CHAPTER 6
Presentation and Disclosure
About This Chapter
Disclosure and presentation requirements for companies that use derivative instruments as part of their risk management strategy are an important part of their financial reporting requirement. This chapter will present qualitative and quantitative disclosures as well as the required disclosures for fair value and cash flow hedges and the hedge of a net investment in foreign subsidiaries. In addition, the chapter will include detailed disclosure notes for the company’s significant accounting policies for derivative instruments and hedging activities for all entities and for industrial/commercial entities.
Accounting guidance for derivatives disclosures makes disclosures about the fair value of financial instruments optional for entities that meet all of the following criteria.1
1.The company is a non-public entity
2.The company’s total net assets (asset minus liabilities) are less than $100 million on the date of the financial statements
3.The company has no instrument that, in whole or in part, is accounted for as a freestanding derivative.
Disclosure objectives for derivative instruments and hedging activities are designed to assist financial statement users in understanding how derivatives are used as a part of the company’s risk management strategy. These objectives are to help the users of the company’s financial statements to:1
1.How and why a company uses derivative instruments
2.How derivative instruments and related hedging activities are accounted for
3.And, how derivative instruments and related hedging activities affect the company’s financial position (balance sheet), financial performance (income statement), and cash flows (statement of cash flows).
Qualitative and Quantitative Disclosures
As described in accounting guidance, an entity that holds or issues derivative instruments (or nonderivative instruments that are designated and qualify as hedging instruments pursuant to the standards) shall disclose, for every annual and interim reporting period where a balance sheet and income statement are presented, a description of the objective, context, and strategies for issuing or holding derivatives. The purpose of these disclosures is to enhance the overall transparency of an entity’s derivative transactions by helping investors and creditors understand what an entity is trying to accomplish with its derivatives.
As discussed in accounting guidance for derivative disclosures, these qualitative disclosures may be more meaningful if described in the context of an entity’s overall risk-management profile. The qualitative disclosures require an entity to: (a) distinguish between objectives and strategies for derivative instruments used for risk management purposes and those used for other purposes (at a minimum based on the instruments primary underlying risk exposure such as interest rate risk, credit risk, etc.), and (b) distinguish between the accounting designations of derivative instruments (e.g., cash flow hedging, fair value hedging, and net investment hedging relationships). For derivative instruments not designated as hedging instruments, a description of the purpose of the derivative activity is also required.
An entity that holds or issues derivative instruments (or nonderivative instruments that are designated and qualify as hedging instruments pursuant to the standards) shall disclose the following, for every annual and interim reporting period, where a balance sheet and income statement are presented:
a.The location and fair value amount of derivative instruments and nonderivative instruments that are designated and qualify as hedging instruments pursuant to recommended accounting guidance.2
1.Present fair value on a gross basis (i.e., not giving effect to netting arrangements or collateral)
2.Segregate assets from liabilities and (a) segregate derivative instruments that are qualifying and designated as hedging instruments from those that are not; within those two categories, segregate by type of contract, and (b) disclose the line item(s) on the balance sheet in which the fair value amounts are included
Disclosure Requirements for Fair Value Hedges3
b.The location and amount of gains and losses related to the following:
1.Derivative instruments qualifying and designated as hedging instruments in fair value hedges (tabular format required)
2.Related hedged items qualifying and designated in fair value hedges
c.For derivative instruments, as well as nonderivative instruments that may give rise to foreign currency transaction gains or losses under accounting guidance for foreign currency transactions, which have been designated and have qualified as fair value hedging instruments, and for the related hedged items, an entity shall disclose:
1.The net gain or loss recognized in earnings during the reporting period representing: (a) the amount of the hedges’ ineffectiveness and (b) the component of the derivative instruments’ gain or loss, if any, excluded from the assessment of hedge effectiveness.
