December 2008 Newsletter
A Quarterly FAS 133 Update from Hedge Trackers, LLC
Mission Critical
- Get a head start. The past two quarters’ astronomical volatility levels are bound to produce some nasty surprises. To avoid last minute shocks, we urge you to (1) work with auditors to review your hedge program and valuation approaches prior to year end; and (2) execute as many hedges as you can midmonth to avoid year-end market illiquidity.
- FAS 161 effective date. FASB amended FAS 161′s effective date to any reporting period beginning after November 15, ’08. (See story on next page.) Note: Hedge Trackers will provide training on FAS 161 disclosures on Dec. 15, ’08. (See more on our website: www.hedgetrackers.com)
- FAS 133r in low gear. The initial FASB effort to fast-track the overhaul of FAS 133 (FAS 133r) has been sidetracked. The project was folded into a broader conversion effort with the IASB.
- Watch out for non-performance risks. FAS 157 requires companies to include nonperformance risk in calculating hedge effectiveness. As highly rated counterparties are downgraded, swollen or simply go bankrupt, companies with derivatives in asset positions may see a significant impact on fair value resulting in ineffectiveness in hedges.
- The risk of (il)liquidity. The credit markets contraction created FX and IR pricing anomalies. Typically, inefficiencies would have quickly evaporated via arbitrage. Not this time. A frozen interbank market has prevented active trading.
From Helen’s Desk
CPE Conference Brief
The sometimes uncomfortable marriage between FAS 133 and 157
Last month, I attended and chaired CPE’s Derivative Accounting Conference. I want to take this opportunity to share some of the key takeaways. Perhaps the most important (and most troubling) discussion revolved around the interaction between FAS 133 and 157, e.g., how derivative hedge accounting concepts align with 157′s requirement to take the entity’s own and the counterpart credit, when measuring fair value.
With the FASB’s Bob Wilkins and Brian Fields, a fellow at the SEC’s Office of the Chief Accountant in attendance, participants had a unique opportunity to hear firsthand the Board and the SEC’s view on this topic. In several cases, the standard setters’ responses were quite counterintuitive and even disturbing.
Effects on FAS 133 journal entries
The standard setters began by reiterating some of the core principles in FAS 133, particularly the concept that only time value (or forward points) can be excluded from effectiveness testing and recorded directly in earnings. FAS 157 has added a new twist: how to handle the fair value changes attributable to credit risk for cash flow hedges?
Under 133, effectiveness tests address the derivative’s ability to offset the gains or losses attributable to the hedged risk. Although hedgers can bifurcate the risk for assessment purposes, when it’s time to record journal entries, the credit risk must be addressed.
Mr. Wilkins indicated that the guidance in the recently issued FAS 133r (the ED is currently on indefinite hold) highlights the acceptable (and perhaps preferred) method of measuring ineffectiveness by attributing the credit features of the derivative to the hedged item.
Asset/Liabilities flip flopping
Under FAS 157, when discounting the fair value of an interest-rate swap to adjust for credit changes, the result can be counterintuitive. In some cases, the credit-related effects on the fair value of a swap may turn a swap asset (using standard market valuation) into a liability (post-credit effect) and vice versa.
This asset/liability flip flop takes place when changes to fair value attributable to changes in the credit of one of the parties not only reduces an asset to zero, but moves it to the other side of the balance sheet.
Both the FASB’s Mr. Wilkins and Mr. Fields, of the SEC indicated they were comfortable with the principle, an approach that one of the attendees labeled as “Mark to Make Believe.”
Looking for bright lines
Finally another recurring theme was the dissonance between the FASB’s efforts to provide principals-based guidance and the push by regulators and the audit firms’ to identify a single correct answer.
All in all it was a stimulating conference and I look forward to chairing the next conference May 14-15 in Washington D.C.
FASB Changes the Effective Date for FAS 161
Effective September 12, ’08, the FASB issued an FSP that clarifies the effective date of FAS 161, the derivatives accounting disclosure standard. The amended paragraph requires companies to adopt 161′s disclosure for any reporting period (Qs or Ks) beginning after November 15, 2008.
As a result, all companies – regardless of fiscal year-end – must prepare to make 161 disclosures for any reporting period in 2009. For companies with calendar year-end, 161 will begin on January 1, 2009 with Q1 disclosures. March 31 year-end companies will adopt FAS 161 for Q4 and will begin data capture 1/1/’09. Companies with October 31 fiscal year-end must adopt 161 Q2 or period beginning Feb. 1, ’09.
