Technically, a derivative is simply an asset whose value is dependent on the value of something else, an underlying asset. A forward contract to buy Euro to fund a summer holiday to Europe will, by the time the holiday arrives, have been either a winning or a losing bet. The value of the derivative, in that instance, is the gain or loss versus just buying the money when you needed it .
Derivatives have become an integral tool used by almost all companies of reasonable size. Their use varies but typically the vast majority of corporate use derivatives to hedge exposures. The exposures might be: Future price of raw materials [e.g. aviation kerosene for an airline, cocoa beans for a manufacturer], Foreign currency [e.g. customer balances in a foreign currency], or Interest rates [e.g. protect against rising interest rates where the company has predominantly variable rate debt]. Financial people [particularly analysts] need to understand how these instruments are reflected in the financials. This is especially the case as the accounting issues are not straightforward. The investor needs to be in a position to appreciate the entries that are made for these items prior to considering a logical approach for analysis. This post discuss about accounting treatment for derrivatives under GAAP-IFRS.
All derivatives are ultimately made up of four types of entity, or a combination of more than one of them.
- Forward contracts – These are the simplest, and take the form described above. They are not tradeable instruments, but an Over The Counter [OTC] contract between two parties.
- Futures contracts – Futures contracts are just forward contracts that are tradeable on regulated markets. The advantage is liquidity. The disadvantage is that the terms of the contracts have to be standardized.
- Swaps – Swaps are just portfolios of forward contracts. If a company swaps its fixed coupon debt into floating rate, with a bank as counterparty, what the bank has actually done is to sell a series of forward contracts on interest rates over the duration of the debt.
- Options – These represent the right, but not the obligation, to buy [call] or sell [put] an asset at a pre-arranged price. The option element makes them complicated, but just as an option is valued by analogy with a forward contract and debt, so a forward contract can be synthesized by the purchase of a call option and the sale of a put option.
So derivatives are interchangeable, and arbitrageable, with one another. The choice of instrument, and whether to deal on regulated exchanges or use OTC contracts, is one of convenience. All so-called “ exotic derivatives ” are merely bundles of contracts of the type described above, though valuing them can be horribly complicated.
IAS 39 Financial instruments is the core standard under IFRS for derivatives. It is a complex and somewhat controversial accounting standard that has been the subject of extensive debate .
- Essentially IAS 39 is based on a simple premise – derivatives must be recognized on the balance sheet at fair value. Historically, under many national GAAP, driven by a historical cost perspective, derivatives remained unrecognized as there is no initial cost, as in a swap, for example.
- The only recognition of their effect may be the matching of the relevant underlying with the derivative on settlement. Therefore a company could have an entire portfolio of derivatives at the year end with little or no recognition in the financials as there is no upfront cost as such. This position would continue to prevail until the relevant hedged transaction took place. The IASB viewed this ‘deferral and matching’ system as a privilege rather than a right and therefore tore up the book on how derivatives were accounted for. The simple step of insisting that derivatives be marked to market at fair value means that recognition is now mandatory.
- In many ways it is the other entry that is of most interest – if an asset/liability is recognized by marking a derivative to market on the balance sheet does the change go to the income statement or equity? IAS 39 has devised a system to make this decision. The example below shows the three different classifications for derivatives. Some comments will help appreciate the nature of these categories:
- No hedge – This applies to derivatives not entered into for hedging purposes and, perhaps more importantly, those that fail to qualify for hedge accounting. In this case the change in value goes through the income statement.
- Fair value hedge – If the derivative does meet the definition of a hedge and there is an existing asset/liability then both are valued at fair value and gains/losses offset in the income statement thereby reflecting the economics of the situation.
- Cash flow hedge – Again this applies if the hedge criteria are satisfied but it is future cash flows that are being protected rather than the fair value of an existing asset/liability.
In this case the derivative is still marked to market. However, as no underlying yet exists the movements in value go directly to equity. Once there the gains/losses wait the underlying and when it happens they are ‘recycled’ to
income [i.e. matched].
