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ACCOUNTING FOR DERIVATIVES

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ACCOUNTING FOR DERIVATIVES

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  1. ACCOUNTING FOR DERIVATIVES Presentation by Bob JensenTrinity University One Trinity Place San Antonio, TX 78212rjensen@trinity.edu http://www.trinity.edu/rjensen/

  2. ACCOUNTING FOR DERIVATIVES Bob Jensen190 Sunset Hill Road Sugar Hill, NH 03586 Phone 603-823-8482 rjensen@trinity.edu http://www.trinity.edu/rjensen/

  3. FAS 133 IAS 39 CICA 13 Bob Jensen’s Free Tutorials, Glossaries, and Cases are athttp://www.trinity.edu/rjensen/caseans/000index.htm Accounting for Derivative Financial Instruments and Hedging Transactions

  4. Key Amendments to FAS 133 FAS 138 FAS 149 FAS 155FAS 159 Accounting for Derivative Financial Instruments and Hedging Transactions

  5. Eliminated by FAS 133 FAS 080 FAS 119 Accounting for Derivative Financial Instruments and Hedging Transactions

  6. FAS 105, 107, 115, 130, 133, 141, 142, 155, 157, 159 Bob Jensen’s Summary of Accounting History and Theory http://www.trinity.edu/rjensen/theory.htm “Not everything that can be counted, counts. And not everything that counts can be counted.” Albert Einstein Fair Value AccountingFAS 105, 107, 115, 130, 133, 141, 142, 155, 157, 159

  7. FAS 115 effective in 1994FV Reporting of AFS Investments in Debt/Equity • Debt securities that the enterprise has the positive intent and ability to hold to maturity are classified as held-to-maturity securities and reported at amortized cost. • Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings. • Debt and equity securities not classified as either held-to-maturity securities or trading securities are classified as available-for-sale securities and reported at fair value, with unrealized gains and losses excluded from earnings and reported in a separate component of shareholders' equity.

  8. FAS 130 effective in 1998Reporting Other Comprehensive Income (OCI) This Statement requires that an enterprise • classify items of other comprehensive income by their nature in a financial statement and • display the accumulated balance of other comprehensive income (AOCI) separately from retained earnings and additional paid-in capital in the equity section of a statement of financial position.

  9. FAS 133 effective in 2000Amended by FAS 137, 138, 149, 155, and 159Accounting for Derivative Financial Instruments and Hedging Activities • Financial Derivatives & Scandals Explode in the Early 1990's • Video or Audio clip from CBS Sixty Minutes SIXTY01.avi or  SIXTY01.mp3 • Audio clip from John Smith of Deloitte & Touche in August 1994  SMITH01.mp3 • Examples of derivative contracts that even the professional analysts could not decipher • The derivatives that Merrill Lynch wrote that drive Orange County into bankruptcy • Other derivatives fraud summaries are at http://www.trinity.edu/rjensen/fraud.htm#DerivativesFraud • Video and audio clips of FASB updates on FAS 133  • Audio 1 --- Dennis Beresford in 1994 in New York City  BERES01.mp3 • Audio 2 --- Dennis Beresford in 1995 in Orlando  BERES02.mp3 • Derivative Financial Instrument Frauds --- Off line --- Click Here

  10. FAS 133 effective in 2000Amended by FAS 137, 138, 149, 155, and 159Accounting for Derivative Financial Instruments and Hedging Activities • Requires booking of most derivative financial instruments at fair value (with some exceptions for NPNS, regular-way, insurance contracts, weather derivatives, short sales, interest-strips, etc.) • Derivatives are to be marked to current fair value at least every 90 days and on reporting dates. Changes in fair value are to be charged or credited to current earnings unless the derivatives qualify for hedge accounting treatment as cash flow, fair value, or FX hedges. Not all economic hedges qualify for hedge accounting relief from current earnings. • Hedge accounting rules under FAS 133 and its amendments are very complex.

