Qualifications

Effectiveness

Transitions

Disclosure

OVERVIEW

Motivated by the FASB's intent to provide greater transparency, FAS 133 makes a dramatic departure from past accounting practice by requiring derivative contracts to be marked-to-market and recorded as assets or liabilities on the balance sheet.

For speculative purposes, derivative gains or losses must be marked-to-market and gains or losses are realized in the current period's income.

When hedging exposures associated with the price of an asset, liability, or a firm commitment, accounting for the derivative is the same as it is for speculative uses. In addition, however, the underlying exposure must also be marked-to-market due to the risk being hedged; and these results must flow through current income, as well. This treatment is called a "fair value hedge."

A hedge of an upcoming, forecasted event is a "cash flow hedge." For cash flow hedges, derivative results must be evaluated, with a determination made as to how much of the result is "effective" and how much is "ineffective." The ineffective component of the hedge results must be realized in current income, while the effective portion is initially posted to "other comprehensive income" and later re-classified as income in the same time frame in which the forecasted cash flow affects earnings. Importantly, the FASB only recognizes hedges as being ineffective for accounting purposes when the hedge effects exceed the effects of the underlying forecasted cash flow, measured on a cumulative basis.

Finally, the last category qualifying for special accounting treatment is the hedge associated with the currency exposure of a net investment in a foreign operation. Again, the hedge must be marked-to-market. This time, the treatment maintains the spirit of the current provisions of the FASB Statement 52, which require effective hedge results to be consolidated with the translation adjustment in other comprehensive income. Differences between total hedge results and the translation adjustment being hedged flow through earnings.

QUALIFICATIONS
Scope      Cash Flow      Fair Value      Foreign Operations     Speculative Trades

Definition of a derivative under FAS 133

A qualifying derivative must satisfy three criteria (Paragraphs 6-9):

1. It has (1) one or more underlyings and (2) one or more notional amounts or payment provisions or both. These contractual terms determine the amount of the settlement or settlements, and, in some cases, whether or not a settlement is required.
2. 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.
3. 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.

Complicating the process for assessing whether or not any contractual arrangement qualifies as a derivative is the fact the FASB has scoped out a host of situations that might otherwise appear to satisfy the above definition.

Exemptions (Paragraphs 10 & 11):

• Regular-way securities trades, where delivery occurs within the time frame of normal market conventions.
• Normal purchases and normal sales where instruments will be delivered in amounts expected to be used within a reasonable period of time in the normal course of business and where there is a high probability that the contracts will result in physical deliver. Contracts that required periodic cash settlements (e.g., futures contracts) do not qualify for this exception.
• Certain insurance contracts which generally fall under FAS 60, 07, and 113. Contracts are exempt from FAS 133 if the payout compensates the insured for an identifiable insurable event other than a change in price.
• Financial guarantee contracts that reimburse for specific losses due to defaults of debtors.
• Off-exchange contracts where settlement amounts are based on (a) climactic, geological, or other physical variables; (b) prices of non-financial assets or liabilities on either party to the contract, where the underlying instrument is not readily convertible to cash; or (c) specific volumes of sales or revenues of one of the parties to the contract.
• Derivatives that serve as impediments to sales accounting.
• Contracts (a) indexed to a companies own stock and classified in stockholders' equity; (b) issued by the reporting entity relating to stock-based compensation; or (c) issued as a contingent consideration from a business combination.

Embedded derivative instruments

Embedded derivatives are components of contractual arrangements that, by themselves (i.e. on a stand-alone basis), would satisfy the criteria in the definition of a derivative. Embedded derivatives are often present in structured note contracts and other debt obligations, but they may also be found in such contracts such as leases, purchase agreements, insurance contracts, guarantees, and other tailored arrangements.

Embedded derivatives reside in "host" contracts; and the combined instrument (i.e., the host and the embedded derivative) is referred to as the "hybrid instrument."

