Statement of
Financial Accounting
Standards No. 133
FAS133 Status Page
FAS133 Summary
Accounting for Derivative Instruments
and Hedging Activities
June 1998
Financial Accounting Standards Board
of the Financial Accounting Foundation
401 MERRITT 7, P.O. BOX 5116, NORWALK, CONNECTICUT 06856-5116
Copyright © 1998 by Financial Accounting Standards Board. All rights reserved. No
part of this publication may be reproduced, stored in a retrieval system, or transmitted, in
any form or by any means, electronic, mechanical, photocopying, recording, or
otherwise, without the prior written permission of the Financial Accounting Standards
Board.
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Statement of Financial Accounting Standards No. 133
Accounting for Derivative Instruments and Hedging Activities
June 1998
CONTENTS
Paragraph
Numbers
Introduction .................................................................................................................. 1–4
Standards of Financial Accounting and Reporting:
Scope and Definition............................................................................................ 5–16
Derivative Instruments ................................................................................... 6–11
Embedded Derivative Instruments ............................................................... 12–16
Recognition of Derivatives and Measurement of Derivatives and
Hedged Items.................................................................................................... 17–42
Fair Value Hedges........................................................................................ 20–27
General ......................................................................................................... 20
The Hedged Item.................................................................................... 21–26
Impairment ................................................................................................... 27
Cash Flow Hedges........................................................................................ 28–35
General ......................................................................................................... 28
The Hedged Forecasted Transaction ...................................................... 29–35
Foreign Currency Hedges............................................................................. 36–42
Foreign Currency Fair Value Hedges..................................................... 37–39
Foreign Currency Cash Flow Hedges .................................................... 40–41
Hedges of the Foreign Currency Exposure of a Net
Investment in a Foreign Operation............................................................. 42
Accounting by Not-for-Profit Organizations and Other Entities That
Do Not Report Earnings......................................................................................... 43
Disclosures ......................................................................................................... 44–45
Reporting Changes in the Components of Comprehensive Income .................. 46–47
Effective Date and Transition ............................................................................ 48–56
Appendix A: Implementation Guidance ............................................................... 57–103
Section 1: Scope and Definition........................................................................ 57–61
Section 2: Assessment of Hedge Effectiveness............................................... 62–103
Appendix B: Examples Illustrating Application of This Statement.................... 104–205
Section 1: Hedging Relationships ................................................................. 104–175
Section 2: Examples Illustrating Application of the Clearly-and-
Closely-Related Criterion to Derivative Instruments Embedded
in Hybrid Instruments................................................................................... 176–200
Section 3: Examples Illustrating Application of the Transition
Provisions ..................................................................................................... 201–205
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Appendix C: Background Information and Basis for Conclusions..................... 206–524
Appendix D: Amendments to Existing Pronouncements.................................... 525–538
Appendix E: Diagram for Determining Whether a Contract Is a
Freestanding Derivative Subject to the Scope of This Statement ............................. 539
Appendix F: Glossary.................................................................................................. 540
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FAS 133: Accounting for Derivative Instruments and Hedging
Activities
FAS 133 Summary
This Statement establishes accounting and reporting standards for derivative instruments,
including certain derivative instruments embedded in other contracts, (collectively referred to as
derivatives) and for hedging activities. It requires that an entity recognize all derivatives as
either assets or liabilities in the statement of financial position and measure those instruments at
fair value. If certain conditions are met, a derivative may be specifically designated as (a) a
hedge of the exposure to changes in the fair value of a recognized asset or liability or an
unrecognized firm commitment, (b) a hedge of the exposure to variable cash flows of a
forecasted transaction, or (c) a hedge of the foreign currency exposure of a net investment in a
foreign operation, an unrecognized firm commitment, an available-for-sale security, or a
foreign-currency-denominated forecasted transaction.
The accounting for changes in the fair value of a derivative (that is, gains and losses)
depends on the intended use of the derivative and the resulting designation.
??For a derivative designated as hedging the exposure to changes in the fair value of a
recognized asset or liability or a firm commitment (referred to as a fair value hedge), the
gain or loss is recognized in earnings in the period of change together with the offsetting
loss or gain on the hedged item attributable to the risk being hedged. The effect of that
accounting is to reflect in earnings the extent to which the hedge is not effective in
achieving offsetting changes in fair value.
??For a derivative designated as hedging the exposure to variable cash flows of a forecasted
transaction (referred to as a cash flow hedge), the effective portion of the derivative’s gain
or loss is initially reported as a component of other comprehensive income (outside
earnings) and subsequently reclassified into earnings when the forecasted transaction affects
earnings. The ineffective portion of the gain or loss is reported in earnings immediately.
??For a derivative designated as hedging the foreign currency exposure of a net investment in
a foreign operation, the gain or loss is reported in other comprehensive income (outside
earnings) as part of the cumulative translation adjustment. The accounting for a fair value
hedge described above applies to a derivative designated as a hedge of the foreign currency
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exposure of an unrecognized firm commitment or an available-for-sale security. Similarly,
the accounting for a cash flow hedge described above applies to a derivative designated as a
hedge of the foreign currency exposure of a foreign-currency-denominated forecasted
transaction.
??For a derivative not designated as a hedging instrument, the gain or loss is recognized in
earnings in the period of change.
Under this Statement, an entity that elects to apply hedge accounting 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. Those methods must be consistent with the entity’s approach to managing risk.
This Statement applies to all entities. A not-for-profit organization should recognize the
change in fair value of all derivatives as a change in net assets in the period of change. In a fair
value hedge, the changes in the fair value of the hedged item attributable to the risk being hedged
also are recognized. However, because of the format of their statement of financial performance,
not-for-profit organizations are not permitted special hedge accounting for derivatives used to
hedge forecasted transactions. This Statement does not address how a not-for-profit organization
should determine the components of an operating measure if one is presented.
This Statement precludes designating a nonderivative financial instrument as a hedge of
an asset, liability, unrecognized firm commitment, or forecasted transaction except that a
nonderivative instrument denominated in a foreign currency may be designated as a hedge of the
foreign currency exposure of an unrecognized firm commitment denominated in a foreign
currency or a net investment in a foreign operation.
This Statement amends FASB Statement No. 52, Foreign Currency Translation, to
permit special accounting for a hedge of a foreign currency forecasted transaction with a
derivative. It supersedes FASB Statements No. 80, Accounting for Futures Contracts, No. 105,
Disclosure of Information about Financial Instruments with Off-Balance-Sheet Risk and
Financial Instruments with Concentrations of Credit Risk, and No. 119, Disclosure about
Derivative Financial Instruments and Fair Value of Financial Instruments. It amends FASB
Statement No. 107, Disclosures about Fair Value of Financial Instruments, to include in
Statement 107 the disclosure provisions about concentrations of credit risk from Statement 105.
This Statement also nullifies or modifies the consensuses reached in a number of issues
addressed by the Emerging Issues Task Force.
This Statement is effective for all fiscal quarters of fiscal years beginning after June 15,
1999. Initial application of this Statement should be as of the beginning of an entity’s fiscal
quarter; on that date, hedging relationships must be designated anew and documented pursuant to
the provisions of this Statement. Earlier application of all of the provisions of this Statement is
encouraged, but it is permitted only as of the beginning of any fiscal quarter that begins after
issuance of this Statement. This Statement should not be applied retroactively to financial
statements of prior periods.
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INTRODUCTION
1. This Statement addresses the accounting for derivative instruments,1 including certain
derivative instruments embedded in other contracts, and hedging activities.
2. Prior to this Statement, hedging activities related to changes in foreign exchange rates were
addressed in FASB Statement No. 52, Foreign Currency Translation. FASB Statement No. 80,
Accounting for Futures Contracts, addressed the use of futures contracts in other hedging
activities. Those Statements addressed only certain derivative instruments and differed in the
criteria required for hedge accounting. In addition, the Emerging Issues Task Force (EITF)
addressed the accounting for various hedging activities in a number of issues.
3. In developing the standards in this Statement, the Board concluded that the following four
fundamental decisions should serve as cornerstones underlying those standards:
a. Derivative instruments represent rights or obligations that meet the definitions of assets or
liabilities and should be reported in financial statements.
b. Fair value is the most relevant measure for financial instruments and the only relevant
measure for derivative instruments. Derivative instruments should be measured at fair
value, and adjustments to the carrying amount of hedged items should reflect changes in
their fair value (that is, gains or losses) that are attributable to the risk being hedged and that
arise while the hedge is in effect.
c. Only items that are assets or liabilities should be reported as such in financial statements.
d. Special accounting for items designated as being hedged should be provided only for
qualifying items. One aspect of qualification should be an assessment of the expectation of
effective offsetting changes in fair values or cash flows during the term of the hedge for the
risk being hedged.
Those fundamental decisions are discussed individually in paragraphs 217–231 of Appendix C.
4. This Statement standardizes the accounting for derivative instruments, including certain
derivative instruments embedded in other contracts, by requiring that an entity recognize those
items as assets or liabilities in the statement of financial position and measure them at fair value.
If certain conditions are met, an entity may elect to designate a derivative instrument as follows:
a. A hedge of the exposure to changes in the fair value of a recognized asset or liability, or of
an unrecognized firm commitment, 2 that are attributable to a particular risk (referred to as
a fair value hedge)
b. A hedge of the exposure to variability in the cash flows of a recognized asset or liability, or
of a forecasted transaction, that is attributable to a particular risk (referred to as a cash flow
hedge)
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c. A hedge of the foreign currency exposure of (1) an unrecognized firm commitment (a
foreign currency fair value hedge), (2) an available-for-sale security (a foreign currency fair
value hedge), (3) a forecasted transaction (a foreign currency cash flow hedge), or (4) a net
investment in a foreign operation.
This Statement generally provides for matching the timing of gain or loss recognition on the
hedging instrument with the recognition of (a) the changes in the fair value of the hedged asset
or liability that are attributable to the hedged risk or (b) the earnings effect of the hedged
forecasted transaction. Appendix A provides guidance on identifying derivative instruments
subject to the scope of this Statement and on assessing hedge effectiveness and is an integral part
of the standards provided in this Statement. Appendix B contains examples that illustrate
application of this Statement. Appendix C contains background information and the basis for the
Board’s conclusions. Appendix D lists the accounting pronouncements superseded or amended
by this Statement. Appendix E provides a diagram for determining whether a contract is a
freestanding derivative subject to the scope of this Statement.
STANDARDS OF FINANCIAL ACCOUNTING AND REPORTING
Scope and Definition
5. This Statement applies to all entities. Some entities, such as not-for-profit organizations
and defined benefit pension plans, do not report earnings as a separate caption in a statement of
financial performance. The application of this Statement to those entities is set forth in
paragraph 43.
Derivative Instruments
6. A derivative instrument is a financial instrument or other contract with all three of the
following characteristics:
a. It has (1) one or more underlyings and (2) one or more notional amounts 3 or payment
provisions or both. Those terms determine the amount of the settlement or settlements, and,
in some cases, whether or not a settlement is required. 4
b. 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 factors.
c. 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.
7. Underlying, notional amount, and payment provision. An underlying is a specified interest
rate, security price, commodity price, foreign exchange rate, index of prices or rates, or other
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variable. 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. The settlement of a derivative instrument with a notional
amount is determined by interaction of that notional amount with the underlying. The
interaction may be simple multiplication, or it may involve a formula with leverage factors or
other constants. A payment provision specifies a fixed or determinable settlement to be made if
the underlying behaves in a specified manner.
