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Trading and Capital-Markets Activities Manual

Trading Activities: Accounting (Continue)
Source: Federal Reserve System 
(The complete Activities Manual (pdf format) can be downloaded from the Federal Reserve's web site)

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ACCOUNTING FOR DERIVATIVE INSTRUMENTS 

As discussed in the previous subsection, the general accounting framework for securities portfolios divides them into three categories: held-to-maturity (accounted for at amortized cost), available-for-sale (accounted for at fair value, with unrealized changes in fair value recorded in equity), and trading securities (accounted for at fair value, with changes in fair value recorded in earnings). 

In contrast, derivative instruments can be classified in one of the following categories: (1) no hedge designation, (2) fair-value hedge, (3) cash-flow hedge, and (4) foreign-currency hedge. The general accounting framework for derivative instruments under GAAP is set forth below:

  If the derivative does not have a hedge designation, the gains or losses based on changes in fair value of the derivative instrument are included in current income. 
  If the derivative is determined to be a hedge of exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment (fair-value hedge), the gains or losses based on changes in fair value are included in current net income with the offsetting gain or loss on the hedged item attributable to the risk being hedged. 
  If the derivative is determined to be a hedge of exposure to variable cash flows of a forecasted transaction (cash-flow hedge), the gains or losses based on changes in fair value are included in other comprehensive income outside of net income. 
  If the derivative represents a hedge of the foreign-currency exposure of a net investment in foreign operation, an unrecognized firm commitment, an available-for-sale security, or a foreign-currency-denominated forecasted transaction (foreign-currency hedge), the gains or losses based on changes in fair value are included in comprehensive income, outside of net income, as part of the cumulative translation adjustment. 

This general framework is set forth in SFAS 133, ''Accounting for Derivative Instruments and Hedging Activities.'' This statement, issued in June 1998 and amended by SFAS 137 and SFAS 138, became effective for fiscal years beginning after June 15, 2000. Thus, banks operating on a calendar year adopted the guidance on January 1, 2001. The following guidelines apply to banks' application of SFAS 133: 

  Initial adoption commenced at the beginning of the institution's fiscal quarter. Thus, for most banks, the standard would be applied in the first quarter of 2001. On that date, hedging relationships should be designated anew and documented as indicated in SFAS 133. 
  SFAS 133 cannot be applied retroactively to financial statements of prior periods. 
  At the date of initial application, an entity should recognize all freestanding derivative instruments in the statement of financial position as either assets or liabilities, measured at fair value. 
  The transition adjustments required to implement SFAS 133 should be presented as the cumulative effect of a change in accounting principle in accordance with Accounting Principles Board (APB) Opinion No. 20, ''Accounting Changes.'' 

SFAS 133 comprehensively changes accounting and disclosure standards for derivatives. SFAS 133 amends SFAS 52, ''Foreign Currency Translation,'' to permit special accounting for foreign currency hedges and makes the following standards obsolete: 

  SFAS 80 Accounting for Futures Contracts 
  SFAS 105 Disclosure of Information About Financial Instruments with Off Balance Sheet Risk and Financial Instruments with Concentrations of Credit Risk 
  SFAS 107 Disclosures About Fair Value of Financial Instruments 
  SFAS 119 Disclosure About Derivative Financial Instruments and Fair Value of Financial Instruments 

SFAS 133 requires entities to recognize all derivatives on the balance sheet as either assets or liabilities and to report them at their fair value. The accounting recognition of changes in the fair value of a derivative (gains or losses) depends on the intended use of the derivative and the resulting designation. For qualifying hedges, an entity is required to establish at the inception of the hedge the method it will use for assessing the effectiveness of the hedging derivative and the measurement approach for determining the ineffective aspect of the hedge. The methods applied should be consistent with the entity's approach to managing risk. SFAS 133 also precludes designating a non-derivative financial instrument as a hedge of an asset, a liability, an unrecognized firm commitment, or a forecasted transaction, except if any of these are denominated in a foreign currency. 

Proper classification of derivative instruments is a key examination issue. Inappropriately classifying a derivative instrument as a hedge would result in the improper treatment of gains and losses in earnings and regulatory capital. Institutions should retain adequate documentation to support their hedge activity. Examiners should scrutinize any institutions that do not comply with these new GAAP requirements. 

Definitions 

Some of the terms most common to financial instruments are defined below. 

