The Decision on Derivatives

Over the years, FASB has had difficulty keeping pace with the financial innovations companies use to manage or hedge the risk exposure from rapidly changing global financial markets. Although a few pronouncements have provided rules on accounting for derivatives, that guidance is somewhat piecemeal and often internally inconsistent and incomplete because only a few of the financial instruments used today are covered specifically.

After several years of deliberation, exploring possible alternatives and compromising on some of its original positions, FASB issued Statement no. 133, Accounting for Derivative Instruments and Hedging Activities . The statement applies to all derivative instruments (as defined in the standard), even those yet to be developed. Although Statement no. 133 addresses many of the current accounting concerns and accommodates many hedging strategies, the new approach is overly complicated, difficult to apply and not necessarily representative of how business is managed.

IMPLICATIONS FOR USERS AND PREPARERS
Statement no. 133 represents a major change in hedge accounting. It strives to increase the visibility, comparability and understanding of the risks associated with holding derivatives by requiring entities to report all derivatives at fair value as assets or liabilities. Statement no. 133 also reduces the inconsistency, incompleteness and complexity of previous guidance and practice by providing companies with comprehensive rules for all derivatives and hedging activities.

Users. Statement no. 133 makes derivatives more visible by requiring companies to report them at fair value on their statements of financial position. Generally, derivatives represent a mutual exchange of promises, with no initial exchange of tangible consideration. Since no initial investment is required in such a transaction, the derivative would, before Statement no. 133, be off balance sheet, thereby possibly concealing its risks. A company’s ability to settle a derivative at a gain by receiving cash or at a loss by paying cash is evidence that rights and obligations exist. By requiring all derivatives to be reported at fair values, Statement no. 133 ensures those assets and liabilities will be visible on financial statements. As a result, many company balance sheets may increase in size.

The new approach improves understandability because deferred gains and losses no longer will be reported as liabilities and assets, respectively. Unrealized gains are not probable future obligations and unrealized losses are not probable future economic benefits and thus should not be reported to users as such on the balance sheet.

Statement no. 133 should reduce the inconsistency between current accounting guidance and practices, since all derivatives, both current and those yet to be developed, are subject to its requirements. Previously, entities depended on existing, but possibly conflicting, guidance and often created their own accounting practices. The result was inadequate information for users. Under the new rules, comparability should increase since all entities must account for derivatives with a similar purpose in a similar manner.

Preparers. It may be costly for some entities to implement Statement no. 133 because of the major changes to hedge accounting that add complexity and may require companies to make significant modifications to their management information systems. Because Statement no. 133 applies to all derivatives, entities no longer have to develop accounting practices for new instruments that are not specifically addressed in the accounting literature. Because the accounting treatment of a derivative now is based on why an entity holds the instrument rather than on the type of instrument, the application should be more consistent.

Entities, now required to measure all derivatives at fair value and report them on their balance sheets as assets or liabilities, can look to FASB Statement no. 107, Disclosures about Fair Value of Financial Instruments , for guidance on determining or estimating an instruments fair value. However, for guidance on determining the fair value of a foreign currency forward contract,

CPAs should look to Statement no. 133 since the existing accounting literature discusses a variety of different evaluation methods. Statement no. 133 requires that an entity define, at the time it designates a hedging relationship, the method it will use to assess the hedges effectiveness in achieving offsetting changes in fair value or offsetting cash flows attributable to the risk being hedged. It also requires an entity to use that defined method consistently throughout the hedge period. This effectiveness assessment is more flexible and may be easier to understand than a similar requirement in FASB Statement no. 80, Accounting for Futures Contracts . The correlation test in Statement no. 80 is difficult to apply in practice. Under Statement no. 133, an entity will not have to demonstrate risk reduction on an entity-wide basis to designate a fair value or cash flow hedge. However, the flexibility of the effectiveness assessment may allow for potential abuse and great disparity in techniques. As a result, FASB may require more specific effectiveness tests later.

