114 - National Association of Insurance Commissioners

114 - National Association of Insurance Commissioners
Statutory Issue Paper No. 114
Accounting for Derivative Instruments and Hedging Activities
STATUS
Finalized October 16, 2001
Original SSAP and Current Authoritative Guidance: SSAP No. 86
Type of Issue
Common Area
SUMMARY OF ISSUE
1.
SSAP No. 31—Derivative Instruments (SSAP No. 31) contains guidance on accounting for
derivative instruments. The applicable GAAP guidance is included in Financial Accounting Standard No.
133, Accounting for Derivative Instruments and Hedging Activities (FAS 133), FAS 137, Accounting for
Derivative Instruments and Hedging Activities—Deferral of the Effective Date of FASB Statement No.
133 an amendment of FASB Statement No. 133 (FAS 137), FAS 138, Accounting for Certain Derivative
Instruments and Certain Hedging Activities—an amendment of FASB Statement No. 133 (FAS 138) and
their related Emerging Issues Task Force Issues.
2.
The purpose of this issue paper is to address the concepts outlined in FAS 133 and establish a
comprehensive statutory accounting model for derivative instruments. This issue paper will also reassess
the provisions of SSAP No. 31. The result will be a new SSAP, which will supersede SSAP No. 31. The
purpose also includes development of an accounting model for derivatives that is consistent with the
Statutory Accounting Principles Statement of Concepts and Statutory Hierarchy (Statement of Concepts).
SUMMARY CONCLUSION:
3.
SSAP No. 31 is superseded in its entirety by the conclusions outlined in this issue paper.
4.
This issue paper addresses the recognition of derivatives and measurement of derivatives used in:
a.
b.
c.
Hedging transactions;
Income generation transactions; and
Replication transactions
Definitions (for purposes of this issue paper)
5.
“Derivative instrument” means an agreement, option, instrument or a series or combination
thereof:
a.
To make or take delivery of, or assume or relinquish, a specified amount of one or more
underlying interests, or to make a cash settlement in lieu thereof; or
b.
That has a price, performance, value or cash flow based primarily upon the actual or
expected price, level, performance, value or cash flow of one or more underlying
interests.
6.
Derivative instruments include, but are not limited to; options, warrants used in a hedging
transaction and not attached to another financial instrument, caps, floors, collars, swaps, forwards, futures
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and any other agreements or instruments substantially similar thereto or any series or combination
thereof.
a.
“Caps” are option contracts in which the cap writer (seller), in return for a premium,
agrees to limit, or cap, the cap holder’s (purchaser) risk associated with an increase in a
reference rate or index. For example, in an interest rate cap, if rates go above a specified
interest rate level (the strike price or the cap rate), the cap holder is entitled to receive
cash payments equal to the excess of the market rate over the strike price multiplied by
the notional principal amount. Because a cap is an option-based contract, the cap holder
has the right but not the obligation to exercise the option. If rates move down, the cap
holder has lost only the premium paid. A cap writer has virtually unlimited risk resulting
from increases in interest rates above the cap rate;
b.
“Collar” means an agreement to receive payments as the buyer of an option, cap or floor
and to make payments as the seller of a different option, cap or floor;
c.
“Floors” are option contracts in which the floor writer (seller), in return for a premium,
agrees to limit the risk associated with a decline in a reference rate or index. For example,
in an interest rate floor, if rates fall below an agreed rate, the floor holder (purchaser) will
receive cash payments from the floor writer equal to the difference between the market
rate and an agreed rate multiplied by the notional principal amount;
d.
“Forwards” are agreements (other than a futures) between two parties that commit one
party to purchase and the other to sell the instrument or commodity underlying the
contract at a specified future date. Forward contracts fix the price, quantity, quality, and
date of the purchase and sale. Some forward contracts involve the initial payment of cash
and may be settled in cash instead of by physical delivery of the underlying instrument;
e.
“Futures” are standardized forward contracts traded on organized exchanges. Each
exchange specifies the standard terms of futures contracts it sponsors. Futures contracts
are available for a wide variety of underlying instruments, including insurance,
agricultural commodities, minerals, debt instruments (such as U.S. Treasury bonds and
bills), composite stock indices, and foreign currencies;
f.
“Options” are contracts that give the option holder (purchaser of the option rights) the
right, but not the obligation, to enter into a transaction with the option writer (seller of the
option rights) on terms specified in the contract. A call option allows the holder to buy
the underlying instrument, while a put option allows the holder to sell the underlying
instrument. Options are traded on exchanges and over the counter;
g.
“Swaps” are contracts to exchange, for a period of time, the investment performance of
one underlying instrument for the investment performance of another underlying
instrument, typically without exchanging the instruments themselves. Swaps can be
viewed as a series of forward contracts that settle in cash rather than by physical delivery.
Swaps generally are negotiated over-the-counter directly between the dealer and the end
user. Interest rate swaps are the most common form of swap contract. However, foreign
currency and commodity swaps also are common;
h.
“Warrants” are instruments that give the holder the right to purchase an underlying
financial instrument at a given price and time or at a series of prices and times outlined in
the warrant agreement. Warrants may be issued alone or in connection with the sale of
other securities, for example, as part of a merger or recapitalization agreement, or to
facilitate divestiture of the securities of another business entity.
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7.
“Firm commitment” is an agreement with an unrelated party, binding on both parties and
expected to be legally enforceable, with the following characteristics:
a.
The agreement specifies all significant terms, including the quantity to be exchanged, the
fixed price, and the timing of the transaction. The fixed price may be expressed as a
specified amount of an entity’s functional currency or of a foreign currency. It may also
be expressed as a specified interest rate or specified effective yield;
b.
The agreement includes a disincentive for nonperformance that is sufficiently large to
make performance probable; and
c.
For investments in subsidiary, controlled, and affiliated entities (as defined by SSAP No.
46—Investments in Subsidiary, Controlled, and Affiliated Entities) and investments in
limited liability companies (as defined by SSAP No. 48—Joint Ventures, Partnerships
and Limited Liability Companies) it must be probable that acquisition will occur within a
reasonable period of time.
8.
A hedging transaction is defined as a derivative transaction which is entered into and maintained
to reduce:
a.
The risk of a change in the fair value or cash flow of assets and liabilities which the
reporting entity has acquired or incurred or has a firm commitment to acquire or incur or
for which the entity has forecasted acquisition or incurrence; or
b.
The currency exchange rate risk or the degree of exposure as to assets and liabilities
which a reporting entity has acquired or incurred or has a firm commitment to acquire or
incur or for which the entity has forecasted acquisition or incurrence.
9.
“Income generation transaction” is defined as derivatives written or sold to generate additional
income or return to the reporting entity. They include covered options, caps, and floors (e.g., a reporting
entity writes an equity call option on stock that it already owns).
10.
“Replication (Synthetic Asset) transaction” is a derivative transaction entered into in conjunction
with other investments in order to reproduce the investment characteristics of otherwise permissible
investments. A derivative transaction entered into by an insurer as a hedging or income generation
transaction shall not be considered a replication (synthetic asset) transaction.
11.
“Forecasted transaction” is a transaction that is expected to occur for which there is no firm
commitment. Because no transaction or event has yet occurred and the transaction or event when it
occurs will be at the prevailing market price, a forecasted transaction does not give an entity any present
rights to future benefits or a present obligation for future sacrifices.
12.
An “underlying” is a specified interest rate, security price, commodity price, foreign exchange
rate, index of prices or rates, or other variable. An underlying may be a price or rate of an asset or
liability but is not the asset or liability itself.
Embedded Derivative Instruments
13.
Contracts that do not in their entirety meet the definition of a derivative instrument, such as
bonds, insurance policies, and leases, may contain “embedded” derivative instruments—implicit or
explicit terms that affect some or all of the cash flows or the value of other exchanges required by the
contract in a manner similar to a derivative instrument. The effect of embedding a derivative instrument
in another type of contract (“the host contract”) is that some or all of the cash flows or other exchanges
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that otherwise would be required by the contract, whether unconditional or contingent upon the
occurrence of a specified event, will be modified based on one or more underlyings. An embedded
derivative instrument shall not be separated from the host contract and accounted for separately as a
derivative instrument.
Impairment
14.
This issue paper adopts the impairment guidelines established by SSAP No. 5—Liabilities,
Contingencies and Impairments of Assets (SSAP No. 5) for the underlying financial assets or liabilities.
Recognition and Measurement of Derivatives Used in Hedging Transactions
15.
Derivative instruments represent rights or obligations that meet the definitions of assets (SSAP
No. 4—Assets and Nonadmitted Assets) or liabilities (SSAP No. 5) and shall be reported in financial
statements. In addition, derivative instruments also meet the definition of financial instruments as defined
in SSAP No. 27—Disclosure of Information about Financial Instruments with Off-Balance-Sheet Risk,
Financial Instruments with Concentrations of Credit Risk and Disclosures about Fair Value of Financial
Instruments (SSAP No. 27). Should the cost basis of the derivative instrument be undefined (i.e., no
premium is paid), the instrument shall be disclosed in accordance with paragraphs 8-10 of SSAP No. 27.
Derivative instruments are admitted assets to the extent they conform to the requirements of this issue
paper.
16.
Derivative instruments used in hedging transactions that meet the criteria of a highly effective
hedge shall be considered an effective hedge and valued and reported in a manner that is consistent with
the hedged asset or liability (referred to as hedge accounting). For instance, assume an entity has a
financial instrument on which it is currently receiving income at a variable rate but wishes to receive
income at a fixed rate and thus enters into a swap agreement to exchange the cash flows. If the
transaction qualifies as an effective hedge and a financial instrument on a statutory basis is valued and
reported at amortized cost, then the swap would also be valued and reported at amortized cost. Derivative
instruments used in hedging transactions that do not meet the criteria of an effective hedge shall be
accounted for at fair value and the changes in the fair value shall be recorded as unrealized gains or
unrealized losses (referred to as fair value accounting).
17.
Entities shall not bifurcate the effectiveness of derivatives. A derivative instrument is either
classified as an effective hedge or an ineffective hedge. Entities must account for the derivative using fair
value accounting if it is deemed to be ineffective. Entities may redesignate a derivative in a hedging
relationship even though the derivative was used in a previous hedging relationship that proved to be
ineffective. An entity shall prospectively discontinue hedge accounting for an existing hedge if any one
of the following occurs:
a.
Any criterion in paragraphs 20-23 is no longer met;
b.
The derivative expires or is sold, terminated, or exercised (impact recorded as realized
gains or losses or, for effective hedges of firm commitments or forecasted transactions, in
a manner that is consistent with the hedged transaction – see paragraph 18);
c.
The entity removes the designation of the hedge; or
d.
The derivative is deemed to be impaired in accordance with paragraph 14. A permanent
decline in a counterparty’s credit quality/rating is one example of impairment required by
paragraph 14, for derivatives used in hedging transactions.
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18.
For those derivatives which qualify for hedge accounting, the change in the carrying value or
cash flow of the derivative shall be recorded consistently with how the changes in the carrying value or
cash flow of the hedged asset, liability, firm commitment or forecasted transaction are recorded.
Hedge Designations
19.
An entity may designate a derivative instrument as hedging the exposure to:
a.
Changes in the fair value of an asset or a liability or an identified portion thereof that is
attributable to a particular risk. This type of hedge can be utilized regardless of whether
the hedged asset or liability is recorded in the financial statements at fair value;
b.
Variability in expected future cash flows that is attributable to a particular risk. That
exposure may be associated with an existing recognized asset or liability (such as all or
certain future interest payments on variable-rate debt) or a forecasted transaction; or
c.
Foreign currency exposure. Specific examples include a fair value or cash flow hedge of
a firm commitment or financial instrument.
Fair Value Hedges
20.
Fair value hedges qualify for hedge accounting if all of the following criteria are met:
a.
At inception of the hedge, the formal documentation requirements of paragraph 26 are
met;
b.
Both at inception of the hedge and on an ongoing basis, the hedging relationship must be
highly effective in achieving offsetting changes in fair value attributable to the hedged
risk during the period that the hedge is designated. An assessment of effectiveness is
required whenever financial statements or earnings are reported, and at least every three
months. All assessments of effectiveness shall be consistent with the risk management
strategy documented for that particular hedging relationship;
c.
The term highly effective has the same meaning as the notion of high correlation as
utilized in FAS No. 80, Accounting for Futures Contracts (FAS 80). As a result, highly
effective describes a fair value hedging relationship where the change in the fair value of
the derivative hedging instrument is within 80 to 125 percent of the opposite change in
the fair value of the hedged item attributable to the hedged risk. It shall also apply when
an R-squared of .80 or higher is achieved when using a regression analysis technique.
Further guidance on determining effectiveness can be found within Exhibit A and B;
d.
The hedged item is specifically identified as either all or a specific portion of a
recognized asset or liability or of an unrecognized firm commitment. The hedged item is
a single asset or liability (or a specific portion thereof) or is a portfolio of similar assets or
a portfolio of similar liabilities (or a specific portion thereof); and
e.
If similar assets or similar liabilities are aggregated and hedged as a portfolio, the
individual assets or individual liabilities must share the risk exposure for which they are
designated as being hedged. The change in fair value attributable to the hedged risk for
each individual item in a hedged portfolio must be expected to respond in a generally
proportionate manner to the overall change in fair value of the aggregate portfolio
attributable to the hedged risk.
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Cash Flow Hedges
21.
Cash flow hedges qualify for hedge accounting if all of the following criteria are met:
a.
At inception of the hedge, the formal documentation requirements of paragraph 26 are
met;
b.
Both at inception of the hedge and on an ongoing basis, the hedging relationship shall be
highly effective in achieving offsetting cash flows attributable to the hedged risk during
the term of the hedge. An assessment of effectiveness is required whenever financial
statements or earnings are reported, and at least every three months. All assessments of
effectiveness shall be consistent with the originally documented risk management
strategy for that particular hedging relationship; and
c.
The term highly effective has the same meaning as the notion of high correlation as
utilized in FAS No. 80. As a result, highly effective describes a cash flow hedging
relationship where the change in the cash flows of the derivative hedging instrument is
within 80 to 125 percent of the opposite change in the cash flows of the hedged item
attributable to the hedged risk. It shall also apply when an R-squared of .80 or higher is
achieved when using a regression analysis technique. Further guidance on determining
effectiveness can be found within Exhibit A and B.
Hedging Forecasted Transactions
22.
A forecasted transaction is eligible for designation as a hedged transaction in a cash flow hedge if
all of the following additional criteria are met:
a.
The forecasted transaction is specifically identified as a single transaction or a group of
individual transactions. If the hedged transaction is a group of individual transactions,
those individual transactions must share the same risk exposure for which they are
designated as being hedged. Thus, a forecasted purchase and a forecasted sale cannot
both be included in the same group of individual transactions that constitute the hedged
transaction.
b.
The occurrence of the forecasted transaction is probable. An assessment of the likelihood
that a forecasted transaction will take place should not be based solely on management's
intent because intent is not verifiable. The transaction's probability should be supported
by observable facts and the attendant circumstances. Consideration should be given to the
following circumstances in assessing the likelihood that a transaction will occur:
i.
ii.
iii.
iv.
v.
The frequency of similar past transactions;
The financial and operational ability of the entity to carry out the transaction;
Substantial commitments of resources to a particular activity (for example, a
manufacturing facility that can be used in the short run only to process a
particular type of commodity);
The extent of loss or disruption of operations that could result if the transaction
does not occur; and
The likelihood that transactions with substantially different characteristics might
be used to achieve the same business purpose (for example, an entity that intends
to raise cash may have several ways of doing so, ranging from a short-term bank
loan to a common stock offering).
The term probable requires a significantly greater likelihood of occurrence than the
phrase more likely than not. In addition, both the length of time until a forecasted
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transaction is projected to occur and the quantity of the forecasted transaction are
considerations in determining probability. Other factors being equal, the more distant a
forecasted transaction is, the less likely it is that the transaction would be considered
probable and the stronger the evidence that would be needed to support an assertion that
it is probable. For example, a transaction forecasted to occur in five years may be less
likely than a transaction forecasted to occur in one year. However, forecasted interest
payments for the next 20 years on variable-rate debt typically would be probable if
supported by an existing contract. Additionally, other factors being equal, the greater the
physical quantity or future value of a forecasted transaction, the less likely it is that the
transaction would be considered probable and the stronger the evidence that would be
required to support an assertion that it is probable. For example, less evidence generally
would be needed to support forecasted investments of $100,000 in a particular month
than would be needed to support forecasted investments of $950,000 in that month by an
entity, even if its investments have averaged $950,000 per month for the past 3 months.
A forecasted transaction that is expected to occur with 2 months of the original forecasted
date (or time frame) may still be considered probable. If the transaction will not occur
until greater than 2 months after the original forecasted date, it is no longer probable and
will be accounted for as per the following paragraph.
If a forecasted transaction is determined to no longer be probable per the standards above,
hedge accounting shall cease immediately and any deferred gains or losses on the
derivative must be recognized in unrealized gains or losses. If an entity demonstrates a
pattern of determining that hedged forecasted transactions probably will not occur, such
action would call into question both the entity's ability to accurately predict forecasted
transactions and the propriety of using hedge accounting in the future for similar
forecasted transactions. Accordingly, hedging of forecasted transactions will no longer
be permitted by that entity.
c.
If the hedged transaction is the forecasted purchase or sale of a nonfinancial asset, the
designated risk being hedged is (1) the risk of changes in the functional-currencyequivalent cash flows attributable to changes in the related foreign currency exchange
rates or (2) the risk of changes in the cash flows relating to all changes in the purchase
price or sales price of the asset (reflecting its actual location if a physical asset), not the
risk of changes in the cash flows relating to the purchase or sale of a similar asset in a
different location or of a major ingredient.
d.
If the hedged transaction is the forecasted purchase or sale of a financial asset or liability
or the variable cash inflow or outflow of an existing financial asset or liability, the
designated risk being hedged is (1) the risk of changes in the cash flows of the entire
asset or liability, such as those relating to all changes in the purchase price or sales price
(regardless of whether that price and the related cash flows are stated in the entity’s
functional currency or a foreign currency), (2) the risk of changes in its cash flows
attributable to changes in the designated benchmark interest rate, (3) the risk of changes
in the functional-currency-equivalent cash flows attributable to changes in the related
foreign currency exchange rates, or (4) the risk of changes in its cash flows attributable to
default or changes in the obligor’s creditworthiness, and changes in the spread over the
benchmark interest rate with respect to the hedged item’s credit sector at inception of the
hedge. Two or more of the above risks may be designated simultaneously as being
hedged. The benchmark interest rate being hedged in a hedge of interest rate risk must
specifically be identified as part of the designation and documentation at the inception of
the hedging relationship. An entity may not designate prepayment risk as the risk being
hedged.
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Foreign Currency Hedges
23.
For foreign currency hedges, this issue paper adopts paragraphs 36-42 (except for last sentence of
paragragh 38) of FAS No. 133 and paragraphs 4.b.- 4.o. of FAS No. 138 which amend FAS No. 133.
Hedge Effectiveness
24.
The measurement of hedge effectiveness for a particular hedging relationship shall be consistent
with the entity’s risk management strategy and the method of assessing hedge effectiveness that was
documented at the inception of the hedging relationship, as discussed in paragraph 26.
25.
