FAS 133 has generated substantial confusion and expense, especially for end-users acquiring derivatives as hedges. This article will give a general overview, whilst next week's will focus on hedge accounting. FAS 133, or Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities, as it is more formally known, was issued by the Financial Accounting Standards Board (FASB) in June 1998, but the board delayed its effective date to mid 2000 and twice made substantive amendments. Because of its complexity, FASB established the Derivatives Implementation Group (DIG) to address issues about its implementation and interpretation. To date, DIG has issued guidance on over 175 distinct topics with respect to FAS 133.
For a dealer that already marks its derivatives to market and discloses these transactions on its balance sheet, FAS 133 is a non-event. For end-users that use derivatives to hedge particular risks, however, FAS 133 has proven to be a nightmare. Much of Freddie Mac's accounting fiasco, for example, was caused by its efforts to blunt the earnings impact of implementing FAS 133.
Despite the complexity, FAS 133 does provide a logical framework for accounting for derivatives. The devil, of course, is in the detail. FAS 133 generally requires a party to carry its derivatives at fair value and recognize those gains and losses currently unless the derivative is hedging the volatility of certain assets, cash flows or foreign currency fluctuations. Even then, it will still have to account for the derivative on its balance sheet even if there is no immediate effect on earnings.
Definition Of A Derivative
The definition of a derivative under FAS 133 is so broad and flexible that FAS 133 should, as the FASB intended, apply to nearly all derivatives, even those that have not yet even been developed. Under FAS 133, a derivative is an instrument, whether traded in a recognized market or over the counter, that has three basic characteristics. First, the instrument must have at least one 'underlying' and at least one notional amount or payment provision or both. For example, in an interest rate swap, the underlying would be an interest rate index and the notional amount would typically be the amount of debt to be hedged.
Second, the instrument must require little or no initial net investment. For example, an interest rate swap normally requires no initial net investment by either party to the swap. Third, the instrument must allow for net settlement. In a plain-vanilla interest rate swap, for example, the out-of-money party only pays the net difference between the variable and the fixed-rate payment.
Exclusions From FAS 133
A principal challenge of FAS 133 is to first determine if a derivative is excluded from its reach. For a variety of reasons, FASB has expressly excluded several types of transactions despite the existence of the three basic characteristics. Contracts for the purchase or sale of something to be used in the normal course of the contracting party's business are excluded, provided that net settlement is unlikely.
Most insurance contracts, loan commitments and financial guarantees are also excluded. Contracts involving a company's own stock are not accounted for as derivatives. Certain contracts that are not traded on an exchange are excluded. These include derivatives based on climatic, geological or other physical variables, contracts based on the price or value of a non-financial asset or liability (e.g., a lease residual value), and contracts based on the level of sales or service revenues of one of the parties (e.g., rent based on sales of the lessee).
Embedded Derivatives
Embedded derivatives are expressly included under FAS 133. An embedded derivative is a group of contract terms that, standing alone, appear to be a derivative. FAS 133 requires a party to account for and report an embedded derivative in the same manner as any other derivative, unless the embedded derivative meets certain exclusionary criteria. The principal type of excluded embedded derivative is one that is "clearly and closely related" to the host contract. For example, terms of an interest-bearing note that tie the interest rate to an interest rate index may, collectively, be a derivative embedded in the note. Because, however, the amount of interest due under the note is "clearly and closely related" to the note itself, the terms tying the interest rate to an index are not a derivative for purposes of FAS 133. FASB also does not consider interest-only and principal-only strips and foreign currency embedded derivatives to be subject to FAS 133.
Overview Of Accounting For Derivatives
FAS 133 requires a party to reflect the fair value of a derivative on its balance sheet, regardless of whether its earnings are immediately affected. Depending on a derivative's use, the gain or loss from changes in the derivative's fair value may be included immediately in earnings or deferred on the balance sheet.
A party must record a gain or loss resulting from a change in a derivative's fair value immediately in earnings unless the derivative is a hedge. Any gain or loss from a non-hedge derivative immediately flows to earnings. In the case of a hedge, however, the party generally defers gain or loss on the derivative until the hedged item affects earnings. For example, an increase in the value of an interest rate swap entered into for a speculative purpose results in immediate gain recognition on the income statement. On the other hand, an increase in the value of an interest rate swap used as a hedge produces gain that is deferred until the related loss from fluctuating interest rates affects earnings. Thus, the timing of when a gain or loss affects earnings depends on whether the derivative is a hedge.
FAS 133 strictly defines a hedge. The party must designate a derivative as a hedge in writing at its inception. The party must expect that the designated derivative will be "highly effective" as a hedge against a specific risk. Finally, the party must monitor the derivative's effectiveness. If the derivative ceases to be a highly effective hedge, it is no longer eligible for hedge accounting and any gains or losses would be recognized immediately in earnings.
FAS 133 provides unique accounting for three different types of hedges: fair value hedges; cash flow hedges and foreign currency hedges. Fair value hedges are derivatives acquired to hedge against fluctuations in the fair value of recognized assets, recognized liabilities or firm commitments. Cash flow hedges are derivatives acquired to protect against variations in cash flow from forecasted transactions. Finally, foreign currency hedges consist of three types: fair value hedges of foreign currency exposure, cash flow hedges of foreign currency exposure and foreign currency exposure resulting from a net investment in a foreign operation.
Financial Statement Disclosure
FAS 133 and the Securities and Exchange Commission rules require certain disclosures of a party's derivatives activity. Under FAS 133, a party must disclose its reasons for holding derivatives that are not hedges (i.e., speculative positions). With respect to hedge positions, FAS 133 requires numerous disclosures. These disclosures include the reporting party's objective in maintaining the hedge position and the strategies used to achieve the objective. The party must also disclose its risk management policy with respect to each type of hedge and the items or transactions it is hedging.
FAS 133 also requires specific quantitative disclosures. These quantitative disclosures allow the financial statement user to determine the financial statement impact of the party's hedge positions. Finally, in addition to compliance with FAS 133, the SEC requires additional disclosures that allow financial statement users to evaluate the market risk of holders of derivative positions.
This week's Learning Curve was written by Mary Grossman, an attorney and a CPA and Christian Johnson, associate professor of Law at Loyola Law School and a CPA. Grossman and Johnson can be reached at mgrossman@centurytel.net and cjohns6@luc.edu, respectively.
