ACCOUNTING FOR DERIVATIVES

ACCOUNTING FOR DERIVATIVES
Presentation by Bob Jensen Trinity University One Trinity Place San Antonio, TX

Bob Jensen 190 Sunset Hill Road Sugar Hill, NH 03586 Phone

Accounting for Derivative Financial Instruments and Hedging Transactions
FAS IAS CICA 13 Bob Jensen’s Free Tutorials, Glossaries, and Cases are at

Key Amendments to FAS 133 FAS 138 FAS 149 FAS 155 FAS 159

Eliminated by FAS 133 FAS 080 FAS 119

Fair Value Accounting FAS 105, 107, 115, 130, 133, 141, 142, 155, 157, 159
Bob Jensen’s Summary of Accounting History and Theory “Not everything that can be counted, counts. And not everything that counts can be counted.” Albert Einstein

FAS 115 effective in 1994 FV Reporting of AFS Investments in Debt/Equity
Debt securities that the enterprise has the positive intent and ability to hold to maturity are classified as held-to-maturity securities and reported at amortized cost. Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings. Debt and equity securities not classified as either held-to-maturity securities or trading securities are classified as available-for-sale securities and reported at fair value, with unrealized gains and losses excluded from earnings and reported in a separate component of shareholders' equity.

FAS 130 effective in 1998 Reporting Other Comprehensive Income (OCI)
This Statement requires that an enterprise classify items of other comprehensive income by their nature in a financial statement and display the accumulated balance of other comprehensive income (AOCI) separately from retained earnings and additional paid-in capital in the equity section of a statement of financial position.

FAS 133 effective in 2000 Amended by FAS 137, 138, 149, 155, and 159 Accounting for Derivative Financial Instruments and Hedging Activities Financial Derivatives & Scandals Explode in the Early 1990's Video or Audio clip from CBS Sixty Minutes SIXTY01.avi or SIXTY01.mp3 Audio clip from John Smith of Deloitte & Touche in August 1994 SMITH01.mp3 Examples of derivative contracts that even the professional analysts could not decipher The derivatives that Merrill Lynch wrote that drive Orange County into bankruptcy Other derivatives fraud summaries are at Video and audio clips of FASB updates on FAS 133 Audio Dennis Beresford in 1994 in New York City BERES01.mp3 Audio Dennis Beresford in 1995 in Orlando BERES02.mp3 Derivative Financial Instrument Frauds --- Off line --- Click Here

FAS 133 effective in 2000 Amended by FAS 137, 138, 149, 155, and 159 Accounting for Derivative Financial Instruments and Hedging Activities Requires booking of most derivative financial instruments at fair value (with some exceptions for NPNS, regular-way, insurance contracts, weather derivatives, short sales, interest-strips, etc.) Derivatives are to be marked to current fair value at least every 90 days and on reporting dates. Changes in fair value are to be charged or credited to current earnings unless the derivatives qualify for hedge accounting treatment as cash flow, fair value, or FX hedges. Not all economic hedges qualify for hedge accounting relief from current earnings. Hedge accounting rules under FAS 133 and its amendments are very complex.

Bob Jensen's threads on Enron are at Bob Jensen's threads on Derivative Financial Instruments Fraud are at Also note How Enron Used SPEs and Derivatives Jointly is Explained at Bob Jensen’s threads on derivatives accounting are at

Frank Partnoy’s Works Of all the many documents and books that I have read about derivative financial instruments, the most important have been the books and documents written by Frank Partnoy. Some of his books are listed at the bottom of this message.

Frank Partnoy’s Works The single most important document is his Senate Testimony. More than any other single thing that I've ever read about the Enron disaster, this testimony explains what happened at Enron and what danger lurks in the entire world from continued unregulated OTC markets in derivatives. I think this document should be required reading for every business and economics student in the world. Perhaps it should be required reading for every student in the world. Among other things it says a great deal about human greed and behavior that pump up the bubble of excesses in government and private enterprise that destroy the efficiency and effectiveness of what would otherwise be the best economic system ever designed.

