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Capital-Markets Activities Manual
Activities: Accounting (Continue)
Source: Federal Reserve System
(The complete Activities
Manual (pdf format) can be downloaded from the Federal Reserve's web
ACCOUNTING FOR FOREIGN-CURRENCY INSTRUMENTS
The primary source of authoritative guidance
for accounting for foreign-currency translations and foreign-currency
transactions is SFAS 52. The standard encompasses futures contracts, forward
agreements, and currency swaps as they relate to foreign-currency hedging.
SFAS 52 draws a distinction between foreign-exchange ''translation'' and
''transactions.'' Translation, generally, focuses on the combining of
foreign and domestic entities so they can be presented and reported in
the consolidated financial statements in one currency. Foreign-currency
transactions, in contrast, are transactions (such as purchases or sales)
by an operation in currencies other than its ''functional currency.''
For U.S. depository institutions, the functional currency will generally
be the dollar for its U.S. operations and the local currency of wherever
its foreign operations transact business.
Translation is the conversion of the financial
statements of a foreign operation (a branch, division, or subsidiary)
denominated in the operation's functional currency to U.S. dollars, generally
for inclusion in consolidated financial statements. The balance sheets
of foreign operations are translated at the exchange rate in effect on
the statement date, while income-statement amounts are generally translated
at an appropriate weighted amount. Meeting this criterion will be particularly
difficult when an anticipated transaction is not expected to take place
in the near future.
Detailed guidance for determining the functional
currency is set forth in appendix 1 of SFAS 52: ''An entity's functional
currency is the currency of the primary economic environment in which
the entity operates; normally, that is the currency of the environment
in which an entity primarily generates and expends cash. The functional
currency of an entity is, in principle, a matter of fact. In some cases,
the facts will clearly identify the functional currency; in other cases,
they will not.''
SFAS 52 indicates the salient economic
indicators and other possible factors that should be considered both individually
and collectively when determining the functional currency: cash flow,
price and market sales indicators, expense indicators, financing indicators,
inter-company transactions and arrangements, and other factors.
Gains or losses on foreign-currency transactions,
in contrast to translation, are recognized in income as they occur, unless
they arise from a qualifying hedge. SFAS 52 provides guidance about the
types of foreign-currency transactions for which gain or loss is not currently
recognized in earnings. Gains and losses on the following foreign-currency
transactions should not be included in determining net income but should
be reported in the same manner as translation adjustments:
• foreign-currency transactions
that are designated and effective as economic hedges of a net investment
in a foreign entity, commencing as of the designation date
• inter-company foreign-currency transactions that are long-term
investments (that is, settlement is not planned or anticipated in the
foreseeable future), when the entities to the transaction are consolidated,
combined, or accounted for by the equity method in the reporting institution's
NETTING OR OFFSETTING ASSETS AND LIABILITIES
Interpretation 39 (FIN 39), ''Offsetting
of Amounts Related to Certain Contracts,'' provides guidance on the netting
of assets and liabilities arising from (1) traditional activities, such
as loans and deposits, and (2) derivative instruments. The assets and
liabilities from derivatives are primarily the fair values, or estimated
market values, for swaps and other contracts, and the receivables and
payables on these instruments. FIN 39 clarifies the definition of a ''right
of setoff'' that GAAP has long indicated must exist before netting of
assets and liabilities can occur in the balance sheet. One of the main
purposes of FIN 39 was to clarify that FASB's earlier guidance on the
netting of assets and liabilities (Technical Bulletin 88-2) applies to
amounts recognized for OBS derivative instruments as well.
Balance-sheet items arise from off-balance-sheet
interest-rate and foreign-currency instruments in primarily two ways.
First, those banking organizations and other companies that engage in
various trading activities involving OBS derivative instruments (for example,
interest-rate and currency swaps, forwards, and options) are required
by GAAP to mark to market these positions by recording their fair values
(estimated market values) on the balance sheet and recording any changes
in these fair values (unrealized gains and losses) in earnings. Second,
interest-rate and currency swaps have receivables and payables that accrue
over time, reflecting expected cash inflows and outflows that must periodically
be exchanged under these contracts, and these receivables and payables
must be recorded on the balance sheet as assets and liabilities, respectively.7
Under FIN 39, offsetting, or the netting
of assets and liabilities, is not permitted unless all of the following
four criteria are met:
• Two parties must owe each other determinable amounts.
• The reporting entity must have a right to set off its obligation
with the amount due to it.
• The reporting entity must actually intend to set off these amounts.
• The right of setoff must be enforceable at law.
When all four criteria are met, a bank
or other company may offset the related asset and liability and report
the net amount in its GAAP financial statements. On the other hand, if
any one of these criteria is not met, the fair value of contracts in a
loss position with a given counterparty will not be offset against the
fair value of contracts in a gain position with that counterparty, and
organizations will be required to record gross unrealized gains on such
contracts as assets and to report gross unrealized losses as liabilities.
