THE CHALLENGE

For the last six years, the Financial Accounting Standards Board (FASB) has been considering the way derivative instruments are reported in corporations' financial statements. The Board concluded that current accounting rules for derivatives are incomplete, inconsistent, difficult to apply and not transparent in financial statements, and therefore proposed a new standard.

Four fundamental principals underlie the new accounting rules:

1. Derivatives are assets and liabilities, and should be reported in financial statements as such;
2. Fair value is the only relevant measure for derivative instruments;
3. Gains or losses on derivatives cannot be deferred; however,
4. Special accounting is permitted for items which qualify as hedges.

Of importance is that the new rules provide no circumstance for which a company can retain off-balance sheet accounting treatment for derivatives. Any derivative instrument must be reflected in the balance sheet at its fair value.

Derivatives that meet the criteria for an effective hedge qualify for special hedge accounting treatment. Three types of hedges are recognized: fair value hedges, cash flow hedges and hedges of corporations' net investments in foreign operations. 

FAIR VALUE HEDGES

Derivatives can be used to hedge changes in the fair value (market value) of financial assets or liabilities like debt securities. For instance, a fixed rate bond's market value changes when interest rates go up or down. Hedging the bond's price risk with a derivative would be considered a fair value hedge.

Changes in the fair value of the derivative flow directly to the income statement, but are offset by changes in the fair value of the hedged item which are recognized in the income statement at the same time.

 

FAIR VALUE HEDGE ACCOUNTING
Example:	Company issues fixed rate debt, then swaps debt to floating rate.
Accounting for swap:	Swap is marked to market and changes in value are recognized in current earnings.
Accounting for debt:	Change in value of debt related to change in market interest rates is recognized in earnings.
Combination of swap change in value plus debt change in value is offset in earnings.

 

CASH FLOW HEDGES

Derivatives can also be used to hedge changes in future cash flows arising from existing assets or liabilities, or from forecasted transactions. For example, interest payments on a company's variable rate debt expose a company to interest rate risk. Hedging this exposure using an interest rate swap (to convert the debt from floating rate to fixed interest rate) would be considered a cash flow hedge under the new rules.

In a cash flow hedge, changes in the fair value of the interest rate swap would accumulate first in the statement of comprehensive income. (This is similar to how foreign exchange translation gains and losses are accumulated as a separate component of equity under existing accounting rules.) A portion of these gains or losses would be transferred out of comprehensive income to the income statement whenever interest is paid on the hedged debt. The net result will be a fixed rate of interest expense.

 

CASH FLOW HEDGE ACCOUNTING
Example:	Company issues floating rate debt, then swaps to fixed rate.
Accounting for swap:	Swap is marked to market and changes in value are recognized first in statement of comprehensive income and then in earnings as interest payments on hedged debt are made. At maturity, swap's value reduces to zero. Swap's carrying value is adjusted each period to reflect actual swap payments or receipts.
Accounting for floating rate debt:	Variable interest rate expense is recognized in earnings as incurred.
Combination of swap change in value plus debt change in value is offset in earnings.

 

HEDGES FOR NET INVESTMENT IN FOREIGN OPERATIONS

The new rules still permit companies to hedge foreign currency exposure related to an investment in a foreign operation. The new accounting is similar to current rules except that the translation gains or losses on the investment and the hedge are reported in the statement of comprehensive income instead of equity.

 

DERIVATIVES AND INCOME STATEMENT VOLATILITY

Income statements of companies that utilize derivatives as hedges will be largely unaffected by the accounting changes. Under the new rules, effective hedges (hedges which have a high correlation to the asset or liability being hedged) should not introduce income statement volatility.

So as long as the hedge works effectively, changes in the fair value of the derivative should be opposite to and offset changes in the fair value/cash flow of the hedged item.

 

INCREASED DERIVATIVES DISCLOSURE

One of the benefits of the new rules is that more information about a company's hedging program will be revealed to investors. In addition to the more detailed information provided in financial statements, a company must also provide an expanded description of its risk management philosophy and strategy. From this, investors and analysts will be better able to determine whether or not a company is hedging critical financial exposures. This increases the likelihood that companies with prudent hedging programs will be rewarded by the market.

 

SUMMING UP

Accounting standards groups around the world have been watching the FASB's progress as it tackles the issue of accounting for derivative instruments. The International Accounting Standards Committee continues to review the new US standard and is expected to make a decision shortly about whether it will follow the US lead. As well, the Canadian Institute of Chartered Accountants may adopt FASB's standards so Canadian companies would be required to adhere to these new rules in the not-too-distant future.

 

 

For more information on FASB and these new rules, visit its site at: http://www.rutgers.edu/Accounting/raw/fasb/index.html.