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http://www.trinity.edu/rjensen/caseans/000index.htm
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Presentation by
Bob Jensen Trinity University San Antonio, TX 78212 rjensen@trinity.edu
http://www.trinity.edu/rjensen/
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Undisclosed Assets and Liabilities Unbooked Assets and Liabilities Meaningless Measures of Value & Risk Rise in Scandals in the 1980s & 1990s Complex Frauds --- Partnoys Fiasco Explosion of Swap Contracts Evolution Toward Fair Value Accounting
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Complex Contracts & Technical Jargon Complex Scoping of Coverage --- NPNS Complex Hedge Accounting Rules Many Derivatives Are Difficult to Value Difficult to Find Embedded Derivatives Complex Effectiveness Testing Rules Continuous Stream --- DIG, Amendments Implementation Failures --- Freddie Mac, etc. Held-to-Maturity Interim Distortions Hedge Acctg. Denied to Most Macro Hedges
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Determine whether a contract is scoped into the standards and, if so, whether it is Qualified for Hedge Accounting
Understand the basic journal entries Cry out loud if forced to implement the standards
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FOUR CORNERSTONES
Derivatives are contracts that create rights and obligations that meet the definitions of assets and liabilities Fair value is the only relevant measure for derivatives
Value risk can be hedged into cash flow risk, and cash flow risk can be hedged into value risk, but both risks cannot simultaneously be eliminated. Hedge effectiveness tests can be varied with the type of risk being hedged.
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DIG is made up of FASB staff members, Big 5 members and Industry professionals. Active DIG observers include the SEC and certain regulators. DIGs mandate is to assist the FASB in answering implementation questions by identifying practice issues that arise from applying Statement 133 and to advise the FASB staff on how to resolve the issues. Issues are discussed by DIG, tentatively concluded by the FASB staff and posted on the FASB website (www.fasb.org) for two months before being presented to the Board for negative clearance.
DIG Site http://www.fasb.org/derivatives/
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Flow chart for deciding whether derivative is scoped into FAS 133
Flow chart for deciding how to account for a derivative financial instrument qualified for hedge accounting. Cash Flow Hedge (booked item vs. forecasted transact.) Fair Value Hedge (booked item vs. firm commitment) Foreign Currency (FX) Hedge (fair value vs. cash flow)
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A derivative instrument is a contract with all three of the following characteristics (6):
Underlying and either a notional amount or a payment provision or both Relatively small initial net investment Net settlement or its equivalent (excludes most short
sales & Take-Or-Pays, but see FAS 133 Paragraph 290)
Definition includes freestanding as well as embedded derivative instruments A number of exclusions exist
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Statement 133 created a new definition of the term derivative Some instruments that are not usually considered derivatives are included (e.g. certain purchase/sales contracts) The definition is based on certain distinguishing characteristics.
Certain scope exceptions exist; not everything that meets the definition of a derivative is subject to the requirements of Statement 133.
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Notional amount is used to determine the settlement amount (for example, a price x a number of shares)
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Underlying
- Stock price
Notional Amount
- Number of shares - Number of currency units
- Dollar amount
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No initial net investment A smaller initial net investment than other types of contracts that have a similar response to changes in market factors
A derivative does not require an initial net investment of the notional amount
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FREESTANDING DERIVATIVES Characteristic 3Readily Convertible to Known Amounts of Cash 9 and 57(c)
Readily convertible assets have:
Interchangeable (fungible) units Quoted prices available in an active market that can rapidly absorb the quantity held by the entity without significantly affecting the price
For example:
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Regular-way security trades Normal purchases and normal sales Traditional insurance contracts Most financial guarantee contracts OTC contracts with certain underlyings Derivatives that are an impediment to sales accounting
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Contracts that have a market mechanism to facilitate net settlement (but note FAS 138)
As long as it is probable contracts will not settle net and will result in physical delivery (but note FAS 138 and FAS 149)
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(1) May
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FREESTANDING DERIVATIVES Exceptions OTC Contracts with Certain Underlyings 10(e) and 58(c)
Climatic variables:
Geological variables:
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FREESTANDING DERIVATIVES ExceptionsOTC Contracts with Certain Underlyings 10(e) and 58(c)
The price or value of nonfinancial assets of one of the parties that is not readily convertible to cash or the price or value of nonfinancial liabilities of one of the parties that does not require delivery of readily convertible assets
