Businesses increasingly make use of a variety of “derivative financial instruments” such as put and call options, futures, forward contracts, and swaps in their operations. A
“derivative” generally means that the financial instrument in question “derives”
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its value from some other asset or liability to which it relates.
Derivatives are frequently used to manage (“hedge”) certain price and financial risks on other assets and liabilities of a business. For example, a business that would prefer to borrow money on a fixed interest rate basis may find that it can borrow more efficiently if it is willing to borrow on a floating rate basis. The floating rate loan would expose the business to the risk of increasing interest rates over the term of the loan. Various derivatives could be used to eliminate or substantially reduce the risk of interest rate changes associated with the floating rate debt.
Alternatively, a business could simply invest in derivatives on a “speculative” basis in an effort to achieve investment gains on the derivatives. In that case, the derivatives would not be matched or connected with other assets or liabilities of the business. There are significant differences in the risks associated with investing in derivatives on a speculative basis as compared to the use of derivatives to hedge other risks. Similarly, there are differences in the accounting rules for derivatives depending on whether they are being used to hedge or held as a speculative investment.
One significant feature of most derivatives is the fact that not all of the potential risk associated with these instruments is apparent from the face of the financial statements.
If a business invests in a highly
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risky stock or bond, the amount of financial risk to which the business is exposed is shown on the face of the financial statements. The business can’t lose more than it has invested in such investments and so the maximum exposure is the amount at which these items is carried on the financial statements (their book value). Unlike an investment in bonds or stocks, where the maximum exposure is the loss of the investment as shown on the financial statements, the risk of loss associated with derivative instruments frequently greatly exceeds the relatively small amount shown on the financial statements. For example, assume that a business writes a call option on one hundred shares of stock in
company X. Writing a call option means that the business agrees to sell stock to the buyer of the call option for a specified price (assume $100 per share) if the option holder elects to exercise the call option. Assume that the business writing the call does not own any shares of stock in X. On the date the option is written, the business shows no investment in the option. The business would have received a payment (referred to as a
“premium”) for writing the option and that would be reported as a liability pending exercise or lapse of the option. However, the financial exposure of the business is not limited to the amount of the premium reported as a liability. In fact, it has an exposure that is somewhat unlimited. For example, if the price of the stock rises to $200 and the option is exercised, the business would have to buy the shares of X at $200 per share and sell them at $100 per share, reporting a loss of $10,000.
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If the price of X stock goes higher, the exposure is higher. This “off balance sheet exposure” explains much of the focus on accounting for derivatives.
The accounting for, and disclosures related to, derivative financial instruments are now set forth primarily in ASC 815. In general, all derivatives must now be accounted for as assets or liabilities in the financial statements and must be reported at their fair market value.
1. DEFINITION OF DERIVATIVES
A derivative is a financial instrument or other contract with all three of the following features. First, the instrument must have one or more under-lyings and one or more notional amounts or payment provisions or both. ASC 815-10-15-83(a). An “underlying” is some price or rate (interest rate, security price, commodity price, exchange rate, index).
A notional amount is a number of currency units, shares, or other units of measure. A
“payment provision” is a settlement to be made based on movement in the value of the underlying.
To illustrate, consider a wheat future. A wheat future is an agreement to deliver a certain grade of wheat at a specified location on a specified date at a specified price. The underlying would be the price of the particular grade of wheat at the location and on the date for delivery. The notional amount would be the number of bushels of wheat covered by the futures contract. Typically, in the case of a futures
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contract, the contract will provide that the wheat need not actually be delivered.
Rather, the contract will provide that the contract can be “settled” by making a payment equal to the difference between the contract price in the wheat future and the market price of the wheat as of the settlement date of the futures contract.
The second requirement of a derivative is that there is little or no initial investment or a
very small investment in relation to the notional amount. ASC 815-10-15-83(b). For the parties to the wheat future described above, there is little or no investment by either party to the wheat future on the date that the future is created. This can be compared to an actual purchase of wheat in which the buyer of the wheat would have to invest the full value of the wheat on the date of purchase.
