1-0 ACCOUNTING FOR DERIVATIVES Presentation by Bob Jensen Trinity University One Trinity Place San Antonio, TX 78212 [email protected]

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ACCOUNTING FOR DERIVATIVES

Presentation byBob Jensen

Trinity University

One Trinity Place San Antonio, TX [email protected]

http://www.trinity.edu/rjensen/

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Bob Jensen190 Sunset Hill Road Sugar Hill, NH 03586

Phone 603-823-8482

[email protected] http://www.trinity.edu/rjensen/

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FAS 133 IAS 39 CICA 13

Bob Jensen’s Free Tutorials, Glossaries, and Cases are at

http://www.trinity.edu/rjensen/caseans/000index.htm

Accounting for Derivative Financial Instruments and Hedging

Transactions

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Key Amendments to FAS 133FAS 138FAS 149FAS 155

FAS 159


Transactions

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Eliminated by FAS 133FAS 080

FAS 119


Transactions

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FAS 105, 107, 115, 130, 133, 141, 142, 155, 157, 159 Bob Jensen’s Summary of Accounting History and Theory

http://www.trinity.edu/rjensen/theory.htm

“Not everything that can be counted, counts. And not everything that counts can be counted.” Albert Einstein

Fair Value AccountingFAS 105, 107, 115, 130, 133, 141, 142, 155, 157, 159

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FAS 115 effective in 1994FV Reporting of AFS Investments in Debt/Equity

Debt securities that the enterprise has the positive intent and ability to hold to maturity are classified as held-to-maturity securities and reported at amortized cost.

Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings.

Debt and equity securities not classified as either held-to-maturity securities or trading securities are classified as available-for-sale securities and reported at fair value, with unrealized gains and losses excluded from earnings and reported in a separate component of shareholders' equity.

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FAS 130 effective in 1998Reporting Other Comprehensive Income (OCI)

This Statement requires that an enterprise

(a) classify items of other comprehensive income by their nature in a financial statement and

(b) display the accumulated balance of other comprehensive income (AOCI) separately from retained earnings and additional paid-in capital in the equity section of a statement of financial position.

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FAS 133 effective in 2000Amended by FAS 137, 138, 149, 155, and 159

Accounting for Derivative Financial Instruments and Hedging Activities Financial Derivatives & Scandals Explode in the Early 1990's Video or Audio clip from CBS Sixty Minutes SIXTY01.avi or SIXTY01.mp3 Audio clip from John Smith of Deloitte & Touche in August 1994

SMITH01.mp3 Examples of derivative contracts that even the professional analysts could not

decipher The derivatives that Merrill Lynch wrote that drive Orange County into

bankruptcy Other derivatives fraud summaries are at http://

www.trinity.edu/rjensen/fraud.htm#DerivativesFraud Video and audio clips of FASB updates on FAS 133

Audio 1 --- Dennis Beresford in 1994 in New York City BERES01.mp3 Audio 2 --- Dennis Beresford in 1995 in Orlando BERES02.mp3

Derivative Financial Instrument Frauds --- Off line --- Click Here

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FAS 133 effective in 2000Amended by FAS 137, 138, 149, 155, and 159

Accounting for Derivative Financial Instruments and Hedging Activities

Requires booking of most derivative financial instruments at fair value (with some exceptions for NPNS, regular-way, insurance contracts, weather derivatives, short sales, interest-strips, etc.)

Derivatives are to be marked to current fair value at least every 90 days and on reporting dates. Changes in fair value are to be charged or credited to current earnings unless the derivatives qualify for hedge accounting treatment as cash flow, fair value, or FX hedges. Not all economic hedges qualify for hedge accounting relief from current earnings.

Hedge accounting rules under FAS 133 and its amendments are very complex.

