FAS 133 Overview (MP3 Audio Version)
Bob Jensen at Trinity University

Table of Contents

Interest Rate Swap Valuation, Forward Rate Derivation,  and Yield Curves
for FAS 133 and IAS 39 on Accounting for Derivative Financial Instruments 
See http://www.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm

Introduction

Financial Derivatives & Scandals Explode in the Early 1990's

Derivative Financial Instruments Frauds --- http://www.trinity.edu/rjensen/fraud.htm

 

Warnings to Users of Financial Accounting Textbooks

For this Spring 2002 Semester, I naively adopted, as a supplementary textbook, the following book:

Business Analysis & Valuation:  Using Financial Statements by Krishna G. Palepu, Paul M. Healy, and Victor L. Bernard, (South-Western, Second Edition, 2000)
Note that there are two versions of this book:  One version is a short paperback version without cases and the other is a long hard copy version with cases.  The paperback version's identification number is 
ISBN 0-324-01565-8.  
See http://www.swcollege.com/acct/palepu/palepu.html 

Now I greatly regret my naive assumption that the above Edition 2, with a copyright date of Year 2000, incorporated the immensely important FAS 133 issued in June 1998 and followed by an extended standard FAS 138.  Sadly, the PHB book makes no mention that, for the first time in history, derivative financial instruments must be booked and adjusted to fair values at least every 90 days.  Unbooked derivatives caused the collapse of Enron, Long Term Capital, and Orange County.   Huge  dangers in derivatives investing are sensationalized in a 1993 CBS (Sixty Minutes) video at 
http://www.cs.trinity.edu/~rjensen/000overview/mp3/133summ.htm#Introduction 
My introduction and cases on derivative financial instruments accounting are at http://www.trinity.edu/rjensen/caseans/000index.htm 

What is even more complicated is that long-standing historical cost rules are changed for booking of traditional assets (e.g.,  inventories and equipment) and liabilities (e.g., bonds and capital leases) under FAS 133/138 fair values if they are being hedged in certain ways by derivative instruments.  This includes fair value adjustments at least every 90 days for positive and negative changes in value of accounts normally maintained at historical cost.  The fact that the Year 1998 FAS 133 is completely  ignored in the Year 2000 PHB Edition 2 gives rise to serious errors and misleading analyses of value and risk.

I will return to the PHB textbook in a moment.  In fairness, I should note that virtually all authors of financial accounting textbooks have most likely failed to appreciate how the frustrating FAS 133/138 rules impact in so many unsuspecting and complicated ways upon other standards and GAAP in general.  Textbook authors, like accounting educators in general, became confronted with the most complex and convoluted new standard ever issued in accountancy.

I suspect that authors, especially authors of new editions of intermediate accounting textbooks, did not fully comprehend the immense complexities of FAS 133/138 when they inserted a module or complete chapter on FAS 133/138.  What is required is to also incorporate the implications of FAS 133/138 on all other chapters of the book.  As a user of such a book, you need to provide red flags for your students on errors in this regard.  Two illustrative red flags are noted below:

Red Flag 1
You should check the asset and liability modules in the book and verify that the authors incorporated the changes described under the "Basis Adjustment" in the glossary at http://www.trinity.edu/rjensen/acct5341/speakers/glossf.htm#B-Terms
What is even more confusing is that the international IAS 39 kissing-kin to the United States FAS 133 takes a different position on basis adjustment.

Red Flag 2
You should check to see if FAS 133 is incorporated into the modules dealing with FAS 115 on valuation of financial instruments and FAS 52 on foreign currency.

There are too many other red flags to document in this message.  A quick and dirty check on author due care and diligence entails looking up FAS 133 in the book's index.  If citations are not listed for multiple chapters, chances are the book is misleading.  I provide some examples below.

Let me return to the PHB textbook that will be frustrating me and my students this semester.  Several warnings are given below as examples:

Illustrative Warnings for PHB Textbook Users
WARNING 1
Any item impacted by FAS 133/138 may be highly misleading and cause students to make errors in the CPA examination and in their jobs.  For example, on Page 5-14 of the PHB textbook you will find the following:

Convertible debt is a hybrid security.  Typically it commands a lower rate of interest than a straight debenture, since the seller also receives the option to convert the debt into common shares.  The value of the conversion right depends on the conversion price, the firm's current stock price, the government bond rate, and the estimated variance on the firm's stock returns.  A good case can be made for separating the debt and equity components of a convertible issue, since the value of each can be separately estimated.  The value of the debt claim will vary over time with interest rates.  The value of the option will vary with the firm's stock price.

