FAS 133 - Accounting for Derivative Instruments and Hedging Activities
FAS 133 Summary
Bob
Jensen's SFAS 133 Glossary
NO. 186-B | JUNE 1998 Financial Accounting Series
Statement of Financial Accounting Standards No. 133
Accounting for Derivative Instruments and Hedging Activities
Financial Accounting Standards Board of the Financial Accounting
Foundation
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Summary
This Statement establishes accounting and reporting standards
for derivative instruments, including certain derivative
instruments embedded in other contracts, (collectively referred
to as derivatives) and for hedging activities. It requires that
an entity recognize all derivatives as either assets or
liabilities in the statement of financial position and measure
those instruments at fair value. If certain conditions are met,
a derivative may be specifically designated as (a) a hedge of
the exposure to changes in the fair value of a recognized asset
or liability or an unrecognized firm commitment, (b) a hedge of
the exposure to variable cash flows of a forecasted transaction,
or (c) a hedge of the foreign currency exposure of a net
investment in a foreign operation, an unrecognized firm
commitment, an available-for-sale security, or a foreign-
currency-denominated forecasted transaction.
The accounting for changes in the fair value of a derivative
(that is, gains and losses) depends on the intended use of the
derivative and the resulting designation.
_ For a derivative designated as hedging the exposure to
changes in the fair value of a recognized asset or
liability or a firm commitment (referred to as a fair value
hedge), the gain or loss is recognized in earnings in the
period of change together with the offsetting loss or gain
on the hedged item attributable to the risk being hedged.
The effect of that accounting is to reflect in earnings the
extent to which the hedge is not effective in achieving
offsetting changes in fair value.
_ For a derivative designated as hedging the exposure to
variable cash flows of a forecasted transaction (referred
to as a cash flow hedge), the effective portion of the
derivative's gain or loss is initially reported as a
component of other comprehensive income (outside earnings)
and subsequently reclassified into earnings when the
forecasted transaction affects earnings. The ineffective
portion of the gain or loss is reported in earnings
immediately.
_ For a derivative designated as hedging the foreign currency
exposure of a net investment in a foreign operation, the
gain or loss is reported in other comprehensive income
(outside earnings) as part of the cumulative translation
adjustment. The accounting for a fair value hedge
described above applies to a derivative designated as a
hedge of the foreign currency exposure of an unrecognized
firm commitment or an available-for-sale security.
Similarly, the accounting for a cash flow hedge described
above applies to a derivative designated as a hedge of the
foreign currency exposure of a foreign-currency-denominated
forecasted transaction.
_ For a derivative not designated as a hedging instrument,
the gain or loss is recognized in earnings in the period of
change.
Under this Statement, an entity that elects to apply hedge accounting is
required to establish at the inception of the hedge the method it will use
for assessing the effectiveness of the hedging derivative and the
measurement approach for determining the ineffective aspect of the hedge.
Those methods must be consistent with the entity's approach to managing
risk.
This Statement applies to all entities. A not-for-profit
organization should recognize the change in fair value of all derivatives
as a change in net assets in the period of change. In a fair value hedge,
the changes in the fair value of the hedged item attributable to the risk
being hedged also are recognized. However, because of the format of their
statement of financial performance, not-for-profit organizations are not
permitted special hedge accounting for derivatives used to hedge forecasted
transactions. This Statement does not address how a not-for-profit
organization should determine the components of an operating measure if one
is presented.
This Statement precludes designating a nonderivative
financial instrument as a hedge of an asset, liability, unrecognized firm
commitment, or forecasted transaction except that a nonderivative
instrument denominated in a foreign currency may be designated as a hedge
of the foreign currency exposure of an unrecognized firm commitment
denominated in a foreign currency or a net investment in a foreign
operation.
This Statement amends FASB Statement No. 52, Foreign
Currency
Translation, to permit special accounting for a hedge of a foreign
currency forecasted transaction with a derivative. It supersedes FASB
Statements No. 80, Accounting for Futures Contracts, No. 105,
Disclosure of Information about Financial Instruments with
Off-Balance-Sheet Risk and Financial Instruments with Concentrations of
Credit Risk, and No. 119, Disclosure about Derivative Financial
Instruments and Fair Value of Financial Instruments. It amends
FASB Statement No. 107, Disclosures about
Fair Value of
Financial Instruments, to include in Statement 107 the disclosure
provisions about concentrations of credit risk from Statement 105. This
Statement also nullifies or modifies the consensuses reached in a number of
issues addressed by the Emerging Issues Task Force.
This Statement is effective for all fiscal quarters of fiscal
years beginning after June 15, 1999. Initial application of this Statement
should be as of the beginning of an entity's fiscal quarter; on that date,
hedging relationships must be designated anew and documented pursuant to
the provisions of this Statement. Earlier application of all of the
provisions of this Statement is encouraged, but it is permitted only as of
the beginning of any fiscal quarter that begins after issuance of this
Statement. This Statement should not be applied retroactively to financial
statements of prior periods.
Statement of Financial Accounting Standards No. 133
Accounting for Derivative Instruments and Hedging Activities
June 1998
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Copyright (c) 1998 by Financial Accounting Standards Board. All rights
reserved. No part of this publication may be reproduced, stored in a
retrieval system, or transmitted, in any form or by any means, electronic,
mechanical, photocopying, recording, or otherwise, without the prior
written permission of the Financial Accounting Standards Board.
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Statement of Financial Accounting Standards No. 133
Accounting for Derivative Instruments and Hedging Activities
June 1998
FAS 133 Contents
CONTENTS
Paragraph
Numbers
Introduction 1 -- 4
Standards of Financial Accounting and Reporting:
Scope and Definition 5 -- 16
Derivative Instruments 6 -- 11
Embedded Derivative Instruments 12 -- 16
Recognition of Derivatives and Measurement of
Derivatives
and Hedged Items 17 -- 42
Fair Value Hedges 20 -- 27
General 20
The Hedged Item 21 -- 26
Impairment 27
Cash Flow Hedges 28 -- 35
General 28
The Hedged Forecasted Transaction 29 -- 35
Foreign Currency Hedges 36 -- 42
Foreign Currency Fair Value Hedges 37 -- 39
Foreign Currency Cash Flow Hedges 40 -- 41
Hedges of the Foreign Currency Exposure of a Net
Investment in a Foreign Operation 42
Accounting by Not-for-Profit Organizations and Other
Entities That Do Not Report Earnings 43
Disclosures 44 -- 45
Reporting Changes in the Components of
Comprehensive Income 46 -- 47
Effective Date and Transition 48 -- 56
Appendix A: Implementation Guidance 57 -- 103
Section 1: Scope and Definition 57 -- 61
Section 2: Assessment of Hedge Effectiveness 62 -- 103
Appendix B: Examples Illustrating Application
of This Statement 104 -- 205
Section 1: Hedging Relationships 104 -- 175
Section 2: Examples Illustrating Application of the
Clearly-and-Closely-Related Criterion to Derivative
Instruments
Embedded in Hybrid Instruments 176 -- 200
Section 3: Examples Illustrating Application of the
Transition Provisions 201 -- 205
Appendix C: Background Information and Basis
for Conclusions 206 -- 524
Appendix D: Amendments to Existing
Pronouncements 525 -- 538
Appendix E: Diagram for Determining Whether a Contract
Is a
Freestanding Derivative Subject to the Scope of This
Statement 539
Appendix F: Glossary 540
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Statement of Financial Accounting Standards No. 133
Accounting for Derivative Instruments and Hedging Activities
June 1998
FAS 133 INTRODUCTION
INTRODUCTION
1. This Statement addresses the accounting for derivative
instruments, \1/ including certain derivative instruments
embedded in other contracts, and hedging activities.
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\1/ Words defined in Appendix F, the glossary, are set in
boldface type the first time they appear.
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2. Prior to this Statement, hedging activities related to
changes in foreign exchange rates were addressed in FASB
Statement No. 52, Foreign Currency
Translation. FASB Statement
No. 80, Accounting for Futures Contracts,
addressed the use of
futures contracts in other hedging activities. Those Statements
addressed only certain derivative instruments and differed in
the criteria required for hedge accounting. In addition, the
Emerging Issues Task Force (EITF) addressed the accounting for
various hedging activities in a number of issues.
3. In developing the standards in this Statement, the Board
concluded that the following four fundamental decisions should serve as
cornerstones underlying those standards:
a. Derivative instruments represent rights or obligations that
meet the definitions of assets or liabilities and should be
reported in financial statements.
b. Fair value is the most relevant measure for financial
instruments and the only relevant measure for derivative
instruments. Derivative instruments should be measured at
fair value, and adjustments to the carrying amount of
hedged items should reflect changes in their fair value
(that is, gains or losses) that are attributable to the
risk being hedged and that arise while the hedge is in
effect.
c. Only items that are assets or liabilities should be
reported as such in financial statements.
d. Special accounting for items designated as being hedged
should be provided only for qualifying items. One aspect
of qualification should be an assessment of the expectation
of effective offsetting changes in fair values or cash
flows during the term of the hedge for the risk being
hedged.
Those fundamental decisions are discussed individually in
paragraphs 217 -- 231 of Appendix C.
4. This Statement standardizes the accounting for
derivative instruments, including certain derivative instruments embedded
in other contracts, by requiring that an entity recognize those items as
assets or liabilities in the statement of financial position and measure
them at fair value. If certain conditions are met, an entity may elect to
designate a derivative instrument as follows:
a. A hedge of the exposure to changes in the fair value of a
recognized asset or liability, or of an unrecognized firm
commitment, \2/ that are attributable to a particular risk
(referred to as a fair value hedge)
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\2/ An unrecognized firm commitment can be viewed as an
executory contract that represents both a right and an
obligation. When a previously unrecognized firm commitment
that is designated as a hedged item is accounted for in
accordance with this Statement, an asset or a liability is
recognized and reported in the statement of financial
position related to the recognition of the gain or loss on
the firm commitment. Consequently, subsequent references
to an asset or a liability in this Statement include a firm
commitment.
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b. A hedge of the exposure to variability in the cash flows of
a recognized asset or liability, or of a forecasted
transaction, that is attributable to a particular risk
(referred to as a cash flow hedge)
c. A hedge of the foreign currency exposure of (1) an
unrecognized firm commitment (a foreign currency fair value
hedge), (2) an available-for-sale security (a foreign
currency fair value hedge), (3) a forecasted transaction (a
foreign currency cash flow hedge), or (4) a net investment
in a foreign operation.
This Statement generally provides for matching the timing of gain or loss
recognition on the hedging instrument with the recognition of (a) the
changes in the fair value of the hedged asset or liability that are
attributable to the hedged risk or (b) the earnings effect of the hedged
forecasted transaction. Appendix A provides guidance on identifying
derivative instruments subject to the scope of this Statement and on
assessing hedge effectiveness and is an integral part of the standards
provided in this Statement. Appendix B contains examples that illustrate
application of this Statement. Appendix C contains background information
and the basis for the Board's conclusions. Appendix D lists the accounting
pronouncements superseded or amended by this Statement. Appendix E provides
a diagram for determining whether a contract is a freestanding derivative
subject to the scope of this Statement.
FAS 133 STANDARDS OF FINANCIAL ACCOUNTING AND REPORTING
STANDARDS OF FINANCIAL ACCOUNTING AND REPORTING
Scope and Definition
5. This Statement applies to all entities. Some entities,
such as not-for-profit organizations and defined benefit pension plans, do
not report earnings as a separate caption in a statement of financial
performance. The application of this Statement to those entities is set
forth in paragraph 43.
Derivative Instruments
6. A derivative instrument is a financial instrument or
other contract with all three of the following characteristics:
a. It has (1) one or more underlyings and (2) one or more
notional amounts \3/ or payment provisions or both. Those
terms determine the amount of the settlement or
settlements, and, in some cases, whether or not a
settlement is required. \4/
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\3/ Sometimes other names are used. For example, the notional
amount is called a face amount in some contracts.
\4/ The terms underlying, notional amount, payment provision,
and settlement are intended to include the plural forms in
the remainder of this Statement. Including both the
singular and plural forms used in this paragraph is more
accurate but much more awkward and impairs the readability.
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b. It requires no initial net investment or an initial net
investment that is smaller than would be required for other
types of contracts that would be expected to have a similar
response to changes in market factors.
c. Its terms require or permit net settlement, it can readily
be settled net by a means outside the contract, or it
provides for delivery of an asset that puts the recipient
in a position not substantially different from net
settlement.
7. Underlying, notional amount, and payment
provision. An underlying is a specified interest rate, security price,
commodity price, foreign exchange rate, index of prices or rates, or other
variable. An underlying may be a price or rate of an asset or liability
but is not the asset or liability itself. A notional amount is a number of
currency units, shares, bushels, pounds, or other units specified in the
contract. The settlement of a derivative instrument with a notional amount
is determined by interaction of that notional amount with the underlying.
The interaction may be simple multiplication, or it may involve a formula
with leverage factors or other constants. A payment provision specifies a
fixed or determinable settlement to be made if the underlying behaves in a
specified manner.
8. Initial net investment. Many derivative
instruments require no initial net investment. Some require an initial net
investment as compensation for time value (for example, a premium on an
option) or for terms that are more or less favorable than market conditions
(for example, a premium on a forward purchase contract with a price less
than the current forward price). Others require a mutual exchange of
currencies or other assets at inception, in which case the net investment
is the difference in the fair values of the assets exchanged. A derivative
instrument does not require an initial net investment in the contract that
is equal to the notional amount (or the notional amount plus a premium or
minus a discount) or that is determined by applying the notional amount to
the underlying.
9. Net settlement. A contract fits the
description in paragraph 6(c) if its settlement
provisions meet one of the following criteria:
a. Neither party is required to deliver an asset that is
associated with the underlying or that has a principal
amount, stated amount, face value, number of shares, or
other denomination that is equal to the notional amount (or
the notional amount plus a premium or minus a discount).
For example, most interest rate swaps do not require that
either party deliver interest-bearing assets with a
principal amount equal to the notional amount of the
contract.
b. One of the parties is required to deliver an asset of the
type described in paragraph 9(a), but there is a
market
mechanism that facilitates net settlement, for example, an
exchange that offers a ready opportunity to sell the
contract or to enter into an offsetting contract.
c. One of the parties is required to deliver an asset of the
type described in paragraph 9(a), but that asset
is readily
convertible to cash \5/ or is itself a derivative
instrument. An example of that type of contract is a
forward contract that requires delivery of an exchange-
traded equity security. Even though the number of shares
to be delivered is the same as the notional amount of the
contract and the price of the shares is the underlying, an
exchange-traded security is readily convertible to cash.
Another example is a swaption -- an option to require
delivery of a swap contract, which is a derivative.
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\5/ FASB Concepts Statement No. 5, Recognition
and Measurement
in Financial Statements of Business Enterprises, states
that assets that are readily convertible to cash "have (i)
interchangeable (fungible) units and (ii) quoted prices
available in an active market that can rapidly absorb the
quantity held by the entity without significantly affecting
the price" (paragraph 83(a)). For contracts
that involve
multiple deliveries of the asset, the phrase in an active
market that can rapidly absorb the quantity held by the
entity should be applied separately to the expected
quantity in each delivery.
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Derivative instruments embedded in other contracts are addressed
in paragraphs 12 -- 16.
10. Notwithstanding the conditions in paragraphs 6 -- 9,
the
following contracts are not subject to the requirements of this
Statement:
a. "Regular-way" security trades. Regular-way security trades
are contracts with no net settlement provision and no
market mechanism to facilitate net settlement (as described
in paragraphs 9(a) and 9(b)). They provide for
delivery of
a security within the time generally established by
regulations or conventions in the marketplace or exchange
in which the transaction is being executed.
b. Normal purchases and normal sales. Normal purchases and
normal sales are contracts with no net settlement provision
and no market mechanism to facilitate net settlement (as
described in paragraphs 9(a) and 9(b)). They
provide for
the purchase or sale of something other than a financial
instrument or derivative instrument that will be delivered
in quantities expected to be used or sold by the reporting
entity over a reasonable period in the normal course of
business.
c. Certain insurance contracts. Generally, contracts of the
type that are within the scope of FASB Statements No. 60,
Accounting and Reporting by Insurance Enterprises, No. 97,
Accounting and Reporting by Insurance Enterprises for
Certain Long-Duration Contracts and for Realized Gains and
Losses from the Sale of Investments, and No. 113,
Accounting and Reporting for Reinsurance of Short-Duration
and Long-Duration Contracts, are not subject to the
requirements of this Statement whether or not they are
written by insurance enterprises. That is, a contract is
not subject to the requirements of this Statement if it
entitles the holder to be compensated only if, as a result
of an identifiable insurable event (other than a change in
price), the holder incurs a liability or there is an
adverse change in the value of a specific asset or
liability for which the holder is at risk. The following
types of contracts written by insurance enterprises or held
by the insureds are not subject to the requirements of this
Statement for the reasons given:
(1) Traditional life insurance contracts. The
payment of death benefits is the result of an
identifiable insurable event (death of the
insured) instead of changes in a variable.
(2) Traditional property and casualty contracts. The
payment of benefits is the result of an
identifiable insurable event (for example, theft
or fire) instead of changes in a variable.
However, insurance enterprises enter into other types of contracts
that may be subject to the provisions of this Statement. In
addition, some contracts with insurance or other enterprises
combine derivative instruments, as defined in this Statement, with
other insurance products or nonderivative contracts, for example,
indexed annuity contracts, variable life insurance contracts, and
property and casualty contracts that combine traditional coverages
with foreign currency options. Contracts that consist of both
derivative portions and nonderivative portions are addressed in
paragraph 12.
d. Certain financial guarantee contracts. Financial guarantee
contracts are not subject to this Statement if they provide
for payments to be made only to reimburse the guaranteed
party for a loss incurred because the debtor fails to pay
when payment is due, which is an identifiable insurable
event. In contrast, financial guarantee contracts are
subject to this Statement if they provide for payments to
be made in response to changes in an underlying (for
example, a decrease in a specified debtor's
creditworthiness).
e. Certain contracts that are not traded on an exchange.
Contracts that are not exchange-traded are not subject to
the requirements of this Statement if the underlying on
which the settlement is based is one of the following:
(1) A climatic or geological variable or other
physical variable
(2) The price or value of (a) a nonfinancial asset of
one of the parties to the contract provided that
the asset is not readily convertible to cash or
(b) a nonfinancial liability of one of the
parties to the contract provided that the
liability does not require delivery of an asset
that is readily convertible to cash
(3) Specified volumes of sales or service revenues of
one of the parties to the contract.
If a contract has more than one underlying and some,
but not all, of them qualify for one of the
exceptions in paragraphs 10(e)(1), 10(e)(2), and
10(e)(3), the application of this Statement to
that contract depends on its predominant
characteristics. That is, the contract is
subject to the requirements of this Statement if
all of its underlyings, considered in
combination, behave in a manner that is highly
correlated with the behavior of any of the
component variables that do not qualify for an
exception.
f. Derivatives that serve as impediments to sales accounting.
A derivative instrument (whether freestanding or embedded
in another contract) whose existence serves as an
impediment to recognizing a related contract as a sale by
one party or a purchase by the counterparty is not subject
to this Statement. For example, the existence of a
guarantee of the residual value of a leased asset by the
lessor may be an impediment to treating a contract as a
sales-type lease, in which case the contract would be
treated by the lessor as an operating lease. Another
example is the existence of a call option enabling a
transferor to repurchase transferred assets that is an
impediment to sales accounting under FASB Statement No.
125, Accounting for Transfers and Servicing
of Financial
Assets and Extinguishments of Liabilities.
11. Notwithstanding the conditions of paragraphs 6 -- 10,
the
reporting entity shall not consider the following contracts to
be derivative instruments for purposes of this Statement:
a. Contracts issued or held by that reporting entity that are
both (1) indexed to its own stock and (2) classified in
stockholders' equity in its statement of financial position
b. Contracts issued by the entity in connection with stock-
based compensation arrangements addressed in FASB Statement
No. 123, Accounting for Stock-Based Compensation
c. Contracts issued by the entity as contingent consideration
from a business combination. The accounting for contingent
consideration issued in a business combination is addressed
in APB Opinion No. 16, Business Combinations.
In applying
this paragraph, the issuer is considered to be the entity
that is accounting for the combination using the purchase
method.
In contrast, the above exceptions do not apply to the counterparty in those
contracts. In addition, a contract that an entity either can or must
settle by issuing its own equity instruments but that is indexed in part or
in full to something other than its own stock can be a derivative
instrument for the issuer under paragraphs 6 -- 10,
in
which case it would be accounted for as a liability or an asset in
accordance with the requirements of this Statement.
Embedded Derivative Instruments
12. Contracts that do not in their entirety meet the
definition of a derivative instrument (refer to paragraphs 6
-- 9), such as bonds, insurance policies, and
leases, may contain
"embedded" derivative instruments -- implicit or explicit terms that affect
some or all of the cash flows or the value of other exchanges required by
the contract in a manner similar to a derivative instrument. The effect of
embedding a derivative instrument in another type of contract ("the host
contract") is that some or all of the cash flows or other exchanges that
otherwise would be required by the contract, whether unconditional or
contingent upon the occurrence of a specified event, will be modified based
on one or more underlyings. An embedded derivative instrument shall be
separated from the host contract and accounted for as a derivative
instrument pursuant to this Statement if and only if all of the following
criteria are met:
a. The economic characteristics and risks of the embedded
derivative instrument are not clearly and closely related
to the economic characteristics and risks of the host
contract. Additional guidance on applying this criterion
to various contracts containing embedded derivative
instruments is included in Appendix A of this Statement.
b. The contract ("the hybrid instrument") that embodies both
the embedded derivative instrument and the host contract is
not remeasured at fair value under otherwise applicable
generally accepted accounting principles with changes in
fair value reported in earnings as they occur.
c. A separate instrument with the same terms as the embedded
derivative instrument would, pursuant to paragraphs 6 --
11, be a derivative instrument subject to the
requirements
of this Statement. (The initial net investment for the
hybrid instrument shall not be considered to be the initial
net investment for the embedded derivative.)
13. For purposes of applying the provisions of
paragraph 12, an embedded derivative instrument
in which the
underlying is an interest rate or interest rate index \6/ that alters net
interest payments that otherwise would be paid or received on an
interest-bearing host contract is considered to be clearly and closely
related to the host contract unless either of the following conditions
exist:
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\6/ Examples are an interest rate cap or an interest rate
collar. An embedded derivative instrument that alters net
interest payments based on changes in a stock price index
(or another non-interest-rate index) is not addressed in
paragraph 13.
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a. The hybrid instrument can contractually be settled in a
such a way that the investor (holder) would not recover
substantially all of its initial recorded investment.
b. The embedded derivative could at least double the
investor's initial rate of return on the host contract and
could also result in a rate of return that is at least
twice what otherwise would be the market return for a
contract that has the same terms as the host contract and
that involves a debtor with a similar credit quality.
Even though the above conditions focus on the investor's rate of return and
the investor's recovery of its investment, the existence of either of those
conditions would result in the embedded derivative instrument not being
considered clearly and closely related to the host contract by both parties
to the hybrid instrument. Because the existence of those conditions is
assessed at the date that the hybrid instrument is acquired (or incurred)
by the reporting entity, the acquirer of a hybrid instrument in the
secondary market could potentially reach a different conclusion than could
the issuer of the hybrid instrument due to applying the conditions in this
paragraph at different points in time.
14. However, interest-only strips and principal-only
strips are not subject to the requirements of this Statement provided they
(a) initially resulted from separating the rights to receive contractual
cash flows of a financial instrument that, in and of itself, did not
contain an embedded derivative that otherwise would have been accounted for
separately as a derivative pursuant to the provisions of
paragraphs 12 and 13
and (b) do not incorporate
any terms not present in the original financial instrument described above.
15. An embedded foreign currency derivative instrument
shall not be separated from the host contract and considered a
derivative instrument under paragraph 12 if the
host
contract is not a financial instrument and it requires payment(s)
denominated in (a) the currency of the primary economic environment in
which any substantial party to that contract operates (that is, its
functional currency) or (b) the currency in which the price of the related
good or service that is acquired or delivered is routinely denominated in
international commerce (for example, the U.S. dollar for crude oil
transactions). Unsettled foreign currency transactions, including
financial instruments, that are monetary items and have their principal
payments, interest payments, or both denominated in a foreign currency are
subject to the requirement in Statement 52 to recognize any foreign
currency transaction gain or loss in earnings and shall not be considered
to contain embedded foreign currency derivative instruments under this
Statement. The same proscription applies to available-for-sale or trading
securities that have cash flows denominated in a foreign currency.
16. In subsequent provisions of this Statement, both (a) a
derivative instrument included within the scope of this Statement by
paragraphs 6 -- 11 and (b) an embedded
derivative
instrument that has been separated from a host contract as required by
paragraph 12 are collectively referred to as
derivative
instruments. If an embedded derivative instrument is separated from its
host contract, the host contract shall be accounted for based on generally
accepted accounting principles applicable to instruments of that type that
do not contain embedded derivative instruments. If an entity cannot
reliably identify and measure the embedded derivative instrument that
paragraph 12 requires be separated from the host
contract, the entire contract shall be measured at fair value with gain or
loss recognized in earnings, but it may not be designated as a hedging
instrument pursuant to this Statement.
Recognition of Derivatives and Measurement of Derivatives and Hedged Items
17. An entity shall recognize all of its derivative
instruments in its statement of financial position as either assets or
liabilities depending on the rights or obligations under the contracts.
All derivative instruments shall be measured at fair value. The guidance
in FASB Statement No. 107, Disclosures about
Fair
Value of Financial Instruments, as amended, shall apply in determining
the fair value of a financial instrument (derivative or hedged item). If
expected future cash flows are used to estimate fair value, those expected
cash flows shall be the best estimate based on reasonable and supportable
assumptions and projections. All available evidence shall be considered in
developing estimates of expected future cash flows. The weight given to
the evidence shall be commensurate with the extent to which the evidence
can be verified objectively. If a range is estimated for either the amount
or the timing of possible cash flows, the likelihood of possible outcomes
shall be considered in determining the best estimate of future cash flows.
18. The accounting for changes in the fair value (that is,
gains or losses) of a derivative depends on whether it has been designated
and qualifies as part of a hedging relationship and, if so, on the reason
for holding it. Either all or a proportion of a derivative may be
designated as the hedging instrument. The proportion must be expressed as a
percentage of the entire derivative so that the profile of risk exposures
in the hedging portion of the derivative is the same as that in the entire
derivative. (Thus, an entity is prohibited from separating a compound
derivative into components representing different risks and designating any
such component as the hedging instrument, except as permitted at the date
of initial application by the transition provisions in
paragraph 49.) Subsequent references in this
Statement to a
derivative as a hedging instrument include the use of only a proportion of
a derivative as a hedging instrument. Two or more derivatives, or
proportions thereof, may also be viewed in combination and jointly
designated as the hedging instrument. Gains and losses on derivative
instruments are accounted for as follows:
a. No hedging designation. The gain or loss on a derivative
instrument not designated as a hedging instrument shall be
recognized currently in earnings.
b. Fair value hedge. The gain or loss on a derivative
instrument designated and qualifying as a fair value
hedging instrument as well as the offsetting loss or gain
on the hedged item attributable to the hedged risk shall be
recognized currently in earnings in the same accounting
period, as provided in paragraphs 22 and 23.
c. Cash flow hedge. The effective portion of the gain or loss
on a derivative instrument designated and qualifying as a
cash flow hedging instrument shall be reported as a
component of other comprehensive income (outside earnings)
and reclassified into earnings in the same period or
periods during which the hedged forecasted transaction
affects earnings, as provided in paragraphs 30
and 31. The
remaining gain or loss on the derivative instrument, if
any, shall be recognized currently in earnings, as provided
in paragraph 30.
d. Foreign currency hedge. The gain or loss on a derivative
instrument or nonderivative financial instrument designated
and qualifying as a foreign currency hedging instrument
shall be accounted for as follows:
(1) The gain or loss on the hedging derivative or
nonderivative instrument in a hedge of a foreign-
currency-denominated firm commitment and the
offsetting loss or gain on the hedged firm
commitment shall be recognized currently in
earnings in the same accounting period, as
provided in paragraph 37.
(2) The gain or loss on the hedging derivative
instrument in a hedge of an available-for-sale
security and the offsetting loss or gain on the
hedged available-for-sale security shall be
recognized currently in earnings in the same
accounting period, as provided in paragraph 38.
(3) The effective portion of the gain or loss on the
hedging derivative instrument in a hedge of a
forecasted foreign-currency-denominated
transaction shall be reported as a component of
other comprehensive income (outside earnings) and
reclassified into earnings in the same period or
periods during which the hedged forecasted
transaction affects earnings, as provided in
paragraph 41. The remaining gain or loss on the
hedging instrument shall be recognized currently
in earnings.
(4) The gain or loss on the hedging derivative or
nonderivative instrument in a hedge of a net
investment in a foreign operation shall be
reported in other comprehensive income (outside
earnings) as part of the cumulative translation
adjustment to the extent it is effective as a
hedge, as provided in paragraph 42.
19. In this Statement, the change in the fair
value of an entire financial asset or liability for a period refers to
the difference between its fair value at the beginning of the period (or
acquisition date) and the end of the period adjusted to exclude (a) changes
in fair value due to the passage of time and (b) changes in fair value
related to any payments received or made, such as in partially recovering
the asset or partially settling the liability.
Fair Value Hedges
General
20. An entity may designate a derivative instrument as
hedging the exposure to changes in the fair value of an asset or a
liability or an identified portion thereof ("hedged item") that is
attributable to a particular risk. Designated hedging instruments and
hedged items qualify for fair value hedge accounting if all of the
following criteria and those in paragraph 21 are
met:
a. At inception of the hedge, there is formal documentation of
the hedging relationship and the entity's risk management
objective and strategy for undertaking the hedge, including
identification of the hedging instrument, the hedged item,
the nature of the risk being hedged, and how the hedging
instrument's effectiveness in offsetting the exposure to
changes in the hedged item's fair value attributable to the
hedged risk will be assessed. There must be a reasonable
basis for how the entity plans to assess the hedging
instrument's effectiveness.
(1) For a fair value hedge of a firm commitment, the
entity's formal documentation at the inception of
the hedge must include a reasonable method for
recognizing in earnings the asset or liability
representing the gain or loss on the hedged firm
commitment.
(2) An entity's defined risk management strategy for
a particular hedging relationship may exclude
certain components of a specific hedging
derivative's change in fair value, such as time
value, from the assessment of hedge
effectiveness, as discussed in paragraph 63 in
Section 2 of Appendix A.
b. Both at inception of the hedge and on an ongoing basis, the
hedging relationship is expected to be highly effective in
achieving offsetting changes in fair value attributable to
the hedged risk during the period that the hedge is
designated. An assessment of effectiveness is required
whenever financial statements or earnings are reported, and
at least every three months. If the hedging instrument
(such as an at-the-money option contract) provides only
one-sided offset of the hedged risk, the increases (or
decreases) in the fair value of the hedging instrument must
be expected to be highly effective in offsetting the
decreases (or increases) in the fair value of the hedged
item. All assessments of effectiveness shall be consistent
with the risk management strategy documented for that
particular hedging relationship (in accordance with
paragraph 20(a) above).
c. If a written option is designated as hedging a recognized
asset or liability, the combination of the hedged item and
the written option provides at least as much potential for
gains as a result of a favorable change in the fair value
of the combined instruments \7/ as exposure to losses from
an unfavorable change in their combined fair value. That
test is met if all possible percentage favorable changes in
the underlying (from zero percent to 100 percent) would
provide at least as much gain as the loss that would be
incurred from an unfavorable change in the underlying of
the same percentage.
==========================================================================
\7/ The reference to combined instruments refers to the written
option and the hedged item, such as an embedded purchased
option.
==========================================================================
(1) A combination of options (for example, an
interest rate collar) entered into
contemporaneously shall be considered a written
option if either at inception or over the life of
the contracts a net premium is received in cash
or as a favorable rate or other term. (Thus, a
collar can be designated as a hedging instrument
in a fair value hedge without regard to the test
in paragraph 20(c) unless a net premium is
received.) Furthermore, a derivative instrument
that results from combining a written option and
any other nonoption derivative shall be
considered a written option.
A nonderivative instrument, such as a Treasury note, shall not be
designated as a hedging instrument, except as provided in
paragraphs 37 and 42
of this Statement.
The Hedged Item
21. An asset or a liability is eligible for designation as
a hedged item in a fair value hedge if all of the following criteria are
met:
a. The hedged item is specifically identified as either all or
a specific portion of a recognized asset or liability or of
an unrecognized firm commitment. \8/ The hedged item is a
single asset or liability (or a specific portion thereof)
or is a portfolio of similar assets or a portfolio of
similar liabilities (or a specific portion thereof).
==========================================================================
\8/ A firm commitment that represents an asset or liability
that a specific accounting standard prohibits recognizing
(such as a noncancelable operating lease or an unrecognized
mortgage servicing right) may nevertheless be designated as
the hedged item in a fair value hedge. A mortgage banker's
unrecognized "interest rate lock commitment" (IRLC) does
not qualify as a firm commitment (because as an option it
does not obligate both parties) and thus is not eligible
for fair value hedge accounting as the hedged item.
(However, a mortgage banker's "forward sale commitments,"
which are derivatives that lock in the prices at which the
mortgage loans will be sold to investors, may qualify as
hedging instruments in cash flow hedges of the forecasted
sales of mortgage loans.)
==========================================================================
(1) If similar assets or similar liabilities are
aggregated and hedged as a portfolio, the
individual assets or individual liabilities must
share the risk exposure for which they are
designated as being hedged. The change in fair
value attributable to the hedged risk for each
individual item in a hedged portfolio must be
expected to respond in a generally proportionate
manner to the overall change in fair value of the
aggregate portfolio attributable to the hedged
risk. That is, if the change in fair value of a
hedged portfolio attributable to the hedged risk
was 10 percent during a reporting period, the
change in the fair values attributable to the
hedged risk for each item constituting the
portfolio should be expected to be within a
fairly narrow range, such as 9 percent to 11
percent. In contrast, an expectation that the
change in fair value attributable to the hedged
risk for individual items in the portfolio would
range from 7 percent to 13 percent would be
inconsistent with this provision. In aggregating
loans in a portfolio to be hedged, an entity may
choose to consider some of the following
characteristics, as appropriate: loan type, loan
size, nature and location of collateral, interest
rate type (fixed or variable) and the coupon
interest rate (if fixed), scheduled maturity,
prepayment history of the loans (if seasoned),
and expected prepayment performance in varying
interest rate scenarios. \9/
==========================================================================
\9/ Mortgage bankers and other servicers of financial
assets that designate a hedged portfolio by
aggregating servicing rights within one or more
risk strata used under paragraph 37(g) of
Statement 125 would not necessarily comply with
the requirement in this paragraph for portfolios
of similar assets. The risk stratum under
paragraph 37(g) of Statement 125 can be based on
any predominant risk characteristic, including
date of origination or geographic location.
==========================================================================
(2) If the hedged item is a specific portion of an
asset or liability (or of a portfolio of similar
assets or a portfolio of similar liabilities),
the hedged item is one of the following:
(a) A percentage of the entire asset or liability (or
of the entire portfolio)
(b) One or more selected contractual cash flows (such
as the portion of the asset or liability
representing the present value of the interest
payments in the first two years of a four-year
debt instrument)
(c) A put option, a call option, an interest rate
cap, or an interest rate floor embedded in an
existing asset or liability that is not an
embedded derivative accounted for separately
pursuant to paragraph 12 of this Statement
(d) The residual value in a lessor's net investment
in a direct financing or sales-type lease.
If the entire asset or liability is an instrument with variable cash
flows, the hedged item cannot be deemed to be an implicit
fixed-to-variable swap (or similar instrument) perceived to be
embedded in a host contract with fixed cash flows.
b. The hedged item presents an exposure to changes in fair
value attributable to the hedged risk that could affect
reported earnings. The reference to affecting reported
earnings does not apply to an entity that does not report
earnings as a separate caption in a statement of financial
performance, such as a not-for-profit organization, as
discussed in paragraph 43.
c. The hedged item is not (1) an asset or liability that is
remeasured with the changes in fair value attributable to
the hedged risk reported currently in earnings (for
example, if foreign exchange risk is hedged, a foreign-
currency-denominated asset for which a foreign currency
transaction gain or loss is recognized in earnings), (2) an
investment accounted for by the equity method in accordance
with the requirements of APB Opinion No. 18, The
Equity
Method of Accounting for Investments in Common Stock, (3) a
minority interest in one or more consolidated subsidiaries,
(4) an equity investment in a consolidated subsidiary, (5)
a firm commitment either to enter into a business
combination or to acquire or dispose of a subsidiary, a
minority interest, or an equity method investee, or (6) an
equity instrument issued by the entity and classified in
stockholders' equity in the statement of financial
position.
d. If the hedged item is all or a portion of a debt security
(or a portfolio of similar debt securities) that is
classified as held-to-maturity in accordance with FASB
Statement No. 115, Accounting for Certain
Investments in
Debt and Equity Securities, the designated risk being
hedged is the risk of changes in its fair value
attributable to changes in the obligor's creditworthiness
or if the hedged item is an option component of a held-to-
maturity security that permits its prepayment, the
designated risk being hedged is the risk of changes in the
entire fair value of that option component. (The designated
hedged risk for a held-to-maturity security may not be the
risk of changes in its fair value attributable to changes
in market interest rates or foreign exchange rates. If the
hedged item is other than an option component that permits
its prepayment, the designated hedged risk also may not be
the risk of changes in its overall fair value.)
e. If the hedged item is a nonfinancial asset or liability
(other than a recognized loan servicing right or a
nonfinancial firm commitment with financial components),
the designated risk being hedged is the risk of changes in
the fair value of the entire hedged asset or liability
(reflecting its actual location if a physical asset). That
is, the price risk of a similar asset in a different
location or of a major ingredient may not be the hedged
risk. Thus, in hedging the exposure to changes in the fair
value of gasoline, an entity may not designate the risk of
changes in the price of crude oil as the risk being hedged
for purposes of determining effectiveness of the fair value
hedge of gasoline.
f. If the hedged item is a financial asset or liability, a
recognized loan servicing right, or a nonfinancial firm
commitment with financial components, the designated risk
being hedged is (1) the risk of changes in the overall fair
value of the entire hedged item, (2) the risk of changes in
its fair value attributable to changes in market interest
rates, (3) the risk of changes in its fair value
attributable to changes in the related foreign currency
exchange rates (refer to paragraphs 37 and 38), or (4) the
risk of changes in its fair value attributable to changes
in the obligor's creditworthiness. If the risk designated
as being hedged is not the risk in paragraph 21(f)(1)
above, two or more of the other risks (market interest rate
risk, foreign currency exchange risk, and credit risk) may
simultaneously be designated as being hedged. An entity
may not simply designate prepayment risk as the risk being
hedged for a financial asset. However, it can designate
the option component of a prepayable instrument as the
hedged item in a fair value hedge of the entity's exposure
to changes in the fair value of that "prepayment" option,
perhaps thereby achieving the objective of its desire to
hedge prepayment risk. The effect of an embedded
derivative of the same risk class must be considered in
designating a hedge of an individual risk. For example,
the effect of an embedded prepayment option must be
considered in designating a hedge of market interest rate
risk.
22. Gains and losses on a qualifying fair value hedge
shall be accounted for as follows:
a. The gain or loss on the hedging instrument shall be recognized
currently in earnings.
b. The gain or loss (that is, the change in fair value) on the
hedged item attributable to the hedged risk shall adjust
the carrying amount of the hedged item and be recognized
currently in earnings.
If the fair value hedge is fully effective, the gain or loss on the hedging
instrument, adjusted for the component, if any, of that gain or loss that
is excluded from the assessment of effectiveness under the entity's defined
risk management strategy for that particular hedging relationship (as
discussed in paragraph 63 in Section 2 of
Appendix A),
would exactly offset the loss or gain on the hedged item attributable to
the hedged risk. Any difference that does arise would be the effect of
hedge ineffectiveness, which consequently is recognized currently in
earnings. The measurement of hedge ineffectiveness for a particular
hedging relationship shall be consistent with the entity's risk management
strategy and the method of assessing hedge effectiveness that was
documented at the inception of the hedging relationship, as discussed in
paragraph 20(a). Nevertheless, the amount of
hedge
ineffectiveness recognized in earnings is based on the extent to which
exact offset is not achieved. Although a hedging relationship must comply
with an entity's established policy range of what is considered "highly
effective" pursuant to paragraph 20(b) in
order for that
relationship to qualify for hedge accounting, that compliance does not
assure zero ineffectiveness. Section 2 of Appendix A illustrates assessing
hedge effectiveness and measuring hedge ineffectiveness. Any hedge
ineffectiveness directly affects earnings because there will be no
offsetting adjustment of a hedged item's carrying amount for the
ineffective aspect of the gain or loss on the related hedging instrument.
23. If a hedged item is otherwise measured at fair value
with changes in fair value reported in other comprehensive income (such as
an available-for-sale security), the adjustment of the hedged item's
carrying amount discussed in paragraph 22 shall
be
recognized in earnings rather than in other comprehensive income in order
to offset the gain or loss on the hedging instrument.
24. The adjustment of the carrying amount of a hedged
asset or liability required by paragraph 22
shall be
accounted for in the same manner as other components of the carrying amount
of that asset or liability. For example, an adjustment of the carrying
amount of a hedged asset held for sale (such as inventory) would remain
part of the carrying amount of that asset until the asset is sold, at which
point the entire carrying amount of the hedged asset would be recognized as
the cost of the item sold in determining earnings. An adjustment of the
carrying amount of a hedged interest-bearing financial instrument shall be
amortized to earnings; amortization shall begin no later than when the
hedged item ceases to be adjusted for changes in its fair value
attributable to the risk being hedged.
25. An entity shall discontinue prospectively the
accounting specified in paragraphs 22 and
23 for an existing hedge if any one of the
following occurs:
a. Any criterion in paragraphs 20 and 21 is no longer met.
b. The derivative expires or is sold, terminated, or
exercised.
c. The entity removes the designation of the fair value hedge.
In those circumstances, the entity may elect to designate prospectively a
new hedging relationship with a different hedging instrument or, in the
circumstances described in paragraphs 25(a) and 25(c)
above, a different hedged item or a hedged transaction if the hedging
relationship meets the criteria specified in paragraphs
20 and 21
for a fair value hedge or
paragraphs 28 and 29
for a cash flow hedge.
26. In general, if a periodic assessment indicates
noncompliance with the effectiveness criterion in paragraph
20(b), an entity shall not recognize the
adjustment of the carrying
amount of the hedged item described in paragraphs 22
and
23 after the last date on which compliance with
the
effectiveness criterion was established. However, if the event or change in
circumstances that caused the hedging relationship to fail the
effectiveness criterion can be identified, the entity shall recognize in
earnings the changes in the hedged item's fair value attributable to the
risk being hedged that occurred prior to that event or change in
circumstances. If a fair value hedge of a firm commitment is discontinued
because the hedged item no longer meets the definition of a firm
commitment, the entity shall derecognize any asset or liability previously
recognized pursuant to paragraph 22 (as a result
of an
adjustment to the carrying amount for the firm commitment) and recognize a
corresponding loss or gain currently in earnings.
Impairment
27. An asset or liability that has been designated as
being hedged and accounted for pursuant to paragraphs 22 --
24 remains subject to the applicable
requirements in generally accepted
accounting principles for assessing impairment for that type of asset or
for recognizing an increased obligation for that type of liability. Those
impairment requirements shall be applied after hedge accounting has been
applied for the period and the carrying amount of the hedged asset or
liability has been adjusted pursuant to paragraph 22
of
this Statement. Because the hedging instrument is recognized separately as
an asset or liability, its fair value or expected cash flows shall not be
considered in applying those impairment requirements to the hedged asset or
liability.
Cash Flow Hedges
General
28. An entity may designate a derivative instrument as
hedging the exposure to variability in expected future cash flows that is
attributable to a particular risk. That exposure may be associated with an
existing recognized asset or liability (such as all or certain future
interest payments on variable-rate debt) or a forecasted transaction (such
as a forecasted purchase or sale). \10/ Designated hedging instruments and
hedged items or transactions qualify for cash flow hedge accounting if all
of the following criteria and those in paragraph 29
are
met:
==========================================================================
\10/ For purposes of paragraphs 28-35, the
individual cash flows
related to a recognized asset or liability and the cash
flows related to a forecasted transaction are both referred
to as a forecasted transaction or hedged transaction.
==========================================================================
a. At inception of the hedge, there is formal documentation of
the hedging relationship and the entity's risk management
objective and strategy for undertaking the hedge, including
identification of the hedging instrument, the hedged
transaction, the nature of the risk being hedged, and how
the hedging instrument's effectiveness in hedging the
exposure to the hedged transaction's variability in cash
flows attributable to the hedged risk will be assessed.
There must be a reasonable basis for how the entity plans
to assess the hedging instrument's effectiveness.
(1) An entity's defined risk management strategy for
a particular hedging relationship may exclude
certain components of a specific hedging
derivative's change in fair value from the
assessment of hedge effectiveness, as discussed
in paragraph 63 in Section 2 of Appendix A.
(2) Documentation shall include all relevant details,
including the date on or period within which the
forecasted transaction is expected to occur, the
specific nature of asset or liability involved
(if any), and the expected currency amount or
quantity of the forecasted transaction.
(a) The phrase expected currency amount refers to hedges
of foreign currency exchange risk and requires
specification of the exact amount of foreign currency
being hedged.
(b) The phrase expected . . . quantity refers to hedges of
other risks and requires specification of the physical
quantity (that is, the number of items or units of
measure) encompassed by the hedged forecasted
transaction. If a forecasted sale or purchase is
being hedged for price risk, the hedged transaction
cannot be specified solely in terms of expected
currency amounts, nor can it be specified as a
percentage of sales or purchases during a period. The
current price of a forecasted transaction also should
be identified to satisfy the criterion in paragraph
28(b) for offsetting cash flows.
The hedged forecasted transaction shall be described with sufficient
specificity so that when a transaction occurs, it is clear whether
that transaction is or is not the hedged transaction. Thus, the
forecasted transaction could be identified as the sale of either the
first 15,000 units of a specific product sold during a specified
3-month period or the first 5,000 units of a specific product sold in
each of 3 specific months, but it could not be identified as the sale
of the last 15,000 units of that product sold during a 3-month period
(because the last 15,000 units cannot be identified when they occur,
but only when the period has ended).
b. Both at inception of the hedge and on an ongoing basis, the
hedging relationship is expected to be highly effective in
achieving offsetting cash flows attributable to the hedged
risk during the term of the hedge, except as indicated in
paragraph 28(d) below. An assessment of
effectiveness is
required whenever financial statements or earnings are
reported, and at least every three months. If the hedging
instrument, such as an at-the-money option contract,
provides only one-sided offset against the hedged risk, the
cash inflows (outflows) from the hedging instrument must be
expected to be highly effective in offsetting the
corresponding change in the cash outflows or inflows of the
hedged transaction. All assessments of effectiveness shall
be consistent with the originally documented risk
management strategy for that particular hedging
relationship.
c. If a written option is designated as hedging the
variability in cash flows for a recognized asset or
liability, the combination of the hedged item and the
written option provides at least as much potential for
favorable cash flows as exposure to unfavorable cash flows.
That test is met if all possible percentage favorable
changes in the underlying (from zero percent to 100
percent) would provide at least as much favorable cash
flows as the unfavorable cash flows that would be incurred
from an unfavorable change in the underlying of the same
percentage. (Refer to paragraph 20(c)(1).)
d. If a hedging instrument is used to modify the interest
receipts or payments associated with a recognized financial
asset or liability from one variable rate to another
variable rate, the hedging instrument must be a link
between an existing designated asset (or group of similar
assets) with variable cash flows and an existing designated
liability (or group of similar liabilities) with variable
cash flows and be highly effective at achieving offsetting
cash flows. A link exists if the basis (that is, the rate
index on which the interest rate is based) of one leg of an
interest rate swap is the same as the basis of the interest
receipts for the designated asset and the basis of the
other leg of the swap is the same as the basis of the
interest payments for the designated liability. In this
situation, the criterion in the first sentence in paragraph
29(a) is applied separately to the designated
asset and the
designated liability.
A nonderivative instrument, such as a Treasury note, shall not be
designated as a hedging instrument for a cash flow hedge.
The Hedged Forecasted Transaction
29. A forecasted transaction is eligible for designation
as a hedged transaction in a cash flow hedge if all of the following
additional criteria are met:
a. The forecasted transaction is specifically identified as a
single transaction or a group of individual transactions.
If the hedged transaction is a group of individual
transactions, those individual transactions must share the
same risk exposure for which they are designated as being
hedged. Thus, a forecasted purchase and a forecasted sale
cannot both be included in the same group of individual
transactions that constitute the hedged transaction.
b. The occurrence of the forecasted transaction is probable.
c. The forecasted transaction is a transaction with a party
external to the reporting entity (except as permitted by
paragraph 40) and presents an exposure to
variations in
cash flows for the hedged risk that could affect reported
earnings.
d. The forecasted transaction is not the acquisition of an
asset or incurrence of a liability that will subsequently
be remeasured with changes in fair value attributable to
the hedged risk reported currently in earnings (for
example, if foreign exchange risk is hedged, the forecasted
acquisition of a foreign-currency-denominated asset for
which a foreign currency transaction gain or loss will be
recognized in earnings). However, forecasted sales on
credit and the forecasted accrual of royalties on probable
future sales by third-party licensees are not considered
the forecasted acquisition of a receivable. If the
forecasted transaction relates to a recognized asset or
liability, the asset or liability is not remeasured with
changes in fair value attributable to the hedged risk
reported currently in earnings.
e. If the variable cash flows of the forecasted transaction
relate to a debt security that is classified as held-to-
maturity under Statement 115, the risk being hedged is the
risk of changes in its cash flows attributable to default
or changes in the obligor's creditworthiness. For those
variable cash flows, the risk being hedged cannot be the
risk of changes in its cash flows attributable to changes
in market interest rates.
f. The forecasted transaction does not involve a business
combination subject to the provisions of Opinion 16 and is
not a transaction (such as a forecasted purchase, sale, or
dividend) involving (1) a parent company's interests in
consolidated subsidiaries, (2) a minority interest in a
consolidated subsidiary, (3) an equity-method investment,
or (4) an entity's own equity instruments.
g. If the hedged transaction is the forecasted purchase or
sale of a nonfinancial asset, the designated risk being
hedged is (1) the risk of changes in the functional-
currency-equivalent cash flows attributable to changes in
the related foreign currency exchange rates or (2) the risk
of changes in the cash flows relating to all changes in the
purchase price or sales price of the asset (reflecting its
actual location if a physical asset), not the risk of
changes in the cash flows relating to the purchase or sale
of a similar asset in a different location or of a major
ingredient. Thus, for example, in hedging the exposure to
changes in the cash flows relating to the purchase of its
bronze bar inventory, an entity may not designate the risk
of changes in the cash flows relating to purchasing the
copper component in bronze as the risk being hedged for
purposes of assessing offset as required by paragraph
28(b).
h. If the hedged transaction is the forecasted purchase or
sale of a financial asset or liability or the variable cash
inflow or outflow of an existing financial asset or
liability, the designated risk being hedged is (1) the risk
of changes in the cash flows of the entire asset or
liability, such as those relating to all changes in the
purchase price or sales price (regardless of whether that
price and the related cash flows are stated in the entity's
functional currency or a foreign currency), (2) the risk of
changes in its cash flows attributable to changes in market
interest rates, (3) the risk of changes in the functional-
currency-equivalent cash flows attributable to changes in
the related foreign currency exchange rates (refer to
paragraph 40), or (4)
the risk of changes in its cash flows
attributable to default or changes in the obligor's
creditworthiness. Two or more of the above risks may be
designated simultaneously as being hedged. An entity may
not designate prepayment risk as the risk being hedged
(refer to paragraph 21(f)).
30. The effective portion of the gain or loss on a
derivative designated as a cash flow hedge is reported in other
comprehensive income, and the ineffective portion is reported in earnings.
More specifically, a qualifying cash flow hedge shall be accounted for as
follows:
a. If an entity's defined risk management strategy for a
particular hedging relationship excludes a specific
component of the gain or loss, or related cash flows, on
the hedging derivative from the assessment of hedge
effectiveness (as discussed in paragraph 63 in
Section 2 of
Appendix A), that excluded component of the gain or loss
shall be recognized currently in earnings. For example, if
the effectiveness of a hedge with an option contract is
assessed based on changes in the option's intrinsic value,
the changes in the option's time value would be recognized
in earnings. Time value is equal to the fair value of the
option less its intrinsic value.
b. Accumulated other comprehensive income associated with the
hedged transaction shall be adjusted to a balance that
reflects the lesser of the following (in absolute amounts):
(1) The cumulative gain or loss on the derivative
from inception of the hedge less (a) the excluded
component discussed in paragraph 30(a) above and
(b) the derivative's gains or losses previously
reclassified from accumulated other comprehensive
income into earnings pursuant to paragraph 31
(2) The portion of the cumulative gain or loss on the
derivative necessary to offset the cumulative
change in expected future cash flows on the
hedged transaction from inception of the hedge
less the derivative's gains or losses previously
reclassified from accumulated other comprehensive
income into earnings pursuant to paragraph 31.
That adjustment of accumulated other comprehensive income
shall incorporate recognition in other comprehensive income
of part or all of the gain or loss on the hedging
derivative, as necessary.
c. A gain or loss shall be recognized in earnings, as
necessary, for any remaining gain or loss on the hedging
derivative or to adjust other comprehensive income to the
balance specified in paragraph 30(b) above.
Section 2 of Appendix A illustrates assessing hedge
effectiveness and measuring hedge ineffectiveness. Examples 6
and 9 of Section 1 of Appendix B illustrate the application of
this paragraph.
31. Amounts in accumulated other comprehensive income
shall be reclassified into earnings in the same period or periods during
which the hedged forecasted transaction affects earnings (for example, when
a forecasted sale actually occurs). If the hedged transaction results in
the acquisition of an asset or the incurrence of a liability, the gains and
losses in accumulated other comprehensive income shall be reclassified into
earnings in the same period or periods during which the asset acquired or
liability incurred affects earnings (such as in the periods that
depreciation expense, interest expense, or cost of sales is recognized).
However, if an entity expects at any time that continued reporting of a
loss in accumulated other comprehensive income would lead to recognizing a
net loss on the combination of the hedging instrument and the hedged
transaction (and related asset acquired or liability incurred) in one or
more future periods, a loss shall be reclassified immediately into earnings
for the amount that is not expected to be recovered. For example, a loss
shall be reported in earnings for a derivative that is designated as
hedging the forecasted purchase of inventory to the extent that the cost
basis of the inventory plus the related amount reported in accumulated
other comprehensive income exceeds the amount expected to be recovered
through sales of that inventory. (Impairment guidance is provided in
paragraphs 34 and 35.)
32. An entity shall discontinue prospectively the
accounting specified in paragraphs 30 and
31 for an existing hedge if any one of the
following occurs:
a. Any criterion in paragraphs 28 and 29 is no longer met.
b. The derivative expires or is sold, terminated, or
exercised.
c. The entity removes the designation of the cash flow hedge.
In those circumstances, the net gain or loss shall remain in accumulated
other comprehensive income and be reclassified into earnings as specified
in paragraph 31. Furthermore, the entity may
elect to
designate prospectively a new hedging relationship with a different hedging
instrument or, in the circumstances described in paragraphs
32(a) and 32(c), a different hedged transaction
or a hedged item if the
hedging relationship meets the criteria specified in
paragraphs 28 and 29
for a cash flow hedge or
paragraphs 20 and 21
for a fair value
hedge.
33. If a cash flow hedge is discontinued because it is
probable that the original forecasted transaction will not occur, the net
gain or loss in accumulated other comprehensive income shall be immediately
reclassified into earnings.
34. Existing requirements in generally accepted accounting
principles for assessing asset impairment or recognizing an increased
obligation apply to an asset or liability that gives rise to variable cash
flows (such as a variable-rate financial instrument), for which the
variable cash flows (the forecasted transactions) have been designated as
being hedged and accounted for pursuant to paragraphs 30
and 31. Those impairment requirements shall be
applied
each period after hedge accounting has been applied for the period,
pursuant to paragraphs 30 and 31 of
this Statement. The fair value or expected cash flows of a hedging
instrument shall not be considered in applying those requirements. The
gain or loss on the hedging instrument in accumulated other comprehensive
income shall, however, be accounted for as discussed in
paragraph 31.
35. If, under existing requirements in generally accepted
accounting principles, an impairment loss is recognized on an asset or an
additional obligation is recognized on a liability to which a hedged
forecasted transaction relates, any offsetting net gain related to that
transaction in accumulated other comprehensive income shall be reclassified
immediately into earnings. Similarly, if a recovery is recognized on the
asset or liability to which the forecasted transaction relates, any
offsetting net loss that has been accumulated in other comprehensive income
shall be reclassified immediately into earnings.
Foreign Currency Hedges
36. Consistent with the functional currency concept in
Statement 52, an entity may designate the following types of hedges of
foreign currency exposure, as specified in paragraphs
37-42:
a. A fair value hedge of an unrecognized firm commitment or an
available-for-sale security
b. A cash flow hedge of a forecasted foreign-currency-
denominated transaction or a forecasted intercompany
foreign-currency-denominated transaction
c. A hedge of a net investment in a foreign operation.
The criterion in paragraph 21(c)(1) requires
that a
recognized asset or liability that may give rise to a foreign currency
transaction gain or loss under Statement 52 (such as a foreign-
currency-denominated receivable or payable) not be the hedged item in a
foreign currency fair value or cash flow hedge because it is remeasured
with the changes in the carrying amount attributable to what would be the
hedged risk (an exchange rate change) reported currently in earnings.
Similarly, the criterion in paragraph 29(d)
requires
that the forecasted acquisition of an asset or the incurrence of a
liability that may give rise to a foreign currency transaction gain or loss
under Statement 52 not be the hedged item in a foreign currency cash flow
hedge because, subsequent to acquisition or incurrence, the asset or
liability will be remeasured with changes in the carrying amount
attributable to what would be the hedged risk reported currently in
earnings. A foreign currency derivative instrument that has been entered
into with another member of a consolidated group can be a hedging
instrument in the consolidated financial statements only if that other
member has entered into an offsetting contract with an unrelated third
party to hedge the exposure it acquired from issuing the derivative
instrument to the affiliate that initiated the hedge.
Foreign Currency Fair Value Hedges
37. Unrecognized firm commitment. A derivative
instrument or a nonderivative financial instrument \11/ that may give rise
to a foreign currency transaction gain or loss under Statement 52 can be
designated as hedging changes in the fair value of an unrecognized firm
commitment, or a specific portion thereof, attributable to foreign currency
exchange rates. The designated hedging relationship qualifies for the
accounting specified in paragraphs 22 -- 27 if
all the
fair value hedge criteria in paragraphs 20 and
21 are met.
==========================================================================
\11/ The carrying basis for a nonderivative financial instrument
that gives rise to a foreign currency transaction gain or
loss under Statement 52 is not addressed by this Statement.
==========================================================================
38. Available-for-sale security. A
nonderivative financial instrument shall not be designated as the hedging
instrument in a fair value hedge of the foreign currency exposure of an
available-for-sale security. A derivative instrument can be designated as
hedging the changes in the fair value of an available-for-sale
debt security (or a specific portion thereof) attributable to
changes in foreign currency exchange rates. The designated hedging
relationship qualifies for the accounting specified in
paragraphs 22 -- 27 if all the fair value hedge
criteria in
paragraphs 20 and 21
are met. An
available-for-sale equity security can be hedged for changes in
the fair value attributable to changes in foreign currency exchange rates
and qualify for the accounting specified in paragraphs 22
-- 27 only if the fair value hedge criteria in
paragraphs 20 and 21
are met and the following
two conditions are satisfied:
a. The security is not traded on an exchange (or other
established marketplace) on which trades are denominated in
the investor's functional currency.
b. Dividends or other cash flows to holders of the security
are all denominated in the same foreign currency as the
currency expected to be received upon sale of the security.
The change in fair value of the hedged available-for-sale equity security
attributable to foreign exchange risk is reported in earnings pursuant to
paragraph 23 and not in other comprehensive
income.
39. Gains and losses on a qualifying foreign currency fair
value hedge shall be accounted for as specified in
paragraphs 22 -- 27. The gain or loss on a
nonderivative hedging
instrument attributable to foreign currency risk is the foreign currency
transaction gain or loss as determined under Statement 52. \12/ That
foreign currency transaction gain or loss shall be recognized currently in
earnings along with the change in the carrying amount of the hedged firm
commitment.
