FAS 133 ASC 815 Accounting for Derivatives & Hedging|
FAS 133 ASC 815
Financial Accounting Standard No. 133, Accounting for Derivative Instruments and Hedging Activities, Statement (generally referred to as FAS 133 or SFAS 133 ) was issued by the U.S. Financial Accounting Standards Board in June 1998 [the full text of FAS 133 is available here in PDF format, and a Summary of FAS 133 is available here]. The Statement of Financial Accounting Standards No. 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. An international accounting standard similar to FAS 133 exists for accounting for derivatives, and is designated as IAS 39.
FAS 133 complexities. FAS 133 and IAS 39 are widely considered the most complex accounting standards ever issued by the FASB or IASB. The FAS 133 Statement is over 200 pages and IAS 39 is a daunting 400 pages. Both statements deal with controversial and critical issues, such as valuation, hedge accounting, FAS 133 hedge effectiveness testing & measurement, fair value accounting, documentation & disclosure, embedded derivatives and risk control & governance. FAS 133 continues to present significant challenges to U.S. companies using derivative instruments to hedge financial and business risks. IAS 39 represents a similar challenge internationally for corporate management and accountants.
FAS 133 Hedge Accounting
Hedge accounting methodology is established by provisions of FAS 133 for reporting of gains and losses on transactions intended to hedge exposed positions, referred to as FAS 133 designated hedges. Various criteria must be met as specified in FAS 133 in order to use hedge accounting for U.S. financial reporting, along with determination of whether the transactions are cash flow hedges or fair value hedges. Transaction documentation that complies with the requirements of FAS 133 is essential in order to obtain hedge accounting treatment (FAS 133 specifies a number of hedge documentation requirements).
For transactions that qualify under FAS 133 criteria, hedge accounting treatment allows gains and losses on hedging instruments such as forward contracts and derivatives to be deferred and recognized when the offsetting gain or loss on the item being hedged is recognized. The 'ineffective' component of hedge results must be realized in current income, while the effective portion is initially posted to Other Comprehensive Income (OCI) and then later re-classified to income in the same time period in which the forecasted cash flow is recognized in earnings. Other Comprehensive Income is a place to “park” gains and losses on hedges until it is time to recognized them in current income. It is part of the income statement, but not current earnings. FAS 133 hedge transactions may be either fair value hedges, cash flow hedges, or foreign currency hedges, as described below.
Fair value hedges. For a derivative designated under FAS 133 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 FAS 133 accounting is to reflect in earnings the extent to which the hedge is not effective in achieving offsetting changes in fair value.
Cash flow hedges. For a derivative designated under FAS 133 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.
Foreign currency hedges. For a derivative designated under FAS 133 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 FAS 133 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 (FX) exposure of a foreign-currency-denominated forecasted transaction.
An analysis and appropriate accounting opinion for a foreign currency hedging transaction structure is shown here. This FAS 133 analysis is for a participating forward that is structured using FX options.
FAS 133 hedge effectiveness. In U.S. accounting terminology, hedge effectiveness is a FAS 133 specified criteria that must be met and demonstrated through hedge effectiveness testing in order to use hedge accounting for U.S. financial reporting. This FAS 133 provision has proven problematic in the energy industry where partial hedges for such exposure components as basis risk are widely used. Other issues that presented difficulties for energy companies and commodity operations, such as FAS 133 accounting for full requirements electrical power contracts (which have an implicit option component) and Normal Purchases & Normal Sales contracts for physical supply, have been addressed in the FAS 133 implementation clarifications by the FASB, as mentioned below.
Effectiveness testing. Under FAS 133, an entity that elects to apply hedge accounting is required to establish at the inception of the hedge (at the time the transaction is designated as a 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. FAS 133 requires that the hedge effectiveness testing methodology then be applied consistently on an ongoing basis. Methodologies for measuring FAS 133 hedge effectiveness may include the dollar-offset method for retrospective testing and regression analysis methods for prospective effectiveness testing. See also FAS 133 Hedge Accounting.
Dollar-offset Method. In measuring hedge effectiveness for FAS 133 purposes, the Dollar-offset Method refers to the ratio of the change in value of the hedged item (for that portion attributable to the hedged risk), compared to the change in value of the derivative being used as a hedge.
80 - 120 Rule. While never explicitly required in FAS 133, a widely-used reference for assessing hedge effectiveness is the 80-120 rule. Under this standard, hedges qualify for hedge accounting treatment only if the results from the derivative are expected to correspond to no less than 80 percent and no more than 120 percent of the associated changes of the item being hedged.
One basis widely cited for use of the 80 - 120 rule is the use of a similar measure in the International Accounting Standard 39 (IAS 39 as described below). That standard requires that actual results from a hedge transaction be within a range of 80 - 125%. Logic and general industry conventions suggests that the approach used under IAS 39 could also be applied as a hedge effectiveness guideline under FAS 133, with a very similar range being defined for initial and ongoing hedge effectiveness testing with the 80 - 120 rule being applied to determine any hedge impairment.