However, FIN 39 relaxes the third criterion (the parties' intent requirement)
to permit the netting of fair values of OBS derivative contracts executed
with the same counterparty under a legally enforceable master netting
agreement.8 A master netting arrangement exists if the reporting institution
has multiple contracts, whether for the same type of conditional or exchange
contract or for different types of contracts, with a single counterparty
that are subject to a contractual agreement that provides for the net
settlement of all contracts through a single payment in a single currency
in the event of default or termination of any one contract. FIN 39 defines
''right of setoff'' and specifies conditions that must be met to permit
offsetting for accounting purposes. FASB's Interpretation 41 (FIN 41),
''Offsetting of Amounts Relating to Certain Repurchase and Reverse Repurchase
Agreements,'' was issued in December 1994. This interpretation modifies
FIN 39 to permit offsetting in the balance sheet of payables and receivables
that represent repurchase agreements and reverse repurchase agreements
under certain circumstances in which net settlement is not feasible. (See
FIN 41 for further information.)
7. In contrast, the notional amounts of
off-balance-sheet derivative instruments, or the principal amounts of
the underlying asset or assets to which the values of the contracts are
indexed, are not recorded on the balance sheet. Note, however, that if
the OBS instrument is carried at market value, that value will include
any receivable or payable components. Thus, for those OBS instruments
that are subject to a master netting agreement, the accrual components
in fair value are also netted.
8. The risk-based capital guidelines provide generally that a credit-equivalent
amount is calculated for each individual interest-rate and exchange-rate
contract. The credit-equivalent amount is determined by summing the positive
mark-to-market values of each contract with an estimate of the potential
future credit exposure. The credit-equivalent amount is then assigned
to the appropriate risk-weight category. Netting of swaps and similar
contracts is recognized for risk-based capital purposes only when accomplished
through ''netting by novation.'' This is defined as a written bilateral
contract between two counterparties under which any obligation to each
other is automatically amalgamated with all other obligations for the
same currency and value date, legally substituting one single net amount
for the previous gross obligations.
1. To determine whether the organization's written accounting policies
relating to trading and hedging with derivatives instruments have been
approved by senior management for conformance with generally accepted
accounting practices, and that such policies conform with regulatory reporting
2. To determine whether capital-markets and trading activities appear
in regulatory reports, as reported by accounting personnel in conformance
with written accounting policies.
3. To determine whether securities held in available-for-sale or held-to-maturity
accounts meet the criteria of SFAS 115 and are, therefore, properly excluded
from the trading account.
4. To determine whether market values of traded assets are accurately
reflected in regulatory reports.
5. To determine whether financial instruments are netted for financial
reporting and regulatory reporting for only those counterparties whose
contracts conform with specific criteria permitting such setoff.
6. To determine whether management's assertions that financial instruments
are hedges meet the necessary criteria for exclusion from classification
as trading instruments.
7. To ascertain whether the organization has adequate support that a purported
hedge reduces risk in conformance with SFAS 133.
8. To determine whether the amount and recognition of deferred losses
arising from hedging activities are properly recorded and are being amortized
9. To recommend corrective action when policies, procedures, practices,
internal controls, or management information systems are found to be deficient,
or when violations of law, rulings, or regulations have been noted.
These procedures list a number of processes and activities to be reviewed
during a full-scope examination. The examiner-in-charge will establish
the general scope of examination and work with the examination staff to
tailor specific areas for review as circumstances warrant. As part of
this process, the examiner reviewing a function or product will analyze
and evaluate internal-audit comments and previous examination work-papers
to assist in designing the scope of examination. In addition, after a
general review of a particular area to be examined, the examiner should
use these procedures, to the extent they are applicable, for further guidance.
Ultimately, it is the seasoned judgment of the examiner and the examiner-in-charge
as to which procedures are warranted in examining any particular activity.
1. Obtain a copy of the organization's accounting policies and review
them for conformance with the relevant sections regarding trading and
hedging transactions of authoritative pronouncements by FASB, AICPA (for
Y-series reports), and Call Report Instructions.
2. Using a sample of securities purchase and sales transactions, check
a. Securities sub-ledgers accurately state the cost, and the market values
of the securities agree to outside quotations.
b. Securities are properly classified among trading, available-for-sale,
and held-to-maturity classifications.
c. Transactions that transfer securities from the trading account to either
held-to-maturity or available-for-sale are authorized and conform with
authoritative accounting guidance (such transfers should be rare, according
to SFAS 115).
3. Obtain a sample of financial instruments held in the trading account
and compare the reported market value against outside quotations or compare
valuation assumptions against market data.