In general, embedded derivatives must be separated from the host contract for accounting purposes. Provided they meet the qualifying criteria for being a derivative under FAS 133, embedded derivatives must be accounted for as if they were free standing derivatives, unless (a) the characteristics and risks of the embedded derivative are clearly and closely related to those of the host, or (b) the hybrid instrument is remeasured at fair value with changes reported in earnings.

Even in cases where the embedded derivative is clearly and closely related to the host, if the embedded derivative incorporates a leverage factor or if an investor may not recover substantially all of the initial recorded investment, the embedded derivative may be required to be accounted for separately from the host. (Paragraph 13)

Interest-only and principal-only strips are specifically exempted from FAS 133, provided (a) the original securities from which these derivatives were constructed have no embedded derivatives that would otherwise be covered under FAS 133, and (b) the strips do not contain any features that were not initially a part of the original instrument. (Paragraph 14)

Embedded foreign currency derivatives are exempt from FAS 133 if (a) the host is not a financial instrument and settlements are required in the functional currency of any substantial party to the contract, or (b) the settlements are denominated in the currency of the price that is routinely used for international commerce of the underlying good or service. (Paragraph 15)

Cash Flow Accounting Treatment

A hedge of an upcoming, forecasted event is a "cash flow hedge." To qualify for cash flow hedge treatment, a key requirement is that exposure involves the risk of an uncertain (i.e., variable) cash flow. Derivative results must be evaluated, with a determination made as to how much of the result is "effective" and how much is "ineffective." The ineffective component of the hedge results must be realized in current income, while the effective portion is initially posted to "other comprehensive income" (OCI) and later re-classified to income in the same time frame in which the forecasted cash flow affects earnings.

For purposes of determining the amount that is appropriate to be posted to OCI, this assessment must be made on a cumulative basis. Contributions to earnings are required only if the derivative results exceed the cash flow effects of the hedged items. (Paragraph 30b)

Cash flow hedge accounting is not automatic. Specific criteria must be satisfied both at the inception of the hedge and on an ongoing basis. If, after initially qualifying for cash flow accounting, the criteria for hedge accounting stop being satisfied, hedge accounting is no longer appropriate. With the discontinuation of hedge accounting, any accumulated OCI would remain there, unless (except in extenuating circumstances) it is probable that the forecasted transaction will not occur by the end of the originally specified time period or within an additional two-month period of time thereafter. (Paragraph 33)

Reporting entities have complete discretion to un-designate cash flow hedge relationships at will and later re-designate them, assuming all hedge criteria are again (or still) satisfied. (Paragraph 32c)

Examples of exposures that qualify for cash flow hedge accounting:

• Interest rate exposures that relate to a variable or floating interest rates
• Planned purchases or sales of assets
• Planned issuances of debt or deposits
• Planned purchases or sales of foreign currencies
• Currency risk associated with prospective cashflows that are not denominated in the functional currency

Eligible risks (Paragraphs 29g and 29h):

• Currency risk associated with (a) a forecasted transaction in a currency other than the functional currency, (b) an unrecognized firm commitment, or (c) a recognized foreign-currency denominated debt instrument.
• The entire price risk associated with purchases or sales of non-financial goods. That is, unless the purchase or sale specifically relates to buying or selling individual components, the full price of the good in question must be viewed as the hedged item.
• For financial instruments, hedgeable exposures include cash flow effects to (a) changes in the full price of the instrument in question, (b) changes the benchmark rate of interest (i.e., the risk-free rate of interest or the rate associated with LIBOR-based swaps), (c) changes associated with the hedged item's credit spread relative to the interest rate bench mark (d) changes in cash flows associated with default or the obligors' creditworthiness, and (e) changes in currency exchange rates. (Paragraph 29h)

Prerequisite requirements to qualify for cash flow accounting treatment

• Hedges must be documented at the inception of the hedge, with the objective and strategy stated, along with an explicit description of the methodology used to assess hedge effectiveness. (Paragraph 28a)
• Dates (or periods) for the expected forecasted events and the nature of the exposure involved (including quantitative measures of the size of the exposure) must be explicitly documented. (Paragraph 28a)
• The hedge must be expected to be "highly effective," both at the inception of the hedge and on an ongoing basis. Effectiveness measures must relate the gains or losses of the derivative to changes in the cash flows associated with the hedged item. (Paragraph 28b)
  The forecasted transaction must be probable. (Paragraph 29b)
  The forecasted transaction must be made with a different counterparty than the reporting entity. (Paragraph 29c)