The gain or loss on a derivative designated as a cash flow hedge and assessed to be effective is
reported consistently with the hedged item. If an entity’s defined risk management strategy for a
particular hedging relationship excludes a specific component of the gain or loss, or related cash flows, on
the hedging derivative from the assessment of hedge effectiveness (as discussed in Exhibit B), that
excluded component of the gain or loss shall be recognized as an unrealized gain or loss. For example, if
the effectiveness of a hedge with an option contract is assessed based on changes in the option’s intrinsic
value, the changes in the option’s time value would be recognized in unrealized gains or losses. Time
value is equal to the fair value of the option less its intrinsic value.
Documentation Guidance
26.
27.
At inception of the hedge, documentation must include:
a.
A formal documentation of the hedging relationship and the entity’s risk management
objective and strategy for undertaking the hedge, including identification of the hedging
instrument, the hedged item, the nature of the risk being hedged, and how the hedging
instrument’s effectiveness in offsetting the exposure to changes in the hedged item’s fair
value or variability in cash flows attributable to the hedged risk will be assessed. There
must be a reasonable basis for how the entity plans to assess the hedging instrument’s
effectiveness;
b.
An entity’s defined risk management strategy for a particular hedging relationship may
exclude certain components of a specific hedging derivative’s change in fair value, such
as time value, from the assessment of hedge effectiveness, as discussed in paragraph 63
of FAS 133;
c.
Signature of approval, for each instrument, by person(s) authorized, either by the entity's
board of directors or a committee authorized by the board, to approve such transactions;
and
d.
A description of the reporting entity's methodology used to verify that opening
transactions do not exceed limitations promulgated by the state of domicile.
For all derivatives terminated, expired, or exercised during the year:
a.
Signature of approval, for each instrument, by person(s) authorized, either by the entity's
board of directors or a committee authorized by the board, to approve such transactions;
b.
A description, for each instrument, of the nature of the transaction, including:
i.
The date of the transaction;
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ii.
iii.
iv.
v.
vi.
vii.
28.
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A complete and accurate description of the specific derivative, including
description of the underlying securities, currencies, rates, indices, commodities,
derivatives, or other financial market instruments;
Number of contracts or notional amount;
Date of maturity, expiry or settlement;
Strike price, rate or index (termination price for futures contracts);
Counterparty, or exchange on which the transaction was traded; and
Consideration paid or received, if any, on termination.
c.
Description of the reporting entity's methodology to verify that derivatives were effective
hedges; and
d.
Identification of any derivatives that ceased to be effective as hedges.
For derivatives open at quarter-end:
a.
b.
c.
d.
A description of the methodology used to verify the continued effectiveness of hedges;
An identification of any derivatives which have ceased to be effective as hedges;
A description of the reporting entity's methodology to determine fair values of
derivatives;
Copy of Master Agreements, if any, where indicated on Schedule DB Part E Section 1.
Recognition and Measurement of Derivatives Used in Income Generation Transactions
General
29.
Income generation transactions are defined as derivatives written or sold to generate additional
income or return to the reporting entity. They include covered options, caps, and floors (e.g., a reporting
entity writes an equity call option on stock that it already owns).
30.
Because these transactions require writing derivatives, they expose the reporting entity to
potential future liabilities for which the reporting entity receives a premium up front. Because of this risk,
dollar limitations and additional constraints are imposed requiring that the transactions be "covered" (i.e.,
offsetting assets can be used to fulfill potential obligations). To this extent, the combination of the
derivative and the covering asset works like a reverse hedge where an asset owned by the reporting entity
in essence hedges the derivative risk.
31.
As with derivatives in general, these instruments include a wide variety of terms regarding
maturities, range of exercise periods and prices, counterparties, underlying instruments, etc.
32.
The principal features of income generation transactions are:
a.
b.
c.
d.
Premium received is initially recorded as a deferred liability;
The accounting of the covering asset or underlying interest controls the accounting of the
derivative. The covering asset/underlying interest is accounted at either fair value (e.g.,
common stocks) or (amortized) cost (e.g., bonds);
The gain/loss on termination of the derivative is a capital item. For life insurance
companies, it shall be subject to IMR treatment if interest rate related;
For options which are exercised, the remaining premium shall adjust the proceeds (cost)
associated with the exercise resulting in no explicit gain or loss reported for the derivative
itself.
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Written Fixed Income Covered Call Options
33.
The principal features of written fixed income covered call options are:
a.
b.
c.
d.
34.
The general approach is to value at cost (i.e., consideration received) without
amortization over the life of the contract if the original duration is less than one year,
otherwise carry at amortized cost;
An alternative to the general approach combines the accounting of the written option with
the covering asset and then uses standard accounting for callable bonds (yield to worst
amortization) on the adjusted asset. This method prevents the possibility of future loss
recognition upon exercise while at the same time providing recognition of the income
feature of the option over time. This approach would appear most relevant for longerlived covered European call options, which are in substance like callable bonds;
For life insurance companies, the gain or loss flows through the IMR if the covering asset
or underlying interest is subject to the IMR using callable bond rules to determine the
remaining life;
Reporting entities are responsible for timely recognition of any probable losses that may
occur as a result of the strategy. If the exercise price is below the covering asset's book
value, the asset shall be evaluated for write down or disclosure treatment in accordance
with SSAP No. 5. All relevant factors such as whether the option is currently exercisable,
the fair value of the bond relative to its exercise price, to what extent the statement value
of the option premium offsets any loss on the asset, or how any IMR transaction on
exercise would affect unassigned funds (surplus) and income shall be considered.
Written fixed income covered call options shall be accounted for as follows:
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STATUS OF OPTION
Open
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COVERING ASSET VALUED AT COVERING ASSET VALUED AT
AMORTIZED COST
FAIR VALUE
Record premium as deferred
liability.
Record premium as deferred
liability.
Carry at amortized value.
(Alternatively carry at
consideration received if original
duration is less than 1 year to
maturity.)
Changes in fair value recorded as
unrealized adjustments to
unassigned funds (surplus) –
gain/loss.
Alternatively, attach premium to
covering asset and amortize (under
yield to worse scenario) using
standard callable bond accounting.
Closed – Expired
Premium received recognized as
realized capital gain.
Premium received recognized as
realized capital gain.
Gain from expiration to flow
through IMR, if applicable.
(1)
Closed – Exercised
Adjust disposition proceeds.
(Include in capital gain/loss of
disposed asset.)
Adjust disposition proceeds.
(Include in capital gain/loss of
disposed asset.)
Gain or loss from disposition to
flow through IMR, if applicable.
(1)
Closed – Terminated
Recognize net amount as realized
capital gain/loss.
Recognize net amount as realized
capital gain/loss.
Gain or loss from disposition to
flow through IMR, if applicable.
(1)
NOTE:
(1) If premium is attached to covering asset, the accounting treatment for the covering asset
applies.
Written Covered Put Options
35.
The principal features of written covered put options are:
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a.
b.
c.
36.
Issue Paper
The accounting for the underlying interest instead of the covering asset governs the
accounting of the written put while it is open. For example, if a reporting entity wrote a
put requiring it to purchase a certain common stock (underlying interest) at a specific
price, the reporting entity might cover that option by holding cash or cash equivalents
(covering asset). The accounting for the common stock would govern the accounting of
the option in this case;
As with covered call writing for life insurance companies, gain/loss on termination may
be subject to IMR over the remaining life of the underlying interest;
As with covered call writing, entities writing put options for income generation purposes
are responsible for timely recognition of any probable losses that may occur as a result of
the strategy.
Written covered put options shall be accounted for as follows:
STATUS OF OPTION
Open
Closed – Expired
UNDERLYING INTEREST
VALUED AT AMORTIZED
COST
UNDERLYING INTEREST
VALUED AT FAIR VALUE
Record premium as deferred
liability.
Record premium as deferred
liability.
Carry at amortized value.
(Alternatively carry at
consideration received if original
duration is less than 1 year to
maturity.)
Changes in fair value recorded as
unrealized adjustments to
unassigned funds (surplus) –
gain/loss.
Premium received recognized as
realized capital gain.
Premium received recognized as
realized capital gain.
Gain from expiration to flow
through IMR, if applicable.
Closed – Exercised
Adjust acquisition cost by premium
received.
Adjust acquisition cost by premium
received.
Closed – Terminated
Recognize net amount as realized
capital gain/loss.
Recognize net amount as realized
capital gain/loss.
Gain or loss from disposition to
flow through IMR, if applicable.
Written Fixed Income Caps and Floors
37.
The principal features of written fixed income caps and floors are:
a.
The value of the premium received shall be amortized into income over the life of the
contract. For caps and floors, where the entity is selling off possible excess
interest/income, the value of the covering asset is not relevant;
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b.
38.
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Gain/loss may be subject to IMR. The expected maturity would be the derivative
contract's maturity.
Written fixed income caps and floors shall be accounted for as follows:
STATUS OF OPTION
Open
COVERING ASSET VALUED AT COVERING ASSET VALUED AT
AMORTIZED COST
FAIR VALUE
Record premium as deferred
liability.
Record premium as deferred
liability.
Carry at amortized value.
(Alternatively carry at
consideration received if original
duration is less than 1 year to
maturity.)
Changes in fair value recorded as
unrealized adjustments to
unassigned funds (surplus) –
gain/loss.
Amortize over life of contract to
produce constant yield.
Record any interest expense as
“Other Investment Income” –
negative value.
Closed – Matured
Would usually mature at zero
amortized value.
Premium received recognized as
realized capital gain.
Any remaining unamortized value
recognized as ordinary income
through a final amortization
adjustment.
Closed – Exercised
Not applicable.
Not applicable.
Closed – Terminated
Recognize net amount as realized
capital gain/loss.
Recognize net amount as realized
capital gain/loss.
Gain/loss on termination to flow
through IMR, if applicable.
Recognition and Measurement of Derivatives Used in Replication (Synthetic Asset) Transactions
39.
Replication (Synthetic Asset) transaction means a derivative transaction entered into in
conjunction with other investments in order to reproduce the investment characteristics of otherwise
permissible investments. A derivative transaction entered into by an insurer as a hedging or income
generation transaction shall not be considered a replication (synthetic asset) transaction.
40.
Any premium paid or received shall be carried as an asset or liability on the balance sheet
(Aggregate Write-in for Invested Asset (or) Liability). Premiums paid or received on the replication
(synthetic asset) derivative should be amortized into investment income or expense until the exercise,
termination or maturity date of the derivative.
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41.
If the replication (synthetic asset) transaction would be carried at amortized cost and the cash
instrument used is carried at amortized cost, then the derivative used should be carried at amortized cost.
The derivative may be valued at fair value when both the replication (synthetic asset) and the cash
instrument are valued at amortized cost. This is consistent with the alternative valuation methods
available for hedges. If the replication (synthetic asset) transaction would be carried at fair value and/or
the cash instrument used is carried at fair value, then the derivative used should be carried at fair value.
(a)
If the Replication
(Synthetic Asset)
is Valued at:
1.
2.
3.
4.
Amortized Cost
Fair value
Amortized Cost
Fair value
(b)
And Cash
Instrument(s)
Used is (are)
Valued at:
Amortized Cost
Fair value
Fair value
Amortized Cost
(c)
The
Derivative is
Valued at:
Amortized Cost
Fair value
Fair value
Fair value
(d)
Alternative
Derivative
Value
Basis:
Fair value
N/A
N/A
N/A
42.
In the case of No. 3 in the chart above, the fair values for the cash instrument and derivative,
when added together, shall not exceed the replication (synthetic asset) statement value. If this does occur,
the excess shall reduce the fair value of the derivative.
43.
If the replication (synthetic asset) transaction involves the exchange of interest related cash flows
(default free assets), then the cash flows should be accrued as investment income. If the replication
(synthetic asset) transaction involves the exchange of total return or change in index cash flows, then the
cash flows should be segregated between interest income and fair value (equity) changes. The interest
income portion should be accrued as investment income.
44.
If the derivative is carried at fair value, the periodic change in the fair value should be recorded as
an unrealized gain or loss adjustment to surplus until the transaction is terminated. If the replication
(synthetic asset) transaction involves the exchange of total return or change in index cash flows, then the
cash flows should be segregated between interest income and fair value (equity) changes. The fair value
(equity) change should be recognized as a deferred asset/liability until the termination of the contract.
Gains or losses on the derivative at termination or sale should be recognized as realized.
Disclosure Requirements
45.
Reporting entities shall disclose the following for all derivative contracts used:
a.
General disclosures:
i.
ii.
iii.
iv.
A description of the reporting entity’s objectives for using derivatives, i.e.,
hedging, income generation or replication;
A description of the context needed to understand those objectives and its
strategies for achieving those objectives;
The description for hedging objectives shall identify the category, e.g., fair value
hedges, cash flow hedges, or foreign currency hedges, and for all objectives, the
type of instrument(s) used;
A description of the accounting policies for derivatives including the policies for
recognizing (or reasons for not recognizing) and measuring the derivatives used,
and when recognized, where those instruments and related gains and losses are
reported;
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v.
vi.
b.
The net gain or loss recognized in unrealized gains or losses during the reporting
period representing the component of the derivative instruments’ gain or loss, if
any, excluded from the assessment of hedge effectiveness; and
The net gain or loss recognized in unrealized gains or losses during the reporting
period resulting from derivatives that no longer qualify for hedge accounting.
Disclosures by type of instrument outstanding, e.g., call options, floors, etc.:
i.
ii.
iii.
c.
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Notional or contract amounts;
Carrying and fair values; and
A discussion of the market risk, credit risk, and cash requirements of the
derivatives.
For derivatives held for other-than-hedging purposes in addition to a and b above:
i.
ii.
Average fair value of the derivatives during the reporting period together with
the related end-of-period fair value distinguishing between assets and liabilities;
Net gains or losses detailed by class, business activity or other category that is
consistent with the management of those activities and where the net gains or
losses are reported.
d.
The financial statements shall disclose details of covered items and/or written
transactions to allow evaluation of cash flow implications for all written covered options
used for income generation.
e.
For derivatives accounted for as cash flow hedges of a forecasted transaction, disclose:
i.
iii.
f.
The maximum length of time over which the entity is hedging its exposure to the
variability in future cash flows for forecasted transactions excluding those
forecasted transactions related to the payment of variable interest on existing
financial instruments; and
The amount of gains and losses classified in unrealized gains/losses related to
cash flow hedges that have been discontinued because it was no longer probable
that the original forecasted transactions would occur by the end of the originally
specified time period or within 2 months of that date.
The disclosure requirements of 45 a, 45 b, and 45 e shall be included in the Annual
Statement. Refer to the preamble for further discussion regarding interim disclosure
requirements. The disclosure requirements of paragraphs 45.a.- 45.e. shall be included in
the annual audited statutory financial reports. Paragraph 55 of the Preamble states that
disclosures made within specific schedules or exhibits to the Annual Statement need not
be duplicated in a separate note.
Effective Date
46.
Upon adoption of this issue paper, the NAIC will release a Statement of Statutory Accounting
Principle (SSAP) for comment. The SSAP will contain the adopted Summary Conclusion of this issue
paper. Users of the Accounting Practices and Procedures Manual should note that issue papers are not
represented in the Statutory Hierarchy (see Section IV of the Preamble) and therefore the conclusions
reached in this issue paper should not be applied until the corresponding SSAP has been adopted by the
Plenary of the NAIC. It is expected that the SSAP will contain an effective date of years ending on or
after December 31, 2002.
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DISCUSSION
47.
The purpose of this issue paper is two-fold. First, to provide a comprehensive source on
accounting for derivatives used in hedges, income generation and replication transactions. Second, to
address the GAAP guidance that has been issued subsequent to the finalization of SSAP No. 31. In
general, this issue paper adopts the framework established by FAS No. 133 for fair value and cash flow
hedges, but not its technical guidance (discussed further in subsequent paragraphs). This issue paper
adopts the provisions of FAS No. 133 and 138 related to foreign currency hedges. With the exception of
guidance specific to foreign currency hedges and amendments specific to refining the hedging of interest
rate risk (under FAS 138, the risk of changes in the benchmark interest rate would be the hedged risk),
this issue paper rejects FAS No. 137 and 138 as well as the various related Emerging Issues Task Force
interpretations (complete listing found in RELEVANT LITERATURE section of this issue paper). It
should be noted that the conclusions reached in this issue paper are not intended to usurp the rules and
regulations put forth by states in their respective investment laws. The contents of this issue paper are
intended to provide accounting guidance on the use of derivatives as allowed by an insurer’s state of
domicile. It is not intended to imply that insurers may use derivatives or cash instruments that the
insurer’s state of domicile does not allow under the state’s insurance regulatory requirements, e.g., in
replication transactions.
Definitions
48.
This issue paper defines a derivative instrument somewhat differently than FAS No. 133. The
Statutory Accounting Principles (SAP) working group evaluated the FAS No. 133 definition and found
that it was inconsistent with the manner in which derivatives are regulated in the insurance industry.
While FAS 133 defines derivatives in the context of the characteristics contained in an instrument, the
working group concluded that a definition based upon the legal form/contractual rights and obligations is
more relevant to statutory reporting. As a result, the definition of a derivative in paragraph 5 of this issue
paper is not intended to include life contracts, accident and health contracts, property and casualty
contracts and deposit-type contracts as defined within SSAP No. 50—Classifications and Definitions of
Insurance or Managed Care Contracts in Force. Some of these contracts may be considered derivatives
under the FAS No. 133 definition.
Embedded Derivative Instruments
49.
FAS No. 133 requires that a contract containing an embedded derivative be accounted for
separately from the host contract unless the embedded instrument is clearly and closely related to
economic characteristics and risks of the host contract. This issue paper rejects that requirement and
stipulates that such embedded derivatives shall not be accounted for separately from the host contract.
The SAP working group does not believe this provision is applicable to insurance companies as
evidenced by the FASB’s difficulty in providing guidance for certain life contracts that include features
not associated with insured events. In addition, the SAP working group believes the insurance specific
definition of a derivative used in paragraph 5 of this issue paper excludes a majority of the contracts that
would include embedded derivatives.
Impairment
50.
This issue paper adopts the impairment guidelines of SSAP No. 5. The application of such shall
be consistent with the hedged or replicated asset. For instance, a derivative used in a hedging transaction
would follow the impairment guidelines for the hedged asset, whereas a derivative used in a replication
transaction would follow the impairment guidelines for the asset it is replicating. For derivatives used in
hedging transactions one example of an impairment in accordance with SSAP No. 5 would be the
permanent decline in the counterparty’s credit rating/quality. This example is not applicable to
replication transactions as a reporting entity might be try to replicate a similar scenario.
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Recognition and Measurement of Derivatives Used in Hedging Transactions
51.
The SAP working group believes that a prudent use of derivatives can be an important tool in a
sound risk management strategy. Risk management is the practice of defining the risk level an entity
desires, identifying the risk level it currently has, and using derivative or other financial instruments to
adjust the actual risk level to the desired risk level. Therefore, this issue paper allows holders of
derivative instruments used in hedging transactions that meet the criteria of an effective hedge to value
and report the derivative in a manner that is consistent with the hedged asset or liability (referred to as
hedge accounting). This would allow derivatives that effectively hedge assets valued at amortized cost to
also be valued at amortized cost.
52.
This treatment is a dramatic departure from the requirements of FAS No. 133 in which all
derivatives are valued and reported at fair value. This is possible for GAAP accounting because of the
existence of FAS No. 115, Accounting for Certain Investments in Debt and Equity Securities (FAS No.
115) which requires a majority of GAAP (debt and equity) investments to be recorded at fair value.