4. Review the organization's controls over reporting certain financial
instruments on a net basis. Using a sample of transactions, review the
contractual terms to determine that the transactions qualify for netting
for financial reporting and regulatory reporting purposes, according to
the criteria specified by FIN 39, FIN 41, or regulatory reporting requirements.
5. Review the organization's methods for identifying and quantifying risk
for purposes of hedging. Review the adequacy of documented risk reduction
(SFAS 52 and SFAS 133) and the enterprise or business-unit risk reduction
(SFAS 80) that are necessary conditions to applying hedge accounting treatment.
6. Obtain schedules of the gains or losses resulting from hedging activities
and review whether the determination was appropriate and reasonable.
7. Determine if accounting reversals are well documented.
8. Determine if accounting profits and losses prepared by control staff
are reviewed by the appropriate level of management and that the senior
staff in the front office (head trader, treasurer) has agreed with accounting
numbers. Determine if the frequency of review by senior managers is adequate
for the institution's volume and level of earnings.
9. Recommend corrective action when policies, procedures, practices, internal
controls, or management information systems are found to be deficient,
or when violations of law, rulings, or regulations have been noted.
Internal Control Questionnaire
1. Does the organization have a well-staffed accounting unit that is responsible
for following procedures and instructions for recording transactions;
marking to market when appropriate; filing regulatory and stockholder
reports; and dealing with regulatory, tax, and accounting issues?
2. Do the organization's accounting policies conform to the relevant sections
regarding trading and hedging transactions of authoritative pronouncements
by FASB and AICPA, and to the Call Report Instructions? If the organization
is a foreign institution, does the organization have appropriate policies
and procedures to convert foreign accounting principles to U.S. reporting
guidance? Is there an adequate audit trail to reconcile the financial
statements to regulatory reports?
3. For revaluation-
a. Do securities sub-ledgers accurately state the cost, and do market
values of the securities agree to outside quotations?
b. Are securities properly classified among trading, available-for-sale,
and held-to-maturity classifications?
c. Evaluate the transfer of securities from the trading account to either
held-to-maturity or available-for-sale for authorization in conformance
with authoritative accounting guidance. Are such transfers rare? (According
to SFAS 115, such transfers should be rare.)
4. Do the revaluation rates used for a sample of financial instruments
held in the trading account appear within range when compared with supporting
documentation of market rates?
5. Do the contractual terms of a sample of transactions qualify for netting
for financial reporting and regulatory reporting purposes, according to
the criteria specified by FIN 39, FIN 41, or regulatory reporting requirements?
6. Does the financial institution have procedures to document risk reduction
(SFAS 52 and SFAS 133), and does it have enterprise or business-unit risk
reduction (SFAS 133) conditions to apply hedge accounting treatment? Do
the procedures apply to the full range of applicable products used for
investment? Is record retention adequate for this process?
7. Are the methods for assessing gains or losses resulting from hedging
activities appropriate and reasonable?
8. Are accounting reversals justified by supervisory personnel and are
they well documented?
9. Are profits and losses prepared by control staff reviewed by the appropriate
level of management and senior staff (head trader, treasurer) for agreement?
Is the frequency of review by senior managers adequate for the institution's
volume and level of earnings?
Appendix-Related Financial Statement Disclosures
SECURITIES PORTFOLIO DISCLOSURES UNDER SFAS 115
For securities classified as available-for-sale and separately for securities
classified as held-tomaturity, all reporting institutions should disclose
the aggregate fair value, gross unrealized holding gains, gross unrealized
holding losses, and amortized cost basis by major security type as of
each date for which a statement of financial position is presented. Financial
institutions should include the following major security types in their
disclosure, though additional types may be included as appropriate:
• equity securities
• debt securities issued by the U.S. Treasury and other U.S. government
corporations and agencies
• debt securities issued by states of the United States and political
subdivisions of the states
• debt securities issued by foreign governments
• corporate debt securities
• mortgage-backed securities
• other debt securities
For investments in debt securities classified as available-for-sale and
separately for securities classified as held-to-maturity, all reporting
institutions should disclose information about the contractual maturities
of those securities as of the date of the most recent statement of financial
position presented. Maturity information may be combined in appropriate
groupings. In complying with this requirement, financial institutions
should disclose the fair value and the amortized cost of debt securities
based on at least four maturity groupings: (1) within one year, (2) after
one year through five years, (3) after five years through 10 years, and
(4) after 10 years. Securities not due at a single maturity date, such
as mortgage-backed securities, may be disclosed separately rather than
allocated over several maturity groupings; if allocated, the basis for
allocation also should be disclosed. For each period for which the results
of operations are presented, an institution should disclose-
• the proceeds from sales of available-for-sale securities and
the gross realized gains and gross realized losses on those sales,
• the basis on which cost was determined in computing realized
gain or loss (that is, specific identification, average cost, or other
• the gross gains and gross losses included in earnings from transfers
of securities from the available-for-sale category into the trading category,
• the change in net unrealized holding gain or loss on available-for-sale
securities that has been included in the separate component of shareholders'
equity during the period, and
• the change in net unrealized holding gain or loss on trading
securities that has been included in earnings during the period.
