A new standard takes root.

NEW ACCOUNTING FOR

DERIVATIVES AND HEDGING ACTIVITIES

By Arlette C. Wilson and Ronald H. Rasch

In Brief

Benefits and Concerns

Culminating a process that began in 1992, FASB has finally issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. Under this statement, all derivatives are to be recognized in the balance sheet as either assets or liabilities at their fair value. Special accounting for corresponding gains and losses is allowed for qualifying derivatives that are--

* fair value hedges

* cash flow hedges, or

* hedges of a foreign currency exposure of a net investment in a foreign operation

The statement addresses a number of problems in accounting for derivatives. It increases their visibility, provides comparability, eliminates inconsistency between standards as well as the deferral of gains and losses on such instruments, and provides comprehensive guidance.

While the basic rules are simple, implementation may be more complex. As a result, the statement is not without its critics, particularly those in the banking industry. Among the criticisms are the claims that it will lead to volatility in earnings and equity, fail to recognize the difficulty in measuring fair value for many derivatives, and be costly to implement.

There are other implementation problems as well. These include determining which instruments are derivative instruments and assessing hedge effectiveness.

ompanies in today's global economy face complex risk profiles. Financial markets have continued to change, grow, and diversify to meet the need for effective risk management. The market for derivatives has experienced tremendous growth over the last few years. "We are in a situation today in which the notional amount of derivatives outstanding has reached some $70 trillion," the chair of the SEC said in a recent speech.

As financial market players have become more competent in identifying and evaluating financial risks, their risk management tools have become more creative. FASB has been hard-pressed to keep pace with the rapid development of these new products, resulting in a somewhat piecemeal, and often internally inconsistent, set of rules to account for these instruments.

The business press, Congress, and various regulators expressed concern regarding risks associated with the increased use and complexity of derivatives and hedging activities. Concern about inadequate financial reporting of these risks was heightened by the publicity surrounding major losses incurred by some banks, commercial corporations, and local governments attributed to the use of derivatives. As a result, the SEC urged FASB to deal expeditiously with reporting problems in this area.

FASB began deliberating issues related to derivatives and hedging activities in January 1992. Because of the urgency for improved financial information about derivatives and related activities, FASB decided to redirect some of its efforts toward enhanced disclosures. In October 1994, FASB issued SFAS No. 119, Disclosure About Derivative Financial Instruments and Fair Value of Financial Instruments, as an interim step.

Even with improved disclosures, several problems persisted. Many derivatives were not recognized in financial statements since they required no initial cash investment. Deferred gains and losses were reported as freestanding liabilities and assets. Only a few derivative instruments were specifically addressed in accounting standards, and these requirements often exhibited internal inconsistencies.

In June 1998, SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, was issued. It deals with recognition and measurement and provides comprehensive guidance for all derivatives--even those instruments yet to be developed. Although not a perfect solution, the new approach of SFAS No.133 addresses many of the problems with previous accounting.

Basic Requirements

Even though FASB made numerous changes to its original June 30, 1996, exposure draft to address criticisms, it never strayed from the basic model: to recognize all derivatives on the balance sheet at their fair value. FASB believes all derivatives result in real cash obligations (liabilities) or rewards (assets) and should be included as such on the balance sheet.

Accounting for the change in fair value of the derivative (gain or loss) depends upon the reason for holding the derivative. Special accounting is allowed for hedging a--

* fair value exposure of a recognized asset or liability or of a firm commitment (fair value hedge),

* cash flow exposure of an existing asset or liability or of a forecasted transaction (cash flow hedge), or

* foreign currency exposure of a net investment in a foreign operation.

Gains or losses on derivatives not designated or qualifying for one of the above hedges are recognized in earnings in the period of change.

Fair Value Hedges. A derivative that qualifies and is designated as a fair value hedge, is marked to market value with the corresponding gain or loss recognized in current earnings. The gain or loss attributable to the risk being hedged on the hedged item will also be included in current earnings. This results in the hedged item's carrying amount being adjusted for the change in fair value attributable to the hedged risk. The derivative gain or loss is included in the same period as the offsetting loss or gain on the hedged item. Any amount not completely offset in current earnings represents hedge ineffectiveness.

Cash Flow Hedges. A derivative that qualifies and is designated as a cash flow hedge is marked to market value with the corresponding gain or loss reported in other comprehensive income or earnings, as necessary, to adjust the balance in other comprehensive income to an amount that equals the lesser of a) the cumulative gain or loss on the derivative or b) the cumulative change in expected future cash flows on the hedged transaction. The result is that the excess cumulative gain or loss on the derivative would be considered ineffective and recognized in earnings. The accumulated gains and losses reported in equity are recognized in earnings in the same period(s) that the hedged asset, liability, or forecasted transaction affects earnings. If the hedged asset (liability) is an interest-bearing investment (debt), the accumulated gain or loss would be recognized in earnings when interest revenue (expense) is recorded. If the hedged forecasted transaction is the purchase of raw materials, the accumulated gain or loss is reported in earnings when the finished product is sold and is included in the income statement as cost of goods sold. If the hedged forecasted transaction is the acquisition of equipment, the accumulated gain or loss would be reported in earnings as the asset is depreciated.

