1. Financial Reporting for Derivatives and Risk Management Activities Thomas J. Linsmeier University of Illinois AAA Annual Meeting August 16, 1998

2. 2 Workshop Topics zCommon types of derivatives zRisk management activities zNew financial reporting standards yFASB Statement 133 ySEC Financial Reporting Release 48 xAttend session at 10:30 a.m. tomorrow zIllustrative examples zEvaluation of Statement 133

3. 3 What Are Derivatives? z“Derivatives”-- A generic term used to describe a wide variety of financial and commodity instruments whose value depends on or is derived from the value of an underlying asset/liability, reference rate, or index.

4. 4 Common Derivatives zForwards / Futures zOptions zSwaps zHybrids / Embedded derivatives

5. 5 LongShort Cash Market LongShort Forward Market Agree to Terms Cash Market Price Now Forward Price Future Date Instrument or Commodity Forward / Future Contracts Obligate one party to buy and another party to sell an underlying instrument or commodity at a future date Instrument or Commodity

6. 6 Options zOptions provide the holder the right, but not the obligation, to buy or sell the underlying instrument or commodity at a predetermined price called the “strike” or “exercise” price zOptions normally are in the form of a “Call” or a “Put” yCalls - enable the holder to buy the underlying instrument or commodity at the strike price yPuts - enable the holder to sell the underlying instrument or commodity at the strike price zRequire “up-front” payment or “premium”

7. 7 Purchased Call Purchased Put Exercise Price Price of underlying instrument Payoff Payoff Profiles of Purchased Puts and Calls Price of underlying instrument Exercise Price Payoff

8. 8 Swaps zTwo parties exchange recurring payments zSimilar to series of forward contracts zInterest-rate swaps most common

9. 9 Note: LIBOR is London Interbank Offered Rate Fixed-Rate Payer Fixed-Rate Receiver Floating Rate (LIBOR) X Notional Principal Fixed Rate of 6.75% X Notional Principal “Plain-Vanilla” Interest Rate Swap

10. 10 Importance of Forwards, Futures, Swaps, and Options zInstruments that involve the exchange of cash flows zCan be used to alter existing cash flows zComprise the basic risk management tools

11. 11 Hybrid Instruments: Embedded Derivatives zSimple derivatives are the fundamental building blocks of these complex structures zStructured note: Note with embedded option or swap zComplex swap: “Plain vanilla” swap with embedded options or leverage features

12. 12 Managing Risks with Derivatives zLow cost, ease, and speed of transacting make derivatives attractive for managing risk zDifferent derivatives provide means of adjusting the timing, amount, and variability of cash flows / fair values zIdeal for both hedging and speculation

13. 13 How Are Derivatives Used? zRisk management (hedging) yCommodity price risk yInterest rate risk yForeign currency price risk zSpeculation

14. 14 Commodity Price Risk zCost of mining gold: $350 per pounce zCurrent gold spot price: $400 per ounce zGold reserves sufficient for ten years of production zCompany exposed to risk of decreases in future prices of gold zCash flow exposure yforecasted transaction

15. 15 Original Exposure Gold Production Cost Upside potential Downside Risk 50 400 Gold price Profit Loss 350

16. 16 400 Gold price 0 Risk Management Tool: Short Forward Current forward price Profit Loss

17. 17 Original Exposure Net Position Short Forward Net Position: $50 Profit “Locked in” 50 400 350 Gold price Profit Loss

18. 18 Interest Rate Risk zCompany issued a $100 million floating rate note with interest payments based on LIBOR zInterest expense: LIBOR X $100 Million zLIBOR currently is 7% zCompany exposed to risk of increases in LIBOR zCash flow exposure yexisting liability

19. 19 Interest Expense $7 Million (.07 x $100. million) 0 7% LIBOR Risk of increase Potential decrease Exposure at Each Interest Payment Date

20. 20 Fixed-Rate Payer Company with Exposure Bank or Other Intermediary Receive Floating Rate (LIBOR) X Notional Principal Pay 7.00% Fixed Rate X Notional Principal Risk Management Tool: Interest Rate Swap Fixed-Rate Receiver

