FAS 133 and IAS 39 Glossary and Transcriptions of Experts
Accounting for Derivative Instruments and Hedging Activities
Bob Jensen at Trinity University

Warning 1:  Many of the links were broken when the FASB changed all of its links.  If a link to a FASB site does not work , go to the new FASB link and search for the document.  The FASB home page is at http://www.fasb.org/ 

Warning 2: The DIG documents are not yet available in the Codification Database, but they can now be accessed at  http://www.fasb.org/derivatives/ 
Over 300 pages of  DIG pronouncements can be downloaded from  http://www.fasb.org/derivatives/allissuesp2.pdf 

Warning 3:  The international standard IAS 39 has been amended many times and continued to be amended. The IASB tends to change paragraph numbers with many of its amendments and directly amends the preceding version of a standard. Hence some of the IAS 39 paragraphs quoted in this glossary may be relocated and/or altered in the latest and greatest version of IAS 39.

Warning 4:  In 2009, the FASB and the IASB are contemplating huge changes in FAS 133 and IAS 39.

SERIOUS Doubts Over Proposed Changes to FAS 133 and IAS 39

The FASB proposes dubious changes in FAS 133 on Accounting for Derivative Financial Instruments and Hedging Activities while the IASB is studying similar changes in IAS 39. With the SEC currently sitting on the fence in deciding if and when to replace FASB standards with IASB standards, I fully predict that IAS 39 will pretty much follow the revise FAS 133 as it did when IAS 39 was initially adopted, although IAS 39 will continue to have wider coverage of financial instruments in general whereas FAS 133 will narrowly focus on derivative financial instruments and hedge accounting.

When the FASB initially signaled possible revisions for changing hedge accounting rules in FAS 133, a wave of protests from industry hit the fan. The article below is the response of Ira Kawaller who serves on the FASB's Derivatives Implementation Group (DIG) and who is one of the leading consultants on FAS 133 and hedging in general which is his where he has historic roots as a PhD in economics --- http://www.kawaller.com/about.shtml
Ira has written nearly 100 trade articles on FAS 133. I don't think he consults on IAS 39. Ira's home page is at http://www.kawaller.com/about.shtml
Ira also maintains a small hedge fund where he walks the talk about interest rate hedging. However, I'm no expert on hedge funds and will not comment on any particular hedge fund.

I might note in passing for enthusiasts of the new FASB Codification Database for all FASB standards that FAS 133 coverage in the Codification database is relatively sparse. Professionals and students in hedge accounting most likely will have to connect back to original (non-codified) FASB literature. For example, none of the wonderful illustrations in Appendices A and B of FAS 133 are codified. And the extremely helpful, albeit complicated, pronouncements of the FASB's Derivatives Implementation Group (DIG) are excluded from the Codification database --- http://www.fasb.org/derivatives/
Most of the DIG pronouncements are included in context at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm
I will never have a lot of respect for the Codification database until it includes much, much more on FAS 133.

Below is a publication in which Dr. Kawaller presents serious doubts regarding revisions to FAS 133 that the FASB is now considering (and the IASB is now considering for IAS 39).

The problem is even more severe for entities with fixed-rate exposures. In this case, there’s a clear disconnect between what swaps are designed to do versus what the FASB requires for hedge accounting.
"Paved With Good Intentions:  The Road to Better Accounting for Hedges," The CPA Journal, August 2009 --- http://www.kawaller.com/pdf/CPA_Paved_w_Good_Intent_Aug_2009.pdf

With 10 years of experience under the current regime of accounting for derivative contracts and hedging transactions, the FASB has determined that it’s time to make some adjustments. Accountants should be wary of the changes. Besides affecting the accounting procedure relating to these instruments and activities, the proposed changes may also seriously impact the manner in which certain derivative hedges are structured— particularly in connection with interest rate risk management activities.

Accounting rules for derivatives and hedging transactions were put forth by the FASB in SFAS 133, Accounting for Derivative Instruments and Hedging Activities. This standard was initially issued in June 1998. It has been amended twice since then, with relatively minor adjustments, but in 2008 the FASB issued a more substantive exposure draft with significant proposed changes. Although the comment period on this exposure draft is over, the project appears to be in limbo. Proposed changes have neither been accepted nor rejected. Further adjustments are likely to be made as the FASB moves to harmonize U.S. accounting guidance with International Financial Reporting Standards (IFRS). When attention turns to derivatives, this latest exposure draft could very likely serve as a starting point. The prospective decisions about the accounting treatment for these derivatives could have a profound impact on the structure and composition of derivatives transactions

The Current Standard SFAS 133 has long been recognized as one of the most complicated accounting standards the FASB has ever issued. A core principle of this standard is that derivative instruments must be recognized on the balance sheet as assets or liabilities at their fair market value. The critical issue, then, is the question of how to handle gains or losses. Should they be reported in current income or elsewhere? Ultimately, SFAS 133 ended up providing different answers for different situations. The “normal” treatment simply requires gains and losses recognized in earnings. This treatment, however, is often problematic for companies that use derivatives for hedging purposes. For such entities, the preferred treatment would recognize gains or losses of derivatives concurrently with the earnings impacts of the items being hedged. The normal accounting treatment generally won’t yield this desired result, but the alternative “hedge accounting” will.

For purposes of this discussion, attention is restricted to the two primary hedge accounting types: cash flow and fair value. For cash flow hedges, the exposure being hedged (i.e., the hedged item) must be an uncertain cash flow, forecasted to occur in a later time period. In these cases, effective gains or losses on derivatives are originally recorded in other comprehensive income (OCI) and later reclassified from OCI to earnings when the hedged item generates its earnings impact. Ineffective results are recorded directly in earnings. In essence, this accounting treatment serves to defer the derivatives’ gains or losses—but only for the portion of the derivatives’ results that are deemed to be effective—thus pairing the earnings recognition for the derivative and the hedged item in a later accounting period.

Continued in article

Bob Jensen and Tom Selling have been having an active, to say the least, exchange over hedge accounting where Tom Selling advocates elimination of all hedge accounting (by carrying all derivatives at fair value with changes in value being posted to current earnings). Bob Jensen thinks this is absurd, especially for derivatives that hedge unbooked transactions such as forecasted transactions or unbooked purchase contracts for commodities. Not having hedge accounting causes asymmetric distortions of earnings where the changes in value of the hedging contracts cannot be offset by changes in value of the (unbooked) hedged items. You can read more about our exchanges under the terms "Insurance Contracts" at
http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#I-Terms
Scroll down to "Insurance Contracts"

Bob Jensen's free tutorials, audio clips, and videos on FAS 133 and IAS 39 are linked at http://www.trinity.edu/rjensen/caseans/000index.htm

Warning 5:  In February 2008 the FASB for the first time allowed users free access to its "FASB Accounting Standards Codification" database. Access will be free for at least one year, although registration is required for free access. Much, but not all, information in separate booklets and PDF files may now be accessed much more efficiently as hypertext in one database. The Glossary below has not been updated for the Codification Database. Although the database is off to a great start, there is much information in this Glossary and in the FASB standards that cannot be found in the Codification Database. You can read the following at http://asc.fasb.org/asccontent&trid=2273304&nav_type=left_nav

Welcome to the Financial Accounting Standards Board (FASB) Accounting Standards Codification™ (Codification).

The Codification is the result of a major four-year project involving over 200 people from multiple entities. The Codification structure is significantly different from the structure of existing accounting standards. The Notice to Constituents provides information you should read to obtain a good understanding of the Codification history, content, structure, and future consequences.

Click here to view the Notice to Constituents (Adobe Acrobat format).

The FASB's Accounting Standard Codification Online Database (FASCOD) --- http://asc.fasb.org/home

I have been using FASCOD regularly, especially Section 815 on accounting for derivative financial instruments and hedging. I find this quite easy to use and appreciate the cross referencing to other standards. It would help in some instances to also reference to the printed standards.

Although there are narrowed-down glossaries for some of the sections like Section 815 (10)(S20), there is also a wonderful "Master Glossary" at http://asc.fasb.org/glossary&nav_type=left_nav#null

When you are into a section's outline, especially note the "Collapse" and "Expand" hot words that let you expand or collapse the outline for a desired level of detail and links to illustrations. Some of the illustrations are new in Section 815. Also there are links to SEC standards and interpretations that have been added to the database.

I did encounter a problem trying to print FASCOD quotations. For some reason, FASCOD pastes as hidden text. I could read it in a MS Word document but not in Print Preview or in printed hard copy. In MS Word I went to Tools, Options, View and clicked on Hidden Text. That did not solve my problem --- not being able to print FASCOD quotations. Then I went to Tools, Options, Print and clicked on Hidden Text. That made my FASCOD quotations appear in both Print Preview and hard copy.

FASB member Tom Linsmeier has been in charge of the FASCOD development. Tom indicates that his team was unaware of the above hidden text problem that some users are having. He says that his team is now looking into why the hidden text printing problem arose in the first place. It may well be that the above problem for some of us will disappear in the future.

Now if we only had such an IASCOD database for international standards. In fairness, the IASB standards, interpretations, exposure drafts, and a glossary can be downloaded into your computer and updated for an annual fee. This database has useful cross referencing and database search features. In many ways it is quite well done. However, it does not slice and dice content into better codification schema.

The IASB has some political correctness issues when it appears to be copying United States GAAP and/or technology. Hopefully the IASB will look at the economics involved in developing FASCOD over four years with over 200 professionals and millions of dollars and decide that the codification schema used by the FASB is suitable, with some tweaking, for the international standards. Of course the actual IASCOD content will be international GAAP rather than U.S. GAAP. It will still be a huge expense to slice and dice international GAAP for purposes of IASCOD. It will also entail a change in delivery. IASCOD will be served up online, whereas the current IASB database of standards, interpretations, exposure drafts, etc. must be downloaded into each user's computer for a fee initially and for annual updates.

The current IASB database can be downloaded from http://www.iasb.org/Home.htm
I find that it is best to leave its red-circle icon as a Startup icon on my computer screen (it could be just a bit smaller). Then it 's very easy to click the database on and off. In some ways the downloaded IASB database is programmed quite cleverly, especially the way it does database search. I give five stars for its search engine.

