This is the second in a two-part series examining the U.S. accounting change. Last week's article gave a general overview, this week the authors focus on hedge accounting.
The complexity of FAS 133 stems from the accounting treatment for derivatives that are used primarily by endusers to hedge particular risks. Dealers are typically not caught up in the detail and complexity of FAS 133 because they must mark their derivative investments to market and do not employ the specialized hedge accounting rules found in FAS 133.
A party is required to record a gain or loss resulting from a change in a derivative's fair value immediately in earnings unless the derivative is a hedge. Gain or loss from a "non-hedge derivative" flows to earnings as it occurs. In the case of a hedge, however, the party generally defers gain or loss on the derivative until the hedged item affects earnings. The accounting statement provides unique and specialized accounting treatment for three different types of hedges that involve derivatives: fair-value hedges; cash-flow hedges; and foreign currency hedges.
Fair-Value Hedges
Fair-value hedges are derivatives acquired to hedge against fluctuations in the fair value of recognized assets, recognized liabilities or firm commitments. A derivative used as a fair-value hedge must be reported on the balance sheet at fair value. FAS 133 provides special rules for matching the gain or loss resulting from changes in the fair value of a derivative with changes in the value of the hedged asset, liability or firm commitment. The matching occurs through adjustments in the carrying value of the hedged item. The investing party adjusts the carrying value of the hedged item for changes in the hedged item's value attributable to the hedged risk. The gain or loss from that adjustment flows to earnings and is then matched with the offsetting gain or loss resulting from the change in the derivative's fair value.
For example, the holder of a fixed-rate note enters into a plain-vanilla interest rate swap (with the holder paying fixed and receiving, for example, LIBOR) as a hedge against changes in the note's value. If the value of the note increases by USD100,000 because interest rates decrease, the noteholder will increase the carrying value of the note on its balance sheet by USD100,000 and will recognize USD100,000 of earnings due to the increase. At the same time, the noteholder will reduce the fair value of the swap on its balance sheet by USD100,000 and record the USD100,000 loss in earnings. The USD100,000 gain from the increased value of the note and the USD100,000 loss from the decreased value of the swap will offset each other. If the derivative is a perfect hedge, the derivative will have no net effect on the investing party's earnings as gains and losses from changes in the hedged item's carrying value and the fair value of the hedge derivative are offsetting.
Not all hedges, however, are intended to be perfect hedges. A party might purchase commodity futures to hedge against changes in the spot price component of a firm commitment. When changes in the value of commodity futures do not exactly match changes in the spot price of the same commodity, the commodity futures are not a perfect hedge. Nonetheless, if the commodity futures purchaser expected the hedge to be, and it, in fact, is highly effective, the party must account for the commodity futures as a fair-value hedge. However, any hedge ineffectiveness will affect earnings as the gains and losses from the futures and the hedged commodity will not completely offset each other.
Cash-Flow Hedges
Cash-flow hedges are derivatives acquired to protect against variations in cash flow from forecasted transactions. A cash-flow hedge must be reported on the balance sheet at its fair value. FAS 133 provides for matching gain and loss from the change in the fair value of a cash-flow hedge derivative with gain and loss from the hedged cash flow. To the extent the derivative is a highly effective hedge against expected variability in future cash flows, gains and losses from adjustments to its fair value are included on the balance sheet's equity section as Other Comprehensive Income.
As the hedged item affects earnings, the deferred gain or loss moves from Other Comprehensive Income on the balance sheet to earnings. For example, a manufacturer might acquire a derivative as a hedge against changes in the price of an expected raw material purchase. If the value of the derivative increases by USD100,000, the fair value of the derivative as reported on the balance sheet increases by USD100,000. The USD100,000 gain is reported in the equity section of the balance sheet as Other Comprehensive Income.
If the derivative is a perfect hedge, the purchase price of the raw material will also have increased by USD100,000. The increased cost of the raw material will reduce earnings by USD100,000 when the manufacturer completes and sells the product. When the sale of the product results in USD100,000 of decreased earnings, the manufacturer offsets the decrease by moving the USD100,000 gain from the derivative, which was stored on the balance sheet in Other Comprehensive Income, to earnings. This example assumes that the derivative was a perfect hedge. Any gain or loss attributable to cash flow hedge ineffectiveness flows to earnings as the change in the fair value of the cash-flow hedge derivative occurs.
Foreign Currency Hedges
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. FAS 133's accounting for foreign currency hedges provides much of its complexity.
Foreign currency hedges can actually be one of three different types: (1) a hedge of the foreign currency exposure of an unrecognized firm commitment or recognized asset or liability; (2) a hedge of the foreign currency exposure of a foreign currency denominated forecasted transaction; or (3) a hedge of the foreign currency exposure of a net investment in a foreign operation.
The first two types of hedges are generally reported as fair-value or cash-flow hedges, respectively, as described above. The third type, a hedge of the foreign currency exposure of a net investment in a foreign operation is, like other derivatives, reported on the balance sheet at its fair value. Any gain or loss resulting from changes in its fair value flows to the Cumulative Translation Adjustment portion of the balance sheet's equity section.
The gain or loss from the hedge recorded as Cumulative Translation Adjustment at least partially offsets amounts recorded in that account because of changes in the value of the currency of the foreign operation. That net amount remains in the Cumulative Translation Adjustment account until the investment in the foreign operation affects earnings.
For example, if a party's investment in a foreign subsidiary decreases by USD1 million because of a drop in currency value, the party charges USD1 million to the Cumulative Translation Adjustment. If the fair value of a derivative purchased to hedge this risk increases by USD900,000 over the same period, the party will credit the Cumulative Translation Adjustment by USD900,000, leaving a net USD100,000 charge in the account. If the party sells the subsidiary, the net USD100,000 charge will then flow to earnings. Thus, the party will have matched the change in the fair value of the derivative with the change in the foreign currency's value, allowing both the hedge and the hedged item to affect earnings at the same time.
This week's Learning Curve was written by Mary Grossman, an attorney and a CPA, and Christian Johnson, an 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.
