Derivative Accounting: Gearing UP for 2011 Year-End Audit and Disclosures

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As companies prepare for their 2011 year-end, we will review and highlight key audit issues. Using auditors’ reactions through 2011, we will discuss current concern areas and review appropriate control environments for derivative programs.
For more information visit www.hedgetrackers.com or 408-350-8580

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Derivative Accounting: Gearing UP for 2011 Year-End Audit and Disclosures

  1. 1. 2011 Audit ReadinessDecember 16, 2011Presented by:Helen Kane, Presidenthkane@hedgetrackers.com
  2. 2. Agenda Audit Environment Key Controls • All Derivatives • At Fair Value • Correct OCI • Accurate Disclosures Control Considerations Quick Update on FASB/IASB Developments © 2011 Hedge Trackers, LLC This publication contains general information and does not represent the rendering of accounting advice and is not a substitute for such professional advice or services.
  3. 3. Shifts Away from documentation minutia Increased focus • Eliminating short-cut/matched terms assumptions • Valuation • Probability • Increased scrutiny of 3rd party events • Measurement of ineffectiveness © 2011 Hedge Trackers, LLC This publication contains general information and does not represent the 3 rendering of accounting advice and is not a substitute for such professional advice or services.
  4. 4. DocumentationIn place (can locate)Meets ASC 815-20-25 requirements • Clarity in layering • Clarity in definition © 2011 Hedge Trackers, LLC This publication contains general information and does not represent the 4 rendering of accounting advice and is not a substitute for such professional advice or services.
  5. 5. Matched Terms AssumptionsPreparation for FASB ED direction (IASB convergence) • SEC standard comment letter • Please provide a copy of the analysis prepared to support the assumption of perfect effectiveness using the short-cut method • No longer accepting “de minimis” testing • Moving all to long-haul (regression) © 2011 Hedge Trackers, LLC This publication contains general information and does not represent the 5 rendering of accounting advice and is not a substitute for such professional advice or services.
  6. 6. ValuationsQuestioning: • Models (appropriateness) • Input Type designation (I, II, III) • Conflict with Counterparty statements • OIS vs. LIBOR • Credit • Static • Potential • Own credit by collateral? • Bank of Ireland/European Banking Counterparties © 2011 Hedge Trackers, LLC This publication contains general information and does not represent the 6 rendering of accounting advice and is not a substitute for such professional advice or services.
  7. 7. ProbabilityIncreased scrutiny of “probability” of anticipated transactions • Historical Experience with actuals vs. forecast • Experience with over hedging over past year • “Three strikes” • Increase of tenor decrease in confidence • Pro-active probable, possible, remote © 2011 Hedge Trackers, LLC This publication contains general information and does not represent the 7 rendering of accounting advice and is not a substitute for such professional advice or services.
  8. 8. Timing of OCI Reclass • Releases follow 3rd party event, not interco • “…the amount in OCI representing • the effective portion • of the gain or loss on a derivative • designated as a cash flow hedge • of a forecasted foreign-currency-denominated intercompany sale • should be reclassified into earnings in the period that the revenue from the sale of the manufactured product to an unrelated third party is recognized.” © 2011 Hedge Trackers, LLC This publication contains general information and does not represent the 8 rendering of accounting advice and is not a substitute for such professional advice or services.
  9. 9. Measurement of IneffectivenessScrutiny of the Hypothetical Derivative • Updating the “Expected Date” • Worst case vs. most likely case • Calculation of ineffectiveness • No assumption of immateriality • When is recasting of the inception value of the hypothetical derivative required (IR) © 2011 Hedge Trackers, LLC This publication contains general information and does not represent the 9 rendering of accounting advice and is not a substitute for such professional advice or services.
  10. 10. SEC Comment Letters • What is the period over which company forecasting probable cash flows • How assessing the probability of cash flows • How frequently have probable cash flows failed to occur • What is impact in earnings of changes in hedge accounting approach © 2011 Hedge Trackers, LLC This publication contains general information and does not represent the 10 rendering of accounting advice and is not a substitute for such professional advice or services.
