The Financial Accounting Standards Board's statement of financial accounting for derivative instruments 133, was issued June 1998. An introduction to the new standard appeared earlier (DW, 10/19).
The effectiveness of a hedging instrument is a primary concern for the corporate accountant as well as the hedge manager. Effectiveness is an assessment of how closely the change in value of a hedged item is reflected in the gain or loss of the hedging instrument. The statement does not specify a single method of assessing hedge effectiveness but strongly recommends that similar hedges be assessed in a similar manner.
A highly effective hedge will be easy to assess and there will be no need to recognize ineffectiveness in earnings. A forward contract that hedges a commodity purchase will be highly effective if the hedge is for the same quantity with the same delivery date and location as the hedged contract.
Hedge ineffectiveness results from the following:
1. A different basis for the hedging instrument and hedged item (a dollar-based derivative for a sterling-based asset).
2. A difference in terms of the derivative instrument and the hedged item--such as quantity, delivery date or location.
3. A change in the value of a derivative due to the creditworthiness of the counterparty.
An assessment of whether the derivative continues to be effective in offsetting the changes in the hedged item is required whenever financial statements or earnings are reported. If the hedge is no longer effective, the gain or loss of the hedging instrument is recognized in current earnings. A new hedge may be initiated to offset the change in value of the hedged item.
An example will illustrate ineffectiveness of a hedging relationship and the proper accounting for an example with basis risk.
Big Gas Co. has one billion cubic feet of natural gas in storage in Webb County, Texas. Big Gas plans to sell the gas on Feb. 20. 1999. Big Gas Co. wants to hedge the sale price and enters into a futures contract to sell the gas at USD2.00/thousand cubic feet on Feb. 20, 1999. The contract is made Dec. 22, 1998. On Dec. 22, the price of gas in Chicago is USD2.00/mcf. There is no gain or loss on the hedge on Dec. 22, and no accounting entry is made. On Dec. 31 the Chicago price is USD1.99/mcf and the price Feb. 20 is USD1.993/mcf. The sale price in Texas on Feb. 20 is USD1.989/mcf. The other balance sheet items are USD1,000,000 in cash and the same amount in equity.
Due to the difference in location--Chicago derivative and Texas sale--the hedge has been ineffective to the extent of USD4,000. The table below illustrates the accounting treatment for these transactions under FAS 133.
The future of assessing ineffectiveness in hedge relationships is more complex. More contracts are being written without the stability or impartiality of a third party, i.e. an exchange. How are the two parties to value such a contract? With slightly different criteria both parties could report gains. Valuation of hedges written between companies with different credit ratings is an issue. Should a company with a single-A bond rating discount a swap with a triple-C rated company because of the credit risk or should the triple-C rated company pay a premium? These questions will be addressed in the near future.
This week's Learning Curve was written by Bill HessbergandNeal Horrellof Harbros U.S.A. and Prebon Yamane.
