Derivatives Implementation Group Meeting June 24 and 25, 1999 Agenda

Transcription

1 Derivatives Implementation Group Meeting June 24 and 25, 1999 Agenda Agenda Item# Item Description

2 Statement 133 Implementation Issues Definition of a Derivative Asymmetrical Default Provisions Hedging General Basing Assessment on a Shorter Period Than the Life of the Derivative Provisions that Permit the Debtor or Creditor to Require Prepayment Cash Flow Hedges Impairment Write-down of Long-Lived Assets Assessing Hedge Effectiveness Period-by-Period or Cumulatively Fair Value Hedges Interaction of Statement 133 and Statement 114 Foreign Currency Hedges Hedging Net Investment with the Combination of a Derivative and a Cash Instrument Issues Resolved by the FASB Staff Definition of a Derivative Prepaid Interest Rate Swaps Derivatives that Incorporate an Underlying on the Issuer s Equity Price Embedded Derivatives Volumetric Production Payments Embedded Derivatives in Certificates Issued by Qualifying Special Purpose Entities Scope Exceptions Exceptions Related to a Nonfinancial Asset of One of the Parties

3 Derivatives Implementation Group Meeting June 24 and 25, 1999 Agenda Agenda Item# Item Description Issues Resolved by the FASB Staff Hedging General Dollar-Offset Approach Required in Assessing Effectiveness Hedged Exposure Limited but Derivative s Is Not Cash Flow Hedges Variable Price Component Fair Value Hedges Assessing Hedge Effectiveness Period-by-Period or Cumulatively Firm Commitment Threatened Lawsuit as a Disincentive for Nonperformance Foreign Currency Hedges The Amount of Ineffectiveness in Net Investment Hedges Cross-Currency Hedges of Net Investment Threshold to Qualify for Net Investment Hedge Accounting Accounting for Premium or Discount on a Forward Contract Used as the Hedging Instrument in a Net Investment Hedge Frequency of Designation of Hedged Net Investment Use of Compound Derivative That Incorporates Exposure to Multiple Risks Transition Provisions Fixed Rate Currency Swaps Transfer of Loans Accounted for Like Available-for-Sale Securities into Trading

4 DERIVATIVES IMPLEMENTATION GROUP 6/24-25/99 AGENDA ITEM 1-7 Inquiry Resolved by FASB Staff Topic: Definition of a Derivative: Prepaid Interest Rate Swaps Paragraph references from Statement No. 133: 6, 9, 13 QUESTION How does Statement 133 affect the accounting for a prepaid interest rate swap contract, that is, an interest rate swap contract for which the fixed leg has been prepaid (at a discounted amount)? BACKGROUND In lieu of obtaining a pay-fixed, receive-variable interest rate swap that is settled net each quarter, an entity may choose to enter into a prepaid interest rate swap contract that obligates the counterparty to make quarterly payments to the entity for the variable leg and for which the entity pays the present value of the fixed leg of the swap at the inception of the contract. Different structures can be used for a prepaid interest rate swap contract, although the amount and timing of the cash flows under the different structures are the same, which makes the different structures of contract terms identical economically. For example, rather than entering into a 2-year pay-fixed, receive-variable swap with a $10,000,000 notional amount, a fixed interest rate of 6.65 percent, and a variable interest rate of 3- month US$ LIBOR (that is, the swap terms in Example 5 of Statement 133), an entity can effectively accomplish a prepaid swap by entering into a contract under either of the following structures. Structure 1 The entity pays $1,228,179 to enter into a prepaid interest rate swap contract that requires the counterparty to make quarterly payments based on a $10,000,000 notional amount and an annual interest rate equal to 3-month US$ LIBOR. The amount of $1,228,179 is the present value of the 8 quarterly payments of $166,250, based on the implied spot rate for each of the 8 payment dates under the assumed initial yield curve in that example. Structure 2 The entity pays $1,228,179 to enter into a structured note ( contract ) with a principal amount of $1,228,179 and loan payments based on a formula equal to times 3-month US$ LIBOR. (Note that = 10,000,000 / 1,228,179.) Under the structured note, there is no repayment of the principal amount at the end of the two-year term. Rather, repayment of the $1,228,179 principal amount is incorporated into the eight quarterly payments and, thus, is dependent on interest rates. RESPONSE The prepaid interest rate swap contract (accomplished under either structure) is a derivative 1

