FAS 133 Accounting for Derivative Instruments and Hedging Activities

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FAS 133 Accounting for Derivative Instruments
and Hedging Activities

• Angela L.J. Hwang, Ph.D.
• Associate Professor
• Eastern Michigan University

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FAS 133 - Key Aspects

• All derivatives are reported at fair value on the
  balance sheet.
• Changes in fair value of a derivative is
  recognized in earnings.
• Special accounting is provided for a derivative
  designated as or qualified for a hedging purpose.
  
• Fair value hedge
• Cash flow hedge
• Foreign currency hedge

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Example

• BestGas Inc., a natural gas marketer in Midwest
  U.S., buys natural gas from producers and sells
  it to end users and local distribution companies.
  
• BestGas has inventory of 10,000,000 mmBtus of
  natural gas with a carrying value _at_3.0 per mmBtu
  in June X1.
• Inventory is intended for delivery to Chicago in
  Dec. X1.
• In June X1, short sell a December gas derivative
  (forward) contract _at_3.3
• The fair value of the gas inventory increases to
  4.0 and the derivative contract increases to
  4.5 in Sept. X1.
• The gas price for delivery to Chicago in Dec. X1
  decreases to 2.5.
• On entering into the derivative, the entity
  neither receives nor pays a premium.

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Example Using a Derivative Contract for Hedging

• Period Spot Price Dec. Forward Price
  Effect
• (Hedged item-Gas Inventory)
  (Derivative contract)
• June
• Sept.
• Period Gain (Loss)
• Dec.
• Period Gain (Loss)
• Cumulative G (L)

0.3
3.0
3.3
4.0
4.5
1.0
(1.2)
(0.2)
2.5
2.5
(1.5)
2.0
0.5
(0.5)
0.8
0.3

• BestGas has perfect foresight in June when
  entering into the derivative contract knowing
  that a net gain of 0.3 per mmBtu is to be
  realized when the inventory is sold and the
  contract is settled in Dec. irrespective to any
  price fluctuations.
• Price Protection.
• - Derivatives preclude from benefiting windfall
  gains if Gas prices increase above 3.3.

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Example Futures Contract for Hedging

• Period Spot Price Dec. Futures Price
  Effect
• (hedged item) (futures contract)
• June
• Sept.
• Period Gain (Loss)
• Dec.
• Period Gain (Loss)
• Cumulative G (L)

0.3
3.0
3.3
4.0
4.5
1.0
(1.2)
(0.2)
To be reported post-FAS133
2.5
2.5
(1.5)
2.0
0.5
(0.5)
0.8
0.3
Reported pre-FAS133
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Great Derivative Debacles

• Company Year Approx. Amount
• Proctor Gamble 1994 .2 billion
• Glaxo 1994 .1 billion
• Gibson Greetings 1994 -
• Orange County 1994 2.0 billion
• Metallgesellshaft 1994 1.5 billion
• Barings 1995 1.3 billion
• Sumitomo 1996 1.8 billion
• Bank Tokyo-Mitsubishi 1997 .1 billion
• Unions Bank Switzerland 1997 .4 billion
• LTCM 1998 3.5 billion

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Pre-FAS 133 Accounting Model
1997 SEC Market Risk Disclosure
1984 FAS 80 Accounting for Futures
1981 FAS 52 Foreign Currency Translation
1990 FAS 105 Disclosure of info. about F/Is
with off-B/S risk and F/Is with concentrations
of credit risk
1991 FAS 107 Disclosure about fair value of F/Is
60 EITF Issues
1994 FAS 119 Disclosure about Derivative
Financial Instruments (F/Is) and Fair Value of
Financial Instruments
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FAS 133 Implementation

• FAS 133 Accounting for derivative instruments
  and hedging activities
• Issuance in June, 1998
• Culmination of a long and difficult project
  spanning over twelve years
• Represent a significant step towards fair value
  accounting
• Provide a uniform hedging model
• Prior GAAP was incomplete, inconsistent
• Accounting for derivatives was not transparent

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FAS 133 - Implementation

• Initially was to be effective for fiscal years
  beginning after June 15, 1999
• Very controversial faced a great deal of
  opposition from industry
• Industry didnt have time to change systems to be
  FAS 133 compliant
• FAS 137 postponed until June 15, 2000
• (Jan. 1, 2001 for firms with calendar-year
  fiscal years)
• Key aspects of FAS 133 were still being resolved
  by the Derivatives Implementation Group

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Derivative
Fair Value
FAS 133
Asset Liability
Effectiveness
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FAS 133 - Documentation

• Formal documentation is required at the inception
  of the hedge to apply special accounting for a
  derivative
• Identification of the hedging instrument(s) and
  the hedged item
• Nature of the risk being hedged
• The risk management objective/strategy
• Assessment/evaluation of hedging effectiveness

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Journal of Accountancy (March 2001) Practical
Issues in Implementing FASB 133http//www.aicpa.o
rg/pubs/jofa/mar2001/hwang.htm

• 1) Inventory derivatives
• 2) Document risk management philosophy
• 3) Identify hedging relationships for hedge
  designation
• 4) Document the hedging relationship
• 5) Determine effectiveness
• 6) Transition adjustments pretax cumulative
  effects and deferred tax effects of transition
• 7) Risk management
• 8) Systems implementation requirements
• 9) Training and education.