8. Initial net investment. Many derivative instruments require no initial net investment.
Some require an initial net investment as compensation for time value (for example, a premium
on an option) or for terms that are more or less favorable than market conditions (for example, a
premium on a forward purchase contract with a price less than the current forward price). Others
require a mutual exchange of currencies or other assets at inception, in which case the net
investment is the difference in the fair values of the assets exchanged. A derivative instrument
does not require an initial net investment in the contract that is equal to the notional amount (or
the notional amount plus a premium or minus a discount) or that is determined by applying the
notional amount to the underlying.
9. Net settlement. A contract fits the description in paragraph 6(c) if its settlement provisions
meet one of the following criteria:
a. Neither party is required to deliver an asset that is associated with the underlying or that has
a principal amount, stated amount, face value, number of shares, or other denomination that
is equal to the notional amount (or the notional amount plus a premium or minus a
discount). For example, most interest rate swaps do not require that either party deliver
interest-bearing assets with a principal amount equal to the notional amount of the contract.
b. One of the parties is required to deliver an asset of the type described in paragraph 9(a), but
there is a market mechanism that facilitates net settlement, for example, an exchange that
offers a ready opportunity to sell the contract or to enter into an offsetting contract.
c. One of the parties is required to deliver an asset of the type described in paragraph 9(a), but
that asset is readily convertible to cash 5 or is itself a derivative instrument. An example of
that type of contract is a forward contract that requires delivery of an exchange-traded
equity security. Even though the number of shares to be delivered is the same as the
notional amount of the contract and the price of the shares is the underlying, an
exchange-traded security is readily convertible to cash. Another example is a swaption—an
option to require delivery of a swap contract, which is a derivative.
Derivative instruments embedded in other contracts are addressed in paragraphs 12–16.
10. Notwithstanding the conditions in paragraphs 6–9, the following contracts are not subject
to the requirements of this Statement:
a.“Regular-way” security trades. Regular-way security trades are contracts with no net
settlement provision and no market mechanism to facilitate net settlement (as described in
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paragraphs 9(a) and 9(b)). They provide for delivery of a security within the time generally
established by regulations or conventions in the marketplace or exchange in which the
transaction is being executed.
b. Normal purchases and normal sales. Normal purchases and normal sales are contracts with
no net settlement provision and no market mechanism to facilitate net settlement (as
described in paragraphs 9(a) and 9(b)). They provide for the purchase or sale of something
other than a financial instrument or derivative instrument that will be delivered in quantities
expected to be used or sold by the reporting entity over a reasonable period in the normal
course of business.
c. Certain insurance contracts. Generally, contracts of the type that are within the scope of
FASB Statements No. 60, Accounting and Reporting by Insurance Enterprises, No. 97,
Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts
and for Realized Gains and Losses from the Sale of Investments, and No. 113, Accounting
and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts, are not
subject to the requirements of this Statement whether or not they are written by insurance
enterprises. That is, a contract is not subject to the requirements of this Statement if it
entitles the holder to be compensated only if, as a result of an identifiable insurable event
(other than a change in price), the holder incurs a liability or there is an adverse change in
the value of a specific asset or liability for which the holder is at risk. The following types
of contracts written by insurance enterprises or held by the insureds are not subject to the
requirements of this Statement for the reasons given:
(1) Traditional life insurance contracts. The payment of death benefits is the result of an
identifiable insurable event (death of the insured) instead of changes in a variable.
(2) Traditional property and casualty contracts. The payment of benefits is the result of an
identifiable insurable event (for example, theft or fire) instead of changes in a variable.
However, insurance enterprises enter into other types of contracts that may be subject to the
provisions of this Statement. In addition, some contracts with insurance or other enterprises
combine derivative instruments, as defined in this Statement, with other insurance products
or nonderivative contracts, for example, indexed annuity contracts, variable life insurance
contracts, and property and casualty contracts that combine traditional coverages with
foreign currency options. Contracts that consist of both derivative portions and
nonderivative portions are addressed in paragraph 12.
d. Certain financial guarantee contracts. Financial guarantee contracts are not subject to this
Statement if they 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, which is an
identifiable insurable event. In contrast, financial guarantee contracts are subject to this
Statement if they provide for payments to be made in response to changes in an underlying
(for example, a decrease in a specified debtor’s creditworthiness).
e. Certain contracts that are not traded on an exchange. Contracts that are not exchange-traded
are not subject to the requirements of this Statement if the underlying on which the
settlement is based is one of the following:
(1) A climatic or geological variable or other physical variable
(2) The price or value of (a) a nonfinancial asset of one of the parties to the contract
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provided that the asset is not readily convertible to cash or (b) a nonfinancial liability of
one of the parties to the contract provided that the liability does not require delivery of
an asset that is readily convertible to cash
(3) Specified volumes of sales or service revenues of one of the parties to the contract.
If a contract has more than one underlying and some, but not all, of them qualify for one of
the exceptions in paragraphs 10(e)(1), 10(e)(2), and 10(e)(3), the application of this
Statement to that contract depends on its predominant characteristics. That is, the contract
is subject to the requirements of this Statement if all of its underlyings, considered in
combination, behave in a manner that is highly correlated with the behavior of any of the
component variables that do not qualify for an exception.
f. Derivatives that serve as impediments to sales accounting. A derivative instrument
(whether freestanding or embedded in another contract) whose existence serves as an
impediment to recognizing a related contract as a sale by one party or a purchase by the
counterparty is not subject to this Statement. For example, the existence of a guarantee of
the residual value of a leased asset by the lessor may be an impediment to treating a contract
as a sales-type lease, in which case the contract would be treated by the lessor as an
operating lease. Another example is the existence of a call option enabling a transferor to
repurchase transferred assets that is an impediment to sales accounting under FASB
Statement No. 125, Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities.
11. Notwithstanding the conditions of paragraphs 6–10, the reporting entity shall not consider
the following contracts to be derivative instruments for purposes of this Statement:
a. Contracts issued or held by that reporting entity that are both (1) indexed to its own stock
and (2) classified in stockholders’ equity in its statement of financial position
b. Contracts issued by the entity in connection with stock-based compensation arrangements
addressed in FASB Statement No. 123, Accounting for Stock-Based Compensation
c. Contracts issued by the entity as contingent consideration from a business combination. The
accounting for contingent consideration issued in a business combination is addressed in
APB Opinion No. 16, Business Combinations. In applying this paragraph, the issuer is
considered to be the entity that is accounting for the combination using the purchase
method.
In contrast, the above exceptions do not apply to the counterparty in those contracts. In addition,
a contract that an entity either can or must settle by issuing its own equity instruments but that is
indexed in part or in full to something other than its own stock can be a derivative instrument for
the issuer under paragraphs 6–10, in which case it would be accounted for as a liability or an
asset in accordance with the requirements of this Statement.
Embedded Derivative Instruments
12. Contracts that do not in their entirety meet the definition of a derivative instrument (refer to
paragraphs 6–9), such as bonds, insurance policies, and leases, may contain “embedded”
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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.
The effect of embedding a derivative instrument in another type of contract (“the host contract”)
is that some or all of the cash flows or other exchanges that otherwise would be required by the
contract, whether unconditional or contingent upon the occurrence of a specified event, will be
modified based on one or more underlyings. An embedded derivative instrument shall be
separated from the host contract and accounted for as a derivative instrument pursuant to this
Statement if and only if all of the following criteria are met:
a. The economic characteristics and risks of the embedded derivative instrument are not clearly
and closely related to the economic characteristics and risks of the host contract. Additional
guidance on applying this criterion to various contracts containing embedded derivative
instruments is included in Appendix A of this Statement.
b. The contract (“the hybrid instrument”) that embodies both the embedded derivative
instrument and the host contract is not remeasured at fair value under otherwise applicable
generally accepted accounting principles with changes in fair value reported in earnings as
they occur.
c. A separate instrument with the same terms as the embedded derivative instrument would,
pursuant to paragraphs 6–11, be a derivative instrument subject to the requirements of this
Statement. (The initial net investment for the hybrid instrument shall not be considered to
be the initial net investment for the embedded derivative.)
13. For purposes of applying the provisions of paragraph 12, an embedded derivative
instrument in which the underlying is an interest rate or interest rate index 6 that alters net
interest payments that otherwise would be paid or received on an interest-bearing host contract is
considered to be clearly and closely related to the host contract unless either of the following
conditions exist:
a. The hybrid instrument can contractually be settled in such a way that the investor (holder)
would not recover substantially all of its initial recorded investment.
b. The embedded derivative could at least double the investor’s initial rate of return on the host
contract and could also result in a rate of return that is at least twice what otherwise would
be the market return for a contract that has the same terms as the host contract and that
involves a debtor with a similar credit quality.
Even though the above conditions focus on the investor’s rate of return and the investor’s
recovery of its investment, the existence of either of those conditions would result in the
embedded derivative instrument not being considered clearly and closely related to the host
contract by both parties to the hybrid instrument. Because the existence of those conditions is
assessed at the date that the hybrid instrument is acquired (or incurred) by the reporting entity,
the acquirer of a hybrid instrument in the secondary market could potentially reach a different
conclusion than could the issuer of the hybrid instrument due to applying the conditions in this
paragraph at different points in time.
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14. However, interest-only strips and principal-only strips are not subject to the requirements
of this Statement provided they (a) initially resulted from separating the rights to receive
contractual cash flows of a financial instrument that, in and of itself, did not contain an
embedded derivative that otherwise would have been accounted for separately as a derivative
pursuant to the provisions of paragraphs 12 and 13 and (b) do not incorporate any terms not
present in the original financial instrument described above.
15. An embedded foreign currency derivative instrument shall not be separated from the host
contract and considered a derivative instrument under paragraph 12 if the host contract is not a
financial instrument and it requires payment(s) denominated in (a) the currency of the primary
economic environment in which any substantial party to that contract operates (that is, its
functional currency) or (b) the currency in which the price of the related good or service that is
acquired or delivered is routinely denominated in international commerce (for example, the U.S.
dollar for crude oil transactions). Unsettled foreign currency transactions, including financial
instruments, that are monetary items and have their principal payments, interest payments, or
both denominated in a foreign currency are subject to the requirement in Statement 52 to
recognize any foreign currency transaction gain or loss in earnings and shall not be considered to
contain embedded foreign currency derivative instruments under this Statement. The same
proscription applies to available-for-sale or trading securities that have cash flows denominated
in a foreign currency.
16. In subsequent provisions of this Statement, both (a) a derivative instrument included within
the scope of this Statement by paragraphs 6–11 and (b) an embedded derivative instrument that
has been separated from a host contract as required by paragraph 12 are collectively referred to
as derivative instruments. If an embedded derivative instrument is separated from its host
contract, the host contract shall be accounted for based on generally accepted accounting
principles applicable to instruments of that type that do not contain embedded derivative
instruments. If an entity cannot reliably identify and measure the embedded derivative
instrument that paragraph 12 requires be separated from the host contract, the entire contract
shall be measured at fair value with gain or loss recognized in earnings, but it may not be
designated as a hedging instrument pursuant to this Statement.
Recognition of Derivatives and Measurement of Derivatives and Hedged Items
17. An entity shall recognize all of its derivative instruments in its statement of financial
position as either assets or liabilities depending on the rights or obligations under the contracts.
All derivative instruments shall be measured at fair value. The guidance in FASB Statement No.