Dis-allowed situations (i.e., when cash flow accounting may not be applied)

• In general, written options may not serve as hedging instruments. An exception to this prohibition (i.e., when a written option may qualify for cash flow accounting treatment) is when the hedged item is a long option. (Paragraph 28c)
• In general, basis swaps do not qualify for cash flow accounting treatment unless both of the variables of the basis swap are linked to two distinct variables associated with two distinct cash flow exposures. (Paragraph 28d)
• Cross currency interest rate swaps do not qualify for cash flow hedge accounting treatment if the combined position results in exposure to a variable rate of interest in the functional currency. This hedge would qualify, however, as a fair value hedge.
• With held-to-maturity fixed income securities under Statement 115, interest rate risk may not be designated as the risk exposure in a cash flow relationship. (Paragraph 29e)
• The forecasted transaction may not involve a business combination subject to Opinion 16 and does not involve (a) a parent's interest in consolidated subsidiaries, (b) a minority interest in a consolidated subsidiary, (c) an equity-method investment, or (d) an entity's own equity instruments. (Paragraph 29f)
• Prepayment risk may not be designated as the hedged item. (Paragraph 29h)
• The interest rate risk to be hedged in a cash flow hedge may not be identified as a benchmark interest rate, if a different variable interest rate is the specified exposure -- e.g., if the exposure is the risk of a higher prime rate, LIBOR may not be designated as the risk being hedged. (Paragraph 29h)

Internal derivatives contracts

• Except in the case when currency derivatives are used in cashflow hedges, derivatives between members of a consolidated group (i.e., internal derivatives) cannot qualify as hedging instruments in the consolidated statement, unless offsetting contracts have been arranged with unrelated third parties on a one-off basis. (Paragraph 36)
• For an internal currency derivative to qualify as a hedging instrument in a consolidated statement, it must be used as a cashflow hedge only for a foreign currency forecasted borrowing, a purchase or sale, or an unrecognized firm commitment, but the exposurefollowing conditions apply:
  • The non-hedging counterpart to the internal derivative must offset its net currency exposure with a third party within 3 days of the internal contract's hedge designation date. (Paragraph 40)
  • The third-party derivative must mature within 31 days of the internal derivative's maturity date. (Paragraph 40)

Fair Value Accounting Treatment

When hedging exposures associated with the price of an asset, liability, or a firm commitment, the total gain or loss on the derivative is recorded in earnings. In addition, the underlying exposure due to the risk being hedged must also be marked-to-market to the extent of the change due to the risk being hedged; and these results flow through current income, as well. This treatment is called a "fair value hedge." Hedgers may elect to hedge all or a specific identified portion of any potential hedged item.

Fair value hedge accounting is not automatic. Specific criteria must be satisfied both at the inception of the hedge and on an ongoing basis. If, after initially qualifying for fair value accounting, the criteria for hedge accounting stop being satisfied, hedge accounting is no longer appropriate. With the discontinuation of hedge accounting, gains or losses of the derivative will continue to be recorded in earnings, but no further basis adjustments to the original hedged item would be made. (Paragraph 26)

Reporting entities have complete discretion to de-designate fair value hedge relationships at will and later re-designate them, assuming all hedge criteria remain. (Paragraph 24)

Examples of exposures that qualify for fair value hedge accounting

• Interest exposures associated with the opportunity cost of fixed rate debt
• Price exposures for fixed rate assets
• Price exposures for firm commitments associated with prospective purchases or sales
• Price exposures associated with the market value of inventory items
• Price exposures on available-for-sale securities

Eligible risks (Paragraph 21f and 36)