I hope that the IASB will invest in more illustrations if and when it develops IASCOD. One of the severe weaknesses of the IASB standards is that they cannot compare with the FASB standards in terms of abundant and useful illustrations. This is especially helpful for those of us in education and training. For example, when teaching IAS 39 having very few illustrations, I often run to FAS 133 and its amendments and DIGs for some illustrations. Now I can turn to Section 815 of FASCOD for added illustrations.

A drawback of the current Section 815 FASCOD content is that it does not yet have sliced and diced content of all the Derivative Implementation Group (DIG) pronouncements. Hopefully the DIG's will be added soon to FASCOD.

Bob Jensen

"Framing the Future: A first look at FASB’s GAAP codification, by Bruce Pounder, Journal of Accountancy, May 2008 --- http://www.aicpa.org/pubs/jofa/may2008/fasb_gaap.htm 

In less than a year, FASB’s Accounting Standards Codification will affect the day-to-day work of nearly every CPA who practices, teaches or researches accounting in accordance with U.S. GAAP.

By April 2009, FASB is expected to make the codification the single source of authoritative GAAP, overriding all existing literature. In other words, the codification content—not the original pronouncements from which the content was derived—will be GAAP. And the online codification research system—not books, loose-leaf services or CDs—will be the primary way that accountants access GAAP.

For many historical reasons, GAAP has become a minimally organized collection of many kinds of accounting pronouncements issued by various standard setters over many decades, as well as “widely recognized and prevalent” industry practices that are not the product of any formal standard-setting process. The present components of GAAP vary greatly in format, structure, completeness, authority and accessibility. As a result, practicing CPAs and financial statement preparers who attempt to apply GAAP often find themselves confused and frustrated. Likewise, accounting students frequently struggle to learn GAAP.

If a standard setter were to develop a body of accounting standards from scratch today, those standards presumably would not resemble the challenging jumble that GAAP has become. Rather than start from scratch, FASB has done the next best thing in an attempt to make GAAP more understandable and user-friendly—FASB has sought to simplify the structure of GAAP by codifying it.

In January, FASB released the Accounting Standards Codification for public review and verification. The codification is not merely a new entrant into the market for products and services designed to help CPAs understand and apply GAAP. Rather, the codification completely changes the way that GAAP will be documented, updated, referenced and accessed. It organizes in an entirely new way thousands of existing authoritative financial accounting and reporting standards and delivers the content via an Internet based research system that helps users search and access the material.

One often–overlooked aspect of the codification is that it will eliminate or flatten the GAAP hierarchy. In other words, there will be no more House of GAAP—no tiered structure with varying levels of authority on each floor. Under the codification, there’s no distinction—all standards are uniformly authoritative.

FASB expects that the codification will help mitigate the risk of noncompliance with accounting standards, provide real time updates as standards change and reduce the amount of time and effort required to research accounting issues.

A MAJOR RESTRUCTURING The primary goal of the codification project is not to change GAAP’s content, but rather to organize it in a more useful way. The codification will contain all current, authoritative accounting standards for nongovernmental entities that have been issued by U.S. standard setters, including FASB, FASB’s Emerging Issues Task Force (EITF), and the AICPA Accounting Standards Executive Committee (AcSEC). Certain SEC guidance also is included.

The codification has, for the most part, left standards unchanged. Appendix A of the Notice to Constituents, an overview document on the codification Web site, highlights areas in which FASB is recommending changes to standards to resolve conflicts in GAAP.

As used above, the word “authoritative” refers to GAAP from levels A through D in the current GAAP hierarchy. Undocumented industry practices and documented but-nonauthoritative guidance have been excluded from the codification. Because there are some exceptions regarding what is included in the codification, users are advised to consult FASB’s Notice to Constituents.

The project effectively disassembled each existing authoritative pronouncement and reassembled the pieces, organizing them into approximately 90 topics. Contents in each topic are further organized first by subtopic, then section and finally paragraph. The paragraph level is the only level that contains substantive content; all higher levels in the topical structure exist merely to organize the paragraph-level content.

Continued in article

Bob Jensen's threads on accounting theory and standard setting --- http://www.trinity.edu/rjensen/Theory01.htm

Bob Jensen’s Amendment to the Teaching Note prepared by Smith and Kohlbeck for the following case:  “Accounting for Derivatives and Hedging Activities Comparisons of Cash Flow Versus Fair Value Accounting,” by Pamela A. Smith and Mark J. Kohlbeck
     Issues in Accounting Education, Volume 23, Number 1, February 2008, pp. 103-118
Bob Jensen's Amendment is at http://www.trinity.edu/rjensen/CaseAmendment.htm

The DIG documents are not yet available in the Codification Database, but they can now be accessed at  http://www.fasb.org/derivatives/ 
Over 300 pages of  DIG pronouncements can be downloaded from  http://www.fasb.org/derivatives/allissuesp2.pdf 

For technical details see the following book:
Structured Finance and Collateralized Debt Obligations: New Developments in Cash and Synthetic Securitization (Wiley Finance) by Janet M. Tavakoli (2008)

FAS 133 and IAS 39 Glossary and Transcriptions of Experts
Accounting for Derivative Instruments and Hedging Activities
Bob Jensen at Trinity University

• Unlike many other nations that either did not have national accounting standards or had weak and incomplete sets of standards, the FASB over the years produced the best set of accounting standards in the world (although there is no such thing a perfect set since companies are always writing contracts to circumvent most any standard). The FASB standards were heavily rule-based due to the continual battles fought by the FASB in the trenches of U.S. firms seeking to manage earnings and keep debt of the balance sheet with ever-increasing contract complexities such as interest rate swaps invented in the 1980s, SPE ploys, securitization "sales," synthetic leasing, etc.
                       

  • The experiences of those frazzled executives in charge of reducing risks in the credit derivatives market are starting to resemble Alice’s adventures in Wonderland. Alice shrank after drinking a potion, but was then too small to reach the key to open the door. The cake she ate did make her grow, but far too much. It was not until she found a mushroom that allowed her to both grow and shrink that she was able to adjust to the right size, and enter the beautiful garden. It took an awfully long time, with quite a number of unpleasant experiences, to get there.
    Aline van Duyn, "The adventure never ends in the derivatives Wonderland," Financial Times, September 11, 2008 --- Click Here
    
     
  • While Lehman Brothers was fighting for its life in the markets today, it was also battling in a Senate panel's hearing on whether the company and others created a set of financial products whose primary purpose is to dodge taxes owned on U.S. stock dividends. The "most compelling" reason for entering into dividend-related stock swaps are the tax savings, Highbridge Capital Management Treasury and Finance Director Richard Potapchuk told the Senate's Permanent Subcommittee on Investigations. Lehman Brothers (nyse: LEH - news - people ), Morgan Stanley (nyse: MS - news - people ) and Deutsche Bank (nyse: DB - news - people ) are among the companies behind the products.
    Anitia Raghaven, The Tax Dodge Derivative, Forbes, September 11, 2008 --- Click Here
     

     

  • What's Right and What's Wrong With (SPEs), SPVs, and VIEs ---
                          http://www.trinity.edu/rjensen//theory/00overview/speOverview.htm

   

The FASB's Derivatives and Hedging Glossary (in the Accounting Standards Codification Database) ---
http://asc.fasb.org/subtopic&trid=2229141&nav_type=left_nav

FASB Accounting  Standards Codification online databaase  --- http://asc.fasb.org/home
Section 815 pertains to FAS 133 --- http://asc.fasb.org/section&trid=2229142&query=Derivative

A Glossary is provided in this Codification database in Section 815 (A20).

Also see the Codification Master Glossary at http://asc.fasb.org/glossary&nav_type=left_nav#null

Timeline of scandals and legislation leading up to FAS 133 and IAS 39 http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds

Bob Jensen's CD --- http://www.cs.trinity.edu/~rjensen/Calgary/CD/

I'm sharing some old (well relatively old) accounting theory quiz and exam material that I added to a folder at http://www.cs.trinity.edu/~rjensen/Calgary/CD/

Question
What are hedge funds, especially after Bernie Madoff made them so famous?

When people ask me this question, my initial response is that a hedge fund no longer necessarily has anything to do with financial risk hedging. Rather a hedge fund is merely a "private" investment "club" that does not offer shares to the general public largely because it would then subject itself to more SEC, stock exchange, and other regulators. Having said this, it's pretty darn easy for anybody with sufficient funds to get into such a "private" club. Minimum investments range from $10,000 to $1,000,000 or higher.

Since Bernie Madoff made hedge funds so famous, the public tends to think that a hedge fund is dangerous, fraudulent, and a back street operation that does not play be the rules. Certainly hedge funds emerged in part to avoid being regulated. Sometimes they are risky due to high leverage, but some funds skillfully hedge to manage risk and are much safer than mutual funds. For example, some hedge funds have shrewd hedging strategies to control risk in interest rate and/or foreign currency trading.

Most hedge funds are not fraudulent. In general, however, it's "buyer beware" for hedge fund investors.

I would never invest in a hedge fund that is not audited by a very reliable CPA auditing firm. Not all CPA auditing firms are reliable (Bernie Madoff proved you can engage a fraudulent auditor operating out of a one-room office). Hence, the first step in evaluating a hedge fund is to investigate its auditor. The first step in evaluating an auditor is to determine if the auditing firm is wealthy enough to be a serious third party in law suits if the hedge fund goes belly up.

But the recent multimillion losses of Carnegie Mellon, the University of Pittsburgh, and other university endowment funds that invested in a verry fraudulent hedge fund purportedly audited by Deloitte suggests that the size and reputation of the auditing firm is not, by itself, sufficient protection against a criminal hedge fund (that was supposedly given a clean opinion by Deloitte in financial reports circulated to the victims of the fraud).

When learning about hedge funds, you may want to begin at http://en.wikipedia.org/wiki/Hedge_Fund

"What is a hedge fund and how is it different from a mutual fund?" by Andy Samuels, Business and Finance 101 Examiner, June 10, 2009 --- Click Here
Jim Mahar pointed out this link.

Having migrated away from their namesake, hedge funds no longer  focus primarily on “hedging” (attempting to reduce risk) because hedge funds are now focused almost blindly on one thing: returns.