5 DERIVATIVES IMPLEMENTATION GROUP 6/24-25/99 AGENDA ITEM 1-7 instrument because it meets the criteria in paragraph 6 and related paragraphs of Statement 133. Accordingly, the prepaid interest rate swap (accomplished under either structure) must be accounted for as a derivative instrument and reported at fair value. Discussion of Structure 1 The prepaid interest rate swap in Structure 1 has an underlying (3-month US$ LIBOR) and a notional amount (paragraph 6(a)). The prepaid interest rate swap requires an initial investment ($1,228,179) that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors, such as an 8-times impact for changes in LIBOR when applied to the initial investment (paragraph 6(b)). Under the prepaid swap in Structure 1, neither party is required to deliver an asset that is associated with the underlying or that has a principal amount, stated amount, face value, number of shares, or other denomination that is equal to the notional amount (or the notional amount plus a premium or minus a discount) (paragraph 6(c) and 9(a)). Discussion of Structure 2 The contract in Structure 2 has an underlying (3-month US$ LIBOR) and a notional amount (paragraph 6(a)). The contract requires an initial investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors, such as an eight-times impact for changes in US$ LIBOR (paragraph 6(b)). The fact that the contract under Structure 2 involves an initial investment equal to the stated $1,228,179 notional amount is not an impediment to satisfying the criterion in paragraph 6(b). Paragraph 8 states, A derivative instrument does not require an initial net investment in the contract that is equal to the notional amount (or the notional amount plus a premium or minus a discount) or that is determined by applying the notional amount to the underlying. Accordingly, if a contract involves significant leverage, it would meet this condition because the notional amount is effectively the stated notional times the multiplication factor that represents the leverage. The contract in Structure 2 is highly leveraged, resulting in an impact that is over eight times as great as simply applying the notional amount to the underlying. Under the contract in Structure 2, neither party is required to deliver an asset that is associated with the underlying or that has a principal amount, stated amount, face value, number of shares, or other denomination that is equal to the notional amount (or the notional amount plus a premium or minus a discount) (paragraph 6(c) and 9(a)). 2

6 DERIVATIVES IMPLEMENTATION GROUP 6/24-25/99 AGENDA ITEM 6-1 Topic: Fair Value Hedges: Basing the Expectation of Highly Effective Offset on a Shorter Period Than the Life of the Derivative Paragraph references from Statement No. 133: 20(a), 20(b), BACKGROUND AND DESCRIPTION OF TRANSACTION To qualify for fair value hedge accounting, Statement 133 requires that an entity must expect the hedging relationship to be highly effective in achieving offsetting changes in fair value for the risk being hedged. The Statement does not specify the method to be used in assessing the hedge s effectiveness in achieving offsetting changes in fair values nor does it specify how the expectation of highly effective offset should be determined. However, the Statement requires that the assessment of effectiveness be consistent with the risk management strategy documented for that particular hedging relationship. QUESTION In a fair value hedge of an asset with a ten-year term with a hedging derivative that has a five-year term, may an entity base its expectation that the hedging relationship will be highly effective in achieving offsetting changes in fair value for the risk being hedged by considering possible changes in value over only the first six months of the derivative s five-year life? POSSIBLE ALTERNATIVES View A It depends on the hedging relationship. If an entity has documented undertaking a dynamic hedging strategy, such as a delta-neutral hedging strategy as described in paragraphs 86 and 87, in which the entity has committed itself to a nearly continuous repositioning strategy for its hedging relationship, the entity may base its assessment of hedge effectiveness on only a very short part of the term of the derivative. In contrast, if the entity has not documented undertaking a dynamic hedging strategy, the entity may not base its expectation of hedge effectiveness by considering possible changes in value over only a part of the term of the derivative. Statement 133 implicitly requires that, except for dynamic hedging strategies, the expectation of effectiveness for a fair value hedge comprehend all possible changes in the underlying over the life of the derivative. View B Yes. An entity may designate a five-year derivative as the hedging instrument in a fair value hedge and document an intent to assess its expectation of hedge effectiveness by considering possible changes in value of the derivative and hedged item over only the first six months of the derivative s five-year life. The entity does not need to contemplate the offsetting effect for the entire term of the hedging instrument. The Statement merely requires that the assessment of effectiveness be consistent with the risk 3

7 DERIVATIVES IMPLEMENTATION GROUP 6/24-25/99 AGENDA ITEM 6-1 management strategy documented for that particular hedging relationship. The Statement specifies no constraints in articulating a risk management strategy. Therefore, the entity may document in its risk management strategy that the period to be considered in forming an expectation about the effectiveness of a hedging relationship is the first six months following inception of the hedge regardless of the life of the derivative. In fact, if the entity is assessing effectiveness quarterly, the entity need consider possible changes in value of the derivative and hedged item only over the next three months. Different lives between the hedging derivative and the hedged asset are simply a different form of basis risk and Statement 133 accepts that a derivative that has some basis risk may nevertheless qualify for fair value hedge accounting. 4

8 DERIVATIVES IMPLEMENTATION GROUP 6/24-25/99 AGENDA ITEM 6-2 Topic: Cash Flow Hedges: Impairment Writedown of Long-Lived Assets Paragraph references from Statement No. 133: 31, 34, 35, and BACKGROUND AND DESCRIPTION OF TRANSACTION This issue relates to situations where the forecasted transaction being hedged are the sales of products produced by long-lived assets. The question focuses on the interaction of the requirements of cash flow hedge accounting under Statement 133 and the requirements of impairment loss recognition for longlived assets under FASB Statement No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of. The following example illustrates the issue: A manufacturer has entered into fixed-price forward sales contracts to hedge the forecasted sales of the manufactured item produced by its long-lived assets. The contracts meet the definition of a derivative in Statement 133 and have been designated as hedging the variability in sales price of forecasted sales of the manufactured item. The item s sales price has declined since the company entered into the forward contracts. As of the reporting date, the contracts have a gain of $50 million, which is recorded in other comprehensive income (OCI) as required by Statement 133. As required by Statement 121, the company has prepared its best estimate of the expected future cash flows from the long-lived assets and determined that an impairment writedown of $80 million must be recorded in current earnings related to those assets. This estimate has been prepared independently of the existence of the forward contracts and is based on current market conditions and all other available data. Statement 133, paragraph 31, states, in part: Amounts in accumulated other comprehensive income shall be reclassified into earnings in the same period or periods during which the hedged forecasted transaction affects earnings (for example, when a forecasted sale actually occurs). Statement 133, paragraph 34 indicates that assets that give rise to variable cash flows (such as a variable-rate financial instrument) for which the variable cash flows are hedged in a cash flow hedge are subject to the existing requirements in generally accepted accounting principles for assessing impairment. Paragraph 34 further states that the fair value or expected cash flows of a hedging instrument in a cash flow hedge should not be considered in performing the impairment assessment. Statement 133, paragraph 35, states, in part: If, under existing requirements in generally accepted accounting principles, an 5

