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CBIZ & MHM Executive Education Series™

How to Make the Most Out of Derivative Financial Instruments Mike Loritz, Mark Winiarski Aug. 20 & Sept. 1

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About Us

• Together, CBIZ & MHM are a Top Ten accounting provider • Offices in most major markets • Tax, audit and attest* and advisory services • Over 2,900 professionals nationwide

A member of Kreston International A global network of independent accounting firms

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Before We Get Started…

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CPE Credit

This webinar is eligible for CPE credit. To receive credit, you will need to answer periodic participation markers throughout the webinar. External participants will receive their CPE certificate via email immediately following the webinar.

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Disclaimer

The information in this Executive Education Series course is a brief summary and may not include all

the details relevant to your situation.

Please contact your service provider to further discuss the impact on your business.

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Presenters

Mike has 18 years of experience in public accounting with diversified

financial companies and other service based companies, including

banking, broker/dealer, investment companies, and other diversified

companies ranging from audits of public entities in the Fortune 100 to

small private entities.

He is a member of MHM's Professional Standards Group, providing

accounting knowledge leadership in the areas of derivative financial

instruments, complex financial instruments, share-based compensation,

fair value, revenue recognition and others.

816-945-5116 • mloritz@cbiz.com

MIKE LORITZ, CPA MHM Shareholder

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Presenters

Located in our Kansas City office, Mark is a member of our Professional

Standards Group (PSG). Mark's role includes instructing in our national

training program, presenting as a subject matter expert at webinars and

conferences, and preparing MHM publications on accounting and

auditing issues.

As a PSG member , Mark consults with clients and engagement teams

across the country in many areas of accounting and auditing. Mark has

served clients as an auditor, consultant and advisor in numerous

industries including manufacturing, distribution, mining, retail sales,

services and software.

913.234.1656 • mwiniarski@cbiz.com • @KCWini

MARK WINIARSKI, CPA MHM Shareholder

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Agenda

The History

02

01

03

04

Risk Management

Accounting Model – Derivative Instruments

Current Events

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THE HISTORY

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Accounting for Derivatives - The History

Why FASB Statement No. 133? • A lack of transparency in the financial statements

• Many derivative positions were not reflected in the financial statements.

• As a result, investors were not aware of potentially significant exposures from derivative instruments that ultimately resulted in the recognition of significant losses (surprise factor).

• Lack of information about how companies used derivative instruments and related strategies • Many would assume that exposures were perfectly hedged, when in

reality, they were not. • It is very rare to have a “perfect hedge.”

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Accounting for Derivatives - The History

Accounting prior to SFAS No 133: • Deferral method - gains or losses on a derivative

position, were deferred as either an asset or a liability and later amortized

• Incurred/Accrual method - amounts actually receivable or payable would be recorded but there was nothing else reflected in the financial statements (monthly settlements for example)

• Fair Value - mark-to-market accounting

Practice was diverse and comparability was difficult!

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Accounting for Derivatives - The History

• 1998 - the Financial Accounting Standards Board (FASB) issued Financial Accounting Standard 133 (SFAS 133) on Accounting for Derivative Financial Instruments and Hedging Activities. • Original effective date of June 15, 1999 • Amended to June 15, 2000 (January 1, 2001 for calendar-year

companies) • Also formed the SFAS 133 Derivatives Implementation Group (DIG) to help

resolve particular implementation questions, especially in areas where the standard is not clear or allegedly onerous • All have since been codified.

• One of the most confusing and complex accounting standards to date • Established the notion of an “embedded derivative” • Source of a significant number of restatements • Very rules-based approach

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RISK MANAGEMENT

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Why are Derivatives Used?

Increased friction between buyers and sellers of underlying assets in established debt, equity, currency and commodities markets put pressure on the securities industry to develop innovative solutions.

• Synthetic assets that derived their value from these underlying assets but allowed for more flexible timing, risk, pricing and contractual arrangements were developed by private parties and market-making firms.

