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Hedge Accounting

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Title: Hedge Accounting


1
Hedge Accounting
  • Rachel Kremer
  • Moore Stephens Frost

2
What is a Derivative?
  • Financial instrument whose fair value is tied to
    a benchmark
  • Stock price
  • Interest rate
  • Mortgage rate
  • Currency rate
  • Commodity price
  • Some other agreed upon reference
  • These are called Underlyings

3
Derivatives
  • Derivatives are used for
  • Investment, or
  • Risk management, or
  • Both

4
Derivatives
  • Option contracts
  • Forward contracts

5
Forward Contracts
  • Have symmetrical gain or loss characteristics,
    providing exposure to both losses and gains from
    market movements
  • No initial premium to be paid
  • Usually settled on or near the delivery date with
    cash, not physical delivery.

6
Option Contracts
  • Assymetrical loss functions
  • Little or no exposure to loss from market
    movement
  • Large benefits from favorable market movement

7
Examples of Derivative Instruments
  • Option contracts
  • Interest rate caps
  • Interest rate floors
  • Fixed rate loan commitments
  • Letters of credit
  • Forward contract
  • Forward interest rate agreement
  • Interest rate collars
  • Futures
  • Swaps
  • Instruments with similar characteristics

8
Risk Management
  • Protect against changes in fair value or cash
    flow of an asset, liability or future
    transaction.
  • Stock price movements, interest rate variations,
    currency fluctuations and commodity price
    volatility.

9
Derivative
  • Under FASB Statement No. 133, a derivative is
    defined as a financial instrument or other
    contract.
  • Derivatives represent rights or obligations and
    must be recorded as assets or liabilities in the
    balance sheet.

10
Measurement
  • Fair value is the only relevant measure for
    derivatives (and the most relevant measure for
    financial instruments in general).
  • Adjustments to the carrying amount of hedged
    items should reflect changes in their fair value
    (i.e., gains or losses) that are attributable to
    the risk being hedged and that arise while the
    hedge is in effect.

11
Definition
  • A derivative is a financial instrument that
    possesses all three of the following
    characteristics
  • It has one or more underlyings and one or more
    notional (or face) amounts or payment
    provisions. The underlying and the notional
    amount determine the settlement amount of the
    derivative contract (or, in some cases, determine
    whether or not settlement is required).

12
Underlying
  • Specified interest rate, security price,
    commodity price, foreign exchange rate, index of
    prices or rates, or other variables.

13
Notional Amount
  • A number of currency units, shares, bushels,
    pounds, or other units specified in a derivative.
    The settlement of a derivative is a function of
    the notional amount and the underlying.

14
Payment Provision
  • Payment provision specifies a fixed or
    determinable settlement to be made if the
    underlying behaves in a specified manner.

15
Three Characteristics (cont.)
  • 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.

16
Three Characteristics (cont.)
  • 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.

17
Fair Value-FASB 133
  • Quoted market prices in active markets are the
    best evidence of fair value and should be used as
    the basis for the measurement, if available.
    Fair value of trading units x mkt price
  • If quoted market price is not available, an
    estimate of fair value should be based on the
    best information available in the circumstances.

18
Hedge Accounting
  • Primary purpose to link items or transactions
    whose changes in fair values or cash flows are
    expected to offset each other.
  • Details of application, however, will vary
    depending on the type of risk being hedged

19
Fair Value Hedge
  • Designated and qualified as fair value
    hedge-----change in fair value is recognized in
    earnings
  • Offset by portion of change in fair value of the
    hedged asset or liability that is related to the
    risk being hedged.
  • Asset/liability recorded at fair value
  • Subject to impairment consideration on carrying
    value.

20
Fair Value Hedge
  • For completely effective hedges, the change in
    the derivatives fair value equals the change in
    the hedged items fair value. No effect on
    earnings.
  • If hedge is not completely effective, earnings
    will be affected (plus/minus) by the change in
    fair value of the derivative and the hedged item.
    Increase/decrease in earnings equals the
    ineffective portion of the change in the
    derivatives fair value.

