Interaction of FAS 157 with FAS 133:

Transcription

1 Interaction of FAS 157 with FAS 133: The Second Wave By: Peter Seward, Vice President, Product Strategy, Reval June 2, 2009 CONTENT Executive Summary Introduction FAS 157 Fair Valuations Impact on FAS 133 Conclusion

2 Executive summary It is generally agreed that FAS 157 fair values require inclusion of a credit charge. This paper examines the impact of credit charges on FAS 133, in particular hedge effectiveness assessment and measurement. Derivatives Implementation Guidance (DIG) rulings are reviewed for reference to credit and changes in credit. It is concluded that this year a second wave of auditor focus will be placed on the interaction between FAS 157 and 133. Introduction Since November 2007, when accounting standard FAS 157 clarified how financial instruments are to be fair valued and classified, banks and non-financial institutions have worked through satisfying the most basic auditor requirements for complying with the regulation. However, entities should now expect a second wave of scrutiny by auditors as they begin to pay close attention to fair value interpretations that take into account the credit component in the true exit price of a financial instrument. While this requirement poses its own challenges, an important consideration of FAS 157 is the impact the regulation has on other standards that require fair valuation of instruments. Because FAS 157 requires derivatives to be fair valued, including embedded derivatives, it is critical that entities consider its impact on FAS 133, Accounting for Derivative Instruments and Hedge Activities. Failure to do so may result in ineffective hedges and, ultimately, costly financial restatements. To bring clarity to the grey areas of interpretation and help entities prepare for the next phase of auditor scrutiny of fair valuations, this document outlines key interactions between the two standards. About the author Peter Seward is responsible for the strategic direction of the Reval SaaS/Web-based platform and Reval Center valuation and hedge accounting service. He has also written the modules Reval IAS 39, IFRS 7 and FAS 161 Doctors. Mr. Seward s 15 years experience in financial services software spans Asia Pacific, Europe and North America. Prior to Reval, he was a sales engineer at Principia Partners, an implementation consultant and custom development project manager for Integrity Treasury Systems in both Sydney and Chicago, and a manager of treasury systems at Rabobank Australia in Sydney. He holds a Bachelor of Science in Mathematics and Economics from the University of Western Australia. The author can be reached at: peter.seward@reval.com Reval.com, Inc. All Rights Reserved 2

3 FAS 157 Fair Valuations FAS 157 requires that exit prices be considered when fair valuing financial instruments Itis accepted that this should include a credit component, i.e. a credit adjustment to a benchmark LIBOR fair value. Important qualities of a successful FAS 157 fair valuation solution are: Using current market data as inputs Accounting for netting agreements and posted collateral Consistency of application A solution is to separately value all derivatives against a benchmark LIBOR curve (benchmark value), then against a LIBOR curve plus counterparty credit curve (asset value), and finally against a LIBOR curve plus entity curve (liability value). If the benchmark value is negative, then the liability value is used. The asset value is used when the benchmark value is positive. Where netting agreements exist, benchmark fair values are summed for all trades under the netting agreement (including posted collateral). If the sum is in a liability position, then liability values are used; otherwise, asset values are used. These values are adjusted for the percentage exposure to each trade after taking into account posted collateral. Impact on FAS 133 If a derivative is not designated in a hedge relationship, then the fair value described above would be marked-to-market and recorded as an unrealized gain/loss in profit and loss. If a derivative is included in a hedge relationship, it is also clear that it should be fair valued as described above. What is not clear is how a derivative fair value in a hedge relationship should be assessed and measured, and how it should be separated into included and excluded components. Also, it is unclear how a hedged item (or its proxy) should be fair valued, i.e. inclusive or exclusive of credit adjustments. If only derivatives are credit adjusted then previously perfectly effective hedges will now have ineffectiveness equal to the derivative s credit adjustment. The answers to these questions are material. About Reval Reval is a leading, global Software-as-a-Service (SaaS) provider of comprehensive and integrated Treasury and Risk Management (TRM) solutions. Our cloud-based software and related offerings enable enterprises to better manage cash, liquidity and financial risk, and includes specialized capabilities to account for and report on complex financial instruments and hedging activities. The scope and timeliness of the data and analytics we provide allow chief financial officers, treasurers and finance managers to operate more confidently in an increasingly complex and volatile global business environment. Using Reval, companies can optimize treasury and risk management activities across the enterprise for greater operational efficiency, security, control and compliance. Founded in 1999, Reval is headquartered in New York with regional centers across North America, EMEA and Asia Pacific. For more information, visit or info@reval.com Reval.com, Inc. All Rights Reserved 3