  11. Key FAS 133 and IAS 39 Terms Notional | Underlying | Net Settlement | Little or No Initial Investment Financial Instrument | Derivative Instrument Purchase Commitment | Firm Commitment | Forecasted Transaction | Speculation Stand Alone | Cash Flow Hedge | Fair Value Hedge | FX Hedge Purchased Options | Written Options | Long Forwards | Short Forwards | Swaps | Futures Contracts European versus American versus Asian options Spot Price, Forward Price, Strike Price, Premium, Intrinsic Value, Time Value Freestanding, Embedded, Structured (tailormade rather than convential financing) OCI versus Firm Commitment | Delta

  12. ACCOUNTING FOR DERIVATIVES Bob Jensen's threads on Enron are at http://www.trinity.edu/rjensen/fraud.htm  Bob Jensen's threads on Derivative Financial Instruments Fraud are at http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds  Also note http://www.trinity.edu/rjensen/Fraud.htm#FrankPartnoyTestimony  How Enron Used SPEs and Derivatives Jointly is Explained at http://www.trinity.edu/rjensen//theory/00overview/speOverview.htm Bob Jensen’s threads on derivatives accounting are at  http://www.trinity.edu/rjensen/caseans/000index.htm

  13. Frank Partnoy’s Works Of all the many documents and books that I have read about derivative financial instruments, the most important have been the books and documents written by Frank Partnoy. Some of his books are listed at the bottom of this message.

  14. Frank Partnoy’s Works The single most important document is his Senate Testimony. More than any other single thing that I've ever read about the Enron disaster, this testimony explains what happened at Enron and what danger lurks in the entire world from continued unregulated OTC markets in derivatives. I think this document should be required reading for every business and economics student in the world. Perhaps it should be required reading for every student in the world. Among other things it says a great deal about human greed and behavior that pump up the bubble of excesses in government and private enterprise that destroy the efficiency and effectiveness of what would otherwise be the best economic system ever designed.

  15. Frank Partnoy’s Works Testimony of Frank Partnoy Professor of Law, University of San Diego School of Law Hearings before the United States Senate Committee on Governmental Affairs, January 24, 2002 --- http://www.senate.gov/~gov_affairs/012402partnoy.htm

  16. Frank Partnoy’s Works • FIASCO: The Inside Story of a Wall Street Trader • FIASCO: Blood in the Water on Wall Street • FIASCO:  Blut an den weißen Westen der Wall Street Broker. • FIASCO: Guns, Booze and Bloodlust: the Truth About High Finance • Infectious Greed : How Deceit and Risk Corrupted the Financial Markets • Codicia Contagiosa • His other publications include the following highlight: • "The Siskel and Ebert of Financial Matters: Two Thumbs Down for the Credit Reporting Agencies" (Washington University Law Quarterly)

  17. REASONS FOR NEW STANDARDS Undisclosed Assets and LiabilitiesUnbooked Assets and LiabilitiesMeaningless Measures of Value & Risk Rise in Scandals in the 1980s & 1990sComplex Frauds --- Partnoy’s Fiasco Explosion of Swap Contracts Evolution Toward Fair Value Accounting

  18. PROBLEMS WITH NEW STANDARDS Complex Contracts & Technical Jargon Complex Scoping of Coverage --- NPNS Complex Hedge Accounting RulesMany Derivatives Are Difficult to Value Difficult to Find Embedded DerivativesComplex Effectiveness Testing Rules Continuous Stream --- DIG, Amendments Implementation Failures --- Freddie Mac, etc. Held-to-Maturity Interim DistortionsHedge Acctg. Denied to Most Macro Hedges

  19. Differences Between StandardsFAS 133 vs. IAS 39 vs. CICA 13 Differences are relatively minor IAS 39 Macro Hedging Amendment Listing of Major Differences http://www.trinity.edu/rjensen/caseans/canada.htm .

  20. Hedge Accounting Section Objectives After completing this section, you should be able to: • Determine whether a contract is scoped into the standards and, if so, whether it is • Qualified for Hedge Accounting • Treated as a cash flow, fair value, or FX hedge • Understand the basic journal entries • Cry out loud if forced to implement the standards

