ACCOUNTING FOR DERIVATIVE INSTRUMENTS

& HEDGING ACTIVITIES

(for Internal Accounting Systems)

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New Standard - SFAS 133

SFAS 133, Accounting for Derivative Instruments and Hedging Activities, was
issued in June, 1998.

Effective for fiscal years beginning after June 15, 1999. Early adoption is
encouraged for fiscal quarters beginning after June 15, 1998. Retroactive
application not permitted.

Applies to all entities and all derivative instruments.

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Definition of a Derivative

A derivative is a financial instrument or other contract with three characteristics:

One or more underlying and one or more notional amounts or payment provisions or
both. Payment provisions specify settlement terms.

No initial net investment, or an initial investment that is smaller than would be

expected for similar contracts (option or forward premium).

Terms require or permit net settlement, it can be readily settled net outside the
contract (market mechanism), or delivery of an asset puts the recipient in a position
not substantially different from net settlement.

Most futures, forwards, swaps, and options are considered derivatives because:
- their contract terms call for a net cash settlement, or - a mechanism exists in
the marketplace that makes it possible to enter into closing contracts with only a
net cash settlement

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Definition of a Derivative

Exceptions:

Regular-way settled trades.

Normal purchases and sales of nonfinancial, nonexchange-traded instruments that are
expected to be used or sold in the normal course of business.

Traditional insurance contracts.

Financial guarantees where payments are made to reimburse the guaranteed party for
losses when a debtor fails to pay.

Non-exchange-traded contacts based on physical variables, an asset or liability of one

of the parties that is not readily convertible to cash, or specified volumes of revenues of
one of the parties.

Derivatives that serve as impediments to sales accounting.

The reporting entitys contracts: linked to its own stock and classified in equity, issued in
connection with stock-based compensation plans, issued as contingent consideration in
a business combination.

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Contracts with Embedded Derivatives
Derivatives embedded within another contract are included in the scope of the standard if all of the following criteria are
met:

A. The economic characteristics and risks of the embedded derivative are not clearly and closely related to the
economic characteristics and risks of the host contract
B. The contract is not remeasured at fair value with changes in value recorded in earnings
C. A separate instrument with the same terms would meet the definition of a derivative
Clearly and closely related:
inflation-indexed interest payments
payments adjusted due to the debtors creditworthiness
calls and puts that can accelerate principal repayment
floors, caps, and collars on interest rates
indexed rentals
FX denominated interest or principal

Not clearly and closely related:

embedded interest-rate-based derivatives where the investor may not recover substantially all its investment or may
double or better the return
term-extending options (unless includes provision for reset to prevailing market rates)
equity-indexed and commodity-indexed interest payments
convertible debt and convertible preferred stock (holder only; not issuer)
Calls and puts on equity instruments that require cash or assets for settlement
FX embedded derivatives when they represent an option to pay in a foreign currency

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Accounting Treatment of Embedded Derivatives

If scoped in, the derivative must be split (bifurcated) from the underlying
instrument and accounted for separately as a derivative by both issuers and
holders of such structured instruments.

If the embedded derivative cannot be separated from the host contract, the
entire contract should be measured at fair value; however, it is not eligible to be
a hedging instrument.

An entity may elect to either include or exclude contracts with embedded

derivatives that were recorded prior to January 1, 1998 from the new rules;
however, this option must be applied to all such contracts. The new rules must
be applied to all contracts recorded after January 1, 1998.