107, Disclosures about Fair Value of Financial Instruments, as amended, shall apply in
determining the fair value of a financial instrument (derivative or hedged item). If expected
future cash flows are used to estimate fair value, those expected cash flows shall be the best
estimate based on reasonable and supportable assumptions and projections. All available
evidence shall be considered in developing estimates of expected future cash flows. The weight
given to the evidence shall be commensurate with the extent to which the evidence can be
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verified objectively. If a range is estimated for either the amount or the timing of possible cash
flows, the likelihood of possible outcomes shall be considered in determining the best estimate
of future cash flows.
18. The accounting for changes in the fair value (that is, gains or losses) of a derivative
depends on whether it has been designated and qualifies as part of a hedging relationship and, if
so, on the reason for holding it. Either all or a proportion of a derivative may be designated as
the hedging instrument. The proportion must be expressed as a percentage of the entire
derivative so that the profile of risk exposures in the hedging portion of the derivative is the
same as that in the entire derivative. (Thus, an entity is prohibited from separating a compound
derivative into components representing different risks and designating any such component as
the hedging instrument, except as permitted at the date of initial application by the transition
provisions in paragraph 49.) Subsequent references in this Statement to a derivative as a hedging
instrument include the use of only a proportion of a derivative as a hedging instrument. Two or
more derivatives, or proportions thereof, may also be viewed in combination and jointly
designated as the hedging instrument. Gains and losses on derivative instruments are accounted
for as follows:
a. No hedging designation. The gain or loss on a derivative instrument not designated as a
hedging instrument shall be recognized currently in earnings.
b. Fair value hedge. The gain or loss on a derivative instrument designated and qualifying as a
fair value hedging instrument as well as the offsetting loss or gain on the hedged item
attributable to the hedged risk shall be recognized currently in earnings in the same
accounting period, as provided in paragraphs 22 and 23.
c. Cash flow hedge. The effective portion of the gain or loss on a derivative instrument
designated and qualifying as a cash flow hedging instrument shall be reported as a
component of other comprehensive income (outside earnings) and reclassified into
earnings in the same period or periods during which the hedged forecasted transaction
affects earnings, as provided in paragraphs 30 and 31. The remaining gain or loss on the
derivative instrument, if any, shall be recognized currently in earnings, as provided in
paragraph 30.
d. Foreign currency hedge. The gain or loss on a derivative instrument or nonderivative
financial instrument designated and qualifying as a foreign currency hedging instrument
shall be accounted for as follows:
(1) The gain or loss on the hedging derivative or nonderivative instrument in a hedge of a
foreign-currency-denominated firm commitment and the offsetting loss or gain on the
hedged firm commitment shall be recognized currently in earnings in the same
accounting period, as provided in paragraph 37.
(2) The gain or loss on the hedging derivative instrument in a hedge of an available-for-sale
security and the offsetting loss or gain on the hedged available-for-sale security shall be
recognized currently in earnings in the same accounting period, as provided in
paragraph 38.
(3) The effective portion of the gain or loss on the hedging derivative instrument in a hedge
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of a forecasted foreign-currency-denominated transaction shall be reported as a
component of other comprehensive income (outside earnings) and reclassified into
earnings in the same period or periods during which the hedged forecasted transaction
affects earnings, as provided in paragraph 41. The remaining gain or loss on the
hedging instrument shall be recognized currently in earnings.
(4) The gain or loss on the hedging derivative or nonderivative instrument in a hedge of a
net investment in a foreign operation shall be reported in other comprehensive income
(outside earnings) as part of the cumulative translation adjustment to the extent it is
effective as a hedge, as provided in paragraph 42.
19. In this Statement, the change in the fair value of an entire financial asset or liability for a
period refers to the difference between its fair value at the beginning of the period (or acquisition
date) and the end of the period adjusted to exclude (a) changes in fair value due to the passage of
time and (b) changes in fair value related to any payments received or made, such as in partially
recovering the asset or partially settling the liability.
Fair Value Hedges
General
20. An entity may designate a derivative instrument as hedging the exposure to changes in the
fair value of an asset or a liability or an identified portion thereof (“hedged item”) that is
attributable to a particular risk. Designated hedging instruments and hedged items qualify for
fair value hedge accounting if all of the following criteria and those in paragraph 21 are met:
a. At inception of the hedge, there is formal documentation of the hedging relationship and the
entity’s risk management objective and strategy for undertaking the hedge, including
identification of the hedging instrument, the hedged item, the nature of the risk being
hedged, and how the hedging instrument’s effectiveness in offsetting the exposure to
changes in the hedged item’s fair value attributable to the hedged risk will be assessed.
There must be a reasonable basis for how the entity plans to assess the hedging instrument’s
effectiveness.
(1) For a fair value hedge of a firm commitment, the entity’s formal documentation at the
inception of the hedge must include a reasonable method for recognizing in earnings the
asset or liability representing the gain or loss on the hedged firm commitment.
(2) An entity’s defined risk management strategy for a particular hedging relationship may
exclude certain components of a specific hedging derivative’s change in fair value, such
as time value, from the assessment of hedge effectiveness, as discussed in paragraph 63
in Section 2 of Appendix A.
b. Both at inception of the hedge and on an ongoing basis, the hedging relationship is expected
to be highly effective in achieving offsetting changes in fair value attributable to the hedged
risk during the period that the hedge is designated. An assessment of effectiveness is
required whenever financial statements or earnings are reported, and at least every three
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months. If the hedging instrument (such as an at-the-money option contract) provides only
one-sided offset of the hedged risk, the increases (or decreases) in the fair value of the
hedging instrument must be expected to be highly effective in offsetting the decreases (or
increases) in the fair value of the hedged item. All assessments of effectiveness shall be
consistent with the risk management strategy documented for that particular hedging
relationship (in accordance with paragraph 20(a) above).
c. If a written option is designated as hedging a recognized asset or liability, the combination
of the hedged item and the written option provides at least as much potential for gains as a
result of a favorable change in the fair value of the combined instruments 7 as exposure to
losses from an unfavorable change in their combined fair value. That test is met if all
possible percentage favorable changes in the underlying (from zero percent to 100 percent)
would provide at least as much gain as the loss that would be incurred from an unfavorable
change in the underlying of the same percentage.
(1) A combination of options (for example, an interest rate collar) entered into
contemporaneously shall be considered a written option if either at inception or over the
life of the contracts a net premium is received in cash or as a favorable rate or other
term. (Thus, a collar can be designated as a hedging instrument in a fair value hedge
without regard to the test in paragraph 20(c) unless a net premium is received.)
Furthermore, a derivative instrument that results from combining a written option and
any other nonoption derivative shall be considered a written option.
A nonderivative instrument, such as a Treasury note, shall not be designated as a hedging
instrument, except as provided in paragraphs 37 and 42 of this Statement.
The Hedged Item
21. An asset or a liability is eligible for designation as a hedged item in a fair value hedge if all
of the following criteria are met:
a. The hedged item is specifically identified as either all or a specific portion of a recognized
asset or liability or of an unrecognized firm commitment. 8 The hedged item is a single
asset or liability (or a specific portion thereof) or is a portfolio of similar assets or a portfolio
of similar liabilities (or a specific portion thereof).
(1) If similar assets or similar liabilities are aggregated and hedged as a portfolio, the
individual assets or individual liabilities must share the risk exposure for which they are
designated as being hedged. The change in fair value attributable to the hedged risk for
each individual item in a hedged portfolio must be expected to respond in a generally
proportionate manner to the overall change in fair value of the aggregate portfolio
attributable to the hedged risk. That is, if the change in fair value of a hedged portfolio
attributable to the hedged risk was 10 percent during a reporting period, the change in
the fair values attributable to the hedged risk for each item constituting the portfolio
should be expected to be within a fairly narrow range, such as 9 percent to 11 percent.
In contrast, an expectation that the change in fair value attributable to the hedged risk
for individual items in the portfolio would range from 7 percent to 13 percent would be
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inconsistent with this provision. In aggregating loans in a portfolio to be hedged, an
entity may choose to consider some of the following characteristics, as appropriate:
loan type, loan size, nature and location of collateral, interest rate type (fixed or
variable) and the coupon interest rate (if fixed), scheduled maturity, prepayment history
of the loans (if seasoned), and expected prepayment performance in varying interest rate
scenarios. 9
(2) If the hedged item is a specific portion of an asset or liability (or of a portfolio of
similar assets or a portfolio of similar liabilities), the hedged item is one of the
following:
(a) A percentage of the entire asset or liability (or of the entire portfolio)
(b) One or more selected contractual cash flows (such as the portion of the asset or
liability representing the present value of the interest payments in the first two
years of a four-year debt instrument)
(c) A put option, a call option, an interest rate cap, or an interest rate floor embedded
in an existing asset or liability that is not an embedded derivative accounted for
separately pursuant to paragraph 12 of this Statement
(d) The residual value in a lessor’s net investment in a direct financing or sales-type
lease.
If the entire asset or liability is an instrument with variable cash flows, the hedged item
cannot be deemed to be an implicit fixed-to-variable swap (or similar instrument)
perceived to be embedded in a host contract with fixed cash flows.
b. The hedged item presents an exposure to changes in fair value attributable to the hedged risk
that could affect reported earnings. The reference to affecting reported earnings does not
apply to an entity that does not report earnings as a separate caption in a statement of
financial performance, such as a not-for-profit organization, as discussed in paragraph 43.
c. The hedged item is not (1) an asset or liability that is remeasured with the changes in fair
value attributable to the hedged risk reported currently in earnings (for example, if foreign
exchange risk is hedged, a foreign-currency-denominated asset for which a foreign currency
transaction gain or loss is recognized in earnings), (2) an investment accounted for by the
equity method in accordance with the requirements of APB Opinion No. 18, The Equity
Method of Accounting for Investments in Common Stock, (3) a minority interest in one or
more consolidated subsidiaries, (4) an equity investment in a consolidated subsidiary, (5) 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 (6) an equity instrument
issued by the entity and classified in stockholders’ equity in the statement of financial
position.
d. If the hedged item is all or a portion of a debt security (or a portfolio of similar debt
securities) that is classified as held-to-maturity in accordance with FASB Statement No.
115, Accounting for Certain Investments in Debt and Equity Securities, the designated risk
being hedged is the risk of changes in its fair value attributable to changes in the obligor’s
creditworthiness or if the hedged item is an option component of a held-to-maturity security
that permits its prepayment, the designated risk being hedged is the risk of changes in the
entire fair value of that option component. (The designated hedged risk for a
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held-to-maturity security may not be the risk of changes in its fair value attributable to
changes in market interest rates or foreign exchange rates. If the hedged item is other than
an option component that permits its prepayment, the designated hedged risk also may not
be the risk of changes in its overall fair value.)
e. If the hedged item is a nonfinancial asset or liability (other than a recognized loan servicing
right or a nonfinancial 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
(reflecting its actual location if a physical asset). That is, the price risk of a similar asset in a
different location or of a major ingredient may not be the hedged risk. Thus, in hedging the
exposure to changes in the fair value of gasoline, an entity may not designate the risk of
changes in the price of crude oil as the risk being hedged for purposes of determining
effectiveness of the fair value hedge of gasoline
f. If the hedged item is a financial asset or liability, a recognized loan servicing right, or a
nonfinancial firm commitment with financial components, the designated risk being hedged
is (1) the risk of changes in the overall fair value of the entire hedged item, (2) the risk of
changes in its fair value attributable to changes in market interest rates, (3) the risk of
changes in its fair value attributable to changes in the related foreign currency exchange
rates (refer to paragraphs 37 and 38), or (4) the risk of changes in its fair value attributable
to changes in the obligor’s creditworthiness. If the risk designated as being hedged is not
the risk in paragraph 21(f)(1) above, two or more of the other risks (market interest rate risk,
foreign currency exchange risk, and credit risk) may simultaneously be designated as being
hedged. An entity may not simply designate prepayment risk as the risk being hedged for a
financial asset. However, it can designate the option component of a prepayable instrument
as the hedged item in a fair value hedge of the entity’s exposure to changes in the fair value
of that “prepayment” option, perhaps thereby achieving the objective of its desire to hedge
prepayment risk. The effect of an embedded derivative of the same risk class must be
considered in designating a hedge of an individual risk. For example, the effect of an
embedded prepayment option must be considered in designating a hedge of market interest
rate risk.