21. 21 $7 Million (.07 x $100 Million) 0 7 % Net Net Outflow on Swap Negative Outflows = Inflows from Swap Outflows from Swap Risk Management Tool: Interest Rate Swap Pay Fixed Rate of 7%, Receive LIBOR LIBOR

22. 22 $7 Million Net Interest Expense 0 7% Negative Outflows = Inflows from Swap Outflows from Swap Original Interest Expense Net Position at Each Interest Payment Date

23. 23 Reducing Funding Costs With Derivatives zSwapping floating-rate cash flows to fixed-rate reduces funding costs only if rates increase zSwapping fixed-rate cash flows to floating-rate reduces funding costs if rates decrease zFunding costs reduced by “expressing a view” (i.e., by betting on movements in future interest rates)

24. 24 Foreign Currency Price Risk zUS Company commits to purchase machinery from a French manufacturer zPayment of 10 million French francs (FF) to be made six months from now zCurrently $US/FF exchange rate $.20 per FF zUS Company is exposed to risk of increases in the $US price of a FF zFair value exposure yfirm commitment

25. 25 Cost (in $US) 0.20 Risk of Increased $US Cost $2 Million ($.20/FF x FF10 Million) $US Price of a FF Current Exchange Rate Original Exposure

26. 26.25 Exercise price $US price of a FF Payoff in $US Risk Management Tool: Purchased Call Option Strategic Issues: zCompany believes the price of a FF may go down zCompany does not want to pay more than $2.5 million for machinery.

27. 27.25.20 Option payoff functions as a reduction in cost Option payoff $2.5 million NET COST 0 original exposure Net Cost of Machinery Cost (in $US) $2 million $US price of a FF

28. 28 Speculation with Derivatives zSpeculation primarily domain of dealers and sophisticated traders zSpeculative trading based on investors’ views of future market movements zUsing interest rate swaps to reduce funding costs also requires “expressing a view” (i.e. form of speculation) zQuery: Is risk management much different from speculation?

29. 29 Speculating with Derivatives zA manufacturing company anticipates that a certain commodity will soon drop in price. zTo exploit this belief, the company sells the commodity for forward (or future) delivery at a price reflecting the current market consensus zIf the price does decline, the company can buy the commodity in the spot market and deliver it against the forward contract zProfit = Forward price - spot price

30. 30 FASB Statement 133* “Accounting for Derivative Instruments and Hedging Activities” * Portions of the FASB's, "A Review of Statement 133-Accounting for Derivative Instruments and Hedging Activities," copyright 1998 by the Financial Accounting Standards Board, Norwalk, Connecticut 06856, are included by permission.

31. 31 Statement 133: Why The Change? zQuantity and variety of derivatives is increasing zAccounting conventions and standards are outdated, incomplete, and inconsistent zThe resulting financial statements are not transparent

32. 32 Four Cornerstone Decisions of Statement 133 zDerivatives are contracts that create rights and obligations that meet the definition of assets and liabilities zFair value is the only relevant measure for derivatives zOnly assets & liabilities should be on balance sheet zSpecial hedge accounting should be provided, but should be limited to transactions involving offsetting changes in fair values or cash flows for the risk being hedged

33. 33 Statement 133: Key Aspects zAll derivatives are at fair value on the balance sheet zSpecial accounting for the change in value of derivatives designated and qualifying in: yFair value hedges yCash flow (forecasted transaction) hedges yForeign currency hedges

34. 34 Why Allow Hedge Accounting? zTo resolve recognition and measurement anomalies zThese anomalies cause earnings effects in different periods for hedging instrument and hedged item

35. 35 Common Reporting Issues: Qualifying Hedges zDocumentation requirements zEffectiveness and ineffectiveness zGeneral disclosure requirements zSpecific accounting and disclosure rules yfair value, cash flow, foreign currency hedges zHedge termination zImpairment

