[Vision2020] Accounting for Derivatives

[Jeff Harkins]

Not surprisingly, many of you are struggling with 
the accounting standards and principles required 
for derivative financial instruments.

The dominant standard for accounting for 
derivative financial statements is FASB Statement 
133: Accounting for Derivative Instruments and Hedging Activites.

I have appended the official "Summary" of FAS 133 
for you.  I would be willing to try to answer questions that you have.

Keep in mind that FAS 133 runs over 500 
paragraphs and has been amended numerous times since its release in 1998.

Despite it's length, the underlying standard is 
rather crisp as noted by the standard in Paragraph 17:

>Recognition of Derivatives and Measurement of
>Derivatives and Hedged Items
>17. An entity shall recognize all of its derivative instruments
>in its statement of financial position as either
>assets or liabilities depending on the rights or obligations
>under the contracts. All derivative
>instruments shall be measured at fair value.

Here is the Summary:

>SUMMARY
>This Statement establishes accounting and 
>reporting standards for derivative instruments, including certain
>derivative instruments embedded in other 
>contracts, (collectively referred to as derivatives) and for hedging
>activities. It requires that an entity recognize 
>all derivatives as either assets or liabilities in the statement of financial
>position and measure those instruments at fair 
>value. If certain conditions are met, a derivative may be
>specifically designated as (a) a hedge of the 
>exposure to changes in the fair value of a recognized asset or liability
>or an unrecognized firm commitment, (b) a hedge 
>of the exposure to variable cash flows of a forecasted
>transaction, or (c) a hedge of the foreign 
>currency exposure of a net investment in a foreign operation, an unrecognized
>firm commitment, an available-for-sale security, 
>or a foreign-currency-denominated forecasted
>transaction.
>Accounting for Derivative Instruments FAS133
>and Hedging Activities
>FAS133–3
>The accounting for changes in the fair value of 
>a derivative (that is, gains and losses) depends on the intended
>use of the derivative and the resulting designation.
>• For a derivative designated as hedging the 
>exposure to changes in the fair value of a recognized asset or
>liability or a firm commitment (referred to as a 
>fair value hedge), the gain or loss is recognized in earnings
>in the period of change together with the 
>offsetting loss or gain on the hedged item attributable to the risk
>being hedged. The effect of that accounting is 
>to reflect in earnings the extent to which the hedge is not
>effective in achieving offsetting changes in fair value.
>• For a derivative designated as hedging the 
>exposure to variable cash flows of a forecasted transaction (referred
>to as a cash flow hedge), the effective portion 
>of the derivative’s gain or loss is initially reported as a
>component of other comprehensive income (outside 
>earnings) and subsequently reclassified into earnings
>when the forecasted transaction affects 
>earnings. The ineffective portion of the gain or loss is reported in
>earnings immediately.
>• For a derivative designated as hedging the 
>foreign currency exposure of a net investment in a foreign operation,
>the gain or loss is reported in other 
>comprehensive income (outside earnings) as part of the cumulative
>translation adjustment. The accounting for a 
>fair value hedge described above applies to a derivative
>designated as a hedge of the foreign currency 
>exposure of an unrecognized firm commitment or an
>available-for-sale security. Similarly, the 
>accounting for a cash flow hedge described above applies to a derivative
>designated as a hedge of the foreign currency 
>exposure of a foreign-currency-denominated forecasted
>transaction.
>• For a derivative not designated as a hedging 
>instrument, the gain or loss is recognized in earnings in the
>period of change.
>Under this Statement, an entity that elects to 
>apply hedge accounting is required to establish at the inception of
>the hedge the method it will use for assessing 
>the effectiveness of the hedging derivative and the measurement
>approach for determining the ineffective aspect 
>of the hedge. Those methods must be consistent with the entity’s
>approach to managing risk.
>This Statement applies to all 
>entities.Anot-for-profit organization should recognize the change in fair value
>of all derivatives as a change in net assets in 
>the period of change. In a fair value hedge, the changes in the fair
>value of the hedged item attributable to the 
>risk being hedged also are recognized. However, because of the
>format of their statement of financial 
>performance, not-for-profit organizations are not permitted special hedge
>accounting for derivatives used to hedge 
>forecasted transactions. This Statement does not address how a notfor-
>profit organization should determine the 
>components of an operating measure if one is presented.
>This Statement precludes designating a 
>nonderivative financial instrument as a hedge of an asset, liability,
>unrecognized firm commitment, or forecasted 
>transaction except that a nonderivative instrument denominated
>in a foreign currency may be designated as a 
>hedge of the foreign currency exposure of an unrecognized firm
>commitment denominated in a foreign currency or 
>a net investment in a foreign operation.
>This Statement amends FASB Statement No. 52, 
>Foreign Currency Translation, to permit special accounting
>for a hedge of a foreign currency forecasted 
>transaction with a derivative. It supersedes FASB Statements
>No. 80, Accounting for Futures Contracts, No. 
>105, Disclosure of Information about Financial Instruments
>with Off-Balance-Sheet Risk and Financial 
>Instruments with Concentrations of Credit Risk, and No. 119, Disclosure
>about Derivative Financial Instruments and Fair 
>Value of Financial Instruments. It amends FASB
>Statement No. 107, Disclosures about Fair Value 
>of Financial Instruments, to include in Statement 107 the
>disclosure provisions about concentrations of 
>credit risk from Statement 105. This Statement also nullifies or
>modifies the consensuses reached in a number of 
>issues addressed by the Emerging Issues Task Force.
>This Statement is effective for all fiscal 
>quarters of fiscal years beginning after June 15, 1999. Initial application
>of this Statement should be as of the beginning 
>of an entity’s fiscal quarter; on that date, hedging relationships
>must be designated anew and documented pursuant 
>to the provisions of this Statement. Earlier application
>of all of the provisions of this Statement is 
>encouraged, but it is permitted only as of the beginning of
>any fiscal quarter that begins after issuance of 
>this Statement. This Statement should not be applied retroactively
>to financial statements of prior periods.
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