  21. One million lines of journal entries:  Just how expensive is FAS 133? "The Potential Crisis at Fannie Mae," Comstock Funds, August 11, 2005 --- http://snipurl.com/Fannie133 We have no proprietary information about Fannie Mae, but what is publicly known is scary enough. As you may recall, last December the SEC required Fannie to restate prior financial statements while the Office of Federal Oversight (OFHEO) accused the company of widespread accounting regularities that resulted in false and misleading statements. Significantly, the questionable practices included the way Fannie accounted for their huge amount of derivatives. On Tuesday, a company press release gave some alarming hints on how extensive the problem may be. The press release stated that in order to accomplish the restatements, “we have to obtain and validate market values for a large volume of transactions including all of our derivatives, commitments and securities at multiple points in time over the restatement period. To illustrate the breadth of this undertaking, we estimate we will need to record over one million lines of journal entries, determine hundreds of thousands of commitment prices and securities values, and verify some 20,000 derivative prices…” “…This year we expect that over 30 percent of our employees will spend over half their time on it, and many more are involved. In addition we are bringing some 1,500 consultants on board by year’s end to help with the restatement…Altogether, we project devoting six to eight million labor hours to the restatement. We are also investing over $100 million in technology projects to enhance or create new systems related to accounting and reporting…we do not believe the restatement will be completed until sometime during the second half of 2006…” Bob Jensen's tutorials on accounting for derivatives are at http://www.trinity.edu/rjensen/caseans/000index.htm

  22. FOUR CORNERSTONES • Derivatives are contracts that create rights and obligations that meet the definitions of assets and liabilities • Fair value is the only relevant measure for derivatives(Mainly because historical cost is zero or near-zero) • Value risk can be hedged into cash flow risk, and cash flow risk can be hedged into value risk, but both risks cannot simultaneously be eliminated. • Hedge effectiveness tests can be varied with the type of risk being hedged.

  23. Example: Futures ContractsFinancial Risk May Be Unbounded • May be contracts to buy or sell at contracted (future) price that moves along with spot prices on an organized exchange linking buyers and sellers. Cost = Zero! • Notional = standardized quantities per contract for a standard product such as a particular type of corn. • Underlying = the value per unit such as the price of a bushel of corn or a Treasury or Libor interest rate. • Futures are a unique kind of derivative because futures gains and losses are posted daily in cash.

  24. Example: Futures Contracts (Continued) • Since futures contracts are cleared daily for cash, the accounting was relatively simple under the now-defunct FAS 80. • FAS 133 rules are more complicated for hedging contracts --- see 000starta.xls file at http://www.cs.trinity.edu/~rjensen/Calgary/CD/FAS133OtherExcelFiles/cases/ • CBOT --- http://www.cbot.com/ • The prices you first see listed are the forward prices. To find spot prices, click on the link called "Charts." 

  25. Example: Forward ContractsFinancial Risk May Be Unbounded • May be contracts to buy or sell at contracted (future) price that moves along with spot prices in over-the-counter (OTC) private contracts. Cost = Zero! • Notional = unique quantities per contract for a defined product such as a particular type of corn. • Underlying = the value per unit such as the price of a bushel of corn or a Treasury or Libor interest rate. • Unlike futures contracts, forward contracts are neither standardized nor cleared daily for cash gains and losses.

  26. Example: Forward Contracts (Continued) • There were no accounting rules for forward contracts prior to FAS 133. • FAS 133 rules are complicated for hedging contracts --- see 000starta.xls file at http://www.cs.trinity.edu/~rjensen/Calgary/CD/FAS133OtherExcelFiles/cases/ • CBOT --- Does not exchange forward contracts • Contracts are non-standardized and might be subject to credit risk. 

  27. Example: Swap ContractsFinancial Risk May Be Unbounded • Swaps are generally portfolios of forward contracts with regularly-spaced payment dates. Cost = Zero! • Notional = unique quantities per contract for a defined product such the number of bonds being hedged. • Underlying = the value per unit such as the price of a bushel of corn or a Treasury or Libor interest rate. • Interest rate swaps were only invented in 1984, but they became the leading form of cash management and now have notionals over $100 trillion dollars..

  28. Example: Swap Contracts (Continued) • There were no accounting rules for swap contracts prior to FAS 133. • FAS 133 rules are complicated for hedging contracts --- see 000starta.xls file at http://www.cs.trinity.edu/~rjensen/Calgary/CD/FAS133OtherExcelFiles/cases/ • There are a few standardized swaps traded on exchanges • Contracts are non-standardized and might be subject to credit risk. 