However, accounting rules do not recognize any value attached to the conversion right.  The convertible debenture is therefore reported as if it were nonconvertible debt (See APB 14).

The above quotation is just plain wrong and out of date in terms of newer embedded derivative rules.  Paragraph 61(k) of FAS 133 reads as follows:

Convertible debt.
The changes in fair value of an equity interest and the interest rates on a debt instrument are not clearly and closely related. Thus, for a debt security that is convertible into a specified number of shares of the debtor's common stock or another entity's common stock, the embedded derivative (that is, the conversion option) must be separated from the debt host contract and accounted for as a derivative instrument provided that the conversion option would, as a freestanding instrument, be a derivative instrument subject to the requirements of this Statement. 

An alternative for bifurcating debt instrument value into its component conversion option value and remainder value are provided in "Implementation of an Option Pricing-Based Bond Valuation Model for Corporate Debt and Its Components." by Mary E. Barth, et al, Accounting Horizons, December 2000.

WARNING 2
Companies with enormous economic hedges may have hedged items that do not qualify for FAS 133 hedge accounting such that earnings take drastic hits when derivatives are booked at fair value.  Examples include partial-term hedging, weather hedging, and macro (portfolio) hedging.  FAS 138 revisions do not allow hedge accounting for credit risk spreads above LIBOR allowed for benchmarking.  

My point here is that FAS 133 may be the cause of huge discrepancies between evaluations of risk and equity value before versus after FAS 133.  For more about such problems and audio clips from financial analysts on Wall Street, go to http://www.trinity.edu/rjensen/caseans/000index.htm 

WARNING 3
Use of more recent financial statements such as those issued for the Year 2001 may give rise to confusing patterns of financial ratios and other aspects of financial statement analysis such as the analysis in Chapter 9 of the PHB textbook.  All U.S. firms had to implement FAS 133 after January 1, 2001.  Comparisons between Year 2000 financial statements that did not book derivatives and did not change other assets and liabilities under FAS 133 rules.  For example, suppose an unbooked interest rate swap valued at $5 million on December 31, 2000 did not impact on net assets.  The same swap valued at a negative $10 million on December 31, 2001 must be booked as a liability such that there is a $10 million decrease in net assets.  If the swap is a cash flow hedge, the  offsetting $10 million debit goes to Other Comprehensive Income (OCI) in the equity section of the balance sheet.  Such ratios as ROI and ROE can be greatly impacted since current earnings numerators of ROI and ROE are not impacted by the huge fair value booking of this derivative in the denominators.

Since most companies (Enron being a blatant exception) have policies requiring that derivative financial instruments for hedging financial risk and not speculation, we do not expect current earnings to be greatly impacted by the adoption of FAS 133/138 if their hedges qualify for hedge accounting under FAS 133/138.   However, we do expect the total assets and liabilities to be increased by millions or even billions of dollars to fair value booking of previously unbooked derivatives.  This, in turn, must be taken into account when comparing reported outcomes before FAS 133/138 went into effect.  Major changes may be caused by implementation of the accounting FAS 133/138 rules rather than fundamental changes in the economic performances of companies.

My appeal is that all users of financial accounting books carefully check to see if FAS 133/138 impacts on all chapters have been cited.  If not, please beg those authors to issue errata sheets for all false or misleading passages that are impacted by FAS 133 and FAS 138.

It would also help for all textbook users to share their discovered textbook errors in any accounting book on the AECM listserv.  Please help professors and students in other universities avoid teaching false or misleading accountancy and finance.

