| As we previously informed you in Audit Information Bulletin #9503 dated January 19, 1995, the Financial Accounting Standards Board (FASB) adopted a tentative change to the current treatment of hedge accounting for derivative instruments. The change would have effectively replaced current hedge accounting practices with a mark-to-market model for derivative instruments. The CME actively opposed the FASB�s position since gains and losses from hedge derivatives and the corresponding hedged item would not necessarily be matched in the same accounting period. The CME was also concerned that transactions which had the same economic result (e.g. futures contracts versus forward contracts) would be accounted for differently. As a result of widespread criticism from numerous institutions, including the CME, the FASB decided to propose a different model at its January 11, 1996 meeting. Under the new proposal, all derivatives would be measured at fair value and recognized on the balance sheet. Current practice is to account for derivatives as off-balance-sheet items. Firms would be able to offset gains and losses between derivatives designated as hedges and the corresponding hedged item. Gains and losses for derivatives used to hedge anticipated transactions could be deferred until the forecasted transaction occurs. Gains and losses for all other derivatives (trading, non-hedging instruments, etc.) would be recognized in earnings. Attached is a more detailed overview of the proposal. The FASB is planning to issue an Exposure Draft of its proposal on derivatives accounting by June 30, 1996. However, many important issues must still be resolved. We will continue to keep you informed of any significant developments. If you have any questions, please contact the Audit Department at (312) 930-3230.
Derivatives Accounting Proposal 1. Recognition and Measurement of Derivative Financial Instruments All derivatives shall be recognized in the statement of financial position as assets or liabilities and measured at fair value.
2. Basics of Accounting for Gains and Losses - Gains and losses on derivatives shall be accounted for in different ways depending on the designated reason for holding the instrument:
- For instruments designated as hedges of forecasted transactions, gains and losses shall be reported as components of comprehensive income outside of earnings and recognized in earnings when the forecasted transaction occurs.
- For instruments designated as hedges of assets and liabilities, including firm commitments. gains and losses shall be included in earnings; however. offsetting losses and gains on the hedged item are accelerated and recognized in earnings in the same period.
- For all other derivatives, including derivatives designated as trading, derivatives not designated as hedges, and derivatives designated as hedges of other derivatives, gains and losses shall be recognized in earnings.
3. Accounting for Hedges of Forecasted Transactions Derivatives may be designated as hedges of forecasted transactions only if the following conditions are met:
- Consistent with an articulated policy for risk management
- Designation is prospective
- Designation is formally documented
- Forecasted transaction is specifically Identified
- Forecasted transaction is probable
- Forecasted transaction is part of an established business
- Derivative is expected to have cash flows that will offset the changes in cash flows of the hedged transaction.
4. Designation of a derivative as a hedge of a forecasted transaction shall continue in effect until the designated date of the forecasted transaction. If the hedging instrument is sold or closed out before the date of the forecasted transaction. the gain or loss accumulated to that point shall remain in equity and shall be recognized in earnings only at the designated date of the forecasted transaction. If the hedging instrument ceases to qualify for designation for example because the cash flows are no longer expected to offset changes in the cash flows of the forecasted transaction), hedge accounting shall be discontinued prospectively, i.e., the gain or loss accumulated to that point shall remain in equity and shall be recognized in earnings only at the designated date of the forecasted transaction. 5. Gains and losses on hedges of forecasted transactions shall not be added to the basis of an asset or liability that results from the transaction. 6. Accounting for Hedges of Assets and Liabilities Derivatives may be designated as hedges of specific assets or liabilities (including firm commitments) only if the following conditions are met:
- Transaction is consistent with an articulated policy for risk management
- Designation is prospective
- Designation is formally documented
- Both the hedging item and the hedged item have reasonably determinable fair values
- Changes in fair value of the derivative are expected to offset the changes in fair value of the hedged asset or liability.
7. A firm commitment is a contract that obligates both parties to make an exchange and specifies the price and quantity to be exchanged. A firm commitment is an asset and a liability of each party, but that asset and liability generally are not recognized in current practice. Recognizing a gain or loss on a firm commitment entails recognizing the previously unrecognized asset or liability, measured at the amount of the gain or loss on the hedging item. 8. For Instruments designated as hedges of assets and liabilities, including firm commitments, gains and losses are included in earnings; however, offsetting losses and gains on the hedged item are also accelerated and recognized in the same period. Accelerating the gain or loss on the hedged item has the effect of offsetting the change in earnings that would otherwise result from recognizing the loss or gain on the hedging instrument. Accelerating the gain or loss on, the hedged item also has the effect of adjusting the amortized historical cost amount of that asset or liability toward its fair value. The amount of the gain (or loss) accelerated is the lesser of the loss (or gain) on the hedging instrument or the unrecognized gain (or loss) on the hedged item. to top |
