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and Hedging Activities

Associate Professor

Eastern Michigan University

FAS 133 - Key Aspects

▼ All derivatives are reported at fair value on

the balance sheet.

▼ Changes in fair value of a derivative is

recognized in earnings.

▼ Special accounting is provided for a

derivative designated as or qualified for a

hedging purpose.

– Fair value hedge

– Cash flow hedge

– Foreign currency hedge

Example

▼ BestGas Inc., a natural gas marketer in Midwest U.S.,

buys natural gas from producers and sells it to end

users and local distribution companies.

▼ BestGas has inventory of 10,000,000 mmBtus of natural

gas with a carrying value @3.0 per mmBtu in June X1.

▼ Inventory is intended for delivery to Chicago in Dec. X1.

▼ In June X1, short sell a December gas derivative

(forward) contract @3.3

▼ The fair value of the gas inventory increases to $4.0 and

the derivative contract increases to $4.5 in Sept. X1.

▼ The gas price for delivery to Chicago in Dec. X1

decreases to $2.5.

▼ On entering into the derivative, the entity neither

receives nor pays a premium.

Example: Using a Derivative Contract for Hedging

(Hedged item-Gas Inventory) (Derivative contract)

June $3.0 $3.3 $0.3

Period Gain (Loss) 1.0 (1.2) (0.2)

2.5 2.5

Dec.

Period Gain (Loss) (1.5) 2.0 0.5

Cumulative G (L) (0.5) 0.8 $0.3

-BestGas has perfect foresight in June when entering into the derivative

contract knowing that a net gain of $0.3 per mmBtu is to be realized

when the inventory is sold and the contract is settled in Dec. irrespective

to any price fluctuations.

- Price Protection.

- Derivatives preclude from benefiting windfall gains if Gas prices

increase above $3.3.

Example

Futures Contract for Hedging

Period Spot Price Dec. Futures Price Effect

(hedged item) (futures contract)

June $3.0 $3.3 $0.3

Period Gain (Loss) 1.0 (1.2) (0.2)

To be reported

Dec. 2.5 2.5 post-FAS133

Period Gain (Loss) (1.5) 2.0 0.5

Reported

pre-FAS133

Great Derivative Debacles

Company Year Approx. Amount

Proctor & Gamble 1994$ .2 billion

Glaxo 1994$ .1 billion

Gibson Greetings 1994$ -

Orange County 1994$ 2.0 billion

Metallgesellshaft 1994$ 1.5 billion

Barings 1995$ 1.3 billion

Sumitomo 1996$ 1.8 billion

Bank Tokyo-Mitsubishi 1997$ .1 billion

Unions Bank Switzerland 1997$ .4 billion

LTCM 1998$ 3.5 billion

Pre-FAS 133 Accounting Model

1997: SEC Market Risk Disclosure

Disclosure of info. about F/Is with

concentrations of credit risk

off-B/S risk and F/Is with

1990: FAS 105

Translation Futures

60 EITF Issues

and Fair Value of Financial Instruments

FAS 133 – Implementation

▼ FAS 133: Accounting for derivative

instruments and hedging activities

▼ Issuance in June, 1998

spanning over twelve years

▼ Represent a significant step towards fair

value accounting

▼ Provide a uniform hedging model

– Prior GAAP was incomplete, inconsistent

– Accounting for derivatives was not transparent

FAS 133 - Implementation

▼ Initially was to be effective for fiscal years

beginning after June 15, 1999

▼ Very controversial; faced a great deal of

opposition from industry

▼ Industry didn’t have time to change systems to be

FAS 133 compliant

▼ FAS 137 postponed until June 15, 2000

(Jan. 1, 2001 for firms with calendar-year fiscal years)

▼ Key aspects of FAS 133 were still being resolved

by the Derivatives Implementation Group

FAS 133 - Documentation

Formal documentation is required at the

inception of the hedge to apply special

accounting for a derivative

▼ Identification of the hedging

instrument(s) and the hedged item

▼ Nature of the risk being hedged

▼ The risk management objective/strategy

▼ Assessment/evaluation of hedging

effectiveness

Journal of Accountancy (March 2001)

Practical Issues in Implementing FASB 133

http://www.aicpa.org/pubs/jofa/mar2001/hwang.htm

1) Inventory derivatives

2) Document risk management philosophy

3) Identify hedging relationships for hedge designation

4) Document the hedging relationship

5) Determine effectiveness

6) Transition adjustments pretax cumulative effects and

deferred tax effects of transition

7) Risk management

8) Systems implementation requirements

9) Training and education.