Therefore, the GAAP model is consistent within its framework to value many financial instruments at fair
value. FAS No. 115 has been rejected by several SSAPs as regulators have concluded that the
fluctuations of fair value from period to period violates the concepts of conservatism and consistency
(further discussion can be found within Issue Paper Nos. 26, 30, 32 and 43). The result of rejecting FAS
No. 115 results in a mixed valuation model in which certain financial instruments are valued at cost while
some others are recognized at fair value (e.g., non-impaired bonds are recorded at amortized cost, equity
instruments valued at fair value, real estate valued at cost or fair value depending upon management’s
intent). The SAP working group does not believe it is appropriate to value all derivatives at fair value if
the assets they are intended to hedge are not also recognized at fair value. Under the FAS No. 133 model,
an insurer cannot utilize hedge accounting for debt securities that the entity has the positive intent and
ability to hold to maturity as such securities are classified as held-to-maturity securities and reported at
amortized cost. This is due to the fact that fluctuations in fair value of the derivative would not offset the
fluctuations in fair value of the debt security as the debt security is recorded at amortized cost and there is
no impact on surplus for changes in its fair value. By utilizing the concept of emulating valuation of the
hedged assets and derivatives adopted in this issue paper consistency is achieved within the mixed
valuation model. The concept of emulating valuation also supports the conservatism concept of statutory
accounting in that using the amortized values and unrealized gains or losses, derivatives used in hedging
should be protected from significant temporary gains from being incorporated into earnings. Further, the
conservatism concept is supported in permanent losses by application of the impairment requirement.
53.
This issue paper also adopts a provision to recognize the changes in fair value of a derivative that
does not meet the criteria for hedge accounting to be recorded as unrealized gains or losses. SSAP No. 31
requires these changes to be recognized currently in earnings. The SAP working group believes the
SSAP No. 31 treatment is inconsistent with similar guidance for equity investments in that the earnings
process has not been completed.
Hedge Designations
54.
This issue paper adopts the hedge designation framework established in FAS No. 133 in that
entities may designate a derivative instrument as hedging the exposure to changes in fair value, variability
in expected future cash flow or foreign currency exposures. This decision was made so that statutory
accounting would be consistent for entities that must also conform to the documentation requirements of
FAS No. 133.
55.
This issue paper allows entities to hedge a portfolio of similar assets or similar liabilities but does
not advocate hedging of an entire portfolio with dissimilar risks (referred to as macro hedging). If similar
assets or similar liabilities are aggregated and hedged as a portfolio, the individual assets or individual
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Issue Paper
liabilities must share the same risk exposure for which they are designated as being hedged. In a fair
value hedge, the change in fair value attributable to the hedged risk for each individual item in a hedged
portfolio must be expected to respond in a generally proportionate manner to the overall change in fair
value of the aggregate portfolio attributable to the hedged risk. That is, if the change in fair value of a
hedged portfolio attributable to the hedged risk was 10 percent during a reporting period, the change in
the fair values attributable to the hedged risk for each item constituting the portfolio should be expected to
be within a fairly narrow range, such as 9 percent to 11 percent. In contrast, an expectation that the
change in fair value attributable to the hedged risk for individual items in the portfolio would range from
7 percent to 13 percent would be inconsistent with this provision. In aggregating loans in a portfolio to be
hedged, an entity may choose to consider some of the following characteristics, as appropriate: loan type,
loan size, nature and location of collateral, interest rate type (fixed or variable) and the coupon interest
rate (if fixed), scheduled maturity, prepayment history of the loans (if seasoned), and expected
prepayment performance in varying interest rate scenarios.
56.
To qualify for hedge accounting, this issue paper requires that fair value, cash flow and foreign
currency hedges must be highly effective in achieving its offsetting objectives. The term “highly
effective” is specifically defined within this issue paper unlike FAS No. 133. The SAP working group
defined this term so that consistent application of effectiveness could be attained. Additionally, the issue
paper rejects the FAS No. 133 concept of identifying and separately accounting for the effective and
ineffective portions of a single hedge. This issue paper instructs entities not to bifurcate effectiveness; an
entity either has an effective hedge (must use hedge accounting) or an ineffective hedge (must use fair
value accounting). Again, deviation from FAS No. 133 was made for consistency.
57.
The provisions of FAS No. 133 and 138 related to hedging foreign currency are adopted in this
issue paper as they do not violate the principles that define the Statement of Concepts.
Documentation
58.
This issue paper adopts documentation guidance, which is a combination of the requirements of
FAS No. 133 and SSAP No. 31. None of the requirements of SSAP No. 31 were removed and the FAS
No. 133 requirements were added so that entities that also complete GAAP statements would not have to
maintain separate documentation.
Recognition and Measurement of Derivatives Used in Income Generation Transactions
59.
This issue paper retains the requirements of SSAP No. 31 for income generation transactions.
This guidance is needed for those entities who wish to write or sell derivatives in an attempt to generate
additional income and therefore do not use these types of derivatives to hedge risk exposures.
Recognition and Measurement of Derivatives Used in Replication (Synthetic Asset) Transactions
60.
The guidance included for replication transactions was adopted as “NAIC Preferred Accounting
Treatment” by the Emerging Accounting Issues working group on June 7, 1999. Inclusion in this issue
paper of the preferred accounting guidance for replications formalizes its position within the Statutory
Hierarchy.
Disclosures
61.
This issue paper adopts disclosure requirements that represent a combination of the provisions of
FAS No. 133 and SSAP No. 31.
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Drafting Notes/Comments
The issue of disclosing derivatives embedded within financial assets will be addressed by the
Invested Asset (E) Working Group
The issue of accounting for and the reporting of insurance derivatives (used in hedging insurance
exposures) will be addressed by the Insurance Securitization (E) Working Group.
The general reference to FAS No. 133 and 138 for foreign currency hedges will be replaced with
the specific language in the SSAP once the staff has an opportunity to meld the two
pronouncements together.
The reporting guidance referred to in paragraph 18 will be refined by the FAS No. 133 Subgroup
after further deliberation.
The language specific to Insurance Futures and Insurance Futures Options has not been included
in this issue paper due to the lack of activity in this market.
RELEVANT STATUTORY AND GAAP GUIDANCE:
Statutory Accounting
62.
SSAP No. 31—Derivative Instruments provides the current statutory guidance for most derivative
transactions.
63.
The Emerging Accounting Issues Working Group adopted as NAIC preferred accounting
treatment the conclusions reached in this issue paper for replication transactions. The following was
taken from the June 7, 1999, minutes of the Working Group:
Mr. Clark reported that the working group had reached a tentative consensus on the issue of
accounting for replication transactions during an interim conference call on May 12, 1999. This
consensus was exposed on the NAIC website after the 1999 Spring National Meeting, and the
NAIC staff received no comments on it.
Mr. Medley questioned whether the word “consideration” could be used instead of “premium” as
shown on Attachment A Part (b) (see attachment 4 to the 5/12/99 conference call minutes).
Maria Avila (Northwestern Mutual Life), on behalf of interested parties, indicated that the change
would not modify the intent or conclusion of the proposal. Mr. Johnson made a motion to finalize
the tentative consensus, as modified, and grant the proposal preferred NAIC accounting
treatment. Mr. Ford seconded the motion. The working group unanimously adopted the motion.
Mr. Clark stressed that this issue falls under the old working group rules and, thus, the working
group can only grant preferred NAIC accounting treatment. This issue will also be addressed by
the Codification of Statutory Accounting Principles working group when SFAS No. 133,
Accounting for Derivative Instruments and Hedging Activities is reviewed under the maintenance
process.
Generally Accepted Accounting Principles
64.
FAS 133 provides the following guidance (the language shown in italics has been amended by
FAS No. 137 and 138):
INTRODUCTION
1.
This Statement addresses the accounting for derivative instruments, including certain
derivative instruments embedded in other contracts, and hedging activities.
2.
Prior to this Statement, hedging activities related to changes in foreign exchange rates
were addressed in FASB Statement No. 52, Foreign Currency Translation. FASB Statement No.
80, Accounting for Futures Contracts, addressed the use of futures contracts in other hedging
activities. Those Statements addressed only certain derivative instruments and differed in the
criteria required for hedge accounting. In addition, the Emerging Issues Task Force (EITF)
addressed the accounting for various hedging activities in a number of issues.
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Issue Paper
3.
In developing the standards in this Statement, the Board concluded that the following four
fundamental decisions should serve as cornerstones underlying those standards:
a.
b.
c.
d.
Derivative instruments represent rights or obligations that meet the definitions of
assets or liabilities and should be reported in financial statements.
Fair value is the most relevant measure for financial instruments and the only
relevant measure for derivative instruments. Derivative instruments should be
measured at fair value, and adjustments to the carrying amount of hedged items
should reflect changes in their fair value (that is, gains or losses) that are
attributable to the risk being hedged and that arise while the hedge is in effect.
Only items that are assets or liabilities should be reported as such in financial
statements.
Special accounting for items designated as being hedged should be provided
only for qualifying items. One aspect of qualification should be an assessment of
the expectation of effective offsetting changes in fair values or cash flows during
the term of the hedge for the risk being hedged.
Those fundamental decisions are discussed individually in paragraphs 217–231 of Appendix C.
4.
This Statement standardizes the accounting for derivative instruments, including certain
derivative instruments embedded in other contracts, by requiring that an entity recognize those
items as assets or liabilities in the statement of financial position and measure them at fair value.
If certain conditions are met, an entity may elect to designate a derivative instrument as follows:
a.
b.
c.
A hedge of the exposure to changes in the fair value of a recognized asset or
liability, or of an unrecognized firm commitment, that are attributable to a
particular risk (referred to as a fair value hedge)
A hedge of the exposure to variability in the cash flows of a recognized asset or
liability, or of a forecasted transaction, that is attributable to a particular risk
(referred to as a cash flow hedge)
A hedge of the foreign currency exposure of (1) an unrecognized firm
commitment (a foreign currency fair value hedge), (2) an available-for-sale
security (a foreign currency fair value hedge), (3) a forecasted transaction (a
foreign currency cash flow hedge), or (4) a net investment in a foreign operation.
This Statement generally provides for matching the timing of gain or loss recognition on the
hedging instrument with the recognition of (a) the changes in the fair value of the hedged asset or
liability that are attributable to the hedged risk or (b) the earnings effect of the hedged forecasted
transaction. Appendix A provides guidance on identifying derivative instruments subject to the
scope of this Statement and on assessing hedge effectiveness and is an integral part of the
standards provided in this Statement. Appendix B contains examples that illustrate application of
this Statement. Appendix C contains background information and the basis for the Board’s
conclusions. Appendix D lists the accounting pronouncements superseded or amended by this
Statement. Appendix E provides a diagram for determining whether a contract is a freestanding
derivative subject to the scope of this Statement.
Scope and Definition
5.
This Statement applies to all entities. Some entities, such as not-for-profit organizations
and defined benefit pension plans, do not report earnings as a separate caption in a statement of
financial performance. The application of this Statement to those entities is set forth in
paragraph 43.
Derivative Instruments
6.
A derivative instrument is a financial instrument or other contract with all three of the
following characteristics:
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a.
b.
c.
IP No. 114
It has (1) one or more underlyings and (2) one or more notional amounts or
payment provisions or both. Those terms determine the amount of the
settlement or settlements, and, in some cases, whether or not a settlement is
required.
It requires no initial net investment or an initial net investment that is smaller than
would be required for other types of contracts that would be expected to have a
similar response to changes in market factors.
Its terms require or permit net settlement, it can readily be settled net by a means
outside the contract, or it provides for delivery of an asset that puts the recipient
in a position not substantially different from net settlement.
7.
Underlying, notional amount, and payment provision. An underlying is a specified
interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, or
other variable. An underlying may be a price or rate of an asset or liability but is not the asset or
liability itself. A notional amount is a number of currency units, shares, bushels, pounds, or other
units specified in the contract. The settlement of a derivative instrument with a notional amount is
determined by interaction of that notional amount with the underlying. The interaction may be
simple multiplication, or it may involve a formula with leverage factors or other constants. A
payment provision specifies a fixed or determinable settlement to be made if the underlying
behaves in a specified manner.
8.
Initial net investment. Many derivative instruments require no initial net investment.
Some require an initial net investment as compensation for time value (for example, a premium
on an option) or for terms that are more or less favorable than market conditions (for example, a
premium on a forward purchase contract with a price less than the current forward price). Others
require a mutual exchange of currencies or other assets at inception, in which case the net
investment is the difference in the fair values of the assets exchanged. A derivative instrument
does not require an initial net investment in the contract that is equal to the notional amount (or
the notional amount plus a premium or minus a discount) or that is determined by applying the
notional amount to the underlying.
9.
Net settlement. A contract fits the description in paragraph 6.c. if its settlement
provisions meet one of the following criteria:
a.
b.
c.
Neither party is required to deliver an asset that is associated with the underlying
or that has a principal amount, stated amount, face value, number of shares, or
other denomination that is equal to the notional amount (or the notional amount
plus a premium or minus a discount). For example, most interest rate swaps do
not require that either party deliver interest-bearing assets with a principal
amount equal to the notional amount of the contract.
One of the parties is required to deliver an asset of the type described in
paragraph 9.a., but there is a market mechanism that facilitates net settlement,
for example, an exchange that offers a ready opportunity to sell the contract or to
enter into an offsetting contract.
One of the parties is required to deliver an asset of the type described in
paragraph 9.a., but that asset is readily convertible to cash or is itself a derivative
instrument. An example of that type of contract is a forward contract that
requires delivery of an exchange-traded equity security. Even though the
number of shares to be delivered is the same as the notional amount of the
contract and the price of the shares is the underlying, an exchange-traded
security is readily convertible to cash. Another example is a swaption—an option
to require delivery of a swap contract, which is a derivative.
Derivative instruments embedded in other contracts are addressed in paragraphs 12-16.
10.
Notwithstanding the conditions in paragraphs 6-9, the following contracts are not subject
to the requirements of this Statement:
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a.
b.
c.
“Regular-way” security trades. Regular-way security trades are contracts with no
net settlement provision and no market mechanism to facilitate net settlement (as
described in paragraphs 9.a. and 9.b.). They provide for delivery of a security
within the time generally established by regulations or conventions in the
marketplace or exchange in which the transaction is being executed.
Normal purchases and normal sales. Normal purchases and normal sales are
contracts with no net settlement provision and no market mechanism to facilitate
net settlement (as described in paragraphs 9.a. and 9.b.). They provide for the
purchase or sale of something other than a financial instrument or derivative
instrument that will be delivered in quantities expected to be used or sold by the
reporting entity over a reasonable period in the normal course of business.
Certain insurance contracts. Generally, contracts of the type that are within the
scope of FASB Statements No. 60, Accounting and Reporting by Insurance
Enterprises, No. 97, Accounting and Reporting by Insurance Enterprises for
Certain Long-Duration Contracts and for Realized Gains and Losses from the
Sale of Investments, and No. 113, Accounting and Reporting for Reinsurance of
Short-Duration and Long-Duration Contracts, are not subject to the requirements
of this Statement whether or not they are written by insurance enterprises. That
is, a contract is not subject to the requirements of this Statement if it entitles the
holder to be compensated only if, as a result of an identifiable insurable event
(other than a change in price), the holder incurs a liability or there is an adverse
change in the value of a specific asset or liability for which the holder is at risk.
The following types of contracts written by insurance enterprises or held by the
insureds are not subject to the requirements of this Statement for the reasons
given:
(1)
d.
e.
Traditional life insurance contracts. The payment of death benefits is the
result of an identifiable insurable event (death of the insured) instead of
changes in a variable.
(2)
Traditional property and casualty contracts. The payment of benefits is
the result of an identifiable insurable event (for example, theft or fire)
instead of changes in a variable.
However, insurance enterprises enter into other types of contracts that may be
subject to the provisions of this Statement. In addition, some contracts with
insurance or other enterprises combine derivative instruments, as defined in this
Statement, with other insurance products or nonderivative contracts, for
example, indexed annuity contracts, variable life insurance contracts, and
property and casualty contracts that combine traditional coverages with foreign
currency options. Contracts that consist of both derivative portions and
nonderivative portions are addressed in paragraph 12.
Certain financial guarantee contracts. Financial guarantee contracts are not
subject to this Statement if they provide for payments to be made only to
reimburse the guaranteed party for a loss incurred because the debtor fails to
pay when payment is due, which is an identifiable insurable event. In contrast,
financial guarantee contracts are subject to this Statement if they provide for
payments to be made in response to changes in an underlying (for example, a
decrease in a specified debtor’s creditworthiness).
Certain contracts that are not traded on an exchange. Contracts that are not
exchange-traded are not subject to the requirements of this Statement if the
underlying on which the settlement is based is one of the following:
(1)
A climatic or geological variable or other physical variable
(2)
The price or value of (a) a nonfinancial asset of one of the parties to the
contract provided that the asset is not readily convertible to cash or (b) a
nonfinancial liability of one of the parties to the contract provided that the
liability does not require delivery of an asset that is readily convertible to
cash
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(3)
f.
Specified volumes of sales or service revenues of one of the parties to
the contract.
If a contract has more than one underlying and some, but not all, of them qualify
for one of the exceptions in paragraphs 10.e.(1), 10.e.(2), and 10.e.(3), the
application of this Statement to that contract depends on its predominant
characteristics. That is, the contract is subject to the requirements of this
Statement if all of its underlyings, considered in combination, behave in a
manner that is highly correlated with the behavior of any of the component
variables that do not qualify for an exception.
Derivatives that serve as impediments to sales accounting. A derivative
instrument (whether freestanding or embedded in another contract) whose
existence serves as an impediment to recognizing a related contract as a sale by
one party or a purchase by the counterparty is not subject to this Statement. For
example, the existence of a guarantee of the residual value of a leased asset by
the lessor may be an impediment to treating a contract as a sales-type lease, in
which case the contract would be treated by the lessor as an operating lease.
Another example is the existence of a call option enabling a transferor to
repurchase transferred assets that is an impediment to sales accounting under
FASB Statement No. 125, Accounting for Transfers and Servicing of Financial
Assets and Extinguishments of Liabilities.
11.
Notwithstanding the conditions of paragraphs 6-10, the reporting entity shall not consider
the following contracts to be derivative instruments for purposes of this Statement:
a.
b.
c.
Contracts issued or held by that reporting entity that are both (1) indexed to its
own stock and (2) classified in stockholders’ equity in its statement of financial
position
Contracts issued by the entity in connection with stock-based compensation
arrangements addressed in FASB Statement No. 123, Accounting for StockBased Compensation
Contracts issued by the entity as contingent consideration from a business
combination. The accounting for contingent consideration issued in a business
combination is addressed in APB Opinion No. 16, Business Combinations. In
applying this paragraph, the issuer is considered to be the entity that is
accounting for the combination using the purchase method.
In contrast, the above exceptions do not apply to the counterparty in those contracts. In
addition, a contract that an entity either can or must settle by issuing its own equity
instruments but that is indexed in part or in full to something other than its own stock can
be a derivative instrument for the issuer under paragraphs 6-10, in which case it would
be accounted for as a liability or an asset in accordance with the requirements of this
Statement.
Embedded Derivative Instruments
12.
Contracts that do not in their entirety meet the definition of a derivative instrument (refer
to paragraphs 6-9), such as bonds, insurance policies, and leases, may contain “embedded”
derivative instruments—implicit or explicit terms that affect some or all of the cash flows or the
value of other exchanges required by the contract in a manner similar to a derivative instrument.