The third requirement is that the terms of the instrument require or permit net settlement, can be readily settled by a means outside the contract, or provide for delivery of an asset that puts the recipient in a position similar to a net settlement. ASC 815-10- 15-83(c). As noted above, in connection with the wheat future, it is likely that the contract will not actually be settled on the basis of an actual delivery of the wheat.
Instead, the parties will make a cash “settlement” based on the difference between market price and contract price at the end of the contract.
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Where a derivative is “embedded” in a contract or other financial instrument, the embedded derivative is generally required to be broken out separately and reported as a derivative under the rules set forth below. ASC 815-10-25-1. The economics of the embedded derivative must not be clearly and closely related to the “host contract.”
Further, if the hybrid instrument is otherwise required to be reported at fair value under GAAP, the embedded derivative would not be broken out. For example, a debt instrument the interest on which is tied to a stock index would be an equity-related derivative embedded in an ordinary, interest-bearing debt instrument as the host. The “base”
interest rate on the debt would be the interest factor on the debt instrument. As the amount of interest varies based on movements in the specified stock market index, those changes in the interest would be treated as a separate derivative to be accounted for under the rules on derivatives. In lieu of breaking out the embedded derivative and applying fair value measurements as described below to just the embedded derivative, companies may now elect under ASC 815-15-25-4 to apply fair value reporting to the entire contract or financial instrument.
2. ACCOUNTING FOR DERIVATIVES
As noted above, derivatives must now be reported in the financial statements at their fair value, which will fluctuate over time based on movements in the underlying applicable to the derivative. ASC 815-10-25-1. The changes in the fair value will produce
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gains and losses to the business. With respect to derivatives that are not used as hedges, the gains or losses on the derivatives (including unrealized gains or losses) must be reported in current earnings of the business. Because of the volatile nature of most derivatives, the requirement to include these movements in fair value in determining income could produce significant swings in income or loss if they are material in amount.
If the derivative is a hedging instrument, the accounting for gains and losses on the derivative depends on the accounting for the hedged item. Generally, a derivative is a hedging instrument if it is being used to offset the risk that would otherwise be associated with an asset or liability of the business. In general, the gains and losses on the derivative are “matched” with the earnings effects of the hedged items. The types of hedges and the related accounting will be discussed below. FASB Statement No. 133 sets forth detailed procedural requirements that must be followed for determining when a derivative is a hedge, but these procedural rules are beyond the scope of this book.
Extensive disclosures are required in the footnotes related to the objectives for using derivative instruments and other financial instruments used as hedges, the amount of gains and losses on the various classes of instruments, and other information.
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a. Fair Value Hedges
The accounting rules classify derivatives used as hedges into three categories. One of those categories is a “fair value hedge.” A fair value hedge is one that offsets the exposure to changes in the fair value of an asset or liability. ASC 815-20-20. In general, the gain or loss on a “fair value hedge” would be reported in income at the same time as the offsetting gain or loss on the hedged item. The gains and losses on the fair value hedge would be included in current earnings. ASC 815-25-35-1. The changes in fair value of the hedged item are also included in determining current earnings even if such changes would normally be reported as part of other comprehensive income (for example, gains and losses on available for sale securities discussed earlier in this Chapter). The result is that net income will reflect the extent to which the derivative instrument is not an effective hedge. The difference in the change in value of the derivative and the change in value of the hedged item will be reported in income or loss of the business.
An example of a fair value hedge would be purchasing a put option contract related to shares of stock that a business owns. The put contract allows the business to sell the stock at a fixed price. To the extent that the price of the related stock falls in value, the value of the put option increases. Changes in the value of the stock and the put option will be recognized and included in determining net income or loss.
