A CCOUNTING & AUDITING

Foreign Currency Forward Contracts and Flow Hedging Navigating Accounting and Disclosure Requirements

By Josef Rashty and John O'Shaughnessy

ompanies use futures contracts (i.e., instru- wish to trade a contract payment provision calling for fixed ments) to manage exposure to various risks, such as inter- interest payment to another company for a variable interest pay- est rate risk, foreign exchange risk, acquisition of invento- ment. The instrument achieves the objectives of both: One com- C ry or capital equipment price risk, and credit risk. Because pany locks in a fixed and the other speculates on of the great variety of these types of contracts, “instruments” gen- interest changes. The accounting literature uses the “derivative” erally refer to any such contracts that trade in markets such as to further describe such contracts. the Chicago Mercantile Exchange as well as agreements devel- accounting generally requires that companies recog- oped strictly between companies. For example, one company may nize derivatives as and liabilities and subsequently measure

24 OCTOBER 2010 / THE CPA JOURNAL them at . A derivative must a company creates a derivative instrument notional amount or a payment provision, qualify to be able to use hedge accounting. by engaging in a trans- determines the settlement amount. A The alternative is to use nonhedge deriva- action. Before proceeding, it is necessary notional amount (ASC 815-10-15-92) is tive accounting, which reflects derivative to explain some of the technical concepts the number of currency units specified in fair value changes in earnings rather than behind derivatives. a derivative contract, and it determines on the . Nonhedge account- Derivative instruments represent rights or the settlement amount under a derivative ing is generally unappealing to companies obligations and thus, should be shown as instrument. In summary, the settlement of because it creates volatility in earnings. If assets or liabilities. Because of the complex- a derivative instrument is determined by items initially qualify for hedge account- ity and quick evolution of derivative instru- the interaction of the notional amount and ing but subsequently lose their eligibility, ments, they were not required to be report- the underlying. they must revert back to nonhedge account- ed in financial statements until 1998, when Companies must recognize derivative ing and the unrealized gains and losses will FASB issued SFAS 133, Accounting for instruments as assets or liabilities in their be reflected in current earnings. Derivative Instruments and Hedging Activities statement of financial position at fair value The breadth and complexity of deriva- (Accounting Standards Codification [ASC] and remeasure their fair values in subse- tive accounting have created significant Topic 815). quent periods. challenges for companies that use them. FASB defines a derivative as a financial Futures and forwards are contracts to Many companies have failed to account for instrument or other contract with the fol- buy or sell a defined amount of a specif- them properly, resulting in a significant lowing characteristics (ASC 815-10-15-83): ic underlying at a specified price number of restatements. Companies must (a) It has (1) one or more underlyings agreed to at origination, with delivery and understand the economics of the transac- and (2) one or more notional amounts settlement at a specified future date. tion from a risk management perspective, or payment provisions or both. Those Companies use foreign currency forward and be versed in its accounting complexi- terms determine the amount of the set- contracts to hedge against changes in cur- ties. The determination that a transaction tlement or settlements, and, in some rency exchange rates of an existing asset qualifies for hedge accounting is subject to cases, whether or not a settlement is or liability, a firm commitment, or a fore- interpretation. Different conclusions can be required. (b) It requires no initial net casted transaction. Cash flow hedges, on reached as to whether a contract should investment or an initial net investment the other hand, protect against the risk be accounted for as a derivative instrument. that is smaller than would be required that variable prices, costs, rates, or terms There have been many examples of com- for other types of contracts that would will make future cash flows uncertain. panies restating their financial statements be expected to have a similar response A cash flow hedge is a hedge of the vari- because their initial