Derivative Instruments

FASB ASC 815 has two main components. First, it requires that derivatives be recognized as either assets or liabilities in the statement of financial position and that they be measured at fair value. Second, it specifies the accounting for changes in the fair values of derivatives, that is, unrealized gains and losses.

On the first component, not-for-profit organizations would follow the requirements of FASB ASC 815, as would commercial enterprises (albeit not-for-profit organizations are far less likely to have derivative instruments to record as assets and liabilities than are commercial enterprises, particularly financial institutions).

On the second component, FASB ASC 815 provides very specific guidance for determining when derivatives are considered one of several types of hedges—the importance of which is whether changes in the fair values of derivatives are reflected in earnings of the current period or whether these changes are reported not in earnings, but as a component of comprehensive income. For not-for-profit organizations, determination of whether a derivative qualifies as a particular type of hedge is basically irrelevant, since not-for-profit organizations do not report comprehensive income. They only report changes in net assets in a statement of activities. Accordingly, except for special rules that apply to hedges of exposure to a net investment in a foreign operation, which is discussed later in this section, not-for-profit organizations would report all changes in the fair values of derivative instruments that are recorded as assets or liabilities in their statements of activities as increases or decreases in net assets.

FASB ASC 954-815 clarifies the accounting for derivatives by not-for-profit health care organizations. These organizations, which follow the accounting guidance of the AICPA Audit and Accounting Guide, Health Care Organizations, must account for derivatives differently than non–health care not-for-profit organizations. Because not-for-profit health care organizations report a “performance indicator” in accordance with the AICPA Guide, Health Care Organizations, they apply the provisions of FASB ASC 815 pertaining to cash flow hedging in the same manner as for-profit enterprises. The gain or loss items that affect a for-profit enterprise's income from continuing operations similarly should affect the not-for-profit health care organization's performance indicator. Similarly, the gain or loss items that are excluded from a for-profit enterprise's income from continuing operations (such as items reported in comprehensive income) should be excluded from the performance indicator by not-for-profit health care organizations.

FASB ASC 815 defines a derivative instrument as a financial instrument or other contract with all three of the following characteristics:

1. It has (a) one or more “underlyings,” and (b) one or more “notional amounts” or payment provisions or both. These terms determine the amount of the settlement(s) and whether a settlement is required. An underlying is a specified interest rate, security price, commodity price, foreign exchange rate, index of prices or other rates, or other variable. A notional amount is a number of currency units, shares, bushels, pounds, or other units specified in a contract.
2. It requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.
3. Its terms require or permit net settlement, it can readily be settled by a means outside the contract, or it provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.

The following contracts are not subject to the requirements of FASB ASC 815:

1. Regular-way security trades (i.e., those that provide for delivery of a security within the time generally established by regulations or conventions in the marketplace or exchange in which the transaction is being executed).
2. Normal purchases and sales in the normal course of business.
3. Certain insurance contracts, including traditional insurance contracts and traditional property and casualty contracts.
4. Certain financial guarantee contracts (such as those that provide payments to the guaranteed party for a loss incurred because a debtor fails to pay when a payment is due).
5. Certain contracts that are not traded on an exchange (such as those that have a climatic, geological, or other physical variable).
6. Derivatives that serve as impediments to sales accounting (such as a derivative instrument whose existence serves as an impediment to recognizing a related contract as a sale by one party or a purchase by a counterparty).
7. Contracts issued in connection with stock-based compensation arrangements.
8. Contracts issued or held that are both indexed to its own stock and classified in stockholders' equity in the statement of financial position.
9. Contracts issued by an entity as contingent consideration from a business combination.

(The last three exceptions do not apply to the counterparties to those contracts.)

In determining the fair value of derivative instruments, entities are required by FASB ASC 815 to use the guidance of FASB ASC 825 for determining fair value, which had previously only been used to determine the fair value of derivatives for disclosure purposes. Now those methods are used to actually record the fair values of derivative instruments on the statement of financial position.