9 DERIVATIVES IMPLEMENTATION GROUP 6/24-25/99 AGENDA ITEM 6-2 impairment loss is recognized on an asset or an additional obligation is recognized on a liability to which a hedged forecasted transaction relates, any offsetting net gain related to that transaction in accumulated other comprehensive income shall be reclassified immediately into earnings. QUESTION When an impairment loss is recognized on a long-lived asset (or group of assets) that produce the items whose forecasted sale is hedged in a cash flow hedge, should a company concurrently reclassify from OCI into earnings the offsetting cumulative gain on the derivative used as the hedging instrument in the cash-flow hedge? In the example, should the company reclassify the $50 million gain in OCI to earnings to offset the $80 million impairment write-down on the long-lived assets? POSSIBLE ALTERNATIVES View A Yes. When an impairment loss is recognized on a long-lived asset (or group of assets) that produce the items whose forecasted sale is hedged in a cash flow hedge, the company should concurrently reclassify from OCI into earnings the offsetting cumulative gain on the derivative used as the hedging instrument in the cash-flow hedge. In the example in the background section, the company should reclassify $50 million gain in OCI to earnings. Paragraph 35 of Statement 133 requires such a reclassification when an impairment loss is recognized on an asset to which a hedged forecasted transaction relates. Because the impairment of the long-lived assets is based on estimated future cash flows that include the projected cash inflows from the hedged forecasted sales, the relationship required by paragraph 35 between the impaired asset and the hedged forecasted transaction exists. Supporters of View A also believe that if the company does not reclassify the gain in OCI to offset the impairment write-down, the resulting financial reporting would be misleading. The company would report a significant loss in the current period ($80 million) and then report gains in subsequent periods ($50 million) while, in fact, it has a net impairment loss of $30 million. Those supporters note that the impairment loss is as high as it is ($80 million) because it is calculated based on lower estimated cash inflows from the hedged transactions (reflecting an estimated low sales price) even though the cash flow hedge that results in the $50 million derivative gain in OCI is based on the derivative having locked in a higher sales price. They believe that inconsistency must be remedied by reclassifying to earnings the $50 million derivative gain in OCI. That is consistent with paragraph 498, which states in part: The net effect on earnings should be the same as if the derivative gain or loss had been included in the basis of the asset or liability to which the hedged forecasted transaction relates. View A supporters believe that their approach is consistent with paragraph 497 of Statement 133 which indicates that the derivative asset or liability should not be considered in the impairment assessment of the related asset. The derivative asset is not added to the amount of long-lived assets in the impairment loss computation; only the gain deferred in OCI is used to offset the impairment loss charged to earnings 6

10 DERIVATIVES IMPLEMENTATION GROUP 6/24-25/99 AGENDA ITEM 6-2 as required by paragraph 35 of Statement 133. View B No. When an impairment loss is recognized on a long-lived asset (or group of assets) that produce the items whose forecasted sale is hedged in a cash flow hedge, the company should not concurrently reclassify from OCI into earnings the offsetting cumulative gain on the derivative used as the hedging instrument in the cash-flow hedge because the sale is distinct from the impairment. In the example in the background section, the company should not reclassify $50 million gain in OCI to earnings because paragraph 31 of Statement 133 requires that the reclassification should occur in the same period or periods during which the hedged forecasted transaction affects earnings (i.e., when the forecasted sale of the manufactured item actually occurs). If the company were allowed to reclassify the gain deferred in OCI prior to the occurrence of the forecasted sale, it would not achieve the intended purpose of recognizing a fixed-price for its forecasted sale. The sale would be recorded at the then spot price and it would have no amounts remaining in OCI to be reclassified to earnings to bring the spot price amount to the fixed-price amount. View B supporters note that the linkage of the derivative to the forecasted sales was established at inception of the hedge through designation and documentation. This linkage between the hedging instrument and the hedged item drives the cash flow hedge accounting entries to be made. Further, they do not believe that paragraph 35 of Statement 133 is suggesting that this linkage be broken when there is an impairment write-down of a related asset that is not subject to the hedge. Supporters of View B also believe that the gain in OCI may have no relationship with the impairment loss under Statement 121 because, while the gain in OCI is based solely on the current price of the manufactured item, the impairment loss under Statement 121 is based on all the available evidence including the historical business cycle data, demand/supply factors, the current market conditions and expectations about the future. Since the computations of the two amounts (i.e., the gain in OCI and the impairment loss) are unrelated and not comparable dollar-for-dollar, the gain should not offset the impairment loss dollar-for-dollar but instead should remain in OCI until the forecasted sale of the manufactured item (i.e., the hedged transaction) is recognized in earnings. In rebuttal, the supporters of View A point out that paragraph 498 states that the Board decided that the reason that a loss or gain on a hedged asset or liability is recognized in income for example, whether through an ordinary depreciation charge or an impairment write-down should not affect the reclassification into earnings of a related offsetting gain or loss in accumulated other comprehensive income. View B supporters point out that if View A were accepted, the following question would need to be addressed:?? If only a part of the total gain in OCI is transferred to earnings (e.g., because of the limitation described in paragraph 35), how should the remaining gain in OCI be linked to the forecasted sales originally designated as the hedged item? Should these forecasted transactions be decided based on a FIFO basis, LIFO basis, specific identification basis, or pro rata basis? 7