Frank Partnoy’s Works Testimony of Frank Partnoy Professor of Law, University of San Diego School of Law Hearings before the United States Senate Committee on Governmental Affairs, January 24,

Frank Partnoy’s Works FIASCO: The Inside Story of a Wall Street Trader
FIASCO: The Inside Story of a Wall Street Trader FIASCO: Blood in the Water on Wall Street FIASCO: Blut an den weiÃŸen Westen der Wall Street Broker. FIASCO: Guns, Booze and Bloodlust: the Truth About High Finance Infectious Greed : How Deceit and Risk Corrupted the Financial Markets Codicia Contagiosa His other publications include the following highlight: "The Siskel and Ebert of Financial Matters: Two Thumbs Down for the Credit Reporting Agencies" (Washington University Law Quarterly)

REASONS FOR NEW STANDARDS
Undisclosed Assets and Liabilities Unbooked Assets and Liabilities Meaningless Measures of Value & Risk Rise in Scandals in the 1980s & 1990s Complex Frauds --- Partnoy’s Fiasco Explosion of Swap Contracts Evolution Toward Fair Value Accounting

PROBLEMS WITH NEW STANDARDS
Complex Contracts & Technical Jargon Complex Scoping of Coverage --- NPNS Complex Hedge Accounting Rules Many Derivatives Are Difficult to Value Difficult to Find Embedded Derivatives Complex Effectiveness Testing Rules Continuous Stream --- DIG, Amendments Implementation Failures --- Freddie Mac, etc. Held-to-Maturity Interim Distortions Hedge Acctg. Denied to Most Macro Hedges

Differences Between Standards FAS 133 vs. IAS 39 vs. CICA 13
Differences are relatively minor IAS 39 Macro Hedging Amendment Listing of Major Differences .

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

One million lines of journal entries: Just how expensive is FAS 133?
"The Potential Crisis at Fannie Mae," Comstock Funds, August 11, We have no proprietary information about Fannie Mae, but what is publicly known is scary enough. As you may recall, last December the SEC required Fannie to restate prior financial statements while the Office of Federal Oversight (OFHEO) accused the company of widespread accounting regularities that resulted in false and misleading statements. Significantly, the questionable practices included the way Fannie accounted for their huge amount of derivatives. On Tuesday, a company press release gave some alarming hints on how extensive the problem may be. The press release stated that in order to accomplish the restatements, “we have to obtain and validate market values for a large volume of transactions including all of our derivatives, commitments and securities at multiple points in time over the restatement period. To illustrate the breadth of this undertaking, we estimate we will need to record over one million lines of journal entries, determine hundreds of thousands of commitment prices and securities values, and verify some 20,000 derivative prices…” “…This year we expect that over 30 percent of our employees will spend over half their time on it, and many more are involved. In addition we are bringing some 1,500 consultants on board by year’s end to help with the restatement…Altogether, we project devoting six to eight million labor hours to the restatement. We are also investing over $100 million in technology projects to enhance or create new systems related to accounting and reporting…we do not believe the restatement will be completed until sometime during the second half of 2006…” Bob Jensen's tutorials on accounting for derivatives are at

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 (Mainly because historical cost is zero or near-zero) 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.

Example: Futures Contracts Financial Risk May Be Unbounded
May be contracts to buy or sell at contracted (future) price that moves along with spot prices on an organized exchange linking buyers and sellers. Cost = Zero! Notional = standardized quantities per contract for a standard product such as a particular type of corn. Underlying = the value per unit such as the price of a bushel of corn or a Treasury or Libor interest rate. Futures are a unique kind of derivative because futures gains and losses are posted daily in cash.

Example: Futures Contracts (Continued)
Since futures contracts are cleared daily for cash, the accounting was relatively simple under the now-defunct FAS 80. FAS 133 rules are more complicated for hedging contracts --- see 000starta.xls file at CBOT --- The prices you first see listed are the forward prices. To find spot prices, click on the link called "Charts."

