About FAS 133 / IAS 39 - a Guide

FAS 133 define a derivative as follows:

1. It has (1) one or more underlyings and (2) one or more notional amounts or payment provisions or both. These contractual terms determine the amount of the settlement or settlements, and, in some cases, whether or not a settlement is required.
2. It requires no initial net investment, or a smaller initial net investment than required for other contract types with a similar expected response to changes in market factors e.g. an option premium.
3. 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.

Although the definition of a derivative in IAS 39 is slightly different, in practical terms FAS 133 and IAS 39 derivatives definitions capture the same transactions. These definitions includes forward exchange contracts, futures contracts, option contracts, and interest rate swaps. It also includes elements of contracts that previously were not considered derivatives. These are known as 'embedded derivatives''.

All derivatives must be revalued on the balance sheet at fair value from inception. Companies must identify the types of hedge contracts they use or envisage using in the future, and then decide how they will determine fair value on those contracts.

Fair value should be independently verifiable by an auditor, particularly if they are assessed to be material (or potentially material). Companies without the systems or expertise to assess fair value of the contracts held should seek valuations from an independent source. Providers of financial instruments, including banks, often provide valuations to their clients but if the bank is the counterparty to this transaction, it is not clear whether auditors will accept this valuation as ‘independent' - particularly for more exotic-type instruments.

Find out more about automatic fair value calculation in CNS Treasury hedge accounting software

Hedge accounting represents a number of provisions within FAS 133 that allow companies to match the changes in fair value of their hedge contracts to the changes in fair value of the item being hedged. Hedge accounting rules enable companies to either:

1. Defer the P&L impact of a hedge contract to a future period, or
2. Bring forward the P&L impact of a hedged item to an earlier period.

For instance, if you enter a forward contract to hedge a debtor that will arise in six months time, you can defer the P&L impact of that hedge contract in a hedge reserve in equity until the debtor is recognized in the general ledger.

Hedge accounting will only be permitted in the accounts if each hedge contract is documented as follows:

• Risk management objective
• Risk management strategy
• Type of hedge relationship
• Nature of hedging instrument
• Nature of hedged item
• How effectiveness will be assessed

CNS Treasury hedge accounting software streamlines the hedge accounting process, regardless of the derivative being hedge accounted.

The effectiveness of the hedge contract must be assessed prospectively at hedge inception and at each balance date. Hedge effectiveness must also be assessed respectively at each balance date.

For prospective effectiveness testing, the test must prove that the hedge is expected to be 'highly effective'. For retrospective effectiveness testing, the results must be within 80-125% to allow for hedge accounting. Any ineffectiveness i.e. any result different to 100% must be reflected in the P&L immediately.

FAS 133 provides no specific methodology for calculating hedge effectiveness. However, common methods have arisen in the USA for different types of hedges, such as the “Dollar Offset - Cumulative” method for forward exchange contracts which calculates:

[Change in fair value of the hedged item] divided by [Change in fair value of the hedge contract]

For those entities hedging forecast cashflows, companies must illustrate that those forecasts are ‘probable'. Once again, there is no specific guidance within the standard on how to assess forecast probability, but the standard suggests you consider:

• Frequency of past transactions
• How far into the future the forecast is
• How forecast volumes compare to historical volumes

Effectiveness testing is one of the most daunting aspects of the hedge accounting requirements for corporates. However, experience in USA indicates that many common hedge scenarios can be documented and tested relatively simply with an expected result of 100% effectiveness.

CNS Treasury hedge accounting software automatically calculates hedge effectiveness as part of its promise of hedge accounting in 3 clicks.