• These synthetic securities increased the number of buyers and sellers coming into the marketplace to transact for a variety of reasons.

• This increased volume of activity allows more efficient markets, greater liquidity for all investors in both the derivative and underlying asset markets.

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Why are Derivatives Used?

• Risk Management • Derivatives are used by many companies to manage the risk of changing

market conditions on assets/liabilities or variable cash flows on operations.

• Hedge accounting can apply.

• Arbitrage • Lock in riskless profits (excluding credit risk) • Generally used by large financial institutions or traders

• Speculation • Trading derivative products in order to take a position in the market (betting on future movements)

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Why are Derivatives Used?

Derivatives used as speculation

• Companies and investors utilize derivatives as investments because derivatives provide an extreme amount of leverage that can be utilized to magnify investment gains (and losses).

• Example – Futures contract on oil • Notional amount = 40,000 barrels of oil • Company purchases a futures contract to purchase 40,000 barrels of oil at a

price of $70 per barrel for a term of 3 months • Except for initial margin (typically 5% of notional amount, $140,000),

Company does not need to put up any capital and they control $2,800,000 of oil. If oil closes at $80, Company made $400,000, if it closes at $60, they lose $400,000. So on a 14.28% move in oil, the Company makes 186%, plus they get the $140,000 margin back.

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Why are Derivatives Used?

Risk Management • Companies utilize derivatives to offset (hedge) risks that are

inherent in their business models • Examples include:

• Futures contracts to lock in sales prices for commodities being sold (hedging the volatility in sales prices); e.g. copper futures for sales of copper

• Foreign exchange contracts to lock in a fixed exchange rate on its international sales in Europe (hedging the volatility in exchange rates)

• Interest rate swaps to lock in a fixed interest rate for a company’s variable rate debt (hedging the volatility in interest rates)

• Upon entering into these derivative contracts, the company is satisfied with the price that it will receive upon settlement of the derivative. • Ideally any gain or loss on the derivative contract is offset by the

loss or gain from the item being hedged. • The company has received the market rate on the date into which

the derivative contract was entered.

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Common Interest Rate Swap Agreement

Company A Issues $150 Million

in Debt

Bond Holders

Pays LIBOR + 2%

Swap Agreement with

Bank A

Receives LIBOR + 2%

Pays fixed 5%

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ACCOUNTING MODEL

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Accounting Model for Derivatives

• Freestanding • Embedded • Hedge accounting

• Cash Flow • Fair Value • Net investment in foreign operations

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What is a Derivative? – Characteristics of Derivatives

The derivative of a function of a real variable measures the sensitivity to change of a quantity (a function value or dependent variable) which is determined by another quantity (the independent variable). Derivatives are a fundamental tool of calculus. For example, the derivative of the position of a moving object with respect to time is the object's velocity: this measures how quickly the position of the object changes when time is advanced.

Source: Wikipedia

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What is a Derivative? – Characteristics of Derivatives

A derivative financial instrument is an instrument whose value is dependent on or derived from the value of an underlying asset, reference rate, or index. Derivatives have the following characteristics: • One or more underlyings • One or more notional amounts (or payment provisions) • Little or no net investment • Net settlement provisions (or market mechanism to

facilitate net settlement)

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Accounting Model for Derivatives

• A derivative instrument is recorded on the balance sheet as either an asset or liability measured at its fair value. Changes in the derivative instrument’s fair value must be recognized currently in earnings unless specific hedge accounting criteria are met.

• An entity that does not report earnings, such as a not-

for-profit entity, generally is required to report such changes as part of the change in its net assets.

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Derivatives - Basics

• Derivatives can be assets or liabilities! • Specialized accounting may apply if a transaction

qualifies for hedge accounting and the proper election is made. • Documentation requirements must be met. • Quarterly analysis is required (certain limited

exceptions).