Example: Forward Contracts Financial Risk May Be Unbounded
May be contracts to buy or sell at contracted (future) price that moves along with spot prices in over-the-counter (OTC) private contracts. Cost = Zero! Notional = unique quantities per contract for a defined product such as a particular type of corn. Underlying = the value per unit such as the price of a bushel of corn or a Treasury or Libor interest rate. Unlike futures contracts, forward contracts are neither standardized nor cleared daily for cash gains and losses.

Example: Forward Contracts (Continued)
There were no accounting rules for forward contracts prior to FAS 133. FAS 133 rules are complicated for hedging contracts --- see 000starta.xls file at CBOT --- Does not exchange forward contracts Contracts are non-standardized and might be subject to credit risk.

Example: Swap Contracts Financial Risk May Be Unbounded
Swaps are generally portfolios of forward contracts with regularly-spaced payment dates. Cost = Zero! Notional = unique quantities per contract for a defined product such the number of bonds being hedged. Underlying = the value per unit such as the price of a bushel of corn or a Treasury or Libor interest rate. Interest rate swaps were only invented in 1984, but they became the leading form of cash management and now have notionals over $100 trillion dollars..

Example: Swap Contracts (Continued)
There were no accounting rules for swap contracts prior to FAS 133. FAS 133 rules are complicated for hedging contracts --- see 000starta.xls file at There are a few standardized swaps traded on exchanges Contracts are non-standardized and might be subject to credit risk.

Example: Written Option Contracts Financial Risk May Be Unbounded
Contracts to sell or buy at contracted (future) price that moves along with spot prices on an organized exchange linking buyers and sellers. Sale Price > $0=Premium! Example: Selling Puts or Calls. Notional = standardized quantities per contract for a standard product such as a particular type of corn. Underlying = the value per unit such as the price of a bushel of corn or a Treasury or Libor interest rate. Options may also be non-standardized OTC. Use of options dates back to Roman times.

Example: Purchased Option Contracts Financial Risk Is Bounded by Premium Paid
Contracts to buy or sell at contracted (future) price that moves along with spot prices on an organized exchange linking buyers and sellers. Purchase Price > $0=Premium! Example: Buying Puts or Calls. Notional = standardized quantities per contract for a standard product such as a particular type of corn. Underlying = the value per unit such as the price of a bushel of corn or a Treasury or Libor interest rate. Purchased options are the only derivatives where risk is limited to the premium (purchase) price paid initially.

Example: Purchased Options (Continued)
The accounting was relatively simple under the now-defunct FAS 80. FAS 133 rules are more complicated for hedging contracts --- see 000starta.xls file at CME --- Value of Option = Intrinsic Value + Time Value

KEY ASPECTS OF THE 133/39 STANDARDS
Most derivatives are reported at fair value on balance sheet Changes in fair value for derivatives not 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 In June 1999 the FASB issued Statement 137 that deferred the effective date of Statement 133 for one year. FAS 133 will now be effective for all quarters of fiscal years beginning after June 15, 2000.

DERIVATIVES IMPLEMENTATION GROUP (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 ( for two months before being presented to the Board for negative clearance. DIG Site

Bob Jensen’s Flow Chart http://www. trinity
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)

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 (5% Rule in Para A5 of FAS 149) 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

FREESTANDING DERIVATIVES Overview
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.

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 DIG Issue K1 provides guidance relating to determining whether separate transactions, which by themselves do not meet the definition of a derivative, should be reviewed as a unit. The characteristics are trying to capture a contract that allows or requires one or both counterparties to share/obtain/transfer the risks or benefits inherent in the asset/liability underlying the contract without paying for the asset/liability at the inception of the contract or owning it at the maturity of the contract.

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

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) DIG Issue A6 clarifies that a lack of a specific stated notional amount (e.g. requirements contract) may still meet the notional amount characteristic.