Option to purchase or sell real estate owned by one party (even if it can be net settled)
Firm commitment to sell machinery (if unique) owned by one party (even if it can be net settled)
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FREESTANDING DERIVATIVES Exceptions OTC Contracts with Certain Underlyings 10(e) and 58(c)
Exceptions include specified volumes of sales or service revenues of one of the parties. For example:
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FREESTANDING DERIVATIVES Contracts Not Considered Derivatives for Purposes of Statement 133, 11
Instruments indexed to an entitys own stock and classified in stockholders equity Stock-based compensation covered by Statement 123 (issuer only) Contingent consideration in a business combination covered by Opinion 16 (purchaser only)
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Embedded derivatives are implicit or explicit terms that affect the cash flows or value of other exchanges required by a contract in a manner similar to a derivative The combination of a host contract and an embedded derivative is referred to as a hybrid contract Examples of hybrid contracts are: Structured notes Convertible securities Securities with caps, floors, or collars
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EMBEDDED DERIVATIVES When Does a Contract Have an Embedded Derivative Subject to This Statement? 12
No
Yes
No
No
Factors to consider:
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Equity
Lease
Inflation Interest
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For a highly effective hedge, there must be offsetting fair value changes for hedged item and hedging instrument
Changes in fair value of hedged item and hedging instrument are recorded in earnings Basis of hedged item is adjusted by the change in value
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In qualified hedge accounting, the offset to changes in the hedging derivative is OCI for cash flow hedges but not for fair value hedges. For a qualified fair value hedge, the offset is = Firm Commitment for a purchase contract with a contracted price = Hedged Item carrying value if the hedged item such as inventory is already on the books at historical cost = P&L current earnings if the hedged item such as inventory is already on the books at fair value
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FAIR VALUE HEDGE ACCOUNTING For Hedged Item Booked at Historical Cost
Measurement of Derivative Accounting Model
Measurement of Hedged Item Offsetting Gain or Loss Attributable to Risk Being Hedged
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Hedged item may be a forecasted transaction with no contracted future price (i.e., not a firm commit.) Effective portion of derivatives gain or loss reported in OCI Earnings recognition matches hedged transaction Ineffective gain or loss recorded in earnings
Derivative instrument recorded at fair value, effective portion through OCI, ineffective through earnings Amounts in OCI recognized in earnings when hedged transaction impacts earnings under FAS 133 but not under IAS 39. In other words, IAS 39 requires basis adjustment when the derivative expires whereas FAS 133 carries OCI forward until hedged item is disposed of in a transaction.
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Accounting Model
OCI Equity
(1) Earnings
Hedging Instruments
For a fair value hedge of foreign exchange risk related to AFS securities or a recognized foreign-currency-denominated debt instrument, an entity can only use a derivative instrument For a fair value hedge of foreign exchange risk related to a firm commitment, an entity can use either a derivative or a nonderivative instrument For a cash flow hedge of a forecasted foreign currency denominated transaction (including forecasted intercompany transactions, recognized foreign-currency-denominated debt instruments and firm commitments accounted for as forecasted transactions), an entity can only use a derivative instrument For a hedge of a net investment in a foreign operation, an entity can use either a derivative or a non-derivative instrument
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1
Hedged Item $ -0(1)
2
$(20)
Total
$(20)
Derivative
20
$20
(2)
-0$(20)
20
$ -0-
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CASE 1
Cash Flow Hedge of Forecasted Inventory Sale
ABC is hedging the risk of changes in cash flows related to a forecasted sale of 100,000 bushels of Commodity A to be sold at the end of period 1. The inventory carrying value is $1 million, and current market value is $1.1 million On the first day of period 1, ABC enters into Derivative Z to sell 100,000 bushels at $1.1 million at the end of period
Earnings
25,000
$1,100,000
The variability of cash flows related to the forecasted inventory sale is offset by change in value of derivative.
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ABC has 1,000 bushels of a Commodity with a fair value of $1.1 million and a carrying value of $1.0 million
ABC wants to hedge overall fair value of the Commodity On 1/1/X1, ABC enters into an at-the-money matching derivative to hedge the changes in fair value of the 1,000 bushels of the Commodity
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Effectiveness will be assessed by comparing entire change in fair value of derivative to change in market price of inventory (time value will be ignored for illustration purposes only) On 1/31/X1, the fair value of the derivative has increased by $25,000 and the fair value of the inventory has decreased by $25,000
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25,000 25,000
25,000 25,000