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 Accounting Model for Derivatives

All derivatives will be recognized on the balance sheet at their fair values. Changes in value
of derivatives will be accounted for differently depending on the reason for holding the
instrument. Specifically:

General rule - Gains and losses recognized in earnings. Special exceptions apply when
derivatives are used as hedges:

Hedges of fixed rate assets and liabilities and firm commitments (fair value
hedges) - The full gain or loss on the derivative as well as gains and losses on the
hedged item for the risk being hedged are recorded in earnings. Ineffectiveness
will impact earnings.
Hedges of floating rate instruments and forecasted transactions (cash flow
hedges) - The effective portion of the gain or loss on the derivative is reported as a
component of equity and recognized in earnings when the forecasted transaction
occurs. The ineffective portion of the hedge is immediately reported in earnings.
Foreign currency hedges - The foreign currency exposure of a firm commitment,
available-for-sale debt and certain equity securities, forecasted transaction or net
investment in a foreign entity may be hedged. Gains and losses on derivatives
used to hedge such exposures are accounted for under the rules for fair value or
cash flow hedges as appropriate.
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 Criteria for Hedge Accounting
Formal designation and documentation of hedge and strategy.
High initial and ongoing effectiveness (may be assumed when critical terms match).
Net written options may be used if the combined written option and hedged item
provide at least as much potential for gains as exposure to losses.
A basis swap may be used to hedge provided it is a link between the cash flows of an
asset and a liability. For example, a pay prime to receive LIBOR basis swap would
have to be designated as a hedge of a prime-based asset and a LIBOR-based liability.

Hedgeable risks include: 1) full fair value or cash flows, 2) market interest rate risk, 3)
foreign currency risk, 4) obligors credit risk, 5) some combination of these risks. In
addition, the option component of a prepayable instrument may be hedged.

May hedge: 1) individual or a portfolio of similar items -- similar assets, liabilities,

forecasted transactions which share the same risk, 2) percentage of the entire hedged
item, 3) a selected contractual cash flow, 4) put, call, cap, floor that is not separated
from a host contract, or 5) residual value in a direct financing/sales-type lease.

Hedged item cannot be: 1) remeasured to earnings, 2) an equity method investment,

3) minority interest, 4) equity investment in a consolidated subsidiary, 4) a firm
commitment related to a business combination, acquisition or disposition of a
subsidiary, 5) an issued equity instrument classified in stockholders equity, 6) the
interest rate or foreign currency risk of a held to maturity security. 8
 Hedges of Foreign Currency Exposure
Foreign Currency Fair Value Hedge:
a derivative instrument designated as hedging the foreign currency exposure to losses in
the fair value of:
a firm commitment (non-derivative instruments may also be used to hedge FX firm
commitments)
- however, a hedge of a foreign currency-denominated intercompany firm commitment
cannot receive hedge accounting treatment. FAS 133 defines a firm commitment as
an agreement with an unrelated party
- an available for-sale debt security
an available for-sale equity security, if the security is not traded on an exchange where
trades are denominated in the investors functional currency and dividends or other
cash flows are all denominated in the currency expected to be received upon sale
non-derivative instruments cannot be designated as the hedging instrument on available
for-sale securities
accounted for in the same manner as a fair value hedge
Just a reminder.... foreign currency denominated assets and liabilities (other than AFS
securities) are not eligible for hedge accounting treatment

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Hedges of Foreign Currency Exposure

Foreign Currency Cash Flow Hedge:

a derivative instrument designated as hedging the foreign currency exposure to variability
in cash flows associated with a foreign-currency denominated forecasted transaction
(including inter-company forecasted transactions) qualifies for hedge accounting if:
the entity is a party to the transaction
the transaction is denominated in a currency other than the entity's functional currency
a derivative contract with a central treasury unit (CTU) (eg. STIRT desk) can be
designated as a hedge provided that the CTU enters into an offsetting contract with an
unrelated third party
a non-derivative instrument cannot be designated as a hedging instrument in a foreign
currency cash flow hedge
accounted for in the same manner as a cash flow hedge

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Hedges of Foreign Currency Exposure

