November 2001

Implementation of SFAS 138, Amendments to SFAS 133

By Angela L. J. Hwang, Robert E. Jensen, and John S. Patouhas

In June 2000, FASB issued SFAS 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities—an amendment of FASB Statement No. 133. It includes the following four major amendments:

Normal Purchases and Normal Sales Exception

In their normal course of business, companies that consume or produce commodities often enter contracts to physically deliver nonfinancial assets, such as electricity, natural gas, oil, aluminum, wheat, or corn. Although these physical contracts are typically settled by the delivery of the commodity, they often include cash settlement provisions in case one party does not deliver or accept delivery of the goods, although these provisions are not intended as derivatives. Historically, the accounting principles for executory contracts applied to physical contracts.

FASB decided contracts that permit but do not require settlement by delivery of a commodity are often used interchangeably with other derivatives and present similar risks; therefore, they should be considered derivatives. As a result, the “normal purchases and normal sales” exception in paragraph 10(b) of SFAS 133 did not apply to these commodities contracts because they could be settled at net or liquidated through a market mechanism that would facilitate net settlement. Normal purchases and sales provide commodities that the reporting entity would use or sell in a reasonable period of time during the normal course of business.

In response to concerns that SFAS 133 inappropriately classified such physical contracts as derivatives, SFAS 138 amends paragraph 10(b) by expanding the normal purchases and normal sales exception to contracts that contain net settlement provisions if it is probable (at inception and throughout the term of the individual contract) that the contract will not settle at net and will result in physical delivery. The entity must document this conclusion. While this amendment will affect many forward contracts, exchange-traded futures that require periodic cash settlements do not qualify for the exception.

Interest Rate

SFAS 138 sought to reduce the implementation confusion caused by the definition of interest rate risk used in SFAS 133. The new standard combines all components of risk into interest rate risk and credit risk, and broadens the concept of interest rate risk to include the interest rate benchmarked in the hedged item’s index, including the popular LIBOR (London interbank offer rate) hedging rate that, strictly speaking, also captures risk movements beyond the risk-free rate. In the SFAS 138 amendments, credit risk consists of all elements of interest rate risk other than the benchmark interest rate.

Under certain conditions, SFAS 133 allows interest rate swaps to use a shortcut method that assumes no ineffectiveness. The shortcut method does not apply, however, to a hedging strategy that designates the benchmark interest rate as the hedged risk when the hedged item is stated at a different index, such as the prime rate. The basis difference between those indices would affect the assessment and measurement of hedge ineffectiveness and possibly force more items into quarterly hedge effectiveness testing.

SFAS 138 has broadened the scope of qualifying hedges. It allows companies to hedge interest rates with available derivative products based on LIBOR. Hedge effectiveness will increase because changes in credit spreads will not be considered a source of ineffectiveness if hedging with a benchmark interest rate. It has also complicated the accounting, however, forcing more frequent effectiveness testing. Entities should evaluate how they hedge interest rate risk and determine whether new policies are required. Examples of the SFAS 138 amendments can be downloaded from derivatives/examplespg.html. A spreadsheet tutorial with examples of hedging the benchmark interest rate can be downloaded from www.cs.trinity. edu/~rjensen/000overview/mp3/138bench.htm.

Hedging of Foreign Currency– Denominated Items

One important provision of SFAS 138 is that it allows joint hedging of interest rate risk and foreign exchange (FX) risk in one compound hedge. SFAS 138 widens the net of qualified FX hedges to include the following:

Prior to SFAS 138, hedge accounting for foreign currency risk exposures was limited to fair value hedges of unrecognized FCD firm commitments, cash flow hedges of forecasted FCD transactions, and net investments in FCD foreign operations.

Example. FCD items (e.g., a fixed-rate bond in deutsche marks) are subject to two underlying risks: fair value risk in terms of changes in German interest rates, and changes in the FX rates (between the deutsche mark and the U.S. dollar). Before SFAS 138, the debtor would first hedge the interest rate risk by locking in the combined value of the bond and swap at a fixed amount in marks with a swap in which variable interest was received and fixed interest was paid. Then another derivative contract, such as a forward contract to hedge against the possible fall of the mark against the dollar, would hedge the combined FCD value for FX risk. Under SFAS 133, the FCD debt was remeasured (via the income statement) based on the prevailing spot rate of exchange and the derivative was marked to market (also via the income statement). However, these two adjustments rarely match, creating unintended earnings volatility.

Under the SFAS 138 amendments, it is now possible to acquire a single compound derivative to hedge the joint fair value risk of interest rate and FX movements. One such derivative is a cross-currency interest swap, which would receive a fixed interest rate in foreign currency and pay a variable interest rate in domestic currency. SFAS 138 permits these recognized FCD assets and liabilities to be designated as the hedged items in fair value or cash flow hedges.

Intercompany Exposures

Multinational corporations enter into many transactions with FX risk exposure. A centralized treasury center that assesses corporate-wide FX exposure and hedges the net exposure with a single derivative offers significant cost savings over subsidiaries acquiring their own third-party hedges.