22. Gains and losses on a qualifying fair value hedge shall be accounted for as follows:
a. The gain or loss on the hedging instrument shall be recognized currently in earnings.
b. The gain or loss (that is, the change in fair value) on the hedged item attributable to the
hedged risk shall adjust the carrying amount of the hedged item and be recognized currently
in earnings.
If the fair value hedge is fully effective, the gain or loss on the hedging instrument, adjusted for
the component, if any, of that gain or loss that is excluded from the assessment of effectiveness
under the entity’s defined risk management strategy for that particular hedging relationship (as
discussed in paragraph 63 in Section 2 of Appendix A), would exactly offset the loss or gain on
the hedged item attributable to the hedged risk. Any difference that does arise would be the
effect of hedge ineffectiveness, which consequently is recognized currently in earnings. The
measurement of hedge ineffectiveness for a particular hedging relationship shall be consistent
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with the entity’s risk management strategy and the method of assessing hedge effectiveness that
was documented at the inception of the hedging relationship, as discussed in paragraph 20(a).
Nevertheless, the amount of hedge ineffectiveness recognized in earnings is based on the extent
to which exact offset is not achieved. Although a hedging relationship must comply with an
entity’s established policy range of what is considered “highly effective” pursuant to paragraph
20(b) in order for that relationship to qualify for hedge accounting, that compliance does not
assure zero ineffectiveness. Section 2 of Appendix A illustrates assessing hedge effectiveness
and measuring hedge ineffectiveness. Any hedge ineffectiveness directly affects earnings
because there will be no offsetting adjustment of a hedged item’s carrying amount for the
ineffective aspect of the gain or loss on the related hedging instrument.
23. If a hedged item is otherwise measured at fair value with changes in fair value reported in
other comprehensive income (such as an available-for-sale security), the adjustment of the
hedged item’s carrying amount discussed in paragraph 22 shall be recognized in earnings rather
than in other comprehensive income in order to offset the gain or loss on the hedging instrument.
24. The adjustment of the carrying amount of a hedged asset or liability required by
paragraph 22 shall be accounted for in the same manner as other components of the carrying
amount of that asset or liability. For example, an adjustment of the carrying amount of a hedged
asset held for sale (such as inventory) would remain part of the carrying amount of that asset
until the asset is sold, at which point the entire carrying amount of the hedged asset would be
recognized as the cost of the item sold in determining earnings. An adjustment of the carrying
amount of a hedged interest-bearing financial instrument shall be amortized to earnings;
amortization shall begin no later than when the hedged item ceases to be adjusted for changes in
its fair value attributable to the risk being hedged.
25. An entity shall discontinue prospectively the accounting specified in paragraphs 22 and 23
for an existing hedge if any one of the following occurs:
a. Any criterion in paragraphs 20 and 21 is no longer met.
b. The derivative expires or is sold, terminated, or exercised.
c. The entity removes the designation of the fair value hedge.
In those circumstances, the entity may elect to designate prospectively a new hedging
relationship with a different hedging instrument or, in the circumstances described in paragraphs
25(a) and 25(c) above, a different hedged item or a hedged transaction if the hedging relationship
meets the criteria specified in paragraphs 20 and 21 for a fair value hedge or paragraphs 28 and
29 for a cash flow hedge.
26. In general, if a periodic assessment indicates noncompliance with the effectiveness
criterion in paragraph 20(b), an entity shall not recognize the adjustment of the carrying amount
of the hedged item described in paragraphs 22 and 23 after the last date on which compliance
with the effectiveness criterion was established. However, if the event or change in
circumstances that caused the hedging relationship to fail the effectiveness criterion can be
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identified, the entity shall recognize in earnings the changes in the hedged item’s fair value
attributable to the risk being hedged that occurred prior to that event or change in circumstances.
If a fair value hedge of a firm commitment is discontinued because the hedged item no longer
meets the definition of a firm commitment, the entity shall derecognize any asset or liability
previously recognized pursuant to paragraph 22 (as a result of an adjustment to the carrying
amount for the firm commitment) and recognize a corresponding loss or gain currently in
earnings.
Impairment
27. An asset or liability that has been designated as being hedged and accounted for pursuant to
paragraphs 22–24 remains subject to the applicable requirements in generally accepted
accounting principles for assessing impairment for that type of asset or for recognizing an
increased obligation for that type of liability. Those impairment requirements shall be applied
after hedge accounting has been applied for the period and the carrying amount of the hedged
asset or liability has been adjusted pursuant to paragraph 22 of this Statement. Because the
hedging instrument is recognized separately as an asset or liability, its fair value or expected
cash flows shall not be considered in applying those impairment requirements to the hedged
asset or liability.
Cash Flow Hedges
General
28. An entity may designate a derivative instrument as hedging the exposure to variability in
expected future cash flows that is attributable to a particular risk. That exposure may be
associated with an existing recognized asset or liability (such as all or certain future interest
payments on variable-rate debt) or a forecasted transaction (such as a forecasted purchase or
sale). 10 Designated hedging instruments and hedged items or transactions qualify for cash flow
hedge accounting if all of the following criteria and those in paragraph 29 are met:
a. At inception of the hedge, there is formal documentation of the hedging relationship and the
entity’s risk management objective and strategy for undertaking the hedge, including
identification of the hedging instrument, the hedged transaction, the nature of the risk being
hedged, and how the hedging instrument’s effectiveness in hedging the exposure to the
hedged transaction’s variability in cash flows attributable to the hedged risk will be
assessed. There must be a reasonable basis for how the entity plans to assess the hedging
instrument’s effectiveness.
(1) An entity’s defined risk management strategy for a particular hedging relationship may
exclude certain components of a specific hedging derivative’s change in fair value from
the assessment of hedge effectiveness, as discussed in paragraph 63 in Section 2 of
Appendix A.
(2) Documentation shall include all relevant details, including the date on or period within
which the forecasted transaction is expected to occur, the specific nature of asset or
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liability involved (if any), and the expected currency amount or quantity of the
forecasted transaction.
(a) The phrase expected currency amount refers to hedges of foreign currency
exchange risk and requires specification of the exact amount of foreign currency
being hedged.
(b) The phrase expected . . . quantity refers to hedges of other risks and requires
specification of the physical quantity (that is, the number of items or units of
measure) encompassed by the hedged forecasted transaction. If a forecasted sale or
purchase is being hedged for price risk, the hedged transaction cannot be specified
solely in terms of expected currency amounts, nor can it be specified as a
percentage of sales or purchases during a period. The current price of a forecasted
transaction also should be identified to satisfy the criterion in paragraph 28(b) for
offsetting cash flows.
The hedged forecasted transaction shall be described with sufficient specificity so that
when a transaction occurs, it is clear whether that transaction is or is not the hedged
transaction. Thus, the forecasted transaction could be identified as the sale of either the
first 15,000 units of a specific product sold during a specified 3-month period or the
first 5,000 units of a specific product sold in each of 3 specific months, but it could not
be identified as the sale of the last 15,000 units of that product sold during a 3-month
period (because the last 15,000 units cannot be identified when they occur, but only
when the period has ended).
b. Both at inception of the hedge and on an ongoing basis, the hedging relationship is expected
to be highly effective in achieving offsetting cash flows attributable to the hedged risk
during the term of the hedge, except as indicated in paragraph 28(d) below. An assessment
of effectiveness is required whenever financial statements or earnings are reported, and at
least every three months. If the hedging instrument, such as an at-the-money option
contract, provides only one-sided offset against the hedged risk, the cash inflows (outflows)
from the hedging instrument must be expected to be highly effective in offsetting the
corresponding change in the cash outflows or inflows of the hedged transaction. All
assessments of effectiveness shall be consistent with the originally documented risk
management strategy for that particular hedging relationship.
c. If a written option is designated as hedging the variability in cash flows for a recognized
asset or liability, the combination of the hedged item and the written option provides at least
as much potential for favorable cash flows as exposure to unfavorable cash flows. That test
is met if all possible percentage favorable changes in the underlying (from zero percent to
100 percent) would provide at least as much favorable cash flows as the unfavorable cash
flows that would be incurred from an unfavorable change in the underlying of the same
percentage. (Refer to paragraph 20(c)(1).)
d. If a hedging instrument is used to modify the interest receipts or payments associated with a
recognized financial asset or liability from one variable rate to another variable rate, the
hedging instrument must be a link between an existing designated asset (or group of similar
assets) with variable cash flows and an existing designated liability (or group of similar
liabilities) with variable cash flows and be highly effective at achieving offsetting cash
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flows. A link exists if the basis (that is, the rate index on which the interest rate is based) of
one leg of an interest rate swap is the same as the basis of the interest receipts for the
designated asset and the basis of the other leg of the swap is the same as the basis of the
interest payments for the designated liability. In this situation, the criterion in the first
sentence in paragraph 29(a) is applied separately to the designated asset and the designated
liability.
A nonderivative instrument, such as a Treasury note, shall not be designated as a hedging
instrument for a cash flow hedge.
The Hedged Forecasted Transaction
29. A forecasted transaction is eligible for designation as a hedged transaction in a cash flow
hedge if all of the following additional criteria are met:
a. The forecasted transaction is specifically identified as a single transaction or a group of
individual transactions. If the hedged transaction is a group of individual transactions, those
individual transactions must share the same risk exposure for which they are designated as
being hedged. Thus, a forecasted purchase and a forecasted sale cannot both be included in
the same group of individual transactions that constitute the hedged transaction.
b. The occurrence of the forecasted transaction is probable.
c. The forecasted transaction is a transaction with a party external to the reporting entity
(except as permitted by paragraph 40) and presents an exposure to variations in cash flows
for the hedged risk that could affect reported earnings.
d. The forecasted transaction is not the acquisition of an asset or incurrence of a liability that
will subsequently be remeasured with changes in fair value attributable to the hedged risk
reported currently in earnings (for example, if foreign exchange risk is hedged, the
forecasted acquisition of a foreign-currency-denominated asset for which a foreign currency
transaction gain or loss will be recognized in earnings). However, forecasted sales on credit
and the forecasted accrual of royalties on probable future sales by third-party licensees are
not considered the forecasted acquisition of a receivable. If the forecasted transaction
relates to a recognized asset or liability, the asset or liability is not remeasured with changes
in fair value attributable to the hedged risk reported currently in earnings.
e. If the variable cash flows of the forecasted transaction relate to a debt security that is
classified as held-to-maturity under Statement 115, the risk being hedged is the risk of
changes in its cash flows attributable to default or changes in the obligor’s creditworthiness.