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The CPA Journal (Nov. 2001) Implementation of
SFAS 138, Amendments to SFAS 133http//www.nyssc
pa.org/cpajournal/2001/1100/dept/d115401.htm

• SFAS 138 (issued in June, 2000)
• Accounting for Certain Derivative Instruments and
  Certain Hedging Activitiesan amendment of FASB
  Statement No. 133.
• It includes the following major amendments
• 1) The normal purchases and normal sales
  exception is expanded to
• certain commodity contracts.
• 2) The risk that can be hedged in an interest
  rate hedge is redefined.
• 3) Recognized foreign currency-denominated assets
  and liabilities
• may be hedged with a single cross-currency
  compound hedge.
• 4) Net hedging of certain intercompany
  derivatives may be designated as cash flow
  hedges of foreign currency risk.
• Amendments to DIG Guidance

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FAS 133 - Amendments

• FAS 149 (issued in 04/2003 effective in 06/2003)
  
• Amendment of Statement 133 on Derivative
  Instruments and Hedging Activities
• The changes in this Statement improve financial
  reporting by requiring that contracts with
  comparable characteristics be accounted for
  similarly. In particular, this Statement
• clarifies under what circumstances a contract
  with an initial net investment meets the
  characteristic of a derivative discussed in
  paragraph 6(b) of Statement 133,
• clarifies when a derivative contains a financing
  component,
• amends the definition of an underlying to conform
  it to language used in FASB Interpretation No.
  45, Guarantors Accounting and Disclosure
  Requirements for Guarantees, Including Indirect
  Guarantees of Indebtedness of Others, and
• amends certain other existing pronouncements.
  Those changes will result in more consistent
  reporting of contracts as either derivatives or
  hybrid instruments. (Summary, FAS 149)

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FAS 133 Amendments

• From the FASB website in May 2004
• Available in March 2004 New 880-page updated
  edition
• The FASB staff has prepared a new updated edition
  of Accounting for Derivative Instruments and
  Hedging Activities. This essential aid to
  implementation presents Statement No. 133,
  Accounting for Derivative Instruments and Hedging
  Activities as amended by Statements No. 137,
  Accounting for Derivative Instruments and Hedging
  ActivitiesDeferral of the Effective Date of FASB
  Statement No. 133, No. 138, Accounting for
  Certain Derivative Instruments and Certain
  Hedging Activities, and No. 149, Amendment of
  Statement 133 on Derivative Instruments and
  Hedging Activities. Also, this publication
  includes the full text of Statement 133
  Implementation Issues (172) discussed by the
  Derivatives Implementation Group (DIG) and
  cleared by the FASB prior to February 10, 2004,
  with cross-references between the issues and the
  paragraphs of the Statement.

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How Should Transactions be Reported?
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Journal of Accounting Education (2002)
Comparative Analysis of Accounting Treatments
for Derivatives

• Case 1 Fair value hedge
• Case 2 Cash flow hedge
• Case 3 Speculative or derivative not designated
• Case 4 No derivative
• Loss on the hedged item but gain on the
  derivative
• in above cases
• Loss on the derivative
• Derivatives provide price protection.
• Derivatives preclude from benefiting windfall
  gains.

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Features

• A real-world example
• Explain concepts/application of derivatives
• Two-time period example
• Impact of journal entries on financial statements
• Comparative analysis of the economic results
• A web-downloadable spreadsheet for readers
  customization

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Scenario

• Inventory of 20,000,000 mmBtus of natural gas
  with a carrying value _at_3.000 in June X1.
• Inventory is intended for delivery to Chicago in
  Dec. X1
• Short sell a December futures contract _at_3.480
• Delivery point for the the futures contract is at
  the Henry Hub
• On entering into the derivative, the entity
  neither receives nor pays a premium. Time value
  is ignored for simplification.

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READING HIGHLIGHTS

• What problem is faced by BestGas?
• What does BestGas do to solve the problem?
• What is a futures contract?
• What is a forward contract?
• How does a futures contract help risk management?
• Why is a futures contract called a derivative
  instrument?
• How does a derivative instrument provide
  leverage?
• In your opinion, how should a derivative be
  recorded conceptually?
• What were the problems with the accounting
  standards prior to FAS 133?
• What purposes do FAS 133 attempt to achieve?
• What value does FAS 133 require derivatives to be
  recorded?
• How do accounting treatments differ among a fair
  value hedge, speculation, no derivative?
• How do the economic impacts differ among fair
  value hedge, speculation, no derivative in
  BestGas case?
• How does accounting for a cash flow hedge differ
  from a fair value hedge?

