This checklist describes the US Financial Accounting Standards Board’s framework for derivatives and hedge accounting in the context of companies using these instruments to reduce exposure to risk.
FAS 133 was published in 1998 and introduced in 2001 to establish accounting and reporting standards for stand-alone derivatives and those embedded in other contracts. The aim was to provide greater transparency by requiring companies to record derivative contracts as assets or liabilities on their balance sheets.
Gains and losses on derivatives can be deferred until they mature, but only if the company proves that they are being used to manage risk rather than for market speculation. Companies have to provide evidence that the timing and the amount of the derivative matches the commodity against which it is being hedged.
The reporting requirements are extremely onerous. Hedges have to be documented before or as soon as they are implemented, and companies have to explain why the transaction is being undertaken. Every three months derivatives have to be marked to market to prove that the underlying exposure is being hedged effectively.
Although FAS 133 offers detailed direction on how derivatives can qualify for hedge accounting, critics say that the rules manage to be both overly complex and vague. Indeed, the FASB is in the process of trying to simplify the standard.
Currently, three categories of hedge are allowed by the standard:
fair-value hedges for recognized assets;
cash flow hedges for recognized assets or forecast transactions;
hedges for foreign currency exposure.
If a hedge is “highly effective,” it will not affect reported earnings. According to the standard, a hedge is defined as “highly effective” if changes in the fair value or cash flow of the hedged item and the hedging derivative offset each other to a significant extent.
At the moment the rules are complex, and because of the quarterly reporting requirement some derivatives will fail to meet the “highly effective” definition throughout their lifespan.
A number of companies have also had to restate their accounts because of their failure to satisfy the complex reporting documentation required by FAS 133. Hotel and casino operator Wynn had to restate its earnings for 2003, 2004, and part of 2005. Sunglasses manufacturer Oakley had to restate its reports for five years up to 2005. And at the beginning of 2007 General Electric said its restatement would reduce earnings by a total of $343 million. Earnings were to be cut for 2001 and 2002, and increased for 2003, 2004, and 2005.
FAS 133 introduced more transparent accounting standards following substantial hedging losses in the mid-1990s arising from the use of derivatives.
FAS 133 is one of the most complex accounting standards ever introduced, running to over 200 pages. This has led to some major companies being forced to restate their earnings over a number of years.
Initially there was concern that the non-applicability of hedge accounting in some circumstances could lead to unnecessary volatility in corporate earnings. This now seems to be less of a concern as companies have come to grips with the measures.