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Key FAS 133 and IAS 39 Terms

Notional | Underlying | Net Settlement | Little or No Initial Investment

Financial Instrument | Derivative Instrument

Purchase Commitment | Firm Commitment | Forecasted Transaction | Speculation

Stand Alone | Cash Flow Hedge | Fair Value Hedge | FX Hedge

Purchased Options | Written Options | Long Forwards | Short Forwards | Swaps | Futures Contracts

European versus American versus Asian options

Spot Price, Forward Price, Strike Price, Premium, Intrinsic Value, Time Value

Freestanding, Embedded, Structured (tailormade rather than convential financing)

OCI versus Firm Commitment | Delta

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Bob Jensen's threads on Enron are at http://www.trinity.edu/rjensen/fraud.htm Bob Jensen's threads on Derivative Financial Instruments Fraud are at

http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds Also note http://www.trinity.edu/rjensen/Fraud.htm#FrankPartnoyTestimony

How Enron Used SPEs and Derivatives Jointly is Explained at http://www.trinity.edu/rjensen//theory/00overview/speOverview.htm

Bob Jensen’s threads on derivatives accounting are at

http://www.trinity.edu/rjensen/caseans/000index.htm

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Frank Partnoy’s Works

Of all the many documents and books that I have read about derivative financial instruments, the most important have been the books and documents written by Frank Partnoy. Some of his books are listed at the bottom of this message.

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The single most important document is his Senate Testimony. More than any other single thing that I've ever read about the Enron disaster, this testimony explains what happened at Enron and what danger lurks in the entire world from continued unregulated OTC markets in derivatives. I think this document should be required reading for every business and economics student in the world. Perhaps it should be required reading for every student in the world. Among other things it says a great deal about human greed and behavior that pump up the bubble of excesses in government and private enterprise that destroy the efficiency and effectiveness of what would otherwise be the best economic system ever designed.

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Testimony of Frank Partnoy Professor of Law, University of San Diego School of Law Hearings before the United States Senate Committee on Governmental Affairs, January 24, 2002 --- http://www.senate.gov/~gov_affairs/012402partnoy.htm

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FIASCO: The Inside Story of a Wall Street Trader

FIASCO: Blood in the Water on Wall Street

FIASCO: Blut an den weiÃŸen Westen der Wall Street Broker.

FIASCO: Guns, Booze and Bloodlust: the Truth About High Finance

Infectious Greed : How Deceit and Risk Corrupted the Financial Markets

Codicia Contagiosa His other publications include the following highlight: "The Siskel and Ebert of Financial Matters: Two Thumbs Down for the Credit

Reporting Agencies" (Washington University Law Quarterly)

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REASONS FOR NEW STANDARDS

Undisclosed Assets and LiabilitiesUnbooked Assets and LiabilitiesMeaningless Measures of Value & RiskRise in Scandals in the 1980s & 1990sComplex Frauds --- Partnoy’s FiascoExplosion of Swap ContractsEvolution Toward Fair Value Accounting

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PROBLEMS WITH NEW STANDARDS

Complex Contracts & Technical JargonComplex Scoping of Coverage --- NPNSComplex Hedge Accounting RulesMany Derivatives Are Difficult to ValueDifficult to Find Embedded DerivativesComplex Effectiveness Testing RulesContinuous Stream --- DIG, AmendmentsImplementation Failures --- Freddie Mac, etc.Held-to-Maturity Interim DistortionsHedge Acctg. Denied to Most Macro Hedges

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Differences Between StandardsFAS 133 vs. IAS 39 vs. CICA 13

Differences are relatively minor

IAS 39 Macro Hedging Amendment

Listing of Major Differenceshttp://www.trinity.edu/rjensen/caseans/canada.htm

.

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Hedge Accounting Section Objectives

After completing this section, you should be able to: Determine whether a contract is scoped into the

standards and, if so, whether it is

– Qualified for Hedge Accounting

– Treated as a cash flow, fair value, or FX hedge

Understand the basic journal entries Cry out loud if forced to implement the standards

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One million lines of journal entries: Just how expensive is FAS 133?

"The Potential Crisis at Fannie Mae," Comstock Funds, August 11, 2005 --- http://snipurl.com/Fannie133 We have no proprietary information about Fannie Mae, but what is publicly known is scary enough. As you may

recall, last December the SEC required Fannie to restate prior financial statements while the Office of Federal Oversight (OFHEO) accused the company of widespread accounting regularities that resulted in false and misleading statements. Significantly, the questionable practices included the way Fannie accounted for their huge amount of derivatives. On Tuesday, a company press release gave some alarming hints on how extensive the problem may be.

