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FAS 133 IAS 30 CICA 13

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Title: FAS 133 IAS 30 CICA 13


1
Accounting for Derivative Financial Instruments
and Hedging Transactions
  • FAS 133 IAS 30 CICA 13
  • Bob Jensens Free Tutorials, Glossaries,
    and Cases are at http//www.trinity.edu/rjensen
    /caseans/000index.htm

2
ACCOUNTING FOR DERIVATIVES
  • Presentation by
  • Bob JensenTrinity University San Antonio, TX
    78212rjensen_at_trinity.edu
  • http//www.trinity.edu/rjensen/

3
REASONS FOR NEW STANDARDS
Undisclosed Assets and LiabilitiesUnbooked
Assets and LiabilitiesMeaningless Measures of
Value Risk Rise in Scandals in the 1980s
1990sComplex Frauds --- Partnoys
Fiasco Explosion of Swap Contracts Evolution
Toward Fair Value Accounting
4
PROBLEMS WITH NEW STANDARDS
Complex Contracts Technical Jargon Complex
Scoping of Coverage --- NPNS Complex Hedge
Accounting RulesMany Derivatives Are Difficult
to Value Difficult to Find Embedded
DerivativesComplex Effectiveness Testing
Rules Continuous Stream --- DIG,
Amendments Implementation Failures --- Freddie
Mac, etc. Held-to-Maturity Interim
DistortionsHedge Acctg. Denied to Most Macro
Hedges
5
Differences Between StandardsFAS 133 vs. IAS 39
vs. CICA 13
Differences are relatively minor IAS 39 Macro
Hedging Pending Amendment Listing of Major
Differences http//www.trinity.edu/rjensen/caseans
/canada.htm .
6
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

7
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
  • 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.

8
KEY ASPECTS OF THE STANDARDS
  • Most derivatives are reported at fair value on
    balance sheet
  • Changes in fair value for derivatives not
    designated and 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

9
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.
  • DIGs 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/

10
Bob Jensens Flow Charthttp//www.trinity.edu/rje
nsen/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)

11
DERIVATIVE DEFINITION 616
  • 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
  • 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

12
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.

13
FREESTANDING DERIVATIVES Three Characteristics
69 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

14
FREESTANDING DERIVATIVES Characteristic
1Underlying 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., Moodys)
  • An index on any of above or other (e.g., SP 500,
    CPI)
  • Other specific items

15
FREESTANDING DERIVATIVES Characteristic
1Notional 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)

16
FREESTANDING DERIVATIVES Characteristic
1Examples 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

17
FREESTANDING DERIVATIVES Characteristic
1Payment 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
    basis points then payment of an
    applicable amount would be required

18
FREESTANDING DERIVATIVES Characteristic
2Initial 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

19
FREESTANDING DERIVATIVES Characteristic 3Net
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

20
FREESTANDING DERIVATIVES Characteristic
3Readily 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

21
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

22
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)
  • As long as it is probable contracts will not
    settle net and will result in physical delivery
    (but note FAS 138 and FAS 149)

23
FAS 138 Scope-Excluded Contracts (Contd)
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
24
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

25
FREESTANDING DERIVATIVES ExceptionsOTC
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)

26
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

27
FREESTANDING DERIVATIVES Contracts Not
Considered Derivativesfor Purposes of Statement
133, 11
  • Instruments indexed to an entitys 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)

28
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

29
EMBEDDED DERIVATIVES When Does a Contract Have
an Embedded Derivative Subject to This Statement?
12
Would it be a derivative if it was freestanding?
Is the contract carried at fair value
through earnings?
Is it clearly and closely related to the
host contract?
No
Yes
No
Apply This Statement
Yes
No
Yes
Do Not Apply This Statement
30
EMBEDDED DERIVATIVES Clearly and Closely
RelatedGeneral 12 and 6061
  • 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/acc
    t5341/speakers/133flow.htm

31
EMBEDDED DERIVATIVES Clearly and Closely
RelatedUnderlyings
  • Type of Host Underlying
  • Debt Interest
  • Inflation
  • Creditworthiness
  • Equity Price of share in entity
  • Lease Inflation
  • Interest

32
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.

33
FAIR VALUE HEDGE 2022
  • 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

34
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 PL current
    earnings if the hedged item such as
    inventory is already on the books at fair value

35
FAIR VALUE HEDGE ACCOUNTINGFor Hedged Item
Booked at Historical Cost
  • Measurement of Derivative

Change in Fair Value
EarningsChangesOffset(1)
Accounting Model
Measurement of Hedged Item
Offsetting Gain or Loss Attributable to Risk
Being Hedged
(1) Ineffectiveness affects net earnings
36
CASH FLOW HEDGE 2931
  • A cash flow hedge is a hedging relationship where
    the variability of the hedged items 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 derivatives gain or loss
    reported in OCI
  • Earnings recognition matches hedged transaction
  • Ineffective gain or loss recorded in earnings

37
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.

38
CASH FLOW HEDGE ACCOUNTING
Measurement of Derivative
OCI Equity
Effective
Change in Fair Value
Accounting Model
(1)
Ineffective
Earnings
(1) Based on Timing of Earnings Impact of
Hedged Item (interest, cost of sales,
depreciation)
39
FOREIGN CURRENCY HEDGE 3642 (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

40
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

41
OBJECTIVE OF HEDGE ACCOUNTING
  • 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-

Periods 1 2 Total
42
Change to Forward/Futures PowerPoint ShowAnd
Compare Examples 1 and 4
  • Go to 02ForFutCalgary.ppt
  • End of Calgary Introduction

43
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

44
CASE 1 Cash Flow Hedge of Forecasted Inventory
Sale
  • 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

45
CASE 1 Cash Flow Hedge of Forecasted Inventory
Sale
  • 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

46
CASE 1 Cash Flow Hedge of Forecasted Inventory
Sale
  • 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.

47
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

48
CASE 2 (Contd)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

49
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
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