21
Cash Flow Hedge
  • At Inception, formal documentation must include
  • Hedging relationship and the entitys risk
    management objective and strategy for undertaking
    the hedge, including
  • identification of the hedging instrument,
  • the hedged transaction,
  • the nature of the risk being hedged,
  • and how the hedging instruments effectiveness
    in hedging the exposure to the hedged
    transactions variability in cash flows
    attributable to the hedged risk will be assessed.
  • There must be a reasonable basis for how the
    entity plans to assess the hedging instruments
    effectiveness.

22
Cash Flow Hedge
  • Documentation shall include all relevant details,
    including the date on or period within which the
    forecasted transaction is expected to occur, the
    specific nature of asset or liability involved
    (if any), and the expected currency amount or
    quantity of the forecasted transaction.

23
Expected Quantity
  • Expected quantity requires specification of the
    physical quantity encompassed by the hedged
    forecasted transaction.
  • If the forecasted sale/purchase is hedged for
    price risk, then it cant be specified in dollars
    or of sales or purchases during a period. The
    current price of a forecasted transaction also
    should be identified.

24
Expected Quantity
  • Should be described with sufficient detail such
    that when a transaction occurs it is apparent as
    to whether that transaction is or is not the
    hedged transaction.

25
Measuring Effectiveness
  • At inception of hedge AND on an ongoing basis,
    the hedging relationship is expected to be highly
    effective in achieving offsetting cash flows
    attributable to the hedged risk during the term
    of the hedge.
  • Assessment of effectiveness is required financial
    statements or earnings are reported, and at least
    every three months.

26
Hedged Forecasted Transaction
  • All of the following criteria must be met
  • The forecasted transaction is specifically
    identified as a single transaction or a group of
    individual transactions. If the hedged
    transaction is a group of individual
    transactions, those individual transactions must
    share the same risk exposure for which they are
    designated as being hedged. Thus, a forecasted
    purchase and a forecasted sale cannot both be
    included in the same group of individual
    transactions that constitute the hedged
    transaction.

27
Hedged Forecasted Transaction
  • The occurrence of the forecasted transaction is
    probable.
  • The forecasted transaction is a transaction with
    an outside external party to the reporting entity
    and presents an exposure to variations in cash
    flows for the hedged risk that could affect
    reported earnings.
  • The forecasted transaction is not the
    acquisition of an asset or incurrence of a
    liability that will subsequently be remeasured
    with changes in fair value attributable to the
    hedged risk reported currently in earnings. If
    the forecasted transaction relates to a
    recognized asset or liability, the asset or
    liability is not remeasured with changes in fair
    value attributable to the hedged risk reported
    currently in earnings.

28
Hedged Forecasted Transaction
  • If the variable cash flows of the forecasted
    transaction relate to a debt security that is
    classified as held-to-maturity under Statement
    115, the risk being hedged is the risk of changes
    in its cash flows attributable to credit risk,
    foreign exchange risk, or both. For those
    variable cash flows, the risk being hedged cannot
    be the risk of changes in its cash flows
    attributable to interest rate risk.
  • The forecasted transaction does not involve a
    business combination subject to the provisions of
    Statement 141 and is not a transaction (such as a
    forecasted purchase, sale, or dividend) involving
    (1) a parent companys interests in consolidated
    subsidiaries, (2) a minority interest in a
    consolidated subsidiary, (3) an equity-method
    investment, or (4) an entitys own equity
    instruments.

29
Hedged Forecasted Transaction
  • If the hedged transaction is the forecasted
    purchase or sale of a nonfinancial asset, the
    designated risk being hedged is (1) the risk of
    changes in the functional-currency-equivalent
    cash flows attributable to changes in the related
    foreign currency exchange rates or (2) the risk
    of changes in the cash flows relating to all
    changes in the purchase price or sales price of
    the asset reflecting its actual location if a
    physical asset (regardless of whether that price
    and the related cash flows are stated in the
    entitys functional currency or a foreign
    currency), not the risk of changes in the cash
    flows relating to the purchase or sale of a
    similar asset in a different location or of a
    major ingredient.

30
Accounting
  • Generally, accounting for changes in the fair
    value of a derivative depends on the intended use
    of the derivative.
  • For a derivative not designated as a hedge, gains
    or losses are reflected in current earnings.

