Magazine article The CPA Journal

New Accounting for Derivatives Illustrated

Magazine article The CPA Journal

New Accounting for Derivatives Illustrated

Article excerpt

The Financial Accounting Standards Board recently issued SFAS No. 133, Accounting for Derivative Instruments and for Hedging Activities. This statement will be effective for all fiscal quarters of all fiscal years beginning after June 15, 1999, and applies to all entities, including not-for-profit organizations and defined benefit plans. Since derivatives are used extensively in risk management, the new accounting standard may affect many financial institutions and other large entities. An article discussing the concepts and principles that drive the new standard appeared in the October issue of The CPA Journal. The focus here is on the application of the new standard to specific transactions.

Basic Accounting

All derivatives are measured and reported at fair value as assets or liabilities in the statement of financial position. Reporting of the corresponding changes in fair value depends upon management's purpose for holding the derivative. Special accounting treatment is allowed for derivatives designated and qualifying as 1) a hedge of a risk of change in fair value of a recognized asset or liability or an unrecognized firm commitment (fair value hedge), 2) a hedge of the risk of a change in the cash flows associated with a recognized asset or liability or associated with a forecasted transaction (cash flow hedge), or 3) a hedge of a foreign currency exposure of an unrecognized firm commitment, an available for sale security, a forecasted transaction, or a net investment in a foreign operation (foreign currency hedge). Changes in fair value of derivatives not specifically designated as one of the above hedges are included in current earnings. Interest rate swaps are used to illustrate the difference between a cash flow hedge and fair value hedge. Swaps that are currently accounted for similarly require different accounting methods depending on the purpose for holding the swap.

Cash Flow Hedge

The derivative gain or loss is reported in other comprehensive income or in current earnings, as necessary, to adjust the balance in other comprehensive income to an amount that equals the lesser of a) the cumulative gain or loss on the derivative or b) the cumulative change in expected future cash flows on the hedged transaction. The result is that the excess cumulative gain or loss on the derivative is considered ineffective and recognized in earnings. The accumulated gains and losses are recognized in earnings in the same period(s) as the hedged asset, liability, or forecasted transaction affects earnings.

An interest rate swap could be entered into to hedge the cash flow associated with a recognized asset. A company holding variable-rate investments would have varied cash inflows as the market rate changes. To hedge these future cash inflows, the company could enter into an interest rate swap to receive a fixed flow of income and pay a variable rate of interest that would effectively convert the variable-rate investments to fixed-rate investments. The future cash inflows related to these investments would then be constant, and the swap would result in an effective cash flow hedge.

To illustrate the accounting for this type of swap, assume that on January 1, 1997, Company X is holding $10 million in three-year, variable rate investments. Simultaneously, X enters into a threeyear interest rate swap to receive eight percent (which is also the variable rate on January 1, 1997) and pay the variable rate on a notional amount of $10 million with settlement and reset annually on December 31. Variable rate, swap settlement, and swap fair value amounts are included in Exhibit 1, which also provides the journal entries for 1997 and 1998 for transactions and required adjustments.

There is no settlement at December 31, 1997, since the variable rate was the same as the fixed-rate received on the swap at January 1, 1997. However, the swap would be marked to fair value at year-end. Since a) the investments are variable-rate and the swap has a variable leg and b) the notional amounts, payment dates, and remaining terms of the swap are the same as those of the debt, it is assumed that the cumulative cash flows on the interest rate swap and the cumulative changes in cash flows on the investments attributable to changes in market interest rates will completely offset. …

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