November 1998 Issue

NEW ACCOUNTING FOR DERIVATIVES ILLUSTRATED

By Ronald H. Rasch and
Arlette C. Wilson

The Financial Accounting Standards Board recently issued SFAS No. 133, Accounting for Derivative Instruments and for Hedging Activities. This statement will be effective for all fiscal quarters of all fiscal years beginning after June 15, 1999, and applies to all entities, including not-for-profit organizations and defined benefit plans. Since derivatives are used extensively in risk management, the new accounting standard may affect many financial institutions and other large entities. An article discussing the concepts and principles that drive the new standard appeared in the October issue of The CPA Journal. The focus here is on the application of the new standard to specific transactions.

Basic Accounting

All derivatives are measured and reported at fair value as assets or liabilities in the statement of financial position. Reporting of the corresponding changes in fair value depends upon management's purpose for holding the derivative. Special accounting treatment is allowed for derivatives designated and qualifying as 1) a hedge of a risk of change in fair value of a recognized asset or liability or an unrecognized firm commitment (fair value hedge), 2) a hedge of the risk of a change in the cash flows associated with a recognized asset or liability or associated with a forecasted transaction (cash flow hedge), or 3) a hedge of a foreign currency exposure of an unrecognized firm commitment, an available for sale security, a forecasted transaction, or a net investment in a foreign operation (foreign currency hedge). Changes in fair value of derivatives not specifically designated as one of the above hedges are included in current earnings. Interest rate swaps are used to illustrate the difference between a cash flow hedge and fair value hedge. Swaps that are currently accounted for similarly require different accounting methods depending on the purpose for holding the swap.

Cash Flow Hedge

The derivative gain or loss is reported in other comprehensive income or in current 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 is considered ineffective and recognized in earnings. The accumulated gains and losses are recognized in earnings in the same period(s) as the hedged asset, liability, or forecasted transaction affects earnings.

An interest rate swap could be entered into to hedge the cash flow associated with a recognized asset. A company holding variable-rate investments would have varied cash inflows as the market rate changes. To hedge these future cash inflows, the company could enter into an interest rate swap to receive a fixed flow of income and pay a variable rate of interest that would effectively convert the variable-rate investments to fixed-rate investments. The future cash inflows related to these investments would then be constant, and the swap would result in an effective cash flow hedge.

To illustrate the accounting for this type of swap, assume that on January 1, 1997, Company X is holding $10 million in three-year, variable rate investments. Simultaneously, X enters into a three-year interest rate swap to receive eight percent (which is also the variable rate on January 1, 1997) and pay the variable rate on a notional amount of $10 million with settlement and reset annually on December 31. Variable rate, swap settlement, and swap fair value amounts are included in Exhibit 1, which also provides the journal entries for 1997 and 1998 for transactions and required adjustments.

There is no settlement at December 31, 1997, since the variable rate was the same as the fixed-rate received on the swap at January 1, 1997. However, the swap would be marked to fair value at year-end. Since a) the investments are variable-rate and the swap has a variable leg and b) the notional amounts, payment dates, and remaining terms of the swap are the same as those of the debt, it is assumed that the cumulative cash flows on the interest rate swap and the cumulative changes in cash flows on the investments attributable to changes in market interest rates will completely offset. Therefore, the hedge ineffectiveness is zero, and the entire change in fair value of the derivative is included in other comprehensive income and reported in stockholders' equity. The swap amount is reported as an asset on the balance sheet.

Entries for 1998 include receipt of interest on the investments and settlement ($100,000) of the swap. Because the earnings impact of the hedged item (interest revenue on the investment) is reported in 1998, some of the accumulated change in value of the swap is included in earnings in 1998 to the extent necessary to adjust interest revenue to the effective hedge rate of eight percent (which is the same as the amount of settlement). The statement does not prescribe the classification of gains and losses in the statement of financial performance. Therefore, we chose to classify it as interest revenue since the cash flow for interest is being hedged. The swap account is reduced by the settlement amount and then adjusted to fair value at year-end for 1998. The $44,100 necessary to adjust the accumulated unrealized gain in stockholders' equity would be included in other comprehensive income.

