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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 FOREIGN-CURRENCY INSTRUMENTS 

The primary source of authoritative guidance for accounting for foreign-currency translations and foreign-currency transactions is SFAS 52. The standard encompasses futures contracts, forward agreements, and currency swaps as they relate to foreign-currency hedging. SFAS 52 draws a distinction between foreign-exchange ''translation'' and ''transactions.'' Translation, generally, focuses on the combining of foreign and domestic entities so they can be presented and reported in the consolidated financial statements in one currency. Foreign-currency transactions, in contrast, are transactions (such as purchases or sales) by an operation in currencies other than its ''functional currency.'' For U.S. depository institutions, the functional currency will generally be the dollar for its U.S. operations and the local currency of wherever its foreign operations transact business. 

Foreign-Currency Translations 

Translation is the conversion of the financial statements of a foreign operation (a branch, division, or subsidiary) denominated in the operation's functional currency to U.S. dollars, generally for inclusion in consolidated financial statements. The balance sheets of foreign operations are translated at the exchange rate in effect on the statement date, while income-statement amounts are generally translated at an appropriate weighted amount. Meeting this criterion will be particularly difficult when an anticipated transaction is not expected to take place in the near future. 

Detailed guidance for determining the functional currency is set forth in appendix 1 of SFAS 52: ''An entity's functional currency is the currency of the primary economic environment in which the entity operates; normally, that is the currency of the environment in which an entity primarily generates and expends cash. The functional currency of an entity is, in principle, a matter of fact. In some cases, the facts will clearly identify the functional currency; in other cases, they will not.'' 

SFAS 52 indicates the salient economic indicators and other possible factors that should be considered both individually and collectively when determining the functional currency: cash flow, price and market sales indicators, expense indicators, financing indicators, inter-company transactions and arrangements, and other factors. 

Foreign-Currency Transactions 

Gains or losses on foreign-currency transactions, in contrast to translation, are recognized in income as they occur, unless they arise from a qualifying hedge. SFAS 52 provides guidance about the types of foreign-currency transactions for which gain or loss is not currently recognized in earnings. Gains and losses on the following foreign-currency transactions should not be included in determining net income but should be reported in the same manner as translation adjustments: 

  foreign-currency transactions that are designated and effective as economic hedges of a net investment in a foreign entity, commencing as of the designation date 
  inter-company foreign-currency transactions that are long-term investments (that is, settlement is not planned or anticipated in the foreseeable future), when the entities to the transaction are consolidated, combined, or accounted for by the equity method in the reporting institution's financial statements. 

NETTING OR OFFSETTING ASSETS AND LIABILITIES FASB 

Interpretation 39 (FIN 39), ''Offsetting of Amounts Related to Certain Contracts,'' provides guidance on the netting of assets and liabilities arising from (1) traditional activities, such as loans and deposits, and (2) derivative instruments. The assets and liabilities from derivatives are primarily the fair values, or estimated market values, for swaps and other contracts, and the receivables and payables on these instruments. FIN 39 clarifies the definition of a ''right of setoff'' that GAAP has long indicated must exist before netting of assets and liabilities can occur in the balance sheet. One of the main purposes of FIN 39 was to clarify that FASB's earlier guidance on the netting of assets and liabilities (Technical Bulletin 88-2) applies to amounts recognized for OBS derivative instruments as well. 

Balance-sheet items arise from off-balance-sheet interest-rate and foreign-currency instruments in primarily two ways. First, those banking organizations and other companies that engage in various trading activities involving OBS derivative instruments (for example, interest-rate and currency swaps, forwards, and options) are required by GAAP to mark to market these positions by recording their fair values (estimated market values) on the balance sheet and recording any changes in these fair values (unrealized gains and losses) in earnings. Second, interest-rate and currency swaps have receivables and payables that accrue over time, reflecting expected cash inflows and outflows that must periodically be exchanged under these contracts, and these receivables and payables must be recorded on the balance sheet as assets and liabilities, respectively.7 

Under FIN 39, offsetting, or the netting of assets and liabilities, is not permitted unless all of the following four criteria are met: 
  
  Two parties must owe each other determinable amounts. 
  The reporting entity must have a right to set off its obligation with the amount due to it. 
  The reporting entity must actually intend to set off these amounts. 
  The right of setoff must be enforceable at law. 

