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April 2010 Newsletter View in pdf
Understanding the Emerging Requirements
Hedge Trackers will be continuing efforts to better understand the requirements of emerging guidance, as well as trends in implementation of existing guidance through increasing interactions with audit firms and regulators. The past few months we have been increasing our formal and informal communications with the SEC, the FASB and a number of audit firms. We had the opportunity to meet the new SEC Fellow replacing Brian Fields who has focused on derivative issues during his tenure. We also had the opportunity to query the FASBs currency translation specialist and derivative project leader earlier in early January while developing the Advanced FAS52 course. PWC’s national office spent time with us reviewing trends and directions and we had the opportunity to discuss EYs preferences in regression testing. We plan to continue these proactive sessions with firms and regulators in an effort to continue bringing best practices to our clients in the always exciting derivative accounting landscape.
FASB announces Proposed Technical Update to ASC815 Hedge Accounting!
The FASB’s most recent board minutes announced that the hedge accounting model to be included in the exposure draft to ammend ASC815 will incorporate all changes to current hedge accounting proposed in the June 2008 FASB Exposure Draft, Accounting for Hedging Activities, except that the proposed Update would retain hedging of risk components (bifurcation-byrisk), which the Exposure Draft proposed to eliminate. Following are a few of the key elements in the original Exposure Draft that we feel might most impact our clients.
Effectiveness Testing & Measurement
As part of the hedge effectiveness assessment, entities would be required to demonstrate that changes in fair value of the hedging instrument would be reasonably effective in offsetting risk, as opposed to the current highly effective requirement.
Entities would be required to perform a qualitative (rather than quantitative) test at inception to demonstrate that a reasonably effective economic relationship exists between the hedging instrument and the hedged item or forecasted transaction. However, in certain situations a quantitative test may be necessary at inception. (No specifics have been provided as to what the qualitative testing might look like, or when a quantitative test might be required.) On an ongoing basis, an entity would only need to reassess effectiveness when circumstances suggest that the hedging relationship may no longer be reasonably effective.
The shortcut method and critical terms match method would be eliminated. An entity would no longer have the ability to assume a hedging relationship is reasonably effective and recognize no ineffectiveness in net income during the term of the hedge. This would converge with IAS39.
In a cash flow hedging relationship, ineffectiveness will be recognized on both over and under-hedging. Currently, ineffectiveness is only recognized to the extent the change in value of the derivative exceeds the change in value of the hedged item. This would introduce a divergence from IAS39.
The focus will move away from “testing” to “measurement” of actual ineffectiveness in the relationship.
Dedesignation of Hedging Relationship
Entities would not be permitted to discontinue hedge accounting by simply removing the designation of a hedging relationship. Hedge accounting can be discontinued only if the criteria for hedge accounting are no longer met or the hedging instrument expires, is sold, terminated, or exercised. Currently the designation can be removed at any time at the discretion of the entity. This would introduce a divergence from IAS 39.
Treatment of Option Premiums
Entities would be required to amortize the option premium to income on a “rational basis” over the hedging period, although incremental time value is still captured in OCI. This differs from current treatment under DIG G20 where the change in value of the option, including the premium, is captured in OCI until the underlying transaction is recognized, at which time the premium is reclassified to the P&L along with gains, if any. The rational basis is not clear. This may result in amortizing the option effect straightline, so the derivative would be recorded at fair value on balance sheet, an amount reflecting the straightline amortization to-date would be recorded in income, any ineffective amounts would be recorded in income and “the rest” would end up recorded in OCI. We will be issuing representative journal entries as soon as an exposure draft is issued should this be included. Anything other than marking to marketthe time value of the option through income will diverge from IAS39.
Hedging of Intercompany Items
The FASB may not be including the intercompany features originally represented in the exposure draft. Under the original proposals many corporate felt entities would be specifically prevented from hedging intercompany transactions unless the earning effect of that transaction survived consolidation.
It is unclear under the original draft how direct the connection needed to be between the intercompany and third party transactions.
Keep an Eye Out
We expect the exposure draft to be issued before the end of April and will be following the changes closely and will keep you updated on the timing, details and interpretations of these proposed changes as they are made available.
Most recent Board Minutes are available:
Advanced ASC 830 Topic
Considerations when Accounting for Other Comprehensive Income in a Foreign Currency Functional Subsidiary
Those of you familiar with ASC 830-30 (or more commonly known as FAS 52 Foreign Currency Translation) will recognize that as a rule all activity on the income statement is translated at the current income statement rate, assets and liabilities at the month end rate, and equity at its historic rate. The delta between the income statement rate and the balance sheet rate ends up recorded in Cumulative Translation Adjustment (CTA) as a change in equity. The rule set is so reliable a simple proof can and has been used as a control by corporate accounting organizations to support the amount of CTA recorded in a given period.
In preparation for the advanced FAS 52 (ASC 830) training course recently offered we prepared a translation example for a local currency functional subsidiary which hedged its non-functional currency anticipated cash flows under ASC 815 (FAS 133). The parent was USD reporting and we wanted to demonstrate how the foreign subsidiary’s results would consolidate into USD. One of the exercises of this example included “proofing” the CTA results upon consolidation. When the CTA proof did not produce the results expected, we had to investigate further how the items in equity were treated in the consolidation process. What we found was the component of Other Comprehensive Income (OCI) related to cash flow hedges wasn’t following the rules as we would have expected.
