Accounting for Derivatives

Overview

The single inviolate accounting requirement for derivatives is that they must be marked-to-market and recorded as assets or liabilities on the balance sheet. Beyond that, the accounting treatment will depend on the intended use of the derivative and/or whether specific conditions have been satisfied.

For speculative purposes, derivative gains or losses must be marked-to-market and gains or losses are recorded in the current period’s income.

When hedging exposures associated with the price of an asset, liability, or a firm commitment, accounting for the derivative is the same as it is for speculative uses. In addition, however, the underlying exposure must also be marked-to-market due to the risk being hedged; and these results must flow through current income, as well. This treatment is called a “fair value hedge.”

A hedge of an upcoming, forecasted event would be a “cash flow hedge.” For cash flow hedges, derivative results must be evaluated, with a determination made as to how much of the result is “effective” and how much is “ineffective.” The ineffective component of the hedge results must be recorded in current income, while the effective portion is initially posted to “other comprehensive income” and later re-classified to income in the same time frame in which the forecasted cash flow affects earnings. Importantly, as of this writing, the FASB only recognizes hedges as being ineffective for accounting purposes when the hedge effects exceed the effects of the underlying forecasted cash flow, measured on a cumulative basis; but this asymmetric provision is under consideration and is subject to change.

1. It has (1) one or more underlyings and (2) one or more notional amounts or payment provisions or both. These contractual terms determine the amount of the settlement or settlements, and, in some cases, whether or not a settlement is required.
2. It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.
3. Its terms require or permit net settlement, it can readily be settled net by a means outside the contract, or it provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.

Complicating the process for assessing whether or not any contractual arrangement qualifies as a derivative is the fact the FASB has scoped out a host of situations that might otherwise appear to satisfy the above definition.

Exemptions (815-10-15)

• Regular-way securities trades, where delivery occurs within the time frame of normal market conventions.
• Normal purchases and normal sales where instruments will be delivered in amounts expected to be used within a reasonable period of time in the normal course of business and where there is a high probability that the contracts will result in physical deliver. Contracts that required periodic cash settlements (e.g., futures contracts) do not qualify for this exception.
• Certain insurance contracts which generally fall under FAS 60, 07, and 113. Contracts are exempt from treatment as a derivative if the payout compensates the insured for an identifiable insurable event other than a change in price.
• Financial guarantee contracts that reimburse for specific losses due to defaults of debtors.
• Off-exchange contracts where settlement amounts are based on (a) climactic, geological, or other physical variables; (b) prices of non-financial assets or liabilities on either party to the contract, where the underlying instrument is not readily convertible to cash; or (c) specific volumes of sales or revenues of one of the parties to the contract.
• Derivatives that serve as impediments to sales accounting.
• Contracts (a) indexed to a company's own stock and classified in stockholders' equity; (b) issued by the reporting entity relating to stock-based compensation; or (c) issued as a contingent consideration from a business combination.

Embedded derivative instruments
Embedded derivatives are components of contractual arrangements that, by themselves (i.e. on a stand-alone basis), would satisfy the criteria in the definition of a derivative. Embedded derivatives are often present in structured note contracts and other debt obligations, but they may also be found in such contracts such as leases, purchase agreements, insurance contracts, guarantees, and other tailored arrangements.

Embedded derivatives reside in "host" contracts; and the combined instrument (i.e., the host and the embedded derivative) is referred to as the "hybrid instrument."

In general, embedded derivatives must be separated from the host contract for accounting purposes. Provided they meet the qualifying criteria for being a derivative under the FASB criteria, embedded derivatives must be accounted for as if they were free standing derivatives, unless (a) the characteristics and risks of the embedded derivative are clearly and closely related to those of the host, or (b) the hybrid instrument is re-measured at fair value with changes reported in earnings.

If the embedded derivative incorporates a leverage factor or if an investor may not recover substantially all of the initial recorded investment, the embedded derivative would be required to be accounted for separately from the host. (815-15-25)

Interest-only and principal-only strips are specifically exempted from being treated as derivatives, provided (a) the original securities from which these derivatives were constructed have no embedded derivatives that would otherwise be covered under FAS 133, and (b) the strips do not contain any features that were not initially a part of the original instrument. (815-10-15)

A hedge of an upcoming, forecasted event is a "cash flow hedge." To qualify for cash flow hedge treatment, a key requirement is that exposure involves the risk of an uncertain (i.e., variable) cash flow. Derivative results must be evaluated, with a determination made as to how much of the result is "effective" and how much is "ineffective." The ineffective component of the hedge results must be reported in current income, while the effective portion is initially posted to "other comprehensive income" (OCI) and later re-classified to income in the same time frame in which the forecasted cash flow affects earnings.

