Session C - Financial Instruments Update


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Session C - Financial Instruments Update

  1. 1. Financial Instruments Financial Executives International Current Financial Reporting Issues Conference New York, New York November 12, 2001 John E. Stewart
  2. 2. Agenda <ul><ul><li>FASB Statement 133 </li></ul></ul><ul><ul><li>FASB Statement 140 </li></ul></ul><ul><ul><li>Financial Instruments Projects </li></ul></ul><ul><ul><ul><li>FASB </li></ul></ul></ul><ul><ul><ul><li>JWG </li></ul></ul></ul><ul><ul><ul><li>AICPA </li></ul></ul></ul><ul><ul><li>EITF Issues </li></ul></ul><ul><ul><li>SEC Hot Topics </li></ul></ul>
  3. 3. FASB Statement 133 - Overview <ul><ul><li>Amended twice since June 1998 </li></ul></ul><ul><ul><ul><li>137 deferred effective date </li></ul></ul></ul><ul><ul><ul><li>138 amended several areas </li></ul></ul></ul><ul><ul><li>Single, integrated accounting framework </li></ul></ul><ul><ul><li>Statement 133 is effective for all fiscal quarters of all fiscal years beginning after June 15, 2000 </li></ul></ul><ul><ul><ul><li>January 1 for calendar-year fiscal years </li></ul></ul></ul><ul><ul><li>DIG process </li></ul></ul><ul><ul><li>DIG guidance and open items (200+ issues) </li></ul></ul>
  4. 4. DIG - FASB staff Q&A <ul><ul><li>A - Definition of a derivative </li></ul></ul><ul><ul><li>B - Embedded derivatives </li></ul></ul><ul><ul><li>C - Scope exceptions </li></ul></ul><ul><ul><li>D - Recognition and measurement of derivatives </li></ul></ul><ul><ul><li>E - Hedging - general </li></ul></ul><ul><ul><li>F - Fair value hedges </li></ul></ul><ul><ul><li>G - Cash flow hedges </li></ul></ul><ul><ul><li>H - Foreign currency hedges </li></ul></ul><ul><ul><li>I - Disclosures </li></ul></ul><ul><ul><li>J - Transition provisions </li></ul></ul><ul><ul><li>K - Miscellaneous </li></ul></ul>
  5. 5. Scope <ul><li>Always ask two questions: </li></ul><ul><ul><li>Is the contract a derivative? </li></ul></ul><ul><ul><ul><li>Very broad </li></ul></ul></ul><ul><ul><li>If not, is the contract embedded with a derivative? </li></ul></ul><ul><ul><ul><li>Foreign currency </li></ul></ul></ul><ul><ul><ul><li>Convertible debt </li></ul></ul></ul><ul><ul><ul><li>Beneficial interests </li></ul></ul></ul><ul><ul><ul><li>Prepaid swaps </li></ul></ul></ul><ul><ul><ul><li>Dual trigger and other insurance contracts </li></ul></ul></ul><ul><ul><ul><li>Indexed debt (equity, commodity, etc.) </li></ul></ul></ul><ul><ul><ul><li>Etc., etc. </li></ul></ul></ul>
  6. 6. Valuation - What needs to be valued? <ul><ul><li>Each freestanding derivative </li></ul></ul><ul><ul><li>Each embedded derivative </li></ul></ul><ul><ul><li>Each host contract upon bifurcation </li></ul></ul><ul><ul><li>Each item hedged in a fair value hedge </li></ul></ul><ul><ul><li>Cash flows in a cash flow hedge </li></ul></ul><ul><ul><li>Intrinsic value and time value </li></ul></ul><ul><li>Required quarterly for recognition, measurement and assessment of hedge effectiveness </li></ul>
  7. 7. Qualification <ul><ul><li>Contemporaneous, formal documentation required at hedge at inception </li></ul></ul><ul><ul><ul><li>Objectives and strategy </li></ul></ul></ul><ul><ul><ul><li>Hedged item </li></ul></ul></ul><ul><ul><ul><li>Hedging instrument </li></ul></ul></ul><ul><ul><ul><li>Risk being hedged </li></ul></ul></ul><ul><ul><ul><li>How effectiveness will be assessed </li></ul></ul></ul><ul><ul><li>SEC has required restatement for improper documentation </li></ul></ul><ul><ul><li>All criteria for hedge accounting must be met </li></ul></ul>
  8. 8. <ul><ul><li>Scope </li></ul></ul><ul><ul><ul><li>Equity warrants </li></ul></ul></ul><ul><ul><ul><li>Loan commitments </li></ul></ul></ul><ul><ul><ul><li>Financial guarantees and insurance </li></ul></ul></ul><ul><ul><ul><li>Residual value guarantees </li></ul></ul></ul><ul><ul><li>Normal purchases and sales </li></ul></ul><ul><ul><ul><li>Electricity </li></ul></ul></ul><ul><ul><ul><li>CPI </li></ul></ul></ul><ul><ul><ul><li>Forwards plus options </li></ul></ul></ul><ul><ul><ul><li>Cross indexes </li></ul></ul></ul><ul><ul><li>When and how to bifurcate </li></ul></ul><ul><ul><li>Shortcut qualification </li></ul></ul>Complexities - A sampler!