The press release stated that in order to accomplish the restatements, “we have to obtain and validate market values for a large volume of transactions including all of our derivatives, commitments and securities at multiple points in time over the restatement period. To illustrate the breadth of this undertaking, we estimate we will need to record over one million lines of journal entries, determine hundreds of thousands of commitment prices and securities values, and verify some 20,000 derivative prices…”

“…This year we expect that over 30 percent of our employees will spend over half their time on it, and many more are involved. In addition we are bringing some 1,500 consultants on board by year’s end to help with the restatement…Altogether, we project devoting six to eight million labor hours to the restatement. We are also investing over $100 million in technology projects to enhance or create new systems related to accounting and reporting…we do not believe the restatement will be completed until sometime during the second half of 2006…”

Bob Jensen's tutorials on accounting for derivatives are at http://www.trinity.edu/rjensen/caseans/000index.htm

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FOUR CORNERSTONES

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

Fair value is the only relevant measure for derivatives(Mainly because historical cost is zero or near-zero)

Value risk can be hedged into cash flow risk, and cash flow risk can be hedged into value risk, but both risks cannot simultaneously be eliminated.

Hedge effectiveness tests can be varied with the type of risk being hedged.

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Example: Futures ContractsFinancial Risk May Be Unbounded

May be contracts to buy or sell at contracted (future) price that moves along with spot prices on an organized exchange linking buyers and sellers. Cost = Zero!

Notional = standardized quantities per contract for a standard product such as a particular type of corn.

Underlying = the value per unit such as the price of a bushel of corn or a Treasury or Libor interest rate.

Futures are a unique kind of derivative because futures gains and losses are posted daily in cash.

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Example: Futures Contracts (Continued)

Since futures contracts are cleared daily for cash, the accounting was relatively simple under the now-defunct FAS 80.

FAS 133 rules are more complicated for hedging contracts --- see 000starta.xls file at http://www.cs.trinity.edu/~rjensen/Calgary/CD/FAS133OtherExcelFiles/cases/

CBOT --- http://www.cbot.com/

The prices you first see listed are the forward prices. To find spot prices, click on the link called "Charts."

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Example: Forward ContractsFinancial Risk May Be Unbounded

May be contracts to buy or sell at contracted (future) price that moves along with spot prices in over-the-counter (OTC) private contracts. Cost = Zero!

Notional = unique quantities per contract for a defined product such as a particular type of corn.


Unlike futures contracts, forward contracts are neither standardized nor cleared daily for cash gains and losses.

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Example: Forward Contracts (Continued)

There were no accounting rules for forward contracts prior to FAS 133.

FAS 133 rules are complicated for hedging contracts --- see 000starta.xls file at http://www.cs.trinity.edu/~rjensen/Calgary/CD/FAS133OtherExcelFiles/cases/

CBOT --- Does not exchange forward contracts

Contracts are non-standardized and might be subject to credit risk.

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Example: Swap Contracts Financial Risk May Be Unbounded

Swaps are generally portfolios of forward contracts with regularly-spaced payment dates. Cost = Zero!

Notional = unique quantities per contract for a defined product such the number of bonds being hedged.


Interest rate swaps were only invented in 1984, but they became the leading form of cash management and now have notionals over $100 trillion dollars..

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Example: Swap Contracts (Continued)

There were no accounting rules for swap contracts prior to FAS 133.

FAS 133 rules are complicated for hedging contracts --- see 000starta.xls file at http://www.cs.trinity.edu/~rjensen/Calgary/CD/FAS133OtherExcelFiles/cases/

There are a few standardized swaps traded on exchanges

Contracts are non-standardized and might be subject to credit risk.

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Example: Written Option ContractsFinancial Risk May Be Unbounded

Contracts to sell or buy at contracted (future) price that moves along with spot prices on an organized exchange linking buyers and sellers. Sale Price > $0=Premium! Example: Selling Puts or Calls.