==========================================================================
\12/ The foreign currency transaction gain or loss on a hedging
instrument is determined, consistent with paragraph 15
of
Statement 52, as the increase or decrease in functional
currency cash flows attributable to the change in spot
exchange rates between the functional currency and the
currency in which the hedging instrument is denominated.
==========================================================================
Foreign Currency Cash Flow Hedges
40. A nonderivative financial instrument shall not be
designated as a hedging instrument in a foreign currency cash flow hedge.
A derivative instrument designated as hedging the foreign currency exposure
to variability in the functional-currency-equivalent cash flows associated
with either a forecasted foreign-currency-denominated transaction (for
example, a forecasted export sale to an unaffiliated entity with the price
to be denominated in a foreign currency) or a forecasted intercompany
foreign-currency-denominated transaction (for example, a forecasted sale to
a foreign subsidiary or a forecasted royalty from a foreign subsidiary)
qualifies for hedge accounting if all of the following criteria are met:
a. The operating unit that has the foreign currency exposure
is a party to the hedging instrument (which can be an
instrument between a parent company and its subsidiary --
refer to paragraph 36).
b. The hedged transaction is denominated in a currency other
than that unit's functional currency.
c. All of the criteria in paragraphs 28 and 29 are met, except
for the criterion in paragraph 29(c) that
requires that the
forecasted transaction be with a party external to the
reporting entity.
d. If the hedged transaction is a group of individual
forecasted foreign-currency-denominated transactions, a
forecasted inflow of a foreign currency and a forecasted
outflow of the foreign currency cannot both be included in
the same group.
41. A qualifying foreign currency cash flow hedge shall be
accounted for as specified in paragraphs 30 -- 35.
Hedges of the Foreign Currency Exposure of a Net Investment
in a Foreign Operation
42. A derivative instrument or a nonderivative financial
instrument that may give rise to a foreign currency transaction gain or
loss under Statement 52 can be designated as hedging the foreign currency
exposure of a net investment in a foreign operation. The gain or loss on a
hedging derivative instrument (or the foreign currency transaction gain or
loss on the nonderivative hedging instrument) that is designated as, and is
effective as, an economic hedge of the net investment in a foreign
operation shall be reported in the same manner as a translation adjustment
to the extent it is effective as a hedge. The hedged net investment shall
be accounted for consistent with Statement 52; the provisions of this
Statement for recognizing the gain or loss on assets designated as being
hedged in a fair value hedge do not apply to the hedge of a net investment
in a foreign operation.
Accounting by Not-for-Profit Organizations and Other Entities
That Do Not Report Earnings
43. An entity that does not report earnings as a separate
caption in a statement of financial performance (for example, a
not-for-profit organization or a defined benefit pension plan) shall
recognize the gain or loss on a hedging instrument and a nonhedging
derivative instrument as a change in net assets in the period of change
unless the hedging instrument is designated as a hedge of the foreign
currency exposure of a net investment in a foreign operation. In that
case, the provisions of paragraph 42 of this
Statement
shall be applied. Entities that do not report earnings shall recognize the
changes in the carrying amount of the hedged item pursuant to
paragraph 22 in a fair value hedge as a change
in net assets in the
period of change. Those entities are not permitted to use cash flow hedge
accounting because they do not report earnings separately. Consistent with
the provisions of FASB Statement No. 117, Financial
Statements of Not-for-Profit Organizations, this Statement does not
prescribe how a not-for-profit organization should determine the components
of an operating measure, if one is presented.
Disclosures
44. An entity that holds or issues derivative instruments
(or nonderivative instruments that are designated and qualify as hedging
instruments pursuant to paragraphs 37 and
42) shall disclose its objectives for holding or
issuing those
instruments, the context needed to understand those objectives, and its
strategies for achieving those objectives. The description shall
distinguish between derivative instruments (and nonderivative instruments)
designated as fair value hedging instruments, derivative instruments
designated as cash flow hedging instruments, derivative instruments (and
nonderivative instruments) designated as hedging instruments for hedges of
the foreign currency exposure of a net investment in a foreign operation,
and all other derivatives. The description also shall indicate the
entity's risk management policy for each of those types of hedges,
including a description of the items or transactions for which risks are
hedged. For derivative instruments not designated as hedging instruments,
the description shall indicate the purpose of the derivative activity.
Qualitative disclosures about an entity's objectives and strategies for
using derivative instruments may be more meaningful if such objectives and
strategies are described in the context of an entity's overall risk
management profile. If appropriate, an entity is encouraged, but not
required, to provide such additional qualitative disclosures.
45. An entity's disclosures for every reporting period for
which a complete set of financial statements is presented also shall
include the following:
Fair value hedges
a. For derivative instruments, as well as nonderivative
instruments that may give rise to foreign currency
transaction gains or losses under Statement 52, that have
been designated and have qualified as fair value hedging
instruments and for the related hedged items:
(1) The net gain or loss recognized in earnings
during the reporting period representing (a) the
amount of the hedges' ineffectiveness and (b) the
component of the derivative instruments' gain or
loss, if any, excluded from the assessment of
hedge effectiveness, and a description of where
the net gain or loss is reported in the statement
of income or other statement of financial
performance
(2) The amount of net gain or loss recognized in
earnings when a hedged firm commitment no longer
qualifies as a fair value hedge.
Cash flow hedges
b. For derivative instruments that have been designated and
have qualified as cash flow hedging instruments and for the
related hedged transactions:
(1) The net gain or loss recognized in earnings
during the reporting period representing (a) the
amount of the hedges' ineffectiveness and (b) the
component of the derivative instruments' gain or
loss, if any, excluded from the assessment of
hedge effectiveness, and a description of where
the net gain or loss is reported in the statement
of income or other statement of financial
performance
(2) A description of the transactions or other events
that will result in the reclassification into
earnings of gains and losses that are reported in
accumulated other comprehensive income, and the
estimated net amount of the existing gains or
losses at the reporting date that is expected to
be reclassified into earnings within the next 12
months
(3) The maximum length of time over which the entity
is hedging its exposure to the variability in
future cash flows for forecasted transactions
excluding those forecasted transactions related
to the payment of variable interest on existing
financial instruments
(4) The amount of gains and losses reclassified into
earnings as a result of the discontinuance of
cash flow hedges because it is probable that the
original forecasted transactions will not occur.
Hedges of the net investment in a foreign operation
c. For derivative instruments, as well as nonderivative
instruments that may give rise to foreign currency
transaction gains or losses under Statement 52, that have
been designated and have qualified as hedging instruments
for hedges of the foreign currency exposure of a net
investment in a foreign operation, the net amount of gains
or losses included in the cumulative translation adjustment
during the reporting period.
The quantitative disclosures about derivative instruments may be more
useful, and less likely to be perceived to be out of context or otherwise
misunderstood, if similar information is disclosed about other financial
instruments or nonfinancial assets and liabilities to which the derivative
instruments are related by activity. Accordingly, in those situations, an
entity is encouraged, but not required, to present a more complete picture
of its activities by disclosing that information.
Reporting Changes in the Components of Comprehensive Income
46. An entity shall display as a separate classification
within other comprehensive income the net gain or loss on derivative
instruments designated and qualifying as cash flow hedging instruments that
are reported in comprehensive income pursuant to paragraphs
30 and 41.
47. As part of the disclosures of accumulated other
comprehensive income, pursuant to paragraph 26 of FASB
Statement No. 130, Reporting Comprehensive
Income, an entity
shall separately disclose the beginning and ending accumulated derivative
gain or loss, the related net change associated with current period hedging
transactions, and the net amount of any reclassification into earnings.
Effective Date and Transition
48. This Statement shall be effective for all fiscal
quarters of all fiscal years beginning after June 15, 1999. Initial
application of this Statement shall be as of the beginning of an entity's
fiscal quarter; on that date, hedging relationships shall be designated
anew and documented pursuant to the provisions of this Statement. Earlier
application of all of the provisions of this Statement is encouraged but is
permitted only as of the beginning of any fiscal quarter that begins after
issuance of this Statement. Earlier application of selected provisions of
this Statement is not permitted. This Statement shall not be applied
retroactively to financial statements of prior periods.
49. At the date of initial application, an entity shall
recognize all freestanding derivative instruments (that is, derivative
instruments other than embedded derivative instruments) in the statement of
financial position as either assets or liabilities and measure them at fair
value, pursuant to paragraph 17.\13/ The
difference
between a derivative's previous carrying amount and its fair value shall be
reported as a transition adjustment, as discussed in
paragraph 52. The entity also shall recognize
offsetting gains and
losses on hedged assets, liabilities, and firm commitments by adjusting
their carrying amounts at that date, as discussed in
paragraph 52(b). Any gains or losses on
derivative instruments that
are reported independently as deferred gains or losses (that is,
liabilities or assets) in the statement of financial position at the date
of initial application shall be derecognized from that statement; that
derecognition also shall be reported as transition adjustments as indicated
in paragraph 52. Any gains or losses on
derivative
instruments reported in other comprehensive income at the date of initial
application because the derivative instruments were hedging the fair value
exposure of available-for-sale securities also shall be reported as
transition adjustments; the offsetting losses and gains on the securities
shall be accounted for pursuant to paragraph 52(b).
Any
gain or loss on a derivative instrument reported in accumulated other
comprehensive income at the date of initial application because the
derivative instrument was hedging the variable cash flow
exposure of a forecasted (anticipated) transaction related to an
available-for-sale security shall remain in accumulated other comprehensive
income and shall not be reported as a transition adjustment. The
accounting for any gains and losses on derivative instruments that arose
prior to the initial application of the Statement and that were previously
added to the carrying amount of recognized hedged assets or liabilities is
not affected by this Statement. Those gains and losses shall not be
included in the transition adjustment.
==========================================================================
\13/ For a compound derivative that has a foreign currency
exchange risk component (such as a foreign currency
interest rate swap), an entity is permitted at the date of
initial application to separate the compound derivative
into two parts: the foreign currency derivative and the
remaining derivative. Each of them would thereafter be
accounted for at fair value, with an overall limit that the
sum of their fair values could not exceed the fair value of
the compound derivative. An entity may not separate a
compound derivative into components representing different
risks after the date of initial application.
==========================================================================
50. At the date of initial application, an entity also
shall recognize as an asset or liability in the statement of financial
position any embedded derivative instrument that is required pursuant to
paragraphs 12 -- 16 to be separated from its
host
contract if the hybrid instrument in which it is embedded was issued,
acquired, or substantively modified by the entity after December 31, 1997.
For all of its hybrid instruments that exist at the date of initial
application and were issued or acquired before January 1, 1998 and not
substantively modified thereafter, an entity may choose either (a) not to
apply this Statement to any of those hybrid instruments or (b) to recognize
as assets or liabilities all the derivative instruments embedded in those
hybrid instruments that would be required pursuant to
paragraphs 12 -- 16 to be separated from their
host contracts. That
choice is not permitted to be applied to only some of an entity's
individual hybrid instruments and must be applied on an all-or-none basis.
51. If an embedded derivative instrument is to be
separated from its host contract in conjunction with the initial
application of this Statement, the entity shall consider the following in
determining the related transition adjustment:
a. The carrying amount of the host contract at the date of
initial application shall be based on its fair value on the
date that the hybrid instrument was issued or acquired by
the entity and shall reflect appropriate adjustments for
subsequent activity, such as subsequent cash receipts or
payments and the amortization of any premium or discount on
the host contract arising from the separation of the
embedded derivative.
b. The carrying amount of the embedded derivative instrument
at the date of initial application shall be its fair value.
c. The transition adjustment shall be the difference at the
date of initial application between (1) the previous
carrying amount of the hybrid instrument and (2) the sum of
the new net carrying amount of the host contract and the
fair value of the embedded derivative instrument. The
entity shall not retroactively designate a hedging
relationship that could have been made had the embedded
derivative instrument initially been accounted for separate
from the host contract.
52. The transition adjustments resulting from adopting
this Statement shall be reported in net income or other comprehensive
income, as appropriate, as the effect of a change in accounting principle
and presented in a manner similar to the cumulative effect of a change in
accounting principle as described in paragraph 20 of APB
Opinion
No. 20, Accounting Changes. Whether a
transition adjustment
related to a specific derivative instrument is reported in net income,
reported in other comprehensive income, or allocated between both is based
on the hedging relationships, if any, that had existed for that derivative
instrument and that were the basis for accounting under generally accepted
accounting principles before the date of initial application of this
Statement.
a. If the transition adjustment relates to a derivative
instrument that had been designated in a hedging
relationship that addressed the variable cash flow exposure
of a forecasted (anticipated) transaction, the transition
adjustment shall be reported as a cumulative-effect-type
adjustment of accumulated other comprehensive income.
b. If the transition adjustment relates to a derivative
instrument that had been designated in a hedging
relationship that addressed the fair value exposure of an
asset, a liability, or a firm commitment, the transition
adjustment for the derivative shall be reported as a
cumulative-effect-type adjustment of net income.
Concurrently, any gain or loss on the hedged item (that is,
difference between the hedged item's fair value and its
carrying amount) shall be recognized as an adjustment of
the hedged item's carrying amount at the date of initial
application, but only to the extent of an offsetting
transition adjustment for the derivative. That adjustment
of the hedged item's carrying amount shall also be reported
as a cumulative-effect-type adjustment of net income. The
transition adjustment related to the gain or loss reported
in accumulated other comprehensive income on a derivative
instrument that hedged an available-for-sale security,
together with the loss or gain on the related security (to
the extent of an offsetting transition adjustment for the
derivative instrument), shall be reclassified to earnings
as a cumulative-effect-type adjustment of both net income
and accumulated other comprehensive income.
c. If a derivative instrument had been designated in multiple
hedging relationships that addressed both the fair value
exposure of an asset or a liability and the variable cash
flow exposure of a forecasted (anticipated) transaction,
the transition adjustment for the derivative shall be
allocated between the cumulative-effect-type adjustment of
net income and the cumulative-effect-type adjustment of
accumulated other comprehensive income and shall be
reported as discussed in paragraphs 52(a) and 52(b)
above.
Concurrently, any gain or loss on the hedged item shall be
accounted for at the date of initial application as
discussed in paragraph 52(b) above.
d. Other transition adjustments not encompassed by paragraphs
52(a), 52(b), and 52(c) above shall be reported
as part of
the cumulative-effect-type adjustment of net income.
53. Any transition adjustment reported as a
cumulative-effect- type adjustment of accumulated other comprehensive
income shall be subsequently reclassified into earnings in a manner
consistent with paragraph 31. For those amounts,
an
entity shall disclose separately in the year of initial application the
amount of gains and losses reported in accumulated other comprehensive
income and associated with the transition adjustment that are being
reclassified into earnings during the 12 months following the date of
initial application.
54. At the date of initial application, an entity may
transfer any held-to-maturity security into the available-for-sale category
or the trading category. An entity will then be able in the future to
designate a security transferred into the available-for-sale category as
the hedged item, or its variable interest payments as the cash flow hedged
transactions, in a hedge of the exposure to changes in market interest
rates, changes in foreign currency exchange rates, or changes in its
overall fair value. (paragraph 21(d) precludes a
held-to- maturity security from being designated as the hedged item in a
fair value hedge of market interest rate risk or the risk of changes in its
overall fair value. paragraph 29(e) similarly
precludes
the variable cash flows of a held-to-maturity security from being
designated as the hedged transaction in a cash flow hedge of market
interest rate risk.) The unrealized holding gain or loss on a
held-to-maturity security transferred to another category at the date of
initial application shall be reported in net income or accumulated other
comprehensive income consistent with the requirements of paragraphs 15(b)
and 15(c) of Statement 115 and reported with the other transition
adjustments discussed in paragraph 52 of this
Statement.
Such transfers from the held-to-maturity category at the date of initial
adoption shall not call into question an entity's intent to hold other debt
securities to maturity in the future. \14/
==========================================================================
\14/ EITF Topic No. D-51, "The
Applicability of FASB Statement
No. 115 to Desecuritizations of Financial
Assets,"
indicates that certain financial assets received or
retained in a desecuritization must be held to maturity to
avoid calling into question the entity's intent to hold
other debt securities to maturity in the future. In
conjunction with the initial adoption of this Statement,
the held-to-maturity restriction on those financial assets
held on the date of initial application is removed, and
those financial assets that had been received or retained
in a previous desecuritization are available in the future
to be designated as the hedged item, or their variable
interest payments as the hedged transaction, in a hedge of
the exposure to changes in market interest rates.
Consequently, the sale of those financial assets before
maturity would not call into question the entity's intent
to hold other debt securities to maturity in the future.
==========================================================================
55. At the date of initial application, an entity may
transfer any available-for-sale security into the trading category. After
any related transition adjustments from initially applying this Statement
have been recognized, the unrealized holding gain or loss remaining in
accumulated other comprehensive income for any transferred security at the
date of initial application shall be reclassified into earnings (but not
reported as part of the cumulative-effect-type adjustment for the
transition adjustments), consistent with paragraph 15(b) of Statement 115.
If a derivative instrument had been hedging the variable cash flow exposure
of a forecasted transaction related to an available-for-sale security that
is transferred into the trading category at the date of initial application
and the entity had reported a gain or loss on that derivative instrument in
other comprehensive income (consistent with paragraph 115 of Statement
115), the entity also shall reclassify those derivative gains and losses
into earnings (but not report them as part of the cumulative-effect-type
adjustment for the transition adjustments).
56. At the date of initial application, mortgage bankers
and other servicers of financial assets may choose to restratify their
servicing rights pursuant to paragraph 37(g) of Statement 125 in a manner
that would enable individual strata to comply with the requirements of this
Statement regarding what constitutes "a portfolio of similar assets." As
noted in footnote 9 of this Statement, mortgage bankers and other servicers
of financial assets that designate a hedged portfolio by aggregating
servicing rights within one or more risk strata used under paragraph 37(g)
of Statement 125 would not necessarily comply with the requirement in
paragraph 21(a) of this Statement for portfolios
of
similar assets, since the risk stratum under paragraph 37(g) of Statement
125 can be based on any predominant risk characteristic, including date of
origination or geographic location. The restratification of servicing
rights is a change in the application of an accounting principle, and the
effect of that change as of the initial application of this Statement shall
be reported as part of the cumulative-effect-type adjustment for the
transition adjustments.
The provisions of this Statement need
not be applied to immaterial items.
This Statement was adopted by the unanimous vote of the seven
members of the Financial Accounting Standards Board:
Edmund L. Jenkins, Chairman
Joseph V. Anania
Anthony T. Cope
John M. Foster
Gaylen N. Larson
James J. Leisenring
Gerhard G. Mueller
FAS 133 Appendix A: IMPLEMENTATION GUIDANCE
Appendix A
IMPLEMENTATION GUIDANCE
Section 1: Scope and Definition
Application of paragraphs 6 -- 11
57. The following discussion further explains the three
characteristics of a derivative instrument discussed in
paragraphs 6 -- 9.
a. Underlying. An underlying is a variable that, along with
either a notional amount or a payment provision, determines
the settlement of a derivative. An underlying usually is
one or a combination of the following:
(1) A security price or security price index
(2) A commodity price or commodity price index
(3) An interest rate or interest rate index
(4) A credit rating or credit index
(5) An exchange rate or exchange rate index
(6) An insurance index or catastrophe loss index
(7) A climatic or geological condition (such as
temperature, earthquake severity, or rainfall),
another physical variable, or a related index.
However, an underlying may be any variable whose changes are observable or
otherwise objectively verifiable. paragraph 10(e)
specifically excludes a contract with settlement based on certain variables
unless the contract is exchange-traded. A contract based on any variable
that is not specifically excluded is subject to the requirements of this
Statement if it has the other two characteristics identified in
paragraph 6 (which also are discussed in paragraphs
57(b) and paragraphs 57(c) below).
b. Initial net investment. A derivative requires no initial
net investment or a smaller initial net investment than
other types of contracts that have a similar response to
changes in market factors. For example, entering into a
commodity futures contract generally requires no net
investment, while purchasing the same commodity requires an
initial net investment equal to its market price. However,
both contracts reflect changes in the price of the
commodity in the same way (that is, similar gains or losses
will be incurred). A swap or forward contract also
generally does not require an initial net investment unless
the terms favor one party over the other. An option
generally requires that one party make an initial net
investment (a premium) because that party has the rights
under the contract and the other party has the obligations.
The phrase initial net investment is stated from the
perspective of only one party to the contract, but it
determines the application of the Statement for both
parties. \15/
==========================================================================
\15/ Even though a contract may be a derivative as described in
paragraphs 6-10 for both parties, the exceptions
in
paragraph 11 apply only to the issuer of the
contract and
will result in different reporting by the two parties. The
exception in paragraph 10(b) also may apply to
one of the
parties but not the other.
==========================================================================
c. Net settlement. A contract that meets any one of the
following criteria has the characteristic described as net
settlement:
(1) Its terms implicitly or explicitly require or
permit net settlement. For example, a penalty
for nonperformance in a purchase order is a net
settlement provision if the amount of the penalty
is based on changes in the price of the items
that are the subject of the contract. Net
settlement may be made in cash or by delivery of
any other asset, whether or not it is readily
convertible to cash. A fixed penalty for
nonperformance is not a net settlement provision.
(2) There is an established market mechanism that
facilitates net settlement outside the contract.
The term market mechanism is to be interpreted
broadly. Any institutional arrangement or other
agreement that enables either party to be
relieved of all rights and obligations under the
contract and to liquidate its net position
without incurring a significant transaction cost
is considered net settlement.
(3) It requires delivery of an asset that is readily
convertible to cash. The definition of readily
convertible to cash in FASB Concepts Statement
No. 5, Recognition and Measurement in
Financial
Statements of Business Enterprises, includes, for
example, a security or commodity traded in an
active market and a unit of foreign currency that
is readily convertible into the functional
currency of the reporting entity. A security
that is publicly traded but for which the market
is not very active is readily convertible to cash
if the number of shares or other units of the
security to be exchanged is small relative to the
daily transaction volume. That same security
would not be readily convertible if the number of
shares to be exchanged is large relative to the
daily transaction volume. The ability to use a
security that is not publicly traded or an
agricultural or mineral product without an active
market as collateral in a borrowing does not, in
and of itself, mean that the security or the
commodity is readily convertible to cash.
58. The following discussion further explains some of the
exceptions discussed in paragraph 10.
a. "Regular-way" security trades. The exception in paragraph
10(a) applies only to a contract that requires
delivery of
securities that are readily convertible to cash. \16/ To
qualify, a contract must require delivery of such a
security within the period of time after the trade date
that is customary in the market in which the trade takes
place. For example, a contract to purchase or sell a
publicly traded equity security in the United States
customarily requires settlement within three business days.
If a contract for purchase of that type of security
requires settlement in three business days, the regular-way
exception applies, but if the contract requires settlement
in five days, the regular-way exception does not apply.
This Statement does not change whether an entity recognizes
regular-way security trades on the trade date or the
settlement date. However, trades that do not qualify for
the regular-way exception are subject to the requirements
of this Statement regardless of the method an entity uses
to report its security trades.
==========================================================================
\16/ Contracts that require delivery of securities that are not
readily convertible to cash are not subject to the
requirements of this Statement unless there is a market
mechanism outside the contract to facilitate net
settlement.
==========================================================================
b. Normal purchases and normal sales. The exception in
paragraph 10(b) applies only to a contract that
requires
future delivery of assets (other than financial instruments
or derivative instruments) that are readily convertible to
cash \17/ and only if there is no market mechanism to
facilitate net settlement outside the contract. To qualify
for the exception, a contract's terms also must be
consistent with the terms of an entity's normal purchases
or normal sales, that is, the quantity purchased or sold
must be reasonable in relation to the entity's business
needs. Determining whether or not the terms are consistent
will require judgment. In making those judgments, an
entity should consider all relevant factors, such as (1)
the quantities provided under the contract and the entity's
need for the related assets, (2) the locations to which
delivery of the items will be made, (3) the period of time
between entering into the contract and delivery, and (4)
the entity's prior practices with regard to such contracts.
Evidence such as past trends, expected future demand, other
contracts for delivery of similar items, an entity's and
industry's customs for acquiring and storing the related
commodities, and an entity's operating locations should
help in identifying contracts that qualify as normal
purchases or normal sales.
==========================================================================
\17/ Contracts that require delivery of assets that are not
readily convertible to cash are not subject to the
requirements of this Statement unless there is a market
mechanism outside the contract to facilitate net
settlement.
==========================================================================
c. 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.
59. The following discussion illustrates the application of
paragraphs 6 -- 11 in several situations.
a. Forward purchases or sales of to-be-announced securities or
securities when-issued, as-issued, or if-issued. A
contract for the purchase and sale of a security when, as,
or if issued or to be announced is excluded from the
requirements of this Statement as a regular-way security
trade if (1) there is no other way to purchase or sell that
security and (2) settlement will occur within the shortest
period possible for that security.
b. Credit-indexed contracts (often referred to as credit
derivatives). Many different types of contracts are
indexed to the creditworthiness of a specified entity or
group of entities, but not all of them are derivative
instruments. Credit-indexed contracts that have certain
characteristics described in paragraph 10(d) are
guarantees
and are not subject to the requirements of this Statement.
Credit-indexed contracts that do not have the
characteristics necessary to qualify for the exception in
paragraph 10(d) are subject to the requirements
of this
Statement. One example of the latter is a credit-indexed
contract that requires a payment due to changes in the
creditworthiness of a specified entity even if neither
party incurs a loss due to the change (other than a loss
caused by the payment under the credit-indexed contract).
c. Take-or-pay contracts. Under a take-or-pay contract, an
entity agrees to pay a specified price for a specified
quantity of a product whether or not it takes delivery.
Whether a take-or-pay contract is subject to this Statement
depends on its terms. For example, if the product to be
delivered is not readily convertible to cash and there is
no net settlement option, the contract fails to meet the
criterion in paragraph 6(c) and is not subject
to the
requirements of this Statement. However, a contract that
meets all of the following conditions is subject to the
requirements of this Statement: (1) the product to be
delivered is readily convertible to cash, (2) the contract
does not qualify for the normal purchases and normal sales
exception in paragraph 10(b), and (3) little or no initial
net investment in the contract is required.
d. Short sales (sales of borrowed securities). \18/ Short
sales typically involve the following activities:
==========================================================================
\18/ This discussion applies only to short sales with the
characteristics described here. Some groups of
transactions that are referred to as short sales may have
different characteristics. If so, a different analysis
would be appropriate, and other derivative instruments may
be involved.
==========================================================================
(1) Selling a security (by the short seller to the
purchaser)
(2) Borrowing a security (by the short seller from
the lender)
(3) Delivering the borrowed security (by the short
seller to the purchaser)
(4) Purchasing a security (by the short seller from
the market)
(5) Delivering the purchased security (by the short
seller to the lender).
Those five activities involve three separate contracts. A contract
that distinguishes a short sale involves activities (2) and (5), borrowing
a security and replacing it by delivering an identical security. Such a
contract has two of the three characteristics of a derivative instrument.
The settlement is based on an underlying (the price of the security) and a
notional amount (the face amount of the security or the number of shares),
and the settlement is made by delivery of a security that is readily
convertible to cash. However, the other characteristic, little or no
initial net investment, is not present. The borrowed security is the
lender's initial net investment in the contract. Consequently, the
contract relating to activities (2) and (5) is not a derivative instrument.
The other two contracts (one for activities (1) and (3) and the other for
activity (4)) are routine and do not generally involve derivative
instruments. However, if a forward purchase or sale is involved, and the
contract does not qualify for the exception in paragraph
10(a), it is subject to the requirements of
this Statement.
e. Repurchase agreements and "wash sales" (accounted for as
sales as described in paragraphs 68 and 69 of Statement
125). A transfer of financial assets accounted for as a
sale under Statement 125 in which the transferor is both
obligated and entitled to repurchase the transferred asset
at a fixed or determinable price contains two separate
features, one of which may be a derivative. The initial
exchange of financial assets for cash is a sale-purchase
transaction -- generally not a transaction that involves a
derivative instrument. However, the accompanying forward
contract that gives the transferor the right and obligation
to repurchase the transferred asset involves an underlying
and a notional amount (the price of the security and its
denomination), and it does not require an initial net
investment in the contract. Consequently, if the forward
contract requires delivery of a security that is readily
convertible to cash or otherwise meets the net settlement
criterion in paragraph 9, it is subject to the
requirements
of this Statement.
Application of the Clearly-and-Closely-Related Criterion in
paragraphs 12 -- 16
60. In discussing whether a hybrid instrument contains an
embedded derivative instrument (also simply referred to as an
embedded derivative) that warrants separate accounting,
paragraph 12 focuses on whether the economic
characteristics and
risks of the embedded derivative are clearly and closely related to the
economic characteristics and risks of the host contract. If the host
contract encompasses a residual interest in an entity, then its economic
characteristics and risks should be considered that of an equity instrument
and an embedded derivative would need to possess principally equity
characteristics (related to the same entity) to be considered clearly and
closely related to the host contract. However, most commonly, a financial
instrument host contract will not embody a claim to the residual interest
in an entity and, thus, the economic characteristics and risks of the host
contract should be considered that of a debt instrument. For example, even
though the overall hybrid instrument that provides for repayment of
principal may include a return based on the market price (the underlying as
defined in this Statement) of XYZ Corporation common stock, the host
contract does not involve any existing or potential residual interest
rights (that is, rights of ownership) and thus would not be an equity
instrument. The host contract would instead be considered a debt
instrument, and the embedded derivative that incorporates the equity-based
return would not be clearly and closely related to the host contract. If
the embedded derivative is considered not to be clearly and closely related
to the host contract, the embedded derivative must be separated from the
host contract and accounted for as a derivative instrument by both
parties to the hybrid instrument, except as provided by
paragraph 11(a).
61. The following guidance is relevant in deciding whether
the economic characteristics and risks of the embedded derivative are
clearly and closely related to the economic characteristics and risks of
the host contract.
a. Interest rate indexes. An embedded derivative in which the
underlying is an interest rate or interest rate index and a
host contract that is considered a debt instrument are
considered to be clearly and closely related unless, as
discussed in paragraph 13, the embedded
derivative contains
a provision that (1) permits any possibility whatsoever
that the investor's (or creditor's) undiscounted net cash
inflows over the life of the instrument would not recover
substantially all of its initial recorded investment in the
hybrid instrument under its contractual terms or (2) could
under any possibility whatsoever at least double the
investor's initial rate of return on the host contract and
also result in a rate of return that is at least twice what
otherwise would be the market return for a contract that
has the same terms as the host contract and that involves a
debtor with a similar credit quality. The requirement to
separate the embedded derivative from the host contract
applies to both parties to the hybrid instrument even
though the above tests focus on the investor's net cash
inflows. Plain-vanilla servicing rights, which involve an
obligation to perform servicing and the right to receive
fees for performing that servicing, do not contain an
embedded derivative that would be separated from those
servicing rights and accounted for as a derivative.
b. Inflation-indexed interest payments. The interest rate and
the rate of inflation in the economic environment for the
currency in which a debt instrument is denominated are
considered to be clearly and closely related. Thus,
nonleveraged inflation-indexed contracts (debt instruments,
capitalized lease obligations, pension obligations, and so
forth) would not have the inflation-related embedded
derivative separated from the host contract.
c. Credit-sensitive payments. The creditworthiness of the
debtor and the interest rate on a debt instrument are
considered to be clearly and closely related. Thus, for
debt instruments that have the interest rate reset in the
event of (1) default (such as violation of a credit-risk-
related covenant), (2) a change in the debtor's published
credit rating, or (3) a change in the debtor's
creditworthiness indicated by a change in its spread over
Treasury bonds, the related embedded derivative would not
be separated from the host contract.
d. Calls and puts on debt instruments. Call options (or put
options) that can accelerate the repayment of principal on
a debt instrument are considered to be clearly and closely
related to a debt instrument that requires principal
repayments unless both (1) the debt involves a substantial
premium or discount (which is common with zero-coupon
bonds) and (2) the put or call option is only contingently
exercisable. Thus, if a substantial premium or discount is
not involved, embedded calls and puts (including contingent
call or put options that are not exercisable unless an
event of default occurs) would not be separated from the
host contract. However, for contingently exercisable calls
and puts to be considered clearly and closely related, they
can be indexed only to interest rates or credit risk, not
some extraneous event or factor. In contrast, call options
(or put options) that do not accelerate the repayment of
principal on a debt instrument but instead require a cash
settlement that is equal to the price of the option at the
date of exercise would not be considered to be clearly and
closely related to the debt instrument in which it is
embedded and would be separated from the host contract. In
certain unusual situations, a put or call option may have
been subsequently added to a debt instrument in a manner
that causes the investor (creditor) to be exposed to
performance risk (default risk) by different parties for
the embedded option and the host debt instrument,
respectively. In those unusual situations, the embedded
option and the host debt instrument are not clearly and
closely related.
e. Calls and puts on equity instruments. A put option that
enables the holder to require the issuer of an equity
instrument to reacquire that equity instrument for cash or
other assets is not clearly and closely related to that
equity instrument. Thus, such a put option embedded in the
equity instrument to which it relates should be separated
from the host contract by the holder of the equity
instrument. That put option also should be separated from
the host contract by the issuer of the equity instrument
except in those cases in which the put option is not
considered to be a derivative instrument pursuant to
paragraph 11(a) because it is classified in
stockholders'
equity. A purchased call option that enables the issuer of
an equity instrument (such as common stock) to reacquire
that equity instrument would not be considered to be a
derivative instrument by the issuer of the equity
instrument pursuant to paragraph 11(a). Thus, if
the call
option were embedded in the related equity instrument, it
would not be separated from the host contract by the
issuer. However, for the holder of the related equity
instrument, the embedded written call option would not be
considered to be clearly and closely related to the equity
instrument and should be separated from the host contract.
f. Floors, caps, and collars. Floors or caps (or collars,
which are combinations of caps and floors) on interest
rates and the interest rate on a debt instrument are
considered to be clearly and closely related, provided the
cap is at or above the current market price (or rate) and
the floor is at or below the current market price (or rate)
at issuance of the instrument. Thus, the derivative
embedded in a variable-rate debt instrument that has a
floor on the interest rate (that is, the floor option)
would not be separated from the host contract and accounted
for separately even though, in a falling interest rate
environment, the debt instrument may have a return to the
investor that is a significant amount above the market
return of a debt instrument without the floor provision
(refer to paragraph 13(b)).
g. Term-extending options. An embedded derivative provision
that either (1) unilaterally enables one party to extend
significantly the remaining term to maturity or
(2) automatically extends significantly the remaining term
triggered by specific events or conditions is not clearly
and closely related to the interest rate on a debt
instrument unless the interest rate is concurrently reset
to the approximate current market rate for the extended
term and the debt instrument initially involved no
significant discount. Thus, if there is no reset of
interest rates, the embedded derivative must be separated
from the host contract and accounted for as a derivative
instrument. That is, a term-extending option cannot be
used to circumvent the restriction in paragraph 61(a)
regarding the investor's not recovering substantially all
of its initial recorded investment.
h. Equity-indexed interest payments. The changes in fair
value of an equity interest and the interest yield on a
debt instrument are not clearly and closely related. Thus,
an equity-related derivative embedded in an equity-indexed
debt instrument (whether based on the price of a specific
common stock or on an index that is based on a basket of
equity instruments) must be separated from the host
contract and accounted for as a derivative instrument.
i. Commodity-indexed interest or principal payments. The
changes in fair value of a commodity (or other asset) and
the interest yield on a debt instrument are not clearly and
closely related. Thus, a commodity-related derivative
embedded in a commodity-indexed debt instrument must be
separated from the noncommodity host contract and accounted
for as a derivative instrument.
j. Indexed rentals:
(1) Inflation-indexed rentals. Rentals for the use
of leased assets and adjustments for inflation on
similar property are considered to be clearly and
closely related. Thus, unless a significant
leverage factor is involved, the inflation-
related derivative embedded in an inflation-
indexed lease contract would not be separated
from the host contract.
(2) Contingent rentals based on related sales. Lease
contracts that include contingent rentals based
on certain sales of the lessee would not have the
contingent-rental-related embedded derivative
separated from the host contract because, under
paragraph 10(e)(3), a non-exchange-traded
contract whose underlying is specified volumes of
sales by one of the parties to the contract would
not be subject to the requirements of this
Statement.
(3) Contingent rentals based on a variable interest
rate. The obligation to make future payments for
the use of leased assets and the adjustment of
those payments to reflect changes in a variable-
interest-rate index are considered to be clearly
and closely related. Thus, lease contracts that
include contingent rentals based on changes in
the prime rate would not have the contingent-
rental-related embedded derivative separated from
the host contract.
k. 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.
(For example, if the common stock was not readily
convertible to cash, a conversion option that requires
purchase of the common stock would not be accounted for as
a derivative.) That accounting applies only to the holder
(investor) if the debt is convertible to the debtor's
common stock because, under paragraph 11(a), a
separate
option with the same terms would not be considered to be a
derivative for the issuer.
l. Convertible preferred stock. Because the changes in fair
value of an equity interest and interest rates on a debt
instrument are not clearly and closely related, the terms
of the preferred stock (other than the conversion option)
must be analyzed to determine whether the preferred stock
(and thus the potential host contract) is more akin to an
equity instrument or a debt instrument. A typical
cumulative fixed-rate preferred stock that has a mandatory
redemption feature is more akin to debt, whereas cumulative
participating perpetual preferred stock is more akin to an
equity instrument.
Section 2: Assessment of Hedge Effectiveness
Hedge Effectiveness Requirements of This Statement
62. This Statement requires that an entity define at the
time it designates a hedging relationship the method it will use to assess
the hedge's effectiveness in achieving offsetting changes in fair value or
offsetting cash flows attributable to the risk being hedged. It also
requires that an entity use that defined method consistently throughout the
hedge period (a) to assess at inception of the hedge and on an ongoing
basis whether it expects the hedging relationship to be highly effective in
achieving offset and (b) to measure the ineffective part of the hedge. If
the entity identifies an improved method and wants to apply that method
prospectively, it must discontinue the existing hedging relationship and
designate the relationship anew using the improved method. This Statement
does not specify a single method for either assessing whether a hedge is
expected to be highly effective or measuring hedge ineffectiveness. The
appropriateness of a given method of assessing hedge effectiveness can
depend on the nature of the risk being hedged and the type of hedging
instrument used. Ordinarily, however, an entity should assess
effectiveness for similar hedges in a similar manner; use of different
methods for similar hedges should be justified.
63. In defining how hedge effectiveness will be assessed,
an entity must specify whether it will include in that assessment all of
the gain or loss on a hedging instrument. This Statement permits (but does
not require) an entity to exclude all or a part of the hedging instrument's
time value from the assessment of hedge effectiveness, as follows:
a. If the effectiveness of a hedge with an option contract is
assessed based on changes in the option's intrinsic value,
the change in the time value of the contract would be
excluded from the assessment of hedge effectiveness.
b. If the effectiveness of a hedge with an option contract is
assessed based on changes in the option's minimum value,
that is, its intrinsic value plus the effect of
discounting, the change in the volatility value of the
contract would be excluded from the assessment of hedge
effectiveness.
c. If the effectiveness of a hedge with a forward or futures
contract is assessed based on changes in fair value
attributable to changes in spot prices, the change in the
fair value of the contract related to the changes in the
difference between the spot price and the forward or
futures price would be excluded from the assessment of
hedge effectiveness.
In each circumstance above, changes in the excluded component would be
included currently in earnings, together with any ineffectiveness that
results under the defined method of assessing ineffectiveness. As noted in
paragraph 62, the effectiveness of similar
hedges
generally should be assessed similarly; that includes whether a component
of the gain or loss on a derivative is excluded in assessing effectiveness.
No other components of a gain or loss on the designated hedging instrument
may be excluded from the assessment of hedge effectiveness.
64. In assessing the effectiveness of a cash flow hedge,
an entity generally will need to consider the time value of money if
significant in the circumstances. Considering the effect of the time value
of money is especially important if the hedging instrument involves
periodic cash settlements. An example of a situation in which an entity
likely would reflect the time value of money is a tailing strategy with
futures contracts. When using a tailing strategy, an entity adjusts the
size or contract amount of futures contracts used in a hedge so that
earnings (or expense) from reinvestment (or funding) of daily settlement
gains (or losses) on the futures do not distort the results of the hedge.
To assess offset of expected cash flows when a tailing strategy has been
used, an entity could reflect the time value of money, perhaps by comparing
the present value of the hedged forecasted cash flow with the results of
the hedging instrument.
65. Whether a hedging relationship qualifies as highly
effective sometimes will be easy to assess, and there will be no
ineffectiveness to recognize in earnings during the term of the hedge. If
the critical terms of the hedging instrument and of the entire hedged asset
or liability (as opposed to selected cash flows) or hedged forecasted
transaction are the same, the entity could conclude that changes in fair
value or cash flows attributable to the risk being hedged are expected to
completely offset at inception and on an ongoing basis. For example, an
entity may assume that a hedge of a forecasted purchase of a commodity with
a forward contract will be highly effective and that there will be no
ineffectiveness to be recognized in earnings if:
a. The forward contract is for purchase of the same quantity
of the same commodity at the same time and location as the
hedged forecasted purchase.
b. The fair value of the forward contract at inception is
zero.
c. Either the change in the discount or premium on the forward
contract is excluded from the assessment of effectiveness
and included directly in earnings pursuant to paragraph 63
or the change in expected cash flows on the forecasted
transaction is based on the forward price for the
commodity.
66. Assessing hedge effectiveness and measuring the
ineffective part of the hedge, however, can be more complex. For example,
hedge ineffectiveness would result from the following circumstances, among
others:
a. A difference between the basis of the hedging instrument
and the hedged item or hedged transaction (such as a
Deutsche mark -- based hedging instrument and Dutch guilder
-- based hedged item), to the extent that those bases do
not move in tandem
b. Differences in critical terms of the hedging instrument and
hedged item or hedged transaction, such as differences in
notional amounts, maturities, quantity, location, or
delivery dates.
Ineffectiveness also would result if part of the change in the fair value
of a derivative is attributable to a change in the counterparty's
creditworthiness.
67. A hedge that meets the effectiveness test specified in
paragraphs 20(b) and 28(b)
(that is,
both at inception and on an ongoing basis, the entity expects the hedge to
be highly effective at achieving offsetting changes in fair values or cash
flows) also must meet the other hedge accounting criteria to qualify for
hedge accounting. If the hedge initially qualifies for hedge accounting,
the entity would continue to assess whether the hedge meets the
effectiveness test and also would measure any ineffectiveness during the
hedge period. If the hedge fails the effectiveness test at any time (that
is, if the entity does not expect the hedge to be highly effective at
achieving offsetting changes in fair values or cash flows), the hedge
ceases to qualify for hedge accounting. The discussions of measuring hedge
ineffectiveness in the examples in the remainder of this section of
Appendix A assume that the hedge satisfied all of the criteria for hedge
accounting at inception.
Assuming No Ineffectiveness in a Hedge with an Interest Rate
Swap
68. An assumption of no ineffectiveness is especially
important in a hedging relationship involving an interest-bearing financial
instrument and an interest rate swap because it significantly simplifies
the computations necessary to make the accounting entries. An entity may
assume no ineffectiveness in a hedging relationship of interest rate risk
involving an interest-bearing asset or liability and an interest rate swap
if all of the applicable conditions in the following list are met:
Conditions applicable to both fair value hedges and cash flow
hedges
a. The notional amount of the swap matches the principal
amount of the interest-bearing asset or liability.
b. The fair value of the swap at its inception is zero.
c. The formula for computing net settlements under the
interest rate swap is the same for each net settlement.
(That is, the fixed rate is the same throughout the term,
and the variable rate is based on the same index and
includes the same constant adjustment or no adjustment.)
d. The interest-bearing asset or liability is not prepayable.
e. Any other terms in the interest-bearing financial
instruments or interest rate swaps are typical of those
instruments and do not invalidate the assumption of no
ineffectiveness.
Conditions applicable to fair value hedges only
f. The expiration date of the swap matches the maturity date
of the interest-bearing asset or liability.
g. There is no floor or ceiling on the variable interest rate
of the swap.
h. The interval between repricings of the variable interest
rate in the swap is frequent enough to justify an
assumption that the variable payment or receipt is at a
market rate (generally three to six months or less).
Conditions applicable to cash flow hedges only
i. All interest receipts or payments on the variable-rate
asset or liability during the term of the swap are
designated as hedged, and no interest payments beyond the
term of the swap are designated as hedged.
j. There is no floor or cap on the variable interest rate of
the swap unless the variable-rate asset or liability has a
floor or cap. In that case, the swap must have a floor or
cap on the variable interest rate that is comparable to the
floor or cap on the variable-rate asset or liability. (For
this purpose, comparable does not necessarily mean equal.
For example, if a swap's variable rate is LIBOR and an
asset's variable rate is LIBOR plus 2 percent, a 10 percent
cap on the swap would be comparable to a 12 percent cap on
the asset.)
k. The repricing dates match those of the variable-rate asset
or liability.
l. The index on which the variable rate is based matches the
index on which the asset or liability's variable rate is
based.
69. The fixed rate on a hedged item need not exactly match
the fixed rate on a swap designated as a fair value hedge. Nor does the
variable rate on an interest-bearing asset or liability need to be the same
as the variable rate on a swap designated as a cash flow hedge. A swap's
fair value comes from its net settlements. The fixed and variable rates on
a swap can be changed without affecting the net settlement if both are
changed by the same amount. That is, a swap with a payment based on LIBOR
and a receipt based on a fixed rate of 5 percent has the same net
settlements and fair value as a swap with a payment based on LIBOR plus 1
percent and a receipt based on a fixed rate of 6 percent.
70. Comparable credit risk at inception is not a condition
for assuming no ineffectiveness even though actually achieving perfect
offset would require that the same discount rate be used to determine the
fair value of the swap and of the hedged item or hedged transaction. To
justify using the same discount rate, the credit risk related to both
parties to the swap as well as to the debtor on the hedged interest-bearing
asset (in a fair value hedge) or the variable-rate asset on which the
interest payments are hedged (in a cash flow hedge) would have to be the
same. However, because that complication is caused by the interaction of
interest rate risk and credit risk, which are not easily separable,
comparable creditworthiness is not considered a necessary condition to
assume no ineffectiveness in a hedge of interest rate risk.
After-Tax Hedging of Foreign Currency Risk
71. Statement 52 permitted hedging of foreign currency
risk on an after-tax basis. The portion of the gain or loss on the hedging
instrument that exceeded the loss or gain on the hedged item was required
to be included as an offset to the related tax effects in the period in
which those tax effects are recognized. This Statement continues those
provisions.
Illustrations of Assessing Effectiveness and Measuring
Ineffectiveness
72. The following examples illustrate some ways in which
an entity may assess hedge effectiveness and measures hedge ineffectiveness
for specific strategies. The examples are not intended to imply that other
reasonable methods are precluded. However, not all possible methods are
reasonable or consistent with this Statement. This section also discusses
some methods of assessing hedge effectiveness and determining hedge
ineffectiveness that are not consistent with this Statement and thus may
not be used.
Example 1: Fair Value Hedge of Natural Gas Inventory with
Futures Contracts
73. Company A has 20,000 MMBTU's of natural gas stored at
its location in West Texas. To hedge the fair value exposure of the
natural gas, the company sells the equivalent of 20,000 MMBTU's of natural
gas futures contracts on a national mercantile exchange. The futures
prices are based on delivery of natural gas at the Henry Hub gas collection
point in Louisiana.
Assessing the hedge's expected effectiveness
74. The price of Company A's natural gas inventory in West
Texas and the price of the natural gas that is the underlying for the
futures it sold will differ as a result of regional factors (such as
location, pipeline transmission costs, and supply and demand). \19/ Company
A therefore may not automatically assume that the hedge will be highly
effective at achieving offsetting changes in fair value, and it cannot
assess effectiveness by looking solely to the change in the price of
natural gas delivered to the Henry Hub.
==========================================================================
\19/ The use of a hedging instrument with a different underlying
basis than the item or transaction being hedged is
generally referred to as a cross-hedge. The principles for
cross-hedges illustrated in this example also apply to
hedges involving other risks. For example, the
effectiveness of a hedge of market interest rate risk in
which one interest rate is used as a surrogate for another
interest rate would be evaluated in the same way as the
natural gas cross-hedge in this example.
==========================================================================
75. Both at inception of the hedge and on an ongoing
basis, Company A might assess the hedge's expected effectiveness based on
the extent of correlation in recent years for periods similar to the spot
prices term of the futures contracts between the spot prices of natural gas
in West Texas and at the Henry Hub. \20/ If those prices have been and are
expected to continue to be highly correlated, Company A might reasonably
expect the changes in the fair value of the futures contracts attributable
to changes in the spot price of natural gas at the Henry Hub to be highly
effective in offsetting the changes in the fair value of its natural gas
inventory. In assessing effectiveness during the term of the hedge,
Company A must take into account actual changes in spot prices in West
Texas and at the Henry Hub.
==========================================================================
\20/ The period of time over which correlation of prices should
be assessed would be based on management's judgment in the
particular circumstance.
==========================================================================
76. Company A may not assume that the change in the spot
price of natural gas located at Henry Hub, Louisiana, is the same as the
change in fair value of its West Texas inventory. The physical hedged item
is natural gas in West Texas, not natural gas at the Henry Hub. In
identifying the price risk that is being hedged, the company also may not
assume that its natural gas in West Texas has a Louisiana natural gas
"component." Use of a price for natural gas located somewhere other than
West Texas to assess the effectiveness of a fair value hedge of natural gas
in West Texas would be inconsistent with this Statement and could result in
an assumption that a hedge was highly effective when it was not. If the
price of natural gas in West Texas is not readily available, Company A
might use a price for natural gas located elsewhere as a base for
estimating the price of natural gas in West Texas. However, that base
price must be adjusted to reflect the effects of factors, such as location,
transmission costs, and supply and demand, that would cause the price of
natural gas in West Texas to differ from the base price.
Measuring hedge ineffectiveness
77. Consistent with the company's method of assessing
whether the hedge is expected to be highly effective, the hedge would be
ineffective to the extent that (a) the actual change in the fair value of
the futures contracts attributable to changes in the spot price of natural
gas at the Henry Hub did not offset (b) the actual change in the spot price
of natural gas in West Texas per MMBTU multiplied by 20,000. That method
excludes the change in the fair value of the futures contracts attributable
to changes in the difference between the spot price and the forward price
of natural gas at the Henry Hub in determining ineffectiveness. The
excluded amount would be reported directly in earnings.
Example 2: Fair Value Hedge of Tire Inventory with a Forward
Contract
78. Company B manufactures tires. The production of those
tires incorporates a variety of physical components, of which rubber and
steel are the most significant, as well as labor and overhead. The company
hedges its exposure to changes in the fair value of its inventory of 8,000
steel-belted radial tires by entering into a forward contract to sell
rubber at a fixed price.
Assessing the hedge's expected effectiveness
79. Company B decides to base its assessment of hedge
effectiveness on changes in the fair value of the forward contract
attributable to changes in the spot price of rubber. To determine whether
the forward contract is expected to be highly effective at offsetting the
change in fair value of the tire inventory, Company B could estimate and
compare such changes in the fair value of the forward contract and changes
in the fair value of the tires (computed as the market price per tire
multiplied by 8,000 tires) for different rubber and tire prices. Company B
also should consider the extent to which past changes in the spot prices of
rubber and tires have been correlated. Because tires are a nonfinancial
asset and rubber is only an ingredient in manufacturing them, Company B may
not assess hedge effectiveness by looking to the change in the fair value
of only the rubber component of the steel-belted radial tires (
paragraph 21(e)). Both at inception of the hedge
and during its
term, the company must base its assessment of hedge effectiveness on
changes in the market price of steel-belted radial tires and changes in the
fair value of the forward contract attributable to changes in the spot
price of rubber.
Measuring hedge ineffectiveness
80. It is unlikely that this transaction would be highly
effective in achieving offsetting changes in fair value. However, if
Company B concludes that the hedge will be highly effective and the hedge
otherwise qualifies for hedge accounting, the ineffective part of the hedge
would be measured consistent with the company's method of assessing whether
the hedge is expected to be highly effective. Based on that method, the
hedge would be ineffective to the extent that the actual changes in (a) the
fair value of the forward contract attributable to the change in the spot
price of rubber and (b) the market price of steel-belted radials multiplied
by the number of tires in inventory did not offset. Because Company B
bases its assessment of effectiveness on changes in spot prices, the change
in the fair value of the forward contract attributable to changes in the
difference between the spot and forward price of rubber would be excluded
from the measure of effectiveness and reported directly in earnings.
Example 3: Fair Value Hedge of Growing Wheat with Futures
Contracts
81. Company C has a tract of land on which it is growing
wheat. Historically, Company C has harvested at least 40,000 bushels of
wheat from that tract of land. Two months before its expected harvest, the
company sells 2-month futures contracts for 40,000 bushels of wheat, which
it wants to designate as a fair value hedge of its growing wheat, rather
than as a cash flow hedge of the projected sale of the wheat after harvest.
Assessing the hedge's expected effectiveness and measuring
ineffectiveness
82. Even though the futures contracts are for the same
type of wheat that Company C expects to harvest in two months, the futures
contracts and hedged wheat have different bases because the futures
contracts are based on fully grown, harvested wheat, while the hedged item
is unharvested wheat with two months left in its growing cycle. The
company therefore may not automatically assume that the hedge will be
highly effective in achieving offsetting changes in fair value.
83. To determine whether the futures contracts are
expected to be highly effective in providing offsetting changes in fair
value for the growing wheat, Company C would need to estimate and compare
the fair value of its growing wheat and of the futures contracts for
different levels of wheat prices. Company C may not base its estimate of
the value of its growing wheat solely on the current price of wheat because
that price is for grown, harvested wheat. The company might, however, use
the current price of harvested wheat together with other relevant factors,
such as additional production and harvesting costs and the physical
condition of the growing wheat, to estimate the current fair value of its
growing wheat crop.
84. It is unlikely that wheat futures would be highly
effective in offsetting the changes in value of growing wheat. However, if
Company C concludes that the hedge qualifies as highly effective, it would
use the same method for measuring actual hedge effectiveness that it uses
initially and on an ongoing basis to assess whether the hedge is expected
to be highly effective. The hedge would be ineffective to the extent that
the actual changes in fair value of the futures contract and of the growing
wheat crop did not offset.
Example 4: Fair Value Hedge of Equity Securities with Option
Contracts
85. Company D holds 10,000 shares of XYZ stock. It
purchases put option contracts on 20,000 shares of XYZ stock with a strike
price equal to the current price of the stock to hedge its exposure to
changes in the fair value of its investment position attributable to
changes in the price of XYZ stock. Company D manages the position using a
"delta-neutral" strategy. That is, it monitors the option's "delta" --
the
ratio of changes in the option's price to changes in the price of XYZ
stock. As the delta ratio changes, Company D buys or sells put options so
that the next change in the fair value of all of the options held can be
expected to counterbalance the next change in the value of its investment
in XYZ stock. For put options, the delta ratio moves closer to one as the
share price of the stock falls and moves closer to zero as the share price
rises. The delta ratio also changes as the exercise period decreases, as
interest rates change, and as expected volatility changes. Company D
designates the put options as a fair value hedge of its investment in XYZ
stock.
Assessing the hedge's expected effectiveness and measuring
ineffectiveness
86. Because Company D plans to change the number of
options that it holds to the extent necessary to maintain a delta- neutral
position, it may not automatically assume that the hedge will be highly
effective at achieving offsetting changes in fair value. Also, because the
"delta-neutral" hedging strategy is based on expected changes in the
option's fair value, the company may not assess effectiveness based on
changes in the option's intrinsic value. Instead, Company D would estimate
(a) the gain or loss on the option position that would result from various
decreases or increases in the market price of XYZ stock and (b) the loss or
gain on its investment in XYZ stock for the same market price changes. To
assess the effectiveness of the hedge both at inception and on an ongoing
basis, the company could compare the respective gains and losses from
different market price changes. The ongoing assessment of effectiveness
also must consider the actual changes in the fair value of the put options
held and of the investment in XYZ stock during the hedge period.
87. Consistent with the company's method of assessing
effectiveness, the hedge would be ineffective to the extent that the actual
realized and unrealized gains or losses from changes in the fair value of
the options held is greater or less than the change in value of the
investment in XYZ stock. The underlying for the put option contracts is
the market price of XYZ stock. Therefore, if Company D continually
monitors the delta ratio and adjusts the number of options held
accordingly, the changes in the fair value of the options and of the hedged
item may almost completely offset, resulting in only a small amount of
ineffectiveness to be recognized in earnings.
Example 5: Fair Value Hedge of a Treasury Bond with a Put
Option Contract
88. Company E owns a Treasury bond and wants to protect
itself against the fair value exposure to declines in the price of the
bond. The company purchases an at-the-money put option on a Treasury
security with the same terms (remaining maturity, notional amount, and
interest rate) as the Treasury bond held and designates the option as a
hedge of the fair value exposure of the Treasury bond. Company E plans to
hold the put option until it expires.
Assessing the hedge's expected effectiveness and measuring
ineffectiveness
89. Because Company E plans to hold the put option (a
static hedge) rather than manage the position with a delta-neutral
strategy, it could assess whether it expects the hedge to be highly
effective at achieving offsetting changes in fair value by calculating and
comparing the changes in the intrinsic value of the option and changes in
the price (fair value) of the Treasury bond for different possible market
prices. In assessing the expectation of effectiveness on an ongoing basis,
the company also must consider the actual changes in the fair value of the
Treasury bond and in the intrinsic value of the option during the hedge
period.
90. However, because the pertinent critical terms of the
option and the bond are the same in this example, the company could expect
the changes in value of the bond attributable to changes in market interest
rates and changes in the intrinsic value of the option to offset completely
during the period that the option is in the money. That is, there will be
no ineffectiveness because the company has chosen to exclude changes in the
option's time value from the effectiveness test. Because of that choice,
Company E must recognize changes in the time value of the option directly
in earnings.
Example 6: Fair Value Hedge of an Embedded Purchased Option
with a Written Option
91. Company F issues five-year, fixed-rate debt with an
embedded (purchased) call option and, with a different counterparty, writes
a call option to neutralize the call feature in the debt. The embedded
call option and the written call option have the same effective notional
amount, underlying fixed interest rate, and strike price. (The strike
price of the option in the debt usually is referred to as the call price.)
The embedded option also can be exercised at the same times as the written
option. Company F designates the written option as a fair value hedge of
the embedded prepayment option component of the fixed-rate debt.
Assessing the hedge's expected effectiveness and measuring
ineffectiveness
92. To assess whether the hedge is expected to be highly
effective in achieving offsetting changes in fair value, Company F could
estimate and compare the changes in fair values of the two options for
different market interest rates. Because this Statement does not permit
derivatives, including embedded derivatives whether or not they are
required to be accounted for separately, to be separated into components,
Company F can only designate a hedge of the entire change in fair value of
the embedded purchased call option. The resulting changes in fair value
will be included currently in earnings. Changes in the fair value of the
written option also will be included currently in earnings; any
ineffectiveness thus will be automatically reflected in earnings. (The
hedge is likely to have some ineffectiveness because the premium for the
written call option is unlikely to be the same as the premium for the
embedded purchased call option.)
Example 7: Cash Flow Hedge of a Forecasted Purchase of
Inventory with a Forward Contract
93. Company G forecasts the purchase of 500,000 pounds of
Brazilian coffee for U.S. dollars in 6 months. It wants to hedge the cash
flow exposure associated with changes in the U.S. dollar price of Brazilian
coffee. Rather than acquire a derivative based on Brazilian coffee, the
company enters into a 6-month forward contract to purchase 500,000 pounds
of Colombian coffee for U.S. dollars and designates the forward contract as
a cash flow hedge of its forecasted purchase of Brazilian coffee. All other
terms of the forward contract and the forecasted purchase, such as delivery
locations, are the same.
Assessing the hedge's expected effectiveness and measuring
ineffectiveness
94. Company G bases its assessment of hedge effectiveness
and measure of ineffectiveness on changes in forward prices, with the
resulting gain or loss discounted to reflect the time value of money.
Because of the difference in the bases of the forecasted transaction
(Brazilian coffee) and forward contract (Colombian coffee), Company G may
not assume that the hedge will automatically be highly effective in
achieving offsetting cash flows. Both at inception and on an ongoing
basis, Company G could assess the effectiveness of the hedge by comparing
changes in the expected cash flows from the Colombian coffee forward
contract with the expected net change in cash outflows for purchasing the
Brazilian coffee for different market prices. (A simpler method that
should produce the same results would consider the expected future
correlation of the prices of Brazilian and Colombian coffee, based on the
correlation of those prices over past six-month periods.)