judgment that called to changes in market factors. (c) Its able cash flow of an anticipated or fore- for derivative accounting subsequently terms require or permit net settlement, it casted transaction that will probably occur, proved to be incorrect. can readily be settled net by a means but the amount of which has not been fixed outside the contract, or it provides for at the time of initiation of the hedge Background delivery of an asset that puts the recip- transaction. Forecasted transactions must Derivatives are financial instruments ient in a position not substantially dif- be probable future transactions that do not whose value stems from fluctuations of their ferent from net settlement. meet the definition of a firm commitment underlying assets, liabilities, interest rates, Generally Accepted Accounting under GAAP. Forecasted transactions foreign currency exchange rates, or indices. Principles (GAAP) requires that if a hedge can be contractually established or merely Companies must recognize derivatives as transaction meets the criteria that permit probable because of a company’s past or assets or liabilities on the balance sheet at the use of hedge accounting, an entity may expected business practices. In other words, fair value and periodically remeasure them. elect to designate a derivative as one of the unlike firm commitment transactions, either If a derivative qualifies as a hedge instru- following hedges: some terms of the transaction are variable ment, it can decrease the volatility on a com- I Fair value—a hedge of the exposure to or the transaction itself is not contractual- pany’s statement of operations or income. changes in the fair value of a recognized ly certain. An example of this type of trans- For example, if a derivative qualifies as a asset or liability or of an unrecognized firm action is illustrated below. cash flow hedge, a company can report the commitment that are attributable to a par- Effectiveness. A transaction must be effective portion of the gain or loss on the ticular risk. effective to qualify for hedge accounting derivative instrument as a component of I Cash flow—a hedge of the exposure to under ASC 815. Hedge effectiveness refers other comprehensive income (loss), rather variability in the cash flows of a recog- to the extent that the changes in the fair than on the , and reclassi- nized asset or liability, or of a forecasted value of hedging instrument offset the fy it into earnings in the same period or peri- transaction. changes in the fair value of the hedged item ods during which the hedged transaction I Net investment—a hedge of the foreign (the underlying). Although there is no spe- affects earnings. currency exposure of a net investment in cific guidance to determine that a hedge The accounting rules for derivatives are a foreign operation. is highly effective, FASB staff has stated the most complex ever issued by FASB. An underlying or a hedged item (ASC informally that in order for a hedge to be The discussion below will examine the 815-10-15-88) is a variable within a deriva- highly effective, the cumulative change in accounting and disclosures required when tive instrument that, along with either a the value of the derivative instrument

OCTOBER 2010 / THE CPA JOURNAL 25 expressed as a ratio of the cumulative ment may be excluded from the effective- liability (ASC 815-35-55-2). The follow- change in the fair value of the hedged item ness assessment. When entities exclude the ing table reflects the monthly statement of (the underlying) must fall within the time value for the effectiveness testing pur- operations of Entity S: range of 80% to 120%. poses, the excluded time value will be 2,000 LCU If the hedge is highly effective, then reflected in the income statement. Expenditures 12,000 the treatment of the difference in the In order to maintain the advantages of Net loss 10,000 LCU changes in fair value of the derivative hedge accounting treatment, an entity must In this illustration, the hedged item (the instrument and the hedged item (the under- comply with rigorous GAAP documenta- underlying) is the exchange rate or the lying) depends upon the type of hedge. For tion requirements for its hedging transac- exchange rate index, and the notional amount example, for derivative instruments that tions. This must be performed at the incep- is the fixed number of currency units (20,000 qualify as cash flow hedges, the effective tion of the hedging relationship and on an LCU) which is the payment provision for the portion of the gain or loss on the deriva- ongoing basis (at least quarterly). The