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

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 basis points then payment of an applicable amount would be required

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 It is important to note that the phrase initial net investment is stated from the perspective of only one party to the contract but determines applicability of Statement 133 to both. DIG Issue A1 concludes that the prepayment of a contract is considered an initial net investment and, therefore, not accounted for as a derivative instrument in accordance with the Standard. However, an assessment needs to be made whether the nonderivative contract includes an embedded derivative. DIG Issue A9 concludes that a prepaid interest rate swap must be accounted for as a derivative.

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 DIG Issue A5 concludes that a contract which contains both a variable (based on changes in the underlying) and a fixed penalty for nonperformance does not meet the net settlement provision. DIG Issue A7 concludes that an assignment clause does not preclude the contract from possessing the net settlement characteristic. DIG Issue A8 concludes that a nonperformance penalty provision, with no net settlement parameters to compensate the non-defaultering party for any loss incurred, and precludes the defaultering party from receiving the effects of favorable price changes (asymmetrical default provision), does not give a commodity forward contract the characteristics of net settlement under ¶9(A). DIG Issue A13 concludes that a contract that provides for a structured payout of the gain (or loss) resulting from that contract meets the characteristic of net settlement in paragraph 9(a) (and related paragraph 57(c)(1)) of Statement 133 if the fair value of the cash flows to be received (or paid) by the holder under the structured payout are approximately equal to the amount that would have been received (or paid) if the contract had provided for an immediate payout related to settlement of the gain (or loss) under the contract. DIG Issue A15 concludes that, consistent with paragraph 57(c)(2) and the guidance in Implementation Issue A2, the ability to enter into an offsetting contract, in and of itself, does not constitute a market mechanism because the rights and obligations from the original contract survive.

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 DIG Issue A2 concludes that in applying the net settlement criterion the focus should be whether a venue exists that will relieve either party of all rights and obligations under the contract and to liquidate their net positions without incurring significant transaction costs. DIG Issue A3 concludes that market mechanism relates to the contract and not the underlying of the contract. The market mechanism test is applied on a contract-by-contract basis; therefore, the liquidity related to the number of contracts held is not relevant. DIG Issue A10 concludes that an asset can be considered to be readily convertible to cash only if the net amount of cash that would be received from an active market is not significantly less than the amount an entity would typically have received under a net settlement provision. An entity should consider conversion costs to be significant only if they are ten percent or more of the gross sales proceeds at inception of the contract. DIG Issue A14 concludes that generally shares of common stock to be received upon exercise of a warrant are considered readily convertible to cash, as that phrase is used in paragraph 9(c), if the sale or transfer of the shares is restricted by governmental or contractual requirement (other than in connection with being pledged as collateral) for 31 days or less from the earliest date of receipt of the shares or if the holder has the power by contract or otherwise to cause the requirement to be met within 31 days of the earliest date of receipt. If the sale of an actively traded security were restricted for more than 31 days, that limitation is considered sufficiently significant that the shares to be received upon exercise of those warrants are considered not readily convertible to cash, as that phrase is used in paragraph 9(c).

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 DIG Issue C6 clarifies that a derivative instrument held by a transferor that relates to assets transferred in a transaction accounted for as a financing, but which does not itself serve as an impediment to sale accounting, is not subject to SFAS 133 if recognizing both the derivative instrument and either the transferred asset or the liability, would result in double accounting. DIG Issue C7 clarifies the requirement for certain financial guarantee contracts to be excluded from the scope of the Standard. DIG Issue B10 concludes that the existence of a death benefit provision does not preclude an equity-indexed life insurance contract from being subject to the Statement.

