FASB Transition Provisions Pre-Existing Hedge Ineffectiveness of a Derivative

FASB: Transition Provisions: Pre-Existing Hedge Ineffectiveness of a Derivative

Derivatives Implementation Group

Statement 133 Implementation Issue No. J15

Title: Transition Provisions: Pre-Existing Hedge Ineffectiveness of a Derivative
Paragraph references: 30(b), 49, 52(a), 52(b)
Date cleared by Board: March 21, 2001
Date posted to website: April 10, 2001

QUESTIONS

  1. If prior to adopting Statement 133 the effectiveness1 of a cash-flow-type hedging relationship was effectively assessed based on the changes in only a component of the derivative's fair value (for example, on only the changes in the intrinsic value of an option contract or the spot value of a forward contract) and the other component(s) of the derivative's initial fair value (for example, the premium on a purchased option contract or the discount or premium on a forward contract) was being amortized to earnings over the life of the contract, should the transition adjustment for the derivative at the date of adoption be allocated between the cumulative-effect-type adjustment of net income and the cumulative-effect-type adjustment of other comprehensive income?

  2. If prior to adopting Statement 133 the effectiveness of a fair-value-type hedging relationship was effectively assessed based on the changes in only a component of the derivative's fair value (for example, on only the changes in the intrinsic value of an option contract or the spot value of a forward contract) and the other component(s) of the derivative's initial fair value (for example, the premium on a purchased option contract or the discount or premium on a forward contract) was being amortized to earnings over the life of the contract,, should the limit in paragraph 52(b) applicable to the transition adjustment on the hedged asset be (a) the full transition adjustment of the derivative (full derivative value less amortized cost) or (b) only the transition adjustment of the derivative related to the components deemed effective (that is, associated with the variability of the hedged transaction) because the change in the components of the derivative deemed ineffective (that is, being amortized to earnings over the life of the contract) is an excluded component of the hedge?

BACKGROUND

Paragraph 52(a) states:

    If the transition adjustment relates to a derivative instrument that had been designated in a hedging relationship that addressed the variable cash flow exposure of a forecasted (anticipated) transaction, the transition adjustment shall be reported as a cumulative-effect-type adjustment of accumulated other comprehensive income.
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1Prior to Statement 133, the terms ineffectiveness and effectiveness were not applicable or generally referred to when using an option as a hedging instrument. However, these terms are used throughout this issue for purposes of consistent application of this guidance in this issue since these terms and related concepts are used throughout and explained in Statement 133.

Paragraph 30(b) addresses the limitation on amounts recorded in other comprehensive income for cash flow hedges. Specifically, it states:

    Accumulated other comprehensive income associated with the hedged transaction shall be adjusted to a balance that reflects the lesser of the following (in absolute amounts):

(1)   The cumulative gain or loss on the derivative from inception of the hedge less (a) the excluded component discussed in paragraph 30(a) above and (b) the derivative's gains or losses previously reclassified from accumulated other comprehensive income into earnings pursuant to paragraph 31

(2)   The portion of the cumulative gain or loss on the derivative necessary to offset the cumulative change in expected future cash flows on the hedged transaction from inception of the hedge less the derivative's gains or losses previously reclassified from accumulated other comprehensive income into earnings pursuant to paragraph 31.

That adjustment of accumulated other comprehensive income shall incorporate recognition in other comprehensive income of part or all of the gain or loss on the hedging derivative, as necessary.

Paragraph 52(b) of Statement 133 (as amended) states, in part:

    If the transition adjustment relates to a derivative instrument that had been designated in a hedging relationship that addressed the fair value exposure of an asset, a liability, or a firm commitment, the transition adjustment for the derivative shall be reported as a cumulative-effect-type adjustment of net income. Concurrently, any gain or loss on the hedged item shall be recognized as an adjustment of the hedged item's carrying amount at the date of initial application, but only to the extent of an offsetting transition adjustment for the derivative. Only for purposes of applying the preceding sentence in determining the hedged item's transition adjustment, the gain or loss on the hedged item may be either (1) the overall gain or loss on the hedged item determined as the difference between the hedged item's fair value and its carrying amount on the date of initial application (that is, not limited to the portion attributable to the hedged risk nor limited to the gain or loss occurring during the period of the preexisting hedging relationship) or (2) the gain or loss on the hedged item attributable to the hedged risk (limited to the hedged risks that can be designated under paragraph 21 of this Statement) during the period of the preexisting hedging relationship. That adjustment of the hedged item's carrying amount shall also be reported as a cumulative-effect-type adjustment of net income.