Having been referred to as “mutual funds for the super rich” by investopedia.com, hedge funds are very similar to mutual funds in that they pool money together from many investors. Hedge funds, like mutual funds, are also managed by a financial professionals, but differ because they are geared toward wealthier individuals.

Hedge funds, unlike mutual funds, employ a wider array of ivesting techniques, which are considered more aggresive. For example, hedge funds often use leverage to amplify their returns (or losses if things go wrong).

The other key difference between hedge funds and mutual funds is the amount of regulation involved. Hedge funds are relatively unregulated because investors in hedge funds are assumed to be more sophisticated investors, who can both afford and understand the potential losses. In fact, U.S. laws require that the majority of investors in the fund are accredited.

Most hedge funds draw in investors because of the trustworthy reputations of the executives of the fund. Word-of-mouth praise and affiliations are often the key to success. Bernie Madoff succeed in luring customers based on two leading factors:  (1) His esteemed reputation on Wall Street and (2) His highly regarded connections in the Jewish community where he drew in most of his victims.

Bob Jensen's threads on frauds are linked at http://www.trinity.edu/rjensen/fraud.htm
In particular see http://www.trinity.edu/rjensen/fraud001.htm
And see http://www.trinity.edu/rjensen/FraudRotten.htm

"What’s a Couple of Hundred Trillion When You’re Talking Derivatives?" by Floyd Norris, The New York Times, September 23, 2006 --- http://www.nytimes.com/2006/09/23/business/23charts.html

Everett McKinley Dirksen, the Senate Republican leader in the 1950’s, is supposed to have said, “A billion here and a billion there, and pretty soon you’re talking real money.” What would he have thought of derivatives today?

The International Swaps and Derivatives Association, a trade group, reported this week that the outstanding nominal value of swaps and derivatives at the end of June was $283.2 trillion.

Compare that with the combined gross domestic product of the United States, the European Union, Canada, Japan and China, which is about $34 trillion. The total value of all homes in the United States is about the same amount.

To be sure, notional value is an exaggerated term as it greatly overstates the amount at risk in many contracts. But the growth rate is real, and in the fastest-growing area of swaps — credit default swaps — notional value is closer to the amount at risk, because such swaps promise to make up the losses if a borrower defaults on the notional amount.

The value of outstanding credit default swaps doubles every year — a trend that must eventually stop — and now equals $26 trillion. That is about the same as the total amount of bond debt in the United States, and corporate debt, on which most credit swaps are traded, comes to just $5.2 trillion.

The credit derivatives cover the risks of default by individual companies, and offer insurance against default for bond indexes and specified bond portfolios.

The growth of the market has forced the swaps and derivatives association to change the way its credit swaps work. It used to be that if a company defaulted, the writer of a credit swap would have to pay par value for the bond he had guaranteed, and could then sell the bond to reduce his losses.

But in some cases defaults led to bond rallies, as those who had purchased credit swaps scrambled to get bonds to deliver. Now traders can choose cash settlements, with the amounts to be paid determined through auctions.

Until 1997, the association provided separate numbers on currency and interest rate contracts, but innovations blurred the distinction between those categories, and now it publishes a combined total. At the end of June, the figure was $250.8 trillion, up 25 percent over the previous 12 months.

Growth in that market slowed markedly early in this decade, as worldwide markets cooled, and there was even one annual decline, from mid-2000 to mid-2001. But growth picked up in 2002 as economies began to recover.

The volume outstanding of equity derivatives is rising by about 30 percent a year, and now totals $5.6 trillion. It could go farther, with world stock market capitalization now about $41 trillion, according to Standard & Poor’s.

Robert Pickel, the chief executive of the association, said that the growth in derivatives enables “more and more firms to benefit from these risk management tools.” On the other hand, the situation allows more and more traders to load up on risk if they choose, and hedge funds have become major derivatives traders.

The combination of large unregulated hedge funds trading ever larger amounts of unregulated derivatives in nontransparent markets makes some people nervous. But so far, anyway, little is being done to change the situation, and nothing devastating has happened to markets.

Continued in article

Jensen Comment
One of the main differences between a "financial instrument" versus a "derivative financial instrument" is that the notional is generally not at risk in a "derivative financial instrument." For example if Company C borrows $600 million from Bank B in a financial instrument, the notional amount ($600 million) is at risk immediately after the notional is transferred to Company C. On the other hand, if Company C and Company D contract for an interest rate swap on a notional of $600 million using Bank B as an intermediary, the $600 million notional never changes hands. Only the swap payments for the differences in interest rates are at risk and these are only a small fraction of the $600 million notional. Sometimes the swap payments are even guaranteed by the intermediary, thereby eliminating credit risk.

So where's the risk of a derivative financial instrument that caused all the fuss beginning in the 1980s and led to the most complex accounting standards ever written (FAS 133 in the U.S. and IAS 39 internationally)?

Often there is little or no risk if the derivative contracts are held to maturity. The problem is that derivatives are often settled before maturity at huge gains to one party and huge losses to the counterparty. For example, if Company C swaps fixed-rate interest payments on $600 million (having current value risk with no cash flow variation risk) for variable-rate interest payments on $600 million (having cash flow variation risk but no market value variation risk), Company C has taken on enormous cash flow risk that may become very large if interest rates change greatly in a direction not expected by Company C. If Company C wants to settle its swap contract before maturity it may have to pay an enormous amount of money to do so either to counterparty Company D or to some other company who will take the swap off the hands of Company C. The risk is not the $600 million notional; Rather the risk is in the shifting value of the swap contract itself which can be huge even if it is less than the $600 million notional amount.

Perhaps derivative financial instrument risk is even better illustrated by futures contracts. Futures contracts are traded on organized exchanges such as the Chicago Board of Trade. If Company A speculates in oil futures on January 1, there is no exchange of cash on a 100,000 barrel notional that gives Company A the right to sell oil at a future date (say in one year) at a forward price (say $100 per barrel) one year from now. As a speculation, Company A has gambled by hoping to buy 100,000 barrels of oil one year from now for less than $100 per barrel and sell it for the contracted $100 price.

But futures contracts are unique in that they are net settled in cash each day over the entire one year contract period. If the spot price of oil is $55 on January 12 and $60 on January 13, Company A must provide $500,000 = ($60-$55)(100,000 barrels) to the counterparty on January 13 even though the futures contract itself does not mature until December 31. If Company A has not hedged its position, its risk can become astounding if oil prices dramatically rise. Company A's futures contract had zero value on January 1 (futures contracts rarely have value initially except in the case of options contracts), but the value of the futures contract may become an enormous asset or an enormous liability each each day thereafter depending upon oil spot price movements relative to the forward price ($100) that was contracted.

Hence, derivative contracts may have enormous risks even though the notionals themselves are not at risk. Prior to FAS 133 these risks were generally not booked or even disclosed. In the 1980s newer types of derivative contracts emerged (such as interest rate swaps) in part because it was possible to have enormous amounts of off-balance-sheet debt that did not even have to be disclosed, let alone booked, in financial statements. Astounding frauds transpired that led to huge pressures on the SEC and the FASB to better account for derivative financial instruments.

Most corporations adopted policies of not speculating in derivatives by allowing derivatives to be used only to hedge risk. However, such policies are very misleading since there are two main types of risk --- cash flow risk versus value risk. It is impossible to simultaneously hedge both types of risk, and hedging one type increases the risk of the other type. For example, a company that swaps fixed for floating rate interest payments increases cash flow risk by eliminating value risk (which it may want if it plans to settle debt prior to maturity). The counterparty that swaps floating rate interest payments for fixed rate payments eliminates cash flow risk by taking on value risk. It is impossible to hedge both cash flow and value risk simultaneously.

Hence, to say that a corporation has a policy allowing hedging but not speculating in derivative financial instruments is nonsense. A policy to only hedge cash flow risk may create enormous value risk. A policy to only hedge value risk may create enormous cash flow risk.

As the NYT article above points out that derivative financial instruments are increasingly popular in world commerce. As a result risk exposures have greatly increased even if all contracts were used for hedging purposes only. The problem is that a hedge only reduces or eliminates one type of risk at the "cost" of increasing the other type of risk. Derivative contracts increase one type or the other type of risk the instant they are signed.  Hedging shifts risk but does not eliminate risk per se.

You can read more about scandals in derivative financial instruments contracting (such as one company's "trillion dollar bet" that nearly toppled Wall Street and Enron's derivative scandals) at http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds

You can download the CD containing my slide shows and videos on how to account for derivative financial instruments at http://www.cs.trinity.edu/~rjensen/Calgary/CD/

My FAS 133 and IAS 39 Glossary is Below.

Table of Contents and Links

Bob Jensen's FAS 133 Glossary on Derivative Financial Instruments and Hedging Activities

          Also see a comprehensive risk and trading glossary at http://risk.ifci.ch/SiteMap.htm

Glossary for the energy industry --- Also see http://snipurl.com/EnergyGlossary  

Related glossaries are listed at http://www.trinity.edu/rjensen/bookbus.htm 

Click here for tutorial links 

Risk Glossary --- http://www.riskglossary.com/

If you are having trouble finding something try a Google search.  Especially note that you can add terms and phrases at http://www.google.com/advanced_search?hl=en
For example, you can add a phrase in the second cell and individual words in the top cell.  You can fill in both cells simultaneously to narrow your search.

Also note that you can seek definitions in Google.  In the top cell type in --- define “phrase” where your phrase can be one word like “contango” or “backwardation” or a phrase like “asian option”.
It is important to first type in the word “define” without quotation marks.

Second try a search within the standard itself.  
You can find digital versions of FAS 133 by scrolling down at http://www.fasb.org/st/#fas153 
DIG text is can be searched at http://www.fasb.org/derivatives/ 
Free digital versions of IAS 39 are available but they are difficult to find in EU law.  Fee-based versions are available at http://www.iasb.org/ 

Illustrations --- See Illustrations 

Dear Professor Bob Jensen,

The Journal of Deivatives Accounting (JDA) is preparing to publish its first issue and I would be grateful if you could post the following announcement on your web site.