4 The following sections discuss the impact of FAS 157 on FAS 133 with respect to changes in creditworthiness, shortcut method, cash flow hedges, fair value hedges and net investment hedges. Derivatives Implementation Group (DIG) guidance issues are referred to where appropriate. Changes in Credit Worthiness DIG issue G10 emphasizes para 28(b) of FAS 133, which in part states: Both at inception of the hedge and on an ongoing basis, the hedging relationship is expected to be highly effective in achieving offsetting cash flows attributable to the hedged risk during the term of the hedge.... For a derivative transaction, an entity must conclude that both it and its counterparty will be expected to meet their contractual obligations on an ongoing basis for a hedge to prospectively continue to qualify for hedge accounting. DIG G10 also says that... a change in the counterparty s creditworthiness would not necessarily indicate that the counterparty would default on its obligations, such a change would warrant further evaluation. The reasonable conclusion is that changing credit worthiness is not a sufficient reason to discontinue hedge accounting, providing an entity or counterparty is still expected to be able to meet its contractual obligations. DIG G10 then goes on to say that assessing a counterparty s creditworthiness is applicable to both cash flow and fair value hedges and for all assessment methods, including shortcut, i.e. an entity must always consider a counterparty s ability to meet contractual requirements to prospectively continue hedge accounting. Shortcut Method Some assessment methods are simple. For example, the shortcut method (para 68 of FAS 133) assumes an effective hedge relationship (assessment) and no ineffectiveness (measurement), and so the adjustment to the carrying value of the asset/liability in the case of fair value hedges or the effective component in the case of cash flow hedges is the credit-adjusted periodic change in the hedging derivative. Implicitly, the hedged item has the same credit adjustment as the derivative. Other assessment methods are not so straightforward: Cash Flow Hedges 2009 Reval.com, Inc. All Rights Reserved 4

5 Critical Terms Match DIG G9 states in part:... if the critical terms of the hedging instrument or the hedged forecasted transaction have changed or if there have been adverse developments regarding the risk of counterparty default, the entity must measure the amount of ineffectiveness that must be recorded currently in earnings pursuant to the guidance in Implementation Issue No. G7, Measuring the Ineffectiveness of a Cash Flow Hedge under Paragraph 30(b) When the Shortcut Method Is Not Applied. In addition, the entity must assess whether the hedging relationship is expected to continue to be highly effective (using either a dollaroffset test or a statistical method such as regression analysis). There can be at least two interpretations of this paragraph: A strong interpretation is that if there is any change in the credit of the derivative counterparty, then ineffectiveness should be reported. A milder interpretation is that if there is a change in the rating of the derivative counterparty, then ineffectiveness should be reported. Note: In addition to Critical Terms Match, this applies to DIG G7 and other cash flow hedges. Variable Cash Flow Method (Method 1) DIG G7 also states: The change in variable cash flows method will result in no ineffectiveness being recognized in earnings if the following conditions are met: 1) the floating-rate leg of the swap and the hedged variable cash flows of the asset or liability are based on the same interest rate index (for example, three-month LIBOR), 2) the interest rate reset dates applicable to the floating-rate leg of the swap and to the hedged variable cash flows of the asset or liability are the same, 3) the hedging relationship does not contain any other basis differences (for example, ineffectiveness could be created if the variable leg of the swap contains a cap and the floating-rate asset or liability does not), and 2009 Reval.com, Inc. All Rights Reserved 5

6 4) the likelihood of the obligor not defaulting is assessed as being probable. However, ineffectiveness would be expected to result if any basis differences existed. For example, ineffectiveness would be expected to result from a difference in the indices used to determine cash flows on the variable leg of the swap (for example, the three-month Treasury rate) and the hedged variable cash flows of the asset or liability (for example, three-month LIBOR) or a mismatch between the interest rate reset dates applicable to the variable leg of the swap and the hedged variable cash flows of the hedged asset or liability... This explanation is clear in saying that no ineffectiveness should be recorded where the terms of the variable legs of the hedging and hedged instrument are the same. That would imply that if credit were included in valuing the variable leg cash flows of the swap, then credit should also be applied to the variable leg cash flows of the hedged item as long as the likelihood of the obligor not defaulting is probable. In the language of the standard, credit-adjusted values should be used for both assessment and measurement. This would also apply to cases where the variable leg s critical terms are different, as long as the likelihood of the obligor not defaulting is probable. Hypothetical Derivative Method (Method 2) DIG G7 states:... Essentially, the hypothetical derivative would need to satisfy all of the applicable conditions in paragraph 68 (as amended) necessary to qualify for use of the shortcut method except criterion 68(dd). Thus, the hypothetical swap would be expected to perfectly offset the hedged cash flows. The change in the fair value of the perfect hypothetical swap can be regarded as a proxy for the present value of the cumulative change in expected future cash flows on the hedged transaction as described in paragraph 30(b)(2).... There are differing interpretations of the impact of FAS 157 on hypothetical derivatives. It has been argued that since it is a perfect hedge of the designated risk, then it is a perfect hedge with the counterparty of the actual swap; therefore, the same credit adjustment to the actual swap should be applied to the hypothetical. It follows, then, that the hypothetical derivative should also be valued with the same credit curve as the actual swap, regardless of whether the hypothetical is in an asset or a liability position Reval.com, Inc. All Rights Reserved 6

