Some years before the financial scandal of Enron, which was mainly caused by the misuse
of derivatives, the Financial Accounting Standard Board (FASB) began deliberating
on issues related to derivatives and hedging transactions.1 The cause of thinking about
changes in accounting for derivatives was a problematic situation in 1986 (comparable
to current situation in Germany). For example, the applicatory use was very complicated
and transactions with derivatives were not transparent enough. There were only clear
standards for a few product groups and transactions with derivatives were not reported
on the balance sheet.2
In consequence, first in 1986, a work program called Project on Financial Instruments
was founded.3 In 1992 the members of the FASB received the responsibility in working
on derivatives and continued improving the existing statement for about six years in
more than 100 meetings. In June 1998 (06/16/1998) the Statement for Financial Accounting
Standard (SFAS) No. 133 “Accounting for Derivative Instruments and Hedging
Instruments” passed as an outcome of these efforts and is valid for every entity.4
Some public voices say, it is one of the most complex and controversial standards ever
issued by the FASB.5
Statement No. 133 replaced FASB Statement No. 80 (Accounting for Future Contracts),
No. 105 (Disclosure of Information about Financial Instruments with Off-Balance-Sheet
Risk and Financial Instruments with Concentrations of Credit Risk) and No. 119 (Disclosures
about Derivative Financial Instruments and Fair Value of Financial Instruments).
6 Also FASB Statement No. 52 (Foreign Currency Translation) and No. 107
(Disclosures about Fair Value of Financial Instruments) were amended, by including the
“disclosure provisions about concentration of credit risk” form Statement No. 105 in
Statement No.107.
Despite the fact that the new Statement was issued in June 1998 it only was effective on
financial statements for fiscal years beginning after June 15, 2000. [...]
1 Cp. Ernst & Young LLP (2002), p. 1.
2 Cp. Henne, T.(2000), p. 51.
3 Cp. Zander, D. (2000), p. 985.
4 Cp. Maulshagen ,A./Maulshagen, O. (1998), p. 2151.
5 Cp. International Treasurer (1999).
6 Cp. Ernst & Young LLP (2002), p. 1.
Contents
Figures
1 Overview
2 Different kinds of derivatives
2.1 Classic financial instruments
2.2 Derivatives in the meaning of SFAS No. 133
3 Criteria for special accounting
4 Basic methods of hedge accounting
4.1 Fair value hedge accounting
4.2 Cash flow hedge accounting
4.3 Foreign currency hedge accounting
5 Current topics on accounting for derivatives
6 Conclusions
Appendix A
Appendix B
Appendix C
Literary Sources
Figures
Figure 1: Derivative instruments
Figure 2: Classification of derivatives
Figure 3: Significant differences in dealing with a fair value handge and a cash flow hedges
1 Overview
Some years before the financial scandal of Enron, which was mainly caused by the misuse of derivatives, the Financial Accounting Standard Board (FASB) began deliberating on issues related to derivatives and hedging transactions.[1] The cause of thinking about changes in accounting for derivatives was a problematic situation in 1986 (comparable to current situation in Germany). For example, the applicatory use was very complicated and transactions with derivatives were not transparent enough. There were only clear standards for a few product groups and transactions with derivatives were not reported on the balance sheet.[2]
In consequence, first in 1986, a work program called Project on Financial Instruments was founded.[3] In 1992 the members of the FASB received the responsibility in working on derivatives and continued improving the existing statement for about six years in more than 100 meetings. In June 1998 (06/16/1998) the Statement for Financial Accounting Standard (SFAS) No. 133 “Accounting for Derivative Instruments and Hedging Instruments” passed as an outcome of these efforts and is valid for every entity.[4] Some public voices say, it is one of the most complex and controversial standards ever issued by the FASB.[5]
Statement No. 133 replaced FASB Statement No. 80 (Accounting for Future Contracts), No. 105 (Disclosure of Information about Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk) and No. 119 (Disclosures about Derivative Financial Instruments and Fair Value of Financial Instruments).[6] Also FASB Statement No. 52 (Foreign Currency Translation) and No. 107 (Disclosures about Fair Value of Financial Instruments) were amended, by including the “disclosure provisions about concentration of credit risk” form Statement No. 105 in Statement No.107.
Despite the fact that the new Statement was issued in June 1998 it only was effective on financial statements for fiscal years beginning after June 15, 2000. With this transitional period the FASB wanted to facilitate the implementation of this “complex standard”[7] and to give enough time to reorganize the software systems.[8]
Establishing the Derivatives Implementation Group (DIG) in 1998 was to help to identify current implementation problems which occur in practice. In its meetings the DIG works out explanations how to use SFAS No. 133 and hands them over to the FASB. There they are discussed again and if there is no contradiction, they will be published in the FASB Implementation Guide.[9]
This paper will first elucidate what different types of derivatives exist and will describe the most important ones. Thereafter the special usage of the diverse types will be explained succinctly, followed by what Statement No. 133 says about its definitions of derivatives and which criteria must be fulfilled in order to account derivatives as hedge items. Finally the reader should have an overview of what Statement No. 133 is about and why it is so complex. Also its consequences on accounting derivatives on US-GAAP should be lined out.