36. 36 Documentation Requirements (Paragraphs 20(a), 28(a)) Formal documentation is required at the inception of the hedge and must include: yIdentification of the hedging instrument and the hedged item yThe nature of the risk being hedged yThe risk management objective/strategy yHow effectiveness will be assessed

37. 37 Required Documentation - Example of Cash Flow Hedge of Note Purchase zOn 1/1/x1, XYZ purchases a call option on 5- year treasury notes as a hedging instrument in a cash flow hedge of a forecasted $100 million 5-year treasury note purchase at 12/31/x1 zXYZ designates the decreases in cash flows related to decreasing interest rates as the hedged risk zFor effectiveness measurement, the call premium is excluded from the test. The call option notional amount and forecasted note amount match.

38. 38 Effectiveness (Paragraphs 20 and 28) zEffectiveness is defined as the derivative instrument’s ability to generate offsetting changes in the fair value or cash flows of the the hedged item. Key aspects: yFor both fair value and cash flow hedges, the hedge is expected to be highly effective yEffectiveness is measured at inception and must be assessed whenever earnings are reported (at least quarterly) yEffectiveness measures intended to be similar to “high correlation” in Statement 80

39. 39 Example of Highly Effective Fair Value Hedge 6/30/x112/31/x1

40. 40 Hedge Effectiveness Test zAn item may be excluded from the effectiveness test because it does not provide offsetting cash flows, such as an option’s time value (time value is the amount paid for the option, excluding payments for intrinsic value) zAn item may be included in the effectiveness test, but may generate ineffectiveness

41. 41 Effectiveness Implications zIf the highly effectiveness test is failed, the entire hedge does not qualify for special accounting zIf the highly effectiveness test is met, some ineffectiveness may occur and a portion of the derivative gain or loss may be recorded through earnings zIneffectiveness is recorded differently in cash flow and fair value hedges, depending on the hedging relationship

42. 42 Ineffectiveness (Paragraphs 22 and 30) Items included in the effectiveness test that may generate ineffectiveness include: yDifferent value of hedged item and notional principal yDifferent maturity or repricing dates yDifferent underlying interest rate basis e.g. LIBOR versus Prime yCurrency differences yCredit differences

43. 43 General Disclosure Requirements (Paragraph 44) For all derivative instruments that qualify as hedging instruments, the entity shall disclose for each type of hedge the: yObjectives for holding derivatives yContext needed to understand those objectives yStrategies for achieving those objectives yEntity’s risk management policy yDescription of the items or transactions that are being hedged.

44. 44 Accounting for Fair Value Hedges (Paragraphs 20-27) A fair value hedge is a hedge of the exposure to a change in fair value of a recognized asset or liability or of an unrecognized firm commitment attributable to a particular risk. Key aspects: yAssets or liabilities exposed to price risk yChange in value of hedged item and hedging instrument recorded in earnings yResult is matching for effective hedge yEffective gain or loss adjusts basis of hedged item

45. 45 Board Views - Fair Value Hedges zFair value hedging is reasonable because the hedged item is a firm commitment or an asset or a liability zOffsetting fair value changes of the hedged item and the hedging instrument through earnings provides a natural offset

46. 46 Disclosure Requirements: Fair Value Hedges (Paragraph 45(a)) zNet gain or loss recognized in earnings during the reporting period representing : yhedge ineffectiveness ythe component of the derivatives gain or loss excluded from the assessment of hedge effectiveness ywhere the net gain or loss is reported zThe amount of net gain or loss is recognized in earnings when a hedged firm commitment no longer qualifies as a fair value hedge.