FAS 138 Scope-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) FAS 149 Electric Power Bookout Exception As long as it is probable contracts will not settle net and will result in physical delivery (but note FAS 138 and FAS 149)

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

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 DIG Issue C1 clarifies the exception related to physical variables. Specifically: - If the contract contains a payment provision that requires the issuer to pay the holder a specified dollar amount based on a financial variable, the contract is subject to SFAS 133. - If the contract contains a payment provision that requires the issuer to pay the holder a specified dollar amount that is linked solely to a climatic or other physical variable, the contract is not subject to SFAS 133.

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) DIG Issue C5 provides an interpretation of this exception that is currently not contained in the standard. Specifically: - Applies only to nonfinancial assets that are unique. - Applies only if the nonfinancial assets related to the underlying is owned by the party to the contract that has the short position (the Seller). The language in Issue C5 has been incorporated in FAS 138.

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 In most cases this exception cannot be extended to anticipated profits.

FREESTANDING DERIVATIVES Contracts Not Considered Derivatives for 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) DIG Issue C2 relates to the exception for instruments indexed to an entity’s own stock and classified in Stockholders Equity. The conclusion reached states that temporary equity is considered stockholders equity even though it is required to be displayed outside of permanent equity. DIG Issue C3 confirms that any contract covered by the scope of SFAS 123 is not considered a derivative contract subject to SFAS 133 by the issuer.

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 DIG Issue B12 concludes that an investor’s beneficial interest in a qualifying special purpose entity should be evaluated for embedded derivatives based upon the terms of the beneficial interest, not the detailed holdings of the qualifying special purpose entity. DIG Issue B18 indicates that a contract that meets the definition of a derivative in its entirety, but qualifies for a scope exemption under paragraph 10(b) it is not subject to the accounting requirements of Statement 133.

Do Not Apply This Statement
EMBEDDED DERIVATIVES When Does a Contract Have an Embedded Derivative Subject to This Statement? ¶12 Is the contract carried at fair value through earnings? Would it be a derivative if it was freestanding? Is it clearly and closely related to the host contract? No Yes No Apply This Statement Yes No Yes Do Not Apply This Statement

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 DIG Issue B16 provides a four step decision sequence to be followed in determining whether calls and puts that can accelerate the settlement of debt instruments should be considered to be clearly and closely related to the debt host contract.

EMBEDDED DERIVATIVES Clearly and Closely Related—Underlyings
Type of Host Underlying Debt Interest Inflation Creditworthiness Equity Price of share in entity Lease Inflation Interest

EMBEDDED DERIVATIVES Clearly 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. The following items are discussed in paragraph 61: interest rate index inflation-indexed interest payments credit-sensitive payments call and puts on debt instruments calls and puts on equity instruments floors, caps and collars term-extending options equity-indexed interest payments commodity-indexed interest or principal payments indexed rentals convertible debt convertible preferred stock DIG Issue B14 concludes that the economic characteristics and risks of a floor and cap on the price of an asset embedded in a contract to purchase that asset are clearly and closely related to the purchase contract such that separation of the embedded derivative is not necessary.

EMBEDDED DERIVATIVES FAS 155
Specifically, FAS 155 standard allows financial instruments that have embedded derivatives to be accounted for as a whole (eliminating the need to bifurcate the derivative from its host) if the holder elects to account for the whole instrument on a fair value basis. The following items are discussed in paragraph 61: interest rate index inflation-indexed interest payments credit-sensitive payments call and puts on debt instruments calls and puts on equity instruments floors, caps and collars term-extending options equity-indexed interest payments commodity-indexed interest or principal payments indexed rentals convertible debt convertible preferred stock DIG Issue B14 concludes that the economic characteristics and risks of a floor and cap on the price of an asset embedded in a contract to purchase that asset are clearly and closely related to the purchase contract such that separation of the embedded derivative is not necessary.

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 For a perfectly effective hedge, the hedging instrument’s gain or loss will be completely offset by the change in fair value of the hedged item attributable to the hedged risk. Consequently, there will be no net effect on earnings for the period. All ineffectivenes, even for an effective hedge, hits net income.