For those variable cash flows, the risk being hedged cannot be the risk of changes in its cash
flows attributable to changes in market interest rates.
f. The forecasted transaction does not involve a business combination subject to the provisions
of Opinion 16 and is not a transaction (such as a forecasted purchase, sale, or dividend)
involving (1) a parent company’s interests in consolidated subsidiaries, (2) a minority
interest in a consolidated subsidiary, (3) an equity-method investment, or (4) an entity’s own
equity instruments.
g. If the hedged transaction is the forecasted purchase or sale of a nonfinancial asset, the
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designated risk being hedged is (1) the risk of changes in the functional-currency-equivalent
cash flows attributable to changes in the related foreign currency exchange rates or (2) the
risk of changes in the cash flows relating to all changes in the purchase price or sales price
of the asset (reflecting its actual location if a physical asset), not the risk of changes in the
cash flows relating to the purchase or sale of a similar asset in a different location or of a
major ingredient. Thus, for example, in hedging the exposure to changes in the cash flows
relating to the purchase of its bronze bar inventory, an entity may not designate the risk of
changes in the cash flows relating to purchasing the copper component in bronze as the risk
being hedged for purposes of assessing offset as required by paragraph 28(b).
h. 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 (1) the risk of changes in the cash flows of the entire asset or liability,
such as those relating to all changes in the purchase price or sales price (regardless of
whether that price and the related cash flows are stated in the entity’s functional currency or
a foreign currency), (2) the risk of changes in its cash flows attributable to changes in
market interest rates, (3) the risk of changes in the functional-currency-equivalent cash
flows attributable to changes in the related foreign currency exchange rates (refer to
paragraph 40), or (4) the risk of changes in its cash flows attributable to default or changes
in the obligor’s creditworthiness. Two or more of the above risks may be designated
simultaneously as being hedged. An entity may not designate prepayment risk as the risk
being hedged (refer to paragraph 21(f)).
30. The effective portion of the gain or loss on a derivative designated as a cash flow hedge is
reported in other comprehensive income, and the ineffective portion is reported in earnings.
More specifically, a qualifying cash flow hedge shall be accounted for as follows:
a. If an entity’s defined risk management strategy for a particular hedging relationship
excludes a specific component of the gain or loss, or related cash flows, on the hedging
derivative from the assessment of hedge effectiveness (as discussed in paragraph 63 in
Section 2 of Appendix A), that excluded component of the gain or loss shall be recognized
currently in earnings. For example, if the effectiveness of a hedge with an option contract is
assessed based on changes in the option’s intrinsic value, the changes in the option’s time
value would be recognized in earnings. Time value is equal to the fair value of the option
less its intrinsic value.
b. Accumulated other comprehensive income associated with the hedged transaction shall be
adjusted to a balance that reflects the lesser of the following (in absolute amounts):
(1) The cumulative gain or loss on the derivative from inception of the hedge less (a) the
excluded component discussed in paragraph 30(a) above and (b) the derivative’s gains
or losses previously reclassified from accumulated other comprehensive income into
earnings pursuant to paragraph 31
(2) The portion of the cumulative gain or loss on the derivative necessary to offset the
cumulative change in expected future cash flows on the hedged transaction from
inception of the hedge less the derivative’s gains or losses previously reclassified from
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accumulated other comprehensive income into earnings pursuant to paragraph 31.
That adjustment of accumulated other comprehensive income shall incorporate recognition
in other comprehensive income of part or all of the gain or loss on the hedging derivative, as
necessary.
c. A gain or loss shall be recognized in earnings, as necessary, for any remaining gain or loss
on the hedging derivative or to adjust other comprehensive income to the balance specified
in paragraph 30(b) above.
Section 2 of Appendix A illustrates assessing hedge effectiveness and measuring hedge
ineffectiveness. Examples 6 and 9 of Section 1 of Appendix B illustrate the application of this
paragraph.
31. Amounts in accumulated other comprehensive income shall be reclassified into earnings in
the same period or periods during which the hedged forecasted transaction affects earnings (for
example, when a forecasted sale actually occurs). If the hedged transaction results in the
acquisition of an asset or the incurrence of a liability, the gains and losses in accumulated other
comprehensive income shall be reclassified into earnings in the same period or periods during
which the asset acquired or liability incurred affects earnings (such as in the periods that
depreciation expense, interest expense, or cost of sales is recognized). However, if an entity
expects at any time that continued reporting of a loss in accumulated other comprehensive
income would lead to recognizing a net loss on the combination of the hedging instrument and
the hedged transaction (and related asset acquired or liability incurred) in one or more future
periods, a loss shall be reclassified immediately into earnings for the amount that is not expected
to be recovered. For example, a loss shall be reported in earnings for a derivative that is
designated as hedging the forecasted purchase of inventory to the extent that the cost basis of the
inventory plus the related amount reported in accumulated other comprehensive income exceeds
the amount expected to be recovered through sales of that inventory. (Impairment guidance is
provided in paragraphs 34 and 35.)
32. An entity shall discontinue prospectively the accounting specified in paragraphs 30 and 31
for an existing hedge if any one of the following occurs:
a. Any criterion in paragraphs 28 and 29 is no longer met.
b. The derivative expires or is sold, terminated, or exercised.
c. The entity removes the designation of the cash flow hedge.
In those circumstances, the net gain or loss shall remain in accumulated other comprehensive
income and be reclassified into earnings as specified in paragraph 31. Furthermore, the entity
may elect to designate prospectively a new hedging relationship with a different hedging
instrument or, in the circumstances described in paragraphs 32(a) and 32(c), a different hedged
transaction or a hedged item if the hedging relationship meets the criteria specified in paragraphs
28 and 29 for a cash flow hedge or paragraphs 20 and 21 for a fair value hedge.
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33. If a cash flow hedge is discontinued because it is probable that the original forecasted
transaction will not occur, the net gain or loss in accumulated other comprehensive income shall
be immediately reclassified into earnings.
34. Existing requirements in generally accepted accounting principles for assessing asset
impairment or recognizing an increased obligation apply to an asset or liability that gives rise to
variable cash flows (such as a variable-rate financial instrument), for which the variable cash
flows (the forecasted transactions) have been designated as being hedged and accounted for
pursuant to paragraphs 30 and 31. Those impairment requirements shall be applied each period
after hedge accounting has been applied for the period, pursuant to paragraphs 30 and 31 of this
Statement. The fair value or expected cash flows of a hedging instrument shall not be considered
in applying those requirements. The gain or loss on the hedging instrument in accumulated other
comprehensive income shall, however, be accounted for as discussed in paragraph 31.
35. If, under existing requirements in generally accepted accounting principles, an impairment
loss is recognized on an asset or an additional obligation is recognized on a liability to which a
hedged forecasted transaction relates, any offsetting net gain related to that transaction in
accumulated other comprehensive income shall be reclassified immediately into earnings.
Similarly, if a recovery is recognized on the asset or liability to which the forecasted transaction
relates, any offsetting net loss that has been accumulated in other comprehensive income shall be
reclassified immediately into earnings.
Foreign Currency Hedges
36. Consistent with the functional currency concept in Statement 52, an entity may designate
the following types of hedges of foreign currency exposure, as specified in paragraphs 37-42:
a. A fair value hedge of an unrecognized firm commitment or an available-for-sale security
b. A cash flow hedge of a forecasted foreign-currency-denominated transaction or a forecasted
intercompany foreign-currency-denominated transaction
c. A hedge of a net investment in a foreign operation.
The criterion in paragraph 21(c)(1) requires that a recognized asset or liability that may give rise
to a foreign currency transaction gain or loss under Statement 52 (such as a
foreign-currency-denominated receivable or payable) not be the hedged item in a foreign
currency fair value or cash flow hedge because it is remeasured with the changes in the carrying
amount attributable to what would be the hedged risk (an exchange rate change) reported
currently in earnings. Similarly, the criterion in paragraph 29(d) requires that the forecasted
acquisition of an asset or the incurrence of a liability that may give rise to a foreign currency
transaction gain or loss under Statement 52 not be the hedged item in a foreign currency cash
flow hedge because, subsequent to acquisition or incurrence, the asset or liability will be
remeasured with changes in the carrying amount attributable to what would be the hedged risk
reported currently in earnings. A foreign currency derivative instrument that has been entered
into with another member of a consolidated group can be a hedging instrument in the
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consolidated financial statements only if that other member has entered into an offsetting
contract with an unrelated third party to hedge the exposure it acquired from issuing the
derivative instrument to the affiliate that initiated the hedge.
Foreign Currency Fair Value Hedges
37. Unrecognized firm commitment. A derivative instrument or a nonderivative financial
instrument 11 that may give rise to a foreign currency transaction gain or loss under Statement 52
can be designated as hedging changes in the fair value of an unrecognized firm commitment, or a
specific portion thereof, attributable to foreign currency exchange rates. The designated hedging
relationship qualifies for the accounting specified in paragraphs 22–27 if all the fair value hedge
criteria in paragraphs 20 and 21 are met.
38. Available-for-sale security. A nonderivative financial instrument shall not be designated as
the hedging instrument in a fair value hedge of the foreign currency exposure of an
available-for-sale security. A derivative instrument can be designated as hedging the changes in
the fair value of an available-for-sale debt security (or a specific portion thereof) attributable to
changes in foreign currency exchange rates. The designated hedging relationship qualifies for the
accounting specified in paragraphs 22–27 if all the fair value hedge criteria in paragraphs 20 and
21 are met. An available-for-sale equity security can be hedged for changes in the fair value
attributable to changes in foreign currency exchange rates and qualify for the accounting
specified in paragraphs 22–27 only if the fair value hedge criteria in paragraphs 20 and 21 are
met and the following two conditions are satisfied:
a. The security is not traded on an exchange (or other established marketplace) on which trades
are denominated in the investor’s functional currency.
b. Dividends or other cash flows to holders of the security are all denominated in the same
foreign currency as the currency expected to be received upon sale of the security.
The change in fair value of the hedged available-for-sale equity security attributable to foreign
exchange risk is reported in earnings pursuant to paragraph 23 and not in other comprehensive
income.
39. Gains and losses on a qualifying foreign currency fair value hedge shall be accounted for as
specified in paragraphs 22–27. The gain or loss on a nonderivative hedging instrument
attributable to foreign currency risk is the foreign currency transaction gain or loss as determined
under Statement 52. 12 That foreign currency transaction gain or loss shall be recognized
currently in earnings along with the change in the carrying amount of the hedged firm
commitment.
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Foreign Currency Cash Flow Hedges
40. A nonderivative financial instrument shall not be designated as a hedging instrument in a
foreign currency cash flow hedge. A derivative instrument designated as hedging the foreign
currency exposure to variability in the functional-currency-equivalent cash flows associated with
either a forecasted foreign-currency-denominated transaction (for example, a forecasted export
sale to an unaffiliated entity with the price to be denominated in a foreign currency) or a
forecasted intercompany foreign-currency-denominated transaction (for example, a forecasted
sale to a foreign subsidiary or a forecasted royalty from a foreign subsidiary) qualifies for hedge
accounting if all of the following criteria are met:
a. The operating unit that has the foreign currency exposure is a party to the hedging
instrument (which can be an instrument between a parent company and its subsidiary—refer
to paragraph 36).
b. The hedged transaction is denominated in a currency other than that unit’s functional
currency.
c. All of the criteria in paragraphs 28 and 29 are met, except for the criterion in paragraph
29(c) that requires that the forecasted transaction be with a party external to the reporting
entity.
d. If the hedged transaction is a group of individual forecasted foreign-currency-denominated
transactions, a forecasted inflow of a foreign currency and a forecasted outflow of the
foreign currency cannot both be included in the same group.