  29. Example: Written Option ContractsFinancial Risk May Be Unbounded • Contracts to sell or buy at contracted (future) price that moves along with spot prices on an organized exchange linking buyers and sellers. Sale Price > $0=Premium! Example: Selling Puts or Calls. • Notional = standardized quantities per contract for a standard product such as a particular type of corn. • Underlying = the value per unit such as the price of a bushel of corn or a Treasury or Libor interest rate. • Options may also be non-standardized OTC. Use of options dates back to Roman times.

  30. Example: PurchasedOption ContractsFinancial Risk Is Bounded by Premium Paid • Contracts to buy or sell at contracted (future) price that moves along with spot prices on an organized exchange linking buyers and sellers. Purchase Price > $0=Premium! Example: Buying Puts or Calls. • Notional = standardized quantities per contract for a standard product such as a particular type of corn. • Underlying = the value per unit such as the price of a bushel of corn or a Treasury or Libor interest rate. • Purchased options are the only derivatives where risk is limited to the premium (purchase) price paid initially.

  31. Example: Purchased Options (Continued) • The accounting was relatively simple under the now-defunct FAS 80. • FAS 133 rules are more complicated for hedging contracts --- see 000starta.xls file at http://www.cs.trinity.edu/~rjensen/Calgary/CD/FAS133OtherExcelFiles/cases/ • CME --- http://www.cme.com/trading/dta/del/delayed_quotes3520.html • Value of Option = Intrinsic Value + Time Value 

  32. KEY ASPECTS OF THE 133/39 STANDARDS • Most derivatives are reported at fair value on balance sheet • Changes in fair value for derivatives not qualifying in a hedging relationship are recorded in earnings • Hedge accounting is provided for the change in value of derivatives designated and qualifying as: • Fair value hedges • Cash flow hedges • Foreign currency hedges • Hedge effectiveness tests may be tough hurdles over time

  33. DERIVATIVES IMPLEMENTATIONGROUP (DIG) • DIG is made up of FASB staff members, Big 5 members and Industry professionals. Active DIG observers include the SEC and certain regulators. • DIG’s mandate is to assist the FASB in answering implementation questions by identifying practice issues that arise from applying Statement 133 and to advise the FASB staff on how to resolve the issues. • Issues are discussed by DIG, tentatively concluded by the FASB staff and posted on the FASB website (www.fasb.org) for two months before being presented to the Board for negative clearance. • DIG Site http://www.fasb.org/derivatives/

  34. Bob Jensen’s Flow Charthttp://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm • Flow chart for deciding whether derivative is scoped into FAS 133 • Flow chart for deciding how to account for a derivative financial instrument qualified for hedge accounting.Cash Flow Hedge (booked item vs. forecasted transact.)Fair Value Hedge (booked item vs. firm commitment)Foreign Currency (FX) Hedge (fair value vs. cash flow)

  35. DERIVATIVE DEFINITION ¶6–16 • The definition is based on distinguishing characteristics • A derivative instrument is a contract with all three of the following characteristics (¶6): • Underlying and either a notional amount or a payment provision or both • Relatively small initial net investment (5% Rule in Para A5 of FAS 149) • Net settlement or its equivalent (excludes most short sales & Take-Or-Pays, but see FAS 133 Paragraph 290) • Definition includes freestanding as well as embedded derivative instruments • A number of exclusions exist

  36. FREESTANDING DERIVATIVESOverview • Statement 133 created a new definition of the term derivative • Some instruments that are not usually considered derivatives are included (e.g. certain purchase/sales contracts) • The definition is based on certain distinguishing characteristics. • Certain scope exceptions exist; not everything that meets the definition of a derivative is subject to the requirements of Statement 133.