ACCOUNTING FOR DERIVATIVES
Statement no. 133 allows special accounting treatment for derivatives specifically designated as hedges of the

• Exposure to changes in the fair value of a recognized asset or liability or of an unrecognized firm commitment (fair value hedge).
• Exposure to variability in the cash flows of a recognized asset or liability or of a forecasted transaction (cash flow hedge).
• Foreign currency exposure of a net investment in a foreign operation, an unrecognized firm commitment, an available-for-sale security or a forecasted transaction.

An entity should include in current earnings the changes in the fair value of derivatives not qualifying for hedge accounting.

Fair value hedge. An entity should recognize in current earnings the entire gain or loss from a change in a derivatives fair value in the period of the change. Also included in earnings is the change in fair value of the hedged item attributable to the risk being hedged. The gain or loss on the hedged item is the amount that perfectly offsets the derivative loss or gain, adjusted for identified hedge ineffectiveness, if any, so that a company’s earnings reflect identified hedge ineffectiveness for the risk being hedged.

Illustration. On January 1, 1999, Company X issues a $1 million, 8.5%, three-year note payable. Since this is a fixed-rate debt, its fair value will vary as market rates change. To hedge this fair value exposure, on January 1, 1999, Company X simultaneously enters into a three-year, interest rate swap on a $1 million notional amount. (A notional is a number of currency units, shares, bushels, pounds or other units specified in a derivative.) The swap is designed so Company X will receive a fixed rate of interest on the notional amount and pay the counterparty to the swap a variable rate of interest on the same notional amount. Instead of the two parties swapping each of these interest amounts, a net settlement is paid or received.

Company X is to receive 8.5% and pay LIBOR (London Interbank Offered Rate) with settlement and reset of the variable rate at the end of each year. The swap effectively converts the fixed-rate debt to a variable rate of LIBOR, since the 8.5% the company receives from the swap pays the 8.5% interest on the debt and the company pays only a variable rate on the swap.

LIBOR is 8.5% on January 1, 1999, and 8% on December 31, 1999. On that date, the fair value of the swap is $9,125, which represents an asset since Company X is in a net receive position. The fair value of the debt is $1,010,713. Of the $10,713 change in the notes fair value, assume $8,915 is attributable to the interest rate change, with the remainder to default risk. The company would record the following adjusting entries at

Even though the change in the notes fair value is $10,713, only the $8,915 attributable to interest rate exposure is recognized in current earnings.

The carrying value of the note at December 31, 1999, is $1,008,915, which results in an effective rate of 8% for the debt. The company recognizes the premium as an effective yield adjustment over the remaining two years of the note and records the following entries for December 31, 2000:

The interest expense recorded is based on the new effective yield of 8%. The swap is settled by the company receiving cash for the difference between the 8.5% it received and the 8% LIBOR it paid.

However, a company may delay amortization of this basis adjustment (the premium on the note payable) so it begins no later than when the item stops being adjusted for changes in fair value attributable to the risk being hedged. In the above example, the note will be adjusted for the last time on December 31, 2000, since it matures on December 31, 2001. The company can wait until 2001 to amortize the discount or premium adjustment on the debts carrying value as a result of interest rate changes and record the interest expense as cash paid for 1999 and 2000.

For derivatives with option-like characteristics that provide one-sided protection against a hedged risk having both upside and downside potential, an entity will recognize changes in the hedged items fair value in current earnings only during periods when the derivative has an intrinsic value.

The value of an option contains two elements:

• The intrinsic value, which is based on the degree to which the option is in the money. (In the money refers to the amount the owner would gain by exercising the option at that time.)
• The time value, which represents the markets estimate of how likely it is the option will be in the money before it lapses.

Only in-the-money options have intrinsic value; the deeper out of the money an option is, the less likely it is to have any significant time value.

Cash flow hedge. An entity will report in other comprehensive income or in earnings the change in fair value of a derivative designated as a cash flow hedge, as necessary, to adjust the balance in other comprehensive income so it equals the lesser of either (a) the cumulative gain or loss on the derivative or (b) the cumulative change in expected future cash flows on the hedged transaction. The result is that the excess cumulative gain or loss on the derivative will be considered ineffective and recognized in earnings.

