Derivatives & Hedge Accounting
For an unrecognized firm commitment to qualify as a hedged item it must
(1) Be binding on both parties. (2) Be specific with respect to all significant items including quantity to be exchanged, the fixed price, and the timing of the transaction. (3) Contain a nonperformance clause that makes performance probable.
The following disclosures are required about credit risk for financial instruments with off-balance-sheet credit risk:
(1) The amount of accounting loss the entity would incur should any party to the financial instrument fail to perform according to the terms of the contract and the collateral, if any, is of no value. (2) The class of financial instruments held. (3) Categorization between instruments held for trading purposes and purposes other than trading.
Derivatives have the following characteristics (NUNS).
(1) net investment: There is either no initial net investment or an initial net investment that is smaller than would normally be required for a similar market instrument. (2) An underlying and a notional amount: The notional amount is the number of units and the underlying is the factor that affects the derivative's value (price, interest rate, exchange rate). In a forward exchange contract, the notional amount would be the number of foreign currency units (FCUs) and the underlying would be the future exchange rate. (3) Net settlement: The derivative is settled in a net amount. A holder of a forward exchange contract does not actually buy or sell the FCUs, but instead receives or pays the difference between the contracted exchange rate and the market rate.
Disclosures related to financial instruments, both derivative and nonderivative, that are used as hedging instruments must include the following information:
(1) objectives and the strategies for achieving them, (2) context to understand the instrument, (3) risk management policies, and (4) a list of hedged instruments. These disclosures have to be separated by type of hedge and reported every time a complete set of financial statements is issued.
Two primary criteria must be met in order for a derivative instrument to qualify as a hedging instrument. First, sufficient documentation must be provided at the beginning of the process to identify
(1) the objective and strategy of the hedge, (2) the hedging instrument and the hedged item, and (3) how the effectiveness of the hedge will be assessed on an ongoing basis. Second, the hedge must be "highly effective" throughout its life.
Credit risk concentration disclosures
-Credit risk associated with contract if parties fail to perform -Activity, region, or economic characteristics of each significant concentration -Maximum amount of loss due to credit risk -Entity's collateral or other security requirements -Policy to mitigate credit risk
Due to a lack of resources or expertise with derivatives, compliance with hedge accounting rules can be difficult for smaller private companies. FASB made the following changes to simplify hedge accounting for private companies:
-Election can be done on a swap-by-swap basis, and swaps are assumed to be perfectly effective. -Swaps are reported at the settlement amount, not the fair value. -Swap documentation doesn't have to be in place until financial statements are issued.
List the required disclosures for derivatives designated as fair value hedges.
-Net gain/loss recognized in earnings and where net gain/loss is reported in the financial statements -Net gain/loss recognized in earnings from hedged firm commitments that no longer qualify for hedge treatment
What is the formal documentation required at the inception of a fair value hedge?
-The hedging relationship -The objective and strategy for undertaking the hedge -Identification of the hedging instrument and hedged item -Nature of the risk being hedged -How effectiveness of the hedge will be assessed
To qualify for simplified hedge accounting rules for interest rate (IR) swaps,
-the variable rate on the swap and original debt must be linked to the same index, -the IR swap's fair value at inception must be close or equal to zero, -and the notional amount must be less than or equal to the debt's principal balance.
What are the three basic elements of a derivative?
1. Requires no initial net investment 2. One or more underlying and one or more notional amounts 3. Terms require or permit a net settlement
Alvarez Corporation has two hybrid financial instruments. According to ASC Topic 815, how can Alvarez account for these instruments?
Alvarez can elect not to bifurcate the hybrid instruments on an instrument by instrument basis.
According to ASC Topic 815, any financial or physical variable that has either observable changes or objectively verifiable changes qualifies as a(n): (1) Hedge (2) Financial Instrument (3) Notional Amount (4) Underlying
Answer: (4) Underlying An underlying is commonly a specified price or rate such as a stock price, interest rate, currency rate, commodity price, or a related index. However, any physical or financial variable with observable changes or objectively verifiable changes qualifies as an underlying.
Disclosure requirements for financial instruments include: (A) Method(s) and significant assumptions used in estimating fair value. (B) Distinction between financial instruments held or issued for trading purposes and purposes other than trading. (C) A note containing a summary table cross-referencing the location of other financial instruments disclosed in another area of the financial statements. (D) All of the listed choices should be disclosed.
Answer: (D) All of the listed choices should be disclosed.
Accounts receivable, debt, and derivatives are among the financial instruments that have counterparty credit risk. Their value depends on the counterparty's ability to perform according to the terms of the contract. For all financial instruments with this risk, the financial statements (F/S) must disclose the concentration of credit risk.
Concentration of credit risk refers to a disproportionally large risk of exposure to common issues related to activities, regions, or economic characteristics (eg, multiple contracts with the same counterparty, several of the same type of contract). The risk is not reflected in the balance sheet but is important for F/S users to understand a company's exposure to common risk factors.
For IR swaps, there are two inherent risks that cannot be reflected on the financial statements (off-balance-sheet risk) but must be disclosed in connection with the derivative agreement: (1) The risk of exchanging a lower interest rate for a higher rate (ie, interest rate risk) (2) The risk that the counterparty might default on the agreement (ie, credit risk)
Financial instruments with off-balance-sheet risks require disclosures in the notes to the financial statements. In addition, concentration of credit risk (eg, multiple contracts with the same party) should be disclosed.