settlement of derivative instrument. tive instrument is reported as a compo- assessment must include an evaluation of According to ASC 830, Foreign nent of other comprehensive income (loss) whether the relationship between the Currency Matters, companies should reflect and is reclassified into earnings in the same derivative instrument and the hedged item the foreign currency fluctuation on the period or periods during which the hedged (the underlying) is considered highly effec- intercompany accounts that are not hedged forecasted transaction affects earnings. tive. In the absence of such documentation, or are de-designated (i.e., discontinued as Therefore, an entity can eliminate volatil- an instrument might not qualify for hedge a hedge) (ASC 830-20). Furthermore, they ity by using hedge accounting. If, howev- accounting. should use average rates or other approx- er, the derivative does not qualify as a imations to reflect the foreign currency hedging instrument by being highly inef- Example translation of revenues and (ASC fective, any difference between the change Entity S is the wholly owned sub- 830-55-10, 11). This provision affects the in the value of the derivative and the sidiary of Entity A and is primarily de-designated hedges and is reflected in hedged item (i.e., the ineffective portion) engaged in research and development activ- periods 2 and 3 of this example. will be reflected in the income statement. ities. The revenues of Entity S have been Exhibit 1 reflects the conversion rates There are two methods under GAAP to consistently equal to 20% of its total between USD and LCU for four periods: calculate the effectiveness of a cash flow expenses—Entity A finances the remain- In period 0, Entity A initiates its hedge doc- hedge: the spot and forward price meth- ing 80% of S’s expenditures. The func- umentation for a hedge contract for two ods. Use of the spot price method excludes tional currency of Entity A is its local 10,000 LCU, representing a two-period for- the time value and will result in more currency unit (LCU). The functional cur- ward contract. It must be noted that that volatile earnings, because changes to the rency of Entity A is the U.S. dollar (USD). initiation of a hedge contract is not fair value of the hedging instrument that The results of operations of Entity A are reflected in the financial statements but relate to the difference between the spot subject to foreign currency exchange fluc- requires footnote disclosures. and forward prices will be recognized in tuation due to changes in the exchange value For the sake of simplicity, this example the income statement. Use of the forward of LCU to USD; Entity A, however, has a ignores the calculation and presentation method, while more complex, may result natural hedge for 20% of Entity S’s expen- of present value. Assume also that average in less earnings volatility than the spot price ditures. Therefore, Entity A enters into a rates are the same as spot rates. A discus- method, because the difference between two-period forward contract for a cash flow sion of fair value adjustments will follow spot and forward prices are recognized in hedge to purchase 20,000 LCU for below. Furthermore, assume that Entity A other comprehensive income. approximately 83% of S’s 24,000 LCU uses the spot exchange rates to test the While GAAP permits entities to exclude expenditures for two periods (10,000 LCU hedge effectiveness and therefore excludes all or a part of the hedging instrument’s per period). the time value. As a result, the foreign time value from the assessment of hedge The objective of the cash flow hedge is exchange (FX) gain and loss due to time effectiveness, no other components of a to cover the exposure to variability in the value (TV) is reflected in the income state- gain or loss on the designated hedge instru- cash flows of a forecasted intercompany ment. Furthermore, the effect of taxes on the financial results is ignored. EXHIBIT 1 Period 1 Forward Fair Value Rates The following journal entry recognizes change in the fair value of forward contract: Periods Spot Rate Forward Rate Forward Points Average Rate Cash flow hedge asset (des.) 1 $400 2 Period 0 $1.12 $1.10 $0.02 $1.12 FX gain (loss) (excl. TV) $200 OCI (loss) 3 $600 Period 1 $1.15 $1.12 $0.03 $1.15 1. 20,000 LCU (2 × 10,000) × Period 2 $1.18 $1.16 $0.02 $1.18 ($1.12 − $1.10 forward rates) = $400 Period 3 $1.22 $1.17 $0.05 – 2. Foreign exchange is the difference between 1 and 3

