There is no doubt about it – FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, is one of the most complex accounting principles out there.  Since it was issued in 1998, there have been many interpretations and clarifications regarding the application of this Statement.  There also have been many financial statement restatements due to its misapplication.  Although Statement No. 133 is very complicated, many restatements can be traced back to misapplication of three important basic requirements:

• Initially identifying a derivative instrument;
• Documenting a hedged item sufficiently and at inception of the hedging relationship; and
• Measuring hedge effectiveness accurately and periodically.

This article includes reminders about these basic concepts. 

Reminder No. 1 - Look for the Derivative
A common source of financial statement restatements is not recognizing that a derivative instrument exists in the first place.  Because all derivatives are assets or liabilities that must be recorded on the balance sheet at fair value, it is important to be able to identify a derivative.  A derivative instrument is a financial instrument or other contract with all of the following characteristics:

• It has (1) one or more underlyings and (2) one or more notional amounts or payment provisions or both. 
• It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market forces.
• Its terms require or permit net settlement, it can readily be settled net by a means outside the contract, or it provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.

An underlying is a variable that, along with either a notional amount or a payment provision, determines the settlement of a derivative.  An underlying may be a price or rate of an asset or liability but is not the asset or liability itself.  A notional amount is a number of currency units, shares, bushels, pounds, or other units specified in the contract.  Below are some common derivative contracts with the underlying and notional amounts identified:

As noted above, certain contracts for the purchase or sale of commodities and/or inventories may meet the definition of a derivative.  These contracts need not be accounted for as derivatives, however, if they meet the definition of “normal purchases or sales,” and the company has documented its basis for that conclusion.  Failure to comply with the documentation requirements precludes application of the normal purchases and sales exception and will require a company to follow derivative accounting for the contract.
Contracts that do not in their entirety meet the definition of a derivative instrument, such as bonds, insurance policies, and leases, may contain “embedded” derivative instruments — implicit or explicit terms that affect some or all of the cash flows or the value of other exchanges required by the contract in a manner similar to a derivative instrument.  An embedded derivative instrument must be separated from the host contract and accounted for as a derivative instrument pursuant to Statement No. 133 if certain criteria are met. 

Once a contract or financial instrument has been determined to meet the definition of a derivative, it must be recognized as either an asset or liability and measured at fair value. The affect on the income statement is dependent on whether the derivative is designated as a hedge and if so, what type of hedge. 

Reminder No. 2 - Document the Hedge
Many companies would like to elect the privilege of hedge accounting treatment allowed by Statement No. 133 (designating transactions as fair value hedges, cash flow hedges, or foreign currency hedges), but not all companies are diligent in meeting the requirements to do so.  Yes, hedge accounting is a privilege.  Statement No. 133 requires that certain criteria be met for all types of hedges in order for them to qualify for hedge accounting.  There also are additional criteria that are unique to each specific type of hedge. 

To qualify for hedge accounting, hedge documentation must be prepared at inception of the hedging relationship.  Inadequate or incomplete documentation, in and of itself, will disqualify a company from applying hedge accounting.  To sufficiently meet the requirements in Statement No. 133, formal hedge documentation must contain the following, at a minimum:

• A description of the hedge item or transaction;
• A statement designating which type of hedge accounting is being followed;
• A description of the hedging instrument that is sufficiently specific so that when a transaction occurs, it is clear whether that particular transaction is the hedged transaction;
• A statement of the intended hedge objective, including a discussion of the nature of the risk being hedged and any related hedge strategy or methodology;
• A discussion explaining how the hedging instrument’s retrospective and prospective effectiveness in offsetting the change in fair value or cash flows associated with the hedge risk will be assessed, including reference to any components of a specific hedging derivative’s gain or loss that will be excluded from the assessment of hedge effectiveness; and
• A discussion of the method that will be used to measure hedge ineffectiveness.

The method used to assess effectiveness and measure ineffectiveness should be described with sufficient specificity so that a third party could perform the assessment or measurement based on the documentation and arrive at the same result.  Both at inception of the hedge and on an ongoing basis, the hedging relationship is expected to be highly effective during the term of the hedge. 

Reminder No. 3 – Measure Hedge Effectiveness
Both at inception of the hedge and on an ongoing basis, the hedging relationship is expected to be highly effective during the term of the hedge.  An assessment of effectiveness is required whenever financial statements or earnings are reported, and at least every three months.  Statement No. 133 does not specify a single method for either assessing whether a hedge is expected to be highly effective or measuring hedge ineffectiveness.  The appropriateness of a given method of assessing hedge effectiveness can depend on the nature of the risk being hedged and the type of hedging instrument used. 

Entities may not have to perform a detailed hedge-effectiveness analysis, however, if the critical terms of the hedging instrument and the hedged item are the same.  The critical terms of a hedging instrument and a hedged item generally consist of:

• The notional and principal amounts;
• Receive/pay rates and the related bases;
• The contract term and maturity or remaining term;
• Repricing or reset dates; and
• Settlement and receive/pay dates.

For example, an entity may assume no ineffectiveness in a hedging relationship of interest rate risk involving a recognized interest-bearing asset or liability and an interest rate swap, and therefore avoid the documentation requirement related to hedge effectiveness if certain conditions are met.  Statement No. 133 generally precludes application of this shortcut method when the interest-bearing asset or liability is prepayable at other than fair value.  It is important to remember that this shortcut method can only be applied in very limited circumstances. 

In those situations in which the critical terms of the hedging instrument and the hedged item are not identical, it is likely that the determination of hedge effectiveness could involve the use of various statistical techniques, including regression analysis.  Another method for measuring ineffectiveness in cases where the critical terms of the hedging instrument do not match those of the hedged item (e.g., an interest-rate swap with reset dates different from those of the hedged variable-rate debt) would be to estimate the fair value of the swap with terms that are identical to those of the underlying variable-rate debt and compare the fair value of the “modeled” swap with the fair value of the actual swap. 

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