Options may also be non-standardized OTC. Use of options dates back to Roman times.

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Example: Purchased Option ContractsFinancial Risk Is Bounded by Premium Paid

Contracts to buy or sell at contracted (future) price that moves along with spot prices on an organized exchange linking buyers and sellers. Purchase Price > $0=Premium! Example: Buying Puts or Calls.



Purchased options are the only derivatives where risk is limited to the premium (purchase) price paid initially.

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Example: Purchased Options (Continued)

The accounting was relatively simple under the now-defunct FAS 80.

FAS 133 rules are more complicated for hedging contracts --- see 000starta.xls file at http://www.cs.trinity.edu/~rjensen/Calgary/CD/FAS133OtherExcelFiles/cases/

CME --- http://www.cme.com/trading/dta/del/delayed_quotes3520.html

Value of Option = Intrinsic Value + Time Value

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KEY ASPECTS OF THE 133/39 STANDARDS

Most derivatives are reported at fair value on balance sheet Changes in fair value for derivatives not qualifying in a hedging

relationship are recorded in earnings Hedge accounting is provided for the change in value of

derivatives designated and qualifying as: Fair value hedges Cash flow hedges Foreign currency hedges

Hedge effectiveness tests may be tough hurdles over time

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DERIVATIVES IMPLEMENTATIONGROUP (DIG)

DIG is made up of FASB staff members, Big 5 members and Industry professionals. Active DIG observers include the SEC and certain regulators.

DIG’s mandate is to assist the FASB in answering implementation questions by identifying practice issues that arise from applying Statement 133 and to advise the FASB staff on how to resolve the issues.

Issues are discussed by DIG, tentatively concluded by the FASB staff and posted on the FASB website (www.fasb.org) for two months before being presented to the Board for negative clearance.

DIG Site http://www.fasb.org/derivatives/

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Bob Jensen’s Flow Charthttp://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm

Flow chart for deciding whether derivative is scoped into FAS 133

Flow chart for deciding how to account for a derivative financial instrument qualified for hedge accounting.

Cash Flow Hedge (booked item vs. forecasted transact.)Fair Value Hedge (booked item vs. firm commitment)Foreign Currency (FX) Hedge (fair value vs. cash flow)

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DERIVATIVE DEFINITION ¶6–16

The definition is based on distinguishing characteristics A derivative instrument is a contract with all three of the

following characteristics (¶6): Underlying and either a notional amount or a payment

provision or both Relatively small initial net investment

(5% Rule in Para A5 of FAS 149) Net settlement or its equivalent (excludes most short sales & Take-

Or-Pays, but see FAS 133 Paragraph 290) Definition includes freestanding as well as embedded derivative

instruments A number of exclusions exist

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FREESTANDING DERIVATIVESOverview

Statement 133 created a new definition of the term derivative

Some instruments that are not usually considered derivatives are included (e.g. certain purchase/sales contracts)

The definition is based on certain distinguishing characteristics.

Certain scope exceptions exist; not everything that meets the definition of a derivative is subject to the requirements of Statement 133.

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FREESTANDING DERIVATIVES Three Characteristics ¶6–9 and 57

A derivative instrument is a contract with all three of the following characteristics:

1. Underlying and either a notional amount or a payment provision or both

2. No initial net investment or smaller initial net investment than contracts with similar responses to changes in market factors

3. Net settlement or its equivalent

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FREESTANDING DERIVATIVES Characteristic 1—Underlying

¶7 and 57(a)

An underlying is a variable, such as: An interest rate (e.g., LIBOR) The price of a security or commodity (e.g., price of a

share of ABC stock or a bushel of wheat) A foreign exchange rate (e.g., Euro/U.S. $ spot rate) A measure of creditworthiness (e.g., Moody’s) An index on any of above or other (e.g., S&P 500, CPI) Other specific items

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FREESTANDING DERIVATIVES Characteristic 1—Notional Amount ¶7

A notional amount is a number of: Currency units Shares Bushels Pounds Other units

Notional amount is used to determine the settlement amount (for example, a price x a number of shares)

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FREESTANDING DERIVATIVES Characteristic 1—Examples of Underlyings and

Notional Amounts

Derivative Underlying Notional Amount

- Stock option - Stock price - Number of shares

- Currency forward - Exchange rate - Number of currency units

- Commodity future - Commodity price - Number of commodity units

- Interest rate swap - Interest index - Dollar amount

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FREESTANDING DERIVATIVES Characteristic 1—

Payment Provision ¶7

A payment provision specifies a fixed or determinable settlement if the underlying behaves in a specified way.