  11. 11. Key Controls
  12. 12. All DerivativesAll derivatives identified at month end • Treasury Traded • Disclose volume of all trading in quarter • Trade date vs. settlement date accounting on compensating contracts over quarter end • Segregation of duties: confirms sent directly to accounting/electronically confirmed by acctg. • Validate # and notional outstanding • Best Practice: acctg. informed at or before execution © 2011 Hedge Trackers, LLC This publication contains general information and does not represent the 12 rendering of accounting advice and is not a substitute for such professional advice or services.
  13. 13. All DerivativesAll derivatives identified at month end • Traded Outside of Treasury • Contracts that meet the definition of a derivative • fixed price/rate • fixed quantity • small or no cash up front • Commodity or highly brokered goods • Natural gas, electricity • Steel, aluminum • Avoid derivative accounting with Normal Purchase/ Normal Sale election if taking/making physical delivery: ASC 815-10-15-22 © 2011 Hedge Trackers, LLC This publication contains general information and does not represent the 13 rendering of accounting advice and is not a substitute for such professional advice or services.
  14. 14. All DerivativesAll derivatives identified at month end • Traded Outside of Treasury • Contracts in a 3rd currency = FX forwards • Not functional currency of substantial party to the contract • Not local currency of delivery point to/from • Not currency of international commerce for that good • Watch for leases in Mexico, Russia, etc. © 2011 Hedge Trackers, LLC This publication contains general information and does not represent the 14 rendering of accounting advice and is not a substitute for such professional advice or services.
  15. 15. Third Currency ContractsExamples: • Eastern European sales with US Corp in Euro • USD sales between local currency functional sub and 3rd party clientRequirement • Bifurcate the “currency forward contract” and mark to market through income ASC 815-15-15-10 © 2011 Hedge Trackers, LLC This publication contains general information and does not represent the 15 rendering of accounting advice and is not a substitute for such professional advice or services.
  16. 16. All Derivatives at Fair ValueAre all derivatives on the books at fair value • Hierarchy of Inputs: Types I, II, III Beware of inefficient markets (prices) at year end Beware of thin markets at year end • Independent valuations • Use counterparty to validate, not set values • You own the inputs! © 2011 Hedge Trackers, LLC This publication contains general information and does not represent the 16 rendering of accounting advice and is not a substitute for such professional advice or services.
  17. 17. ASC 820-10 (old FAS 157)Market Price Considerations • Counterparty credit quality • Consider impact of master netting arrangements • Consider impact of new ISDA/debt terms that make derivative positions callable every 6 months • Own Credit • Two approaches: discounting current position, discounting possible future positions • Absence of “efficient markets” creates basis risk • IR: 1M vs. 3M • FX/IR: Cross currency swaps © 2011 Hedge Trackers, LLC This publication contains general information and does not represent the 17 rendering of accounting advice and is not a substitute for such professional advice or services.
  18. 18. CDS Rates – 2011 - US © 2011 Hedge Trackers, LLC This publication contains general information and does not represent the 18 rendering of accounting advice and is not a substitute for such professional advice or services.
  19. 19. CDS Rates – 2011 - Europe © 2011 Hedge Trackers, LLC This publication contains general information and does not represent the 19 rendering of accounting advice and is not a substitute for such professional advice or services.
  20. 20. CDS Rates – 2011 - Global © 2011 Hedge Trackers, LLC This publication contains general information and does not represent the 20 rendering of accounting advice and is not a substitute for such professional advice or services.
  21. 21. 3M vs 1M LIBOR © 2011 Hedge Trackers, LLC This publication contains general information and does not represent the 21 rendering of accounting advice and is not a substitute for such professional advice or services.
  22. 22. Value in OCIAudit focus shifting from assessments to measurementAppropriate documentationAll values in OCI associated with anticipated, possible transactions • Reclass follows hedged item NOT cash • Credit effects • Any element of hindsight to determine hedged item is problematic • © 2011 Hedge Trackers, LLC This publication contains general information and does not represent the 22 rendering of accounting advice and is not a substitute for such professional advice or services.
  23. 23. Documentation• Testing: • Correct assumptions on sources of ineffectiveness • Testing those sources • Similarity of items hedged together in pool • Validation of data points• Insufficient specificity • Debt: what layer, which accrual • FX: Which Euro entity revenue first? © 2011 Hedge Trackers, LLC This publication contains general information and does not represent the 23 rendering of accounting advice and is not a substitute for such professional advice or services.