Hedges of a Foreign Currency Exposure of a Net Investment in a Foreign Operation. The change in value of a derivative designated as a hedge of the foreign currency exposure of a net investment in a foreign operation is included in other comprehensive income and reported as a separate component of stockholders' equity to the extent that the derivative instrument is an effective economic hedge. Translation gains and losses from the net investment are also reported in other comprehensive income and accumulated as a component of stockholders' equity.

Benefits of the New Accounting

Michael H. Sutton, the SEC's former chief accountant, said of the accounting prior to these new rules, "The current accounting model for derivatives--which often means no accounting--is unacceptable." The SEC has strongly endorsed FASB's new comprehensive accounting requirements that will increase visibility and comparability of the risks associated with derivatives while reducing the inconsistency and incompleteness of previous guidance. Analysts and accounting experts have applauded the new requirements as being in investors' best interests.

Increased Visibility. Many derivatives were not recognized in the financial statements because they required no initial cash investment. When instruments were recognized, realized and unrealized gains and losses on the derivative may have been deferred (not recognized in earnings) and reported either as part of the carrying amount of the hedged item or as freestanding liabilities and assets. It was difficult to determine the effects of the derivative since the financial statements often did not report the material rights or obligations associated with derivative instruments. The new approach requires, for the first time, that entities report the fair value of their derivatives on the balance sheet as assets or liabilities, allowing investors to better evaluate their impact.

Increased Comparability. Previous hedge accounting measured some derivatives at cost and others at fair value. Since the new method requires all derivatives, even those designated as hedges, to be reported at fair value, comparability of financial reporting between companies should be enhanced.

Reduced Inconsistency. SFAS No. 52, Foreign Currency Translation, assessed risk on a transaction basis, while SFAS No. 80, Accounting for Futures Contracts, required the risk condition to be assessed on an enterprise level. An action taken to reduce the risk of an individual item could simultaneously increase risk exposure of the enterprise as a whole. SFAS No. 80 allowed hedge accounting for both firm commitments and forecasted transactions, while SFAS No. 52 allowed only firm commitments to be hedged. SFAS No. 80 allowed cross-hedging, while SFAS No. 52 only permitted cross-hedging when it was not practical or feasible to hedge in the identical currency. Futures contracts were reported at fair value, while foreign currency forwards were reported at amounts that reflected changes in foreign currency rates, but not other value changes.

The different approaches of these two statements made it difficult to account by analogy for instruments not specifically addressed in the literature. Because sources often conflicted, the resulting accounting was inconsistent. The new requirements provide consistent guidance for all derivatives and hedging activities, and can accommodate future developments.

Comprehensive Guidance. Previous accounting guidance was developed in a piecemeal fashion and was limited to hedges of foreign currency transactions and net investments of foreign operations and hedges with futures contracts. EITF consensus also provided some guidance for interest rate swaps. However, as new instruments were developed, accounting by analogy was necessary since these instruments had not been specifically addressed by standard-setters. The new approach applies to all derivatives, even those yet to be developed, thereby providing comprehensive guidance for all types of derivative instruments.

Deferred Gains or Losses Not Reported as Liabilities or Assets. A major criticism of previous accounting was that gains and losses deferred until later periods to be matched with the losses and gains of the hedged item were temporarily reported as liabilities or assets. It was difficult to justify a deferred gain as a liability, since it did not require future sacrifice of resources, or a deferred loss as an asset, since it did not provide future benefits. Gains or losses not included in current earnings will now be included as part of other comprehensive income and reported in equity.

Concerns of the New Accounting

When the exposure draft was issued in June 1996, there was widespread criticism from the business community. To address its critics, FASB made numerous changes to the original proposal. After their concerns were addressed, some derivative dealers and a number of corporate executives quietly admitted the rule wasn't so bad. But even though support for the new rules has grown, the banking industry continues to strongly oppose the new approach. Some of their concerns, as well as the remaining concerns of other preparers, are discussed below.

Volatility in Earnings and Equity. A major complaint is that the new requirements will result in volatility in earnings and equity. Events that might contribute to this volatility are cash flow hedges, fluctuations in the fair value of derivatives, and imperfect hedges.

