Accounting for Derivative Financial
Instruments and Hedging
Transactions
FAS 133
IAS 30
CICA 13
Bob Jensen’s Free Tutorials, Glossaries, and Cases are at
http://www.trinity.edu/rjensen/caseans/000index.htm
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ACCOUNTING FOR DERIVATIVES
Presentation by
Bob Jensen
Trinity University
San Antonio, TX 78212
rjensen@trinity.edu
http://www.trinity.edu/rjensen/
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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
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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
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Differences Between Standards
FAS 133 vs. IAS 39 vs. CICA 13
Differences are relatively minor
IAS 39 Macro Hedging Pending Amendment
Listing of Major Differences
http://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
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
Understand the basic journal entries

Cry out loud if forced to implement the standards
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:

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
Fair value hedges

Cash flow hedges

Foreign currency hedges
Hedge effectiveness tests may be tough hurdles over time
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 (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 Chart
http://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 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.
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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:
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
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)
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FREESTANDING DERIVATIVES
Characteristic 1—Examples of Underlyings and
Notional Amounts
Derivative
- Stock option
Underlying
- Stock price
- Currency forward - Exchange rate
Notional Amount
- Number of shares
- Number of
currency units
- Commodity future - Commodity price - Number of
commodity units
- Interest rate swap - Interest index
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- 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
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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:

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Public securities, commodities, and foreign
currencies
FREESTANDING DERIVATIVES
Exceptions ¶10 and 58
The following are not subject to Statement 133:
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
“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
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)
As long as it is probable contracts will not settle
net and will result in physical delivery (but note FAS 138
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
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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
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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
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
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)
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:
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
Leases based on sales of the lessee

Royalty agreements
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)
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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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EMBEDDED DERIVATIVES
When Does a Contract Have an Embedded
Derivative Subject to This Statement? ¶12
Yes
No
Would it be a
derivative if it
was freestanding?
Yes
No
Do Not Apply This Statement
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Is it clearly and
closely related
to the host
contract?
Yes
No
Apply This Statement
Is the contract
carried at fair
value through
earnings?
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
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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.
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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:
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
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
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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FAIR VALUE HEDGE ACCOUNTING
For Hedged Item Booked at Historical Cost
Accounting Model
Measurement of Derivative
Change in Fair Value
Measurement of Hedged Item
Offsetting Gain or Loss
Attributable to Risk Being
Hedged
(1) Ineffectiveness affects net earnings
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Earnings
Changes
Offset
(1)
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:
•
•
•
•
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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
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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Accounting Model
CASH FLOW HEDGE ACCOUNTING
Change in Fair Value
Effective
(1)
Earnings
(1) Based on Timing of Earnings
Impact of Hedged Item
(interest, cost of sales, depreciation)
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OCI
Equity
Measurement of Derivative
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 nonderivative 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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OBJECTIVE OF HEDGE ACCOUNTING
Timing of gain/loss recognition on hedging instrument and
hedged item
Periods
1
Hedged Item
Derivative
Total
$ -0-
(1)
$(20)
20
(2)
-0-
$20
1-40
2
$(20)
$(20)
20
$ -0-
Change to Forward/Futures PowerPoint Show
And 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
Derivative Z
25,000
To record settlement of Derivative Z
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25,000
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
Sale of inventory
Total
$
25,000
1,075,000
$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 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
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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
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CASE 2
Fair Value Hedge of Inventory
Journal entries at end of period:
Derivative
25,000
Earnings
25,000
To record derivative at fair value
Earnings
Inventory
To record loss on hedged inventory
1-48
25,000
25,000