For any sales of or transfers from securities classified as held-to-maturity,
the amortized cost amount of the sold or transferred security, the related
realized or unrealized gain or loss, and the circumstances leading to
the decision to sell or transfer the security should be disclosed in the
notes to the financial statements for each period for which the results
of operations are presented. Such sales or transfers should be rare, except
for sales and transfers due to the changes in circumstances as previously
ACCOUNTING DISCLOSURES FOR DERIVATIVES
AND HEDGING ACTIVITIES
Under SFAS 133, institutions that hold or
issue derivative instruments, or non-derivative instruments qualifying
as hedge instruments, should disclose their objectives for holding or
issuing the instruments and their strategies for achieving the objectives.
Institutions should distinguish whether the derivative instrument is to
be used as a fair-value, cash-flow, or foreign-currency hedge. The description
should include the risk-management policy for each of the types of hedges.
Institutions not using derivative instruments as hedging instruments should
indicate the purpose of the derivative activity.
For foreign-currency-transaction gains or losses that qualify as fair-value
• the net gain or loss recognized
in earnings during the reporting period, which represents the amount of
hedge ineffectiveness and the component of gain or loss, if any, excluded
from the assessment of hedge effectiveness, and a description of where
the net gain or loss is reported in the income statement; and
• the amount of net gain or loss recognized in earnings when a
hedged firm commitment no longer qualifies as a fair-value hedge.
For cash-flow gains or losses that qualify
as cash-flow hedges, report-
• the net gain or loss recognized in earnings during the reporting
period, which represents the amount of ineffectiveness and the component
of the derivative's gain or loss, if any, excluded from the assessment
of hedge effectiveness, and a description of where the net gain or loss
is reported in the income statement;
• a description of the transactions or other events that will result
in the reclassification into earnings of gains and losses that are reported
in accumulated other comprehensive income (OCI), and the estimated net
amount of the existing gains or losses at the reporting date that is expected
to be reclassified into earnings within the next 12 months;
• the maximum length of time over which the entity is hedging its
exposure to the variability in further cash flows for forecasted transactions,
excluding those forecasted transactions related to the payment of variable
interest on existing financial instruments; and
• the amount of gains and losses reclassified into earnings as
a result of the discontinuance of cash-flow hedges because it is probable
that the original forecasted transactions will not occur by the end of
the originally specified time period or within an additional time period
as outlined in SFAS 133.
For derivatives, as well as non-derivatives,
that may give rise to foreign-currency-transaction gains or losses under
SFAS 52, and that have been designated as and qualify for foreign-currency
hedges, the net amount of gains or losses included in the cumulative translation
adjustment during the reporting period should be disclosed.
Reporting Changes in Other Comprehensive
Institutions should show as a separate
classification within other comprehensive income (OCI) the net gain or
loss on derivative instruments designated and qualifying as cash-flow
hedges. Additionally, pursuant to SFAS 130, ''Reporting Comprehensive
Income,'' institutions should disclose the beginning and ending accumulated
derivative gain or loss, the related net change associated with current
period hedging transactions, and the net amount of any reclassification
SEC Disclosure Requirements for Derivatives
In the first quarter of 1997, the SEC issued
rules requiring the following expanded disclosures for derivative and
other financial instruments for public companies:
• improved descriptions of accounting
policies for derivatives in the footnotes of the financial statements
• disclosure of quantitative and qualitative
information about derivatives and other financial instruments outside
of the footnotes to the financial statements:
- For the quantitative disclosures about
market-risk-sensitive instruments, registrants must follow one of three
methodologies and distinguish between instruments used for trading purposes
and instruments used for purposes other than trading. The three disclosure
methodology alternatives are (1) tabular presentation of fair values and
contract terms, (2) sensitivity analysis, or (3) value-at-risk disclosures.
Registrants must disclose separate quantitative information for each type
of market risk to which the entity is exposed (for example, interest-rate
or foreign-exchange rate).
-The qualitative disclosures about market risk must include the
registrant's primary market-risk exposures at the end of the reporting
period, how those exposures are managed, and changes in primary risk exposures
or how those risks are managed as compared with the previous reporting
• disclosures about derivative financial
instruments with any financial instruments, firm commitments, commodity
positions and anticipated transactions that are being hedged by such items
(These are included to avoid misleading disclosures.)
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