41. A qualifying foreign currency cash flow hedge shall be accounted for as specified in
paragraphs 30–35.
Hedges of the Foreign Currency Exposure of a Net Investment in a Foreign Operation
42. A derivative instrument or a nonderivative financial instrument that may give rise to a
foreign currency transaction gain or loss under Statement 52 can be designated as hedging the
foreign currency exposure of a net investment in a foreign operation. The gain or loss on a
hedging derivative instrument (or the foreign currency transaction gain or loss on the
nonderivative hedging instrument) that is designated as, and is effective as, an economic hedge
of the net investment in a foreign operation shall be reported in the same manner as a translation
adjustment to the extent it is effective as a hedge. The hedged net investment shall be accounted
for consistent with Statement 52; the provisions of this Statement for recognizing the gain or loss
on assets designated as being hedged in a fair value hedge do not apply to the hedge of a net
investment in a foreign operation.
Accounting by Not-for-Profit Organizations and Other Entities That Do Not Report
Earnings
43. An entity that does not report earnings as a separate caption in a statement of financial
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performance (for example, a not-for-profit organization or a defined benefit pension plan) shall
recognize the gain or loss on a hedging instrument and a nonhedging derivative instrument as a
change in net assets in the period of change unless the hedging instrument is designated as a
hedge of the foreign currency exposure of a net investment in a foreign operation. In that case,
the provisions of paragraph 42 of this Statement shall be applied. Entities that do not report
earnings shall recognize the changes in the carrying amount of the hedged item pursuant to
paragraph 22 in a fair value hedge as a change in net assets in the period of change. Those
entities are not permitted to use cash flow hedge accounting because they do not report earnings
separately. Consistent with the provisions of FASB Statement No. 117, Financial Statements of
Not-for-Profit Organizations, this Statement does not prescribe how a not-for-profit organization
should determine the components of an operating measure, if one is presented.
Disclosures
44. An entity that holds or issues derivative instruments (or nonderivative instruments that are
designated and qualify as hedging instruments pursuant to paragraphs 37 and 42) shall disclose
its objectives for holding or issuing those instruments, the context needed to understand those
objectives, and its strategies for achieving those objectives. The description shall distinguish
between derivative instruments (and nonderivative instruments) designated as fair value hedging
instruments, derivative instruments designated as cash flow hedging instruments, derivative
instruments (and nonderivative instruments) designated as hedging instruments for hedges of the
foreign currency exposure of a net investment in a foreign operation, and all other derivatives.
The description also shall indicate the entity’s risk management policy for each of those types of
hedges, including a description of the items or transactions for which risks are hedged. For
derivative instruments not designated as hedging instruments, the description shall indicate the
purpose of the derivative activity. Qualitative disclosures about an entity’s objectives and
strategies for using derivative instruments may be more meaningful if such objectives and
strategies are described in the context of an entity’s overall risk management profile. If
appropriate, an entity is encouraged, but not required, to provide such additional qualitative
disclosures.
45. An entity’s disclosures for every reporting period for which a complete set of financial
statements is presented also shall include the following:
Fair value hedges
a. For derivative instruments, as well as nonderivative instruments that may give rise to
foreign currency transaction gains or losses under Statement 52, that have been designated
and have qualified as fair value hedging instruments and for the related hedged items:
(1) The net gain or loss recognized in earnings during the reporting period representing (a)
the amount of the hedges’ ineffectiveness and (b) the component of the derivative
instruments’ 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 statement of income or
other statement of financial performance
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(2) 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
b. For derivative instruments that have been designated and have qualified as cash flow
hedging instruments and for the related hedged transactions:
(1) The net gain or loss recognized in earnings during the reporting period representing (a)
the amount of the hedges’ ineffectiveness and (b) the component of the derivative
instruments’ 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 statement of income or
other statement of financial performance
(2) 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, 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
(3) The maximum length of time over which the entity is hedging its exposure to the
variability in future cash flows for forecasted transactions excluding those forecasted
transactions related to the payment of variable interest on existing financial instruments
(4) 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.
Hedges of the net investment in a foreign operation
c. For derivative instruments, as well as nonderivative instruments that may give rise to
foreign currency transaction gains or losses under Statement 52, that have been designated
and have qualified as hedging instruments for hedges of the foreign currency exposure of a
net investment in a foreign operation, the net amount of gains or losses included in the
cumulative translation adjustment during the reporting period.
The quantitative disclosures about derivative instruments may be more useful, and less likely to
be perceived to be out of context or otherwise misunderstood, if similar information is disclosed
about other financial instruments or nonfinancial assets and liabilities to which the derivative
instruments are related by activity. Accordingly, in those situations, an entity is encouraged, but
not required, to present a more complete picture of its activities by disclosing that information.
Reporting Changes in the Components of Comprehensive Income
46. An entity shall display as a separate classification within other comprehensive income the
net gain or loss on derivative instruments designated and qualifying as cash flow hedging
instruments that are reported in comprehensive income pursuant to paragraphs 30 and 41.
47. As part of the disclosures of accumulated other comprehensive income, pursuant to
paragraph 26 of FASB Statement No. 130, Reporting Comprehensive Income, an entity shall
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separately 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.
Effective Date and Transition
48. This Statement shall be effective for all fiscal quarters of all fiscal years beginning after
June 15, 1999. Initial application of this Statement shall be as of the beginning of an entity’s
fiscal quarter; on that date, hedging relationships shall be designated anew and documented
pursuant to the provisions of this Statement. Earlier application of all of the provisions of this
Statement is encouraged but is permitted only as of the beginning of any fiscal quarter that
begins after issuance of this Statement. Earlier application of selected provisions of this
Statement is not permitted. This Statement shall not be applied retroactively to financial
statements of prior periods.
49. At the date of initial application, an entity shall recognize all freestanding derivative
instruments (that is, derivative instruments other than embedded derivative instruments) in the
statement of financial position as either assets or liabilities and measure them at fair value,
pursuant to paragraph 17. 13 The difference between a derivative’s previous carrying amount
and its fair value shall be reported as a transition adjustment, as discussed in paragraph 52. The
entity also shall recognize offsetting gains and losses on hedged assets, liabilities, and firm
commitments by adjusting their carrying amounts at that date, as discussed in paragraph 52(b).
Any gains or losses on derivative instruments that are reported independently as deferred gains
or losses (that is, liabilities or assets) in the statement of financial position at the date of initial
application shall be derecognized from that statement; that derecognition also shall be reported
as transition adjustments as indicated in paragraph 52. Any gains or losses on derivative
instruments reported in other comprehensive income at the date of initial application because the
derivative instruments were hedging the fair value exposure of available-for-sale securities also
shall be reported as transition adjustments; the offsetting losses and gains on the securities shall
be accounted for pursuant to paragraph 52(b). Any gain or loss on a derivative instrument
reported in accumulated other comprehensive income at the date of initial application because
the derivative instrument was hedging the variable cash flow exposure of a forecasted
(anticipated) transaction related to an available-for-sale security shall remain in accumulated
other comprehensive income and shall not be reported as a transition adjustment. The
accounting for any gains and losses on derivative instruments that arose prior to the initial
application of the Statement and that were previously added to the carrying amount of
recognized hedged assets or liabilities is not affected by this Statement. Those gains and losses
shall not be included in the transition adjustment.
50. At the date of initial application, an entity also shall recognize as an asset or liability in the
statement of financial position any embedded derivative instrument that is required pursuant to
paragraphs 12–16 to be separated from its host contract if the hybrid instrument in which it is
embedded was issued, acquired, or substantively modified by the entity after December 31,
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1997. For all of its hybrid instruments that exist at the date of initial application and were issued
or acquired before January 1, 1998 and not substantively modified thereafter, an entity may
choose either (a) not to apply this Statement to any of those hybrid instruments or (b) to
recognize as assets or liabilities all the derivative instruments embedded in those hybrid
instruments that would be required pursuant to paragraphs 12–16 to be separated from their host
contracts. That choice is not permitted to be applied to only some of an entity’s individual
hybrid instruments and must be applied on an all-or-none basis.
51. If an embedded derivative instrument is to be separated from its host contract in
conjunction with the initial application of this Statement, the entity shall consider the following
in determining the related transition adjustment:
a. The carrying amount of the host contract at the date of initial application shall be based on
its fair value on the date that the hybrid instrument was issued or acquired by the entity and
shall reflect appropriate adjustments for subsequent activity, such as subsequent cash
receipts or payments and the amortization of any premium or discount on the host contract
arising from the separation of the embedded derivative.
b. The carrying amount of the embedded derivative instrument at the date of initial application
shall be its fair value.
c. The transition adjustment shall be the difference at the date of initial application between (1)
the previous carrying amount of the hybrid instrument and (2) the sum of the new net
carrying amount of the host contract and the fair value of the embedded derivative
instrument. The entity shall not retroactively designate a hedging relationship that could
have been made had the embedded derivative instrument initially been accounted for
separate from the host contract.
52. The transition adjustments resulting from adopting this Statement shall be reported in net
income or other comprehensive income, as appropriate, as the effect of a change in accounting
principle and presented in a manner similar to the cumulative effect of a change in accounting
principle as described in paragraph 20 of APB Opinion No. 20, Accounting Changes. Whether a
transition adjustment related to a specific derivative instrument is reported in net income,
reported in other comprehensive income, or allocated between both is based on the hedging
relationships, if any, that had existed for that derivative instrument and that were the basis for
accounting under generally accepted accounting principles before the date of initial application
of this Statement.
a. If the transition adjustment relates to a derivative instrument that had been designated in a
hedging relationship that addressed the variable cash flow exposure of a forecasted
(anticipated) transaction, the transition adjustment shall be reported as a
cumulative-effect-type adjustment of accumulated other comprehensive income.
b. If the transition adjustment relates to a derivative instrument that had been designated in a
hedging relationship that addressed the fair value exposure of an asset, a liability, or a firm
commitment, the transition adjustment for the derivative shall be reported as a
cumulative-effect-type adjustment of net income. Concurrently, any gain or loss on the
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hedged item (that is, difference between the hedged item’s fair value and its carrying
amount) shall be recognized as an adjustment of the hedged item’s carrying amount at the
date of initial application, but only to the extent of an offsetting transition adjustment for the
derivative. That adjustment of the hedged item’s carrying amount shall also be reported as a
cumulative-effect-type adjustment of net income. The transition adjustment related to the
gain or loss reported in accumulated other comprehensive income on a derivative instrument
that hedged an available-for-sale security, together with the loss or gain on the related
security (to the extent of an offsetting transition adjustment for the derivative instrument),
shall be reclassified to earnings as a cumulative-effect-type adjustment of both net income
and accumulated other comprehensive income.
c. If a derivative instrument had been designated in multiple hedging relationships that
addressed both the fair value exposure of an asset or a liability and the variable cash flow
exposure of a forecasted (anticipated) transaction, the transition adjustment for the
derivative shall be allocated between the cumulative-effect-type adjustment of net income
and the cumulative-effect-type adjustment of accumulated other comprehensive income and
shall be reported as discussed in paragraphs 52(a) and 52(b) above. Concurrently, any gain
or loss on the hedged item shall be accounted for at the date of initial application as
discussed in paragraph 52(b) above.
d. Other transition adjustments not encompassed by paragraphs 52(a), 52(b), and 52(c) above
shall be reported as part of the cumulative-effect-type adjustment of net income.