For example, at the date of adopting Statement 133, an enterprise holds 2 purchased option contracts that were originally out of the money and purchased for $20 each. One has been used in a fair-value-type hedging relationship and the other has been used in a cash-flow-type hedging relationship. Both options are currently out of the money and both have a carrying value of $5 due to amortization of the purchase price. The fair value of each option at the transition date is $100, which is entirely composed of time value. The enterprise has been amortizing the premiums paid for the options (all of which is considered time value) by the straight-line method because only the changes in the option's intrinsic value would be effective in each respective hedging relationship. For both options, the transition adjustment is equal to the difference between the amortized cost of the option (that is, the carrying amount prior to the adoption of Statement 133) and the fair value of the option.

RESPONSE

Question 1

Generally yes. If prior to adopting Statement 133 the effectiveness of a cash-flow-type hedging relationship was effectively assessed based on the changes in only a component of the derivative's fair value, the transition adjustment for the derivative at the date of adoption should be allocated between the cumulative-effect-type adjustment of net income and the cumulative-effect-type adjustment of other comprehensive income but only if the other component(s) of the derivative's initial fair value (for example, the premium on a purchased option contract or the discount or premium on a forward contract) was being amortized to earnings over the life of the contract prior to the adoption of Statement 133. Because prior to the adoption of Statement 133 the changes in only a component of the derivative were deemed effective as a hedge (that is, associated with the hedged item) and the ineffective component was recognized in earnings (that is, being amortized to earnings over the life of the contract), only the portion of the transition adjustment equal to the changes in the derivative's effective component from inception of the derivative should be included in the cumulative-effect-type adjustment of other comprehensive income. Any remaining transition adjustment for the derivative should be recorded in the cumulative-effect-type adjustment of net income. In the example above, of the $95 transition adjustment, zero would be included in the cumulative-effect-type adjustment of other comprehensive income (because there was zero change in the option's intrinsic value from at the inception of the hedge to the date of adopting Statement 133) and $95 would be included in the cumulative-effect-type adjustment of net income.

If the other component(s) of the derivative's initial fair value (for example, the premium on a purchased option contract or the discount or premium on a forward contract) was not recognized in earnings prior to the adoption of Statement 133 (for example, because an entity determined it was not necessary to amortize the initial premium (initial time value) to earnings under generally accepted accounting principles or because the initial fair value of the other component(s) of the hedging derivative at the inception of the hedge was zero (for example, a zero-cost collar) and thus no amortization to earnings occurred), the entire transition adjustment would be included in the cumulative-effect-type adjustment of other comprehensive income.

Whether an enterprise plans to designate a derivative as a hedging instrument upon adoption of Statement 133 is not relevant to the accounting for the transition adjustment in this Issue.

Question 2

If prior to adopting Statement 133 the effectiveness of a fair-value-type hedging relationship was effectively assessed based on the changes in only a component of the derivative's fair value and the changes in the other component(s) of the derivative's initial fair value (for example, the premium on a purchased option contract or the discount or premium on a forward contract) was being amortized to earnings over the life of the contract prior to the adoption of Statement 133, only the portion of the transition adjustment equal to the changes in the derivative's effective component from inception of the hedging relationship should be considered when determining the transition adjustment for the hedged item. Consequently, the transition adjustment to a hedged item is limited to recognizing an amount that is not greater than the gain or loss recognized on the hedging derivative excluding any value attributable to an excluded component(s). In the example above, the hedged item would not be adjusted because the entire transition adjustment of $95 relates to the time value of the option.

If the other component(s) of the derivative's initial fair value (for example, the premium on a purchased option contract or the discount or premium on a forward contract) was not recognized in earnings prior to the adoption of Statement 133 (for example, because an entity determined it was not necessary to amortize the initial premium (initial time value) to earnings under generally accepted accounting principles or because the initial fair value of the other component(s) of the hedging derivative at the inception of the hedge was zero (for example, a zero-cost collar) and thus no amortization to earnings occurred), this additional limitation to the transition adjustment on the hedged asset (as discussed in the preceding paragraph) would not be applicable. Instead, the provisions of paragraph 52(b) would be applied as amended.

Whether an enterprise plans to designate a derivative as a hedging instrument upon adoption of Statement 133 is not relevant to the accounting for the transition adjustment in this Issue.

The above response has been authored by the FASB staff and represents the staff's views, although the Board has discussed the above response at a public meeting and chosen not to object to dissemination of that response. Official positions of the FASB are determined only after extensive due process and deliberation.