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 Straight-line amortization of option premiums and forward points is no longer permitted. The time value component is part of the fair value of a derivative and, under Statement 133, must be remeasured at fair value each period. Prior to SFAS 133, the hedged item’s carrying value was sometimes adjusted for the value of the hedging derivative instrument. For example, when hedging a fixed rate debt obligation with a treasury futures contract, the carrying value of the debt obligation was adjusted by the entire fair value change in the treasury futures contract. In contrast, under SFAS 133, the hedged item’s carrying value is adjusted for the fair value change of the hedged item due to the risk being hedged. Prior to SFAS 133, the hedging instrument (derivative) was sometimes not recognized in the financial statements, e.g., synthetic alteration accounting.

FAIR VALUE HEDGE ACCOUNTING For Hedged Item Booked at Historical Cost
Measurement of Derivative Change in Fair Value Earnings Changes Offset (1) Accounting Model Measurement of Hedged Item Offsetting Gain or Loss Attributable to Risk Being Hedged (1) Ineffectiveness affects net earnings

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 For cash flow hedges, ineffectiveness will not always be recorded in earnings. If the hedge is a cumulative underhedge, ineffectiveness will not be recorded. This will be discussed in the cash flow hedges section.

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. The accounting model will create volatility in capital relating to OCI adjustment, and in earnings relating to ineffectiveness. Since hedged item is a forecasted transaction, there is no “offsetting” adjustment. This accounting is significantly different than pre-SFAS 133 accounting. Under synthetic alteration, the fair value of the interest rate swap was not recognized. Under Statement 80, the fair value of the derivative instrument was recognized, but deferred on the balance sheet. In order to be consistent with two of the four cornerstones - only assets and liabilities should be recorded on the balance sheet and special hedge accounting is appropriate if certain criteria is met - the board concluded that unrealized gains and losses related to derivative instruments designated as hedging instruments in cash flow hedge relationships should be recorded in OCI.

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)

Fair Value Hedge Fair value hedge accounting does not use OCI like in cash flow and FX hedges. The reason is that changes in fair value of hedged items do not change earnings in the same manner as changes in cash flows and FX hedged items. Fair value hedge of a historical cost hedged item requires shifting from historical cost accounting to fair value accounting for the hedged item (but only during the hedging period). Fair value hedge of a firm commitment requires use of a fair value hedge accounting account the FASB invented that is called “Firm Commitment” but should be named something else.

FAS 159 effective in 2008 The Fair Value Option for Financial Assets and Financial Liabilities
Allows entities to voluntarily choose to measure eligible financial instruments at fair value (the “fair value option”) (Exceptions for items covered by some other standards such as consolidated entities, pensions, post-employment contracts, leases, and financial insurance contracts) Changes in fair value recognized in earnings. (no OCI) Election made on an instrument-by-instrument basis Irrevocable

FASB issued the FVO to: Provide an opportunity to mitigate volatility in earnings caused by a mixed attribute accounting model Reduce the need for applying complex hedge accounting provisions Expand the use of fair value measurements International convergence

Scope: Recognized financial assets and liabilities (but not forecasted transactions under FAS 133) Firm commitments that would otherwise not be recognized at inception and that involve only financial instruments Written loan commitments Certain rights and obligations under insurance contracts or warranty obligations A financial host contract in a nonfinancial hybrid instrument Certain nonfinancial assets and liabilities

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

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 DIG Agenda Item 9-5 concludes that a foreign-currency-denominated debt instrument that is designated as the hedging instrument in a net investment hedge may also be designated as the hedged item in a fair value hedge of interest rate risk.

OBJECTIVE OF HEDGE ACCOUNTING
Timing of gain/loss recognition on hedging instrument and hedged item Hedged Item $ (1) $(20) $(20) Derivative 20 (2) $ $(20) $ -0- Periods 1 2 Total The Standard generally provides for matching of the gain/loss of hedging instrument and hedged item. Results of accounting model will be increased volatility in earnings and capital.

