You play games with 133. They don't [tell you--unsure] very well. The only thing they say is, it's sort of like the notion of hedge effectiveness of Statement 80. But if you go to Statement 80, they don't tell you the hedge effectiveness is in 80. The only people that told us what hedge effectiveness is, is the SEC. And the notion in 80 was that the changes have to be either --- If we talk about the changes in one and the other, their notion was between 80 and 125% of value. So if one goes up by 100%, the other one is either going to have to go up between 80 and 125%. That's highly [effective--unsure].

No what I think they're saying is we don't want to make the decision, SEC you're stuck with it. If you don't like us, you are going to decide how this is applied whether we think this is highly effective or not. But that's the notion that they're going to be talking about in the process.

If [X-Anti--unsure] or at any reporting quarterly reporting date is no longer highly effective, it's got to stop. And this is part of the documentation remember at the start? Always going to measure effectiveness. So there's going to be some internal auditable items to decide whether firms can continue doing hedge accounting.

When I was at the SEC, Kathy can confirm this very --- it was hell to get anybody not to do hedge accounting. There was not any guidance to force people off. So all of the embedded derivatives you know, hybrid derivatives were accounted for as if they were not speculative in the least bit. And we worked really hard to even find a notion to say you had to do that. [To give ingredients--unsure] setting to that enforcement tape [unsure] ingredient tapes is just [unsure]. And the SEC on top of that piled on at the end; there's an enforcement action. Why? It was the only case we could find where we were absolutely sure they were speculated, because they doubled on the bet about 10-15 times. Every time they lose, they just wrote out more complicated derivative contract with a deferred loss.

And so that was to say here's a setting where you must fair value, because we couldn't get anybody else in enforcement to fair value, the auditor or the registrant. So there's going to be efforts here to force people off special accounting.

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Example of highly effective fair value hedge

Here's a perfectly effective fair value hedge. Where you've got the change in the fair value of the fixed rate debt being perfectly offset by the change related to the fair value change in the received fixed interest rate swap, and a fair value hedge. Perfectly offset at 6/30/X1, changes at that time and at 12/31/X1. That would be a perfect offset.

Example of a Highly Effective Hedge

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Now notion of hedge and effectiveness says you're within 80 to 125% if the rules under 80, as interpreted by the SEC gets applied to SFAS 133 you can say that was effective if this was between 80 and 125% of each other.

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Hedge effectiveness tests up front

Remember you got under documentation to find how you are going to measure effectiveness. Now go back to the option, that up-front premium that time, value, money component of an option versus its intrinsic value component. That time value components do not change with changes in interest rates. That was the expected cost on average up front in the expected changes in the underlying.

But that's not going to change anymore. That was the central moment, not the variation. So you could exclude the time, value, money component in an effectiveness test. And just say when the underlying changes, the rate of price change in the line of option changes or the forward changes, the part that causes the change in value that correlated with the hedged item or the cash flows. So you can separate.

Hedge Effectiveness Test

An item may be excluded from the effective- ness test because it does not provide offsetting cash flows, such as an option’s time value (time value is the amount paid for the option, excluding payments for intrinsic value)

An item may be included in the effectiveness test, but may generate ineffectiveness

An item maybe excluded from the effectiveness test because it does not provide offsetting cash flows such as an option time value. An item may be included in the effectiveness test, but may generate ineffectiveness too. So the firm gets the choice, and the FASB did not want to define this because the nature of the items that gets hedged and the risks that are; they're changed over time.

But they want a very precise terminology. And so this effectiveness, ineffectiveness stuff is a core principal that we have to get our students to understand as we move forward.

What's going on with this effectiveness test? What are the implications? If the highly effectiveness test has failed as I said, then the entire hedge does not qualify for special accounting. You get out of the range. You can't link the hedged item with the hedging instrument. That's --- but remember what 33 says --- 133 says, that derivatives still going to be on the balance sheet at fair value with changes in income, with changes in that fair value go into income. You are just not going to be able to attach it or relate it to all to hedged items.

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Implications of the effectiveness test;

Effectivness Implications Test

If the highly effectiveness test is failed, the entire hedge does not qualify for special accounting

If the highly effectiveness test is met, some ineffectiveness may occur and a portion of the derivative gain or loss may be recorded through earnings

Ineffectiveness is recorded differently in cash flow and fair value hedges, depending on the hedging relationship

If the highly effectiveness test is met some of the --- some of the ineffectiveness may occur at the 80 or 125% range [unclear]. Some of the ineffectiveness may occur and still have you get special accounting --- hedge accounting treatment. But a portion --- and a portion of the derivative gain or loss may be recorded through earnings. The [unclear] will love to say must be recorded through earnings.

So let me tell you [unclear]. Think about a forecasted transaction. The gain or loss in a derivative remembers the derivatives accounting example? Where's that gain or loss going to go? It's not going to go under [unclear] because you will want to delay its recognition in earnings until the forecasted transaction has effect in earnings.

So how do you do that in a forecasted transaction since it's not on the books? We park it in other comprehensive income. That's what you're going to do. And then as the forecasted transaction leads through earnings, you're going to amortize the other comprehensive gain or loss to earnings. Now what's --- there's two forms of ineffectiveness that might occur here. The change in derivative might be less than the change in the effect on the forecasted transaction.

And so the ineffectiveness is we didn't cover all the risk in changes in the forecasted transactions. What are you going to do with that ineffectiveness? Is the forecasted transaction going to ever be recognized in the books? No, that's the issue. So for the portion when the change in the forecasted transaction effect changes in the rates or prices is greater than the other comprehensive --- the change in the derivative that ineffectiveness can't flow through the reports at all.

Paragraphs 22 & 30:  Ineffectivness

Items included in the effectiveness test that may generate ineffectiveness include:

  • Different value of hedged item and notional principal
  • Different maturity or repricing dates
  • Different underlying interest rate basis e.g. LIBOR versus Prime
  • Currency differences
  • Credit differences

But if the change in the derivative on a forecasted transaction is bigger than the change in forecasted transactions, you are going to [bifurcate--unsure of spelling] the change in the derivative and the portion that's effective goes to [other--unsure] comprehensive income. The portion that's ineffective must go to earnings immediately. [Unclear]

Let's say the hedged item has a one million-dollar gain. The forecasted transaction [implication--unsure] could be a one million dollar gain and what is happening in the derivative is that there is a 1.2 million dollar loss. The derivative was effective in only hedging one million of the change, right? $200,000 of that loss is ineffective, too much loss. How are you going to account for that? The hundred --- the one million is going on a comprehensive income --- other comprehensive income and the $200,000 is going to go in earnings.

The ineffective portion's going to go in earnings. When the loss or gain on the derivatives is greater than the loss or gain on the hedged item, the forecasted transaction. But the other way you're stuck. One million lost on a derivative, 1.2 million-dollar gain on the forecasted transaction; the derivative's fully effected. Not completely, but it balances to 1.2.

So the ineffective portion's at $200,000 change in the forecasted transaction. Where the hell are you going to put that? You can't do anything because you can't recognize the forecasted transaction until it happens. That's why we can't --- the ineffectiveness is not always going to flow through earnings on the cash flow hedge exposure.

Question/Comment. [Is that all --- X-anti--rest too faint]?

Tom. No, it's X-pulsed.

Question/Comment. So why do you say the hedge [unsure] if [unsure]? If it's X-pulsed ---

Tom. It's oh Charlie --- yea, yea, yea, I know what you're saying ---

Question/Comment. Why can't I [unclear]

Tom. It's not X-pulsed on a forecasted transaction. It's X-pulsed to interest rate or price change. So this is an interest rate or price change that causes the forecasted transaction to be different than what you thought six months ago, but it hasn't occurred yet.

Question/Comment. Would you give us an example of what the SEC [unsure] 120% change if you went to a 180 to 125% [unsure]?

Tom. And I didn't pick it with that much foresight. But I'm glad you brought that up. I didn't --- I didn't put it on the edge entirely --- it would've been effective. But that ineffectiveness can't always get to earnings. They didn't find a way to do it for the cash flow hedge. But they are going to find it for all the fair value hedges. The ineffectiveness will be recognized. Yes.

Question/Comment. Well if this is a firm commitment and the ---

Tom. Cash flow hedge, for a fair value hedge, which is a firm commitment ---

Question/Comment. Yes, is that ---?

Tom. All of the ineffectiveness will be ---

Question/Comment. Will offset?

Tom. The extent that it does not offset will be reflected in earnings. And I'll get to that in a moment.

Question/Comment. Well what you'll have is a firm commitment book?

Tom. That's right.

Question/Comment. And the hedge book?

Tom. That's right. And it will be --- the changes will be for different amounts. And since the changes are for different amounts, the ineffectiveness goes to earnings, because for fair value hedge, all the changes go to earnings.

Question/Comment. Then you know, you will have to separate the two for a fair value hedge.

Tom. No, no but you have to report the amount that's ineffectiveness in the footnote.

Question/Comment. [ --- you do that in earnings--unsure]

Tom. Yes, ineffectiveness is recorded differently in a cash flow hedge, in a fair value hedge depending on the hedging relationship you just --- told my --- told my point. You just told my point. For a fair value hedge, what's going to happen is derivatives are going to be at fair value with changes going into income. And the portion that you're hedging is going to be marked at fair value with changes going into income to the extent that it's not fully offsetting, that will be reflected in earnings. You might not be able to pick it up on your line items in your income statements so in the footnotes are going to have to tell you that it's ineffective.

Question/Comment. Yes, but these are relatively large companies that are involved in hedging materiality [unclear], so just how much information do you think is going to be disclosed?

Tom. Yes, absolutely; yes.