The effect of embedding a derivative instrument in another type of contract (“the host contract”) is
that some or all of the cash flows or other exchanges that otherwise would be required by the
contract, whether unconditional or contingent upon the occurrence of a specified event, will be
modified based on one or more underlyings. An embedded derivative instrument shall be
separated from the host contract and accounted for as a derivative instrument pursuant to this
Statement if and only if all of the following criteria are met:
a.
The economic characteristics and risks of the embedded derivative instrument
are not clearly and closely related to the economic characteristics and risks of
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b.
c.
the host contract. Additional guidance on applying this criterion to various
contracts containing embedded derivative instruments is included in Appendix A
of this Statement.
The contract (“the hybrid instrument”) that embodies both the embedded
derivative instrument and the host contract is not remeasured at fair value under
otherwise applicable generally accepted accounting principles with changes in
fair value reported in earnings as they occur.
A separate instrument with the same terms as the embedded derivative
instrument would, pursuant to paragraphs 6-11, be a derivative instrument
subject to the requirements of this Statement. (The initial net investment for the
hybrid instrument shall not be considered to be the initial net investment for the
embedded derivative.)
13.
For purposes of applying the provisions of paragraph 12, an embedded derivative
instrument in which the underlying is an interest rate or interest rate index that alters net interest
payments that otherwise would be paid or received on an interest-bearing host contract is
considered to be clearly and closely related to the host contract unless either of the following
conditions exist:
a.
b.
The hybrid instrument can contractually be settled in a such a way that the
investor (holder) would not recover substantially all of its initial recorded
investment.
The embedded derivative could at least double the investor’s initial rate of return
on the host contract and could also result in a rate of return that is at least twice
what otherwise would be the market return for a contract that has the same
terms as the host contract and that involves a debtor with a similar credit quality.
Even though the above conditions focus on the investor’s rate of return and the investor’s
recovery of its investment, the existence of either of those conditions would result in the
embedded derivative instrument not being considered clearly and closely related to the host
contract by both parties to the hybrid instrument. Because the existence of those conditions is
assessed at the date that the hybrid instrument is acquired (or incurred) by the reporting entity,
the acquirer of a hybrid instrument in the secondary market could potentially reach a different
conclusion than could the issuer of the hybrid instrument due to applying the conditions in this
paragraph at different points in time.
14.
However, interest-only strips and principal-only strips are not subject to the requirements
of this Statement provided they (a) initially resulted from separating the rights to receive
contractual cash flows of a financial instrument that, in and of itself, did not contain an embedded
derivative that otherwise would have been accounted for separately as a derivative pursuant to
the provisions of paragraphs 12 and 13 and (b) do not incorporate any terms not present in the
original financial instrument described above.
15.
An embedded foreign currency derivative instrument shall not be separated from the host
contract and considered a derivative instrument under paragraph 12 if the host contract is not a
financial instrument and it requires payment(s) denominated in (a) the currency of the primary
economic environment in which any substantial party to that contract operates (that is, its
functional currency) or (b) the currency in which the price of the related good or service that is
acquired or delivered is routinely denominated in international commerce (for example, the U.S.
dollar for crude oil transactions). Unsettled foreign currency transactions, including financial
instruments, that are monetary items and have their principal payments, interest payments, or
both denominated in a foreign currency are subject to the requirement in Statement 52 to
recognize any foreign currency transaction gain or loss in earnings and shall not be considered to
contain embedded foreign currency derivative instruments under this Statement. The same
proscription applies to available-for-sale or trading securities that have cash flows denominated in
a foreign currency.
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16.
In subsequent provisions of this Statement, both (a) a derivative instrument included
within the scope of this Statement by paragraphs 6-11 and (b) an embedded derivative
instrument that has been separated from a host contract as required by paragraph 12 are
collectively referred to as derivative instruments. If an embedded derivative instrument is
separated from its host contract, the host contract shall be accounted for based on generally
accepted accounting principles applicable to instruments of that type that do not contain
embedded derivative instruments. If an entity cannot reliably identify and measure the embedded
derivative instrument that paragraph 12 requires be separated from the host contract, the entire
contract shall be measured at fair value with gain or loss recognized in earnings, but it may not
be designated as a hedging instrument pursuant to this Statement.
Recognition of Derivatives and Measurement of Derivatives and Hedged Items
17.
An entity shall recognize all of its derivative instruments in its statement of financial
position as either assets or liabilities depending on the rights or obligations under the contracts.
All derivative instruments shall be measured at fair value. The guidance in FASB Statement No.
107, Disclosures about Fair Value of Financial Instruments, as amended, shall apply in
determining the fair value of a financial instrument (derivative or hedged item). If expected future
cash flows are used to estimate fair value, those expected cash flows shall be the best estimate
based on reasonable and supportable assumptions and projections. All available evidence shall
be considered in developing estimates of expected future cash flows. The weight given to the
evidence shall be commensurate with the extent to which the evidence can be verified
objectively. If a range is estimated for either the amount or the timing of possible cash flows, the
likelihood of possible outcomes shall be considered in determining the best estimate of future
cash flows.
18.
The accounting for changes in the fair value (that is, gains or losses) of a derivative
depends on whether it has been designated and qualifies as part of a hedging relationship and, if
so, on the reason for holding it. Either all or a proportion of a derivative may be designated as
the hedging instrument. The proportion must be expressed as a percentage of the entire
derivative so that the profile of risk exposures in the hedging portion of the derivative is the same
as that in the entire derivative. (Thus, an entity is prohibited from separating a compound
derivative into components representing different risks and designating any such component as
the hedging instrument, except as permitted at the date of initial application by the transition
provisions in paragraph 49.) Subsequent references in this Statement to a derivative as a
hedging instrument include the use of only a proportion of a derivative as a hedging instrument.
Two or more derivatives, or proportions thereof, may also be viewed in combination and jointly
designated as the hedging instrument. Gains and losses on derivative instruments are
accounted for as follows:
a.
b.
c.
d.
No hedging designation. The gain or loss on a derivative instrument not
designated as a hedging instrument shall be recognized currently in earnings.
Fair value hedge. The gain or loss on a derivative instrument designated and
qualifying as a fair value hedging instrument as well as the offsetting loss or gain
on the hedged item attributable to the hedged risk shall be recognized currently
in earnings in the same accounting period, as provided in paragraphs 22 and 23.
Cash flow hedge. The effective portion of the gain or loss on a derivative
instrument designated and qualifying as a cash flow hedging instrument shall be
reported as a component of other comprehensive income (outside earnings) and
reclassified into earnings in the same period or periods during which the hedged
forecasted transaction affects earnings, as provided in paragraphs 30 and 31.
The remaining gain or loss on the derivative instrument, if any, shall be
recognized currently in earnings, as provided in paragraph 30.
Foreign currency hedge. The gain or loss on a derivative instrument or
nonderivative financial instrument designated and qualifying as a foreign
currency hedging instrument shall be accounted for as follows:
(1)
The gain or loss on the hedging derivative or nonderivative instrument in
a hedge of a foreign-currency-denominated firm commitment and the
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(2)
(3)
(4)
offsetting loss or gain on the hedged firm commitment shall be
recognized currently in earnings in the same accounting period, as
provided in paragraph 37.
The gain or loss on the hedging derivative instrument in a hedge of an
available-for-sale security and the offsetting loss or gain on the hedged
available-for-sale security shall be recognized currently in earnings in the
same accounting period, as provided in paragraph 38.
The effective portion of the gain or loss on the hedging derivative
instrument in a hedge of a forecasted foreign-currency-denominated
transaction shall be reported as a component of other comprehensive
income (outside earnings) and reclassified into earnings in the same
period or periods during which the hedged forecasted transaction affects
earnings, as provided in paragraph 41. The remaining gain or loss on
the hedging instrument shall be recognized currently in earnings.
The gain or loss on the hedging derivative or nonderivative instrument in
a hedge of a net investment in a foreign operation shall be reported in
other comprehensive income (outside earnings) as part of the cumulative
translation adjustment to the extent it is effective as a hedge, as provided
in paragraph 42.
19.
In this Statement, the change in the fair value of an entire financial asset or liability for a
period refers to the difference between its fair value at the beginning of the period (or acquisition
date) and the end of the period adjusted to exclude (a) changes in fair value due to the passage
of time and (b) changes in fair value related to any payments received or made, such as in
partially recovering the asset or partially settling the liability.
Fair Value Hedges
General
20.
An entity may designate a derivative instrument as hedging the exposure to changes in
the fair value of an asset or a liability or an identified portion thereof (“hedged item”) that is
attributable to a particular risk. Designated hedging instruments and hedged items qualify for fair
value hedge accounting if all of the following criteria and those in paragraph 21 are met:
a.
b.
At inception of the hedge, there is formal documentation of the hedging
relationship and the entity’s risk management objective and strategy for
undertaking the hedge, including identification of the hedging instrument, the
hedged item, the nature of the risk being hedged, and how the hedging
instrument’s effectiveness in offsetting the exposure to changes in the hedged
item’s fair value attributable to the hedged risk will be assessed. There must be
a reasonable basis for how the entity plans to assess the hedging instrument’s
effectiveness.
(1)
For a fair value hedge of a firm commitment, the entity’s formal
documentation at the inception of the hedge must include a reasonable
method for recognizing in earnings the asset or liability representing the
gain or loss on the hedged firm commitment.
(2)
An entity’s defined risk management strategy for a particular hedging
relationship may exclude certain components of a specific hedging
derivative’s change in fair value, such as time value, from the
assessment of hedge effectiveness, as discussed in paragraph 63 in
Section 2 of Appendix A.
Both at inception of the hedge and on an ongoing basis, the hedging relationship
is expected to be highly effective in achieving offsetting changes in fair value
attributable to the hedged risk during the period that the hedge is designated. An
assessment of effectiveness is required whenever financial statements or
earnings are reported, and at least every three months. If the hedging
instrument (such as an at-the-money option contract) provides only one-sided
offset of the hedged risk, the increases (or decreases) in the fair value of the
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hedging instrument must be expected to be highly effective in offsetting the
decreases (or increases) in the fair value of the hedged item. All assessments of
effectiveness shall be consistent with the risk management strategy documented
for that particular hedging relationship (in accordance with paragraph 20.a.
above).
If a written option is designated as hedging a recognized asset or liability, the
combination of the hedged item and the written option provides at least as much
potential for gains as a result of a favorable change in the fair value of the
combined instruments as exposure to losses from an unfavorable change in their
combined fair value. That test is met if all possible percentage favorable
changes in the underlying (from zero percent to 100 percent) would provide at
least as much gain as the loss that would be incurred from an unfavorable
change in the underlying of the same percentage.
(1)
A combination of options (for example, an interest rate collar) entered
into contemporaneously shall be considered a written option if either at
inception or over the life of the contracts a net premium is received in
cash or as a favorable rate or other term. (Thus, a collar can be
designated as a hedging instrument in a fair value hedge without regard
to the test in paragraph 20.c. unless a net premium is received.)
Furthermore, a derivative instrument that results from combining a
written option and any other nonoption derivative shall be considered a
written option.
A nonderivative instrument, such as a Treasury note, shall not be designated as a hedging
instrument, except as provided in paragraphs 37 and 42 of this Statement.
The Hedged Item
21.
An asset or a liability is eligible for designation as a hedged item in a fair value hedge if
all of the following criteria are met:
a.
The hedged item is specifically identified as either all or a specific portion of a
recognized asset or liability or of an unrecognized firm commitment. The hedged
item is a single asset or liability (or a specific portion thereof) or is a portfolio of
similar assets or a portfolio of similar liabilities (or a specific portion thereof).
(1)
If similar assets or similar liabilities are aggregated and hedged as a
portfolio, the individual assets or individual liabilities must share the risk
exposure for which they are designated as being hedged. The change in
fair value attributable to the hedged risk for each individual item in a
hedged portfolio must be expected to respond in a generally
proportionate manner to the overall change in fair value of the aggregate
portfolio attributable to the hedged risk. That is, if the change in fair
value of a hedged portfolio attributable to the hedged risk was 10 percent
during a reporting period, the change in the fair values attributable to the
hedged risk for each item constituting the portfolio should be expected to
be within a fairly narrow range, such as 9 percent to 11 percent. In
contrast, an expectation that the change in fair value attributable to the
hedged risk for individual items in the portfolio would range from 7
percent to 13 percent would be inconsistent with this provision. In
aggregating loans in a portfolio to be hedged, an entity may choose to
consider some of the following characteristics, as appropriate: loan type,
loan size, nature and location of collateral, interest rate type (fixed or
variable) and the coupon interest rate (if fixed), scheduled maturity,
prepayment history of the loans (if seasoned), and expected prepayment
performance in varying interest rate scenarios.
(2)
If the hedged item is a specific portion of an asset or liability (or of a
portfolio of similar assets or a portfolio of similar liabilities), the hedged
item is one of the following:
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(a)
(b)
(c)
(d)
b.
c.
d.
e.
f.
A percentage of the entire asset or liability (or of the entire
portfolio)
One or more selected contractual cash flows (such as the
portion of the asset or liability representing the present value of
the interest payments in the first two years of a four-year debt
instrument)
A put option, a call option, an interest rate cap, or an interest rate
floor embedded in an existing asset or liability that is not an
embedded derivative accounted for separately pursuant to
paragraph 12 of this Statement
The residual value in a lessor’s net investment in a direct
financing or sales-type lease.
If the entire asset or liability is an instrument with variable cash flows, the
hedged item cannot be deemed to be an implicit fixed-to-variable swap
(or similar instrument) perceived to be embedded in a host contract with
fixed cash flows.
The hedged item presents an exposure to changes in fair value attributable to
the hedged risk that could affect reported earnings. The reference to affecting
reported earnings does not apply to an entity that does not report earnings as a
separate caption in a statement of financial performance, such as a not-for-profit
organization, as discussed in paragraph 43.
The hedged item is not (1) an asset or liability that is remeasured with the
changes in fair value attributable to the hedged risk reported currently in earnings
(for example, if foreign exchange risk is hedged, a foreign-currency-denominated
asset for which a foreign currency transaction gain or loss is recognized in
earnings), (2) an investment accounted for by the equity method in accordance
with the requirements of APB Opinion No. 18, The Equity Method of Accounting
for Investments in Common Stock, (3) a minority interest in one or more
consolidated subsidiaries, (4) an equity investment in a consolidated subsidiary,
(5) a firm commitment either to enter into a business combination or to acquire or
dispose of a subsidiary, a minority interest, or an equity method investee, or (6)
an equity instrument issued by the entity and classified in stockholders’ equity in
the statement of financial position.
If the hedged item is all or a portion of a debt security (or a portfolio of similar
debt securities) that is classified as held-to-maturity in accordance with FASB
Statement No. 115, Accounting for Certain Investments in Debt and Equity
Securities, the designated risk being hedged is the risk of changes in its fair
value attributable to changes in the obligor’s creditworthiness or if the hedged
item is an option component of a held-to-maturity security that permits its
prepayment, the designated risk being hedged is the risk of changes in the entire
fair value of that option component. (The designated hedged risk for a held-tomaturity security may not be the risk of changes in its fair value attributable to
changes in market interest rates or foreign exchange rates. If the hedged item is
other than an option component that permits its prepayment, the designated
hedged risk also may not be the risk of changes in its overall fair value.)
If the hedged item is a nonfinancial asset or liability (other than a recognized loan
servicing right or a nonfinancial firm commitment with financial components), the
designated risk being hedged is the risk of changes in the fair value of the entire
hedged asset or liability (reflecting its actual location if a physical asset). That is,
the price risk of a similar asset in a different location or of a major ingredient may
not be the hedged risk. Thus, in hedging the exposure to changes in the fair
value of gasoline, an entity may not designate the risk of changes in the price of
crude oil as the risk being hedged for purposes of determining effectiveness of
the fair value hedge of gasoline
If the hedged item is a financial asset or liability, a recognized loan servicing
right, or a nonfinancial firm commitment with financial components, the
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designated risk being hedged is (1) the risk of changes in the overall fair value of
the entire hedged item, (2) the risk of changes in its fair value attributable to
changes in market interest rates, (3) the risk of changes in its fair value
attributable to changes in the related foreign currency exchange rates (refer to
paragraphs 37 and 38), or (4) the risk of changes in its fair value attributable to
changes in the obligor’s creditworthiness. If the risk designated as being hedged
is not the risk in paragraph 21.f.(1) above, two or more of the other risks (market
interest rate risk, foreign currency exchange risk, and credit risk) may
simultaneously be designated as being hedged.
An entity may not simply
designate prepayment risk as the risk being hedged for a financial asset.
However, it can designate the option component of a prepayable instrument as
the hedged item in a fair value hedge of the entity’s exposure to changes in the
fair value of that “prepayment” option, perhaps thereby achieving the objective of
its desire to hedge prepayment risk. The effect of an embedded derivative of the
same risk class must be considered in designating a hedge of an individual risk.
For example, the effect of an embedded prepayment option must be considered
in designating a hedge of market interest rate risk.
22.
Gains and losses on a qualifying fair value hedge shall be accounted for as follows:
a.
b.
The gain or loss on the hedging instrument shall be recognized currently in
earnings.
The gain or loss (that is, the change in fair value) on the hedged item attributable
to the hedged risk shall adjust the carrying amount of the hedged item and be
recognized currently in earnings.
If the fair value hedge is fully effective, the gain or loss on the hedging instrument, adjusted for
the component, if any, of that gain or loss that is excluded from the assessment of effectiveness
under the entity’s defined risk management strategy for that particular hedging relationship (as
discussed in paragraph 63 in Section 2 of Appendix A), would exactly offset the loss or gain on
the hedged item attributable to the hedged risk. Any difference that does arise would be the
effect of hedge ineffectiveness, which consequently is recognized currently in earnings. The
measurement of hedge ineffectiveness for a particular hedging relationship shall be consistent
with the entity’s risk management strategy and the method of assessing hedge effectiveness that
was documented at the inception of the hedging relationship, as discussed in paragraph 20.a.
Nevertheless, the amount of hedge ineffectiveness recognized in earnings is based on the extent
to which exact offset is not achieved. Although a hedging relationship must comply with an
entity’s established policy range of what is considered “highly effective” pursuant to paragraph
20.b. in order for that relationship to qualify for hedge accounting, that compliance does not
assure zero ineffectiveness. Section 2 of Appendix A illustrates assessing hedge effectiveness
and measuring hedge ineffectiveness. Any hedge ineffectiveness directly affects earnings
because there will be no offsetting adjustment of a hedged item’s carrying amount for the
ineffective aspect of the gain or loss on the related hedging instrument.
23.
If a hedged item is otherwise measured at fair value with changes in fair value reported in
other comprehensive income (such as an available-for-sale security), the adjustment of the
hedged item’s carrying amount discussed in paragraph 22 shall be recognized in earnings rather
than in other comprehensive income in order to offset the gain or loss on the hedging instrument.
24.
The adjustment of the carrying amount of a hedged asset or liability required by
paragraph 22 shall be accounted for in the same manner as other components of the carrying
amount of that asset or liability. For example, an adjustment of the carrying amount of a hedged
asset held for sale (such as inventory) would remain part of the carrying amount of that asset
until the asset is sold, at which point the entire carrying amount of the hedged asset would be
recognized as the cost of the item sold in determining earnings. An adjustment of the carrying
amount of a hedged interest-bearing financial instrument shall be amortized to earnings;
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amortization shall begin no later than when the hedged item ceases to be adjusted for changes in
its fair value attributable to the risk being hedged.
25.
An entity shall discontinue prospectively the accounting specified in paragraphs 22 and
23 for an existing hedge if any one of the following occurs:
a.
b.
c.