47. 47 Accounting for Cash Flow Hedges (Paragraphs 28-35) A cash flow hedge is a hedging relationship where the variability of the hedged item’s cash flows is offset by the cash flows of the hedging instrument. Key Aspects: yForecasted transactions or balance sheet items with variable cash flows qualify yEffective gain or loss to OCI yEarnings recognition matches hedged item yIneffective gain or loss may be recorded in earnings

48. 48 Board Views - Cash Flow Hedges zBoard decided to permit cash flow hedge accounting as an accommodation to constituents zBecause the hedged forecasted transaction is not recorded on the books, derivative gains and losses are deferred in other comprehensive income (OCI), adding a layer of complexity

49. 49 Board Views - Cash Flow Hedges (continued) zGains and losses on derivative contracts do not represent future economic sacrifices (liabilities) or benefits (assets) zDeferring gains or losses on derivatives as a separate component of OCI, rather than as a separate asset or liability, avoids conceptual difficulties and increases visibility for cash flow hedge transactions

50. 50 Disclosure Requirements: Cash Flow Hedges (Paragraph 45(b)) zNet gain or loss recognized in earnings during the reporting period zDescription of transactions or other events that will result in reclassification of gains and losses deferred in accumulated OCI into earnings within next 12 months zMaximum length of time entity is hedging forecasted transaction variable cash flows zDiscontinued hedge gains and losses because it is probable forecasted transaction will not occur

51. 51 Accounting for Currency Hedges (Paragraphs 36-42) Board intended to increase the consistency of hedge accounting guidance by broadening the scope of eligible foreign currency hedges. Key aspects: yCash flow and fair value hedges permitted yCarry forward most of the ideas in Statement 52 xHedge of net investment in sub xUse of nonderivative instrument ySome expansion of hedge accounting particularly for forecasted transactions

52. 52 Accounting for Hedge Termination (Paragraph 25) Terminate hedge accounting prospectively when: yeligibility of qualification criteria not met yderivative expires, is sold, terminated or exercised yhedge designation is removed

53. 53 Impairment Issues (Paragraph 27) zHedged item is still subject to impairment reviews zApply after basis of hedged item is adjusted for changes in fair value or cash flows zFair value of hedging instrument is not considered

54. 54 Implementation Issues zWhat qualifies as a derivative instrument, including embedded derivatives? ySee Paragraphs 6-16, Appendix A, Section1, and Appendix E zWhat qualifies as a hedged item? ySee Paragraphs 21 and 29 and Appendix C

55. 55 Implementation Issues (continued) zAssessment of hedge effectiveness ySee Appendix A, Section 2 zTransition provisions ySee Paragraphs 48-56 and Appendix B, Section 3

56. 56 Illustrative Examples zFair value hedge zCash flow hedge zAppendix B, Section 1

57. 57 Definition of a Fair Value Hedge A fair value hedge is a hedge of the exposure to a change in fair value of a recognized asset or liability or of an unrecognized firm commitment attributable to a particular risk. 6/30/x1 12/31/x1

58. 58 DEFINITION OF FAIR VALUE Fair value is defined as the amount at which an asset (or liability) can be bought (or incurred) or sold (or settled) in a current transaction between willing parties, other than in a forced or liquidation sale. yQuoted market prices are the best indicator. yIn the absence of quoted prices, use other valuation techniques.

59. 59 DEFINITION OF A RECOGNIZED ASSET OR LIABILITY zA recognized asset or liability is defined as an asset or liability recorded on the balance sheet (i.e., not a future transaction or an unrecorded intangible asset). zHedgeable assets or liabilities include: y Available-for-sale securities y Commodity-type inventory y Fixed-rate loan obligations

60. 60 DEFINITION OF A FIRM COMMITMENT zA firm commitment has the characteristics of an asset or liability and must be: xSpecific as to price, quantity, and timing xWith an unrelated party, binding on both parties and usually legally enforceable xProbable due to significant disincentive for nonperformance zExample: Agreement with an unrelated party to purchase five machines (a fixed quantity) for $500 per machine (a fixed price) in six months (fixed timing)

61. 61 Fair Value Hedge Accounting Key concepts: zDerivatives are always recorded on the balance sheet at fair value. zThe change in a derivative’s fair value is always recognized in earnings. zOffsetting gains/losses on hedged items are recognized in earnings and adjust the carrying amount of those items.

