Derivatives accounting

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See also IAS 39.

Contents

FASB historical treatment of derivatives

IMPORTANT NOTICE The guidance on Statement 133 implementation issues available below are superseded by FASB Accounting Standards Codification Topic 105, Generally Accepted Accounting Principles.

The below Statement 133 implementation issues includes both tentative conclusions and conclusions that have been formally cleared by the Board. The issues that have been cleared are distinguished in the following index with an asterisk (*) placed to the left of the issue title. The index also indicates the date cleared by the Board or, for uncleared issues, the date the guidance was released.

Each of the cleared issues indicates that the "response has been authored by the FASB staff and represents the staff's views, although the Board has discussed the above response at a public meeting and chosen not to object to dissemination of that response. Official positions of the FASB are determined only after extensive due process and deliberation."

Recent Modifications

The staff's previous tentative conclusions in Proposed Statement 133 Implementation Issue No. B12, “Beneficial Interests Issued by Qualifying Special-Purpose Entities” were withdrawn on June 12, 2009, due to the issuance of FASB Statement No. 166, Accounting for Transfers of Financial Assets, which removed the concept of a qualifying special-purpose entity from FASB Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.

FASB 133 - The derivatives accounting standard

FASB Statement 133 Implementation

Source: Guidance on Statement 133 Implementation Issues See this FASB page for current issues related to accounting for derivatives.

"The guidance on Statement 133 implementation issues outlined below includes both tentative conclusions and conclusions that have been formally cleared by the Board. The issues that have been cleared are distinguished in the following index with an asterisk (*) placed to the left of the issue title. The index also indicates the date cleared by the Board or, for uncleared issues, the date the guidance was released.

Each of the cleared issues indicates that the "response has been authored by the FASB staff and represents the staff's views, although the Board has discussed the above response at a public meeting and chosen not to object to dissemination of that response. Official positions of the FASB are determined only after extensive due process and deliberation."

Each of the uncleared issues indicates that the "response represents a tentative conclusion. The status of the guidance will remain tentative until it is formally cleared by the FASB and incorporated into an FASB staff implementation guide."

A service is available at no charge to notify interested parties by email whenever implementation guidance on FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, is newly posted. See link here:

Guiding principles for the replacement of IAS 39

Fair value related principles

  • 7. Fair value should not be required for items which are managed on an amortised cost basis in accordance with the firm’s business model;
  • 8. Fair value is an appropriate measurement for trading activities, stand alone derivatives (subject to the need to avoid unintended consequences of the new hedging rules), and potentially other instruments managed on a fair value basis;
  • 9. The current restrictions on use of the fair value option should not be relaxed. Thus, the fair value option treatment should continue to reflect the approach carefully worked out with the Basel Committee in 2005 and reflected in the amendment to IAS 39.
  • 10. The new standard should provide for valuation adjustments to avoid misstatement of both initial and subsequent profit or loss recognition when there is significant valuation uncertainty. For financial instruments that are either not actively traded, or have insufficient market depth, or rely on valuation models using unobservable inputs, there is considerable valuation uncertainty. A solution could be to partially de-link the valuation process (in mark-to-market) from certain aspects of income and profit recognition when significant uncertainty exists. The size of the adjustment could be based on the degree of uncertainty created by the weakness in the data or underlying modelling approach.
  • 11. Fair value measurement should be supported by appropriate disclosures.


Exempt hedged OTC swaps (FAS 133 or IAS 39)

A proposal has been made by Reval, a firm which provides derivative risk management and hedge accounting software to over 250 world’s largest and most complex corporations and financial institutions, that OTC derivatives that qualify for hedge accounting treatment under FAS 133 or IAS 39 be exempt from the regulatory reform being proposed and from the requirements for clearing or margining.

Any hedges that are marked-to-market without an effective offset as defined by the standard, or a hedge that subsequently fails rigorous hedge accounting effectiveness tests, should still be regulated and monitored under the pending regulatory reform.

Exempting OTC derivatives that qualify for hedge accounting under existing standards will aid reform efforts by encouraging risk management, eliminating potential loopholes, promoting transparency, and eliminating the time and expense of designating trades as either standardized or non-standardized trades.

First, OTC derivatives that manage to pass the rigorous tests under FAS 133 hedge accounting and on-going internal and external audits are not the derivatives that were used to create the leverage that caused considerable stress on the financial system.

These are, for the most part, plain vanilla OTC interest rate, foreign exchange and commodity derivatives used by corporations to hedge risk exposures to their businesses, not by hedge fund traders to make a profit or by market-makers selling too many credit default swaps.

Regulations have already been in place in the U.S. since 2001 for companies who speculate using derivatives. In fact FAS 133, and subsequently IAS 39 for most international companies, was created to require companies to bring derivatives to the balance sheet with a mark-to-market requirement, thereby forcing companies who were previously using derivatives off-balance sheet for speculative purposes to be more transparent and record the periodic profit and loss changes. For those companies using derivatives for hedging purposes, complex rules were put in place that would essentially create an offset to the resulting derivative P&L change.

Far from a typical retrospective accounting standard, FAS 133 and IAS 39 require complex proof to show that a hedge will remain effective against the corresponding exposure with a high degree, deemed to be within a band of 80% to 125% correlation for the prospective life of the derivative. The inability to demonstrate this, and failure to comply with the hundreds of pages in the standard, would result in unwanted P&L volatility from resulting derivative mark-to-market changes that have no offset from the exposure being hedged.

As a result, most end-users of derivatives have to deploy fairly conservative hedging strategies to achieve the benefit of hedge accounting compliance, which means little or no leverage and the inability to sell naked options.

Goldman Sachs and level 3 derivatives

Source: It’s not all golden at Goldman Reuters, August 6, 2009

"... Level 3, of course, is the category banks use for assets deemed too hard-to-value and all but untradeable. And at the end of June, Goldman reported having $15 billion in derivatives contracts that were classified as Level 3.

Overall, untradeable derivatives accounted for 27% of the $54 billion in Level 3 assets at Goldman in quarter two. And on fair value basis, Level 3 derivatives accounted for nearly 7% of the dollar value of all of the firm’s derivative contracts.

And there’s reason to worry about those untradeable Level 3 derivative contracts at Goldman because right now those transactions aren’t fairing well. In the second quarter, Goldman reported a net unrealized loss of $1.4 billion on its Level 3 derivatives–blaming the loss on “tighter credit spreads on the underlying instruments.”

The unrealized loss is significant because it represents a reversal of what had been a positive trend at Goldman.

In the first quarter, Goldman reported a net unrealized gain of $975 million on its Level 3 derivative contracts, largely due to “increases in commodities prices … and changes in credit spreads corroborated by trading activity.” And for all of 2008, Goldman reported a net unrealized gain of $5.58 billion. In 2007, Level 3 derivatives posted an equally impressive net unrealized gain of $4.5 billion.

Back in October 2007, Peter Eavis, part of The Wall Street Journal’s Heard on the Street team, did an excellent story for Fortune on how unrealized gains from Level 3 derivatives were juicing Goldman’s results while the first cracks were beginning to appear at other Wall Street firms. In that story, Eavis speculated some of that paper gain might be due to Goldman’s “stupendously prescient bet against mortgages.”

Maybe the second-quarter turn to an unrealized loss on untradeable derivatives was an aberration and things will revert to the norm in the current quarter. Or maybe this is an unwinding of some of those subprime hedges that worked so well for the firm during the height of the housing meltdown.

Either way, it bears watching and makes you wonder what are the underlying assets in those troublesome Level 3 derivatives on Goldman’s books."

GASB 53 - Accounting for state and local governments use of derivatives

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