ACCOUNTING

March 2000

THE EFFECT OF ACCOUNTING FOR DERIVATIVES ON OTHER COMPREHENSIVE INCOME

By Jefferson P. Jones and Arlette C. Wilson

In June 1997, FASB issued SFAS No. 130, Reporting Comprehensive Income, which requires that all items recognized under accounting standards as components of comprehensive income be reported in a financial statement that is displayed with the same prominence as other financial statements. In June 1998, FASB issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, which results in the reporting of some unrealized derivative gains and losses as components of other comprehensive income. Many accountants want or need to know how the basic accounting for derivatives creates components of other comprehensive income and would benefit from examples of how to report some of these unrealized gains and losses in the statement of comprehensive income.

Other Comprehensive Income

Comprehensive income is the total non-owner change in equity for a given period. Comprehensive income is composed of net income and other comprehensive income (OCI). Prior to the issuance of SFAS No. 130, OCI components did not flow through any type of performance statement, but accumulated directly in equity. Under SFAS No. 130, these non-owner changes in equity must be reported in a financial statement with the same prominence as other financial statements. A total for comprehensive income can be reported in a statement of income and comprehensive income, statement of comprehensive income, or statement of changes in equity.

Prior to the issuance of SFAS No. 133, OCI items included--

* unrealized gains and losses from available-for-sale securities,
* unrealized pension cost from minimum pension liability adjustment, and
* translation gains and losses.

SFAS No. 133 results in two additional components of OCI: unrealized gains and losses from cash flow hedges and unrealized gains and losses from a foreign currency hedge of a net investment in a foreign operation.

The change in OCI components for a given period is reported in comprehensive income. The accumulated total for each item is still reported as a separate component of stockholders' equity. Often, the unrealized gains and losses initially reported in OCI are later realized and reported in net income. In this case, the reporting of OCI requires reclassifying these gains and losses.

For example, assume that during 1998, Company X invested in two available for sale securities. As of December 31, 1998, the following information is available:

The unrealized gain of $1,800 would be included in OCI for 1998. Assume that security A is sold for $11,200 in 1999 and security B had a fair value of $19,100 as of December 31, 1999. OCI would report a gain of $800 for the year representing the increase in value of security B and a reclassification (removal of the $500 gain reported in 1998 for security A) of $500. This net $300 increase in OCI represents the change in unrealized gain from December 31, 1998 ($1,800) to unrealized gain at December 31, 1999 ($2,100). The accumulated unrealized gain of $2,100 is reported in equity on the December 31, 1999, balance sheet.

Reclassifying the $500 gain is appropriate because the gain on sale of $1,200 reported in net income for 1999 includes that gain of $500 that was reported in OCI for 1998. The $500 gain was included in 1998 comprehensive income via OCI and in 1999 comprehensive income via net income. If the $500 gain were not removed from OCI in 1999, it would be double counted.

Basic Accounting for Derivatives

According to SFAS No. 133, derivatives will now be measured at fair value and reported in the statement of financial position as assets or liabilities. Accounting for the change in fair value will depend upon the reason for holding the derivative and whether it has been designated and qualifies for hedge accounting.

A derivative designated and qualifying as a hedge of the exposure to variable cash flows associated with an existing asset or liability or with a forecasted transaction is referred to as a cash flow hedge. Gain or loss on a derivative designated as a cash flow hedge will be reported in OCI at an amount that adjusts accumulated OCI to the lesser of 1) the cumulative gain or loss on the derivative or
2) the cumulative change in expected future cash flows on the hedged transaction. The accumulated gain or loss is removed from equity and included in earnings in the same periods as the hedged item affects earnings.

For example, if the hedged transaction were the purchase of raw material, the derivative gain or loss would be included in earnings when the finished good is sold and the raw material affects net income as cost of goods sold rather than when the material is purchased. If the hedged transaction were the purchase of equipment, the derivative gain or loss would be included in earnings as the equipment is depreciated.