  9. 9. Complexities - A sampler, continued! <ul><ul><li>Hedging the benchmark rate (methods 2 and 3) </li></ul></ul><ul><ul><li>Forward points in forward currency hedges </li></ul></ul><ul><ul><li>Purchased and complex options </li></ul></ul><ul><ul><li>Basis risk for nonfinancial assets </li></ul></ul><ul><ul><li>Aggregating (e.g. commercial paper programs and loans) </li></ul></ul><ul><ul><li>Tracking OCI </li></ul></ul><ul><ul><li>Impairment of long-lived assets </li></ul></ul>
  10. 10. Complexities - A sampler, continued! <ul><ul><li>Central treasury </li></ul></ul><ul><ul><li>Assessing effectiveness </li></ul></ul><ul><ul><li>Mortgage servicing rights </li></ul></ul><ul><ul><li>Net investment hedges </li></ul></ul><ul><ul><li>Call monetization </li></ul></ul><ul><ul><li>Prohibitions </li></ul></ul><ul><ul><li>Interaction with other literature (APBs and FASBs) </li></ul></ul><ul><ul><li>Be sure to read the DIG issues! </li></ul></ul>
  11. 11. Other considerations <ul><ul><li>Disclosures </li></ul></ul><ul><ul><li>Open DIG issues </li></ul></ul><ul><ul><li>Transition for DIG issues </li></ul></ul><ul><ul><li>Impact on EITF guidance </li></ul></ul><ul><ul><li>New EITF issues </li></ul></ul>
  12. 12. FASB Statement 140 - Transfers of financial assets <ul><ul><li>Clarify criteria for determining whether a transferred asset has been sold under Statement 125 </li></ul></ul><ul><ul><li>Modify requirements for SPE to be a “qualifying” SPE </li></ul></ul><ul><ul><li>Modify the accounting for collateral in financings </li></ul></ul><ul><ul><li>Require extensive disclosures for securitizations </li></ul></ul>
  13. 13. FASB Statement 140 - Transfers of financial assets <ul><ul><li>Final statement issued September 2000 </li></ul></ul><ul><ul><li>Effective for transactions after 3/31/01 </li></ul></ul><ul><ul><li>Disclosures and collateral provisions required for fiscal years ending after 12/15/00 </li></ul></ul><ul><ul><li>Supercedes all of Statement 125 </li></ul></ul><ul><ul><li>FASB Staff Q&A (123 items) </li></ul></ul><ul><ul><li>Impact on EITF issues </li></ul></ul><ul><ul><li>Many implementation questions </li></ul></ul>
  14. 14. FASB Statement 140 - A sampler of implementation issues <ul><ul><li>Isolation (FDIC and other) - Technical Bulletin 01-1 </li></ul></ul><ul><ul><li>Constraints, partial sales, calls and puts, ROAPs </li></ul></ul><ul><ul><li>QSPE status </li></ul></ul><ul><ul><ul><li>Holdings </li></ul></ul></ul><ul><ul><ul><li>Derivative use </li></ul></ul></ul><ul><ul><ul><li>Servicing (D-99) </li></ul></ul></ul><ul><ul><ul><li>Warehousing </li></ul></ul></ul><ul><ul><ul><li>Liability management (commercial paper) </li></ul></ul></ul><ul><ul><li>Disclosures </li></ul></ul><ul><ul><ul><li>Scope </li></ul></ul></ul><ul><ul><ul><li>Securitizations </li></ul></ul></ul><ul><ul><ul><li>Collateral </li></ul></ul></ul>
  15. 15. Measurement of financial instruments - FASB project <ul><ul><li>Goal is to provide guidance for measuring and accounting for all financial assets and liabilities at fair value </li></ul></ul><ul><ul><li>Implementation guidance </li></ul></ul><ul><ul><ul><li>How to determine fair value </li></ul></ul></ul><ul><ul><ul><li>Scope of instruments </li></ul></ul></ul><ul><ul><ul><li>Company’s own creditworthiness </li></ul></ul></ul><ul><ul><li>Presentation issues </li></ul></ul><ul><ul><li>Preliminary views document issued in Q4 1999 </li></ul></ul><ul><ul><li>Intermediate objective - more specific guidance on how to determine fair value and improve disclosure </li></ul></ul><ul><ul><li>Coordination with JWG project </li></ul></ul>
