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FAS133 Regulation hedge accounting
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SAP AG 2000 SAP Corporate Finance Management / 1
FAS 133
SAP AG 2000 SAP Corporate Finance Management / 2
Agenda
Sample Business Scenario
Hedge Management - Applicationand Customizing
1111
2222
FAS 133 - Key Concepts
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SAP AG 2000 SAP Corporate Finance Management / 3
Agenda
Sample Business Scenario
Hedge Management - Applicationand Customizing
1111
2222
FAS 133 - Key Concepts
3333
SAP AG 2000 SAP Corporate Finance Management / 4
Hedging vs Hedge Accounting
Hedging:
Hedging of an open risk position by building up an offsetting position, so that gains and losses from the open underlying transaction and the hedging transaction clear each other
Problem From an Accounting Perspective:
If different balance sheet values are applied to the underlying and hedging transactions (carrying value and valuation), then the mutually clearing gains and losses are shown in different periods (distortion of the income statement in at least two periods)
Hedge Accounting:
Exceptional accounting rule that enables the mutually clearing gains and losses from the underlying transaction and the hedging transaction to be shown in the same period and, therefore, to allow a correct statement of profit
SAP AG 2000 SAP Corporate Finance Management / 5
Hedge Accounting - Definition
Hedge Accounting…
…matches the impact of the hedged item and the
hedging instrument in the income statement. Without hedge accounting, income volatility can result...
SAP AG 2000 SAP Corporate Finance Management / 6
FAS 133 - Definition
FAS 133 is a US-GAAP regulation which was issued by the FASB (Financial Accounting Standards Board)
FAS 133 standardizes accounting for derivative instruments by requiring that
all derivatives have to be reported on the balance sheet
all derivatives have to be valuated at their fair value
Full adoption of these requirements would create large volatility in a company‘s income statement.
To prevent this, the board has introduced special accounting rules.
If a company can prove that a derivative is designated to hedge a certain specified risk, there is an opportunity to defer the earnings impact of changes in fair value of the derivative. This is referred to as qualifying for hedge accounting under FAS 133.
SAP AG 2000 SAP Corporate Finance Management / 7
FAS 133 - Fundamental Decisions
“Derivative instruments represent rights or obligations that meet the definitions of assets or liabilities and should be reported in financial statements.”
“Fair value is the most relevant measure for financial instruments and the only relevant measure for derivative instruments.”
“Only items that are assets or liabilities should be reported as such in financial statements.”
“Special accounting for items designated as being hedged should be provided only for qualifying items. One aspect of qualification should be an assessment of the expectation of effective offsetting changes in fair values or cash flows during the term of the hedge for the risk being hedged.”
In developing FAS 133, the Financial Accounting StandardsBoard (FASB) concluded...
SAP AG 2000 SAP Corporate Finance Management / 8
Hedge Accounting - Basic Questions
Which basic forms of hedge accounting exist (hedge categories)?
Which basic transactions can be hedged (hedged items)?
Which hedging instruments can be used?
When does a hedge qualify for hedge accounting? Which hedge accounting rules have to be applied to the hedged item and the hedging instrument?
SAP AG 2000 SAP Corporate Finance Management / 9
Hedge Accounting - Basic Questions
Which basic forms of hedge accounting exist (hedge categories)?
Which basic transactions can be hedged (hedged items)?
Which hedging instruments can be used?
When does a hedge qualify for hedge accounting? Which hedge accounting rules have to be applied to the hedged item and the hedging instrument?