Any criterion in paragraphs 20 and 21 is no longer met.
The derivative expires or is sold, terminated, or exercised.
The entity removes the designation of the fair value hedge.
In those circumstances, the entity may elect to designate prospectively a new hedging
relationship with a different hedging instrument or, in the circumstances described in paragraphs
25.a. and 25(c) above, a different hedged item or a hedged transaction if the hedging relationship
meets the criteria specified in paragraphs 20 and 21 for a fair value hedge or paragraphs 28 and
29 for a cash flow hedge.
26.
In general, if a periodic assessment indicates noncompliance with the effectiveness
criterion in paragraph 20.b., an entity shall not recognize the adjustment of the carrying amount of
the hedged item described in paragraphs 22 and 23 after the last date on which compliance with
the effectiveness criterion was established. However, if the event or change in circumstances that
caused the hedging relationship to fail the effectiveness criterion can be identified, the entity shall
recognize in earnings the changes in the hedged item’s fair value attributable to the risk being
hedged that occurred prior to that event or change in circumstances. If a fair value hedge of a
firm commitment is discontinued because the hedged item no longer meets the definition of a firm
commitment, the entity shall derecognize any asset or liability previously recognized pursuant to
paragraph 22 (as a result of an adjustment to the carrying amount for the firm commitment) and
recognize a corresponding loss or gain currently in earnings.
Impairment
27.
An asset or liability that has been designated as being hedged and accounted for
pursuant to paragraphs 22-24 remains subject to the applicable requirements in generally
accepted accounting principles for assessing impairment for that type of asset or for recognizing
an increased obligation for that type of liability. Those impairment requirements shall be applied
after hedge accounting has been applied for the period and the carrying amount of the hedged
asset or liability has been adjusted pursuant to paragraph 22 of this Statement. Because the
hedging instrument is recognized separately as an asset or liability, its fair value or expected
cash flows shall not be considered in applying those impairment requirements to the hedged
asset or liability.
Cash Flow Hedges
General
28.
An entity may designate a derivative instrument as hedging the exposure to variability in
expected future cash flows that is attributable to a particular risk. That exposure may be
associated with an existing recognized asset or liability (such as all or certain future interest
payments on variable-rate debt) or a forecasted transaction (such as a forecasted purchase or
sale). Designated hedging instruments and hedged items or transactions qualify for cash flow
hedge accounting if all of the following criteria and those in paragraph 29 are met:
a.
At inception of the hedge, there is formal documentation of the hedging
relationship and the entity’s risk management objective and strategy for
undertaking the hedge, including identification of the hedging instrument, the
hedged transaction, the nature of the risk being hedged, and how the hedging
instrument’s effectiveness in hedging the exposure to the hedged transaction’s
variability in cash flows attributable to the hedged risk will be assessed. There
must be a reasonable basis for how the entity plans to assess the hedging
instrument’s effectiveness.
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(1)
b.
c.
d.
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An entity’s defined risk management strategy for a particular hedging
relationship may exclude certain components of a specific hedging
derivative’s change in fair value from the assessment of hedge
effectiveness, as discussed in paragraph 63 in Section 2 of Appendix A.
(2)
Documentation shall include all relevant details, including the date on or
period within which the forecasted transaction is expected to occur, the
specific nature of asset or liability involved (if any), and the expected
currency amount or quantity of the forecasted transaction.
(a)
The phrase expected currency amount refers to hedges of
foreign currency exchange risk and requires specification of the
exact amount of foreign currency being hedged.
(b)
The phrase expected . . . quantity refers to hedges of other risks
and requires specification of the physical quantity (that is, the
number of items or units of measure) encompassed by the
hedged forecasted transaction. If a forecasted sale or purchase
is being hedged for price risk, the hedged transaction cannot be
specified solely in terms of expected currency amounts, nor can
it be specified as a percentage of sales or purchases during a
period. The current price of a forecasted transaction also should
be identified to satisfy the criterion in paragraph 28.b. for
offsetting cash flows.
The hedged forecasted transaction shall be described with sufficient
specificity so that when a transaction occurs, it is clear whether that
transaction is or is not the hedged transaction. Thus, the forecasted
transaction could be identified as the sale of either the first 15,000 units
of a specific product sold during a specified 3-month period or the first
5,000 units of a specific product sold in each of 3 specific months, but it
could not be identified as the sale of the last 15,000 units of that product
sold during a 3-month period (because the last 15,000 units cannot be
identified when they occur, but only when the period has ended).
Both at inception of the hedge and on an ongoing basis, the hedging relationship
is expected to be highly effective in achieving offsetting cash flows attributable to
the hedged risk during the term of the hedge, except as indicated in paragraph
28.d. below. An assessment of effectiveness is required whenever financial
statements or earnings are reported, and at least every three months. If the
hedging instrument, such as an at-the-money option contract, provides only onesided offset against the hedged risk, the cash inflows (outflows) from the hedging
instrument must be expected to be highly effective in offsetting the corresponding
change in the cash outflows or inflows of the hedged transaction. All
assessments of effectiveness shall be consistent with the originally documented
risk management strategy for that particular hedging relationship.
If a written option is designated as hedging the variability in cash flows for a
recognized asset or liability, the combination of the hedged item and the written
option provides at least as much potential for favorable cash flows as exposure
to unfavorable cash flows. That test is met if all possible percentage favorable
changes in the underlying (from zero percent to 100 percent) would provide at
least as much favorable cash flows as the unfavorable cash flows that would be
incurred from an unfavorable change in the underlying of the same percentage.
(Refer to paragraph 20.c.(1).)
If a hedging instrument is used to modify the interest receipts or payments
associated with a recognized financial asset or liability from one variable rate to
another variable rate, the hedging instrument must be a link between an existing
designated asset (or group of similar assets) with variable cash flows and an
existing designated liability (or group of similar liabilities) with variable cash flows
and be highly effective at achieving offsetting cash flows. A link exists if the
basis (that is, the rate index on which the interest rate is based) of one leg of an
interest rate swap is the same as the basis of the interest receipts for the
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designated asset and the basis of the other leg of the swap is the same as the
basis of the interest payments for the designated liability. In this situation, the
criterion in the first sentence in paragraph 29.a. is applied separately to the
designated asset and the designated liability.
A nonderivative instrument, such as a Treasury note, shall not be designated as a hedging
instrument for a cash flow hedge.
The Hedged Forecasted Transaction
29.
A forecasted transaction is eligible for designation as a hedged transaction in a cash flow
hedge if all of the following additional criteria are met:
a.
The forecasted transaction is specifically identified as a single transaction or a
group of individual transactions. If the hedged transaction is a group of individual
transactions, those individual transactions must share the same risk exposure for
which they are designated as being hedged. Thus, a forecasted purchase and a
forecasted sale cannot both be included in the same group of individual
transactions that constitute the hedged transaction.
b.
The occurrence of the forecasted transaction is probable.
c.
The forecasted transaction is a transaction with a party external to the reporting
entity (except as permitted by paragraph 40) and presents an exposure to
variations in cash flows for the hedged risk that could affect reported earnings.
d.
The forecasted transaction is not the acquisition of an asset or incurrence of a
liability that will subsequently be remeasured with changes in fair value
attributable to the hedged risk reported currently in earnings (for example, if
foreign exchange risk is hedged, the forecasted acquisition of a foreign-currencydenominated asset for which a foreign currency transaction gain or loss will be
recognized in earnings). However, forecasted sales on credit and the forecasted
accrual of royalties on probable future sales by third-party licensees are not
considered the forecasted acquisition of a receivable. If the forecasted
transaction relates to a recognized asset or liability, the asset or liability is not
remeasured with changes in fair value attributable to the hedged risk reported
currently in earnings.
e.
If the variable cash flows of the forecasted transaction relate to a debt security
that is classified as held-to-maturity under Statement 115, the risk being hedged
is the risk of changes in its cash flows attributable to default or changes in the
obligor’s creditworthiness. For those variable cash flows, the risk being hedged
cannot be the risk of changes in its cash flows attributable to changes in market
interest rates.
f.
The forecasted transaction does not involve a business combination subject to
the provisions of Opinion 16 and is not a transaction (such as a forecasted
purchase, sale, or dividend) involving (1) a parent company’s interests in
consolidated subsidiaries, (2) a minority interest in a consolidated subsidiary, (3)
an equity-method investment, or (4) an entity’s own equity instruments.
g.
If the hedged transaction is the forecasted purchase or sale of a nonfinancial
asset, the designated risk being hedged is (1) the risk of changes in the
functional-currency-equivalent cash flows attributable to changes in the related
foreign currency exchange rates or (2) the risk of changes in the cash flows
relating to all changes in the purchase price or sales price of the asset (reflecting
its actual location if a physical asset), not the risk of changes in the cash flows
relating to the purchase or sale of a similar asset in a different location or of a
major ingredient. Thus, for example, in hedging the exposure to changes in the
cash flows relating to the purchase of its bronze bar inventory, an entity may not
designate the risk of changes in the cash flows relating to purchasing the copper
component in bronze as the risk being hedged for purposes of assessing offset
as required by paragraph 28.b..
h.
If the hedged transaction is the forecasted purchase or sale of a financial asset
or liability or the variable cash inflow or outflow of an existing financial asset or
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liability, the designated risk being hedged is (1) the risk of changes in the cash
flows of the entire asset or liability, such as those relating to all changes in the
purchase price or sales price (regardless of whether that price and the related
cash flows are stated in the entity’s functional currency or a foreign currency), (2)
the risk of changes in its cash flows attributable to changes in market interest
rates, (3) the risk of changes in the functional-currency-equivalent cash flows
attributable to changes in the related foreign currency exchange rates (refer to
paragraph 40), or (4) the risk of changes in its cash flows attributable to default
or changes in the obligor’s creditworthiness. Two or more of the above risks may
be designated simultaneously as being hedged. An entity may not designate
prepayment risk as the risk being hedged (refer to paragraph 21.f.).
30.
The effective portion of the gain or loss on a derivative designated as a cash flow hedge
is reported in other comprehensive income, and the ineffective portion is reported in earnings.
More specifically, a qualifying cash flow hedge shall be accounted for as follows:
a.
If an entity’s defined risk management strategy for a particular hedging
relationship excludes a specific component of the gain or loss, or related cash
flows, on the hedging derivative from the assessment of hedge effectiveness (as
discussed in paragraph 63 in Section 2 of Appendix A), that excluded component
of the gain or loss shall be recognized currently in earnings. For example, if the
effectiveness of a hedge with an option contract is assessed based on changes
in the option’s intrinsic value, the changes in the option’s time value would be
recognized in earnings. Time value is equal to the fair value of the option less its
intrinsic value.
b.
Accumulated other comprehensive income associated with the hedged
transaction shall be adjusted to a balance that reflects the lesser of the following
(in absolute amounts):
(1)
The cumulative gain or loss on the derivative from inception of the hedge
less (a) the excluded component discussed in paragraph 30.a. above
and (b) the derivative’s gains or losses previously reclassified from
accumulated other comprehensive income into earnings pursuant to
paragraph 31
(2)
The portion of the cumulative gain or loss on the derivative necessary to
offset the cumulative change in expected future cash flows on the
hedged transaction from inception of the hedge less the derivative’s
gains or losses previously reclassified from accumulated other
comprehensive income into earnings pursuant to paragraph 31.
That adjustment of accumulated other comprehensive income shall incorporate
recognition in other comprehensive income of part or all of the gain or loss on the
hedging derivative, as necessary.
c.
A gain or loss shall be recognized in earnings, as necessary, for any remaining
gain or loss on the hedging derivative or to adjust other comprehensive income
to the balance specified in paragraph 30.b. above.
Section 2 of Appendix A illustrates assessing hedge effectiveness and measuring hedge
ineffectiveness. Examples 6 and 9 of Section 1 of Appendix B illustrate the application of this
paragraph.
31.
Amounts in accumulated other comprehensive income shall be reclassified into earnings
in the same period or periods during which the hedged forecasted transaction affects earnings
(for example, when a forecasted sale actually occurs). If the hedged transaction results in the
acquisition of an asset or the incurrence of a liability, the gains and losses in accumulated other
comprehensive income shall be reclassified into earnings in the same period or periods during
which the asset acquired or liability incurred affects earnings (such as in the periods that
depreciation expense, interest expense, or cost of sales is recognized). However, if an entity
expects at any time that continued reporting of a loss in accumulated other comprehensive
income would lead to recognizing a net loss on the combination of the hedging instrument and
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the hedged transaction (and related asset acquired or liability incurred) in one or more future
periods, a loss shall be reclassified immediately into earnings for the amount that is not expected
to be recovered. For example, a loss shall be reported in earnings for a derivative that is
designated as hedging the forecasted purchase of inventory to the extent that the cost basis of
the inventory plus the related amount reported in accumulated other comprehensive income
exceeds the amount expected to be recovered through sales of that inventory. (Impairment
guidance is provided in paragraphs 34 and 35.)
32.
An entity shall discontinue prospectively the accounting specified in paragraphs 30 and
31 for an existing hedge if any one of the following occurs:
a.
b.
c.
Any criterion in paragraphs 28 and 29 is no longer met.
The derivative expires or is sold, terminated, or exercised.
The entity removes the designation of the cash flow hedge.
In those circumstances, the net gain or loss shall remain in accumulated other comprehensive
income and be reclassified into earnings as specified in paragraph 31. Furthermore, the entity
may elect to designate prospectively a new hedging relationship with a different hedging
instrument or, in the circumstances described in paragraphs 32.a. and 32.c., a different hedged
transaction or a hedged item if the hedging relationship meets the criteria specified in paragraphs
28 and 29 for a cash flow hedge or paragraphs 20 and 21 for a fair value hedge.
33.
If a cash flow hedge is discontinued because it is probable that the original forecasted
transaction will not occur, the net gain or loss in accumulated other comprehensive income shall
be immediately reclassified into earnings.
34.
Existing requirements in generally accepted accounting principles for assessing asset
impairment or recognizing an increased obligation apply to an asset or liability that gives rise to
variable cash flows (such as a variable-rate financial instrument), for which the variable cash
flows (the forecasted transactions) have been designated as being hedged and accounted for
pursuant to paragraphs 30 and 31. Those impairment requirements shall be applied each period
after hedge accounting has been applied for the period, pursuant to paragraphs 30 and 31 of this
Statement. The fair value or expected cash flows of a hedging instrument shall not be
considered in applying those requirements. The gain or loss on the hedging instrument in
accumulated other comprehensive income shall, however, be accounted for as discussed in
paragraph 31.
35.
If, under existing requirements in generally accepted accounting principles, an
impairment loss is recognized on an asset or an additional obligation is recognized on a liability to
which a hedged forecasted transaction relates, any offsetting net gain related to that transaction
in accumulated other comprehensive income shall be reclassified immediately into earnings.
Similarly, if a recovery is recognized on the asset or liability to which the forecasted transaction
relates, any offsetting net loss that has been accumulated in other comprehensive income shall
be reclassified immediately into earnings.
Foreign Currency Hedges
36.
Consistent with the functional currency concept in Statement 52, an entity may designate
the following types of hedges of foreign currency exposure, as specified in paragraphs 37-42:
a.
b.
c.
A fair value hedge of an unrecognized firm commitment or an available-for-sale
security
A cash flow hedge of a forecasted foreign-currency-denominated transaction or a
forecasted intercompany foreign-currency-denominated transaction
A hedge of a net investment in a foreign operation.
The criterion in paragraph 21.c.(1) requires that a recognized asset or liability that may give rise
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denominated receivable or payable) not be the hedged item in a foreign currency fair value or
cash flow hedge because it is remeasured with the changes in the carrying amount attributable to
what would be the hedged risk (an exchange rate change) reported currently in earnings.
Similarly, the criterion in paragraph 29.d. requires that the forecasted acquisition of an asset or
the incurrence of a liability that may give rise to a foreign currency transaction gain or loss under
Statement 52 not be the hedged item in a foreign currency cash flow hedge because, subsequent
to acquisition or incurrence, the asset or liability will be remeasured with changes in the carrying
amount attributable to what would be the hedged risk reported currently in earnings. A foreign
currency derivative instrument that has been entered into with another member of a consolidated
group can be a hedging instrument in the consolidated financial statements only if that other
member has entered into an offsetting contract with an unrelated third party to hedge the
exposure it acquired from issuing the derivative instrument to the affiliate that initiated the hedge.
Foreign Currency Fair Value Hedges
37.
Unrecognized firm commitment. A derivative instrument or a nonderivative financial
instrument that may give rise to a foreign currency transaction gain or loss under Statement 52
can be designated as hedging changes in the fair value of an unrecognized firm commitment, or
a specific portion thereof, attributable to foreign currency exchange rates. The designated
hedging relationship qualifies for the accounting specified in paragraphs 22-27 if all the fair value
hedge criteria in paragraphs 20 and 21 are met.
38.
Available-for-sale security. A nonderivative financial instrument shall not be designated
as the hedging instrument in a fair value hedge of the foreign currency exposure of an availablefor-sale security. A derivative instrument can be designated as hedging the changes in the fair
value of an available-for-sale debt security (or a specific portion thereof) attributable to changes
in foreign currency exchange rates. The designated hedging relationship qualifies for the
accounting specified in paragraphs 22-27 if all the fair value hedge criteria in paragraphs 20 and
21 are met. An available-for-sale equity security can be hedged for changes in the fair value
attributable to changes in foreign currency exchange rates and qualify for the accounting
specified in paragraphs 22-27 only if the fair value hedge criteria in paragraphs 20 and 21 are
met and the following two conditions are satisfied:
a.
b.
The security is not traded on an exchange (or other established marketplace) on
which trades are denominated in the investor’s functional currency.
Dividends or other cash flows to holders of the security are all denominated in
the same foreign currency as the currency expected to be received upon sale of
the security.
The change in fair value of the hedged available-for-sale equity security attributable to foreign
exchange risk is reported in earnings pursuant to paragraph 23 and not in other comprehensive
income.
39.
Gains and losses on a qualifying foreign currency fair value hedge shall be accounted for
as specified in paragraphs 22-27. The gain or loss on a nonderivative hedging instrument
attributable to foreign currency risk is the foreign currency transaction gain or loss as determined
under Statement 52. That foreign currency transaction gain or loss shall be recognized currently
in earnings along with the change in the carrying amount of the hedged firm commitment.
Foreign Currency Cash Flow Hedges
40.
A nonderivative financial instrument shall not be designated as a hedging instrument in a
foreign currency cash flow hedge. A derivative instrument designated as hedging the foreign
currency exposure to variability in the functional-currency-equivalent cash flows associated with
either a forecasted foreign-currency-denominated transaction (for example, a forecasted export
sale to an unaffiliated entity with the price to be denominated in a foreign currency) or a
forecasted intercompany foreign-currency-denominated transaction (for example, a forecasted
sale to a foreign subsidiary or a forecasted royalty from a foreign subsidiary) qualifies for hedge
accounting if all of the following criteria are met:
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a.
b.
c.
d.
The operating unit that has the foreign currency exposure is a party to the
hedging instrument (which can be an instrument between a parent company and
its subsidiary—refer to paragraph 36).
The hedged transaction is denominated in a currency other than that unit’s
functional currency.
All of the criteria in paragraphs 28 and 29 are met, except for the criterion in
paragraph 29.c. that requires that the forecasted transaction be with a party
external to the reporting entity.
If the hedged transaction is a group of individual forecasted foreign-currencydenominated transactions, a forecasted inflow of a foreign currency and a
forecasted outflow of the foreign currency cannot both be included in the same
group.