Derivative 

A derivative instrument is a financial instrument or other contract with all three of the following characteristics:

  It has one or more under-lyings, and 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 what would be required for other types of contracts expected to have a similar response to changes in market factors. 
  Its terms require or permit net settlement, it can be readily settled net by 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. 

Underlying 

An underlying is a specified interest rate, security price, commodity price, foreign-exchange rate, index of prices or rates, or other variable. An underlying may be a price or rate of an asset or liability but is not the asset or liability itself. 

Notional amount 

A notional amount is a number of currency units, shares, bushels, pounds, or other units specified in the contract. 

Payment provision 

A payment provision specifies a fixed or determinable settlement to be made if the underlying behaves in a specified manner. 

Hedge 

A hedge is an identifiable asset, liability, firm commitment, or anticipated transaction. 

Offset 

Offset is the liquidating of a purchase of futures through the sale of an equal number of contracts of the same delivery month on the same underlying instrument on the same exchange, or the covering of a short sale of futures through the purchase of an equal number of contracts of the same delivery month on the same underlying instrument on the same exchange. 

Special Types of Derivatives 

Credit derivatives are financial instruments that permit one party (the beneficiary) to transfer the credit risk of a reference asset, which it typically owns, to another party (the guarantor) without actually selling the assets. Credit derivatives that provide for payments to be made only to reimburse the guaranteed party for a loss incurred because the debtor fails to pay when payment is due (financial guarantees), which is an identifiable event, are not considered derivatives under SFAS 133 for accounting purposes. Those credit derivatives not accounted for under SFAS 133 would not be recorded in the financial statements as assets or liabilities at fair value, but, if material, would typically be disclosed in the financial statements. Credit derivatives not considered financial guarantees, as defined above, are reported as derivatives as determined by SFAS 133. 

Equity derivatives are derivatives that are linked to various indexes and individual securities in the equity markets. SFAS 133 covers the accounting treatment for equity derivatives that are not indexed to an institution's own stock. Equity derivatives indexed to the institution's own stock are determined in accordance with APB No. 18, ''The Equity Method of Accounting for Investments in Common Stock,'' and SFAS 123, ''Accounting for Stock-Based Compensation.'' 

Hedging Activities 

Accounting for Fair-Value Hedges A fair-value hedge is a derivative instrument that hedges exposure to changes in the fair value of an asset or a liability, or an identified portion thereof, that is attributable to a particular risk. To qualify for fair-value-hedge accounting, the hedge must meet all of the following criteria: 

  Formal documentation must be made at the inception of the hedging relationship of the institution's risk-management objective and strategy for undertaking the hedge. This includes documenting the hedged instrument, the hedged item, the nature of the risk, and how the hedge's effectiveness in offsetting the exposure to changes in the fair value will be assessed. 
  Assessment is required whenever financial statements or earnings are reported, and at least every three months, to ensure the hedge relationship is highly effective in achieving offsetting changes in fair value to the hedged risk. 

An asset or liability is eligible for designation as a hedged item in a fair-value hedge if all of the following criteria are met:
 
  The hedged item is specifically identified as an asset, liability, or a firm commitment. The hedged item can be a single asset, liability, or firm commitment or a portfolio of similar assets, liabilities, or firm commitments. 
  The hedged item is not one of the following: 

- an asset or liability that is already reported at fair value; 
- an investment accounted for by the equity method; 
- a minority interest in one or more consolidated subsidiaries; 
- an equity investment in a consolidated subsidiary; 
- a firm commitment either to enter into a business combination or to acquire or dispose of a subsidiary, a minority interest, or an equity-method investee; or 
- an equity instrument issued by the institution and classified as stockholders' equity in the statement of financial position. 

  If the hedged item is all or a portion of a debt security classified as held-to-maturity, the designated risk being hedged is the risk of changes in its fair value attributable to changes in the obligor's creditworthiness. If the hedged item is an option component of a held-to-maturity security that permits its repayment, the designated risk being hedged is the risk of changes in the entire fair value of that option component. 
  If the hedged item is a non-financial asset or liability or is not a recognized loan-servicing right or a non-financial firm commitment with financial components, the designated risk being hedged is the risk of changes in the fair value of the entire hedged asset or liability. 
  If the hedged item is a financial asset or liability, a recognized loan-servicing right, or a non-financial firm commitment with financial components, the designated risk being hedged is- 

- the risk of changes in the overall fair value of the entire hedged item, 
- the risk of changes in its fair value attributable to changes in market interest rates, 
- the risk of changes in its fair value attributable to changes in the related foreign currency exchange rates, or 
- the risk of changes in its fair value attributable to changes in the obligor's creditworthiness. 