SAP AG 2000 SAP Corporate Finance Management / 10
Cash flow hedge:
Hedging of underlying transactions (included in the balance sheet) or of anticipated transactions against fluctuations in future cash flows
Fair value hedge:
Hedging of underlying transactions included in the balance sheet (or of clearly identified parts of underlying transactions) against changes in their Fair Value
Hedge categories:
Fair value hedge
Cash flow hedge
(Foreign currency hedge = special case)
FAS 133 - Hedge Categories
SAP AG 2000 SAP Corporate Finance Management / 11
Fair Value Hedge vs Cash Flow Hedge (1)
Risk:
possible fluctuations in future fair values from balance sheet items (and firm commitments)
Hedging by:
Removal of price fixing, making future payment flows ‘variable’
Cause:
Future payment flows fixed by contract (for example, purchase or sales prices, interest, exchange rates)
Fair Value Hedge
Risk:
possible fluctuations in future fair values from balance sheet items and expected transactions
Hedging by:
Price fixing, determining future payment flows by contract
Cause:
Non-fixed future payment flows (for example, purchase or sales prices, interest, exchange rates)
Cash Flow Hedge
SAP AG 2000 SAP Corporate Finance Management / 12
Fair Value Hedge vs Cash Flow Hedge (2)
Fixed-interest financial instruments
Variable-interest financial instruments
Possible fluctuations in future market
values
Fair value hedge
Possible fluctuations in future cash flows
Cash flow hedge
SAP AG 2000 SAP Corporate Finance Management / 13
Hedge Accounting - Basic Questions
Which basic forms of hedge accounting exist (hedge categories)?
Which basic transactions can be hedged (hedged items)?
Which hedging instruments can be used?
When does a hedge qualify for hedge accounting? Which hedge accounting rules have to be applied to the hedged item and the hedging instrument?
SAP AG 2000 SAP Corporate Finance Management / 14
Hedged Items
Recognized assets and liabilities - It is also permissible to designate percentage shares of assets/liabilities or certain contracted payment flows or their values as hedge items
Unrecognized firm commitments are contractual obligations or liabilities with external third parties. All important parameters such as quantity and price are fixed.
Forecasted transactions are expected future underlying transactions that are not recorded in the balance sheet, and are not contract-related.
SAP AG 2000 SAP Corporate Finance Management / 15
Firm Commitments vs Forecasted Transactions
Firm Commitments
Contracts with fixedprices, quantities and settlement times
The risk is the possible changes in the future fair values
Forecasted Transactions
No fixed agreements
The risk is the possible fluctuations in the future cash flows
Fair value risk/fair value hedge
Cash flow risk/cash flow hedge
SAP AG 2000 SAP Corporate Finance Management / 16
Hedge Accounting - Basic Questions
Which basic forms of hedge accounting exist (hedge categories)?
Which basic transactions can be hedged (hedged items)?
Which hedging instruments can be used?
When does a hedge qualify for hedge accounting? Which hedge accounting rules have to be applied to the hedged item and the hedging instrument?
SAP AG 2000 SAP Corporate Finance Management / 17
Hedging Instruments (I)
The following can be used as hedging instruments....
All derivative financial instruments that are concluded with external third parties
Exception: written options
Further exceptions:
Own equity capital instruments
Instruments whose fair value cannot be determined reliably
SAP AG 2000 SAP Corporate Finance Management / 18
Hedging Instruments (II)
Note that....
Hedging instruments can be used either partially (percentage share) or completely
Simultaneous use of several derivatives as a hedging instrument is possible
Designation of a derivative as a hedge for several (sub) risks is permitted
SAP AG 2000 SAP Corporate Finance Management / 19
Hedge Accounting - Basic Questions
Which basic forms of hedge accounting exist (hedge categories)?
Which basic transactions can be hedged (hedged items)?
Which hedging instruments can be used?
When does a hedge qualify for hedge accounting? Which hedge accounting rules have to be applied to the hedged item and the hedging instrument?
SAP AG 2000 SAP Corporate Finance Management / 20
Qualifying Criteria
The derivative needs to be linked with the exposure in a hedging relationship, stating the hedge strategy at the beginning of the hedging relationship.