My closing point is that subscribers of the AECM are probably overlooking a great opportunity to share discovered errors in the published literature.  Have you found errors were noting?
The AECM free subscription site is at http://pacioli.loyola.edu/aecm/ 

 

Personal Survival Tactics According to John Woods

Audio from Arthur Anderson Partner John Woods  WOODS01.mp3

  • Enthusiasm
  • Disillusionment
  • Panic and hysteria
  • Search for the guilty
  • Punishment of the innocent
  • Praise and honor of the non-participants

 

FAS 133 Impacts on Prior FASB Standards and EITF Rulings
Summarized in FAS 133 Appendix B Paragraphs 525-538

Supersedes:
Audio of James J. Rozsypal, Partner in Arthur Andersen  ROZSY02.mp3

  • Statement 80 (futures contracts)
  • Statement 105 (disclosures of off-balance-sheet risk)
  • Statement 119 (derivative disclosures)
  • Numerous EITF Issues

Amends or Relies Upon:

  • Statement 52 (foreign currency)
  • Statement 107 (fair value disclosures)
  • Statement 115 (accounting for debt and equity securities)
  • Various EITF Issues

Need for FAS 133 and IAS 39

  • Quantity and variety of derivatives are increasing
  • Accounting conventions and standards were outdated, incomplete, and inconsistent
  • Effects of derivatives were not transparent in the financial statements

 

 

Some Helpers and Resources

  • The FASB staff has prepared a new updated edition of Accounting for Derivative Instruments and Hedging Activities. This essential aid to implementation presents Statement 133 as amended by Statements 137 and 138. Also, it includes the results of the Derivatives Implementation Group (DIG), as cleared by the FASB through December 10, 2001, with cross-references between the issues and the paragraphs of the Statement.

    “The staff at the FASB has prepared this publication to bring together in one document the current guidance on accounting for derivatives,” said Kevin Stoklosa, FASB project manager. “To put it simply, it’s a ‘one-stop-shop’ approach that we hope our readers will find easier to use.”

    Accounting for Derivative Instruments and Hedging Activities—DC133-2

    Prices: $30.00 each copy for Members of the Financial Accounting Foundation, the Accounting Research Association (ARA) of the AICPA, and academics; $37.50 each copy for others.

    International Orders: A 50% surcharge will be applied to orders that are shipped overseas, except for shipments made to U.S. possessions, Canada, and Mexico. Please remit in local currency at the current exchange rate.

    To order:


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

    The DIG
    In the meantime, the FASB formed the FAS 133 Derivatives Implementation Group (DIG) to help resolve particular implementation questions, especially in areas where the standard is not clear or allegedly onerous.  The FASB's DIG website (that contains its mission and pronouncements) is at http://www.fasb.org/derivatives/  DIG issues are also summarized (in red borders) at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#0000Begin.

     

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

  • FASB's FAS 138 Amendments to FAS 133
    FAS 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities an amendment of FASB Statement No. 133 , Released June 15, 2000 --- http://www.rutgers.edu/Accounting/raw/fasb/public/index.html 

    I have created a summary document called "FAS 133 As Amended and DIGed:
    Introduction to FAS 138 Amendments and Some Key DIG Issues    " at 
    http://www.cs.trinity.edu/~rjensen/000overview/mp3/138intro.htm     

  • In May 3003, Financial Accounting Standards Board (FASB) issued Statement No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. The Statement amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under Statement 133 --- http://www.fasb.org/news/nr043003.shtml 

    Norwalk, CT, April 30, 2003—Today the Financial Accounting Standards Board (FASB) issued Statement No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. The Statement amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under Statement 133.

    The new guidance amends Statement 133 for decisions made:

    • as part of the Derivatives Implementation Group process that effectively required amendments to Statement 133,
    • in connection with other Board projects dealing with financial instruments, and
    • regarding implementation issues raised in relation to the application of the definition of a derivative, particularly regarding the meaning of an “underlying” and the characteristics of a derivative that contains financing components.

    The amendments set forth in Statement 149 improve financial reporting by requiring that contracts with comparable characteristics be accounted for similarly. In particular, this Statement clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative as discussed in Statement 133. In addition, it clarifies when a derivative contains a financing component that warrants special reporting in the statement of cash flows. Statement 149 amends certain other existing pronouncements. Those changes will result in more consistent reporting of contracts that are derivatives in their entirety or that contain embedded derivatives that warrant separate accounting.

    Effective Dates and Order Information

    This Statement is effective for contracts entered into or modified after June 30, 2003, except as stated below and for hedging relationships designated after June 30, 2003. The guidance should be applied prospectively.