Standards under FASB ASC 820 for measuring fair value are uniformly applied across all accounting standards that require fair value measurement, including financial instruments.

Certain revisions were made to FASB ASC 815 to address several issues that were causing implementation difficulties. While these changes are unlikely to impact many not-for-profit organizations, the reader should be aware of the following:

1. The normal purchases and sales exception, as listed above, may be applied to contracts that implicitly or explicitly permit net settlement and contracts that have a market mechanism to facilitate net settlement.
2. The specific risks that can be identified as the hedged risk are redefined so that in a hedge of interest rate risk, the risk of changes in the benchmark interest rate would be the hedged risk.
3. Recognized foreign-currency-denominated assets and liabilities for which a foreign currency transaction gain or loss is recognized in earnings under the provisions of FASB ASC 830 may be the hedged item in fair value hedges or cash flow hedges.
4. Certain intercompany derivatives may be designated as the hedging instruments in cash flow hedges of foreign currency risk in the consolidated financial statements if those intercompany derivatives are offset by unrelated third-party contracts on a net basis.

This chapter presents a basic overview of FASB ASC 815's requirements as to derivative financial instruments because they are generally not a major accounting concern for not-for-profit organizations. Readers needing detailed information regarding specific derivative accounting questions are advised to consult other sources that specifically address derivative financial instruments.

As mentioned above, not-for-profit organizations recognize the gain or loss on a hedging derivative instrument and a nonhedging derivative instrument as a change in net assets in the period of change. However, if the hedging instrument is designated as a hedge of the foreign currency exposure of a net investment in a foreign operation, then the hedge is reported in the same manner as a translation adjustment to the extent it is effective as a hedge in a manner that is consistent with FASB ASC 830. In other words, the FASB ASC 815 provisions for recognizing the gain or loss on assets designated as being hedged in a fair value hedge do not apply to the hedge of a net investment in a foreign operation.

The FASB issued Accounting Standards Update No. 2010-11 Derivatives and Hedging (Topic 815) Scope Exception Related to Embedded Credit Derivatives (FASB ASC 2010-11), which states that “All entities that enter into contracts containing an embedded credit derivative feature related to the transfer of credit risk that is not only in the form of subordination of one financial instrument to another will be affected by the amendments in this update because the amendments clarify that the embedded credit derivative scope exception in paragraphs 815-15-15-8 through 15-9 does not apply to such contract.” Although applicable to not-for-profit organizations, it would not be expected that FASB ASC 2010-11 would affect many not-for-profit organizations, and is beyond the scope of this book.

The FASB also issued ASU 2013-10 Derivatives and Hedging (Topic 815) Inclusion of the Fed Funds Effective Swap Rate (or Overnight Index Swap Rate) as a Benchmark Interest Rate for Hedge Accounting Purposes (ASU 2013-10). As mentioned above, the determination of whether a derivative is a hedge does not impact not-for-profit organizations (other than health care not-for-profit organizations as far as reporting an operating measure) and the provisions of ASU 2013-10 will not impact the types of not-for-profit organizations included in this book.

The FASB issued ASU 2018-16 Derivatives and Hedging (Topic 815) Inclusion of the Secured Overnight Financing Rate (SOFR) Overnight Index Swap (OIS) Rate as a Benchmark Interest Rate for Hedge Accounting Purposes. However, as in the preceding paragraph, since the types of not-for-profit organizations included in this book do not impacted by hedge accounting, this ASU will have no impact on then.

Disclosure Requirements—Not-for-Profit Organizations

The disclosure requirements of SFAS 133 (FASB ASC 815) relating to not-for-profit organizations that hold or issue derivative instruments would relate to those derivative instruments designated as hedges of the foreign currency exposure of a net investment in a foreign operation. The disclosures would consist of the organization's objectives for holding or issuing those instruments, the context needed to understand those objectives, and the organization's strategies for achieving those objectives. For other derivative instruments, the description should include the purpose of the derivative activity. Gains or losses included in the statement of activities relating to changes in the fair value of derivative instruments would also be disclosed, if not evident from the statement of activities.