11 DERIVATIVES IMPLEMENTATION GROUP 6/24-25/99 AGENDA ITEM 6-2 Supporters of View A point out that the above question is not new nor unique to View A. The question already exists for other situations, such as when hedged inventory is written down for a LOCOM adjustment. 8

12 DERIVATIVES IMPLEMENTATION GROUP 6/24-25/99 AGENDA ITEM 6-3 Topic: Cash Flow Hedges: Assessing Hedge Effectiveness Period-by- Period or Cumulatively Paragraph references from Statement No. 133: 28(b), 30, 64 BACKGROUND AND DESCRIPTION OF TRANSACTION Paragraph 28(b) of Statement 133 states, in part: Both at inception of the [cash flow] hedge and on an ongoing basis, the hedging relationship is expected to be highly effective in achieving offsetting cash flows attributable to the hedged risk during the term of the hedge, except as indicated in paragraph 28(d) below. An assessment of effectiveness is required whenever financial statements or earnings are reported, and at least every three months. All assessments of effectiveness shall be consistent with the originally documented risk management strategy for that particular hedging relationship. Paragraph 30(b) states that the effective portion of the gain or loss on a derivative designated as a cash flow hedge is reported in other comprehensive income. Paragraph 30(b) specifies how the effective portion to be reported in other comprehensive income should be calculated. The calculation of the effective portion is, in part, based on cumulative gain or loss on the derivative from inception of the hedge. QUESTION In periodically assessing retrospectively the effectiveness of a cash flow hedge in having achieved offsetting changes in cash flows, an entity compares the change in the hedging instrument s cash flows to the change in the hedged transaction s cash flows attributable to the hedged risk. Should the entity base that comparison on (a) the cash flow changes that have occurred during the period being assessed (that is, on a period-by-period basis) or (b) the cumulative cash flow changes to date from the inception of the hedge? Is an entity permitted to use either a period-by-period approach or a cumulative approach on individual cash flow hedges? POSSIBLE ALTERNATIVES View A In periodically assessing retrospectively the effectiveness of a cash flow hedge in having achieved offsetting changes in cash flows, the entity should compare the cumulative changes in the hedging instrument s cash flows to the cumulative changes in the hedged transaction s cash flows attributable to the risk hedged. Assessing effectiveness retrospectively on a cumulative basis is consistent with the requirement in 9

13 DERIVATIVES IMPLEMENTATION GROUP 6/24-25/99 AGENDA ITEM 6-3 paragraph 30(b) to base the calculation of the effective portion of a cash flow hedge on cumulative gain or loss on the derivative from inception of the hedge. Paragraph 95 in Example 7 of the Statement also indicates that effectiveness would be assessed retrospectively on a cumulative basis. It states the following: In assessing hedge effectiveness on an ongoing basis, Company G also must consider the extent of offset between the change in expected cash flows on its Colombian coffee contract and the change in expected cash flows for the forecasted purchase of Brazilian coffee. Both changes would be measured on a cumulative basis for actual changes in the forward price of the respective coffees during the hedge period. [Emphasis added.] Furthermore, certain strategies, like tailing, would only be considered effective using a cumulative approach. It is clear under paragraph 64 that the Board intended to allow a tailing strategy. View B In periodically assessing retrospectively the effectiveness of a cash flow hedge in having achieved offsetting changes in cash flows, the entity should base its comparison of changes in cash flows on a period-by-period approach. Cash flow patterns of the hedging instrument or the hedged transaction in periods prior to the period being assessed are not relevant. Assessing hedge effectiveness cumulatively does not require an entity to promptly dedesignate a hedge when the hedging relationship becomes no longer effective because of the occurrence of certain events. Further, although locking in the gain or loss on an expected or forecasted transaction may not require the change in the cash flow on the hedging instrument and on the hedged transaction to be highly correlated throughout the term of the hedge, a highly correlated hedging relationship is highly unlikely to result in an ineffective cash flow hedge. To ensure effectiveness of a hedge, the period-by-period approach is superior to the cumulative approach in assessing hedge effectiveness. View C Entities should be allowed to choose either approach in designating how effectiveness will be assessed, depending on the nature of the hedge documented in accordance with paragraph 28(a). For example, an entity may decide that the cumulative approach is generally preferred, yet may wish to use the period-by-period approach in certain circumstances. Consistent with paragraph 62, an entity should assess effectiveness for similar hedges in a similar manner; use of different methods for similar hedges should be justified. 10

