EXECUTIVE EDUCATION SERIES: Hedge Accounting

Presented by: Shareholders

Mike Loritz and James Comito

October 10, 2013

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Before We Get Started…

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The information in this Executive Education Series

course is a brief summary and may not include all the details relevant to your situation.

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discuss the impact on your financial statements.

Disclaimer

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Today’s Presenters

James Comito, CPA Shareholder 858.795.2029 | jcomito@cbiz.com A member of MHM’s Professional Standards Group, James has expertise in all aspects of revenue recognition, business combinations, impairment of goodwill and other intangible assets, accounting for stock-based compensation, accounting for equity and debt instruments and other accounting issues. Additionally, he has significant experience with a variety of other regulatory and corporate governance issues pertaining to publicly traded companies, including all aspects of internal control. In addition, James frequently speaks on accounting and auditing matters at various events for MHM.

Mike Loritz, CPA Shareholder 913.234.1226 | mloritz@cbiz.com Mike has 17 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, investment securities, share-based compensation, fair value, revenue recognition and others.

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Today’s Agenda

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Derivatives Accounting - History

Risk Management

Hedging – Economic vs. Accounting

4 Presentation and Disclosures

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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Accounting for Derivatives - The History

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

No significant progress on the Hedging Project since the 2010 Exposure Draft.

DERIVATIVES & RISK MANAGEMENT

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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 the use by large banks & some brokers (commodities) Hedging accounting does not apply

Speculation Trading derivative products in order to take a position in the market

(betting on future movements) Hedge accounting does not apply

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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 it’s 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 $100 million

in debt

Bond Holders

Pays LIBOR + 2%

Swap Agreement with Bank A

Receives LIBOR + 2%

Pays fixed 5%

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Common Types of Derivatives

Option-Based Interest rate cap or floor Put or call option (equity)

Currency

Forward Agreements

Forward Rate Foreign exchange

Commodity

Future Agreements Equity

Currency Commodity

Swaps Interest rate

Currency Commodity

Credit Default

Forward Based

WHAT IS HEDGING?

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? From an economic standpoint,

hedging is using derivative instruments to offset risks (or volatility) that are present in a company’s business model in order to maintain a predictable outcome.

• Fair value: maintain the fair value of an item

• Cash flow: achieve predictable cash flows

From an accounting standpoint, there are specific criteria that must be met prior to a company’s implementation of hedge accounting.

What is Hedging?

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What is Hedging?

Derivatives that are accounted for as freestanding are recorded at fair value at each reporting date with the change recorded in earnings.

Derivatives that are accounted for as hedging instruments are also recorded at fair value; however, the accounting for the impact to earnings is based upon the type of hedge that has been implemented.

Regardless of whether hedge accounting is utilized, ALL derivatives are recorded on the balance sheet at their estimated fair value.

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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 (i.e. item has fixed cash flows).

Foreign currency hedge - If the hedged item is denominated in a foreign currency, then an entity may designate the hedge as either of the above or a net investment hedge.

What is Hedging?

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.

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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.

Intent is to convert a fixed cash flow instrument with a

variable fair value to a fixed fair value.

EXAMPLE: FIXED RATE DEBT Special treatment = Hedged Item

Types of Hedging

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Types of 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 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.

Intent is to convert a variable cash flow instrument to a

predictable set of cash flows.

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Cash Flow Hedge

EXAMPLES: VARIABLE RATE DEBT, FORECASTED SALES & PURCHASES

Special Accounting Treatment:

The unrealized gain/loss on the hedging instrument

Types of Hedging

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Types of Hedging

Foreign Currency Hedge Foreign currency hedges designated as either fair

value hedges or cash-flow hedges are accounted for in the same manner a typical fair value and cash flow hedges. Forward purchase/sale

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.

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Types of Hedging

Foreign Currency Hedge 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.

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Types of Hedging

Foreign Currency Hedge Example: A US domiciled company with foreign operations wishes to decrease the potential volatility to equity as a result of the currency translation adjustment. The company could enter into a foreign currency derivative (i.e. option, currency swap, forward, etc.) to hedge the volatility. This is similar to a fair value hedge.

Special Accounting Treatment The unrealized gain/loss on the hedging instrument

is recorded as a component of the currency translation adjustment.

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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.

Stresses the need for the documentation to be prepared contemporaneously with the designation of the hedging relationship.

ASC 815

ASC 815

Hedging is a Privilege, Not a Right!

Formal Documentation Under ASC 815 Hedge Documentation

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You can replace this text with

your own text. Keep the text

short and simple

Hedging relationship

Documentation must include:

Hedge Documentation

• 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.

• How ineffectiveness will be measured

Entity’s risk management objective and strategy for

undertaking the hedge

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Hedge Documentation – Effectiveness Assessment:

Both at the inception of the hedge and on an ongoing basis, the hedging relationship is expected to be highly effective in achieving 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

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.

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Types of Hedging

Perfectly Effective Hypothetical Derivative The PEH has terms that identically match the critical terms of the floating-rate asset or liability:

same notional amount, same re-pricing dates, the index on which the hypothetical swap's variable rate is based

matching the index on which the asset or liability's variable rate is based, mirror image caps and floors, and a zero fair value at the inception of the hedging relationship

The hypothetical swap would be expected to perfectly offset the hedged cash flows. The change in the fair value of the "perfect" hypothetical swap can be regarded as a proxy for the present value of the cumulative change in expected future cash flows on the hedged transaction.

REPORTING & DISCLOSURE REQUIREMENTS

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Disclosures

Users of the financial statements should be able to understand: How and why an entity uses derivative instruments (or

such non-derivative instruments) How derivative instruments (or such non-derivative

instruments) and related hedged items are accounted for under Topic 815:

How derivative instruments (or such non-derivative instruments) and related hedged items affect all of the following: An entity’s financial position An entity’s financial performance An entity’s cash flows.

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Disclosures

Disclosures regarding hedging activities: The Company’s objectives for holding or issuing such

instruments The context needed to understand those objectives The strategies for achieving those objectives Information that would enable users of the financial

statements to understand the volume of activity in those instruments May be presented in various formats, including description, tabular,

etc.

Disclosures should be disaggregated by risk exposure.

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Disclosures

Disclosures regarding hedging activities: Disclosures should be further disaggregated by type: Fair Value hedge Cash Flow hedge Net investment in a foreign subsidiary Those used as economic hedges (but not designated as such)

Location and fair value of derivative instruments as

well as the gains/losses Should be presented in tabular format & disaggregated by type Should be reported gross

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Questions?

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The requisite hedge accounting

documentation

Maintenance of hedge accounting - Effectiveness testing,

ineffectiveness - Additional transactions

Accounting and reporting

(disclosures)

Valuation Structuring and risk management

Sensitivity analyses

CBIZ & Mayer Hoffman McCann P.C.

MHM’s Derivatives Assistance Group

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If You Enjoyed This Webinar…

Join us for these related EES courses: Dec. 17: Fourth Quarter Accounting and Financial Reporting

Issues Update Archived recording: Commodity Hedging – A Risk

Management Tool Against Price Volatility of Commodities

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