53. Any transition adjustment reported as a cumulative-effect-type adjustment of accumulated
other comprehensive income shall be subsequently reclassified into earnings in a manner
consistent with paragraph 31. For those amounts, an entity shall disclose separately in the year
of initial application the amount of gains and losses reported in accumulated other
comprehensive income and associated with the transition adjustment that are being reclassified
into earnings during the 12 months following the date of initial application.
54. At the date of initial application, an entity may transfer any held-to-maturity security into
the available-for-sale category or the trading category. An entity will then be able in the future
to designate a security transferred into the available-for-sale category as the hedged item, or its
variable interest payments as the cash flow hedged transactions, in a hedge of the exposure to
changes in market interest rates, changes in foreign currency exchange rates, or changes in its
overall fair value. (Paragraph 21(d) precludes a held-to-maturity security from being designated
as the hedged item in a fair value hedge of market interest rate risk or the risk of changes in its
overall fair value. Paragraph 29(e) similarly precludes the variable cash flows of a
held-to-maturity security from being designated as the hedged transaction in a cash flow hedge
of market interest rate risk.) The unrealized holding gain or loss on a held-to-maturity security
transferred to another category at the date of initial application shall be reported in net income or
accumulated other comprehensive income consistent with the requirements of paragraphs 15(b)
and 15(c) of Statement 115 and reported with the other transition adjustments discussed in
paragraph 52 of this Statement. Such transfers from the held-to-maturity category at the date of
initial adoption shall not call into question an entity’s intent to hold other debt securities to
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maturity in the future.14
55. At the date of initial application, an entity may transfer any available-for-sale security into
the trading category. After any related transition adjustments from initially applying this
Statement have been recognized, the unrealized holding gain or loss remaining in accumulated
other comprehensive income for any transferred security at the date of initial application shall be
reclassified into earnings (but not reported as part of the cumulative-effect-type adjustment for
the transition adjustments), consistent with paragraph 15(b) of Statement 115. If a derivative
instrument had been hedging the variable cash flow exposure of a forecasted transaction related
to an available-for-sale security that is transferred into the trading category at the date of initial
application and the entity had reported a gain or loss on that derivative instrument in other
comprehensive income (consistent with paragraph 115 of Statement 115), the entity also shall
reclassify those derivative gains and losses into earnings (but not report them as part of the
cumulative-effect-type adjustment for the transition adjustments).
56. At the date of initial application, mortgage bankers and other servicers of financial assets
may choose to restratify their servicing rights pursuant to paragraph 37(g) of Statement 125 in a
manner that would enable individual strata to comply with the requirements of this Statement
regarding what constitutes “a portfolio of similar assets.” As noted in footnote 9 of this
Statement, mortgage bankers and other servicers of financial assets that designate a hedged
portfolio by aggregating servicing rights within one or more risk strata used under paragraph
37(g) of Statement 125 would not necessarily comply with the requirement in paragraph 21(a) of
this Statement for portfolios of similar assets, since the risk stratum under paragraph 37(g) of
Statement 125 can be based on any predominant risk characteristic, including date of origination
or geographic location. The restratification of servicing rights is a change in the application of
an accounting principle, and the effect of that change as of the initial application of this
Statement shall be reported as part of the cumulative-effect-type adjustment for the transition
adjustments.
The provisions of this Statement need
not be applied to immaterial items.
This Statement was adopted by the unanimous vote of the seven members of the Financial
Accounting Standards Board:
Edmund L. Jenkins, Chairman
Joseph V. Anania
Anthony T. Cope
John M. Foster
Gaylen N. Larson
James J. Leisenring
Gerhard G. Mueller
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Appendix A: IMPLEMENTATION GUIDANCE
Section 1: Scope and Definition
Application of Paragraphs 6–11
57. The following discussion further explains the three characteristics of a derivative
instrument discussed in paragraphs 6–9.
a. Underlying. An underlying is a variable that, along with either a notional amount or a
payment provision, determines the settlement of a derivative. An underlying usually is one
or a combination of the following:
(1) A security price or security price index
(2) A commodity price or commodity price index
(3) An interest rate or interest rate index
(4) A credit rating or credit index
(5) An exchange rate or exchange rate index
(6) An insurance index or catastrophe loss index
(7) A climatic or geological condition (such as temperature, earthquake severity, or
rainfall), another physical variable, or a related index.
However, an underlying may be any variable whose changes are observable or otherwise
objectively verifiable. Paragraph 10(e) specifically excludes a contract with settlement
based on certain variables unless the contract is exchange-traded. A contract based on any
variable that is not specifically excluded is subject to the requirements of this Statement if it
has the other two characteristics identified in paragraph 6 (which also are discussed in
paragraphs 57(b) and paragraphs 57(c) below).
b. Initial net investment. A derivative requires no initial net investment or a smaller initial net
investment than other types of contracts that have a similar response to changes in market
factors. For example, entering into a commodity futures contract generally requires no net
investment, while purchasing the same commodity requires an initial net investment equal to
its market price. However, both contracts reflect changes in the price of the commodity in
the same way (that is, similar gains or losses will be incurred). A swap or forward contract
also generally does not require an initial net investment unless the terms favor one party
over the other. An option generally requires that one party make an initial net investment (a
premium) because that party has the rights under the contract and the other party has the
obligations. The phrase initial net investment is stated from the perspective of only one
party to the contract, but it determines the application of the Statement for both parties. 15
c. Net settlement. A contract that meets any one of the following criteria has the characteristic
described as net settlement:
(1) Its terms implicitly or explicitly require or permit net settlement. For example, a
penalty for nonperformance in a purchase order is a net settlement provision if the
amount of the penalty is based on changes in the price of the items that are the subject
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of the contract. Net settlement may be made in cash or by delivery of any other asset,
whether or not it is readily convertible to cash. A fixed penalty for nonperformance is
not a net settlement provision.
(2) There is an established market mechanism that facilitates net settlement outside the
contract. The term market mechanism is to be interpreted broadly. Any institutional
arrangement or other agreement that enables either party to be relieved of all rights and
obligations under the contract and to liquidate its net position without incurring a
significant transaction cost is considered net settlement.
(3) It requires delivery of an asset that is readily convertible to cash. The definition of
readily convertible to cash in FASB Concepts Statement No. 5, Recognition and
Measurement in Financial Statements of Business Enterprises, includes, for example, a
security or commodity traded in an active market and a unit of foreign currency that is
readily convertible into the functional currency of the reporting entity. A security that
is publicly traded but for which the market is not very active is readily convertible to
cash if the number of shares or other units of the security to be exchanged is small
relative to the daily transaction volume. That same security would not be readily
convertible if the number of shares to be exchanged is large relative to the daily
transaction volume. The ability to use a security that is not publicly traded or an
agricultural or mineral product without an active market as collateral in a borrowing
does not, in and of itself, mean that the security or the commodity is readily convertible
to cash.
58. The following discussion further explains some of the exceptions discussed in
paragraph 10.
a. “Regular-way” security trades. The exception in paragraph 10(a) applies only to a contract
that requires delivery of securities that are readily convertible to cash. 16 To qualify, a
contract must require delivery of such a security within the period of time after the trade
date that is customary in the market in which the trade takes place. For example, a contract
to purchase or sell a publicly traded equity security in the United States customarily requires
settlement within three business days. If a contract for purchase of that type of security
requires settlement in three business days, the regular-way exception applies, but if the
contract requires settlement in five days, the regular-way exception does not apply. This
Statement does not change whether an entity recognizes regular-way security trades on the
trade date or the settlement date. However, trades that do not qualify for the regular-way
exception are subject to the requirements of this Statement regardless of the method an
entity uses to report its security trades.
b. Normal purchases and normal sales. The exception in paragraph 10(b) applies only to a
contract that requires future delivery of assets (other than financial instruments or derivative
instruments) that are readily convertible to cash 17 and only if there is no market mechanism
to facilitate net settlement outside the contract. To qualify for the exception, a contract’s
terms also must be consistent with the terms of an entity’s normal purchases or normal sales,
that is, the quantity purchased or sold must be reasonable in relation to the entity’s business
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needs. Determining whether or not the terms are consistent will require judgment. In
making those judgments, an entity should consider all relevant factors, such as (1) the
quantities provided under the contract and the entity's need for the related assets, (2) the
locations to which delivery of the items will be made, (3) the period of time between
entering into the contract and delivery, and (4) the entity's prior practices with regard to such
contracts. Evidence such as past trends, expected future demand, other contracts for
delivery of similar items, an entity's and industry's customs for acquiring and storing the
related commodities, and an entity's operating locations should help in identifying contracts
that qualify as normal purchases or normal sales.
c. Certain contracts that are not traded on an exchange. A contract that is not traded on an
exchange is not subject to the requirements of this Statement if the underlying is:
(1) A climatic or geological variable or other physical variable. Climatic, geological, and
other physical variables include things like the number of inches of rainfall or snow in a
particular area and the severity of an earthquake as measured by the Richter scale.
(2) The price or value of (a) a nonfinancial asset of one of the parties to the contract unless
that asset is readily convertible to cash or (b) a nonfinancial liability of one of the
parties to the contract unless that liability requires delivery of an asset that is readily
convertible to cash.
(3) Specified volumes of sales or service revenues by one of the parties. That exception is
intended to apply to contracts with settlements based on the volume of items sold or
services rendered, for example, royalty agreements. It is not intended to apply to
contracts based on changes in sales or revenues due to changes in market prices.
If a contract's underlying is the combination of two or more variables, and one or more
would not qualify for one of the exceptions above, the application of this Statement to that
contract depends on the predominant characteristics of the combined variable. The contract
is subject to the requirements of this Statement if the changes in its combined underlying are
highly correlated with changes in one of the component variables that would not qualify for
an exception.
59. The following discussion illustrates the application of paragraphs 6–11 in several
situations.
a. Forward purchases or sales of to-be-announced securities or securities when-issued,
as-issued, or if-issued. A contract for the purchase and sale of a security when, as, or if
issued or to be announced is excluded from the requirements of this Statement as a
regular-way security trade if (1) there is no other way to purchase or sell that security and
(2) settlement will occur within the shortest period possible for that security.
b. Credit-indexed contracts (often referred to as credit derivatives). Many different types of
contracts are indexed to the creditworthiness of a specified entity or group of entities, but
not all of them are derivative instruments. Credit-indexed contracts that have certain
characteristics described in paragraph 10(d) are guarantees and are not subject to the
requirements of this Statement. Credit-indexed contracts that do not have the characteristics
necessary to qualify for the exception in paragraph 10(d) are subject to the requirements of
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this Statement. One example of the latter is a credit-indexed contract that requires a
payment due to changes in the creditworthiness of a specified entity even if neither party
incurs a loss due to the change (other than a loss caused by the payment under the
credit-indexed contract).
c. Take-or-pay contracts. Under a take-or-pay contract, an entity agrees to pay a specified
price for a specified quantity of a product whether or not it takes delivery. Whether a
take-or-pay contract is subject to this Statement depends on its terms. For example, if the
product to be delivered is not readily convertible to cash and there is no net settlement
option, the contract fails to meet the criterion in paragraph 6(c) and is not subject to the
requirements of this Statement. However, a contract that meets all of the following
conditions is subject to the requirements of this Statement: (1) the product to be delivered is
readily convertible to cash, (2) the contract does not qualify for the normal purchases and
normal sales exception in paragraph 10(b), and (3) little or no initial net investment in the
contract is required.
d. Short sales (sales of borrowed securities). 18 Short sales typically involve the following
activities:
(1) Selling a security (by the short seller to the purchaser)
(2) Borrowing a security (by the short seller from the lender)
(3) Delivering the borrowed security (by the short seller to the purchaser)
(4) Purchasing a security (by the short seller from the market)
(5) Delivering the purchased security (by the short seller to the lender).