  16. 16. Financial instruments - JWG project <ul><ul><li>Joint Working Group of standard setters </li></ul></ul><ul><ul><ul><li>Australia, Canada, France, Germany, Japan, New Zealand, Nordic countries, U.K., U.S., and IASC </li></ul></ul></ul><ul><ul><ul><li>Special report issued December 2000 </li></ul></ul></ul><ul><ul><ul><li>Comments were due June 30, 2001 </li></ul></ul></ul><ul><ul><ul><li>IASB involvement </li></ul></ul></ul><ul><ul><li>All financial instruments at fair value through earnings </li></ul></ul><ul><ul><li>No hedge accounting </li></ul></ul><ul><ul><li>New derecognition standards (  Statement 140) </li></ul></ul><ul><ul><li>New disclosures </li></ul></ul>
  17. 17. Debt versus equity - FASB project <ul><ul><li>Better distinguish between debt and equity instruments where classification has become problematic </li></ul></ul><ul><ul><ul><li>Examples include preferred stock that at the issuer’s option can be exchanged for notes payable, convertible debt, and mandatorily redeemable preferred stock </li></ul></ul></ul><ul><ul><li>Deals with classification issues and initial measurement </li></ul></ul><ul><ul><li>Addresses minority interest </li></ul></ul>
  18. 18. Debt versus equity - Important and controversial issues <ul><ul><li>Unbundling instruments with debt and equity attributes, like convertible debt </li></ul></ul><ul><ul><li>Determining what instruments need to be split up and how to classify the pieces of such instruments (obligations-based approach) </li></ul></ul><ul><ul><li>Reclassifying of minority interest to equity </li></ul></ul><ul><ul><ul><li>Consequences </li></ul></ul></ul><ul><ul><li>Transition -- restate with exceptions </li></ul></ul>
  19. 19. Debt versus equity - Status <ul><ul><li>The obligation-based approach would require: </li></ul></ul><ul><ul><ul><li>Obligation components that require settlement by a transfer of assets would be classified as liabilities </li></ul></ul></ul><ul><ul><ul><li>Components that require or permit settlement by a transfer of a fixed number of the shares determined at issuance would initially be classified as equity; otherwise, classified as liabilities </li></ul></ul></ul><ul><ul><li>Implications on several common instruments </li></ul></ul><ul><ul><li>Interaction with EITF issues </li></ul></ul><ul><ul><li>Exposure draft issued in October 2000 </li></ul></ul><ul><ul><ul><li>Comments were due April 30, 2001 </li></ul></ul></ul><ul><ul><ul><li>Roundtable in October 2001 </li></ul></ul></ul>
  20. 20. Other projects - Overview <ul><ul><li>FASB Concepts Statement No. 7 - present value measurement </li></ul></ul><ul><ul><li>IAS 39 - financial instruments and implementation guide </li></ul></ul><ul><ul><li>AICPA - loan loss allowances </li></ul></ul><ul><ul><li>AICPA - purchase of high risk receivables </li></ul></ul><ul><ul><li>International activity - leases </li></ul></ul><ul><ul><li>FASB DIG D-1 project </li></ul></ul><ul><ul><li>FASB and SPEs </li></ul></ul>