The change in fair value of a derivative designated and qualifying as a cash flow hedge is reported in other comprehensive income and included as a separate component of equity. Derivative gains or losses accumulate in equity until the hedged item affects earnings at which time the derivative change is removed from equity and included in earnings. Previous accounting allowed these derivative gains or losses to be deferred as assets or liabilities until the future transaction occurred; therefore, the gains or losses had no impact on earnings or equity until the hedged transaction occurred.

Fluctuations of fair value for derivatives designated as fair value hedges should not cause much volatility since the fair value of the hedged item is also changing and the offsetting gains and losses from both the derivative and hedged item are included in earnings in the same period.

Imperfect hedges will result in part of the derivative gain or loss affecting current earnings. For example, a company holding fixed-rate debt of $20 million (fair value exposure) wants to hedge this debt by entering into an interest rate swap to receive a fixed-rate and pay a variable rate. An imperfect hedge would result if the notional on the swap were $25 million, either because this was the only notional available at the time, or because the company wanted a greater notional than necessary (believing rates would decline). The gain or loss on the $5 million notional difference will not be offset with a corresponding loss or gain on debt. An imperfect hedge would also result if the due date of the debt were different than the maturity of the swap, or if the settlement and reset dates were different.

Banks argue that this volatility in earnings and reported capital levels may give an inaccurate picture of the banks' financial condition. However, FASB, as well as other accounting experts, believe that previous reporting practices obscured the existing volatility. The new requirements do not create volatility, but only unmask it.

Banks also argue that, in managing this volatility, companies may be discouraged from using prudent risk management activities. Companies have made, and will continue to make, uneconomical decisions trying to achieve certain financial statement results. Companies have gone to uneconomical extremes to keep leases off the balance sheet, have paid more taxes using FIFO to increase net income, and have incurred tremendous costs meeting the criteria for a pooling-of-interests. They probably will also make uneconomical decisions regarding risk management activities.

Lack of Reliable Measures for Fair Value. Banks are also concerned that there are no readily available, reliable, standardized measures of fair market value for many derivatives, especially the more exotic instruments. However, FASB believes that adequate techniques exist to reliably measure derivatives. Fair value measurement guidelines established in SFAS No. 107, Disclosure About Fair Value of Financial Instruments, are considered to be adequate. SFAS No. 133 does not impose a higher reliability threshold than currently used to comply with SFAS No. 107.

Cost and Time to Implement. There is no dispute that implementation costs will increase, but there is a wide discrepancy between estimates. The Financial Executives Institute projects the changeover will cost companies an average of more than $100,000 per company. However, the SEC estimates the cost at $8,000.

Companies are also concerned that they will not have enough time to build computer systems to accommodate the new rules. The new requirements are effective for all fiscal quarters of all fiscal years beginning after June 15, 1999. FASB believes that much of the information required to implement this statement was previously required to be disclosed pursuant to SFAS Nos. 107 and 119 and, therefore, companies should have sufficient time to assimilate and develop the required implementation information.

Different Accounting for Hedges of Firm Commitments Versus Forecasted Transactions. Some believe there is no substantive difference between qualifying forecasted transactions and firm commitments and both should be treated the same way. FASB believes firm commitments are distinct from forecasted transactions. Therefore, the new requirements account for hedging of forecasted transactions as cash flow hedges and hedging of firm commitments as fair value hedges. For a forecasted transaction that later becomes a qualified firm commitment, the hedge accounting for a forecasted transaction must be discontinued. The firm commitment can then be hedged prospectively.

No Hedge Accounting for Covered Call Strategies. The FASB agrees that hedge accounting should be available for certain written options. For a written option to qualify for hedge accounting, either the upside and downside potential of the net position must be symmetrical or the upside potential must be greater than the downside potential. Hedge accounting is not permitted for a covered call strategy; because the risk profile of the combined position is asymmetrical, the exposure to losses is greater than the potential for gains. Therefore, a company writing a covered call option on an available-for-sale security would include the gain or loss on the option in current earnings, while the loss or gain on the security would be reported in other comprehensive income.

No Hedge Accounting for Written Options. Net written options cannot be used as hedging instruments unless the option is designated as hedging an option embedded in a financial instrument and certain criteria are met. Therefore changes in fair value would be included in current earnings. Options entered into, whether freestanding or embedded in a derivative, would be considered a net written option if, either at inception or throughout the life of the contract, a net premium is received in cash or as a favorable rate or other term. Many derivatives with written options, such as the sale of swap options, are important to interest rate risk management.

The entire change in fair value of a leverage swap will be reported in current earnings since any embedded written option causes the entire instrument to be considered a written option. Also, a company writing a covered call option on an available for-sale security would include the gain or loss on the option in current earnings, while the loss or gain on the security would be reported in other comprehensive income.