FAS 133 Documentation & Disclosure
One of the objectives of FAS 133 is to provide a common framework for derivatives accounting. FAS 133 requires that all derivatives be reported at fair market value on the balance sheet. This means that companies must recognize derivatives as assets or liabilities, and these must be recognized on the company's balance sheet.
FAS 133 documentation process. One of the major tasks in implementing a system for FAS 133 compliance lies in the design and documentation of an organization's trading and risk management practices.
For derivatives that are designated as FAS 133 hedges, the following must be disclosed:
Risk management policies must be specified, identifying exposures to be hedged and hedging strategies for managing the associated risks
The hedged item must be explicitly identified
Ineffective hedge results must be disclosed, and
Any component of the derivatives' results that is excluded from the hedge effectiveness assessment must be disclosed.
Within a U.S. accounting context of FAS 133, embedded derivatives are portions of transactions that meet the definition of a derivative when the entire nonderivative transaction cannot be considered a financial instruments derivative. Embedded derivatives, such as options, may be part of equity and debt financings and foreign exchange (FX) transactions. Other types of transactions such as insurance contracts, leases and purchase agreements may also include embedded derivatives FAS 133 may require structured securities issued by companies to be bifurcated into "plain vanilla" and embedded derivatives components. These embedded derivatives can then be valued based on current yield curves and volatilities. See also FAS 133 and PIPES (Private Investments in Public Equities).
Evolution of FAS 133 Rules
Since 1998 when FAS 133 was first issued, there has been an on-going evolution of the accounting rules for derivatives and physical energy supply contracts. This has included the issuance of FAS 138, FAS 149, and the various Derivatives Implementation Group (DIG) and Emerging Issues Task Force (EITF) rules subsequently adopted by the Financial Accounting Standards Board.
FAS 133 implementation guidance. DIG, an acronym for the FASB's Derivatives Implementation Group, is a task force that was created by the FASB in 1998 concurrent with their issuance of FASB Statement No. 133, to assist the FASB in providing guidance on questions that companies would face when they began implementing FAS 133. The Emerging Issues Task Force is a unit of the Financial Accounting Foundation that addresses accounting issues not yet addressed by a published FASB Statement of Financial Accounting Standards. Issues such as the FAS 133 accounting treatment for full requirements electric power supply contracts and Normal Purchases and Normal Sales of physical supply transactions have been addressed by DIG and EITF, with their recommended solutions adopted by the FASB.
FAS 133 amendments. Financial Accounting Standard 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities, was issued by the Financial Accounting Standards Board in June 2000 to amend FAS 133. The full text of FAS 138 is available here in PDF format. Financial Accounting Standard 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities, was issued by the Financial Accounting Standards Board in April 2003 to further amend FAS 133. The full text of FAS 149 is also available in PDF format.
The Financial Accounting Standards Board (FASB), which is the designated organization in the U.S. private sector for establishing standards of financial accounting and reporting, is responsible for setting the accounting rules for reporting derivatives and hedging transactions. The standards approved by the FASB, such as FAS 133, are officially recognized as authoritative by the U.S. Securities and Exchange Commission and the American Institute of Certified Public Accountants.
Future FAS 133 revisions. As of early 2005 the FASB was considering yet again more revisions to FAS 133. These proposed changes to FAS 133 are a response to investors' concerns that disclosure rules for derivative instruments do not adequately convey the risks of such derivatives. The FAS 133 accounting rules have drawn wide attention following the debacles at U.S. mortage gaints Fannie Mae and Freddie Mac, which used derivatives to hedge risks in their massive mortgage portfolios. Fannie Mae has now been ordered by regulators to restate financial results back to 2001 and recognize at least $9 billion in losses related to derivatives. Whereas Freddie Mac had a $5 billion upward restatement in 2003 that covered three years of financial statements. These financial disasters have again focused attention on FAS 133.
International accounting standards for reporting of derivative transactions are generally governed by International Accounting Standard 39 (IAS 39), Financial Instruments: Recognition and Measurement, issued on December 17, 2003, by the International Accounting Standards Board (IASB). The IAS 39 standard is generally considered similar quite similar to FAS 133. A summary of IAS 39 is available on the web. The complexity of IAS 39 and the range of issues that must be addressed by IAS 39 make the implementation process quite complicated for most companies. Implementation of IAS 39 is required in many countries for 2005. IASB's goal is to obtain global convergence of accounting standards by the adoption of their International Financial Reporting Standards (IFRS).
The European Commission voted in October 2004 to adopt an amended version of IAS 39 (amended IAS 39) rather than the version published by the IASB. This amended version adopted for the EU excludes certain requirements relating to hedging. The IASB has said it intends to produce an amended standard for IAS 39 by June 2005, with formal implementation from January 1, 2006. An amended standard would still need EU approval to be adopted in Europe.
Risk Limited can assist you and your organization in complying with current FAS 133 and IAS 39 requirements and developing processes and systems that meet best practices standards for FAS 133 or IAS 39 compliance. Contact Risk Limited if you need information or if we can be of assistance to you on FAS 133 or IAS 39 issues.
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