As companies prepare to comply with 161 for the first time this quarter, several challenges emerge.
FAS 161 is effective for any reporting period beginning after 11/15/08, which basically means all companies must make 161 disclosures with their next filing. But knowing it should be done and figuring out how to do it are two very different things. Increasingly, companies and their advisers find that in order to comply with FAS 161, they must collect data that they may not already be capturing and report numbers that require some unexpected equations (especially in the case of hedges at foreign subsidiaries or late designations or re-designations). It is therefore crucial that companies begin to collect the required information ASAP, to identify any potential issues and resolve them ahead of the deadline for submitting the next financial statement.
161 = 133 + More
FAS 161 amended and expanded the disclosure requirements of FAS 133, specifically, paragraphs 44-45. The new disclosure requirements are designed to stimulate more robust answers to three basic questions:
1. How and why the entity is using derivative instruments;
2. How derivatives and related hedged items are accounted for under FAS 133 and related guidance; and
3. Finally, how the derivatives and hedges affect an entity financial position (balance sheet) and financial performance (income statement/P&L).
As was the case with FAS 133, the basic drive behind the derivative disclosure is to provide investors and regulators greater insight into not only the “what” of derivatives (how many, or at what fair value), but also the “why,” i.e., how the derivatives or other designated hedges achieve the company’s risk management objectives, and “how and where” does the gain or loss from the instruments affect companies’ financial position (balance sheet) as well as its financial performance (the P&L).
Under FAS 161, companies are required to discuss their derivative activities, volume and objectives by first dividing up their contracts into (1) trading; and (2) risk-management derivatives (which include non-designated derivatives). The information 161 demands should be presented in tables, and further organized by risk type (FX, Interest Rate, Commodity or Credit), as well as hedge designation (cash flow, fair value and hedges of net investment in a foreign subsidiary).
Breaking It All Down
At first sight, the disclosure requirements do not sound all that different from the current FAS 133 disclosures. Indeed, because 161 amended FAS 133, the revamped disclosures are to be made along with other 133 disclosures, and not in a separate footnote.
As companies begin to prepare their 161 tables in time for next period-end, many find that they are facing a host of unexpected difficulties. Below are some of the issues Hedge Trackers has encountered to date; this checklist of potential difficulties can help companies prepare for FAS 161’s disclosures.
1. A complete time series. While every company will have to comply with FAS 161 for the current quarter, any company with a year-end other than Dec 31, 2009 will face a data challenge: FAS 161 requires disclosures for earlier periods for comparative purposes beginning in the first year after the year of initial adoption. Take the case of a 3/31/09 year-end company, which adopted 161 for Q4 of its fiscal year. When it comes time to compare data year over year income statement, the company will only have a single quarter of data for 2009 compared to four quarters for 2010. The only way to make sure the 2010 comparisons make sense is to collect a full year of data, and that will be easier to collect now.
2. Currency contract delivered versus net settled gains/losses. FAS 161requires that companies keep track and disclose the gain or loss on each derivative, whether the company took delivery or settled using a compensating contract. Currently, the price of value of the derivative upon settlement, be it via a compensating contract or actual delivery, is not generally captured for financial reporting purposes.
As a result, companies need to figure out what “convention” to use when capturing the fair value of the derivative at its termination date. Approaches might include using a market rate on settlement date, using the income statement rate for the period or even the prior period end rate. It’s easier to figure out the exit price when derivatives are settled via a compensating or offsetting contract. In such cases, the net cash represents the contract’s terminal value. It is a lot less clear when the company takes actual delivery. Either way, to comply with 161, companies must be able to capture the gain or loss on the derivative at termination, and disclose it using an appropriate rate assumption, whether it is a non-designated, cash flow fair value or net investment hedge.
3. Consolidating derivative data held by non-US entities. FAS 161 poses another substantial challenge: it requires companies to quantify and disclose year to date gains and losses on derivatives (outstanding and closed) on the books of their foreign subsidiaries (see example below). Foreign subsidiaries already capture the changes in the fair value of any derivative hedges, and record those in OCI or income, the effective and ineffective and/or excluded amounts in their functional currency. Under FAS 161, the parent company must now also capture the “life cycle” of the derivative and translate the changing value (effective, ineffective or excluded portions), which begs the question: at what rate? This question must be addressed for each of the financial performance/income statement tables. Companies will need a translation approach to produce the consolidated disclosures.
FAS 161 Disclosures for Derivatives Held by a Foreign Entity
Example: A euro-functional entity of a US Company sold British pound six months forward. Each month, the euro value of the 6M forward increased by EUR20. At the end of the period, the contract closed out at EUR120 profit. During that six months period, the EUR/USD rate increased .05 per month, from 1.30 to 1.60. How will your company capture the USD gain in your FAS 161 table? Next assume the gains and losses did not come in ratably and rates did not move ratably and the complexity of capturing the gains and losses on numerous contracts over different periods is manifest.
4. Dig up the collateral. Another important aspect of FAS 161 is that it requires companies to scan their debt and other financial instruments or arrangements for any event or clause that would trigger a collateral call on a derivative. FAS 161’s Paragraph 44d instructs companies to disclose for any annual and interim reporting period for which a statement of financial position is prepared: (a) “The existence and nature of credit risk related contingent features and the circumstances in which the features would be triggered in derivative instruments that are in a net liability position at the end of the reporting period.” Such feature may be embedded in a debt covenant or an ISDA agreement.
5. Check your references. FAS 161 also emphasizes the requirement to cross-reference footnotes in the financial statements. Paragraph 44E instructs companies as follows: “If information on derivative instruments is disclosed in more than a single footnote, an entity shall cross reference from the derivative footnote to other footnotes in which derivative related information is disclosed.” Cross referencing is required, not optional. Our current understanding is that a company is not required to cross reference to MD&A, however it might further the FASB objective of assisting the reader in identifying all the relevant information in the 10-K or 10-Q.
6. Figuring out how and how much. In raising the bar on derivative disclosures, FAS 161 requires companies to disclose the extent of their derivative activities, i.e., the volume of contracts, but it stops short of providing a format for such information. Instead, the FASB left that decision to management. In its amendment of paragraph 44 of FAS 133, FAS 161 instructs companies to provide “information that would enable users of its financial statements to understand the volume of its derivative activity. Entities shall select the formats and specifics… that are most relevant and practicable for their individual facts and circumstances”.
7. No netting (how gross). FAS 161 makes another important distinction: According to the standard, “The fair value of derivative instruments should be presented on a gross basis, even when the derivative instruments are subject to master netting arrangements and qualify for net presentation in the statement of financial position in according with FASB Interpretation 39, “Offsetting of Amounts Related to Certain Contracts.”
Conclusion: Getting It All Together
It’s hard to do things right, when scrambling for information under increasingly tight reporting deadlines. The first time won’t be easy, but there are a couple of key decisions managements must make at the outset so that current and future tables make sense:
1. What rate to use for converting the derivative P&L, excluded portion, ineffective portion, effective
portions and any amounts reclassed out of OCI on subsidiaries’ balance sheet?
2. How to calculate the end price of a derivative if the company took delivery of the currency vs. an offsetting spot?
3. Calculating the gain or loss on realized hedged items.
4. Finally – how much context to provide in order to make sense of volume data. If a company has significant derivative positions (and those are presented on a gross basis), management may want to put those numbers within context, e.g., the volume of business activity in the particular currency, or the offsetting debt outstanding.
