FAS 133 Accounting for Derivative Instruments and Hedging Activities

1. FAS 133 Accounting for Derivative Instruments and Hedging Activities Angela L.J. Hwang, Ph.D. Associate Professor Eastern Michigan University

2. FAS 133 - Key Aspects • All derivatives are reported at fair value on the balance sheet. • Changes in fair value of a derivative is recognized in earnings. • Special accounting is provided for a derivative designated as or qualified for a hedging purpose. • Fair value hedge • Cash flow hedge • Foreign currency hedge

3. Example • BestGas Inc., a natural gas marketer in Midwest U.S., buys natural gas from producers and sells it to end users and local distribution companies. • BestGas has inventory of 10,000,000 mmBtus of natural gas with a carrying value @3.0 per mmBtu in June X1. • Inventory is intended for delivery to Chicago in Dec. X1. • In June X1, short sell a December gas derivative (forward) contract @3.3 • The fair value of the gas inventory increases to $4.0 and the derivative contract increases to $4.5 in Sept. X1. • The gas price for delivery to Chicago in Dec. X1 decreases to $2.5. • On entering into the derivative, the entity neither receives nor pays a premium.

4. Example: Using a Derivative Contract for Hedging Period Spot Price Dec. Forward Price Effect (Hedged item-Gas Inventory)(Derivative contract) June Sept. Period Gain (Loss) Dec. Period Gain (Loss) Cumulative G (L) $3.0 $3.3 $0.3 4.0 4.5 1.0 (1.2) (0.2) 2.5 2.5 (1.5) 2.0 0.5 (0.5) 0.8 $0.3 • BestGas has perfect foresight in June when entering into the derivative contract knowing that a net gain of $0.3 per mmBtu is to be realized when the inventory is sold and the contract is settled in Dec. irrespective to any price fluctuations. • Price Protection. • - Derivatives preclude from benefiting windfall gains if Gas prices increase above $3.3.

5. Example Futures Contract for Hedging Period Spot Price Dec. Futures Price Effect (hedged item)(futures contract) June Sept. Period Gain (Loss) Dec. Period Gain (Loss) Cumulative G (L) $3.0 $3.3 $0.3 4.0 4.5 1.0 (1.2) (0.2) To be reported post-FAS133 2.5 2.5 (1.5) 2.0 0.5 (0.5) 0.8 $0.3 Reported pre-FAS133

6. Great Derivative Debacles Company Year Approx. Amount Proctor & Gamble 1994 $ .2 billion Glaxo 1994 $ .1 billion Gibson Greetings 1994 $ - Orange County 1994 $ 2.0 billion Metallgesellshaft 1994 $ 1.5 billion Barings 1995 $ 1.3 billion Sumitomo 1996 $ 1.8 billion Bank Tokyo-Mitsubishi 1997 $ .1 billion Unions Bank Switzerland 1997 $ .4 billion LTCM 1998 $ 3.5 billion

7. Pre-FAS 133 Accounting Model 1997: SEC Market Risk Disclosure 1984: FAS 80 Accounting for Futures 1981: FAS 52 Foreign Currency Translation 1990: FAS 105 Disclosure of info. about F/Is with off-B/S risk and F/Is with concentrations of credit risk 1991: FAS 107 Disclosure about fair value of F/Is 60 EITF Issues 1994: FAS 119 Disclosure about Derivative Financial Instruments (F/Is) and Fair Value of Financial Instruments

8. FAS 133 – Implementation • FAS 133: Accounting for derivative instruments and hedging activities • Issuance in June, 1998 • Culmination of a long and difficult project spanning over twelve years • Represent a significant step towards fair value accounting • Provide a uniform hedging model • Prior GAAP was incomplete, inconsistent • Accounting for derivatives was not transparent

9. FAS 133 - Implementation • Initially was to be effective for fiscal years beginning after June 15, 1999 • Very controversial; faced a great deal of opposition from industry • Industry didn’t have time to change systems to be FAS 133 compliant • FAS 137 postponed until June 15, 2000 (Jan. 1, 2001 for firms with calendar-year fiscal years) • Key aspects of FAS 133 were still being resolved by the Derivatives Implementation Group

10. Derivative Fair Value FAS 133 Asset Liability Effectiveness

11. FAS 133 - Documentation Formal documentation is required at the inception of the hedge to apply special accounting for a derivative • Identification of the hedging instrument(s) and the hedged item • Nature of the risk being hedged • The risk management objective/strategy • Assessment/evaluation of hedging effectiveness

12. Journal of Accountancy (March 2001)Practical Issues in Implementing FASB 133http://www.aicpa.org/pubs/jofa/mar2001/hwang.htm 1) Inventory derivatives 2) Document risk management philosophy 3) Identify hedging relationships for hedge designation 4) Document the hedging relationship 5) Determine effectiveness 6) Transition adjustments pretax cumulative effects and deferred tax effects of transition 7) Risk management 8) Systems implementation requirements 9) Training and education.