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Scope Exceptions to Topic 815

The following contracts are not subject to the requirements of derivative accounting:

• Regular way trades

• Normal purchases and normal sales

• Certain insurance contracts

• Financial guarantee contracts

• Certain contracts that are not traded on an exchange

• Derivatives that serve as impediments to sales accounting

• Investments in life insurance

• Certain investment contracts

• Loan commitments

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Scope Exceptions to Topic 815

The following contracts are not subject to the requirements of derivative accounting:

• Contracts issued or held by that reporting entity shall not be considered to be derivative instruments:

• Contracts issued or held by that reporting entity that are both 1) indexed in its own stock and 2) classified in stockholders’ equity.

• Contracts issued by the entity that are subject to Share Based Compensation guidance.

• Contacts issued by the entity as contingent consideration from a business combination.

• Forward contracts that require settlement by the reporting entity’s delivery of cash in exchange for the acquisition of a fixed number of its equity shares.

• The above exceptions do not apply to the counterparty in those contracts. In addition, a contract that an entity either can or must settle by issuing its own equity instruments but that is indexed in part or in full to something other than its own stock can be a derivative, in which case it would be accounted for as an asset or liability.

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HEDGE ACCOUNTING

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What is Hedging?

• From an economic standpoint: • Hedging is using derivative instruments to offset risks

(or volatility, as defined as variability in economic results) that are present in an entity’s business model.

• From an accounting standpoint: • There are specific criteria that must be met prior to a

company’s implementation of hedge accounting.

What is the difference in accounting for derivatives as investments versus utilizing hedge accounting?

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What is Hedging?

• Derivatives that are accounted for as investments are recorded at fair value and marked to market at each reporting date with the change recorded in earnings.

• Provided that the requisite hedging criteria are met, derivatives that are accounted for as hedges are also recorded at fair value; however, the accounting for the derivatives is based upon the type of hedge that has been implemented.

• It should be noted that regardless of whether hedge accounting is utilized, ALL derivatives are recorded on the balance sheet at their estimated fair value.

• For accounting purposes, there are generally three types of hedges: 1. Fair value hedge 2. Cash flow hedge 3. Foreign currency hedge

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What is Hedging?

• Fair value hedge – Economic purpose is to enter into a derivative instrument whose changes in fair value directly offset the changes in fair value of the hedged item.

• Cash flow hedge – Economic purpose is to enter into a derivative instrument whose gains and losses on settlement directly offset the losses and gains incurred upon settlement of the transaction being hedged. The Company is hedging the forecasted transactions that are highly expected to occur in the future.

• Foreign currency hedge – If the hedged item is denominated in a foreign currency, then an entity may designate the hedge as either 1) a fair value hedge of that item, 2) a cash-flow hedge of that item, or 3) a hedge of a net investment in a foreign operation. • With the exception of 3) the economic purposes of 1) and 2) are the same as

described above.

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What is Hedging?

Fair value hedge • In a fair value hedge the gain or loss on a derivative instrument

designated and qualifying as a fair value hedging instrument as well as the offsetting loss or gain on the hedged item attributable to the hedged risk are recognized currently in earnings in the same accounting period.

• Certain assets and liabilities are eligible to be designated as the hedged item in a fair value hedge. These items must meet all of the following criteria: • The hedged item is a recognized asset or liability or unrecognized

firm commitment (or specified portion thereof). • The hedged item presents an exposure to changes in fair value

attributable to the hedged risk that could effect reported earnings.

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What is Hedging?

Fair value hedge Certain assets and liabilities are eligible to be designated as the hedged item in a fair value hedge. These items must meet all of the following criteria:

• The hedged item is not 1. an asset or liability that is remeasured with the changes in fair value

attributable to the hedged risk reported currently in earnings, 2. an investment accounted for by the equity method, 3. a non-controlling interest in one or more consolidated subsidiaries, 4. an equity investment in a consolidated subsidiary, 5. a firm commitment either to enter into a business combination or to

acquire or dispose of a subsidiary, non-controlling interest, or equity method investee, or

6. an equity instrument issued by the entity and classified in stockholders’ equity.