Regards

Mamouda

Dear Colleagues,

There is a new addition to accounting research Journals. The Journal of Derivatives Accounting (JDA) is an international quarterly publication which provides authoritative accounting and finance literature on issues of financial innovations such as derivatives and their implications to accounting, finance, tax, standards setting, and corporate practices. This refereed journal disseminates research results and serves as a means of communication among academics, standard setters, practitioners, and market participants.

The first and special issue of the JDA, to appear in the Winter of 2003, will be dedicated to:

"Stock Options: Developments in Share-Based Compensation (Accounting, Standards, Tax and Corporate Practice)"

This special issue will consider papers dealing with:

* Analysis of applicable national and international accounting standards * Convergence between IASB and FASB * Accounting treatment (Expensing) * Valuation * Corporate and market practice * Design of stock options * Analysis of the structure of stock options contracts * Executives pay incentives and performance * Taxation * Management and Corporate Governance

For more details on how to submit your work to the journal, please visit http://www.worldscinet.com/jda.html 

Sincerely,
The Editorial Board Journal of Derivatives Accounting (JDA)

An earlier FAS 133 Amendment on the Heels of the Previous (FAS 138) Amendment --- A Mere 104 Pages

Derivative Financial Instruments Frauds --- 
http://www.trinity.edu/rjensen/fraud.htm

A Condensed Multimedia Overview With Video and Audio from Experts --- http://www.cs.trinity.edu/~rjensen/000overview/mp3/133summ.htm 

A Longer and More Boring Introduction to FAS 133, FAS 138, and IAS 39 --- http://www.trinity.edu/rjensen/caseans/000index.htm 

The Devil's Derivatives Dictionary at http://www.margrabe.com/Devil/DevilF_J.html 

To understand more about derivative financial instruments, I suggest that you begin by going to the file at 
http://www.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm  
Especially note the discussion of the shortcut method at the end of the above document.

A helpful site on FAS 133 is at http://fas133.com 

Differences between FAS 133 and IAS 39 --- http://www.iasplus.com/country/compare.htm 

Auditing Requirements for Derivative Financial Securities
Auditing Derivative Instruments, Hedging Activities, and Investments in Securities
http://www.aicpa.org/members/div/auditstd/riasai/sas92.htm 

A Nice Summary of SAS 92 is Available Online (Auditing, Derivative Financial Instruments, Hedging)

SAS 92-New Guidance on Auditing Derivatives and Securities
by Joe Sanders, Ph.D., CPA and Stan Clark, Ph.D., CPA 
http://www.ohioscpa.com/member/publications/Journal/1st2001/page10.asp  

Auditors face many challenges in auditing derivatives and securities. These instruments have become more complex, their use more common and the accounting requirements to provide fair value information are expanding. There is also an increasing tendency for entities to use service organizations to help manage activities involving financial instruments. To assist auditors with these challenges, the Auditing Standards Board (ASB) issued SAS 92, Auditing Derivative Instruments, Hedging Activities and Investments in Securities. The ASB is also currently developing a companion Audit Guide. SAS 92 supersedes SAS 81, Auditing Investments.

SAS 92 provides a framework for auditors to use in planning and performing auditing procedures for assertions about all financial instruments and hedging activities. The Audit Guide will show how to use the framework provided by the SAS for a variety of practice issues. The purpose of this article is to summarize and explain some of the more significant aspects of SAS 92.

Scope SAS 92 applies to:

Derivative instruments, as defined in SFAS 133, Accounting for Derivative Instruments and Hedging Activity. Hedging activities which also fall under SFAS 133. Debt and equity securities, as defined in SFAS 115, Accounting for Certain Investments in Debt and Equity Securities. The auditor should also refer to APB 18, The Equity Method of Accounting for Investments in Common Stock. Special Skill or Knowledge

SEC Chairman Arthur Levitt, in his speech on renewing the covenant with investors stated, "I recognize that new financial instruments, new technologies and even new markets demand more specialized know-how to effectively audit many of today's companies".1 One of the first items noted in SAS 92 is that the auditor may need to seek assistance in planning and performing audit procedures for financial instruments. This advice is based primarily on the complexity of SFAS 133. Understanding an entities' information system for derivatives, including work provided by a service organization, may require the auditor to seek assistance from within the firm or from an outside expert. SAS 73 provides guidance on using the work of a specialist.

Inherent Risk Assessment

The inherent risk related to financial instruments is the susceptibility to a material misstatement, assuming there are no related controls. Assessing inherent risk for financial instruments, particularly complex derivatives, can be difficult. To assess inherent risk for financial instruments, auditors should understand both the economics and business purpose of the entity's financial activities. Auditors will need to make inquiries of management to understand how the entity uses financial instruments and the risks associated with them. SAS 92 provides several examples of considerations that might affect the auditor's assessment of the inherent risk for assertions about financial instruments:2

The complexity of the features of the derivative or security. Whether the transaction that gave rise to the derivative or security involved the exchange of cash. The entity's experience with derivatives or securities. Whether the derivative is freestanding or an embedded feature of an agreement. The evolving nature of derivatives and the applicable generally accepted accounting principles. Significant reliance on outside parties. Control Risk Assessment

SAS 92 includes a section on control risk assessment. Control risk is the risk that a material misstatement could occur and would not be prevented or detected in a timely manner by an entity's internal control. Management is responsible for providing direction to financial activities through clearly stated policies. These policies should be documented and might include:

Policies regarding the types of instruments and transactions that may be entered into and for what purposes. Limits for the maximum allowable exposure to each type of risk, including a list of approved securities broker-dealers and counterparties to derivative transactions. Methods for monitoring the financial risks of financial instruments, particularly derivatives, and the related control procedures. Internal reporting of exposures, risks and the results of actions taken by management. Auditors should understand the contents of financial reports received by management and how they are used. For example, "stop loss" limits are used to protect against sudden drops in the market value of financial instruments. These limits require all speculative positions to be closed out immediately if the unrealized loss on those positions reaches a certain level. Management reports may include comparisons of stop loss positions and actual trading positions to the policies set by the board of directors.

The entity's use of a service organization will require the auditor to gain an understanding of the nature of the service organization's services, the materiality of the transactions it processes, and the degree of interaction between its activities and those of the entity. It may also require the auditor to gain an understanding of the service organization's controls over the transactions the service organization processes for it.

Designing Substantive Procedures Based on Risk Assessments

The auditor should use the assessed levels of inherent and control risk to determine the acceptable level of detection risk for assertions about financial instruments and to determine the nature, timing, and extent of the substantive tests to be performed to detect material misstatements of the assertions. Substantive procedures should address the following five categories of assertions included in SAS 31, Evidential Matter:

1. Existence or occurrence. Existence assertions address whether the derivatives and securities reported in the financial statements through recognition or disclosure exist at the balance sheet date. Occurrence assertions address whether changes in derivatives or securities reported as part of earnings, other comprehensive income, cash flows or through disclosure occurred. Examples of substantive procedures for existence or occurrence assertions include:3

Confirmation with the holder of the security, including securities in electronic form or with the counterparty to the derivative. Confirmation of settled or unsettled transactions with the broker-dealer counterparty. Physical inspection of the security or derivative contract. Inspecting supporting documentation for subsequent realization or settlement after the end of the reporting period. Performing analytical procedures. 2. Completeness. Completeness assertions address whether all of the entity's derivatives and securities are reported in the financial statements through recognition or disclosure. Since derivatives may involve only a commitment to perform under a contract and not an initial exchange of tangible consideration, auditors should not focus exclusively on evidence relating to cash receipts and disbursements.

3. Rights and obligations. These assertions address whether the entity has rights and obligations associated with derivatives and securities reported in the financial statements. For example, are assets pledged or do side agreements exist that allow the purchaser of a security to return the security after a specified period of time? Confirming significant terms with the counterparty to a derivative or the holder of a security would be a substantive procedure testing assertions about rights and obligations.

4. Valuation. Under SFAS 115 and SFAS 133 many financial instruments must now be measured at fair value, and fair value information must be disclosed for most derivatives and securities that are measured at some other amount.

The auditor should obtain evidence corroborating the fair value of financial instruments measured or disclosed at fair value. The method for determining fair value may be specified by generally accepted accounting principles and may vary depending on the industry in which the entity operates or the nature of the entity. Such differences may relate to the consideration of price quotations from inactive markets and significant liquidity discounts, control premiums, commissions and other costs that would be incurred to dispose of the financial instrument.

If the derivative or security is valued by the entity using a valuation model (for example, the Black-Scholes option pricing model), the auditor should assess the reasonableness and appropriateness of the model. The auditor should also determine whether the market variables and assumptions used are reasonable and appropriately supported. Estimates of expected future cash flows, for example, to determine the fair value of long-term obligations should be based on reasonable and supportable assumptions.

The method for determining fair value also may vary depending on the type of asset or liability. For example, the fair value of an obligation may be determined by discounting expected future cash flows, while the fair value of an equity security may be its quoted market price. SAS 92 provides guidance on audit evidence that may be used to corroborate these assertions about fair value.

5. Presentation and disclosure. These assertions address whether the classification, description and disclosure of derivatives and securities are in conformity with GAAP. For some derivatives and securities, GAAP may prescribe presentation and disclosure requirements, for example:

Certain securities are required to be classified into categories based on management's intent and ability such as trading, available-for-sale or held-to-maturity. Changes in the fair value of derivatives used to hedge depend on whether the derivative is a fair-value hedge or an expected cash flow hedge, and on the degree of effectiveness of the hedge. Hedging Transactions

Hedging will require large amounts of documentation by the client. For starters, the auditor will need to examine the companies' established policy for risk management. For each derivative, management should document what risk it is hedging, how it is expected to hedge that risk and how the effectiveness will be tested. Without documentation, the client will not be allowed hedge accounting. Auditors will need to gather evidence to support the initial designation of an instrument as a hedge, the continued application of hedge accounting and the effectiveness of the hedge.