For example:

if interest rates increase by say 300 basispoints then payment of an applicableamount would be required

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FREESTANDING DERIVATIVES Characteristic 2—

Initial Net Investment ¶8 and 57(b)

A derivative requires either: No initial net investment A smaller initial net investment than other types of

contracts that have a similar response to changes in market factors

A derivative does not require an initial net investment of

the notional amount

An exchange of currencies is not a net investment

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FREESTANDING DERIVATIVES Characteristic 3—Net Settlement

¶9 and 57(c)

There are 3 ways to meet the net settlement requirement:

1. Net settlement explicitly required or permitted by the contract (transfer of cash or other assets)

2. Net settlement by a market mechanism outside the contract (e.g., futures exchange)

3. Delivery of a derivative or an asset that is readily convertible to cash

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FREESTANDING DERIVATIVES Characteristic 3—Readily Convertible

to Known Amounts of Cash ¶9 and 57(c)

Readily convertible assets have: Interchangeable (fungible) units Quoted prices available in an active market that

can rapidly absorb the quantity held by the entity without significantly affecting the price

For example: Public securities, commodities, and foreign

currencies

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FREESTANDING DERIVATIVES Exceptions ¶10 and 58

The following are not subject to Statement 133: “Regular-way” security trades Normal purchases and normal sales Traditional insurance contracts Most financial guarantee contracts OTC contracts with certain underlyings Derivatives that are an impediment to sales

accounting

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FAS 138Scope-Excluded Contracts

Normal purchase/sale exception expanded to include:

Contracts that permit net settlement (9a) Contracts that have a market mechanism to

facilitate net settlement (but note FAS 138) FAS 149 Electric Power Bookout Exception

As long as it is probable contracts will not settle As long as it is probable contracts will not settle net and will result in physical delivery (but note FAS 138 net and will result in physical delivery (but note FAS 138 and FAS 149)and FAS 149)

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FAS 138 Scope-Excluded Contracts (Cont’d)

Net settlement of similar contracts should be rare

Excluded from exception:

• Contracts that require cash settlement or otherwise settle periodically

• Contracts that have price based on underlying unrelated to asset sold or purchased(1)

• Contracts denominated in foreign currency not meeting embedded derivative separation exception rules of paragraphs 15(a) and 15(b) (1)

(1) May be considered compound derivatives

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FREESTANDING DERIVATIVES Exceptions OTC Contracts with

Certain Underlyings ¶10(e) and 58(c)

Climatic variables: Temperature Rain or snowfall totals Wind speed

Geological variables: Earthquake severity (Richter scale)

Other physical variables

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FREESTANDING DERIVATIVES Exceptions—OTC Contracts with

Certain Underlyings ¶10(e) and 58(c)

The price or value of nonfinancial assets of one of the parties that is not readily convertible to cash or the price or value of nonfinancial liabilities of one of the parties that does not require delivery of readily convertible assets

Option to purchase or sell real estate owned by one party (even if it can be net settled)

Firm commitment to sell machinery (if unique)owned by one party (even if it can be net settled)

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FREESTANDING DERIVATIVES Exceptions OTC Contracts with Certain

Underlyings ¶10(e) and 58(c)

Exceptions include specified volumes of sales or service revenues of one of the parties.