26 OCTOBER 2010 / THE CPA JOURNAL 3. 20,000 LCU × ($1.15 − $1.12 spot 1. 10,000 LCU × ($1.18 − $1.15) = $300 (R) Will be reversed at time of settlement rates) = $600 (R) Will be reversed at time of settlement Second, the following entry reflects the The following journal entry reflects the The following journal entry recognizes impact of ASC 830, Foreign Currency end of the period 1 designated hedge trans- change in the fair value of the designated Matters, on the 20,000 LCU de-designat- action: portion of the forward contract: ed hedge at the end of period 3: Expenditures 1 $11,200 Cash flow hedge asset (des.)1 $400 Other income (exp.) 1(R) $800 OCI (loss) 2 $300 FX gain or loss (excluded TV) 2 $100 Intercompany liability1(R) $800 Intercompany liability 3 $11,500 OCI (loss)3 $300 1. 20,000 LCU × ($1.18 − $1.22) = $800 1. 10,000 LCU × $1.12 = $11,200 1. 10,000 LCU × ($1.16 − $1.12 forward (R) Will be reversed at time of settlement 2. 10,000 LCU × ($1.15 − $1.12 spot rates) = $400 Exhibit 2 reflects a partial presentation rates) = $300 2. Difference between 1 and 3 of Entity A’s income statement subsequent 3. 10,000 LCU × $1.15 = $11,500 3. 10,000 LCU × ($1.18 − $1.15 spot to its engagement in hedging activities and This journal entry reflects that Entity A rates) = $300 prior to settlement for its intercompany bal- has been able to eliminate the impact of The following journal entry reflects the end ance during each period. foreign currency fluctuation through other of period 2 designated hedge transaction: As shown in Exhibit 2, Entity A has comprehensive income (loss). Expenditures 1 $11,200 been able to accomplish the following: OCI (loss)2 $ 600 I It has stabilized its expenses and its Period 2 Intercompany liability 3 $11,800 gross loss. Entity A de-designates (or simply discon- 1. 10,000 LCU × $1.12 = $11,200 I It has been able to project and achieve tinues) the 10,000 LCU derivative at the 2. 10,000 LCU × ($1.18 − $1.12) = $600 its cash flow objectives. end of period 1 and settles the derivative in 3. 10,000 LCU × $1.18 = $11,800 Clearly, A is better off financially as a period 3. The following journal entry recog- result of the derivative transaction, but that nizes change in the fair value of the de-des- Period 3 was not the objective. The goal was to pro- ignated portion of the forward contract: The following two sets of entries will be vide visibility on the projection of cash and Cash flow hedge asset reversed upon the hedge settlement. expenses, and Entity A was able to achieve (de-designated) 1(R) $400 First, Entity A de-designates an additional this goal. Other income (exp.) 1(R) $400 10,000 LCU derivative at the end of Entity A has not been able to achieve 1. 10,000 LCU × ($1.16 − $1.12 forward period 2 and settles the total amount of the the following: rates) = $400 derivative in period 3. The following jour- I The FX loss (excluded time value) did (R) Will be reversed at time of settlement nal entry recognizes the change in the fair not get reflected in other comprehensive The following journal entry reflects the value of the de-designated forward contract: income and expenses because Entity A impact of ASC 830, Foreign Currency Cash flow hedge asset chose to exclude the time value from the Matters, on the 10,000 LCU de-designat- (de-designated) 1(R) $200 assessment of hedge effectiveness. As dis- ed hedge at the end of period 2: Other income () 1(R) $200 cussed above, such an election results in Other income (exp.) 1(R) $300 1. 20,000 LCU × ($1.17 − $1.16 forward more earnings volatility. Intercompany liability 1(R) $300 rates) = $200 I There was a gap between the time of the hedge settlement and the date of occur- rence of transaction, and as a result, EXHIBIT 2 Entity A has not been able to achieve the Effect of Hedging on the Income Statement following: I The intercompany balance is adjust- ed in every period for foreign curren- Description1 Period 1 Period 2 Period 3 cy translation under ASC 830, and Revenues $ 2,300 $ 2,360 $ 0 the amount is reflected in the income statement. Expenses not hedged $ 2,300 $ 2,360 $ 0 I The cash flow hedge assets, which Expenses hedged $11,200 $11,200 $ 0 were created during the hedge period, Gross loss $11,200 $11,200 $ 0 are adjusted for fluctuations in forward FX gain (loss) (excluding time value) ($ 200) $ 100 $ 0 rates, and the amount is reflected in the statement of operations. Other income (expense) – $ 400 $ 200 As a result of the two factors above, Other expense, ASC 830 – ($ 300) ($ 800) the amount of net loss has fluctuated Net loss $11,400 $11,000 $ 600 from one period to the next; nevertheless, 1. Average LCU rates for the conversion of revenues and expenses for period 1 all of these adjustments are reversed and period 2 are $1.15 and $1.18, respectively. The intercompany debt would be when the hedge transaction is settled. settled at $1.17 in period 3. It should also be noted that if the hedge had failed the effectiveness test, then the