The CPA Journal (Nov. 2001)

Implementation of SFAS 138,

Amendments to SFAS 133

http://www.nysscpa.org/cpajournal/2001/1100/dept/d115401.htm

Accounting for Certain Derivative Instruments and Certain

Hedging Activities—an amendment of FASB Statement No. 133.

It includes the following major amendments:

1) The normal purchases and normal sales exception is expanded to

certain commodity contracts.

2) The risk that can be hedged in an interest rate hedge is redefined.

3) Recognized foreign currency-denominated assets and liabilities

may be hedged with a single cross-currency compound hedge.

4) Net hedging of certain intercompany derivatives may be

designated as cash flow hedges of foreign currency risk.

▼ Amendments to DIG Guidance

FAS 133 - Amendments

FAS 149 (issued in 04/2003; effective in 06/2003)

Amendment of Statement 133 on Derivative Instruments and Hedging

Activities

that contracts with comparable characteristics be accounted for

similarly. In particular, this Statement

(1) clarifies under what circumstances a contract with an initial net

investment meets the characteristic of a derivative discussed in

paragraph 6(b) of Statement 133,

(2) clarifies when a derivative contains a financing component,

(3) amends the definition of an underlying to conform it to language used in

FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure

Requirements for Guarantees, Including Indirect Guarantees of

Indebtedness of Others, and

(4) amends certain other existing pronouncements. Those changes will

result in more consistent reporting of contracts as either derivatives or

hybrid instruments. ” (Summary, FAS 149)

FAS 133 – Amendments

▼From the FASB website in May 2004…

▼Available in March 2004— New 880-page updated edition

▼The FASB staff has prepared a new updated edition of Accounting for

Derivative Instruments and Hedging Activities. This essential aid to

implementation presents Statement No. 133, Accounting for Derivative

Instruments and Hedging Activities as amended by Statements No. 137,

Accounting for Derivative Instruments and Hedging Activities—Deferral

of the Effective Date of FASB Statement No. 133, No. 138, Accounting for

Certain Derivative Instruments and Certain Hedging Activities, and No.

149, Amendment of Statement 133 on Derivative Instruments and Hedging

Activities. Also, this publication includes the full text of Statement 133

Implementation Issues (172) discussed by the Derivatives

Implementation Group (DIG) and cleared by the FASB prior to

February 10, 2004, with cross-references between the issues and the

paragraphs of the Statement.

How Should Transactions be Reported?

Journal of Accounting Education (2002)

Comparative Analysis of

Accounting Treatments for Derivatives

▼ Case 1: Fair value hedge

▼ Case 2: Cash flow hedge

▼ Case 3: Speculative or derivative not designated

▼ Case 4: No derivative

✹ Loss on the hedged item but gain on the derivative

in above cases

✹ Loss on the derivative

✹ Derivatives provide price protection.

✹ Derivatives preclude from benefiting windfall gains.

Features

▼ A real-world example

▼ Explain concepts/application of derivatives

▼ Two-time period example

▼ Impact of journal entries on financial

statements

▼ Comparative analysis of the economic results

▼ A web-downloadable spreadsheet for readers’

customization

Scenario

▼ Inventory of 20,000,000 mmBtus of natural

gas with a carrying value @3.000 in June X1.

▼ Inventory is intended for delivery to Chicago

in Dec. X1

▼ Short sell a December futures contract

@3.480

▼ Delivery point for the the futures contract is

at the Henry Hub

▼ On entering into the derivative, the entity

neither receives nor pays a premium. Time

value is ignored for simplification.

READING HIGHLIGHTS

• What problem is faced by BestGas?

• What does BestGas do to solve the problem?

• What is a futures contract?

• What is a forward contract?

• How does a futures contract help risk management?

• Why is a futures contract called a derivative instrument?

• How does a derivative instrument provide “leverage”?

• In your opinion, how should a derivative be recorded conceptually?

• What were the problems with the accounting standards prior to FAS

133?

• What purposes do FAS 133 attempt to achieve?

• What value does FAS 133 require derivatives to be recorded?

• How do accounting treatments differ among a fair value hedge,

speculation, no derivative?

• How do the economic impacts differ among fair value hedge,

speculation, no derivative in BestGas’ case?

• How does accounting for a cash flow hedge differ from a fair value

hedge?

All Derivatives

▼ All derivatives are reported at fair

value on the balance sheet.