Question/Comment. [Too faint]

Tom. No it's separate; no you're going to put them separate. You are going to account for them like we talked about the equipment being separately. We are going to be given materiality constraints, you don't know whether they --- if they are in the same area of the income statement, other income, other expense whether they might not net them with materiality. But in concept they are separate items. You've got a materiality issue throughout.

Items included in the effectiveness test that may generate ineffectiveness. Why might not a derivative be a fully effective hedge? Here's a list of items:

Different value of the hedged item in the notional principal, for some reason you --- may be you've got --- you can't get a futures contract with the exact right notional amount. I don't know why you wouldn't be able to. But if there's different values, if you get into something different, that could be ineffective.

Different maturity or re-pricing dates on the two contracts can clearly give you ineffectiveness. It could be that you've got your interest payments on some odd date. And whether the futures contract of the exchanged rated contract is unspecified dates and it's two days off. Well any change in interest rates over those two dates, two days could be ineffective, will be ineffective.

Differences under interest rate basis, like variable rate measured at LIBOR variable rate measured at Prime could cause you some differences. And sometimes derivatives will, you'll have your hedged item let's say at Prime and the derivative at LIBOR. They are highly correlated with each other but not perfectly positive when correlated.

Currency differences might also arise. We don't always have foreign currency contracts for every sort of currency. Because there's not enough demand for the contract. But Dutch Guilder and the Deutsche Mark if you look at them moving together they're [unsure] and have been forever. So why then do we need a derivative contract to fed reserves of those two countries, so are they in cahoots with each other, do they inform each other? So you don't ever see it as a Guilder exchange contract. Marks are more, we've got more Marks have we've more German exposure. So often you hedge the risk with a US Dollar--Deutsche Mark exchange contract.

Credit differences might also arise. If you don't scope that out of the effectiveness test, there's credit differences between the parties to the two contracts and you think that would be very likely that could result in effectiveness. Charlie.

Question/Comment. This issue of ineffectiveness, if you would apply to a company for example such as General Motors which is [unsure] messing around with protecting gold prices, etc. [rest too faint]

Tom. They are messing around with gold prices and likely gets hedge accounting change unless they have some gold price exposure that's [unsure]. So we wouldn't be getting into hedging and if we don't get into hedging we are not into effectiveness and ineffectiveness. That's just speculating the smart kids letting the smart kid speculate. But remember under the documentation and these disclosure requirements, they are going to have to tell you why they are in derivatives.

Question/Comment. [Unsure] in other words the audience [unsure]. The price of gold in either direction of risk management?

Tom. That's right, they are putting very strong criterions limiting special accounting. Special to settings where --- that's why the standard's so long. Remember I said the key aspect of fair value derivatives is [unclear]. All the rest of this is putting muscle around and limiting when you can get into the [hedge--rest faded].

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General disclosure requirements;

General disclosure requirements, for all derivative instruments that qualify as hedging instruments, the entities shall disclose each type of the hedge --- or each type of the hedge what is the objective for holding a derivative? The context needed to understand those objectives, what are the original exposure sorts of things? The context as to why they are into these thing strategies for achieving those directives are they doing a forward in shutting down all movements? Are the doings of an option and shutting down one side? Why are they doing that sort of thing? Their risk management policies, can they get into hybrid instruments within embedded items that can blow it up or is it simple? What is the policy of the company? And a description of the items or transactions that are being hedged not just the hedging instrument, but the hedged item.

SFAS Para 44:  General Disclosure Requirements

For all derivative instruments that qualify as hedging instruments, the entity shall disclose for each type of hedge the:

  • Objectives for holding derivatives
  • Context needed to understand those objectives
  • Strategies for achieving those objectives
  • Entity’s risk management policy
  • Description of the items or transactions that are being hedged.

So everything we were doing in the simplified examples up front where you were saying what was your original exposures and [layered derivatives--unsure] on that, they want that context that sort of description available to companies to understand what they are doing. And frankly as an investor, that's pretty darn interesting to be able to understand what you're buying when you're buying Proctor and Gamble. I think they thought toothpaste and mouthwash a few times back --- years back. Not betting on interest rate changes. Yes.

Question/Comment. I'm a little confused when you keep saying that they have to tell you this. But now this may be clearing up, is it safe to say that for the documentation, that documentation is really going to have to also be all the things that are part of the documentation, except the kind that has to be disclosed?

Tom. Almost all, we are not giving great details about the effectiveness test and ineffectiveness test. We think that's too complicated for the investors. They don't need to know what the tests are; they need to know what is the amount of ineffectiveness. So some of the documentation is more detailed than what we're disclosing, but we're disclosing a lot of the substance of what is happening in these transactions within the general disclosure requirements.

Now these are general disclosure requirements that apply to all hedges. We are going to special extra ones for each type of hedge that I'll get to in a moment. But this is going to be just as important as what we are going to find in the financial statements. If we expect corporate [governance--unsure] by investors by what they are doing, these sorts of disclosures.

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Accounting for fair value hedges;

Now let's go to the specific accounting and disclosure rules for fair value and cash flow and foreign currency hedges. Accounting for a fair value hedge, fair value hedge is an exposure to a change in the fair value of a recognized asset or liability, or an unrecognized firm commitment attributable to a particular risk. But note we were struggling before break a little bit as to when --- whether an existing asset or liability or a firm commitment is a fair value hedge or a cash flow hedge. Note that the start of this definition is the exposure, is the fair value and we can find exposures to fair values in these types of items. So that any exposures to cash flow we can find exposures in these types of items.

Paragraphs 20-27:  Accounting for Fair Value Hedges

A fair value hedge is a hedge of the exposure to a change in fair value of a recognized asset or liability or of an unrecognized firm commitment attributable to a particular risk. Key aspects:

  • Assets or liabilities exposed to price risk
  • Change in value of hedged item and hedging instrument recorded in earnings
  • Result is matching for effective hedge
  • Effective gain or loss adjusts basis of hedged item

In both of these we will find existing assets or liabilities. Unless --- but we first need to know the sensitivity to price changes are and what we're trying to manage too. I mean we can try to manage a part of those cash flows or all of the cash flows, so what are we thinking about? Key aspects, assets or liabilities must be exposed to price risk. There must be --- there must be some exposure to having this work. The change in the value of the hedged item and the hedging instruments are recorded in earnings.

So what we are going to end up seeing is --- that we are going to end up seeing that the derivative, whatever the gain or loss in the derivative is going into earnings. Now the effectiveness test [causes--unsure] how much the hedged item will go to earnings, to the extent that it affected the hedged items basis, gets adjusted up or down. But the effect of the change in those items, the extent that it's ineffective they don't get a chance [unclear]. So if there is a discrepancy, the gain or loss on the hedged [taking--unsure] instruments can be different than that gain or loss on a hedged item going through earnings at the current time. But the problem that is going to come up that I hate about this choice is we're going to have a [mucked--unsure] measurement attribute for the hedged item, if you don't measure the full fair value change in the hedged item. If it's only the interest rate risk component or the currency risk component, we are going to end up starting off before in that hedge item --- that item at --- whatever the measurement attribute is. Under [GAP--not sure] and the --- we're going to take a portion of the effective of fair value change in that item and change it.

I think that's terrible. You know what are we going to call that measurement attribute? The [mucked--ditto] attribute? You know I don't know. You've got a problem of fixing the derivative but in this process we're hurting the accounting for the hedged item.

Question/Comment. We do that a lot, a lot of times. I mean if you buy securities at two different, you'll know securities will be fair value.

Tom. I mean you've got a portion at historical cost and a portion at fair value. I can't --- what is that attribute? Historical cost adjusted for changes in interest rates effective changes ---

Question/Comment. [Unclear]

Tom. But I think that hurts the meaning of whatever that dollar value amount is, what does it represent? It's very hard to be able to tell.

So results if it's a change in the value of hedge item --- the result is that if it's a perfectly effective hedge, the earnings effects are going to offset. But we're only going to allow the hedged items changed for the amount that it is effective. So if it is ineffective, the derivative's going to change by a different amount than the hedged item and the ineffectiveness will be recognized in the earnings, in that period.

Question/Comment. So we could have two similar machines and we hedge one, but we didn't hedge the other so we are going to change the carrying amount of one machine but not of the other.

Tom. What we'll find for a non-financial asset or liability you can't hedge a portion of that, according to SFAS 133. So you're going to get the full fair value on --- one, it's going to be a fair value; the other is going to be historical cost.

Question/Comment. [Too faint]

Tom. Sure it will come into play --- sure it will come into play. The extent that the derivative changed different, yea --- the extent that it's not fully effected, you are not going to get all the way to fair value in the hedged item.

Question/Comment. Which one's going to be fair value? You contract ---

Tom. Both are going to be ---

Question/Comment. You have a firm commitment to buy two machines in the next six months. You hedge one and not the other. Now which one winds up being of fair value and which one is ---?

Tom. The firm commitment that's hedged is actually recognized on the books. Firm commitment that is not hedged is not on the books, the derivative's on the book.

Question/Comment. Ok, but on five machines, the one you buy in six months that goes to hedge will be [recorded--unsure] at fair value. The purchase price [faded].

Tom. You are always recording the machine at its transaction date at its price, period.

Question/Comment. So they're both recorded at fair value.

Tom. That's right.

Question/Comment. That's a different definition of fair value then.

Tom. No, because the firm commitment will be on the books prior to this, and be written off as a gain or loss at the transaction date. The earnings effect will be different. Firm commitment's going to be a separate line item. And it's going to be written off as a gain or loss depending on the positions of the cash flow effects to earn --- the gain or loss the net cash flow is going to be flowing through earnings over time in this thing, in representing the net. But the machinery is going to be on the books, in either instance, at the same price.