How to Measure Non-Performance Risk
Over the past quarter, credit risk concerns shot into stratospheric levels. How does the rise in non-performance risk and widening CDS spreads affect corporate end users? The answer is in the interface between FAS 133 and FAS 157, which provides guidance on how to measure the fair value of financial instruments.
Taking inventory
Companies with outstanding FX, IR or commodities contracts (in an asset position) with bankrupt, downgraded or other institutions that have seen their CDS spreads widen significantly, must take their counterparties’ non-performance risk into account when performing effectiveness tests. [For appropriate guidance, look to DIG Issue G10 (or F.4.3 in IAS 39.]
In a nutshell, the GAAP guidance is as follows:
- Cash flow hedges. Once it’s probable that the counterparty will default, the hedging company is no longer able to assert that the hedging relationship is expected to be highly effective. As a result, the company must discontinue hedge accounting and will need to write down the derivatives’ asset position.
- Fair value hedges. The credit impact will hit the derivative’s fair value; however, because the component of the derivative fair value that offsets changes in the benchmark rates will likely remain unaffected, only the credit-related ineffectiveness must be recognized in earnings.
Playing Catch Up
As of Q3/08, it appeared that auditors were only beginning to formulate their official guidance; however, the gist of the guidance is as follows:
- Termination of a hedge (either because you have closed the hedge or because the counterparty declares bankruptcy), does NOT cause a movement of gains or losses out of OCI or any carrying value adjustments to be reversed from hedged items in fair value hedges.
- Hedge accounting is still “good” up to the point that the hedge must be terminated because the counterparty is no longer deemed creditworthy. It doesn’t invalidate the application of hedge accounting up until that point, nor does it trigger any release from OCI.
- If a derivative asset has to be written down to near zero, the write down is immediate and impacts earnings, but the OCI balance pre credit event remains untouched until the hedged item is recorded.
A possible broader effect may be for corporates to consider trading on the exchanges where there’s zero performance risk; and/or require collateral from their financial counterparties.
Resisting the OCI Temptation
The past months’ volatility in FX rates (in particular the rise in the US dollar) and the worsening global economic situation may affect corporate cash flow hedges in two ways:
- The nearly across-the-board rise in the USD may lead to substantial gains in OCI for hedges covering a long non-USD position; meanwhile
- Actual revenues may fall short of quarterly forecasts.
However, just because companies don’t make their “numbers” does not mean they can automatically take the large gains in OCI on hedges designated for that hedge period and record them in earnings, no matter how tempting.
Under FAS 133 cash-flow hedge requirement, as long as the expected transaction is still probable to occur within an additional two months period (following the hedge period), the gains or losses in OCI that are related to the forecasted transaction must remain in OCI. Only the portion of OCI that is related to the actual revenues can be recorded in income. The accounting in this case is consistent with the economic intent of the hedge. Hedges of expected revenue are designed to deliver a rate, not a gain. Their job is to provide management with predictability as to the expected dollar value corresponding to FX-denominated revenue streams. While the economic down turn certainly makes these OCI gains look particularly attractive, they are inaccessible, at least for now. [Please refer to paragraph 33 and DIG G3 is for further information on this issue.]
Upcoming Hedge Trackers Training
- Dec. 17 (2008) – FAS 161/157 – GAAP Update
- January 22 – FAS 52 & FAS 133 – Key Concepts – 2 Half Days
- January 23 – FAS 133 Practical Applications – Half Day
- February 26 – FAS 161 and FAS 133 – Key Concepts – 2 Half Days
- February 27 – FAS 133 Practical Applications – Half Day
- March 19 – FAS 52 and FAS 133 – Key Concepts – 2 Half Days
- March 20 FAS 133 Practical Applications – Half Day
- April 17– FAS 161/157 – GAAP Update
- May 21 – FAS 52 and FAS 133 Key Concepts – 2 Half Days
- May 22 – FAS 133 Practical Applications – Half Day
- June 23 – Interest Rates & Commodities – 2 Half Days
- July 27 – FAS 52 and FAS 133 Key Concepts – 2 Half Days
- July 28 – FAS 133 Practical Applications – Half Day
- August 19 – IFRS – Half Day
- September 24 – FAS 52 and FAS 133 Key Concepts – 2 Half Days
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