When all four criteria are met, a bank or other company may offset the related asset and liability and report the net amount in its GAAP financial statements. On the other hand, if any one of these criteria is not met, the fair value of contracts in a loss position with a given counterparty will not be offset against the fair value of contracts in a gain position with that counterparty, and organizations will be required to record gross unrealized gains on such contracts as assets and to report gross unrealized losses as liabilities. However, FIN 39 relaxes the third criterion (the parties' intent requirement) to permit the netting of fair values of OBS derivative contracts executed with the same counterparty under a legally enforceable master netting agreement.8 A master netting arrangement exists if the reporting institution has multiple contracts, whether for the same type of conditional or exchange contract or for different types of contracts, with a single counterparty that are subject to a contractual agreement that provides for the net settlement of all contracts through a single payment in a single currency in the event of default or termination of any one contract. FIN 39 defines ''right of setoff'' and specifies conditions that must be met to permit offsetting for accounting purposes. FASB's Interpretation 41 (FIN 41), ''Offsetting of Amounts Relating to Certain Repurchase and Reverse Repurchase Agreements,'' was issued in December 1994. This interpretation modifies FIN 39 to permit offsetting in the balance sheet of payables and receivables that represent repurchase agreements and reverse repurchase agreements under certain circumstances in which net settlement is not feasible. (See FIN 41 for further information.) 

7. In contrast, the notional amounts of off-balance-sheet derivative instruments, or the principal amounts of the underlying asset or assets to which the values of the contracts are indexed, are not recorded on the balance sheet. Note, however, that if the OBS instrument is carried at market value, that value will include any receivable or payable components. Thus, for those OBS instruments that are subject to a master netting agreement, the accrual components in fair value are also netted. 
8. The risk-based capital guidelines provide generally that a credit-equivalent amount is calculated for each individual interest-rate and exchange-rate contract. The credit-equivalent amount is determined by summing the positive mark-to-market values of each contract with an estimate of the potential future credit exposure. The credit-equivalent amount is then assigned to the appropriate risk-weight category. Netting of swaps and similar contracts is recognized for risk-based capital purposes only when accomplished through ''netting by novation.'' This is defined as a written bilateral contract between two counterparties under which any obligation to each other is automatically amalgamated with all other obligations for the same currency and value date, legally substituting one single net amount for the previous gross obligations.

Accounting 

Examination Objectives 

1. To determine whether the organization's written accounting policies relating to trading and hedging with derivatives instruments have been approved by senior management for conformance with generally accepted accounting practices, and that such policies conform with regulatory reporting principles. 

2. To determine whether capital-markets and trading activities appear in regulatory reports, as reported by accounting personnel in conformance with written accounting policies. 

3. To determine whether securities held in available-for-sale or held-to-maturity accounts meet the criteria of SFAS 115 and are, therefore, properly excluded from the trading account. 

4. To determine whether market values of traded assets are accurately reflected in regulatory reports. 

5. To determine whether financial instruments are netted for financial reporting and regulatory reporting for only those counterparties whose contracts conform with specific criteria permitting such setoff. 

6. To determine whether management's assertions that financial instruments are hedges meet the necessary criteria for exclusion from classification as trading instruments. 

7. To ascertain whether the organization has adequate support that a purported hedge reduces risk in conformance with SFAS 133. 

8. To determine whether the amount and recognition of deferred losses arising from hedging activities are properly recorded and are being amortized appropriately. 

9. To recommend corrective action when policies, procedures, practices, internal controls, or management information systems are found to be deficient, or when violations of law, rulings, or regulations have been noted.

Accounting 

Examination Procedures 

These procedures list a number of processes and activities to be reviewed during a full-scope examination. The examiner-in-charge will establish the general scope of examination and work with the examination staff to tailor specific areas for review as circumstances warrant. As part of this process, the examiner reviewing a function or product will analyze and evaluate internal-audit comments and previous examination work-papers to assist in designing the scope of examination. In addition, after a general review of a particular area to be examined, the examiner should use these procedures, to the extent they are applicable, for further guidance. Ultimately, it is the seasoned judgment of the examiner and the examiner-in-charge as to which procedures are warranted in examining any particular activity. 

1. Obtain a copy of the organization's accounting policies and review them for conformance with the relevant sections regarding trading and hedging transactions of authoritative pronouncements by FASB, AICPA (for Y-series reports), and Call Report Instructions. 

2. Using a sample of securities purchase and sales transactions, check the following: 
a. Securities sub-ledgers accurately state the cost, and the market values of the securities agree to outside quotations. 
b. Securities are properly classified among trading, available-for-sale, and held-to-maturity classifications. 
c. Transactions that transfer securities from the trading account to either held-to-maturity or available-for-sale are authorized and conform with authoritative accounting guidance (such transfers should be rare, according to SFAS 115). 

3. Obtain a sample of financial instruments held in the trading account and compare the reported market value against outside quotations or compare valuation assumptions against market data. 

