Trading and Capital-Markets Activities Manual
Activities: Accounting (Continue)
ACCOUNTING FOR DERIVATIVE INSTRUMENTS
As discussed in the previous subsection, the general accounting framework for securities portfolios divides them into three categories: held-to-maturity (accounted for at amortized cost), available-for-sale (accounted for at fair value, with unrealized changes in fair value recorded in equity), and trading securities (accounted for at fair value, with changes in fair value recorded in earnings).
In contrast, derivative instruments can be classified in one of the following categories: (1) no hedge designation, (2) fair-value hedge, (3) cash-flow hedge, and (4) foreign-currency hedge. The general accounting framework for derivative instruments under GAAP is set forth below:
• If the derivative does not have
a hedge designation, the gains or losses based on changes in fair value
of the derivative instrument are included in current income.
This general framework is set forth in SFAS 133, ''Accounting for Derivative Instruments and Hedging Activities.'' This statement, issued in June 1998 and amended by SFAS 137 and SFAS 138, became effective for fiscal years beginning after June 15, 2000. Thus, banks operating on a calendar year adopted the guidance on January 1, 2001. The following guidelines apply to banks' application of SFAS 133:
• Initial adoption commenced at
the beginning of the institution's fiscal quarter. Thus, for most banks,
the standard would be applied in the first quarter of 2001. On that date,
hedging relationships should be designated anew and documented as indicated
in SFAS 133.
SFAS 133 comprehensively changes accounting and disclosure standards for derivatives. SFAS 133 amends SFAS 52, ''Foreign Currency Translation,'' to permit special accounting for foreign currency hedges and makes the following standards obsolete:
• SFAS 80 Accounting for Futures
SFAS 133 requires entities to recognize all derivatives on the balance sheet as either assets or liabilities and to report them at their fair value. The accounting recognition of changes in the fair value of a derivative (gains or losses) depends on the intended use of the derivative and the resulting designation. For qualifying hedges, an entity is required to establish at the inception of the hedge the method it will use for assessing the effectiveness of the hedging derivative and the measurement approach for determining the ineffective aspect of the hedge. The methods applied should be consistent with the entity's approach to managing risk. SFAS 133 also precludes designating a non-derivative financial instrument as a hedge of an asset, a liability, an unrecognized firm commitment, or a forecasted transaction, except if any of these are denominated in a foreign currency.
Proper classification of derivative instruments is a key examination issue. Inappropriately classifying a derivative instrument as a hedge would result in the improper treatment of gains and losses in earnings and regulatory capital. Institutions should retain adequate documentation to support their hedge activity. Examiners should scrutinize any institutions that do not comply with these new GAAP requirements.
Some of the terms most common to financial instruments are defined below.
A derivative instrument is a financial instrument or other contract with all three of the following characteristics:
• It has one or more under-lyings,
and one or more notional amounts or payment provisions or both.
An underlying is a specified interest rate, security price, commodity price, foreign-exchange rate, index of prices or rates, or other variable. An underlying may be a price or rate of an asset or liability but is not the asset or liability itself.
A notional amount is a number of currency units, shares, bushels, pounds, or other units specified in the contract.
A payment provision specifies a fixed or determinable settlement to be made if the underlying behaves in a specified manner.
A hedge is an identifiable asset, liability, firm commitment, or anticipated transaction.
Offset is the liquidating of a purchase of futures through the sale of an equal number of contracts of the same delivery month on the same underlying instrument on the same exchange, or the covering of a short sale of futures through the purchase of an equal number of contracts of the same delivery month on the same underlying instrument on the same exchange.
Special Types of Derivatives
Credit derivatives are financial instruments that permit one party (the beneficiary) to transfer the credit risk of a reference asset, which it typically owns, to another party (the guarantor) without actually selling the assets. Credit derivatives that provide for payments to be made only to reimburse the guaranteed party for a loss incurred because the debtor fails to pay when payment is due (financial guarantees), which is an identifiable event, are not considered derivatives under SFAS 133 for accounting purposes. Those credit derivatives not accounted for under SFAS 133 would not be recorded in the financial statements as assets or liabilities at fair value, but, if material, would typically be disclosed in the financial statements. Credit derivatives not considered financial guarantees, as defined above, are reported as derivatives as determined by SFAS 133.
Equity derivatives are derivatives that are linked to various indexes and individual securities in the equity markets. SFAS 133 covers the accounting treatment for equity derivatives that are not indexed to an institution's own stock. Equity derivatives indexed to the institution's own stock are determined in accordance with APB No. 18, ''The Equity Method of Accounting for Investments in Common Stock,'' and SFAS 123, ''Accounting for Stock-Based Compensation.''
Accounting for Fair-Value Hedges A fair-value hedge is a derivative instrument that hedges exposure to changes in the fair value of an asset or a liability, or an identified portion thereof, that is attributable to a particular risk. To qualify for fair-value-hedge accounting, the hedge must meet all of the following criteria:
• Formal documentation must be made
at the inception of the hedging relationship of the institution's risk-management
objective and strategy for undertaking the hedge. This includes documenting
the hedged instrument, the hedged item, the nature of the risk, and how
the hedge's effectiveness in offsetting the exposure to changes in the
fair value will be assessed.
An asset or liability is eligible for designation
as a hedged item in a fair-value hedge if all of the following criteria
An institution is subject to applicable GAAP requirements for assessment of impairment for assets, or recognition of an increased obligation for liabilities. An institution shall also discontinue the accounting treatment for a financial instrument as a fair-value hedge if any of the following conditions occurs:
• Any criterion of the fair-value
hedge or hedged item is no longer met.
Accounting for Cash-Flow Hedges
A cash-flow hedge is a derivative hedging the exposure to variability in expected cash flows attributed to a particular risk. That exposure may be associated with an existing asset or liability (that is, variable-rate debt) or a forecasted transaction (that is, a forecasted purchase or sale). Designated hedging instruments and hedged items or transactions qualify for cash-flow-hedge accounting if all of the following criteria are met:
• Formal documentation is required
at inception of the hedging relationship, and the institution's risk-management
objective and strategy for undertaking the hedge must be done as noted
in ''Accounting for Fair-Value Hedges.''
A forecasted transaction is eligible for designation as a hedged item in a cash-flow hedge if all of the following additional criteria are met:
• The forecasted transaction is
specifically identified as a single transaction or a group of individual
- a parent company's interest in consolidated
• If the hedged transaction is the forecasted purchase or sale of a financial asset or liability or the variable cash inflow or outflow of an existing financial asset or liability, the designated risk being hedged is-
- the risk of changes in the cash flows
of the entire asset or liability,
As required for fair-value-hedge accounting,
an institution shall discontinue the accounting for cash-flow hedges if-
If cash-flow-hedge accounting is discontinued, the accumulated amount in other comprehensive income remains and is reclassified into earnings when the hedged forecasted transaction affects earnings. Existing GAAP for impairment of an asset or recognition of an increased liability applies.
Accounting for Foreign-Currency Hedges
Consistent with the functional-currency concept of SFAS 52, ''Foreign Currency Translation'' (discussed below), SFAS 133 indicates that an institution may designate the following types of hedges as hedges of foreign-currency exposure:
• a fair value of an unrecognized
firm commitment or an available-for-sale security
Continue to ACCOUNTING FOR FOREIGN-CURRENCY INSTRUMENTS
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