Hedge Accounting

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Hedge Accounting

• Rachel Kremer
• Moore Stephens Frost

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What is a Derivative?

• Financial instrument whose fair value is tied to
  a benchmark
• Stock price
• Interest rate
• Mortgage rate
• Currency rate
• Commodity price
• Some other agreed upon reference
• These are called Underlyings

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Derivatives

• Derivatives are used for
• Investment, or
• Risk management, or
• Both

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Derivatives

• Option contracts
• Forward contracts

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Forward Contracts

• Have symmetrical gain or loss characteristics,
  providing exposure to both losses and gains from
  market movements
• No initial premium to be paid
• Usually settled on or near the delivery date with
  cash, not physical delivery.

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Option Contracts

• Assymetrical loss functions
• Little or no exposure to loss from market
  movement
• Large benefits from favorable market movement

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Examples of Derivative Instruments

• Option contracts
• Interest rate caps
• Interest rate floors
• Fixed rate loan commitments
• Letters of credit
• Forward contract
• Forward interest rate agreement

• Interest rate collars
• Futures
• Swaps
• Instruments with similar characteristics

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Risk Management

• Protect against changes in fair value or cash
  flow of an asset, liability or future
  transaction.
• Stock price movements, interest rate variations,
  currency fluctuations and commodity price
  volatility.

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Derivative

• Under FASB Statement No. 133, a derivative is
  defined as a financial instrument or other
  contract.
• Derivatives represent rights or obligations and
  must be recorded as assets or liabilities in the
  balance sheet.

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Measurement

• Fair value is the only relevant measure for
  derivatives (and the most relevant measure for
  financial instruments in general).
• Adjustments to the carrying amount of hedged
  items should reflect changes in their fair value
  (i.e., gains or losses) that are attributable to
  the risk being hedged and that arise while the
  hedge is in effect.

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Definition

• A derivative is a financial instrument that
  possesses all three of the following
  characteristics
• It has one or more underlyings and one or more
  notional (or face) amounts or payment
  provisions. The underlying and the notional
  amount determine the settlement amount of the
  derivative contract (or, in some cases, determine
  whether or not settlement is required).

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Underlying

• Specified interest rate, security price,
  commodity price, foreign exchange rate, index of
  prices or rates, or other variables.

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Notional Amount

• A number of currency units, shares, bushels,
  pounds, or other units specified in a derivative.
  The settlement of a derivative is a function of
  the notional amount and the underlying.

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Payment Provision

• Payment provision specifies a fixed or
  determinable settlement to be made if the
  underlying behaves in a specified manner.

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Three Characteristics (cont.)

• 2. It requires no initial net investment or an
  initial net investment that is smaller than would
  be required for other types of contracts that
  would be expected to have a similar response to
  changes in market factors.

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Three Characteristics (cont.)

• 3. Its terms require or permit net settlement, it
  can readily be settled net by a means outside the
  contract, or it provides for delivery of an asset
  that puts the recipient in a position not
  substantially different from net settlement.

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Fair Value-FASB 133

• Quoted market prices in active markets are the
  best evidence of fair value and should be used as
  the basis for the measurement, if available.
  Fair value of trading units x mkt price
• If quoted market price is not available, an
  estimate of fair value should be based on the
  best information available in the circumstances.

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Hedge Accounting

• Primary purpose to link items or transactions
  whose changes in fair values or cash flows are
  expected to offset each other.
• Details of application, however, will vary
  depending on the type of risk being hedged

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Fair Value Hedge

• Designated and qualified as fair value
  hedge-----change in fair value is recognized in
  earnings
• Offset by portion of change in fair value of the
  hedged asset or liability that is related to the
  risk being hedged.
• Asset/liability recorded at fair value
• Subject to impairment consideration on carrying
  value.

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Fair Value Hedge

• For completely effective hedges, the change in
  the derivatives fair value equals the change in
  the hedged items fair value. No effect on
  earnings.
• If hedge is not completely effective, earnings
  will be affected (plus/minus) by the change in
  fair value of the derivative and the hedged item.
  Increase/decrease in earnings equals the
  ineffective portion of the change in the
  derivatives fair value.