For example: Leases based on sales of the lessee Royalty agreements

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FREESTANDING DERIVATIVES Contracts Not Considered Derivativesfor Purposes of Statement 133, ¶11

Instruments indexed to an entity’s own stock and classified in stockholders’ equity

Stock-based compensation covered by Statement 123 (issuer only)

Contingent consideration in a business combination covered by Opinion 16 (purchaser only)

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EMBEDDED DERIVATIVES Definition ¶12

Embedded derivatives are implicit or explicit terms that affect the cash flows or value of other exchanges required by a contract in a manner similar to a derivative

The combination of a host contract and an embedded derivative is referred to as a hybrid contract

Examples of hybrid contracts are: Structured notes Convertible securities Securities with caps, floors, or collars

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Is the contractcarried at fairvalue through

earnings?

Would it be aderivative if it

was freestanding?

Is it clearly and closely related

to the hostcontract?

No Yes No

Yes No Yes

Do Not Apply This Statement

Apply T

his Statem

entEMBEDDED DERIVATIVES

When Does a Contract Have an Embedded Derivative Subject to This Statement? ¶12

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EMBEDDED DERIVATIVES Clearly and Closely Related—General

¶12 and 60–61

Clearly and closely related refers to: Economic characteristics Risks

Factors to consider: The type of host The underlying

See Flow Chart http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm

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EMBEDDED DERIVATIVES Clearly and Closely Related—Underlyings

Type of Host Underlying

Debt InterestInflationCreditworthiness

Equity Price of share in entity

Lease InflationInterest

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EMBEDDED DERIVATIVESClearly and Closely Related

Paragraph 61 provides guidance for determining 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.

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EMBEDDED DERIVATIVESFAS 155

Specifically, FAS 155 standard allows financial instruments that have embedded derivatives to be accounted for as a whole (eliminating the need to bifurcate the derivative from its host) if the holder elects to account for the whole instrument on a fair value basis.

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FAIR VALUE HEDGE ¶20–22

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

Hedged item is exposed to price risk For a highly effective hedge, there must be offsetting fair

value changes for hedged item and hedging instrument Changes in fair value of hedged item and hedging

instrument are recorded in earnings Basis of hedged item is adjusted by the change in value

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FAIR VALUE HEDGE ACCOUNTING

Key concepts: Derivatives are always adjusted on the balance sheet at fair value (i.e.,

marked-to-market) (¶17)

In qualified hedge accounting, the offset to changes in the hedging derivative is OCI for cash flow hedges but not for fair value hedges.

For a qualified fair value hedge, the offset is = “Firm Commitment” for a purchase contract with a contracted price = “Hedged Item” carrying value if the hedged item such as inventory is already on the books at historical cost

= “P&L” current earnings if the hedged item such as inventory is already on the books at fair value

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Measurement of Derivative

FAIR VALUE HEDGE ACCOUNTINGFor Hedged Item Booked at Historical Cost

Change in Fair Value

Offsetting Gain or LossAttributable to Risk Being

Hedged

Measurement of Hedged Item

EarningsChanges

Offset(1)

Acc

ou

nti

ng

Mo

del

(1) Ineffectiveness affects net earnings

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CASH FLOW HEDGE ¶29–31

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

• Hedged item may be a forecasted transaction with no contracted future price (i.e., not a firm commit.)

• Effective portion of derivative’s gain or loss reported in OCI

• Earnings recognition matches hedged transaction

• Ineffective gain or loss recorded in earnings

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CASH FLOW HEDGE ACCOUNTING

Derivative instrument recorded at fair value, effective portion through OCI, ineffective through earnings

Amounts in OCI recognized in earnings when hedged transaction impacts earnings under FAS 133 but not under IAS 39. In other words, IAS 39 requires basis adjustment when the derivative expires whereas FAS 133 carries OCI forward until hedged item is disposed of in a transaction.

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EffectiveChange in Fair Value Ineffective

(1)

OCIEquity

Earnings

(1) Based on Timing of Earnings Impact of Hedged Item (interest, cost of sales, depreciation)

CASH FLOW HEDGE ACCOUNTINGA

cco

un

tin

g M

od

el Measurement of Derivative

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Fair Value Hedge

Fair value hedge accounting does not use OCI like in cash flow and FX hedges. The reason is that changes in fair value of hedged items do not change earnings in the same manner as changes in cash flows and FX hedged items.