    The provisions of this Statement that relate to Statement 133 Implementation Issues that have been effective for fiscal quarters that began prior to June 15, 2003, should continue to be applied in accordance with their respective effective dates. In addition, certain provisions relating to forward purchases or sales of when-issued securities or other securities that do not yet exist, should be applied to existing contracts as well as new contracts entered into after June 30, 2003.

    Copies of Statement 149 may be obtained through the FASB Order Department at 800-748-0659 or by placing an order on-line at the FASB website.

 

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

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

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

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

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

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

Recommended Tutorials on FAS 133

Recommended Glossaries

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

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

 

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

Why is FAS 133 so difficult to Implement?

Objectives

Presentation

Agenda

May 11

The Implementation Process

Objectives

Presentation

Agenda

May 25

Identifying and Evaluating Derivatives

Objectives

Presentation

Agenda

June 1

Evaluating Hedging Strategies 1: Commodity & FX Hedges

Objectives

Presentation

Agenda

June 8

Evaluating Hedging Strategies 2: Financial Instrument Hedges

Presentation

June 15

Tax Guidelines & Issues

Objectives

Presentation

Agenda

Exit value accounting is required under GAAP for personal financial statements and companies that are deemed no longer going concerns.  Some theorists advocate exit value accounting for going concerns as well as non-going concerns.  Both nationally (under FAS 133) and internationally (under IAS 39),  fair value accounting is presently required for derivative financial instruments.  Both the FASB and the IASC have exposure drafts advocating fair value accounting for all financial instruments.

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

If an item is viewed as a financial instrument rather than inventory, the accounting becomes more complicated under SFAS 115.  Traders in financial instruments adjust such instruments to fair value with all changes in value passing through current earnings.  Business firms who are not deemed to be traders must designate the instrument as either available-for-sale (AFS) or hold-to-maturity (HTM).  A HTM instrument is maintained at original cost.  An AFS financial instrument must be marked-to-market, but the changes in value pass through OCI rather than current earnings until the instrument is actually sold or otherwise expires.   Under international standards, the IASC requires fair value adjustments for most financial instruments.  This has led to strong reaction from businesses around the world, especially banks.  There are now two major working group debates.  In 1999 the Joint Working Group of the Banking Associations sharply rebuffed the IAS 39 fair value accounting in two white papers that can be downloaded from http://www.iasc.org.uk/frame/cen3_112.htm.

 

Bob Jensen Glossary Cases Helpers Top of Page

 

 

Controversial Issues 

 

Fundamental Issues and Controversies
Jim Leisingring from the FASB in 1998 (see Appendix A for the full text)  from Tape 37

I think the REAL issue with the banks is that they're derivatives dealers, and they really didn't want the transactions scrutinized at the level that's necessary to account for them. --- particularly account for them at the way that we wanted them accounted for. I don't think it has much to do with bank accounting frankly, but I will leave that for others to decide.

Russ Mallett from PwC on April 23, 1999 at a PwC Educators Conference in Dallas 

FAS 133 is not necessarily neutral in the economy as hoped by FAS 133 (¶ 241) and is Leading to Some Bad Economic Hedges and Other Decisions in Companies

An unhappy executive at Chase Bank  
    Audio of Mike Koegler of Chase Bank  KOEGLER3.mp3
    Audio of Mike Koegler of Chase Bank  KOEGLER4.mp3

  • The main issue is increased volatility from fair value adjustments 
  • The bottom line is crucial no matter how voluminous are the supplementary disclosures

 

 

 

 

Issues Before the FASB and the DIG
  • Major arguments against FAS 133 are addressed Appendix C of FAS 133
  • Implementation issues can be addressed to the Derivatives Implementation Group (DIG) formed by the FASB as an advisory body.  Unlike the EITF, the DIG has no voting power.  However, DIG pronouncements will greatly impact upon how companies will implement FAS 133 and most likely will impact upon future lawsuits

DIG Examples 

The FASB listened to complaints about treasury lock hedging and proposed allowing treasury locks in FAS 138 amendments to FAS 133 released on June 15, 2000.
See "Benchmark Interest Rates" at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#B-Terms 
  • PENDING ISSUE 77 --- Derivative must have zero value on date of FAS 133 adoption
  • CROSS CURRENCY SWAP CONTROVERSY

Audio of J.C. Mercier, BankBoston MERC30.mp3  

Note that FAS 138 amendments to FAS 133 softened the restriction against hedge accounting treatments for cross-currency swaps.  