Items Prohibited From Designation as Hedged Items. Interest rate risk may not be designated as the risk being hedged for a debt security classified as held-to-maturity. Designating a derivative as a hedge of a held-to-maturity debt undermines the notion of that classification. In such a situation, if a company entered into an interest rate swap to convert interest from a fixed rate to a variable rate to create a synthetic variable-rate financial instrument, the swap would not qualify for hedge accounting and therefore would not be accounted for like a basic variable rate security.

Other items prohibited from designation as hedged items in a fair value hedge include 1) an asset or liability that is measured at fair value with changes in fair value attributable to the hedged risk reported in earnings currently and 2) an investment accounted for by the equity method. FASB also decided that only a recognized asset or liability may be designated as a hedged item, thereby prohibiting the hedging of internally developed intangible assets and mortgage servicing rights that have not been recognized as assets.

Potential Implementation Problems

The basic concept of accounting for derivatives and hedging activities initially appears relatively simple. However, implementing this basic accounting may be problematic. A few potential implementation problems are discussed below.

Determining Which Instruments Are Derivative Instruments. A financial instrument or contract would be considered a derivative if it has an underlying and notional amount, requires no initial net investment or an initial investment smaller than other contracts with similar response to changes in market factors, and requires or permits net settlement outside the contract or provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement. This appears to be relatively straightforward. However, the statement adds that, notwithstanding those conditions for determining whether an instrument or contract is a derivative--

* certain contracts are not subject to the requirements and

* some contracts that may fit the definition of a derivative are not considered derivatives for purposes of the statement.

Some specific exceptions are listed in the statement and explained further in its Appendix A. But what if a new instrument is developed in the future that FASB might include in these exceptions, but the instrument meets the criteria for a derivative?

Derivatives embedded in a nonderivative instrument (the host contract) are separated from the host contract and accounted for as a derivative instrument only if certain criteria exist. One of these criteria, "The economic characteristics and risks of the embedded derivative instrument are not clearly and closely related to the economic characteristics and risks of the host contract," is somewhat subjective. Recognizing the potential difficulty, FASB provided additional guidance on applying this criterion to various contracts containing embedded derivative instruments in Appendix A of the statement.

There are also exceptions to this general rule of separating the embedded derivative from the host contract. An embedded derivative in which the underlying is an interest rate or interest rate index that alters net interest payment on an interest-bearing host contract is considered to be clearly and closely related to the host contract unless certain conditions exist. An embedded foreign currency derivative instrument cannot be separated from the host contract if the host contract is not a financial instrument and requires payment denominated in the functional currency. If an entity cannot reliably identify and measure the separated embedded derivative, the entire contract is measured at fair value with the resulting gain or loss included in current earnings.

FASB provides several illustrations of the application of the criteria for determining whether a financial instrument or contract is a derivative subject to the requirements of the statement in its Appendix A. FASB appears to have carefully considered all existing financial instruments, but will future developments clearly fit the definition of a derivative or one of the exception groups? If not, FASB may have to issue interpretations as these new instruments appear in the risk management portfolios of companies.

Assessment of Hedge Effectiveness. For fair value hedges, the hedging relationship should be highly effective in achieving offsetting changes in fair value attributable to the hedge risk during the period the hedge is designated. For a cash flow hedge, the hedging relationship should be highly effective in achieving offsetting cash flows attributable to the hedged risk during the term of the hedge. An assessment of effectiveness is required whenever financial statements or earnings are reported, and at least every three months. At the time a company designates a hedging relationship, it must define the method it will use to assess the hedge's effectiveness in achieving offsetting changes in fair value or cash flows attributable to the risk being hedged. Assessing hedge effectiveness is relatively easy if all the critical terms of the hedging instrument and the entire hedged asset or liability or the hedged forecasted transaction are the same. In that situation, complete effectiveness can be assumed. However, assessing hedge ineffectiveness and measuring the ineffective part of the hedge can be more complex. Identifying a hedge as ineffective may be easier than measuring its ineffectiveness. Differences in critical terms of the hedging instrument and the hedged item or transaction--such as differences in notional amounts, maturities, quantity, or delivery dates--would indicate hedge ineffectiveness. But measuring this ineffectiveness may not be as obvious. Realizing the potential difficulty in assessing and measuring ineffectiveness, FASB provided several illustrations as guidance. However, these illustrations are not exhaustive. Preparers may experience difficulty assessing and measuring the ineffectiveness of those instruments that do not exhibit similar characteristics to derivative instruments included in the illustrations. *

Arlette C. Wilson, PhD, CPA, is the KPMG Peat Marwick Professor of Accounting and Ronald H. Rasch, PhD, an associate professor, both at Auburn University.

An article prepared by the authors containing examples of the accounting required by SFAS No. 133 will be published later this year in the Accounting Department.