4. Review the organization's controls over reporting certain financial instruments on a net basis. Using a sample of transactions, review the contractual terms to determine that the transactions qualify for netting for financial reporting and regulatory reporting purposes, according to the criteria specified by FIN 39, FIN 41, or regulatory reporting requirements. 

5. Review the organization's methods for identifying and quantifying risk for purposes of hedging. Review the adequacy of documented risk reduction (SFAS 52 and SFAS 133) and the enterprise or business-unit risk reduction (SFAS 80) that are necessary conditions to applying hedge accounting treatment. 

6. Obtain schedules of the gains or losses resulting from hedging activities and review whether the determination was appropriate and reasonable. 

7. Determine if accounting reversals are well documented. 

8. Determine if accounting profits and losses prepared by control staff are reviewed by the appropriate level of management and that the senior staff in the front office (head trader, treasurer) has agreed with accounting numbers. Determine if the frequency of review by senior managers is adequate for the institution's volume and level of earnings. 

9. Recommend corrective action when policies, procedures, practices, internal controls, or management information systems are found to be deficient, or when violations of law, rulings, or regulations have been noted. 

Accounting 

Internal Control Questionnaire 

1. Does the organization have a well-staffed accounting unit that is responsible for following procedures and instructions for recording transactions; marking to market when appropriate; filing regulatory and stockholder reports; and dealing with regulatory, tax, and accounting issues? 

2. Do the organization's accounting policies conform to the relevant sections regarding trading and hedging transactions of authoritative pronouncements by FASB and AICPA, and to the Call Report Instructions? If the organization is a foreign institution, does the organization have appropriate policies and procedures to convert foreign accounting principles to U.S. reporting guidance? Is there an adequate audit trail to reconcile the financial statements to regulatory reports? 

3. For revaluation- 
a. Do securities sub-ledgers accurately state the cost, and do market values of the securities agree to outside quotations? 
b. Are securities properly classified among trading, available-for-sale, and held-to-maturity classifications? 
c. Evaluate the transfer of securities from the trading account to either held-to-maturity or available-for-sale for authorization in conformance with authoritative accounting guidance. Are such transfers rare? (According to SFAS 115, such transfers should be rare.) 

4. Do the revaluation rates used for a sample of financial instruments held in the trading account appear within range when compared with supporting documentation of market rates? 

5. Do the contractual terms of a sample of transactions qualify for netting for financial reporting and regulatory reporting purposes, according to the criteria specified by FIN 39, FIN 41, or regulatory reporting requirements? 

6. Does the financial institution have procedures to document risk reduction (SFAS 52 and SFAS 133), and does it have enterprise or business-unit risk reduction (SFAS 133) conditions to apply hedge accounting treatment? Do the procedures apply to the full range of applicable products used for investment? Is record retention adequate for this process? 

7. Are the methods for assessing gains or losses resulting from hedging activities appropriate and reasonable? 

8. Are accounting reversals justified by supervisory personnel and are they well documented? 

9. Are profits and losses prepared by control staff reviewed by the appropriate level of management and senior staff (head trader, treasurer) for agreement? Is the frequency of review by senior managers adequate for the institution's volume and level of earnings?

Accounting 

Appendix-Related Financial Statement Disclosures

SECURITIES PORTFOLIO DISCLOSURES UNDER SFAS 115 

For securities classified as available-for-sale and separately for securities classified as held-tomaturity, all reporting institutions should disclose the aggregate fair value, gross unrealized holding gains, gross unrealized holding losses, and amortized cost basis by major security type as of each date for which a statement of financial position is presented. Financial institutions should include the following major security types in their disclosure, though additional types may be included as appropriate: 

  equity securities 
  debt securities issued by the U.S. Treasury and other U.S. government corporations and agencies 
  debt securities issued by states of the United States and political subdivisions of the states 
  debt securities issued by foreign governments 
  corporate debt securities 
  mortgage-backed securities 
  other debt securities 

For investments in debt securities classified as available-for-sale and separately for securities classified as held-to-maturity, all reporting institutions should disclose information about the contractual maturities of those securities as of the date of the most recent statement of financial position presented. Maturity information may be combined in appropriate groupings. In complying with this requirement, financial institutions should disclose the fair value and the amortized cost of debt securities based on at least four maturity groupings: (1) within one year, (2) after one year through five years, (3) after five years through 10 years, and (4) after 10 years. Securities not due at a single maturity date, such as mortgage-backed securities, may be disclosed separately rather than allocated over several maturity groupings; if allocated, the basis for allocation also should be disclosed. For each period for which the results of operations are presented, an institution should disclose- 

  the proceeds from sales of available-for-sale securities and the gross realized gains and gross realized losses on those sales, 
  the basis on which cost was determined in computing realized gain or loss (that is, specific identification, average cost, or other method used), 
  the gross gains and gross losses included in earnings from transfers of securities from the available-for-sale category into the trading category, 
  the change in net unrealized holding gain or loss on available-for-sale securities that has been included in the separate component of shareholders' equity during the period, and 
  the change in net unrealized holding gain or loss on trading securities that has been included in earnings during the period. 