Inputs to OCI were being captured at the ISR (income statement rate) in one period and subsequent reclassifications to the P&L in a later period used the later period’s ISR. The OCI value changed in the same fashion inventory or deferred revenue changes its USD value while held in a foreign subsidiary. In effect, creating a CTA impact on the OCI balance. Was this appropriate or should OCI be reclassified at the original historic values? We approached the FASB informally and ran the issue past an ASC 830 expert together with an ASC815 expert and confirmed that indeed a CTA adjustment is created by the timing of inflows and outflows related to OCI.
Soon after preparing this course an audit firm challenged a client indicating that the reclassification of OCI to earnings must come through consolidation at the original historic rate. This would have required the company to override the translation process whereby all income statement activity is translated at the ISR. Thus, required tracking individual gains and losses back to USD based on the date each element of OCI had been recorded. However we were able to mitigate this situation and no changes were required as originally proposed by the audit firm.
We advise all clients to first determine if this situation impacts your organization and prepare how you will address this situation if it is highlighted as a part of your audit review.
Derivative Accounting Under IFRS
Key Differences from US GAAP
While the FASB continues to move forward with their technical updates to ASC815, the ultimate goal, as reflected in many of the proposed changes, will be convergence with the IAS39 (SEC set final vote on convergence for 2011). A recent PWC survey found that 15% of US companies are already reporting under IFRS, with an additional 75% already beginning to explore the impact of IFRS adoption. Wherever your company stands in this process, it is important to begin to understand some of the fundamental differences between IFRS and US GAAP. Under IFRS:
- Definition of a derivative requires no net settlement feature and no notional amount. The instrument need only have a value that changes in response to changes in underlying variables, require little or no initial net investment and be settled at a future date.
- Fair value is the amount at which an asset could be exchanged or a liability settled between knowledgeable willing parties – i.e. bid price for assets and ask price for liabilities, rather than mid- market pricing.
- Credit considered only in the pricing of assets, not liabilities, although this issue is currently under consideration.
- Benchmark hedging not limited to Treasuries and LIBOR.
- No documentation requirements surrounding normal purchase/normal sale, called “Own Use” contracts.
- No matched terms or short-cut assumptions.
- An entity cannot include option time value (a la G20) in hedged item for effectiveness purposes.
- Forecast transaction must be “highly probable” to occur under IFRS v. “probable” under US GAAP.
- Hedge Period: “a reasonably specific and narrow range of time” (No two month rule or DIG G16 accommodations).
- Parent can execute cash flow and net investment hedges on behalf of subsidiary regardless of functional currency.
- Allows basis adjustments to non-financial assets/liabilities rather than amortization of gain/loss from OCI for cash flow hedges, i.e. Fixed assets, inventory, deferred revenue.
- Non-financial instruments, such as cash, can be used as cash flow currency hedging instruments.
Hedge Trackers is currently outsourcing accounting for several companies reporting under IFRS, as well as advising others on the implications of making the transition. Please let us know if we can assist you in moving forward with this process, or just providing more basic background information.
Venezuela’s Three-Year Cumulative Inflation Rate Exceeds 100%
With the release of Venezuela’s December 2009 National Consumer Price Index, the cumulative three-year inflation rate exceeded 100%. As such, under ASC 830-10-45-122 an entity with a year or quarter end of December 31, 2010 should consider Venezuela’s economy to be highly inflationary as of January 1, 2010. Several accounting issues arise from this status.
First, during a highly inflationary period the functional currency of the Venezuelan entity must be considered the reporting currency of the consolidated entity and the financial statements beginning value in (USD) reporting currency for January 1, 2010 must be calculated.
ASC 830-30-45-6 (FAS 52 27(b)) indicates that in “the absence of unusual circumstances, the [exchange] rate applicable to conversion of a currency for purposes of dividend remittances shall be used to translate foreign currency statements”. There are two exchange rates in Venezuela – the official rate and the parallel rate. Until recently most companies were using the official rate; however the official rate is now unavailable for dividend remittances in many industries. The SEC has indicated that there is no “one size fits all” approach for registrants, and that the decision of which rate to use should be based upon the facts and circumstances specific to a company.
A functional currency change can also impact hedge accounting treatment. ASC 815-20-25-30(b) requires the hedged item in a foreign currency hedge, be “denominated in a currency other than the hedging unit’s functional currency.” As such, hedge accounting of USD in Venezuela may no longer be appropriate after the functional currency change because the hedged risk no longer represents a risk that is eligible for hedge accounting. Existing hedges may need to be redesignated against changes in Venezuelan denominated revenues or expenses.
Finally, there are additional disclosures related to the highly inflationary transition, as well as to the exchange rate issues. According to recent PWC guidance, registrants should disclosure:
- The inflation index used to determine highly inflationary status,
- Exchange rates (official vs. parallel rate) used for re-measurement and translation purposes, and if such exchange rates may not reflect economic reality.
- sks and accounting effect of an exchange rate change on future operations, financial position, and cash flows.
- Disclosures to enable an investor to assess the effect of Venezuelan entities on the consolidated financial statements and any reasonably likely material future effects on consolidated results and cash flows.
- Any expected material accounting effect upon transition to highly inflationary status as of January 1, 2010 for their Venezuelan entities.