95. In assessing hedge effectiveness on an ongoing basis,
Company G also must consider the extent of offset between the change in
expected cash flows on its Colombian coffee contract and the change in
expected cash flows for the forecasted purchase of Brazilian coffee. Both
changes would be measured on a cumulative basis for actual changes in the
forward price of the respective coffees during the hedge period.
96. Because the only difference between the forward
contract and forecasted purchase relates to the type of coffee (Colombian
versus Brazilian), Company G could consider the changes in the cash flows
on a forward contract for Brazilian coffee to be a measure of perfectly
offsetting changes in cash flows for its forecasted purchase of Brazilian
coffee. For example, for given changes in the U.S. dollar prices of
six-month and three-month Brazilian and Colombian contracts, Company G
could compute the effect of a change in the price of coffee on the expected
cash flows of its forward contract on Colombian coffee and of a forward
contract for Brazilian coffee as follows:
Estimate of Change in Cash
Flows
Estimate of
Hedging Forecasted
Instrument: Transaction:
Forward Forward
Contract on Contract on
Colombian Brazilian
Coffee Coffee
Forward price of Colombian and
Brazilian coffee:
At hedge inception -- 6-month
price $ 2.54 $ 2.43
3 months later -- 3-month
price 2.63 2.53
Cumulative change in price --
gain $ .09 $ .10
x 500,000 pounds of coffee x 500,000 x 500,000
--------- ----------
Estimate of change in cash flows $45,000 $50,000
========= ==========
97. Using the above amounts, Company G could evaluate
effectiveness 3 months into the hedge by comparing the $45,000 change on
its Colombian coffee contract with what would have been a perfectly
offsetting change in cash flow for its forecasted purchase -- the $50,000
change on an otherwise identical forward contract for Brazilian coffee.
The hedge would be ineffective to the extent that there was a difference
between the changes in the present value of the expected cash flows on (a)
the company's Colombian coffee contract and (b) a comparable forward
contract for Brazilian coffee (the equivalent of the present value of
$5,000 in the numerical example).
Example 8: Cash Flow Hedge with a Basis Swap
98. Company H has a 5-year, $100,000 variable-rate asset
and a 7-year, $150,000 variable-rate liability. The interest on the asset
is payable by the counterparty at the end of each month based on the prime
rate as of the first of the month. The interest on the liability is
payable by Company H at the end of each month based on LIBOR as of the
tenth day of the month (the liability's anniversary date). The company
enters into a 5-year interest rate swap to pay interest at the prime rate
and receive interest at LIBOR at the end of each month based on a notional
amount of $100,000. Both rates are determined as of the first of the
month. Company H designates the swap as a hedge of 5 years of interest
receipts on the $100,000 variable-rate asset and the first 5 years of
interest payments on $100,000 of the variable-rate liability.
Assessing the hedge's expected effectiveness and measuring
ineffectiveness
99. Company H may not automatically assume that the hedge
always will be highly effective at achieving offsetting changes in cash
flows because the reset date on the receive leg of the swap differs from
the reset date on the corresponding variable- rate liability. Both at
hedge inception and on an ongoing basis, the company's assessment of
expected effectiveness could be based on the extent to which changes in
LIBOR have occurred during comparable 10-day periods in the past. Company
H's ongoing assessment of expected effectiveness and measurement of actual
ineffectiveness would be on a cumulative basis and would incorporate the
actual interest rate changes to date. The hedge would be ineffective to
the extent that the cumulative change in cash flows on the prime leg of the
swap did not offset the cumulative change in expected cash flows on the
asset, and the cumulative change in cash flows on the LIBOR leg of the swap
did not offset the change in expected cash flows on the hedged portion of
the liability. The terms of the swap, the asset, and the portion of the
liability that is hedged are the same, with the exception of the reset
dates on the liability and the receive leg of the swap. Thus, the hedge
will only be ineffective to the extent that LIBOR has changed between the
first of the month (the reset date for the swap) and the tenth of the month
(the reset date for the liability).
Example 9: Cash Flow Hedge of Forecasted Sale with a Forward
Contract
100. Company I, a U.S. dollar functional currency company,
forecasts the sale of 10,000 units of its principal product in 6 months to
French customers for FF500,000 (French francs). The company wants to hedge
the cash flow exposure of the French franc sale related to changes in the
US$-FF exchange rate. It enters into a 6-month forward contract to
exchange the FF500,000 it expects to receive in the forecasted sale for the
U.S. dollar equivalent specified in the forward contract and designates the
forward contract as a cash flow hedge of the forecasted sale.
Assessing the hedge's expected effectiveness and measuring
ineffectiveness
101. Company I chooses to assess hedge effectiveness at
inception and during the term of the hedge based on (a) changes in the fair
value of the forward contract attributable to changes in the US$-FF spot
rate and (b) changes in the present value of the current U.S. dollar
equivalent of the forecasted receipt of FF500,000. Because the critical
terms of the forward contract and the forecasted transaction are the same,
presumably there would be no ineffectiveness unless there is a reduction in
the expected sales proceeds from the forecasted sales. Because Company I
is assessing effectiveness based on spot rates, it would exclude the change
in the fair value of the forward contract attributable to changes in the
difference between the forward rate and spot rate from the measure of hedge
ineffectiveness and report it directly in earnings.
Example 10: Attempted Hedge of a Forecasted Sale with a Written
Call Option
102. Company J forecasts the sale in 9 months of 100 units
of product with a current market price of $95 per unit. The company's
objective is to sell the upside potential associated with the forecasted
sale by writing a call option for a premium. The company plans to use the
premium from the call option as an offset to decreases in future cash
inflows from the forecasted sale that will occur if the market price of the
product decreases below $95. Accordingly, Company J sells an at-the- money
call option on 100 units of product with a strike price of $95 for a
premium. The premium represents only the time value of the option. The
option is exercisable at any time within nine months.
103. Company J's objective of using the premium from the
written call option as an offset to any decrease in future cash inflows
would not meet the notion of effectiveness in this Statement. Future
changes in the market price of the company's product will not affect the
premium that Company J received, which is all related to time value in this
example and thus is the maximum amount by which Company J can benefit.
That is, the company could not expect the cash flows on the option to
increase so that, at different price levels, a decrease in cash flows from
the forecasted sale would be offset by an increase in cash flows on the
option.
FAS 133 Appendix B: EXAMPLES ILLUSTRATING APPLICATION OF THIS STATEMENT
Appendix B
EXAMPLES ILLUSTRATING APPLICATION OF THIS STATEMENT
Section 1: Hedging Relationships
104. This appendix presents examples that illustrate the
application of this Statement. The examples do not address all possible
uses of derivatives as hedging instruments. For simplicity, commissions
and most other transaction costs, initial margin, and income taxes are
ignored unless otherwise stated in an example. It is also assumed in each
example that there are no changes in creditworthiness that would alter the
effectiveness of any of the hedging relationships.
Example 1: Fair Value Hedge of a Commodity Inventory
105. This example illustrates the accounting for a fair
value hedge of a commodity inventory. In the first scenario, the terms of
the hedging derivative have been negotiated to produce no ineffectiveness
in the hedging relationship. In the second scenario, there is
ineffectiveness in the hedging relationship. To simplify the illustration
and focus on basic concepts, the derivative in these two scenarios is
assumed to have no time value. In practice, a derivative used for a fair
value hedge of a commodity would have a time value that would change over
the term of the hedging relationship. The changes in that time value would
be recognized in earnings as they occur, either because they represent
ineffectiveness or because they are excluded from the assessment of
effectiveness (as discussed in paragraph 63).
Other
examples in this section illustrate accounting for the time value component
of a derivative.
Scenario 1 -- No Ineffectiveness in the Hedging Relationship
106. ABC Company decides to hedge the risk of changes
during the period in the overall fair value of its entire inventory of
Commodity A by entering into a derivative contract, Derivative Z. On the
first day of period 1, ABC enters into Derivative Z and neither receives
nor pays a premium (that is, the fair value at inception is zero). ABC
designates the derivative as a hedge of the changes in fair value of the
inventory due to changes in the price of Commodity A during period 1. The
hedging relationship qualifies for fair value hedge accounting. ABC will
assess effectiveness by comparing the entire change in fair value of
Derivative Z with the change in the market price of the hedged commodity
inventory. ABC expects no ineffectiveness because (a) the notional amount
of Derivative Z matches the amount of the hedged inventory (that is,
Derivative Z is based on the same number of bushels as the number of
bushels of the commodity that ABC designated as hedged) and (b) the
underlying of Derivative Z is the price of the same variety and grade of
Commodity A as the inventory at the same location.
107. At inception of the hedge, Derivative Z has a fair
value of zero and the hedged inventory has a carrying amount of $1,000,000
and a fair value of $1,100,000. On the last day of period 1, the fair
value of Derivative Z has increased by $25,000, and the fair value of the
inventory has decreased by $25,000. The inventory is sold, and Derivative
Z is settled on the last day of period 1. The following table illustrates
the accounting for the situation described above.
Debit (Credit)
Cash Derivative Inventory Earnings
---------- ---------- ---------- --------
Period 1
Recognize change in
fair value of
derivative $25,000 $(25,000)
Recognize change in
fair value of
inventory ($25,000) 25,000
Recognize revenue
from sale $1,075,000 (1,075,000)
Recognize cost of
sale of inventory (975,000) 975,000
Recognize settlement
of derivative 25,000 (25,000)
---------- -------- ---------- ----------
Total $1,100,000 $ 0 $(1,000,000) $(100,000)
========== ======== =========== ==========
108. If ABC had sold the hedged inventory at the inception
of the hedge, its gross profit on that sale would have been $100,000. The
above example illustrates that, by hedging the risk of changes in the
overall fair value of its inventory, ABC recognized the same gross profit
at the end of the hedge period even though the fair value of its inventory
decreased by $25,000.
Scenario 2 -- Ineffectiveness in the Hedging Relationship
109. No ineffectiveness was recognized in earnings in the
above situation because the gain on Derivative Z exactly offsets the loss
on the inventory. However, if the terms of Derivative Z did not perfectly
match the inventory and its fair value had increased by $22,500 as compared
with the decline in fair value of the inventory of $25,000, then
ineffectiveness of $2,500 would have been recognized in earnings. The
following table illustrates that situation (all other facts are assumed to
be the same as in Scenario 1).
Debit (Credit)
------------------------------------------------------
Cash Derivative Inventory Earnings
---------- ---------- ---------- ----------
Period 1
Recognize change in
fair Value of
derivative $22,500 $ (22,500)
Recognize change in
fair value of
inventory $ (25,000) 25,000
Recognize revenue $1,075,000 (1,075,000)
from sale
Recognize cost of
sale of inventory (975,000) 975,000
Recognize settlement
of derivative 22,500 (22,500)
---------- ---------- ------------ -----------
Total $1,097,500 $ 0 $(1,000,000) $ (97,500)
========== ========== ============ ===========
110. The difference between the effect on earnings in this
scenario and the effect on earnings in Scenario 1 is the $2,500 of hedge
ineffectiveness.
Example 2: Fair Value Hedge of Fixed-Rate Interest-Bearing Debt
Purpose of the Example
111. This example demonstrates the mechanics of reporting
an interest rate swap used as a fair value hedge of an interest- bearing
liability. It is not intended to demonstrate how to compute the fair value
of an interest rate swap or an interest- bearing liability. This example
has been simplified by assuming that the interest rate applicable to a
payment due at any future date is the same as the rate for a payment due at
any other date (that is, the yield curve is flat). Although that is an
unrealistic assumption, it makes the amounts used in the example easier to
understand without detracting from the purpose of the example.
112. The fair values of the swap in this example are
determined using the "zero-coupon method." That method involves computing
and summing the present value of each future net settlement that would be
required by the contract terms if future spot interest rates match the
forward rates implied by the current yield curve. The discount rates used
are the spot interest rates implied by the current yield curve for
hypothetical zero coupon bonds due on the date of each future net
settlement on the swap. The zero-coupon method is not the only acceptable
method. Explanations of other acceptable methods of determining the fair
value of an interest rate swap can be obtained from various published
sources. Fair values also may be available from dealers in interest rate
swaps and other derivatives.
113. In this example, the term and notional amount of the
interest rate swap match the term and principal amount of the
interest-bearing liability being hedged. The fixed and variable interest
rates used to determine the net settlements on the swap match the current
yield curve, and the sum of the present values of the expected net
settlements is zero at inception. Thus, paragraph 68
of
this Statement permits the reporting entity to assume that there will be no
ineffectiveness. Assessment of effectiveness at one of the swap's
repricing dates would confirm the validity of that assumption.
114. A shortcut method can be used to produce the same
reporting results as the method illustrated in this example. This shortcut
is only appropriate for a fair value hedge of a fixed- rate asset or
liability using an interest rate swap and only if the assumption of no
ineffectiveness is appropriate. \21/ The steps in the shortcut method are
as follows:
==========================================================================
\21/ A slightly different shortcut method for interest rate
swaps used as cash flow hedges is illustrated in Example 5.
==========================================================================
a. Determine the difference between the fixed rate to be
received on the swap and the fixed rate to be paid on the
bonds.
b. Combine that difference with the variable rate to be paid
on the swap.
c. Compute and recognize interest expense using that combined
rate and the fixed-rate liability's principal amount.
(Amortization of any purchase premium or discount on the
liability also must be considered, although that
complication is not incorporated in this example.)
d. Determine the fair value of the interest rate swap.
e. Adjust the carrying amount of the swap to its fair value
and adjust the carrying amount of the liability by an
offsetting amount.
Amounts determined using the shortcut method and the facts in this example
will match the amounts in paragraph 117 even
though the
shortcut does not involve explicitly amortizing the hedge accounting
adjustments on the debt. That is, the quarterly adjustments of the debt
and explicit amortization of previous adjustments will have the same net
effect on earnings as the shortcut method.
Assumptions
115. On July 1, 20X1, ABC Company borrows $1,000,000 to be
repaid on June 30, 20X3. On that same date, ABC also enters into a
two-year receive-fixed, pay-variable interest rate swap. ABC designates the
interest rate swap as a hedge of the changes in the fair value of the
fixed-rate debt attributable to changes in market interest rates. The
terms of the interest rate swap and the debt are as follows:
Interest Rate Fixed-Rate
Swap Debt
------------- -------------
Trade date and borrowing July 1, 20X1 July 1, 20X1
date \*/
Termination date and June 30, 20X3 June 30, 20X3
maturity date
Notional amount and $1,000,000 $1,000,000
principal amount
Fixed interest rate \*/ 6.41% 6.41%
Variable interest rate 3-month US$ Not applicable
LIBOR
Settlement dates and End of each End of each
interest payment dates \*/ calendar calendar
quarter quarter
Reset dates End of each Not applicable
calendar
quarter
through March
31, 20X3
==========================================================================
\*/ These terms need not match for the assumption of no
ineffectiveness to be appropriate. (Refer to paragraphs 68
and 69.)
==========================================================================
116. The US$ LIBOR rates that are in effect at inception
of the hedging relationship and at each of the quarterly reset dates are
assumed to be as follows:
Reset 3-Month
Date LIBOR Rate
-------- ----------
7/ 1/X1 6.41%
9/30/X1 6.48%
12/31/X1 6.41%
3/31/X2 6.32%
6/30/X2 7.60%
9/30/X2 7.71%
12/31/X2 7.82%
3/31/X3 7.42%
Amounts to Be Reported
117. The following table summarizes the fair values of the
debt and the swap at each quarter end, the details of the changes in the
fair values during each quarter (including accrual and payment of interest,
the effect of changes in rates, and level- yield amortization of hedge
accounting adjustments), the expense for each quarter, and the net cash
payments for each quarter. The calculations of fair value of both the debt
and the swap are made using LIBOR. (A discussion of the appropriate
discount rate appears in paragraph 70.)
Fixed-Rate Interest Net
Debt Rate Swap Expense Payment
------------ ---------- ---------- -----------
July 1, 20X1 $(1,000,000) $ 0
Interest accrued (16,025) 0 $ (16,025)
Payments (receipts) 16,025 0 $ 16,025
Effect of change in
rates 1,149 (1,149) 0
------------ ---------- ----------- -----------
September 30, 20X1 (998,851) (1,149) $ (16,025) $ 16,025
=========== ===========
Interest accrued (16,025) (19) $ (16,044)
Payments (receipts) 16,025 175 $ 16,200
Amortization of
basis adjustments (156) 0 (156)
Effect of change in
rates (993) 993 0
------------ -------- ---------- -----------
December 31, 20X1 (1,000,000) 0 $ (16,200) $ 16,200
=========== ==========
Interest accrued (16,025) 0 $ (16,025)
Payments (receipts) 16,025 0 $ 16,025
Amortization of
basis adjustments 0 0 0
Effect of change in
rates (1,074) 1,074 0
------------ -------- ----------- -----------
March 31, 20X2 (1,001,074) 1,074 $ (16,025) $ 16,025
=========== ===========
Interest accrued (16,025) 17 $ (16,008)
Payments (receipts) 16,025 (225) $ 15,800
Amortization of
basis adjustments 208 0 208
Effect of change in
rates 12,221 (12,221) 0
------------ --------- ----------- -----------
June 30, 20X2 (988,645) (11,355) $ (15,800) $ 15,800
=========== ===========
Interest accrued (16,025) (216) $ (16,241)
Payments (receipts) 16,025 2,975 $ 19,000
Amortization of
basis adjustments (2,759) 0 (2,759)
Effect of change in
rates 789 (789) 0
------------ --------- ------------- -----------
September 30, 20X2 (990,615) (9,385) $ (19,000) $ 19,000
============ ===========
Interest accrued (16,025) (181) $ (16,206)
Payments (receipts) 16,025 3,250 $ 19,275
Amortization of
basis adjustments (3,069) 0 (3,069)
Effect of change in
rates 532 (532) 0
------------ --------- ----------- -----------
December 31, 20X2 (993,152) (6,848) $ (19,275) $ 19,275
=========== ===========
Interest accrued (16,025) (134) $ (16,159)
Payments (receipts) 16,025 3,525 $ 19,550
Amortization of
basis adjustments (3,391) 0 (3,391)
Effect of change in
rates (978) 978 0
------------ -------- ----------- -----------
March 31, 20X3 (997,521) (2,479) $ (19,550) $ 19,550
=========== ===========
Interest accrued (16,025) (46) $ (16,071)
Payments (receipts) 1,016,025 2,525 $ 1,018,550
Amortization of
basis adjustments (2,479) 0 (2,479)
----------- --------- ----------- -----------
June 30, 20X3 $ 0 $ 0 $ (18,550) $ 1,018,550
=========== ========== ========== ===========
118. The table demonstrates two important points that
explain why the shortcut method described in paragraph
114 produces the same results as the computation
in the above table when
there is no ineffectiveness in the hedging relationship.
a. In every quarter, the effect of changes in rates on the
swap completely offsets the effect of changes in rates on
the debt. That is as expected because there is no
ineffectiveness.
b. In every quarter except the last when the principal is
repaid, the expense equals the cash payment.
119. The following table illustrates the computation of
interest expense using the shortcut method described in
paragraph 114. The results are the same as the
results computed in
the above table.
(a) (b) (c) (d) (e)
Difference Variable (a) + Debt's Interest
between Rate on (b) Principal Expense
Fixed Swap Sum Amount
Rates ((c) x (d))/4
Quarter Ended
------------- ------ ------ ------ -------- --------
September 30, 0.00% 6.41% 6.41% $1,000,000 $16,025
20X1
December 31, 0.00% 6.48% 6.48% 1,000,000 16,200
20X1
March 31, 0.00% 6.41% 6.41% 1,000,000 16,025
20X2
June 30, 0.00% 6.32% 6.32% 1,000,000 15,800
20X2
September 30, 0.00% 7.60% 7.60% 1,000,000 19,000
20X2
December 31, 0.00% 7.71% 7.71% 1,000,000 19,275
20X2
March 31, 0.00% 7.82% 7.82% 1,000,000 19,550
20X3
June 30, 0.00% 7.42% 7.42% 1,000,000 18,550
20X3
120. As stated in the introduction to this example, a flat
yield curve is assumed for simplicity. An upward-sloping yield curve would
have made the computations more complex. paragraph 116
would have shown different interest rates for each quarterly repricing
date, and the present value of each future payment would have been computed
using a different rate (as described in paragraph 112).
However, the basic principles are the same. As long as there is no
ineffectiveness in the hedging relationship, the shortcut method is
appropriate.
Example 3: Fair Value Hedge -- Using a Forward Contract to
Purchase Foreign Currency to Hedge a Firm Commitment Denominated
in a Different Foreign Currency
121. This example illustrates a fair value hedge of a firm
commitment to purchase an asset for a price denominated in a foreign
currency. In this example, the hedging instrument and the firm commitment
are denominated in different foreign currencies. Consequently, the hedge
is not perfectly effective, and ineffectiveness is recognized immediately
in earnings. (The entity in the example could have designed a hedge with
no ineffectiveness by using a hedging instrument denominated in the same
foreign currency as the firm commitment with terms that match the
appropriate terms in the firm commitment.)
122. MNO Company's functional currency is the U.S. dollar.
On February 3, 20X7, MNO enters into a firm commitment to purchase a
machine for delivery on May 1, 20X7. The price of the machine will be
270,000 Dutch guilders (Dfl270,000). Also on February 3, 20X7, MNO enters
into a forward contract to purchase 240,000 Deutsche marks (DM240,000) on
May 1, 20X7. MNO will pay $0.6125 per DM1 (a total of $147,000), which is
the current forward rate for an exchange on May 1, 20X7. MNO designates
the forward contract as a hedge of its risk of changes in the fair value of
the firm commitment resulting from changes in the U.S. dollar -- Dutch
guilder forward exchange rate.
123. MNO will assess effectiveness by comparing the
overall changes in the fair value of the forward contract to the changes in
fair value in U.S. dollars of the firm commitment due to changes in U.S.
dollar -- Dutch guilder forward exchange rates. MNO expects the forward
contract to be highly effective as a hedge because:
a. DM240,000 is approximately equal to Dfl270,000 at the May
1, 20X1 forward exchange rate in effect on February 3,
20X7.
b. Settlement of the forward contract and the firm commitment
will occur on the same date.
c. In recent years, changes in the value in U.S. dollars of
Deutsche marks over three-month periods have been highly
correlated with changes in the value in U.S. dollars of
Dutch guilders over those same periods.
Ineffectiveness will result from the difference between changes in the U.S.
dollar equivalent of DM240,000 (the notional amount of the forward
contract) and changes in the U.S. dollar equivalent of Dfl270,000 (the
amount to be paid for the machine). The difference between the spot rate
and the forward exchange rate is not excluded from the hedging relationship
because changes in the fair value of the firm commitment are being measured
using forward exchange rates. \22/
==========================================================================
\22/ If the hedged item were a foreign-currency-denominated
available-for-sale security instead of a firm commitment,
Statement 52 would have required its carrying value to be
measured using the spot exchange rate. Therefore, the
spot-forward difference would have been recognized
immediately in earnings either because it represented
ineffectiveness or because it was excluded from the
assessment of effectiveness.
==========================================================================
124. The forward exchange rates in effect on certain key
dates are assumed to be as follows:
$-DM $-Dfl
Forward Forward
Exchange Exchange
Rate for Rate for
Settlement Settlement
Date on 5/1/X7 on 5/1/X7
------------------ ------------- ----------
Inception of the $0.6125 = DM1 $0.5454 = Dfl1
hedge -- 2/3/X7
Quarter end -- $0.5983 = DM1 $0.5317 = Dfl1
3/31/X7
Machine purchase -- $0.5777 = DM1 $0.5137 = Dfl1
5/1/X7
125. The U.S. dollar equivalent and changes in the U.S.
dollar equivalent of the forward contract and the firm commitment, the
changes in fair value of the forward contract and the firm commitment, and
the ineffectiveness of the hedge on those same key dates are shown in the
following table. A 6 percent discount rate is used in this example.
2/3/X7 3/31/X7 5/1/X7
---------- ---------- ----------
Forward contract
$-DM forward exchange rate
for settlement on May 1, 20X7 $ 0.6125 $ 0.5983 $ 0.5777
Units of currency (DM) x 240,000 x 240,000 x 240,000
---------- ---------- ----------
Forward price of DM240,000 in 147,000 143,592 138,648
dollars
Contract price in dollars (147,000) (147,000) (147,000)
---------- ---------- ----------
Difference $ 0 $ (3,408) $ (8,352)
========= ========= =========
Fair value (present value of
the difference) $ 0 $ (3,391) $ (8,352)
========= ========= =========
Change in fair value during
the period $ (3,391) $ (4,961)
========= =========
Firm commitment
$-Dfl forward exchange rate
for settlement on May 1, 20X7 $ 0.5454 $ 0.5317 $ 0.5137
Units of currency (Dfl) x 270,000 x 270,000 x 270,000
---------- ---------- ----------
Forward price of Dfl270,000
in dollars (147,258) (143,559) (138,699)
Initial forward price in
dollars 147,258 147,258 147,258
---------- ---------- ----------
Difference $ 0 $ 3,699 $ 8,559
========= ========= =========
Fair value (present value of
the difference) $ 0 $ 3,681 $ 8,559
========= ========= =========
Change in fair value during
the period $ 3,681 $ 4,878
========= =========
Hedge ineffectiveness
(difference between changes
in fair values of the forward
contract denominated in
Deutsche marks and the firm
commitment denominated in
Dutch guilders) $ 290 $ (83)
========= =========
This Statement requires that MNO recognize immediately in earnings all
changes in fair values of the forward contract. Because MNO is hedging the
risk of changes in fair value of the firm commitment attributable to
changes in the forward exchange rates, this Statement also requires
recognizing those changes immediately in earnings.
126. On May 1, 20X7, MNO fulfills the firm commitment to
purchase the machine and settles the forward contract. The entries
illustrating fair value hedge accounting for the hedging relationship and
the purchase of the machine are summarized below.
Debit (Credit)
---------------------------------------------------------
Firm Forward
Cash Commitment Contract Machine Earnings
-------- ---------- -------- -------- --------
March 31, 20X7
Recognize change in
fair value of firm
commitment $ 3,681 $ (3,681)
Recognize change in
fair value of
forward contract $(3,391) 3,391
--------
(290)
--------
April 30, 20X7
Recognize change in
fair value of firm
commitment 4,878 (4,878)
Recognize change in
fair value of
forward contract (4,961) 4,961
--------
83
--------
May 1, 20X7
Recognize settlement
of forward contract $ (8,352) 8,352
Recognize purchase
of machine (138,699) (8,559) -0- $147,258 -0-
-------- ---------- -------- -------- --------
Total $(147,051) $ 0 $ 0 $147,258 $ (207)
======== ========= ======== ======= ========
Note:
To simplify this example and focus on the effects of the hedging
relationship, other amounts that would be involved in the purchase of
the machine by MNO (for example, shipping costs and installation costs)
have been ignored.
The effect of the hedge is to recognize the machine at its price in Dutch
guilders (Dfl270,000) translated at the forward rate in effect at the
inception of the hedge ($0 .5454 per Dfl1).
Example 4: Cash Flow Hedge of the Forecasted Sale of a
Commodity Inventory
127. This example illustrates the accounting for a cash
flow hedge of a forecasted sale of a commodity. The terms of the hedging
derivative have been negotiated to match the terms of the forecasted
transaction. Thus, there is no ineffectiveness. The assumptions in this
example are similar to those in Example 1, including the assumption that
there is no time value in the derivative. However, the entity has chosen
to hedge the variability of the cash flows from the forecasted sale of the
commodity instead of the changes in its fair value.
128. ABC Company decides to hedge the risk of changes in
its cash flows relating to a forecasted sale of 100,000 bushels of
Commodity A by entering into a derivative contract, Derivative Z. ABC
expects to sell the 100,000 bushels of Commodity A on the last day of
period 1. On the first day of period 1, ABC enters into Derivative Z and
designates it as a cash flow hedge of the forecasted sale. ABC neither
pays nor receives a premium on Derivative Z (that is, its fair value is
zero). The hedging relationship qualifies for cash flow hedge accounting.
ABC expects that there will be no ineffectiveness from the hedge because
(a) the notional amount of Derivative Z is 100,000 bushels and the
forecasted sale is for 100,000 bushels, (b) the underlying of Derivative Z
is the price of the same variety and grade of Commodity A that ABC expects
to sell (assuming delivery to ABC's selling point), and (c) the settlement
date of Derivative Z is the last day of period 1 and the forecasted sale is
expected to occur on the last day of period 1.
129. At inception of the hedge, the expected sales price
of 100,000 bushels of Commodity A is $1,100,000. On the last day of period
1, the fair value of Derivative Z has increased by $25,000, and the
expected sales price of 100,000 bushels of Commodity A has decreased by
$25,000. Both the sale of 100,000 bushels of Commodity A and the
settlement of Derivative Z occur on the last day of period 1. The
following table illustrates the accounting, including the net impact on
earnings and other comprehensive income (OCI), for the situation described
above.
Debit (Credit)
-------------------------------------------------
Cash Derivative OCI Earnings
------------ ---------- ---------- ----------
Recognize change in
fair value of
derivative $ 25,000 $ (25,000)
Recognize revenue $ 1,075,000 $ (1,075,000)
from sale
Recognize settlement
of derivative 25,000 (25,000)
Reclassify change in
fair value of
derivative to
earnings 25,000 (25,000)
------------ -------- --------- -------------
Total $ 1,100,000 $ 0 $ 0 $ (1,100,000)
============ ======== ========= =============
130. At the inception of the hedge, ABC anticipated that
it would receive $1,100,000 from the sale of 100,000 bushels of Commodity
A. The above example illustrates that by hedging the risk of changes in
its cash flows relating to the forecasted sale of 100,000 bushels of
Commodity A, ABC still received a total of $1,100,000 in cash flows even
though the sales price of Commodity A declined during the period.
Example 5: Cash Flow Hedge of Variable-Rate Interest-Bearing
Asset
Purpose of the Example
131. This example demonstrates the mechanics of accounting
for an interest rate swap used as a cash flow hedge of variable interest
receipts. It is not intended to demonstrate how to compute the fair value
of an interest rate swap. As in Example 2, the zero-coupon method \23/ is
used to determine the fair values. (Unlike Example 2, the yield curve in
this example is assumed to be upward sloping, that is, interest rates are
higher for payments due further into the future). In this example, the
term, notional amount, and repricing date of the interest rate swap match
the term, repricing date, and principal amount of the interest-bearing
asset on which the hedged interest receipts are due. The swap terms are
"at the market" (as described in paragraphs 68
and
69), so it has a zero value at inception. Thus,
the
reporting entity is permitted to assume that there will be no
ineffectiveness.
==========================================================================
\23/ paragraph 112 discusses the zero-coupon
method.
==========================================================================
132. A shortcut method can be used to produce the same
reporting results as the method illustrated in this example. This shortcut
is only appropriate if the assumption of no ineffectiveness applies for an
interest rate swap used as a cash flow hedge of interest receipts on a
variable-rate asset (or interest payments on a variable-rate liability).
The steps in the shortcut method are as follows: \24/
==========================================================================
\24/ A slightly different shortcut method for interest rate
swaps used as fair value hedges is illustrated in Example 2.
==========================================================================
a. Determine the difference between the variable rate to be
paid on the swap and the variable rate to be received on
the bonds.
b. Combine that difference with the fixed rate to be received
on the swap.
c. Compute and recognize interest income using that combined
rate and the variable-rate asset's principal amount.
(Amortization of any purchase premium or discount on the
asset must also be considered, although that complication
is not incorporated in this example.)
d. Determine the fair value of the interest rate swap.
e. Adjust the carrying amount of the swap to its fair value
and adjust other comprehensive income by an offsetting
amount.
Background and Assumptions
133. On July 1, 20X1, XYZ Company invests $10,000,000 in
variable-rate corporate bonds that pay interest quarterly at a rate equal
to the 3-month US$ LIBOR rate plus 2.25 percent. The $10,000,000 principal
will be repaid on June 30, 20X3.
134. Also on July 1, 20X1, XYZ enters into a two-year
receive- fixed, pay-variable interest rate swap and designates it as a cash
flow hedge of the variable-rate interest receipts on the corporate bonds.
The risk designated as being hedged is the risk of changes in cash flows
attributable to changes in market interest rates. The terms of the
interest rate swap and the corporate bonds are shown below.
Interest Rate Corporate Bonds
Swap
------------ ------------
Trade date and July 1, 20X1 July 1, 20X1
borrowing date \*/
Termination date June 30, 20X3 June 30, 20X3
Notional amount $10,000,000 $10,000,000
Fixed interest rate 6.65% Not applicable
Variable interest 3-month US$ 3-month US$
rate \+/ LIBOR LIBOR + 2.25%
Settlement dates and End of each End of each
interest payment calendar calendar
dates \*/ quarter quarter
Reset dates End of each End of each
calendar calendar
quarter through quarter through
March 31, 20X3 March 31, 20X3
==========================================================================
\*/ These terms need not match for the assumption of no
ineffectiveness to be appropriate. (Refer to paragraphs 68
and 69.)
\+/ Only the interest rate basis (for example, LIBOR) must
match. The spread over LIBOR does not invalidate the
assumption of no ineffectiveness.
==========================================================================
135. Because the conditions described in
paragraph 68 are met, XYZ is permitted to assume
that there is no
ineffectiveness in the hedging relationship and to recognize in other
comprehensive income the entire change in the fair value of the swap.
136. The three-month US$ LIBOR rates in effect at the
inception of the hedging relationship and at each of the quarterly reset
dates are assumed to be as follows:
Reset Date 3-Month LIBOR Rate
---------- ------------------
7/ 1/X1 5.56%
9/30/X1 5.63%
12/31/X1 5.56%
3/31/X2 5.47%
6/30/X2 6.75%
9/30/X2 6.86%
12/31/X2 6.97%
3/31/X3 6.57%
Amounts to Be Reported
137. XYZ must reclassify to earnings the amount in
accumulated other comprehensive income as each interest receipt affects
earnings. In determining the amounts to reclassify each quarter, it is
important to recognize that the interest rate swap does not hedge the
bonds. Instead, it hedges the eight variable interest payments to be
received. That is, each of the eight quarterly settlements on the swap is
associated with an interest payment to be received on the bonds. Under the
zero- coupon method discussed in paragraph 131,
the
present value of each quarterly settlement is computed separately. Because
each payment occurs at a different point on the yield curve, a different
interest rate must be used to determine its present value. As each
individual interest receipt on the bonds is recognized in earnings, the
fair value of the related quarterly settlement on the swap is reclassified
to earnings. The fair values and changes in fair values of the interest
rate swap and the effects on earnings and other comprehensive income (OCI)
for each quarter are as follows:
Swap OCI Earnings Cash
Debit Debit Debit Debit
(Credit) (Credit) (Credit) (Credit)
-------- -------- -------- -------
July 1, 20X1 $ 0
Interest accrued 0
Payment (receipt) (27,250) $27,250
Effect of change in 52,100 $(52,100)
rates
Reclassification to
earnings 27,250 $(27,250)
-------- -------- -------- -------
September 30, 20X1 24,850 (24,850) $(27,250) $27,250
======== =======
Interest accrued 330 (330)
Payment (receipt) (25,500) $25,500
Effect of change in
rates 74,120 (74,120)
Reclassification to 25,500 $(25,500)
earnings
-------- -------- -------- -------
December 31, 20X1 73,800 (73,800) $(25,500) $25,500
======== =======
Interest accrued 1,210 (1,210)
Payment (receipt) (27,250) $27,250
Effect of change in
rates 38,150 (38,150)
Reclassification to 27,250 $(27,250)
earnings
-------- -------- -------- -------
March 31, 20X 85,910 (85,910) $(27,250) $27,250
======== =======
Interest accrued 1,380 (1,380)
Payment (receipt) (29,500) $29,500
Effect of change in
rates (100,610) 100,610
Reclassification to
earnings 29,500 $(29,500)
-------- -------- -------- -------
June 30, 20X2 (42,820) 42,820 $(29,500) $29,500
======== =======
Interest accrued (870) 870
Payment (receipt) 2,500 $(2,500)
Effect of change in 8,030 (8,030)
rates
Reclassification to
earnings (2,500) $ 2,500
-------- -------- -------- -------
September 30, 20X2 (33,160) 33,160 $ 2,500 $(2,500)
======== =======
Interest accrued (670) 670
Payment (receipt) 5,250 $(5,250)
Effect of change in 6,730 (6,730)
rates
Reclassification to (5,250) $ 5,250
earnings
-------- -------- ------- -------
December 31, 20X2 (21,850) 21,850 $ 5,250 $(5,250)
======== =======
Interest accrued 440) 440
Payment (receipt) 8,000 $(8,000)
Effect of change in 16,250 (16,250)
rates
Reclassification to (8,000) $ 8,000
earnings
-------- -------- -------- -------
March 31, 20X3 1,960 (1,960) $ 8,000 $(8,000)
======== =======
Interest accrued 40 (40)
Payment (receipt) (2,000) $ 2,000
Reclassification to 2,000 $ (2,000)
earnings
-------- -------- -------- -------
June 30, 20X3 $ 0 $ 0 $ (2,000) $ 2,000
======== ======== ======== =======
138. The table shows that, in each quarter, the net cash
receipt or payment on the swap equals the income or expense to be recorded.
The net effect on earnings of the interest on the bonds and the
reclassification of gains or losses on the swap is shown below.
Earnings
Gains
For the (Losses)
Quarter Interest Reclassified
Ending on Bonds from OCI Net Effect
---------- --------- ---------- --------------
9/30/X1 $ 195,250 $ 27,250 $ 222,500
12/31/X1 197,000 25,500 222,500
3/31/X2 195,250 27,250 222,500
6/30/X2 193,000 29,500 222,500
9/30/X2 225,000 (2,500) 222,500
12/31/X2 227,750 (5,250) 222,500
3/31/X3 230,500 (8,000) 222,500
6/30/X3 220,500 2,000 222,500
---------- -------- ----------
Totals $1,684,250 $ 95,750 $1,780,000
========== ======== ==========
139. In this example, the shortcut method described in
paragraph 132 works as follows. The difference
between
the variable rate on the swap and the variable rate on the asset is a net
receipt of 2.25 percent. That rate combined with the 6.65 percent fixed
rate received on the swap is 8.9 percent. The computed interest income is
$890,000 per year or $222,500 per quarter, which is the same as the amount
in the table in paragraph 138.
Example 6: Accounting for a Derivative's Gain or Loss in a Cash
Flow Hedge -- Effectiveness Based on the Entire Change in the
Derivative's Fair Value
140. This example has been designed to illustrate
application of the guidance for cash flow hedges described in
paragraph 30 of this Statement. At the beginning
of period 1, XYZ
Company enters into a qualifying cash flow hedge of a transaction
forecasted to occur early in period 6. XYZ's documented policy is to
assess hedge effectiveness by comparing the changes in present value of the
expected future cash flows on the forecasted transaction to all of the
hedging derivative's gain or loss (that is, no time value component will be
excluded as discussed in paragraph 63). In this
hedging
relationship, XYZ has designated changes in cash flows related to the
forecasted transaction attributable to any cause as the hedged risk.
141. The following table includes the assumptions for this
example and details the steps necessary to account for a cash flow hedge
that is not perfectly effective.
Present
Value of
Expected
Future
Cash Flows
Fair Value of on Hedged
Derivative Transaction
Increase (Decrease) Increase (Decrease)
------------------------ -----------------------
(A) (B) (C) (D) (E) (F)
Change Change Lesser of
During during the Two
the Cumulative the Cumulative Cumulative Adjustment
Period Change Period Change Changes to OCI
Period
------- -------- -------- -------- -------- -------- --------
1 $ 100 $ 100 $ (96) $ (96) $ 96 $ 96
2 94 194 (101) (197) 194 98
3 (162) 32 160 (37) 32 (162)
4 (101) (69) 103 66 (66) (98)
5 30 (39) (32) 34 (34) 32
Step 1: Determine the change in fair value of the derivative
and the change in present value of the cash flows on the
hedged transaction (columns A and C).
Step 2: Determine the cumulative changes in fair value of the
derivative and the cumulative changes in present value of
the cash flows on the hedged transaction (columns B and D).
Step 3: Determine the lesser of the absolute values of the two
amounts in Step 2 (column E).
Step 4: Determine the change during the period in the lesser
of the absolute values (column F).
Step 5: Adjust the derivative to reflect its change in fair
value and adjust other comprehensive income by the amount
determined in Step 4. Balance the entry, if necessary,
with an adjustment to earnings.
142. The following are the entries required to account for
the above cash flow hedge.
Debit (Credit)
--------------------------------------
Period Description Derivative Earnings OCI
---------- -------- ----------
1 Adjust derivative to
fair value and OCI by
the calculated amount $ 100 $(4) $(96)
2 Adjust derivative to
fair value and OCI by
the calculated amount 94 4 (98)
3 Adjust derivative to
fair value and OCI by
the calculated amount (162) 0 162
4 Adjust derivative to
fair value and OCI by
the calculated amount (101) 3 98
5 Adjust derivative to
fair value and OCI by
the calculated amount 30 2 (32)
143. The following table reconciles the beginning and
ending balances in accumulated other comprehensive income.
Accumulated Other Comprehensive Income -- Debit (Credit)
Beginning Change in Ending
Balance Fair Balance
Period Value Reclassification
------ -------- ------ ---------------- --------
1 $ 0 $(96) $ 0 $ (96)
2 (96) (94) (4) (194)
3 (194) 162 0 (32)
4 (32) 98 0 66
5 66 (30) (2) 34
The reclassification column relates to reclassifications between earnings
and other comprehensive income. In period 2, the $(4) in that column
relates to the prior period's derivative gain that was previously
recognized in earnings. That amount is reclassified to other comprehensive
income in period 2 because the cumulative gain on the derivative is less
than the amount necessary to offset the cumulative change in the present
value of expected future cash flows on the hedged transaction. In period
5, the $(2) in the reclassification column relates to the derivative loss
that was recognized in other comprehensive income in a prior period. At
the end of period 4, the derivative's cumulative loss of $69 was greater in
absolute terms than the $66 increase in the present value of expected
future cash flows on the hedged transaction. That $3 excess had been
recognized in earnings during period 4. In period 5, the value of the
derivative increased (and reduced the cumulative loss) by $30. The present
value of the expected cash flows on the hedged transaction decreased (and
reduced the cumulative increase) by $32. The gain on the derivative in
period 5 was $2 smaller, in absolute terms, than the decrease in the
present value of the expected cash flows on the hedged transaction.
Consequently, the entire gain on the derivative is recognized in other
comprehensive income. In addition, in absolute terms, the $3 cumulative
excess of the loss on the derivative over the increase in the present value
of the expected cash flows on the hedged transaction (which had previously
been recognized in earnings) increased to $5. As a result, $2 is
reclassified from other comprehensive income to earnings so that the $5
cumulative excess has been recognized in earnings.
Example 7: Designation and Discontinuance of a Cash Flow Hedge
of the Forecasted Purchase of Inventory
144. This example illustrates the effect on earnings and
other comprehensive income of discontinuing a cash flow hedge by
dedesignating the hedging derivative before the variability of the cash
flows from the hedged forecasted transaction has been eliminated. It also
discusses the effect that the location of a physical asset has on the
effectiveness of a hedging relationship.
145. On February 3, 20X1, JKL Company forecasts the
purchase of 100,000 bushels of corn on May 20, 20X1. It expects to sell
finished products produced from the corn on May 31, 20X1. On February 3,
20X1, JKL enters into 20 futures contracts, each for the purchase of 5,000
bushels of corn on May 20, 20X1 (100,000 in total) and immediately
designates those contracts as a hedge of the forecasted purchase of corn.
146. JKL chooses to assess effectiveness by comparing the
entire change in fair value of the futures contracts to changes in the cash
flows on the forecasted transaction. JKL estimates its cash flows on the
forecasted transaction based on the futures price of corn adjusted for the
difference between the cost of corn delivered to Chicago and the cost of
corn delivered to Minneapolis. JKL does not choose to use a tailing
strategy (as described in paragraph 64). JKL
expects
changes in fair value of the futures contracts to be highly effective at
offsetting changes in the expected cash outflows for the forecasted
purchase of corn because (a) the futures contracts are for the same variety
and grade of corn that JKL plans to purchase and (b) on May 20, 20X1, the
futures price for delivery on May 20, 20X1 will be equal to the spot price
(because futures prices and spot prices converge as the delivery date
approaches). However, the hedge may not be perfectly effective. JKL will
purchase corn for delivery to its production facilities in Minneapolis, but
the price of the futures contracts is based on delivery of corn to Chicago.
If the difference between the price of corn delivered to Chicago and the
price of corn delivered to Minneapolis changes during the period of the
hedge, the effect of that change will be included currently in earnings
according to the provisions of paragraph 30 of
this
Statement.
147. On February 3, 20X1, the futures price of corn for
delivery to Chicago on May 20, 20X1 is $2.6875 per bushel resulting in a
total price of $268,750 for 100,000 bushels.
148. On May 1, 20X1, JKL dedesignates the related futures
contracts and closes them out by entering into offsetting contracts on the
same exchange. As of that date, JKL had recognized in accumulated other
comprehensive income gains on the futures contracts of $26,250. JKL still
plans to purchase 100,000 bushels of corn on May 20, 20X1. Consequently,
the gains that occurred prior to dedesignation will remain in other
comprehensive income until the finished product is sold. If JKL had not
closed out the futures contracts when it dedesignated them, any further
gains or losses would have been recognized in earnings.
149. On May 20, 20X1, JKL purchases 100,000 bushels of corn, and
on May 31, 20X1, JKL sells the finished product.
150. The futures prices of corn that are in effect on key
dates are assumed to be as follows:
Futures Price per Futures Price
Bushel for Adjusted for
Delivery to Delivery to
Chicago on Minneapolis on
Date May 20, 20X1 May 20, 20X1
-------------------- ------------ ----------------
Inception of hedging
relationship --
February 3, 20X1 $2.6875 $2.7375
End of quarter --
March 31, 20X1 3.1000 3.1500
Discontinue hedge --
May 1, 20X1 2.9500 3.0000
Purchase of corn --
May 20, 20X1 2.8500 2.9000
151. The changes in fair value of the futures contracts
between inception (February 3, 20X1) and discontinuation (May 1, 20X1) of
the hedge are as follows:
February 3 -- April 1 --
March 31, 20X1 May 1, 20X1
------------- ----------
Futures price at
beginning of period $2.6875 $3.1000
Futures price at end of
period 3.1000 2.9500
--------- ---------
Change in price per
bushel 0.4125 (0.1500)
Bushels under contract
(20 contracts @ 5,000
bushels each) x100,000 x100,000
--------- ---------
Change in fair value --
gain (loss) $ 41,250 $ (15,000)
========= =========
152. The following table displays the entries to recognize
the effects of (a) entering into futures contracts as a hedge of the
forecasted purchase of corn, (b) dedesignating and closing out the futures
contracts, (c) completing the forecasted purchase of corn, and (d) selling
the finished products produced from the corn. Because the difference in
prices between corn delivered to Chicago and corn delivered to Minneapolis
($.05 per bushel, as illustrated in paragraph 150)
did
not change during the period of the hedge, no ineffectiveness is recognized
in earnings. If that difference had changed, the resulting ineffectiveness
would have been recognized immediately in earnings.
Debit (Credit)
--------------------------------------------
Cash Inventory OCI Earnings
-------- --------- -------- --------
March 31, 20X1 (end of
quarter)
Recognize change in
fair value of futures
contracts $41,250 $(41,250)
May 1, 20X1
(discontinue hedge)
Recognize change in
fair value of futures
contracts (15,000) 15,000
May 20, 20X1
Recognize purchase of
corn (290,000) $290,000
May 31, 20X1
Recognize cost of sale
of product (290,000) $290,000
Reclassify changes in
fair value of futures
contracts to earnings 26,250 (26,250)
-------- --------- -------- --------
Total $(263,750) $ 0 $ 0 $263,750
========= ========= ========= ========
Note:
To simplify this example and focus on the effects of the hedging
relationship, the margin account with the clearinghouse and certain
amounts that would be involved in a sale of JKL's inventory (for
example, additional costs of production, selling costs, and sales
revenue) have been ignored.
The effect of the hedging strategy is that the cost of the corn recognized
in earnings when the finished product was sold was $263,750. If the
hedging relationship had not been discontinued early, the cost recognized
in earnings would have been $273,750, which was the futures price of the
corn, adjusted for delivery to Minneapolis, at the inception of the hedge.
Without the strategy, JKL would have recognized $290,000, which was the
price of corn delivered to Minneapolis at the time it was purchased.
Example 8: Changes in a Cash Flow Hedge of Forecasted Interest
Payments with an Interest Rate Swap
Background
153. This example describes the effects on earnings and
other comprehensive income of certain changes in a cash flow hedging
relationship. It presents two different scenarios. In the first, the
variability of the hedged interest payments is eliminated before the
hedging derivative expires. In the second, the interest rate index that is
the basis for the hedged interest payments is changed to a different index
before the hedging derivative expires.
154. MNO Company enters into an interest rate swap (Swap
1) and designates it as a hedge of the variable interest payments on a
series of $5 million notes with 90-day terms. MNO plans to continue
issuing new 90-day notes over the next five years as each outstanding note
matures. The interest on each note will be determined based on LIBOR at
the time each note is issued. Swap 1 requires a settlement every 90 days,
and the variable interest rate is reset immediately following each payment.
MNO pays a fixed rate of interest (6.5 percent) and receives interest at
LIBOR. MNO neither pays nor receives a premium at the inception of Swap 1.
The notional amount of the contract is $5 million, and it expires in 5
years.
155. Because Swap 1 meets all of the conditions discussed
in paragraph 68, MNO is permitted to assume that
there
will be no ineffectiveness in the hedging relationship and to use the
shortcut method illustrated in Example 2.
Scenario 1 -- Two Undesignated Interest Rate Swaps
156. At the end of the second year of the 5-year hedging
relationship, MNO discontinues its practice of issuing 90-day notes.
Instead, MNO issues a 3-year, $5 million note with a fixed rate of interest
(7.25 percent). Because the interest rate on the three-year note is fixed,
the variability of the future interest payments has been eliminated. Thus,
Swap 1 no longer qualifies for cash flow hedge accounting. However, the
net gain or loss on Swap 1 in accumulated other comprehensive income is not
reclassified to earnings immediately. Immediate reclassification is
required (and permitted) only if it becomes probable that the hedged
transactions (future interest payments) will not occur. The variability of
the payments has been eliminated, but it still is probable that they will
occur. Thus, those gains or losses will continue to be reclassified from
accumulated other comprehensive income to earnings as the interest payments
affect earnings (as required by paragraph 31).
\25/
==========================================================================
\25/ If the term of the fixed rate note had been longer than
three years, the amounts in accumulated other comprehensive
income still would have been reclassified into earnings
over the next three years, which was the term of the
designated hedging relationship.
==========================================================================
157. Rather than liquidate the pay-fixed, receive-variable
Swap 1, MNO enters into a pay-variable, receive-fixed interest rate swap
(Swap 2) with a 3-year term and a notional amount of $5 million. MNO
neither pays nor receives a premium. Like Swap 1, Swap 2 requires a
settlement every 90 days and reprices immediately following each
settlement. The relationship between 90-day interest rates and longer term
rates has changed since MNO entered into Swap 1 (that is, the shape of the
yield curve is different). As a result, Swap 2 has different terms and its
settlements do not exactly offset the settlements on Swap 1. Under the
terms of Swap 2, MNO will receive a fixed rate of 7.25 percent and pay
interest at LIBOR.
158. The two swaps are not designated as hedging
instruments and are reported at fair value. The changes in fair value are
reported immediately in earnings and offset each other to a significant
degree.
Scenario 2 -- Two Interest Rate Swaps Designated as a Hedge of
Future Variable Interest Payments
159. At the end of the second year of the 5-year hedging
relationship, MNO discontinues its practice of issuing 90-day notes and
issues a 3-year, $5 million note with a rate of interest that adjusts every
90 days to the prime rate quoted on that day. Swap 1 is no longer
effective as a cash flow hedge because the receive-variable rate on the
swap is LIBOR, and the prime rate and LIBOR are expected to change
differently. Thus, the cash flows from the swap will not effectively
offset changes in cash flows from the three-year note.
160. The net gain or loss on Swap 1 in accumulated other
comprehensive income as of the date MNO issues the three-year note is not
reclassified into earnings immediately. Immediate reclassification would
be required only if it becomes probable that the hedged transactions
(future interest payments) will not occur. The expected amounts of those
payments have changed (because they will be based on prime instead of
LIBOR, as originally expected), but it still is probable that the payments
will occur. Thus, those gains or losses will continue to be reclassified
to earnings as the interest payments affect earnings.
161. Rather than liquidate Swap 1 and obtain a separate
derivative to hedge the variability of the prime-rate-based interest
payments, MNO enters into a pay-LIBOR, receive-prime basis swap. The basis
swap has a $5 million notional amount and a 3-year term and requires a
settlement every 90 days. MNO designates Swap 1 and the basis swap in
combination as the hedging instrument in a cash flow hedge of the variable
interest payments on the three-year note. On the three-year note, MNO pays
interest at prime. On the basis swap, MNO receives interest at prime and
pays interest at LIBOR. On Swap 1, MNO receives interest at LIBOR and pays
interest at 6.5 percent. Together, the cash flows from the two derivatives
are effective at offsetting changes in the interest payments on the
three-year note. Changes in fair values of the two swaps are recognized in
other comprehensive income and are reclassified to earnings when the hedged
forecasted transactions (the variable interest payments) affect earnings
(as required by paragraph 31). Because the two
swaps in
combination meet the conditions discussed in paragraph
68, MNO is permitted to assume no
ineffectiveness and use the shortcut
method illustrated in Example 5.
Example 9: Accounting for a Derivative's Gain or Loss in a Cash
Flow Hedge -- Effectiveness Based on Changes in Intrinsic Value
162. This example illustrates application of the
accounting guidance for cash flow hedges described in
paragraph 30 of this Statement. At the beginning
of period 1, XYZ
Company purchases for $9.25 an at-the-money call option on 1 unit of
Commodity X with a strike price of $125.00 to hedge a purchase of 1 unit of
that commodity projected to occur early in period 5. XYZ's documented
policy is to assess hedge effectiveness by comparing changes in cash flows
on the hedged transaction (based on changes in the spot price) with changes
in the option contract's intrinsic value. Because the hedging instrument
is a purchased call option, its intrinsic value cannot be less than zero.
If the price of the commodity is less than the option's strike price, the
option is out-of-the-money. Its intrinsic value cannot decrease further
regardless of how far the commodity price falls, and the intrinsic value
will not increase until the commodity price increases to exceed the strike
price. Thus, changes in cash flows from the option due to changes in its
intrinsic value will offset changes in cash flows on the forecasted
purchase only when the option is in-the-money or at- the-money. That
phenomenon is demonstrated in period 3 in the following table when the
commodity price declines by $1.25. Because the commodity price is $.75
below the option's strike price, the option's intrinsic value declines by
only $.50 (to zero). The effect reverses in period 4 when the commodity
price increases by $6.50 and the option's intrinsic value increases by
$5.75.
Period 1 Period 2 Period 3 Period 4
------- -------- ------- -------
Assumptions
Ending market price
of Commodity X $127.25 $125.50 $124.25 $130.75
======= ======= ======= =======
Ending fair value of option: $ 7.50 $ 5.50 $ 3.00 $ 0.00
Time value
Intrinsic value 2.25 0.50 0.00 5.75
------- -------- ------- -------
Total $ 9.75 $ 6.00 $ 3.00 $ 5.75
======= ======= ======= =======
Change in time value $ (1.75) $(2.00) $ (2.50) $ (3.00)
Change in intrinsic value 2.25 (1.75) (0.50) 5.75
------- -------- ------- -------
Total current-period gain (loss)
on derivative $ 0.50 $(3.75) $ (3.00) $ 2.75
======= ======= ======= =======
Gain (loss) on derivative,
adjusted to remove the
component excluded from
effectiveness test:
For the current period $ 2.25 $(1.75) $ (0.50) $ 5.75
Cumulative 2.25 0.50 0.00 5.75
Change in expected future cash
flows on hedged transaction:
For the current period (2.25) 1.75 1.25 (6.50)
Cumulative (2.25) (0.50) 0.75 (5.75)
Balance to be reflected in
accumulated other comprehensive
income (paragraph 30(b))
Lesser (in absolute amounts) of
derivative's cumulative gain
(loss) or amount necessary to
offset the cumulative change in
expected future cash flows on
hedged transaction $ 2.25 $ 0.50 $ 0.00 $ 5.75
====== ====== ====== ======
163. The following are the entries required to account for
the above cash flow hedge. The steps involved in determining the amounts
are the same as in Example 6.
Debit (Credit)
-------------------------------------
Period Description Derivative Earnings OCI
-------- --------------- ---------- ------- ---------
1 Adjust derivative to
fair value and OCI by
the calculated amount $ 0.50 $1.75 $(2.25)
2 Adjust derivative to
fair value and OCI by
the calculated amount (3.75) 2.00 1.75
3 Adjust derivative to
fair value and OCI by
the calculated amount (3.00) 2.50 0.50
4 Adjust derivative to
fair value and OCI by
the calculated amount 2.75 3.00 (5.75)
164. The following table reconciles the beginning and
ending balances in accumulated other comprehensive income.
Accumulated Other Comprehensive
Income -- Debit (Credit)
Beginning Change in Ending
Balance Intrinsic Balance
Period Value
------ ------ ------ ------
1 $0.00 $(2.25) $(2.25)
2 (2.25) 1.75 (0.50)
3 (0.50) 0.50 0.00
4 0.00 (5.75) (5.75)
The amount reflected in earnings relates to the component excluded from the
effectiveness test, that is, the time value component. No
reclassifications between other comprehensive income and earnings of the
type illustrated in Example 6 are required because no hedge ineffectiveness
is illustrated in this example. (The change in cash flows from the hedged
transaction was not fully offset in period 3. However, that is not
considered ineffectiveness. As described in paragraph
20(b), a purchased call option is considered
effective if it provides
one-sided offset.)
Example 10: Cash Flow Hedge of the Foreign Currency Exposure in
a Royalty Arrangement
165. This example illustrates the accounting for a hedging
relationship involving a single hedging derivative and three separate
forecasted transactions. The three transactions occur on three separate
dates, but the payment on receivables related to all three occurs on the
same date. The settlement of the hedging derivative will occur on the date
the receivable is paid.
166. DEF Company's functional currency is the U.S. dollar.
ZYX's functional currency is the Deutsche mark (DM). Effective January 1,
20X1, DEF enters into a royalty agreement with ZYX Company that gives ZYX
the right to use DEF's technology in manufacturing Product X. On April 30,
20X1, ZYX will pay DEF a royalty of DM1 million for each unit of Product X
sold by that date. DEF expects ZYX to sell one unit of Product X on
January 31, one on February 28, and one on March 31. The forecasted
royalty is probable because ZYX has identified a demand for Product X and
no other supplier has the capacity to fill that demand.
167. Also on January 1, 20X1, DEF enters into a forward
contract to sell DM3 million on April 30, 20X1 for a price equal to the
forward price of $0.6057 per Deutsche mark. DEF designates the forward
contract as a hedge of the risk of changes in its
functional-currency-equivalent cash flows attributable to changes in the
Deutsche mark -- U.S. dollar exchange rates related to the forecasted
receipt of DM3 million from the royalty agreement. The spot price and
forward price of Deutsche marks at January 1, 20X1 and the U.S. dollar
equivalent of DM3 million at those prices are assumed to be as follows:
$ Equivalent of
Prices at $ per DM DM3 Million
January 1, 20X1
--------------- -------- --------------
Spot price $0.6019 $1,805,700
4-month forward price 0.6057 1,817,100
168. DEF will exclude from its assessment of effectiveness
the portion of the fair value of the forward contract attributable to the
spot-forward difference (the difference between the spot exchange rate and
the forward exchange rate). That is, DEF will recognize changes in that
portion of the derivative's fair value in earnings but will not consider
those changes to represent ineffectiveness. DEF will estimate the cash
flows on the forecasted transactions based on the current spot exchange
rate and will discount that amount. Thus, DEF will assess effectiveness by
comparing (a) changes in the fair value of the forward contract
attributable to changes in the dollar spot price of Deutsche marks and (b)
changes in the present value of the forecasted cash flows based on the
current spot exchange rate. Those two changes will exactly offset because
the currency and the notional amount of the forward contract match the
currency and the total of the expected foreign currency amounts of the
forecasted transactions. Thus, if DEF dedesignates a proportion of the
forward contract each time a royalty is earned (as described in the
following paragraph), the hedging relationship will meet the "highly
effective" criterion.