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b. Cash Flow Hedges
A second category of derivatives used as hedges are “cash flow hedges.” A cash flow hedge is a derivative instrument that offsets exposure in expected future cash flows attributable to a particular risk. It may relate to the expected cash flows on an existing asset or liability or to a forecasted (future planned) transaction. ASC 815-20-20. In general, the gain or loss attributable to changes in the fair value of a derivative instrument designated as a cash flow hedge is initially reported as part of other
comprehensive income and is subsequently reclassified to net income or loss when the hedged cash flows affect net income or loss. However, to the extent that gain or loss recognized on the derivative instrument is not part of the hedging strategy, this gain or loss is recognized currently in earnings. ASC 815-30-35-3.
A cash flow hedge related to a forecasted transaction might be the following. A company expects to sell a commodity two months in the future but has no contract fixing the selling price. To lock in the price of the commodity (cash to be received), the company could enter into a futures contract on the commodity calling for “delivery” on the date of the expected sale. The plan to sell the commodity is a forecasted transaction because the company does not have a fixed contract for the sale of the commodity but has an expectation of doing so in the future.
A cash flow hedge of an existing liability could occur if a company has variable rate long-term debt on
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its books and enters into an interest rate swap entitling the company to receive variable interest and pay fixed interest. Future variations in the interest payable on the variable rate debt instrument would be offset by payments under the swap.
In both of these cases, changes in fair value of the commodity future or the interest rate swap would be recognized and reported in other comprehensive income. These gains or losses would be reclassified to net income in the future (when the commodity is sold in the first case or as interest is paid on the debt in the second case).
c. Foreign Currency Hedges
A third general category of derivatives used for hedging is foreign currency hedges. The accounting for the gain or loss on a derivative instrument hedging a foreign currency exposure depends on the nature of the item being hedged. When the derivative instrument (or a non-derivative financial instrument) is a hedge of a foreign currency denominated “firm commitment,” gain or loss from the derivative instrument and the foreign currency denominated firm commitment are both recognized currently in earnings.
An example would be entering into a contract to buy equipment in the future with the purchase price denominated in units of a foreign currency and entering into a forward contract now to purchase the required foreign currency for a fixed amount of U.S. dollars.
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A derivative instrument that hedges the changes in fair value of a recognized asset or liability for which a foreign currency translation gain or loss is recognized in net income or loss is subject to the fair value hedge rules discussed above. Gain or loss from the derivative instrument and the hedged item are both recognized currently in earnings.
A derivative instrument can hedge changes in the fair value of an available for sale security attributable to changes in foreign currency exchange rates. If the available for
sale security is a debt security, the gain or loss on the derivative instrument and the gain or loss on the hedged debt security are recognized currently in earnings. Similar rules apply to available for sale equity securities if (1) the security is not traded on an exchange where trades are denominated in the investor’s functional currency and (2) dividends or other cash flows are all denominated in the same foreign currency as is expected to be received on a sale of the security.
A derivative instrument can hedge foreign currency exposure related to cash flows associated with a forecasted transaction or a recognized asset or liability or a firm commitment. For this to be a foreign currency hedge, the hedged item must not be in the functional currency of the issuer (see Chapter 19 for a discussion of functional currency).
In the case of a foreign currency asset or liability, all of the variability in the hedged item’s functional currency equivalent cash flows must be eliminated by the hedge.
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Accounting for gains and losses on foreign currency cash flows hedges is the same as discussed above in connection with cash flow hedges generally. An example of a foreign currency cash flow hedge of a forecasted transaction would be where a company has determined future royalty receipts to be received in a foreign currency and enters into a forward contract to sell the expected foreign currency amounts for dollars.
A derivative instrument (or a non-derivative financial instrument) can be used to hedge the net investment in a foreign operation. Gain or loss on such instruments is reported in the same manner as a translation adjustment related to the foreign operations (see Chapter 19). ASC 815-35-35-1.