Identification of hedging instrument (derivative)
Identification of hedged item (underlying exposure)
Identification of nature of risk being hedged (e.g. interest rate risk, exchange rate risk)
Documentation of how the hedging instrument´s effectiveness in offsetting value changes in the hedged item will be assessed.
Determine the algorithm (method) used for assessing effectiveness (e.g. methods based on spot or forward rates, discounted or non-discounted)
Determine the components of the derivative´s value change that are included in the subsequent effectiveness assessment
FAS 133 requires that certain criteria be met for all types of hedges in order for them to qualify for hedge accounting:
SAP AG 2000 SAP Corporate Finance Management / 21
Qualifying Criteria - Effectiveness
The effectiveness of a hedge is a measure of how a derivative protects against the underlying risk (exposure).
The “Effectiveness Ratio” shows the value changes in the derivative compared to the value changes in the underlying risk.
Both at inception of the hedge and on an ongoing basis, the hedging relationship is expected to be highly effective (effectiveness ratio of between 80 and 120%) in achieving offsettting value changes. An effectiveness assessment is required whenever financial statements or earnings are reported, and at least every three months.
An effectiveness assessment is not required if the hedging relationship qualifies for the shortcut method in the case of a perfect hedge, that is when the critical terms of hedging instrument and hedged item are the same (e.g. notional and principle amount, receive/pay rates and the related bases, contract term and maturity, settlement dates).
SAP AG 2000 SAP Corporate Finance Management / 22
Accounting treatment:
• Show the change in fair value of derivatives in the P/L• Show the change in fair value of the hedged item (firm commitment) in the P/L
Hedge categories
Fair value hedge
Cash flow hedge
FAS 133 - Hedge Categories
Conclusion: Synchronous P/L treatment of derivative and underlying transaction in order to avoid volatility in profits
Transactions + exposure: • Fair value of a recognized asset/liability • Fair value of an unrecognized firm commitment
SAP AG 2000 SAP Corporate Finance Management / 23
Transactions + exposure: • Variability in future cash flows of recogn. asset/liab. • Variability in future cash flows of forecasted transact.
Hedge categories
Fair value hedge
Cash flow hedge
Accounting treatment:• Effective portion of the change in market value of the derivative is recorded on a cumulative basis in Other Comprehensive Income (OCI) • The ineffective portion is recorded in the current P/L • The accumulated amounts in Other Comprehensive Income are reclassified to the P/L in the same period in which the corresponding underlying transaction is posted to the P/L .
FAS 133 - Hedge Categories
Conclusion: Synchronous P/L treatment of derivative and underlying transaction in order to avoid volatility in profits
SAP AG 2000 SAP Corporate Finance Management / 24
Agenda
Example Business Scenario
Hedge Management - Applicationand Customizing
System Demo
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FAS 133 - Key Concepts
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4444
SAP AG 2000 SAP Corporate Finance Management / 25
Integration in CFM
Hedge Manage-
ment
FI-GLFI-GL
Market Risk Analyzer
MarketData
Transaction Manager
managing financial deals and positions
valuation of instruments and transfer to Financial Accounting
Accounts
Calculations e.g. net present value calculation
OCI
Basic values for calculations
SAP AG 2000 SAP Corporate Finance Management / 26
• Forecasted Transactions: sales and purchases with FX forwards and FX options
• Firm Commitments: sales and purchases with FX forwards and FX options
• Recogn. Fin. Assets/Liab. : cash flow hedge using interest-rate swap & floating-rate instrument • Recogn. Fin. Assets/Liab. : fair value hedge using interest-rate swap & fixed-rate instrument
FAS133 - Scope of the first release (with CFM 1.0)
• Interest rate (IR) • FX- risk
Risk categories
Hedge scenarios
SAP AG 2000 SAP Corporate Finance Management / 27
SAP Hedge Management - Functions
Making hedge decisions
Monitoring ongoing effectivenessand OCI balances
Hedge Management Application
Managing exposures
SAP AG 2000 SAP Corporate Finance Management / 28
SAP Hedge Management - Functions
Define Transaction Category and Activity
Define Exposure
Define Hedge Plan
Making hedge decisionsMonitoring ongoing effectivenessand OCI balances
Hedge Management ApplicationManaging exposures
Po-sition
ForecastForecast Recogn. Fin.Assets/Liab.Recogn. Fin.Assets/Liab.