For any sales of or transfers from securities classified as held-to-maturity, the amortized cost amount of the sold or transferred security, the related realized or unrealized gain or loss, and the circumstances leading to the decision to sell or transfer the security should be disclosed in the notes to the financial statements for each period for which the results of operations are presented. Such sales or transfers should be rare, except for sales and transfers due to the changes in circumstances as previously discussed. 

ACCOUNTING DISCLOSURES FOR DERIVATIVES AND HEDGING ACTIVITIES

Under SFAS 133, institutions that hold or issue derivative instruments, or non-derivative instruments qualifying as hedge instruments, should disclose their objectives for holding or issuing the instruments and their strategies for achieving the objectives. Institutions should distinguish whether the derivative instrument is to be used as a fair-value, cash-flow, or foreign-currency hedge. The description should include the risk-management policy for each of the types of hedges. Institutions not using derivative instruments as hedging instruments should indicate the purpose of the derivative activity.

Fair-Value Hedges


For foreign-currency-transaction gains or losses that qualify as fair-value hedges, report-

  the net gain or loss recognized in earnings during the reporting period, which represents the amount of hedge ineffectiveness and the component of gain or loss, if any, excluded from the assessment of hedge effectiveness, and a description of where the net gain or loss is reported in the income statement; and 
  the amount of net gain or loss recognized in earnings when a hedged firm commitment no longer qualifies as a fair-value hedge. 

Cash-Flow Hedges 

For cash-flow gains or losses that qualify as cash-flow hedges, report- 

  the net gain or loss recognized in earnings during the reporting period, which represents the amount of ineffectiveness and the component of the derivative's gain or loss, if any, excluded from the assessment of hedge effectiveness, and a description of where the net gain or loss is reported in the income statement; 
  a description of the transactions or other events that will result in the reclassification into earnings of gains and losses that are reported in accumulated other comprehensive income (OCI), and the estimated net amount of the existing gains or losses at the reporting date that is expected to be reclassified into earnings within the next 12 months; 
  the maximum length of time over which the entity is hedging its exposure to the variability in further cash flows for forecasted transactions, excluding those forecasted transactions related to the payment of variable interest on existing financial instruments; and 
  the amount of gains and losses reclassified into earnings as a result of the discontinuance of cash-flow hedges because it is probable that the original forecasted transactions will not occur by the end of the originally specified time period or within an additional time period as outlined in SFAS 133. 

Foreign-Currency Hedges 

For derivatives, as well as non-derivatives, that may give rise to foreign-currency-transaction gains or losses under SFAS 52, and that have been designated as and qualify for foreign-currency hedges, the net amount of gains or losses included in the cumulative translation adjustment during the reporting period should be disclosed. 

Reporting Changes in Other Comprehensive Income 

Institutions should show as a separate classification within other comprehensive income (OCI) the net gain or loss on derivative instruments designated and qualifying as cash-flow hedges. Additionally, pursuant to SFAS 130, ''Reporting Comprehensive Income,'' institutions should disclose the beginning and ending accumulated derivative gain or loss, the related net change associated with current period hedging transactions, and the net amount of any reclassification into earnings. 

SEC Disclosure Requirements for Derivatives 

In the first quarter of 1997, the SEC issued rules requiring the following expanded disclosures for derivative and other financial instruments for public companies: 

  improved descriptions of accounting policies for derivatives in the footnotes of the financial statements 

  disclosure of quantitative and qualitative information about derivatives and other financial instruments outside of the footnotes to the financial statements: 

- For the quantitative disclosures about market-risk-sensitive instruments, registrants must follow one of three methodologies and distinguish between instruments used for trading purposes and instruments used for purposes other than trading. The three disclosure methodology alternatives are (1) tabular presentation of fair values and contract terms, (2) sensitivity analysis, or (3) value-at-risk disclosures. Registrants must disclose separate quantitative information for each type of market risk to which the entity is exposed (for example, interest-rate or foreign-exchange rate).
 -The qualitative disclosures about market risk must include the registrant's primary market-risk exposures at the end of the reporting period, how those exposures are managed, and changes in primary risk exposures or how those risks are managed as compared with the previous reporting period. 

  disclosures about derivative financial instruments with any financial instruments, firm commitments, commodity positions and anticipated transactions that are being hedged by such items (These are included to avoid misleading disclosures.) 

Continue to REGULATORY REPORTING 

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