Hedge Trackers reviews how FASB Exposure Draft on Financial Instruments - Derivative Instruments & Hedging Activities - will impact Foreign Currency Hedge Programs

Impact of Exposure Draft on Derivative Accounting for Currency Risk Presented by Helen Kane June 8, 2010

Exposure Draft Status
What is the Same
Effectiveness
Option “Amortization”
Dedesignation
Foreign Denominated Debt
Disclosure
Agenda

Codification Revision Status
On May 26th two Exposure Drafts Issued
Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities (Topics 825 & 815 )
Redline version to 815 not available until “late July”
Comment period ends Sept. 30, 2010
Early adoption prohibited
Other Comprehensive Income
IASB has been working on similar standards in 3 pieces
Derivative accounting related standard not yet released

Outline of Exposure Draft
Summary
Questions
For all respondents
For users of financial statements
For preparers and auditors
Proposed guidance: ¶1-137
Proposed implementation guidance ¶ IG1-IG178
Background , Basis for Conclusions ¶ BC1-BC252
App A: IASB Comparison: ¶ A1 Table
App B: Methods for Measuring Changes in Credit ¶B1-B20
App C: Amendments to Codification ¶C1 Table

Objective of Revision (BC212)
Simplify hedge accounting to improve compliance
Make financial reporting of hedge activities useful and transparent
Concern that falling in and out of hedge accounting distorts financials

What Hasn’t Changed (BC213)
Types of items and transactions currently eligible for hedge accounting under Topic 815 would continue
Benchmark interest rate
FX (including interco transactions)
Credit risk
Overall
Cash Flow, Fair Value, Net Investment hedging

What is Different

Effectiveness Testing (BC 218-220)
Old
Emphasis on Quarterly Testing
Hedge accounting applied inconsistently period to period due to “failures”
New
Testing reserved for corner cases, and updated only under unusual circumstances (117)
Consistent application of special hedge accounting (119)

Old
Focus on sophisticated quantitative statistical modeling and testing
“ Highly Effective” litmus test (80-125% offset)
New
Focus on qualitative support for economic relationship between derivative and hedged item
Use “Reasonably Effective” ( judgment not numbers BC220) -- holistic consideration of what lead to hedge relationship
Prevents IR Swap from hedging tire inventory

Effectiveness Documentation (116)
Old
Document effectiveness test so that 3 rd party can re-perform the test and achieve similar results
Algorithms
Data points
Data sources
Partial compensation in derivative could trigger de/redesignation
New
Document sources of volatility in the cash flows of the forecasted transaction(116)
Document factors supporting conclusion of reasonably effective over the life of hedging relationship
Modification of derivative requires “update” in documentation of continuing relationship

Old
Matched terms: FX & Commodity assumption that hedge is perfectly effective
Short-cut: IR assumption that hedge is perfectly effective
New
No longer have ability to assume hedge relationship is completely effective and recognize no ineffectiveness in net income during term of the hedge (114)

Effectiveness Measurement (BC 224-229)
Old
Over-performance of the derivative only source of ineffectiveness in cash flow hedges
Inconsistent practice on credit effect on derivative & hedged item
New
Cash Flow Hedge over and underperformance of derivative impacts earnings (123)
Hedged item recorded in income at Hypo rate
Entity shall not ignore credit on derivative instrument fair value (114)
Impact hedged item with derivative credit

Debit/Credit Example
DR Derivative Asset Pre-Credit Deriv FV
CR OCI Pre-Credit PEHD FV
DR/CR P&L per Docs Delta
DR OCI Deriv Credit Adj.
CR Derivative Asset Deriv Credit Adj.

Effectiveness Measurement (BC 116-118)
Old
Precision in measuring ineffectiveness due to timing “not material”
Di minimis testing
New
An entity shall not assume there will never be any ineffectiveness (115)
When hedging group of transactions in specified period, can use single PEHD that settles within reasonable time (118)
Qualify when forward points difference on dates in period are minimal
Avoid perfection

Option Amortization

G20 Concept Plus….
“Include time value” concept on options remains with variations
Update requires effective option premium expense to be amortized to income in “rational way”

G20 Updated
Our guess on entries assuming $100 premium for 4-month option, PEHD inception $92:
Day 1
Dr Deriv Asset 100
Cr Cash 100

G20 Updated
Month End 1, Option Fair Value = 50, PEHD =55
Dr OCI (PEHD change assumption) 37
Cr Deriv Asset (adjust to FV) 50
Dr Ineffectiveness 13
Dr Effective P&L Acct 23
Cr OCI (PEHD premium/ # months) 23
Dr OCI (credit adj) 1
Cr Deriv Asset 1

G20 Updated
Balances
Deriv Asset Dr 49
P&L Effective Dr 23
P&L Ineffective Dr 13
OCI Dr 15
Cash Cr 100

De-designation

No Election to Dedesignate
Once hedge relationship designated, only terminated if
Qualifying criteria for designation no longer met
Relationship no longer expected to be reasonably effective
Probable not to occur, no longer firm commitment
Hedging instrument expires, sold, terminated or exercised
Compensating trade must documented at execution

Why No Dedesignation?
No longer able to remove the designation
Board notes “the economics of the relationship between the instrument and the hedged item have not changed”
Ergo, “the accounting should not change”
Need to validate that as FX exposures go from anticipated to realized that “qualifying criteria are no longer met”
Quarterly redesignation net investment???

Ineffectiveness Conclusion
“The Board believes that ineffectiveness should be recognized in net income if an entity enters into a derivative that would not mature on the date of the forecasted transaction and provide cash flows that would exactly offset the hedged cash flows.” (BC228)

Foreign Denominated Financial Instruments

Financial Instruments Fundamental Change
Initial measurement principle
Financial instruments (financial assets and liabilities) will be measured at inception at fair value (12)
Subsequent measurement principle
Financial assets and liabilities will be measured at fair value each reporting date unless qualifying for scope exception
Changes in value will be recorded in Net Income or for some debt instruments to Other Comprehensive Income (19-24)

Foreign Denominated Debt (92)
Change in non-functional currency denominated debt is composed of two pieces:
Change in price in the currency denominated
Change in exchange rates between currency of denomination and functional currency
Both changes in fair value of qualifying* debt will be recognized as a single number in OCI (92)
Amends Topic 830
*for qualifying debt instruments (21-24)

Disclosure

Additional Disclosure Requirements (127)
Disclose the following for assets and liabilities reported within a single line item in BS:
Carrying amount of assets or liabilities included in line item
Cumulative Fair Value Hedge Adjustment
Fair Value changes other than from Hedge accounting
Carrying amount

Reference Paragraphs
Derivative & Hedging Guidance buried throughout the standard:
Questions from FASB on hedging
Questions 56-58 and 61-64
Proposed guidance: 110-128
Implementation guide: IG172-180
Background/conclusions: BC216-235

Answers
Contact: hkane@hedgetrackers.com

Hedge Trackers reviews how FASB Exposure Draft on Financial Instruments - Derivative Instruments & Hedging Activities - will impact Foreign Currency Hedge Programs

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Hedge Trackers reviews how FASB Exposure Draft on Financial Instruments - Derivative Instruments & Hedging Activities - will impact Foreign Currency Hedge Programs Presentation Transcript