To satisfy these accounting requirements, management's policy for financial instrument transactions might also include the following elements whenever the entity engages in hedging activities:

An assessment of the risks that need to be hedged The objectives of hedging and the strategy for achieving those objectives. The methods management will use to measure the effectiveness of the strategy. Reporting requirements for the monitoring and review of the hedge program. Impairment Losses

Management's responsibility to determine whether a decline in fair value is other than temporary is explicitly recognized in SAS 92. The auditor will need to evaluate whether management has considered relevant information in determining whether other-than-temporary impairment exists. SAS 92 provides examples of circumstances that indicate an other-than-temporary impairment condition may exist:4

Management Representations

The auditor must obtain written representations from management confirming their intent and ability assertions related to derivatives and securities. For example, the intent and ability to hold a debt security until it matures or to enter into a forecasted transaction for which hedge accounting is applied. Appendix B of SAS 85 (AU Sec. 333.17) includes illustrative representations about derivative and security transactions.

Summary

SAS 92 provides guidance for auditing derivatives and securities. Accounting requirements related to these instruments, SFAS 115 and SFAS 133, are very complex and because of their extensive use of fair value measures require significant use of judgment by the accountant. SAS 92 establishes a framework for auditors to assess whether the entity has complied with the provisions of SFAS 115 and SFAS 133. However, because of the subjective nature of many of the requirements of these two standards, considerable auditor judgment will be required to comply with SAS 92.

Effective Date

This SAS is effective for audits of financial statements for fiscal years ending on or after June 30, 2001. Early adoption is permitted.

 

Keeping Up With Financial Instruments Derivatives

Bob Jensen's CD --- http://www.cs.trinity.edu/~rjensen/Calgary/CD/

I'm sharing some old (well relatively old) accounting theory quiz and exam material that I added to a folder at http://www.cs.trinity.edu/~rjensen/Calgary/CD/

You can find some great tutorials go to CBOE at http://www.cboe.com/education/ .   But these do not help with learning how to account for the derivatives under FAS 133 and IAS 39.  The same holds for the CBOT at http://www.cbot.com/cbot/pub/page/0,3181,909,00.html  and the CME at http://www.cme.com/edu/ 

New York Mercantile Exchange (NYMEX) for energy and metals under the Education tab at http://www.nymex.com/jsp/index.jsp 

Optionetics has some good tutorials with respect to options but these do not explain options accounting --- http://www.optionetics.com/education/trading.asp 

Daniel Oglevee's Course Site --- http://www.cob.ohio-state.edu/fin/autumn2004/723.htm 

In 2000, ISDA filed a letter to the Financial Accounting Standards Board (FASB) urging changes to FAS 133, its derivatives and hedge accounting standard. ISDA’s letter urged alterations to six areas of the standard: hedging the risk-free rate; hedging using purchased options; providing hedge accounting for foreign currency assets and liabilities; extending the exception for normal purchase and sales; and central treasury netting. The FASB subsequently rejected changes to purchased option provisions, conceded some on normal purchases and sales, extending the exception to contracts that implicitly or explicitly permit net settlement, declined to amend FAS 133 to facilitate partial term hedging and agreed to consider changing the restrictions on hedge accounting for foreign currency. 
ISDA ®INTERNATIONAL SWAPS AND DERIVATIVES ASSOCIATION, INC.http://www.isda.org/wwa/Retrospective_2000_Master.pdf  

A good tutorial on energy futures and options hedging is given by the New York Mercantile Exchange (NYMEX) under the Education tab at http://www.nymex.com/jsp/index.jsp 

Two Questions
How did Bob Jensen spend his summer vacation?
What can physicists do when they can't find jobs in physics?

Answers

I've spent a great deal of my summer and my Fall 2004 Semester leave plowing through a book entitled Quantitative Finance and Risk Managment:  A Physicists Approach by Jan W. Dash, by Jan W. Dash (World Scientific Publishing, 2004, ISBN 981-238-712-9)
This is a great book by a good writer.

For a more introductory warm up I recommend Derivatives:  An Introduction by Robert A Strong, Edition 2 (Thomson South-Western, 2005, ISBN 0-324-27302-9)

And what about opportunities for physicists?
See "A Geek's Walk on Wall Street," by Peter Coy, Business Week, November 15, Page 26.  This is a review of a book entitled My Life as a Quant, by Emanuel Derman (Wiley, 2005) --- http://www.businessweek.com/@@x3mnUmYQYMjg7RMA/premium/content/04_46/b3908024_mz005.htm 

As one of Wall Street's leading quants, Derman did throw off some intense gamma radiation. He worked at Goldman from 1985 until 2003 except for one year at Salomon Brothers. At Goldman, he moved from fixed income to equity derivatives to risk management, becoming a managing director in 1997. He co-invented a tool for pricing options on Treasury bonds, working with Goldman colleagues Bill Toy and the late Fischer Black, who co-invented the Black-Scholes formula for valuing options on stocks. Derman received the industry's "Financial Engineer of the Year" award in 2000. Now he directs the financial-engineering program at Columbia University.

Derman failed at what he really wanted, which was to become an important physicist. He was merely very smart in a field dominated by geniuses, so he kicked around from one low-paying research job to another. "At age 16 or 17, I had wanted to be another Einstein," he writes. "By 1976...I had reached the point where I merely envied the postdoc in the office next door because he had been invited to give a seminar in France." His move to Wall Street -- an acknowledgment of failure -- brought him financial rewards beyond the dreams of academic physicists and a fair measure of satisfaction as well.

In the tradition of the idiosyncratic memoir, My Life As a Quant is a grab bag of the author's interests. It quotes Schopenhauer and Goethe while supplying not one but three diagrams of a muon neutrino colliding with a proton. There is a long section on the brilliant and punctilious Fischer Black; a glimpse of physicist Richard Feynman; and an embarrassing encounter with finance giant Robert Merton, who sat next to the author on a long flight (Derman treated him rudely before realizing who he was).

Derman's mood seems to vary from bemused on good days to sour on bad ones. The chapter on his postdoc travels is titled "A Sort of Life"; his brief career at Bell Labs, "In the Penal Colony"; his tenure at Salomon Brothers, "A Severed Head." Pre-IPO Goldman Sachs comes off as relatively gentle yet stimulating. He writes: "It was the only place I never secretly hoped would crash and burn."

Continued in the article

Bob Jensen's threads (including video tutorials) on derivative financial instruments and the Freddie and Fannie scandals are at http://www.trinity.edu/rjensen/caseans/000index.htm 

Bob Jensen's threads on the trillions of dollars of worldwide frauds using derivative financial instruments are at http://www.trinity.edu/rjensen/fraudRotten.htm#DerivativesFrauds 

 

You can read a great deal about energy derivatives in The Derivatives 'Zine at http://www.margrabe.com/Energy.html 
Other topics include the following:

The Derivatives 'Zine by Dr. Risk THE WILLIAM MARGRABE GROUP, INC., CONSULTING, PRESENTS

Home ABOUT CONTACT SEARCH LINKS DICTIONARY ACCOUNTING & FAS 133 BIG APPLET ASK DR. RISK! CREDIT RISK CREDIT DP CURRENCY ENERGY EQUITY FIXED INCOME TRADING POST PERSONAL IF ONLY ... DEAL MARKET RISK MODEL RISK BOOKSHELF MATH APPENDIX JAVA JOBS! CALENDAR HUMOR GAMES DEVIL'S DD

Ask Dr. Risk!

• Free answers: Dr. Risk promises any correspondent from a business domain with a website (e.g., Mack@CSFB.com) at least a five-minute response to your important question, as soon as he has a free moment, probably within one month. 
• Fast answers: If you absolutely, positively will have to have an answer overnight, set up your consulting account, ahead of time, with the William Margrabe Group, Inc.. Introductory offer: $300 / hour with one-minute granularity. If we can't provide the answer, we'll refer you to someone who can. If we can't refer you, we'll inform you fast for free.
• No answers: LDiablo@hotmail.com, Chris1492@aol.com, BillyG@MSN.com, and Desperate@Podunk.edu, etc. can no longer count on even brief answers, unless their questions are sufficiently intriguing. Sorry. 

A question of sufficiently general interest to make it into the 'Zine, tends to generate a more comprehensive response. All questions and answers become the property of The William Margrabe Group, Inc

QUANTITATIVE FINANCE AND RISK MANAGEMENT A Physicist's Approach
by Jan W Dash

This book is designed for scientists and engineers desiring to learn quantitative finance, and for quantitative analysts and finance graduate students. Parts will be of interest to research academics --- http://www.worldscientific.com/books/economics/5436.html 

804pp	Pub. date: Jul 2004
ISBN 981-238-712-9	US$98 / £73

Contents:

• Introduction, Overview, and Exercise
• Risk Lab (Nuts and Bolts of Risk Management)
• Exotics, Deals, and Case Studies
• Quantitative Risk Management
• Path Integrals, Green Functions, and Options
• The Macro-Micro Model (A Research Topic)

The above sources are not much good about accounting for derivatives under FAS 133, FAS 138, and IAS 39.  For that, go to the following source:

http://www.trinity.edu/rjensen/caseans/000index.htm 

FAS 133 Tutorial, SmartPros --- http://www.smartpros.com/x33017.xml 

FAS 133, the standard for financial reporting of derivatives and hedging transactions, was adopted in 1998 by the Financial Accounting Standards Board to resolve inconsistent previous reporting standards and practices. It went into effect at most U.S. companies at the beginning of 2001.

Courtesy of Kawaller & Company, SmartPros presents this FAS 133 tutorial to help you understand the provisions of the standard. For news pertaining to FAS 133, click on the links to the right in Related Stories.

PwC Tutorial on IAS 39 --- http://www.pwcglobal.com/images/gx/eng/fs/bcm/032403iashedge.pdf 

PowerPoint Show Highlighting Some Complaints About IAS 39 and IAS 32 --- http://www.atel.lu/atel/fr/publications/Publications/030524_EACT%20mtg_Milan.ppt 

"IAS 32 and IAS 39 Revised:  An Overview," Ernst & Young, February 2004  --- http://www.ey.com/global/download.nsf/International/IAS32-39_Overview_Febr04/$file/IAS32-39_Overview_Febr04.pdf 
I shortened the above URL to http://snipurl.com/RevisedIAS32and39 

Sharing Professor  --- John Hull (who writes about financial instrument derivatives) --- http://www.rotman.utoronto.ca/~hull/

His great books (not free) are great, but he also shares (for free) some software and data --- http://www.rotman.utoronto.ca/~hull/

Options, Futures, and Other Derivatives, 5th Edition  Fundamentals of Futures and Options Markets, 4th Edition

Forwarded by Carl Hubbard on September 12, 2003

I would like to bring to your attention Analysis of Derivatives for the CFA(r) Program by Don M. Chance, CFA, recently published this year by the Association for Investment Management and Research(r). While designed for the CFA program, this publication is a terrific text for academic derivatives and risk management courses.