For purposes of determining the amount that is appropriate to be posted to OCI, this assessment must be made on a cumulative basis. Contributions to earnings are currently required only if the derivative results exceed the cash flow effects of the hedged items. (815-30-35) This provision is currently under consideration and subject to change, whereby ineffective earnings amounts would be determined symmetrically, reflecting either excess hedge results or shortfalls.

Cash flow hedge accounting is not automatic. Specific criteria must be satisfied both at the inception of the hedge and on an ongoing basis. If, after initially qualifying for cash flow accounting, the criteria for hedge accounting stop being satisfied, hedge accounting is no longer appropriate. With the discontinuation of hedge accounting, any accumulated OCI would remain there, unless (except in extenuating circumstances) it is probable that the forecasted transaction will not occur by the end of the originally specified time period or within an additional two-month period of time thereafter. (815-30-40)

Reporting entities have complete discretion to un-designate cash flow hedge relationships at will and later re-designate them, assuming all hedge criteria are again (or still) satisfied. (815-30-40) This provision, too, is under consideration and subject to change.

Examples of exposures that qualify for cash flow hedge accounting

• Interest rate exposures that relate to a variable or floating interest rates
• Planned purchases or sales of assets
• Planned issuances of debt or deposits
• Planned purchases or sales of foreign currencies
• Currency risk associated with prospective cash flows that are not denominated in the functional currency

Eligible risks (815-20-25)

• Currency risk associated with (a) a forecasted transaction in a currency other than the functional currency, (b) an unrecognized firm commitment, or (c) a recognized foreign-currency denominated debt instrument.
• The entire price risk associated with purchases or sales of non-financial goods. That is, unless the purchase or sale specifically relates to buying or selling individual components, the full price of the good in question must be viewed as the hedged item.
• For financial instruments, hedgeable exposures include cash flow effects to (a) changes in the full price of the instrument in question, (b) changes the benchmark rate of interest (i.e., the risk-free rate of interest or the rate associated with LIBOR-based swaps), (c) changes associated with the hedged item's credit spread relative to the interest rate bench mark (d) changes in cash flows associated with default or the obligors' creditworthiness, and (e) changes in currency exchange rates.

Prerequisite requirements to qualify for cash flow accounting treatment (815-20-25)

• Hedges must be documented at the inception of the hedge, with the objective and strategy stated, along with an explicit description of the methodology used to assess hedge effectiveness.
• Dates (or periods) for the expected forecasted events and the nature of the exposure involved (including quantitative measures of the size of the exposure) must be explicitly documented.
• The hedge must be expected to be "highly effective," both at the inception of the hedge and on an ongoing basis. Effectiveness measures must relate the gains or losses of the derivative to changes in the cash flows associated with the hedged item.
• The forecasted transaction must be probable.
• The forecasted transaction must be made with a different counterparty than the reporting entity.

Dis-allowed situations (i.e., when cash flow accounting may not be applied) (815-20-25)

• In general, written options may not serve as hedging instruments. An exception to this prohibition (i.e., when a written option may qualify for cash flow accounting treatment) is when the hedged item is a long option.
• In general, basis swaps do not qualify for cash flow accounting treatment unless both of the variables of the basis swap are linked to two distinct variables associated with two distinct cash flow exposures.
• Cross currency interest rate swaps do not qualify for cash flow hedge accounting treatment if the combined position results in exposure to a variable rate of interest in the functional currency. This hedge would qualify, however, as a fair value hedge.
• With held-to-maturity fixed income securities under Statement 115, interest rate risk may not be designated as the risk exposure in a cash flow relationship.
• The forecasted transaction may not involve a business combination subject to Opinion 16 and does not involve (a) a parent's interest in consolidated subsidiaries, (b) a minority interest in a consolidated subsidiary, (c) an equity-method investment, or (d) an entity's own equity instruments.
• Prepayment risk may not be designated as the hedged item.
• The interest rate risk to be hedged in a cash flow hedge may not be identified as a benchmark interest rate, if a different variable interest rate is the specified exposure—e.g., if the exposure is the risk of a higher prime rate, LIBOR may not be designated as the risk being hedged.