13. The CPA Journal (Nov. 2001)Implementation of SFAS 138, Amendments to SFAS 133http://www.nysscpa.org/cpajournal/2001/1100/dept/d115401.htm SFAS 138 (issued in June, 2000): Accounting for Certain Derivative Instruments and Certain Hedging Activities—an amendment of FASB Statement No. 133. It includes the following major amendments: 1) The normal purchases and normal sales exception is expanded to certain commodity contracts. 2) The risk that can be hedged in an interest rate hedge is redefined. 3) Recognized foreign currency-denominated assets and liabilities may be hedged with a single cross-currency compound hedge. 4) Net hedging of certain intercompany derivatives may be designated as cash flow hedges of foreign currency risk. • Amendments to DIG Guidance

14. FAS 133 - Amendments FAS 149 (issued in 04/2003; effective in 06/2003) Amendment of Statement 133 on Derivative Instruments and Hedging Activities “ The changes in this Statement improve financial reporting by requiring that contracts with comparable characteristics be accounted for similarly. In particular, this Statement • clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative discussed in paragraph 6(b) of Statement 133, • clarifies when a derivative contains a financing component, • amends the definition of an underlying to conform it to language used in FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, and • amends certain other existing pronouncements. Those changes will result in more consistent reporting of contracts as either derivatives or hybrid instruments. ” (Summary, FAS 149)

15. FAS 133 – Amendments • From the FASB website in May 2004… • Available in March 2004— New 880-page updated edition • The FASB staff has prepared a new updated edition of Accounting for Derivative Instruments and Hedging Activities. This essential aid to implementation presents Statement No. 133, Accounting for Derivative Instruments and Hedging Activities as amended by Statements No. 137, Accounting for Derivative Instruments and Hedging Activities—Deferral of the Effective Date of FASB Statement No. 133,No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities, and No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. Also, this publication includes the full text of Statement 133 Implementation Issues (172) discussed by the Derivatives Implementation Group (DIG) and cleared by the FASB prior to February 10, 2004, with cross-references between the issues and the paragraphs of the Statement.

16. How Should Transactions be Reported?

17. Journal of Accounting Education (2002)Comparative Analysis of Accounting Treatments for Derivatives • Case 1: Fair value hedge • Case 2: Cash flow hedge • Case 3: Speculative or derivative not designated • Case 4: No derivative • Loss on the hedged item but gain on the derivative in above cases • Loss on the derivative • Derivatives provide price protection. • Derivatives preclude from benefiting windfall gains.

18. Features • A real-world example • Explain concepts/application of derivatives • Two-time period example • Impact of journal entries on financial statements • Comparative analysis of the economic results • A web-downloadable spreadsheet for readers’ customization

19. Scenario • Inventory of 20,000,000 mmBtus of natural gas with a carrying value @3.000 in June X1. • Inventory is intended for delivery to Chicago in Dec. X1 • Short sell a December futures contract @3.480 • Delivery point for the the futures contract is at the Henry Hub • On entering into the derivative, the entity neither receives nor pays a premium. Time value is ignored for simplification.

20. READING HIGHLIGHTS • What problem is faced by BestGas? • What does BestGas do to solve the problem? • What is a futures contract? • What is a forward contract? • How does a futures contract help risk management? • Why is a futures contract called a derivative instrument? • How does a derivative instrument provide “leverage”? • In your opinion, how should a derivative be recorded conceptually? • What were the problems with the accounting standards prior to FAS 133? • What purposes do FAS 133 attempt to achieve? • What value does FAS 133 require derivatives to be recorded? • How do accounting treatments differ among a fair value hedge, speculation, no derivative? • How do the economic impacts differ among fair value hedge, speculation, no derivative in BestGas’ case? • How does accounting for a cash flow hedge differ from a fair value hedge?