• Other issues related to held to maturity investments, nonfinancial assets and liabilities and the risks being hedged for financial assets and liabilities.

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What is Hedging?

Cash flow hedge • In a cash flow hedge, the effective portion of the gain

or loss on a derivative instrument designated and qualifying as a cash flow hedging instrument shall be reported as a component of other comprehensive income (outside of earnings) and • The gain/loss is then reclassified into earnings in the

same period or periods during which the hedged forecasted transaction affects earnings.

• Any portion of the derivative instrument that is designated as a cash flow hedge that is determined to be ineffective should be recognized in earnings immediately.

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What is Hedging?

Foreign currency hedge • Foreign currency hedges designated as either fair value hedges or

cash-flow hedges are accounted for in the same manner as regular fair value and cash flow hedges.

• A derivative instrument or a non-derivative financial instrument that may give rise to a foreign currency transaction gain or loss can be designated as hedging the foreign currency exposure of a net investment in a foreign operation. • The gain or loss on a hedging derivative instrument (or the foreign

currency transaction gain or loss on the non-derivative hedging instrument) that is designated as, and is effective as, an economic hedge of the net investment in a foreign operation shall be reported in the same manner as a translation adjustment to the extent it is effective as a hedge. The provisions of the guidance for recognizing the gain or loss on assets designated as being in a fair value hedge do not apply to the hedge of a net investment in a foreign operation.

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Requirements for Utilization of Hedge Accounting

An entity may designate a derivative instrument as a fair value, cash flow, or foreign currency hedge if: • At the inception of the hedge, there is formal documentation

of the hedging relationship and the entity’s risk management objective and strategy for undertaking the hedge, including: • Identification of the hedging instrument • Identification of the hedged item or forecasted transaction(s) • Identification of how the hedging instrument’s effectiveness in

offsetting the exposure to changes in the hedged item’s fair value (fair value hedge) or the hedged transaction’s variability in cash flows (cash flow hedge) attributable to the hedged risk will be assessed. There must be a reasonable basis for how the entity plans to assess the hedging instrument’s effectiveness.

• And:

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Requirements for Utilization of Hedge Accounting

• Both at the inception of the hedge and on an ongoing basis, the hedging relationship is expected to be highly effective in achieving • A) offsetting changes in the fair value attributable to the

hedged risk during the period that the hedge is designated (in the case of a fair value hedge) or

• B) offsetting cash flows attributable to the hedged risk during the term of the hedge (in the case of a cash flow hedge).

• An assessment of effectiveness is required whenever financial statements or earnings are reported; at least every three months.

• All assessments of effectiveness must be consistent with the originally documented risk management strategy for that particular hedging relationship.

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Interest Rate Swaps

For Example:

• Company XYZ has outstanding $10,000,000 of non-amortizing variable rate debt for which interest payments are due on a quarterly basis. The note accrues interest at the 3 month London Interbank Offered Rate (“LIBOR”) plus 5% and matures via a bullet payment in 5 years.

• In this case, in order to hedge the Company’s interest rate risk related to its future interest rate payments (cash flow hedge), the Company would enter into a 5 year interest rate swap for a notional amount of $10,000,000 at a current swap rate (fixed rate). This would be a cash flow hedge (provided that the documentation requirements were met).

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Interest Rate Swaps

Example, cont’d:

• The Company would pay the fixed rate of 2.6% on the $10,000,000 notional amount on a quarterly basis and would receive the 3 month LIBOR rate on a quarterly basis. The LIBOR received is set a quarter prior to payment so the payment is made 3 months in arrears. Accordingly, the Company knows 3 months in advance what the payment will be.

• Payments are settled on a net basis so if the 3 month LIBOR is greater than 2.6% then the Company will receive a payment.

• Therefore, the Company has effectively turned its variable rate debt into fixed rate debt with an effective interest rate of 7.6% (2.6% fixed + 5% spread).