Internal derivatives contracts (815-20-25)

• Except in the case when currency derivatives are used in cash flow hedges, derivatives between members of a consolidated group (i.e., internal derivatives) cannot qualify as hedging instruments in the consolidated statement, unless offsetting contracts have been arranged with unrelated third parties on a one-off basis.
• For an internal currency derivative to qualify as a hedging instrument in a consolidated statement, it must be used as a cash flow hedge only for a foreign currency forecasted borrowing, a purchase or sale, or an unrecognized firm commitment, but the exposure following conditions apply:
• The non-hedging counterpart to the internal derivative must offset its net currency exposure with a third party within 3 days of the internal contract's hedge designation date.
• The third-party derivative must mature within 31 days of the internal derivative's maturity date.

When hedging exposures associated with the price of an asset, liability, or a firm commitment, the total gain or loss on the derivative is recorded in earnings. In addition, the carrying value of the underlying exposure must be adjusted by an amount attributable to the risk being hedged; and these results flow through current income, as well. This treatment is called a "fair value hedge." Hedgers may elect to hedge all or a specific identified portion of any potential hedged item.

Fair value hedge accounting is not automatic. Specific criteria must be satisfied both at the inception of the hedge and on an ongoing basis. If, after initially qualifying for fair value accounting, the criteria for hedge accounting stop being satisfied, hedge accounting is no longer appropriate. With the discontinuation of hedge accounting, gains or losses of the derivative will continue to be recorded in earnings, but no further basis adjustments to the original hedged item would be made. (815-25-40)

Reporting entities have complete discretion to de-designate fair value hedge relationships at will and later re-designate them, assuming all hedge criteria remain. (815-25-40) As noted earlier, this provision is under consideration and subject to change.

Examples of exposures that qualify for fair value hedge accounting (815-25-40)

• Interest exposures associated with the opportunity cost of fixed rate debt
• Price exposures for fixed rate assets
• Price exposures for firm commitments associated with prospective purchases or sales
• Price exposures associated with the market value of inventory items
• Price exposures on available-for-sale securities

Eligible risks (815-20-25)

• The risk of the change in the overall fair value
• The risk of changes in fair value due to changes in the benchmark interest rates (i.e., the risk-free rate of interest or the rate associated with LIBOR-based swaps), foreign exchange rates, credit worthiness, or the spread over the benchmark interest rate relevant to the hedged item's credit risk.
• Currency risk associated with (a) an unrecognized firm commitment, (b) a recognized foreign-currency-denominated debt instrument, or (c) an available-for-sale security

Prerequisite requirements to qualify for fair value accounting treatment (815-20-25)

• Hedges must be documented at the inception of the hedge, with the objective and strategy stated, along with an explicit description of the methodology used to assess hedge effectiveness.
• The hedge must be expected to be "highly effective," both at the inception of the hedge and on an ongoing basis. Effectiveness measures must relate the gains or losses of the derivative to those changes in the fair value of the hedged item that are due to the risk being hedged.
• If the hedged item is a portfolio of similar assets or liabilities, each component must share the risk exposure, and each item is expected to respond to the risk factor in comparable proportions.
• Portions of a portfolio may be hedged if they are (a) a percentage of the portfolio; (b) one or more selected cash flows; (c) an embedded option (provided it is not accounted for as a stand-alone option); (d) the residual value in a lessor's net investment in a direct financing or sale-type lease.
• A change in the fair value of the hedged item must present an exposure to the earnings of the reporting entity.
• Fair value hedge accounting is permitted when cross currency interest rate swaps result in the entity being exposed to a variable rate of interest in the functional currency

Dis-allowed situations (i.e., when fair value accounting may not be applied) (815-20-25)

• In general, written options may not serve as hedging instruments. An exception to this prohibition (i.e., when a written option may qualify for cash flow accounting treatment) is when the hedged item is a long option. Any combinations that include written options and involve the net receipt of premium—either at the inception or over the life of the hedge—are considered to be a written option position.
• Assets or liabilities that are re-measured with changes in value attributable to the hedged risk reported in earnings—e.g., non-financial assets or liabilities that are denominated in a currency other than the functional currency—do not qualify for hedge accounting. The prohibition does not apply to foreign-currency-denominated debt instruments that require re-measurement of the carrying value at spot exchange rates.
• Investments accounted for by the equity method do not qualify for hedge accounting.
• Equity investments in consolidated subsidiaries are not eligible for hedge accounting.
• Firm commitments to enter into business combinations or to acquire or dispose of a subsidiary, a minority interest or an equity method investee are not eligible for hedge accounting.
• A reporting entity's own equity is not eligible for hedge accounting.
• For held-to-maturity debt securities the risk of a change in fair value due to interest rate changes is not eligible for hedge accounting. Fair value hedge accounting may be applied to a prepayment option that is embedded in a held-to-maturity security, however, if the entire fair value of the option is designated as the exposure.
• Prepayment risk may not be designated as the risk being hedged for a financial asset.
• Except for currency derivatives, derivatives between members of a consolidated group cannot be considered to be hedging instruments in the consolidated statement, unless offsetting contracts have been arranged with unrelated third parties on a one-off basis.