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Board views about fair value hedges.

Fair value hedging is reasonable because the hedged item is a firm commitment or an asset or a liability. They like this. I understand this gets complicated. So the fair value hedge is reasonable because the hedged item is a firm commitment or an asset or liability. They think it's reasonable because they will never be recognizing in the hedged item something that is not an asset or liability.

Board Views About Fair Value Hedges

Fair value hedging is reasonable because the hedged item is a firm commitment or an asset or a liability

Offsetting fair value changes of the hedged item and the hedging instrument through earnings provides a natural offset

They are going to be accelerating the recognition anomaly differences. They're going to be creating recognition anomaly differences for the firm commitment. But they think that's ok, remember the cornerstone issue that they're working off of. Assets or liabilities, we should not put on the book assets or liabilities if they're not assets or liabilities. We are not going to have that problem in fair value hedging.

And they also like the fact even though this is complicated and a mess, that the offsetting fair value changes of the hedged item in the hedging instrument flow through earnings. And the amount of the ineffectiveness is captured in the current period earnings. That's the Boards view about why they like and feel comfortable with fair value hedging. That will be contrasting with what I put up in a moment as to why they are uncomfortable with cash flow hedges.

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Disclosure requirements for fair value hedges;

They foreshadow the net gain or loss recognized in earnings during the report --- they must report the net gain or loss recognized earnings during the reporting period that represents hedge ineffectiveness in disclosure. Given, assuming materiality, the component of the derivative gain or loss excluded from the assessment and hedge effectiveness, remember we said all of the derivative change in gain or loss in value does not have to go in the effectiveness test. But by definition, the amount that's outside the effectiveness test automatically goes into earnings. Now that doesn't make much sense in the fair value hedge as we know --- I mean, it's not a big point in the fair value hedge. Because we know the derivative is going to go [onto what is--not sure] fair value and all the changes in the fair value is going to income. That's what's going on, some of its going to automatically go into income and have no consideration in determining what --- how much the hedged item is going to be changed.

Paragraph 45(a): Disclosure Requirements: Fair Value Hedges

Net gain or loss recognized in earnings during the reporting period representing:

  • hedge ineffectiveness
  • the component of the derivatives gain or loss excluded from the assessment of hedge effectiveness
  • where the net gain or loss is reported

The amount of net gain or loss is recognized in earnings when a hedged firm commitment no longer qualifies as a fair value hedge.

Others can be going into the effectiveness test with the extent that it doesn't, it will not be considered in determining how much of fair value of the hedged item can change. They also want you to tell us where the gain or net gain or loss is reported. Where would the line item in the income statement if you're trying to look for these things? Is it buried with other stuff or is it not.

They also want you to think about what happens when you discontinue hedges to the hedged item. The amount of net gain or loss recognized in earnings when that hedged firm commitment no longer qualifies as a fair value hedge. So if you set up a fair value hedge of a firm commitment and therefore accelerate the recognition of the asset or liability called firm commitment on your balance sheet and then you are wrong about that, they are going to make you disclose what happened to it. And what is going to happen there when you're wrong about it, when you no longer have it on the books, you've got to go back to the other GAP. You don't recognize firm commitments on the balance sheet, the gain or loss effects must be disclosed to let people know what's happening with your decisions when they were wrong. The implications on earnings [but that--unsure] you will have to eat the effects immediately.

Question/Comment. I have a question on the fair value hedge. On a firm commitment when do you put than on [faded]?

Tom. I designated it; I met the hedge. I got the documentation saying this is a hedging relationship. So and you're not going to have a firm commitment on the books until interest rate or price changes.

Question/Comment. [Too faint]

Tom. Because you only can put on the firm commitment the change in the fair value attributable to the risk being managed.

Question/Comment. [Too faint]

Tom. You are not --- you are not going to change the fair value [until--unsure] interest rate change, therefore currency rate change or whatever the exposure is, if you start off and there's no firm commitment when you start the hedging relationship. And this is --- in between before you come out and actually buy the machine [unsure] for example; there is a reporting period. And in that reporting period the Dollar-French Franc exchange rate changed. That caused the option's intrinsic value to change on a fair value hedge.

All of the option's intrinsic value change is going to recognize in earnings and the firm commitments to be recognized the extent that the hedging relationship is effective.

Question/Comment. [Too fast] contents of 20 and 22 cents you are going to recognize as 22 cents as the firm commitment and then the offset of that goes to [gain or loss--unsure].

Tom. Right, you are going to recognize the opposite of that in the derivative likely. You are going to be picking up two things.

Question/Comment. Other than that, that's called fair commitment.

Tom. That's right, absolutely and that's what I was not answering well before break. There's something new that's there that will go away when they buy the machine. It's no longer a firm commitment when they buy the machine. They will write that off if it's a debit it will be lost, if it's a credit, it'll be a gain. When they write it off.

Question/Comment. But the firm commitment itself is going to be written off against the basis of the machine isn't it?

Tom. No, absolutely not. We do not basis adjust the machine. We write off the firm commitment, it's no longer an asset or a liability that we have. And the gain or loss flows through income in the period that we bought the machine. We are not affecting the depreciation expense on the machine on a go-forward basis on the hedge of a firm commitment.

Question/Comment. Effectively being [offset--unsure] is not recording the offset though, am I right?

Tom. You are recording in the period that you buy the machine, the net cash that you had to pay for the machine.

Question/Comment. It's going to be like $2200.00 ---

Tom. We are going to get to an example with entries. That's exactly the example I've got coming up, right? So let's save it until we get to the example.

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Accounting for cash flow hedges;

A cash flow hedge is a hedging relationship where the variability of the hedged item, cash flows is offset by the cash flows of the hedging instrument. That's what the cash flow hedging is. Key aspects, forecasted transactions are balance sheet items of variable cash flows qualify. We've covered that. Existing assets or liabilities subject to cash flow risk or forecasted transactions. The effective gain or loss, now here we are going to do effectiveness differently, didn't we? Now I know this gets complicated but what [unsure] the fair value hedge is the level of effectiveness decided how much the hedged item value will change.

Paragraphs 28-35
Accounting for Cash Flow Hedges

A cash flow hedge is a hedging relationship where the variability of the hedged item’s cash flows is offset by the cash flows of the hedging instrument. Key Aspects:

  • Forecasted transactions or balance sheet items with variable cash flows qualify
  • Effective gain or loss to OCI
  • Earnings recognition matches hedged item
  • Ineffective gain or loss may be recorded in earnings

Here the level of effectiveness will tell you how much of the derivative gain or loss goes to other comprehensive income. Because there is not hedged item, is there? There can't be in a forecasted transaction. So what we are going to do is put the derivative on the books and have the change in fair value either go to, [out of--unsure] other comprehensive income that's fully effected or to other comprehensive income. And earnings to the extent that it's ineffective and the change is greater than the change in the fair value --- the change in the cash flow of the hedged item. I told you that before. We'll get back to that. The effective gain or loss goes to other comprehensive income and then that other comprehensive income holding, that's going to bleed into earnings, as the earnings effect of the forecasted transaction or existing asset or liabilities exposed to cash flow changes bleeds into earnings.

The ineffective gain or loss note I just said --- is that I've been saying --- may be recorded in earnings. That, that one point --- one million or 1.2 million example; it may be in earnings. To the extent that the change in the derivatives gain or loss is greater than the change in the forecasted transaction, that ineffective portion will go into earnings. We know the other way we can't do anything about. Yes?

Question/Comment. Tom, the [unsure] effectiveness gain or loss go [unsure] below the line because it's a forecasted [unsure]?

Tom. Why is it going in other comprehensive income? This is the compromised [board--unsure]. The compromise was --- where did --- what did we used to do with those things? We buried them [unsure] time purposes, equity account items or equity account items. The board --- why did we get Statement 130? You just saw the reason why we got Statement 130. They say, think those changes in value are important economic consequences for the period they don't --- no longer wanted buried in equity without disclosure, so we've got other comprehensive income. But it was a political compromise why does it make it conceptually? It does not. It's there because the companies built one to [perfect--unsure] earnings.

Question/Comment. [Unsure] classified [unsure].

Tom. That's right, yes. Mostly after awhile and then it's going to come out [unsure] into earnings.

Question/Comment. [Unclear]

Tom. Because it's a forecasted transaction, because remember we're trying to [object the--unsure] special accounting is to match the earnings effect --- the earnings effect of the hedged item in the hedging instrument. And here we're not going to have an earnings effect until a hedged item, the forecasted transaction, gets to earnings then the OCI will be amortized into earnings. Complicated, isn't it? Hugo?

Question/Comment. Formerly why do the firm gain or loss reported as liabilities or assets?

Tom. Remember, yes, formerly, but the board said they don't want to recognize it for a gain or loss as ---

Question/Comment. I think it's just [spoken--unsure]. Essentially what the board is saying, if you have a gain or loss on a derivative of a forecasted transaction the company is [either--unsure] better or worse off exposed to [unsure] increase in equity, not in other financial income. But ---

Tom. No, no in other comprehensive income.

Question/Comment. Not in earnings, in other comprehensive income, but this reflects an increase in stockholders equity level because under the old rules they can do quotas, assets or liabilities. They will report the [unsure] assets and liabilities [unsure] reported directly to stockholders equity level [unsure].

Tom. Well where you're miss-speaking, is other comprehensive income doesn't have to be reported in stockholder's equity. Statement 130 would suggest it could be [appended--unsure] to the bottom of the income statement, it could be a separate statement of financial performance, or it could be in the scheduled changes in owners equity.