2.The amount of net gain or loss recognized in earnings when a hedged firm commitment no longer qualifies as a fair value hedge. Disclosure requirements for cash flow hedges:
d.The location and amount of gains and losses by the type of contract related to:
1.The effective portion recognized in other comprehensive income (tabular format required)
2.The effective portion subsequently reclassified to earnings (tabular format required)
3.The ineffective portion and the amount excluded from effectiveness testing (tabular format required)
e.A description of the transactions or other events that will result in the reclassification into earnings of gains and losses that are reported in accumulated other comprehensive income.
f.The estimated net amount of the existing gains or losses at the reporting date that is expected to be reclassified into earnings within the next 12 months.
g.The maximum length of time over which the entity is hedging its exposure to the variability in future cash flows for forecasted transactions excluding those forecasted transactions related to the payment of variable interest on existing financial instruments.
h.The amount of gains and losses reclassified into earnings as a result of the discontinuance of cash flow hedges because it is probable that the original forecasted transactions will not occur by the end of the originally specified time period or within the additional period of time discussed in the standard.
Disclosure Requirements for Net Investment Hedges
Location and amount of gains and losses by type of contract are related to the following:
1.The effective portion recognized in other comprehensive income (tabular format required)
2.The effective portion subsequently reclassified to earnings (tabular format required)
3.The ineffective portion and the amount excluded from effectiveness testing (tabular format required)
The following two comprehensive disclosure examples are presented in two parts. In the first part is an example of a generic disclosure note for all companies using derivative instruments for hedging activities.4 The second qualitative disclosure note will be the required additional exposures for commercial or industrial companies.
Qualitative Disclosures for Derivatives Instruments and Hedging Activities
1. All derivatives are recognized on the balance sheet at their fair value. On the date that the Company enters into a derivative contract, it designates the derivative as: (1) a hedge of (a) the fair value of a recognized asset or liability or (b) an unrecognized firm commitment (a fair value hedge), (2) a hedge of (a) a forecasted transaction or (b) the variability of cash flows that are to be received or paid in connection with a recognized asset or liability (a cash flow hedge), (3) a foreign-currency fair value or cash flow hedge (a foreign currency hedge), (4) a hedge of a net investment in a foreign operation, or (5) an instrument that is held for trading or nonhedging purposes (a “trading” or “nonhedging” instrument).
Changes in the fair value of a derivative that is highly effective and that is designated and qualifies as a fair value hedge, along with changes in the fair value of the hedged asset or liability that are attributable to the hedged risk (including changes that reflect losses or gains on firm commitments), are recorded in current-period earnings. Changes in the fair value of a derivative that is highly effective as and that is designated and qualifies as a cash flow hedge, to the extent that the hedge is effective, are recorded in other comprehensive income, until earnings are affected by the variability of cash flows of the hedged transaction (e.g., until periodic settlements of a variable-rate asset or liability are recorded in earnings). Any hedge ineffectiveness (which represents the amount by which the changes in the fair value of the derivative exceed the variability in the cash flows of the forecasted transaction) is recorded in current-period earnings.
Changes in the fair value of a derivative that is highly effective as and that is designated and qualifies as a foreign-currency hedge is recorded in either current-period earnings or other comprehensive income, depending on whether the hedging relationship satisfies the criteria for a fair value or cash flow hedge. If, however, a derivative is used as a hedge of a net investment in a foreign operation, the changes in the derivative’s fair value, to the extent that the derivative is effective as a hedge, are recorded in the cumulative-translation-adjustment component of other comprehensive income. Changes in the fair value of derivative trading and nonhedging instruments are reported in current-period earnings.
The Company occasionally purchases a financial instrument in which a derivative instrument is “embedded.” Upon purchasing the financial instrument, the Company assesses whether the economic characteristics of the embedded derivative are clearly and closely related to the economic characteristics of the remaining component of the financial instrument (i.e., the host contract) and whether a separate, nonembedded instrument with the same terms as the embedded instrument would meet the definition of a derivative instrument. When it is determined that (1) the embedded derivative possesses economic characteristics that are not clearly and closely related to the economic characteristics of the host contract and (2) a separate, stand-alone instrument with the same terms would qualify as a derivative instrument, the embedded derivative is separated from the host contract, carried at fair value, and designated as either (1) a fair value, cash flow, or foreign-currency hedge or (2) a trading or nonhedging derivative instrument. However, if the entire contract is measured at fair value, with changes in fair value reported in current earnings, or if the Company cannot reliably identify and measure the embedded derivative for purposes of separating that derivative from its host contract, the entire contract is carried on the balance sheet at fair value and is not designated as a hedging instrument.