Special hedge accounting is appropriate for hedges of the currency exposure associated with net investments in foreign operations, which give rise to translation gains or losses that are recorded in the currency translation account (CTA) in shareholders' equity. Derivatives and non-derivatives (i.e., assets or liabilities denominated in the same currency as that of the net investment) may be designated as hedges of these exposures. (815-20-25-66) Effective results of such hedges are recognized in the same manner as a translation adjustment. Ineffective portions of hedge results are recognized in earnings. (815-20-35-1)

Hedge accounting for net investments in foreign operations is not automatic. Specific criteria must be satisfied both at the inception of the hedge and on an ongoing basis. If, after initially qualifying, the criteria for hedge accounting stop being satisfied, hedge accounting is no longer appropriate. With the discontinuation of hedge accounting, gains or losses of the derivative will be recorded in earnings.

Reporting entities have complete discretion to hedge relationships at will and later re-designate them, assuming all hedge criteria remain satisfied.

Prerequisite requirements to qualify for hedge accounting treatment (815-20-25)

• Hedges must be documented at the inception of the hedge, with the objective and strategy stated, along with an explicit description of the methodology used to assess hedge effectiveness. This documentation must include the identification of the hedged item and the hedging instrument and the nature of the risk being hedged.
• The hedge must be expected to be "highly effective," both at the inception of the hedge and on an ongoing basis. Effectiveness measures must relate the gains or losses of the derivative to those changes in the fair value of the hedged item that are due to the risk being hedged.

To qualify for special hedge accounting, hedge effectiveness must be assesses prospectively (i.e., before the fact) and retrospectively (after the fact, but no less frequently than quarterly).  (815-20-25-79) The methods used to for these effectiveness assessments must be defined with the hedge documentation; and this method must be applied as prescribed. If the entity decides to improve upon this method, the original hedge must be de-designated and a new hedge relationship needs to be stipulated. If the same method is not applied to similar hedges, a justification for using differing methods is required. (815-20-25-81)

Entities may elect to exclude specific components of hedge results from the hedge effectiveness assessment. Allowable excluded items are (a) differences between spot and forward (or futures prices), if the derivative is or contains a forward or futures contract, or (b) the time value or the volatility value of options, if the derivative is or contains an option contract. (815-20-25-82)

As a rule, whenever the underlying exposure relates to a price, interest rate, or currency exchange rate that is not precisely identical to the underlying of the associated hedging derivative, some degree of hedge ineffectiveness must be expected.  On the other hand,, when entities are able to clearly identify and enter into a hypothetical derivative—i.e., a derivative that perfectly offsets the changes in fair values or cash flows of the designated hedged item—they can and should expect the hedge to perform perfectly, generating no earnings impacts attributable to hedge ineffectiveness.  (815-20-25-84)

Objectives, strategies, and magnitudes relevant for using derivatives, whether for hedging or for speculation, must be disclosed. Additional disclosures are also mandated when hedge relations apply (815-10-50, 815-25-45, 815-25-50, and 815-30-45).

• The context needed to understand intended hedge objectives—i.e., how the derivatives affect the entity's financial position, financial performance, and cash flows
• The accounting treatment applied in connection with derivative transactions, for both the hedged item and the hedging derivative when hedge accounting is applied
• The location of the fair values of the amounts of derivatives reported in the statement of financial performance or the statement of financial positions—reported on a gross basis, presented as assets or liabilities and segregated by market segment (e.g., interest rate, FX, commodity, or other)
• The location and amount of the gains and losses on any hedging derivative and related hedged items reported in the statement of financial performance or the statement of financial position
• Identification of effective vs. ineffective outcomes, as well as components of results that had been excluded from hedge effectiveness consideration
• The net gain or loss recognized in earnings when a firm commitment no longer qualifies as a hedged item in a fair value hedge
• For cash flow hedges, a description of the conditions that will result in the reclassification of accumulated other comprehensive income into earnings and a schedule of the estimated reclassification expected in the coming 12 months
• For cash flow hedges except hedges of variable interest rate exposures, the maximum length of time which hedging is anticipated
• The amount reclassified into earnings as a result of discontinued cash flow hedges because associated forecasted transactions are no longer probable