Firm commitment
Firm commitment
Assets/Liabilities
Sale Pur-chase
Cash Flow
SAP AG 2000 SAP Corporate Finance Management / 29
Define Hedge Plan
SAP AG 2000 SAP Corporate Finance Management / 30
Define Exposure
SAP AG 2000 SAP Corporate Finance Management / 31
SAP Hedge Management - Functions
Define Hedge Category
Define Target Hedge Ratio that is to be hedged
Designate Derivative(s) to one/many hedge(s)
Choose Hedge Strategy for hedging relationship
Monitoring ongoing effectivenessand OCI balances
Hedge Management ApplicationManaging exposures
Making hedge decisions
Fair value hedge Cash flow hedge
SAP AG 2000 SAP Corporate Finance Management / 32
Define Hedge
SAP AG 2000 SAP Corporate Finance Management / 33
Define Hedging Relationship
SAP AG 2000 SAP Corporate Finance Management / 34
SAP‘s system solution to FAS133: Key aspects
many-to-many links between derivative (hedging instrument) and underlying exposure (Hedged Item)
SAP’s solution offers...
16 different calculation categories for calculating fair value changes in the effectiveness test
automatic posting of all postings relating to an event.
Various reports for fulfilling FASB and company reporting requirements for monitoring hedging relationships, effectiveness results and balances on certain deferral acounts.
SAP AG 2000 SAP Corporate Finance Management / 35
SAP Hedge Management - Functions
Effectiveness Test
Determine whether the derivative effectively hedges changes in fair value
or future cash flows - Effectiveness Assessment Once the hedging relationship is determined as having been effective, the
system will perform the Effectiveness Measurement which determines the amounts of the derivative´s changes in fair value and distributes those values according to the rules of FAS 133
Making hedge decisions
Hedge Management ApplicationManaging exposures
Monitoring ongoing effectivenessand OCI balances
SAP AG 2000 SAP Corporate Finance Management / 36
Hedge Strategy - Customizing
Precondition ...
Effectiveness Calculation Types
SAP AG 2000 SAP Corporate Finance Management / 37
Hedge Strategy - Customizing
Precondition...
Effectiveness AssessmentTypes
SAP AG 2000 SAP Corporate Finance Management / 38
Hedge Strategy - Customizing
Hedge Strategy - Customizing
SAP AG 2000 SAP Corporate Finance Management / 39
Effectiveness testing - Process
Hedge Strategy definitionHedge Strategy definition
Effectiveness assessment prospective
Effectiveness assessment prospective
Effectiveness assessment retrospective
Effectiveness assessment retrospective
Effectiveness measurementEffectiveness measurement
Customizing
Choose Hedge Strategy for hedging relationship
Choose Hedge Strategy for hedging relationship
Application
Done once: Done once: at inception of hedging relationshipat inception of hedging relationship
Done on an ongoing Done on an ongoing basisbasis
SAP AG 2000 SAP Corporate Finance Management / 40
FAS 133 Reports I
Hedging Relationship per Derivative
This report shows the derivatives and the exposures they are hedging. It is thus possible to report on the derivatives that are hedging/are not hedging exposures, and where hedge capacities remain.
OCI Balance Overview Report
This report provides the OCI and P&L balance for derivatives and their hedging relationships as of the selected date.
Exposure Expiration Report
This reports enables you to monitor the expiration for a specified exposure. Upon expiration, the system updates the hedging relationships and generates accounting entries (for instance, OCI reclassification) according to the hedge category (cash flow hedge, fair value hedge) and the transaction activity (such as sale or purchase).
