In June, the Financial Accounting Standards Board issued its Statement of Financial Accounting Standards number 133, titled accounting for derivative instruments and hedging activities. SFAS 133 supersedes all previous statements regarding derivatives. The Board based its unanimous approval on two accounting concepts. First, derivatives represent rights or obligations that meet the definitions of assets or liabilities, and should be reported in financial statements. Second, derivatives should be measured at fair value and adjustments to the carrying amount of hedged items should be reflected in the gain or loss of the related hedge. Before SFAS 133, hedging instruments were presented off balance sheet, and their gain or loss was treated in a variety of methods. With SFAS 133, the Board designated four groups of derivatives for accounting treatment. These are:
1. Fair value hedges;
2. Cashflow hedges;
3. Foreign currency hedges;
4. Non-hedging derivatives.(i.e. trading derivatives)
Trading derivatives are carried as assets or liabilities and the gain or loss of their fair value is recognized in current earnings.
The reporting requirements for fair value, cashflow and foreign currency hedges are more rigorous. At the inception of these hedges, formal documentation is required stating management's objective and strategy for creating the hedge. During the life of the hedge, correlation testing must be made to ensure that the hedge continues to be effective in offsetting the changes in the value of the hedged item.
A fair value hedge is a derivative that is expected to be effective in offsetting changes in the fair value of an asset or liability. The gain or loss of the derivative and the gain or loss of the hedged asset or liability will be recognized in current earnings.
A cashflow hedge is a derivative that will protect against the expected future cashflows and may be associated with an existing asset or liability. Hedging interest payments on variable-rate debt would be a cashflow hedge. The gain or loss on the hedge will be recognized in Other Comprehensive Income (OCI) and reclassified into current earnings when the hedged transaction affects earnings. OCI is included in the equity section of the balance sheet.
Foreign currency hedges are treated as fair value or cash flow hedges with one exception. The gain or loss on the hedge of a net investment in a foreign operation is an equity section item and is covered by SFAS 52.
A cash flow problem will illustrate the application of SFAS 133. On Oct. 9,1998, Big Gas Co. contracts to sell one billion cubic feet (bcf) of natural gas to Local Provider Inc. during January 1999. The price will be the market price on Jan. 31, 1999. Also, on Oct. 9, 1998, Big Gas Co. enters into a swap receiving the fixed price of USD2.00 per thousand cubic feet (mcf) on Jan. 31, 1999. The Oct. 9, 1998 price of natural gas is USD2.015 per mcf. The Dec. 31, 1998 price is USD2.04 per mcf. The Jan. 31, 1999 price is USD2.01 per mcf. Assume that the only other balance sheet items are USD1 million in cash and the same amount in equity. Big Gas Co. makes the following entries, see example below.
This week's Learning Curve was written by Bill Hessbergand Neal Horrell, of Harbros U.S.A.