7 A more common view is that the hypothetical reflects the cash flows of the hedged item, and only the entity s credit could be applicable if credit were to be taken into account. Since FAS 159 is not being applied (fair valuing of the hedged item) then the debt should be valued without any credit. In this case, the credit adjustment would not be applied to the hypothetical. Another view is that no ineffectiveness should be recorded due to credit. In this case, the amount of the credit adjustment of the swap should be applied to the hypothetical derivative. Auditors have required clients to assess and measure hedging relationships under any of these views. Therefore, it is important that when entities consider a hedge accounting software solution, they choose a system that is flexible enough to handle any auditor requirement. In addition, whichever method is adopted, both assessment and measurement should be based on credit-adjusted values. Note: In the case of hypothetical futures contracts, credit would not be included in the valuation of the actual futures contract, so it would not be included in valuation of the hypothetical future. Change in Fair Value Method (Method 3) DIG G7 DIG G10 states in part: A change in the creditworthiness of the derivative s counterparty in a cash flow hedge of interest rate risk would also have an immediate impact if ineffectiveness were measured under the Change in Fair Value Method discussed in Statement 133 Implementation Issue No. G7. In this case, a credit adjustment needs to be made to the derivative and not the hedged cash flows. Included/Excluded Components (Para 63 FAS 133) Some assessment methods allow for separation of a derivative s fair value into included and excluded components. A logical question is, to which category should the credit adjustments be allocated? Since credit adjustment impacts discounting, then any included component that includes discounting (e.g. spot or forward discounted, minimum value, fair value) should include some of the credit effect in the discounting. Note: This does not mean that all of the credit effect will be in the included component. Some of it may be in the excluded component Reval.com, Inc. All Rights Reserved 7

8 Any other method (spot or forward undiscounted or intrinsic value) should include all the impact of credit in the excluded component. This should apply to both actual and hypothetical derivatives where the option to include credit on the hypothetical has been chosen. Fair Value Hedges Debt Designated risk of changes in benchmark LIBOR rate (para 21[f][2]) Some auditors argue that hedges that change in fair value because of changes in the benchmark LIBOR rate should only generate ineffectiveness when the change in fair value (due to changes in benchmark LIBOR rate )of the swap and the debt differ. This implies that changes in the fair value of the swap due to changes in credit (due to FAS 157 valuations from period to period as credit spreads change) should not be treated as ineffectiveness. To achieve this, the debt should also be valued using the same credit curve as the swap. Other auditors and practitioners come to the same conclusion by noting that if the benchmark LIBOR rate is credit adjusted, it is no longer the benchmark rate. Debt Changes in full fair value (para 22[e]) DIG G10 states in part:... a change in the creditworthiness of the derivative s counterparty in a fair value hedge would have an immediate impact because that change in creditworthiness would affect the change in the derivative s fair value, which would immediately affect both the assessment whether the relationship qualifies for hedge accounting and the amount of ineffectiveness recognized in earnings under fair value hedge accounting. Credit adjustments need to be applied to the derivative for measurement. Net Investment Hedges Included and Excluded Components (Para 63 FAS 133) Net investment hedges typically use a spot assessment method (undiscounted or discounted) with time value (discounted forward points) treated as an excluded component and taken to earnings. As with the comment above for cash flow hedges, the impact of a credit adjustment would be in the excluded component only for a net investment hedge Reval.com, Inc. All Rights Reserved 8

9 Conclusion FAS 157 impacts FAS 133 in many unexpected ways. Ineffectiveness may appear in previously perfectly effective hedges. It is useful, however, to look to the evolution of FAS 133 implementation to understand that, as time passes, more consistent interpretations of and deeper adherence to FAS 157 will emerge among auditing firms. Until then, entities must arm themselves with software solutions that are flexible enough to cope with different possible treatments of the same hedge relationships Reval.com, Inc. All Rights Reserved 9