Thursday, September 6, 2012

Financial Derivatives – How are they accounted for under US GAAP?


“Wer's nicht einfach und klar sagen kann, der soll schweigen und weiterarbeiten, bis er's klar sagen kann.”



“If you can’t make it simple, stop talking and continue working until you can make it simple.”



Karl R. Popper


Accounting for financial derivatives under US GAAP is technical. Just take a quick look at FASB Codification 815-10 and you will understand what I mean by “technical”. The purpose of this post is to give you the big picture – the basics that you need to understand to read annual reports and to follow the main US GAAP regulations.

The FASB Codification on derivatives and hedging covers 5 main topics:

  • Scope of application
  • Recognition of derivatives on the balance sheet
  • Valuation of derivatives
  • Netting of derivatives
  • Publication of additional information about derivatives


Scope of application

To be qualified as a derivative, the financial instrument must meet the following cumulative conditions:

  • It must have an underlying (such as a price of a financial asset, a price index, a credit rating, a natural condition, or a factual event) whose changes are verifiable.
  • A notional amount must be fixed.
  • It should contain a payment provision.
  • There must be no or, compared to the notional amount, only a small initial net investment.
  • Whatever the details are, a settlement mechanism is to be fixed.

The FASB explicitly prohibits the practice of so-called “synthetic instrument accounting”. This refers to the practice of combining a cash and a derivative instrument in order to ultimately accounting it as a cash instrument and to conceal the derivative instrument.

Moreover, the attempt to avoid application of the FASB Codification by separating transactions into legally autonomous transactions will not succeed if

  • the transactions were entered into contemporaneously and in contemplation of one another;
  • the transactions were executed with the same counter-party or intermediary;
  • the transactions relate to the same risk;
  • there is no economic need nor substantive business purpose for structuring the transactions separately.


Recognition of derivatives on the balance sheet

Derivatives must be recognized on the balance sheet as assets or liabilities.

US GAAP distinguishes 3 types of derivatives, e.g. hedging derivatives, other risk management derivatives, and other derivatives (namely derivatives held for trading purposes).

Hedging derivatives are further subdivided into 3 categories:

  • The fair value hedge mitigates the exposure to changes in the fair value of a recognized asset or liability.
  • The cash flow hedge mitigates the exposure to variability in the cash flows of a recognized asset or liability.
  • The foreign currency exposure hedge mitigates foreign currency exposure.

A word about embedded derivatives (derivatives incorporated in a single contract regulating an overall transaction) here: They are accounted apart from the embedding contract only if the derivative elements may be sold or traded separately.


Valuation of derivatives

Financial derivatives are evaluated at (initial or subsequent) fair value. The subsequent valuation at fair value leads naturally to a recognition of gains / losses in the firm's income statement.


Netting of derivatives

Under US GAAP, such netting is only possible if provided for by a respective master agreement. In addition, a netting will only be recognized under US GAAP if the accounting entity either offsets rights / obligations under a derivative instrument against obligations / rights to provide collateral or if it has agreed with its counter-party on a payment netting.

Such netting mechanism must not only be explained in the firm's accounting policies but also be applied consistently over time.


Publication of additional information about derivatives

The company must publish additional information about its use of derivatives:

  • How does it use derivatives?
  • Why does it use derivatives? Which objectives and strategies does it pursue with derivatives?
  • Which accounting policy does it apply to derivatives?
  • What is the volume of its derivatives' activity? How do they affect its financial position, financial performance, and cash flows?

The aforementioned volume of the company’s derivative activity must be reported

  • on a gross basis (= before application of agreed netting principles);
  • not taking collateral into account;
  • separately for hedging instruments and other derivatives;
  • separately for each type of underlying (interest rates, foreign exchange, equities, commodities, credit, and other).


Let's get back now to where we have started: Should I stop writing and continue working? Honestly, probably yes... There is obviously too much technical jargon in this post to be comprehensible for a “non-specialist” reader. Ultimately, my post shows a form of laziness: To be clear even for an outsider, the post would have been twice as long and it would have taken twice as much time to write it!


Resources:

  • FASB Codification 815-10 Derivatives and Hedging