SAP AG 2000 SAP Corporate Finance Management / 41
FAS 133 Reports II
Effectiveness Test Report
By using the combined effectiveness assessment and measurement report, hedge effectiveness can be calculated at any point during the lifetime of the hedging relationship, and can be used for simulation purposes, e.g. „what-if“ scenarios.
Prospective Effectiveness Assessment
The Prospective Effectiveness Assessment lets the user record, for a hedging relationship or several hedging relationships and for a given date, whether it is expected to be effective in the future. This data is manually entered as of the first FAS 133 release; double-clicking on the „effective“ column in the report marks a hedging relationship as not being effective prospectively.
Hedging Relationship Dedesignation
This report allows the user to manually dedesignate single hedging relationships as of a certain date, or groups of hedging relationships, e.g. all hedging relationships of a derivative.
SAP AG 2000 SAP Corporate Finance Management / 42
FAS 133 Reports III
Hedge Plan Expiration
This report shows all hedging relationships of hedge plans expiring on a certain date, and dissolves them. It thus ensures that all hedging relationships of a hedge plan are dissolved at the latest upon hedge plan expiration.
Retrospective Effectiveness Assessment: Dissolve Ineffective Hedging Relationships
This reports allows the user to dissolve all or a selection of hedging relationships that have been ineffective in the period just ended.
Manual OCI Reclassification
This report allows the user to manually reclassify all or parts of the OCI balances of the selected hedging relationships.
SAP AG 2000 SAP Corporate Finance Management / 43
FAS 133 Reports IV
Fair value changes to be posted
This report shows all fair value changes that have been calculated for the selected hedges in effective hedging relationships, and thus provides the user with the informations about what needs to be posted for the underlying exposure.
Prematurely reclassified OCI
This report shows all OCI balances that have been reclassified prematurely, i. e. before the underlying exposure affected earnings, or was scheduled to affect earnings. It thus provides the exception reporting required.
SAP AG 2000 SAP Corporate Finance Management / 46
Agenda
Example Business Scenario
Hedge Management - Applicationand Customizing
1111
2222
FAS 133 - Key Concepts
3333
SAP AG 2000 SAP Corporate Finance Management / 47
FX Forward and Forecasted Sale
An internationally operating company hedges forecasted sales figures (forecasted transaction) denominated in a foreign currency using FX forward contracts (cash flow hedge).
The business plan in the scenario is a sales forecast of EUR 10 mill. for the period of September until December of the year 2000.
The company‘s policy is to hedge the exposure at a ratio of 60%.
The treasurer‘s responsibility is to comply with this ratio. He enters into an FX forward contract to sell 10 mill. EUR on 30th of November, of which he designates a portion of 6 mill. EUR to the hedging relationship [the remaining portion of the forward may be entered into for a different purpose].