Question/Comment. But it'll flow through to [accumulated--unsure] other comprehensive income.

Tom. Well, just like earnings flows through to retainers. I mean everything gets to stockholders equity from the income statement, from the statement of financial performance. They both get to equity either retained earnings or other comprehensive income amounts. Yes?

Question/Comment. I didn't quite hear that, did you say --- what if they don't have other comprehensive income, how is that handled?

Tom. They have to have other comprehensive income.

Question/Comment. [Under this one? --unsure]

Tom. Yes.

Question/Comment. [Unsure] under 130.

Tom. What do you mean? I don't ---

Question/Comment. If they ran that through [unsure] approved [unsure] and didn't designate it other comprehensive income ---

Tom. Under 130, you must report other comprehensive income. There's three ways of showing it. But you must report it. And you must report total comprehensive income. One place might be in a supplemental schedule of statement in changes of owner equities account.

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Board views about cash flow hedges;

One of the boards' views about cash flow hedges; they only did it to accommodate constituents. They don't think there's any basis conceptually for resolving a forecasted transaction recognition or measurement anomaly. They don't think that in accounting anywhere do we account for forecasted transactions before they occur. And so what --- they don't believe there's any basis in the conceptual framework to be dealing with this. Because the hedged forecasted transaction is not recorded on the books, derivative gains and losses as a compromise to keep them out of earnings to get the earnings matched going, are deferred in other comprehensive income which adds a layer of complexity to our mind. That's the boards' views. In addition, their views are the gains and losses on derivative contracts do not represent future economic sacrifices on benefits. They will not be treated as deferred gains or losses as assets or liabilities. They will be treated as other comprehensive income items.

Board Views About Cash Flow Hedges

Board decided to permit cash flow hedge accounting as an accommodation to constituents

Because the hedged forecasted transaction is not recorded on the books, derivative gains and losses are deferred in other comprehensive income (OCI), adding a layer of complexity

Gains and losses on derivative contracts do not represent future economic sacrifices (liabilities) or benefits (assets)

Deferring gains or losses on derivatives as a separate component of OCI, rather than as a separate asset or liability, avoids conceptual difficulties and increases visibility for cash flow hedge transactions

Deferring gains or losses on derivatives is a separate component of other comprehensive income rather than a separate asset or liability avoids the conceptual difficulties I just suggested. That's the thinking the board has behind their cash flow hedges. Disclosure requirements related to a cash flow hedge, it means they must disclose a net gain or loss recognized in earnings during the reporting period. How much did it come out of other comprehensive income and earnings? Because the worry is you're going to lose it, it's going to be buried in earnings somewhere. So how much did it get amortized in earnings this period?

Paragraph 45(b)
Disclosure Requirements for Cash Flow Hedges

Net gain or loss recognized in earnings during the reporting period

Description of transactions or other events that will result in reclassification of gains and losses deferred in accumulated OCI into earnings within next 12 months

Maximum length of time entity is hedging forecasted transaction variable cash flows

Discontinued hedge gains and losses because it is probable forecasted transaction will not occur

They also want to know a [foreshadowed or angle--unsure] what might be affecting earnings next period. A description of transactions of events that result in the classification of these unrealized gains or losses in other comprehensive income back in earnings within the next year. There's no --- you can pad --- they don't have any limit on how long a forecasted transaction may last. Maximum length of time the entity is hedging forecasted transaction variable cash flows also must be stated. So if they're actually saying the forecasted transactions five years from now, they have to tell you that. They're saying it's proper --- you will see the definition of forecasted transaction, it must be probable. The longer that period gets out there, the more you wonder about the statement that is probable. And like before when you just can hedge --- discontinue hedge gains and losses because the forecasted transaction is no longer probable, you must talk about how you handled those losses. And what they are going to tell you is the following ---

Question/Comment. If you discontinue the hedge accounting on a cash flow exposure of a forecasted transaction, what might happen if you [had an--unsure] unrealized gain that got handed out? You could [shirk--unsure] that, couldn't you? Not much [shirk--ditto]. You'd discontinue it, you'd got to bleed it into earnings just like you would [unsure] that continue to occur.

Tom. They are not going to let you shirk.

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Accounting for currency hedges;

The board intended to increase the consistency of hedge accounting guidance by broadening the scope of eligible foreign currency hedges. Previously you could not hedge foreign currency exposure with a forward but you could with an option; certain exposures. Now they are going to make it more consistent. The key aspects of this extension to foreign currency exposures are that SFAS 133 allows what you're doing generally for interest rate hedges to end [commodity price--unsure] changes to everything you're doing to currency hedges. And they're doing it separately in this statement because they did not want to eliminate any parts of 52. To the extent that they've changed or extended to 52 it's in this statement. So those cash flow and fair value hedges are permitted for foreign currency hedges. And because some things they don't allow for the other sorts of hedges already were in existence in 52, they are going to let them stay. They didn't take away what was already out of the gate. They are going to allow you to hedge in that investment in the sub. They are going to see in interest rate and commodity price risk sub, they are going to tell you, you can't hedge an equity investment in a sub, and it's after the extent. It has to do with the foreign currency change.

Paragraphs 36-42
Accounting for Currency Hedges

Board intended to increase the consistency of hedge accounting guidance by broadening the scope of eligible foreign currency hedges. Key aspects:

Cash flow and fair value hedges permitted

Carry forward most of the ideas in Statement 52

  • Hedge of net investment in sub
  • Use of nonderivative instrument

Some expansion of hedge accounting particularly for forecasted transactions

The reason why they say that is the net --- when you account for an investment a sub under the equity method, it's not really a fair value exposure, because the change in that earnings that are causing the increase or decrease. So it's very hard to say that it's the underlying that can cause a change in that investment, except to the extent that this is a net investment in a foreign sub that it has a functional currency other than recording currency. Because then what you have to do is translate that back into the recording currency and that is a foreign currency --- that translation gain or loss. Where does that translation gain or loss go to, equity? Other comprehensive income right? And so what they want to do is --- then they are going to allow that derivative change not to be in income, but it's going to be in other comprehensive income. The translation gain or loss, a translation gain or loss goes to other comprehensive income. A transaction gain or loss goes to earnings, under 52.

So they are going to extend this stuff, carry forth most of the ideas, the unusual ideas in 52, hedging in that investment in a sub and the allowed use of a non-derivative instrument as a hedge. That was in 52 and they're not going to take it away for 52. And then they are going to expand hedge accounting for particular --- particularly for forecasted transactions into the foreign currency environment. Last two items before we get to illustration, yes.

Question/Comment. Does the 133 [to faint]

Tom. No, I don't think so. I think this is too recognized that if you take a foreign currency hedge, how did that work before? We had the transaction gain or loss go in earnings. Now we are going to have the derivative recognized and having that change or loss goes into earnings unless they have a previously derivative [faded].

Question/Comment. But previously, we would amortize the discount on premiums [unsure] over the contract period ---

Tom. If it was a cash flow ---

Question/Comment. Well, say you were --- say you hedged a purchase. [Unsure] premium. You would amortize the premium through the revenue or address the basis of the transaction, right? I understand that you can't do that. You can't just amortize on a speculating basis over time.

Tom. Well, I don't know. You can't --- we've got to bring this back to fair value hedges and cash flow hedges. And that's always the way you want to think about these things. Foreign currencies happen to be an application of cash flow hedges in foreign currency and fair value hedges. The extent that the change in the derivative was effectively affecting the fair value of let's say an instrument, a financial instrument with a discounted premium and that means that fair value change the way you are going to have that fair value change reflected is through earnings immediately. So you are not going to change the amortization --- it's not going to bleed through for the discounted premium any longer on a fair value hedge.

On a cash flow hedge, you've to other comprehensive income pent-up and that is going to flow through like the amortization of any discounted premium or any interest rate amortization on a variable rate of existing asset or liability. That is how that is going to happen. So there is going to be some amortization in a cash flow hedge of an existing asset or liability with a variable rate exposure. But it's not going to be consistent across the two because we're going to accelerate the effect of that amortization in the fair value hedge to have that captured in a change in fair value this period in --- for the hedged item.

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Accounting for hedged termination;

Terminating hedge accounting will be done prospectively on a go-forward basis. It's going to occur when the eligibility of the qualifying criteria is not met, they no longer meet all the criterion. When the --- if the derivative expired so they're terminated or exorcised, that's one way to terminate it, the derivatives' no longer there--you can't have a hedging relationship or the hedge designation is removed. That's what is going to happen --- so we can terminate that either by the hedge item going away, the derivative going away, or no longer becoming effective. The effectiveness tests are no longer met. And then we are going to have termination of that relationship.

Paragraph 25
Accounting for Hedge Termination

Terminate hedge accounting prospectively when:

  • eligibility of qualification criteria not met
  • derivative expires, is sold, terminated or exercised
  • hedge designation is removed

In a fair value hedge what happens you stop adjusting the hedge item, right? Derivatives go to be accounted for fair values in change that's what's always true; even without special accounting. Derivatives are going to be accounted for by measuring it at fair value with the changes going to earnings. What's going to stop if you stop a hedged --- a fair value hedge --- is you stop adjusting prospectively the hedged item for any related changes in fair value for interest rates, currencies, etc…

Paragraph 27:  Impairment Issues

Hedged item is still subject to impairment reviews

Apply after basis of hedged item is adjusted for changes in fair value or cash flows

Fair value of hedging instrument is not considered

Under a cash flow hedge, if we terminate it what's going to happen? The derivative was on the books, changes in the derivatives' fair value, instead of going to earnings we're going into comprehensive income. What's going to happen if we terminate the hedge is, we're no longer going to defer that stuff to comprehensive income and we're not going to let them cherry pick by re-classifying the other comprehensive income into income immediately. It's going to have to happen according to the pattern of the documented-hedged relationship. That's what is going to happen to the termination.