The Company formally documents all relationships between hedging instruments and hedged items, as well as its risk-management objective and strategy for undertaking various hedge transactions. This process includes linking all derivatives that are designated as fair value, cash flow, or foreign-currency hedges to (1) specific assets and liabilities on the balance sheet or (2) specific firm commitments or forecasted transactions. The Company also formally assesses (both at the hedge’s inception and on an ongoing basis) whether the derivatives that are used in hedging transactions have been highly effective in offsetting changes in the fair value or cash flows of hedged items and whether those derivatives may be expected to remain highly effective in future periods. When it is determined that a derivative is not (or has ceased to be) highly effective as a hedge, the Company discontinues hedge accounting prospectively, as discussed below.
The Company discontinues hedge accounting prospectively when (1) it determines that the derivative is no longer effective in offsetting changes in the fair value or cash flows of a hedged item (including hedged items such as firm commitments or forecasted transactions); (2) the derivative expires or is sold, terminated, or exercised; (3) it is no longer probable that the forecasted transaction will occur; (4) a hedged firm commitment no longer meets the definition of a firm commitment; or (5) management determines that designating the derivative as a hedging instrument is no longer appropriate or desired.
When hedge accounting is discontinued due to the Company’s determination that the derivative no longer qualifies as an effective fair value hedge, the Company will continue to carry the derivative on the balance sheet at its fair value but cease to adjust the hedged asset or liability for changes in fair value. When hedge accounting is discontinued because the hedged item no longer meets the definition of a firm commitment, the Company will continue to carry the derivative on the balance sheet at its fair value, removing from the balance sheet any asset or liability that was recorded to recognize the firm commitment and recording it as a gain or loss in current-period earnings. When the Company discontinues hedge accounting because it is no longer probable that the forecasted transaction will occur in the originally expected period, the gain or loss on the derivative remains in accumulated other comprehensive income and is reclassified into earnings when the forecasted transaction affects earnings. However, if it is probable that a forecasted transaction will not occur by the end of the originally specified time period or within an additional two-month period of time thereafter, the gains and losses that were accumulated in other comprehensive income will be recognized immediately in earnings. In all situations in which hedge accounting is discontinued and the derivative remains outstanding, the Company will carry the derivative at its fair value on the balance sheet, recognizing changes in the fair value in current-period earnings.
2. Additional footnote disclosures for commercial/industrial users of fair value, cash flow, and net investment hedges
Fair Value Hedges
The Company enters into forward-exchange contracts to hedge the foreign-currency exposure of its firm commitments to purchase certain production parts from Germany and Brazil. The forward contracts that are used in this program mature in 18 months or less, consistent with the related purchase commitments. The Company generally hedges between 60 and 80 percent of its total firm-commitment purchase contracts.
The Company uses interest rate swaps to economically convert a portion of its nonprepayable fixed-rate debt into variable-rate debt. The resulting cost of funds is lower than it would have been if variable-rate debt had been issued directly. Under the interest rate swap contracts, the Company agrees with other parties to exchange, at specified intervals, the difference between fixed-rate and floating-rate interest amounts, which is calculated based on an agreed-upon notional amount. The level of variable-rate debt (after the effects of interest rate swaps have been considered) is maintained at 35 to 50 percent of the total Company debt.
The value of the Company’s inventory of copper and aluminum raw materials changes daily, consistent with price movements in the respective commodities markets. The Company uses futures contracts to manage price risks associated with this inventory and generally hedges 70 to 75 percent of the inventory’s total value.
For the year ended December 31, 20X0, the Company recognized a net gain of $XXX, (reported as [financial-statement line item caption] in the statement of operations), which represented the ineffective portion of all of the Company’s fair value hedges. All components of each derivative’s gain or loss were included in the assessment of hedge effectiveness. The Company also recognized a net gain of $XXX (reported as [financial statement line item caption] in the statement of operations) in relation to firm commitments that no longer qualified as fair value hedge items. The amounts discussed above are also referenced in Footnote X.
Cash Flow Hedges
The Company’s direct-foreign-export sales are denominated in the customers’ local currency. The Company purchases foreign-exchange put options and forward-exchange contracts as hedges of anticipated sales denominated in foreign currencies. The Company enters into these contracts to protect itself against the risk that the eventual dollar-net-cash inflows resulting from direct-foreign-export sales will be adversely affected by changes in exchange rates. Based on the Company’s estimate of future foreign exchange rates, it hedges 50 to 75 percent of anticipated sales for the following 12 months.
