In June 1998, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“FAS 133” or “the Standard”). FAS 133 is one of the most controversial and far-reaching accounting standards issued in recent years. It represents a comprehensive framework of accounting rules that standardizes and creates uniform accounting for all derivatives. Under the Standard, all derivatives must be recognized on the balance sheet at fair value with the offsetting entry related to unrealized gains and/or losses reflected either as part of current earnings or in other comprehensive income, a component of stockholder’s equity. These modifications eliminate the practice of synthetic-instrument and off-balance sheet accounting.
The ultimate goal of the FASB was to increase the visibility of derivatives and require that hedge ineffectiveness be recorded in earnings. Adoption of the Standard will cause an increase in the size of the balance sheet accounts used to record the fair value of derivatives and increase earnings and equity volatility for many exploration and production entities. The Standard applies to all entities, all types of derivatives and is effective for all fiscal quarters of fiscal years beginning after June 15, 2000.
In June 2000, the FASB issued FAS 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities, an Amendment to FASB Statement No. 133. Contracts that contain net settlement provisions may qualify for the normal purchases and normal sales exception if it is probable at inception and throughout the term of the individual contract that the contract will not settle net and will result in physical delivery.
As a result of the complexity of FAS 133, the FASB created the “Derivatives Implementation Group (DIG)“. The DIG is a task force to assist the FASB in answering questions that companies must address when they implement and interpret FAS 133. The objective in forming the group was to establish a mechanism to identify and resolve significant implementation questions in advance of adoption of the standard by many companies. The responsibilities of the DIG are to identify practice issues that arise from applying the requirements of FAS 133 and to advise the FASB on how to resolve those issues. The DIG will remain in place to address matters in application at least through the end of fiscal year 2000.
At the time of this publication, there are many uncertainties pertaining to the application of the Standard that remain unresolved. The issues addressed by the DIG and approved by the FASB should be read in conjunction with the information included within this post. The accounting guidance in place until the implementation of FAS 133 occurs is driven by the concepts contained in FAS 80, “Accounting for Futures Contracts”.
Definition Of A Derivative
A derivative under FAS 133 can be defined as a financial instrument or other contract that possess all three of the following characteristics:
- Value changes by direct reference to (1) one or more underlyings and (2) one or more notional amounts or payment provisions or both;
- No initial net investment (or a small investment for time value); and
- Settled net or by delivery of an asset that is readily convertible to cash.
Key to this definition are the concepts of (a) underlying, (b) notional amount, and (c) payment provision:
An underlying in a derivative is a specified commodity price, interest rate or security price or some other variable. An underlying may be a price or rate of interest but not the asset or liability itself. Accordingly, the underlying generally will be the referenced index that determines whether or not the derivative has a positive or negative value.
A notional amount is amount represents the second half of the equation that goes into determining the settlement amount or amounts under the derivative contract. Accordingly, the settlement of a derivative is determined by the interaction of the notional amount with the underlying. This interaction may consist of simple multiplication or it may involve a more complex formula.
A payment provision specifies a fixed or determinable settlement that is to be made if the underlying behaves in a specified manner. For the energy industry, as an example, the payment provision is the most problematic component as the commodity (such as crude oil and natural gas) is produced and sold in liquid markets. In essence, there are three ways to meet the net settlement requirement as follows:
- Net settlement explicitly required or permitted by the contract (i.e., symmetrical liquidating damage clause);
- Net settlement by a market mechanism outside the contract (i.e. futures exchange); or
- Delivery of a derivative or an asset that is readily convertible to cash.
Thus based on these concepts, the definition of a derivative has been expanded to include not only the typical financial instruments that have been viewed in the past as derivatives but may also include some traditional physical commodity contracts which do not meet the normal purchase and sale exclusion provided for in FAS 133. FAS 138 allows contracts that contain net settlement provisions to qualify for the normal purchases and normal sales exception if it is probable at inception and throughout the term of the individual contract that the contract will not settle net and will result in physical delivery.
Certain exclusions to the parameters of the definition of a derivative under FAS 133 exist. These exclusions relate to normal purchases and sales, contingent consideration resulting from a business combination, certain insurance contracts, and employee compensation arrangements that are indexed to an entity’s own stock and classified as part of stockholders’ equity. Contracts, which meet the definition of a derivative and qualify for one of these exclusions, are not subject to FAS 133.
An embedded derivative is a provision in a contract through its implicit or explicit terms that contains the characteristics of a free-standing derivative which ultimately affect the cash flows or value of other exchanges required by a contract. Thus, the combination of a host contract and an embedded derivative is referred to as a hybrid instrument.
An embedded derivative should be separated from the host contract and accounted for separately in the financial statements if all of the following criteria are met:
- The embedded characteristic in the contract would meet the definition of a derivative;
- Characteristics and risks of the embedded derivative are not clearly and closely related to the host contract; and
- The host contract is not measured at fair value.
Judgment is required to interpret the phrase “clearly and closely related”, which is not defined in FAS 133. “Clearly and closely related” implies the economic features of an embedded derivative and the host contract are somewhat interdependent and the fair value of the embedded derivative and the host contract are impacted by the same variables and vice versa.
Types Of Hedges
The income statement recognition of changes in the fair value of a derivative will depend on the intended use of the derivative. If the derivative does not qualify as a hedging instrument or is not designated as such, the gain or loss on the derivative must be recognized currently in earnings.
To qualify for hedge accounting, the derivative must qualify either as a:
- fair value hedge; or
- cash flow hedge, or
- foreign currency hedge.