If the cash flow hedge had been determined to be ineffective, the excess cumulative change in derivative fair value over cumulative change in expected future cash flows would be included in current earnings. For example, if the change in expected future cash flows for the above illustration were $180,000 at December 31, 1997, the adjusting entry would have been:

dr. Swap 201,300

cr. Unrealized Gain/Loss 180,000

cr. Gain on Swap 21,300

The $21,300 would represent the ineffectiveness and be included in current earnings.

Fair Value Hedge

The entire change in the fair value of the derivative would be recognized in current earnings in the period of change along with the change in fair value of the hedged item attributable to the risk being hedged. The only risks that may be hedged are risk of changes in fair value due to--

* changes in market price of an item,

* changes in market interest rates,

* changes in foreign currency exchange rates, or

* credit (default) risk.

An interest rate swap could be entered into to hedge the fair value of a recognized liability. The fair value of fixed-rate debt will vary with changes in the market rate. Entering into a swap to receive fixed and pay variable interest would result in future cash flows varying with the market rate, and therefore hedge against changes in fair value due to market rate changes.

To illustrate the accounting for this type of swap, assume that on January 1, 1997, Company X borrows $10 million on a three-year, eight percent note. Simultaneously, X enters into a three-year interest rate swap with a notional of $10 million to receive eight percent and pay a variable rate with settlement and reset annually on December 31.

Variable rates and fair values of the debt and swap are included in Exhibit 2, which presents the journal entries for the transactions and adjustments for 1997 and 1998. The entire change in value of the swap would be recognized in current earnings and the swap would be reported as an asset. Although the fair value of the note changed by $194,900, only the part of the change attributable to change in market rate (risk being hedged) is recognized in earnings, resulting in a carrying value of $10,176,400. A new effective rate (seven percent), which is calculated based on this carrying value, is used to record interest expense for 1998 ($10,176,400 X .07). The swap balance remaining after settlement for 1998 ($101,300) is adjusted to its fair value at year-end for 1998. Although still an asset, the swap's fair value has declined. The note's carrying value is also adjusted for changes attributable to the interest rate change ($10,088,748 to $10,055,200).

The amortization of this basis adjustment (premium on note payable) may be delayed to begin no later than when the item ceases to be adjusted for changes in its fair value attributable to the risk being hedged. In the above example, the note will be adjusted for the last time on December 31, 1998, since the debt will mature December 31, 1999. The company could choose to wait until 1999 to amortize the premium adjustment of the debt's carrying value as a result of interest rate changes and record interest expense.

Foreign Currency Hedge

The new requirements will allow a company to designate a derivative as a hedge of the foreign currency exposure of--

* an unrecognized firm commitment (a foreign currency fair value hedge),

* an available-for-sale security (a foreign currency fair value hedge),

* a forecasted transaction (a foreign currency cash flow hedge), or

* a net investment of a foreign operation.

Fair value hedge accounting may be used for derivatives that are hedging the foreign currency exposure of an unrecognized firm commitment or available-for-sale security if all the fair value hedge criteria are met. Cash flow hedge accounting may be used for those derivatives hedging the foreign currency exposure of a forecasted transaction if all the cash flow hedge criteria are met and the hedging instrument hedges
the foreign currency exposure to variability in the functional currency-equivalent cash flows associated with either a forecasted foreign currency-denominated transaction or a forecasted intercompany foreign currency-denominated transaction.

The foreign currency exposure of a net investment in a foreign operation results in translation gains and losses. These translation gains and losses are included in other comprehensive income (outside of earnings) and reported in equity. Losses and gains on derivatives and nonderivative instruments that hedge this foreign currency exposure are also included in other comprehensive income and reported in equity to the extent the hedging instrument is an effective economic hedge.

To illustrate a hedge of a net investment in a foreign operation, assume that on December 31, 1998, Company X has an investment in Foreign Company Y that represents net assets of 10 million LCU (local currency units). On that date, X enters into a foreign currency forward to sell 10 million LCU on December 31, 2000, to hedge the net investment. If the exchange rate decreases by December 31, 1999, the net investment would decline, resulting in a translation loss. However, the selling price of the forward is locked in at December 31, 1998, so a decrease in exchange rate would allow X to purchase at a lower price to settle the contract causing the fair value of the contract to increase. The resulting gain on the forward contract would offset the loss on the net investment. Therefore, the forward contract is an effective economic hedge and the gain would be reported in a similar manner as the translation loss. That is, both the translation loss and the forward contract gain would be included in other comprehensive income and reported in equity. *

John F. Burke, CPA
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