▼ Changes in the fair value of a

derivative is recognized in earnings.

▼ Only entry for derivatives Not

Qualified for hedging purpose

(Case 3).

FAS 133 - Fair Value Hedge

▼ A hedge of the exposure to a change in fair value of a

recognized asset or liability or of an unrecognized firm

commitment attributable to a particular risk

– Inventory

– Fixed Rate debt

– Commodity Purchase/Sale Commitment

▼ Fair value for the hedging instrument (derivative).

▼ Carrying value of the hedged item is adjusted to reflect

the change in value due to the risk being hedged.

▼ If the two items are perfectly effective hedges, the gain

or loss on each item will offset each other.

▼ Ineffectiveness flows through earnings.

FAS 133 - Cash Flow Hedge

▼ A hedging relationship where the variability

of the hedged items cash flows is offset by the

cash flows of the hedging instrument

▼ Hedged item is a forecasted transaction or

balance sheet item with variable cash flows

– Forecasted purchase/sale

– Variable Rate Debt

▼ Change in fair value of derivative is recorded

to Other Comprehensive Income (OCI)

▼ Ineffectiveness flows to earnings via OCI

FAS 133 - Cash Flow Hedge

“Lesser of Two Cumulatives” Rule

• Step 1: Determine the change in fair value of the derivative and the

change in the expected cash flow on the hedged transaction

(Columns B and E).

• Step 2: Determine the cumulative change in fair value of the

derivative and the cumulative change in the expected cash flow on

the hedged transaction (Columns C and F).

• Step 3: Determine the lessor of the absolute value of the amounts in

Step 2 (Column G).

• Step 4: Determine an appropriate balance (in debit or credit) to the

cumulative change in OCI (Column H).

• Step 5: Determine the change in OCI during the period (Column J).

• Step 6: Adjust the derivative to reflect its change in fair value and

adjust OCI by the amount determined in Step 4. Balance the entry,

if necessary, with an adjustment to earnings (Column K).

FAS 133 - Cash Flow Hedge

“Lesser of Two Cumulatives” Rule

• Change in fair value of the derivative

transaction

• Effective hedge: OCI (a deferral)

Conclusions

▼ Same entry to record the derivative at FV when a

derivative is used

▼ FVH: Observe changes in the carrying cost of the

inventory for fair value hedge

▼ CFH: The effective portion of gains or losses on a

derivative designated as a cash flow hedge are deferred

to OCI determined by the “lesser of two cumulatives”

rule. This deferral will be subsequently reclassified as

earnings when the forecasted transaction affects

earnings.

▼ Contract settlement: receives/pays cash from/to a

futures broker if the contracted futures price (i.e., the

futures forward price at inception) is less/more than the

futures spot price because the entity purchases the

commodity at a lower/higher price to close out the

previous short sale position.

Stay tuned…

▼ You can download the following reading material at

http://ahwang.pageout.net by click links in the following order:

Research, Course Contents, Publications,

▼ JOA1 FAS 133 Implementation

▼ JAE1a FAS133 Comparative Analysis

▼ JAE1s FAS 133 Comparative Analysis Worksheet for Students

▼ Reading Sequence on Hwang's FAS133 Research

▼ Seminar participants should read:

▼ “Practical Issues In Implementing FASB Statement 133,” (with

John S. Patouhas) Journal of Accountancy Vol. 191 No. 3 (March

2001): 26-34. (JOA1 FAS 133 Implementation)

▼ Seminar participants should glance through the attached seminar

PowerPoint handouts.

Stay tuned…

▼ Seminar participants should glance through:

▼ “Comparative Analysis of Accounting Treatments for Derivatives,”

Journal of Accounting Education Vol. 20 (2002): 205-233. (

JAE1a FAS133 Comparative Analysis)

▼ A scenario based on a futures contract used by a natural gas company to

hedge price fluctuations of its gas inventory is applied across four cases to

show the impact of derivative designation on the accounting treatment

and to provide a comparative analysis of the financial/economic results

from using different accounting treatments for the derivative.

▼ Seminar participants should work on the case in excel worksheet if

attending the afternoon optional workshop on accounting for derivatives.

▼ JAE1s FAS 133 Comparative Analysis Worksheet for Students

▼ Seminar participants if interested in more Hwang’s publications on FAS

133 should read:

▼ Reading Sequence on Hwang's FAS133 Research

ahwang@emich.edu Angela Hwang

248.723.9365

Thank You

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