169. As each royalty is earned, DEF recognizes a
receivable and royalty income. The forecasted transaction (the earning of
royalty income) has occurred. The receivable is an asset, not a forecasted
transaction, and is not eligible for cash flow hedge accounting. Nor is it
eligible for fair value hedge accounting of the foreign exchange risk
because changes in the receivable's fair value due to exchange rate changes
are recognized immediately in earnings. (paragraph
21(c) prohibits hedge accounting in that
situation.) Consequently, DEF
will dedesignate a proportion of the forward contract corresponding to the
earned royalty. As the royalty is recognized in earnings and each
proportion of the derivative is dedesignated, the related derivative gain
or loss in accumulated other comprehensive income is reclassified into
earnings. After that date, any gain or loss on the dedesignated proportion
of the derivative and any transaction loss or gain on the royalty
receivable \26/ will be recognized in earnings and will substantially
offset each other.
==========================================================================
\26/ Statement 52 requires immediate recognition in earnings of
any foreign currency transaction gain or loss on a foreign-
currency-denominated receivable that is not designated as a
hedging instrument. Therefore, the effect of changes in
spot prices on the royalty receivable must be recognized
immediately in earnings.
==========================================================================
170. The spot prices and forward prices for settlement on
April 30, 20X1 in effect at inception of the hedge (January 1, 20X1) and at
the end of each month between inception and April 30, 20X1 are assumed to
be as follows:
$ per DM
----------------------------------
Forward Price
For Settlement
Spot Price On 4/30/X1
---------- -------------
January 1 $0.6019 $0.6057
January 31 0.5970 0.6000
February 28 0.5909 0.5926
March 31 0.5847 0.5855
April 30 0.5729 0.5729
171. The changes in fair value of the forward contract
that are recognized each month in earnings and other comprehensive income
are shown in the following table. The fair value of the forward is the
present value of the difference between the U.S. dollars to be received on
the forward ($1,817,100) and the U.S. dollar equivalent of DM3 million
based on the current forward rate. A 6 percent discount rate is used in
this example.
Debit (Credit)
-----------------------------------
Forward
Contract Earnings OCI
-------- -------- --------
Fair value on January 1 $ 0
Period ended January 31:
Change in spot-forward
difference 2,364 $(2,364)
Change in fair value of
dedesignated proportion 0 0
Change in fair value of
designated proportion 14,482 $(14,482)
Reclassification of gain 0 (4,827) 4,827
--------
Fair value on January 31 16,846
Period ended February 28:
Change in spot-forward
difference 3,873 (3,873)
Change in fair value of
dedesignated proportion 6,063 (6,063)
Change in fair value of
designated proportion 12,127 (12,127)
Reclassification of gain 0 (10,891) 10,891
--------
Fair value on February 28 38,909
Period ended March 31:
Change in spot-forward
difference 2,718 (2,718)
Change in fair value of
dedesignated proportion 12,458 (12,458)
Change in fair value of 6,213 (6,213)
designated proportion
Reclassification of gain 0 (17,104) 17,104
--------
Fair value on March 31 60,298
Period ended April 30:
Change in spot-forward
difference 2,445 (2,445)
Change in fair value of
dedesignated proportion 35,657 (35,657)
Change in fair value of
designated proportion 0 0
-------- -------- --------
Fair value on April 30 $ 98,400
========
Cumulative effect $(98,400) $ 0
======== ========
172. The effect on earnings of the royalty agreement and
hedging relationship illustrated in this example is summarized by month in
the following table.
Amounts Recognized in Earnings Related to
-------------------------------------------------------
Receivable Forward Contract
-------------------- ----------------------------------------------
Amount
Attributable
to the
Amount Difference
$ Equivalent Foreign Attributable between the Total
of DM1 Currency to the Spot and Amount
Million Transaction Dedesignated Reclassi- Forward Reported
fications in
Period Ended Royalty Gain (Loss) Proportion from OCI Rates Earnings
----------- ---------- -------- -------- -------- ------- --------
January 31 $ 597,000 $ 0 $ 0 $ 4,827 $ 2,364 $604,191
February 28 590,900 (6,100) 6,063 10,891 3,873 605,627
March 31 584,700 (12,400) 12,458 17,104 2,718 604,580
April 30 0 (35,400) 35,657 0 2,445 2,702
---------- -------- -------- -------- ------- --------
$1,772,600 $(53,900) $ 54,178 $ 32,822 $11,400 $1,817,100
========== ======== ======== ======== ======= ========
$98,400
=======
Example 11: Reporting Cash Flow Hedges in Comprehensive Income and
Accumulated Other Comprehensive Income
173. TUV Company's cash flow hedge transactions following
adoption of this Statement through the end of 20X4 are as follows:
a. It continually purchases pork belly futures contracts to hedge its
anticipated purchases of pork belly inventory.
b. In 20X2, it entered into a Deutsche mark forward exchange contract to
hedge the foreign currency risk associated with the expected purchase
of a pork belly processing machine with a five-year life that it
bought from a vendor in Germany at the end of 20X2.
c. In 20X2, it entered into a 10-year interest rate swap concurrent with
the issuance of 10-year variable rate debt (cash flow hedge of future
variable interest payments).
d. In January 20X4, it entered into a two-year French franc forward
exchange contract to hedge a forecasted export sale (denominated in
French francs, expected to occur in December 20X5) of hot dogs to a
large customer in France. In June 20X4, it closed the forward
contract, but the forecasted transaction is still expected to occur.
174. The following table reconciles the beginning and
ending accumulated other comprehensive income balances for 20X4. It
supports the comprehensive income display and disclosures that are required
under Statement 130, as amended by this Statement. It is assumed that
there are no other amounts in accumulated other comprehensive income. The
after-tax amounts assume a 30 percent effective tax rate.
Other Comprehensive Income -- Debit (Credit)
-----------------------------------------------------------------
Accumulated Accumulated
Other Changes in Other
Comprehensive Fair Value Comprehensive
Income as of Recognized Reclassification Income as of
1/1/X4 in 20X4 Adjustments 12/31/X4
------------- ---------- ---------------- -------------
Derivatives
designated as
hedges of:
Inventory
purchases $ 230 $ 85 $ (270) $ 45
Equipment
purchase 120 (30) 90
Variable
interest rate
payments (40) 10 5 (25)
Export sale 0 (50) 0 (50)
------------- ---------- ---------------- -------------
Before-tax
totals $ 310 $ 45 $ (295) $ 60
============= ========== ================ =============
After-tax
totals $ 217 $ 32 $ (207) $ 42
============= ========== ================ =============
175. The following table illustrates an acceptable method,
under the provisions of Statement 130 as amended by this Statement, of
reporting the transactions described in paragraphs 173
and 174 in earnings, comprehensive income, and
shareholders' equity.
Effect of Selected Items on Earnings and Comprehensive Income
Year Ended December 31, 20X4 Debit (Credit)
Effect on earnings before taxes:
Cost of goods sold $ 270
Depreciation 30
Interest (5)
-----
Total 295
Income tax effect (88) \*/
-----
Effect on earnings after taxes $ 207
Other comprehensive income, net of tax:
Cash flow hedges:
Net derivative losses, net of tax
effect of $13 32
Reclassification adjustments, net of
tax effect of $88 (207)
-----
Net change (175)
-----
Effect on total comprehensive income $ 32
=====
==========================================================================
\*/ This example assumes that it is appropriate under the
circumstances, in accordance with FASB Statement No. 109,
Accounting for Income Taxes, to recognize the related income tax
benefit in the current year.
==========================================================================
Effect of Selected Items on Shareholders' Equity
Year Ended December 31, 20X4 Debit (Credit)
Accumulated other comprehensive income:
Balance on December 31, 20X3 $ 217
Net change during the year related to cash
flow hedges (175)
------
Balance on December 31, 20X4 $ 42
======
Section 2: Examples Illustrating Application of the Clearly-
and-Closely-Related Criterion to Derivative Instruments Embedded
in Hybrid Instruments
176. The following examples discuss instruments that
contain a variety of embedded derivative instruments. They illustrate how
the provisions of paragraphs 12 -- 16 of this
Statement
would be applied to contracts with the described terms. If the terms of a
contract are different from the described terms, the application of this
Statement by either party to the contract may be affected. The illustrative
instruments and related assumptions in Examples 12 -- 27 are based on
examples in Exhibit 96-12A of EITF Issue No. 96-12,
"Recognition of Interest Income and Balance Sheet Classification of
Structured Notes."
177. Specifically, each example (a) provides a brief
discussion of the terms of an instrument that contains an embedded
derivative and (b) analyzes the instrument (as of the date of inception) in
relation to the provisions of paragraphs 12 -- 16
that
require an embedded derivative to be accounted for according to this
Statement if it is not clearly and closely related to the host contract.
Unless otherwise stated, the examples are based on the assumptions (1) that
if the embedded derivative and host portions of the contract are not
clearly and closely related, a separate instrument with the same terms as
the embedded derivative would meet the scope requirements in
paragraphs 6 -- 11 and (2) that the contract is not
remeasured at fair value under otherwise applicable generally accepted
accounting principles with changes in fair value currently included in
earnings.
178. Example 12: Inverse Floater. A bond with a coupon
rate of interest that varies inversely with changes in specified general
interest rate levels or indexes (for example, LIBOR).
Example: Coupon = 5.25 percent for 3 months to July 1994;
thereafter at 8.75 percent ? 6-month U.S. $ LIBOR to January 1995.
"Stepping" option allows for spread and caps to step semiannually to
maturity.
Scope Application: An inverse floater contains an embedded
derivative (a fixed-for-floating interest rate swap) that is
referenced to an interest rate index (in this example, LIBOR) that
alters net interest payments that otherwise would be paid by the
debtor or received by the investor on an interest-bearing host
contract. If the embedded derivative could potentially result in the
investor's not recovering substantially all of its initial recorded
investment in the bond (that is, if the inverse floater contains no
floor to prevent any erosion of principal due to a negative interest
rate), the embedded derivative is not considered to be clearly and
closely related to the host contract (refer to
paragraph 13(a)). In that case, the embedded
derivative should
be separated from the host contract and accounted for by both parties
pursuant to the provisions of this Statement. (In this example, there
appears to be no possibility of the embedded derivative increasing the
investor's rate of return on the host contract to an amount that is at
least double the initial rate of return on the host contract [refer to
paragraph 13(b)].) In contrast, if the embedded
derivative could not potentially result in the investor's failing to
recover substantially all of its initial recorded investment in the
bond, the embedded derivative is considered to be clearly and closely
related to the host contract and separate accounting for the
derivative is neither required nor permitted.
179. Example 13: Levered Inverse Floater.
A bond with a coupon that varies indirectly with changes in general
interest rate levels and applies a multiplier (greater than 1.00) to the
specified index in its calculation of interest.
Example: Accrues at 6 percent to June 1994; thereafter at
14.55 percent -- (2.5 x 3-month U.S. $ LIBOR).
Scope Application: A levered inverse floater can be viewed
as an inverse floater in which the embedded interest rate swap is
leveraged. Similar to Example 12, the embedded derivative would not
be clearly and closely related to the host contract if it potentially
could result in the investor's not recovering substantially all of its
initial recorded investment in the bond (refer to
paragraph 13(a)) because there is no floor to
the interest
rate. In that case, the embedded derivative (the leveraged interest
rate swap) should be separated from the host contract and accounted
for by both parties pursuant to the provisions of this Statement. In
contrast, if an embedded derivative could not potentially result in
the investor's failing to recover substantially all of its initial
recorded investment in the bond and if there was no possibility of the
embedded derivative increasing the investor's rate of return on the
host contract to an amount that is at least double the initial rate of
return on the host contract (refer to paragraph
13(b), the embedded derivative is considered to
be clearly and
closely related to the host contract and no separate accounting for
the derivative is required or permitted.
180. Example 14: Delevered Floater. A bond
with a coupon rate of interest that lags overall movements in specified
general interest rate levels or indices.
Example: Coupon = (.5 x 10-year constant maturity
treasuries (CMT)) + 1.25 percent.
Scope Application: A delevered floater may be viewed as
containing an embedded derivative (a deleveraged swap or a series of
forward agreements) that is referenced to an interest rate index (for
example, 50 percent of 10-year CMT) that alters net interest payments
that otherwise would be paid or received on an interest-bearing host
contract but could not potentially result in the investor's failing to
recover substantially all of its initial recorded investment in the
bond (refer to paragraph 13(a)). (In this
example,
there appears to be no possibility of the embedded derivative
increasing the investor's rate of return on the host contract to an
amount that is at least double the initial rate of return on the host
contract [refer to paragraph 13(b)].) The
embedded
derivative is considered to be clearly and closely related to the host
contract as described in paragraph 13 of this
Statement. Therefore, the embedded derivative should not be separated
from the host contract.
181. Example 15: Range Floater. A bond with
a coupon that depends on the number of days that a reference
rate stays within a preestablished collar; otherwise, the bond pays either
zero percent interest or a below-market rate.
Example: Standard range floater -- The investor receives
5.5 percent on each day that 3-month US$ LIBOR is between 3 percent
and 4 percent, with the upper limit increasing annually after a
specified date. The coupon will be equal to zero percent for each day
that 3-month US$ LIBOR is outside that range.
Scope Application: A range floater may be viewed as
containing embedded derivatives (two written conditional exchange
option contracts with notional amounts equal to the par value of the
fixed-rate instrument) that are referenced to an interest rate index
(in this example, LIBOR) that alter net interest payments that
otherwise would be paid by the debtor or received by the investor on
an interest-bearing host contract but could not potentially result in
the investor's failing to recover substantially all of its initial
recorded investment in the bond (refer to paragraph
13(a)). In this example, there appears to be no
possibility of
increasing the investor's rate of return on the host contract to an
amount that is at least double the initial rate of return on the host
contract (refer to paragraph 13(b)). The
embedded
derivatives are considered to be clearly and closely related to the
host contract as described in paragraph 13 of
this
Statement. Therefore, the embedded derivatives should not be
separated from the host contract.
182. Example 16: Ratchet Floater. A bond
that pays a floating rate of interest and has an adjustable cap, adjustable
floor, or both that move in sync with each new reset rate.
Example: Coupon = 3-month U.S. $ LIBOR + 50 basis points.
In addition to having a lifetime cap of 7.25 percent, the coupon will
be collared each period between the previous coupon and the previous
coupon plus 25 basis points.
Scope Application: A ratchet floater may be viewed as
containing embedded derivatives (combinations of purchased and written
options that create changing caps and floors) that are referenced to
an interest rate index (in this example, LIBOR) that alter net
interest payments that otherwise would be paid by the debtor or
received by the investor on an interest-bearing host contract but
could not potentially result in the investor's failing to recover
substantially all of its initial recorded investment in the bond
(refer to paragraph 13(a)). In this example,
there
appears to be no possibility of increasing the investor's rate of
return on the host contract to an amount that is at least double the
initial rate of return on the host contract (refer to
paragraph 13(b)). The embedded derivatives are
considered to
be clearly and closely related to the host contract as described in
paragraph 13 of this Statement. Therefore, the
embedded derivatives should not be separated from the host contract.
183. Example 17: Fixed-to-Floating Note. A
bond that pays a varying coupon (first-year coupon is fixed; second- and
third- year coupons are based on LIBOR, Treasury bills, or prime rate).
Scope Application: A fixed-to-floating note may be viewed
as containing an embedded derivative (a forward-starting interest rate
swap) that is referenced to an interest rate index (such as LIBOR)
that alters net interest payments that otherwise would be paid by the
debtor or received by the investor on an interest- bearing host
instrument but could not potentially result in the investor's failing
to recover substantially all of its initial recorded investment in the
bond (refer to paragraph 13(a)). Likewise, there
is
no possibility of increasing the investor's rate of return on the host
contract to an amount that is both at least double the initial rate of
return on the host contract and at least twice what otherwise would be
the market return for a contract that has the same terms as the host
contract and that involves a debtor with a similar credit quality
(refer to paragraph 13(b)). The embedded
derivative is considered to be clearly and closely related to the host
contract as described in paragraph 13 of this
Statement. Therefore, the embedded derivative should not be separated
from the host contract.
184. Example 18: Indexed Amortizing Note. A
bond that repays principal based on a predetermined amortization schedule
or target value. The amortization is linked to changes in a specific
mortgage-backed security index or interest rate index. The maturity of the
bond changes as the related index changes. This instrument includes a
varying maturity. (It is assumed for this example that the bond's terms
could not potentially result in the investor's failing to recover
substantially all of its initial recorded investment in the bond [refer to
paragraph 13(a)] nor is there the possibility of
increasing the investor's rate of return on the host contract to an amount
that is both at least double the initial rate of return on the host
contract and at least twice what otherwise would be the market return for a
contract that has the same terms as the host contract and that involves a
debtor with a similar credit quality [refer to paragraph
13(b)].)
Scope Application: An indexed amortizing note can be
viewed as a fixed-rate amortizing note combined with a conditional
exchange option contract that requires partial or total "early"
payment of the note based on changes in a specific mortgage- backed
security index or a specified change in an interest rate index.
Because the requirement to prepay is ultimately tied to changing
interest rates, the embedded derivative is considered to be clearly
and closely related to a fixed-rate note. Therefore, the embedded
derivative should not be separated from the host contract.
185. Example 19: Equity-Indexed Note. A bond
for which the return of interest, principal, or both is tied to a specified
equity security or index (for example, the Standard and Poor's 500 [S&P
500] index). This instrument may contain a fixed or varying coupon rate
and may place all or a portion of principal at risk.
Scope Application: An equity-indexed note essentially
combines an interest-bearing instrument with a series of forward
exchange contracts or option contracts. Often, a portion of the
coupon interest rate is, in effect, used to purchase options that
provide some form of floor on the potential loss of principal that
would result from a decline in the referenced equity index. Because
forward or option contracts for which the underlying is an equity
index are not clearly and closely related to an investment in an
interest-bearing note, those embedded derivatives should be separated
from the host contract and accounted for by both parties pursuant to
the provisions of this Statement.
186. Example 20: Variable Principal Redemption
Bond. A bond whose principal redemption value at maturity depends on
the change in an underlying index over a predetermined observation period.
A typical example would be a bond that guarantees a minimum par redemption
value of 100 percent and provides the potential for a supplemental
principal payment at maturity as compensation for the below-market rate of
interest offered with the instrument.
Example: A supplemental principal payment will be paid to
the investor, at maturity, if the final S&P 500 closing value
(determined at a specified date) is less than its initial value at
date of issuance and the 10-year CMT is greater than 2 percent as of a
specified date. In all cases, the minimum principal redemption will
be 100 percent of par.
Scope Application: A variable principal redemption bond
essentially combines an interest-bearing investment with an option
that is purchased with a portion of the bond's coupon interest
payments. Because the embedded option entitling the investor to an
additional return is partially contingent on the S&P 500 index closing
above a specified amount, it is not clearly and closely related to an
investment in a debt instrument. Therefore, the embedded option
should be separated from the host contract and accounted for by both
parties pursuant to the provisions of this Statement.
187. Example 21: Crude Oil Knock-in Note. A
bond that has a 1 percent coupon and guarantees repayment of principal with
upside potential based on the strength of the oil market.
Scope Application: A crude oil knock-in note essentially
combines an interest-bearing instrument with a series of option
contracts. A significant portion of the coupon interest rate is, in
effect, used to purchase options that provide the investor with
potential gains resulting from increases in specified crude oil
prices. Because the option contracts are indexed to the price of
crude oil, they are not clearly and closely related to an investment
in an interest-bearing note. Therefore, the embedded option contract
should be separated from the host contract and accounted for by both
parties pursuant to the provisions of this Statement.
188. Example 22: Gold-Linked Bull Note. A
bond that has a fixed 3 percent coupon and guarantees repayment of
principal with upside potential if the price of gold increases.
Scope Application: A gold-linked bull note can be viewed
as combining an interest-bearing instrument with a series of option
contracts. A portion of the coupon interest rate is, in effect, used
to purchase call options that provide the investor with potential
gains resulting from increases in gold prices. Because the option
contracts are indexed to the price of gold, they are not clearly and
closely related to an investment in an interest-bearing note.
Therefore, the embedded option contracts should be separated from the
host contract and accounted for by both parties pursuant to the
provisions of this Statement.
189. Example 23: Step-up Bond. A bond that
provides an introductory above-market yield and steps up to a new coupon,
which will be below then-current market rates or, alternatively, the bond
may be called in lieu of the step-up in the coupon rate.
Scope Application: A step-up bond can be viewed as a
fixed-rate bond with an embedded call option and a changing interest
rate feature. The bond pays an initial above-market interest rate to
compensate for the call option and the future below-market rate (that
is, below the forward yield curve, as determined at issuance based on
the existing upward-sloping yield curve). Because the call option is
related to changes in interest rates, it is clearly and closely
related to an investment in a fixed- rate bond. Therefore, the
embedded derivatives should not be separated from the host contract.
190. Example 24: Credit-Sensitive Bond. A
bond that has a coupon rate of interest that resets based on changes in the
issuer's credit rating.
Scope Application: A credit-sensitive bond can be viewed
as combining a fixed-rate bond with a conditional exchange contract
(or an option) that entitles the investor to a higher rate of interest
if the credit rating of the issuer declines. Because the
creditworthiness of the debtor and the interest rate on a debt
instrument are clearly and closely related, the embedded derivative
should not be separated from the host contract.
191. Example 25: Inflation Bond. A bond with
a contractual principal amount that is indexed to the inflation rate but
cannot decrease below par; the coupon rate is typically below that of
traditional bonds of similar maturity.
Scope Application: An inflation bond can be viewed as a
fixed- rate bond for which a portion of the coupon interest rate has
been exchanged for a conditional exchange contract (or option) indexed
to the consumer price index, or other index of inflation in the
economic environment for the currency in which the bond is
denominated, that entitles the investor to payment of additional
principal based on increases in the referenced index. Such rates of
inflation and interest rates on the debt instrument are considered to
be clearly and closely related. Therefore, the embedded derivative
should not be separated from the host contract.
192. Example 26: Disaster Bond. A bond that
pays a coupon above that of an otherwise comparable traditional bond;
however, all or a substantial portion of the principal amount is subject to
loss if a specified disaster experience occurs.
Scope Application: A disaster bond can be viewed as a
fixed- rate bond combined with a conditional exchange contract (an
option). The investor receives an additional coupon interest payment
in return for giving the issuer an option indexed to industry loss
experience on a specified disaster. Because the option contract is
indexed to the specified disaster experience, it cannot be viewed as
being clearly and closely related to an investment in a fixed-rate
bond. Therefore, the embedded derivative should be separated from the
host contract and accounted for by both parties pursuant to the
provisions of this Statement.
However, if the "embedded derivative" entitles the holder of the
option (that is, the issuer of the disaster bond) to be compensated
only for changes in the value of specified assets or liabilities for
which the holder is at risk (including the liability for insurance
claims payable due to the specified disaster) as a result of an
identified insurable event (refer to paragraph
10(c)(2)), a separate instrument with the same
terms as the
"embedded derivative" would not meet the Statement's definition of a
derivative in paragraphs 6 -- 11. In that
circumstance, because the criterion in paragraph
12(c) would not be met, there is no embedded
derivative to be
separated from the host contract, and the disaster bond would not be
subject to the requirements of this Statement. The investor is
essentially providing a form of insurance or reinsurance coverage to
the issuer.
193. Example 27: Specific Equity-Linked Bond.
A bond that pays a coupon slightly below that of traditional bonds of
similar maturity; however, the principal amount is linked to the stock
market performance of an equity investee of the issuer. The issuer may
settle the obligation by delivering the shares of the equity investee or
may deliver the equivalent fair value in cash.
Scope Application: A specific equity-linked bond can be
viewed as combining an interest-bearing instrument with, depending on
its terms, a series of forward exchange contracts or option contracts
based on an equity instrument. Often, a portion of the coupon
interest rate is used to purchase options that provide some form of
floor on the loss of principal due to a decline in the price of the
referenced equity instrument. The forward or option contracts do not
qualify for the exception in paragraph 10(e)(2)
because the shares in the equity investee owned by the issuer meet the
definition of a financial instrument. Because forward or option
contracts for which the underlying is the price of a specific equity
instrument are not clearly and closely related to an investment in an
interest- bearing note, the embedded derivative should be separated
from the host contract and accounted for by both parties pursuant to
the provisions of this Statement.
194. Example 28: Dual Currency Bond. A bond
providing for repayment of principal in U.S. dollars and periodic interest
payments denominated in a foreign currency. In this example, a U.S. entity
with the dollar as its functional currency is borrowing funds from an
independent party with those repayment terms as described.
Scope Application: Because the portion of this instrument
relating to the periodic interest payments denominated in a foreign
currency is subject to the requirement in Statement 52 to recognize
the foreign currency transaction gain or loss in earnings, the
instrument should not be considered as containing an embedded foreign
currency derivative instrument pursuant to paragraph
15 of this Statement. In this example, the U.S.
entity has the
dollar as the functional currency and is making interest payments in a
foreign currency. Remeasurement of the liability is required using
future equivalent dollar interest payments determined by the current
spot exchange rate and discounted at the historical effective interest
rate.
195. Example 29: Short-Term Loan with a Foreign
Currency Option. A U.S. lender issues a loan at an above-market
interest rate. The loan is made in U.S. dollars, the borrower's functional
currency, and the borrower has the option to repay the loan in U.S. dollars
or in a fixed amount of a specified foreign currency.
Scope Application: This instrument can be viewed as
combining a loan at prevailing market interest rates and a foreign
currency option. The lender has written a foreign currency option
exposing it to changes in foreign currency exchange rates during the
outstanding period of the loan. The premium for the option has been
paid as part of the interest rate. Because the borrower has the
option to repay the loan in U.S. dollars or in a fixed amount of a
specified foreign currency, the provisions of
paragraph 15 are not relevant to this example.
paragraph 15 addresses
foreign-currency-denominated interest or
principal payments but does not apply to foreign currency options.
Because a foreign currency option is not clearly and closely related
to issuing a loan, the embedded option should be separated from the
host contract and accounted for by both parties pursuant to the
provisions of this Statement. In contrast, if both the principal
payment and the interest payments on the loan had been payable only in
a fixed amount of a specified foreign currency, there would be no
embedded foreign currency derivative pursuant to this Statement.
196. Example 30: Lease Payment in Foreign
Currency. A U.S. company's operating lease with a Japanese lessor is
payable in yen. The functional currency of the U.S. company is the U.S.
dollar.
Scope Application: paragraph 15(a)
provides that contracts, other than financial instruments, that
specify payments denominated in the currency of the primary economic
environment in which any substantial party to that contract operates
shall not be separated from the host contract and considered a
derivative instrument for purposes of this Statement. Using available
information about the lessor and its operations, the U.S. company may
decide it is reasonable to conclude that the yen would be the currency
of the primary economic environment in which the Japanese lessor
operates, consistent with the functional currency notion in Statement
52. (That decision can be based on available information and
reasonable assumptions about the counterparty; representations from
the counterparty are not required.) Thus, the lease should not be
viewed as containing an embedded swap converting U.S. dollar lease
payments to yen. Alternatively, if the lease payments are specified
in a currency seemingly unrelated to each party's functional currency,
such as drachmas (assuming the leased property is not in Greece), the
embedded foreign currency swap should be separated from the host
contract and accounted for as a derivative for purposes of this
Statement because the provisions of paragraph 15
would not apply and a separate instrument with the same terms would
meet the definition of a derivative instrument in
paragraphs 6 -- 11.
197. Example 31: Certain Purchases in a Foreign
Currency. A U.S. company enters into a contract to purchase corn from
a local American supplier in six months for yen; the yen is the functional
currency of neither party to the transaction. The corn is expected to be
delivered and used over a reasonable period in the normal course of
business.
Scope Application: paragraph 10(b)
excludes contracts that require future delivery of commodities that
are readily convertible to cash from the accounting for derivatives if
the commodities will be delivered in quantities expected to be used or
sold by the reporting entity over a reasonable period in the normal
course of business. However, the corn purchase contract must be
examined to determine whether it contains an embedded derivative that
warrants separate accounting. The corn purchase contract can be
viewed as a forward contract for the purchase of corn and an embedded
foreign currency swap from the purchaser's functional currency (the
U.S. dollar) to yen. Because the yen is the functional currency of
neither party to the transaction and the purchase of corn is
transacted internationally in many different currencies, the contract
does not qualify for the exception in paragraph 15
that precludes separating the embedded foreign currency derivative
from the host contract. The embedded foreign currency swap should be
separated from the host contract and accounted for as a derivative for
purposes of this Statement because a separate instrument with the same
terms would meet the definition of a derivative instrument in
paragraphs 6 -- 11.
198. Example 32: Participating Mortgage. A
mortgage in which the investor receives a below-market interest rate and is
entitled to participate in the appreciation in the market value of the
project that is financed by the mortgage upon sale of the project, at a
deemed sale date, or at the maturity or refinancing of the loan. The
mortgagor must continue to own the project over the term of the mortgage.
Scope Application: This instrument has a provision that
entitles the investor to participate in the appreciation of the
referenced real estate (the "project"). However, a separate contract
with the same terms would be excluded by the exception in
paragraph 10(e)(2) because settlement is based
on the value of
a nonfinancial asset of one of the parties that is not readily
convertible to cash. (This Statement does not modify the guidance in
AICPA Statement of Position 97-1, Accounting by
Participating Mortgage Loan Borrowers.)
199. Example 33: Convertible Debt. An
investor receives a below-market interest rate and receives the option to
convert its debt instrument into the equity of the issuer at an established
conversion rate. The terms of the conversion require that the issuer
deliver shares of stock to the investor.
Scope Application: This instrument essentially contains a
call option on the issuer's stock. Under the provisions of this
Statement, the accounting by the issuer and investor can differ. The
issuer's accounting depends on whether a separate instrument with the
same terms as the embedded written option would be a derivative
instrument pursuant to paragraphs 6 -- 11 of
this
Statement. Because the option is indexed to the issuer's own stock
and a separate instrument with the same terms would be classified in
stockholders' equity in the statement of financial position, the
written option is not considered to be a derivative instrument for the
issuer under paragraph 11(a) and should not be
separated from the host contract.
In contrast, if the terms of the conversion allow for a cash
settlement rather than delivery of the issuer's shares at the
investor's option, the exception in paragraph 11(a)
for the issuer does not apply because the contract would not be
classified in stockholders' equity in the issuer's statement of
financial position. In that case, the issuer should separate the
embedded derivative from the host contract and account for it pursuant
to the provisions of this Statement because (a) an option based on the
entity's stock price is not clearly and closely related to an
interest-bearing debt instrument and (b) the option would not be
considered an equity instrument of the issuer.
Similarly, if the convertible debt is indexed to another entity's
publicly traded common stock, the issuer should separate the embedded
derivative from the host contract and account for it pursuant to the
provisions of this Statement because (a) an option based on another
entity's stock price is not clearly and closely related to an
investment in an interest- bearing note and (b) the option would not
be considered an equity instrument of the issuer.
The exception in paragraph 11 does not apply to
the
investor's accounting. Therefore, in both cases described above, the
investor should separate the embedded option contract from the host
contract and account for the embedded option contract pursuant to the
provisions of this Statement because the option contract is based on
the price of another entity's equity instrument and thus is not
clearly and closely related to an investment in an interest-bearing
note. However, if the terms of conversion do not allow for a cash
settlement and if the common stock delivered upon conversion is
privately held (that is, is not readily convertible to cash), the
embedded derivative would not be separated from the host contract
because it would not meet the criteria in paragraph
9.
200. Example 34: Variable Annuity Products.
These products are investment contracts as contemplated in Statements 60
and 97. Similar to variable life insurance products, policyholders direct
their investment account asset mix among a variety of mutual funds composed
of equities, bonds, or both, and assume the risks and rewards of investment
performance. The funds are generally maintained in separate accounts by
the insurance company. Contract terms provide that if the policyholder
dies, the greater of the account market value or a minimum death benefit
guarantee will be paid. The minimum death benefit guarantee is generally
limited to a return of premium plus a minimum return (such as 3 or 4
percent); this life insurance feature represents the fundamental difference
from the life insurance contracts that include significant (rather than
minimal) levels of life insurance. The investment account may have various
payment alternatives at the end of the accumulation period. One
alternative is the right to purchase a life annuity at a fixed price
determined at the initiation of the contract.
Scope Application: Variable annuity product structures as
contemplated in Statement 97 are generally not subject to the scope of
this Statement (except for payment options at the end of the
accumulation period), as follows:
_ Death benefit component. paragraph 10(c)(1)
excludes a death
benefit from the scope of this Statement because the payment of the
death benefit is the result of an identifiable insurable event
instead of changes in an underlying. The death benefit in this
example is limited to the floor guarantee of the investment
account, calculated as the premiums paid into the investment
account plus a guaranteed rate of return, less the account market
value. Statement 60 remains the applicable guidance for the
insurance-related liability accounting.
_ Investment component. The policyholder directs certain premium
investments in the investment account that includes equities,
bonds, or both, which are held in separate accounts that are owned
by the policyholder and separate from the insurer's general account
assets. This component is viewed as a direct investment because
the policyholder directs and owns these investments. This
component is not a derivative because the policyholder has invested
the premiums in acquiring those investments. Furthermore, any
embedded derivatives within those investments should not be
separated from the host contract by the insurer because the
separate account assets are already marked-to-market under
Statement 60. In contrast, if the product were an
equity-index-based interest annuity (rather than a variable
annuity), the investment component would not be viewed as a direct
investment because the policyholder does not own those investments,
which are assets recorded in the general account of the insurance
company. As a result, the host contract would be a debt
instrument, and the equity-index-based derivative should be
separated and accounted for as a derivative instrument.
_ Investment account surrender right at market value. Because
this right is exercised only at the fund market value (without the
insurer's floor guarantee) and relates to an investment owned by
the insured, this right is not within the scope of this Statement.
Payment alternatives at the end of the accumulation period.
Payment alternatives are options subject to the requirements of
this Statement if interest rates or other underlying variables
affect the value.
Section 3: Examples Illustrating Application of the Transition
Provisions
201. Assume that at December 31, 1999, a calendar-year
entity has the following derivatives and hedging relationships in place
(for simplicity, income tax effects are ignored):
Before Transition Adjustment -- December 31, 1999
Asset (Liability)
--------------------
(a) (b) (c) (d) (e) (f)
Assumed Post-
Transition-
GAAP Date
Classification Previous Accounting
Carrying Fair prior to Hedge under This
Item Amount Value Transition Resembles Statement
-----------------------------------------------------------------------------------------
A.
Forward
contract $ 0 $(1,500) Hedges existing
inventory (though
fair value Fair value Fair value
changes have not hedge hedge of
been recognized) inventory
Inventory 5,000 6,400 Hedged by forward
contract
-----------------------------------------------------------------------------------------
B.
Interest
rate swap 0 180 Hedges fixed-rate Fair value Would not
bond hedge qualify as a
hedge of the
held-to-
maturity
security --
account for
swap as a
nonhedging
derivative \*/
Fixed-rate
bond
(classified
as held-to-
maturity) 1,000 800 Hedged by
interest rate
swap
-----------------------------------------------------------------------------------------
==========================================================================
\*/ Prior to the effective date of Statement 133, generally
accepted accounting principles did not prohibit hedge
accounting for a hedge of the interest rate risk in a held-
to-maturity security. Thus, transition adjustments may be
necessary for hedges of that type because that type of
hedging relationship will no longer qualify for hedge
accounting under the provisions of this Statement. At the
date of initial application, an entity may reclassify any
held-to-maturity security into the available-for-sale
category or trading (refer to paragraph 54).
==========================================================================
---------------------------------------------------------------------------------------
Assumed Post-
Transition-
GAAP Date
Classification Previous Accounting
Carrying Fair prior to Hedge under This
Item Amount Value Transition Resembles Statement
-----------------------------------------------------------------------------------------
C.
Interest rate
swap 0 (350) Hedges fixed-rate Fair Fair value
bond value hedge of the
hedge fixed-rate
bond
Fixed-rate
bond 1,000 1,000 Hedged by
(classified as interest rate
available-for- swap (cost basis
sale) is $650;
unrealized
holding gain is
$350)
Other
comprehensive
income (Statement
115) (350) N/A
---------------------------------------------------------------------------------------
Assumed Post-
Transition-
GAAP Date
Classification Previous Accounting
Carrying Fair prior to Hedge under This
Item Amount Value Transition Resembles Statement
-----------------------------------------------------------------------------------------
D.
Foreign currency 1,000 1,200 Hedges firm Fair Fair value
forward contract purchase value hedge of the
commitment hedge firm
commitment
Deferred credit (1,000) N/A Deferred gain
related to
foreign currency
forward contract
Firm commitment to 0 (1,200) Hedged by foreign
pay foreign currency forward
currency to contract
purchase machinery
---------------------------------------------------------------------------------------
Assumed Post-
Transition-
GAAP Date
Classification Previous Accounting
Carrying Fair prior to Hedge under This
Item Amount Value Transition Resembles Statement
-----------------------------------------------------------------------------------------
E.
Swap that was Cash Since the swap
hedging a flow is no longer
Swap (no longer probable hedge held, there is
held) forecasted no new
transaction was designation
Deferred credit -- -- terminated prior
to 12/31/99 and
(1,000) N/A the related gain
was deferred
------------------------------------------------------------------------------------
Assumed Post-
Transition-
GAAP Date
Classification Previous Accounting
Carrying Fair prior to Hedge under This
Item Amount Value Transition Resembles Statement
-----------------------------------------------------------------------------------------
F.
2-year forward 0 1,000 Hedges a probable Cash Forward could
contract forecasted flow possibly
transaction hedge qualify as a
projected to hedging
occur in 1 year instrument
---------------------------------------------------------------------------------------
Assumed Post-
Transition-
GAAP Date
Classification Previous Accounting
Carrying Fair prior to Hedge under This
Item Amount Value Transition Resembles Statement
-----------------------------------------------------------------------------------------
G.
6-month futures 0 0 Hedges a probable Cash Cash flow
contract (cash forecasted flow hedge
settled daily) transaction hedge
projected to
occur in 6 months
Deferred debit 500 N/A Deferred loss N/A
related to
futures contract
---------------------------------------------------------------------------------------
202. To determine transition accounting, existing hedge
relationships must be identified as either a fair value type of hedge or a
cash flow type of hedge as identified pursuant to this Statement. They do
not have to meet the hedge criteria of this Statement. That identification
is indicated in column (e) of the above table.
203. At transition, an entity has an opportunity to
redesignate hedging relationships. This example makes certain assumptions
regarding post-transition-date accounting pursuant to this Statement as
indicated in column (f) of the above table that cannot necessarily be
determined from the information provided in this example. The appropriate
conditions in this Statement must be met to continue hedge accounting for
periods subsequent to transition. However, determining whether a potential
hedging relationship meets the conditions of this Statement does not impact
the transition accounting. For purposes of determining transition
adjustments, existing hedging relationships are categorized as fair value
or cash flow hedges based on their general characteristics, without
assessing whether all of the applicable conditions would be met.
204. After applying the transition provisions, the above
items would be reflected in the financial statements as follows:
---------------------------------------------------------------------------
After Transition Adjustment -- January 1, 2000
Statement of
Financial Income
Position Statement
----------- ----------------
Other Transition Explanation of
Asset Comprehensive Adjustment Accounting at
Item (Liability) Income Gain (Loss) Transition
---------------------------------------------------------------------------------------
A.
Forward $(1,500) N/A $(1,500) Adjust to fair value
contract by recognizing $1,500
loss as a transition
adjustment
Inventory 6,400 N/A 1,400 Recognize offsetting
$1,400 gain as a
transition
adjustment \*/
---------
Net impact $ (100)
=========
---------------------------------------------------------------------------------------
B.
Interest rate 180 N/A $ 180 Adjust to fair value
swap by recognizing $180
gain as a transition
adjustment
Fixed-rate 820 N/A Recognize offsetting
bond $180 loss as a
(classified transition adjustment
as held-to-
maturity) (180)
Net impact $ 0
=======
---------------------------------------------------------------------------------------
C.
Interest rate Adjust to fair value
swap (350) N/A $(350) by recognizing a $350
loss as a transition
adjustment
Fixed-rate Remove offsetting
bond $350 gain previously
(classified reported in OCI
as available- (Statement 115) and
for-sale) 1,000 N/A -- recognize as a
transition adjustment
Other
comprehensive
income (OCI) N/A 350
--------
Net impact $ 0
========
==========================================================================
\*/ The transition adjustment for the gain on the hedged
inventory is limited to the amount that is offset by the
loss on the hedging derivative. The entire $1,400 gain is
recognized in this example because it is less than the
$1,500 loss on the derivative. If the inventory gain had
been more than $1,500, only $1,500 would have been
recognized as a transition adjustment.
==========================================================================
D.
Foreign Adjust to fair value
currency by recognizing $200
forward gain as a transition
contract 1,200 N/A $ 200 adjustment
Deferred Remove deferred
credit 0 N/A 1,000 credit and recognize
as a transition
adjustment
Firm Recognize offsetting
commitment to $1,200 loss as a
pay foreign transition adjustment
currency to
purchase
machinery (1,200) N/A (1,200)
--------
Net impact $ 0
========
---------------------------------------------------------------------------------------
E.
Terminated -- -- $ -- No asset exists for
swap the terminated swap
Remove the deferred
credit and recognize
in OCI -- to be
reclassified into
earnings consistent
with the earnings
effect of the hedged
forecasted
transaction
Deferred
credit -- N/A --
OCI N/A $(1,000) --
---------
Net impact $ 0
=========
---------------------------------------------------------------------------------------
F.
Adjust to fair value
by recognizing $1,000
gain in OCI -- to be
reclassified into
earnings consistent
with the earnings
effect of the hedged
forecasted transaction
Forward
contract 1,000 (1,000) $ 0
=========
---------------------------------------------------------------------------------------
G.
Futures 0 N/A -- Asset already
contract reported at fair
value -- no
adjustment necessary
Remove deferred debit
and recognize in OCI
-- to be reclassified
into earnings
consistent with the
earnings effect of
the hedged forecasted
transaction
Deferred
debit -- N/A --
OCI N/A 500 --
----------
Net impact $ 0
=========
--------------------------------------------------------------------------------------
205. In the initial year of application, an entity would
also disclose the amounts of deferred gains and losses included in other
comprehensive income that are expected to be reclassified into earnings
within the next 12 months.
FAS 133 Appendix C: BACKGROUND INFORMATION AND BASIS FOR CONCLUSIONS
Appendix C
BACKGROUND INFORMATION AND BASIS FOR CONCLUSIONS
CONTENTS
paragraph
Numbers
Introduction 206
Background Information 207-216
Fundamental Decisions Underlying the Statement 217-231
Benefits and Costs of This Statement 232-243
Problems with Previous Accounting and Reporting
Practices 233-237
This Statement Mitigates Those Problems 238-243
Scope and Definition 244-311
Why Hedging Instruments Are Limited to Derivatives
246-247
Defining Characteristics of a Derivative Instrument
248-266
Underlyings and Notional Amounts or Payment Provisions
250-254
Initial Investment in the Contract 255-258
Net Settlement 259-266
Assets That Are Readily Convertible to Cash 264-266
Commodity Contracts 267-272
Normal Purchases and Normal Sales 271-272
Financial Instruments 273-290
Trade Date versus Settlement Date Accounting 274-276
Regular-Way Security Trades 275-276
Insurance Contracts 277-283
Exception for Derivatives That Serve as Impediments to
Recognition of a Sale 284
Exception for Instruments Classified in Stockholders'
Equity 285-286
Stock-Based Compensation Contracts 287
Contingent Consideration in a Business Combination
288-289
Application to Specific Contracts 290
The Scope of Statement 119 291-292
Embedded Derivatives 293-311
Approaches Considered 294-298
Accounting for Embedded Derivatives Separately from
the
Host Contract 299-303
The Clearly-and-Closely-Related Approach 304-311
Fair Value Measurement Guidance 312-319
Consideration of a Discount or Premium in the
Valuation of a Large Position 315
Valuation of Liabilities 316-317
Valuation of Deposit Liabilities 317
Other Fair Value Measurement Guidance 318-319
Demand for Hedge Accounting 320-329
Hedges of Fair Value Exposures 321
Hedges of Cash Flow Exposures 322-329
Hedge Accounting Approaches Considered 330-350
Measure All Financial Instruments at Fair Value
331-334
Mark-to-Fair-Value Hedge Accounting 335-337
Comprehensive Income Approach 338-344
Full-Deferral Hedge Accounting 345-348
Synthetic Instrument Accounting 349-350
Hedge Accounting in This Statement 351-383
Exposures to Changes in Fair Value or Changes in Cash
Flow 353-356
Hedge Accounting in This Statement and Risk Reduction
357-359
A Compound Derivative May Not Be Separated into Risk
Components 360-361
Fair Value Hedges 362-370
Accelerated Recognition of the Gain or Loss on a
Hedged Item 363-368
Attributable to the Risk Being Hedged 364-366
Entire Gain or Loss Attributable to Risk Being Hedged
367-368
Measurement of Hedged Item's Gain or Loss 369
The Exposure Draft's Exception for Certain Firm
Commitments 370
Cash Flow Hedges 371-383
First Two Objectives-Avoid Conceptual Difficulties and
Increase Visibility 373
Third and Fourth Objectives-Reflect Ineffectiveness
and
Impose Limitations 374-383
Measure of Hedge Ineffectiveness 379-381
Limitations on Cash Flow Hedges 382-383
General Criteria to Qualify for Designation as a Hedge
384-431
Designation, Documentation, and Risk Management 385
Highly Effective in Achieving Offsetting Changes in
Fair Values
or Cash Flows 386-401
Basis Swaps 391-395
Written Options 396-401
Exposures to Changes in Fair Value or Cash Flows That
Could Affect Reported Earnings 402-404
The Hedged Item or Transaction Is Not Remeasured
through Earnings
for the Hedged Risk 405-407
Risks That May Be Designated as Being Hedged 408-421
Financial Assets and Liabilities 411-415
Nonfinancial Assets and Liabilities 416-421
Simultaneous Hedges of Fair Value and Cash Flow
Exposures 422-425
Prohibition against Hedge Accounting for Hedges of
Interest Rate Risk
of Debt Securities Classified as Held-to-Maturity
426-431
Additional Qualifying Criteria for Fair Value Hedges
432-457
Specific Identification 432-436
Recognized Asset or Liability or Unrecognized Firm
Commitment 437-442
Definition of a Firm Commitment 440-442
Single Asset or Liability or a Portfolio of Similar
Assets
or Similar Liabilities 443-450
Items the Exposure Draft Prohibited from Designation
as
Hedged Items in Fair Value Hedges 451-457
Oil or Gas That Has Not Been Produced and Similar
Items 452-453
Leases 454
Investment Accounted for by the Equity Method 455
Other Exclusions 456-457
Additional Qualifying Criteria for Cash Flow Hedges
458-473
Specific Identification 458
Single Transaction or Group of Individual Transactions
459-462
Probability of a Forecasted Transaction 463-465
Contractual Maturity 466-468
Transaction with External Third Party 469-471
Forecasted Transactions Prohibited from Designation as
the Hedged
Item in a Cash Flow Hedge 472-473
Foreign Currency Hedges 474-487
Carried Forward from Statement 52 475-480
Fair Value Hedges of Foreign Currency Risk
in Available-for-Sale Securities 479-480
Broadening of Statement 52 481-487
Forecasted Intercompany Foreign Currency Transactions
482-487
Discontinuing Hedge Accounting 488-494
Discontinuing Fair Value Hedge Accounting 489-491
Discontinuing Cash Flow Hedge Accounting 492-494
Interaction with Standards on Impairment 495-498
Current Earnings Recognition of Certain Derivative
Losses 499
Accounting by Not-for-Profit Organizations and Other
Entities
That Do Not Report Earnings 500-501
Disclosures 502-513
Effective Date and Transition 514-524
Transition Provisions for Embedded Derivatives 518-522
Transition Provisions for Compound Derivatives 523-524
BACKGROUND INFORMATION AND BASIS FOR CONCLUSIONS
INTRODUCTION
206. This appendix summarizes considerations that Board
members deemed significant in reaching the conclusions in this Statement.
It includes reasons for accepting certain views and rejecting others.
Individual Board members gave greater weight to some factors than to
others.
Background Information
207. The Board is addressing the accounting for
derivative instruments \27/ and hedging activities as part of its broad
project on financial instruments. That project was added to the Board's
agenda in 1986 to address financial reporting issues that were arising, or
that were given a new sense of urgency, as a result of financial
innovation. The project initially focused on disclosures and resulted in
the issuance of FASB Statements No. 105, Disclosure of Information
about Financial Instruments with Off-Balance-Sheet Risk and Financial
Instruments with Concentrations of Credit Risk, in March 1990, and No.
107, Disclosures about Fair Value of Financial Instruments, in
December 1991. This Statement supersedes Statement 105 and amends
Statement 107.
==========================================================================
\27/ The terms derivative instrument and derivative are used interchangeably
in this appendix.
==========================================================================
208. An FASB staff-authored Research Report, Hedge
Accounting: An Exploratory Study of the Underlying Issues, was
published in September 1991. \28/ An FASB Discussion Memorandum,
Recognition and Measurement of Financial Instruments, was issued
in November 1991 as a basis for considering the financial accounting and
reporting issues of recognition and measurement raised by financial
instruments. The recognition and measurement phase of the financial
instruments project, which began with the issuance of that Discussion
Memorandum, resulted in the issuance of FASB Statements No. 114,
Accounting by Creditors for Impairment of a Loan, and No. 115,
Accounting for Certain Investments in Debt and Equity
Securities, in May 1993, FASB Statement No. 118,
Accounting by Creditors for Impairment of a Loan-Income Recognition
and Disclosures, in October 1994, and FASB Statement No.
125, Accounting for Transfers and Servicing
of Financial Assets
and Extinguishments of Liabilities, in June 1996.
==========================================================================
\28/ Harold Bierman, Jr., L. Todd Johnson, and D. Scott Peterson, FASB
Research Report, Hedge Accounting: An Exploratory Study of the
Underlying Issues.
==========================================================================
209. Concern about financial reporting for derivative
instruments and hedging activities is an international phenomenon. In
October 1995, an FASB staff-authored Special Report, Major Issues
Related to Hedge Accounting, was published jointly with representatives
of the accounting standards-setting bodies of the United Kingdom, Canada,
and Australia and the International Accounting Standards Committee. \29/
That Special Report discusses many of the issues that needed to be resolved
in developing a hedge accounting model.
==========================================================================
\29/ Jane B. Adams and Corliss J. Montesi, FASB Special Report, Major
Issues Related to Hedge Accounting.
==========================================================================
210. The Board began deliberating issues relating to
derivatives and hedging activities in January 1992. From then until June
1996, the Board held 100 public meetings to discuss various issues and
proposed accounting approaches, including 74 Board meetings, 10 meetings
with members of the Financial Accounting Standards Advisory Council, 7
meetings with members of the Financial Instruments Task Force and its
subgroup on hedging, and 9 meetings with outside representatives. In
addition, individual Board members and staff visited numerous companies in
a variety of fields and participated in meetings with different
representational groups, both nationally and internationally, to explore
how different entities manage risk and how those risk management activities
should be accounted for.
211. In June 1993, the Board issued a report, "A Report
on Deliberations, Including Tentative Conclusions on Certain Issues,
related to Accounting for Hedging and Other Risk-adjusting Activities."
That report included background information about the Board's deliberations
and some tentative conclusions on accounting for derivatives and hedging
activities. It also solicited comments from constituents and provided the
basis for two public meetings in September 1993.
212. Concern has grown about the accounting and
disclosure requirements for derivatives and hedging activities as the
extent of use and the complexity of derivatives and hedging activities have
rapidly increased in recent years. Changes in global financial markets and
related financial innovations have led to the development of new
derivatives used to manage exposures to risk, including interest rate,
foreign exchange, price, and credit risks. Many believe that accounting
standards have not kept pace with those changes. Derivatives can be useful
risk management tools, and some believe that the inadequacy of financial
reporting may have discouraged their use by contributing to an atmosphere
of uncertainty. Concern about inadequate financial reporting also was
heightened by the publicity surrounding large derivative losses at a few
companies. As a result, the Securities and Exchange Commission, members of
Congress, and others urged the Board to deal expeditiously with reporting
problems in this area. For example, a report of the General Accounting
Office prepared for Congress in 1994 recommended, among other things, that
the FASB "proceed expeditiously to develop and issue an exposure draft that
provides comprehensive, consistent accounting rules for derivative
products. . . ." \30/ In addition, some users of financial statements
asked for improved disclosures and accounting for derivatives and hedging.
For example, one of the recommendations in the December 1994 report
published by the AICPA Special Committee on Financial Reporting,
Improving Business Reporting-A Customer Focus, was to address
the disclosures and accounting for innovative financial instruments.
==========================================================================
\30/ United States General Accounting Office, Report to Congressional
Requesters, Financial Derivatives: Actions Needed to Protect the
Financial System, May 1994, 16.
==========================================================================
213. Because of the urgency of improved financial
information about derivatives and related activities, the Board decided, in
December 1993, to redirect some of its efforts toward enhanced disclosures
and, in October 1994, issued FASB Statement No. 119,
Disclosure about Derivative Financial Instruments and Fair Value of
Financial Instruments. This Statement supersedes Statement 119.
214. In June 1996, the Board issued an Exposure Draft,
Accounting for Derivative and Similar Financial Instruments and for
Hedging Activities. Approximately 300 organizations and individuals
responded to the Exposure Draft, some with multiple letters. In November
1996, 36 individuals and organizations presented their views at 4 days of
public hearings. In addition, six enterprises participated in a limited
field test of the provisions of the Exposure Draft. In December 1996, the
Board's Financial Instruments Task Force met to discuss the issues raised
during the comment letter process and during the public hearings. The
Board considered the comments and field test results during its
redeliberations of the issues addressed by the Exposure Draft in 21 public
meetings in the first 7 months of 1997. The Financial Instruments Task
Force met again with the Board in April 1997 and discussed, among other
things, proposed changes to the Exposure Draft reflected in a draft of a
Statement. As a consequence of the comments received, the Board made
certain changes to the proposals in the Exposure Draft.
215. In August 1997, a draft of the standards section of
this Statement and related examples was made available to the Financial
Instruments Task Force and other interested parties for comment on its
clarity and operationality. The Board received approximately 150 comment
letters on that draft and discussed those comments in 10 open Board
meetings. Those comments also led to changes to the requirements, intended
to make the Statement clearer and more operational.
216. This Statement is an additional step in the Board's
project on financial instruments and is intended to address the immediate
problems about the recognition and measurement of derivatives while the
Board's vision of having all financial instruments measured at fair value
in the statement of financial position is pursued. Certain provisions of
this Statement will be reconsidered as the Board continues to address the
issues in its broad project on financial instruments.
Fundamental Decisions Underlying the Statement
217. The Board made four fundamental decisions about how
to account for derivatives and hedging activities; those decisions became
the cornerstones of this Statement:
a. Derivative instruments represent rights or obligations that meet the
definitions of assets or liabilities and should be reported in financial
statements.
b. Fair value is the most relevant measure for financial instruments and the
only relevant measure for derivative instruments. Derivative instruments
should be measured at fair value, and adjustments to the carrying amounts of
hedged items should reflect changes in their fair value (that is, gains or
losses) that are attributable to the risk being hedged and that arise while
the hedge is in effect.
c. Only items that are assets or liabilities should be reported as such in
financial statements.
d. Special accounting for items designated as being hedged should be provided
only for qualifying items. One aspect of qualification should be an
assessment of the expectation of effective offsetting changes in fair values
or cash flows during the term of the hedge for the risk being hedged.
218. Derivative instruments represent rights or
obligations that meet the definitions of assets or liabilities and should
be reported in financial statements. Derivatives are assets or
liabilities because they represent rights or obligations. FASB
Concepts Statement No. 6, Elements of
Financial Statements,
describes the characteristics of assets and liabilities as follows:
An asset has three essential characteristics: (a) it embodies a
probable future benefit that involves a capacity, singly or in
combination with other assets, to contribute directly or indirectly to
future net cash inflows, (b) a particular entity can obtain the benefit
and control others' access to it, and (c) the transaction or other
event giving rise to the entity's right to or control of the benefit
has already occurred. . . .
A liability has three essential characteristics: (a) it embodies a
present duty or responsibility to one or more other entities that
entails settlement by probable future transfer or use of assets at a
specified or determinable date, on occurrence of a specified event, or
on demand, (b) the duty or responsibility obligates a particular entity,
leaving it little or no discretion to avoid the future sacrifice, and
(c) the transaction or other event obligating the entity has already
happened. [paragraphs 26 and 36]
219. The ability to settle a derivative in a gain
position by receiving cash, another financial asset, or a nonfinancial
asset is evidence of a right to a future economic benefit and is compelling
evidence that the instrument is an asset. Similarly, the payment of cash, a
financial asset, or a nonfinancial asset that is required to settle a
derivative in a loss position is evidence of a duty to sacrifice assets in
the future and indicates that the instrument is a liability. The Board
believes that recognizing those assets and liabilities will make financial
statements more complete and more informative. Before the issuance of this
Statement, many derivatives were "off-balance-sheet" because, unlike
conventional financial instruments such as stocks, bonds, and loans,
derivatives often reflect at their inception only a mutual exchange of
promises with little or no transfer of tangible consideration.
220. Fair value is the most relevant measure for
financial instruments and the only relevant measure for derivative
instruments. Derivative instruments should be measured at fair value, and
adjustments to the carrying amounts of hedged items should reflect changes
in their fair value (that is, gains or losses) that are attributable to the
risk being hedged and that arise while the hedge is in effect. In 1991,
with the issuance of Statement 107, the Board concluded that disclosure of
fair value information about financial instruments is useful to present and
potential investors, creditors, and other users of financial statements in
making rational investment, credit, and other decisions. Statement 107
describes the Board's rationale:
Fair values of financial instruments depict the market's
assessment of the present value of net future cash flows directly
or indirectly embodied in them, discounted to reflect both current
interest rates and the market's assessment of the risk that the
cash flows will not occur. Investors and creditors are interested
in predicting the amount, timing, and uncertainty of future net
cash inflows to an entity, as those are the primary sources of
future cash flows from the entity to them. Periodic information
about the fair value of an entity's financial instruments under
current conditions and expectations should help those users both in
making their own predictions and in confirming or correcting their
earlier expectations.
Information about fair value better enables investors,
creditors, and other users to assess the consequences of an
entity's investment and financing strategies, that is, to assess
its performance. For example, information about fair value shows
the effects of a decision to borrow using fixed-rate rather than
floating-rate financial instruments or of a decision to invest in
long-term rather than short-term instruments. Also, in a dynamic
economy, information about fair value permits continuous
reassessment of earlier decisions in light of current
circumstances. [paragraphs 40 and
41]
221. The Board believes fair values for financial assets
and liabilities provide more relevant and understandable information than
cost or cost-based measures. In particular, the Board believes that fair
value is more relevant to financial statement users than cost for assessing
the liquidity or solvency of an entity because fair value reflects the
current cash equivalent of the entity's financial instruments rather than
the price of a past transaction. With the passage of time, historical
prices become irrelevant in assessing present liquidity or solvency.
222. The Board also believes fair value measurement is
practical for most financial assets and liabilities. Fair value
measurements can be observed in markets or estimated by reference to
markets for similar instruments. If market information is not available,
fair value can be estimated using other measurement techniques, such as
discounted cash flow analyses and option or other pricing models, among
others.
223. The Board believes fair value is the only
relevant measurement attribute for derivatives. Amortized cost is not a
relevant measure for derivatives because the historical cost of a
derivative often is zero, yet a derivative generally can be settled or sold
at any time for an amount equivalent to its fair value. Statement 115
provides reasoning for the belief that amortized cost may be relevant for
debt securities that will be held to maturity. In the absence of default,
that cost will be realized at maturity, and any interim unrealized gains or
losses will reverse. That reasoning does not hold for derivatives or for
other financial instruments. The volatility of derivatives' fair values
and the irrelevance of amortized cost for derivatives convinced the Board
that fair value is the only relevant measure for derivatives and that all
derivatives should be reported in financial statements at fair value. (The
latter part of the Board's second fundamental decision, which deals with
the mechanics of hedge accounting, is discussed in
paragraphs 362 and 363.)