  21. 21. EITF issues <ul><ul><li>Revenue Recognition and Sales Incentives </li></ul></ul><ul><ul><li>Treatment of Other Costs (Capitalize versus Expense) </li></ul></ul><ul><ul><li>Stock Compensation </li></ul></ul><ul><ul><li>Equity Method Investments </li></ul></ul><ul><ul><li>Financial Instruments </li></ul></ul><ul><ul><li>Real Estate </li></ul></ul><ul><ul><li>Equity Transactions </li></ul></ul><ul><ul><li>Derivative Related </li></ul></ul><ul><ul><li>Nonmonetary Transaction </li></ul></ul><ul><ul><li>Business Combination </li></ul></ul><ul><ul><li>Leases </li></ul></ul><ul><ul><li>Other Issues </li></ul></ul>
  22. 22. EITF issues - Financial instruments <ul><ul><li>Residual interests in securitizations (99-20) </li></ul></ul><ul><ul><li>Measuring fair value of equity securities with restrictions in a nonmonetary exchange (00-N) </li></ul></ul><ul><ul><li>Creditor’s accounting for a modification or exchange of debt (01-7) </li></ul></ul><ul><ul><li>When to combine separate instruments (01-G) </li></ul></ul><ul><ul><li>Other items </li></ul></ul>
  23. 23. EITF issues - Equity transactions <ul><ul><li>Equity instrument received for providing goods or services (00-8) </li></ul></ul><ul><ul><li>Equity instruments granted to nonemployees (00-18) </li></ul></ul><ul><ul><li>Classification of equity derivatives (00-19) </li></ul></ul><ul><ul><li>Convertible securities with beneficial conversion features (00-27) </li></ul></ul><ul><ul><li>Convertible instrument issued for goods or services (01-1) </li></ul></ul><ul><ul><li>Combining 00-19 instruments (01-F) </li></ul></ul>
  24. 24. EITF issues - Derivative related <ul><ul><li>Majority owner's accounting for the minority interest in a subsidiary and a derivative (00-4) </li></ul></ul><ul><ul><li>Derivatives indexed to stock of consolidated subsidiary (00-6) </li></ul></ul><ul><ul><li>Derivative instruments under Issue 96-13 that could require net cash settlement (00-7) </li></ul></ul><ul><ul><li>Gain or loss classification from extinguished hedged debt (00-9) </li></ul></ul><ul><ul><li>Measuring the fair value of energy-related contracts (00-17) </li></ul></ul><ul><ul><li>Determination of whether share settlement is within the control of the issuer (00-19) </li></ul></ul><ul><ul><li>Meaning of “indexed to a company’s own stock” (01-6) </li></ul></ul>
  25. 25. EITF issues - Leases <ul><ul><li>Meeting the ownership transfer requirements of FASB Statement 13 for leases of real estate (00-11) </li></ul></ul><ul><ul><li>Accounting for sales of fractional interests in equipment (01-4) </li></ul></ul><ul><ul><li>Determining when an energy-related contract is a lease (01-8) </li></ul></ul><ul><ul><li>Interaction of FASB Statements 13 and 133 on residual value guarantees (01-H) </li></ul></ul>
  26. 26. SEC “Hot Topics” - Financial instruments <ul><ul><li>Documentation and disclosures related to derivative instruments and hedging activities </li></ul></ul><ul><ul><li>Valuation </li></ul></ul><ul><ul><li>Allowance for loan losses </li></ul></ul><ul><ul><li>Equity and warrant issues </li></ul></ul><ul><ul><li>SPEs </li></ul></ul><ul><ul><li>Nontemporary impairment </li></ul></ul><ul><ul><li>Statement 140 QSPE treatment and disclosures </li></ul></ul><ul><ul><li>Mezzanine classification (D-98) </li></ul></ul>
  27. 27.