31
Accounting for Derivatives
  • For a derivative designated as a fair value
    hedge, the gain or loss on the derivative and the
    offsetting loss or gain on the hedged item are
    recognized in current earnings.
  • The difference reflected in current earnings
    between the gain (loss) on the derivative and the
    loss (gain) on the hedged item represents the
    impact of the ineffective portion of the hedge.

32
Accounting-Cash Flow Hedge
  • For a derivative designated as a cash flow hedge,
    the gain or loss on the derivative is divided
    into two parts
  • 1. The effective part, which is initially
    reported as a component of other comprehensive
    income and subsequently reclassified into current
    earnings in the period that the forecasted
    transaction affects earnings and
  • 2. The ineffective part, which is recognized
    immediately in current earnings.

33
Guidance for Accounting
  • FASB Statement No. 133, Accounting for
    Derivative Instruments and Hedging Activities,
    as amended by,
  • FASB Statement No. 137, Accounting for
    Derivative Instruments and Hedging
    Activities---Deferral of the Effective Date of
    the FASB Statement No. 133
  • FASB Statement No. 138, Accounting for Certain
    Derivative Instruments and Certain Hedging
    Activities, and
  • FASB Statement No. 149, Amendment of Statement of
    133.

34
Other Comprehensive Income
  • The effective portion of the gain or loss on a
    derivative designated as a cash flow hedge is
    reported in other comprehensive income, and the
    ineffective portion is reported in earnings.
  • If an entitys defined risk management strategy
    for a particular hedging relationship excludes a
    specific component of the gain or loss, or
    related cash flows, on the hedging derivative
    from the assessment of hedge effectiveness that
    excluded component of the gain or loss shall be
    recognized currently in earnings.

35
Accumulated Comprehensive Income
  • Accumulated other comprehensive income associated
    with the hedged transaction shall be adjusted to
    a balance that reflects the lesser of the
    following (in absolute amounts)
  • (1)  The cumulative gain or loss on the
    derivative from inception of the hedge less an
    excluded component and the derivatives gains or
    losses previously reclassified from accumulated
    other comprehensive income into earnings.
  • (2)  The portion of the cumulative gain or loss
    on the derivative necessary to offset the
    cumulative change in expected future cash flows
    on the hedged transaction from inception of the
    hedge less the derivatives gains or losses
    previously reclassified from accumulated other
    comprehensive income into earnings.

36
Accumulated Other Comprehensive Income
  • Amounts in accumulated other comprehensive income
    shall be reclassified into earnings in the same
    period or periods during which the hedged
    forecasted transaction affects earnings-when a
    forecasted sale occurs.
  • If the hedged transaction results in the
    acquisition of an asset or the incurrence of a
    liability, the gains and losses in accumulated
    other comprehensive income shall be reclassified
    into earnings in the same period or periods
    during which the asset acquired or liability
    incurred affects earnings (such as in the periods
    that depreciation expense, interest expense, or
    cost of sales is recognized).

37
Accumulated Other Comprehensive Income
  • However, if an entity expects at any time that
    continued reporting of a loss in accumulated
    other comprehensive income would lead to
    recognizing a net loss on the combination of the
    hedging instrument and the hedged transaction
    (and related asset acquired or liability
    incurred) in one or more future periods, a loss
    shall be reclassified immediately into earnings
    for the amount that is not expected to be
    recovered.
  • For example, a loss shall be reported in earnings
    for a derivative that is designated as hedging
    the forecasted purchase of inventory to the
    extent that the cost basis of the inventory plus
    the related amount reported in accumulated other
    comprehensive income exceeds the amount expected
    to be recovered through sales of that inventory.

38
Discontinuing Hedge Accounting
  • An entity shall discontinue prospectively hedge
    accounting for an existing hedge if any one of
    the following occurs
  • Any criterion in standard is no longer met.
  • The derivative expires or is sold, terminated, or
    exercised.
  • The entity removes the designation of the cash
    flow hedge.
  • In those circumstances, the net gain or loss
    shall remain in accumulated other comprehensive
    income and be reclassified into earnings. The
    entity may elect to designate prospectively a new
    hedging relationship with a different hedging
    instrument or a different hedged transaction or a
    hedged item if the hedging relationship meets the
    set criteria.

39
The End!!!!
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