224. Some of the Board's constituents contend that
reporting derivatives at fair value will not result in more useful
information than results from present practice. Some also say that
reporting derivatives at fair value will result in reported gains or losses
and increases or decreases in reported equity that are "artificial" because
they do not reflect economic benefits or detriments. Some of those
concerns are based in part on concerns about using different measurement
attributes for derivatives and for other financial instruments. The Board
agrees that financial statements would be even more useful if all financial
instruments were reported at fair value, and that is its long-term goal.
However, some of the arguments against reporting derivatives at fair value
are made in the context of assertions that fair value measurements do not
provide useful information for either derivatives or other instruments.
The following simple example illustrates why the Board does not agree with
that view.
225. Bank A and Bank B have identical financial positions
at December 31, 20X1, as follows:
Loans $10 billion Liabilities $9 billion
Equity 1 billion
----------- -----------
Total liabilities
Total assets $10 billion and equity $10 billion
=========== ============
Both banks' assets consist entirely of variable-rate loans. Both also have
fixed- rate debt at 9 percent.
226. In January of 20X2, Bank A becomes concerned that
market interest rates will fall below the current level of 10 percent, and
it therefore enters into a pay-variable, receive-fixed-at-10-percent
interest rate swap. Bank B, on the other hand, chooses not to hedge its
variable-rate loans. Bank A's swap will reprice every three months,
beginning on April 15, 20X2. By March 31, 20X2, interest rates have fallen
significantly, and the fair value of Bank A's swap is $1 billion.
227. For simplicity, the example assumes that each bank's
interest income for the first quarter of 20X2 was exactly offset by
expenses so that both had earnings of zero. The effects of deferred taxes
also are ignored. Thus, if the change in fair value of Bank A's interest
rate swap is excluded from its financial statements, as was general
practice before this Statement, both banks' balance sheets at March 31,
20X2 would continue to appear as presented in paragraph
225. However, the two banks are not in the same
economic position-Bank
A has a $1 billion asset that Bank B does not.
228. The following statement of financial position, which
reflects the requirements of this Statement if Bank A accounts for the swap
as a cash flow hedge, better reflects Bank A's economic position at March
31, 20X2:
Loans $10 billion Liabilities $9 billion
----------
Equity:
Interest rate swap 1 billion Beginning equity 1 billion
Gain on swap 1 billion
----------
Total equity 2 billion
----------- ----------
Total liabilities
Total assets $11 billion and equity $11 billion
=========== ===========
Bank A's statement of comprehensive income for the quarter ending March 31,
20X2 will report a gain of $1 billion. Bank B's comprehensive income for
the same period will be reported as zero. Under previous accounting for
swaps, Bank A would only accrue periodic cash receipts or payments on the
swap as the swap reprices and those receipts or payments become due. In
contrast, the financial statements of Banks A and B at March 31, 20X2
presented in accordance with this Statement signal to investors and
creditors that the future reported earnings and cash flows of the banks
will be different. If interest rates remain below 10 percent during the
remainder of the term of the loans, Bank A will report higher earnings and
will receive higher cash inflows than Bank B. Indeed, whatever happens to
interest rates in the future, the two banks are likely to be affected
differently. Under previous reporting practices for interest rate swaps
and many other derivatives, Bank A and Bank B would have looked exactly
alike at March 31, 20X2. However, the two banks are not in the same
economic position at March 31, 20X2, and Bank A's increase in reported
equity reflects the real difference in the position of the two banks. That
increase in equity is by no means "artificial."
229. Only items that are assets or liabilities
should be reported as such in financial statements. Derivatives are
assets or liabilities, and the Board decided that they should be reported
in financial statements (fundamental decision 1) and measured at fair value
(fundamental decision 2). If derivatives are measured at fair value, the
losses or gains that result from changes in their fair values must be
reported in the financial statements. However, those losses or gains are
not separate assets or liabilities because they have none of the essential
characteristics of assets or liabilities as described in
paragraph 218. The act of designating a
derivative as a hedging
instrument does not convert a subsequent loss or gain into an asset or a
liability. A loss is not an asset because no future economic benefit is
associated with it. The loss cannot be exchanged for cash, a financial
asset, or a nonfinancial asset used to produce something of value, or used
to settle liabilities. Similarly, a gain is not a liability because no
obligation exists to sacrifice assets in the future. Consequently, the
Board concluded that losses or gains on derivatives should not be reported
as assets or liabilities in a statement of financial position.
230. Special accounting for items designated as
being hedged should be provided only for qualifying items. One aspect of
qualification should be an assessment of the expectation of effective
offsetting changes in fair values or cash flows during the term of the
hedge for the risk being hedged. Because hedge accounting is elective
and relies on management's intent, it should be limited to transactions
that meet reasonable criteria. The Board concluded that hedge accounting
should not be permitted in all cases in which an entity might assert that a
relationship exists between items or transactions. A primary purpose of
hedge accounting is to link items or transactions whose changes in fair
values or cash flows are expected to offset each other. The Board
therefore decided that one of the criteria for qualification for hedge
accounting should focus on the extent to which offsetting changes in fair
values or cash flows on the derivative and the hedged item or transaction
during the term of the hedge are expected and ultimately achieved.
231. The offset criterion precludes hedge accounting for
certain risk management techniques, such as hedges of strategic risk. For
example, a U.S. manufacturer, with no export business, that designates a
forward contract to buy U.S. dollars for Japanese yen as a hedge of its
U.S. dollar sales would fail the requirement that the cash flows of the
derivative are expected to be highly effective in achieving offsetting cash
flows on the hedged transaction. A weakened yen might allow a competitor
to sell goods imported from Japan more cheaply, undercutting the domestic
manufacturer's prices and reducing its sales volume and revenues. However,
it would be difficult for the U.S. manufacturer to expect a high degree of
offset between a decline in U.S. sales revenue due to increased competition
and cash inflows on a foreign currency derivative. Any relationship between
the exposure and the "hedging" derivative typically would be quite
indirect, would depend on price elasticities, and would be only one of many
factors influencing future results. In addition, the risk that a desired
or expected number of transactions will not occur, that is, the potential
absence of a transaction, is not a hedgeable risk under this Statement.
Hedge accounting in this Statement is limited to the direct effects of
price changes of various kinds (commodity prices, interest rates, and so
on) on fair values of assets and liabilities and the cash flows from
transactions, including qualifying forecasted transactions.
Benefits and Costs of This Statement
232. In accomplishing its mission, the Board follows
certain precepts, including the precept to promulgate standards only when
the expected benefits of the information exceed the perceived cost. The
Board works to determine that a proposed standard will fill a significant
need and that the costs imposed to meet the standard, as compared to other
alternatives, are justified in relation to the overall benefits of the
resulting information.
Problems with Previous Accounting and Reporting Practices
233. The first step in considering whether the benefits
of a new accounting standard will justify the related costs is to identify
the problems in the existing accounting guidance that a new standard seeks
to resolve. The problems with previous accounting and reporting practices
for derivatives and hedging activities are discussed below.
234. The effects of derivatives were not
transparent in the basic financial statements. Under the varied
accounting practices that existed before the issuance of this Statement,
some derivatives were recognized in financial statements, others were not.
If recognized in financial statements, some realized and unrealized gains
and losses on derivatives were deferred from earnings recognition and
reported as part of the carrying amount (or "basis") of a related item or
as if they were freestanding assets and liabilities. Users of financial
statements found it difficult to determine what an entity had or had not
done with derivatives and the related effects because the basic financial
statements often did not report the rights or obligations associated with
derivative instruments.
235. The accounting guidance for derivative instruments
and hedging activities was incomplete. Before the issuance of this
Statement, accounting standards specifically addressed only a few types of
derivatives. Statement 52 addressed foreign exchange forward contracts,
and Statement 80 addressed exchange-traded futures contracts. Only those
two Statements specifically provided for "hedge accounting." That is, only
those Statements provided special accounting to permit a gain or loss on a
derivative to be deferred beyond the period in which it otherwise would be
recognized in earnings because it was designated as a hedging instrument.
The EITF addressed the accounting for some derivatives and for some hedging
activities not covered in either Statement 52 or Statement 80. However,
that effort was on an ad hoc basis and gaps remained in the authoritative
literature. Accounting practice filled some gaps on specific issues, such
as with "synthetic instrument accounting" as described in
paragraph 349, but without commonly understood
limitations on the
appropriate use of that accounting. The result was that (a) many
derivative instruments were carried "off-balance-sheet" regardless of
whether they were formally part of a hedging strategy, (b) practices were
inconsistent among entities, and (c) users of financial reports had
inadequate information.
236. The accounting guidance for derivative
instruments and hedging activities was inconsistent. Under previous
accounting guidance, the required accounting treatment differed depending
on the type of instrument used in a hedge and the type of risk being
hedged. For example, an instrument hedging an anticipated transaction may
have qualified for special accounting if it was a purchased option with
certain characteristics or an interest rate futures contract, but not if it
was a foreign currency forward or futures contract. Derivatives also were
measured differently under previous standards-futures contracts were
reported at fair value, foreign currency forward contracts were reported at
amounts that reflected changes in foreign exchange spot rates but not
changes in forward rates and that were not discounted for the time value of
money, and other derivatives often were unrecognized or were reported at
nominal amounts not closely related to the fair value of the derivatives
(for example, reported at the net cash due that period). Accounting
standards also were inconsistent on whether qualification for hedge
accounting was based on risk assessment at an entity-wide or an
individual-transaction level.
237. The accounting guidance for derivatives and
hedging was difficult to apply. The lack of a single, comprehensive
approach to accounting for derivatives and hedging made the accounting
guidance difficult to apply. The incompleteness of FASB Statements on
derivatives and hedging forced entities to look to a variety of different
sources, including the numerous EITF issues and nonauthoritative
literature, to determine how to account for specific instruments or
transactions. Because there often was nothing directly on point, entities
analogized to other existing guidance. Different sources of analogy often
conflicted, and a wide range of answers sometimes was deemed supportable,
but those answers often were subject to later challenge.
This Statement Mitigates Those Problems
238. This Statement mitigates those four problems. It
increases the visibility, comparability, and understandability of the risks
associated with derivatives by requiring that all derivatives be reported
as assets or liabilities and measured at fair value. It reduces the
inconsistency, incompleteness, and difficulty of applying previous
accounting guidance and practice by providing comprehensive guidance for
all derivatives and hedging activities. The comprehensive guidance in this
Statement also eliminates some accounting practices, such as "synthetic
instrument accounting," that had evolved beyond the authoritative
literature.
239. In addition to mitigating the previous problems,
this Statement accommodates a range of hedge accounting practices by (a)
permitting hedge accounting for most derivative instruments, (b) permitting
hedge accounting for cash flow hedges of forecasted transactions for
specified risks, and (c) eliminating the requirement in Statement 80 that
an entity demonstrate risk reduction on an entity-wide basis to qualify for
hedge accounting. The combination of accommodating a range of hedge
accounting practices and removing the uncertainty about the accounting
requirements for certain strategies should facilitate, and may actually
increase, entities' use of derivatives to manage risks.
240. The benefits of improving financial reporting for
derivatives and hedging activities come at a cost. Even though much of the
information needed to implement this Statement is substantially the same as
was required for prior accounting standards for many hedges, and therefore
should be available, many entities will incur one-time costs for requisite
systems changes. But the benefits of more credible and more understandable
information will be ongoing.
241. The Board believes that accounting requirements
should be neutral and should not encourage or discourage the use of
particular types of contracts. That desire for neutrality must be balanced
with the need to reflect substantive economic differences between different
instruments. This Statement is the product of a series of many compromises
made by the Board to improve financial reporting for derivatives and
hedging activities while giving consideration to cost-benefit issues, as
well as current practice. The Board believes that most hedging strategies
for which hedge accounting is available in current practice have been
reasonably accommodated. The Board recognizes that this Statement does not
provide special accounting that accommodates some risk management
strategies that certain entities wish to use, such as hedging a portfolio
of dissimilar items. However, this Statement clarifies and accommodates
hedge accounting for more types of derivatives and different views of risk,
and provides more consistent accounting for hedges of forecasted
transactions than did the limited guidance that existed before this
Statement.
242. Some constituents have said that the requirements of
this Statement are more complex than existing guidance. The Board
disagrees. It believes that compliance with previous guidance was more
complex because the lack of a single, comprehensive framework forced
entities to analogize to different and often conflicting sources of
guidance. The Board also believes that some constituents' assertions about
increased complexity may have been influenced by some entities' relatively
lax compliance with previous guidance. For example, the Board understands
that not all entities complied with Statement 80's entity-wide risk
reduction criterion to qualify for hedge accounting, and that also may have
been true for requirements for hedging a portfolio of dissimilar items.
The Board also notes that some of the more complex requirements of this
Statement, such as reporting the gain or loss on a cash flow hedge in
earnings in the periods in which the hedged transaction affects earnings,
are a direct result of the Board's efforts to accommodate respondents'
wishes.
243. The Board took several steps to minimize the
incremental costs of the accounting and disclosure requirements of this
Statement. For example, this Statement relies on the valuation guidance
provided in Statement 107, which most entities have been applying for
several years. The Board also decided not to continue the previously
required assessment of risk at an entity-wide level, which constituents
said is very difficult and costly to make. This Statement also reduces the
disclosure requirements that previously were required for derivatives. Some
of the previous disclosure requirements for derivatives were intended to
partially compensate for inadequate accounting; improving the information
provided in the basic financial statements makes possible a reduction in
such disclosures.
Scope and Definition
244. As already discussed, the Board decided that
derivative instruments should be measured at fair value. The Board also
decided that accounting for gains or losses that result from measuring
derivatives at fair value should depend on whether or not the derivative
instrument is designated and qualifies as a hedging instrument. Those
decisions require that the Board clearly identify (a) those instruments to
which this Statement applies and (b) the criteria that must be met for a
relationship to qualify for hedge accounting.
245. The Board decided that this Statement should apply
to many, but not all, instruments that are often described as derivatives.
In reaching that decision, the Board observed that prior accounting
standards did not clearly distinguish derivative instruments from other
financial and nonfinancial instruments. Financial statement preparers,
users, and other interested parties often have trouble clearly
distinguishing between instruments that are commonly considered derivatives
and other instruments. Accordingly, they often do not agree on whether
certain instruments are derivatives. This Statement defines derivative
instruments based on their characteristics; the resulting definition may
not always coincide with what some market participants consider to be
derivatives.
Why Hedging Instruments Are Limited to Derivatives
246. This Statement limits hedge accounting to those
relationships in which derivative instruments and certain
foreign-currency-denominated nonderivative instruments are designated as
hedging instruments and the necessary qualifying criteria are met. The
Board recognizes that there may be valid reasons for entering into
transactions intended to be hedges using nonderivative instruments, but the
Board continues to believe that permitting nonderivative instruments to be
designated as hedging instruments would be inappropriate.
247. Achieving the Board's long-term objective of having
all financial instruments-both derivative and nonderivative-measured at
fair value would eliminate the need for hedge accounting for the risks
inherent in existing financial instruments. Both the hedging instrument
and the hedged item would be measured at fair value. Accounting for the
gains and losses on each in the same way would leave no measurement
anomalies to which to apply hedge accounting. As further discussed in
paragraphs 326 and 327,
the Board
considers hedge accounting for forecasted transactions to be inappropriate
from a conceptual perspective. In practice, hedge accounting for
forecasted (anticipated) transactions has been limited to derivatives, and
the Board does not think it would be appropriate to extend hedge accounting
for what is not a conceptually defensible practice to nonderivative
instruments. To include nonderivative financial instruments, other than in
circumstances already permitted by existing accounting pronouncements, as
hedging instruments also would add complexity and delay issuing guidance on
accounting for derivative instruments. The Board therefore decided to limit
hedge accounting to derivatives. Consequently, items such as securities,
trade receivables and payables, and deposit liabilities at banks may not be
designated as hedging instruments except that, consistent with existing
provisions in Statement 52, nonderivative instruments that give rise to
transaction gains or losses may be designated as hedges of certain foreign
currency exposures.
Defining Characteristics of a Derivative Instrument
248. The Board considered defining a derivative
instrument in this Statement by merely referencing those instruments
commonly understood to be derivatives. That would be similar to the method
used in paragraph 5 of Statement 119, which said that ". . . a derivative
financial instrument is a futures, forward, swap, or option contract, or
other financial instrument with similar characteristics." However, the
expansion of financial markets and continued development of innovative
financial instruments and other contracts could ultimately render obsolete
a definition based solely on examples. Currently, contracts often referred
to as derivatives have characteristics similar to other contracts that
often are not considered to be derivative instruments. For example,
purchase orders for certain raw materials have many similarities to forward
contracts that are referenced to those same raw materials. The Board is
concerned that the existing distinctions between many types of contracts
are likely to become even more blurred as new innovative instruments are
developed. Therefore, to distinguish between similar contracts and to deal
with new instruments that may be developed in the future, this Statement
provides a definition of derivative instruments based on distinguishing
characteristics rather than merely referring to classes of instruments or
titles used to describe them.
249. For purposes of this Statement, a derivative
instrument is a financial instrument or other contract that has all three
of the following characteristics:
a. It has (1) one or more underlyings and (2) one or more notional amounts or
payment provisions or both.
b. It requires no initial net investment or an initial net investment
that is smaller than would be required for other types of contracts
that would be expected to have a similar response to changes in market
factors.
c. Its terms require or permit net settlement, it can readily be settled
net by a means outside the contract, or it provides for delivery of an
asset that puts the recipient in a position not substantially
different from net settlement.
The Board believes those three characteristics capture the essence of
instruments, such as futures and options, that have long been considered
derivatives and instruments that are sufficiently similar to those
traditional derivatives that they should be accounted for similarly. The
following paragraphs discuss each characteristic in more depth. Section 1
of Appendix A provides additional discussion of the three characteristics
of a derivative instrument.
Underlyings and Notional Amounts or Payment Provisions
250. Derivative instruments typically permit the parties
to participate in some or all of the effects of changes in a referenced
price, rate, or other variable, which is referred to as the
underlying, for example, an interest rate or equity index or the
price of a specific security, commodity, or currency. As the term is used
in this Statement, a referenced asset or liability, if any, is not itself
the underlying of a derivative contract. Instead, the
price or rate of the associated asset or liability,
which is used to determine the settlement amount of the derivative
instrument, is the underlying.
251. By itself, an underlying cannot determine the value
or settlement of a derivative. Most derivatives also refer to a
notional amount, which is a number of units specified in the
contract. The multiplication or other arithmetical interaction of the
notional amount and the underlying determines the settlement of the
derivative. However, rather than referring to a notional amount, some
derivatives instead contain a payment provision that requires
settlement if an underlying changes in a specified way. For example, a
derivative might require a specified payment if a referenced interest rate
increases by 300 basis points. Reference to either a notional amount or a
payment provision is needed to compute the contract's periodic settlements
and resulting changes in fair value.
252. In concept, any observable variable, including
physical as well as financial variables, may be the underlying for a
derivative instrument. For example, a contract might specify a payment to
be made if it rains more than one inch on a specified day. However,
throughout the project that led to this Statement, discussion focused on
more traditional derivatives for which the underlying is some form of
price, including an interest rate or exchange rate. For example,
paragraph 6 of the Exposure Draft referred to
"a rate, an index
of prices, or another market indicator" in describing an underlying.
Relatively late in the process that led to this Statement, the Board
considered expanding its scope to include all derivatives based on physical
variables but decided not to do so. It was concerned that constituents had
not had sufficient opportunity to consider the implications and potential
measurement difficulties of including contracts based on physical
variables. The Board believes many contracts for which the underlying is a
physical variable are currently accounted for as insurance contracts, and
it considers that accounting to be adequate for now. However, the Board
decided that any derivative instrument that is traded on an exchange,
including one based on a physical variable, should be subject to the
requirements of this Statement. Accordingly, any derivative based on a
physical variable that eventually becomes exchange traded will
automatically become subject to the requirements of this Statement. The
Board does not believe that measurement or other implementation problems
exist for exchange-traded instruments.
253. This Statement also excludes from its scope a
derivative instrument for which the underlying is the price or value of a
nonfinancial asset of one of the parties to the contract provided that the
asset is not readily convertible to cash. Similarly excluded is a
derivative instrument for which the underlying is the price or value of a
nonfinancial liability of one of the parties to the contract provided that
the liability does not require delivery of an asset that is not readily
convertible to cash. A contract for which the underlying is specified
volumes of sales or service revenues by one of the parties also is
excluded. Many such contracts are insurance contracts. An example is a
contract based on the condition or value of a building. Others contain an
element of compensation for service or for use of another entity's asset.
An example is a royalty agreement based on sales of a particular product.
254. Because a derivative may have an underlying that is
a combination of variables, the Board added a requirement to clarify the
application of paragraph 10(e). Some of the
variables
in an underlying that is a combination of variables may be subject to the
exceptions in paragraph 10(e) and others may
not. The
Board did not intend for all contracts with those types of underlyings to
be excluded automatically from the scope of this Statement. A contract with
a combined underlying is subject to the requirements of this Statement if
its settlement is expected to change in a way that is highly correlated
with the way it would change if it was based on an underlying that would
not be eligible for one of the exceptions in paragraph
10(e).
Initial Investment in the Contract
255. The second characteristic of a derivative instrument
refers to the relative amount of the initial net investment in the
contract. Providing the opportunity to participate in the price changes of
an underlying without actually having to own an associated asset or owe an
associated liability is the basic feature that distinguishes most
traditional derivative instruments from nonderivative instruments.
Therefore, the Board decided that a contract that at inception requires the
holder or writer to invest or receive an amount approximating the notional
amount of the contract is not a derivative instrument. The following
example illustrates that fundamental difference between a derivative
instrument and a nonderivative instrument.
256. A party that wishes to participate in the changes in
the fair value of 10,000 shares of a specific marketable equity security
can, of course, do so by purchasing 10,000 shares of that security.
Alternatively, the party may enter into a forward purchase contract with a
notional amount of 10,000 shares of that security and an underlying that is
the price of that security. Purchasing the shares would require an initial
investment equal to the current price for 10,000 shares and would result in
benefits such as the receipt of dividends (if any) and the ability to vote
the shares. A simple forward contract entered into at the current forward
price for 10,000 shares of the equity instrument would not require an
initial investment equal to the notional amount but would offer the same
opportunity to benefit or lose from changes in the price of that security.
257. Some respondents to the Exposure Draft suggested
that the definition of a derivative instrument should include contracts
that require gross exchanges of currencies (for example, currency swaps
that require an exchange of different currencies at both inception and
maturity). They noted that those contracts are commonly viewed as
derivatives, are used in the same manner as derivatives, and therefore
should be included in the definition of a derivative instrument. The Board
agreed and notes that this Statement's definition of a derivative
instrument, as revised from the Exposure Draft, explicitly includes such
currency swaps. The Board observes that the initial exchange of currencies
of equal fair values in those arrangements does not constitute an initial
net investment in the contract. Instead, it is the exchange of one kind of
cash for another kind of cash of equal value. The balance of the
agreement, a forward contract that obligates and entitles both parties to
exchange specified currencies, on specified dates, at specified prices, is
a derivative instrument.
258. paragraphs 6-11 of this Statement
address only those contracts that in their entirety are derivative
instruments. A contract that requires a relatively large initial net
investment may include one or more embedded derivative instruments. The
Board's conclusions on embedded derivatives are discussed in
paragraphs 293-311.
Net Settlement
259. The third distinguishing characteristic of a
derivative instrument as defined in this Statement is that it can be
readily settled with only a net delivery of assets. Therefore, a
derivative contract must meet one of the following criteria:
a. It does not require either party to deliver an asset that is
associated with its underlying or that has a principal amount, stated
amount, face value, number of shares, or other denomination that is
equal to the notional amount (or the notional amount plus a premium or
minus a discount).
b. It requires one of the parties to deliver such an asset, but there is
a market mechanism that facilitates net settlement.
c. It requires one of the parties to deliver such an asset, but that
asset either is readily convertible to cash or is itself a derivative
instrument.
260. The Exposure Draft proposed that derivative
instruments be distinguished from other instruments by determining whether
(a) the holder could settle the contract with only a net cash payment,
either by its contractual terms or by custom, and (b) the net payment was
determined by reference to changes in the underlying. \31/ Under the
Exposure Draft, a contract that required ownership or delivery of an asset
associated with the underlying would have been a derivative instrument if a
mechanism existed in the market to enter into a closing contract with only
a net settlement or if the contract was customarily settled with only a net
cash payment based on changes in the underlying. The Board focused in the
Exposure Draft on whether there is a mechanism in the market for net
settlement because it observed that many derivative instruments are
actively traded and can be closed or settled before the contract's
expiration or maturity by net settlement in active markets. The Board
included the requirement for customary settlement in the Exposure Draft for
two reasons: (a) to prevent circumvention of the requirements of this
Statement by including nonsubstantive delivery provisions in a contract
that otherwise would be considered a derivative and (b) to include in the
definition of a derivative all contracts that are typically settled net
even if the ability to settle net is not an explicit feature of the
contract.
==========================================================================
\31/ The term underlying as used in the Exposure Draft encompassed the asset
or liability, the price of which was the underlying for the contract.
==========================================================================
261. Several respondents to the Exposure Draft requested
clarification of its net settlement provisions. Respondents observed that
the phrase mechanism in the market was unclear and could lead
to different interpretations in practice. They asked whether
only an organized exchange would constitute the type of market
mechanism that the Board had in mind, or whether a willingness of market
participants to enter into such a contract in the over-the-counter or other
markets would require that the contract be viewed as a derivative
instrument. This Statement responds to those questions by indicating in
paragraph 57(c)(2) that the Board intends market
mechanism to be interpreted broadly to include any institutional
arrangement or side agreement that permits either party to be relieved of
all rights and obligations under the contract and to liquidate its net
position without incurring a significant transaction cost.
262. Respondents also questioned whether customary
referred to the customs of the reporting entity or the customs of the
marketplace. They said that it would be difficult to discern the custom of
the marketplace for a non-exchange-traded instrument for which settlement
information is not publicly available. They also observed that market
customs vary by industry and over time. A criterion based on such customs
therefore might lead to different answers at different points in time (for
example, customs that currently require gross settlement might subsequently
change) and for different participants to the contracts (for example, a
bank might customarily settle a certain type of contract with only a net
payment of cash, while a manufacturing entity might customarily settle the
same type of contract by delivering the assets associated with the
underlying). The definition of a derivative in this Statement does not
refer to customary settlement. The Board decided that the provisions of
paragraph 9 would achieve the objective of the
Exposure
Draft.
263. During its redeliberations, the Board discussed
whether the definition of a derivative instrument should depend on whether
net settlement occurs in cash or for another asset. The Board also
discussed whether this Statement should apply to a derivative instrument in
which at least one of the items to be exchanged in the future is something
other than a financial instrument. The Board decided that the medium of
exchange used in the net settlement of a derivative contract should not
determine whether the instrument is within the scope of this Statement. A
contract that can readily be settled net, whether the settlement is for
cash or another asset, should be within the scope of this Statement. As a
result of that decision, the Board also decided to delete
financial from the term derivative financial
instruments in describing the instruments that are within the scope of
this Statement.
Assets that are readily convertible to cash
264. The Board decided that a contract that requires
delivery of an asset associated with the underlying in a denomination equal
to the notional amount should qualify as a derivative instrument if the
asset is readily convertible to cash. (paragraphs 271
and 272 and 275
and
276, respectively, discuss two exceptions to
that provision.) As
indicated in footnote 5, the term readily convertible to cash
refers to assets that "have (i) interchangeable (fungible) units and (ii)
quoted prices available in an active market that can rapidly absorb the
quantity held by the entity without significantly affecting the price."
265. Net settlement is an important characteristic that
distinguishes a derivative from a nonderivative because it permits a
contract to be settled without either party's accepting the risks and costs
customarily associated with owning and delivering the asset associated with
the underlying (for example, storage, maintenance, and resale). However,
if the assets to be exchanged or delivered are themselves readily
convertible to cash, those risks are minimal or nonexistent. Thus, the
parties generally should be indifferent as to whether they exchange cash or
the assets associated with the underlying. The Board recognizes that
determining whether assets are readily convertible to cash will require
judgment and sometimes will lead to different applications in practice.
However, the Board believes that the use of readily convertible
to cash permits an appropriate amount of flexibility and describes an
important characteristic of the derivative instruments addressed by this
Statement.
266. The Board considered using the idea of readily
obtainable elsewhere as is used in Statement 125 to determine whether a
derivative instrument that requires that the holder or writer own or
deliver the asset or liability that is associated with the underlying is
within the scope of this Statement. However, the Board noted that readily
obtainable elsewhere relates to the availability of an asset; not
necessarily its liquidity. The Board decided that readily
convertible to cash is the appropriate criterion because it addresses
whether the asset can be converted to cash with little effort, not just
whether the asset is readily available in the marketplace.
Commodity Contracts
267. Statements 105, 107, and 119 did not address
commodity-based contracts because those contracts require or permit future
delivery of an item that is not a financial instrument. Statement 105
explained that for a commodity-based contract ". . . the future economic
benefit is receipt of goods or services instead of a right to receive cash
or an ownership interest in an entity and the economic sacrifice is
delivery of goods or services instead of an obligation to deliver cash or
an ownership interest in an entity" (paragraph 32).
Some respondents to the Exposure Draft that preceded Statement 119
suggested that the scope be expanded to include commodity-based contracts.
The Board decided not to expand the scope at that time principally because
of that project's accelerated timetable.
268. The Exposure Draft proposed that the definition of
derivative include only financial instruments.
Nevertheless, the Exposure Draft would have included certain commodity
contracts because they often have many of the same characteristics as other
derivative contracts. They often are used interchangeably with other
derivatives, and they present risks similar to other derivatives. The Board
initially proposed to resolve that apparent conflict by amending the
definition of financial instrument in Statement 107 to include
contracts that permit a choice of settlement by delivering either a
commodity or cash. As discussed in paragraph 263,
the
Board decided to change the scope of this Statement to address the
accounting for derivative instruments rather than just derivative financial
instruments. Therefore, it was not necessary to amend the definition of a
financial instrument in Statement 107 to include certain commodity-based
contracts in the scope of this Statement.
269. Changing the scope of this Statement from derivative
financial instruments to derivative instruments results in
including some contracts that settle net for a commodity or other
nonfinancial asset. The Board believes that including commodity-based
contracts with the essential characteristics of a derivative instrument
within the scope of this Statement will help to avoid accounting anomalies
that result from measuring similar contracts differently. The Board also
believes that including those commodity-based contracts in this Statement
will provide worthwhile information to financial statement users and will
resolve concerns raised by some respondents to the Exposure Drafts that
preceded Statements 107 and 119.
270. The Exposure Draft would have included only
commodity-based contracts that permitted net cash settlement, either by
their contractual terms or by custom. For the reasons discussed in
paragraphs 264-266, the Board decided, instead,
to include a
contract that requires delivery of an asset associated with the underlying
if that asset is readily convertible to cash (for example, gold, silver,
corn, and wheat). Different accounting will result depending on whether or
not the assets associated with the underlying for a contract are readily
convertible to cash. The Board considers that difference to be appropriate
because contracts that settle net or by delivering assets readily
convertible to cash provide different benefits and pose different risks
than those that require exchange of cash or other assets for an asset that
is not readily convertible to cash.
Normal Purchases and Normal Sales
271. The Board decided that contracts that require
delivery of nonfinancial assets that are readily convertible to cash need
not be accounted for as derivative instruments under this Statement if the
assets constitute normal purchases or normal sales of
the reporting entity unless those contracts can readily be settled net.
The Board believes contracts for the acquisition of assets in quantities
that the entity expects to use or sell over a reasonable period in the
normal course of business are not unlike binding purchase orders or other
similar contracts to which this Statement does not apply. The Board notes
that the normal purchases and normal sales exemption is necessary only for
contracts based on assets that are readily convertible to cash.
272. The Board understands that the normal purchases and
normal sales provision sometimes will result in different parties to a
contract reaching different conclusions about whether the contract is
required to be accounted for as a derivative instrument. For example, the
contract may be for ordinary sales by one party (and therefore not a
derivative instrument) but not for ordinary purchases by the counterparty
(and therefore a derivative instrument). The Board considered requiring
both parties to account for a contract as a derivative instrument if the
purchases or sales by either party were other than ordinary in the normal
course of business. However, that approach would have required that one
party to the contract determine the circumstances of the other party to
that same contract. Although the Board believes that the accounting by both
parties to a contract generally should be symmetrical, it decided that
symmetry would be impractical in this instance and that a potential
asymmetrical result is acceptable.
Financial Instruments
273. Some contracts require the holder or writer to
deliver a financial asset or liability that is associated with the
underlying and that has a denomination equal to the notional amount of the
contract. Determining whether those contracts are derivative instruments
depends, at least in part, on whether the related financial assets or
liabilities are readily convertible to cash.
Trade Date versus Settlement Date Accounting
274. Existing accounting practice is inconsistent about
the timing of recognition of transfers of various financial instruments.
Some transfers of securities are recognized as of the date of trade (often
referred to as trade date accounting). Other transfers are recognized as of
the date the financial instrument is actually transferred and the
transaction is settled (often referred to as settlement date accounting).
During the period between trade and settlement dates, the parties
essentially have entered into a forward contract that might meet the
definition of a derivative if the financial instrument is readily
convertible to cash. Requiring that all forward contracts for purchases
and sales of financial instruments that are readily convertible to cash be
accounted for as derivatives would effectively require settlement date
accounting for all such transactions. Resolving the issue of trade date
versus settlement date accounting was not an objective of the project that
led to this Statement. Therefore, the Board decided to explicitly exclude
forward contracts for "regular-way" security trades from the scope of this
Statement.
Regular-way security trades
275. Regular-way security trades are those that are
completed (or settled) within the time period generally established by
regulations and conventions in the marketplace or by the exchange on which
the transaction is being executed. The notion of a regular-way security
trade is based on marketplace regulations or conventions rather than on the
normal practices of an individual entity. For example, if it is either
required or customary for certain securities on a specified exchange to
settle within three days, a contract that requires settlement in more than
three days is not a regular-way security trade even if the entity
customarily enters into contracts to purchase such securities more than
three days forward. The Board considered other approaches that focused on
reasonable settlement periods or customary settlement periods for the
specific parties to a transfer. The Board decided that those approaches
were inferior because they lacked the consistency and discipline that are
provided by focusing on regular-way security trades. The Board also
believes that participants can reasonably determine settlement periods
required by the regulations or conventions of an active marketplace.
Regulations or conventions may be more difficult to determine for foreign
or less active exchanges. However, the provisions in
paragraph 10(a) apply only if the holder or
writer of the contract
is required to deliver assets that are readily convertible to cash.
Therefore, the regulations or conventions of the marketplace should be
reasonably apparent because the related market must be active enough to
rapidly absorb the quantities involved without significantly affecting the
price.
276. The Board considered limiting the exclusion for
regular-way security trades to purchases or sales of existing securities.
A forward contract for a regular-way trade of an existing
security entitles the purchaser to receive and requires the seller to
deliver a specific security. The delay is a matter of market regulations
and conventions for delivery. In contrast, a forward contract for a
when-issued or other security that does not yet exist does not entitle or
obligate the parties to exchange a specific security. Instead, it entitles
the issuer and holder to participate in price changes that occur before the
security is issued. For that reason, the Board would have preferred that a
forward contract on a security that does not yet exist be subject to the
requirements of this Statement. However, the Board was concerned that
including, for example, to-be-announced (TBA) Government National Mortgage
Association (GNMA) forward contracts and other forward contracts for
when-issued securities within the scope of this Statement might subject
some entities to potentially burdensome regulatory requirements for
transactions in derivatives. On balance, the Board decided to extend the
regular-way exemption to purchases and sales of when-issued and TBA
securities. However, the exemption applies only if (a) there is no other
way to purchase or sell the security and (b) the trade will settle within
the shortest period permitted for the security.
Insurance Contracts
277. The Exposure Draft explicitly excluded insurance
contracts, as defined in Statements 60, 97, and 113, from its definition of
a derivative financial instrument. The insurance contracts described in
those Statements also were excluded from the scope of Statement 107, which
states:
The Board concluded that disclosures about fair value should not be
required for insurance contracts. . . . The Board believes that
definitional and valuation difficulties are present to a certain extent
in those contracts and obligations, and that further consideration is
required before decisions can be made about whether to apply the
definition to components of those contracts and whether to require
disclosures about fair value for the financial components. [
paragraph 74]
278. During the deliberations before issuance of the
Exposure Draft, the Board decided to specifically preclude an insurance
contract from qualifying as a derivative because it believed definitional
and valuation difficulties still existed. The Exposure Draft observed that
the insurance industry and the accounting and actuarial professions have
not reached a common understanding about how to estimate the fair value of
insurance contracts. Developing measurement guidance for them might have
delayed the issuance of guidance on accounting for derivatives. The Board
intends to reconsider the accounting for insurance contracts in other
phases of its financial instruments project.
279. Although the term insurance contract is
frequently used in Statements 60, 97, and 113, it is not clearly defined in
those or other accounting pronouncements. As a result, the Exposure
Draft's provision that insurance contracts and reinsurance contracts
generally are not derivative instruments may not have been workable. The
Board was concerned that the phrase insurance contracts might be
interpreted quite broadly to encompass most agreements or contracts issued
by insurance enterprises as part of their ongoing operations.
280. The accounting provisions for insurance contracts in
Statements 60, 97, and 113 are significantly different from the accounting
provisions for derivative instruments in this Statement. The Board was
concerned that contracts that are substantially the same as other
derivative instruments might, instead, be accounted for as insurance
contracts. The Board therefore decided to eliminate the Exposure Draft's
proposed scope exclusion for insurance contracts and, instead, require that
those contracts be included in or excluded from the scope of this Statement
based on their characteristics.
281. Insurance contracts often have some of the same
characteristics as derivative instruments that are within the scope of this
Statement. Often, however, they lack one or more of those characteristics.
As a result, most traditional insurance contracts will not be derivative
instruments as defined in this Statement. They will be excluded from that
definition because they entitle the holder to compensation only if, as a
result of an identifiable insurable event (other than a change in price),
the holder incurs a liability or there is an adverse change in the value of
a specific asset or liability for which the holder is at risk. However,
contracts that in their entirety meet this Statement's definition of a
derivative instrument, whether issued by an insurance enterprise or another
type of enterprise, must be accounted for as such. The Board does not
believe that a decision on whether a contract must be accounted for as a
derivative should depend on the identity of the issuer. To help in
applying the provisions of this Statement, paragraph
10(c) provides some examples illustrating the
application of the
definition to insurance contracts.
282. The Board acknowledges that many of the problems
with determining the fair value of traditional insurance liabilities are
still unresolved. The Board notes, however, that many of the issues of how
to measure the fair value of insurance contracts do not apply to
instruments issued by insurance enterprises that, in their entirety,
qualify as derivative instruments under this Statement. Instead, the
methods for estimating the fair values of those contracts should be similar
to the methods used for derivative instruments with similar characteristics
issued by other types of enterprises.
283. Although many contracts issued by insurance
enterprises will not, in their entirety, meet the definition of a
derivative instrument, some may include embedded derivatives that are
required by this Statement to be accounted for separately from the host
contract. Contracts that may include embedded derivatives include, but are
not limited to, annuity contracts that promise the policyholder a return
based on selected changes in the S&P 500 index, variable life and annuity
contracts, and property and casualty contracts that combine protection for
property damage and changes in foreign currency exchange rates. Section 2
of Appendix B provides additional guidance on insurance contracts with
embedded derivative instruments.
Exception for Derivatives That Serve as Impediments to Recognition of a Sale
284. The existence of certain derivatives affects the
accounting for the transfer of an asset or a pool of assets. For example,
a call option that enables a transferor to repurchase transferred financial
assets that are not readily available would prevent accounting for that
transfer as a sale. The consequence is that to recognize the call option
would be to count the same thing twice. The holder of the option already
recognizes in its financial statements the assets that it has the option to
purchase. Thus those types of derivatives are excluded from the scope of
this Statement.
Exception for Instruments Classified in Stockholders' Equity
285. As noted in paragraph 3(a) of this
Statement, derivative instruments are assets or liabilities. Consequently,
items appropriately classified in stockholders' equity in an entity's
statement of financial position are not within the scope of this Statement.
The Board decided to clarify that point by explicitly excluding from the
scope of this Statement the accounting for such equity instruments.
286. The Board considered whether this Statement also
should exclude instruments that an entity either can or must settle by
issuing its own stock but that are indexed to something else. For example,
the Board discussed whether an instrument that requires settlement in the
issuer's or holder's common stock but that is indexed to changes in the S&P
500 index should be excluded from the scope of this Statement. The Board
currently has a project on its agenda that considers whether certain
instruments are equity or liabilities. That project will address the issue
of whether instruments to be settled in the entity's stock but indexed to
something other than its stock are liabilities or equity. The Board will
reconsider the application of this Statement to such contracts as necessary
when that project is completed. Until that time, contracts that provide
for settlement in shares of an entity's stock but that are indexed in part
or in full to something other than the entity's stock are to be accounted
for as derivative instruments if the contracts satisfy the criteria in
paragraphs 6-10 of this Statement. Those
contracts are
to be classified as assets or liabilities and not as part of stockholders'
equity.
Stock-Based Compensation Contracts
287. paragraph 11(b) of this Statement
excludes the issuer's accounting for derivative instruments issued in
connection with stock-based compensation arrangements addressed in
FASB Statement No. 123, Accounting for
Stock-Based
Compensation. Many such instruments would be excluded by
paragraph 11(a) because they are classified in
stockholders' equity.
However, Statement 123 also addresses stock-based compensation arrangements
that are derivatives and that qualify as a liability of the issuer. The
Board decided that the issuer's accounting for those contracts is
adequately addressed by Statement 123. As with the other exclusions in
paragraph 11, the holder's accounting for a
derivative
instrument in a compensation arrangement addressed by Statement 123 is
subject to this Statement.
Contingent Consideration in a Business Combination
288. Opinion 16 addresses the purchaser's (issuer's)
accounting for contingent consideration provided in a purchase business
combination. The effect of a contingent consideration arrangement on the
accounting for a business combination often is significant and depends on
the terms and conditions of both the business combination and the
contingent consideration arrangement. Although contingent consideration
arrangements may share at least some of the characteristics of derivative
instruments addressed by this Statement, the Board decided that without
further study it would be inappropriate to change the accounting for them
by the entity that accounts for the business combination. The Board
currently has a project on its agenda to reconsider the accounting for
business combinations. It will consider this issue as part of that
project.
289. This Statement does apply to contracts that are
similar to, but not accounted for as, contingent consideration under the
provisions of Opinion 16 if those contracts satisfy the scope provisions
either for a derivative instrument (paragraphs 6-10)
or
for a contract with an embedded derivative instrument (
paragraphs 12-16). In addition, this Statement
applies to a seller's
(holder's) accounting for contingent consideration that meets its
definition of a derivative. For example, assume that a purchaser of a
business issues to the seller a freestanding financial instrument (as
addressed in EITF Issue No. 97-8,
"Accounting for
Contingent Consideration Issued in a Purchase Business Combination") that
provides contingent consideration in a purchase business combination under
Opinion 16. That freestanding instrument is assumed to meet this
Statement's definition of a derivative instrument. The purchaser's
accounting for the instrument is explicitly excluded from the scope of this
Statement, but the seller who receives the instrument must account for it
according to the requirements of this Statement.
Application to Specific Contracts
290. Several respondents to the Exposure Draft asked the
Board for specific guidance about whether some contracts meet the
definition of a derivative instrument, including sales of securities not
yet owned ("short sales"), take-or-pay contracts, and contracts with
liquidating damages or other termination clauses. The Board cannot
definitively state whether those types of contracts will always (or never)
meet the definition because their terms and related customary practices
vary. In addition, the terms of the contracts or customary practices may
change over time, thereby affecting the determination of whether a
particular type of contract meets the definition of a derivative
instrument. Appendix A provides examples illustrating how the definition
of a derivative instrument applies to certain specific situations.
The Scope of Statement 119
291. This Statement's definition of derivative contracts
excludes certain contracts that were included in the scope of Statement
119. For example, a loan commitment would be excluded if it (a) requires
the holder to deliver a promissory note that would not be readily
convertible to cash and (b) cannot readily be settled net. Other
conditional and executory contracts that were included in the scope of
Statement 119 may not qualify as derivative instruments under the
definition in this Statement. The Board decided that some change in scope
from Statement 119 is an appropriate consequence of defining derivative
instruments based on their primary characteristics.
292. This Statement supersedes Statement 119. Therefore,
one result of excluding instruments that were included in the scope of
Statement 119 from the scope of this Statement is that some disclosures
previously required for those excluded contracts will no longer be
required. The Board considers that result to be acceptable. Moreover,
Statement 107 continues to require disclosure of the fair value of all
financial instruments by the entities to which it applies.
Embedded Derivatives
293. The Board considers it important that an entity not
be able to avoid the recognition and measurement requirements of this
Statement merely by embedding a derivative instrument in a nonderivative
financial instrument or other contract. Therefore, certain embedded
derivatives are included in the scope of this Statement if they would be
subject to the Statement on a freestanding basis. However, the Board also
decided that some derivatives embedded in host contracts, such as many of
the prepayment or call options frequently included as part of mortgage
loans and other debt instruments, should be excluded from the scope of this
Statement.
Approaches Considered
294. The Board considered a number of approaches for
determining which contracts with embedded derivatives should be included in
the scope of this Statement. Some approaches focused either on an
instrument's yield or on its predominant characteristics. The Board
decided that those approaches would likely include callable or prepayable
debt and perhaps other instruments that often are not thought of as
including an embedded derivative, even though they do. The Board also was
concerned about the operationality of those approaches.
295. The scope of the Exposure Draft included a contract
with both nonderivative and derivative characteristics if some or all of
its contractually required cash flows were determined by reference to
changes in one or more underlyings in a manner that multiplied or otherwise
exacerbated the effect of those changes. That scope was intended to
incorporate embedded forwards, swaps, and options with a notional amount
that was greater than the face value of the "host" contract or that
otherwise "leveraged" the effect of changes in one or more underlyings.
Numerous respondents to the Exposure Draft asked for clarification of the
phrase multiplies or otherwise exacerbates and said that they did not
understand why certain instruments were included in the scope of the
Exposure Draft while others were not.
296. The Board agreed with respondents that the approach
in the Exposure Draft was difficult to apply in a consistent manner. The
Board also concluded that the Exposure Draft inappropriately excluded some
instruments from its scope and inappropriately included others. For
example, an instrument that paid a simple multiple of a market interest
rate (for example, 120 percent of U.S. dollar LIBOR) might be considered to
have an embedded derivative that requires separate accounting. In contrast,
a structured note that paid a return based on 100 percent of the
appreciation in the fair value of an equity instrument would not be
considered to have an embedded derivative that requires separate
accounting.
297. Some respondents to the Exposure Draft suggested
that all financial instruments with embedded derivatives be excluded from
the scope of this Statement because existing accounting standards for
nonderivative instruments provide adequate guidance for those compound
financial instruments. The Board rejected that suggestion for three
reasons. First, applying existing accounting standards for nonderivative
instruments would not necessarily achieve the Board's goal of increasing
the transparency of derivatives in the financial statements. For example,
existing guidance for the issuer's accounting for indexed debt instruments
is incomplete and would not necessarily result in recognition of changes in
the fair value of the embedded derivative in either the balance sheet or
the income statement. Second, a derivative can be embedded in a contract
other than a financial instrument, such as a purchase order. The existing
accounting pronouncements for such contracts do not adequately address the
accounting for embedded derivatives in those contracts. Third, excluding
all compound instruments from its scope would make it possible to
circumvent the provisions of this Statement. One apparent reason that
structured notes have become prevalent is that combining various features
of derivative and nonderivative instruments produces different accounting
results than accounting for each component separately, and participants in
transactions involving structured notes sometimes considered the accounting
results attractive. Excluding all instruments that embed derivative
instruments in nonderivative host contracts from the scope of this
Statement would likely increase the incentive to combine those instruments
to avoid accounting for derivative instruments according to the provisions
of this Statement.
298. Under the approach in the Exposure Draft, contracts
designed to result in a rate of return that differs in a nontrivial way
from the change in price that would be realized from a direct investment
(or obligation) in the referenced asset(s) or other item(s) of an amount
comparable to the notional amount or par value of the contract would have
been accounted for as derivative instruments. Clarifying the phrase
multiplies or otherwise exacerbates would have
addressed some of the problems raised by respondents to the Exposure Draft,
but it still would have focused solely on whether the derivative feature
resulted in a meaningful amount of positive or negative leverage. It would
not have addressed whether the derivative component and host contract are
of the type generally expected to be combined. The results still seemed
counterintuitive in that an instrument that paid interest of 120 percent of
LIBOR (assuming that 120 percent was not deemed to be a trivial amount of
leverage) would be accounted for as a derivative instrument, but a note
indexed to 100 percent of the S&P 500 index would not.
Accounting for Embedded Derivatives Separately from the Host Contract
299. The Exposure Draft would have required that both a
host contract and an embedded derivative feature, together, be
accounted for as a derivative instrument if prescribed criteria were met.
As a result, some contracts with embedded derivative features would have
been accounted for like derivatives and could have been designated as
hedging instruments. Some respondents to the Exposure Draft were concerned
that its approach would permit an entity to use a cash instrument as a
hedging instrument, which was generally precluded by the Exposure Draft,
simply by embedding an insignificant leverage factor in the interest
formula. The Board agreed with those respondents and decided that (a) it
was inappropriate to treat instruments that include both nonderivative and
derivative components entirely as derivative instruments and (b)
nonderivative instruments should only be eligible as hedging instruments in
selected circumstances.
300. For several reasons, the Board decided to change the
accounting for instruments with embedded derivatives. Most importantly,
accounting for the entire instrument as a derivative or nonderivative is
inconsistent with the accounting for hedged items required by this
Statement. For a fair value hedge, the Exposure Draft would have required
that all or a proportionate part of the total changes in fair value of a
hedged item be recognized. However, this Statement requires recognizing at
its fair value only the portion or proportion of a hedged item attributable
to the risk being hedged. That change to a "separation-by-risk" approach
is consistent with accounting for a derivative separately from the host
contract in which it is embedded. Accounting for the derivative separately
from the host contract also is more consistent with the objective of
measuring derivative instruments at fair value and does not result in
measuring derivative instruments differently simply because they are
combined with other instruments.
301. The Board recognizes that there may be circumstances
in which an embedded derivative cannot be reliably identified and measured
for separation from the host contract. In those circumstances, this
Statement requires that the entire contract, including both its derivative
and nonderivative portions, be measured at fair value with changes in fair
value recognized currently in earnings. The Board expects that an entity
that enters into sophisticated investment and funding strategies such as
structured notes or other contracts with embedded derivatives will be able
to obtain the information necessary to reliably identify and measure the
separate components. Accordingly, the Board believes it should be unusual
that an entity would conclude that it cannot reliably separate an embedded
derivative from its host contract.
302. Instruments that include embedded derivatives that
are not accounted for separately from the host contract because the entity
is unable to reliably identify and measure the derivative may not be
designated as hedging instruments. That prohibition applies to the entire
contract, as well as any portion of it, and addresses some of respondents'
concerns about designating nonderivative instruments as hedging
instruments. Prohibiting an entire contract with an embedded derivative
from being designated as a hedging instrument will avoid the inappropriate
use of nonderivative instruments as hedging instruments. It also should
serve as an incentive to identify and separate derivative features from
their host contracts.
303. Measuring an embedded derivative separately from its
host contract will require judgment, and sometimes such measurements may be
difficult. The Board considered providing specific guidelines for making
such measurements but decided that such guidance could be unduly
restrictive and could not address all relevant concerns. Instead, the
Board decided only to clarify that the objective is to estimate the fair
value of the derivative features separately from the fair value of the
nonderivative portions of the contract. Estimates of fair value should
reflect all relevant features of each component and their effect on a
current exchange between willing parties. For example, an embedded
purchased option that expires if the contract in which it is embedded is
prepaid would have a different value than an option whose term is a
specified period that is not subject to truncation.
The Clearly-and-Closely-Related Approach
304. This Statement requires that an embedded derivative
be accounted for separately from a nonderivative host contract if (a) the
derivative, considered on a freestanding basis, would be accounted for as a
derivative instrument under this Statement and (b) the economic
characteristics of the derivative and the host contract are not
clearly and closely related to one another. The first of those
criteria ensures that only derivative instruments as defined by, and
subject to the requirements of, this Statement are accounted for
separately. For example, the issuer would not account separately for an
option embedded in a hybrid instrument if, on a freestanding basis, that
option would be an equity instrument of the entity that is properly
classified in stockholders' equity. Whether the issuer should account
separately for an equity instrument embedded in an asset or a liability is
an issue in the Board's project on liabilities and equity.
305. The second criterion listed in
paragraph 304 focuses on whether an embedded
derivative bears a
close economic relationship to the host contract. As a practical matter,
the Board decided that not all embedded derivative features should be
required to be accounted for separately from the host contract. Many
hybrid instruments with embedded derivatives that bear a close economic
relationship to the host contract were developed many years ago, for
reasons that clearly were not based on achieving a desired accounting
result. Prepayable mortgages and other prepayable debt instruments are
examples of such familiar compound instruments with embedded derivatives.
The accounting for those types of hybrid instruments is well established
and generally has not been questioned. However, other embedded
derivatives, such as an equity- or commodity-linked return included in a
debt instrument that may cause the value of the instrument to vary
inversely with changes in interest rates, do not bear a close economic
relationship to the host contract. Even though conceptually all embedded
derivatives should be accounted for separately, the Board decided, as a
practical accommodation, that only an embedded derivative that is not
considered to be clearly and closely related to its host contract should be
accounted for separately.
306. The Board expects the clearly-and-closely-related
approach to affect a significant number and wide variety of structured
notes and other contracts that include embedded derivatives. Applying the
approach will require judgment, which may lead to different accounting for
similar instruments. To reduce that possibility, Appendix B provides
examples illustrating how to apply the approach.
307. The clearly-and-closely-related approach sometimes
will result in different accounting by the parties to a contract. For
example, the issuer of convertible debt would not account for the embedded
derivative feature separately from the host contract if the derivative
component, on a freestanding basis, would not be subject to the
requirements of this Statement because of the exclusion in
paragraph 11(a). However, an investor in the
convertible debt
instrument would not be afforded that exclusion and would be required to
account for the conversion feature separately from the host contract if the
criteria in paragraph 12 are met.
308. The holder and issuer of an equity instrument with
an embedded put, such as puttable common stock, would not, however,
necessarily treat the embedded derivative differently. A put option
embedded in an equity security has the potential to convert the equity
security to cash or another asset, and conversion to cash according to the
terms of the instrument is not a usual characteristic of an equity
security. Accordingly, a put option embedded in an equity security is not
clearly and closely related to the host contract if exercise of the put
option would result in the payment of cash or delivery of another asset by
the issuer of a security (except in those circumstances in which the put
option is not considered to be a derivative pursuant to
paragraph 11(a) because it is classified in
shareholders' equity).
Because the embedded put is more closely related to a liability than an
equity security, both the issuer and the holder would account for it
separately if the criteria in paragraph 12 are
met.
However, if exercise of the put would result in the issuance of additional
equity instruments rather than paying cash or delivering another asset, the
put is considered to be clearly and closely related to the equity security.
309. paragraphs 13-15 of this
Statement discuss some common relationships between interest rate features
and host contracts, and foreign currency exchange rate features and host
contracts. That guidance is provided to simplify the analysis of whether
some of the more common types of contracts include embedded derivatives
that require separate accounting. paragraph 13
clarifies that most interest-bearing instruments that include derivative
features that serve only to alter net interest payments that otherwise
would be made on an interest-bearing host contract are considered to be
clearly and closely related to the host contract. However, an embedded
derivative that affects interest rates in such a way that the investor
might not recover substantially all of its initial recorded investment is
not considered to be clearly and closely related to the host contract and
therefore should be accounted for separately. Similarly, an embedded
derivative that could at least double the investor's initial rate of return
on the host contract and also could result in a rate of return that is at
least twice what otherwise would be the market return for a contract that
has the same terms as the host contract and that involves a debtor with
similar credit quality is not considered to be clearly and closely related
and should be accounted for separately. The test for separate accounting
pursuant to paragraph 13 should be applied based
on what
is possible under the contractual terms and not on a probability basis.
For example, an embedded derivative that could under any circumstances
result in the hybrid instrument's being settled in such a way that the
holder does not recover substantially all of its initial recorded
investment would not be considered to be clearly and closely related to the
host contract even though the possibility that such a situation would occur
is remote.
310. The Board recognizes that the provisions of
paragraph 13(a) might raise the question of
whether an
interest-only strip is subject to the provisions of this Statement because
the holder of an interest-only strip may not recover substantially all of
its initial recorded investment. The Board notes that accounting for
interest-only and principal-only strips is related to issues concerning
accounting for retained interests in securitizations that the Board is
currently reconsidering in conjunction with the implementation of Statement
125. Accordingly, the Board decided to exclude from the scope of this
Statement interest-only and principal-only strips that meet the criteria in
paragraph 14 and further consider the accounting
for
them in conjunction with its consideration of accounting for retained
interests in securitization.
311. paragraph 15 provides that an
embedded foreign currency derivative is not to be separated from the host
contract and considered a derivative pursuant to paragraph
12 if the host contract is not a financial
instrument and specifies
payments denominated in either of the following currencies:
a. The currency of the primary economic environment in which any
substantial party to the contract operates (that is, its functional
currency)
b. The currency in which the price of the related good or service is
routinely denominated in international commerce (such as the U.S.
dollar for crude oil transactions).
For example, a lease of U.S. real estate with payments denominated in
Deutsche marks contains an embedded derivative that should be viewed as
clearly and closely related to the host lease contract and thus does not
require separate accounting if the Deutsche mark is the functional currency
of at least one substantial party to the lease. The Board decided that it
was important that the payments be denominated in the functional currency
of at least one substantial party to the transaction to ensure
that the foreign currency is integral to the arrangement and thus
considered to be clearly and closely related to the terms of the lease. A
contract with payments denominated in a currency that is not the functional
currency of any substantial party to that contract includes an embedded
derivative that is not considered to be clearly and closely related to the
host contract and should be accounted for separately under the provisions
of this Statement. The second exclusion in paragraph 15
also permits contractual payments to be denominated in the currency in
which the price of the related commodity or service is routinely stated in
international commerce without requiring separate accounting for an
embedded derivative. The Board decided that it would be appropriate to
consider the currency in which contracts for a given commodity are
routinely denominated to be clearly and closely related to those contracts,
regardless of the functional currency of the parties to that contract.
Fair Value Measurement Guidance
312. The definition of fair value in this Statement is
derived from paragraphs 42-44 of Statement 125. The definition originated
in paragraphs 5, 6, and 18-29 of Statement 107.
313. This Statement refers to Statement 107 for guidance
in applying the definition of fair value. Some respondents to the Exposure
Draft asked either for additional guidance on estimating the fair value of
financial instruments or for amendments of part of the guidance in
Statement 107. They said that the guidance in Statement 107 is not robust
enough for recognition purposes (as opposed to disclosure) and allows too
much variability in the estimates of fair value, especially for items not
traded on a public exchange. The Board decided for several reasons to
retain the guidance provided by Statement 107. Statement 107 has been in
effect for several years, and entities are familiar with its measurement
guidance. In addition, Board members were concerned that reevaluating and
making the fair value guidance more prescriptive would significantly delay
issuance of this Statement. On balance, the Board decided that the
measurement guidance in Statement 107 is sufficient for use in applying
this Statement. The Board will consider measurement issues and likely
provide additional guidance or change Statement 107's guidance in some
areas, perhaps including the areas discussed in the following paragraphs in
the course of its project on the fair value measurement of financial
instruments.
314. Respondents to the Exposure Draft also provided
comments on specific measurement issues, focusing on the following three
areas: (a) consideration of a discount or premium in the valuation of a
large position, (b) consideration of changes in creditworthiness in valuing
a debtor's liabilities, and (c) the valuation of deposit liabilities.
Those areas are discussed below.