  37. FREESTANDING DERIVATIVES Three Characteristics ¶6–9 and 57 A derivative instrument is a contract with all three of the following characteristics: 1. Underlying and either a notional amount or a payment provision or both 2. No initial net investment or smaller initial net investment than contracts with similar responses to changes in market factors 3. Net settlement or its equivalent

  38. FREESTANDING DERIVATIVES Characteristic 1—Underlying ¶7 and 57(a) An underlying is a variable, such as: • An interest rate (e.g., LIBOR) • The price of a security or commodity (e.g., price of a share of ABC stock or a bushel of wheat) • A foreign exchange rate (e.g., Euro/U.S. $ spot rate) • A measure of creditworthiness (e.g., Moody’s) • An index on any of above or other (e.g., S&P 500, CPI) • Other specific items

  39. FREESTANDING DERIVATIVES Characteristic 1—Notional Amount ¶7 A notional amount is a number of: • Currency units • Shares • Bushels • Pounds • Other units Notional amount is used to determine the settlement amount (for example, a price x a number of shares)

  40. FREESTANDING DERIVATIVES Characteristic 1—Examples of Underlyings and Notional Amounts DerivativeUnderlyingNotional Amount - Stock option - Stock price - Number of shares - Currency forward - Exchange rate - Number of currency units - Commodity future - Commodity price - Number of commodity units - Interest rate swap - Interest index - Dollar amount

  41. FREESTANDING DERIVATIVES Characteristic 1—Payment Provision ¶7 A payment provision specifies a fixed or determinable settlement if the underlying behaves in a specified way. For example: if interest rates increase by say 300 basis points then payment of an applicable amount would be required

  42. FREESTANDING DERIVATIVES Characteristic 2—Initial Net Investment ¶8 and 57(b) A derivative requires either: • No initial net investment • A smaller initial net investment than other types of contracts that have a similar response to changes in market factors A derivative does not require an initial net investment of the notional amount An exchange of currencies is not a net investment

  43. FREESTANDING DERIVATIVES Characteristic 3—Net Settlement ¶9 and 57(c) There are 3 ways to meet the net settlement requirement: 1. Net settlement explicitly required or permitted by the contract (transfer of cash or other assets) 2. Net settlement by a market mechanism outside the contract (e.g., futures exchange) 3. Delivery of a derivative or an asset that is readily convertible to cash

  44. FREESTANDING DERIVATIVES Characteristic 3—Readily Convertible to Known Amounts of Cash ¶9 and 57(c) Readily convertible assets have: • Interchangeable (fungible) units • Quoted prices available in an active market that can rapidly absorb the quantity held by the entity without significantly affecting the price For example: • Public securities, commodities, and foreign currencies

  45. FREESTANDING DERIVATIVES Exceptions ¶10 and 58 The following are not subject to Statement 133: • “Regular-way” security trades • Normal purchases and normal sales • Traditional insurance contracts • Most financial guarantee contracts • OTC contracts with certain underlyings • Derivatives that are an impediment to sales accounting

  46. FAS 138Scope-Excluded Contracts Normal purchase/sale exception expanded to include: • Contracts that permit net settlement (9a) • Contracts that have a market mechanism to facilitate net settlement (but note FAS 138) • FAS 149 Electric Power Bookout Exception As long as it is probable contracts will not settle net and will result in physical delivery (but note FAS 138 and FAS 149)

  47. FAS 138 Scope-Excluded Contracts (Cont’d) Net settlement of similar contracts should be rare Excluded from exception: • Contracts that require cash settlement or otherwise settle periodically • Contracts that have price based on underlying unrelated to asset sold or purchased(1) • Contracts denominated in foreign currency not meeting embedded derivative separation exception rules of paragraphs 15(a) and 15(b) (1) (1) May be considered compound derivatives

  48. FREESTANDING DERIVATIVES Exceptions OTC Contracts with Certain Underlyings ¶10(e) and 58(c) Climatic variables: • Temperature • Rain or snowfall totals • Wind speed Geological variables: • Earthquake severity (Richter scale) Other physical variables

  49. FREESTANDING DERIVATIVES Exceptions—OTC Contracts with Certain Underlyings ¶10(e) and 58(c) The price or value of nonfinancial assets of one of the parties that is not readily convertible to cash or the price or value of nonfinancial liabilities of one of the parties that does not require delivery of readily convertible assets • Option to purchase or sell real estate owned by one party (even if it can be net settled) • Firm commitment to sell machinery (if unique)owned by one party (even if it can be net settled)

  50. FREESTANDING DERIVATIVES Exceptions OTC Contracts with Certain Underlyings ¶10(e) and 58(c) Exceptions include specified volumes of sales or service revenues of one of the parties. For example: • Leases based on sales of the lessee • Royalty agreements