Summary Of Changes In Derivative Accounting
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Statement 133 provides guidance for accounting for derivatives and hedging securities. The statement has created some implementation errors when financial statements are adjusted to comply with it. It has been argued that the statement needs to be revised for two main reasons, because it lacks proper disclosure and has not created adequate transparency for financial statements. FASB has been actively discussing changes to FAS 133 to correct these errors and to create a better understanding of why derivatives are sued, how they are accounted for, and how these methods of accounting affect the overall financial position of the company involved. This paper will discuss the original concepts and provisions from FAS 133, how these concepts were created, the detrimental consequences when the statement was adopted, and finally how FASB is amending FAS 133 to fix these problems.
Currently a derivative instrument is a three part definition where all parts must be present. The first is that the instrument has one or more underlyings, notional amounts or payments provisions. An underlying is defined by FAS 133 as a “specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, or other variable.” This refers to the rate involved and not the actual instrument in question. Notional amount refers to the physical amount of currency or product that is determined by the contract. The combination of notional amounts and the underlying will show the amount of the settlement if the settlement is indeed required. The last term used in the definition, payment provisions, is used to show a specific settlement given that the underlying acts in a certain manner.
The second characteristic of a derivative instrument is that it will not require any or a minimal initial net investment. The minimal initial net investment is considered to be an initial investment that is less than a similar instrument considering the current market conditions. FAS 133 states that, “A derivative instrument does not require an initial net investment in the contract that is equal to the notional amount or that is determined by applying the notional amount to the underlying.”
The final characteristic of a derivative instrument is that it needs to meet one of the three criteria of a net settlement. A derivative instrument could be where neither party in the settlement is required to deliver the underlying asset that is equivalent to the notional amount. The contract could also be regarded as a derivative instrument if a market facilitator controls the settlement, even if one of the parties is required to deliver the asset. Finally, the last criteria that would allow a contract to be defined as a derivative is that the asset included in the settlement is a liquid asset. This would keep the recipient in a position that is not substantially different from the net settlement.
FAS 133 was created to determine accounting and reporting standards for the derivative instruments that were just defined. When the Board decided to create this standard they considered there to be four essential points that will be called the derivative “cornerstones” of the statement. First, FAS 133 states that the rights and obligations that derivative instruments represent should only be reported in financial statements if they meet the definition of assets and liabilities. Concept No. 6 gives guidance in determining which of these rights and obligations should be considered assets and liabilities. The second cornerstone is that fair value is the only measure for derivatives, the most relevant measure for financial instruments and hedged items should be adjusted according to the amount of risk being hedged. The third cornerstone is that only the derivative itself will be defined as an asset or liability, not the losses or gains generated by it. The final cornerstone is that items designated as hedged can receive accounting treatment only if they qualify. The treatment of these accounting items depends on the type of risk being hedged by the derivative.
There are three risk hedging types that are defined by FAS 133. In establishing the reporting standards FAS 133 states that “the accounting for changes in the fair value of the derivative depends on the intended use of the derivative and the resulting designation.” A derivative could be used to hedge the exposure to changes in fair value of the asset or liability. FAS 133 gives guidance on how to account for a fair value hedge as follows, the gain or loss from the hedged risk will be recognized on the current financial statements as an adjustment to the hedging instrument. A cash flow hedge is the second designated hedge in FAS 133. An entity has the right to elect a financial instrument as a cash flow hedge if the cash flows from the financial instrument are offset by the hedged item’s cash flows. The gain/loss from the financial instrument will be recognized at fair value in current earnings and the gain/loss on the hedged item will be treated differently if it is the effective portion or ineffective portion. The effective portion will be reported in other comprehensive income, while the ineffective portion will be recorded as company earnings. FAS 133 also provides guidance for a few types foreign of currency hedges; “an unrecognized firm commitment (a foreign currency fair value hedge), an available-for-sale security (a foreign currency fair value hedge), a forecasted transaction (a foreign currency cash flow hedge), or a net investment in a foreign operation.”
In addition to these rules pertaining to derivatives there are also extensive rules governing the accounting for embedded contracts. FAS 133 states that embedded derivatives are “Contracts that do not in their entirety meet the definition of a derivative instrument, such as bonds, insurance policies, and leases, may contain вЂ?embedded’
derivative instruments—implicit or explicit terms that affect some or all of the cash flows or the value of other exchanges required by the contract in a manner similar to a derivative instrument.” An embedded derivative will be subject to the rules in FAS 133 and accounted for as a derivative if all of the following criteria are met. The derivative cannot be clearly and closely related to the host contact, it could not have been carried at fair value, and if a similar derivative to that of the embedded derivative would be considered freestanding.
In this case, the contract in which the derivative is embedded will be called the host contract. The overall contract that combines the host and the embedded derivative is considered to be a hybrid contract. If an embedded derivative is separated from