Consideration of a Discount or Premium in the Valuation of a Large Position
315. Consistent with Statement 107, the definition of
fair value in this Statement precludes an entity from using a "blockage"
factor (that is, a premium or discount based on the relative size of the
position held, such as a large proportion of the total trading units of an
instrument) in determining the fair value of a large block of financial
instruments. The definition of fair value requires that fair value be
determined as the product of the number of trading units of an asset times
a quoted market price if available. Statement 107 further clarifies the
issue:
Under the definition of fair value in paragraph 5,
the quoted price for a
single trading unit in the most active market is the basis for
determining market price and reporting fair value. This is the case
even if placing orders to sell all of an entity's holdings of an asset
or to buy back all of a liability might affect the price, or if a
market's normal volume for one day might not be sufficient to absorb
the quantity held or owed by an entity. [paragraph
6]
Some respondents to the Exposure Draft indicated that the guidance in
Statement 107 (and implicitly the definition of fair value in
this Statement) should be revised to require or permit consideration of a
discount in valuing a large asset position. They asserted that an entity
that holds a relatively large amount (compared with average trading volume)
of a traded asset and liquidates the entire amount at one time likely would
receive an amount less than the quoted market price. Although respondents
generally focused on a discount, holding a relatively large amount of an
asset might sometimes result in a premium over the market price for a
single trading unit. The Board currently believes that the use of a
blockage factor would lessen the reliability and comparability of reported
estimates of fair value.
Valuation of Liabilities
316. Some respondents to the Exposure Draft noted that
Statement 107 permits an entity to choose whether to consider changes in
its own creditworthiness in determining the fair value of its debt and
asked for further guidance on that issue. The definition of fair value in
Statement 125 says that in measuring liabilities at fair value by
discounting estimated future cash flows, an objective is to use discount
rates at which those liabilities could be settled in an arm's-length
transaction. However, the FASB's pronouncements to date have not broadly
addressed whether changes in a debtor's creditworthiness after incurrence
of a liability should be reflected in measuring its fair value. Pending
resolution of the broad issue of the effect of a debtor's creditworthiness
on the fair value of its liabilities, the Board decided to use the
definition in Statement 125 but not to provide additional guidance on
reflecting the effects of changes in creditworthiness.
Valuation of Deposit Liabilities
317. The guidance in Statement 107 precludes an entity
from reflecting a long-term relationship with depositors, commonly known as
a core deposit intangible, in determining the fair value of a deposit
liability. Paragraph 12 of Statement 107 states, in part:
In estimating the fair value of deposit liabilities, a financial
entity shall not take into account the value of its long-term
relationships with depositors, commonly known as core deposit
intangibles, which are separate intangible assets, not financial
instruments. For deposit liabilities with no defined maturities, the
fair value to be disclosed under this Statement is the amount payable
on demand at the reporting date.
Some respondents to the Exposure Draft requested that this Statement permit
the fair value of deposit liabilities to reflect the effect of the core
deposit intangible. The Board decided to make no change to the guidance in
Statement 107 on that issue because it will be addressed as part of the
Board's current project on measuring financial instruments at fair value.
Issues of whether the fair values of certain liabilities (or assets) should
reflect their values as if they were settled immediately or whether they
should be based on their expected settlement dates, as well as issues of
whether or when it would be appropriate to measure portfolios of assets or
liabilities rather than individual items in those portfolios, are central
to that project.
Other Fair Value Measurement Guidance
318. Statement 107 requires disclosure of the fair value
of financial instruments "for which it is practicable to estimate that
value" (emphasis added). Unlike Statement 107, this Statement provides no
practicability exception that would permit an entity to avoid
the required fair value measurements. The Board believes that prudent risk
management generally would require an entity to measure the fair value of
any derivative that it holds as well as any item (or the portion of the
item attributable to the identified risk) designated as being hedged in a
fair value hedge.
319. This Statement requires that in measuring the change
in fair value of a forward contract by discounting future cash flows, the
estimate of future cash flows be based on changes in forward rates rather
than spot rates. Thus, the gain or loss on, for example, a foreign
currency forward contract would be based on the change in the forward rate,
discounted to reflect the time value of money until the settlement date.
The Board notes that the accounting literature in effect before the
issuance of this Statement discusses different methods of estimating the
value of a foreign currency forward contract. The Board decided that the
valuation of a foreign currency forward contract should consider that (a)
currencies will be exchanged at a future date, (b) relative interest rates
determine the difference between spot and forward rates, and (c) valuation
is affected by the time value of money. The net present value technique is
the only method that considers all three items as well as the current
settlement of present gains or losses that arise from changes in the spot
rate.
Demand for Hedge Accounting
320. The Report on Deliberations describes hedge
accounting as a "special accounting treatment that alters the normal
accounting for one or more components of a hedge so that counterbalancing
changes in the fair values of hedged items and hedging instruments, from
the date the hedge is established, are not included in earnings in
different periods" (paragraph 28). Demand
for special
accounting for hedges of the fair value exposure associated with assets and
liabilities arises, in part, because of accounting anomalies-that is,
differences in the way hedged items and hedging instruments are recognized
and measured. Recognition anomalies arise because some assets and
liabilities are recognized in the statement of financial position, while
others, such as many firm commitments, are not. Measurement anomalies
arise because existing accounting standards use different measurement
attributes for different assets and liabilities. Some assets and
liabilities are measured based on historical costs, others are measured
based on current values, and still others are measured at the lower of cost
or market value, which is a combination of historical costs and current
values. Accounting recognition and measurement decisions generally have
been made independently for each kind of asset or liability without
considering relationships with other assets or liabilities. Hedge
accounting for assets and liabilities initially arose as a means of
compensating for situations in which measurement anomalies between a hedged
item and hedging instrument result in recognizing offsetting gains and
losses in earnings in different periods.
Hedges of Fair Value Exposures
321. For hedges of fair value exposures, this Statement
provides for certain gains and losses on designated assets and liabilities
to be recognized in earnings in the same period as the losses and gains on
the related derivative hedging instrument. Accounting for all financial
instruments at fair value with all changes in fair value recognized
similarly, such as in earnings, would eliminate the need for special
accounting to accommodate the current mixed-attribute measurement model for
fair value hedges of financial assets and liabilities. Fair value
accounting for all financial instruments would not, however, affect either
the perceived need for special accounting for fair value hedges of
nonfinancial assets and liabilities or constituents' desire for special
accounting for cash flow hedges of forecasted transactions.
Hedges of Cash Flow Exposures
322. Although accounting anomalies do not exist for cash
flow hedges of forecasted transactions, many constituents want special
accounting for transactions designed to manage cash flow risk associated
with forecasted transactions. Entities often hedge the cash flow risk of
forecasted transactions by using a derivative to "lock in" or "fix"
the
price of the future transaction, or to mitigate the cash flow risk for a
certain period of time. They want to recognize the gain or loss on the
derivative hedging instrument in earnings in the period or periods in which
the forecasted transaction will affect earnings. If the hedging instrument
is held until the forecasted transaction occurs, that accounting would base
the earnings effect of the transaction on the "fixed price."
323. Some constituents suggested that there is little
distinction between forecasted transactions and firm commitments and,
consequently, that hedges of forecasted transactions should be accounted
for in the same way as hedges of firm commitments. They said that (a) some
forecasted transactions may be as probable as, if not more probable than,
some firm commitments, (b) it is often difficult to distinguish between
forecasted transactions and firm commitments, and (c) entities do not view
forecasted transactions and firm commitments separately for risk management
purposes.
324. The Board believes there are several differences
between firm commitments and forecasted transactions, irrespective of the
probability of occurrence, that make it possible to distinguish between
them. Firm commitments and forecasted transactions create different
exposures to risk. Firm commitments are fixed-price contracts that expose
an entity to a risk of a change in fair value. For example, an increase in
the market price of a commodity will not affect the cash to be paid to
purchase that commodity under a firmly committed contract; however, it will
affect the value of that contract. In contrast, forecasted transactions do
not have a fixed price and do expose an entity to a risk of a change in the
cash to be paid to purchase the commodity in the future. Because firm
commitments and forecasted transactions give rise to different exposures,
different hedging strategies must be used. For example, an entity that
hedges a firm commitment to purchase an item (a long position) would
generally enter into a derivative to "undo" that fixed price (such as an
offsetting short position). In contrast, an entity that hedges a
forecasted purchase of an item would generally enter into a derivative
(such as a contract to purchase the item-a long position) to "fix" the
price.
325. Although many firm commitments are not recognized in
financial statements, they qualify as assets or liabilities with
determinable values, which makes them different from forecasted
transactions. The value of a firm commitment is equal to the unrealized
gain or loss on the commitment. In contrast, a forecasted transaction has
no value and cannot give rise to a gain or loss. Regardless of their
probability of occurrence, forecasted transactions are not present rights
or obligations of the entity.
326. The Board recognizes that hedging is used to cope
with uncertainty about the future and that the risks associated with
forecasted transactions may appear to be similar to those associated with
assets and liabilities, including firm commitments. However, the
fundamental purpose of financial statements is to present relevant measures
of existing assets and liabilities and changes in them. The Board believes
there is no conceptual justification for providing special accounting for
the effects of transactions that have already occurred based solely on
management's assertions about other transactions expected to occur in the
future. The Board believes it would be conceptually preferable to provide
descriptive information about intended links between current and forecasted
future transactions in accompanying notes than to let those intended links
directly affect the financial statements. As indicated by the Board's
third fundamental decision, deferring a derivative gain or loss as a
separate asset or liability in the statement of financial position is
conceptually inappropriate because the gain or loss neither is itself a
liability or an asset nor is it associated with the measurement of another
existing asset or liability.
327. To the extent that hedge accounting is justifiable
conceptually, it is for the purpose of dealing with anomalies caused by the
mixed-attribute accounting model. The lack of an associated asset,
liability, gain, or loss to be recognized in the financial statements means
that there are no measurement anomalies for a forecasted transaction.
Gains and losses on derivative instruments designated as hedges of
forecasted transactions can be distinguished from gains and losses on other
derivatives only on the basis of management intent. That makes hedge
accounting for forecasted transactions problematic from a practical, as
well as a conceptual, perspective. Furthermore, it generally is more
difficult to assess the effectiveness of a hedge of a forecasted
transaction than of a hedge of an existing asset or liability, because a
forecasted transaction reflects expectations and intent, not measurable
present rights or obligations.
328. Regardless of those conceptual and practical
questions, the Board decided to accommodate certain hedges of forecasted
transactions because of the current widespread use of and demand for
special accounting for forecasted transactions. However, because the Board
does not consider hedge accounting for forecasted transactions to be
conceptually supportable, the Board chose to impose limits on that
accounting, as discussed further in paragraphs 382
and
383.
329. This Statement provides for gains and losses on
derivatives designated as cash flow hedges of forecasted transactions to be
initially recognized in other comprehensive income and reclassified into
earnings in the period(s) that the forecasted transaction affects earnings.
As the Board pursues its long-term objective of measuring all financial
instruments at fair value in the statement of financial position, it will
reconsider whether special accounting for hedges of forecasted transactions
should continue to be permitted. Special accounting for hedges of
forecasted financial instrument transactions would serve no purpose if all
financial instruments were measured at fair value both at initial
recognition and subsequently, with changes in fair value reported in
earnings. This Statement consequently prohibits hedge accounting for the
acquisition or incurrence of financial instruments that will be
subsequently measured at fair value, with changes in fair value reported in
earnings.
Hedge Accounting Approaches Considered
330. Over its six years of deliberations, the Board
considered four broad approaches, and combinations of those approaches, in
addition to the one proposed in the Exposure Draft, as a way to resolve
issues related to hedge accounting. Those four broad approaches are
discussed below. The hedge accounting approach proposed in the Exposure
Draft is discussed in conjunction with the hedge accounting adopted in this
Statement (which is discussed beginning at paragraph
351).
Measure All Financial Instruments at Fair Value
331. Consistent with its conclusion that fair value is
the most relevant measure for all financial instruments, the Board
considered measuring all financial instruments at fair value. Using that
single measurement attribute for initial recognition and subsequent
measurement would have resolved problems caused by the current
mixed-attribute measurement model, at least for financial instruments, and
would have been relatively simple and more readily understandable to
financial statement users. It also would have increased comparability for
identical balance sheet positions between entities, and it would have
obviated the need for special accounting for hedges of financial
instruments.
332. Several respondents to the Exposure Draft said that
fair value measurement should be expanded to all financial instruments, and
a few respondents suggested expanding fair value measurement to all assets
and liabilities. Some respondents said that it is inconsistent or
inappropriate to expand fair value measurement to derivatives before it is
expanded to all financial instruments. Other respondents said that fair
value measurement for all financial instruments is not a desirable goal.
333. The Board believes changing the accounting model so
that all financial instruments are measured at fair value in the statement
of financial position is the superior conceptual solution to hedging
issues. However, the Board decided that it was not appropriate at this
time to require fair value measurement for all financial instruments.
Board members decided that they must first deliberate and reach agreement
on conceptual and practical issues related to the valuation of certain
financial instruments, including liabilities, and portfolios of financial
instruments. The Board is pursuing issues related to fair value
measurement of all financial assets and liabilities in a separate project.
334. The Board is committed to work diligently toward
resolving, in a timely manner, the conceptual and practical issues related
to determining the fair values of financial instruments and portfolios of
financial instruments. Techniques for refining the measurement of the fair
values of all financial instruments continue to develop at a rapid pace,
and the Board believes that all financial instruments should be carried in
the statement of financial position at fair value when the conceptual and
measurement issues are resolved. For now, the Board believes it is a
significant improvement in financial reporting that this Statement requires
that all derivatives be measured at fair value in the statement of
financial position.
Mark-to-Fair-Value Hedge Accounting
335. Having concluded that its long-term objective of
measuring all financial instruments at fair value was not attainable at
this time, the Board decided that it needed to permit some form of hedge
accounting. One alternative, termed mark-to- fair-value hedge accounting,
would have required that an entity measure both the derivative and the
hedged item at fair value and report the changes in the fair value of both
items in earnings as they occur. Similar to measuring all financial
instruments at fair value, that approach would have accommodated a wide
variety of risk management strategies and would have overcome the problems
attributable to the mixed-attribute measurement model by using a common
measurement attribute for both the derivative and the hedged item.
Additionally, that approach would have been relatively easy for entities to
apply and for financial statement users to understand because hedged items
would be reported at fair value and the net ineffectiveness of a hedge
would be reported in earnings. There would have been no need to specify
which risks could be separately hedged or how to reflect basis risk.
However, like measuring all financial instruments at fair value,
mark-to-fair-value hedge accounting would not have addressed constituents'
desire for special accounting for cash flow hedges of forecasted
transactions.
336. Although the Board liked the idea of extending fair
value measurement by marking hedged items to fair value with changes in
fair value reported in earnings, it ultimately decided not to adopt
mark-to-fair-value hedge accounting for two main reasons. First, measuring
hedged items at fair value would have recognized, at the inception of a
hedge, unrealized gains and losses on the hedged item that occurred before
the hedge period ("preexisting" gains and losses). The Board believes that
preexisting gains and losses on the hedged item are unrelated to the hedge
and should not provide earnings offset for derivative gains and losses
(consistent with its second fundamental decision [
paragraphs 220-228]). Recognizing those gains
and losses at the
inception of a hedge would result in recognizing a gain or loss simply
because the hedged item was designated as part of a hedge. That ability to
selectively recognize preexisting gains and losses caused some Board
members to reject the mark-to-fair-value approach.
337. Another reason the Board rejected that approach is
that constituents objected to its effect on earnings-that is, earnings
would have reflected changes in the fair value of a hedged item unrelated
to the risk being hedged. For example, a hedge of one risk (such as
interest rate risk) could have caused recognition in earnings of gains and
losses from another risk (such as credit risk) because the mark-to-fair-
value approach would have required recognition of the full change in fair
value of the hedged item, including the changes in fair value attributable
to risk components not being hedged. The hedge accounting approach
proposed in the Exposure Draft also could have resulted in recognition of
the change in fair value of a hedged item attributable to risk components
not being hedged. However, the approach in the Exposure Draft
would have (a) limited how much of those fair value changes were recognized
in earnings and (b) prevented the change in the fair value of the hedged
item that is not offset by the change in fair value on the hedging
instrument from being recognized in earnings.
Comprehensive Income Approach
338. The Board considered another hedge accounting
approach, referred to as the comprehensive income approach, that would have
required that derivatives be measured at fair value and classified in one
of two categories, trading or risk management. Gains
and losses on derivatives classified as trading would be recognized in
earnings in the periods in which they occur. Unrealized gains and losses
on risk management derivatives would be reported as a component of other
comprehensive income until realized. Realized gains and losses on risk
management derivatives would be reported in earnings.
339. That approach would have been relatively easy to
apply, it would have made derivatives and related risks transparent, and it
would have accommodated some risk management strategies. Hedges of assets,
liabilities, and some forecasted transactions would have been accommodated
if the duration of the derivative was structured by management to achieve
recognition, in the desired period, of any realized gains or losses. Also,
because the approach would not have permitted deferral of derivative gains
or losses as liabilities or assets, it would not have violated the
fundamental decision that only assets and liabilities should be reported as
such.
340. The Board rejected the comprehensive income approach
for three main reasons. First, the Board does not believe that the
distinction between realized and unrealized gains and losses that is the
basis for the comprehensive income approach is relevant for financial
instruments. The Board acknowledges that the current accounting model
often distinguishes between realized and unrealized gains and losses. That
distinction, however, is inappropriate for financial instruments. The
occurrence of gains and losses on financial instruments-not the act of
settling them-affects an entity's economic position and thus should affect
its reported financial performance. The Board is concerned that the
comprehensive income approach would provide an opportunity for an entity to
manage its reported earnings, per-share amounts, and other comprehensive
income. Financial instruments generally are liquid, and an entity can
easily sell or settle a financial instrument, realize a gain or loss, and
maintain the same economic position as before the sale by reacquiring the
same or a similar instrument.
341. Second, under the comprehensive income approach,
offsetting gains and losses often would not have been reported in earnings
at the same time. For example, if an entity used a series of short-term
derivatives as a fair value hedge of a long-term fixed-rate loan, the gains
and losses on the derivatives would have been recognized in earnings over
the life of the loan each time an individual derivative expired or was
terminated. However, the offsetting unrealized losses and gains on the
loan would not have been recognized in those same periods. Similarly,
offsetting gains and losses on a derivative and a nonfinancial asset or
liability would have been recognized together in earnings only if both
transactions were specially structured to be realized in the same period.
The Board decided on the approach in this Statement, in part, because
offsetting gains and losses on fair value hedges would be recognized in
earnings in the same period.
342. The third reason the Board did not adopt the
comprehensive income approach is that all unrealized gains and losses on
derivatives classified as risk management would have been reported in other
comprehensive income without offsetting losses or gains, if any, on the
hedged item. Thus, the resulting other comprehensive income could have
implied a change in net assets when net assets did not change or when they
changed in the opposite direction. For example, a $1,000 increase in the
fair value of a derivative would have increased other comprehensive income
and the carrying amount of the derivative by $1,000. If there was also an
offsetting $1,000 loss on the hedged asset or liability, which would not
have been reflected in other comprehensive income, the change in other
comprehensive income would have implied that net assets had increased by
$1,000 when there had been no real change.
343. The hedge accounting approach in this Statement also
may result in reporting some derivative gains and losses in other
comprehensive income. However, the Board notes that the approach in this
Statement limits the amounts reported in other comprehensive income to
gains and losses on derivatives designated as hedges of cash flow
exposures. The transactions that will give rise to cash flow exposures do
not provide offsetting changes in fair value when the related price or rate
changes. Consequently, the gains and losses reported in other comprehensive
income under this Statement are a faithful representation of the actual
volatility of comprehensive income. The Board's reasoning for recognizing
in other comprehensive income gains and losses on derivatives designated as
hedges of cash flow exposures is further discussed in
paragraph 377.
344. Only a few respondents to the Exposure Draft
advocated the comprehensive income approach. Although they did not
specifically comment on that approach, many respondents objected to
recognizing derivative gains and losses in earnings in a period other than
the one in which the hedged item affects earnings. Some opposed reporting
derivative gains and losses in other comprehensive income because of the
potential for volatility in reported stockholders' equity or net assets,
which they considered undesirable.
Full-Deferral Hedge Accounting
345. The Board considered maintaining the approach
outlined in Statement 80. Statement 80 permitted deferral of the entire
change in the fair value of a derivative used as a hedging instrument by
adjusting the basis of a hedged asset or liability, or by recognizing a
separate liability or asset associated with a hedge of an unrecognized firm
commitment or a forecasted transaction, if the appropriate hedge criteria
were met. Many respondents to the Exposure Draft advocated a full-deferral
approach. They noted that a full-deferral approach would have been
familiar to entities that have applied hedge accounting in the past. That
approach also would have provided a mechanism to moderate the earnings
"mismatch" that is attributable to the mixed-attribute measurement model.
By deferring the earnings recognition of a derivative's gain or loss until
the loss or gain on the hedged item has been recognized, offsetting gains
or losses on the derivative and hedged item would be recognized in earnings
at the same time.
346. However, the full-deferral approach goes beyond
correcting for the anomalies created by using different attributes to
measure assets and liabilities. The Board rejected that approach for three
reasons. First, full-deferral hedge accounting inappropriately permits
gains or losses on derivatives designated as hedging the cash flow exposure
of forecasted transactions to be reported as separate liabilities or assets
in the statement of financial position. Those gains and losses do not
represent probable future sacrifices or benefits, which are necessary
characteristics of liabilities and assets. Thus, reporting deferred gains
or losses as separate liabilities or assets is inconsistent with the
Board's conceptual framework.
347. Second, a full-deferral approach is inconsistent
with the Board's long-term goal of reporting all financial instruments at
fair value in the statement of financial position. For fair value hedges,
a full-deferral approach could only have been described as deferring the
derivative gain or loss as an adjustment of the basis of the hedged item.
For a cash flow hedge of a forecasted purchase of an asset or incurrence of
an obligation, a full-deferral approach would have resulted in
systematically adjusting the initial carrying amount of the acquired asset
or incurred liability away from its fair value.
348. Finally, the full-deferral approach permits a
derivative's gain or loss for a period to be deferred regardless of whether
there is a completely offsetting decrease or increase in the fair value of
the hedged item for that period. The Board believes it is inappropriate to
treat that portion of a hedge that does not achieve its objective as if it
had been effective.
Synthetic Instrument Accounting
349. A number of respondents to the Exposure Draft
suggested that a different kind of special accounting be provided for
"synthetic instrument" strategies. Synthetic instrument accounting, which
evolved in practice, views two or more distinct financial instruments
(generally a cash instrument and a derivative instrument) as having
synthetically created another single cash instrument. The objective of
synthetic instrument accounting is to present those multiple instruments in
the financial statements as if they were the single instrument that the
entity sought to create. Some respondents to the Exposure Draft advocated
a synthetic instrument accounting approach for interest rate swaps that are
used to modify the interest receipts or payments associated with a hedged
financial instrument. That approach, which its advocates also refer to as
"the accrual approach," would require the accrual of only the most imminent
net cash settlement on the swap. It would not require recognition of the
swap itself in the financial statements.
350. The Board decided not to allow synthetic instrument
accounting because to do so would be inconsistent with (a) the fundamental
decision to report all derivatives in the financial statements, (b) the
fundamental decision to measure all derivatives at fair value, (c) the
Board's objective to increase the transparency of derivatives and
derivative activities, and (d) the Board's objective of providing
consistent accounting for all derivative instruments and for all hedging
strategies. Synthetic instrument accounting also is not conceptually
defensible because it results in netting assets against liabilities (or
vice versa) for no reason other than an asserted "connection" between the
netted items.
Hedge Accounting in This Statement
351. The hedge accounting approach in this Statement
combines elements from each of the approaches considered by the Board. The
Board believes the approach in this Statement is consistent with all four
of its fundamental decisions and is a significant improvement in financial
reporting. It is also more consistent than the approach in the Exposure
Draft with what many respondents said was necessary to accommodate their
risk management strategies.
352. Some respondents suggested that the financial
statement results of applying this Statement will not reflect what they
perceive to be the economics of certain hedging and risk management
activities. However, there is little agreement about just what the
"economics" of hedging and risk management activities are. Because
entities have different and often conflicting views of risk and manage risk
differently, the Board does not think that a single approach to hedge
accounting could fully reflect the hedging and risk management strategies
of all entities. The Board also believes that some aspects of "risk
management" are hard to distinguish from speculation or "position taking"
and that speculative activities should not be afforded special accounting.
Thus, providing hedge accounting to the whole range of activities
undertaken by some under the broad heading of "risk management" would be
inconsistent with improving the usefulness and understandability of
financial reporting.
Exposures to Changes in Fair Value or Changes in Cash Flow
353. The accounting prescribed by this Statement is based
on two types of risk exposures. One reflects the possibility that a change
in price will result in a change in the fair value of a particular asset or
liability-a fair value exposure. The other reflects the
possibility that a change in price will result in variability in expected
future cash flows-a cash flow exposure.
354. Fair value exposures arise from existing assets or
liabilities, including firm commitments. Fixed-rate financial assets and
liabilities, for example, have a fair value exposure to changes in market
rates of interest and changes in credit quality. Nonfinancial assets and
liabilities, on the other hand, have a fair value exposure to changes in
the market price of a particular item or commodity. Some assets and
liabilities have fair value exposures arising from more than one type of
risk.
355. Some cash flow exposures relate to forecasted
transactions. For example, a change in the market price of an asset will
change the expected cash outflows for a future purchase of the asset and
may affect the subsequent earnings impact from its use or sale. Similarly,
a change in market interest rates will change the expected cash flows for
the future interest payments resulting from the forecasted issuance of
fixed-rate debt (for which the interest rate has not yet been fixed).
Other cash flow exposures relate to existing assets and liabilities. For
example, a change in market interest rates will affect the future cash
receipts or payments associated with a variable-rate financial asset or
liability.
356. Fair value exposures and cash flow exposures often
are mutually exclusive, and hedging to reduce one exposure generally
increases the other. For example, hedging the variability of interest
receipts on a variable-rate loan with a receive- fixed, pay-variable swap
"fixes" the interest receipts on the loan and eliminates the exposure to
risk of a change in cash flows, but it creates an exposure to the risk of a
change in the fair value of the swap. The net cash flows on the loan and
the swap will not change (or will change minimally) with market rates of
interest, but the combined fair value of the loan and the swap will
fluctuate. Additionally, the changes in the fair value of an asset or
liability are inseparable from its expected cash flows because those cash
flows are a major factor in determining fair value.
Hedge Accounting in This Statement and Risk Reduction
357. The Board believes that entity-wide risk reduction
should be a criterion for hedge accounting; it therefore would have
preferred to require an entity to demonstrate that a derivative reduces the
risk to the entity as a criterion for hedge accounting. However, requiring
that a derivative contribute to entity-wide risk reduction would
necessitate a single, restrictive definition of risk, such as
either fair value risk or cash flow risk. Actions to
mitigate the risk of a change in fair value generally exacerbate the
variability of cash flows. Likewise, actions to mitigate the variability
of cash flows of existing assets and liabilities necessitate "fixing" cash
flows, which in turn generally exacerbates an entity's exposure to changes
in fair value. Because this Statement provides hedge accounting for both
fair value risk and cash flow risk, an objective assessment of entity-wide
risk reduction would be mechanically impossible in most situations.
Therefore, the Board did not continue the requirement in Statement 80 that
a hedging transaction must contribute to reducing risk at the entity-wide
level to qualify for hedge accounting.
358. As discussed in paragraph 322, a
hedge of a forecasted transaction can be described as "fixing" the price of
the item involved in the transaction if the hedging instrument is held
until the hedged transaction occurs. "Fixing" the price of an expected
future transaction is a form of risk management on an individual-
transaction basis. The Exposure Draft would have provided cash flow hedge
accounting only for derivative instruments with a contractual maturity or
repricing date that was on or about the date of the hedged forecasted
transaction. However, as discussed further in paragraph
468, the Board removed that criterion for cash
flow hedge accounting
principally because of respondents' objections to it. This Statement also
places no limitations on an entity's ability to prospectively designate,
dedesignate, and redesignate a qualifying hedge of the same forecasted
transaction. The result of those provisions is that this Statement permits
an entity to exclude derivative gains or losses from earnings and recognize
them in other comprehensive income even if its objective is to achieve a
desired level of risk based on its view of the market rather than to reduce
risk. If an entity enters into and then discontinues a derivative
transaction designated as a hedge of a forecasted transaction for which the
exposure has not changed, one of those actions-either the hedge or the
discontinuance of it-must increase, rather than reduce, risk.
359. The considerations just discussed, together with the
intense focus on the part of many investors on earnings as a measure of
entity performance, lead some Board members to prefer that the gain or loss
on a derivative designated as a hedge of a forecasted transaction but not
intended to be held until the transaction occurs be recognized directly in
earnings. However, those Board members also consider comprehensive income
to be a measure of an entity's financial performance that is at least as,
if not more, important as earnings. Consequently, those Board members
found it acceptable to recognize in other comprehensive income the gain or
loss on a derivative designated as a hedge of a forecasted transaction,
regardless of whether that derivative is held until the hedged transaction
occurs. Those Board members observe, however, that recognizing such gains
and losses in other comprehensive income rather than in earnings creates
additional pressure concerning the method and prominence of the display of
both the items in other comprehensive income and total comprehensive
income.
A Compound Derivative May Not Be Separated into Risk Components
360. The Exposure Draft would have prohibited separating
a derivative into either separate proportions or separate
portions and designating any component as a hedging instrument
or designating different components as hedges of different exposures. Some
respondents objected to both prohibitions. They said that either a pro
rata part of a derivative, such as 60 percent, or a portion of a
derivative, such as the portion of the change in value of a combined
interest rate and currency swap deemed to be attributable to changes in
interest rates, should qualify for separate designation as a hedging
instrument. The Board decided to permit designation of a pro rata part of
a derivative as a hedge. Example 10 in Appendix B illustrates that
situation.
361. The Board decided to retain the prohibition against
separating a compound derivative into components representing different
risks. This Statement permits separation of a hedged item or transaction
by risk and also places the burden on management to design an appropriate
effectiveness test, including a means of measuring the change in fair value
or cash flows attributable to the risk being hedged. In view of those
requirements, the Board decided that it was especially important that, to
the extent possible, the gain or loss on the derivative be an objectively
determined market-based amount rather than an amount "separated out" of an
overall gain or loss on the derivative as a whole. Otherwise, even for a
derivative for which a quoted price is available, the effectiveness test
would compare two computed amounts of gain or loss deemed to be
"attributable to the risk being hedged" with no tie to a total gain or loss
separately observable in the market, which would make the effectiveness
test less meaningful. To permit that would have required that the Board
provide guidance on how to compute the fair value of the "synthetic"
derivative that is separated out of a compound derivative, both at
inception and during the term of the hedge. That would have added
complexity to the requirements in this Statement without, in the Board's
view, adding offsetting benefits to justify the additional complexity.
However, the Board decided to permit separation of the foreign currency
component of a compound derivative at the date of initial application of
this Statement, as discussed in paragraph 524.
Fair Value Hedges
362. As discussed in paragraph 320,
the demand for special accounting for hedges of existing assets and
liabilities, including unrecognized firm commitments, arises because of
differences in the way derivatives and hedged assets and liabilities are
measured. This Statement requires derivatives designated as part of a fair
value hedge to be measured at fair value with changes in fair value
reported in earnings as they occur. Without special accounting, the gain
or loss on a derivative that hedges an item not measured at fair value
would be reported in earnings without also reporting the potentially
offsetting loss or gain on the item being hedged. Those who engage in
hedging transactions do not consider that result to appropriately reflect
the relationship between a derivative and hedged item or how they manage
risk. Accordingly, this Statement permits gains and losses on designated
assets and liabilities to be recognized in earnings in the same period as
the losses and gains on related derivative hedging instruments.
Accelerated Recognition of the Gain or Loss on a Hedged Item
363. Similar to the Exposure Draft, this Statement (a)
requires that the gains or losses on a derivative used as a fair value
hedging instrument be recognized in earnings as they occur and (b) permits
earnings offset by accelerating the recognition of the offsetting losses or
gains attributable to the risk being hedged and adjusting the carrying
amount of the hedged item accordingly. That notion is consistent with part
of the Board's second fundamental decision, namely, that adjustments to the
carrying amount of hedged items should reflect offsetting changes in their
fair value arising while the hedge is in effect. This Statement modifies
the proposals in the Exposure Draft for recognizing the gains and losses on
the hedged item in two ways, which are explained below.
Attributable to the risk being hedged
364. The Exposure Draft proposed that the gain or loss on
the hedged item that would be recognized under fair value hedge accounting
incorporate all risk factors and, therefore, reflect the full change in
fair value of the hedged item to the extent of an offsetting gain or loss
on the hedging instrument. That focus was intended to prevent a hedged
asset or liability from being adjusted farther away from its fair value
than it was at inception of the hedge. For example, if the fair value of a
hedged asset increased due to a change in interest rates but simultaneously
decreased due to a change in credit quality, the Exposure Draft would have
prevented an entity that was hedging only interest rate risk from
accelerating recognition of the interest rate gain without also effectively
accelerating the credit quality loss. Accelerating only the interest rate
gain would adjust the hedged asset away from its fair value.
365. Respondents to the Exposure Draft opposed the
proposed approach for the very reason that the Board originally favored
it-the approach would not have segregated the sources of the change in a
hedged item's fair value. Respondents focused on the earnings impact and
expressed concern about recognizing in earnings the fair value changes on
the hedged item related to an unhedged risk. They said that recognizing
the changes in fair value of the hedged item attributable to all risks
would cause unrepresentative earnings volatility and would be misleading in
reflecting the results of the entity's hedging activities.
366. The Board believes that the earnings effect of the
approach proposed in the Exposure Draft would have reflected an
exacerbation of the mixed-attribute measurement model, rather than
"unrepresentative earnings volatility." However, because of the concerns
expressed by respondents, the Board reconsidered the proposed requirements.
The Board generally focuses on the appropriate recognition and measurement
of assets and liabilities in developing accounting standards. However, the
principal purpose of providing special accounting for hedging activities is
to mitigate the effects on earnings of different existing recognition and
measurement attributes. Consequently, in this instance, the Board found
the focus of respondents on the earnings impact of the approach to hedge
accounting to be persuasive and decided to modify the Exposure Draft to
focus on the risk being hedged. The Board decided to adopt an approach
that accelerates the earnings recognition of the portion of the hedged
item's gain or loss attributable to the risk being hedged for the following
reasons:
a. It provides the matching of gains and losses on the hedging instrument
and the hedged item that respondents desire.
b. It accounts for all or a portion of the change in fair value of the
hedged item, and, consequently, it is not inconsistent with the
Board's long-term objective of measuring all financial instruments at
fair value.
Entire gain or loss attributable to risk being hedged
367. The Exposure Draft proposed that the gain or loss on
the hedged item be recognized in earnings only to the extent that it
provided offset for the loss or gain on the hedging instrument. Under that
proposal, earnings would have reflected hedge ineffectiveness to the extent
that the derivative gain or loss exceeded an offsetting loss or gain on the
hedged item. It would not have reflected hedge ineffectiveness to the
extent that the gain or loss on the derivative was less than the loss or
gain on the hedged item. For example, ineffectiveness of $10 would have
been recognized if the gain on the derivative was $100 and the
corresponding loss on the hedged item was $90, but not if the gain on the
derivative was $90 and the loss on the hedged item was $100. The Board
would have preferred to reflect all hedge ineffectiveness in earnings.
However, the Exposure Draft did not propose that the excess gain or loss on
the hedged item be reflected in earnings because that could have resulted
in reporting in earnings a gain or loss on the hedged item attributable to
changes in unhedged risks.
368. When the Board modified the Exposure Draft to focus only on the gain or loss
on the hedged item attributable to the risk being hedged, it decided to report all
hedge ineffectiveness in earnings. Recognizing the hedged item's gain or loss due
only to the hedged risk will not result in earnings recognition of gains or losses
related to unhedged risks.
Measurement of Hedged Item's Gain or Loss
369. In this Statement, the gain or loss on the hedged
item that is accelerated and recognized in earnings is the portion of the
gain or loss that is attributable to the risk being hedged. Although the
Board considered several approaches to measuring the gain or loss
attributable to the risk being hedged, it decided not to provide detailed
guidance on how that gain or loss should be measured. The Board believes
that the appropriate measurement of the gain or loss on a hedged item may
depend on how an entity manages the hedged risk. Consistent with its
decision to require an entity to define at inception how it will assess
hedge effectiveness, the Board decided that an entity also should define at
inception how it will measure the gain or loss on a hedged item
attributable to the risk being hedged. The measurement of that gain or
loss should be consistent with the entity's approach to managing risk,
assessing hedge effectiveness, and determining hedge ineffectiveness. It
follows that the gain or loss on the hedged item attributable to the risk
being hedged can be based on the loss or gain on the derivative, adjusted
in certain ways that will be identified during the assessment of hedge
effectiveness. Both Section 2 of Appendix A and Appendix B discuss and
illustrate situations in which the gain or loss on a hedging derivative
must be adjusted to measure the loss or gain on the hedged item.
The Exposure Draft's Exception for Certain Firm Commitments
370. The Exposure Draft proposed a specific exception for
a derivative that hedges the foreign currency exposure of a firm commitment
to purchase a nonfinancial asset for a fixed amount of foreign currency.
That exception would have permitted an entity to consider separately the
financial aspect and the nonfinancial aspect of the firm commitment for
purposes of designating the hedged item and thus to record the purchased
asset at a fixed-dollar (or other functional currency) equivalent of the
foreign currency price. The exception is no longer necessary because this
Statement permits separate consideration of financial and nonfinancial
risks for all fair value hedges of firm commitments.
Cash Flow Hedges
371. As discussed in paragraphs
322-329, the Board decided to permit hedge
accounting for certain hedges
of forecasted transactions because of the widespread use of and demand for
that accounting. The "need" for special accounting for cash flow hedges
arises because the hedged transactions are recognized in periods after the
one in which a change in the fair value of the derivative occurs and is
recognized. Without special accounting, gains and losses on derivatives
would be reported in a period different from the earnings impact of the
hedged transaction or the related asset acquired or liability incurred.
372. In developing a hedge accounting approach for hedges
of cash flow exposures, the Board identified four objectives: (a) to avoid
the recognition of the gain or loss on a derivative hedging instrument as a
liability or an asset, (b) to make gains and losses not yet recognized in
earnings visible, (c) to reflect hedge ineffectiveness, and (d) to limit
the use of hedge accounting for cash flow hedges.
First Two Objectives-Avoid Conceptual Difficulties and Increase Visibility
373. The Board believes that recognizing gains or losses
on derivatives in other comprehensive income, rather than as liabilities or
assets, best meets the first two objectives. Many respondents to the
Exposure Draft objected to that approach because of the potential for
volatility in reported equity. Instead, they advocated reporting a
derivative's gain or loss as a freestanding liability or asset. The Board
did not change its decision for several reasons. First, the Board believes
that reporting a derivative's gain or loss as a liability or an asset is
inappropriate and misleading because a gain is not a liability and a loss
is not an asset. Second, the Board believes the volatility in other
comprehensive income that results from gains and losses on derivatives that
hedge cash flow exposures properly reflects what occurred during the hedge
period. There are no gains or losses to offset the losses or gains on the
derivatives that are reported in other comprehensive income because the
hedged transaction has not yet occurred. Third, the Board believes the
advantages of reporting all derivatives at fair value, together with
recognizing gains and losses on derivatives that hedge cash flow exposures
in other comprehensive income, outweigh any perceived disadvantages of
potential equity volatility.
Third and Fourth Objectives-Reflect Ineffectiveness and Impose Limitations
374. The Board proposed in the Exposure Draft that the
best way to meet the last two objectives (reflect ineffectiveness and
impose limitations) would be to reclassify a gain or loss on a derivative
designated as a hedging instrument into earnings on the projected date of
the hedged forecasted transaction. Effectiveness thus would have been
reflected at the date the forecasted transaction was projected to occur.
In addition, there would have been little, if any, opportunity for earnings
management because gains and losses would not have been reclassified into
earnings when realized, when a forecasted transaction actually occurs, or
when a forecasted transaction's occurrence is no longer considered
probable. The Exposure Draft explained that requiring recognition at the
date the forecasted transaction is initially expected to occur emphasizes
the importance of carefully evaluating and forecasting future transactions
before designating them as being hedged with specific derivatives.
375. Respondents generally opposed the approach in the
Exposure Draft because it often would not have matched the derivative gain
or loss with the earnings effect of the forecasted transaction, thereby
making earnings appear volatile. Respondents generally advocated
recognizing a derivative gain or loss in earnings in the same period or
periods as the earnings effect of (a) the forecasted transaction (such as a
forecasted sale) or (b) the subsequent accounting for the asset acquired or
liability incurred in conjunction with the forecasted transaction. To
accomplish that result, many respondents advocated deferring the gain or
loss on the derivative beyond the date of the forecasted transaction as an
adjustment of the basis of the asset acquired or liability incurred in the
forecasted transaction.
376. The Board considered two approaches that would have
provided basis adjustment for assets acquired or liabilities incurred in
conjunction with a forecasted transaction. One approach would have
initially deferred a derivative gain or loss as a separate (freestanding)
liability or asset and later reported it as an adjustment of the basis of
the acquired asset or incurred liability when it was recorded. The Board
rejected that approach because a deferred loss is not an asset and a
deferred gain is not a liability; reporting them as if they were would be
misleading. The other approach would have initially recognized the
derivative gain or loss in other comprehensive income and later reported it
as an adjustment of the basis of the acquired asset or incurred liability
when it was recorded. The Board rejected that approach because it would
have distorted reported periodic comprehensive income. For example,
removing a gain from other comprehensive income and reporting it as an
adjustment of the basis of an acquired asset would result in a decrease in
periodic comprehensive income (and total stockholders' equity) caused
simply by the acquisition of an asset at its fair value-a transaction that
should have no effect on comprehensive income. Additionally, both
approaches would have systematically measured the acquired asset or
incurred liability at an amount other than fair value at the date of
initial recognition. That is, the adjustment would have moved the initial
carrying amount of the acquired asset or incurred liability away from its
fair value.
377. The Board decided to require that the gain or loss
on a derivative be reported initially in other comprehensive income and
reclassified into earnings when the forecasted transaction affects
earnings. That requirement avoids the problems caused by adjusting the
basis of an acquired asset or incurred liability and provides the same
earnings impact. The approach in this Statement, for example, provides for
(a) recognizing the gain or loss on a derivative that hedged a forecasted
purchase of a machine in the same periods as the depreciation expense on
the machine and (b) recognizing the gain or loss on a derivative that
hedged a forecasted purchase of inventory when the cost of that inventory
is reflected in cost of sales.
378. The Board was concerned that recognizing all
derivative gains and losses in other comprehensive income and reclassifying
them into earnings in the future, perhaps spread out over a number of
years, would not meet its third objective of reflecting hedge
ineffectiveness, if any. The Board therefore decided to require that, in
general, the ineffective part of a cash flow hedge be immediately
recognized in earnings.
Measure of hedge ineffectiveness
379. The Board believes that, in principle, earnings
should reflect (a) the component of a derivative gain or loss that is
excluded from the defined assessment of hedge effectiveness and (b) any
hedge ineffectiveness. However, the Board had concerns about the effect of
that approach on other comprehensive income and earnings for a period in
which the change in the present value of the future expected cash flows on
the hedged transaction exceeds the change in the present value of the
expected cash flows on the derivative. In that circumstance, the result
would be to defer in other comprehensive income a nonexistent gain or loss
on the derivative and to recognize in earnings an offsetting nonexistent
loss or gain. For example, if the derivative hedging instrument had a $50
loss for a period in which the change in the present value of the expected
cash flows on the hedged transaction was a $55 gain, an approach that
reflected all hedge ineffectiveness in earnings would result in reflecting
a $55 loss in other comprehensive income and reporting a $5 gain in
earnings.
380. To avoid that result, the Board decided that only
ineffectiveness due to excess expected cash flows on the derivative should
be reflected in earnings. The Board discussed whether that approach should
be applied period by period or cumulatively and decided that the
ineffectiveness of a cash flow hedge should be determined on a cumulative
basis since the inception of the hedge.
381. To illustrate the difference between the
period-by-period and cumulative approaches, consider a derivative that had
gains (expected cash inflows) of $75 in period 1 and $70 in period 2. The
derivative hedges a forecasted transaction for which expected cash outflows
increased by $70 and $75 in the same periods, respectively. At the end of
period 2, the changes in expected cash flows on the hedge are completely
offsetting on a cumulative basis. That is, the derivative has expected
cash inflows of $145 and the hedged transaction has an offsetting increase
in expected cash outflows of $145. If hedge ineffectiveness is measured
and accounted for on a cumulative basis, the $5 excess derivative gain
reported in earnings in period 1 would be reversed in period 2. At the end
of period 2, retained earnings would reflect zero gain or loss, and
comprehensive income would reflect $145 of derivative gain. However,
measuring and accounting for hedge ineffectiveness on a period-by-period
basis would give a different result because earnings and comprehensive
income would be affected for the $5 excess derivative gain in period 1 but
not the $5 excess hedged transaction loss in period 2. As a result, at the
end of period 2, retained earnings would reflect a $5 gain, even though
actual ineffectiveness since hedge inception was a zero gain or loss.
Other comprehensive income would reflect a gain of $140, even though the
derivative's actual effectiveness since the inception of the hedge was a
gain of $145. Thus, in a situation like the one illustrated, retained
earnings under the cumulative approach will more accurately reflect total
hedge ineffectiveness since the inception of the hedge, and comprehensive
income will more accurately reflect total hedge effectiveness for the hedge
period. The Board rejected a period-by-period approach because, under that
approach, retained earnings would not reflect total hedge ineffectiveness,
and comprehensive income would not reflect total hedge effectiveness.
Section 2 of Appendix A provides some examples of how the ineffective
portion of a derivative gain or loss might be estimated, and Section 1 of
Appendix B further illustrates application of the cumulative approach.
Limitations on cash flow hedges
382. Because hedge accounting for forecasted transactions
is not conceptually supportable and is not necessary to compensate for
recognition or measurement anomalies, the Board decided that this Statement
should provide only limited hedge accounting for hedges of forecasted
transactions (the Board's fourth objective). In the Exposure Draft, the
Board concluded that the best way to limit hedge accounting for a hedge of
a forecasted transaction was to require that the gain or loss on a
derivative that hedges a forecasted transaction be reclassified into
earnings on the projected date of the forecasted transaction and to limit
hedge accounting to the life of the hedging instrument. In formulating
this Statement, the Board decided that, because of current practice, it was
acceptable to provide for an earnings effect that is more consistent with
the entity's objective in entering into a hedge. Consequently, the Board
decided to provide limitations on hedges of forecasted transactions through
the criteria for qualification for cash flow hedge accounting. The Board
believes the criteria discussed in paragraphs 458-473
provide sufficient limitations.
383. The Board also considered limiting hedge accounting
for hedges of cash flow exposures based on pragmatic, but arbitrary,
limitations. The pragmatic approaches that were considered included
limitations based on the length of time until the expected occurrence of
the forecasted transaction, the amount of the gain or loss reflected in
other comprehensive income, and specific linkage to existing assets or
liabilities. For example, a limitation might have required that cash
flows occur within five years to qualify as hedgeable. The Board decided
that it was more appropriate to rely on specified criteria for cash flow
hedges than to apply arbitrary, pragmatic limitations.
General Criteria to Qualify for Designation as a Hedge
384. This Statement requires that certain criteria be met
for a hedge to qualify for hedge accounting. The criteria are intended to
ensure that hedge accounting is used in a reasonably consistent manner for
transactions and exposures that qualify as hedgeable pursuant to this
Statement. The criteria discussed in this section are required for both
fair value hedges and cash flow hedges. Criteria that are unique to either
fair value hedges or cash flow hedges are discussed separately.
Designation, Documentation, and Risk Management
385. The Board decided that concurrent designation and
documentation of a hedge is critical; without it, an entity could
retroactively identify a hedged item, a hedged transaction, or a method of
measuring effectiveness to achieve a desired accounting result. The Board
also decided that identifying the nature of the risk being hedged and using
a hedging derivative consistent with an entity's established policy for
risk management are essential components of risk management and are
necessary to add verifiability to the hedge accounting model.
Highly Effective in Achieving Offsetting Changes in Fair Values or Cash Flows
386. To qualify for hedge accounting, this Statement
requires that an entity must expect a hedging relationship to be highly
effective in achieving offsetting changes in fair value or cash flows for
the risk being hedged. That requirement is consistent with the Board's
fourth fundamental decision, which is that one aspect of qualification for
special hedge accounting should be an assessment of the effectiveness of a
derivative in offsetting the entity's exposure to changes in fair value or
variability of cash flows. This Statement does not specify how
effectiveness should be assessed; assessment of effectiveness should be
based on the objective of management's risk management strategy. However,
this Statement does require that the method of assessing effectiveness be
reasonable and that the same method be used for similar hedges unless
different methods are explicitly justified. The Board considers it
essential that an entity document at the inception of the hedge how
effectiveness will be assessed for each hedge and then apply that
effectiveness test on a consistent basis for the duration of the designated
hedge. However, if an entity identifies an improved method for assessing
effectiveness, it may discontinue the existing hedging relationship and
then designate and document a new hedging relationship using the improved
method prospectively.
387. In formulating this Statement, the Board would have
preferred specific effectiveness tests for fair value hedges and for cash
flow hedges to (a) provide limitations on hedge accounting, (b) result in
consistent application of hedge accounting guidance, and (c) increase the
comparability of financial statements. The Exposure Draft therefore
proposed specific effectiveness tests that would have required an
expectation that the changes in fair value or net cash flows of the
derivative would "offset substantially all" of the changes in fair value of
the hedged item or the variability of cash flows of the hedged transaction
attributable to the risk being hedged. Those proposed offset tests were
intended to be similar to, though more stringent than, the related
requirements of Statement 80:
At the inception of the hedge and throughout the hedge period, high
correlation of changes in (1) the market value of the futures
contract(s) and (2) the fair value of, or interest income or expense
associated with, the hedged item(s) shall be probable so that the
results of the futures contract(s) will substantially offset the
effects of price or interest rate changes on the exposed item(s).
[paragraph 4(b); footnote reference omitted.]
388. Respondents to the Exposure Draft commented that the
proposed effectiveness tests for fair value and cash flow hedges would have
precluded certain risk management strategies from qualifying for hedge
accounting because those tests were based on singular objectives for fair
value and cash flow hedges. For example, the effectiveness tests in the
Exposure Draft would have prohibited delta-neutral hedging strategies,
partial-term hedging strategies, rollover hedging strategies, and hedging
based on changes in the intrinsic value of options. Respondents also noted
that risk management objectives and strategies differ between entities as
well as between different types of hedges within an entity. Based on those
concerns, the Board reconsidered the effectiveness tests proposed in the
Exposure Draft.
389. The Board attempted to develop a workable
effectiveness test that would appropriately deal with the variety of risk
management objectives and strategies that exist in practice. It ultimately
decided to remove the specific effectiveness tests and, instead, to require
that a hedge be expected to be highly effective in achieving offsetting
changes in either fair value or cash flows, consistent with an entity's
documented risk management objectives and strategy. The Board intends
"highly effective" to be essentially the same as the notion of "high
correlation" in Statement 80.
390. Because that modification places more emphasis on
each entity's approach to risk management, the Board decided to require an
expanded description and documentation of an entity's risk management
objectives and strategy, including how a derivative's effectiveness in
hedging an exposure will be assessed. It also decided that the description
of how an entity plans to assess effectiveness must (a) include
identification of whether all of the gain or loss on the derivative hedging
instrument will be included in the assessment and (b) have a reasonable
basis. Those limitations, along with examples of different ways to assess
hedge effectiveness in a variety of circumstances, are discussed in Section
2 of Appendix A. The Board may need to revisit the idea of more specific
effectiveness tests if an evaluation of the application of this Statement
indicates either too great a disparity in the techniques used for assessing
effectiveness or widespread abuse of the flexibility provided.
Basis Swaps
391. Basis swaps are derivative instruments that are used
to modify the receipts or payments associated with a recognized,
variable-rate asset or liability from one variable amount to another
variable amount. They do not eliminate the variability of cash flows;
instead, they change the basis or index of variability. The Exposure Draft
would have required that an entity expect the net cash flows of a
derivative to "offset substantially all" of the variability of cash flows
associated with the asset or liability to qualify for cash flow hedge
accounting. That requirement would have precluded basis swaps from
qualifying as hedging instruments.
392. Some respondents to the Exposure Draft criticized
its prohibition of hedge accounting for basis swaps. They commented that
it should not matter whether an interest rate swap, for example, is used to
change the interest receipts or payments associated with a hedged asset or
liability from fixed to variable, variable to fixed, or variable to
variable. They noted that the fair value and cash flow criteria
accommodated only fixed-to-variable and variable-to-fixed swaps.
Additionally, some respondents commented that basis swaps should be
eligible for hedge accounting treatment because they are an effective means
of creating comparable asset-liability positions. For example, if an
entity holds a variable-rate, LIBOR- based asset and a variable-rate,
prime-based liability, an easy way to match that asset and liability
position is to "swap" either the LIBOR asset to prime or the prime
liability to LIBOR.
393. Many respondents advocating the use of basis swaps
as hedging instruments suggested accommodating basis swaps by accounting
for all swaps on a synthetic instrument basis. For the reasons discussed
in paragraphs 349 and 350,
the
Board decided not to provide special accounting based on the creation of
synthetic instruments. The Board recognizes, however, that basis swaps can
provide offsetting cash flows when they are used to hedge a combined
asset-liability position in which the asset and liability have different
rate bases. For that reason, this Statement provides an exception for a
basis swap that is highly effective as a link between an asset (or group of
similar assets) with variable cash flows and a liability (or a group of
similar liabilities) with variable cash flows.
394. Some respondents to the Task Force Draft objected to
what they saw as stricter requirements for a basis swap to qualify for
hedge accounting than for other derivatives. They noted that to qualify
for hedge accounting, other strategies need not link an asset and a
liability. The Board notes that the requirement that a basis swap link the
cash flows of an asset and a liability is necessary for a basis swap to
qualify under the general criterion that a derivative must provide
offsetting cash flows to an exposure to qualify for cash flow hedge
accounting. That is, one leg of the basis swap that links an asset and a
liability will provide offsetting cash flows for the asset, and the other
leg will provide offsetting cash flows for the liability. Thus, the
criteria for basis swaps are essentially the same as-not stricter than-the
criteria for other strategies to qualify for hedge accounting.
395. To ensure that a basis swap does, in fact, result in
offsetting cash flows, this Statement also requires that the basis of one
leg of the swap be the same as the basis of the identified asset and that
the basis of the other leg of the swap be the same as the basis of the
identified liability. Some respondents to the Task Force Draft suggested
that the only requirement should be that one leg of the basis swap be
highly effective in offsetting the variable cash flows of the asset and the
other leg be highly effective in offsetting the variable cash flows of the
liability. The Board noted that such a provision could have an additive
effect if neither leg is entirely effective. The sum of the two amounts of
ineffectiveness might not satisfy the effectiveness test that other
derivatives must meet to qualify for hedge accounting. The Board therefore
decided to retain the requirement that the basis of one leg of the basis
swap be the same as that of a recognized asset and that the basis of the
other leg be the same as that of a recognized liability. Section 2 of
Appendix A provides an example of assessing the effectiveness of a hedge
with a basis swap.
Written Options
396. A written option exposes its writer to the
possibility of unlimited loss but limits the gain to the amount of premium
received. The Board is concerned about permitting written options to be
designated as hedging instruments because a written option serves only to
reduce the potential for gain in the hedged item or hedged transaction. It
leaves the potential for loss on the hedged item or hedged transaction
unchanged except for the amount of premium received on the written option.
Consequently, on a net basis, an entity may be worse off as a result of
trying to hedge with a written option. Because of those concerns, the
Exposure Draft proposed prohibiting a written option from being eligible
for designation as a hedging instrument.
397. Respondents to the Exposure Draft objected to
categorically prohibiting written options from being designated as hedging
instruments. A number of respondents specifically referred to the use of a
written option to hedge the call option feature in a debt instrument. They
explained that it may be more cost-effective to issue fixed-rate, callable
debt and simultaneously enter into a receive-fixed, pay-variable interest
rate swap with an embedded written call option than to directly issue
variable-rate, noncallable debt. The Board agreed that hedge accounting
should be available for that use of written options. Consequently, this
Statement permits designation of a written option as hedging the purchased
option embedded in a financial instrument. The Board notes that if the
option features in both instruments are exactly opposite, any gains or
losses on the two options generally will offset. Section 2 of Appendix A
includes an example illustrating such a strategy.
398. The requirements in this Statement for hedge
accounting for strategies that use written options are based on symmetry of
the gain and loss potential of the combined hedged position. To qualify
for hedge accounting, either the upside and downside potential of the net
position must be symmetrical or the upside potential must be greater than
the downside potential. That is, the combination of the hedged item and
the written option must result in a position that provides at least as much
potential for gains (or favorable cash flows) as exposure to losses (or
unfavorable cash flows). Evaluation of the combined position's relative
potential for gains and losses is based on the effect of a favorable or
unfavorable change in price of a given percentage. For example, a 25
percent favorable change in the fair value of the hedged item must provide
a gain on the combined position that is at least as large as the loss on
that combined position that would result from a 25 percent unfavorable
change in the fair value of the hedged item.
399. This Statement does not permit hedge accounting for
"covered call" strategies-strategies in which an entity writes an option on
an asset that it owns (unless that asset is a call option that is embedded
in another instrument). In that strategy, any loss on the written option
will be covered by the gain on the owned asset. However, a covered call
strategy will not qualify for hedge accounting because the risk profile of
the combined position is asymmetrical (the exposure to losses is greater
than the potential for gains). In contrast, the risk profile of the asset
alone is "symmetrical or better" (the potential for gains is at least as
great as the exposure to losses).
400. The symmetry requirement for hedges with written
options described in paragraph 398 is intended
to
preclude a written option that is used to sell a portion of the gain
potential on an asset or liability from being eligible for hedge
accounting. For example, assume that an entity has an investment in equity
securities that have a current fair value of $150 per share. To sell some,
but not all, of the upside potential of those securities, the entity writes
a call option contract to sell the securities for $150 per share and
purchases a call option contract to buy the same securities at $160 per
share. On a net basis, the entity still has unlimited upside potential
because there are infinite possible outcomes above $160 per share, but its
downside risk is limited to $150 per share. Without the requirement to
compare increases and decreases of comparable percentages, an entity could
assert that its written option strategy warrants hedge accounting because,
after entering into the written and purchased option contracts, there is
still more potential for gains than for losses from its combined position
in the equity securities and option contracts. The Board decided that
hedge accounting should not be available for a transaction that merely
"sells" part of the potential for gain from an existing asset.
401. This Statement does not require that a written
option be entered into at the same time the hedged item is issued or
acquired because the combined position is the same regardless of when the
position originated (assuming, of course, that the price of the hedged item
is the same as the underlying for the option at the time the hedge is
entered into). In addition, the Board decided not to limit the items that
may be hedged with written options to financial instruments. The Board
decided that this Statement's provisions for hedging with written options
should accommodate similar risk management strategies regardless of the
nature of the asset or liability that is the hedged item.
Exposures to Changes in Fair Value or Cash Flows That Could Affect Reported Earnings
402. This Statement requires that a hedged item or hedged
forecasted transaction embody an exposure to changes in fair value or
variations in cash flow, for the risk being hedged, that could affect
reported earnings. That is, a change in the fair value of a hedged item or
variation in the cash flow of a hedged forecasted transaction attributable
to the risk being hedged must have the potential to change the amount that
could be recognized in earnings. For example, the future sale of an asset
or settlement of a liability that exposes an entity to the risk of a change
in fair value may result in recognizing a gain or loss in earnings when the
sale or settlement occurs. Changes in market price could change the amount
for which the asset or liability could be sold or settled and,
consequently, change the amount of gain or loss recognized. Forecasted
transactions that expose an entity to cash flow risk have the potential to
affect reported earnings because the amount of related revenue or expense
may differ depending on the price eventually paid or received. Thus, an
entity could designate the forecasted sale of a product at the market price
at the date of sale as a hedged transaction because revenue will be
recorded at that future sales price.
403. Some respondents to the Exposure Draft asked the
Board to permit some transactions that create an exposure to variability in
cash flows to qualify as hedgeable transactions even though they could not
affect reported earnings. They asserted that hedges of those transactions
successfully reduce an entity's cash flow exposure. The Board decided to
retain the criterion of an earnings exposure because the objective of hedge
accounting is to allow the gain or loss on a hedging instrument and the
loss or gain on a designated hedged item or transaction to be recognized in
earnings at the same time. Moreover, without an earnings exposure, there
would be no way to determine the period in which the derivative gain or
loss should be included in earnings to comply with this Statement.