• The risk of the change in the overall fair value 
• The risk of changes in fair value due to changes in the benchmark interest rates (i.e., the risk-free rate of interest or the rate associated with LIBOR-based swaps), foreign exchange rates, credit worthiness, or the spread over the benchmark interest rate relevant to the hedged item's credit risk.
• Currency risk associated with (a) an unrecognized firm commitment, (b) a recognized foreign-currency-denominated debt instrument, or (c) an available-for-sale security

Prerequisite requirements to qualify for fair value accounting treatment

• Hedges must be documented at the inception of the hedge, with the objective and strategy stated, along with an explicit description of the methodology used to assess hedge effectiveness. (Paragraph 28a)
• The hedge must be expected to be "highly effective," both at the inception of the hedge and on an ongoing basis. Effectiveness measures must relate the gains or losses of the derivative to those changes in the fair value of the hedged item that are due to the risk being hedged. (Paragraph 20b)
• If the hedged item is a portfolio of similar assets or liabilities, each component must share the risk exposure, and each item is expected to respond to the risk factor in comparable proportions. (Paragraph 21a)
• Portions of a portfolio may be hedged if they are (a) a percentage of the portfolio; (b) one or more selected cash flows; (c) an embedded option (provided it is not accounted for as a stand-alone option); (d) the residual value in a lessor's net investment in a direct financing or sale-type lease. (Paragraph 21a2 and 21f)
• A change in the fair value of the hedged item must present an exposure to the earnings of the reporting entity. (Paragraph 21b)
• Fair value hedge accounting is permitted when cross currency interest rate swaps result in the entity being exposed to a variable rate of interest in the functional currency

Dis-allowed situations (i.e., when fair value accounting may not be applied)

• In general, written options may not serve as hedging instruments. An exception to this prohibition (i.e., when a written option may qualify for cash flow accounting treatment) is when the hedged item is a long option. FAS 133 also defines any combinations that include a written option and involves the net receipt of premium -- either at the inception or over the life of the hedge -- as a written option position. (Paragraph 20c)
• Assets or liabilities that are remeasured with changes in value attributable to the hedged risk reported in earnings -- e.g., non-financial assets or liabilities that are denominated in a currency other than the functional currency -- do not qualify for hedge accounting. The prohibition does not apply to foreign-currency-denominated debt instruments that require remeasurement of the carrying value at spot exchange rates. (Paragraph 21c, 29d, and 36)
• Investments accounted for by the equity method do not qualify for hedge accounting. (Paragraph 21c)
• Equity investments in consolidated subsidiaries are not eligible for hedge accounting. (Paragraph 21c)
• Firm commitments to enter into business combinations or to acquire or dispose of a subsidiary, a minority interest or an equity method investee are not eligible for hedge accounting. (Paragraph 21c)
• A reporting entity's own equity is are not eligible for hedge accounting. (Paragraph 21c)
• For held-to-maturity debt securities the risk of a change in fair value due to interest rate changes is not eligible for hedge accounting. Fair value hedge accounting may be applied to a prepayment option that is embedded in a held-to-maturity security, however, if the entire fair value of the option is designated as the exposure. (Paragraph 21d)
• Prepayment risk may not be designated as the risk being hedged for a financial asset. (Paragraph 21f)
• Except for currency derivatives, derivatives between members of a consolidated group cannot be considered to be hedging instruments in the consolidated statement, unless offsetting contracts have been arranged with unrelated third parties on a one-off basis. (Paragraph 36)

Hedges of Net Investments in Foreign Operations

Special hedge accounting is appropriate for hedges of the currency exposure associated with net investments in foreign operations, which give rise to translation gains or losses under SFAS 52. Derivatives and non-derivatives (i.e.., assets or liabilities denominated in the same currency as that of the net investment) may be designated as hedges of these exposures. Effective results of such hedges are recognized in the same manner as a translation adjustment. Ineffective portions of hedge results are recognized in earnings. (Paragraph 42)

Hedge accounting for net investments in foreign operations is not automatic. Specific criteria must be satisfied both at the inception of the hedge and on an ongoing basis. If, after initially qualifying, the criteria for hedge accounting stop being satisfied, hedge accounting is no longer appropriate. With the discontinuation of hedge accounting, gains or losses of the derivative will be recorded in earnings.