  24. 24. Qualification busterFailure to produce inception documentationRenewals of credit arrangements • Floors on debt are forcing mark to market treatment of swaps: ineffectiveness and lack of “variability in cash flows” • Violation of reset election commitment (depends on firm) © 2011 Hedge Trackers, LLC This publication contains general information and does not represent the 24 rendering of accounting advice and is not a substitute for such professional advice or services.
  25. 25. EffectivenessDoes your regression support the hedge objective • How are you calculating (input verification) • How modeling underlying variances • Constant tenor vs. constant derivative • R2, Slope, A Nova statistic (T, P, F)Probability Issues? • Possible • Probable not to occur © 2011 Hedge Trackers, LLC This publication contains general information and does not represent the 25 rendering of accounting advice and is not a substitute for such professional advice or services.
  26. 26. DisclosuresTables: Income Statement tables (including OCI) are current year values for unrealized AND realized gains/lossesVolumes Information about the volume of trade and trade activity © 2011 Hedge Trackers, LLC This publication contains general information and does not represent the 26 rendering of accounting advice and is not a substitute for such professional advice or services.
  27. 27. Control Considerations• Segregation of duties (avoid fraud/rogues) • Independent confirmation & reconciliation • Independent valuation• Limits: Trade, Instrument, Coverage, Credit, Trader• Systems controls• Accounting vs. Treasury roles• Conflicts of interest © 2011 Hedge Trackers, LLC This publication contains general information and does not represent the 27 rendering of accounting advice and is not a substitute for such professional advice or services.
  28. 28. FASB/IASB Update
  29. 29. FASB/IASB UpdateConvergence:• Decision to converge or not to converge due in 2010 postponed• “Condorsement”: vocabulary introduced in SEC speech addressing variation on convergence © 2011 Hedge Trackers, LLC This publication contains general information and does not represent the 29 rendering of accounting advice and is not a substitute for such professional advice or services.
  30. 30. Condorsement or Condoresement Mr. Beswick stated, "So what would be a reasonable approach for the U.S.? In our October (2010) update we highlighted that the majority of jurisdictions are following either a convergence or an endorsement approach. In my opinion, if the U.S. were to move to IFRS, somewhere in between could be the right approach. I will call it a condoresement approach. Yes, I admit I just made up a word. © 2011 Hedge Trackers, LLC This publication contains general information and does not represent the 30 rendering of accounting advice and is not a substitute for such professional advice or services.
  31. 31. Condorsement Mr. Beswick continued, "So how would this approach work? Well, to begin, U.S. GAAP would continue to exist. The IASB and the FASB would finish the major projects…The FASB would not begin work on any major new projects … Rather, …the FASB would work to converge existing U.S. GAAP to IFRS over a period of time for standards that are not on the IASBs agenda. This …would entail making sure on a standard by standard basis, existing IFRS standards are suitable for our capital markets." © 2011 Hedge Trackers, LLC This publication contains general information and does not represent the 31 rendering of accounting advice and is not a substitute for such professional advice or services.
  32. 32. Hedging ProjectsFASB:• 2/11 Request for feedback on IASB proposal• 11/11 Education Session—Discussions about the IASB’s hedge accounting model, presented by the IASB staff.• Nothing on project schedule through 6/12 © 2011 Hedge Trackers, LLC This publication contains general information and does not represent the 32 rendering of accounting advice and is not a substitute for such professional advice or services.
  33. 33. Hedging Projects FASB: • 5/10 Issued Hedge Acctounting ED as part of Financial Instruments ED • 2/11 Requested feedback on IASB proposal • 11/11 Education Session—Discussions about the IASB’s hedge accounting model, presented by the IASB staff. • Nothing on project schedule through 6/12 © 2011 Hedge Trackers, LLC This publication contains general information and does not represent the 33 rendering of accounting advice and is not a substitute for such professional advice or services.
  34. 34. Hedge Accounting ProjectsIASB• New derivative guidance fatal flaw draft in circulation• Pre-release expected early 2012• Implementation date 2015, perhaps 2016 © 2011 Hedge Trackers, LLC This publication contains general information and does not represent the 34 rendering of accounting advice and is not a substitute for such professional advice or services.
  35. 35. Answers hkane@hedgetrackers.com www.hedgetrackers.com 408.350.8580Silicon Valley | Chicago | Los Angeles 35

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