The Company receives royalties from each of its European subsidiaries. The Company uses foreign-currency forward-exchange contracts and swap contracts that expire in less than 12 months to hedge against the effect that fluctuations in exchange rates may have on forecasted intercompany royalty cash flows. The Company purchases foreign-currency put options, with contract terms that normally expire within less than six months to hedge against the adverse effects that fluctuations in exchange rates may have on foreign-currency-denominated trade receivables.
The Company uses interest rate swaps to economically convert a portion of its variable-rate debt to fixed-rate debt. The resulting cost of funds is lower than it would have been had fixed-rate borrowings been issued directly. The level of fixed-rate debt, after the effects of interest rate swaps have been considered, is maintained at 50 to 65 percent of the total Company debt.
The Company enters into long-term sales contracts at spot prices with a number of its customers. As a hedge against possible price fluctuations in anticipated commodity purchases (which will be necessary to fulfill the sales contracts), the Company purchases copper and aluminum futures and options contracts. The futures and options contracts limit the unfavorable effect that potential price increases would have on metal purchases, and the futures contracts likewise limit the favorable effect of potential price declines.
For the year ended December 31, 20X0, the Company recognized a net loss of $XXX (reported as [financial-statement line item caption] in the statement of operations), which represented the total ineffectiveness of all cash flow hedges. All components of each derivative’s gain or loss were included in the assessment of hedge effectiveness. In addition, after discontinuing certain of its cash flow hedges, the Company determined that it was not probable that certain forecasted transactions would occur by the end of the originally specified time period or within an additional two-month period of time thereafter. Therefore, the Company reclassified a net gain of $XXX as [financial-statement line item caption] into the statement of operations from accumulated other comprehensive income. The amounts discussed above are also referenced in Footnote X.
As of December 31, 20X0, $XXX of deferred net gains on derivative instruments accumulated in other comprehensive income are expected to be reclassified as earnings during the next 12 months. Transactions and events that: (1) are expected to occur over the next 12 months and (2) will necessitate reclassifying the derivative gains as earnings include (a) royalties earned, (b) actual direct-foreign-export sales, (c) the repricing of variablerate debt, and (d) the sale of machinery and equipment that includes previously hedged purchases of aluminum and copper raw materials. The maximum term over which the Company is hedging exposures to the variability of cash flows (for all forecasted transactions, excluding interest payments on variable-rate debt) is 18 months. The amounts discussed above are also referenced in Footnote X.
Hedges of Net Investments in Foreign Operations
The Company has numerous investments in foreign subsidiaries. The net assets of these subsidiaries are exposed to volatility in currency exchange rates. The Company uses both derivative and nonderivative financial instruments to hedge this exposure and measures the ineffectiveness of such hedges based on the change in spot foreign exchange rates. The Company manages currency exposure related to the net assets of the Company’s Latin American subsidiaries primarily through foreign-currency-denominated debt agreements that the Company (the “parent company”) enters into. Gains and losses in the parent company’s net investments in its subsidiaries are economically offset by losses and gains in the parent company’s foreign-currency-denominated debt obligations.
The Company also enters into foreign-currency forward-exchange contracts to hedge the foreign-currency exposure of its investments in European and Asian subsidiaries. These agreements are in place for each subsidiary and have contract terms of nine months to one year.
For the year ended December 31, 20X0, $XXX of net losses related to (1) the foreign-currency-denominated debt agreements and (2) the forward exchange contracts were included in the Company’s cumulative translation adjustment. For the same period, $XXX of net losses was recorded in earnings representing the amount of the hedges’ ineffectiveness. The amounts discussed above are also referenced in Footnote X.
The presentation and disclosure requirements for derivative instruments and hedging activities are quite extensive. Companies that use derivatives to hedge their business risks must have extensive internal controls build around the documentation and the accounting for these financial instruments.
This book is designed to equip managers and executives with an understanding of the complex world of derivative instruments. The focus throughout the book is on operating managers and executives who are responsible for managing operating and financial risks that could adversely impact the company’s financial position. My goal is to make the accounting for derivatives and hedging activities understandable. In addition, the goal of the book is have an accounting toolkit when evaluating the impacts on the financial statements when engaging in this type of risk management activities.