404. The earnings exposure criterion specifically
precludes hedge accounting for derivatives used to hedge (a) transactions
with stockholders as stockholders, such as projected purchases of treasury
stock or payments of dividends, (b) intercompany transactions (except for
foreign-currency-denominated forecasted intercompany transactions, which
are discussed in paragraphs 482-487) between
entities
included in consolidated financial statements, and (c) the price of stock
expected to be issued pursuant to a stock option plan for which recognized
compensation expense is not based on changes in stock prices after the date
of grant. However, intercompany transactions may present an earnings
exposure for a subsidiary in its freestanding financial statements; a hedge
of an intercompany transaction would be eligible for hedge accounting for
purposes of those statements.
The Hedged Item or Transaction Is Not Remeasured through Earnings for the Hedged Risk
405. Special hedge accounting is not necessary if both
the hedged item and the hedging instrument are measured at fair value with
changes in fair value reported in earnings as they occur because offsetting
gains and losses will be recognized in earnings together. The Board
therefore decided to specifically prohibit hedge accounting if the related
asset or liability is, or will be, measured at fair value, with changes in
fair value reported in earnings when they occur. That prohibition results
from the Board's belief that a standard on hedge accounting should not
provide the opportunity to change the accounting for an asset or liability
that would otherwise be reported at fair value with changes in fair value
reported in earnings. Thus, for a fair value hedge, the prohibition is
intended to prevent an entity from recognizing only the change in fair
value of the hedged item attributable to the risk being hedged rather than
its entire change in fair value. For a cash flow hedge, the prohibition is
intended to prevent an entity from reflecting a derivative's gain or loss
in accumulated other comprehensive income when the related asset or
liability will be measured at fair value upon acquisition or incurrence.
406. The Exposure Draft would have excluded from its
scope all of the assets and liabilities of an entity that follows
specialized industry practice under which it measures substantially all of
its assets at fair value and recognizes changes in those fair values in
earnings. That exclusion was aimed at preventing those entities from
avoiding fair value accounting. Respondents to the Exposure Draft noted
that exclusion also would have prohibited those entities from applying
hedge accounting to hedged assets or liabilities that are not measured at
fair value, such as long-term debt. The Board decided to remove the
exclusion and instead focus on assets and liabilities that are reported at
fair value because that approach would (a) be consistent with the notion
that eligibility for hedge accounting should be based on the criteria in
this Statement, (b) provide consistent fair value accounting for all
derivatives, and (c) be responsive to the concerns of constituents.
407. The criteria in this Statement also preclude hedge
accounting for an asset or a liability that is remeasured for changes in
price attributable to the risk being hedged, with those changes in value
reported currently in earnings. The criteria therefore preclude fair value
or cash flow hedge accounting for foreign currency risk associated with any
asset or liability that is denominated in a foreign currency and remeasured
into the functional currency under Statement 52. The Board believes that
special accounting is neither appropriate nor necessary in that situation
because the transaction gain or loss on the foreign-currency-denominated
asset or liability will be reported in earnings along with the gain or loss
on the undesignated derivative. The criteria also preclude a cash flow
hedge of the forecasted acquisition or incurrence of an item that will be
denominated in a foreign currency and remeasured into the functional
currency each period after acquisition or incurrence. However, the
criteria do not preclude a cash flow hedge of the foreign currency exposure
associated with the forecasted purchase of a nonmonetary item for a foreign
currency, even if the purchase will be on credit, because nonmonetary items
are not subsequently remeasured into an entity's functional currency. Nor
do the criteria preclude hedging the forecasted sale of a nonmonetary asset
for a foreign currency, even if the sale will be on credit.
Risks That May Be Designated as Being Hedged
408. The Board recognizes that entities are commonly
exposed to a variety of risks in the course of their activities, including
interest rate, foreign exchange, market price, credit, liquidity, theft,
weather, health, catastrophe, competitive, and business cycle risks. The
Exposure Draft did not propose detailed guidance on what risks could be
designated as being hedged, other than to note in the basis for conclusions
that special hedge accounting for certain risk management transactions,
such as hedges of strategic risk, would be precluded. In redeliberating
the issue of risk, the Board reaffirmed that hedge accounting cannot be
provided for all possible risks and decided to be more specific about the
risks for which hedge accounting is available.
409. Because this Statement, unlike the Exposure Draft,
bases the accounting for a hedged item in a fair value hedge on changes in
fair value attributable to the risk being hedged, the Board decided that it
needed to limit the types of risks that could be designated as being
hedged. The absence of limits could make meaningless the notion of hedge
effectiveness by ignoring the consequence of basis or other differences
between the hedged item or transaction and the hedging instrument in
assessing the initial and continuing qualification for hedge accounting.
410. For example, an entity using a LIBOR-based interest
rate futures contract as a hedge of a prime-based asset might assert that
the risk being hedged is the fair value exposure of the prime-based asset
to changes in LIBOR. Because that designation would ignore the basis
difference between the prime-based hedged asset and the LIBOR-based
derivative hedging instrument, it could result in asserted "automatic"
compliance with the effectiveness criterion. That type of designation
might also lead an entity to assert that the amount of the change in the
hedged item's fair value attributable to the hedged risk corresponds to the
change in the fair value of the hedging derivative and, therefore, to
erroneously conclude that the derivative's change in fair value could be
used as a surrogate for changes in the fair value of the hedged item
attributable to the hedged risk. Such a designation also would remove any
possibility that actual ineffectiveness of a hedge would be measured and
reflected in earnings in the period in which it occurs.
Financial Assets and Liabilities
411. For financial instruments, this Statement specifies
that hedge accounting is permitted for hedges of changes in fair value or
variability of future cash flows that result from changes in four types of
risk. As indicated in paragraph 21(f), those
four risks
also apply to fair value hedges of firm commitments with financial
components.
a. Market price risk. A fair value hedge focuses on the
exposure to changes in the fair value of the entire hedged item.
The definition of fair value requires that the fair value of a
hedged item be based on a quoted market price in an active market,
if available. Similarly, a cash flow hedge focuses on variations in
cash flows, for example, the cash flows stemming from the purchase
or sale of an asset, which obviously are affected by changes in the
market price of the item. The Board therefore concluded that the
market price risk of the entire hedged item (that is, the risk of
changes in the fair value of the entire hedged item) should be
eligible for designation as the hedged risk in a fair value hedge.
Likewise, variable cash flows stemming from changes in the market
price of the entire item are eligible for designation as the hedged
risk in a cash flow hedge.
b. Market interest rate risk. For financial assets and
liabilities, changes in market interest rates may affect the right
to receive (or obligation to pay or transfer) cash or other
financial instruments in the future or the fair value of that right
(or obligation). The time value of money is a broadly accepted
concept that is incorporated in generally accepted accounting
principles (for example, in APB Opinion No. 21,
Interest on Receivables and Payables, and FASB
Statement No. 91, Accounting for
Nonrefundable Fees and Costs
Associated with Originating or Acquiring Loans and Initial Direct
Costs of Leases). Because the marketplace has developed
techniques to delineate and extract interest rate risk from
financial instruments, the Board decided that the risk that changes
in market interest rates will affect the fair value or cash flows
of the hedged item warrants being identified as a risk that may be
designated as being hedged.
c. Foreign exchange risk. The fair value (expressed in the
entity's functional currency) of an asset such as a foreign debt or
equity security that is classified as available for sale, as well
as the fair value of the financial component of a firm commitment
that is denominated in a currency other than the entity's
functional currency, generally is exposed to changes in foreign
exchange rates. Similarly, the cash flows of a forecasted
transaction generally are exposed to changes in foreign exchange
rates if the transaction will be denominated in a foreign currency.
Statement 52 specifies special accounting for reflecting the
effects of changes in foreign exchange rates, and this Statement
continues much of that accounting. The Board therefore decided
that the risk of changes in foreign exchange rates on the fair
value of certain hedged items and on the cash flows of hedged
transactions warrants being identified as a risk that may be
designated as being hedged.
d. Default (credit) risk. A financial asset embodies a right to
receive cash or another financial instrument from a counterparty.
A financial asset thus embodies a risk that the counterparty will
fail to perform according to the terms of the contract; that risk
generally is referred to as credit risk. Because that risk affects
the fair value of a financial asset, as well as the related cash
flows, the Board decided that the risk of the counterparty's
default on its obligation is a risk that may be designated as being
hedged. Focusing on those four risks is consistent with the belief
that the largest amount of present hedging activity is aimed at
protecting against market price, credit, foreign exchange, or
interest rate risk. Those also were the risks generally
accommodated by special hedge accounting before this Statement.
Focusing on those four risks also is consistent with responses to
the Exposure Draft. Although the notice for recipients did not ask
respondents to comment on the type of risks that should be eligible
for hedge accounting, respondents generally discussed hedging
transactions in terms of those four risks.
412. This Statement also focuses on those four specified
risks because a change in the price associated with one of those risks
ordinarily will directly affect the fair value of an asset or liability or
the cash flows of a future transaction in a determinable or predictable
manner. Price changes associated with other risks may not be as direct.
For example, price changes associated with "strategic risk" exposures do
not have a direct impact on the fair value of a hedged item or cash flow of
a forecasted transaction and thus may not be designated as the risk being
hedged. Strategic hedges are described in paragraph
231.
413. This Statement does not permit designating a
subcomponent of market price, market interest rate, foreign exchange, or
credit risk as the risk being hedged. However, some of those subcomponents
may be embodied in a separable portion of a financial instrument. For
example, prepayment risk is a subcomponent of market interest rate risk,
but the prepayment risk in a financial asset stems from the embedded
written call option. An entity may hedge prepayment risk by separately
designating a hedge of the embedded call option. Even though this
Statement does not require an embedded prepayment option to be accounted
for separately because it is deemed to be clearly and closely related to
the host contract, that embedded call option still is a derivative.
Because this Statement does not permit a compound derivative to be
separated into risk components for hedge accounting purposes, only the
market price risk of the entire option qualifies as the hedged risk. Hedge
effectiveness therefore must be measured based on changes in the fair value
of the option.
414. Measuring the effectiveness of a fair value hedge
requires determining whether a gain or loss on a hedging derivative offsets
the loss or gain in the value of the hedged item that is attributable to
the risk being hedged. Once the change in the value of a hedged item
attributable to a particular risk has been offset by the change in value of
a hedging derivative, a second, identical derivative cannot also be an
effective hedge of that same risk. Similarly, an embedded derivative in a
hedged item will modify the nature of the risk to which that item is
exposed. Thus, all embedded derivatives relating to the same risk class
(that is, market prices, market interest rates, foreign exchange rates, or
credit) in a hedged item must be considered together in assessing the
effectiveness of an additional (freestanding) derivative as the hedging
instrument.
415. For example, an entity might enter into a firm
commitment to purchase an asset for 1,000,000 Deutsche marks (DM), with a
provision that caps the U.S. dollar equivalent price at $600,000. A hedge
of the foreign currency risk in that commitment cannot be effective unless
it takes into account the effect of the cap. Similarly, a hedge of the
effect on the holder of changes in market interest rates on the
unconditional receivable component of a prepayable bond cannot ignore the
effect of the embedded prepayment option. To disregard the effects of
embedded derivatives related to the same risk class could result in a
designated hedge that is not effective at achieving offsetting changes in
fair value attributable to the risk being hedged.
Nonfinancial Assets and Liabilities
416. The Board decided to limit fair value and cash flow
hedge accounting for hedges of nonfinancial assets and liabilities (other
than recognized loan servicing rights and nonfinancial firm commitments
with financial components) to hedges of the risk of changes in the market
price of the entire hedged item in a fair value hedge or the
entire asset to be acquired or sold in a hedged forecasted
transaction, with one exception. The risk of changes in the
functional-currency-equivalent cash flows attributable to changes in
foreign exchange rates may be separately hedged in a cash flow hedge of the
forecasted purchase or sale of a nonfinancial item. The Board decided not
to permit the market price risk of only a principal ingredient or other
component of a nonfinancial hedged item to be designated as the risk being
hedged because changes in the price of an ingredient or component of a
nonfinancial item generally do not have a predictable, separately
measurable effect on the price of the item that is comparable to the effect
of, say, a change in market interest rates on the price of a bond.
417. For example, if an entity wishes to enter into a
cash flow hedge of the variability in cash inflows from selling tires, the
market price risk of rubber alone could not be designated as the risk being
hedged. There is no mechanism in the market for tires to directly relate
the amount or quality of rubber in a tire to the price of the tire.
Similarly, if a derivative is used in a fair value hedge to hedge the
exposure to changes in the fair value of tires held in inventory, the
entity could not designate the market price of rubber as the hedged risk
even though rubber is a component of the tires. The fair value of the tire
inventory is based on the market price of tires, not rubber, even though
the price of rubber may have an effect on the fair value of the tires.
Permitting an entity to designate the market price of rubber as the risk
being hedged would ignore other components of the price of the tires, such
as steel and labor. It also could result in automatic compliance with the
effectiveness test even though the price of rubber may not be highly
correlated with the market price of tires. As discussed in the
effectiveness examples in Section 2 of Appendix A, the use of a
rubber-based derivative as a fair value hedge of the tire inventory or a
cash flow hedge of its sale or purchase may qualify for hedge accounting.
To do so, however, the entire change in the fair value of the derivative
and the entire change in the fair value of the hedged item must be expected
to be highly effective at offsetting each other, and all of the remaining
hedge criteria must be met. Any ineffectiveness must be included currently
in earnings.
418. Some respondents to the Task Force Draft objected to
this Statement's different provisions about risks that may be hedged in
financial versus nonfinancial items. They asserted that an entity also
should be permitted to separate a nonfinancial item into its principal
components for hedge accounting purposes. The Board considers those
differing requirements to be an appropriate consequence of the nature of
the items being hedged.
419. For example, the effect of changes in market
interest rates qualifies for designation as the hedged risk in a financial
item but not in a nonfinancial item. An increase in market interest rates
will result in a decrease in the fair value of a fixed-rate financial asset
because the market rate of interest directly affects the present value
computation of the item's future cash flows. Similarly, an increase in
market interest rates will result in an increase in the cash flows of a
variable-rate financial asset. For both fixed- and variable-rate financial
assets, the effect of a change in market interest rates is not only direct
but also predictable and separately determinable. For instance, holding
factors like credit risk constant, it is relatively easy to calculate the
effect of a 100-basis-point increase in market interest rates on the market
price of a fixed-rate bond with a specified interest rate and specified
time to maturity. It is even easier to determine the effect of a
100-basis-point increase in interest rates on the cash flows stemming from
a variable-rate bond. In contrast, although an increase of 100 basis
points in market interest rates may affect the market price of a
residential building, techniques do not currently exist to isolate and
predict that effect.
420. The effect of changes in interest rates on the
market price of residential real estate is much less direct than the effect
of interest rate changes on financial items. Interest rates may indirectly
affect the market price of a single-family house because of the effect of a
change in market interest rates on consumer buying behavior or rental
rates. For example, an increase in market interest rates may lead to
decreased consumer demand for real estate mortgage loans and, in turn, for
real estate purchases. Enticing consumers to purchase real estate in a
higher interest-rate environment may necessitate lower prices. However, a
myriad of other factors may affect the price of residential real estate,
and any effect of interest rates is not predictable, immediate, or subject
to isolation.
421. Unlike a change in market interest rates, it may be
possible to isolate the effect of a change in foreign exchange rates on the
functional currency cash flows stemming from a nonfinancial item. For
example, an entity with a U.S. dollar functional currency owns residential
real estate located in France with a market price of FF5,000,000. If the
price of residential real estate in France and the U.S. dollar-French franc
exchange rate are not correlated, an increase of $0.01 in the value of the
franc will increase the U.S. dollar equivalent of the sales price of the
real estate by $50,000 (FF5,000,000 x 0.01). This Statement thus permits
the effect of changes in foreign exchange rates to be designated as the
hedged risk in a cash flow hedge of a forecasted transaction involving a
nonfinancial item.
Simultaneous Hedges of Fair Value and Cash Flow Exposures
422. The Exposure Draft would have prohibited the
simultaneous designation of an asset or liability as a fair value hedged
item and that asset's or liability's cash flows as a hedged forecasted
transaction. The Board had previously concluded that, in certain
circumstances, if an entity were permitted to apply hedge accounting at the
same time for hedges of both the fair value and the cash flow variability
of a single item, the results would be questionable because the entity may
be hedging some (if not all) of the same cash flows twice. For example,
simultaneous hedging of both the fair value of 1,000 barrels of existing
crude oil inventory in a fair value hedge and the forecasted sale of
refined oil from those 1,000 barrels of oil in a cash flow hedge would
change the nature of the entity's exposure to oil price movements. The two
hedges would take the entity from a net long position to a net short
position; together they would not necessarily neutralize risk.
423. The Board decided to remove the restriction on
simultaneous fair value and cash flow hedges. That change was made, in
part, because of the change to base both the assessment of hedge
effectiveness and hedge accounting on the change in fair value or cash
flows attributable to the risk being hedged. The Board believes this
Statement can accommodate simultaneous fair value and cash flow hedging in
certain situations if different risk exposures are being hedged because
hedge accounting in this Statement accounts for each risk exposure
separately. For example, an entity might designate both a cash flow hedge
of the interest rate risk associated with a variable-rate financial asset
and a fair value hedge of the credit risk on that asset.
424. Removing the restriction on simultaneous fair value
and cash flow hedges is not, however, intended to permit simultaneous
hedges of the same risk, such as credit risk or market price risk, with
both a fair value hedge and a cash flow hedge. For example, the Board does
not consider the simultaneous hedge of the fair value of crude oil and the
cash flows from selling a product made from that oil described in
paragraph 422 to be consistent with the
requirements of this
Statement because the crude oil and the refined product do not present
separate earnings exposures. The entity cannot sell both the crude oil
and a refined product made from the same oil-it can only do one or the
other. Regardless of how it intends to use the crude oil, the entity can
choose to hedge its exposure to changes in the price of a specific amount
of crude oil as either a fair value exposure or a cash flow exposure, but
not as both.
425. Some respondents to the Exposure Draft opposed the
prohibition on simultaneous hedges because it would preclude swapping
foreign-currency-denominated variable-rate debt to U.S. dollar fixed-rate
debt. That strategy was not eligible for hedge accounting under the
Exposure Draft because the variable interest rate exposure is a cash flow
exposure and the foreign currency exposure was deemed to be a fair value
exposure. Even though this Statement no longer includes a restriction on
simultaneous hedges, the foreign currency aspect of that strategy is not
hedgeable under this Statement because the debt will be remeasured into the
entity's functional currency under Statement 52, with the related
transaction gain or loss reported in earnings. An entity might, however,
be able to achieve income statement results similar to hedge accounting
using separate interest rate and foreign currency derivatives and
designating only the interest rate derivative as a hedging instrument.
Income statement offset would be achieved for the foreign currency aspect
because the change in fair value of the undesignated foreign currency
derivatives will flow through earnings along with the remeasurement of the
debt into the functional currency.
Prohibition against Hedge Accounting for Hedges of Interest Rate
Risk of Debt Securities Classified as Held-to-Maturity
426. This Statement prohibits hedge accounting for a fair
value or cash flow hedge of the interest rate risk associated with a debt
security classified as held-to-maturity pursuant to Statement 115. During
the deliberations that preceded issuance of Statement 115, the Board
considered whether such a debt security could be designated as being hedged
for hedge accounting purposes. Although the Board's view at that time was
that hedging debt securities classified as held-to-maturity is inconsistent
with the basis for that classification, Statement 115 did not restrict
hedge accounting of those securities because constituents argued that the
appropriateness of such restrictions should be considered in the Board's
project on hedging.
427. The Exposure Draft proposed prohibiting a
held-to-maturity debt security from being designated as a hedged item,
regardless of the risk being hedged. The Exposure Draft explained the
Board's belief that designating a derivative as a hedge of the changes in
fair value, or variations in cash flow, of a debt security that is
classified as held-to-maturity contradicts the notion of that
classification. Respondents to the Exposure Draft objected to the proposed
exclusion, asserting the following: (a) hedging a held-to-maturity
security does not conflict with an asserted intent to hold that security to
maturity, (b) a held-to-maturity security contributes to interest rate risk
if it is funded with shorter term liabilities, and (c) prohibiting hedge
accounting for a hedge of a held-to-maturity security is inconsistent with
permitting hedge accounting for other fixed-rate assets and liabilities
that are being held to maturity.
428. The Board continues to believe that providing hedge
accounting for a held-to- maturity security conflicts with the notion
underlying the held-to-maturity classification in Statement 115 if the risk
being hedged is the risk of changes in the fair value of the entire hedged
item or is otherwise related to interest rate risk. The Board believes an
entity's decision to classify a security as held-to-maturity implies that
future decisions about continuing to hold that security will not be
affected by changes in market interest rates. The decision to classify a
security as held-to-maturity is consistent with the view that a change in
fair value or cash flow stemming from a change in market interest rates is
not relevant for that security. In addition, fair value hedge accounting
effectively alters the traditional income recognition pattern for that debt
security by accelerating gains and losses on the security during the term
of the hedge into earnings, with subsequent amortization of the related
premium or discount over the period until maturity. That accounting
changes the measurement attribute of the security away from amortized
historical cost. The Board also notes that the rollover of a shorter term
liability that funds a held-to-maturity security may be eligible for hedge
accounting. The Board therefore decided to prohibit both a fixed-rate
held-to- maturity debt security from being designated as a hedged item in a
fair value hedge and the variable interest receipts on a variable-rate
held-to-maturity security from being designated as hedged forecasted
transactions in a cash flow hedge if the risk being hedged includes changes
in market interest rates.
429. The Board does not consider it inconsistent to
prohibit hedge accounting for a hedge of market interest rate risk in a
held-to-maturity debt security while permitting it for hedges of other
items that an entity may be holding to maturity. Only held-to-maturity debt
securities receive special accounting (that is, being measured at amortized
cost when they otherwise would be required to be measured at fair value) as
a result of an asserted intent to hold them to maturity.
430. The Board modified the Exposure Draft to permit
hedge accounting for hedges of credit risk on held-to-maturity debt
securities. It decided that hedging the credit risk of a held-to-maturity
debt security is not inconsistent with Statement 115 because that Statement
allows a sale or transfer of a held-to-maturity debt security in response
to a significant deterioration in credit quality.
431. Some respondents to the Task Force Draft said that a
hedge of the prepayment risk in a held-to-maturity debt security should be
permitted because it does not contradict the entity's stated intention to
hold the instrument to maturity. The Board agreed that in designating a
security as held-to-maturity, an entity declares its intention not to
voluntarily sell the security as a result of changes in market interest
rates, and "selling" a security in response to the exercise of a call
option is not a voluntary sale. Accordingly, the Board decided to permit
designating the embedded written prepayment option in a held-to-maturity
security as the hedged item. Although prepayment risk is a subcomponent of
market interest rate risk, the Board notes that prepayments, especially of
mortgages, occur for reasons other than changes in interest rates. The
Board therefore does not consider it inconsistent to permit hedging of
prepayment risk but not interest rate risk in a held-to-maturity security.
Additional Qualifying Criteria for Fair Value Hedges
Specific Identification
432. This Statement requires specific identification of
the hedged item. The hedged item must be (a) an entire recognized asset or
liability, or an unrecognized firm commitment, (b) a portfolio of similar
assets or similar liabilities, or (c) a specific portion of a recognized
asset or liability, unrecognized firm commitment, or portfolio of similar
items. If an entity hedges a specified portion of a portfolio of similar
assets or similar liabilities, that portion should relate to every item in
the portfolio. If an entity wishes to hedge only certain similar items in
a portfolio, it should first identify a smaller portfolio of only the items
to be hedged.
433. The Exposure Draft would not have permitted
designation of a portion of an asset or a liability as a hedged item.
Under the Exposure Draft, those items could only have been hedged in their
entirety or on a percentage basis. Some respondents to the Exposure Draft
objected to that limitation because it precluded identification of only
selected contractual cash flows as the item being hedged (referred to as
partial-term hedging for a debt security). For example, it would have
prohibited identification of the interest payments for the first two years
of a four-year fixed-rate debt instrument as the hedged item and,
therefore, would have precluded hedge accounting for a hedge of that debt
with a two-year interest rate swap.
434. The Board was reluctant to permit identification of
a selected portion (rather than proportion) of an asset or liability as the
hedged item because it believes that, in many cases, partial-term hedge
transactions would fail to meet the offset requirement. For example, the
changes in the fair value of a two-year interest rate swap cannot be
expected to offset the changes in fair value attributable to changes in
market interest rates of a four-year fixed-rate debt instrument. For
offset to be expected, a principal repayment on the debt (equal to the
notional amount on the swap) would need to be expected at the end of year
two. The Board decided to remove the prohibition against partial-term
hedging and other designations of a portion of an asset or liability to be
consistent with the modification to the Exposure Draft to require an entity
to define how the expectation of offsetting changes in fair value or cash
flows would be assessed. However, removal of that criterion does not
necessarily result in qualification for hedge accounting for partial-term
or other hedges of part of an asset or a liability.
435. The criterion in paragraph 21(a)
that permits a hedged item in a fair value hedge to be a designated portion
of an asset or liability (or a portfolio of similar assets or similar
liabilities) makes the following eligible for designation as a hedged item:
a. A percentage of the entire asset or liability (or of the entire
portfolio)
b. One or more selected contractual cash flows (such as the asset or
liability representing the interest payments in the first two years of
a four-year debt instrument) \32/
c. A put option, a call option, an interest rate cap, or an interest rate
floor embedded in an existing asset or liability that is not an
embedded derivative accounted for separately under this Statement
d. The residual value in a lessor's net investment in a direct-financing
or sales-type lease.
If the entire asset or liability is a variable-rate instrument, the hedged
item cannot be a fixed-to-variable interest rate swap (or similar
instrument) perceived to be embedded in a fixed-rate host contract. The
Board does not intend for an entity to be able to use the provision that a
hedged item may be a portion of an asset or liability to justify hedging a
contractual provision that creates variability in future cash flows as a
fair value hedge rather than as a cash flow hedge. In addition, all other
criteria, including the criterion that requires a hedge to be expected to
be highly effective at achieving offset, must still be met for items such
as the above to be designated and to qualify for hedge accounting.
==========================================================================
\32/ However, as noted in paragraph 434, it will
likely
be difficult to find a derivative that will be effective as a fair
value hedge of selected cash flows.
==========================================================================
436. As discussed in paragraphs 414
and 415, in designating a hedge of a component
of an
asset or liability, an entity must consider the effect of any derivatives
embedded in that asset or liability related to the same risk class. To
disregard the effects of an embedded derivative related to the same risk
class could result in a designated hedge that is not effective at achieving
offsetting changes in fair value or cash flows. The same unacceptable
result would occur if a freestanding derivative that was accounted for as
hedging a particular item was ignored in considering whether another
derivative would qualify as a hedge of the same risk in that item.
Recognized Asset or Liability or Unrecognized Firm Commitment
437. This Statement requires that the item designated as
hedged in a fair value hedge be a recognized asset or liability or an
unrecognized firm commitment. The Board decided that an unrecognized asset
or liability that does not embody a firm commitment should not be eligible
for designation as a hedged item because applying fair value hedge
accounting to such an unrecognized asset or liability would result in
recognizing a portion of it. For example, fair value hedge accounting for
an unrecognized intangible asset, such as an internally generated core
deposit intangible, would have the effect of recognizing the change in the
present value of the intangible asset. The Board believes a change to
require or permit recognition of certain intangible assets or potential
liabilities that are not now recognized should be made only after careful
consideration of the related conceptual and practical issues rather than
being a by-product of hedge accounting.
438. This Statement permits an unrecognized firm
commitment, including one that is embodied in an unrecognized asset or
liability such as an operating lease with substantial cancellation
penalties, to be designated as the hedged item in a fair value hedge. The
Board recognizes that permitting certain such firm commitments to be
designated as hedged items may be viewed as inconsistent with not
permitting other unrecognized assets and liabilities to be hedged items.
The Board considered limiting the firm commitments that can be hedged
items, for example, to those for which there is no explicit authoritative
accounting requirement that precludes recognition of the related asset or
liability. However, the Board was unable to identify a specific limitation
that would be both workable and equitable. Moreover, the Board notes that
a firm commitment as defined in this Statement must have a fixed price and
a disincentive for nonperformance sufficiently large to make performance
probable (discussed further in paragraphs 440
and
441), which makes hedging a firm commitment less
problematic than hedging an unrecognized item such as an internally
generated intangible asset. Accordingly, with the limited exceptions
discussed in paragraphs 455 and
456, the Board decided to permit all firm
commitments as defined in
this Statement to qualify as hedged items in fair value hedges.
439. This Statement requires that hedge accounting
adjustments to the carrying amount of hedged assets and liabilities be
subsequently reported in earnings in the same manner as other adjustments
of the carrying amount of the hedged item. For example, gains and losses
on an interest-bearing debt instrument that are attributable to interest
rate risk generally would be amortized over the life of the instrument as a
yield adjustment. For some unrecognized firm commitments, such as a firm
commitment to purchase inventory, the nature of the hedged item will
clearly specify a basis for recognizing hedge accounting adjustments in
income. For others, such as the operating lease discussed in
paragraph 438, there will be no obvious pattern
of income
recognition for hedge accounting adjustments. This Statement requires that
an entity specify as part of its initial hedge designation how hedge
accounting adjustments will be subsequently recognized in income. The
Board believes that such designation at inception of a hedge is consistent
with other provisions in this Statement that prohibit retroactive decisions
after the results of a hedge are known.
Definition of a Firm Commitment
440. Because this Statement provides fair value hedge
accounting for hedges of unrecognized firm commitments, a definition of
firm commitment is necessary. For purposes of this Statement, a
firm commitment is defined as:
An agreement with an unrelated party, binding on both parties and
usually legally enforceable, with the following characteristics:
a. The agreement specifies all significant terms, including the
quantity to be exchanged, the fixed price, and the timing of the
transaction. The fixed price may be expressed as a specified
amount of an entity's functional currency or of a foreign
currency. It also may be expressed as a specified interest rate
or specified effective yield.
b. The agreement includes a disincentive for nonperformance that is
sufficiently large to make performance probable.
That definition is based on the definition of a firm commitment in
Statements 52 and 80.
441. Some respondents to the Exposure Draft focused more
on the "probability" aspect of the definition than on the requirements that
the agreement be binding on both parties and that it specify the
significant terms of the transaction, including the price. For example,
some respondents wanted to treat as a firm commitment for hedge accounting
purposes a group of contracts that are binding on one party but not on the
other. They said that if the entity is a party to a sufficient number of
those contracts, sufficient evidence would be available to permit a
reasonable estimate of the number of transactions that would be consummated
under the agreements. The Board notes that an agreement that is binding on
one party but not on the other is an option rather than a firm commitment.
In developing hedge accounting requirements, the Board believes that the
fundamental nature of a financial instrument should not be ignored.
442. The definition of a firm commitment in this
Statement requires that the fixed price be specified in terms of a currency
(or an interest rate) rather than an index or in terms of the price or a
number of units of an asset other than a currency, such as ounces of gold.
A price that varies with the market price of the item that is the subject
of the firm commitment cannot qualify as a "fixed" price. For example, a
price that is specified in terms of ounces of gold would not be a fixed
price if the market price of the item to be purchased or sold under the
firm commitment varied with the price of gold. To avoid such a situation,
the Board decided that it was necessary to require that the fixed price in
a firm commitment be specified in terms of a currency or a rate. A similar
situation can exist for a firm commitment that is denominated in a foreign
currency if the price of the item to be purchased or sold varies with
changes in exchange rates. The Board accepted that possibility because it
had been accepted under Statement 52, and it did not want to undertake a
complete reconsideration of the hedging provisions of that Statement at
this time. Therefore, the price may be specified in any currency-it need
not be in the entity's functional currency.
Single Asset or Liability or a Portfolio of Similar Assets or Similar Liabilities
443. This Statement retains the provision from the
Exposure Draft that prohibits a portfolio of dissimilar items from being
designated as a hedged item. Many respondents said that hedge accounting
should be extended to hedges of portfolios of dissimilar items (often
called macro hedges) because macro hedging is an effective and
efficient way to manage risk. To qualify for designation as a hedged item
on an aggregate rather than individual basis, the Exposure Draft would have
required that individual items in a portfolio of similar assets or
liabilities be expected to respond to changes in a market variable in an
equivalent way. The Exposure Draft also included a list of specific
characteristics to be considered in determining whether items were
sufficiently similar to qualify for hedging as a portfolio. Respondents
said that, taken together, the list of characteristics and the "equivalent
way" requirement would have meant that individual items could qualify as
"similar" only if they were virtually identical.
444. To deal with the concerns of respondents, the Board
modified the Exposure Draft in two ways. First, the Board deleted the
requirement that the value of all items in a portfolio respond in an
equivalent way to changes in a market variable. Instead, this Statement
requires that the items in a portfolio share the risk exposure for which
they are designated as being hedged and that the fair values of individual
items attributable to the hedged risk be expected to respond
proportionately to the total change in fair value of the hedged portfolio.
The Board intends proportionately to be interpreted strictly, but the term
does not mean identically. For example, a group of assets would
not be considered to respond proportionately to a change in interest rates
if a 100-basis-point increase in interest rates is expected to result in
percentage decreases in the fair values of the individual items ranging
from 7 percent to 13 percent. However, percentage decreases within a range
of 9 percent to 11 percent could be considered proportionate if that change
in interest rates reduced the fair value of the portfolio by 10 percent.
445. The second way in which the Board modified the
Exposure Draft was to delete the requirement to consider all specified risk
characteristics of the items in a portfolio. The Board considered
completely deleting the list of risk characteristics included in the
Exposure Draft, and the Task Force Draft did not include that list.
However, respondents to that draft asked for additional guidance on how to
determine whether individual assets or liabilities qualify as "similar."
In response to those requests, the Board decided to reinstate the list of
characteristics from the Exposure Draft. The Board intends the list to be
only an indication of factors that an entity may find helpful.
446. Those two changes are consistent with other changes
to the Exposure Draft to focus on the risk being hedged and to rely on
management to define how effectiveness will be assessed. It is the
responsibility of management to appropriately assess the similarity of
hedged items and to determine whether the derivative and a group of hedged
items will be highly effective at achieving offset. Those changes to the
Exposure Draft do not, however, permit aggregation of dissimilar items.
Although the Board recognizes that certain entities are increasingly
disposed toward managing specific risks within portfolios of assets and
liabilities, it decided to retain the prohibition of hedge accounting for a
hedge of a portfolio of dissimilar items for the reasons discussed in the
following paragraphs.
447. Hedge accounting adjustments that result from
application of this Statement must be allocated to individual items in a
hedged portfolio to determine the carrying amount of an individual item in
various circumstances, including (a) upon sale or settlement of the item
(to compute the gain or loss), (b) upon discontinuance of a hedging
relationship (to determine the new carrying amount that will be the basis
for subsequent accounting), and (c) when other generally accepted
accounting principles require assessing that item for impairment. The
Board decided that a hedge accounting approach that adjusts the basis of
the hedged item could not accommodate a portfolio of dissimilar items
(macro hedging) because of the difficulties of allocating hedge accounting
adjustments to dissimilar hedged items. It would be difficult, if not
impossible, to allocate derivative gains and losses to a group of items if
their values respond differently (both in direction and in amount) to a
change in the risk being hedged, such as market interest rate risk. For
example, some components of a portfolio of dissimilar items may increase in
value while other components decrease in value as a result of a given price
change. Those allocation difficulties are exacerbated if the items to be
hedged represent different exposures, that is, a fair value risk and a cash
flow risk, because a single exposure to risk must be chosen to provide a
basis on which to allocate a net amount to multiple hedged items.
448. The Board considered alternative approaches that
would require amortizing the hedge accounting adjustments to earnings based
on the average holding period, average maturity or duration of the items in
the hedged portfolio, or in some other manner that would not allocate
adjustments to the individual items in the hedged portfolio. The Board
rejected those approaches because determining the carrying amount for an
individual item when it is (a) impaired or (b) sold, settled, or otherwise
removed from the hedged portfolio would ignore its related hedge accounting
adjustment, if any. Additionally, it was not clear how those approaches
would work for certain portfolios, such as a portfolio of equity
securities.
449. Advocates of macro hedging generally believe that it
is a more effective and efficient way of managing an entity's risk than
hedging on an individual-item basis. Macro hedging seems to imply a notion
of entity-wide risk reduction. The Board also believes that permitting
hedge accounting for a portfolio of dissimilar items would be appropriate
only if risk were required to be assessed on an entity-wide basis. As
discussed in paragraph 357, the Board decided
not to
include entity-wide risk reduction as a criterion for hedge accounting.
450. Although this Statement does not accommodate
designating a portfolio of dissimilar items as a hedged item, the Board
believes that its requirements are consistent with (a) the hedge accounting
guidance that was in Statements 52 and 80, (b) what the Board generally
understands to have been current practice in accounting for hedges not
addressed by those Statements, and (c) what has been required by the SEC
staff. The Board's ultimate goal of requiring that all financial
instruments be measured at fair value when the conceptual and measurement
issues are resolved would better accommodate risk management for those
items on a portfolio basis. Measuring all financial instruments at fair
value with all gains or losses recognized in earnings would, without
accounting complexity, faithfully represent the results of operations of
entities using sophisticated risk management techniques for hedging on a
portfolio basis.
Items the Exposure Draft Prohibited from Designation as Hedged Items in Fair Value
Hedges
451. The Exposure Draft proposed to prohibit the
following from being designated as a hedged item in a fair value hedge:
a. Oil or gas that has not yet been produced, unmined mineral ore, an
agricultural product in process of growing, and similar items
b. An intangible asset
c. An investment accounted for by the equity method
d. Mortgage servicing rights not recognized as assets in accordance with
FASB Statement No. 122, Accounting for
Mortgage
Servicing Rights
e. A lease, as defined in FASB Statement No. 13,
Accounting for Leases
f. A liability for insurance contracts written, as defined and discussed
in FASB Statements No. 60, Accounting and Reporting by
Insurance Enterprises, No. 97, Accounting and Reporting by
Insurance Enterprises for Certain Long-Duration Contracts and for
Realized Gains and Losses from the Sale of Investments, and No.
113, Accounting and Reporting for Reinsurance of Short-Duration
and Long- Duration Contracts, except for a financial guarantee.
The Board proposed those exclusions, in part, because of concerns about the
reliability of available measures of fair values for those items. However,
this Statement focuses on changes in the fair value of a hedged item
attributable to the risk being hedged, rather than the entire change in the
fair value of a hedged item. That shift in focus somewhat mitigated the
Board's concerns about determining changes in fair value for those hedged
items. The Board agrees with respondents to the Exposure Draft that
eligibility for designation as a hedged item should rely on the fair value
hedge criteria. Consequently, the Board decided to remove the prohibitions
proposed in the Exposure Draft, some of which are discussed further in the
following paragraphs. The Board notes, however, that some intangible
assets would fail to qualify for hedge accounting because they are neither
recognized assets nor firm commitments and would not meet the criterion
that requires that the hedged item embody an exposure that could affect
reported earnings.
Oil or Gas That Has Not Been Produced and Similar Items
452. The Board decided to permit designating as a hedged
item in a fair value hedge oil or gas that has not been produced, unmined
mineral ore, agricultural products in process of growing, and similar
items. In reconsidering whether to specifically prohibit such items from
hedge accounting, the Board addressed issues such as (a) whether the costs
capitalized to extract, harvest, or mine those items would qualify as a
"recognized" asset (one of the criteria for a fair value hedge), (b)
whether the amounts recognized for those items bear a close relationship to
their fair values, and (c) whether the offset test could ever be met
because, for example, extracting and otherwise turning unproduced oil or
gas into a salable product would require significant costs. The unproduced
oil or gas thus is a different asset from the product upon which a forward
sales contract would be based. The Board also considered limiting
qualification as a "recognized asset or liability" to those assets and
liabilities whose initial recorded amounts represent their fair value at
acquisition or incurrence.
453. The Board ultimately decided that hedge accounting
qualification for oil or gas that has not been produced, unmined mineral
ore, agricultural products in process of growing, and similar items should
be consistent-that is, all of them should be either eligible or ineligible
for designation as a hedged item. It decided that such items should be
eligible for designation, subject to the other criteria for hedge
accounting. However, the Board has significant reservations about how the
fair value of such items would be determined and how the effectiveness of a
fair value hedge of such items would be assessed. It notes that oil or gas
that has not yet been produced, unmined mineral ore, agricultural products
in the process of growing, and similar items are not final, salable
products. Consequently, a derivative based on a final, salable product has
a different basis than the hedged item and may not be highly effective at
providing offsetting changes in fair value. It would be more likely that
such a derivative would be highly effective at providing offsetting cash
flows for the forecasted sale of a product made from oil in the ground, for
example. Section 2 of Appendix A provides additional discussion and
examples on assessing offset for agricultural products in the process of
growing and similar items.
Leases
454. In developing the Exposure Draft, the Board had
concerns about the consistency of permitting fair value hedge accounting of
a specific risk inherent in a lessor's net investment in a direct
financing, sales-type, or leveraged lease (for example, the interest rate
risk associated with the minimum lease payments but not the unguaranteed
residual value). Under Statement 13, the unguaranteed residual value is
viewed simply as a final payment on which income is earned during the lease
term. The Board ultimately decided to make all recognized assets and
liabilities and unrecognized firm commitments related to leases eligible
for designation as hedged items in fair value hedges because it believes
that the modification to the Exposure Draft to permit designation of a
portion of an item as being hedged would enable a lessor to split out the
residual value from its net investment in identifying the hedged item.
However, an entity may not designate an operating lease that does not
qualify under this Statement's definition of a firm commitment as a hedged
item in a fair value hedge because a hedged item must be either a
recognized asset or liability or a firm commitment as defined in this
Statement.
Investment Accounted for by the Equity Method
455. The Board decided to retain the prohibition in the
Exposure Draft from designating an investment accounted for by the equity
method as a hedged item to avoid conflicts with the existing accounting
requirements for that item. Providing fair value hedge accounting for an
equity method investment conflicts with the notion underlying
APB Opinion No. 18, The Equity Method of
Accounting for
Investments in Common Stock. Opinion 18 requires an investor in common
stock and corporate joint ventures to apply the equity method of accounting
when the investor has the ability to exercise significant influence over
the operating and financial policies of the investee. Under the equity
method of accounting, the investor generally records its share of the
investee's earnings or losses from its investment. It does not account for
changes in the price of the common stock, which would become part of the
basis of an equity method investment under fair value hedge accounting.
Changes in the earnings of an equity method investee presumably would
affect the fair value of its common stock. Applying fair value hedge
accounting to an equity method investment thus could result in some amount
of double counting of the investor's share of the investee's earnings. The
Board believes that result would be inappropriate. In addition to those
conceptual issues, the Board was concerned that it would be difficult to
develop a method of implementing fair value hedge accounting, including
measuring hedge ineffectiveness, for equity method investments and that the
results of any method would be difficult to understand. For similar
reasons, this Statement also prohibits fair value hedge accounting for an
unrecognized firm commitment to acquire or dispose of an investment
accounted for by the equity method.
Other Exclusions
456. For reasons similar to those discussed above, the
Board also decided to specifically prohibit designation of (a) a minority
interest in one or more consolidated subsidiaries and (b) an equity
investment in a consolidated subsidiary as the hedged item in a fair value
hedge. Those assets do not qualify for designation as a hedged item in a
fair value hedge, and a forecasted transaction to acquire or sell them does
not qualify as a hedged transaction in a cash flow hedge. Thus, a firm
commitment to acquire or sell one of them also does not qualify as a hedged
item in a fair value hedge. For the same reason, a firm commitment to
enter into a business combination does not qualify as a hedged item in a
fair value hedge.
457. This Statement also specifically prohibits an equity
instrument classified by an entity in its stockholders' equity in the
statement of financial position from being designated as a hedged item.
That prohibition is consistent with the requirements that (a) a hedged item
be a recognized asset or liability and (b) the hedged item present an
exposure to changes in fair value that could affect reported earnings.
That prohibition does not, of course, apply to the holder of an equity
instrument. paragraph 286 discusses the
application of
this Statement to obligations (or rights) that may be settled in an
entity's own stock but that are indexed to something other than that stock.
Additional Qualifying Criteria for Cash Flow Hedges
Specific Identification
458. To qualify for cash flow hedge accounting, this
Statement requires that an entity specifically identify the forecasted
transaction that gives rise to the cash flow exposure. That information is
necessary to (a) assess the likelihood that the transaction will occur, (b)
determine if the cumulative cash flows of the designated derivative are
expected to be highly effective at offsetting the change in expected cash
flow of the forecasted transaction attributable to the risk being hedged,
and (c) assess the hedge's effectiveness on an ongoing basis. The expected
market price of the transaction, both at inception of the hedge and
subsequently, is necessary information to determine the change in expected
cash flows. Because the circumstances of each entity and transaction are
different, the information needed to assess the expected offset may vary.
Single Transaction or Group of Individual Transactions
459. The Exposure Draft would have required that an
entity be able to predict the date on which a forecasted transaction will
occur for it to qualify for cash flow hedge accounting. The Exposure Draft
also would have required the gain or loss on a derivative that hedges a
forecasted transaction to be reclassified into earnings on the date that
the forecasted transaction was expected to occur. This Statement instead
requires the gain or loss on a hedge of a forecasted transaction to be
reclassified into earnings in the same period(s) that the hedged
transaction affects earnings. That change makes it less important for an
entity to be able to predict the exact date on which a hedged forecasted
transaction will occur. The Board decided to require an entity to identify
the hedged forecasted transaction with sufficient specificity to make it
clear whether a particular transaction is a hedged transaction when it
occurs. An entity should not be able to choose when to reclassify into
earnings a gain or loss on a hedging instrument in accumulated other
comprehensive income after the gain or loss has occurred by asserting that
the instrument hedges a transaction that has or has not yet occurred.
However, the Board does not consider it necessary to require that an entity
be able to specify at the time of entering into a hedge the date on which
the hedged forecasted transaction will occur to prevent such after-the-fact
designation.
460. The following example illustrates the requirement
for specific identification of the hedged transaction. Company A
determines with a high degree of probability that it will issue $5,000,000
of fixed-rate bonds with a 5-year maturity sometime during the next 6
months, but it cannot predict exactly when the debt issuance will occur.
That situation might occur, for example, if the funds from the debt
issuance are needed to finance a major project to which Company A is
already committed but the precise timing of which has not yet been
determined. To qualify for cash flow hedge accounting, Company A might
identify the hedged forecasted transaction as, for example, the first
issuance of five-year, fixed-rate bonds that occurs during the next six
months.
461. The Board understands that it sometimes will be
impractical (perhaps impossible) and not cost-effective for an entity to
identify each individual transaction that is being hedged. An example is a
group of sales or purchases over a period of time to or from one or more
parties. The Board decided that an entity should be permitted to aggregate
individual forecasted transactions for hedging purposes in some
circumstances. As for a hedge of a single forecasted transaction, an
entity must identify the hedged transactions with sufficient specificity
that it is possible to determine which transactions are hedged transactions
when they occur. For example, an entity that expects to sell at least
300,000 units of a particular product in its next fiscal quarter might
designate the sales of the first 300,000 units as the hedged transactions.
Alternatively, it might designate the first 100,000 sales in each month as
the hedged transactions. It could not, however, simply designate any sales
of 300,000 units during the quarter as the hedged transaction because it
then would be impossible to determine whether the first sales transaction
of the quarter was a hedged transaction. Similarly, an entity could not
designate the last 300,000 sales of the quarter as the hedged transaction
because it would not be possible to determine whether sales early in the
quarter were hedged or not.
462. To qualify for hedging as a group rather than
individually, the aggregated transactions must share the risk exposure for
which they are being hedged. If a forecasted transaction does not share
the risk exposure for which the group of items is being hedged, it should
not be part of the group being hedged. The Board considers that
requirement to be necessary to ensure that a single derivative will be
effective as a hedge of the aggregated transactions. To illustrate, under
the guidance in this Statement, a single derivative of appropriate size
could be designated as hedging a given amount of aggregated forecasted
transactions such as the following:
a. Forecasted sales of a particular product to numerous customers within
a specified time period, such as a month, a quarter, or a year
b. Forecasted purchases of a particular product from the same or
different vendors at different dates within a specified time period
c. Forecasted interest payments on several variable-rate debt instruments
within a specified time period.
However, the transactions in each group must share the risk exposure for
which they are being hedged. For example, the interest payments in group
(c) above must vary with the same index to qualify for hedging with a
single derivative. In addition, a forecasted purchase and a forecasted
sale cannot both be included in the same group of individual transactions.
Although they may be based on the same underlying, they have opposite
exposures.
Probability of a Forecasted Transaction
463. The Board concluded that, similar to Statement 80,
changes in the fair value of a derivative should be excluded from current
earnings only if the related forecasted transaction is probable. An
assessment of the likelihood that a forecasted transaction will take place
should not be based solely on management's intent because intent is not
verifiable. The transaction's probability should be supported by
observable facts and the attendant circumstances. Consideration should be
given to the following circumstances in assessing the likelihood that a
transaction will occur.
a. The frequency of similar past transactions
b. The financial and operational ability of the entity to carry out the
transaction
c. Substantial commitments of resources to a particular activity (for
example, a manufacturing facility that can be used in the short run
only to process a particular type of commodity)
d. The extent of loss or disruption of operations that could result if
the transaction does not occur
e. The likelihood that transactions with substantially different
characteristics might be used to achieve the same business purpose
(for example, an entity that intends to raise cash may have several
ways of doing so, ranging from a short-term bank loan to a common
stock offering).
464. The term probable is used in this
Statement consistent with its use in paragraph 3
of
FASB Statement No. 5, Accounting for
Contingencies,
which defines probable as an area within a range of the likelihood that a
future event or events will occur confirming the fact of the loss. That
range is from probable to remote, as follows:
Probable. The future event or events are likely to occur.
Reasonably possible. The chance of the future event or
events occurring is more than remote but less than likely.
Remote. The chance of the future event or events occurring
is slight.
The term probable requires a significantly greater likelihood of
occurrence than the phrase more likely than not.
465. In addition, the Board believes that both the length
of time until a forecasted transaction is projected to occur and the
quantity of the forecasted transaction are considerations in determining
probability. Other factors being equal, the more distant a forecasted
transaction is, the less likely it is that the transaction would be
considered probable and the stronger the evidence that would be needed to
support an assertion that it is probable. For example, a transaction
forecasted to occur in five years may be less likely than a transaction
forecasted to occur in one year. However, forecasted interest payments for
the next 20 years on variable-rate debt typically would be probable if
supported by an existing contract. Additionally, other factors being equal,
the greater the physical quantity or future value of a forecasted
transaction, the less likely it is that the transaction would be considered
probable and the stronger the evidence that would be required to support an
assertion that it is probable. For example, less evidence generally would
be needed to support forecasted sales of 100,000 units in a particular
month than would be needed to support forecasted sales of 950,000 units in
that month by an entity, even if its sales have averaged 950,000 units per
month for the past 3 months.
Contractual Maturity
466. When an entity enters into a hedge that uses a
derivative with a maturity that extends approximately to the date the
forecasted transaction is expected to occur, the derivative "locks in" a
price or rate for the entire term of the hedge, provided that the hedging
instrument is held to its maturity. Consistent with that view, the
Exposure Draft proposed that, to qualify for hedge accounting, the
contractual maturity or repricing date of the derivative must be on or
about the same date as the projected date of the hedged forecasted
transaction.
467. Respondents to the Exposure Draft objected to that
requirement because it would have precluded rollover strategies and hedges
of a portion of the term of a forecasted transaction from qualifying for
hedge accounting. A rollover strategy involves establishing over time a
series of short-term futures, options, or both in consecutive contract
months to hedge a forecasted transaction. In a rollover strategy, the
complete series of derivatives is not acquired at the inception of the
hedge; rather, short-term derivatives are initially acquired as part of a
plan to replace maturing derivatives with successive new short-term hedging
derivatives. The Exposure Draft explained the Board's belief that, even
though an entity may ultimately achieve the same or similar result with a
series of short-term contracts, a single short-term derivative by itself
does not lock in a price or rate for the period until the forecasted
transaction is expected to occur.
468. The Board decided to remove the maturity criterion
and thus to permit hedge accounting for rollover strategies. Respondents
asserted that those strategies are a common, cost-effective, risk
management practice that may achieve results similar to the results of
using a single long-term derivative as the hedging instrument. Although the
Board notes that a rollover strategy or other hedge using a derivative that
does not extend to the transaction date does not necessarily "fix" the
price of a forecasted transaction, it decided to accede to respondents'
requests to permit hedge accounting for rollover strategies. The Board
also decided that removing the maturity criterion was acceptable because it
makes the qualifying requirements for fair value and cash flow hedge
accounting more consistent. Prohibiting hedges of a portion of a
forecasted transaction term from qualifying for cash flow hedge accounting
would have been inconsistent with permitting fair value hedge accounting
for hedges of a portion of the life of a hedged asset or liability.
Transaction with External Third Party
469. The Exposure Draft proposed that, to qualify for
hedge accounting, a hedged forecasted exposure must be a
transaction, which Concepts Statement 6
defines as
an external event involving transfer of something of value (future economic
benefit) between two (or more) entities. That definition was intended to
clearly distinguish a transaction from an internal cost allocation or an
event that happens within an entity. The Exposure Draft explained that the
Board considers hedge accounting to be appropriate only when there is a
hedgeable risk arising from a transaction with an external party.
Accounting allocations and intercompany transactions, in and of themselves,
do not give rise to economic exposure.
470. A number of respondents to the Exposure Draft
objected to the requirement that a hedgeable transaction be with an
external party because it prohibited an intercompany transaction, including
one denominated in a foreign currency, from being designated as a
forecasted transaction and afforded hedge accounting.
471. Although the requirements of this Statement are not
described in terms of the Concepts Statement 6
definition of a
transaction, the requirements for hedges of other than foreign currency
risk are the same as in the Exposure Draft. As discussed in
paragraphs 482-487, the Board decided to
accommodate cash flow
hedges of the foreign currency risk in forecasted intercompany foreign
currency transactions. However, for other than foreign currency hedges,
this Statement requires that a forecasted transaction be with a party
external to the reporting entity to qualify as a hedged transaction, which
is consistent with the Exposure Draft. Therefore, depreciation expense,
cost of sales, and similar internal accounting allocations do not qualify
as hedgeable forecasted transactions. Forecasted transactions between
members of a consolidated entity, except for intercompany transactions
denominated in a foreign currency, are not hedgeable transactions except
for purposes of separate stand-alone subsidiary financial statements. Thus,
a consolidated entity cannot apply hedge accounting to forecasted
intercompany transactions, unless the risk being hedged is a foreign
currency exposure. A subsidiary could, however, apply hedge accounting to
a hedge of a forecasted intercompany transaction in its separate,
stand-alone financial statements because those transactions are with a
party "external to" the reporting entity in those stand-alone statements.
Forecasted Transactions Prohibited from Designation as the Hedged Item in a
Cash Flow Hedge
472. This Statement prohibits cash flow hedge accounting
for forecasted transactions involving (a) an entity's interests in
consolidated subsidiaries, (b) minority interests in consolidated
subsidiaries, (c) investments accounted for by the equity method, or (d) an
entity's own equity instruments classified in stockholders' equity. The
reasons for those prohibitions are similar to those for prohibiting the
same items from being hedged items in fair value hedges, as discussed in
paragraphs 455-457. In addition, the Board noted
that
implementing cash flow hedge accounting for those items could present
significant practical and conceptual problems, such as determining when to
transfer to earnings amounts accumulated in other comprehensive income.
Finally, certain of those items, such as issuances and repurchases of an
entity's own equity instruments, would not qualify for hedge accounting
because they do not present a cash flow risk that could affect earnings.
473. Prohibiting the forecasted purchase of a
consolidated subsidiary from being the hedged item in a cash flow hedge
effectively prohibits cash flow hedge accounting for a forecasted business
combination to be accounted for as a purchase, and
paragraph 29(f) of this Statement makes that
prohibition explicit.
The Board noted that the current accounting for a business combination is
based on considering the combination as a discrete event at the
consummation date. Applying cash flow hedge accounting to a forecasted
business combination would be inconsistent with that current accounting.
It also would be, at best, difficult to determine when to reclassify the
gain or loss on the hedging derivative to earnings.
Foreign Currency Hedges
474. The Board's objectives in providing hedge accounting
for hedges of foreign currency exposures are the following:
a. To continue to permit hedge accounting for the types of hedged items
and hedging instruments that were permitted hedge accounting under
Statement 52
b. To increase the consistency of hedge accounting guidance for foreign
currency hedges and other types of hedges by broadening the scope of
foreign currency hedges that are eligible for hedge accounting, as
necessary.
Carried Forward from Statement 52
475. Because the scope of this project did not include a
comprehensive reconsideration of accounting for foreign currency
translation, this Statement makes two exceptions to retain certain
provisions of Statement 52. The Board decided to make those exceptions to
the hedge accounting requirements in this Statement because of the
accounting anomalies that otherwise would be created by this Statement and
the existing guidance in Statement 52.
476. Although the Board decided not to extend hedge
accounting to nonderivative instruments used as hedging instruments, as
discussed in paragraphs 246 and
247, it decided to permit an entity to designate
a nonderivative
financial instrument denominated in a foreign currency as a hedge of a firm
commitment. It did so for practical reasons. The Board understands that
such hedges are extensively used in practice, and it does not think
constituents would understand why that practice should be prohibited now,
given the acceptance of it in Statement 52.
477. This Statement also makes an exception to permit an
entity to designate a financial instrument denominated in a foreign
currency (derivative or nonderivative) as a hedge of the foreign currency
exposure of a net investment in a foreign operation. Net investment hedges
are subject only to the criteria in paragraph 20
of
Statement 52. The net investment in a foreign operation can be viewed as a
portfolio of dissimilar assets and liabilities that would not meet the
criterion in this Statement that the hedged item be a single item or a
group of similar items. Alternatively, it can be viewed as part of the fair
value of the parent's investment account. Under either view, without a
specific exception, the net investment in a foreign operation would not
qualify for hedging under this Statement. The Board decided, however, that
it was acceptable to retain the current provisions of Statement 52 in that
area. The Board also notes that, unlike other hedges of portfolios of
dissimilar items, hedge accounting for the net investment in a foreign
operation has been explicitly permitted by the authoritative literature.
478. The Exposure Draft would have retained the approach
required by paragraph 20 of Statement 52 for
measuring
the effective portion of a foreign currency forward contract that is
designated as a hedge of the net investment in a foreign operation. The
resulting difference between the effective portion and the change in fair
value of the hedging derivative would have been reported currently in
earnings. The approach in Statement 52 was appropriate given how forward
contracts were measured under that Statement. Unlike Statement 52, this
Statement requires that forward contracts be measured at fair value, which
incorporates discounting future cash flows. Accordingly, the Exposure
Draft's requirements would have always produced an amount to be recognized
in earnings that would have been of opposite sign to the effective portion
recognized in the cumulative translation adjustment component of other
comprehensive income. That amount could have been explained only in terms
of the arithmetic process that produced it. The Board therefore decided
that the effective portion of a forward contract that is a hedge of a net
investment should be determined not by looking only to changes in spot
rates but should include the effects of discounting in the same way as for
forward contracts used in other foreign currency hedges.
Fair Value Hedges of Foreign Currency Risk in Available-for-Sale Securities
479. This Statement permits the portion of the change in
value of foreign- currency-denominated debt securities and certain foreign
marketable equity securities classified as available-for-sale that is
attributable to foreign exchange risk to qualify for fair value hedge
accounting. The requirements of this Statement in that area are generally
consistent with the provisions of EITF Issues No. 96-15, "Accounting for
the Effects of Changes in Foreign Currency Exchange Rates on Foreign-
Currency-Denominated Available-for-Sale Debt Securities," and No. 97-7,
"Accounting for Hedges of the Foreign Currency Risk Inherent in an
Available-for-Sale Marketable Equity Security." However, unlike those EITF
Issues, this Statement does not permit a nonderivative instrument to be
used as the hedging instrument in a hedge of an available-for-sale
security.
480. Foreign available-for-sale debt securities give rise
to hedgeable foreign exchange risk because they embody cash flows
denominated in a foreign currency. The cash flows embodied in an
investment in a marketable equity security, on the other hand, are not
inherently "denominated" in a particular currency. Therefore, both the
EITF and the Board concluded that a marketable equity security has
hedgeable foreign exchange risk only if both of the following criteria are
met:
a. The marketable equity security (or an instrument that represents an
interest in it, such as an American Depository Receipt) is not traded
on an exchange (or other established marketplace) on which trades are
denominated in the investor's functional currency.
b. The dividends or other cash flows to be received by the investor are
all denominated in the same foreign currency as the currency expected
to be received upon sale of the security.