14 DERIVATIVES IMPLEMENTATION GROUP 6/24-25/99 AGENDA ITEM 6-4 Topic: Fair Value Hedges: Interaction of Statement 133 and Statement 114 Paragraph references from Statement No. 133: 18, 27 BACKGROUND AND DESCRIPTION OF TRANSACTION Company A formally documents a qualifying fair value hedge (for fair value changes attributable to changes in market interest rates) between a fixed-rate loan receivable and an interest rate swap. The 5- year, fixed-rate loan has a principal amount of $1,000,000 payable at maturity and an interest rate of 10 percent. One year after inception of the hedging relationship, there has been an adverse change to the borrower s creditworthiness and market interest rates for debtors of the borrower s original credit sector have decreased to 9.5 percent, resulting in a loss of $16,022 on the derivative and an offsetting gain of $16,022 on the fixed-rate loan attributable to changes in market interest rates. Assume that the repayment of the loan is not dependent on the underlying collateral. In applying the requirements of FASB Statement No. 114, Accounting by Creditors for Impairment of a Loan, to the loan, Company A determines that the loan is impaired and that the present value of expected future cash flows discounted at the loan s effective interest rate at inception of the loan is $950,000, (Refer to Row C in the following Exhibit, which presents calculations at the end of the first year of the loan s term of the net present value of original and probable estimates of expected future cash flows based on the loan s original effective interest rate and a market rate). Paragraph 27 of Statement 133 states: An asset or liability that has been designated as being hedged and accounted for pursuant to paragraphs remains subject to the applicable requirements in generally accepted accounting principles for assessing impairment for that type of asset or for recognizing an increased obligation for that type of liability. Those impairment requirements shall be applied after hedge accounting has been applied for the period and the carrying amount of the hedged asset or liability has been adjusted pursuant to paragraph 22 of this Statement. Statement 133 gives an entity flexibility in deciding when to begin the amortization to earnings of the adjustments of the loan s carrying amount arising from fair value hedge accounting. Paragraph 24 states, in part: An adjustment of the carrying amount of a hedged interest-bearing financial instrument shall be amortized to earnings; amortization shall begin no later than when the hedged item ceases to be adjusted for changes in its fair value attributable to the risk being hedged. 11

15 DERIVATIVES IMPLEMENTATION GROUP 6/24-25/99 AGENDA ITEM 6-4 QUESTION Because fair value hedge accounting under Statement 133 requires the carrying amount of a hedged loan to be adjusted for changes in fair value attributable to the hedged risk, does Statement 133 implicitly affect the measurement of impairment under Statement 114 by requiring the present value of expected future cash flows to be discounted by the new effective rate (based on the adjusted recorded investment) rather than by the old effective rate? POSSIBLE ALTERNATIVES View A No. Statement 133 did not affect the measurement of impairment under Statement 114. After adjusting the carrying amount of the hedged loan pursuant to paragraph 22 of Statement 133, Company A should apply the explicit requirements of paragraph 13 of Statement 114 by: a. Comparing the recorded investment of the loan after the effect of the fair value hedge, or $1,016,022, to the $950,000 present value of expected future cash flows discounted using the loan s original effective interest rate, then b. Recognizing an impairment by creating a valuation allowance (with the offsetting charged to baddebt expense) for the difference of $66,022. Paragraph 14 of Statement 114 states, The effective interest rate of a loan is the rate of return implicit in the loan (that is, the contractual interest rate adjusted for any net deferred loan fees or costs, premium or discount existing at the origination or acquisition of the loan). View A proponents explain that Statement 114 s requirements should be followed explicitly and that Statement 133 does not explicitly amend Statement 114 s requirements. A subset of View A proponents are sympathetic to View B but believe acceptance of View B would require that the Board formally amend Statement 114. View B Yes. Statement 133 has implicitly affected the measurement of impairment under Statement 114 by requiring the present value of expected future cash flows to be discounted by the new effective rate based on the adjusted the recorded investment in a hedged loan. The adjustment under fair value hedge accounting of the loan s carrying amount for changes in fair value attributable to the hedged risk under Statement 133 should be considered to be an adjustment of the loan s recorded investment. In the example, after adjusting the carrying amount of the hedged loan pursuant to paragraph 22 of Statement 133, Company A should apply the requirements of paragraph 13 of Statement 114 by: a. Comparing the recorded investment of the loan after the effect of the fair value hedge, or $1,016,022, to the $965,221 present value of expected future cash flows discounted using the rate that reflects the rate of return implicit in the loan after adjusting the carrying amount of the hedged 12