62. 62 STATEMENT 133 CRITERIA: Hedgeable Items Changes in fair value of the following items can be hedged: zFinancial assets or liabilities (four specific risks can be hedged) zNon-financial assets or liabilities (the only risk that can be hedged is the risk of changes in fair value of the entire hedged asset or liability) Note: Assets or liabilities already measured at fair value through earnings, such as trading securities, cannot be hedged items.

63. 63 STATEMENT 133 CRITERIA: Risks That Can Be Hedged zFor financial assets or liabilities, the hedged risk can be the risk of changes in fair value : yOf the entire hedged item yDue to market interest rates yDue to foreign currency exchange rates yDue to an obligor’s creditworthiness zNote: Prepayment risk cannot be the hedged risk. (However, the option component of a prepayable instrument can be designated as the hedged item.)

64. 64 Transactions not affecting earnings do not qualify for hedge accounting, such as: STATEMENT 133 CRITERIA: Items Not Qualifying For Hedge Accounting zProjected purchases of treasury stock zIntercompany transactions (except foreign currency) zAnticipated stock issuances in relation to a stock option plan for which no compensation expense is recognized for changes in stock price

65. 65 STATEMENT 133 CRITERIA: Items Not Qualifying For Hedge Accounting (continued) zOther exclusions: yEquity method investments yMinority interests in consolidated subsidiaries yEquity investments in consolidated subsidiaries yFirm commitments to enter into business combinations yAn equity instrument issued by the entity and recorded in stockholders equity

66. 66 Example: Fair Value Hedge of Firm Commitment zXYZ manufactures titanium products. Its titanium supplier requires a 6-month firm commitment. On 1/1/x1, XYZ enters into a firm commitment with its supplier to buy 10,000 units of titanium at the current forward rate of $310 per unit on 6/30/x1. zXYZ wants to purchase and record the titanium at whatever the market price will be on 6/30/x1. Therefore, on 1/1/x1, XYZ enters into a forward contract to sell 10,000 units of titanium at the current forward rate of $310 per unit. zHedge effectiveness is based on changes in the 6/30/x1 forward price of titanium.

67. 67 Example: Fair Value Hedge of Firm Commitment $128,709 = (310 - 297) * 10,000, present valued at 6% for 3 months $250,000 = (310 - 285) * 10,000

68. 68 Example: Fair Value Hedge of Firm Commitment Journal entries at 3/31/x1: Forward contract128,079 Gain on forward contract128,079 To record change in fair value of forward contract Loss on firm commitment128,079 Firm commitment128,079 To record change in fair value of firm commitment

69. 69 Example: Fair Value Hedge of Firm Commitment Journal entries at 6/30/x1: Forward contract121,921 Gain on forward contract121,921 To record change in fair value of forward contract Loss on firm commitment121,921 Firm commitment121,921 To record change in fair value of firm commitment ($121,921 = $250,000 less $128,079)

70. 70 Example: Fair Value Hedge of Firm Commitment Journal entries at June 30 (con’t): Cash 250,000 Forward contract 250,000 To record cash receipt upon settlement of forward contract

71. 71 Example: Fair Value Hedge of Firm Commitment Journal entries at June 30 (con’t): Titanium 3,100,000 Cash 3,100,000 To record purchase of titanium at contracted rate Firm Commitment 250,000 Titanium 250,000 To derecognize the firm commitment and adjust the carrying amount of the titanium purchase

72. 72 Cash Flow Hedge A cash flow hedge is a hedging relationship where the variability of the hedged item’s cash flows are offset by the cash flows of the hedging instrument.