Reporting entities have complete discretion to hedge relationships at will and later re-designate them, assuming all hedge criteria remain satisfied.

Prerequisite requirements to qualify for hedge accounting treatment

• Hedges must be documented at the inception of the hedge, with the objective and strategy stated, along with an explicit description of the methodology used to assess hedge effectiveness. This documentation must include the identification of the hedged item and the hedging instrument and the nature of the risk being hedged. (Paragraph 20a)
• The hedge must be expected to be "highly effective," both at the inception of the hedge and on an ongoing basis. Effectiveness measures must relate the gains or losses of the derivative to those changes in the fair value of the hedged item that are due to the risk being hedged. (Paragraph 20b)

Speculative Trades (Not Qualifying for Hedge Accounting)

The accounting treatment is the same for derivatives intended for speculative purposes or for which the prerequisite hedge criteria are not satisfied. Gains and losses of the derivative are realized currently in earnings. The objective for using the derivative contract(s) must still be disclosed.

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EFFECTIVENESS

Hedge Effectiveness Methodologies

FAS 133 requires the method used to assess hedge effectiveness to be defined at the time of hedge designation; and this method must then be applied consistently - both at the inception of the hedge and on an ongoing basis. If the entity decides to improve upon this method, the original hedge must be de-designated and a new hedge relationship needs to be stipulated. If the same method is not applied to similar hedges, a justification for using differing methods is required.

Entities may elect to exclude specific components of hedge results from the hedge effectiveness assessment. Allowable excluded items are (a) differences between spot and forward (or futures prices), if the derivative is or contains a forward or futures contract, or (b) the time value or the volatility value of options, if the derivative is or contains an option contract. (Paragraph 63) Hedge effectiveness may be assumed to be perfect in two specific situations (Paragraph 68):

• If the hedging instrument is a forward contract that perfectly matches the intended forecasted transaction, with the forward having a market value equal to zero at the inception of the hedge.
• If the hedging instrument is a plain-vanilla interest rate swap (i.e., with no optionality) that perfectly matches (in terms of notional amounts, tenors, settlement frequencies, and payment dates) the hedged item to which it is paired.

In order to qualify for hedge accounting, gains or losses on the derivative must offset changes in the fair value or changes in cash flows of the associated hedged item. Put another way, the combined effect of the derivative and the hedged item should result in a gain or loss that is constrained to be a small fraction of the initial value of the exposed item, X, with a high level of confidence, Y. It is left to the discretion of the client, however, to specify parameter values for X and Y, respectively.

Besides these determinations, the client also needs to specify the time span from which the price data are collected (e.g., two year's worth of data). Also, the span of time for which price changes are measured will be dictated by the hedging horizon (i.e., the time frame over which the hedge will be maintained), with a maximum of a quarter of a year.

For instance, consider the case of a fair value hedging relationship where the hedging entity constructs a data set from the most recent three-years of daily price data, resulting in approximately 1,000 paired observations of 91-day price changes. Their objective, then, would be to assess whether hedges have been effective in offsetting price changes of the hedged item over quarter-year time horizons.

Assuming the client specified a maximum price effect of 2% (i.e., X = 2%) with a confidence level of 95% (i.e., Y = 95%), in order to qualify for hedge accounting, the following condition would have to be satisfied in 95 percent of the 1,000 cases:

where E and D refer to the values associated with the exposure (i.e., the hedged item) and the derivative instrument, respectively.

For interest rate exposures, it is critical to take the passage of time into consideration. That is, it is inappropriate to measure changes in a constant maturity instrument when the maturity of the instrument in question is diminishing over time. For example, to assess the prospective effectiveness of a five-year swap used to hedge of a five-year bond, 91-day value changes would be the calculated using rates for 4 ¾-year securities at the end of the quarter versus 5-year securities at the beginning of the quarter.

Warning: The FASB has not sanctioned any particular methodology for assessing prospective hedge effectiveness. And while the above discussion represents the perspective of Kawaller & Company, hedging entities are encouraged to discuss this -- or any alternative approach -- with their external auditors before adopting it.