Fair value hedge of a historical cost hedged item requires shifting from historical cost accounting to fair value accounting for the hedged item (but only during the hedging period).

Fair value hedge of a firm commitment requires use of a fair value hedge accounting account the FASB invented that is called “Firm Commitment” but should be named something else.

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FAS 159 effective in 2008The Fair Value Option for Financial Assets and Financial Liabilities

Allows entities to voluntarily choose to measure eligible financial instruments at fair value (the “fair value option”)(Exceptions for items covered by some other standards such as consolidated entities, pensions, post-employment contracts, leases, and financial insurance contracts)

Changes in fair value recognized in earnings. (no OCI)

Election made on an instrument-by-instrument basis

Irrevocable

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FASB issued the FVO to:

Provide an opportunity to mitigate volatility in earnings caused by a mixed attribute accounting model

Reduce the need for applying complex hedge accounting provisions

Expand the use of fair value measurements International convergence

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Scope:

• Recognized financial assets and liabilities (but not forecasted transactions under FAS 133)

• Firm commitments that would otherwise not be recognized at inception and that involve only financial instruments

• Written loan commitments

• Certain rights and obligations under insurance contracts or warranty obligations

• A financial host contract in a nonfinancial hybrid instrument

• Certain nonfinancial assets and liabilities

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FOREIGN CURRENCY HEDGE ¶36–42 (as amended by FAS 138)

The Board intended to increase the consistency of hedge accounting guidance by broadening the scope of eligible foreign currency hedges. At the same time, the Board chose to continue certain prior practices. Key aspects:

Includes hedges of cash flow, fair value, and net investments in foreign operations

Carries forward the functional currency concept from Statement 52

Permits limited use of nonderivative instruments Expands hedge accounting, particularly for forecasted

transactions and tandem currency hedges

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Hedging Instruments

For a fair value hedge of foreign exchange risk related to AFS securities or a recognized foreign-currency-denominated debt instrument, an entity can only use a derivative instrument

For a fair value hedge of foreign exchange risk related to a firm commitment, an entity can use either a derivative or a non-derivative instrument

For a cash flow hedge of a forecasted foreign currency denominated transaction (including forecasted intercompany transactions, recognized foreign-currency-denominated debt instruments and firm commitments accounted for as forecasted transactions), an entity can only use a derivative instrument

For a hedge of a net investment in a foreign operation, an entity can use either a derivative or a non-derivative instrument

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Timing of gain/loss recognition on hedging instrument and

hedged item

Hedged Item $ -0- (1) $(20) $(20)

Derivative 20 (2) -0- 20

$20 $(20) $ -0-

OBJECTIVE OF HEDGE ACCOUNTING

Periods 1 2 Total

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IAS 39 should be applied by all enterprises to all financial instruments except:

(a) those interests in subsidiaries, associates, and joint ventures that are accounted for under IAS 27,

Consolidated Financial Statements and Accounting for Investments in Subsidiaries; IAS 28,

Accounting for Investments in Associates; and IAS 31, Financial Reporting of Interests in Joint Ventures;

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(b) rights and obligations under leases, to which IAS 17, Leases, applies; however, (i) lease receivables recognized on a lessor's balance sheet are subject to the derecognition provisions of this Standard (paragraphs 35-65 and 170(d)) and

(ii) this Standard does apply to derivatives that are embedded in leases (see paragraphs 22-26);

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c) employers' assets and liabilities under employee benefit plans, to which IAS 19, Employee Benefits, applies;

(d) rights and obligations under insurance contracts as defined in paragraph 3 of IAS 32, Financial Instruments: Disclosure and Presentation, but this Standard does apply to derivatives that are embedded in insurance contracts (see paragraphs 22-26);

(e) equity instruments issued by the reporting enterprise including options, warrants, and other financial instruments that are classified as shareholders' equity of the reporting enterprise (however, the holder of such instruments is required to apply this Standard to those instruments);