41.
A qualifying foreign currency cash flow hedge shall be accounted for as specified in
paragraphs 30-35.
Hedges of the Foreign Currency Exposure of a Net Investment in a Foreign Operation
42.
A derivative instrument or a nonderivative financial instrument that may give rise to a
foreign currency transaction gain or loss under Statement 52 can be designated as hedging the
foreign currency exposure of a net investment in a foreign operation. The gain or loss on a
hedging derivative instrument (or the foreign currency transaction gain or loss on the
nonderivative hedging instrument) that is designated as, and is effective as, an economic hedge
of the net investment in a foreign operation shall be reported in the same manner as a translation
adjustment to the extent it is effective as a hedge. The hedged net investment shall be
accounted for consistent with Statement 52; the provisions of this Statement for recognizing the
gain or loss on assets designated as being hedged in a fair value hedge do not apply to the
hedge of a net investment in a foreign operation.
Accounting by Not-for-Profit Organizations and Other Entities That Do Not Report Earnings
43.
An entity that does not report earnings as a separate caption in a statement of financial
performance (for example, a not-for-profit organization or a defined benefit pension plan) shall
recognize the gain or loss on a hedging instrument and a nonhedging derivative instrument as a
change in net assets in the period of change unless the hedging instrument is designated as a
hedge of the foreign currency exposure of a net investment in a foreign operation. In that case,
the provisions of paragraph 42 of this Statement shall be applied. Entities that do not report
earnings shall recognize the changes in the carrying amount of the hedged item pursuant to
paragraph 22 in a fair value hedge as a change in net assets in the period of change. Those
entities are not permitted to use cash flow hedge accounting because they do not report earnings
separately. Consistent with the provisions of FASB Statement No. 117, Financial Statements of
Not-for-Profit Organizations, this Statement does not prescribe how a not-for-profit organization
should determine the components of an operating measure, if one is presented.
Disclosures
44.
An entity that holds or issues derivative instruments (or nonderivative instruments that
are designated and qualify as hedging instruments pursuant to paragraphs 37 and 42) shall
disclose its objectives for holding or issuing those instruments, the context needed to understand
those objectives, and its strategies for achieving those objectives. The description shall
distinguish between derivative instruments (and nonderivative instruments) designated as fair
value hedging instruments, derivative instruments designated as cash flow hedging instruments,
derivative instruments (and nonderivative instruments) designated as hedging instruments for
hedges of the foreign currency exposure of a net investment in a foreign operation, and all other
derivatives. The description also shall indicate the entity’s risk management policy for each of
those types of hedges, including a description of the items or transactions for which risks are
hedged. For derivative instruments not designated as hedging instruments, the description shall
indicate the purpose of the derivative activity. Qualitative disclosures about an entity’s objectives
and strategies for using derivative instruments may be more meaningful if such objectives and
strategies are described in the context of an entity’s overall risk management profile. If
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appropriate, an entity is encouraged, but not required, to provide such additional qualitative
disclosures.
45.
An entity’s disclosures for every reporting period for which a complete set of financial
statements is presented also shall include the following:
Fair value hedges
a.
For derivative instruments, as well as nonderivative instruments that may give
rise to foreign currency transaction gains or losses under Statement 52, that
have been designated and have qualified as fair value hedging instruments and
for the related hedged items:
(1)
The net gain or loss recognized in earnings during the reporting period
representing (a) the amount of the hedges’ ineffectiveness and (b) the
component of the derivative instruments’ gain or loss, if any, excluded
from the assessment of hedge effectiveness, and a description of where
the net gain or loss is reported in the statement of income or other
statement of financial performance
(2)
The amount of net gain or loss recognized in earnings when a hedged
firm commitment no longer qualifies as a fair value hedge.
Cash flow hedges
b.
For derivative instruments that have been designated and have qualified as cash
flow hedging instruments and for the related hedged transactions:
(1)
The net gain or loss recognized in earnings during the reporting period
representing (a) the amount of the hedges’ ineffectiveness and (b) the
component of the derivative instruments’ gain or loss, if any, excluded
from the assessment of hedge effectiveness, and a description of where
the net gain or loss is reported in the statement of income or other
statement of financial performance
(2)
A description of the transactions or other events that will result in the
reclassification into earnings of gains and losses that are reported in
accumulated other comprehensive income, and the estimated net
amount of the existing gains or losses at the reporting date that is
expected to be reclassified into earnings within the next 12 months
(3)
The maximum length of time over which the entity is hedging its
exposure to the variability in future cash flows for forecasted transactions
excluding those forecasted transactions related to the payment of
variable interest on existing financial instruments
(4)
The amount of gains and losses reclassified into earnings as a result of
the discontinuance of cash flow hedges because it is probable that the
original forecasted transactions will not occur.
Hedges of the net investment in a foreign operation
c.
For derivative instruments, as well as nonderivative instruments that may give
rise to foreign currency transaction gains or losses under Statement 52, that
have been designated and have qualified as hedging instruments for hedges of
the foreign currency exposure of a net investment in a foreign operation, the net
amount of gains or losses included in the cumulative translation adjustment
during the reporting period.
The quantitative disclosures about derivative instruments may be more useful, and less likely to
be perceived to be out of context or otherwise misunderstood, if similar information is disclosed
about other financial instruments or nonfinancial assets and liabilities to which the derivative
instruments are related by activity. Accordingly, in those situations, an entity is encouraged, but
not required, to present a more complete picture of its activities by disclosing that information.
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Reporting Changes in the Components of Comprehensive Income
46.
An entity shall display as a separate classification within other comprehensive income the
net gain or loss on derivative instruments designated and qualifying as cash flow hedging
instruments that are reported in comprehensive income pursuant to paragraphs 30 and 41.
47.
As part of the disclosures of accumulated other comprehensive income, pursuant to
paragraph 26 of FASB Statement No. 130, Reporting Comprehensive Income, an entity shall
separately disclose the beginning and ending accumulated derivative gain or loss, the related net
change associated with current period hedging transactions, and the net amount of any
reclassification into earnings.
Effective Date and Transition
48.
This Statement shall be effective for all fiscal quarters of all fiscal years beginning after
June 15, 1999. Initial application of this Statement shall be as of the beginning of an entity’s
fiscal quarter; on that date, hedging relationships shall be designated anew and documented
pursuant to the provisions of this Statement. Earlier application of all of the provisions of this
Statement is encouraged but is permitted only as of the beginning of any fiscal quarter that
begins after issuance of this Statement. Earlier application of selected provisions of this
Statement is not permitted. This Statement shall not be applied retroactively to financial
statements of prior periods.
49.
At the date of initial application, an entity shall recognize all freestanding derivative
instruments (that is, derivative instruments other than embedded derivative instruments) in the
statement of financial position as either assets or liabilities and measure them at fair value,
pursuant to paragraph 17. The difference between a derivative’s previous carrying amount and
its fair value shall be reported as a transition adjustment, as discussed in paragraph 52. The
entity also shall recognize offsetting gains and losses on hedged assets, liabilities, and firm
commitments by adjusting their carrying amounts at that date, as discussed in paragraph 52.b.
Any gains or losses on derivative instruments that are reported independently as deferred gains
or losses (that is, liabilities or assets) in the statement of financial position at the date of initial
application shall be derecognized from that statement; that derecognition also shall be reported
as transition adjustments as indicated in paragraph 52. Any gains or losses on derivative
instruments reported in other comprehensive income at the date of initial application because the
derivative instruments were hedging the fair value exposure of available-for-sale securities also
shall be reported as transition adjustments; the offsetting losses and gains on the securities shall
be accounted for pursuant to paragraph 52.b.. Any gain or loss on a derivative instrument
reported in accumulated other comprehensive income at the date of initial application because
the derivative instrument was hedging the variable cash flow exposure of a forecasted
(anticipated) transaction related to an available-for-sale security shall remain in accumulated
other comprehensive income and shall not be reported as a transition adjustment. The
accounting for any gains and losses on derivative instruments that arose prior to the initial
application of the Statement and that were previously added to the carrying amount of recognized
hedged assets or liabilities is not affected by this Statement. Those gains and losses shall not be
included in the transition adjustment.
50.
At the date of initial application, an entity also shall recognize as an asset or liability in the
statement of financial position any embedded derivative instrument that is required pursuant to
paragraphs 12-16 to be separated from its host contract if the hybrid instrument in which it is
embedded was issued, acquired, or substantively modified by the entity after December 31,
1997. For all of its hybrid instruments that exist at the date of initial application and were issued
or acquired before January 1, 1998 and not substantively modified thereafter, an entity may
choose either (a) not to apply this Statement to any of those hybrid instruments or (b) to
recognize as assets or liabilities all the derivative instruments embedded in those hybrid
instruments that would be required pursuant to paragraphs 12-16 to be separated from their host
contracts. That choice is not permitted to be applied to only some of an entity’s individual hybrid
instruments and must be applied on an all-or-none basis.
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51.
If an embedded derivative instrument is to be separated from its host contract in
conjunction with the initial application of this Statement, the entity shall consider the following in
determining the related transition adjustment:
a.
b.
c.
The carrying amount of the host contract at the date of initial application shall be
based on its fair value on the date that the hybrid instrument was issued or
acquired by the entity and shall reflect appropriate adjustments for subsequent
activity, such as subsequent cash receipts or payments and the amortization of
any premium or discount on the host contract arising from the separation of the
embedded derivative.
The carrying amount of the embedded derivative instrument at the date of initial
application shall be its fair value.
The transition adjustment shall be the difference at the date of initial application
between (1) the previous carrying amount of the hybrid instrument and (2) the
sum of the new net carrying amount of the host contract and the fair value of the
embedded derivative instrument. The entity shall not retroactively designate a
hedging relationship that could have been made had the embedded derivative
instrument initially been accounted for separate from the host contract.
52.
The transition adjustments resulting from adopting this Statement shall be reported in net
income or other comprehensive income, as appropriate, as the effect of a change in accounting
principle and presented in a manner similar to the cumulative effect of a change in accounting
principle as described in paragraph 20 of APB Opinion No. 20, Accounting Changes. Whether a
transition adjustment related to a specific derivative instrument is reported in net income,
reported in other comprehensive income, or allocated between both is based on the hedging
relationships, if any, that had existed for that derivative instrument and that were the basis for
accounting under generally accepted accounting principles before the date of initial application of
this Statement.
a.
b.
c.
If the transition adjustment relates to a derivative instrument that had been
designated in a hedging relationship that addressed the variable cash flow
exposure of a forecasted (anticipated) transaction, the transition adjustment shall
be reported as a cumulative-effect-type adjustment of accumulated other
comprehensive income.
If the transition adjustment relates to a derivative instrument that had been
designated in a hedging relationship that addressed the fair value exposure of an
asset, a liability, or a firm commitment, the transition adjustment for the derivative
shall be reported as a cumulative-effect-type adjustment of net income.
Concurrently, any gain or loss on the hedged item (that is, difference between
the hedged item’s fair value and its carrying amount) shall be recognized as an
adjustment of the hedged item’s carrying amount at the date of initial application,
but only to the extent of an offsetting transition adjustment for the derivative.
That adjustment of the hedged item’s carrying amount shall also be reported as a
cumulative-effect-type adjustment of net income. The transition adjustment
related to the gain or loss reported in accumulated other comprehensive income
on a derivative instrument that hedged an available-for-sale security, together
with the loss or gain on the related security (to the extent of an offsetting
transition adjustment for the derivative instrument), shall be reclassified to
earnings as a cumulative-effect-type adjustment of both net income and
accumulated other comprehensive income.
If a derivative instrument had been designated in multiple hedging relationships
that addressed both the fair value exposure of an asset or a liability and the
variable cash flow exposure of a forecasted (anticipated) transaction, the
transition adjustment for the derivative shall be allocated between the
cumulative-effect-type adjustment of net income and the cumulative-effect-type
adjustment of accumulated other comprehensive income and shall be reported
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d.
as discussed in paragraphs 52.a. and 52.b. above. Concurrently, any gain or
loss on the hedged item shall be accounted for at the date of initial application as
discussed in paragraph 52.b. above.
Other transition adjustments not encompassed by paragraphs 52.a., 52.b. and
52.c. above shall be reported as part of the cumulative-effect-type adjustment of
net income.
53.
Any transition adjustment reported as a cumulative-effect-type adjustment of
accumulated other comprehensive income shall be subsequently reclassified into earnings in a
manner consistent with paragraph 31. For those amounts, an entity shall disclose separately in
the year of initial application the amount of gains and losses reported in accumulated other
comprehensive income and associated with the transition adjustment that are being reclassified
into earnings during the 12 months following the date of initial application.
54.
At the date of initial application, an entity may transfer any held-to-maturity security into
the available-for-sale category or the trading category. An entity will then be able in the future to
designate a security transferred into the available-for-sale category as the hedged item, or its
variable interest payments as the cash flow hedged transactions, in a hedge of the exposure to
changes in market interest rates, changes in foreign currency exchange rates, or changes in its
overall fair value. (Paragraph 21.d. precludes a held-to-maturity security from being designated
as the hedged item in a fair value hedge of market interest rate risk or the risk of changes in its
overall fair value. Paragraph 29.e. similarly precludes the variable cash flows of a held-tomaturity security from being designated as the hedged transaction in a cash flow hedge of market
interest rate risk.) The unrealized holding gain or loss on a held-to-maturity security transferred
to another category at the date of initial application shall be reported in net income or
accumulated other comprehensive income consistent with the requirements of paragraphs 15.b.
and 15.c. of Statement 115 and reported with the other transition adjustments discussed in
paragraph 52 of this Statement. Such transfers from the held-to-maturity category at the date of
initial adoption shall not call into question an entity’s intent to hold other debt securities to maturity
in the future.
55.
At the date of initial application, an entity may transfer any available-for-sale security into
the trading category. After any related transition adjustments from initially applying this
Statement have been recognized, the unrealized holding gain or loss remaining in accumulated
other comprehensive income for any transferred security at the date of initial application shall be
reclassified into earnings (but not reported as part of the cumulative-effect-type adjustment for
the transition adjustments), consistent with paragraph 15.b. of Statement 115. If a derivative
instrument had been hedging the variable cash flow exposure of a forecasted transaction related
to an available-for-sale security that is transferred into the trading category at the date of initial
application and the entity had reported a gain or loss on that derivative instrument in other
comprehensive income (consistent with paragraph 115 of Statement 115), the entity also shall
reclassify those derivative gains and losses into earnings (but not report them as part of the
cumulative-effect-type adjustment for the transition adjustments).
56.
At the date of initial application, mortgage bankers and other servicers of financial assets
may choose to restratify their servicing rights pursuant to paragraph 37.g. of Statement 125 in a
manner that would enable individual strata to comply with the requirements of this Statement
regarding what constitutes “a portfolio of similar assets.” As noted in footnote 9 of this Statement,
mortgage bankers and other servicers of financial assets that designate a hedged portfolio by
aggregating servicing rights within one or more risk strata used under paragraph 37.g. of
Statement 125 would not necessarily comply with the requirement in paragraph 21.a. of this
Statement for portfolios of similar assets, since the risk stratum under paragraph 37.g. of
Statement 125 can be based on any predominant risk characteristic, including date of origination
or geographic location. The restratification of servicing rights is a change in the application of an
accounting principle, and the effect of that change as of the initial application of this Statement
shall be reported as part of the cumulative-effect-type adjustment for the transition adjustments.
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Accounting for Derivative Instruments and Hedging Activities
65.
IP No. 114
FAS 137 provides the following:
Amendments to Statement 133
3.
Statement 133 is amended as follows:
a. The first sentence of paragraph 48 is replaced by the following:
This Statement shall be effective for all fiscal quarters of all fiscal years
beginning after June 15, 2000.
b. Paragraph 50 is replaced by the following:
At the date of initial application, an entity shall choose to either (a) recognize as
an asset or liability in the statement of financial position all embedded derivative
instruments that are required pursuant to paragraphs 12-16 to be separated from
their host contracts or (b) select either January 1, 1998 or January 1, 1999 as a
transition date for embedded derivatives. If the entity chooses to select a
transition date, it shall recognize as separate assets and liabilities (pursuant to
paragraphs 12-16) only those derivatives embedded in hybrid instruments
issued, acquired, or substantively modified by the entity on or after the selected
transition date. That choice is not permitted to be applied to only some of an
entity’s individual hybrid instruments and must be applied on an all-or-none
basis.
Effective Date
4.
This Statement is effective upon issuance. An entity that has already applied the
provisions of Statement 133 and has issued interim or annual financial statements reflecting that
application may not revert to a previous method of accounting for derivative instruments and
hedging activities.
66.
FAS 138 provides the following (certain sections not affecting the excerpted FAS No. 133
guidance excluded):
Amendments to Statement 133
4.
Statement 133 is amended as follows:
Amendment Related to Normal Purchases and Normal Sales
a.
Paragraph 10.b. is replaced by the following:
Normal purchases and normal sales. Normal purchases and normal sales are
contracts that provide for the purchase or sale of something other than a financial
instrument or derivative instrument that will be delivered in quantities expected to
be used or sold by the reporting entity over a reasonable period in the normal
course of business. However, contracts that have a price based on an underlying
that is not clearly and closely related to the asset being sold or purchased (such
as a price in a contract for the sale of a grain commodity based in part on
changes in the S&P index) or that are denominated in a foreign currency that
meets neither of the criteria in paragraphs 15.a. and 15.b. shall not be
considered normal purchases and normal sales. Contracts that contain net
settlement provisions as described in paragraphs 9.a. and 9.b. may qualify for
the normal purchases and normal sales exception if it is probable at inception
and throughout the term of the individual contract that the contract will not settle
net and will result in physical delivery. Net settlement (as described in
paragraphs 9.a. and 9.b.) of contracts in a group of contracts similarly designated
as normal purchases and normal sales would call into question the classification
of all such contracts as normal purchases or normal sales. Contracts that
require cash settlements of gains or losses or are otherwise settled net on a
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periodic basis, including individual contracts that are part of a series of sequential
contracts intended to accomplish ultimate acquisition or sale of a commodity, do
not qualify for this exception. For contracts that qualify for the normal purchases
and normal sales exception, the entity shall document the basis for concluding
that it is probable that the contract will result in physical delivery. The
documentation requirements can be applied either to groups of similarly
designated contracts or to each individual contract.
Amendments to Redefine Interest Rate Risk
b.
Paragraph 21 is amended as follows:
(1)
The first sentence of subparagraph (d) is replaced by the following:
If the hedged item is all or a portion of a debt security (or a
portfolio of similar debt securities) that is classified as held-tomaturity in accordance with FASB Statement No. 115,
Accounting for Certain Investments in Debt and Equity
Securities, the designated risk being hedged is the risk of
changes in its fair value attributable to credit risk, foreign
exchange risk, or both. If the hedged item is an option
component of a held-to-maturity security that permits its
prepayment, the designated risk being hedged is the risk of
changes in the entire fair value of that option component.
(2)
(3)
(4)
(5)
(6)
(7)
In the first parenthetical sentence of subparagraph (d), changes in
market interest rates or foreign exchange rates is replaced by interest
rate risk.
In subparagraph (f)(2), market interest rates is replaced by the
designated benchmark interest rate (referred to as interest rate risk).
In subparagraph (f)(3), (refer to paragraphs 37 and 38) is replaced by
(referred to as foreign exchange risk) (refer to paragraphs 37, 37A, and
38).