An interest rate (IR) swap is a derivative contract that allows two parties to exchange a stream of variable-rate interest payments with fixed-rate payments.
IR swaps allow businesses to hedge exposure to changes in interest rates. If a company believes that interest rates are likely to rise, it can hedge the exposure by exchanging its variable-rate cash flows for fixed-rate cash flows (or vice versa) to reduce risk.
Financial instruments with off-balance-sheet risks require disclosures in the notes to the financial statements.
In addition, concentration of credit risk (eg, multiple contracts with the same party) should be disclosed.
The option's premium (ie, price paid for the instrument) changes each period and can be broken into two parts: intrinsic value and time value.
Intrinsic value is the difference between the strike price and current price in the market. Time value is derived from the amount of time remaining until the option expires.
Options are contracts that provide the buyer of the contract the right but not the obligation to buy (call option) or sell (put option) an underlying asset (eg, common stock) at a predetermined price (ie, exercise price) within a specified timeframe. They can be used to reduce risk (ie, hedging) or to profit from price changes in the underlying asset (ie, speculation).
Option valuation comprises two parts: intrinsic value and time value. For call options, intrinsic value is the current market price of the underlying asset less the option exercise price multiplied by the number of shares. Time value is based on the amount of time the option has until it expires; it decreases as the option approaches expiration.
If a company issues monthly financial statements, the assessment of hedge effectiveness should be performed on a monthly basis.
The effectiveness of the hedging relationship must be assessed when financial statements are prepared and at least every 3 months
For IR swaps, there are two inherent risks that cannot be reflected on the financial statements (off-balance-sheet risk) but must be disclosed in connection with the derivative agreement:
The risk of exchanging a lower interest rate for a higher rate (ie, interest rate risk) The risk that the counterparty might default on the agreement (ie, credit risk)
James Corp entered into an interest rate swap with another entity in which it will be paying interest monthly at the annual rate of prime plus 1% based on a principal amount of $1,000,000 and will receive 7% per year based on the same principal amount. James paid a small fee to an entity that facilitated the arrangement, the terms of which call for a payment by one party or the other based on the difference between the interest amounts. What is the underlying in this transaction?
The underlying is the factor that is used in the formula applied to the notional amount to determine that amount that will be exchanged between the parties. In this case, the amount to be paid will be the prime rate of interest, which is the underlying, plus 1% multiplied by the $1,000,000 principal balance, which is the notional amount.
Notional amounts are the referenced associated asset or liability that is commonly a number of units such as barrels of oil.
Think "Rate x Volume" where the notional amount is the volume and the underlying is the rate.
Concentration of credit risk is disclosed in the notes of the financial statements.
This includes disclosure of the concentration of credit risk presented by activities, regions, or economic characteristics; maximum amount of potential loss; collateral requirements; and mitigation policies.
Due to a lack of resources or expertise with derivatives, compliance with hedge accounting rules can be difficult for smaller private companies. FASB made the following changes to simplify hedge accounting for private companies:
To qualify for the simplified approach: The variable rate on the debt and the variable rate on the IR swap must be linked to the same index (ie, London Interbank Offered Rate). There is no need to cap the rate on the IR swap in relation to the debt (Choice C). An IR swap's fair value at inception must be close or equal to zero (Choice B). A swap's notional amount (ie, face value) must be less than or equal to the debt's principal balance (Choice A).
An American call option provides the holder the right to
acquire an underlying at an exercise or strike price, anytime during the option term.
The forward contract is an agreement between two parties to
buy and sell a specific quantity of a commodity, foreign currency, or financial instrument at an agreed-upon price, with delivery and/or settlement at a designated future date.
A foreign currency hedge is the hedge of an exposure to
changes in the dollar value of assets or liabilities (including certain investments) and planned transactions that are denominated (to be settled) in a currency other than an entity's functional currency.
Options used to profit from price changes are speculation trades, with valuation changes reported in
net income.
A derivative is a financial instrument with
no net investment, an underlying amount and a notional amount, and net settlement.
The general criteria for a hedging instrument are that
sufficient documentation must be provided at the beginning of the process and the hedge must be "highly effective" throughout its life.
Hedging offsets or eliminates exposure to risk. A perfect hedge exists when
the change in a position's value and cash flows is eliminated by the hedge position (ie, perfectly effective).
Fair value hedges are used to reduce the risk of changes in the values of recognized assets and liabilities;
the hedge value changes are reported in income from continuing operations.
Cash flow (CF) hedges are used to reduce the risk of variable CFs from forecasted transactions;
the hedge value changes are reported in other comprehensive income.
A swaption is an option on a swap that provides the holder with
the right to enter into a swap at a specified future date at specified terms or to extend or terminate the life of an existing swap.
Call option valuation equals the sum of its
time value and its intrinsic value [(market value − exercise price) × number of shares].
A fair value hedge is reported at its fair value,
with unrealized gains or losses recognized in net income in the period of change on the same line as the corresponding gain/loss of the hedged item.