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Cash Flow Hedge

• At Inception, formal documentation must include
• Hedging relationship and the entitys risk
  management objective and strategy for undertaking
  the hedge, including
• identification of the hedging instrument,
• the hedged transaction,
• the nature of the risk being hedged,
• and how the hedging instruments effectiveness
  in hedging the exposure to the hedged
  transactions variability in cash flows
  attributable to the hedged risk will be assessed.
  
• There must be a reasonable basis for how the
  entity plans to assess the hedging instruments
  effectiveness.

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Cash Flow Hedge

• Documentation shall include all relevant details,
  including the date on or period within which the
  forecasted transaction is expected to occur, the
  specific nature of asset or liability involved
  (if any), and the expected currency amount or
  quantity of the forecasted transaction.

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Expected Quantity

• Expected quantity requires specification of the
  physical quantity encompassed by the hedged
  forecasted transaction.
• If the forecasted sale/purchase is hedged for
  price risk, then it cant be specified in dollars
  or of sales or purchases during a period. The
  current price of a forecasted transaction also
  should be identified.

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Expected Quantity

• Should be described with sufficient detail such
  that when a transaction occurs it is apparent as
  to whether that transaction is or is not the
  hedged transaction.

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Measuring Effectiveness

• At inception of hedge AND on an ongoing basis,
  the hedging relationship is expected to be highly
  effective in achieving offsetting cash flows
  attributable to the hedged risk during the term
  of the hedge.
• Assessment of effectiveness is required financial
  statements or earnings are reported, and at least
  every three months.

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Hedged Forecasted Transaction

• All of the following criteria must be met
• The forecasted transaction is specifically
  identified as a single transaction or a group of
  individual transactions. If the hedged
  transaction is a group of individual
  transactions, those individual transactions must
  share the same risk exposure for which they are
  designated as being hedged. Thus, a forecasted
  purchase and a forecasted sale cannot both be
  included in the same group of individual
  transactions that constitute the hedged
  transaction.

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Hedged Forecasted Transaction

• The occurrence of the forecasted transaction is
  probable.
• The forecasted transaction is a transaction with
  an outside external party to the reporting entity
  and presents an exposure to variations in cash
  flows for the hedged risk that could affect
  reported earnings.
• The forecasted transaction is not the
  acquisition of an asset or incurrence of a
  liability that will subsequently be remeasured
  with changes in fair value attributable to the
  hedged risk reported currently in earnings. If
  the forecasted transaction relates to a
  recognized asset or liability, the asset or
  liability is not remeasured with changes in fair
  value attributable to the hedged risk reported
  currently in earnings.

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Hedged Forecasted Transaction

• If the variable cash flows of the forecasted
  transaction relate to a debt security that is
  classified as held-to-maturity under Statement
  115, the risk being hedged is the risk of changes
  in its cash flows attributable to credit risk,
  foreign exchange risk, or both. For those
  variable cash flows, the risk being hedged cannot
  be the risk of changes in its cash flows
  attributable to interest rate risk.
• The forecasted transaction does not involve a
  business combination subject to the provisions of
  Statement 141 and is not a transaction (such as a
  forecasted purchase, sale, or dividend) involving
  (1) a parent companys interests in consolidated
  subsidiaries, (2) a minority interest in a
  consolidated subsidiary, (3) an equity-method
  investment, or (4) an entitys own equity
  instruments.

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Hedged Forecasted Transaction

• If the hedged transaction is the forecasted
  purchase or sale of a nonfinancial asset, the
  designated risk being hedged is (1) the risk of
  changes in the functional-currency-equivalent
  cash flows attributable to changes in the related
  foreign currency exchange rates or (2) the risk
  of changes in the cash flows relating to all
  changes in the purchase price or sales price of
  the asset reflecting its actual location if a
  physical asset (regardless of whether that price
  and the related cash flows are stated in the
  entitys functional currency or a foreign
  currency), not the risk of changes in the cash
  flows relating to the purchase or sale of a
  similar asset in a different location or of a
  major ingredient.

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Accounting

• Generally, accounting for changes in the fair
  value of a derivative depends on the intended use
  of the derivative.
• For a derivative not designated as a hedge, gains
  or losses are reflected in current earnings.

