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.
Table of Contents
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
Objectives and Topics
This seminar paper provides an overview of the accounting treatment for derivatives under US-GAAP, specifically focusing on the requirements and complexities introduced by FASB Statement No. 133. The research aims to explain the definition of derivatives, the stringent criteria for hedge accounting, and the practical application of different hedging methods.
- Types and classifications of financial derivatives
- FASB Statement No. 133 definition and requirements
- Criteria for qualifying as a hedge item
- Fair value, cash flow, and foreign currency hedge accounting
- Ongoing implementation challenges and the role of the Derivatives Implementation Group (DIG)
Excerpt from the Book
4.1 Fair value hedge accounting
To give a definition what a fair value hedge stands for, a simple answer is: it “protects against changes in value by fixed terms, rates, or prices”42. Therefore the used hedging instrument must intend to balance contrasting changes in the market value (fair value) of the hedged item.43 As already described in Chapter 3, documentation is required from the beginning. But not only ‘high effectiveness’ must be documented, but also that the hedged item is in relation (hedging function) with the hedging instrument.44 This documentation must contain information about which contract is hedged with which financial instrument and the risk involved. Furthermore the hedging risk policy should be in agreement with the firm’s risk policy. “The entity must believe and regularly assess that its strategy will be effective.”45 Another requirement is the probability to determine the ‘fair value’ dependably of the hedged item.46 If these conditions meet with the four principles47 given above, the following regulations will be observed:
The derivative instrument must be valuated to its momentary value. Changes in the value must be reported in income immediately and fully and during the period the change is caused.48
Changes in the fair value of the hedged item, as far as they are attributable to the risk designated as being hedged, should be recorded simultaneously in income and as an adjustment to the item’s carrying amount. That is the reason why any aspect of a fair value hedging relationship that is ineffective will instantly (in the same period) reflected in income.49
Summary of Chapters
1 Overview: Summarizes the historical context of derivative accounting, the complexity of SFAS No. 133, and the transition period for implementation.
2 Different kinds of derivatives: Classifies key financial instruments like options, swaps, forwards, and futures, and outlines the FASB definition of derivatives.
3 Criteria for special accounting: Details the documentation and effectiveness requirements that financial instruments must meet to qualify as hedging instruments under US-GAAP.
4 Basic methods of hedge accounting: Describes the specific accounting mechanisms for fair value, cash flow, and foreign currency hedges.
5 Current topics on accounting for derivatives: Discusses the role of the Derivatives Implementation Group (DIG) and the ongoing challenges in interpreting and applying SFAS No. 133.
6 Conclusions: Summarizes the criticisms regarding the complexity of the standard and evaluates FASB Statement No. 133 as an intermediate regulatory phase.
Keywords
Derivatives, FASB Statement No. 133, Hedge Accounting, Fair Value Hedge, Cash Flow Hedge, Foreign Currency Hedge, US-GAAP, Hedging Instrument, Effectiveness, Financial Instruments, Derivatives Implementation Group, Risk Management, Documentation, Income Statement, Notional Amount
Frequently Asked Questions
What is the primary focus of this seminar paper?
This paper examines the accounting treatment of derivative financial instruments under the US-GAAP framework, with a specific emphasis on the regulations defined by FASB Statement No. 133.
What are the main categories of derivatives discussed?
The paper covers options, swaps, forwards, and futures as the four fundamental types of derivative financial instruments.
What is the core objective of the research?
The goal is to elucidate the complex criteria for hedge accounting, explain how different hedging methods function, and describe the difficulties firms face during implementation.
Which methodology is used to evaluate the standards?
The paper relies on a literature-based analysis of the FASB Statement No. 133, supported by professional guides from firms like Ernst & Young and academic commentary.
What does the main body of the paper cover?
The main body covers the classification of derivatives, the strict documentation and effectiveness criteria required for hedge accounting, and detailed operational methods for fair value and cash flow hedging.
Which keywords best characterize the work?
Key terms include derivatives, FASB Statement No. 133, hedge accounting, risk management, effectiveness, and US-GAAP compliance.
Why is the role of the Derivatives Implementation Group (DIG) significant?
The DIG is vital because it addresses ongoing practical implementation issues and technical questions that arise after the standard has been issued, helping companies apply the complex rules correctly.
How does fair value hedge accounting handle ineffectiveness?
Under fair value hedge accounting, any portion of a hedging relationship that is deemed ineffective must be instantly reflected in the income statement during the same period the change occurs.
- Quote paper
- Jörg Decker (Author), 2003, Accounting for Derivatives (US-GAAP), Munich, GRIN Verlag, https://www.grin.com/document/15575