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Interest Rate Swaps

Example, cont’d:

• Fixed rate payment = $10,000,000 * .026 / 4 = $65,000

• Variable rate payment = $10,000,000 * 3 month LIBOR (3.0%) or .03 / 4 = $75,000

• Therefore company receives:

• $75,000 - $65,000 = $10,000 at quarterly settlement. The fixed rate payment will be $65,000 at each settlement.

• The variable rate payment is the moving component as the three month LIBOR will change.

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Interest Rate Swaps

Example, cont’d - Accounting: • Assuming an effective cash flow hedge, at each reporting

date, the Company would mark the interest rate swap to estimated fair value with the changes therein being recorded in Other Comprehensive Income.

• The $10,000 quarterly settlement, and other quarterly receipts or payments, are recorded as interest expense.

• Assuming the fair value of the interest rate swap is a positive $500,000 of which $200,000 relates to the value ascribed to the settlements to occur in the next 12 months, the entry would be as follows:

Derivatives – current asset $200,000 Derivatives – long term asset $300,000

Accumulated other comprehensive income $500,000

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Interest Rate Swaps

• Effectiveness testing for interest rate swaps designated as cash flow hedges: • Whether a hedging relationship qualifies as highly effective

will sometimes be easy to assess and there will be no ineffectiveness to recognize in earnings during the term of the hedge.

• This occurs when the critical terms of the hedging instrument (the derivative) and of the entire hedged asset or liability or hedged forecasted transaction are the same. The entity could conclude that the change in fair value or cash flows attributable to the risk being hedged are expected to completely offset at inception and on an ongoing basis. While the example herein is for an interest rate swap, this critical terms match method is not exclusive to interest rate swaps.

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Interest Rate Swaps

Effectiveness testing for interest rate swaps designated as cash flow hedges: • For interest rate swaps, an assumption of non-ineffectiveness can be derived

from the use of the critical terms match or the “short-cut method” which requires that the following conditions are met (is applicable for both fair value and cash flow hedges): • The notional amount of the swap matches the principal amount of the interest

bearing asset or liability being hedged. • At the inception of the hedge, the fair value of the swap is $0. • The formula for computing net settlements under the interest rate swap is the same

for each settlement; that is, the fixed rate is the same throughout the term, and the variable rate is based on the same index and includes the same constant adjustment or no adjustment.

• The interest bearing asset or liability is not prepayable. • The index on which the variable leg of the swap is based matches the benchmark

interest rate designated as the interest rate risk being hedged for that hedging relationship.

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Interest Rate Swaps

• Critical terms match method continued for interest rate swaps: • These conditions apply only to fair value hedges:

• The expiration date of the swap matches the maturity date of the interest bearing asset or liability.

• There is no floor or cap on the variable interest rate of the swap. • The interval between repricings of the variable interest rate in the swap is frequent

enough to justify an assumption that the variable payment or receipt is at a market rate (3 to 6 months or less).

• These conditions apply only to cash flow hedges: • All interest receipts or payments on the variable rate asset or liability during the term

of the swap are designated as hedged, and no interest payments beyond the term of the swap are designated as hedged.

• There is no floor or cap on the variable rate of the swap unless the variable rate asset or liability has a floor or cap.

• The repricing dates match those of the variable rate asset or liability.

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Interest Rate Cap Agreements -Terms

• Interest rate caps can be described by a “term sheet.”

• Maturity (for example - 5 years)

• Notional amount (usually set equal to borrowed amount)

• Strike price (sometimes called the protection level)

• Frequency (how many payments per year)

• Payments per year times maturity tells you how many caplets

• Basis (how you’re going to count days)

• Underlying rate (usually LIBOR of some maturity)

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Interest Rate Cap Agreements

For Example: • Company XYZ has outstanding $10,000,000 of non-amortizing variable rate debt for

which interest payments are due on a quarterly basis. The note accrues interest at the 3 month LIBOR plus 5% and matures via a bullet payment in 5 years.