The treatment in this volume is intended to communicate a practical risk management approach to derivatives for the investment generalist. The topics in the text were determined by a comprehensive job analysis of investment practitioners worldwide. The illustrative in-chapter problems and the extensive end-of-chapter questions and problems serve to reinforce learning and understanding of the material.

We believe that this text responds to the need for a globally relevant guide to applying derivatives analysis to the investment process. We hope you will consider adopting Analysis of Derivatives for the CFA(r) Program for a future course.

Thank you for your attention.

Sincerely,

Helen K. Weaver
Associate
AIMR

656 PAGES
0-935015-93-0 
HB 2003

Message from Ira Kawaller on August 4, 2002

Hi Bob,

I posted a new article on the Kawaller & Company website: “What’s ‘Normal’ in Derivatives Accounting,” originally published in Financial Executive, July / August 2002. It is most relevant for financial managers of non-financial companies, who seek to avoid FAS 133 treatment for their purchase and sales contracts. The point of the article is that this treatment may mask some pertinent risks and opportunities. To view the article, click on http://www.kawaller.com/pdf/FE.pdf  .

I'd be happy to hear from you if you have any questions or comments.

Thanks for your consideration.

Ira Kawaller Kawaller & Company, LLC http://www.kawaller.com 

kawaller@kawaller.com 717-694-6270

Bob Jensen's documents on derivative financial instruments are at http://www.trinity.edu/rjensen/caseans/000index.htm 

March 8, 2002 Message from the Risk Waters Group [RiskWaters@lb.bcentral.com] 

ONLINE TRADING TRAINING NOW AVAILABLE (Investments, Finance, Derivatives) … 
‘Introduction to Trading Room Technology’ from Waters Training. A low-cost, Web-based training solution for financial professionals. Go at your own pace, travel nowhere, and learn about the core trading processes and key technology issues from your own desktop. For more information, go to http://www.waters-training.com  to find out more. Lastly, if you have any colleagues, training managers or business associates who would be interested in this new product, please forward them this message. 
Thank you.

If you are interested in email messages regarding financial risk news, you may be interested in contacting:

Christopher Jeffery  mailto:cjeffery@riskwaters.com 
Editor, RiskNews
http://www.risknews.net 

Governmental Disclosure Rules for Derivative Financial Instruments ---  see Disclosure.

The DIG
In the meantime, the FASB formed the FAS 133 Derivatives Implementation Group (DIG) to help resolve particular implementation questions, especially in areas where the standard is not clear or allegedly onerous.  The FASB's DIG website (that contains its mission and pronouncements) is at http://www.fasb.org/derivatives/  DIG issues are also summarized (in red borders) at http://www.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#0000Begin.

IAS 138 Implementation Guidance
"Implementation of SFAS 138, Amendments to SFAS 133," The CPA Journal, November 2001. (With Angela L.J. Huang and John S. Putoubas), pp. 54-56 --- http://www.nysscpa.org/cpajournal/2001/1100/dept/d115401.htm

April 25, 2002 message from Charlie Stutesman [southwestern.email@swcollege.com] 

Dear Professor Jensen,

In direct contrast to most trade training derivatives texts which emphasize issues related to the pricing and hedging of derivatives, this groundbreaking text is designed for those who want to teach students how to manage derivatives to maximize firm value through risk management. DERIVATIVES AND RISK MANAGEMENT presents the crucial tools necessary for executives and future derivatives players to effectively hedge with derivatives in order to protect firms from losses.

* WRITTEN TO EMPHASIZE THE ROLE OF MANAGERS: Managers will use derivatives to maximize firm value as opposed to traders who may use derivatives to speculate.

* MANAGERIAL APPLICATION BOXES: Preparing users to meet the challenges of today's business decisions, real-world applications bring chapter concepts to life.

* TECHNICAL BOXES: Concepts presented within the chapters are taken to a higher level of conceptual or mathematical rigor.

We encourage you to request a complimentary exam copy of DERIVATIVES AND RISK MANAGEMENT (ISBN: 0-538-86101-0) by Stulz. Simply reply to this message, contact your South-Western, Thomson Learning representative, call the Thomson Learning Academic Resource Center at 1-800-423-0563, or go to:

http://esampling.thomsonlearning.com/s1.asp?Rid=1+JWA+1719&SC=2SCF2262 

South-Western has helped provide generations of learners with a solid foundation and true understanding of finance. Now more than ever, follow the proven leader into a new century with relevant, comprehensive, and up-to-date finance products and information.

Sincerely,

Charlie Stutesman 
Senior Marketing Manager 
charlie.stutesman@swlearning.com 

IAS 39 Implementation Guidance

Supplement to the Publication
Accounting for Financial Instruments - Standards, Interpretations, and Implementation Guidance
http://www.iasc.org.uk/docs/ias39igc/batch6/39batch6f.pdf

The IASB’s Exposure Draft of the macro hedging compromise is entitled “Amendments to IAS 39:  Recognition and Measurement Fair Value Hedge Accounting for a Portfolio Hedge of Interest Rate” and for a short time can be downloaded free from http://www.iasc.org.uk/docs/ed-ias39mh/ed-ias39mh.pdf
See Macro Hedging 

Also see Bob Jensen's Interest Rate Swap Valuation, Forward Rate Derivation,  and Yield Curves
for FAS 133 and IAS 39 on Accounting for Derivative Financial Instruments --- http://www.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm 

Hi Patrick,

The term "better" is a loaded term. One of the main criticisms leveled at IASC standards is that they were too broad, too permissive, and too toothless to provide comparability between different corporate annual reports. The IASC (now called IASB) standards only began ot get respect at IOSCO after they started becoming more like FASB standards in the sense of having more teeth and specificity.

I think FAS 133 is better than IAS 39 in the sense that FAS 133 gives more guidance on specific types of contracts. IAS 39 is so vague in places that most users of IAS 39 have to turn to FAS 133 to both understand a type of contract and to find a method of dealing with that contract. IAS 39 was very limited in terms of examples, but this has been recitified somewhat (i.e., by a small amount) in a recent publication by the IASB: Supplement to the Publication Accounting for Financial Instruments - Standards, Interpretations, and Implementation Guidance http://www.iasc.org.uk/docs/ias39igc/batch6/39batch6f.pdf 

In theory, there are very few differences between IAS 39 and FAS 133. But this is like saying that there is very little difference between the Bible and the U.S. Commercial Code. Many deals may be against what you find in the Bible, but lawyers will find it of less help in court than the U.S. Commercial Code. I admit saying this with tongue in cheek, because the IAS 39 is much closer to FAS 133 than the Bible is to the USCC.

Paul Pacter wrote a nice paper about differences between IAS 39 and FAS 133. However, such a short paper cannot cover all differences that arise in practice. The paper is somewhat dated now, but you can find more recent updates on differences at Differences between FAS 133 and IAS 39 --- http://www.iasplus.com/country/compare.htm

Although there are differences between FAS 133 and IAS 39, I would not make too big a deal out of such differences. IAS 39 was written with one eye upon FAS 133, and the differences are relatively minor. Paul Pacter's summary of these differences can be downloaded from http://www.iasc.org.uk/cmt/0001.asp?s=490603&sc={65834A68-1562-4CF2-9C09-D1D6BF887A00}&sd=860888892&n=3288 

Also note "Comparisons of International IAS Versus FASB Standards" --- http://www.iasplus.com/country/compare.htm

Hope this helps,

Bob (Robert E.) Jensen Jesse H. Jones Distinguished Professor of Business Trinity University, San Antonio, TX 78212 Voice: (210) 999-7347 Fax: (210) 999-8134 Email: rjensen@trinity.edu http://www.trinity.edu/rjensen 

-----Original Message----- 
From: Patrick Charles [mailto:charlesp@CWDOM.DM]  
Sent: Tuesday, February 26, 2002 11:54 AM 
To: CPAS-L@LISTSERV.LOYOLA.EDU 
Subject: US GAAP Vs IASB

Greetings Everyone

Mr Bolkestein said the rigid approach of US GAAP could make it easier to hide companies' true financial situation. "You tick the boxes and out come the answer," he said. "Having rules is a good thing, but having rigid rules is not the best thing.

http://news.ft.com/ft/gx.cgi/ftc?pagename=View&c=Article&cid=FT3AHWRLXXC&live=true&tagid=FTDCZE6JFEC&subheading=accountancy

Finally had a chance to read the US GAAP issue. Robert you mentioned IAS 39, do you have other examples where US GAAP is a better alternative to IASB, or is this an European ploy to get the US to adopt IASB?

Cheers

Mr. Patrick Charles charlesp@cwdom.dm  ICQ#6354999

"Education is an admirable thing, but it is well to remember from time to time that nothing that is worth knowing can be taught."

Bob Jensen's Glossary of FAS 133 and IAS 39

Bob Jensen's Overview of FAS 133 (With Audio) http://www.trinity.edu/rjensen/caseans/000index.htm 

Interest Rate Swap Valuation, Forward Rate Derivation,  and Yield Curves
for FAS 133 and IAS 39 on Accounting for Derivative Financial Instruments 
See http://www.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm

FAS 133 flow chart  http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm

Bob Jensen's Document on the Missing Parts of FAS 133

Summary of Key Paragraphs in FAS 133 on Portfolio/Macro Hedging.

Bob Jensen's Weekly Assignments and Hints Regarding FAS 133

Bob Jensen's Technology Glossary (Includes an Extensive Listing of Accounting and Finance Glossaries)

ACCT 5341 International Accounting Theories Course Helpers

Yahoo Finance is Bob Jensen's Favorite Place to learn more about the mechanics and widespread use of derivative financial instruments.  That web site, however, will not help much with respect to accounting for such instruments under FAS 133.