16 DERIVATIVES IMPLEMENTATION GROUP 6/24-25/99 AGENDA ITEM 6-4 loan pursuant to paragraph 22 of Statement 133 (that is, 9.5 percent), then b. Recognizing an impairment by creating a valuation allowance (with the offsetting entry charged to bad-debt expense) for the difference of $50,801. Supporters of View B point out that the loan s original effective interest rate becomes irrelevant once the recorded amount of the loan is adjusted for any changes in its fair value. Under the fair value hedge, the loan is being adjusted to fair value only for changes in market interest rates. View B proponents cite paragraph 52 of Statement 114, which explains the following: Because the Board believes that only the loss due to credit deterioration should be measured, the Board concluded that the expected future cash flows should be discounted at the loan s effective interest rate. Supporters of View B point out that that there are two possibilities that would achieve the goal in Statement 114 of isolating the change in collectability of the loan in measuring impairment: (1) using the new effective rate and the adjusted recorded investment or (2) using the old effective rate and disregarding the hedging adjustment to the recorded investment in the loan. Since paragraph 27 requires that the loan s carrying amount be adjusted for hedge accounting before the impairment requirements of Statement 114 are applied, the Statement rejects the second alternative and implicitly supports using the new effective rate and the adjusted recorded investment. Those supporters also note that the public minutes for the Board s April 23, 1997 meeting indicate that the Board unanimously supported amending Statement 114 to indicate that when the recorded investment of a loan has been adjusted under fair value hedge accounting, the effective rate is the discount rate that equates the present value of the loan s future cash flows with that adjusted recorded investment. Although that amendment of Statement 114 was not included in Statement 133 (perhaps by oversight), the provisions in paragraph 27 are consistent with that view. Supporters of View B explain that the adjustment of the loan for changes in market interest rates creates a discount or premium that changes the rate of return implicit in the loan. In the example, after the application of hedge accounting but before application of Statement 114, Company A s recorded investment is $1,016,022 with an implicit rate of return of 9.5 percent. Supporters of View B believe that View applies to all entities applying Statement 114, regardless whether those entities have delayed amortizing to earnings the adjustments of the loan s carrying amount arising from fair value hedge accounting until the hedging relationship is dedesignated. Supporters of View B believe that View A is also inappropriate for measuring impairment for loans hedged for changes in the debtor s creditworthiness (credit risk). They point out that if View A is applied to hedges of interest rate risk, a related implementation issue is what method would be applied if a loan being hedged in a fair value hedge for both interest rate risk and credit risk. Some supporters of View B believe the FASB should consider explicit amendment of Statement

17 DERIVATIVES IMPLEMENTATION GROUP 6/24-25/99 AGENDA ITEM 6-4 to clarify the meaning of effective interest rate for loans designated as the hedged item in a hedge of changes in fair value attributable to changes in market interest rates. EXHIBIT Following are calculations (at the end of the first year of the loan s term) of the net present value of the contractual cash flows and the probable expected future cash flows based on the loan s original effective interest rate and the new implicit rate. NPV at End Assumed Cash Flow in Year: A. Original Cash Flows and Original Effective Rate B. Original Cash Flows and New Implicit Rate C. Probable Cash Flows and Original Effective Rate D. Probable Cash Flows and New Implicit Rate Rate of Year % 1,000, , , ,000 1,100, % 1,016, , , ,000 1,100, % 950,000 95,000 95,000 95,000 1,045, % 965,221 95,000 95,000 95,000 1,045,000 14

18 DERIVATIVES IMPLEMENTATION GROUP 6/24-25/99 AGENDA ITEM 6-5 Topic: Foreign Currency Hedges: Hedging Net Investment with the Combination of a Derivative and a Cash Instrument Paragraph references from Statement No. 133: 18, 42 BACKGROUND AND DESCRIPTION OF TRANSACTION A parent company that has the U.S. dollar as its functional currency has a net investment in a Japanese yen functional currency subsidiary. The parent borrows in EMUs on a fixed-rate basis and simultaneously enters into a receive-emu, pay-yen currency swap (for all interest and principal payments) to synthetically convert the borrowing into a yen-denominated borrowing. QUESTION Does Statement 133 permit entities to designate a combination of a derivative and a cash instrument as the hedging instrument in foreign currency net investment hedges? Can the parent company in the above example designate the EMU-denominated borrowing and the currency swap in combination as a hedging instrument for its net investment in the yen subsidiary? POSSIBLE ALTERNATIVES View A Yes. Statement 133 permits designating a combination of a derivative and a cash instrument as the hedging instrument. The company in example may designate the EMU-denominated borrowing and the currency swap in combination as a hedging instrument for its net investment in the yen subsidiary. Paragraph 42 of Statement 133 permits entities to designate a nonderivative as the hedging instrument for a hedge of a net investment in a foreign operation. Further, paragraph 18 permits [t]wo or more derivatives to be viewed in combination and jointly designated as the hedging instrument [emphasis added]. Supporters of View A believe that the derivatives in paragraph 18 should be interpreted as encompassing all permissible hedging instruments. Since the use of nonderivative instruments as the hedging instruments is permitted in a foreign currency net investment hedge, the combination of a cash instrument and a derivative should be permitted to be designated as the hedging instrument. View B No. Statement 133 does not permit designating a combination of a derivative and nonderivative (that is, a cash instrument) as the hedging instrument. The company in example might be able to designate the EMU-denominated debt as the hedging instrument in a cross-currency hedge, but only if it could demonstrate that the EMU and the Japanese yen are effective as tandem currencies with respect to the U.S. dollar. Combining the EMU-denominated borrowing and the EMU-yen currency swap as a hedging instrument is not permitted. 15

19 DERIVATIVES IMPLEMENTATION GROUP 6/24-25/99 AGENDA ITEM 6-5 Paragraph 18 of the Statement 133 allows combination of only two or more derivatives as the hedging instrument; it does not make any reference to a combination of derivatives and nonderivatives. Supporters of View B note that if, under a completely different strategy, an entity wanted to use a $40 million yen-denominated borrowing and a $60 million yen-us$ forward contract to hedge a U.S. company s $100 net investment in the Japanese operations, no combination of the borrowing and forward contract would be necessary; instead, two separate hedging relationships would be designated. The yen-denominated borrowing would be designated as hedging 40 percent of the net investment and the yen-us$ forward contract would be designated as hedging 60 percent of the net investment. 16