• In this case, in order to hedge the Company’s interest rate risk related to its future interest rate payments (a cash flow hedge), the Company would purchase a 5 year interest rate cap agreement for a notional amount of $10,000,000 which has a cap rate of 2.6% (for example) and designated maturities of 3 months. For purposes of this example, the purchase price is $200,000 for the interest rate cap agreement.

• Therefore, given that the Company purchased an interest rate cap agreement with a term of 5 years and quarterly settlements, the interest rate cap agreement is comprised of 20 individual cap agreements, or “caplets”, that are settled on a quarterly basis. As with the interest rate swap, the cap rate is set 3 months prior to settlement and as such, the settlement amount is known 3 months in advance.

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Interest Rate Cap Agreements

For Example, cont’d:

• With an interest rate cap, the Company that purchased the cap agreement will only receive a payment if the 3 month LIBOR closes above the cap rate. At no time will the Company be required to pay additional funds at any of the caplet settlements.

• For example, if the 3 month LIBOR rate closes at 3%, the Company will receive a payment equal to (3% - 2.6%) *10,000,000 / 4 = $10,000.

• Therefore, the Company has ensured that the effective rate of its debt will not go above 7.6% (LIBOR of 2.6%, the cap rate, plus the 5% margin on the underlying debt). However, the Company’s effective rate can go as low as the market will take it; which is not the situation with the interest rate swap.

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Interest Rate Cap Agreements

For Example, cont’d - Accounting: • Assuming an effective cash flow hedge, at each reporting date, the

Company would mark the interest rate cap to estimated fair value with the changes therein being recorded in Other Comprehensive Income.

• The $10,000 quarterly settlement, and other quarterly receipts or payments, are recorded as interest expense.

• Assuming the fair value of the interest rate cap is a positive $500,000 of which $200,000 relates to the value ascribed to the settlements to occur in the next 12 months, the entry would be as follows:

Derivatives – current asset $200,000 Derivatives – long term asset $100,000

Accumulated other comprehensive income $300,000***

*** As the Company originally recorded the $200,000 cost as a long-term derivative asset and for purposes of this example the time value is being included in effectiveness testing.

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Hedge Effectiveness Testing

• In measuring the effectiveness of a cash flow hedge, the Company must measure the correlation of the expected (hedged) result and the actual result (difference should be minimal for an effective hedge).

• In terms of a fair value hedge, the Company must measure the correlation of the change in fair value of the hedged item and the change in fair value of the derivative being utilized in the hedge.

• There are certain situations in which the Company can utilize the critical terms match method, provided that the requisite criteria are met, and can therefore presume that no-ineffectiveness exists.

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Risk Characteristics

Risk Characteristics of Interest Rate Swaps:

• The swap rate is the fixed rate of interest that the receiver (variable rate payer) demands in exchange for the uncertainty of having to pay the short term 3 month LIBOR (floating rate) over the term of the swap.

• Therefore, at the time that the interest rate swap is entered, the total present value of the fixed rate payments to be received (made) is equal to the expected value of the variable rate payments to be made (received). As such, at the date the swap is entered the value of the swap is $0, which is why there is no purchase price for the swap.

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Risk Characteristics

Interest rate swaps involve two primary risks: 1) interest rate risk

2) credit, or counterparty, risk

Interest Rate Risk:

• When a Company enters into an interest rate swap for purposes of risk management, they are stating that they are comfortable with the effective interest rate that has been set as a result of entering into the swap.

• Therefore, because actual interest rate movements do not always match expectations, from the standalone viewpoint of the swap only, swaps entail interest rate risk.

• However, when viewed in conjunction with the cash flows of the underlying debt being hedged, the variable rate receiver has effectively locked in the hedged interest rate at the time the swap was entered into as the any fluctuations in the variable rate being received will be offset by the variable rate being paid on the underlying debt and the Company is effectively left with the fixed rate + the margin on the underlying debt.