28 OCTOBER 2010 / THE CPA JOURNAL amount in other comprehensive income FASB allows a company to measure the income approach as one that uses valuation would have been reclassified into the fair value of its financial assets and liabil- techniques to convert future amounts (e.g., income statement. ities based on one or more of the follow- cash flows or earnings) to a single present The following journal entry reflects the ing valuation techniques: amount (discounted). Those valuation tech- settlement of the derivative: I Market approach, which uses prices niques include the following: present value Intercompany liability $23,300 and other relevant information generated techniques; option-pricing models (which Other income (exp.) 1 $ 500 by market transactions involving identical incorporate present value techniques), such Cash flow hedge assets (des.) 2$800 or comparable assets or liabilities (ASC as the Black-Scholes-Merton formula (a Cash 1 $22,000 820-10-35-29); closed-form model) and a binomial model (a 1. 20,000 × ($0.02 forward points at I Cost approach, which is the amount lattice model); and the multiperiod excess period 0 + $100 [excluding TV FX loss]) required to replace the service capacity of earnings method, which is used to measure 2. $400 in period 1 + $400 in period 2 an asset (i.e., replacement cost) (ASC 820- the fair value of certain intangible assets. 3. 20,000 LCU × $1.10 = $22,000 10-35-34); or GAAP requires that the fair market value Exhibit 3 shows the balance of the I Income approach, in which future of the financial assets be reflected in the hedge-related accounts at the end of each amounts are converted into a single pre- financial statements. If the fair market period presented. sent amount based on market expectations, values of the cash flow hedge assets were Despite some volatility during the including present value techniques, option $410 and $1,230 at the end of period 1 and interim periods, Entity A achieved its pricing, and excess earnings models period 2, respectively, Entity A would objective of recording its expenses at the (ASC 820-10-35-32). record the following journal entries: spot rate of $1.12 and its obligations at Furthermore, FASB has established a the forward rate of $1.10 (the prevailing three-tier fair value hierarchy that priori- Period 1 rates at the initiation of the hedge transac- tizes the inputs used in measuring fair value Cash flow hedge asset $10 tion). The difference between the two rates as follows: OCI (designated) $5 (the forward points) is reflected in the I Level 1, observable inputs such as Other income (de-designated) $5 income statement. quoted prices in active markets (ASC 820- $410 fair market value, less $400 book value 10-35-40); Fair Value Measurement I Level 2, inputs other than quoted prices Period 2 FASB’s objective is for companies to in active markets, observable either directly Cash flow hedge asset $20 estimate the fair value of derivatives sep- or indirectly (ASC 820-10-35-47); and Other income (de-designated) $20 arately from the fair value of the non- I Level 3, unobservable inputs for which $1,230 fair market value, less $1,200 book derivative portions of the contract. there are little or no market data that require value and $10 period 1 fair market value Generally, the fair value of derivative the reporting entity to develop its own instruments in a loss position should not assumptions (ASC 820-10-35-52). Period 3 be offset against the fair value of deriva- In practice, most companies use the OCI $ 5 tive instruments in a gain position (ASC “income approach” and Level 2 inputs to Other income $25 815-10-45-4). value their derivatives. GAAP defines the Cash flow hedge asset $30

EXHIBIT 3 Hedge-Related Accounts

Description Period 1 Period 2 Period 3 After Settlement Cash flow hedge asset (designated) $ 400 $ 800 $ 800* $ 0 Cash flow hedge asset (de-designated) – $ 400 $ 600* $ 0 FX gain (loss) (excluding time value) ($ 200) $ 100 ($ 100) ($ 100) Other comprehensive income $ 300 $ 0 $ 0 $ 0 Intercompany liability $11,500 $23,300 $ 23,300* $ 0 Expenditures $11,200 $22,400 $ 22,400 $22,400 Other income – $ 400 $ 600* $ 500 Other expense, ASC 830 – ($ 300) ($ 1,100)* $ 0 Intercompany liability, ASC 830 – $ 300 $ 1,100* $ 0 Cash – – – ($22,000) * Reversed at the time of hedge settlement