20 DERIVATIVES IMPLEMENTATION GROUP 6/24-25/99 AGENDA ITEM 6-6 Inquiry Resolved by FASB Staff Title: Definition of a Derivative: Derivatives that Incorporate an Underlying on the Issuer s Equity Price Paragraph references from Statement No. 133: 11, 12, 18 QUESTION A company enters into a forward contract that is indexed both to its own stock and the Standard & Poor s Index of 500 Stocks (the S&P 500). Assume that the forward contract meets the definition of a derivative in paragraphs 6 10 and the company must settle the forward contract by issuing its own stock. Can the forward contract qualify for the exception in paragraph 11(a) of Statement 133, under which the forward contract would not be considered a derivative instrument by the issuer under that Statement? BACKGROUND Paragraph 11 of Statement 133 states that contracts issued or held by that reporting entity that are both (1) indexed to its own stock and (2) classified in stockholders equity in its statement of financial position shall not be considered derivative instruments under Statement 133. However, that paragraph also states the following: a contract that an entity either can or must settle by issuing its own equity instrument but that is indexed in part or in full to something other than its own stock can be a derivative instrument for the issuer under paragraphs 6 10, in which case it would be accounted for as a liability or an asset in accordance with the requirements of this Statement. RESPONSE No. The forward contract described above does not qualify for the exception in paragraph 11(a) of Statement 133 because the forward contract is indexed in part to something other than its own stock (namely, the S&P 500 index). Paragraph 286 of Statement 133 provides the rationale for why contracts that provide for settlement in shares of an entity's stock but that are indexed in part or in full to something other than the entity's stock are to be accounted for as derivative instruments if the contracts satisfy the criteria in paragraphs 6 10 of this Statement. The above forward contract meets the requirements in paragraph 6-10 and, therefore, is a derivative in its entirety and must be accounted for in conformity with paragraph 18 of Statement 133, which prohibits separating a derivative into components basing on different risks. Consequently, it would be inappropriate to bifurcate the forward contract according to its differing exposures to changes in 17

21 DERIVATIVES IMPLEMENTATION GROUP 6/24-25/99 AGENDA ITEM 6-6 Company A s stock price and the S&P 500 index. 18

22 DERIVATIVES IMPLEMENTATION GROUP 6/24-25/99 AGENDA ITEM 6-7 Inquiry Resolved by FASB Staff Topic: Paragraph references from Statement No. 133: Scope Exceptions: Exceptions Related to a Nonfinancial Asset of One of the Parties 10(e)(2); DIG Issue C5 QUESTION Would the exception in Paragraph 10(e)(2) of Statement 133 apply if the derivative s underlying on which settlement is based is the price or value of a nonfinancial asset that is unique in that it is physically distinct but yet is one of many like items? For example, Company A is a wholesaler that distributes dishwashers to retail department stores. Company A distributes only various models of Maytag dishwashers. In a contract that otherwise meets the definition of a derivative (because it provides for net settlement), would a Maytag dishwasher of a specific model be considered a unique nonfinancial asset to which the exception in paragraph 10(e)(2) would apply? BACKGROUND Paragraph 10(e)(2) provides an exclusion for contracts that are not traded on an exchange if the underlying upon which settlement is based is the price or value of (a) nonfinancial asset of one of the parties to the contract provided that the asset is not readily convertible to cash or (b) a nonfinancial liability of one of the parties to the contract provided that the liability does not require delivery of an asset that is readily convertible to cash. The guidance in Statement 133 Implementation Issue No. C5, Exception Related to a Nonfinancial Asset of One of the Parties, indicates that the exception in 10(e)(2) applies (a) only to nonfinancial assets that are unique and not to interchangeable (fungible) units of a nonfinancial asset and (b) only if the nonfinancial asset related to the underlying is owned by the party that would not benefit under the contract from an increase in the price or value of the nonfinancial asset. RESPONSE No. A new Maytag dishwasher of a specific model is not a unique nonfinancial asset because a new Maytag dishwasher of that model can be obtained from numerous sources. It would be inappropriate to consider as unique one new dishwasher produced by an assembly line that produces many dishwashers of the same model. To be considered a unique nonfinancial asset, an asset must possess significant characteristics that are specific to itself, for example, the location and physical attributes of specific real estate (such as the Sears Tower) and the details in a unique work of art (such as the Mona Lisa). 19

23 DERIVATIVES IMPLEMENTATION GROUP 6/24-25/99 AGENDA ITEM 6-7 The contract to sell a new Maytag dishwasher of a specific model could not meet the scope exception provided in paragraph 10(e)(2) and thus would be accounted for as a derivative. 20