In practice these are quite complex entries so IAS 39 produces a range of examples with numbers. The following examples are based on the rules in IAS 39:
Example-1: Fair Value Hedges
Six months before year end, a company issues a 3 year $10m fixed interest note at 7.5 per cent, with semi-annual interest payments. It also enters into an interest rate swap to pay LIBOR [London Interbank Offer Rate ] and to receive 7.5 per cent semi-annually; swap terms include a $10m notional principal, 3 year term and semi-annual variable rate reset. LIBOR for the first six month period is 6 per cent. By year end, interest rates have fallen and the fair value of the swap [after settlement] is $125,000 [asset]. What entries are required:
[a]. If traditional historic accounting is used?
[b]. IAS 39 with no hedge accounting?
[c]. IAS 39 with hedge accounting?
Here are the entries :
Swap and loan are subsequently re-measured to fair value
[Debit]. Asset account – held for trading = $125,000
[Credit]. Liability account = $125,000
Example-2: Cash Flow Hedges
LieDharma Limited has tendered for a contract. The price quoted is $10m. However, LieDharma’s functional currency is the Euro. Therefore, as prices would be fixed LieDharma wishes to hedge this exposure. It enters into an FX future with a nominal value of $10m.
The treatments under various scenarios are summarized below :
Traditional transaction approach – The hedge will be ignored until the contract flows occur at which point the gain/loss on the derivative would be recognized. If the contract tender is not successful, the derivative would be settled and reported in income.
Hedge accounting conditions not met – The FX derivative is marked to market at period end through the income statement as it is classified as speculation per IAS 39.
Hedge accounting conditions are met :
– Phase I: Derivative is marked to market on the balance sheet with gains/loss going to equity.
– Phase II: Once cash flows occur, the gain/loss on derivative is matched with the relevant portion of the hedged inflows.
US GAAP Focus On Hedge Accounting
FAS 133 and its IASB equivalent are reasonably similar in terms of broad application. However, given that FAS 133 has extensive guidance and has evolved over a longer period it is no surprise that there are differences in the detail. Here are the key differences :
- In the US available for sale unlisted investments are stated at cost whereas under IFRS they are recorded at fair value once a reasonably reliable measure can be established.
- Both GAAP punish companies that dispose of assets from their held to maturity portfolio classification. Under IFRS there is a ban from using the category for 2 years whereas there is no limit under US GAAP.
- Offsetting assets and liabilities is generally more difficult under US GAAP
- Under US GAAP certain SPE [Special Purpose Entities] are deemed to be qualifying, i.e. QSPE.
- Hedges of an underlying for part of its life are prohibited under US GAAP but allowed, once effective, under IFRS.
- US GAAP allows a short-cut method for establishing hedge qualification whereas under IAS 39 all hedges must be tested for effectiveness if they are going to qualify for hedge accounting.
- Macro hedge accounting is allowed in certain circumstances under IFRS but prohibited under US GAAP.
There is no accepted systematic approach to dealing with derivative gains and losses. In addition to the general complexity surrounding some of the instruments, few companies have had to report them under local GAAP outside the US. The transition to IFRS means that companies will in future report these numbers and as a result analysts will have to interpret them.
Perhaps the most straightforward approach to this issue is to consider a number of interpretation points that must be considered :
Simply reversing out gains/losses on derivatives is not an option. For example a gain/loss on a derivative that relates to a cash market transaction recognized in the financials is a real economic cost/income. Reversing out may, for example in the case of an interest rate hedge, mean the interest expense is under/overstated.
It is also difficult to see how analysts can deal with comparable analysis of companies where one qualifies for hedge accounting and another does not, yet both are economically similar. Our favored approach is only to reverse any derivative gains/losses recognized in the income statement that relate to underlying transactions that are not recognized in the same income statement. Ineffective hedges should be treated as financial income/charges. It remains to be seen whether companies will provide the market with the information to undertake such analysis.
It should be borne in mind that for accurate forecasting a good appreciation of the hedges a company has in place is important. Therefore analysts and investors can utilize the information in the financials to derive this understanding. It should always be borne in mind that current hedging conditions are unlikely to persist beyond a certain time horizon. But, a company can always hedge if it is prepared to pay the price.