Lastly, we should not forget since we're moving around the value of some hedged item in fair value hedges they're going to be subject to normal impairment tests. When do the impairment tests occur? After their basis has been adjusted. After their basis has been adjusted, then we apply the impairment tests to see if they need to be written down. And the fair value of a hedging instrument is always accounted for separately, it's not considered in that test.

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Implementation issues;

Now, we've got some implementation issues that have to be considered when applying the standard comprehensively that we don't have the time to go into great detail about. So what I've given you is a roadmap where to look. Remember I told you they got to work real hard at what a derivative is to distinguish it through things that are like derivatives in the normal company. And they have to --- also they have made a decision that you can't get rid of the thing being a derivative by inventing it in something else that is not a derivative. But you've got to go in and de-couple derivatives from structured notes if --- if --- if --- the risk in the derivative item is not closely and clearly related to the derivative in the [broader--unsure] instruments. What that means is the derivative's fair value is interest rate sensitive and the structured notes fair value is interest rate sensitive, they are not going to force you to take the derivative out.

Implementation Issues

What qualifies as a derivative instrument, including embedded derivatives?

  • See Paragraphs 6-16, Appendix A, Section1, and Appendix E
  • What qualifies as a hedged item?

See Paragraphs 21 and 29 and Appendix C

  • Assessment of hedge effectiveness

See Appendix A, Section 2

  • Transition provisions

See Paragraphs 48-56 and Appendix B, Section 3

But if the derivative's fair value embedded in the structured note is currency sensitive and the notes fair value, the underlying notes fair value is interest rate sensitive, they are going to make you take that out and treat it like a derivative. Now why does that make sense --- it doesn't. Unless you know that eventually they are going to cut a fair value off financial instruments. And then they are going to pick up the other part when it's clearly and closely related. What they're trying to do if they can have very tight criterion not to allow you to avoid the statement by burying the derivative into something else; when it's not related to that thing.

What qualifies as a hedged item? You'll need to go look at Paragraphs 21 and 29, Appendix C, there are limits to what the hedged item might be. They have a whole section of an appendix documenting how you get at the assessment of hedge effectiveness; it's complicated. If you want to apply this statement and implement it fully, you are going to want to visit the hedge effectiveness implementation.

And finally, there are some complicated transition provisions that even for somebody who has spent a lot of time in derivatives made my head hurt, trying to figure out what they were trying to do. Transition provisions, how do you implement it at the start? They are not going to retroactively go back and try to make you catch up for anything. But then they've got a lot of complicated decisions as to what they do with the derivatives and a hedged item in retrospective gains or losses so that there is a fair cumulative change in the accounting principles; you want to look at what I suggest there.

Let's move on and move into some illustrative examples; a illustrative examples. Then hopefully this will clear up some of the complications. Isn't this a bloody complex standard? We are going to look at a fair value hedge, we are going to look at a cash flow hedge. I'm going to tell you the board knows it's complicated. So after we do these basic two hedges if you want, my goal here is to get you to understand the basic ideas. And when you want to go bells and whistles, you are going to have to go to the standard and build from there. And so there's a whole series of illustrations in the standard of how to apply this. We are going to go through two examples and then I will suggest to you Appendix B of Section I as an excellent place to go on with other examples.

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Illustrative Examples

Illustrative Examples

  • Fair value hedge
  • Cash flow hedge
  • Appendix B, Section 1

Example 1 (Fair Value Hedge);

Example 1 Introduction

I want to do is a fair value hedge. And as a reiteration, I remember we said a fair value hedge is a hedge of a change in fair value of either a recognized asset or liability, or an unrecognized firm commitment, attributable --- we'll see --- to a particular risk. And that's defining what the hedged item might be and I'll give you some bigger background on that. Here's again that example of a perfectly effective fair value hedge. Where the hedged instrument in the hedged item changes in fair value perfectly offset over periods of time.

You know we are not too good at defining what fair value is, are we? SFAS 107 didn't give us a very good definition. And the board contemplated working very, very hard at giving a better definition of SFAS 133 and said no, they can't do that. What's holding them up from going to all fair --- for fair value in all financial instruments, they don't know how to measure fair value. They have their liability concerns so you also must know that in this project report is foreshadowing; this is a temporary thing. They are going to park fair value in all financial instruments until they can figure out a way to come up with a liable measure of fair value.

Definition of a Fair Value Hedge

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But they do expand the definition of fair value within this statement beyond what was in SFAS 107. So I want to let you know that their definition of fair value is defined as the amount at which an asset or a liability can be bought or sold in a current transaction between willing parties, other than in forced liquidation --- forced a liquidation sales. So there's no discounted premium for restructured securities, or large block sales that would affect the price because you're flooding the market. It's a normal transaction; it's the price you'd expect to see in a normal small transaction.

Definition of Fair Value

Fair value is defined as the amount at which an asset (or liability) can be bought (or incurred) or sold (or settled) in a current transaction between willing parties, other than in a forced or liquidation sale.

  • Quoted market prices are the best indicator.
  • In the absence of quoted prices, use other valuation techniques.

The starting point is going to be the quoted market price on an exchange for a lot of these instruments; there are not going to be quoted market prices. And so they are just going to have to be estimates and absence of quoted market prices, other valuation techniques can be used that's exactly why we're going to have a new concept statement. Note how everything is sort of building off this project. We're having a new concept statements aren't we [unsure] using present value and measurements. Why do you think they are all concerned about using present value measurements? Where are you going to have to use present values within the [unsure] literature? You have to use it; one way to estimate when you don't have an observable market transaction price is take present value of the expected cash flows, right? That's one way of coming up with the fair value. I think that they address that in the concept statements because they needed further guidance in developing and moving toward accounting for financial instruments.

Now remember it's either an asset --- a recognized asset or liability or firm commitment that get fair value exposure. Under SFAS 133, a recognized asset or liability is defined as an asset or liability recorded in the balance sheet, kind of redundant with the word recognized. But it's not a future transaction or an unrecorded intangible asset. Hedgeable asset or liabilities under this definition include available for sale securities, which have fair value exposure. Fair value is recognized in or available for sale under comprehensive income. We've got an earnings recognition anomaly here if the derivative is being recognized in earnings, right? The changes being recognized in earnings, how will we [affix--unsure] that? For available for sale securities is no longer going to be that gain or loss going to other comprehensive income. To the extent that it's effective it'll be going to --- earnings.

Definition of a Recognized Asset or Liability

A recognized asset or liability is defined as an asset or liability recorded on the balance sheet (i.e., not a future transaction or an unrecorded intangible asset).

Hedgeable assets or liabilities include:

  • Available-for-sale securities
  • Commodity-type inventory
  • Fixed-rate loan obligations

Question/Comment. Only if it's hedged, right? [Rest unclear]

Tom. Yes, exactly. Commodity type inventory also would qualify as well as fixed rate loan obligations. Here's a commodity price risk, here's an interest rate price risk, here's a [two--unsure] total fair value risk --- total fair value risk.

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Example 1 Firm commitment

What's a firm commitment? A firm commitment has the characteristics of an asset or liability, except it's fully executory on both sides and must be specific as to the price, quantity, and timing of the firm commitment transaction. It must be with an unrelated party; binding on both parties and legally enforceable, and it must be probable consistent with the definition of probable under Statement 5 due to significant --- due to a significant [disincentive--unsure] for nonperformance. There must be an [expo--unsure] settling up if this isn't going to happen to be a firm commitment.

Definition of a Firm Commitment

A firm commitment has the characteristics of an asset or liability and must be:

  • Specific as to price, quantity, and timing
  • With an unrelated party, binding on both parties and usually legally enforceable
  • Probable due to significant disincentive for nonperformance

Example: Agreement with an unrelated party to purchase five machines (a fixed quantity) for $500 per machine (a fixed price) in six months (fixed timing)

Now this seems to be a lot more stringent requirement than what you'll see when we get to forecasted transactions, but this is a firm commitment. An example would be an agreement with an unrelated party to purchase five machines for $500 in six month's time. You need to know amount, timing, and quantity and it's got to be enforceable, a likely penalty if it's not.

Question/Comment. What if you have a [unsure] supplier who has allowed the company to cancel the contract because they're good customers and five out of six times they go through contracts but sometimes they cancel them. Let's say aircraft ---

Tom. It's no longer going to be ---

Question/Comment. Or they order [unsure of rest]

Tom. Remember I told you a hedge item that does not qualify as one that's in a normal purchase order for your company. That's not even going to be a hedged item even though it looks like it's a firm commitment, it's not going to be there. Because they are not disturbed the relationship of recognizing in earnings the revenue and expenses in a delayed basis that we have in a basic operating model. But to the extent--what if--I don't know. I don't think that they cover that "what if' within SFAS 133, but it is possible in my reading of the 470 pages that I didn't pick it up. So I don't know the answer, but I don't think they covered that "what if" contingency.

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Example 1 (Fair Value Hedge Accounting)

again we had those key concepts. Derivatives are always recorded on the balance sheet at fair value. The change in the derivatives fair value is always recognized completely in earnings. And the extent that it's an effective offsetting gain or loss on the hedged items, they are going to be recognized in earnings at the same time the derivative change is recognized in earnings and that will adjust the carrying amount of the hedged item. That's in summary what we've been saying about fair value hedge accounting.

Fair Value Hedge Accounting

Key concepts:

Derivatives are always recorded on the balance sheet at fair value.

The change in a derivative’s fair value is always recognized in earnings.