IAS 39 should be applied by all enterprises to all financial instruments except:
(a) those interests in subsidiaries, associates, and joint ventures that are accounted for under IAS 27, Consolidated Financial Statements and Accounting for Investments in Subsidiaries; IAS 28, Accounting for Investments in Associates; and IAS 31, Financial Reporting of Interests in Joint Ventures;

(b) rights and obligations under leases, to which IAS 17, Leases, applies; however, (i) lease receivables recognized on a lessor's balance sheet are subject to the derecognition provisions of this Standard (paragraphs and 170(d)) and (ii) this Standard does apply to derivatives that are embedded in leases (see paragraphs 22-26);

c) employers' assets and liabilities under employee benefit plans, to which IAS 19, Employee Benefits, applies; (d) rights and obligations under insurance contracts as defined in paragraph 3 of IAS 32, Financial Instruments: Disclosure and Presentation, but this Standard does apply to derivatives that are embedded in insurance contracts (see paragraphs 22-26); (e) equity instruments issued by the reporting enterprise including options, warrants, and other financial instruments that are classified as shareholders' equity of the reporting enterprise (however, the holder of such instruments is required to apply this Standard to those instruments);

(f) financial guarantee contracts, including letters of credit, that provide for payments to be made if the debtor fails to make payment when due (IAS 37, Provisions, Contingent Liabilities and Contingent Assets, provides guidance for recognizing and measuring financial guarantees, warranty obligations, and other similar instruments). In contrast, financial guarantee contracts are subject to this Standard if they provide for payments to be made in response to changes in a specified interest rate, security price, commodity price, credit rating, foreign exchange rate, index of prices or rates, or other variable (sometimes called the 'underlying'). Also, this Standard does require recognition of financial guarantees incurred or retained as a result of the derecognition standards set out in paragraphs 35-65;

(g) contracts for contingent consideration in a business combination (see paragraphs of IAS 22 (Revised 1998), Business Combinations); (h) contracts that require a payment based on climatic, geological, or other physical variables (see paragraph 2), but this Standard does apply to other types of derivatives that are embedded in such contracts (see paragraphs 22-26).

3. IAS 39 does not change the requirements relating to: (a) accounting by a parent for investments in subsidiaries in the parent's separate financial statements as set out in paragraphs of IAS 27; (b) accounting by an investor for investments in associates in the investor's separate financial statements as set out in paragraphs of IAS 28; (c) accounting by a joint venturer for investments in joint ventures in the venturer's or investor's separate financial statements as set out in paragraphs 35 and 42 of IAS 31; or (d) employee benefit plans that comply with IAS 26, Accounting and Reporting by Retirement Benefit Plans.

IAS 39 may apply to insurance companies but not insurance contracts
5. IAS 39 applies to the financial assets and liabilities of insurance companies other than rights and obligations arising under insurance contracts, which are excluded by paragraph 1(d).

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

Journal entries at end of period 1 Derivative Z 25,000 OCI ,000 To record Derivative Z at fair value Cash 25,000 Derivative Z ,000 To record settlement of Derivative Z

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 ,000 Earnings ,000 To reclassify amount in OCI to earnings upon inventory sale

Forecasted cash flows: $1,100,000 Actual cash flows: Derivative $ ,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.

CASE 2 Fair 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 This is example 1 from Appendix B of the Standard. Derivative is assumed to have no time value. In application, though, the derivative will have a time value component which must be accounted for. ABC expects no ineffectiveness because (a) the notional amount of Derivative Z matches the amount of the hedged inventory, and (b) the underlying of Derivative Z is the price of the same variety and grade of Commodity A as the inventory at the same location.

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

CASE 2 Fair Value Hedge of Inventory
Journal entries at end of period: Derivative ,000 Earnings ,000 To record derivative at fair value Earnings ,000 Inventory ,000 To record loss on hedged inventory In Case 2, it is assumed that there is no ineffectiveness.

ACCOUNTING FOR DERIVATIVES

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