For example, a company can conclude that cash flow changes are expected to be completely offset at inception and on an ongoing basis if an interest rate swap is used to hedge the cash flows of a variable-rate investment and the following characteristics match:

• The notional amount of the swap and the principal amount of the investment.
• The maturity of the investment and the remaining term of the swap.
• The interest reset dates for the investment and the swap.
• Interest receipt and cash settlement dates.

Under these circumstances, hedge ineffectiveness will be assumed to be zero. However, this assumption is valid only if the creditworthiness of either party to the hedging instrument has not deteriorated substantially. If the above characteristics do not match each other perfectly, then hedge ineffectiveness will occur.

Illustration. On November 1, 1999, Company X holds 100,000 shares of Company Y stock with a current price of $50. The company plans to sell the stock in the fourth quarter of 2000. Concerned that the price might drop, Company X buys put options on the stock at a strike price of $50 and pays a $1 premium for each option. The company would initially record this option as

The $100,000 represents the time value element of the options. Since the strike price equals the current price, there is no intrinsic value at this time. On December 31, 1999, the stock has a market price of $47 and the options have a fair value of $450,000. The options are now in the money by $3 each or a total of $300,000. The other $150,000 represents the time value element, which is the markets estimate of how likely it is the options will become more valuable.

Statement no. 133 requires that the options be marked to fair value, as follows:

Because the options are already recorded at $100,000, the change in fair value is $350,000. This $350,000 change is greater than the cumulative change in expected future cash flows on the sale of the securities ($3 x 100,000 shares). Therefore, the company will recognize the excess cumulative gain on the options in current earnings while the $300,000 will be included in other comprehensive income and reported in equity.

The company will recognize the accumulated gains and losses reported in equity in earnings in the same period(s) as the hedged asset, liability or forecasted transaction affects earnings. In the above example, the $300,000 reported in equity will be included in earnings when the securities are sold. If the company hedges a forecasted acquisition of equipment, it will recognize the accumulated derivative gains or losses in earnings in the same period depreciation is recorded. If the company hedges a forecasted purchase of raw materials, it will include the accumulated gains or losses in earnings when the finished product is sold and the materials are included in cost of sales.

Foreign currency hedge. Statement no. 133 allows a company to designate a derivative as a hedge of the foreign currency exposure of

• An unrecognized firm commitment (a foreign currency fair value hedge).
• An available-for-sale security (a foreign currency fair value hedge).
• A forecasted transaction (a foreign currency cash flow hedge).
• A net investment in a foreign operation.

Entities may use fair value hedge accounting for derivatives that hedge the foreign currency exposure of an unrecognized firm commitment or available-for-sale security if all the fair value hedge criteria are met. Cash flow hedge accounting may be used for derivatives that hedge the foreign currency exposure of a forecasted transaction if all the cash flow hedge criteria are met.

Gains and losses on instruments an entity designates as hedging the foreign currency exposure of a net investment in a foreign operation are included in other comprehensive income (outside of earnings) and reported in equity to the extent the instrument is an effective economic hedge. Translation losses and gains from these net investments also are included in other comprehensive income and reported as a separate component of equity.

Illustration. On January 1, 1999, Company X has a net investment in Company F, a foreign company, which represents 100 million LCU (local currency units). To hedge this exposure, Company X enters into a foreign currency forward to sell 100 million LCU at December 31, 2001. If the exchange rate decreases by yearend, the net investment will decrease, resulting in a translation loss that the company will include in other comprehensive income. However, Company Xs purchase price of the LCU to settle the forward contract will be less than the selling price locked in on January 1, 1999. Since the forward contract is an effective economic hedge of the net investment, the company will include the gain on the forward contract in other comprehensive income. These gains and losses may not be a perfect offset even though it appears to be a 100% hedge. Translation gains and losses are based solely on changes in spot rates, while the forward contract that hedges a net investment takes discounting into account.

CONCERNS WITH NEW APPROACH
Although Statement no. 133 appears to address many of the current problems of derivative and hedge accounting, it also creates some new concerns.