In subparagraph (f)(4), both is inserted between to and changes and the
obligor’s creditworthiness is replaced by the obligor’s creditworthiness
and changes in the spread over the benchmark interest rate with respect
to the hedged item’s credit sector at inception of the hedge (referred to
as credit risk).
In the second sentence of subparagraph (f), market is deleted.
In subparagraph (f), the following sentences and footnote are added
after the second sentence:
The benchmark interest rate being hedged in a hedge of interest
rate risk must be specifically identified as part of the designation
and documentation at the inception of the hedging relationship.
Ordinarily, an entity should designate the same benchmark
interest rate as the risk being hedged for similar hedges,
consistent with paragraph 62; the use of different benchmark
interest rates for similar hedges should be rare and must be
justified. In calculating the change in the hedged item’s fair
value attributable to changes in the benchmark interest rate, the
estimated cash flows used in calculating fair value must be
based on all of the contractual cash flows of the entire hedged
item. Excluding some of the hedged item’s contractual cash
flows (for example, the portion of the interest coupon in excess
of the benchmark interest rate) from the calculation is not
permitted.
(8)
(9)
In the fourth sentence of subparagraph (f), overall is inserted between
exposure to changes in the and fair value of that.
In the last sentence of subparagraph (f), market is deleted.
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Accounting for Derivative Instruments and Hedging Activities
c.
IP No. 114
Paragraph 29 is amended as follows:
(1)
In the first sentence of subparagraph (e), default or changes in the
obligor’s creditworthiness is replaced by credit risk, foreign exchange
risk, or both.
(2)
In the last sentence of subparagraph (e), changes in market interest
rates is replaced by interest rate risk.
(3)
In the first sentence of subparagraph (h), (or the interest payments on
that financial asset or liability) is added after sale of a financial asset or
liability.
(4)
In subparagraph (h)(1), the risk of changes in the cash flows of the entire
asset or liability is replaced by the risk of overall changes in the hedged
cash flows related to the asset or liability.
(5)
In subparagraph (h)(2), market interest rates is replaced by the
designated benchmark interest rate (referred to as interest rate risk).
(6)
In subparagraph (h)(3), (refer to paragraph 40) is replaced by (referred to
as foreign exchange risk) (refer to paragraphs 40, 40A, 40B, and 40C).
(7)
In subparagraph (h)(4), default or changes in the obligor’s
creditworthiness is replaced by default, changes in the obligor’s
creditworthiness, and changes in the spread over the benchmark interest
rate with respect to the hedged item’s credit sector at inception of the
hedge (referred to as credit risk).
(8)
In subparagraph (h), the following sentences are added after the second
sentence:
The benchmark interest rate being hedged in a hedge of interest rate risk must be
specifically identified as part of the designation and documentation at the inception of the
hedging relationship. Ordinarily, an entity should designate the same benchmark interest
rate as the risk being hedged for similar hedges, consistent with paragraph 62; the use of
different benchmark interest rates for similar hedges should be rare and must be justified.
In a cash flow hedge of a variable-rate financial asset or liability, either existing or
forecasted, the designated risk being hedged cannot be the risk of changes in its cash
flows attributable to changes in the specifically identified benchmark interest rate if the
cash flows of the hedged transaction are explicitly based on a different index, for
example, based on a specific bank’s prime rate, which cannot qualify as the benchmark
rate. However, the risk designated as being hedged could potentially be the risk of
overall changes in the hedged cash flows related to the asset or liability, provided that the
other criteria for a cash flow hedge have been met.
d.
Paragraph 54 is amended as follows:
(1)
In the second sentence, market interest rates, changes in foreign
currency exchange rates, is replaced by the designated benchmark interest rate.
(2)
In the third and fourth (parenthetical) sentences, market is deleted.
(3)
In the penultimate sentence of footnote 14, market interest rates is
replaced by interest rate risk.
e.
In the first sentence of paragraph 90, market is deleted.
Amendments Related to Hedging Recognized Foreign-Currency-Denominated Assets and
Liabilities
f.
In paragraph 21.c.(1), (for example, if foreign exchange risk is hedged, a foreigncurrency-denominated asset for which a foreign currency transaction gain or loss
is recognized in earnings) is deleted.
g.
Paragraph 29.d. is amended as follows:
1)
In the first sentence, (for example, if foreign exchange risk is hedged, the
forecasted acquisition of a foreign-currency-denominated asset for which
a foreign currency transaction gain or loss will be recognized in earnings)
is deleted.
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h.
(2)
The second sentence is deleted.
In paragraph 29.g.(2), (reflecting its actual location if a physical asset) is replaced
by reflecting its actual location if a physical asset (regardless of whether that
price and the related cash flows are stated in the entity’s functional currency or a
foreign currency).
i.
The following subparagraph is added after subparagraph (c) of paragraph 30:
d.
In a cash flow hedge of the variability of the functional-currencyequivalent cash flows for a recognized foreign-currency-denominated
asset or liability that is remeasured at spot exchange rates under
paragraph 15 of Statement 52, an amount that will offset the related
transaction gain or loss arising from the remeasurement and adjust
earnings for the cost to the purchaser (income to the seller) of the
hedging instrument shall be reclassified each period from other
comprehensive income to earnings.
j.
Paragraph 36 is amended as follows:
(1)
In the first sentence, Consistent with the functional currency concept in
Statement 52 is replaced by If the hedged item is denominated in a
foreign currency.
(2)
In subparagraph (a), an available-for-sale security is replaced by a
recognized asset or liability (including an available-for-sale security).
(3)
Subparagraph (b) is replaced by the following:
A cash flow hedge of a forecasted transaction, an unrecognized firm
commitment, the forecasted functional-currency-equivalent cash flows
associated with a recognized asset or liability, or a forecasted
intercompany transaction.
(4)
The first two sentences following subparagraph (c) are replaced by the
following:
The recognition in earnings of the foreign currency transaction gain or loss on a foreigncurrency-denominated asset or liability based on changes in the foreign currency spot
rate is not considered to be the remeasurement of that asset or liability with changes in
fair value attributable to foreign exchange risk recognized in earnings, which is discussed
in the criteria in paragraphs 21.c.(1) and 29.d. Thus, those criteria are not impediments
to either a foreign currency fair value or cash flow hedge of such a foreign-currencydenominated asset or liability or a foreign currency cash flow hedge of the forecasted
acquisition or incurrence of a foreign-currency-denominated asset or liability whose
carrying amount will be remeasured at spot exchange rates under paragraph 15 of
Statement 52.
k.
The following paragraph is added after paragraph 36:
36A. The provisions in paragraph 36 that permit a recognized foreign-currencydenominated asset or liability to be the hedged item in a fair value or cash flow
hedge of foreign currency exposure also pertain to a recognized foreigncurrency-denominated receivable or payable that results from a hedged
forecasted foreign-currency-denominated sale or purchase on credit. An entity
may choose to designate a single cash flow hedge that encompasses the
variability of functional currency cash flows attributable to foreign exchange risk
related to the settlement of the foreign-currency-denominated receivable or
payable resulting from a forecasted sale or purchase on credit. Alternatively, an
entity may choose to designate a cash flow hedge of the variability of functional
currency cash flows attributable to foreign exchange risk related to a forecasted
foreign-currency-denominated sale or purchase on credit and then separately
designate a foreign currency fair value hedge of the resulting recognized foreigncurrency-denominated receivable or payable. In that case, the cash flow hedge
would terminate (be dedesignated) when the hedged sale or purchase occurs
and the foreign-currency-denominated receivable or payable is recognized. The
use of the same foreign currency derivative instrument for both the cash flow
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IP No. 114
hedge and the fair value hedge is not prohibited though some ineffectiveness
may result.
l.
The following paragraph is added after paragraph 37:
37A.
Recognized asset or liability. A nonderivative financial instrument shall
not be designated as the hedging instrument in a fair value hedge of the foreign
currency exposure of a recognized asset or liability. A derivative instrument can
be designated as hedging the changes in the fair value of a recognized asset or
liability (or a specific portion thereof) for which a foreign currency transaction gain
or loss is recognized in earnings under the provisions of paragraph 15 of
Statement 52. All recognized foreign-currency-denominated assets or liabilities
for which a foreign currency transaction gain or loss is recorded in earnings may
qualify for the accounting specified in paragraphs 22-27 if all the fair value hedge
criteria in paragraphs 20 and 21 and the conditions in paragraphs 40.a. and 40.b.
are met.
m.
Paragraph 40 is amended as follows:
(1)
The second sentence is replaced by the following:
A derivative instrument designated as hedging the foreign currency
exposure to variability in the functional-currency-equivalent cash flows
associated with a forecasted transaction (for example, a forecasted
export sale to an unaffiliated entity with the price to be denominated in a
foreign currency), a recognized asset or liability, an unrecognized firm
commitment, or a forecasted intercompany transaction (for example, a
forecasted sale to a foreign subsidiary or a forecasted royalty from a
foreign subsidiary) qualifies for hedge accounting if all the following
criteria are met:
(2)
The following subparagraph is added:
e.
If the hedged item is a recognized foreign-currency-denominated
asset or liability, all the variability in the hedged item’s functionalcurrency-equivalent cash flows must be eliminated by the effect
of the hedge. (For example, a cash flow hedge cannot be used
with a variable-rate foreign-currency-denominated asset or
liability and a derivative based solely on changes in exchange
rates because the derivative does not eliminate all the variability
in the functional currency cash flows.)
Amendments Related to Intercompany Derivatives
n.
In the last sentence of paragraph 36, in a fair value hedge or in a cash flow
hedge of a recognized foreign-currency-denominated asset or liability or in a net
investment hedge is added after can be a hedging instrument.
o.
The following paragraphs are added after paragraph 40:
40A.
Internal derivative. A foreign currency derivative contract that has been
entered into with another member of a consolidated group (such as a
treasury center) can be a hedging instrument in a foreign currency cash
flow hedge of a forecasted borrowing, purchase, or sale or an
unrecognized firm commitment in the consolidated financial statements
only if the following two conditions are satisfied. (That foreign currency
derivative instrument is hereafter in this section referred to as an internal
derivative.)
a.
From the perspective of the member of the consolidated group
using the derivative as a hedging instrument (hereafter in this
section referred to as the hedging affiliate), the criteria for foreign
currency cash flow hedge accounting in paragraph 40 must be
satisfied.
b.
The member of the consolidated group not using the derivative
as a hedging instrument (hereafter in this section referred to as
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Issue Paper
the issuing affiliate) must either (1) enter into a derivative
contract with an unrelated third party to offset the exposure that
results from that internal derivative or (2) if the conditions in
paragraph 40B are met, enter into derivative contracts with
unrelated third parties that would offset, on a net basis for each
foreign currency, the foreign exchange risk arising from multiple
internal derivative contracts.
40B.
40C.
Offsetting net exposures. If an issuing affiliate chooses to offset
exposure arising from multiple internal derivative contracts on an
aggregate or net basis, the derivatives issued to hedging affiliates may
qualify as cash flow hedges in the consolidated financial statements only
if all of the following conditions are satisfied:
a.
The issuing affiliate enters into a derivative contract with an
unrelated third party to offset, on a net basis for each foreign
currency, the foreign exchange risk arising from multiple internal
derivative contracts, and the derivative contract with the
unrelated third party generates equal or closely approximating
gains and losses when compared with the aggregate or net
losses and gains generated by the derivative contracts issued to
affiliates.
b.
Internal derivatives that are not designated as hedging
instruments are excluded from the determination of the foreign
currency exposure on a net basis that is offset by the third-party
derivative. In addition, nonderivative contracts may not be used
as hedging instruments to offset exposures arising from internal
derivative contracts.
c.
Foreign currency exposure that is offset by a single net thirdparty contract arises from internal derivative contracts that
mature within the same 31-day period and that involve the same
currency exposure as the net third-party derivative.
The
offsetting net third-party derivative related to that group of
contracts must offset the aggregate or net exposure to that
currency, must mature within the same 31-day period, and must
be entered into within 3 business days after the designation of
the internal derivatives as hedging instruments.
d.
The issuing affiliate tracks the exposure that it acquires from
each hedging affiliate and maintains documentation supporting
linkage of each internal derivative contract and the offsetting
aggregate or net derivative contract with an unrelated third party.
e.
The issuing affiliate does not alter or terminate the offsetting
derivative with an unrelated third party unless the hedging
affiliate initiates that action. If the issuing affiliate does alter or
terminate any offsetting third-party derivative (which should be
rare), the hedging affiliate must prospectively cease hedge
accounting for the internal derivatives that are offset by that
third-party derivative.
A member of a consolidated group is not permitted to offset exposures
arising from multiple internal derivative contracts on a net basis for
foreign currency cash flow exposures related to recognized foreigncurrency-denominated assets or liabilities. That prohibition includes
situations in which a recognized foreign-currency-denominated asset or
liability in a fair value hedge or cash flow hedge results from the
occurrence of a specifically identified forecasted transaction initially
designated as a cash flow hedge.
© 1999-2015 National Association of Insurance Commissioners
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Accounting for Derivative Instruments and Hedging Activities
IP No. 114
Amendments for Certain Interpretations of Statement 133 Cleared by the Board Relating to the
Derivatives Implementation Group Process
p.
In the second sentence of paragraph 12, host is inserted between would be
required by the and contract, whether unconditional.
Amendments to Implement Guidance in Implementation Issue No. G3, “Discontinuation of a Cash
Flow Hedge”
q.
Paragraph 33 is replaced by the following:
The net derivative gain or loss related to a discontinued cash flow hedge shall
continue to be reported in accumulated other comprehensive income unless it is
probable that the forecasted transaction will not occur by the end of the originally
specified time period (as documented at the inception of the hedging
relationship) or within an additional two-month period of time thereafter, except
as indicated in the following sentence. In rare cases, the existence of
extenuating circumstances that are related to the nature of the forecasted
transaction and are outside the control or influence of the reporting entity may
cause the forecasted transaction to be probable of occurring on a date that is
beyond the additional two-month period of time, in which case the net derivative
gain or loss related to the discontinued cash flow hedge shall continue to be
reported in accumulated other comprehensive income until it is reclassified into
earnings pursuant to paragraph 31. If it is probable that the hedged forecasted
transaction will not occur either by the end of the originally specified time period
or within the additional two-month period of time and the hedged forecasted
transaction also does not qualify for the exception described in the preceding
sentence, that derivative gain or loss reported in accumulated other
comprehensive income shall be reclassified into earnings immediately.
r.
The following is added at the end of paragraph 45.b.(4):
by the end of the originally specified time period or within the additional period of
time discussed in paragraph 33.
Amendments to Implement Guidance in Implementation Issue No. H1, “Hedging at the Operating
Unit Level”
s.
In the last sentence of paragraph 37, and the conditions in paragraphs 40.a. and
40(b) is added between paragraphs 20 and 21 and are met.
t.
In the third sentence of paragraph 38, and the conditions in paragraphs 40.a. and
40.b. is added between paragraphs 20 and 21 and are met.
u.
In paragraph 42, provided the conditions in paragraphs 40.a. and 40.b. are met is
added to the end of the first sentence.
Amendments to Implement Guidance in Implementation Issue No. H2, “Requirement That the
Unit with the Exposure Must Be a Party to the Hedge”
v.
Paragraph 40 is amended as follows:
(1)
Subparagraph (a) is replaced by the following:
For consolidated financial statements, either (1) the operating unit that
has the foreign currency exposure is a party to the hedging instrument or
(2) another member of the consolidated group that has the same
functional currency as that operating unit (subject to the restrictions in
this subparagraph and related footnote) is a party to the hedging
instrument. To qualify for applying the guidance in (2) above, there may
be no intervening subsidiary with a different functional currency. (Refer
to paragraphs 36, 40A, and 40B for conditions for which an
intercompany foreign currency derivative can be the hedging instrument
in a cash flow hedge of foreign exchange risk.)
(2)
In subparagraph (b), that is replaced by the hedging.
© 1999-2015 National Association of Insurance Commissioners
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Issue Paper
OTHER SOURCES OF INFORMATION:
67.
The Financial Accounting Standards Board established the Derivatives Implementation Group to
address execution of FAS No. 133. The Derivatives Implementation Group addressed two issues related
to effectiveness that are applicable to this issue paper. The issues have been authored by the FASB staff
and represents the staff’s views, although FASB has discussed the responses at a public meeting and
chosen not to object to dissemination of those responses. Official positions of the FASB are determined
only after extensive due process and deliberation. E7: Hedging—General: Methodologies to Assess
Effectiveness of Fair Value and Cash Flow Hedges and E8: Hedging–General: Assessing Hedge
Effectiveness of Fair Value and Cash Flow Hedges Period-by-Period or Cumulatively under a DollarOffset Approach are included as part of Exhibit A:
RELEVANT LITERATURE:
Statutory Accounting
SSAP No. 31 – Derivative Instruments
Minutes of the June 7, 1999 Emerging Accounting Issues (E) Working Group meeting
Generally Accepted Accounting Principles
FASB Statement No. 80, Accounting for Futures Contracts
FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities
FASB Statement No. 137, Accounting for Derivative Instruments and Hedging Activities—
Deferral of the Effective Date of FASB Statement No. 133 - an amendment of FASB Statement
No. 133
FASB Statement No. 138, Accounting for Certain Derivative Instruments and Certain Hedging
Activities - an amendment of FASB Statement No. 133
EITF 98-10, Accounting for Contracts Involved in Energy Trading and Risk Management
Activities
EITF 98-12, Application of Issue No. 96-13 to Forward Equity Sales Transactions
EITF 99-01, Accounting for Debt Convertible into the Stock of a Consolidated Sub
EITF 99-02, Accounting for Weather Derivatives
EITF 99-03, Application of Issue No. 96-13 to Derivative Instruments with Multiple Settlement
Alternatives
EITF 99-08, Accounting for Transfers of Assets That Are Derivative Instruments but That Are Not
Financial Assets
EITF 99-09, Effect of Derivative Gains and Losses on the Capitalization of Interest
EITF 00-07, Application of Issue No. 96-13 to Equity Derivative Instruments That Contain
Certain Provisions That Require Net Cash Settlement If Certain Events outside the Control of the
Issuer Occur
EITF 00-09, Classification of a Gain or Loss from a Hedge of Debt That Is Extinguished
FASB Derivatives Implementation Group E7: Hedging—General: Methodologies to Assess
Effectiveness of Fair Value and Cash Flow Hedges and E8: Hedging–General: Assessing Hedge
Effectiveness of Fair Value and Cash Flow Hedges Period-by-Period or Cumulatively under a
Dollar-Offset Approach
© 1999-2015 National Association of Insurance Commissioners
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IP No. 114
EXHIBIT A - DISCUSSION OF HEDGING EFFECTIVENESS
The Financial Accounting Standards Board established the Derivatives Implementation Group in 1999 to
address execution of FAS No. 133. The Derivatives Implementation Group addressed two issues related
to effectiveness that are applicable to this issue paper. The issues have been authored by the FASB staff
and represents the staff’s views, although FASB has discussed the responses at a public meeting and
chosen not to object to dissemination of those responses. Official positions of the FASB are determined
only after extensive due process and deliberation.
No. E7: Hedging—General: Methodologies to Assess Effectiveness of Fair Value and Cash Flow
Hedges
Paragraph references: 20.b., 22, 28.b., 62, 86, 87
Date cleared by Board: May 17, 2000
QUESTION
1.
Since Statement 133 provides an entity with flexibility in choosing the method it will use in
assessing hedge effectiveness, must an entity use a dollar-offset approach in assessing effectiveness?
BACKGROUND
2.