 

 

Some Initial Issues to Consider

 

Costs of Detection, Documentation, and IT Changes for Derivative Contracts

 

 

Miscellaneous Considerations
  • FAS 133 Disclosures by Evelyn Angelle from Ernst & Young in Houston   ANGEL50.mp3

  • SEC Market Risk Disclosures in Rule 4-08(n) of Regulation S-X and Item 310 of Regulation S-B

 

Timing and Transition Issues
  • Should a company elect early adoption?    
  • Transition adjustment varies based on derivative hedging relationship prior to adoption:
    • Fair-value-type hedge -- Cumulative-effect-type adjustment of net income
    • Cash-flow-type hedge -- Cumulative-effect-type adjustment of accumulated OCI
    • Freestanding derivative (no hedging relationship) -- Cumulative-effect-type adjustment of net income
  • Derivative gains and losses recorded as adjustments of cost prior to initial application:
    • Are not affected
    • Are not part of the transition adjustment
  • Instruments with embedded derivatives that were issued, acquired, or modified after 12/31/98 are subject to:
    • Fair value accounting for the embedded derivative
    • Transition accounting for the host and embedded derivative

 

 

Bob Jensen Glossary Cases Helpers Top of Page

 

 

 

 

Overview of FAS 133

Overview
  • Companies must identify all financial instruments derivatives

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

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

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

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

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

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

 

  • All derivatives are marked to fair value (at least quarterly)
  • Changes in fair value go to earnings except in the case of qualifying hedges.  FAS 133 and IAS 39 are merely stepping stones to the eventual requirement that all financial instruments be marked-to-market
  • Derivatives that meet explicit tests as qualifying hedges have value changes posted to comprehensive income (FAS 130) as OCI instead of current earnings until all or a portion of the hedges no longer qualify for OCI deferrals 
  • Special accounting is provided for the change in value of derivatives designated and qualifying as:
    • Fair value hedges
    • Cash flow hedges
    • Foreign currency hedges
                    
  • Hedging a portfolio of financial instruments with a portfolio of derivatives is feasible in the standard, but for most practical purposes portfolio hedging is not a practical alternative.   Hedging derivatives must be directly linked to individual hedged items.  (¶ 21, ¶462)
  • The IASC's international counterpart is IAS 39 that is very similar to FAS 133.  Examples of major differences are listed below:

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

IAS 39 Fair Value Hedge Definition: 
a hedge of the exposure to changes in the fair value of a recognised asset or liability (such as a hedge of exposure to changes in the fair value of fixed rate debt as a result of changes in interest rates).

However, a hedge of an unrecognised firm commitment to buy or sell an asset at a fixed price in the enterprise’s reporting currency is accounted for as a cash flow hedge

IAS 39 Fair Value Hedge Accounting:
To the extent that the hedge is effective, the gain or loss from remeasuring the hedging instrument at fair value is recognised immediately in net profit or loss. At the same time, the corresponding gain or loss on the hedged item adjusts the carrying amount of the hedged item and is recognised immediately in net profit or loss.

 

FAS 133 Fair Value Hedge Definition:
Same as IAS 39

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


FAS Fair Value Hedge Accounting:
Same as IAS 39

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

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

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

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

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

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

 

Some Key Constraints for FAS 133 Accounting
A derivative requires either:
  • No initial net investment or
  • A smaller initial net investment than other contracts that have a similar response to changes in market factors (e.g., short sales having the proceeds up front cannot be accounted for as derivatives under FAS 133)

Audio of J.C. Mercier, BankBoston MERC10.mp3

Net settlement requires one of the following:

  • Net settlement explicitly required or permitted by the contract (transfer of cash or other assets)
  • Net settlement by a market mechanism outside the contract (e.g., futures exchange)
  • Delivery of a derivative or an asset that is readily convertible to cash

Audio of J.C. Mercier, BankBoston MERC12.mp3

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

IAS 39
A derivative is a financial instrument—

(a) - whose value changes in response to the change in a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, a credit rating or credit index, or similar variable (sometimes called the ‘underlying’);

(b) - that requires no initial net investment or little initial net investment relative to other types of contracts that have a similar response to changes in market conditions; and

(c) - that is settled at a future date.