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TRANSITIONS

Special transition rules apply for the first quarter in which FAS 133 accounting rules are adopted. Among these provisions are the following:

• The difference between the fair value of all derivatives and it's carrying value as of the end of the prior accounting period is reported as a transition adjustment in earnings or other comprehensive income, as appropriate.
  • If associated with a hedge that would be designated as a cash flow hedge, a cumulative-effect-type adjustment to OCI is required. (Paragraph 52a)
  • If associated with a hedge that would be designated as a fair value hedge, a cumulative-effect-type adjustment of net income is required for both the derivative and the hedged item, and their respective carrying amounts shall be adjusted, accordingly. (Paragraph 52b)
  • The transition adjustment for a fair value-type hedge may be calculated as (a) the difference between the pre-FAS 133 carrying amount of the hedged item and its current fair value, or (b) the gain or loss on the hedged item attributable to the hedged risk, since the inception of the hedge. In either case, the magnitude of this adjustment shall be no larger that offsetting adjustment associated with the derivative. (Paragraph 52b)
  • For a hedge of an available for sale security, where prior gains or losses had been recorded in OCI, cumulative-effect-type adjustments are required for both OCI and net income categories to reclassify prior gains from OCI to net income. The magnitudes of these adjustments are limited to the amounts of the offsetting adjustments for the derivatives. (Paragraph 52b)
• Different treatment applies for embedded derivatives, depending upon when the hybrid instrument was issued, acquired, or substantially modified. (Paragraph 50)
  • After December 31, 1997: Follow normal FAS 133 guidance.
  • Before January 1, 1998 (and not substantially modified after): Entities may elect to continue the pre-FAS 133 accounting treatment. This election must be applied for all hybrid instruments.
• Upon the date of adoption, the carrying amount of the host component of a hybrid instrument shall be based on its fair value as of the date the hybrid instrument was issued or acquired -- subject to traditional adjustments for cash flows, amortization, etc. A transition adjustment shall be made for the difference between (1) the previous carrying amount of the hybrid instrument and (2) the sum of the new carrying amount of the host and the fair value of the embedded derivative. (Paragraph 51)
• The advent of FAS 133 provides entities with the opportunity to transfer (a) any held-to-maturity security to an available-for-sale or trading category, or (b) any available-for-sale security into the trading category. (Paragraphs 54 and 55)

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DISCLOSURE

Disclosure Requirements

The following must be disclosed by all reporting entities that use derivative instruments (Paragraph 44)

• Objectives for using each derivative, whether for hedging or for speculation.
• The context needed to understand objectives.
• Qualitative disclosures are encouraged.

The following must be disclosed if derivatives are used in hedging relationships (Paragraph 45)

• Risk management policies must be specified, identifying exposures to be hedged and hedging strategies for managing the associated risks.
• Identification of the type of hedging relationship (i.e., fair value, cash flow, net investment in foreign operation), if applicable.
• The hedged item must be explicitly identified.
• Ineffective hedge results must be disclosed.
• Any component of the derivatives' results that is excluded from the hedge effectiveness assessment must be disclosed.

Specific requirements for fair value hedges (Paragraph 45a)

• The place on the income statement where derivative gains or losses are reported must be disclosed.
• When a firm commitment no longer qualifies as a hedged item, the net gain or loss recognized in earnings must be disclosed.

Specific requirements for cash flow hedges (Paragraph 45b)

• A description of the conditions that will result in the reclassification of accumulated other comprehensive income into earnings, and a schedule of the estimated reclassification expected in the coming 12 months must be disclosed.
• The maximum length of time over which hedging is anticipated (except for variable interest rate exposures) must be disclosed.
• Entities must disclose the amount reclassified into earnings as a result of discontinued cash flow hedges because the forecasted transaction is no longer probable.
• Specific requirements for hedges of net investments in foreign operations (Paragraph 45c)
• Entities must disclose the amount of the derivatives' results that is included in the cumulative translation adjustment during the reporting period.