Offsetting gains/losses on hedged items are recognized in earnings and adjust the carrying amount of those items.


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Example 1 Hedgeable Items

What are the viable hedged --- hedgeable items under SFAS 133? Changes in the fair value, the following items can be hedged, financial assets or liabilities; four specific risks will fall within the financial asset and liability list. I will share that with you in the next [slot--unsure]. And non-financial assets and liabilities like commodities, changes in fair value, those items can also be hedged. But the only risk that can be hedged is the risk in the change in the whole fair value of the item, not parts. So the extent there's interest rate risk in non-financial asset and liability, they're not going to let you pull it out. They think that it's not as well priced and that there are other factors. Remember we talked about some of the implications of foreign currency changes in the Dollar-Yen exchange rate effecting some value of Toyota's inventory? They think that there's going to be problems.

SFAS 133 Criteria
Hedgeable Items

Changes in fair value of the following items can be hedged:

Financial assets or liabilities (four specific risks can be hedged)

Non-financial assets or liabilities (the only risk that can be hedged is the risk of changes in fair value of the entire hedged asset or liability)

Note: Assets or liabilities already measured at fair value through earnings, such as trading securities, cannot be hedged items.

So it's only the fair value of the entire non-financial asset or liability that can be hedged, or parts of the fair value changes can be hedged in financial assets and liabilities. No assets or liabilities already measured at fair value through earnings such as trading securities are out of the ballpark here. They're already --- if we just account for the derivative in the change in fair value through earnings and the trading securities as they are, we're back to what we are trying to achieve in hedge accounting anyhow. We don't have to go through all the documentation and effectiveness and ineffectiveness. The extent that it's already --- everything is already flowing through earnings the [degrees--unsure] of effectiveness and ineffectiveness is appearing naturally through all the efforts. Yes?

Question/Comment. [Unsure] available for sale which currently goes to comprehensive income [unsure] the effective portion still goes through comprehensive [unsure]

Tom. No, I think it's the effective portion ---

Question/Comment. It seems like you switched that somehow.

Tom. All of it's been moved, must be --- all of it. [Unsure] even the ineffective earnings effected available for sale. You are not going to let it go up at all because you want the ineffective portions' flow through earnings. You can re-classify all of it in [earnings--unsure]. The fact that it's not a full offset [unsure].

But there are those issued that make this an extremely complicated standard. So we got general statements about what is happening and the specific circumstances that we're trying to reach the same objective, but the accounting might be slightly different. Risks that can be hedged for financial assets or liabilities remember there are four categories. It can be the entire items fair value change that can be hedged, or interests rates, currency rates, or even the [unsure] credit worthiness--credit risks. Note: some financial instruments have pre-payment risks, don't they? We can prepay our mortgage, right? They are going to say --- and I don't --- I have not figured out the logic of this. You cannot bifurcate or trifurcate or whatever it is, you can't pull out the pre-payment risks separately and hedge it unless the pre-payment risk is associate with having an embedded option in your contract. And that's what we have with our mortgage, right? A fixed rate mortgage we have an embedded option to be able to pay it back.

SFAS 133 Criteria
Risks That Can be Hedged

For financial assets or liabilities, the hedged risk can be the risk of changes in fair value :

  • Of the entire hedged item
  • Due to market interest rates
  • Due to foreign currency exchange rates
  • Due to an obligor’s creditworthiness

Note: Prepayment risk cannot be the hedged risk. (However, the option component of a prepayable instrument can be designated as the hedged item.)

So the extent that you can represent it as an embedded option, you can pull up the options separately and hedge that risk. But other sorts of pre-payment risks which I don't understand wouldn't be an option, can't be hedged separately. I haven't thought that through well enough to figure that one out. But that's the statement within SFAS 133. It would seem to me that all those are options, or option equivalent.

Items not qualifying for hedge accounting, there's a whole series of other ones. Mostly there are ones that do not qualify for hedge accounting because they don't affect earnings. Projected purchases of treasury stock, the gain or loss is going to go right to stockholders equity. You remember special accountings only occur to try to get the earnings effects to match. There is no earnings effect on that transaction. In addition, we have inner-company transactions between subsidiaries. We can't hedge between subsidiaries unless it's dealing with foreign currency risk, between subsidiaries in a company. And anticipated stock issuances in relation with stock option plan that's not recorded in earnings because it's not a compensation expense, again does not have a earnings effect so you're not going to be able to hedge those sorts of exposures; the fair value interest rates currencies or commodities.

Other exclusions, a whole long lists. Some of them are scoped out because the accounting is specially covered in an existing statement that's under reconsideration for the board under business combinations. And in the business combination area and because of that, since it's such a complicated message or business combinations they didn't want to make the decision ahead of time and lock in. They are going to consider most of these issues within that full project, and that's what most of those items pertain to. But as you can see complicating items, you can't hedge certain items.

SFAS 133 Criteria
Items Not Qualifying for Hedge Accounting

Transactions not affecting earnings do not qualify for hedge accounting, such as:

  • Projected purchases of treasury stock
  • Intercompany transactions (except foreign currency)
  • Anticipated stock issuances in relation to a stock option plan for which no compensation expense is recognized for changes in stock price
  • Equity method investments
  • Minority interests in consolidated subsidiaries
  • Equity investments in consolidated subsidiaries
  • Firm commitments to enter into business combinations
  • An equity instrument issued by the entity and recorded in stockholders equity


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Example 1 Data and Journal Entries

Let's do an example of a fair value of a firm --- fair value hedge of a firm commitment. XYZ manufacturers Titanium products, his Titanium supplier requires a six-month firm commitment. So the supplier's insisting that, that be a firm commitment to buy the Titanium. On 1/1/X1, the firm enters into a confirmed --- a firm commitment with its supplier to buy 10,000 units at the current forward rate of $310 per unit on June 30th; remember amount, timing, quantity, firm commitment. XYZ wants to purchase and record their Titanium at whatever the market price will be on June 30th. They don't want to be in a fixed rate position. They don't want to have to record it at $310; they want to record it at whatever it is on June 30th. So what they do is they enter into a forward contract, remember they're buying these instruments for $310. They enter into a forward contract to allow you to sell it for $310.

Example 1:  Fair Value Hedge of a Firm Commitment

XYZ manufactures titanium products. Its titanium supplier requires a 6-month firm commitment. On 1/1/x1, XYZ enters into a firm commitment with its supplier to buy 10,000 units of titanium at the current forward rate of $310 per unit on 6/30/x1.

XYZ wants to purchase and record the titanium at whatever the market price will be on 6/30/x1. Therefore, on 1/1/x1, XYZ enters into a forward contract to sell 10,000 units of titanium at the current forward rate of $310 per unit.

Hedge effectiveness is based on changes in the 6/30/x1 forward price of titanium.

Opposite exposures, right? If you're going to buy it for $310 and the price goes up, you win. If you're going to sell it for $310 and the price goes up, you lose. You're going to end up counteracting the effects in changes in prices between 1/1 and June 30th. Hedge effectiveness is based on changes in a 6/30/X1 forward price of Titanium. So they're going to be looking at the hedge effectiveness measurement based on the forward prices not the [spot--unsure] prices, which is present value into effect. But what we are going to see is that is a perfectly --- that sort of contract is a perfect hedge.

Here's some information, on January 1st when you contract; spot rate is less than the forward rate that makes sense; time, value and money. The fair value of the forward is zero. Because under forwards, you're exposed to both upward and downward price movements and [unsure] likely it's zero. And the fair value of the firm commitment is zero. This is the example you have been asking me to talk about before. When do we do with this firm commitment? The fair value is zero, because we're only going to recognize the firm commitment to the extent that there's been changes in the fair value to the changes in Titanium prices here. And at times zero there's been no change, has there been, in price.

Example 1:  Added Information

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March 31st prices went down both in the spot and forward markets. In the forward market, we can sell it for $310, when it's $297 now, if it came up. That's a win on our part, isn't it? The forward has value now because it allows us to sell something for what we --- for $310 when it's now $297. You've got a value with debit value for the forward. What's the value of the firm commitment? It's exactly the opposite. It's forcing us to buy it at $310, not $297. So you've got a loss on a negative liability [unsure] a liability from the firm commitment to pay an extra amount above fair value. June 30th we get the same sort of thing. Where the $128,079 is adjusted for fair value, folks.

And then finally on June 30th, if price goes down even further, the spot in the forward rate is the same as $285. Such that the forward is going to deliver to us $250,000, the savings by being able to sell something for $310 when it's worth $285 but the firm commitment is going to make us pay that out. How are we going to account for this situation? At times zero that at the signing of the contract, we do nothing. Firm commitment doesn't have any value because the Titanium price hasn't changed. And the derivative doesn't have any value because it's a forward. So the first answers are going to be at a quarterly recording on March 31st, that is going to need to reflect the changes in value. Remember the idea is, reflect the change in value of derivatives fully in earnings and the change in value of the hedged item, the firm commitment to the extent that it's effective; this is fully effective.

We've got a forward contract that we debit for $128,079 and credit a gain on the forward contract for the value of the forward contract caused by changes in Titanium prices over that three-month period. And we establish a firm commitment to have to pay an extra amount above fair value, a liability of $128,079. That tells you you've got your loss on firm commitment by having it locked in at $310. That's your March 31st.series of entries.

Example 1:  Journal Entries at 3/31/x1

Forward contract                128,079
     Gain on forward contract            128,079
To record change in fair value of forward contract

Loss on firm commitment     128,079
      Firm commitment                    128,079
To record change in fair value of firm commitment


Example 1:  Journal Entries at 6/30/x1

Cash                                250,000
      Forward contract                     250,000

To record cash receipt upon settlement of forward contract

Titanium                     3,100,000
      Cash                                  3,100,000
To record purchase of titanium at contracted rate

Firm Commitment     250,000
      Titanium                            250,000
To derecognize the firm commitment and adjust the carrying amount of the titanium purchase

Question/Comment. And they cannot be netted.