 FAS 133
(a) – same as IAS 39

(b) – same as IAS 39

(c) – FASB definition requires that the terms of the derivative contract require or permit net settlement.

If the embedded derivative cannot be reliably identified and measured, you must abide by the following rules:

  • Account for the entire contract at fair value through earnings
  • The contract may not be designated as a hedging instrument

 

 

Bob Jensen Glossary Cases DIG Helpers Top of Page

 

 

Fair Value Hedge
A fair value derivative 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:
  • Hedged item is exposed to price risk 
  • Changes in fair value of hedged item and hedging instrument are recorded in earnings
  • Basis of hedged item is adjusted by the change in value

See the following FAS 133 Examples:

  • Example 1 (¶ 106) Fair Value Hedge of a Commodity Inventory

  • Example 2 (¶ 111) Fair Value Hedge of Fixed-Rate Debt

  • Example 3 (¶ 121) Forward Contract to Purchase Foreign Currency

Flow Chart for Fair Value Hedge Accounting --- http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm

 

Bob Jensen Glossary Cases Helpers Top of Page

 

 

Effectiveness Tests
  • Permitted Risks
    • Must represent an exposure of earnings
    • For nonfinancial items (other than loan servicing rights) must be risk of ENTIRE changes in fair values
    • For financial assets or liabilities, fair value changes attributable to:
      --  Entire asset/liability
      --  Market interest rates (but not just the Risk Free Rate - See DIG E1)
      --  Foreign exchange rates
      --  Creditworthiness

  •  Hedge Effectiveness  John Woods Audio WOODS30.mp3
     
    Prospective Steps Regression $ Offset
    • Establish expectation of effectiveness
    • Ongoing Reaffirmation of expectations of effectiveness
    		 Yes
    Yes    		 Yes
    Yes
    Retrospective Steps
    • Proving effectiveness has been achieved
    • Measuring ineffectiveness in earnings/equity

    Yes
    No

    Yes
    Yes

     

  • Sources of ineffectiveness include:
    • Different notional and principal amounts
    • Different maturity or repricing dates
    • Different underlying interest rate basis (such as variable rate debt at prime, swap at LIBOR)
    • Currency differences
    • Credit differences

  • Delta ratio D = (D option value)/ D hedged item value)
    range [.894 < D < 1.118] or [80% < D% < 125%]          (¶85)

    Actually, the calculations used to satisfy the "80%-125%" hedge effectiveness rule are not explicitly specified and are, thereby, subject to some discretion.  The spirit, however, is that the effective portion of a hedge falls within the conditional range     [.894 < D < 1.118].

    Delta-neutral strategies are discussed at various points (e.g., ¶85, ¶86, ¶87, and ¶89).  Delta-neutral implies that the option value does not change for relatively small changes in hedged item value.  Many hedge strategies are delta-neutral such that ineffectiveness arises only for relative large changes in the value of the hedged item itself.

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

”Testing and Accounting for Hedge Ineffectiveness Under FAS 133, by Angela L.J. Huang and  Robert E. Jensen, Derivatives Report, February 2003, pp. 1-10.  http://www.riahome.com/estore/detail.asp?ID=TDVN
Bob Jensen's documents on hedge accounting are linked at http://www.trinity.edu/rjensen/caseans/000index.htm 

A Great Article!
"A Consistent Approach to Measuring Hedge Effectiveness," by Bernard Lee, Financial Engineering News --- http://www.fenews.com/fen14/hedge.html 

For a FAS 133 Glossary go to http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm 

A number of common effectiveness testing criteria used when implementing FAS 133 include the following from Quantitative Risk Management, Inc. --- http://www.qrm.com/products/mb/Rmbupdate.htm 

 

FAS Effectiveness Testing --- http://www.qrm.com/products/mb/Rmbupdate.htm 

To provide the maximum flexibility in testing hedge effectiveness, we now offer the following methods:

     

  • Dollar Offset (DO) calculates the ratio of dollar change in profit/loss for hedge and hedged item

     

  • Relative Dollar Offset (RDO) calculates the ratio of dollar change in net position to the initial MTM value of hedged item

     

  • Variability Reduction Measure (VarRM) calculates the ratio of the squared dollar changes in net position to the squared dollar changes in hedged item

     

  • Ordinary Least Square (OLS) measures the linear relationship between the dollar changes in hedged item and hedge. OLS calculates the coefficient of determination (R2) and the slope coefficient (ß) for effectiveness measure and accounts for the historical performance

     

  • Least Absolute Deviation (LAD) is similar to OLS, but employs median regression analysis to calculate R2 and ß.