Those five activities involve three separate contracts. A contract that distinguishes a short
sale involves activities (2) and (5), borrowing a security and replacing it by delivering an
identical security. Such a contract has two of the three characteristics of a derivative
instrument. The settlement is based on an underlying (the price of the security) and a
notional amount (the face amount of the security or the number of shares), and the
settlement is made by delivery of a security that is readily convertible to cash. However, the
other characteristic, little or no initial net investment, is not present. The borrowed security
is the lender's initial net investment in the contract. Consequently, the contract relating to
activities (2) and (5) is not a derivative instrument. The other two contracts (one for
activities (1) and (3) and the other for activity (4)) are routine and do not generally involve
derivative instruments. However, if a forward purchase or sale is involved, and the contract
does not qualify for the exception in paragraph 10(a), it is subject to the requirements of this
Statement.
e. Repurchase agreements and "wash sales" (accounted for as sales as described in paragraphs
68 and 69 of Statement 125). A transfer of financial assets accounted for as a sale under
Statement 125 in which the transferor is both obligated and entitled to repurchase the
transferred asset at a fixed or determinable price contains two separate features, one of
which may be a derivative. The initial exchange of financial assets for cash is a
sale-purchase transaction—generally not a transaction that involves a derivative instrument.
However, the accompanying forward contract that gives the transferor the right and
obligation to repurchase the transferred asset involves an underlying and a notional amount
(the price of the security and its denomination), and it does not require an initial net
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investment in the contract. Consequently, if the forward contract requires delivery of a
security that is readily convertible to cash or otherwise meets the net settlement criterion in
paragraph 9, it is subject to the requirements of this Statement.
Application of the Clearly-and-Closely-Related Criterion in Paragraphs 12–16
60. In discussing whether a hybrid instrument contains an embedded derivative instrument
(also simply referred to as an embedded derivative) that warrants separate accounting, paragraph
12 focuses on whether the economic characteristics and risks of the embedded derivative are
clearly and closely related to the economic characteristics and risks of the host contract. If the
host contract encompasses a residual interest in an entity, then its economic characteristics and
risks should be considered that of an equity instrument and an embedded derivative would need
to possess principally equity characteristics (related to the same entity) to be considered clearly
and closely related to the host contract. However, most commonly, a financial instrument host
contract will not embody a claim to the residual interest in an entity and, thus, the economic
characteristics and risks of the host contract should be considered that of a debt instrument. For
example, even though the overall hybrid instrument that provides for repayment of principal may
include a return based on the market price (the underlying as defined in this Statement) of XYZ
Corporation common stock, the host contract does not involve any existing or potential residual
interest rights (that is, rights of ownership) and thus would not be an equity instrument. The host
contract would instead be considered a debt instrument, and the embedded derivative that
incorporates the equity-based return would not be clearly and closely related to the host contract.
If the embedded derivative is considered not to be clearly and closely related to the host contract,
the embedded derivative must be separated from the host contract and accounted for as a
derivative instrument by both parties to the hybrid instrument, except as provided by paragraph
11(a).
61. The following guidance is relevant in deciding whether the economic characteristics and
risks of the embedded derivative are clearly and closely related to the economic characteristics
and risks of the host contract.
a. Interest rate indexes. An embedded derivative in which the underlying is an interest rate or
interest rate index and a host contract that is considered a debt instrument are considered to
be clearly and closely related unless, as discussed in paragraph 13, the embedded derivative
contains a provision that (1) permits any possibility whatsoever that the investor’s (or
creditor’s) undiscounted net cash inflows over the life of the instrument would not recover
substantially all of its initial recorded investment in the hybrid instrument under its
contractual terms or (2) could under any possibility whatsoever at least double the investor’s
initial rate of return on the host contract and also result in a rate of return that is at least
twice what otherwise would be the market return for a contract that has the same terms as
the host contract and that involves a debtor with a similar credit quality. The requirement to
separate the embedded derivative from the host contract applies to both parties to the hybrid
instrument even though the above tests focus on the investor’s net cash inflows.
Plain-vanilla servicing rights, which involve an obligation to perform servicing and the right
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to receive fees for performing that servicing, do not contain an embedded derivative that
would be separated from those servicing rights and accounted for as a derivative.
b. Inflation-indexed interest payments. The interest rate and the rate of inflation in the
economic environment for the currency in which a debt instrument is denominated are
considered to be clearly and closely related. Thus, nonleveraged inflation-indexed contracts
(debt instruments, capitalized lease obligations, pension obligations, and so forth) would not
have the inflation-related embedded derivative separated from the host contract.
c. Credit-sensitive payments. The creditworthiness of the debtor and the interest rate on a debt
instrument are considered to be clearly and closely related. Thus, for debt instruments that
have the interest rate reset in the event of (1) default (such as violation of a
credit-risk-related covenant), (2) a change in the debtor’s published credit rating, or (3) a
change in the debtor’s creditworthiness indicated by a change in its spread over Treasury
bonds, the related embedded derivative would not be separated from the host contract.
d. Calls and puts on debt instruments. Call options (or put options) that can accelerate the
repayment of principal on a debt instrument are considered to be clearly and closely related
to a debt instrument that requires principal repayments unless both (1) the debt involves a
substantial premium or discount (which is common with zero-coupon bonds) and (2) the put
or call option is only contingently exercisable. Thus, if a substantial premium or discount is
not involved, embedded calls and puts (including contingent call or put options that are not
exercisable unless an event of default occurs) would not be separated from the host contract.
However, for contingently exercisable calls and puts to be considered clearly and closely
related, they can be indexed only to interest rates or credit risk, not some extraneous event
or factor. In contrast, call options (or put options) that do not accelerate the repayment of
principal on a debt instrument but instead require a cash settlement that is equal to the price
of the option at the date of exercise would not be considered to be clearly and closely related
to the debt instrument in which it is embedded and would be separated from the host
contract. In certain unusual situations, a put or call option may have been subsequently
added to a debt instrument in a manner that causes the investor (creditor) to be exposed to
performance risk (default risk) by different parties for the embedded option and the host
debt instrument, respectively. In those unusual situations, the embedded option and the host
debt instrument are not clearly and closely related.
e. Calls and puts on equity instruments. A put option that enables the holder to require the
issuer of an equity instrument to reacquire that equity instrument for cash or other assets is
not clearly and closely related to that equity instrument. Thus, such a put option embedded
in the equity instrument to which it relates should be separated from the host contract by the
holder of the equity instrument. That put option also should be separated from the host
contract by the issuer of the equity instrument except in those cases in which the put option
is not considered to be a derivative instrument pursuant to paragraph 11(a) because it is
classified in stockholders’ equity. A purchased call option that enables the issuer of an
equity instrument (such as common stock) to reacquire that equity instrument would not be
considered to be a derivative instrument by the issuer of the equity instrument pursuant to
paragraph 11(a). Thus, if the call option were embedded in the related equity instrument, it
would not be separated from the host contract by the issuer. However, for the holder of the
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related equity instrument, the embedded written call option would not be considered to be
clearly and closely related to the equity instrument and should be separated from the host
contract.
f. Floors, caps, and collars. Floors or caps (or collars, which are combinations of caps and
floors) on interest rates and the interest rate on a debt instrument are considered to be clearly
and closely related, provided the cap is at or above the current market price (or rate) and the
floor is at or below the current market price (or rate) at issuance of the instrument. Thus, the
derivative embedded in a variable-rate debt instrument that has a floor on the interest rate
(that is, the floor option) would not be separated from the host contract and accounted for
separately even though, in a falling interest rate environment, the debt instrument may have
a return to the investor that is a significant amount above the market return of a debt
instrument without the floor provision (refer to paragraph 13(b)).
g. Term-extending options. An embedded derivative provision that either (1) unilaterally
enables one party to extend significantly the remaining term to maturity or (2) automatically
extends significantly the remaining term triggered by specific events or conditions is not
clearly and closely related to the interest rate on a debt instrument unless the interest rate is
concurrently reset to the approximate current market rate for the extended term and the debt
instrument initially involved no significant discount. Thus, if there is no reset of interest
rates, the embedded derivative must be separated from the host contract and accounted for
as a derivative instrument. That is, a term-extending option cannot be used to circumvent
the restriction in paragraph 61(a) regarding the investor’s not recovering substantially all of
its initial recorded investment.
h. Equity-indexed interest payments. The changes in fair value of an equity interest and the
interest yield on a debt instrument are not clearly and closely related. Thus, an
equity-related derivative embedded in an equity-indexed debt instrument (whether based on
the price of a specific common stock or on an index that is based on a basket of equity
instruments) must be separated from the host contract and accounted for as a derivative
instrument.
i. Commodity-indexed interest or principal payments. The changes in fair value of a
commodity (or other asset) and the interest yield on a debt instrument are not clearly and
closely related. Thus, a commodity-related derivative embedded in a commodity-indexed
debt instrument must be separated from the noncommodity host contract and accounted for
as a derivative instrument.
j. Indexed rentals:
(1) Inflation-indexed rentals. Rentals for the use of leased assets and adjustments for
inflation on similar property are considered to be clearly and closely related. Thus,
unless a significant leverage factor is involved, the inflation-related derivative
embedded in an inflation-indexed lease contract would not be separated from the host
contract.
(2) Contingent rentals based on related sales. Lease contracts that include contingent
rentals based on certain sales of the lessee would not have the contingent-rental-related
embedded derivative separated from the host contract because, under paragraph
10(e)(3), a non-exchange-traded contract whose underlying is specified volumes of
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sales by one of the parties to the contract would not be subject to the requirements of
this Statement.
(3) Contingent rentals based on a variable interest rate. The obligation to make future
payments for the use of leased assets and the adjustment of those payments to reflect
changes in a variable-interest-rate index are considered to be clearly and closely related.
Thus, lease contracts that include contingent rentals based on changes in the prime rate
would not have the contingent-rental-related embedded derivative separated from the
host contract.
k. Convertible debt. The changes in fair value of an equity interest and the interest rates on a
debt instrument are not clearly and closely related. Thus, for a debt security that is
convertible into a specified number of shares of the debtor’s common stock or another
entity’s common stock, the embedded derivative (that is, the conversion option) must be
separated from the debt host contract and accounted for as a derivative instrument provided
that the conversion option would, as a freestanding instrument, be a derivative instrument
subject to the requirements of this Statement. (For example, if the common stock was not
readily convertible to cash, a conversion option that requires purchase of the common stock
would not be accounted for as a derivative.) That accounting applies only to the holder
(investor) if the debt is convertible to the debtor’s common stock because, under paragraph
11(a), a separate option with the same terms would not be considered to be a derivative for
the