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All Derivatives

• All derivatives are reported at fair value on the
  balance sheet.
• Changes in the fair value of a derivative is
  recognized in earnings.
• Only entry for derivatives Not Qualified for
  hedging purpose (Case 3).

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FAS 133 - Fair Value Hedge

• 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
• Inventory
• Fixed Rate debt
• Commodity Purchase/Sale Commitment
• Fair value for the hedging instrument
  (derivative).
• Carrying value of the hedged item is adjusted to
  reflect the change in value due to the risk being
  hedged.
• If the two items are perfectly effective hedges,
  the gain or loss on each item will offset each
  other.
• Ineffectiveness flows through earnings.

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FAS 133 - Cash Flow Hedge

• A hedging relationship where the variability of
  the hedged items cash flows is offset by the cash
  flows of the hedging instrument
• Hedged item is a forecasted transaction or
  balance sheet item with variable cash flows
• Forecasted purchase/sale
• Variable Rate Debt
• Change in fair value of derivative is recorded to
  Other Comprehensive Income (OCI)
• Ineffectiveness flows to earnings via OCI

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FAS 133 - Cash Flow Hedge

• Lesser of Two Cumulatives Rule
• Step 1 Determine the change in fair value of the
  derivative and the change in the expected cash
  flow on the hedged transaction (Columns B and E).
• Step 2 Determine the cumulative change in fair
  value of the derivative and the cumulative change
  in the expected cash flow on the hedged
  transaction (Columns C and F).
• Step 3 Determine the lessor of the absolute
  value of the amounts in Step 2 (Column G).
• Step 4 Determine an appropriate balance (in
  debit or credit) to the cumulative change in OCI
  (Column H).
• Step 5 Determine the change in OCI during the
  period (Column J).
• Step 6 Adjust the derivative to reflect its
  change in fair value and adjust OCI by the amount
  determined in Step 4. Balance the entry, if
  necessary, with an adjustment to earnings (Column
  K).

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FAS 133 - Cash Flow Hedge

• Lesser of Two Cumulatives Rule
• Change in fair value of the derivative
• Change in the expected cash flow on the hedged
  transaction
• Effective hedge OCI (a deferral)
• Ineffective hedge Earnings
• When the transaction is completed
• Reclassify AOCI to earnings

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Conclusions

• Same entry to record the derivative at FV when a
  derivative is used
• FVH Observe changes in the carrying cost of the
  inventory for fair value hedge
• CFH The effective portion of gains or losses on
  a derivative designated as a cash flow hedge are
  deferred to OCI determined by the lesser of two
  cumulatives rule. This deferral will be
  subsequently reclassified as earnings when the
  forecasted transaction affects earnings.
• Contract settlement receives/pays cash from/to a
  futures broker if the contracted futures price
  (i.e., the futures forward price at inception) is
  less/more than the futures spot price because the
  entity purchases the commodity at a lower/higher
  price to close out the previous short sale
  position.

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Stay tuned

• You can download the following reading material
  at http//ahwang.pageout.net by click links in
  the following order Research, Course Contents,
  Publications,
• JOA1 FAS 133 Implementation
• JAE1a FAS133 Comparative Analysis
• JAE1s FAS 133 Comparative Analysis Worksheet for
  Students
• Reading Sequence on Hwang's FAS133 Research
• Seminar participants should read
• Practical Issues In Implementing FASB Statement
  133, (with John S. Patouhas) Journal of
  Accountancy Vol. 191 No. 3 (March 2001) 26-34.
  (JOA1 FAS 133 Implementation)
• Seminar participants should glance through the
  attached seminar PowerPoint handouts.

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Stay tuned

• Seminar participants should glance through
• Comparative Analysis of Accounting Treatments
  for Derivatives, Journal of Accounting Education
  Vol. 20 (2002) 205-233. (JAE1a FAS133
  Comparative Analysis)
• A scenario based on a futures contract used by a
  natural gas company to hedge price fluctuations
  of its gas inventory is applied across four cases
  to show the impact of derivative designation on
  the accounting treatment and to provide a
  comparative analysis of the financial/economic
  results from using different accounting
  treatments for the derivative.
• Seminar participants should work on the case in
  excel worksheet if attending the afternoon
  optional workshop on accounting for derivatives.
• JAE1s FAS 133 Comparative Analysis Worksheet for
  Students
• Seminar participants if interested in more
  Hwangs publications on FAS 133 should read
• Reading Sequence on Hwang's FAS133 Research

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ahwang_at_emich.edu Angela Hwang248.723.9365
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• Thank You

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