 

 

 

Controversies over FAS 133 Effectiveness Rules
Audio Clips of Tim Cerino, Corporate Risk Management, Salomon Smith Barney Some Issues Raised by a DIG Member, Ira Kawaller, 
Senior Consultant to the Chicago Mercantile Exchange
 Ira Kawaller's links to articles http://www.kawaller.com/articles.htm 

 

 

Bob Jensen Glossary Cases Helpers Top of Page

 

 

Cash Flow Hedge
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.  
  • Hedged item is a forecasted transaction or balance sheet item with variable cash flows
  • Gain or loss reported in OCI as long as the hedge is effective and qualifying
  • Earnings recognition matches hedged transaction
  • Ineffective gain or loss recorded in earnings --- the infamous 80%-125% Rule
  • Extends hedging from options to futures and forwards --- Jim Rozsypal Audio ROZSY12.mp3

Changes in value of a cash flow hedge derivative may sometimes have to be partitioned between earnings and OCI

  • Hedges that no longer fully meet the required "effectiveness" tests  $30,000,000 Audio ROZSY30.mp3
  • Changes in option values are partitioned between intrinsic value and time value.  Only the time value portion is eligible for posting to OCI.  Changes in intrinsic value are posted to current earnings.

Flow Chart for Cash Flow Hedge Accounting --- http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm

 

Cash flow hedges ineligible items (¶29)
  • Items remeasured to fair value for hedged risk currently in earnings
    -- Trading securities
    -- Interest on FX receivables/payables
  • Variable interest cash flows on a HTM security
  • Dividends on trust preferred securities classified as minority interests
  • Grouped items if not exposed to the same risk
                    Audio of Mike Koegler of Chase Bank  KOEGLER3.mp3
  • Equity investments in unconsolidated subs
  • Company's own equity instruments
  • Transactions with stockholders
    -- Projected purchases of treasury stock
    --Payments of dividends

 

Short-Cut Method for Interest Rate Swaps
  • Not allowed in exposure draft but forced by Big 5 and others  
    Jim Rozsypal Audio  ROZSY70.mp3

  • The "Short-cut Method" is only available when the assumption of "no ineffectiveness" is appropriate for a fair value hedge of a fixed-rate asset or liability using an interest rate swap. ¶ 114

  • Effectiveness - "Short-cut" method
    • Applies to certain interest-rate swaps only
    • Key terms of swap and hedged item must match
    • Allows company to assume perfect effectiveness
    • Eliminates need to reassess effectiveness thereafter
    • Similar to pre-133 synthetic instrument accounting (except for balance sheet effects)
    • May be difficult to achieve for corporate debt
    • Swap notional amount = hedged item's principal
    • Swap has zero fair value at inception
    • Formula identical for each net settlement under swap
    • Hedged item cannot be prepayable
    • No other terms invalidate assumed effectiveness
      hence short-cut method is not available with optionality embedded clauses  ROZSY72.mp3
    • Creditworthiness of parties need not be comparable
    • Additional cash flow hedge prerequisites
      -- All interest flows on hedged item are designated
      -- No interest flows beyond swap term are designated
      -- No floor or cap in swap unless also in hedged item
      -- Repricing dates the same for swap and hedged item
      -- No basis differences between swap and hedged item
      -- But, rates on item and swap need not be the same

 

  • Effectiveness - "Short-cut" method - (fair value hedge specific)
    • Swap expiration matches interest-bearing asset/liability maturity
    • No floor or cap on floating leg of swap
    • Interval between repricing dates on the floating leg of swap are frequent (3 to 6 months or less)
      --  Justifies current market rate assumption