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Risk Characteristics

Credit, or Counterparty, Risk

• Swaps are also subject to the counterparty’s credit risk: the chance that the other party to the contract will default on its responsibility. Although this risk is very low – banks that deal in LIBOR and interest rate swaps generally have very high credit ratings of double-A or above – it is still higher than that of a risk-free U.S. Treasury bond.

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Risk Characteristics - Caps

• Interest rate caps are option products, and as such, share certain common characteristics with all options:

• An upfront premium is required to purchase a cap.

• The value of a cap depends upon the variability of interest rates; that is, the projected volatility of interest rates, over the life of the cap.

• The longer the maturity of the cap, the more expensive.

• A cap provides “insurance” against higher interest rates.

• The farther out-of-the-money a cap is, that is, the higher the cap rate, the cheaper it will be.

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Pros and Cons – Interest Rate Swaps

Pros • No upfront cash outlay

• Effective hedging vehicle

• Locks in an effective rate

Cons • No upside participation (no gain from decline or rise in interest rates)

• Mark-to-Market accounting can have large effect on net income

• Credit, non-performance risk

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Pros and Cons – Interest Rate Caps

Pros • Effective interest rate risk hedging vehicle with participation in gains from

decrease in interest rates.

• Can only lose premium paid, cannot go to below zero (re: no liability treatment) – Valid only on purchases of caps.

• Caps interest rate

Cons • Upfront cash outlay

• Mark-to-Market accounting can have large effect on net income although losses only to the extent premium paid.

• Credit, non-performance risk

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Hedge Documentation

Formal Documentation Under ASC 815 • ASC 815 contains explicit guidance regarding the

application of hedge accounting models, including documentation and effectiveness assessment requirements.

• One of the fundamental requirements of ASC 815 is that formal documentation be prepared at inception of a hedging relationship.

• The standard stresses the need for the documentation to be prepared contemporaneously with the designation of the hedging relationship.

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Hedge Documentation

The formal documentation must identify the following: • Entity’s risk management objectives and strategies for

undertaking the hedge • Nature of the hedged risk • Derivative hedging instrument • Hedged item or forecasted transaction • Method the entity will use to retrospectively and

prospectively assess the hedging instrument’s effectiveness • Method the entity will use to measure hedge

ineffectiveness

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Hedge Documentation

The shortcut method is an exception from the periodic effectiveness assessment and measurement requirements of ASC 815.

• The short-cut method and the circumstances in which it can be applied are limited. • ASC 815 limits its use to hedges of interest rate risk that

involve interest-rate swaps and recognized interest-bearing assets or liabilities, hedges that are often referred to as “straightforward hedges of interest rate risk.”

• It also requires that general hedge requirements such as contemporaneous formal documentation be met. It then adds additional criteria specifically for short-cut method hedges to be met.

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CURRENT EVENTS

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ASU 2014-03: Simplified Hedge Accounting

• The Simplified Hedge Accounting alternative

• The second accounting alternative provided by the Private Company Council

• Intended to provide a more cost effective method of applying hedge accounting for qualifying transactions.

• Effective date is for periods beginning after December 15, 2014.

• Early adoption is permitted.

This alternative can not be elected by an entity that is a public business entity, a not-for-profit entity, employee

benefit plan or financial institution.

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ASU 2014-03: Simplified Hedge Accounting

Only applies to qualifying receive-variable, pay-fixed interest rate swaps

• Permits hedge accounting adoption up until the financial statements are made available for issuance

• Reduced documentation to apply hedge accounting

• Use of settlement value instead of fair value

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Simplified Hedge Accounting - Requirements

The standard may be adopted for interest rate swaps that meet the following criteria:

1. Debt (hedged cash flows) and swap use the same index and reset period

2. “Plain-vanilla” swap, any floor or cap on the variable interest rate of the swap must be comparable to the same term in the debt

3. Re-pricing and settlement match or differ by no more then a few days

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Simplified Hedge Accounting - Requirements

Criteria continued: 4. Fair value of the swap at inception is at or near zero

5. Swap notional value is equal to or less then the principal of the related debt

6. All interest payments occurring on the borrowing during the term of the swap are designated as hedged whether in total or in proportion to the amount being hedged