73. 73 Statement 133 Criteria: Hedgeable Items Cash flow hedge provisions allow an entity to designate a derivative instrument as a hedge of the exposure to variability attributable to specific risks in the cash flows of: yA recognized asset or liability such as a variable-rate bond yA forecasted transaction such as an anticipated issuance of a fixed-rate debt

74. 74 Statement 133 Criteria: Financial Asset and Financial Liability Hedgeable Risks For forecasted purchase or sale of a financial asset or liability, hedgeable cash flow risks include: yChanges in the cash flows relating to the purchase or sale of the entire asset or liability yChanges in market interest rates yChanges in the obligor’s creditworthiness

75. 75 STATEMENT 133 CRITERIA: Eligible Forecasted Transaction The eligible forecasted transaction must be: zA single transaction or a group of individual transactions zProbable to occur zWith a third party external to the reporting entity and present an exposure to variations in cash flows for the hedged risk that could affect reported earnings

76. 76 STATEMENT 133 CRITERIA: Ineligible Forecasted Transaction The following items do not qualify for hedging: zItems subject to remeasurement with changes in value attributable to the hedged risk reported currently in earnings zInterest rate risk of the forecasted purchase or sale of a held-to-maturity security zForecasted business combinations subject to Opinion 16 or related to a parent company's interest in a consolidated subsidiary or an equity-method investment

77. 77 STATEMENT 133 CRITERIA: Earnings Recognition zAn entity’s risk management strategy may exclude a component of a derivative’s change in fair value yThis amount is recognized currently in earnings zOther ineffective portions of hedge may be recognized in earnings yIs change in derivative less than change in hedged item? zAmounts in OCI shall be reclassified to earnings when the hedged item affects earnings

78. 78 Example: Cash Flow Hedge of Forecasted Inventory Sale zABC designated the risk being hedged as its cash flows related to a forecasted sale of 100,000 bushels of Commodity A at the end of period 1 (the bushels originally were acquired for $1 million). zOn the first day of period 1, ABC enters into Derivative Z to sell 100,000 bushels at $1.1 million at the end of period 1. At hedge inception, the derivative is at-the- money (i.e., its fair value was zero). zHedge has no ineffectiveness because all terms of the forecasted sale and the derivative match. zAt the end of period 1, Derivative Z has a fair value of $25,000 and the 100,000 bushels of Commodity A were sold for $1.075 million.

79. 79 Example: Cash Flow Hedge of Forecasted Inventory Sale Journal entries at end of period 1: Derivative Z 25,000 OCI25,000 To record Derivative Z at fair value Cash 25,000 Derivative Z25,000 To record settlement of Derivative Z

80. 80 Example: Cash Flow Hedge of Forecasted Inventory Sale Journal entries at end of period 1: Cash 1,075,000 Revenue1,075,000 COGS1,000,000 Inventory1,000,000 To record inventory sale OCI 25,000 Earnings25,000 To reclassify amount in OCI to earnings upon inventory sale

81. 81 Example: Cash Flow Hedge of Forecasted Inventory Sale Forecasted cash flows:$1,100,000 Actual cash flows: Derivative $25,000 Sale of inventory$1,075,000 $1,100,000 Variability of cash flows is offset by derivative

82. 82 Advanced Topics zAccounting (1) for the ineffective portion of a hedge and (2) for fair value and cash flow hedges when swaps are the hedging instrument ySee Appendix B, Section1 zAccounting for foreign currency risk in the net investment in a subsidiary ySee FASB Statement 52

83. 83 Advanced Topics (continued) zApplication of the clearly and closely related criterion to determine the existence of embedded derivatives ySee Appendix B, Section 2 zHedging of a portfolio of similar assets or similar liabilities ySee Paragraph 21(a)(1) and Appendix C

84. 84 Advantages of Statement 133 zA clear improvement over existing practice zIncreases transparency of derivatives in financial statements zProvides a complete and consistent accounting model for all types of derivatives and hedging activities zGuidance is consistent with the Conceptual Framework

85. 85 Disadvantages of Statement 133 zExtremely complex standard zFor fair value hedges, hybrid nature of measurement attribute for hedged item zPromotes risk management at transaction level zPromotes derivatives as only hedging instrument

86. 86 A Look to the Future zIs hedge accounting warranted? yRisk management also involves “taking a view”, which is similar to speculation zFair value all financial instruments zDiscontinuation of cash flow hedges of forecasted transactions?

87. 87 Closing Remarks zFor electronic copies of the slides for use in classroom presentations at a college or university, please contact me at linsmeie@uiuc.edu zThanks for your attention!