Hedges of Foreign Currency Exposure of a Net Investment in a Foreign Operation

a derivative or non-derivative instrument may be used as a hedge of this exposure
the transaction gain or loss on the hedging instrument is reported in the same manner
as a translation adjustment (i.e... in equity (comprehensive income) except for any
hedge ineffectiveness which would be recorded in earnings)
a tandem currency can be used as a hedging instrument if based on historical
experience, it is expected that the hedging relationship between the tandem currency
and the functional currency will be highly effective
the fair value of a forward contract should be calculated by discounting the future cash
flows based on the forward rate. Therefore, the gain or loss would be based on the
change in the forward rate discounted to reflect the time value of money until
settlement
amortization of the discount or premium on a forward contract is prohibited

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Commodities

Commodity-based contracts that permit settlement by the delivery of either a

commodity or cash such as commodity futures, options, and swap contracts are
considered derivatives
A contract for the normal purchase or sale of a non-financial asset is not subject
to FAS 133. Normal purchases and normal sales are contracts with no net
settlement provision and no market mechanism (e.g. clearinghouse) to facilitate
net settlement
A non-exchange traded derivative contract to purchase or sell a commodity is not a
derivative within the scope of the statement unless it can be:
1) net settled or

2)the commodity is readily convertible to cash and the purchase is not a normal
purchase

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Transition

Upon adoption, all existing derivatives will be separately reported on the balance
sheet at their fair values with an offset to earnings or comprehensive income.
Hedged items will also be appropriately adjusted.

All transition adjustments to earnings and comprehensive income must be

reported in accordance with APB Opinion 20, Accounting Changes.

At the initial date of application, an entity may transfer held-to-maturity securities to

available-for-sale or trading so interest rate risk can be hedged. Available-for-sale
securities may also be transferred to trading.

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Pros & Cons of New Accounting

Pros
Consistent accounting model
Increased transparency
Ability to hedge foreign currency forecasted transactions (including
intercompany)

Cons
Equity and P&L volatility
Balance sheet distortions
- Same economic strategy has different impacts depending on instrument
being used
Could discourage sound risk management
Implementation costs
Ongoing administrative costs

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QUESTIONS

If you have any questions regarding the accounting treatment of

derivatives, please review the following Accounting Policies:

Financial Accounting Standards Board

www.fasb.org

Bank for International Settlements

www.bis.org

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 Appendix

Examples
Application of FAS 133 to Common Hedge Transactions
Flowchart to determine applicability of FAS 133

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Examples - Fair Value Hedge

Remember...

Change in fair value of the derivative is recorded in P&L

Change in fair value of the item being hedged due to the risk being hedged
recorded in P&L with an offset to its carrying value

Any hedge ineffectiveness will affect P&L

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 Example 1- Foreign Currency Fair Value Hedge
On September 30, 19X1, Bank A purchases a DM denominated AFS Debt security for DM100,000
Assume the following:
Spot Rate Fair Value of the Security
September 30, 19X1 DM = US$.60 DM 100,000 $60,000
December 31, 19X1 DM = US$.40 DM 110,000 $44,000
DM 10,000 gain $16,000 loss
Change in fair value of security due to change in FX rates = DM 100,000 x (US$.60-.40) = $20,000 loss
On September 30, 19X1 Bank A enters into a three month forward contract at DM=$.60. The contract has a
gain of $20,000 at December 31, 19X1

Current Accounting New Accounting

Security initially recorded at $60,000 Security initially recorded at $60,000

Entire FX loss on security at 12/31/X1 of FX loss on security attributable to hedged risk of

$16,000 recorded in other comprehensive $20,000 recorded in earnings
income

Gain on forward contract of $20,000

Gain on forward contract of $20,000 recorded in
recorded in other comprehensive income
earnings

FX gain on unhedged risk of $4,000 (DM 10,000

x $.40) recorded in other comprehensive
income

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Example 2- Fair Value Hedge of Commodity Inventory
On 10/1/X1, Co. A, has 1mm troy oz. of gold bullion inventory on hand at an avg cost of $290/oz
Co. A hedges its position by selling gold contracts at $300/oz for delivery on February 1 to coincide with its
expected physical sale of gold
Co. A designates the hedge as a fair value hedge since it is hedging the changes in the inventory fair value
not changes in cash flows of anticipated sales
On Feb. 1, Co. A closes out its futures contract
Co. A assesses hedge effectiveness based on changes in fair value attributable to changes in spot prices
Spot price of gold - 10/1-$290/oz, 12/31-$280/oz, 2/1-$295/oz
Gold futures - 10/1 - $300/oz, 12/31- $290/oz, 2/1 $295/oz
Current Accounting New Accounting