Regardless of the country in which the issuer of an equity security is
domiciled, that security presents no discernible foreign exchange risk to a
holder who may trade the security for a price denominated in its functional
currency. For example, for an investor with a U.S. dollar functional
currency, its foreign exchange risk related to the equity securities of a
multinational company domiciled in Italy that trade on a U.S. exchange is
essentially the same as its foreign exchange risk in the equity securities
of a U.S. company with significant foreign operations in Italy. In both
situations, the investor's foreign exchange risk is indirect and not
reliably measurable. The operations of the issuer rather than the prices
in which trades in its equity securities are denominated are the source of
the investor's foreign exchange risk.
Broadening of Statement 52
481. Unlike Statement 52, this Statement permits hedge
accounting for hedges of forecasted foreign currency transactions,
including intercompany transactions. Because this Statement permits hedge
accounting for hedges of forecasted interest rate, credit, and market price
exposures, the Board considered it appropriate to include foreign currency
exposures as well. Forecasted intercompany foreign currency transactions
are discussed in the following paragraphs.
Forecasted Intercompany Foreign Currency Transactions
482. This Statement permits an entity to designate the
foreign currency exposure of a forecasted foreign-currency-denominated
intercompany transaction as a hedged transaction in a cash flow hedge. The
Exposure Draft proposed that, in general, forecasted transactions between
members of a consolidated group would not qualify as hedgeable exposures in
the consolidated financial statements. However, if costs are incurred in
one currency and the third-party revenues for recovering those costs are
generated in another currency, the Exposure Draft would have permitted the
entity that incurred the costs to designate the forecasted third-party
revenues as a hedged transaction. The Exposure Draft would have required a
direct, substantive relationship between the costs incurred and the
recovery of those costs from the outside third party. For example, the
Exposure Draft would have permitted an English subsidiary that incurs
manufacturing costs in pounds sterling to hedge the ultimate sale of that
product for French francs by its affiliated French subsidiary to an
unrelated third party. The Board proposed that exception because it
considered those transactions to be, in substance, direct foreign export
sales.
483. A number of respondents said that the guidance
provided in the Exposure Draft was unduly restrictive because forecasted
intercompany royalties and licensing fees, which are based on third-party
sales and remitted from foreign subsidiaries to a parent company, would not
be afforded cash flow hedge accounting. Respondents also took exception to
the requirement that there be a "direct, substantive relationship" between
costs incurred and recovery of those costs.
484. The Board decided to remove the restrictions on
hedge accounting for hedges of forecasted intercompany foreign currency
transactions because, pursuant to Statement 52 as amended by this
Statement, an intercompany transaction that is denominated in a currency
other than the entity's functional currency gives rise to a transaction
gain or loss if exchange rates change. A forecasted intercompany
transaction that is expected to be denominated in a foreign currency can be
viewed as giving rise to the same kind of foreign currency risk.
Therefore, pursuant to this Statement, a forecasted intercompany
transaction that presents an exposure to foreign currency risk and that
otherwise satisfies the criteria for a foreign currency cash flow hedge is
eligible for designation as a hedged transaction.
485. As with other hedges of forecasted transactions,
amounts accumulated in other comprehensive income for a forecasted foreign
currency transaction are to be recognized in earnings in the same period or
periods that the hedged transaction affects earnings. Because an
intercompany dividend does not affect earnings, a forecasted intercompany
dividend cannot qualify as a hedgeable forecasted transaction. In essence,
a hedge of a forecasted intercompany dividend expected to be paid from
future earnings is a hedge of those future earnings. This Statement
prohibits hedge accounting for hedges of future earnings.
486. The Board also made an exception for forecasted
intercompany foreign currency transactions because hedging foreign currency
intercompany cash flows with foreign currency options is a common practice
among multinational companies-a practice that was permitted in specified
circumstances under EITF Issue No. 91-1,
"Hedging
Intercompany Foreign Currency Risks." This Statement modifies Issue 91-1
to permit hedge accounting for intercompany transactions using other
derivatives, such as forward contracts, as the hedging instrument and
expands the situations in which hedge accounting may be applied because the
Board believes the accounting for all derivative instruments should be the
same.
487. For a hedge of a forecasted foreign currency
transaction to qualify for hedge accounting, this Statement requires that
the component of the entity that has the foreign currency exposure be a
party to the hedging transaction. That requirement is necessary because,
under the functional currency approach in Statement 52, all foreign
currency exposures exist only in relation to an entity's functional
currency. Thus, for example, a U.S. parent company cannot directly hedge
the foreign currency risk in its French franc subsidiary's
U.S.-dollar-denominated export sales because the U.S. parent has no
exposure to exchange risk for dollar-denominated sales. However, one
component of a consolidated entity, such as a central treasury operation,
can effectively take on another component's exchange risk by means of an
intercompany transaction. For example, the U.S. parent (or a centralized
treasury operation with a U.S. dollar functional currency) might enter into
a forward contract to buy dollars from its French subsidiary in exchange
for francs. The French subsidiary could designate that intercompany
forward contract (in which the French subsidiary sells dollars for francs)
as a hedge of its forecasted U.S.-dollar- denominated sales. The U.S.
parent then would enter into a sell dollars-buy francs forward contract
with an unaffiliated third party to offset its foreign exchange risk on the
intercompany forward contract. That third-party transaction is required
for the previous intercompany arrangement to qualify in the consolidated
financial statements as a hedge of the French subsidiary's forecasted
dollar sales. (As noted in paragraph 471, a
parent
company is a "third party" in a subsidiary's separate financial statements.
Thus, the French subsidiary could designate the intercompany derivative as
a hedge of its U.S. dollar sales in its stand-alone financial statements
regardless of whether the parent has entered into an offsetting contract
with an outside party.)
Discontinuing Hedge Accounting
488. This Statement requires that an entity discontinue
hedge accounting prospectively if the qualifying criteria are no longer
met; if a derivative expires or is sold, terminated, or exercised; or if
the entity removes the designation of the hedge. The Board believes hedge
accounting is no longer appropriate in those circumstances. This Statement
also requires certain modifications to hedge accounting for the interim
reporting period in which a discontinuance occurs in circumstances
discussed below.
Discontinuing Fair Value Hedge Accounting
489. The Board is concerned that a fair value hedge that
no longer qualifies as being highly effective at achieving offsetting
changes in fair value for the risk being hedged may continue to receive
hedge accounting simply because an entity fails to assess compliance with
that effectiveness criterion on a sufficiently frequent basis. If an
entity determines at the end of a period that a hedge is no longer
effective, it is likely that it was also ineffective during a portion of
that period. To minimize the possibility of providing hedge accounting for
hedges that do not qualify as highly effective, the Board decided that fair
value hedge accounting should not be provided from the point at which the
hedge ceased to qualify. It believes that an entity will be able to
determine the point at which a hedge became ineffective if it assesses
compliance with the effectiveness criterion at the inception of the hedge,
on a recurring basis, and whenever something happens that could affect the
hedging relationship. The Board believes that immediate evaluation of the
effect of relevant changes in circumstances on a hedge's qualification for
hedge accounting should be an integral aspect of an ongoing assessment of
compliance.
490. The Board expects that entities entering into
hedging transactions that do not qualify for an assumption of automatic
effectiveness and zero ineffectiveness under the criteria discussed in
Appendix A will monitor hedge effectiveness frequently-often daily.
However, the Board recognizes that it may not be cost-effective for some
entities to assess compliance with the effectiveness criterion on a daily
or weekly basis. It therefore decided that compliance should be assessed
no less frequently than quarterly. However, if the event or change in
circumstances that caused the hedging relationship to cease to qualify
cannot be identified, the entity is prohibited from applying hedge
accounting from the date at which compliance was last assessed and
satisfied. Otherwise, a hedging relationship that does not satisfy the
conditions for fair value hedge accounting might nevertheless receive such
accounting.
491. For hedges of firm commitments, the Board decided
that if hedge accounting is discontinued because the hedged item no longer
meets the definition of a firm commitment, an entity should derecognize any
previously recognized asset or liability and recognize a corresponding loss
or gain in earnings. That accounting is appropriate because the asset or
liability that represented the value of the firm commitment no longer
exists if the hedged transaction no longer qualifies as a firm commitment,
for example, because performance is no longer probable. The Board believes
those circumstances should be rare. A pattern of discontinuing hedge
accounting and derecognizing firm commitments would call into question the
"firmness" of future hedged firm commitments and the entity's accounting
for future hedges of firm commitments.
Discontinuing Cash Flow Hedge Accounting
492. The Exposure Draft proposed that if cash flow hedge
accounting is discontinued, the derivative gain or loss accumulated in
other comprehensive income to the date of discontinuance would be
recognized in earnings on the originally projected date of the hedged
forecasted transaction. That proposed requirement was intended to instill
discipline in the accounting for cash flow hedges and reduce the
possibility for managing of earnings. Respondents to the Exposure Draft
disagreed with that provision as it related to discontinuances that
resulted from a change in probability. They said that gains and losses
previously recognized in other comprehensive income should be reclassified
into earnings on the date it is decided that the forecasted transaction is
no longer considered probable.
493. The Board considers it inappropriate to defer a gain
or loss on a derivative that arises after a hedged forecasted transaction
is deemed no longer probable. However, if the occurrence of the forecasted
transaction is still reasonably possible, the Board considers it
appropriate to continue to include in accumulated other comprehensive
income the gain or loss that arose before the date the forecasted
transaction is deemed no longer probable. The Board also was concerned
that requiring a gain or loss in accumulated other comprehensive income to
be reported in earnings when a forecasted transaction is no longer probable
but still is reasonably possible (paragraph 464
describes the range of probability) would provide an entity with the
opportunity to manage earnings by changing its estimate of probability. For
those reasons, the Board decided to require earnings recognition of a
related gain or loss in accumulated other comprehensive income only when an
entity determines it is probable that the transaction will not occur.
494. A pattern of determining that hedged forecasted
transactions probably will not occur would call into question both an
entity's ability to accurately predict forecasted transactions and the
propriety of using hedge accounting in the future for similar forecasted
transactions.
Interaction with Standards on Impairment
495. A hedged item may be reported at fair value as a
consequence of applying the provisions of this Statement. That would occur
if the carrying amount of the hedged item equaled its fair value at the
inception of a hedge and all changes in the fair value of a hedged item
were recognized as a result of hedge accounting. However, that is not the
same as continuous measurement at fair value. Therefore, accounting for
changes in the fair value of a hedged item attributable to the risk being
hedged does not exempt the hedged item from accounting provisions of other
Statements that apply to assets or liabilities that are not measured at
fair value. For example, a loan that is designated as a hedged item but is
not otherwise measured at fair value or lower of cost or market value is
subject to the impairment provisions of Statement 114.
496. Respondents to the Exposure Draft questioned whether
the carrying amount of a derivative should be considered in assessing
impairment of a related asset or liability, if any. (In this Statement,
the term impairment includes the recognition of an increase in a
liability as well as a decrease in an asset.) The related asset or
liability would be either an existing asset or liability or an asset or
liability that was acquired or incurred as a result of a hedged forecasted
transaction.
497. The Board decided that it would be inappropriate to
consider the carrying amount of a derivative hedging instrument in an
assessment of impairment of a related asset or liability in either a fair
value hedge or a cash flow hedge. To do so would be inconsistent with the
fact that the derivative is a separate asset or liability.
498. This Statement provides that a derivative gain or
loss recognized in accumulated other comprehensive income as a hedge of a
variable cash flow on a forecasted transaction is to be reclassified into
earnings in the same period or periods as the offsetting loss or gain on
the hedged item. For example, a derivative gain that arose from a cash
flow hedge of a purchase of equipment used in operations is to be included
in earnings in the same periods that depreciation on the equipment is
recognized. The net effect on earnings should be the same as if the
derivative gain or loss had been included in the basis of the asset or
liability to which the hedged forecasted transaction relates. To be
consistent with that provision, the Board decided that a derivative gain
that offsets part or all of an impairment loss on a related asset or
liability should be reclassified into earnings in the period that an
impairment loss is recognized. Similarly, a related derivative loss, if
any, in accumulated other comprehensive income should be reclassified into
earnings in the same period that a recovery of a previous impairment loss
is recognized. The Board decided that the reason that a loss or gain on a
hedged asset or liability is recognized in income-for example, whether
through an ordinary depreciation charge or an impairment write-down-should
not affect the reclassification into earnings of a related offsetting gain
or loss in accumulated other comprehensive income.
Current Earnings Recognition of Certain Derivative Losses
499. The Board sees no justification for delaying
recognition in earnings of a derivative loss that the entity does not
expect to recover through revenues related to the hedged transaction.
Accordingly, this Statement prohibits continuing to report a loss in
accumulated other comprehensive income if the entity expects that doing so
would lead to recognizing a net loss on the combined hedging instrument and
the hedged transaction in a future period(s). For example, a loss on a
derivative designated as a hedge of the forecasted purchase of inventory
should be recognized in earnings immediately to the extent that the loss is
not expected to be recovered through future sales of the inventory.
Statements 52 and 80 included the same requirement.
Accounting by Not-for-Profit Organizations and Other Entities That
Do Not Report Earnings
500. This Statement applies to all entities, including
not-for-profit organizations, defined benefit pension plans, and other
entities that do not report earnings as a separate caption in a statement
of financial performance. For example, a not-for-profit entity reports the
total change in net assets during a period, which is analogous to total
comprehensive income for a business enterprise. The Exposure Draft
indicated that cash flow hedge accounting would not be available to an
entity that does not report earnings. A few respondents objected to what
they interpreted as the Exposure Draft's unequal treatment of
not-for-profit and other entities that do not report earnings. They did
not consider it fair to deny those entities access to hedge accounting for
hedges of forecasted transactions.
501. The effect of cash flow hedge accounting is to
report a derivative gain or loss in other comprehensive income-that is,
outside earnings-in the period in which it occurs and then to reclassify
that gain or loss into earnings in a later period. It thus would be
mechanically impossible for an entity that only reports an amount
comparable to total comprehensive income to apply cash flow hedge
accounting. For this Statement to permit a not-for-profit entity, for
example, to apply cash flow hedge accounting, the Board would first have to
define a subcomponent of the total change in net assets during a period
that would be analogous to earnings for a business enterprise. Neither
Concepts Statement 6 nor Statement 117 defines
such a measure
of operating performance for a not-for-profit entity, and an attempt to
define that measure was beyond the scope of the project that led to this
Statement. Accordingly, the Board decided to retain the provision that cash
flow hedge accounting is not available to a not-for-profit or other entity
that does not report earnings as a separate caption in a statement of
financial performance.
Disclosures
502. This Statement supersedes Statements 105 and 119,
both of which provided disclosure guidance for derivatives and financial
instruments. Consistent with its objective of making the guidance on
financial reporting related to derivatives easier to use, the Board decided
that this Statement should provide comprehensive disclosure guidance, as
well as recognition and measurement guidance, for derivatives. This
Statement therefore carries forward from Statement 119 the requirement for
disclosure of a description of the objectives, context, and strategies for
holding or issuing derivatives. The purpose of that disclosure is to "help
investors and creditors understand what an entity is trying to accomplish
with its derivatives" (Statement 119, paragraph 58).
The Board also decided to require additional qualitative disclosures
describing an entity's risk management policy and the items or transactions
and the risks being hedged for each type of hedge. The Board believes the
qualitative disclosures are necessary to assist investors, creditors, and
other users of financial statements in understanding the nature of an
entity's derivative activities and in evaluating the success of those
activities, their importance to the entity, and their effect on the
entity's financial statements. Many respondents to the Exposure Draft
supported the qualitative disclosures.
503. This Statement modifies some of the disclosure
requirements from the Exposure Draft, mostly as a result of changes to the
accounting requirements proposed in the Exposure Draft. Notwithstanding
the modifications, the Board decided to retain many of the disclosure
requirements in the Exposure Draft given the extent of use and complexity
of derivatives and hedging activities and because many users of financial
statements have asked for improved disclosures.
504. A few respondents to the Task Force Draft suggested
that both the qualitative and the quantitative disclosures should
distinguish between derivatives used for risk management based on the type
of risk (for example, interest rate risk, foreign currency risk, or credit
risk) being hedged rather than based on accounting designations (for
example, fair value hedges versus cash flow hedges). Those respondents
said that disclosures organized in that manner, perhaps including even
narrower distinctions such as the type of asset or liability that is
hedged, would better aid the financial statement user in understanding an
entity's success in managing the different types of risk that it
encounters.
505. The Board agreed that disclosures presented in a
manner that distinguishes between the nature of the risk being hedged would
provide useful information that would help users understand management's
risk management strategies. However, the Board decided not to require that
disclosures about derivative instruments be organized in the manner
suggested by those respondents. The Board made that decision somewhat
reluctantly, based primarily on its concern that it could not require such
disclosures without additional study and that such a requirement would
necessitate a greater level of detail than the disclosures required by this
Statement. Distinguishing between derivatives based on their accounting
designation, as this Statement requires, helps users understand the
information provided in the financial statements. Information about
derivatives used in fair value hedges, cash flow hedges, hedges of the net
investment in a foreign operation, and for other purposes likely would be
needed even if the disclosures distinguished between derivatives based on
the type of risk being hedged. The result could be a rather complicated
multilevel set of disclosures. The Board also notes that this Statement
requires disclosures about the risks that management hedges with
derivatives as part of the description of the "context needed" to
understand the entity's objectives for holding or issuing those
instruments. The Board encourages companies to experiment with ways in
which disclosures about derivative instruments, including how the gains and
losses on them relate to other exposures of the entity, might be presented
to make them more understandable and useful.
506. In response to comments about the volume of the
proposed disclosure requirements in both the Exposure Draft and the Task
Force Draft, the Board reconsidered the costs and benefits of the proposed
disclosures. In reconsidering the proposed disclosures, the Board
concluded that by eliminating certain of the requirements, it could reduce
the cost of applying the Statement without a significant reduction in the
benefits to users. Consequently, the following proposed disclosures were
eliminated:
a. Amount of gains and losses on hedged items and on related derivatives
recognized in earnings for fair value hedges
b. Description of where in the financial statements hedged items and the
gains and losses on those hedged items are reported
c. Cumulative net unamortized amount of gains and losses included in the
carrying amount of hedged items
d. Separate amounts for the reporting period of hedging gains and hedging
losses on derivatives not recognized in earnings for cash flow hedges
e. Description of where derivatives related to cash flow hedges are
reported in the statement of financial position
f. Separate amounts for the reporting period of gains and losses on the
cash flow hedging instrument
g. Amount of gains and losses recognized during the period on derivatives
not designated as hedges
h. Beginning and ending balances in accumulated other comprehensive
income for accumulated derivative gains and losses, and the related
current period changes, separately for the following two categories:
(1) gains and losses related to forecasted transactions for which the
variability of hedged future cash flows has ceased and (2) gains and
losses related to forecasted transactions for which that variability
has not ceased
i. Description of where gains and losses on derivatives not designated as
hedges are reported in the statement of income or other statement of
financial performance.
In addition, the Board replaced some of the remaining proposed disclosures
requiring separate amounts of gains and losses with disclosures requiring
the amount of net gain or loss.
507. The Board also modified the disclosure requirements
as a result of changes to the accounting for fair value and cash flow
hedges. Those modifications include:
Modification to Hedge Accounting Resulting Modification
to Disclosure
a. Require an entity to determine how to Add a requirement to disclose the
net
assess hedge effectiveness and to report amount of hedge ineffectiveness
recognized
all hedge ineffectiveness in earnings. in earnings and the component of the
derivative's gain or loss excluded from the
assessment of hedge effectiveness and
included directly in earnings.
b. Require gains and losses included in Replace proposed disclosure of
designated
accumulated other comprehensive reporting periods in which forecasted
income to be reclassified into earnings transactions are expected to occur
and the
when the forecasted transactions affects amounts to be reclassified into
earnings in
earnings. those periods with a description of the
transactions or other events that will result
in reclassification into earnings of gains and
losses that are reported in accumulated
other comprehensive income and the net
amount of existing gains or losses at the
reporting date that is expected to be
reclassified into earnings within the next 12
months.
c. Require gain or loss included in Require disclosure of gross gains and
losses
accumulated other comprehensive reclassified into earnings as a result of
the
income to be reclassified into earnings discontinuance of cash flow hedges
because
when it is probable that a hedged it is probable that the forecasted
forecasted transaction will not occur. transaction will not occur.
508. Certain respondents were concerned that some of the
cash flow hedge disclosures would reveal proprietary information that could
be used by competitors and market participants, putting the disclosing
entity at a competitive disadvantage. The Board carefully considered those
concerns and decided that the ability of traders and competitors to use the
cash flow hedge disclosures to determine an entity's competitively
sensitive positions would be significantly limited by an entity's ability
to designate and dedesignate derivative instruments as cash flow hedges
during the reporting period, the aggregate nature of the cash flow hedging
disclosures, and the timing and frequency of those disclosures.
Notwithstanding that conclusion, the Board notes that the following
modifications to the disclosures proposed in the Exposure Draft and the
Task Force Draft are directly responsive to the competitive harm concerns
raised by some respondents:
a. Elimination of the proposed disclosure of the separate amounts for the
reporting period of hedging gains and hedging losses on the
derivatives not recognized in earnings
b. Replacement of the proposed disclosure of the designated reporting
periods in which the forecasted transactions are expected to occur and
the amounts of gains and losses to be reclassified to earnings in
those periods with a description of the transactions or other events
that will result in the reclassification into earnings of gains and
losses that are reported in accumulated other comprehensive income,
and the estimated net amount of the existing gains or losses at the
reporting date that is expected to be reclassified into earnings
within the next 12 months
c. Elimination of the proposed disclosure of the separate amounts for the
reporting period of gains and losses on the cash flow hedging
instruments
d. Elimination of the proposed disclosure of the beginning and ending
balances in accumulated other comprehensive income for accumulated
derivative gains and losses, and the related current period changes,
separately for the following two categories: gains and losses related
to forecasted transactions for which the variability of hedged future
cash flows has ceased and gains and losses related to forecasted
transactions for which the variability of hedged future cash flows has
not ceased
e. Replacement of some of the remaining proposed disclosures of separate
amounts of gains and losses with disclosure of the amount
of net gain or loss.
The Board believes the required cash flow hedge disclosures, as modified,
provide necessary information in helping financial statement users assess
the effect on the financial statements of an entity's cash flow hedge
strategies.
509. This Statement also amends Statement 107 to carry
forward the provision in Statement 119 that encourages disclosure of
quantitative information about market risk. That provision has been
revised to clarify that it applies to all financial instruments-not just to
derivatives. The Board believes that disclosure will provide useful
information to users of financial statements about the overall market risk
of an entity's financial instruments. The Board is encouraging, rather
than requiring, that information because it continues to believe that ". .
. the continuing evolution of approaches to risk management limits the
ability to clearly define the most useful approach to disclosing
quantitative information about market risks" (Statement 119,
paragraph 72). The Board observes that the SEC
issued final rules
\33/ in January 1997 that require certain registrants to make quantitative
disclosures of market risk similar to those encouraged by Statement 119.
==========================================================================
\33/ SEC Final Rules, Disclosure of Accounting Policies for Derivative
Financial Instruments and Derivative Commodity Instruments and
Disclosure of Quantitative and Qualitative about Market Risk Inherent
in Derivative Financial Instruments, Other Financial Instruments, and
Derivative Commodity Instruments.
==========================================================================
510. The Board decided that disclosures about
concentrations of credit risk previously included in Statement 105 should
continue to be required because a number of constituents, including some
regulators, have commented on their usefulness. The purpose of those
disclosures is to allow "investors, creditors, and other users to make
their own assessments of the credit risk associated with the area of
concentration" (Statement 105, paragraph 100).
The
Board decided to modify the disclosure about concentrations of credit risk
to require that the amount disclosed be based on the gross fair value of
the financial instruments rather than the "amount of the accounting loss"
(described in Statement 105, paragraph 20(b)).
Preparers found "the amount of the accounting loss" to be confusing, and
users of financial statements have stated that fair value information
provides a better indication of the credit exposure arising from financial
instruments. The disclosure was also modified to require information about
an entity's master netting arrangements and their effect on the maximum
amount of loss due to credit risk. The Board believes that information
provides users with important insight into the potential impact of those
arrangements on concentrations of credit risk of an entity.
511. The Board considered either leaving the disclosures
about concentrations of credit risk in Statement 105 or including them in
this Statement. The Board decided not to retain them in Statement 105
because this Statement supersedes all other guidance in that Statement.
The Board decided not to include those disclosures in this Statement
because they refer to all financial instruments and this Statement
addresses derivative instruments. The Board decided instead to amend
Statement 107 to include those disclosures so that all disclosure
requirements that apply to all financial instruments will be available in
one place.
512. Certain other requirements from Statements 105 and
119 have been deleted, including disclosure of the "face or contract
amount" for all derivative financial instruments held at the balance sheet
date (Statement 105, paragraph 17, and Statement
119,
paragraph 8). The Board originally required that
disclosure, in part, to provide users with "information [that] conveys some
of the same information provided by amounts recognized for on-balance-sheet
instruments" (Statement 105, paragraph 89).
That
disclosure also provided an indication "of the volume of derivative
activity" (Statement 119, paragraph 79).
This
Statement's requirement that all derivatives be recognized in the statement
of financial position at fair value lessens the usefulness of the
disclosure of the face or contract amount. For example, reporting all
derivatives as assets or liabilities in the statement of financial position
will provide an indication of the use of derivatives. More important,
although the face or contract amount of derivative instruments held
provides some indication of derivatives activity, their usefulness for that
purpose may be suspect given that some derivatives are commonly neutralized
either by canceling the original derivative-which lowers the reported
amount-or by acquiring or issuing an offsetting derivative-which increases
the reported amount. The Exposure Draft would have required the disclosure
only when necessary to enable investors and creditors to understand what an
entity is trying to accomplish with its derivatives. Some respondents were
concerned that provision would not have been operational. The Board agreed
and decided that disclosure of the face or contract amount should no longer
be required.
513. Also deleted is the requirement to disclose the
average fair value of derivative financial instruments held for trading
purposes (Statement 119, paragraph 10(a)). The
Board
originally required that disclosure to provide users "with a better
indication of the level of risk assumed by an entity when holding or
issuing derivative financial instruments for trading purposes"
(Statement 119, paragraph 50). The Board had
noted that
"trading positions typically fluctuate, and the ending balance may not
always be representative of the range of balances and related risks that an
entity has assumed during a period" (Statement 119,
paragraph 50). The Board had also indicated that
it did not extend
the disclosure to derivatives used for other than trading purposes because
"the necessary data may be less likely to be available for derivative
financial instruments held or issued for purposes other than trading"
(Statement 119, paragraph 54). Because this
Statement
eliminates the distinction between derivatives held for trading
purposes and those held for purposes other than trading and
because of the Board's continuing concerns about the availability of that
information, particularly for nonfinancial entities, the Board decided to
eliminate that disclosure.
Effective Date and Transition
514. This Statement is effective for fiscal years
beginning after June 15, 1999. Recognizing derivatives as assets and
liabilities and measuring them at fair value is a primary objective of this
Statement, and the Board considers it important to achieve the objective as
early as is reasonably possible following the issuance of this Statement.
However, many respondents indicated that they would need more than a year
following the issuance of this Statement to make the systems changes
necessary to implement it. The Board notes that an effective date of years
beginning after June 15, 1999 will provide an implementation period of at
least a year for all entities. That should be adequate time for entities to
assimilate and develop the information required by this Statement. The
Board also decided to permit an entity to adopt the provisions of this
Statement as of the beginning of any fiscal quarter that begins after
issuance of this Statement. The Board recognizes that the financial
statements of an entity that adopts this Statement during a fiscal year
will be based on differing measurement principles and hedge accounting
requirements for derivative instruments. The Board decided that the
urgency of providing improved information about derivatives outweighed
concerns about the resulting potential lack of consistency within that
year's financial statements.
515. Because hedge accounting is based on an entity's
intent at the time a hedging relationship is established, the Board decided
that retroactive application of the provisions of this Statement was not
appropriate. Accordingly, changes in the fair value of derivatives that
arose before initial application of this Statement and were previously
recognized in net income, added to the carrying amount of hedged assets or
liabilities, or included in other comprehensive income as part of a hedge
of a net investment in a foreign entity are not to be included in
transition adjustments. However, the Board decided that hedging
relationships that existed before the date of initial application are
relevant in determining other transition adjustments. Basing the
transition adjustments on past hedging relationships also should prevent an
entity from selectively affecting the transition adjustments by changing
previously designated hedging relationships.
516. The Board considered whether past changes in the
fair values of derivatives that were deferred as separate assets or
liabilities in the statement of financial position rather than being added
to the carrying amount of hedged assets or liabilities, such as those
related to hedged forecasted transactions, should continue to be deferred
at the date of initial application. Continued deferral of those gains and
losses would be consistent with the continued deferral of amounts that were
previously added to the carrying amount of hedged assets or liabilities.
However, separately deferred losses and gains do not represent assets or
liabilities and thus are different from amounts that adjusted the basis of
an asset or liability or otherwise represent assets or liabilities.
Continuing to report them in the statement of financial position would be
inconsistent with the Board's fundamental decision to recognize in the
statement of financial position only items that are assets or liabilities
(paragraph 229). The Board concluded that gains
and
losses separately characterized as liabilities and assets in the statement
of financial position should be removed and reported in a manner consistent
with the requirements of this Statement.
517. The adjustments to recognize all derivatives as
assets or liabilities at fair value and to reverse certain deferred gains
and losses will affect net income or other comprehensive income at the date
of initial application. Consequently, the Board decided also to require
that an entity recognize concurrently the effect of any preexisting
offsetting differences between the carrying amount and the fair value of
hedged items; that is, differences that arose before the date of initial
application. The Board noted that reporting offsetting unrealized gains and
losses on hedged items is consistent with the notion in this Statement of
accelerating gains and losses on hedged items to provide income statement
offset.
Transition Provisions for Embedded Derivatives
518. paragraphs 12-16 of this
Statement require that certain embedded derivatives be separated from their
host contracts and accounted for as derivative instruments under this
Statement. The Board considered how that requirement for separate
accounting should apply to hybrid instruments outstanding at the date of
initial application of this Statement. In considering that issue, the
Board first considered two alternative ways in which an embedded derivative
could be separated from the host contract after the date of acquisition or
issuance:
a. Based on the fair values of the embedded derivative and the host
contract at the date of initial application
b. Based on the fair values of the embedded derivative and the host
contract at the date of initial acquisition or issuance.
The choice between those two methods determines the carrying amount of the
host contract after separation of the embedded derivative. It also
significantly affects the difficulty of obtaining the necessary information
needed to separate an embedded derivative from the host contract after the
date of initial acquisition or incurrence.
519. Separating a hybrid instrument into its host
contract and its embedded derivative based on fair values at the date of
initial adoption would be the simpler method. Under that method, the fair
value of all of an entity's host contracts and embedded derivatives would
be determined as of the same date, based on information current as of that
date. In contrast, basing the separation of an embedded derivative on fair
values at the date a hybrid instrument was acquired or incurred would
necessitate calculations as of multiple past dates. For an entity with
many hybrid instruments, some of which may have been initiated a decade or
more in the past, separation based on fair values at dates of acquisition
or incurrence could be a significant effort.
520. Although separation based on fair values at the date
of initial application of this Statement would be the easier method, its
results could be questionable. Many host contracts will be
interest-bearing financial instruments, and separating the value of their
embedded derivatives will affect both the carrying amounts of the host
contracts and their effective interest rates. Determining the carrying
amount of such a host contract based on the value of an embedded derivative
at a date significantly later than acquisition or issuance of the
instrument could result in a substantial discount or premium to be
amortized as an adjustment of interest income or expense. For example,
several years before it adopts this Statement, an entity might have
purchased an equity-indexed note in which the principal is linked to the
S&P 500 index. If the S&P 500 index is, say, 60 percent higher on July 1,
1999 when the entity adopts this Statement than it was at the date the note
was acquired and the embedded derivative is separated on that basis, the
carrying amount of the host contract would be artificially low, resulting
in an artificially high reported interest yield. In contrast, separation
based on fair values at the date the equity-indexed note was acquired would
result in carrying amounts for both components that are determined on the
same basis, and the carrying amount for the host contract need not
compensate for subsequent changes in the value of the embedded derivative.
521. For the reasons just discussed, the Board decided
that separation of a hybrid instrument into its host contract and embedded
derivative instrument should be based on fair values at the date the
instrument was acquired or issued. Having made that decision, the Board
decided it was not feasible to require entities to apply the requirements
of paragraphs 12-16 of this Statement to all
hybrid
instruments held or owed at the date of initial adoption. However, the
Board also did not want to provide an entity with the opportunity to embed
numerous derivatives in hybrid instruments during the year or two before
the effective date of this Statement for the purpose of avoiding its
requirements. Therefore, this Statement requires that a hybrid instrument
acquired or issued after December 31, 1997 be separated into its host
contract and embedded derivative. For instruments acquired or issued after
that date, separation on the basis of fair values at the date of
acquisition or issuance should not be unduly burdensome.
522. The Board also considered whether an entity should
be permitted to separate hybrid instruments acquired or issued before
January 1, 1998 into their host contracts and derivative components if it
wishes to do so. That alternative might be provided on either an
individual instrument or an entity-wide basis. The Board recognizes that
an entity might wish to separate the embedded derivative from a hybrid
instrument and designate it as a hedging instrument. However, the Board
was concerned that providing a choice on an instrument-by-instrument basis
might have unintended consequences, such as separate accounting only for
those embedded derivatives that are in a loss position at the date of
initial adoption. The Board therefore decided to provide an entity the
choice of separating out the embedded derivatives of existing hybrid
instruments, but only on an all-or-none basis. The Board also believes
that providing the choice only on an entity-wide basis will make it easier
for users of financial statements to understand the effects of an entity's
choices in transition and the resulting financial information.
Transition Provisions for Compound Derivatives
523. This Statement prohibits separation of a compound
derivative instrument into its components for hedge accounting purposes
(paragraph 18). The Board does not consider that
prohibition to be unduly burdensome on an ongoing basis. To qualify for
hedge accounting, an entity will simply need to obtain separate derivative
instruments in some situations in which compound derivatives may have been
used in the past. However, the Board recognizes that an entity may have
entered into long-term derivative instruments combining, for example,
foreign exchange and interest rate components before it knew that only
separate derivatives would qualify for hedge accounting. The Board
therefore considered whether this Statement should include special
transition provisions for compound derivatives entered into before the date
of initial adoption.
524. The Board understands that many hedging
relationships in which compound derivatives were used involved hybrid
instruments. For example, an entity may have entered into an interest rate
swap with an embedded equity option to hedge outstanding debt with an
embedded equity feature, such as a bond whose principal amount increases
with specified percentage increases in the S&P 500 index. The Board
believes that its decision not to require separate accounting for the
derivative features of hybrid instruments acquired or issued before January
1, 1998 significantly reduces the need to permit compound derivatives
outstanding at the date of initial adoption to be separated into dissimilar
components. However, this Statement prohibits hedge accounting for the
foreign exchange risk in instruments that are remeasured with changes in
carrying amounts attributable to changes in foreign exchange rates included
currently in earnings. A similar prohibition applies to cash flow hedges
of the future acquisition or incurrence of instruments that will be
remeasured with changes in carrying value attributable to changes in
foreign exchange rates included in current earnings. Thus, a compound
derivative that includes a foreign exchange component rarely will qualify
for use as a hedging instrument under this Statement. The Board therefore
decided to permit only the foreign exchange component of a compound
derivative entered into before this Statement is adopted to be separated
for accounting purposes. Thus, for example, a derivative that combines a
foreign currency forward contract with an interest rate swap may be
separated into its components at the date of initial adoption based on the
fair values of the components at that date. In contrast, a combined
interest rate swap and equity option may not be separated into its
components.
FAS 133 Appendix D: AMENDMENTS TO EXISTING PRONOUNCEMENTS
Appendix D
AMENDMENTS TO EXISTING PRONOUNCEMENTS
525. This Statement supersedes the following
pronouncements:
a. FASB Statement No. 80, Accounting for
Futures
Contracts
b. FASB Statement No. 105, Disclosure of
Information about Financial Instruments with Off-Balance-Sheet Risk
and Financial Instruments with Concentrations of Credit Risk
c. FASB Statement No. 119, Disclosure about
Derivative Financial Instruments and Fair Value of Financial
Instruments.
526. In paragraph 8 of Chapter 4,
"Inventory Pricing," of ARB No. 43, Restatement
and
Revision of Accounting Research Bulletins, the following is inserted
after the fourth sentence:
(If inventory has been the hedged item in a fair value hedge, the
inventory's "cost" basis used in the cost-or-market-whichever-is-lower
accounting shall reflect the effect of the adjustments of its carrying
amount made pursuant to paragraph 22(b) of
FASB Statement No. 133, Accounting for
Derivative
Instruments and Hedging Activities.)
527. FASB Statement No. 52, Foreign Currency
Translation, is amended as follows:
a. The following paragraph is inserted after the heading Foreign
Currency Transactions and before paragraph 15:
14A. FASB Statement No. 133, Accounting for
Derivative Instruments and Hedging Activities, addresses the
accounting for freestanding foreign currency derivatives and certain
foreign currency derivatives embedded in other instruments. This
Statement does not address the accounting for derivative instruments.
b. In the last sentence of paragraph 15,
paragraphs 20 and 21 is replaced by
paragraph 20 and and foreign currency
commitments is deleted.
c. In the first sentence of paragraph 16,
forward exchange contracts (paragraphs 17-19) is
replaced by derivative instruments (Statement 133).
d. paragraphs 17-19 and the heading preceding
paragraph 17 are deleted.
e. paragraph 21 is replaced by the following:
Hedges of Firm Commitments
The accounting for a gain or loss on a foreign currency
transaction that is intended to hedge an identifiable foreign
currency commitment (for example, an agreement to purchase or sell
equipment) is addressed by paragraph 37 of
Statement 133.
f. In the second sentence of paragraph 30,
forward contracts determined in conformity with the
requirements of paragraphs 18 and 19 shall be considered transaction
gains or losses is replaced by derivative instruments shall
comply with paragraph 45 of Statement 133.
g. The following sentence is added at the end of
paragraph 31(b):
(paragraph 45(c) of Statement 133 specifies
additional disclosures for instruments designated as hedges of the
foreign currency exposure of a net investment in a foreign
operation.)
h. The definitions of currency swaps, discount or premium on a
forward contract, forward exchange contract, and forward
rate in paragraph 162, the glossary, are
deleted.
528. FASB Statement No. 60,
Accounting and Reporting by Insurance Enterprises, is amended as
follows:
a. paragraph 46, as amended by FASB Statements
No.
115, Accounting for Certain Investments in Debt and Equity
Securities, and No. 124, Accounting for Certain Investments
Held by Not-for-Profit Organizations, is amended as follows:
(1) The phrase except as indicated in the following
sentence is added to the end of the second sentence.
(2) The following sentence is added after the second sentence:
All or a portion of the unrealized gain or loss of a security
that is designated as being hedged in a fair value hedge shall be
recognized in earnings during the period of the hedge, pursuant
to paragraph 22 of FASB
Statement
No. 133, Accounting for Derivative
Instruments and
Hedging Activities.
b. In the first sentence of paragraph 50, as
amended
by FASB Statement No. 97, Accounting and
Reporting by Insurance Enterprises for Certain Long-Duration Contracts
and for Realized Gains and Losses from the Sale of Investments,
and Statement 115, as hedges as described in FASB Statements
No. 52, Foreign Currency Translation, and No. 80, Accounting for
Futures Contracts is replaced by as either hedges of net
investments in foreign operations or cash flow hedges as described in
Statement 133.
529. FASB Statement No. 65, Accounting for
Certain Mortgage Banking Activities, is amended as follows:
a. The following sentence is added after the first sentence of
paragraph 4, as amended by Statements 115 and 124:
If a mortgage loan has been the hedged item in a fair value
hedge, the loan's "cost" basis used in lower-of-cost-or-market
accounting shall reflect the effect of the adjustments of its
carrying amount made pursuant to paragraph 22(b)
of FASB Statement No. 133, Accounting for
Derivative
Instruments and Hedging Activities.
b. In the first sentence of paragraph 9(a), as amended by Statement
115 and FASB Statement No. 125, Accounting
for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities,
the phrase commitment prices is replaced by fair
values.
c. The last sentence of paragraph 9(a), which was added by Statement 115,
is deleted.
d. paragraph 9(b)(1) is deleted.
530. In the third sentence of footnote 4 of
FASB Statement No. 95, Statement of Cash
Flows, as amended
by FASB Statement No. 104, Statement of Cash
Flows-Net Reporting of Certain Cash Receipts and Cash Payments and
Classification of Cash Flows from Hedging Transactions, the phrase
futures contracts, forward contracts, option contracts, or swap
contracts that are accounted for as hedges of identifiable transactions or
events (for example, a cash payment from a futures contract that hedges a
purchase or sale of inventory), including anticipatory hedges, is
replaced by derivative instruments that are accounted for as fair
value hedges or cash flow hedges under FASB Statement No.
133, Accounting for Derivative Instruments
and Hedging Activities.
In the last sentence of footnote 4, identifiable transaction or
event is replaced by asset, liability, firm commitment, or
forecasted transaction.
531. FASB Statement No. 107,
Disclosures about Fair Value of Financial Instruments, is
amended as follows:
a. paragraph 4 is deleted.
b. The last sentence of paragraph 10, which was
added
by Statement 119, is deleted.
c. The paragraph added by Statement 119 after paragraph
13 is replaced by the following; the related
footnote is deleted:
In disclosing the fair value of a financial instrument, an
entity shall not net that fair value with the fair value of
other financial instruments-even if those financial instruments
are of the same class or are otherwise considered to be related,
for example, by a risk management strategy-except to the extent
that the offsetting of carrying amounts in the statement of
financial position is permitted under the general principle in
paragraphs 5 and 6 of FASB Interpretation No. 39,
Offsetting of Amounts Related to Certain Contracts,
or the exceptions for master netting arrangements in paragraph
10 of Interpretation 39 and for amounts related to certain
repurchase and reverse repurchase agreements in paragraphs 3 and
4 of FASB Interpretation No. 41, Offsetting of Amounts
Related to Certain Repurchase and Reverse Repurchase
Agreements.
d. The following paragraphs, with related headings and footnotes, are
added after paragraph 15:
Disclosure about Concentrations of Credit Risk of All
Financial Instruments
15A. Except as indicated in paragraph 15B, an entity shall
disclose all significant concentrations of credit risk arising
from all financial instruments, whether from an
individual counterparty or groups of counterparties. Group
concentrations of credit risk exist if a number of
counterparties are engaged in similar activities and have similar
economic characteristics that would cause their ability to meet
contractual obligations to be similarly affected by changes in
economic or other conditions. The following shall be disclosed
about each significant concentration:
a. Information about the (shared) activity, region, or economic
characteristic that identifies the concentration
b. The maximum amount of loss due to credit risk that, based on
the gross fair value of the financial instrument, the entity
would incur if parties to the financial instruments that make
up the concentration failed completely to perform according to
the terms of the contracts and the collateral or other
security, if any, for the amount due proved to be of no value
to the entity
c. The entity's policy of requiring collateral or other security
to support financial instruments subject to credit risk,
information about the entity's access to that collateral or
other security, and the nature and a brief description of the
collateral or other security supporting those financial
instruments
d. The entity's policy of entering into master netting
arrangements to mitigate the credit risk of financial
instruments, information about the arrangements for which the
entity is a party, and a brief description of the terms of
those arrangements, including the extent to which they would
reduce the entity's maximum amount of loss due to credit risk.
15B. The requirements of the preceding paragraph do not apply to
the following financial instruments, whether written or held:
a. Financial instruments of a pension plan, including plan
assets, when subject to the accounting and reporting
requirements of Statement 87 \*/
-----------------------------
\*/ Financial instruments of a pension plan, other than the
obligations for pension benefits, when subject to the
accounting and reporting requirements of FASB
Statement No. 35, Accounting and Reporting by
Defined
Benefit Pension Plans, are subject to the requirements of
paragraph 15A.
-----------------------------
b. The financial instruments described in
paragraphs 8(a), 8(c), 8(e), and 8(f) of this
Statement, as
amended by FASB Statements No. 112, Employers' Accounting
for Postemployment Benefits, No. 123, Accounting for Stock-Based
Compensation, and 125, except for reinsurance receivables and
prepaid reinsurance premiums.
Encouraged Disclosure about Market Risk of All Financial
Instruments
15C. An entity is encouraged, but not required, to disclose
quantitative information about the market risks of financial
instruments that is consistent with the way it manages or adjusts
those risks.
15D. Appropriate ways of reporting the quantitative information
encouraged in paragraph 15C will differ for different entities and
will likely evolve over time as management approaches and
measurement techniques evolve. Possibilities include disclosing
(a) more details about current positions and perhaps activity
during the period, (b) the hypothetical effects on comprehensive
income (or net assets), or annual income, of several possible
changes in market prices, (c) a gap analysis of interest rate
repricing or maturity dates, (d) the duration of the financial
instruments, or (e) the entity's value at risk from derivatives
and from other positions at the end of the reporting period and
the average value at risk during the year. This list is not
exhaustive, and an entity is encouraged to develop other ways of
reporting quantitative information.
e. Example 1 in paragraph 31 is amended as
follows:
(1) The following heading and sentence are deleted from illustrative
Note V:
Interest rate swap agreements
The fair value of interest rate swaps (used for hedging purposes)
is the estimated amount that the Bank would receive or pay to
terminate the swap agreements at the reporting date, taking into
account current interest rates and the current creditworthiness
of the swap counterparties.
(2) In the table, the subheading Interest rate swaps and the two
following related lines (In a net receivable position and
In a net payable position) are deleted. In the second
sentence of the related footnote *, Interest rate swaps and is
deleted.
532. This Statement carries forward the following
amendments that Statement 119 made to Statement 107:
a. In paragraph 10, the following footnote is
added
after either in the body of the financial statements or in the
accompanying notes:
-----------------------------
\*/ If disclosed in more than a single note, one of the notes shall
include a summary table. The summary table shall contain the
fair value and related carrying amounts and cross-references to
the location(s) of the remaining disclosures required by this
Statement, as amended.
-----------------------------
b. In paragraph 10, the following is added after
the
first sentence:
Fair value disclosed in the notes shall be presented together
with the related carrying amount in a form that makes it clear
whether the fair value and carrying amount represent assets or
liabilities and how the carrying amounts relate to what is
reported in the statement of financial position.
533. In paragraph 28 of FASB Statement No.
113, Accounting and Reporting for Reinsurance
of Short-Duration
and Long-Duration Contracts, the phrase FASB
Statement No. 105, Disclosure of Information
about Financial Instruments
with Off-Balance-Sheet Risk and Financial Instruments with Concentrations
of Credit Risk is replaced by paragraph 15A of FASB
Statement No. 107, Disclosures about Fair
Value of Financial
Instruments, as amended by FASB Statement No. 133,
Accounting for Derivative Instruments and Hedging Activities.
534. FASB Statement No. 115,
Accounting for Certain Investments in Debt and Equity Securities, is
amended as follows:
a. The following sentence is added at the end of paragraph
4, as amended by Statement 124:
This Statement does not apply to investments in derivative
instruments that are subject to the requirements of
FASB Statement No. 133, Accounting for
Derivative
Instruments and Hedging Activities. If an investment would
otherwise be in the scope of this Statement and it has within it
an embedded derivative that is subject to Statement 133, the
host instrument (as described in Statement 133) remains within
the scope of this Statement. A transaction gain or loss on a
held-to-maturity foreign-currency-denominated debt security
shall be accounted for pursuant to FASB Statement No.
52, Foreign Currency Translation.
b. paragraph 13, as amended by FASB
Statement No. 130, Reporting Comprehensive
Income, is
amended as follows:
(1) The phrase until realized except as indicated in the
following sentence is added to the end of the second sentence.
(2) The following sentence is added after the second sentence:
All or a portion of the unrealized holding gain and loss
of an available-for-sale security that is designated as
being hedged in a fair value hedge shall be recognized in
earnings during the period of the hedge, pursuant to
paragraph 22 of Statement 133.
c. In paragraph 15(b), portion of the is
inserted before unrealized, and that has not been
previously recognized in earnings is added after
transfer.
d. In paragraph 16, the following is inserted
after
the first sentence:
(If a security has been the hedged item in a fair value hedge,
the security's "amortized cost basis" shall reflect the effect
of the adjustments of its carrying amount made pursuant to
paragraph 22(b) of Statement 133.)
e. The first sentence of paragraph 19 is
replaced by
the following two sentences:
For securities classified as available-for-sale, all reporting
enterprises shall disclose the aggregate fair value, the total
gains for securities with net gains in accumulated other
comprehensive income, and the total losses for securities with
net losses in accumulated other comprehensive income, by major
security type as of each date for which a statement of financial
position is presented. For securities classified as
held-to-maturity, all reporting enterprises shall disclose the
aggregate fair value, gross unrecognized holding gains, gross
unrecognized holding losses, the net carrying amount, and the
gross gains and losses in accumulated other comprehensive income
for any derivatives that hedged the forecasted acquisition of
the held-to-maturity securities, by major security type as of
each date for which a statement of financial position is
presented.
f. In the third sentence in paragraph 20,
amortized cost is replaced by net carrying amount
(if different from fair value).
g. paragraph 21 is amended as follows:
(1) In paragraph 21(a), on those sales
is replaced by that have been included in earnings as a
result of those sales
(2) In paragraph 21(b), cost was determined
in computing realized gain or loss is replaced by the
cost of a security sold or the amount reclassified out of
accumulated other comprehensive income into earnings was
determined
(3) paragraph 21(d) is replaced by the
following:
The amount of the net unrealized holding gain or loss on
available-for-sale securities for the period that has been
included in accumulated other comprehensive income and the amount
of gains and losses reclassified out of accumulated other
comprehensive income into earnings for the period
(4) paragraph 21(e) is replaced by The
portion of trading gains and losses for the period that relates
to trading securities still held at the reporting date.
h. In the first sentence of paragraph 22,
amortized cost is replaced by net carrying and
the net gain or loss in accumulated other comprehensive income
for any derivative that hedged the forecasted acquisition of the
held-to-maturity security, is added immediately preceding
the related realized.
i. The last four sentences of paragraph 115 are
deleted.
j. The definition of fair value in paragraph
137, the glossary, is replaced by the following:
The amount at which an asset could be bought or sold in a current
transaction between willing parties, that is, other than in a
forced or liquidation sale. Quoted market prices in active
markets are the best evidence of fair value and should be used as
the basis for the measurement, if available. If a quoted market
price is available, the fair value is the product of the number of
trading units times that market price. If a quoted market price
is not available, the estimate of fair value should be based on
the best information available in the circumstances. The estimate
of fair value should consider prices for similar assets and the
results of valuation techniques to the extent available in the
circumstances. Examples of valuation techniques include the
present value of estimated expected future cash flows using a
discount rate commensurate with the risks involved, option-pricing
models, matrix pricing, option-adjusted spread models, and
fundamental analysis. Valuation techniques for measuring assets
should be consistent with the objective of measuring fair value.
Those techniques should incorporate assumptions that market
participants would use in their estimates of values, including
assumptions about interest rates, default, prepayment, and
volatility.
535. FASB Statement No. 124,
Accounting for Certain Investments Held by Not-for- Profit
Organizations, is amended as follows:
a. In paragraph 3, except as noted in
paragraph 5 is added to the end of the
first sentence.
b. The following is added to the end of paragraph 5:
This Statement also does not apply to investments in derivative
instruments that are subject to the requirements of
FASB Statement No. 133, Accounting for
Derivative
Instruments and Hedging Activities. If an investment would
otherwise be in the scope of this Statement and it has within it
an embedded derivative that is subject to Statement 133, the host
instrument (as described in Statement 133) remains within the
scope of this Statement.
c. In the second sentence of paragraph 6, No.
105, Disclosure of Information about Financial Instruments with
Off-Balance-Sheet Risk and Financial Instruments with Concentrations
of Credit Risk, and No. 119, Disclosure about Derivative
Financial Instruments and Fair Value of Financial Instruments are
deleted and No. 133, Accounting for Derivative Instruments and
Hedging Activities, is added to the end of the sentence.
d. In footnote 6 of paragraph 16,
paragraph 20 of Statement 105 is replaced
by
paragraph 15A of Statement 107, as amended by
Statement 133.
e. The definition of fair value in paragraph
112, the glossary, is replaced by the following:
The amount at which an asset could be bought or sold in a current
transaction between willing parties, that is, other than in a
forced or liquidation sale. Quoted market prices in active
markets are the best evidence of fair value and should be used as
the basis for the measurement, if available. If a quoted market
price is available, the fair value is the product of the number of
trading units times that market price. If a quoted market price
is not available, the estimate of fair value should be based on
the best information available in the circumstances. The estimate
of fair value should consider prices for similar assets and the
results of valuation techniques to the extent available in the
circumstances. Examples of valuation techniques include the
present value of estimated expected future cash flows using a
discount rate commensurate with the risks involved, option-pricing
models, matrix pricing, option-adjusted spread models, and
fundamental analysis. Valuation techniques for measuring assets
should be consistent with the objective of measuring fair value.
Those techniques should incorporate assumptions that market
participants would use in their estimates of values, including
assumptions about interest rates, default, prepayment, and
volatility.
536. FASB Statement No. 125,
Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities, is amended as follows:
a. In paragraph 4, and that are not within
the
scope of FASB Statement No. 133, Accounting
for
Derivative Instruments and Hedging Activities is added to the end
of the second sentence.
b. In paragraph 14, Except for instruments
that
are within the scope of Statement 133 is added to the beginning of
the first sentence.
c. In the fourth sentence of paragraph 31,
derivative financial instrument is replaced by
derivative instrument.
d. In paragraph 243, the glossary, the
definition of
derivative financial instrument is replaced by:
Derivative instrument
Refer to paragraphs 6-9 in FASB
Statement No. 133, Accounting for Derivative
Instruments and Hedging Activities.
537. paragraph 2(c) of FASB
Statement No. 126, Exemption from Certain
Required Disclosures
about Financial Instruments for Certain Nonpublic Entities, is replaced
by the following:
The entity has no instrument that, in whole or in part, is
accounted for as a derivative instrument under FASB
Statement No. 133, Accounting for Derivative
Instruments
and Hedging Activities, during the reporting period.
538. paragraph 6 of FASB
Technical Bulletin No. 79-19, Investor's
Accounting for
Unrealized Losses on Marketable Securities Owned by an Equity Method
Investee, as amended by FASB Statement No. 115,
Accounting for Certain Investments in Debt and Equity
Securities, is replaced by the following:
If an investee that is accounted for by the equity method is
required to include unrealized holding gains and losses on
investments in debt and equity securities in other comprehensive
income pursuant to the provisions of FASB Statement
No. 115, Accounting for Certain Investments
in Debt and
Equity Securities, as amended by FASB Statement
No. 133, Accounting for Derivative
Instruments and
Hedging Activities, the investor shall adjust its investment
in that investee by its proportionate share of the unrealized
gains and losses and a like amount shall be included in its other
comprehensive income.
FAS 133 Appendix E: DIAGRAM FOR DETERMINING WHETHER A CONTRACT IS A FREESTANDING DERIVATIVE SUBJECT TO THE SCOPE OF THIS STATEMENT
Appendix E
DIAGRAM FOR DETERMINING WHETHER A CONTRACT IS A FREESTANDING
DERIVATIVE SUBJECT TO THE SCOPE OF THIS STATEMENT
539. The following diagram depicts the process for
determining whether a freestanding contract is within the scope of this
Statement. The diagram is a visual supplement to the written standards
section. It should not be interpreted to alter any requirements of this
Statement nor should it be considered a substitute for the requirements.
The relevant paragraphs in the standards section and Appendix A are
identified in the parenthetical note after the question.
****************************
Graphic not included on line
****************************
FAS 133 Appendix F: GLOSSARY
Appendix F
GLOSSARY
540. This appendix contains definitions of terms or
phrases as used in this Statement.
Comprehensive income
The change in equity of a business enterprise during a period from
transactions and other events and circumstances from nonowner sources.
It includes all changes in equity during a period except those
resulting from investments by owners and distributions to owners
(FASB Concepts Statement No. 6, Elements of
Financial
Statements, paragraph 70).
Derivative instrument
Refer to paragraphs 6-9.
Fair value
The amount at which an asset (liability) could be bought (incurred) or
sold (settled) in a current transaction between willing parties, that
is, other than in a forced or liquidation sale. Quoted market prices
in active markets are the best evidence of fair value and should be
used as the basis for the measurement, if available. If a quoted
market price is available, the fair value is the product of the number
of trading units times that market price. If a quoted market price is
not available, the estimate of fair value should be based on the best
information available in the circumstances. The estimate of fair
value should consider prices for similar assets or similar liabilities
and the results of valuation techniques to the extent available in the
circumstances. Examples of valuation techniques include the present
value of estimated expected future cash flows using discount rates
commensurate with the risks involved, option- pricing models, matrix
pricing, option-adjusted spread models, and fundamental analysis.
Valuation techniques for measuring assets and liabilities should be
consistent with the objective of measuring fair value. Those
techniques should incorporate assumptions that market participants
would use in their estimates of values, future revenues, and future
expenses, including assumptions about interest rates, default,
prepayment, and volatility. In measuring forward contracts, such as
foreign currency forward contracts, at fair value by discounting
estimated future cash flows, an entity should base the estimate of
future cash flows on the changes in the forward rate (rather than the
spot rate). In measuring financial liabilities and nonfinancial
derivatives that are liabilities at fair value by discounting
estimated future cash flows (or equivalent outflows of other assets),
an objective is to use discount rates at which those liabilities could
be settled in an arm's-length transaction.
Financial instrument
Cash, evidence of an ownership interest in an entity, or a contract
that both:
a. Imposes on one entity a contractual obligation \*/ (1) to deliver cash
or another financial instrument \+/ to a second entity or (2) to
exchange other financial instruments on potentially unfavorable
terms with the second entity
b. Conveys to that second entity a contractual right \@/ (1) to receive
cash or another financial instrument from the first entity or (2)
to exchange other financial instruments on potentially favorable
terms with the first entity.
-----------------------------
\*/ Contractual obligations encompass both those that are
conditioned on the occurrence of a specified event and those that are
not. All contractual obligations that are financial instruments meet
the definition of liability set forth in Concepts
Statement
6, although some may not be recognized as
liabilities in financial
statements-may be off-balance-sheet" - because they fail to meet some
other criterion for recognition. For some financial instruments, the
obligation is owed to or by a group of entities rather than a single
entity.
\+/ The use of the term financial instrument in this definition
is recursive (because the term financial instrument is
included in it), though it is not circular. The definition requires a
chain of contractual obligations that ends with the delivery of cash
or an ownership interest in an entity. Any number of obligations to
deliver financial instruments can be links in a chain that qualifies a
particular contract as a financial instrument.
\@/ Contractual rights encompass both those that are
conditioned on the occurrence of a specified event and those that are
not. All contractual rights that are financial instruments meet the
definition of asset set forth in Concepts Statement 6,
although some may not be recognized as assets in financial
statements-may be "off-balance- sheet" - because they fail to meet some
other criterion for recognition. For some financial instruments, the
right is held by or the obligation is due from a group of entities
rather than a single entity.
-----------------------------
Firm commitment
An agreement with an unrelated party, binding on both parties and
usually legally enforceable, with the following characteristics:
a. The agreement specifies all significant terms, including the
quantity to be exchanged, the fixed price, and the timing of the
transaction. The fixed price may be expressed as a specified
amount of an entity's functional currency or of a foreign
currency. It may also be expressed as a specified interest rate
or specified effective yield.
b. The agreement includes a disincentive for nonperformance that is
sufficiently large to make performance probable.
Forecasted transaction
A transaction that is expected to occur for which there is no firm
commitment. Because no transaction or event has yet occurred and the
transaction or event when it occurs will be at the prevailing market
price, a forecasted transaction does not give an entity any present
rights to future benefits or a present obligation for future
sacrifices.
Notional amount
A number of currency units, shares, bushels, pounds, or other units
specified in a derivative instrument.
Underlying
A specified interest rate, security price, commodity price, foreign
exchange rate, index of prices or rates, or other variable. An
underlying may be a price or rate of an asset or liability but is not
the asset or liability itself.
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