24 DERIVATIVES IMPLEMENTATION GROUP 6/24-25/99 AGENDA ITEM 6-8 Inquiry Resolved by FASB Staff Topic: Hedging General: Dollar-Offset Approach Required in Assessing Effectiveness? Paragraph references from Statement No. 133: 20(b), 28(b), 62, 64, 86, 87 QUESTION Since Statement 133 provides entities with flexibility in choosing the method it will use in assessing hedge effectiveness, must an entity use a dollar-offset approach in assessing effectiveness? BACKGROUND Paragraph 20(b) of Statement 133 states, in part: Both at inception of the [fair value] hedge and on an ongoing basis, the hedging relationship is expected to be highly effective in achieving offsetting changes in fair value attributable to the hedged risk during the period that the hedge is designated. An assessment of effectiveness is required whenever financial statements or earnings are reported, and at least every three months. Paragraph 28(b) indicates a similar requirement that the hedging relationship be expected to be highly effective in achieving offsetting changes in cash flows attributable to the hedged risk during the period that the hedge is designated. Paragraph 62 emphasizes that each entity must assess the hedge s effectiveness in achieving offsetting changes in fair value or offsetting cash flows attributable to the risk being hedged. It also states, This Statement does not specify a single method for either assessing whether a hedge is expected to be highly effective or measuring hedge ineffectiveness. RESPONSE Statement 133 requires an entity to consider hedge effectiveness in two different ways in prospective considerations and in retrospective evaluations. a. Prospective considerations. Upon designation of a hedging relationship (as well as on an ongoing basis), the entity must be able to justify an expectation that the relationship will be highly effective over future periods in achieving offsetting changes in fair value or cash flows. That expectation, which is forwardlooking, can be based upon regression or other statistical analysis of past changes in values or cash flows as well as on other relevant information. 21

25 DERIVATIVES IMPLEMENTATION GROUP 6/24-25/99 AGENDA ITEM 6-8 b. Retrospective evaluations. At least quarterly, the hedging entity must determine whether the hedging relationship has been highly effective in having achieved offsetting changes in fair value or cash flows through the date of the periodic assessment. That assessment must utilize a dollar-offset approach to be consistent with the requirements of paragraphs 20(b) and 28(b). Thus, in its retrospective evaluation, an entity might conclude that, under a dollar-offset approach, a designated hedging relationship does not qualify for hedge accounting for the quarter just ended, but that the hedging relationship may be redesignated because, under a regression analysis approach, there is an expectation that the relationship will be highly effective in achieving offsetting changes in fair value or cash flows in future periods. 22

26 DERIVATIVES IMPLEMENTATION GROUP 6/24-25/99 AGENDA ITEM 6-9 Inquiry Resolved by FASB Staff Topic: Paragraph references from Statement No. 133: Hedging General: Hedged Exposure Limited but Derivative's Is Not 20(b), 28(b) QUESTION If the hedged item or hedged forecasted transaction has a risk exposure that is limited (for example, the floating-rate asset or liability has a cap or a floor on the interest rate), may an entity designate as the hedging instrument in a fair value or cash flow hedge a derivative that does not have comparable limits with respect to that same hedged risk exposure? BACKGROUND Paragraphs 20(b) and 28(b) require that, to qualify for fair value or cash flow hedge accounting, the hedging relationship is expected to be highly effective in achieving offsetting changes in fair value (or cash flows) attributable to the hedged risk during the period that the hedge is designated. Paragraph 20(b) states, If the hedging instrument (such as an at-the-money option contract) provides only onesided offset of the hedged risk, the increases (or decreases) in the fair value of the hedging instrument must be expected to be highly effective in offsetting the decreases (or increases) in the fair value of the hedged item. Paragraph 28(b) contains a similar provision for options that provide only one-sided offset of the hedged risk in a cash flow hedge. RESPONSE No. Under Statement 133, if the hedged item or hedged forecasted transaction has a risk exposure that is limited, an entity may not designate as the hedging instrument a derivative that does not have comparable limits with respect to that same hedged risk exposure. Statement 133 requires an entity to find a hedging instrument for which there is an expectation that the changes in its fair value (or cash flows) will be highly effective in offsetting the changes in the hedged item s fair value (or hedged transaction s cash flows), not just for some of the changes or for some range of changes. For example, an entity is not permitted to designate a plain vanilla interest rate swap as the hedging instrument to hedge the interest-rate exposure of a variable interest payments on a floating-interest-rate bond that has an interest rate cap. It is inappropriate under Statement 133 for an entity to designate a derivative as the hedging instrument when the entity expects that the derivative will not be highly effective for certain changes in the underlying, unless the entity has documented undertaking a dynamic hedging strategy in which it has committed itself to an ongoing repositioning strategy for its hedging relationship as follows: 23

27 DERIVATIVES IMPLEMENTATION GROUP 6/24-25/99 AGENDA ITEM 6-9 a. For fair value hedges, in a delta-neutral dynamic hedging strategy, the entity commits to constant monitoring of the option s delta the ratio of changes in the option s price to changes in the price of the hedged item. As the delta ratio changes, that entity must rebalance the portfolio of options (that is, buy or sell options) so that the next change in the fair value of all of the options held can be expected to counterbalance the next change in the value of the hedged item. Thus, in a delta-neutral hedging strategy, the hedging instrument is constantly being changed and the assessment of effectiveness considers only the next change in fair value. (Refer to paragraphs 86 and 87.) b. For cash flow hedges, in a tailing strategy, the entity commits to adjusting the size or contract amount of futures contracts used as the hedging instrument so that earnings (or expense) from reinvestment (or funding) of daily settlement gains (or losses) on the futures do not distort the results of the hedge. (Refer to paragraph 64.) However, if the hedged item or hedged forecasted transaction has a risk exposure that is limited, an entity may designate as the hedging instrument a derivative that has comparable limits with respect to that same hedged risk exposure. For example, an entity is permitted to hedge the interest-rate exposure of a variable interest payments on a floating-interest-rate bond that has an interest rate cap by designating as the hedging instrument an interest rate swap with a matching cap. 24