21. All Derivatives • All derivatives are reported at fair value on the balance sheet. • Changes in the fair value of a derivative is recognized in earnings. • Only entry for derivatives Not Qualified for hedging purpose (Case 3).

22. FAS 133 - Fair Value Hedge • A hedge of the exposure to a change in fair value of a recognized asset or liability or of an unrecognized firm commitment attributable to a particular risk • Inventory • Fixed Rate debt • Commodity Purchase/Sale Commitment • Fair value for the hedging instrument (derivative). • Carrying value of the hedged item is adjusted to reflect the change in value due to the risk being hedged. • If the two items are perfectly effective hedges, the gain or loss on each item will offset each other. • Ineffectiveness flows through earnings.

23. FAS 133 - Cash Flow Hedge • A hedging relationship where the variability of the hedged items cash flows is offset by the cash flows of the hedging instrument • Hedged item is a forecasted transaction or balance sheet item with variable cash flows • Forecasted purchase/sale • Variable Rate Debt • Change in fair value of derivative is recorded to Other Comprehensive Income (OCI) • Ineffectiveness flows to earnings via OCI

24. FAS 133 - Cash Flow Hedge “Lesser of Two Cumulatives” Rule • Step 1: Determine the change in fair value of the derivative and the change in the expected cash flow on the hedged transaction (Columns B and E). • Step 2: Determine the cumulative change in fair value of the derivative and the cumulative change in the expected cash flow on the hedged transaction (Columns C and F). • Step 3: Determine the lessor of the absolute value of the amounts in Step 2 (Column G). • Step 4: Determine an appropriate balance (in debit or credit) to the cumulative change in OCI (Column H). • Step 5: Determine the change in OCI during the period (Column J). • Step 6: Adjust the derivative to reflect its change in fair value and adjust OCI by the amount determined in Step 4. Balance the entry, if necessary, with an adjustment to earnings (Column K).

25. FAS 133 - Cash Flow Hedge “Lesser of Two Cumulatives” Rule • Change in fair value of the derivative • Change in the expected cash flow on the hedged transaction • Effective hedge: OCI (a deferral) • Ineffective hedge: Earnings • When the transaction is completed: Reclassify AOCI to earnings

26. Conclusions • Same entry to record the derivative at FV when a derivative is used • FVH: Observe changes in the carrying cost of the inventory for fair value hedge • CFH: The effective portion of gains or losses on a derivative designated as a cash flow hedge are deferred to OCI determined by the “lesser of two cumulatives” rule. This deferral will be subsequently reclassified as earnings when the forecasted transaction affects earnings. • Contract settlement: receives/pays cash from/to a futures broker if the contracted futures price (i.e., the futures forward price at inception) is less/more than the futures spot price because the entity purchases the commodity at a lower/higher price to close out the previous short sale position.

27. Stay tuned… • You can download the following reading material at http://ahwang.pageout.net by click links in the following order: Research, Course Contents, Publications, • JOA1 FAS 133 Implementation • JAE1a FAS133 Comparative Analysis • JAE1s FAS 133 Comparative Analysis Worksheet for Students • Reading Sequence on Hwang's FAS133 Research • Seminar participants should read: • “Practical Issues In Implementing FASB Statement 133,” (with John S. Patouhas) Journal of Accountancy Vol. 191 No. 3 (March 2001): 26-34. (JOA1 FAS 133 Implementation) • Seminar participants should glance through the attached seminar PowerPoint handouts.

28. Stay tuned… • Seminar participants should glance through: • “Comparative Analysis of Accounting Treatments for Derivatives,” Journal of Accounting Education Vol. 20 (2002): 205-233. (JAE1a FAS133 Comparative Analysis) • A scenario based on a futures contract used by a natural gas company to hedge price fluctuations of its gas inventory is applied across four cases to show the impact of derivative designation on the accounting treatment and to provide a comparative analysis of the financial/economic results from using different accounting treatments for the derivative. • Seminar participants should work on the case in excel worksheet if attending the afternoon optional workshop on accounting for derivatives. • JAE1s FAS 133 Comparative Analysis Worksheet for Students • Seminar participants if interested in more Hwang’s publications on FAS 133 should read: • Reading Sequence on Hwang's FAS133 Research

29. ahwang@emich.edu Angela Hwang248.723.9365

30. Thank You