OCTOBER 2010 / THE CPA JOURNAL 29 Reversal of entries in period 1 and period journal entries for each period reflected I Gains (losses) reflected in earnings due 2 upon settlement of the hedge only the change in the economics of that to their exclusion from assessment of particular period. hedge effectiveness (e.g., the time Best Practices value exclusion above), for the current Preparing and gathering information to Disclosures and prior periods; properly execute a hedge contract is a sig- In March 2008, FASB issued SFAS 161, I Gains (losses) reclassified into earn- nificant undertaking and requires extensive Disclosures About Derivative Instruments ings for the ineffective portion of the coordination among the accounting, and Hedging Activities (ASC 815). This hedge or as a result of discontinuation finance, treasury, risk management, legal, pronouncement expanded the disclosure of hedge program (de-designation) for and information technology departments. requirements for derivatives and amended the current and prior periods. Many companies have elected to outsource SFAS 133 (ASC 815). The required addi- In the “Qualitative and Quantitative the function or use the assistance of tional disclosures became effective for Disclosures About Market Risk” section of expert third parties to design and imple- interim periods beginning after November quarterly and annual reports, companies ment hedge operations. 15, 2008. The following is a summary, must disclose the hedge program and the Hedge accounting requires extensive taken from “Derivatives: New Disclosures economics of a transaction from a risk documentation at inception. A derivative Required,” by Barbara Apostolou and management perspective. The table includ- instrument absent such documentation will Nicholas G. Apostolou, The CPA Journal, ed in this section should reflect the not qualify for hedge accounting. November 2008, of the disclosure provi- notional amount in foreign currency and Additionally, a hedge may also lose its sions related to foreign currency forward its equivalent in U.S. dollars as well as privilege for hedge accounting if it is not contracts: the average rate of the committed amount fully utilized by the end of the program. I Fundamental disclosures, such as the rea- for the hedge program during the period. There is usually a grace period of up to son a company uses foreign currency for- Companies must also disclose the fair 60 days for companies to cure the defi- ward contracts and how it accounts for it; value of derivative instruments and the ciency; otherwise, the transaction loses eli- I Qualitative disclosures, such as objec- method of arriving at such a fair value gibility for hedge accounting treatment. tives of the hedge program, type of hedge measurement in a “Fair Value Measurement” Companies usually hedge between 75% (e.g., cash flow), and volume of transaction; note in quarterly and annual reports. and 80% of their forecasted amount to I Volumetric disclosures, such as the A “Commitment and Contingencies” note cover possible underutilization due to any aggregate U.S. dollar notional amount of should reflect the maximum length of time unforeseen economic circumstances. foreign currency forward contracts held by over which a company is hedging its expo- Most companies that engage in foreign the company as of a specific date; sures. It should also state that the company currency forward contracts choose to ignore I Quantitative disclosures, such as the bal- has arrived at such amounts based on the time value for the measurement of effec- ance sheet tables, reflecting location and forecast of operating expenditures and rev- tiveness (as illustrated in the example fair value of derivatives on gross basis, as enues. Companies must disclose the amount above). The exclusion of time value may well as statement of operations or income of gains and losses related to derivative create some volatility in earnings—as it did tables, reflecting net gains and losses of instruments in a “Other Comprehensive during the recent financial crisis—but the derivatives and segregation of derivatives Income or Loss” note, net of tax effects. impact on earnings is only temporary and designated or not designated as hedging Companies should also disclose whether corrects itself by the end. Nevertheless, this instruments. ASC 815 requires the follow- these transactions are speculative in nature. approach remains popular among compa- ing information to be presented in tabular ASC 815 requires that when a compa- nies that engage in foreign currency for- format in quarterly and annual reports: ny discloses information on derivative ward contracts, because it makes achieve- I Designated derivative assets and lia- instruments in more than a single note, it ment of the effectiveness threshold more bilities for the current period and end should cross-reference those sources of feasible. of last year; information. From an administrative perspective, I Nondesignated derivative assets and companies usually use the end-of-last-peri- liabilities for the current period and end Recent Developments od spot rate as the average for the cur- of last year; FASB and the International Accounting rent-period exchange rate, because an actu- I Gains (losses) recognized in other Standards Board (IASB) are jointly al calculation of an average exchange rate comprehensive income (loss) for the reconsidering the accounting for all finan- is problematic and cannot be determined effective portion of derivative instru- cial instruments, including hedge account- until the period is complete. Furthermore, ments designated and qualified as cash ing. The objective of this joint project is many companies have a policy of revers- flow hedges for the current and prior to improve the usefulness of financial state- ing the prior-period journal entries and cre- periods; ments and simplify the accounting for ating a fresh inception-to-date journal entry I Gains (losses) reclassified from other financial instruments. Despite starting a each period. The advantage of this comprehensive income (loss) to earnings joint project, the two boards have been approach is that any errors to offset the actual amounts of rev- pulled in different directions by political are flushed out as part of the reversal. This enues and expenditures for the current forces, and as a result have reached dif- is unlike this example above, whereby the and prior periods; ferent conclusions.

30 OCTOBER 2010 / THE CPA JOURNAL FASB released its highly anticipated pro- In contrast, the IASB published its ing for derivatives. The IASB has likewise posed update on the accounting for finan- approach on November 12, 2009, with the undertaken similar projects; however, it cial instruments on May 26, 2010. Among release of International Financial Reporting appears that the two standards setters are the proposed changes are requirements to Standard (IFRS) 9, Financial Instruments. heading in different directions rather than measure more financial instruments at fair IFRS 9, which reached fundamentally dif- toward a single, converged standard, with value and simplification of hedge account- ferent conclusions than FASB’s exposure FASB generally emphasizing more fair value ing. Comments on the exposure draft were draft, may be adopted early but is not accounting than the IASB. due by September 30, 2010; no effective effective until January 1, 2013. The IASB is The discussion above is meant to cover date has been proposed. conducting its project in three separate phas- some basic principles and lay the ground- FASB is proposing the following es: classification and measurement, impair- work for the accounting and disclosures changes to modify ASC 815 hedge ment, and hedge accounting. The IASB required for cash flow hedges and foreign accounting, based largely on changes that recently issued guidance which requires that currency forward contracts. The rules and it proposed in 2008: most financial instruments be measured principles of accounting for derivative I Replacing the notion of highly effec- either at amortized cost or at fair value, instruments remain very complex and tive with “reasonably effective,” with changes in fair value recognized in the require careful application of professional I Eliminating the “short-cut method” income statement. The European judgment. K (which was not discussed above), Commission, however, has refused I Requiring that both “overhedges” as well to endorse this standard pending further as “underhedges” result in ineffectiveness, analysis. Josef Rashty, CPA, is the director of com- I Reassessing hedges for reasonable As indicated, the accounting pronounce- pliance and reporting at Informatica effectiveness qualitatively rather than ments surrounding the derivatives are the Corporation, Redwood City, Calif. John quarterly, most complex ever issued by FASB. FASB O'Shaughnessy, PhD, CPA (inactive), is I Prohibiting discretionary de-designation has acknowledged this fact and has embarked a professor of accounting at San Francisco of a hedge prior to its maturity. on several projects to simplify the account- State University, San Francisco, Calif.

OCTOBER 2010 / THE CPA JOURNAL 31