Bob Jensen's Mexcobre Case

For a FAS 133 flow chart, go to http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm 

Internet Links of Possible Interest

Bob Jensen's Transcripts of Presentations by Experts

• The web address for my multimedia overview of FAS 133 can be found at http://www.cs.trinity.edu/~rjensen/000overview/133suma.htm. 
  

• James Leisenring from the Financial Accounting Standards Board
  Stephen Swad from KPMG Peat Marwick LLP
  
  

• James Leisenring from the Financial Accounting Standards Board
  Lynn Turner from the Securities and Exchange Commission
  
  

• Paul Pacter from the International Accounting Standards Committee
  
  

• Walter Teets from Gonzaga University
  
  

PriceWaterhouseCoopers (PWC) Summary Tables (With Some Notes Added by Bob Jensen) 

Derivatives Implementation Group (DIG) 

For a FAS 133 flow chart, go to http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm 

Differences between FAS 133 and IAS 39 --- http://www.iasplus.com/country/compare.htm

Side by Side: IAS 39 Compared with FASB Standards (FAS 133), by Paul Pacter, as published in Accountancy International Magazine, June 1999 --- http://www.iasc.org.uk/news/cen8_142.htm 
Also note "Comparisons of International IAS Versus FASB Standards" --- http://www.deloitte.com/dtt/cda/doc/content/pocketiasus.pdf

IAS 39 history --- http://www.iasc.org.uk/cmt/0001.asp?s=6941204&sc={CB32B469-886C-4486-86B7-36E49358DDE5}&sd=617116004&n=3306 

Limited Revisions to IAS 39, Financial Instruments: Recognition and Measurement (E66) --- http://www.iasc.org.uk/cmt/0001.asp?s=6941204&sc={CB32B469-886C-4486-86B7-36E49358DDE5}&sd=268256258&n=3222

Recognition and Measurement (E66)

E66, Proposed Limited Revisions to IAS 39 and Other Related Standards, proposed the following limited revisions to IAS 39, Financial Instruments: Recognition and Measurement, and other related Standards: changes to require consistent accounting for purchases and sales of financial assets using either trade date accounting or settlement date accounting. IAS 39 currently requires settlement date accounting for sales of financial assets, but permits both trade date and settlement date accounting for purchases; elimination of the requirement in IAS 39 for a lender to recognise certain collateral received from a borrower in its balance sheet; improvement of the wording on impairment recognition; changes to require consistent accounting for temporary investments in equity securities between IAS 39 and other International Accounting Standards; and elimination of redundant disclosure requirements for hedges in IAS 32, Financial Instruments: Disclosure and Presentation. None of the proposed revisions represents a change to a fundamental principle in IAS 39. Instead, the purpose of the proposed changes is primarily to address technical application issues that have been identified following the approval of IAS 39 in December 1998. The IASC Board’s assessment is that the proposed changes will assist enterprises preparing to implement IAS 39 for the first time in 2001 and help ensure a consistent application of the Standard. No further changes to IAS 39 are contemplated.

At its meeting in March 2000, the Board appointed a Committee to develop implementation guidance on IAS 39, Financial Instruments: Recognition. The guidance is expected to be published later this year, after public comment, as a staff guidance document. The IAS 39 Implementation Guidance Committee may refer some issues either to the SIC or to the Board.  http://www.iasc.org.uk/frame/cen2_139.htm

Recommended Reading

Recommended Links

Bob Jensen's Glossary of FAS 133 and IAS 39

A message from Ira Kawaller on January 13, 2002

Hi Bob,

I wanted to alert you to the fact that I posted another article on the Kawaller and Company website, "The New World Under FAS 133." It came out in the latest issue of the GARP Review. It deals with the economics and accounting considerations relating to the use of cross-currency interest rate swaps. The link below brings you to the paper:

http://www.kawaller.com/pdf/garpswaps.pdf

I also posted a new calendar of events, at

http://www.kawaller.com/schedule/calendar.pdf

To navigate to the links in this email message, click on them. If that does not work, copy the link and paste it into the address field of your browser.

Please feel free to contact me if you have any questions, comments, or suggestions. Thanks for your consideration.

Ira Kawaller kawaller@kawaller.com 
http://www.kawaller.com

Bob Jensen's documents on FAS 133, FAS 138, and IAS 39 are at http://www.trinity.edu/rjensen/caseans/000index.htm 

PriceWaterhouseCoopers (PWC) Summary Tables

Source:  A Guide to Accounting for Derivative Instruments and Hedging Activities (New York, Pricewaterhouse Coopers, 1999, pp. 4-5 and pp. 19-22)  

Note that the FASB's FAS 133 becomes required for calendar-year companies on January 1, 2001.  Early adopters can apply the standard prior to the required date, but they cannot apply it retroactively.   The January 1, 2001 effective date follows  postponements from the original starting date of June 15, 1999 stated in Paragraph 48 on Page 29 of FAS 133.   For fiscal-year companies, the effective date is June 15, 2000.  The international counterpart known as the IASC's IAS 39 becomes effective for financial statements for financial years beginning on the same January 1, 2001.  Earlier application permitted for financial years ending after 15 March 1999.  

Note that Bob Jensen has added notes (in red),

OVERVIEW & EXPECTED IMPACT of FAS 133 and IAS 39

Table of Derivatives-Contract Types

Other References --- See References 

Beginning of Bob Jensen's FAS 133 and IAS 39 Glossary
Accounting for Derivative Instruments and Hedging Activities

| A | B | C | D | E | F | G | H | I | J | K | L | M |
| N | O | P | Q | R | S | T | U | V | W | X | Y | Z |

Note that the FASB's FAS 133 becomes required for calendar-year companies on January 1, 2001.  Early adopters can apply the standard prior to the required date, but they cannot apply it retroactively.   The January 1, 2001 effective date follows  postponements from the original starting date of June 15, 1999 stated in Paragraph 48 on Page 29 of FAS 133.   For fiscal-year companies, the effective date is June 15, 2000.  The international counterpart known as the IASC's IAS 39 becomes effective for financial statements for financial years beginning on the same January 1, 2001.  Earlier application permitted for financial years ending after 15 March 1999. 

For a FAS 133 flow chart, go to http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm  

A-Terms

Accounting Exposure =

a term used in alternate ways. In one context, accounting exposure depicts foreign exchange exposure that cannot be captured by the accounting model. In some textbooks accounting exposure is synonymous with translation exposure. See translation exposure.  Also see risks.

Amortization of Basis Adjustments = see basis adjustment.

Anticipated Transaction = see forecasted transaction.

AOCI = accumulated other comprehensive income.  See comprehensive income.

Arbitrage = 

By definition, arbitraging entails investing at zero market (price) risk coupled with the risk of losing relatively minor transactions costs of getting into and closing out contracts.  There might be other risks.  Especially when dealing in forward contracts, there may be credit risks.  Forward contracts are often private agreements between contracting individuals.  Other arbitraging alternatives such as futures and options contracts are generally obtained in trading markets such as the Chicago Board of Trade (CBOT) and the Chicago Board of Options Exchange (CBOE).  In markets like the CBOT or the CBOE, the trading exchanges themselves guarantee payments such that there is no credit risk in hedging or speculating strategies.  Arbitrage entails a hedging strategy that eliminates all market (price) risk while, at the same time, has no chance of losing any money and a positive chance of making a profit.  Sometimes the profit is locked in to a fixed amount in advance.  At other times, the profit is unknown, but can never be less than zero (ignoring transactions costs).

Generally arbitrage opportunities arise when the same item is traded in different markets where information asymmetries between markets allows arbitragers with superior information to exploit investors having inferior information.  In perfectly efficient markets, all information is impounded in prices such that investors who "know more" cannot take advantage of investors who are not up on the latest scoop.  Only in inefficient markets can there be some differences between prices due to unequal impounding of information.

FAS 133 says nothing about arbitrage accounting.  Thus it is necessary to drill arbitrage trans actions down to their basic component contracts such as forwards, futures, and options.  See derivative financial instruments and hedge.

You can learn more about arbitrage from my tutorial on arbitraging at http://www.trinity.edu/rjensen/acct5341/speakers/muppets.htm 

You will find the following definition of arbitrage at http://risk.ifci.ch/00010394.htm 

1) Technically, arbitrage consists of purchasing a commodity or security in one market for immediate sale in another market (deterministic arbitrage). (2) Popular usage has expanded the meaning of the term to include any activity which attempts to buy a relatively underpriced item and sell a similar, relatively overpriced item, expecting to profit when the prices resume a more appropriate theoretical or historical relationship (statistical arbitrage). (3) In trading options, convertible securities, and futures, arbitrage techniques can be applied whenever a strategy involves buying and selling packages of related instruments. (4) Risk arbitrage applies the principles of risk offset to mergers and other major corporate developments. The risk offsetting position(s) do not insulate the investor from certain event risks (such as termination of a merger agreement or the risk of delay in the completion of a transaction) so the arbitrage is incomplete. (5) Tax arbitrage transactions are undertaken to share the benefit of differential tax rates or circumstances of two or more parties to a transaction. (6) Regulatory arbitrage transactions are designed to provide indirect access to a market where one party is denied direct access by law or regulation. (7) Swap- driven arbitrage transactions are motivated by the comparative advantages which swap counterparties enjoy in different debt and currency markets. One counterparty may borrow relatively cheaper in the intermediate- or long-term United States dollar market while the other may have a comparative advantage in floating rate sterling. A cross-currency swap can improve both of their positions. 

At-the-Money = see option and intrinsic value.

Auditing See SAS 92

Available-for-Sale (AFS) Security =

is one of three classifications of securities investments under SFAS 115.  Securities designated as "held-to-maturity" need not be revalued for changes in market value and are maintained at historical cost-based book value.  Securities not deemed as being held-to-maturity securities are adjusted for changes in fair value.  Whether or not the unrealized holding gains or losses affect net income depends upon whether the securities are classified as trading securities versus available-for-sale securities.  Unrealized holding gains and losses on available-for-sale securities are deferred in comprehensive income instead of being posted to current earnings.  This is not the case for securities classified as trading securities rather than trading securities.  See FAS 133 Paragraph 13.  The three classifications are of vital importance to cash flow hedge accounting under FAS 133.  See cash flow hedge and held-to-maturity.   Also see equity method and impairment.

