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Derivatives and Hedging

a. U.S. GAAP Accounting. Derivatives and Hedging. November 6, 2000 FEI CFRI Conference New York, New York. John E. Stewart Arthur Andersen LLP. Statement 133 –– Down to Implementation. Scope Valuation Qualification Complexities Transition. “Cornerstones” of Statement 133.

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Derivatives and Hedging

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  1. a U.S. GAAP Accounting Derivatives and Hedging November 6, 2000 FEI CFRI Conference New York, New York John E. Stewart Arthur Andersen LLP

  2. Statement 133 –– Down to Implementation • Scope • Valuation • Qualification • Complexities • Transition

  3. “Cornerstones” of Statement 133 • Derivatives are assets or liabilities • Fair value is the measure • High hurdle for hedge accounting • Designation and effectiveness are key

  4. Statement 133 Tools • DIG - FASB Staff implementation guidance (100+ issues) • FASB Staff training course • Accounting firm presentations • Accounting firm interpretations • Communication is key • Senior management • Audit committees • Board of Directors

  5. “Natural State” of Derivatives • Report derivatives at fair value • Report all changes in value currently in earnings • Hedge accounting criteria provide only exception

  6. Universe of Statement 133 Hedges Fixed-Rate Assets Fixed-Rate Liabilities Firm Commitments Floating-Rate Assets Floating-Rate Liabilities Forecasted Transactions Cash Flow Hedges Fair Value Hedges Foreign Currency Hedges FX-Denominated Forecasted Transactions (Third Party or Intercompany) Certain FX-Denominated Receivables and Payables FX-Denominated AFS Securities or Firm Commitments Certain FX-Denominated Receivables and Payables Net Investments in Foreign Operations

  7. Statement 133 –– Down to Implementation • November • December Statement 133 is effective for all fiscal quarters of all fiscal years beginning after June 15, 2000 (January 1 for calendar-year fiscal years) • To achieve hedge accounting, need contemporaneous, formal documentation

  8. Statement 133 –– Statement 138 • Statement 133 amended in June 2000 by Statement 138 in four primary areas • Scope of commodity contracts • Interest rate hedging • Foreign currency payables and receivables • Intercompany foreign currency transactions • Ideas turned down • Partial term hedging • Special accounting for option time value

  9. Statement 133 –– Down to Implementation • Scope • Valuation • Qualification • Complexities • Transition

  10. Scope Always Ask Two Questions 1. Is the contract a derivative? 2. If not, is the contract embedded with a derivative? Be sure to read the DIG issues - Definition - Whether and how to bifurcate

  11. Is the Contract a Derivative? Yes • Interest rate swaps • Interest rate caps • Interest rate floors • “Treasury locks” and other forward rate agreements • Forward sales commitments on loans and securities • Foreign currency interest-rate swaps • Foreign currency forward contracts • Foreign currency swaps

  12. Is the Contract a Derivative? No • Normal purchases or normal sales • Certain insurance contracts • Certain financial guarantees • Contracts in shareholders’ equity • Stock compensation • Contingent consideration • Weather derivatives • Contingent rent • Regular-way securities trades • Derivatives that kill sale accounting

  13. Is the Contract a Derivative? • Credit derivatives • Contracts on company’s own equity • Beneficial interests in securitized assets • Energy contracts • Loan commitments (creditor and debtor accounting) • Insurance contracts • Foreign currency derivatives in purchase orders and leases • Equity warrants

  14. Is the Contract Embedded with a Derivative? Hybrid Contract: • Contracts that contain derivative-like features but that are not derivatives themselves Embedded Features: • Features in a Hybrid Contract affecting cash flows or value of other exchanges similar to that of a derivative Host Contract: • What would be left if the Embedded Features were not in the Hybrid Contract

  15. Is the Contract Embedded with a Derivative? Hybrid Contract: Convertible Debt • Contracts that contain derivative-like features but that are not derivatives themselves Embedded Features: Call Option on Equity • Features in a Hybrid Contract affecting cash flows or value of other exchanges similar to that of a derivative Host Contract: Plain Vanilla Debt • What would be left if the Embedded Features were not in the Hybrid Contract

  16. Is the Contract Embedded with a Derivative? Are features clearly and closely related? • Convertible debt securities held • Embedded, purchased equity call option (holder perspective) • Issuer and investor accounting can differ • Credit features • Debt indexed to appreciated equity securities

  17. Statement 133 –– Down to Implementation • Scope • Valuation • What • When • Who • Qualification • Complexities • Transition

  18. Valuation – What Needs to Be Valued? • Each freestanding derivative • Each embedded derivative • Each host contract upon bifurcation • Each item hedged in a fair value hedge • Cash flows in a cash flow hedge • Intrinsic value and time value

  19. Valuation – When Are Values Needed? • Hedge inception to establish hedge effectiveness expectations • On transition (resulting in transition adjustments) • Each quarter end to support compliance with each recognition, measurement, and disclosure requirement

  20. Valuation – Who Will Value? • Accounting firms? Sorry, not for audit clients • Counterparty? Maybe, but is a party to the transaction • Third Party? Maybe, but demand and risk aversion may prevent • Client? Probably, but requires controlled process and reliable data

  21. Statement 133 –– Down to Implementation • Scope • Valuation • Qualification • Complexities • Transition

  22. Qualification • Contemporaneous, formal documentation required at hedge at inception • Objectives and strategy • Hedged item • Hedging instrument • Risk being hedged • How effectiveness will be assessed • SEC has required restatement for improper documentation • All criteria for hedge accounting must be met - no materiality • Be sure to read the DIG issues

  23. Qualification Effectiveness Methodology 1. Expecting high effectiveness at hedge inception 2. Observing whether high effectiveness has occurred 3. Expecting effectiveness prospectively each quarter 4. Measure ineffectiveness to be reported in earnings

  24. Statement 133 –– Down to Implementation • Scope • Valuation • Qualification • Complexities • Transition

  25. Complexities - A sampler! • Scope • Shortcut qualification • Hedging the benchmark rate (methods 2 and 3) • Forward points in forward currency hedges • Purchased and complex options • Basis risk for nonfinancial assets • Aggregating (e.g. commercial paper programs) • Tracking OCI

  26. Complexities - A sampler, continued! • Mortgage servicing rights • Net investment hedges • Call monetization • Prohibitions • Calculation of transition adjustments Be sure to read the DIG issues!

  27. Statement 133 –– Down to Implementation • Scope • Valuation • Qualification • Complexities • Transition

  28. Transition • Bifurcate hybrid instruments • Make any Statement 115 or Statement 125 reclassifications to the extent permitted • Recognize all freestanding and bifurcated derivatives at fair value • Designate and document all hedges anew • Determine and record transition adjustments based on any pre-existing qualifying hedging relationship • Pre-adoption disclosures

  29. Other Considerations • Impact on EITF guidance • Impact of Statement 138 on FASB staff implementation guidance • Statement 125 amendments • DIG meeting scheduled for December • New implementation issues weekly

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