For a derivative designated as a hedge of the foreign currency exposure of a net investment in a foreign operation, the portion of the change in fair value equivalent to the foreign currency transaction gain or loss would be reported in OCI and accumulated in equity. The translation loss or gain on the net investment in a foreign operation is also included in OCI and equity. Any change in fair value of the derivative in excess of the transaction gain or loss would be recognized in current earnings.

A derivative designated and qualifying as a hedge of the exposure to changes in the fair value of a recognized asset or liability or of a firm commitment is referred to as a fair value hedge and has no impact on OCI. Gain or loss on a derivative designated as a fair value hedge is recognized in current earnings. Simultaneously, the loss or gain on the hedged item attributable to the risk being hedged is also included in current earnings. The derivative gain or loss is offset with the hedged item's loss or gain to the extent the hedge is effective, resulting in a net gain or loss reported in current earnings.

OCI Components from Derivative Gains and Losses

OCI components are created when a company has a cash flow hedge or a foreign currency hedge of a net investment.

The following are examples of hedges resulting in OCI:

* Cash flow hedge of an existing liability. An interest rate swap (receive a variable rate and pay a fixed rate on a stated notional) to effectively convert variable-rate debt to a fixed rate would include the change in fair value of the swap in OCI. The unrealized gain or loss would be removed from OCI and included in earnings when interest is recorded on the debt. The OCI gain or loss would adjust interest expense to an amount equal to the fixed rate.

* Cash flow hedge of a forecasted transaction. A futures contract to fix the future purchase or sales price of an item would include the change in fair value of the futures contract in OCI. The unrealized gain or loss would be removed from OCI and included in earnings when the hedged item affects earnings.

* Foreign currency hedge of a net investment in a foreign operation. A forward contract entered into to sell the foreign currency of the foreign operation would hedge the net investment. That is, if the exchange rate decreases, the net investment would also decrease. However, the forward contract would increase in value because the currency could be purchased at a lesser amount than the locked-in selling price. Unrealized gains and losses on the forward contract would be included in OCI. These changes in the forward contract would be removed from OCI when the investment is liquidated.

Example

On January 1, 1999, Company X was holding $10 million of four-year variable-rate debt tied to LIBOR with payment of interest and reset of the rate each December 31. Company X is concerned that interest rates might rise but wants to retain the ability to benefit if rates fall. To protect itself from rising rates, Company X purchases a $200,000 out-of-the-money four-year interest rate cap, with a notional of $10 million and a strike rate of 8.5%. That is, the writer of the cap will pay Company X the difference between LIBOR and 8.5% on $10 million whenever LIBOR exceeds 8.5%. The cap limits the interest rate on the debt to an effective rate of 8.5%: Interest on the debt can be less than 8.5% but no greater. The cap represents a one-sided cash flow hedge of an existing liability.

The cap is out-of-the-money on January 1, 1999, because LIBOR on that date is less than the strike rate. Assume that LIBOR and fair value of the cap separated into intrinsic value and time value components were as shown in the Table.

The standard does not specify how to compute the intrinsic value of a cap option where the option involves a series of payments. In this example, we assume that the intrinsic value of the cap is equal to the expected future cash flows holding constant the cap's current period cash flow for the remaining term of the hedge. At December 31, 1999, the intrinsic value is calculated as the future cash to be received of $50,000 [(9.0% ­ 8.5%) x $10 million] for each of the three remaining years. The intrinsic value as of December 31, 2000, is calculated as the cash received of $100,000 [(9.5% ­ 8.5%) x $10 million] for each of the two remaining years. The remaining fair value of the cap is attributable to time value.

The cap is initially recorded as:

dr. Cap    200,000
cr. Cash   (200,000)

The entire value is attributable to time value because LIBOR is less than 8.5% at this time.

The following entries would be recorded as of December 31, 1999:

dr. Interest Expense    800,000
cr. Cash                   (800,000)