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Accounting for Derivatives

• For a derivative designated as a fair value
  hedge, the gain or loss on the derivative and the
  offsetting loss or gain on the hedged item are
  recognized in current earnings.
• The difference reflected in current earnings
  between the gain (loss) on the derivative and the
  loss (gain) on the hedged item represents the
  impact of the ineffective portion of the hedge.

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Accounting-Cash Flow Hedge

• For a derivative designated as a cash flow hedge,
  the gain or loss on the derivative is divided
  into two parts
• 1. The effective part, which is initially
  reported as a component of other comprehensive
  income and subsequently reclassified into current
  earnings in the period that the forecasted
  transaction affects earnings and
• 2. The ineffective part, which is recognized
  immediately in current earnings.

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Guidance for Accounting

• FASB Statement No. 133, Accounting for
  Derivative Instruments and Hedging Activities,
  as amended by,
• FASB Statement No. 137, Accounting for
  Derivative Instruments and Hedging
  Activities---Deferral of the Effective Date of
  the FASB Statement No. 133
• FASB Statement No. 138, Accounting for Certain
  Derivative Instruments and Certain Hedging
  Activities, and
• FASB Statement No. 149, Amendment of Statement of
  133.

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Other Comprehensive Income

• The effective portion of the gain or loss on a
  derivative designated as a cash flow hedge is
  reported in other comprehensive income, and the
  ineffective portion is reported in earnings.
• If an entitys defined risk management strategy
  for a particular hedging relationship excludes a
  specific component of the gain or loss, or
  related cash flows, on the hedging derivative
  from the assessment of hedge effectiveness that
  excluded component of the gain or loss shall be
  recognized currently in earnings.

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Accumulated Comprehensive Income

• Accumulated other comprehensive income associated
  with the hedged transaction shall be adjusted to
  a balance that reflects the lesser of the
  following (in absolute amounts)
• (1)  The cumulative gain or loss on the
  derivative from inception of the hedge less an
  excluded component and the derivatives gains or
  losses previously reclassified from accumulated
  other comprehensive income into earnings.
• (2)  The portion of the cumulative gain or loss
  on the derivative necessary to offset the
  cumulative change in expected future cash flows
  on the hedged transaction from inception of the
  hedge less the derivatives gains or losses
  previously reclassified from accumulated other
  comprehensive income into earnings.

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Accumulated Other Comprehensive Income

• Amounts in accumulated other comprehensive income
  shall be reclassified into earnings in the same
  period or periods during which the hedged
  forecasted transaction affects earnings-when a
  forecasted sale occurs.
• If the hedged transaction results in the
  acquisition of an asset or the incurrence of a
  liability, the gains and losses in accumulated
  other comprehensive income shall be reclassified
  into earnings in the same period or periods
  during which the asset acquired or liability
  incurred affects earnings (such as in the periods
  that depreciation expense, interest expense, or
  cost of sales is recognized).

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Accumulated Other Comprehensive Income

• However, if an entity expects at any time that
  continued reporting of a loss in accumulated
  other comprehensive income would lead to
  recognizing a net loss on the combination of the
  hedging instrument and the hedged transaction
  (and related asset acquired or liability
  incurred) in one or more future periods, a loss
  shall be reclassified immediately into earnings
  for the amount that is not expected to be
  recovered.
• For example, a loss shall be reported in earnings
  for a derivative that is designated as hedging
  the forecasted purchase of inventory to the
  extent that the cost basis of the inventory plus
  the related amount reported in accumulated other
  comprehensive income exceeds the amount expected
  to be recovered through sales of that inventory.

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Discontinuing Hedge Accounting

• An entity shall discontinue prospectively hedge
  accounting for an existing hedge if any one of
  the following occurs
• Any criterion in standard is no longer met.
• The derivative expires or is sold, terminated, or
  exercised.
• The entity removes the designation of the cash
  flow hedge.
• In those circumstances, the net gain or loss
  shall remain in accumulated other comprehensive
  income and be reclassified into earnings. The
  entity may elect to designate prospectively a new
  hedging relationship with a different hedging
  instrument or a different hedged transaction or a
  hedged item if the hedging relationship meets the
  set criteria.

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The End!!!!

• Any Questions???