Example. A German subsidiary forecasts sales of DM 5 million from a Japanese purchaser in the next three months, and a Japanese subsidiary expects to purchase DM 3 million worth of inventory from a German supplier in the same period. The net exposure would be a long position of DM 2 million and the parent company could hedge its risk by selling a forward contract or buying a put option for DM 2 million.

SFAS 133 discouraged hedge accounting by treasury centers because it required individual members of a consolidated group to enter individual offsetting derivative contracts with third parties, which nullifies the cost savings benefits. The SFAS 138 amendments allow certain intercompany derivatives that are offset by unrelated third-party contracts to be designated as the hedging instrument in cash flow hedges of foreign currency risk in the consolidated financial statements.

Amendments to DIG Guidance

SFAS 138 also amends related interpretations issued by the Derivatives Implementation Group (DIG).

Issue G3: Discontinuation of a cash flow hedge. SFAS 138 amends the accounting for discontinued cash flow hedges by requiring that the net derivative gain or loss from a discontinued cash flow hedge be reported in accumulated other comprehensive income, unless it is probable that the forecasted transaction will not occur by the end of the originally specified time period or within an additional two months.

Issue H1: Hedging at the operating unit level. SFAS 138 extends the functional currency concept of SFAS 52 to foreign currency fair value hedges and to hedges of the net investment in a foreign operation, in addition to foreign currency cash flow hedges. It also requires that the hedged transaction be denominated in a currency other than the hedging unit’s functional currency.

Issue H2: Requirement that the unit with the exposure must be a party to the hedge. The SFAS 138 amendments ensure that the functional currency concept of SFAS 52 is applied to determine whether hedge accounting is appropriate for consolidated financial statements. One of two conditions must be satisfied in order to use hedge accounting:

Example. A second-tier subsidiary (B) whose functional currency is the U.S. dollar has a French franc exposure. A parent company could designate a dollar-franc derivative as a hedge of a first-tier subsidiary’s (A) exposure, provided that A’s functional currency is also the dollar.

However, if A’s functional currency is the Japanese yen, the consolidated parent company could not designate its dollar-franc derivative as a hedge of B’s exposure. In this case, the financial statements of B are first translated into yen before the yen-denominated financial statements of A are translated into dollars for consolidation. As a result, there is no direct FX exposure, because A has a different functional currency than B’s functional currency. Furthermore, there is no direct exposure to the consolidated parent company.

Issue H5: Hedging a firm commitment or a fixed-price agreement denominated in a foreign currency. Unrecognized FCD firm commitments can be designated as either a fair value or a cash flow hedge. A similar DIG position for payments due under an available-for-sale debt security is explicitly permitted by SFAS 138.

What SFAS 138 Did Not Amend

Except for the confusing and highly limited amendments on intercompany derivative contracts, SFAS 138 did not change FASB’s stand against portfolio (macro) hedging. In order to qualify as a SFAS 133/138 hedge, the hedge must, except in unrealistic circumstances, relate to a specific hedged item in a portfolio rather than a subset of items. The only exception applies to subsets of items with identical terms that are nearly fungible. Matching individual hedges against individual hedged items not only magnifies the accounting costs, but also contradicts the way many firms view economic hedges. Some have complained that SFAS 133/138 forces changes in hedging strategies and risk management practices for accounting reasons that defy economic sense.

FASB did not replace SFAS 52, which causes additional complexity when applying it simultaneously with SFAS 133 and 138. SFAS 138 reduces the differences between spot and forward rate adjustments, but difficult issues remain in reconciling the two standards.

Although FASB requires fair value statements, it provides very little measurement guidance for customized derivatives that are either not traded at all or not traded in sufficiently wide markets. Appendix B of SFAS 133 contains some errors and omissions that were not addressed by SFAS 138 or other FASB announcements. In particular, there is no FASB guidance on how swap values were derived in Examples 2 or 5. Corrections and derivation discussions are discussed in the following two documents:

Derivative instruments cannot be designated as held-to-maturity items that are not subject to fair value adjustment. For certain derivatives, this can cause income volatility that is entirely artificial and will ultimately, at maturity, cause all previously recognized fair value gains to wash out against fair value losses. Economic hedges of hedged items (e.g., bond investments) designated as held-to-maturity items cannot receive hedge accounting under SFAS 133 even though the hedges must be booked at fair value. The reason given in Paragraph 29e is that this hedge is a credit hedge. Fair value hedging of fixed-rate debt makes little sense since the item will be held to maturity. Cash flow hedging of variable interest payments will wash out unless the contract is defaulted. The reasons for not allowing such hedges to receive SFAS 133 treatment are clear. It is unclear, however, why the hedges have to be booked to market value if they will be held to maturity.

Angela L. J. Hwang, PhD, assistant professor in the department of accounting at Wayne State University;
Robert E. Jensen, PhD, CPA, Jesse H. Jones Distinguished Professor of Business at Trinity University; and
John S. Patouhas, CPA.


Robert H. Colson, PhD, CPA
The CPA Journal

This Month | About Us | Archives | Advertise| NYSSCPA

The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.

©2009 The New York State Society of CPAs. Legal Notices

Visit the new