An institution is subject to applicable GAAP requirements for assessment of impairment for assets, or recognition of an increased obligation for liabilities. An institution shall also discontinue the accounting treatment for a financial instrument as a fair-value hedge if any of the following conditions occurs: 

  Any criterion of the fair-value hedge or hedged item is no longer met. 
  The derivative expires or is sold, terminated, or exercised. 
  The institution removes the designation of the fair-value hedge. 

Accounting for Cash-Flow Hedges 

A cash-flow hedge is a derivative hedging the exposure to variability in expected cash flows attributed to a particular risk. That exposure may be associated with an existing asset or liability (that is, variable-rate debt) or a forecasted transaction (that is, a forecasted purchase or sale). Designated hedging instruments and hedged items or transactions qualify for cash-flow-hedge accounting if all of the following criteria are met: 

  Formal documentation is required at inception of the hedging relationship, and the institution's risk-management objective and strategy for undertaking the hedge must be done as noted in ''Accounting for Fair-Value Hedges.'' 
  The hedge effectiveness must be assessed as described in ''Accounting for Fair-Value Hedges.'' 
  If an instrument is used to hedge the variable interest rates associated with a financial asset or liability, the hedging instrument must be clearly linked to the financial asset or liability and highly effective in achieving offset. 

A forecasted transaction is eligible for designation as a hedged item in a cash-flow hedge if all of the following additional criteria are met: 

  The forecasted transaction is specifically identified as a single transaction or a group of individual transactions. 
  The occurrence of the forecasted transaction is probable. 
  The forecasted transaction is with a party that is external to the reporting institution. 
  The forecasted transaction is not the acquisition of an asset or incurrence of a liability that will subsequently be re-measured with changes in fair value attributed to the hedged risk currently reported in earnings. 
  If the variable cash flows of the forecasted transaction relate to a debt security that is classified as held-to-maturity, the risk being hedged is the risk of changes in the cash flows attributable to default or the risk of changes in the obligor's creditworthiness. 
  The forecasted transaction does not involve a business combination subject to the provisions of APB Opinion No. 16, ''Business Combinations,'' and is not a transaction involving- 

- a parent company's interest in consolidated subsidiaries, 
- a minority interest in a consolidated subsidiary, 
- an equity-method investment, or 
- an institution's own equity instruments. 

  If the hedged transaction is the forecasted purchase or sale of a financial asset or liability or the variable cash inflow or outflow of an existing financial asset or liability, the designated risk being hedged is- 

- the risk of changes in the cash flows of the entire asset or liability, 
- the risk of changes in its cash flows attributable to changes in market interest rates, 
- the risk of changes in the cash flows of the equivalent functional currency attributable to changes in the related foreign-currency exchange rates, or 
- the risk of changes in cash flows attributable to default or the risk of change in the obligor's creditworthiness. 

As required for fair-value-hedge accounting, an institution shall discontinue the accounting for cash-flow hedges if- 
- any criterion for a cash-flow hedge or the hedged forecasted transaction is no longer met; - the derivative expires or is sold, terminated, or exercised; or 
- the institution removes the designation of the cash-flow hedge. 

If cash-flow-hedge accounting is discontinued, the accumulated amount in other comprehensive income remains and is reclassified into earnings when the hedged forecasted transaction affects earnings. Existing GAAP for impairment of an asset or recognition of an increased liability applies. 

Accounting for Foreign-Currency Hedges 

Consistent with the functional-currency concept of SFAS 52, ''Foreign Currency Translation'' (discussed below), SFAS 133 indicates that an institution may designate the following types of hedges as hedges of foreign-currency exposure: 

  a fair value of an unrecognized firm commitment or an available-for-sale security 
  a cash-flow hedge of a forecasted foreign currency-denominated transaction or a forecasted inter-company foreign-currency-denominated transaction 
  a hedge of a net investment in a foreign operation Foreign-currency fair-value hedges and cash-flow hedges are generally subject to the fair-value-hedge and cash-flow-hedge accounting requirements discussed in those respective subsections. 

Continue to ACCOUNTING FOR FOREIGN-CURRENCY INSTRUMENTS 

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