Flow Chart for AFS Hedge Accounting --- http://www.trinity.edu/rjensen/acct5341/speakers/133flow.htm 

Classification of an available-for-sale security gives rise to alternative gain or loss recognition alternatives under international rules.  Changes in the value of an available-for-sale instrument either be included in earnings for the period in which it arises; or recognized directly in equity, through the statement of changes in equity ( IAS 1 Paragraphs 86-88) until the financial asset is sold, collected or otherwise disposed of, or until the financial asset is determined to be impaired (see IAS Paragraphs 117-119), at which time the cumulative gain or loss previously recognized in equity should be included in earnings for the period.  See IAS 39 Paragraph 103b.

A trading security (not subject to APB 15 equity method accounting and as defined in SFAS 115) cannot be a FAS 133 hedged item.  That is because SFAS 115 requires that trading securities be revalued (like gold) with unrealized holding gains and losses being booked to current earnings.  Conversely, Paragraphs 4c on Page 2, 38 on Page 24, and 479 on Page 209 of FAS 133 state that a forecasted purchase of an available-for-sale can be a hedged item, because available-for-sale securities are revalued under SFAS 115 have holding gains and losses accounted for in comprehensive income rather than current earnings.  Unlike trading securities, available-for-sale securities can be FAS 133-allowed hedge items.   Mention of available-for sale is made in Paragraphs 4, 18, 23, 36, 38, 49, 52-55, 123, 479-480, and 534 of FAS 133.  Held-to-maturity securities can also be FAS 133-allowed hedge items.

Note that if unrealized gains and losses are deferred in other comprehensive income, the deferral lasts until the transactions in the hedged item affect current earnings.  This means that OCI may carry forward on the date hedged securities are purchased and remain on the books until the securities are sold.  This is illustrated in Example 19 on Page 228 of the Derivatives and Hedging Handbook issued by KPMG Peat Marwick LLP in July 1998).  The Example 5.5 illustration on Page 165 notes that hedge effectiveness need only be assessed for price movements in one direction for put and call options since these only provide one-way price protection.

Suppose a company expects dividend income to continue at a fixed rate over the two years in a foreign currency.  Suppose the investment is adjusted to fair market value on each reporting date.  Forecasted dividends may not be firm commitments since there are not sufficient disincentives for failure to declare a dividend.  A cash flow hedge of the foreign currency risk exposure can be entered into under Paragraph 4b on Page 2 of FAS 133.  Whether or not gains and losses are posted to other comprehensive income, however, depends upon whether the securities are classified under SFAS 115 as available-for-sale or as trading securities.   There is no held-to-maturity alternative for equity securities.

One of the things that the FASB has never properly addressed is how to account for hedges of interest rate risk in Available-for-Sale (AFS) securities where gains and losses of both the hedged item and the hedging derivative go to OCI. Based on an old idea from KPMG, I developed my own thoughts on this ---
http://www.trinity.edu/rjensen/CaseAmendment.htm

The difference between a forward exchange rate and a spot rate is not excluded from a fair value hedging relationship for firm commitments measured in forward rates.  However Footnote 22 on Page 68 of FAS 133 reads as follows:

If the hedged item were a foreign-currency-denominated available-for-sale security instead of a firm commitment, Statement 52 would have required its carrying value to be measured using the spot exchange rate. Therefore, the spot-forward difference would have been recognized immediately in earnings either because it represented ineffectiveness or because it was excluded from the assessment of effectiveness.

B-Terms

Backwardation = see basis and contango swap.

Banker Opinions = 

Joint Working Group of Banking Associations Financial Instrument Issues Relating to Banks

- banksjwg.pdf - Discussion Paper 
- jwgfinal.pdf - Final Position on Fair Value Accounting

Hi Dr. Jensen!

It is the official site about the Financial Instruments - Comprehensive Project of the IASC http://www.iasc.org.uk/frame/cen3_112.htm  The site of the IAS Recognition and Measurement Project is: http://www.iasc.org.uk/frame/cen2_139.htm 

Your Trinity-Homepages on Derivatives SFAS No. 133 is my favorite on this subject, espicially the illustrative examples (and the account simulations).

Currently I am focusing on splitting up hybrid financial instruments, especially those with embedded optional building blocks. The book of Smith/Smithson/Willford (1998) Managing Financial Risk and that from Das S. (1998) and Walsey J. (1997) provides a good guidance on how these products are structured.

Best Regard Christian

Basis =

difference between the the current spot price and the forward (strike) price of a derivative such as a futures contract or the forward component  in an options contract.     The basis is negative in normal backwardation.  The basis is is postive in the normal contango.  Various theories exist to explain the two differing convergence patterns. 

There are other definitions of basis found in practice.  Some people define basis as the difference between the spot and futures price.  Alternately basis can be viewed as the benefits minus the costs of  holding the hedged spot underlying until the forward or futures settlement date. 

Still another definition of this term is based on the U.S. tax code where basis is the carrying value of an asset.  It is the last definition that gives rise to the term basis adjustment.  See intrinsic value.  Also see the terms that use "basis" that are listed below.

Still another term is the difference between commodity prices as the difference between physical locations or product quality grades.

Basis Adjustment =

the adjustment of the booked value of an asset or liability as required by SFAS 80 but is no longer allowed for cash flow and foreign currency hedges under FAS 133 according to Paragraph 31 and Paragraphs 375-378 of FAS 133.    Basis adjustment is required for fair value hedges under Paragraphs 22-24 on Pages 15-16 of FAS 133.   An illustration of amortization of fair value hedge basis adjustments appears in Example 2 beginning in Paragraph 111 on Page 60 of FAS 133.   Also see short-cut method.

The carrying value of a hedging offset account (OCI, Firm Commitment, or Balance Sheet Item) may be written off prematurely whenever the hedge becomes severely ineffective.

Under IAS 39, the carrying value of an effective hedge is written off when the hedge expires or is dedesignated. See Paragraphs 162 and 163 of IAS 39.

Under FAS 133, the carrying value of an effective hedge is carried forward until the ultimate disposition of the hedged item (e.g. inventory sale or depreciation of equipment). See Paragraph 31 of FAS 133.

The FASB decision to ban basis adjustment on the date the hedging contract is settled is controversial, although the controversy is a tempest in a teapot from the standpoint of reported net earnings each period.  Suppose you are enter into a firm commitment on 1/1/99 to purchase a building for the amount of yen that you can purchase for $5 million on 1/1/99.  The financial risk is that this commitment requires a payout in Japanese yen on 7/1/99 such that the building's cost may be higher or lower in terms of how many yen must be purchased on 7/1/99.   To hedge the dollar/yen exchange rate, you enter into a forward contract that will give you whatever it takes make up the difference between the yen owed and the yen that $5 million will purchase on 7/1/99.  On 1/1/99 the forward contract has zero value.  Six months later, assume that the forward contract has been value adjusted to $1 million because of the decline in the yen exchange rate. The offsetting credit is $1 million in OCI if since this was not designated as a fair value hedge. 

To close out the derivative on 7/1/99, you debit cash and credit the forward contract for $1 million.    To basis adjust the cost of the building, you would debit OCI for $1 million and credit the building fixed asset account.   The building would end up being booked on 7/1/99 for $4 million instead of its 1/1/99 contracted $5 million.  If you did not basis adjust, the credit would stay in OCI and leave the building booked at a 7/1/99 value of $5 million.   Paragraph 376 on Page 173 of FAS 133 requires that you no longer adjust the basis to $4 million as a result of the foreign currency hedge.   Hence depreciation of the building will be more each year than it would be with basis adjustment. 

The controversy stems over how and when to get that $1 million out of  OCI and into retained earnings.  Under SFAS 80, suppose that with basis adjustment the impact would have been a reduction of annual depreciation by $50,000 over the 20-year life of the building.  In other words,  depreciation would have been $50,000  less each year smaller $4 million adjusted basis rather than the $5 million unadjusted basis.   One argument against basis adjustment in this manner is that the company's risk management outcomes become buried in depreciation expense and are not segregated on the income statement.

Without basis adjustment under FAS 133, you get $50,000 more annual depreciation but identical net earnings because you must amortize the $1 million in OCI over the life of the building.  Here we will assume the amortization is $50,000 per year.  Each year a $50,000 debit is made to OCI and a credit is made to the P&L closing account. When OCI is amortized, investors are reminded on the income statement that, in this example, a $50,000 per year savings accrued because the company successfully hedged $1 million in foreign currency risk exposure.

In Paragraph 31 on Page 22 of FAS 133, the amortization approach is required for this cash flow hedge outcome. You cannot basis adjust in order to take $50,000 per year lowered depreciation over the life of the building.  But you report the same net earnings as if you had basis adjusted.   In any case, FAS 133 does not allow you to take the entire $1 million into 7/1/99 earnings.  Paragraph 376 on Page 173 of FAS 133  elaborates on this controversy. 

What is wrong with the FAS 133 approach, in my viewpoint, is that it may give the appearance that a company  speculated when in fact it merely locked in a price with a cash flow or foreign currency hedge.  The hedge locks in a price.  But the amortization approach (in the case of a long-term asset) or the write-off at the time of the sale (in the case of inventory) isolates the hedge cash flow as an expense or revenue as if the company speculated.   In the above example, the company reports $50,000 revenue per year from the forward contract.  This could have been a $50,000 loss if the dollar had declined against the yen between 1/1/99 and 7/1/99.  If the $50,000 was buried in depreciation charges, it would seem less likely that investors are mislead into thinking that the $50,000 per year arose from speculation in forward contracts.  Companies also point out that the amortization approach greatly adds to record keeping and accounting complexities when there are many such hedging contracts.  Basis adjustment gives virtually the same result with a whole lot less record keeping.

It should also be noted that to the extent that the hedge is ineffective, the ineffective portion gets written off to earnings on the date the asset or liability is acquired.  In the above example, any ineffective portion would have to be declared on 1/199 and never get posted to OCI.   Hence it would never be spread over the life of the building.  According to Paragraph 30 of FAS 133, ineffectiveness is to be defined at the time the hedge is undertaken.  Hedging strategy and ineffectiveness definition with respect to a given hedge defines the extent to which interim adjustments affect interim earnings.

Click here to view the IASC's Paul Pacter commentary on basis adjustment.