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FAS 133 IAS 30 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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ACCOUNTING FOR DERIVATIVES
Presentation by
Bob JensenTrinity University
San Antonio, TX [email protected]
http://www.trinity.edu/rjensen/
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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 Pending 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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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.
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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
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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 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)
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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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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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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Change to Forward/Futures PowerPoint ShowAnd Compare Examples 1 and 4
Go to 02ForFutCalgary.ppt
End of Calgary Introduction
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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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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
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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
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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.
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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