ACCOUNTING FOR DERIVATIVES
Presentation by
Bob Jensen
Trinity University
One Trinity Place
San Antonio, TX 78212
rjensen@trinity.edu
http://www.trinity.edu/rjensen/
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ACCOUNTING FOR DERIVATIVES
Bob Jensen
190 Sunset Hill Road
Sugar Hill, NH 03586
Phone 603-823-8482
rjensen@trinity.edu
http://www.trinity.edu/rjensen/
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Accounting for Derivative Financial
Instruments and Hedging
Transactions
FAS 133
IAS 39
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 Derivative Financial
Instruments and Hedging
Transactions
Key Amendments to FAS 133
FAS 138
FAS 149
FAS 155
FAS 159
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Accounting for Derivative Financial
Instruments and Hedging
Transactions
Eliminated by FAS 133
FAS 080
FAS 119
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Fair Value Accounting
FAS 105, 107, 115, 130, 133, 141, 142, 155, 157, 159
FAS 105, 107, 115, 130, 133, 141, 142, 155, 157, 159
Bob Jensen’s Summary of Accounting History and Theory
http://www.trinity.edu/rjensen/theory.htm
“Not everything that can be counted, counts. And not everything that counts can be counted.”
Albert Einstein
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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.
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FAS 130 effective in 1998
Reporting Other Comprehensive Income (OCI)
This Statement requires that an enterprise
(a)
classify items of other comprehensive income by
their nature in a financial statement and
(b)
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.
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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
http://www.trinity.edu/rjensen/fraud.htm#DerivativesFraud
Video and audio clips of FASB updates on FAS 133

Audio 1 --- Dennis Beresford in 1994 in New York City BERES01.mp3

Audio 2 --- Dennis Beresford in 1995 in Orlando BERES02.mp3
Derivative
Financial Instrument Frauds --- Off line --- Click Here
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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.
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Key FAS 133 and IAS 39 Terms
Notional | Underlying | Net Settlement | Little or No Initial Investment
Financial Instrument
| Derivative Instrument
Purchase Commitment | Firm Commitment | Forecasted Transaction | Speculation
Stand Alone | Cash Flow Hedge | Fair Value Hedge | FX Hedge
Purchased Options | Written Options | Long Forwards | Short Forwards | Swaps | Futures Contracts
European versus American versus Asian options
Spot Price, Forward Price, Strike Price, Premium, Intrinsic Value, Time Value
Freestanding, Embedded, Structured (tailormade rather than convential financing)
OCI versus Firm Commitment | Delta
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ACCOUNTING FOR DERIVATIVES
Bob Jensen's threads on Enron are at http://www.trinity.edu/rjensen/fraud.htm
Bob Jensen's threads on Derivative Financial Instruments Fraud are at
http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
Also note http://www.trinity.edu/rjensen/Fraud.htm#FrankPartnoyTestimony
How Enron Used SPEs and Derivatives Jointly is Explained at
http://www.trinity.edu/rjensen//theory/00overview/speOverview.htm
Bob Jensen’s threads on derivatives accounting are
at http://www.trinity.edu/rjensen/caseans/000index.htm
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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.
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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.
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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, 2002 --http://www.senate.gov/~gov_affairs/01240
2partnoy.htm
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Frank Partnoy’s Works

FIASCO: The Inside Story of a Wall Street Trader

FIASCO: Blood in the Water on Wall Street

FIASCO: Blut an den weißen 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)


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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 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
One million lines of journal entries:
Just how expensive is FAS 133?
"The Potential Crisis at Fannie Mae," Comstock Funds, August 11, 2005 --- http://snipurl.com/Fannie133
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 http://www.trinity.edu/rjensen/caseans/000index.htm
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FOUR CORNERSTONES

Derivatives are contracts that create rights and
obligations that meet the definitions of assets and
liabilities

Fair value is the only relevant measure for derivatives
(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.
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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.
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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
http://www.cs.trinity.edu/~rjensen/Calgary/CD/FAS133
OtherExcelFiles/cases/

CBOT --- http://www.cbot.com/

The prices you first see listed are the forward prices.
To find spot prices, click on the link called "Charts."
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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-thecounter (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.
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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
http://www.cs.trinity.edu/~rjensen/Calgary/CD/FAS133
OtherExcelFiles/cases/

CBOT --- Does not exchange forward contracts

Contracts are non-standardized and might be subject
to credit risk.
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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..
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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
http://www.cs.trinity.edu/~rjensen/Calgary/CD/FAS133
OtherExcelFiles/cases/

There are a few standardized swaps traded on
exchanges

Contracts are non-standardized and might be subject
to credit risk.
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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.
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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.
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Example: Purchased Options (Continued)

The accounting was relatively simple under the nowdefunct FAS 80.

FAS 133 rules are more complicated for hedging
contracts --- see 000starta.xls file at
http://www.cs.trinity.edu/~rjensen/Calgary/CD/FAS133
OtherExcelFiles/cases/

CME --http://www.cme.com/trading/dta/del/delayed_quotes352
0.html

Value of Option = Intrinsic Value + Time Value
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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:

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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
(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
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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)

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)
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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
1-47
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:
1-49

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)
1-50
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
1-53
EMBEDDED DERIVATIVES
Clearly and Closely Related—Underlyings
Type of Host
1-54
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.
1-55
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.
1-56
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:
1-57

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
1-58
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
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.
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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
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FAS 159 effective in 2008
The Fair Value Option for Financial Assets and Financial Liabilities
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
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FAS 159 effective in 2008
The Fair Value Option for Financial Assets and Financial Liabilities
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
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FOREIGN CURRENCY HEDGE
¶36–42 (as amended by FAS 138)
The Board intended to increase the consistency of hedge
accounting guidance by broadening the scope of eligible
foreign currency hedges. At the same time, the Board chose
to continue certain prior practices. Key aspects:
 Includes hedges of cash flow, fair value, and net
investments in foreign operations
 Carries forward the functional currency concept from
Statement 52
 Permits limited use of nonderivative instruments
 Expands hedge accounting, particularly for forecasted
transactions and tandem currency hedges
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Hedging Instruments

For a fair value hedge of foreign exchange risk related to AFS
securities or a recognized foreign-currency-denominated debt
instrument, an entity can only use a derivative instrument

For a fair value hedge of foreign exchange risk related to a firm
commitment, an entity can use either a derivative or a 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
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2
$(20)
$(20)
20
$ -0-
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;
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IAS 39 should be applied by all enterprises to
all financial instruments except:
(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 35-65 and 170(d)) and
(ii) this Standard does apply to derivatives that are
embedded in leases (see paragraphs 22-26);
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IAS 39 should be applied by all enterprises to
all financial instruments except:
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);
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IAS 39 should be applied by all enterprises to
all financial instruments except:
(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;
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IAS 39 should be applied by all enterprises to
all financial instruments except:
(g) contracts for contingent consideration in a business
combination (see paragraphs 65-76 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).
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IAS 39 should be applied by all enterprises to
all financial instruments except:
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 2931 of IAS 27;
(b) accounting by an investor for investments in associates in the
investor's separate financial statements as set out in paragraphs
12-15 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.
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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).
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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
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25,000
25,000