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

Interest Rate Swap Valuation, Forward Rate Derivation,  and Yield Curves
for FAS 133 and IAS 39 on Accounting for Derivative Financial Instruments 
See http://www.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm

 

Cash Flow Hedges on Written Options (¶ 28(c))
Limited eligibility of written options
  • The written option combined with hedged item must provide at least as much gain potential as loss potential
  • Test is met if all possible percentage favorable changes provide favorable cash flows at least equal to unfavorable cash flows incurred from an unfavorable change of the same percentage

Swaps that are written options

  • Cancelable at counterparty's option, without penalty
  • Embedded written options (puts, calls)
  • Index-amortizing swap (series of cancelable swaps)

In sum, any swap combined with a written option

Audio of Mike Koegler of Chase Bank  KOEGLER4.mp3

 

 

Bob Jensen Glossary Cases Helpers Top of Page

 

 

 

Foreign Currency Hedge
The Board intended to increase the consistency of hedge accounting guidance by broadening the scope of eligible foreign currency hedges. 
  • Includes hedges of cash flows, fair value, and net investments in foreign operations
  • Permits limited use of non-derivative instruments
  • Expands hedge accounting, particularly for forecasted transactions, intercompany transactions and tandem currency hedges

 

FASB Retains Statement 52 Concepts
Derivatives or nonderivatives may be designated as hedges of foreign currency risks if:
  • A firm commitment
  • A net investment in a foreign operation hedge

 

FASB Objectives Expand Statement 52 Concepts
  • Forecasted transactions, including intercompany transactions, with foreign currency risk (e.g., royalty receipts/payments) may be hedged with any type of derivative
  • Expanded ability to use tandem currencies (e.g., practicability or feasibility criteria in Statement 52 no longer required)

 

Three Types of Foreign Currency (FX) Hedges
 
  Eligible Hedged Item Eligible Hedging Instrument
Fair Value             AG00092_.gif (502 bytes)
  • Unrecognized Firm Commitments
  • AFS Securities *
  • Derivative or Cash Instrument
  • Derivative Instrument Only
Cash Flow             AG00092_.gif (502 bytes)
  • Forecasted Transaction
  • Forecasted Intercompany Transaction
  • Derivative Instrument Only
  • Derivative Instrument Only
Net Investment   AG00092_.gif (502 bytes)
  • Net Investment in a Foreign Operation:
    --  Beginning Balance Only
  • Derivative or Cash Instrument

Flow Chart for FX Hedge Accounting --- http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm

Some comments about available for sale securities and other complications  
John Woods Audio  WOODS40.mp3

Hedging a FX currency risk exposure --- 
Jin Chang from Lehman Brothers  Audio  CHANG30.mp3

 

 

Items Not Qualifying as Foreign Currency Hedges
  • Recognized Foreign Currency Assets or Liabilities
    --  That may give rise to a foreign currency transaction gain or loss under Statement 52 (e.g., a foreign currency denominated receivable or payable) (¶21 (c) (1))
  • Forecasted Acquisition of Foreign Currency Assets or Liabilities
    --  That may give rise to a foreign currency transaction gain or loss under Statement 52 (¶29 (d))
  • Hedging Entire Fair Value of a Foreign Currency Asset or Liability (Issue H3)
    --  FX exposures may not be hedged; already remeasured in earnings currently
    --  Also Fix - coupon payments arising from fixed-rate debt is not hedgeable as either a firm commitment or forecasted transaction (Issue H4)
  • Compound Currency Swaps Generally Not Eligible as Hedging Instruments

CROSS CURRENCY SWAP CONTROVERSY
      Audio of J.C. Mercier, BankBoston MERC30.mp3 

     This controversy was overcome in most respects by FAS 138 amendments issued in June 2000

 

 

Mortgage Banking Hedges
  • Mortgage Servicing Rights Hedging
    --  Fair value of contracts
  • Warehouse/Pipeline Hedging
    --  Existing commitments
    --  Unexpected fall-out
    --  Unexpected pull-through

 

 

Flow Chart for FAS 133 and IAS 39 Accounting --- http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm

For updated tutorials on FAS 133, FAS 138, and IAS 39, please go to http://www.trinity.edu/rjensen/caseans/000index.htm 

 

Bob Jensen Glossary Cases Helpers Top of Page