SAP AG 2000 SAP Corporate Finance Management / 48
Scenario description
Forecast period: 09/01/00 - 12/31/00
Sales forecast: EUR 10 mill. EUR (forecasted transaction)
Hedge category: Cash flow hedge (hedging the functional currency equivalent of the expected sales forecast)
Hedge instrument: FX forward
Data: Contract date: 11/01/00
Value date: 12/31/00
Forward Rate: 0.87
Spot: 0.86
Swap: 0.01
Amounts:
EUR 10 mill. Sale / USD 11.49 mill. Purchase
SAP AG 2000 SAP Corporate Finance Management / 49
Scenario description
Inception date: 11/01/00
Designation: 6 mill. EUR
Target hedge ratio: 60%
Actual hedge ratio: 60%
Spot EUR/USD: 11/30/00 (valuation): 0.8012/31/00 (expiration): 0.90
SAP AG 2000 SAP Corporate Finance Management / 50
Timeline
HedgePlan
Sept./Oct. November December
FX forward
Sales forecast
Sales forecast InceptionInception ValuationValuation Forecast
expirationForecast
expiration
Ex-posure
Valid fromValid from
Due date
Due date
Contractdate
Contractdate
SettlementSettlement
SAP AG 2000 SAP Corporate Finance Management / 51
Procedure
Hedge Management 09/01/00 - 12/31/00:
Create Exposure, Hedge, Hedging Relationship
Valuation 11/30/00:
Determine Net Present Value
Effectiveness test
Key date valuation
Expiration 12/31/00:
Post derivative
Effectiveness test
Realized gains and losses derivative
Exposure Expiration: reclassification posting of OCI
SAP AG 2000 SAP Corporate Finance Management / 52
Calculate net present value
SAP AG 2000 SAP Corporate Finance Management / 53
Detailed log net present value calculation
SAP AG 2000 SAP Corporate Finance Management / 54
Effectiveness assessment calclulation 30/11/00
SAP AG 2000 SAP Corporate Finance Management / 55
Detailed log Effectiveness assessment
SAP AG 2000 SAP Corporate Finance Management / 56
Detailed log effectiveness assessment
SAP AG 2000 SAP Corporate Finance Management / 57
Key date valuation on 30/11/00
SAP AG 2000 SAP Corporate Finance Management / 58
Posting Logic FX forward
Valuation 11/30/00:
1. Unrealized gain derivative (683.370,41 USD)
2. Transfer to OCI - effectiveness calculation - (410.022,25 USD)
3. Transfer to P/L free - non-designated portion of derivative - (273.348,16 USD)
SAP AG 2000 SAP Corporate Finance Management / 59
Posting Logic FX forward
FX forward clearing account
1 683.370,41 USD
OCI clearing account
1 683.370,41 USD2 410.022,25 USD
3
Transfer to P/L
3 273.348,16 USD
Transfer to OCI
2 410.022,25 USD
273.348,16 USD
0,00 USD 0,00 USD
SAP AG 2000 SAP Corporate Finance Management / 60
Post derivative on 31/12/00
SAP AG 2000 SAP Corporate Finance Management / 61
Effectiveness assessment on 31/12/00
SAP AG 2000 SAP Corporate Finance Management / 62
Realized Gains and Losses derivative
SAP AG 2000 SAP Corporate Finance Management / 63
Exposure expiration report
SAP AG 2000 SAP Corporate Finance Management / 64
Post OCI reclassification at exposure expiration
SAP AG 2000 SAP Corporate Finance Management / 65
Exposure expiration/expiration of derivative 12/31/00:
Posting Logic FX forward
1. Dissolve OCI balance from valuation on 11/30/00 (410.022,25 USD)
2. Dissolve P/L free from valuation on 11/30/00 (273. 348,16USD)
3. Reverse unrealized gain from valuation on 11/30/00 (683.370,41 USD)
4. Realized loss (forex) due to expiration on 11/30/00 (300.000,00 USD)
5. Transfer to P/L free - not designated portion of derivative - (120.000,00 USD) 6. Transfer to OCI - effectiveness calculation - (180.000,00 USD)
7. Reclassification of OCI - Exposure expiration ( 180.000,00 USD)
SAP AG 2000 SAP Corporate Finance Management / 66
Posting Logic FX forward
300.000,00 USD
7
683.370,41 USD
4
7
683.915,78 USD
1 410.022,25 USD
3
273.348,16 USD
5
6
683.370,41 USD1
OCI clearing accountFX forward clearing account
2
2
410.022,25 USD
273.348,16 USD
683.370,41 USD1
300.000,00 USD
0,00 USD 0,00 USD
Transfer to OCI
3
5
410.022,25 USD 410.022,25 USD2180.000,00 USD
Transfer to P/L
2 1
6
273.348,16 USD
4
273.348,16 USD3
2
180.000,00 USD
120.000,00 USD
120.000,00 USD 180.000,00 USD
180.000,00 USD