Volatility in earnings and comprehensive income. Partial and imperfect hedges result in an entity’s having to include in current earnings some of the changes in a derivatives fair value. Earnings fluctuations occur with fluctuations in the fair value of derivatives. Equity volatility increases when an entity reports and includes in equity unrealized gains and losses from derivatives designated as cash flow hedges in other comprehensive income. The accumulated gains and losses are included in earnings in the same period(s) as the earnings impact of the hedged item. The greater the fluctuations in derivative fair values, the greater the volatility in comprehensive income and equity. (The previous rule allowed these holding gains [losses] to be deferred as liabilities [assets], which did not affect earnings or equity.)

Banks criticize the new approach, saying it creates volatility. For example, if a bank uses financial futures to lock in interest rates on future borrowings and rates fall, the bank has a short-term cash loss on the futures, which it expects to make up by paying less to future depositors. As this is a cash flow hedge, the loss will flow through the banks other comprehensive income and be reported in equity until interest is recorded on the future borrowings. Previous accounting treatment would have allowed the bank to defer the loss and report it as an asset. The new accounting unmasks volatility by requiring entities to report what previously would have gone unreported.

Firm commitments vs. forecasted transactions. Some believe there is no substantive difference between qualifying forecasted transactions and firm commitments; thus, both should be treated the same way. However, FASB believes firm commitments are distinct and, thus, Statement no. 133 accounts for the hedging of forecasted transactions as cash flow hedges while it accounts for the hedging of firm commitments as fair value hedges, substantially different accounting for similar activities. For a forecasted transaction that later becomes a firm commitment, forecasted transaction accounting must be discontinued. The firm commitment can then be hedged prospectively. However, the redesignation of the derivative may not qualify in all circumstances.

Different accounting for essentially the same transaction. A company whose strategy is to establish an asset-liability match can account for a hedging instrument differently depending on whether it designates the instrument as hedging the investment or the debt. For example, a company holding investments tied to LIBOR and fixed-rate debt will enter into an interest rate swap to receive a fixed rate and pay LIBOR, synthetically creating an asset-liability match. If the company designates the swap as a hedge of the investment, it will be accounted for as a cash flow hedge since it will synthetically convert variable cash inflows to fixed amounts. However, if the swap is designated as a hedge of the debt, it will be accounted for as a fair value hedge since it is assumed the swap converts the debt from a fixed rate to a variable rate.

No hedge accounting for covered call strategies. FASB agrees that hedge accounting should be available for certain written options. For a written option to qualify for hedge accounting, either the upside and downside potential of the net position must be symmetrical or the upside potential must be greater than the downside potential. Hedge accounting is not permitted for a covered call strategy because the risk profile of the combined position is asymmetrical; the exposure to losses is greater than the potential for gains. Therefore, a company writing a covered call option on an available-for-sale security will include the gain or loss on the option in current earnings while it will report the loss or gain on the security in other comprehensive income.

Items that cannot be designated as hedged. For a debt security classified as held to maturity, an entity cannot designate interest rate risk as the risk being hedged. Doing so undermines the notion of that classification, which is based on an underlying intent that renders irrelevant the changes in the investments value. If a company enters into an interest rate swap to convert interest from a fixed rate to a variable rate to create a synthetic variable rate financial instrument, the swap will not qualify for hedge accounting and therefore will not be accounted for as a basic variable rate security.

Other items that cannot be designated as hedged in a fair value hedge include (1) an asset or liability that is measured at fair value with changes in fair value attributable to the hedged risk reported in earnings currently and (2) an investment accounted for by the equity method. FASB also decided that only a recognized asset or liability may be designated as a hedged item, prohibiting the hedging of internally developed intangible assets and mortgage servicing rights that have not been recognized as assets.

A MAJOR IMPROVEMENT?
The new derivative accounting rules are required for all entities in all industries and are effective for fiscal quarters of fiscal years beginning after June 15, 1999. Although the new approach represents a major improvement over previous rules, understanding and implementing these requirements may be problematic for some companies. FASB has already developed a training course to help those affected by Statement no. 133 and is preparing an implementation guide. While FASB provided several illustrations in the appendix to Statement no. 133, these illustrations are by no means exhaustive. As financial engineers develop new and more exotic instruments in the future, instruments with characteristics different from those that exist today, FASB may need to provide companies with guidance on an ongoing basis.