Paragraph 20.b. of Statement 133 states, in part:
Both at inception of the [fair value] hedge and on an ongoing basis, the hedging relationship is
expected to be highly effective in achieving offsetting changes in fair value attributable to the
hedged risk during the period that the hedge is designated. An assessment of effectiveness is
required whenever financial statements or earnings are reported, and at least every three months.
3.
Paragraph 28.b. indicates a similar requirement that the hedging relationship be expected to be
highly effective in achieving offsetting changes in cash flows attributable to the hedged risk during the
period that the hedge is designated.
4.
Paragraph 22 of Statement 133 states, in part:
The measurement of hedge ineffectiveness for a particular hedging relationship shall be
consistent with the entity’s risk management strategy and the method of assessing hedge
effectiveness that was documented at the inception of the hedging relationship, as discussed in
paragraph 20.a. Nevertheless, the amount of hedge ineffectiveness recognized in earnings is
based on the extent to which exact offset is not achieved.
5.
Paragraph 62 emphasizes that each entity must “define at the time it designates a hedging
relationship the method it will use to assess the hedge’s effectiveness in achieving offsetting changes in
fair value or offsetting cash flows attributable to the risk being hedged.” It also states, “This Statement
does not specify a single method for either assessing whether a hedge is expected to be highly effective or
measuring hedge ineffectiveness.”
RESPONSE
6.
No. Statement 133 requires an entity to consider hedge effectiveness in two different ways—in
prospective considerations and in retrospective evaluations.
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a.
Issue Paper
Prospective considerations
Upon designation of a hedging relationship (as well as on an ongoing basis), the entity must be
able to justify an expectation that the relationship will be highly effective over future periods in
achieving offsetting changes in fair value or cash flows. That expectation, which is forwardlooking, can be based upon regression or other statistical analysis of past changes in fair values or
cash flows as well as on other relevant information.
b.
Retrospective evaluations
At least quarterly, the hedging entity must determine whether the hedging relationship has been
highly effective in having achieved offsetting changes in fair value or cash flows through the date
of the periodic assessment. That assessment can be based upon regression or other statistical
analysis of past changes in fair values or cash flows as well as on other relevant information. If
an entity elects at the inception of a hedging relationship to utilize the same regression analysis
approach for both prospective considerations and retrospective evaluations of assessing
effectiveness, then during the term of that hedging relationship those regression analysis
calculations should generally incorporate the same number of data points. Electing to utilize a
regression or other statistical analysis approach instead of a dollar-offset approach to perform
retrospective evaluations of assessing hedge effectiveness may affect whether an entity can apply
hedge accounting for the current assessment period as discussed below.
7.
Paragraph 62 requires that at the time an entity designates a hedging relationship, it must define
and document the method it will use to assess the hedge’s effectiveness. That paragraph also states that
ordinarily “an entity should assess effectiveness for similar hedges in a similar manner; use of different
methods for similar hedges should be justified.” Furthermore, it requires that an entity use that defined
and documented methodology consistently throughout the period of the hedge. If an entity elects at the
inception of a hedging relationship to utilize a regression analysis approach for prospective considerations
of assessing effectiveness and the dollar-offset method to perform retrospective evaluations of assessing
effectiveness, then that entity must abide by the results of that methodology as long as that hedging
relationship remains designated. Thus, in its retrospective evaluation, an entity might conclude that,
under a dollar-offset approach, a designated hedging relationship does not qualify for hedge accounting
for the period just ended, but that the hedging relationship may continue because, under a regression
analysis approach, there is an expectation that the relationship will be highly effective in achieving
offsetting changes in fair value or cash flows in future periods. In its retrospective evaluation, if that
entity concludes that, under a dollar-offset approach, the hedging relationship has not been highly
effective in having achieved offsetting changes in fair value or cash flows, hedge accounting may not be
applied in the current period. Whenever a hedging relationship fails to qualify for hedge accounting in a
certain assessment period, the overall change in fair value of the derivative for that current period is
recognized in earnings (not reported in other comprehensive income for a cash flow hedge) and the
change in fair value of the hedged item would not be recognized in earnings for that period (for a fair
value hedge).
8.
If an entity elects at the inception of a hedging relationship to utilize a regression analysis (or
other statistical analysis) approach for either prospective considerations or retrospective evaluations of
assessing effectiveness, then that entity must periodically update its regression analysis (or other
statistical analysis). For example, if there is significant ineffectiveness measured and recognized in
earnings for a hedging relationship, which is calculated each assessment period, the regression analysis
should be rerun to determine whether the expectation of high effectiveness is still valid. As long as an
entity reruns its regression analysis and determines that the hedging relationship is still expected to be
highly effective, then it can continue to apply hedge accounting without interruption.
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9.
In all instances, the actual measurement of hedge ineffectiveness to be recognized in earnings
each reporting period is based on the extent to which exact offset is not achieved as specified in paragraph
22 of Statement 133 (for fair value hedges) or paragraph 30 (for cash flow hedges). That requirement
applies even if a regression or other statistical analysis approach for both prospective considerations and
retrospective evaluations of assessing effectiveness supports an expectation that the hedging relationship
will be highly effective and demonstrates that it has been highly effective, respectively.
10.
The application of a regression or other statistical analysis approach to assessing effectiveness is
complex. Those methodologies require appropriate interpretation and understanding of the statistical
inferences.
E8: Hedging–General: Assessing Hedge Effectiveness of Fair Value and Cash Flow Hedges Periodby-Period or Cumulatively under a Dollar-Offset Approach
Paragraph references: 20.b., 28.b., 30, 62, 64, 67
Date cleared by Board: June 28, 2000
QUESTION
1.
In periodically assessing retrospectively the effectiveness of a fair value hedge (or a cash flow
hedge) in having achieved offsetting changes in fair values (or cash flows), an entity compares the change
in the hedging instrument’s fair value (or cash flows) to the change in the hedged item’s fair value (or
hedged transaction’s cash flows) attributable to the hedged risk. If an entity elects at inception of a
hedging relationship to utilize the dollar-offset approach for retrospective evaluations of assessing
effectiveness, then should that entity base that comparison on (a) the fair value (or cash flow) changes that
have occurred during the period being assessed (that is, on a period-by-period basis) or (b) the cumulative
fair value (or cash flow) changes to date from the inception of the hedge? Is that entity permitted to use
either a period-by-period approach or a cumulative approach on individual fair value hedges (or cash flow
hedges) under a dollar-offset approach?
BACKGROUND
2.
Paragraph 20.b. of Statement 133 states, in part:
Both at inception of the [fair value] hedge and on an ongoing basis, the hedging relationship is
expected to be highly effective in achieving offsetting changes in fair value attributable to the
hedged risk during the period that the hedge is designated. An assessment of effectiveness is
required whenever financial statements or earnings are reported, and at least every three
months.…All assessments of effectiveness shall be consistent with the risk management strategy
documented for that particular hedging relationship.
3.
Paragraph 28.b. states, in part:
Both at inception of the [cash flow] hedge and on an ongoing basis, the hedging relationship is
expected to be highly effective in achieving offsetting cash flows attributable to the hedged risk
during the term of the hedge, except as indicated in paragraph 28.d. below. An assessment of
effectiveness is required whenever financial statements or earnings are reported, and at least
every three months.…All assessments of effectiveness shall be consistent with the originally
documented risk management strategy for that particular hedging relationship.
4.
Paragraph 30.b. states that “the effective portion of the gain or loss on a derivative designated as a
cash flow hedge is reported in other comprehensive income.” Paragraph 30.b. specifies how the effective
portion to be reported in other comprehensive income should be calculated. The calculation of the
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Issue Paper
effective portion is, in part, based on “cumulative gain or loss on the derivative from inception of the
hedge.”
5.
Paragraph 67 of the Statement states, in part:
If the hedge initially qualifies for hedge accounting, the entity would continue to assess whether
the hedge meets the effectiveness test and also would measure any ineffectiveness during the
hedge period. If the hedge fails the effectiveness test at any time (that is, if the entity does not
expect the hedge to be highly effective at achieving offsetting changes in fair values or cash
flows), the hedge ceases to qualify for hedge accounting.
RESPONSE
6.
In periodically (that is, at least quarterly) assessing retrospectively the effectiveness of a fair
value hedge (or a cash flow hedge) in having achieved offsetting changes in fair values (or cash flows)
under a dollar-offset approach, Statement 133 permits an entity to use either a period-by-period approach
or a cumulative approach on individual fair value hedges (or cash flow hedges). The period-by-period
approach involves comparing the changes in the hedging instrument’s fair values (or cash flows) that
have occurred during the period being assessed to the changes in the hedged item’s fair value (or hedged
transaction’s cash flows) attributable to the risk hedged that have occurred during the same period. The
cumulative approach involves comparing the cumulative changes (to date from inception of the hedge) in
the hedging instrument’s fair values (or cash flows) to the cumulative changes in the hedged item’s fair
value (or hedged transaction’s cash flows) attributable to the risk hedged. At inception of the hedge, an
entity may choose either approach in designating how effectiveness will be assessed, depending on the
nature of the hedge documented in accordance with paragraphs 20.a. and 28.a. For example, an entity
may decide that the cumulative approach is generally preferred, yet may wish to use the period-by-period
approach in certain circumstances.
7.
Paragraph 62 requires that at the time an entity designates a hedging relationship, it must define
and document the method it will use to assess the hedge’s effectiveness. That paragraph also states that
ordinarily “an entity should assess effectiveness for similar hedges in a similar manner; use of different
methods for similar hedges should be justified.” Furthermore, it requires that an entity use that defined
and documented methodology consistently throughout the period of the hedge. If an entity elects at
inception of a hedging relationship to base its comparison of changes in fair value (or cash flows) on a
cumulative approach, then that entity must abide by the results of that methodology as long as that
hedging relationship remains designated. Electing to utilize a period-by-period approach instead of a
cumulative approach (or vice versa) to perform retrospective evaluations of assessing hedge effectiveness
under the dollar-offset method may affect whether an entity can apply hedge accounting for the current
assessment period.
8.
If an entity elects to base its comparison of changes in fair value (or cash flows) on a period-byperiod approach, the period cannot exceed three months. Fair value (or cash flow) patterns of the hedging
instrument or the hedged item (or hedged transaction) in periods prior to the period being assessed are not
relevant.
9.
The foregoing guidance relates to an entity’s periodic retrospective assessment and determining
whether a hedging relationship continues to qualify for hedge accounting; it does not relate to the actual
measurement of hedge ineffectiveness to be recognized in earnings under hedge accounting. The actual
measurement of ineffectiveness is based on the extent to which exact offset is not achieved as specified in
paragraph 22 for fair value hedges or paragraph 30 for cash flow hedges.
10.
The above response has been authored by the FASB staff and represents the staff’s views,
although the Board has discussed the above response at a public meeting and chosen not to object to
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IP No. 114
dissemination of that response. Official positions of the FASB are determined only after extensive due
process and deliberation.
EXHIBIT B – ASSESSMENT OF HEDGING EFFECTIVENESS
The following is based on paragraphs 62-70 of FAS 133 to offer additional guidance on assessing
hedging effectiveness. The intent of such is to remain consistent with FAS 133 with respect to assessing
hedge effectiveness.
1.
This issue paper requires that an entity define at the time it designates a hedging relationship the
method it will use to assess the hedge’s effectiveness in achieving offsetting changes in fair value or
offsetting cash flows attributable to the risk being hedged. It also requires that an entity use that defined
method consistently throughout the hedge period to assess at inception of the hedge and on an ongoing
basis whether it expects the hedging relationship to be highly effective in achieving offset. If the entity
identifies an improved method and wants to apply that method prospectively, it must discontinue the
existing hedging relationship and designate the relationship anew using the improved method. Although
this issue paper suggests a method for assessing whether a hedge is expected to be highly effective or
measuring hedge ineffectiveness, the appropriateness of a given method of assessing hedge effectiveness
can depend on the nature of the risk being hedged and the type of hedging instrument used. Ordinarily,
however, an entity should assess effectiveness for similar hedges in a similar manner; use of different
methods for similar hedges should be justified.
2.
In defining how hedge effectiveness will be assessed, an entity must specify whether it will
include in that assessment all of the gain or loss on a hedging instrument. This issue paper permits (but
does not require) an entity to exclude all or a part of the hedging instrument’s time value from the
assessment of hedge effectiveness, as follows:
a.
b.
c.
If the effectiveness of a hedge with an option contract is assessed based on changes in the
option’s intrinsic value, the change in the time value of the contract would be excluded
from the assessment of hedge effectiveness.
If the effectiveness of a hedge with an option contract is assessed based on changes in the
option’s minimum value, that is, its intrinsic value plus the effect of discounting, the
change in the volatility value of the contract would be excluded from the assessment of
hedge effectiveness.
If the effectiveness of a hedge with a forward or futures contract is assessed based on
changes in fair value attributable to changes in spot prices, the change in the fair value of
the contract related to the changes in the difference between the spot price and the
forward or futures price would be excluded from the assessment of hedge effectiveness.
In each circumstance above, changes in the excluded component would be included in unrealized gains or
losses. As noted in paragraph 1, the effectiveness of similar hedges generally should be assessed
similarly; that includes whether a component of the gain or loss on a derivative is excluded in assessing
effectiveness. No other components of a gain or loss on the designated hedging instrument may be
excluded from the assessment of hedge effectiveness.
3.
In assessing the effectiveness of a cash flow hedge, an entity generally will need to consider the
time value of money if significant in the circumstances. Considering the effect of the time value of
money is especially important if the hedging instrument involves periodic cash settlements. An example
of a situation in which an entity likely would reflect the time value of money is a tailing strategy with
futures contracts. When using a tailing strategy, an entity adjusts the size or contract amount of futures
contracts used in a hedge so that earnings (or expense) from reinvestment (or funding) of daily settlement
gains (or losses) on the futures do not distort the results of the hedge. To assess offset of expected cash
flows when a tailing strategy has been used, an entity could reflect the time value of money, perhaps by
© 1999-2015 National Association of Insurance Commissioners
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Issue Paper
comparing the present value of the hedged forecasted cash flow with the results of the hedging
instrument.
4.
Whether a hedging relationship qualifies as highly effective sometimes will be easy to assess. If
the critical terms of the hedging instrument and of the entire hedged asset or liability (as opposed to
selected cash flows) or hedged forecasted transaction are the same, the entity could conclude that changes
in fair value or cash flows attributable to the risk being hedged are expected to completely offset at
inception and on an ongoing basis. For example, an entity may assume that a hedge of a forecasted
purchase of a commodity with a forward contract will be highly effective if:
a.
b.
c.
The forward contract is for purchase of the same quantity of the same commodity at the
same time and location as the hedged forecasted purchase.
The fair value of the forward contract at inception is zero.
Either the change in the discount or premium on the forward contract is excluded from
the assessment of effectiveness and included directly in unrealized gains and losses
pursuant to paragraph 22B or the change in expected cash flows on the forecasted
transaction is based on the forward price for the commodity.
5.
However, assessing hedge effectiveness can be more complex. For example, hedge effectiveness
would be reduced by the following circumstances, among others: a. A difference between the basis of the
hedging instrument and the hedged item or hedged transaction (such as a Deutsche mark-based hedging
instrument and Dutch guilder-based hedged item), to the extent that those bases do not move in tandem. b.
Differences in critical terms of the hedging instrument and hedged item or hedged transaction, such as
differences in notional amounts, maturities, quantity, location, or delivery dates. Hedge effectiveness also
would be reduced if part of the change in the fair value of a derivative is attributable to a change in the
counterparty’s creditworthiness.
6.
A hedge that meets the effectiveness test specified in paragraphs 20.b. and 21.b. (that is, both at
inception and on an ongoing basis, the entity expects the hedge to be highly effective at achieving
offsetting changes in fair values or cash flows) also must meet the other hedge accounting criteria to
qualify for hedge accounting. If the hedge initially qualifies for hedge accounting, the entity would
continue to assess whether the hedge meets the effectiveness test. If the hedge fails the effectiveness test
at any time (that is, if the entity does not expect the hedge to be highly effective at achieving offsetting
changes in fair values or cash flows), the hedge ceases to qualify for hedge accounting. The discussions
of measuring hedge effectiveness in the examples in the remainder of this Exhibit assume that the hedge
satisfied all of the criteria for hedge accounting at inception.
Assuming Effectiveness in a Hedge with an Interest Rate Swap
7.
An entity may assume effectiveness in a hedging relationship of interest rate risk involving an
interest-bearing asset or liability and an interest rate swap if all of the applicable conditions in the
following list are met:
Conditions applicable to both fair value hedges and cash flow hedges
a.
b.
c.
d.
The notional amount of the swap matches the principal amount of the interest-bearing
asset or liability.
The fair value of the swap at its inception is zero.
The formula for computing net settlements under the interest rate swap is the same for
each net settlement. (That is, the fixed rate is the same throughout the term, and the
variable rate is based on the same index and includes the same constant adjustment or no
adjustment.)
The interest-bearing asset or liability is not prepayable.
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Any other terms in the interest-bearing financial instruments or interest rate swaps are
typical of those instruments and do not invalidate the assumption of no ineffectiveness.
Conditions applicable to fair value hedges only
f.
g.
h.
The expiration date of the swap matches the maturity date of the interest-bearing asset or
liability.
There is no floor or ceiling on the variable interest rate of the swap.
The interval between repricings of the variable interest rate in the swap is frequent
enough to justify an assumption that the variable payment or receipt is at a market rate
(generally three to six months or less).
Conditions applicable to cash flow hedges only
i.
j.
k.
l.
All interest receipts or payments on the variable-rate asset or liability during the term of
the swap are designated as hedged, and no interest payments beyond the term of the swap
are designated as hedged.
There is no floor or cap on the variable interest rate of the swap unless the variable-rate
asset or liability has a floor or cap. In that case, the swap must have a floor or cap on the
variable interest rate that is comparable to the floor or cap on the variable-rate asset or
liability. (For this purpose, comparable does not necessarily mean equal. For example, if
a swap's variable rate is LIBOR and an asset's variable rate is LIBOR plus 2 percent, a 10
percent cap on the swap would be comparable to a 12 percent cap on the asset.)
The repricing dates match those of the variable-rate asset or liability.
The index on which the variable rate is based matches the index on which the asset or
liability’s variable rate is based.
8.
The fixed rate on a hedged item need not exactly match the fixed rate on a swap designated as a
fair value hedge. Nor does the variable rate on an interest-bearing asset or liability need to be the same as
the variable rate on a swap designated as a cash flow hedge. A swap’s fair value comes from its net
settlements. The fixed and variable rates on a swap can be changed without affecting the net settlement if
both are changed by the same amount. That is, a swap with a payment based on LIBOR and a receipt
based on a fixed rate of 5 percent has the same net settlements and fair value as a swap with a payment
based on LIBOR plus 1 percent and a receipt based on a fixed rate of 6 percent.
9.
Comparable credit risk at inception is not a condition for assuming effectiveness even though
actually achieving perfect offset would require that the same discount rate be used to determine the fair
value of the swap and of the hedged item or hedged transaction. To justify using the same discount rate,
the credit risk related to both parties to the swap as well as to the debtor on the hedged interest-bearing
asset (in a fair value hedge) or the variable-rate asset on which the interest payments are hedged (in a cash
flow hedge) would have to be the same. However, because that complication is caused by the interaction
of interest rate risk and credit risk, which are not easily separable, comparable creditworthiness is not
considered a necessary condition to assume no ineffectiveness in a hedge of interest rate risk.
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