Tom. What's that? They cannot be netted. They --- assuming materiality, they can't be netted.

Question/Comment. At the line or below the line?

Tom. I would suspect those --- when you say below the line, you're talking about operating income?

Question/Comment. Net income, net income.

Tom. Above the line, it's earnings. [Unsure] in earnings, all fair value effects go to earnings and other comprehensive income.

Question/Comment. And the balance sheet [rest unclear].

Tom. No, that's right, absolutely. We're --- we are treating this as if we've got one thing going on and another thing going on. The derivative's another thing, but the odd thing here is we're picking up something on the balance sheet we wouldn't normally pick up. Ok, no we go to the fair value hedge of the firm commitment. On June 30th, we have an additional gain on the forward contract to bring us up to the $250,000 gain. And we've got an additional loss on the firm commitment so it's adjusting we're going to have to pay even more beyond fair value for the Titanium product. So you've got the gain or loss picked up.

Then what do we do? On June 30th, we settle the forward contract don't we? We get the cash, $250. That's the value they're going to have to settle us for on that contract. Also on June 30th we are going to have to record the Titanium at its fair value. The $3,100,000 at the transaction price rate, yes it's not its fair value, it's the transaction price rate that we're calling fair value on this contract. And we're going to wipe out the firm commitment. It's no longer a firm commitment. We're going to --- no, it is at fair value, [I did not net it--unsure] at fair value, good. So we're going to end up adjusting the fair value of the Titanium for the firm commitment. So we do get the fair value. I wasn't answering your question right before.

Question/Comment. This is why [unsure] question a number of us have. Under prior fractions would've happen is this $250,000 gain in the forward contract will be [unsure] reduce the cost of Titanium just like this is happening. You would actually have the same result as the effect of the [unsure] of Titanium. Prior practices [unsure]. It is offset ---

Tom. The deferred gain [unsure] increase the fair value of the Titanium, wouldn't it?

Question/Comment. Well, you'd have deferred gain to get credit ---

Tom. I'm not going to kill myself over that. I would suggest that was going to be --- that would be originally in the carrying value of derivatives but it would have to be amortized [to expense for accounting--unsure of phrase]. It would not end up on the Titanium. A contact, but I think it's going to some material that might end up being buried in the cost of the Titanium, in the end. But in concept, that's something that you're gaining benefit over the derivative contract from.

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Example 2 (Cash flow hedge);

Now a cash flow hedge example: a cash flow hedge is a hedging relationship where the variability of the hedged items' cash flows are offset by the cash flows of the hedging instrument. So know what happens here; you've got a cash out for LIBOR debt, so it's going to have a variable amount of cash flows, and that swap ends up having the change in effect so that it fixes the outflow at three. And so in this setting you would've been $285 under LIBOR, but the swap ends up having a net inflow of .15 fixing what's happening of its --- extra outflow fixing the expense at three. And another situation when it goes up to 3.35 under the variable rate, it offsets to bring it back to three. So that is what's going to be the nature of the hedging relationship when they say offset. It's going to offset meaning going to a non-variable cash flow. In other words, you change the cash flows exposure to a fair value exposure.

Example 2:  Cash Flow Hedge

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Example 2 SFAS 133 Criteria Hedgeable Items

Cash flow hedge provisions allow an entity to designate a derivative to a recognized asset or liability such as a variable rate bond and a forecasted transaction such as anticipated issuance of a fixed rate debt. Note: fixed rate debt can have a cash flow exposure because it's only the interest portions over a certain time can be exposed. SFAS 133 criterion: financial asset and liability, hedgeable risks.

SFAS 133 Criteria:  Hedgeable Items

Cash flow hedge provisions allow an entity to designate a derivative instrument as a hedge of the exposure to variability attributable to specific risks in the cash flows of:

  • A recognized asset or liability such as a variable-rate bond
  • A forecasted transaction such as an anticipated issuance of a fixed-rate debt

When we're looking at financial assets and liabilities for forecasted purchase or sale of the financial asset or liability, the hedgeable cash flow risks include changes on the cash flow related to the purchase or sale of the entire asset or liability. The full cash flow hedge, or to market interest rate or to credit worthiness. So if the cash flow exposure's here, when they talk about cash flows, that's all they're picking up. What are we missing here? We're missing currency hedges but that's going to be picked up in that extra stuff, the extra part of the statement and so it really should be currency in there too. They are not talking about a cash flow hedge in a financial asset or liability related to commodities. That's going to be in non-financial [faded].

SFAS 133 Criteria: Financial Asset and
Financial Liability Hedgeable Risks

For forecasted purchase or sale of a financial asset or liability, hedgeable cash flow risks include:

  • Changes in the cash flows relating to the purchase or sale of the entire asset or liability
  • Changes in market interest rates
  • Changes in the obligor’s creditworthiness

Eligible forecasted transactions must be either a single transaction or a group of individual transactions that are probable to occur consistent with SFAS 5, and be with a third party to the reporting entity and present exposures to variations in cash flows for hedged risks that could effect reported earnings. And the whole notion again here is if it could effect reported earnings, then we want to be able to deal with recognizing the derivative gain in earnings at the same time. If it couldn't effect reported earnings, we are not going to be able to have this recognition or measurement anomaly that we need to fix.

SFAS 133 Criteria:
Eligible Forecasted Transaction

The eligible forecasted transaction must be:

  • A single transaction or a group of individual transactions
  • Probable to occur
  • With a third party external to the reporting entity and present an exposure to variations in cash flows for the hedged risk that could affect reported earnings

Ineligible forecasted transactions that do not qualify for cash flow hedging include items subject to re-measurement with changes in the value, attributable to hedge risks reported currently in earnings. It's already in earnings, if you don't want to defer the derivative gains or loss and other comprehensive income. And that is going to come up with a foreign currency hedge of a transaction gain or loss. A foreign currency exposure of a transaction related to --- transaction gain or loss goes to earnings. And so we are going to want to be able [unsure] cash flow hedge when that's not going to be eligible, because you don't want to bring it to other comprehensive income. You want the derivative gain or loss in earnings. The interest rate risk of a forecasted purchase or sell of a held-to-maturity-security, well the whole idea about having held-to-maturity-security is, you're holding it to the end so you're not exposing the interest rates. So don't tell me you've got an interest rate exposure. Because you're going to hold it until the end and you're not going to be exposed to interest rates because you're going to keep it until the end.

SFAS 133 Criteria:
Ineligible Forecasted Transaction

The following items do not qualify for hedging:

  • Items subject to remeasurement with changes in value attributable to the hedged risk reported currently in earnings
  • Interest rate risk of the forecasted purchase or sale of a held-to-maturity security
  • Forecasted business combinations subject to Opinion 16 or related to a parent company's interest in a consoli- dated subsidiary or an equity-method investment

Forecasted business combinations subject to Opinion 16 are related to a parent companies interest blah, blah, blah. That's just --- let's keep the business combination project separate. They've got enough problems with that without considering the implications of the hedge accounting model in that business combinations project at this time.

SFAS 133 criterion in terms of earnings recognition, and entities risk management strategy may exclude a component or derivatives change in fair value. In other words, in the effectiveness test again you don't always have to look at the full change in the derivative to determine the effective amount. This amount is recognized currently in earnings. It's by definition ineffective. But you can exclude it and not end up having to lose special accounting, if you exclude it as being something that you're not managing. Other ineffective portions, now if you put them in the [effectiveness--unsure] test, other ineffective portions of the hedge may be recognized in earnings, we talked about this several times. Is the change in derivative less than --- value less than the change in the hedged items' value? If the change in the derivatives value is there, that's all going to go in other comprehensive income. But if the change in the derivative value is more, the portion that's ineffective goes into earnings.

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Example 2 Cash Flow Hedge Earnings Recognition

SFAS 133 Criteria: Earnings Recognition

An entity’s risk management strategy may exclude a component of a derivative’s change in fair value

This amount is recognized currently in earnings

Other ineffective portions of hedge may be recognized in earnings

Is change in derivative less than change in hedged item?

Amounts in OCI shall be reclassified to earnings when the hedged item affects earnings

Amounts and other comprehensive income as we said shall be [re-classified--unsure] to the earnings when the hedged item effect earnings. Example: here's a cash flow hedge of a forecasted inventory sale. So it's revenue, right? What are we going to get in cash from a sale of inventory? We're really hedging the revenues. We're not hedging the inventory itself; we're hedging the revenues. ABC designated the risk being hedged as its cash flows are related to a forecasted sale of a 100,000 bushels of Commodity A at the end of period one. So a year from now --- the bushels cost was a million dollars. That was --- will be the cost to [consult--unsure] and the first day of period one we want to hedge that cash flow risk. Right now it can go up and down as market rates go up or down, right? They obviously must be worried about the market rate going down.

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Example 2 Data and Journal Entries

ABC enters into a derivative contract to sell those 100,000 bushels at a fixed price of 1.1 million dollars at the end of period one. It's a forward contract. At hedge inception, the derivative's at the money that means that 1.1 million dollars is forward discounted to the present is equal to the rate today. So its fair value was zero in its inception. The hedge has no ineffectiveness because all the terms of the forecasted sale on the derivative match. There are not changes in fair value other than attributable to the underlying we're worrying about and the terms are exactly the same 100,000, same date.