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(f) financial guarantee contracts, including letters of credit, that provide for payments to be made if the debtor fails to make payment when due (IAS 37, Provisions, Contingent Liabilities and Contingent Assets, provides guidance for recognizing and measuring financial guarantees, warranty obligations, and other similar instruments). In contrast, financial guarantee contracts are subject to this Standard if they provide for payments to be made in response to changes in a specified interest rate, security price, commodity price, credit rating, foreign exchange rate, index of prices or rates, or other variable (sometimes called the 'underlying'). Also, this Standard does require recognition of financial guarantees incurred or retained as a result of the derecognition standards set out in paragraphs 35-65;

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(g) contracts for contingent consideration in a business combination (see paragraphs 65-76 of IAS 22 (Revised 1998), Business Combinations);

(h) contracts that require a payment based on climatic, geological, or other physical variables (see paragraph 2), but this Standard does apply to other types of derivatives that are embedded in such contracts (see paragraphs 22-26).

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3. IAS 39 does not change the requirements relating to:(a) accounting by a parent for investments in subsidiaries in the parent's separate financial statements as set out in paragraphs 29-31 of IAS 27;(b) accounting by an investor for investments in associates in the investor's separate financial statements as set out in paragraphs 12-15 of IAS 28;(c) accounting by a joint venturer for investments in joint ventures in the venturer's or investor's separate financial statements as set out in paragraphs 35 and 42 of IAS 31; or(d) employee benefit plans that comply with IAS 26, Accounting and Reporting by Retirement Benefit Plans.

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IAS 39 may apply to insurance companiesbut not insurance contracts

5. IAS 39 applies to the financial assets and liabilities of insurance companies other than rights and obligations arising under insurance contracts, which are excluded by paragraph 1(d).

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CASE 1 Cash Flow Hedge of Forecasted Inventory Sale

ABC is hedging the risk of changes in cash flows related to a forecasted sale of 100,000 bushels of Commodity A to be sold at the end of period 1. The inventory carrying value is $1 million, and current market value is $1.1 million

On the first day of period 1, ABC enters into Derivative Z to sell 100,000 bushels at $1.1 million at the end of period

At hedge inception, the derivative is at-the-money (fair value is 0)

All terms of the commodity and the derivative match (i.e., no expected ineffectiveness)

On last day of Period 1, fair value of Derivative Z increased by $25,000 and expected sales price of 100,000 bushels of Commodity A decreased $25,000

From Example 4, Appendix B of Standard

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Journal entries at end of period 1

Derivative Z 25,000

OCI 25,000

To record Derivative Z at fair value

Cash 25,000

Derivative Z 25,000

To record settlement of Derivative Z

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Journal entries at end of period 1

Cash 1,075,000

CGS 1,000,000

Revenue 1,075,000

Inventory 1,000,000

To record inventory sale

OCI 25,000

Earnings 25,000

To reclassify amount in OCI to earnings upon inventory sale

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Forecasted cash flows: $1,100,000

Actual cash flows:

Derivative $ 25,000

Sale of inventory 1,075,000

Total $1,100,000

The variability of cash flows related to the forecasted inventory sale is offset by change in value of derivative.

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CASE 2Fair Value Hedge of Inventory

ABC has 1,000 bushels of a Commodity with a fair value of $1.1 million and a carrying value of $1.0 million

ABC wants to hedge overall fair value of the Commodity

On 1/1/X1, ABC enters into an at-the-money “matching” derivative to hedge the changes in fair value of the 1,000 bushels of the Commodity

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CASE 2 (Cont’d)Fair Value Hedge of Inventory

Effectiveness will be assessed by comparing entire change in fair value of derivative to change in market price of inventory (time value will be ignored for illustration purposes only)

On 1/31/X1, the fair value of the derivative has increased by $25,000 and the fair value of the inventory has decreased by $25,000

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CASE 2Fair Value Hedge of Inventory

Journal entries at end of period:

Derivative 25,000

Earnings 25,000

To record derivative at fair value

Earnings 25,000

Inventory 25,000

To record loss on hedged inventory

Documents

1-0 ACCOUNTING FOR DERIVATIVES Presentation by Bob Jensen Trinity University One Trinity Place San Antonio, TX 78212 [email protected]