1. Fair Value Hedge – A fair value hedge represents the hedge of an exposure to changes in the fair value of an asset, liability or an unrecognized firm commitment that is attributable to a particular risk. An example of a fair value hedge would be a forward contract pertaining to an unrecognized firm commitment (fixed price sales and purchase contracts) or an interest rate swap contract associated with fixed rate debt.
A fair value hedge is reflected in the financial statements at market value each reporting period and the associated unrealized gain or loss incurred with respect to such instrument is included in earnings.
Changes in the fair value of the corresponding unrecognized firm commitment or asset/liability being hedged is also recognized in the financial statements each reporting period. As a result, both the income statement and balance sheet of an organization is increased for these transactions. The only component that would affect net income, in any given reporting period, would be any ineffectiveness identified as part of the effectiveness assessment made by the organization.
2. Cash Flow Hedges – A cash flow hedge is a hedge of an exposure to variability in cash flows that is attributable to a particular risk which may be associated with an existing recognized asset or liability (floating rate debt) or a forecasted transaction.
Some common examples include the use of futures, swaps or costless collar arrangements associated with future natural resource productions or an interest rate swap associated with variable rate debt.
A cash flow hedge is reflected in the financial statements at market value each reporting period and the associated unrealized gain or loss incurred with respect to such instrument is included in other comprehensive income, a component of stockholders’ equity.
The amount that is deferred in other comprehensive income is always the lesser of (in absolute value terms) (1) the estimated changes in the expected future cash flows of the hedged item that are attributable to the hedged risk; or (2) the cumulative gain or loss on the derivative instrument.
The corresponding forecasted transaction or recognized asset and liability is not reflected/adjusted in the financial statements. The only component that would affect net income, in any given reporting period, would be any ineffectiveness identified as part of the effectiveness assessment made by the organization.
FAS 133 generally retained FAS 52 hedge accounting provisions. In this regard, FAS 133 includes a narrow scope of transactions for which hedge accounting may be applied to foreign currency/operations activities.
3. Foreign Currency Hedges – A foreign currency hedge is the hedge of a foreign currency exposure to an unrecognized firm commitment, an available-for-sale security, a forecasted transaction or a net investment in a foreign operation. A foreign currency hedge can have the dynamics of a fair value transaction, cash flow transaction or foreign currency hedge of a net investment in a foreign operation depending on the nature of the underlying physical transaction(s). Foreign currency hedges are accounted for in a manner consistent with the general provisions of a fair value hedge or cash flow hedge as previously described.
Certain criteria must be met for a derivative financial instrument to fall within one of the hedging categories described above. Some of the criteria are similar to the concepts utilized for the determination of hedge accounting at present, while others are a formalization of a process which may already be in place.
- First, an entity must indicate what it is doing with the derivative financial instrument through formal documentation of the hedge relationship and risk management objective and strategy at the beginning of the contract term. The formal documentation encompasses a specific designation of the hedge instrument and related item, the nature of the risk being hedged and the method of assessing “effectiveness“.
- The hedging item should be consistent with the respective risk management policy and expected to be “highly effective” at inception and on an ongoing basis throughout the term of the contract.
The FASB declined to quantify “highly effective”, however, the DIG provided interpretive guidance with respect to this matter in DIG Issue E6. The assessment of effectiveness is required to be performed at least every three months and whenever financial statements or earnings are reported to the public.
The method for assessing effectiveness should be included as part of the documentation requirements prior to the beginning of the designation of the hedging relationship. Hedge effectiveness must be achieved initially and on an ongoing basis. As such, the measurement of hedge effectiveness is prospective as well as retrospective. Ordinarily, it is expected that an entity would assess effectiveness for similar hedges in a similar manner; use of different methods for similar hedges should be justified.
Effectiveness allows an entity to utilize hedge accounting; however, ineffectiveness must still be measured and recorded in the financial statements. If a derivative has been determined to be highly effective, some ineffectiveness is likely to occur and some gain or loss reflected in earnings.
Items which may generate ineffectiveness include:
- different maturity or repricing dates;
- different underlying;
- location and quality differentials; and
- credit differences.
As it relates to cash flow hedges, the amount deferred in other comprehensive income is the lesser of (in absolute value terms):
- the estimated changes in the expected future cash flows of the hedged item that are attributable to the hedged risk; and
- the cumulative gain or loss on the derivative instrument.
In essence, there is a limitation of the amounts pertaining to unrealized gains and/or losses that may be accumulated in other comprehensive income. Therefore, the cumulative gain or loss on the derivative in excess of the estimated changes in expected future cash flows will be recorded in the income statement as ineffectiveness. Any changes that an entity might make to its method of assessing effectiveness would have to be justified and would be applied prospectively by a discontinuance of the existing hedging relationship and a new designation of the relationship through the use of the improved method. In addition, if an enterprise changes the method of assessing effectiveness on a hedged item, the enterprise should also change the method of assessment for similar hedges.
Discontinuance of Hedge Accounting
Under the parameters of FAS 133, discontinuance of hedge accounting would transpire in two situations as follows:
- Failure to meet any of the qualifying hedge criteria; and
- Derivatives were to expire or be sold, terminated, exercised or simply dedesignated as a hedging instrument.
The disclosure requirements in financial statements under FAS 133 are quite extensive in that it has expanded qualitative disclosures to include the objective and strategy, risk management policy and description of hedged items. In addition, FAS 133 expanded the disclosure pertaining to derivatives to include the amount of ineffectiveness reflected in earnings, the earnings impact from discontinued hedges, the amount of gains and losses included in other comprehensive income to be included in earnings within the next twelve months and the purpose of derivatives that do not qualify as a hedging instrument.