Example 2:  Cash Flow Hedge of
a Forecasted Inventory Sale

ABC designated the risk being hedged as its cash flows related to a forecasted sale of 100,000 bushels of Commodity A at the end of period 1 (the bushels originally were acquired for $1 million).

On the first day of period 1, ABC enters into Derivative Z to sell 100,000 bushels at $1.1 million at the end of period 1. At hedge inception, the derivative is at-the-money (i.e., its fair value was zero).

Hedge has no ineffectiveness because all terms of the forecasted sale and the derivative match.

At the end of period 1, Derivative Z has a fair value of $25,000 and the 100,000 bushels of Commodity A were sold for $1.075 million.

At the end of period one, Derivative Z has a fair value of $25,000. Why would it have a fair value of $25,000 if prices go up or down? Down, because we're going to get to sell it for more than we thought, by locking in at the 1.1. And the 100,000 bushels is worth less than the $1.1 million. The price went down.

Let's look at the accounting. Journal entries, at again the beginning of the year there are no need for journal entries. The fair value of a derivative is zero was at the money. We are not going to recognize the hedged item in the books at all. So what are we going to do? Derivative Z is going --- but at the end of period one, Derivative Z has a $25,000 value. It's letting you sell something for 1.1 million that has a fair value of 1.075. It's got $25,000 in value. So we recognized the Derivative Z contract and since this is a hedging relationship, the change in the fair value of the derivative does not go to earnings with other comprehensive income. At that date, we also settle that contract and get that cash, $25,000. What else happens at that date? We sell it, what do we record the sale at? Its price that day, $1,075,000, we record the cost, it gets sold, the [matching--unsure] has it at a million and we bleed into earnings the gain on the derivative's contract, such that now we are accounting for this as if it was a transaction without derivatives, right? The original one is what we recorded if we hadn't hedged it. But the gain we got by hedging this goes to earnings.

Example 2 Journal Entries at the End of Period 1

Derivative  Z                25,000
     OCI                                       25,000
To record Derivative Z at fair value

Cash                                25,000
     Derivative Z                               25,000
To record settlement of Derivative Z

Cash                            1,075,000
     Revenue                           1,075,000

Cost of goods sold   1,000,000
     Inventory                           1,000,000
To record inventory sale

OCI                                25,000
     Earnings                               25,000
To reclassify amount in OCI to earnings upon inventory sale

Question/Comment. Tom, you mentioned earlier the idea of amortizing what's in OCI in [terms--unsure]. For example, if this had been a forecasted purchase of a plant asset ---

Tom. What would've happened is ---

Question/Comment. [Over--unsure] five years, let's say ---

Tom. And straight line depreciation for five years ---

Question/Comment. Right, right.

Tom. You'd bleed this in 1/5, 1/5, 1/5.

Question/Comment. Thank you.

Tom. What's the effect of this thing? Forecasted cash flows for a $1,100,000; actual cash flows really were $25,000 in the derivative and $1,075,000 in the sale of the inventory. So what will be net getting? A $1,100,000 the variability of the cash flows was offset by the derivatives. But we recognized the derivative gain as a derivative gain, not as revenue from that contract.

Example 2:  Cash Flow Summary

Forecasted cash flows:                 $1,100,000

Actual cash flows:

Derivative                                $25,000

Sale of inventory                    $1,075,000


Variability of cash flows is offset by derivative


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Advanced Topics

Accounting for the ineffective portion of the hedge, I don't even think that's really advanced and I think we've talked about that. But if you want to --- still want to see that, you are going to look at Appendix B, Section I of the Statement, to see how that would work. And also [the kind--unsure] for fair value and cash flow hedges under a swap arrangement, it'll hurt, it's complicated. There's a simplified method and a full method and it will take time.

Advanced Topics

Accounting (1) for the ineffective portion of a hedge and (2) for fair value and cash flow hedges when swaps are the hedging instrument

See SFAS 133 Appendix B, Section1

Accounting for foreign currency risk in the net investment in a subsidiary

See SFAS 52

Application of the clearly and closely related criterion to determine the existence of embedded derivatives

See SFAS 133 Appendix B, Section 2

Hedging of a portfolio of similar assets or similar liabilities

See SFAS 133 Paragraph 21(a)(1) and Appendix C

Accounting for foreign currency risk in the net investment in the sub is really like a fair value hedge in that are. So I don't know if all that's --- all that complicated but it's not in SFAS 133. Everything that pertains to that's still in Statement 52. Other advanced topics are the application of that clearly and closely related criterion to determining existing --- existence of embedded derivative. There's a whole section in Appendix B to help you pull out and realize what that is. And then, there is the possibility that you don't --- one problem with this statement I'll say in a moment is [key concentrates--unsure] on transaction's risk management. And so what could really happen if I hedged the exposure to one item here? He can [unsure] the total exposure depending if I had liability which would be bigger on the other side, and it's stupid, uneconomic accounting. It really is. So they would have loved to have gone entity risk reduction, entity wide hedging, they couldn't figure out any way to hedge [her--unsure] in terms of effective and ineffectiveness. So they [cut--unsure] it.

But there one concession is you can hedge a portfolio, similar assets or similar liabilities, but it's got to be really damn similar, REALLY similar. So if the fair value price changed in the hedged item 10% and one of them, the other one has to change either 9 or 11%; if it's 7 or 13%, it's not similar. You can't group them together. Did you want to look at that?

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Evaluation of SFAS 133

Let's close with my evaluation of this statement, three slides. I think it's a clear improvement over existing practice. I think at the start of this model, the model was broken as being in what I had my enforcement hat on at the SEC. You can ask Kathy Cole who used to be at the SEC, this was a bloody, impossible mess to get any sort of consistency in the accounting under the old model. So this is an improvement, it's a complex improvement, but it's an improvement. It increases the transparency of derivatives in the financial statements by reporting their effects separately and having them as assets and liabilities. It provides a complete and consistent accounting model for all sorts of derivatives and hedging transactions; that's the improvement over existing practice.

Advantages of SFAS 133

A clear improvement over existing practice

Increases transparency of derivatives in financial statements

Provides a complete and consistent accounting model for all types of derivatives and hedging activities

Guidance is consistent with the Conceptual Framework

And the choices that were made are consistent --- much more consistent --- consistent with our conceptual framework than the ability to defer gains or losses and assets or liabilities for adjusting the basis of a hedged item. To treat it as if it was different for a company that hedges a risk than not. This is the same darn asset. So it pulls those things apart. There's more consistent --- guidance consistent with the conceptual framework.

What's the problem? This is complex as you can get. It's going to be a challenge for us to figure out, much less to [communicate to our --unsure] students. Secondly, for fair value hedges, remember we've got this hybrid nature of the measurement attribute. If we're not hedging the whole fair value, we're changing it for just a portion of the fair value change, what's that? They also are really [cute--unsure] whenever I say about this firm commitment. We do not record deferred gains or losses as assets or liabilities, they say. Well, what are we measuring the firm commitment's value at? In the amount of deferred gain or loss. It's still an asset or liability, but it's kind of [cute--ditto] in that process.

Disadvantages of SFAS 133

Extremely complex standard

For fair value hedges, hybrid nature of measurement attribute for hedged item

Promotes risk management at transaction level

Promotes derivatives as only hedging instrument

Two other bad things, it promotes risk management at a transactions level. The derivative's sellers love our accounting because they can go out and it promotes everybody to think about hedging the risk in one sort of hedge item, or one sort of forecasted transaction. It doesn't tell them --- think big picture folks --- think about whether it's netting out in all your other courses --- all you other instrument's positions and transactions in your portfolio. Maybe then you don't need a derivative to hedge this thing. If we force you to think about this one little transaction, I guess they are going to sell more derivatives.

Note from Bob Jensen:  What is also troublesome in SFAS 133 is the lack of guidance for measuring fair value.  Derivatives must be booked at fair value, but there is very little guidance for measuring fair value when contracts are either customized or traded in markets too thin for reliable value estimation.  The majority of interest rate swaps and forward contracts are custom contracts for which there are no markets.   Professors Sundem and Abdel-Khalik make a claim that the historical cost model itself is broken and that SFAS 133 is simply another futile attempt to patch up a broken model.

Question/Comment. Can I [unsure] one more [unsure]?

Tom. Yes, I won't disagree.

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Look to the Future

I think it's going to come to the point where we ask the question is hedge accounting appropriate? Is this really --- I taking a view in this sort of [unsure] notion any different than speculation? Is it really appropriate for us to do all this work? Think that question is going to be asked more. Now we are going to take care of some of the problems because the board has committed to move to fair value in all financial instruments. And so this hybrid nature of the hedged item will go away. We won't have any hedging criterion, any designation, none of this stuff [unsure] hedging because all financial instruments are going to be fair value with changes going into earnings. Effectiveness and ineffectiveness are going to appear on the right periods; no earnings or recognition anomalies, measurement or recognition anomalies.

Look to the Future

Is hedge accounting warranted?

Risk management also involves "taking a view", which is similar to speculation

Fair value all financial instruments

Discontinuation of cash flow hedges of forecasted transactions?

Finally they foreshadow in SFAS 133; they hate cash flow hedges. And when they go back to this, they must take it away. Will they have the political power to take it away will be the question. Because they don't think there's an earnings recognition or measurement anomaly on the cash flow side. So those are some things that might be on the horizon.

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Closing Remarks

Closing Remarks

For electronic copies of the slides for use in classroom presentations at a college or university, please contact me at linsmeie@uiuc.edu

Thanks for your attention!

Closing remarks as I said before, if you want copies of these slides for your use you can send --- ask me for them. Finally, thanks for your attention.

Bob Jensen's SFAS 133 Glossary and Transcriptions of Experts

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