In June 1998, after long years of debate, the Financial Accounting Standards Board issued its new standard on derivatives, Statement No. 133, Accounting for Derivative Instruments and Hedging Activities. The goal of the Statement is to resolve the many inconsistencies that have haunted derivatives accounting. It will dramatically change the way hedging relationships are reported and create earnings and capital volatility that may be unavoidable. This overview describes some of the key provisions of FAS 133.
BACKGROUND
The FASB believes that once remaining conceptual and measurement issues are resolved, all financial instruments are to be carried on the balance sheet at fair value. FAS 133 thus is an interim step on the path toward the FASB's ultimate goal.
The key changes FAS 133 introduces are:
* All derivatives are recognized in the balance sheet at fair value.
* A type of hedge accounting continues, but the treatment varies
according to the type of hedge--"fair value," "cash flow" or net
investment in a foreign operation.
* Because all derivatives are now on the balance sheet, the
mechanics of the new hedge accounting for fair value hedges
require adjusting the carrying values of other accounts on the
balance sheet (that is, the hedged items) in order to preserve
the hedging effect in the income statement.
* Portions of the hedge considered ineffective are recognized in
earnings and not deferred, creating volatility in earnings.
* Gains or losses on derivatives that qualify as cash flow hedges
are initially recognized in other comprehensive income (OCI),
creating additional volatility in equity.
* New and potentially onerous qualification criteria for hedge
accounting are established.
* The new rules are more flexible for foreign currency hedging,
allowing the use of a broader range of hedging instruments
and hedge strategies than previously were allowed.
* Derivatives are now defined based on distinguishing
characteristics rather than by reference to specific instruments.
This results in some new classes of instruments being
considered derivatives.
* Disclosure requirements are modified significantly.
FAS 133 is effective for fiscal years beginning after June 15, 2000. Most companies will delay adopting FAS 133 until January 1, 2001, when adoption is required.
DEFINITION OF A DERIVATIVE
FAS 133 defines a derivative to be a financial instrument with four distinguishing characteristics:
* The instrument has an underlying variable (like a stock price or
interest rate) that causes fluctuations in its cash flows or fair
value.
* The instrument has a notional amount which, when combined
with movements in the underlying, determines the settlement
amount(s) of the derivative. Note that the parties involved do
not invest in or purchase the notional amount.
* The instrument does not require a significant net investment.
* The instrument permits net settlement in cash rather than by
delivery of the notional amount.
HEDGE ACCOUNTING
FAS 133 establishes "special (or hedge) accounting" for three different types of hedges: hedges of changes in the fair value of assets, liabilities or firm commitments (referred to as fair value hedges); hedges of the variable cash flows of forecasted transactions (cash flow hedges); and hedges of net investments in foreign operations. Though the accounting treatment and criteria for each of the three types of hedges are different, all three require that the effective portion of gains or losses from the hedging instrument and from the hedged item be recognized in earnings concurrently. Gains and losses that are not effective in a hedging relationship are recorded in current-period earnings. Changes in the fair value of derivatives that do not meet the criteria of one of these three categories of hedges are also included in current-period earnings.
Hedge accounting can only be obtained for permissible hedgeable risks and for specific items or transactions that qualify. Permissible hedgeable risks under FAS 133 for financial instrument-related exposures are market price risk, market interest-rate risk, foreign exchange risk, and credit (default) risk.
The hedged item can be the entire item or a percentage of the entire item, or pools of similar items (or specific portions thereof). Such items can include selected cash flows. However, risks cannot be hedged on an enterprise-wide or "macro" basis. To qualify as either a fair value or cash flow hedge, the hedge relationship must demonstrate "effectiveness" whenever earnings are reported.
EMBEDDED DERIVATIVES
In addition to financial instruments traditionally called derivatives, such as swaps and futures, certain embedded derivatives are included in the scope of FAS 133 if, were they freestanding, they would be considered derivatives under FAS 133. For example, a bond that may be converted into stock of the issuer is a debt instrument that contains an embedded derivative.
This week's Learning Curve was written by Jay Glacy, senior consulting actuary at Ernst & Young in Hartford, Conn.