2
Different kinds of derivatives
Literature mentions “four key financial instruments that can be combined in various forms with each other or with various guises of themselves to form all other financial products”[10]. These key products are shown in figure 1 and are options, swaps, forwards and futures. In figure 1 also different types of each ‘key instrument’ are listed.
illustration not visible in this excerpt
Figure 1: Derivative instruments[11]
2.1 Classic financial instruments
Options
Options are “the right but not the obligation to buy (sell) some underlying[12] cash instrument at a pre-determined rate on a pre-determined expiration date in a pre-set notional amount[13] ”[14]. If the right is to buy something, the option is called ‘Call’, if it is to sell something its term is ‘Put’. They are traded at the stock market or ‘Over The Counter’ (OTC) with an asymmetric risk profile. The asymmetric is ground on the fact that the buyer-risk is limited, in contrast to the seller-risk which is theoretically unlimited.[15] There exist two different kinds of options:
- an American Version that gives the owner the right to act during a defined period and
- a European Version that fixes the point of time to act.[16]
Swaps
Swaps are defined as the exchange of a sequence of cash flows that derive from two different financial instruments; they are always a portfolio of forward contracts.[17] They can be divided into interest rate swaps and currency swaps. An interest rate swap is a transaction in which two parties exchange interest payment streams of differing character based on an underlying principal amount. The most typical swaps entail swapping fixed rates for variable rates and vice versa.[18] “Currency swaps […] take the form of cross-currency interest rate swaps. These are generalized single-currency rate swaps with the liability in different currencies. They can be floating in one currency exchanged for fixed in another currency for floating to fixed or even fixed to fixed.”[19]
Futures
Futures are conditional forward operations with a symmetric risk profile. They are standardized concerning period of redemption, nominal and basic value. The buyer/seller obligates himself to buy/sell the fixed quantity of a currency or interest difference at a specific future point in time for a fixed price. A so called clearing center is substantial. It is placed between the two contract parties and its role is to guarantee the fulfillment of the agreed commitments described in the contract. After both parties paid an initial margin to the clearing center the ‘loosing’ contractor must pay in variation margins which are paid on a margin account.[20]
Forwards
Forwards are common forwards (firm commitment to buy or sell foreign currencies or goods) operations that may be traded OTC which means between a bank and bank, a bank and a corporate or exchange trades.[21]
2.2 Derivatives in the meaning of SFAS No. 133
FASB Statement No. 133, which is the most significant statement concerning derivatives has its own definition about these financial instruments. But because this definition is very complex and can not be fully described in this paper, only some key concepts will be depicted based on Ernst & Young:[22]
- “The contract must be based on one or more notional amounts or payment provisions or both, even though title to that amount never changes hands. The underlying and notional amount determines the amount of settlement, and even whether or not a settlement is required.”
- “The contract can readily be settled by a net cash payment, or with an asset that is readily convertible to cash.”
- “A derivative’s cash flows or fair value must fluctuate and vary based on the changes in one or more underlying variables.”
- “The contract requires no initial net investment, or an insignificant initial net investment.”
After this short overview about derivatives and what SFAS No. 133 mentions about them the following chapter will describe which criteria are needed to account derivatives as a hedging instrument.
[...]
[1] Cp. Ernst & Young LLP (2002), p. 1.
[2] Cp. Henne, T.(2000), p. 51.
[3] Cp. Zander, D. (2000), p. 985.
[4] Cp. Maulshagen ,A./Maulshagen, O. (1998), p. 2151.
[5] Cp. International Treasurer (1999).
[6] Cp. Ernst & Young LLP (2002), p. 1.
[7] Maulshagen ,A./Maulshagen, O. (1998), p. 2151 f.
[8] Cp. Kurznachrichten (1999a) p. 1131, cp. Kurznachrichten (1999c) p. 1569.
[9] Cp. Kurznachrichten (1999b) p. 1340.
[10] Edwardes, W. (2000), p. 44.
[11] based on Reichel, H./Kütter, G./Bedau, J. (2001), p. 18.
[12] An underlying may be a price or rate of an asset or liability.
[13] The notional amount is the fixed amount or quantity that determines the size of the change caused by the movement of the underlying.
[14] Schmidt, M. (2002), p. 4 f.
[15] Cp. Henne, T. (2000), p. 9.
[16] Cp. Schmidt, M. (2002), p. 4.
[17] Cp. Henne, T. (2000), p. 10.
[18] Cp. Schmidt, M. (2002), p. 88 f.
[19] Edwards, W. (2000), p. 55.
[20] Cp. Henne, T. (2000), p. 6.
[21] Cp. Schmidt, M. (2002), p. 4.
[22] Cp. Ernst & Young LLP (2002), p. 2.
- Citation du texte
- Jörg Decker (Auteur), 2003, Accounting for Derivatives (US-GAAP), Munich, GRIN Verlag, https://www.grin.com/document/15575
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