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Simplified Hedge Accounting - Documentation and Elections

• Document the election on a swap by swap basis the election to apply the simplified-hedge accounting approach • Documentation should address each of the qualifying

criteria • Document the election to record and disclose the

swap at settlement value or fair value

• Elect to adopt using the retrospective approach or a modified retrospective approach

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Accounting for Derivatives – Project Agenda

Financial Instruments & Hedging Project • On June 6, 2008, the FASB issued an Exposure Draft,

Accounting for Hedging Activities. • Suggested some targeted changes to current hedge

accounting guidance • On May 26, 2010, the FASB issued a proposed Accounting

Standards Update, Accounting for Financial Instruments and Revisions to the Accounting for Derivative Instruments and Hedging Activities. • Feedback received from the 2008 draft was considered • Less rigorous qualitative assessment to qualify for hedge

accounting

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Accounting for Derivatives – Project Agenda

Hedging Project – June 29, 2015 Meeting • Effectiveness Threshold

• Retain the highly effective threshold • Presentation & Timing

• The change in the fair value of the hedging derivative would no longer be split between effective and ineffective portions

• Fair value hedges: if the hedging relationship meets the highly effective threshold, the entire change in the fair value of the derivative would be recorded in the same income statement line as the hedged item.

• Cash flow hedges: if the hedging relationship meets the highly effective threshold, the entire change in the fair value of the derivative would be recorded in other comprehensive income.

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Accounting for Derivatives – Project Agenda

Hedging Project – June 29, 2015 Meeting • Component Hedging

• A non-financial hedged item may be a contractually specified component or ingredient linked to an index or rate stated in the contract.

• Hedge Effectiveness Testing • Initial quantitative testing of all hedges required unless

they meet the requirements for the shortcut or critical terms match methods

• Required to perform subsequent quantitative effectiveness testing only if facts and circumstances change

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Accounting for Derivatives – Project Agenda

Hedging Project – June 29, 2015 Meeting • Disclosures

• Require additional disclosures related to cumulative basis adjustments for fair value hedges,

• Amend certain tabular disclosures in current GAAP to focus on the impact of hedge accounting on income statement line items, and

• Require enhanced qualitative disclosures to describe quantitative goals, if any, set to achieve hedge accounting objectives.

• Hedge Documentation • Quantitative testing portion of hedge documentation

requirements before or at the three-month effectiveness testing period.

• The timing of the preparation of all other hedge documentation would not change.

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Accounting for Derivatives – Project Agenda

Hedging Project – June 29, 2015 Meeting • De-Designation

• Continued to be allowed • Benchmark Interest Rates

• Variable rate - an entity may designate the contractually specified index rate in cash flow hedges of interest rate risk, thus eliminating the concept of benchmark interest rates for variable-rate financial instruments

• Fixed rate - retain the existing definition of benchmark interest rates and also add the Securities Industry and Financial Markets Association Municipal Swap Index (SIFMA) to the list of acceptable rates

• Short-Cut • An entity may apply a long-haul method if for some reason use

of the short-cut method was or is no longer appropriate (method must be documented at inception).

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? QUESTIONS

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If You Enjoyed This Webinar…

Upcoming courses: • 8/27 & 9/11: PPA Plan Restatement - Emerging Opportunities for Pre-Approved Plans

• 9/1: How to Make the Most Out of Derivatives and Hedging

• 9/8 & 11/11: Revenue Recognition Updates for Manufacturers

• 9/17: Controlling and Managing Healthcare Costs - Practical Guidance to Maximize Value

• 9/17: Creative Ways to Structure Bonus Plans and Ensure Current Tax Deduction

Recent Thought Leadership: • Enhance Your Organization's Cybersecurity Strategy

• Proposed Changes to Family Valuation Discounts

• Six Ways the AICPA Plans to Improve Audit Quality

• Modifications Coming to Inventory Measurement

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