No entry is made to adjust the carrying 12/31- loss on change in fair value of inventory
amount of inventory until futures (due to decrease in spot prices) of $10mm (280-
contract is closed out 290 x 1mm oz)recorded in earnings

12/31-gain on futures contract of 12/31-gain on futures contract of $10mm (1mm

$10mm is not recorded oz x (300-290) recorded in earnings

2/1-loss on futures contract of $5mm is 2/1-gain on change in fair value of inventory(due

recognized as a basis adjustment of the to increase in spot prices)of $15mm (1mm oz x
carrying amount of inventory 295-280)recorded in earnings

2/1-loss on futures contract of $5mm (1mm oz x

(290-295) is recognized in earnings

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Examples - Cash Flow Hedge

Remember...

Change in fair value of the derivative that is effective in hedging the change
in cash flows of the hedged item is initially recorded in comprehensive
income (i.e., directly to equity)

Amounts in comprehensive income are released to P&L at the same time as

the P&L impact of the item being hedged

Any hedge ineffectiveness will affect P&L

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 Example 3 - Foreign Currency Cash Flow Hedge
On January 1, Company A, a USD functional currency company, forecasts the
sale of 10,000 units of a product in six months to French customers for
EUR500,000
Company A wants to hedge the FX cash flow exposure of the sale
It enters into a six month forward contract to exchange the EUR500,000 expected
to be received for the USD equivalent
The forward contract is designated as a cash flow hedge of the forecasted sale
Company A chooses to asses hedge effectiveness based on changes in spot rates
(i.e., forward points are excluded from hedge effectiveness and are reported
directly in earnings)
Current Accounting New Accounting

Hedge accounting not allowed January 1 - no entry required since the

forward rate equals the contract rate

July 1- Change in fair value of forward

contract recorded in other comprehensive
income

July 1- Change in fair value of the premium

on the forward contract recorded in
earnings

July 1 - Sale recorded

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Example 4 - Cash Flow Hedge of a Commodity
On January 1 19X1, Co.A purchases a 1year $10 million gold-linked bull note that guarantees the repayment
of the principal and has a 1% coupon plus additional return if gold prices increase over specified levels
The note should be viewed as combining an interest-bearing instrument with a purchased option contract
Because the purchased option is indexed to the price of gold (and not related to interest rates), it is not clearly
and closely related to a fixed-rate note. Therefore the embedded purchased option contract should be
separated from the host contract (bifurcated) and accounted for separately
Company A designates the purchased option as a hedge of anticipated gold purchases on January 1, 19X2
Company A has determined that there is a high effectiveness between changes in the intrinsic value of the
option and the variability of cash flows for gold purchases
Since the effectiveness of the hedge is assessed based on the intrinsic value of the option, changes in time
value (fair value of the option less intrinsic value) recognized in earnings since it is the ineffective portion
Assume that at the options maturity, it has an intrinsic value of $1mm

Current Accounting New Accounting

1/1- purchase of the gold-linked bull note is 1/1- the purchase of the gold-linked note is bifurcated; the
recorded embedded purchased option is recorded separately

Coupon interest recorded Coupon interest and amortization of discount recorded on

Interest income on the debt security
recognized based on the difference
between the amortized cost of the security
at the end of the period and at the
beginning of the period
the debt security
12/31- change in intrinsic value of the purchased option is
recorded in comprehensive income
12/31- the ineffective portion of the hedge (time value of
option) is recorded in earnings

1/1/X2-gold purchase occurs

the gain on the purchased option is recorded in earnings

when the gold is sold
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