Accounting for Interest-Bearing Instruments as Derivatives and Hedges

By Dyson, Robert A. | The CPA Journal, January 2002 | Go to article overview

Accounting for Interest-Bearing Instruments as Derivatives and Hedges


Dyson, Robert A., The CPA Journal


IN BRIEF

Guidance to Identifying Common Derivative Transactions

Reporting entities and their auditors must properly identify derivatives and hedges to determine that management authorization is appropriate and, if applicable, that transactions are identified as hedges at their inception and accounted for properly. If hedge documentation is not appropriate and transactions are marked to market, an entity's profitability could be materially and unexpectedly impacted. The author approaches accounting for derivatives and hedges in the same way they are normally encountered: from the beginning of a transaction. The author analyzes the accounting and reasoning behind six cases based on actual transaction where derivatives were used by nonfinancial entities.

The voluminous and complex rules for accounting for derivatives and hedges are presented in SFAS 133, Accounting for Derivative Instruments and Hedging Activities, as amended by SFASs 137 and 138 and interpreted by over 33 consensuses issued by the Emerging Issues Task Force (EITF) and over 160 issues of the FASB Derivatives Implementation Group. The rules themselves tend to be legalistic and occasionally emphasize form over substance.

One of the biggest problems in implementing derivative and hedge accounting rules is identifying a transaction as a derivative and, if applicable, a hedge. Derivatives are difficult to identify because, by definition, there are no significant expenditures or recording of assets or liabilities. The traditional means of identifying unrecorded transactionsreviewing the general ledger and cash journals for large transactions-will not uncover derivatives. The best way of identifying derivatives and hedges is to rely on the entity's internal controls to flag such transactions. Derivatives and hedges potentially represent an important component of an entity's risk management activities and would require authorization by an appropriate level of management. As a backup, analysis of the transactions that typically spawn derivatives and hedges would facilitate discovery for entities not regularly engaged in such trading.

Case 1: Interest Rate Swap

Construction Retail, LLC, a nonpublic company, was organized to construct and operate a shopping mall. In January 2002, Construction obtained a construction loan from National Bank, which provided up to $150 million in financing at an interest rate of one-month LIBOR plus 1.90% and a maturity date of September 15, 2006. If certain covenants were met, the agreement provided for a reduced interest rate of one-month LIBOR plus 1.75% and an extension of the maturity date for two years. In 2003, National increased the amount available under the loan to $160 million.

On February 1, 2002, Construction entered an interest rate swap agreement with National. The swap agreement covered the period from February 1, 2002, to September 15, 2006, and effectively fixed the interest rate at 7.0% on the first $150 million of borrowings. Interest accrued quarterly. Construction did not pay anything for the swap. This transaction reflects Construction's bet that interest rates will go up and that interest costs at the fixed rate will be lower than those at the variable rate. (Construction may also be seeking a fixed interest expense for budgetary purposes.) National, however, is betting that interest rates will go down and it will receive more interest revenue at the fixed rate.

Identifying the instrument as a derivative. The first step is to determine whether Construction entered a derivative transaction. The best place to start is Construction's internal controls. Because Construction did not pay anything for the swap, the agreement would not be recorded in the accounting records. If its internal processes fail, analysis that should ordinarily be performed on the construction loan agreement should identify the swap. The red flag for an interest rate swap is a fixed rate on a loan with a stated variable rate. …

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