FASB ASC 815-10-65 provides users of financial statements with an enhanced understanding of the qualitative aspects of an organization's use of derivatives and how those derivatives are reported in the financial statements. Qualitative disclosures about an entity's objectives and strategies for using derivative instruments may be more meaningful if such objectives and strategies are described in the context of an entity's overall risk exposures relating to interest rate risk, foreign currency exchange rate risk, commodity price risk, credit risk, and equity price risk. Those additional qualitative disclosures, if made, should include a discussion of those exposures even though the entity does not manage some of those exposures by using derivative instruments. An entity is encouraged, but not required, to provide such additional qualitative disclosures about those risks and how they are managed.

The specific disclosure requirements are quite extensive and include the following:

1. An entity with derivative instruments should disclose information to enable users of the financial statements to understand:
   1. How and why an entity uses derivative instruments;
   2. How derivative instruments and related hedged items are accounted for under this statement and related interpretations;
   3. How derivative instruments and related hedged items affect an entity's financial position, financial performance, and cash flows.
2. An entity that holds or issues derivative instruments should disclose the following for every annual and interim reporting period for which a statement of financial position and statement of activities are presented:
   1. Its objectives for holding or issuing those instruments, the context needed to understand those objectives, and its strategies for achieving those objectives. Information about those instruments should be disclosed in the context of each instrument's primary underlying risk exposure (for example, interest rate, credit, foreign exchange rate, or overall price). Further, those instruments should be distinguished between those used for risk management purposes and those used for other purposes. Derivative instruments used for risk management purposes include those designated as hedging instruments as well as those used as economic hedges and for other purposes related to the entity's risk exposures. For derivative instruments designated as hedging instruments, the description should distinguish between derivative instruments designated as fair value hedging instruments, derivative instruments designated as cash flow hedging instruments, and derivative instruments designated as hedging instruments of the foreign currency exposure in a net investment in a foreign operation. For derivative instruments not designated as hedging instruments, the description should indicate the purpose of the derivative activity.
   2. Information that would enable users of its financial statements to understand the volume of its derivative activity.
3. An entity that holds or issues derivative instruments should disclose for every annual and interim reporting period for which a statement of financial position and statement of activities are presented:
   1. The location and fair value amounts of derivative instruments reported in the statement of financial position.
      1. The fair value of derivative instruments should be presented on a gross basis, even when the derivative instruments are subject to master netting arrangements and qualify for net presentation in the statement of financial position. Cash collateral payables and receivables associated with the derivative instruments should not be added to or netted against the fair value amounts.
      2. Fair value amounts should be presented as separate asset and liability values segregated between derivatives that are designated and qualifying as hedging instruments and those that are not. Within each of those two broad categories (designated and qualifying hedges versus those that are not), fair value amounts should be presented separately by type of derivative contract—for example, interest rate contracts, foreign exchange contracts, equity contracts, commodity contracts, credit contracts, other contracts, and so forth.
      3. The disclosure should identify the line item(s) in the statement of financial position in which the fair value amounts for these categories of derivative instruments are included.
   2. The location and amount of the gains and losses reported in the statement of activities on derivative instruments and related hedged items. (Certain of these disclosures focus on changes in the fair values of hedging derivatives reported as other comprehensive income, which will not apply to not-for-profit organizations.) Gains and losses should be presented separately for:
      1. Derivative instruments designated and qualifying as hedging instruments in fair value hedges and related hedged items designated and qualifying in fair value hedges.
      2. The effective portion of gains and losses on derivative instruments designated and qualifying in cash flow hedges and net investment hedges that was recognized during the current period.
      3. The effective portion of gains and losses on derivative instruments designated and qualifying in cash flow hedges and net investment hedges recorded in accumulated other comprehensive income during the term of the hedging relationship and reclassified into earnings during the current period. (This will not apply to not-for-profit organizations as they do not report other comprehensive income.)
      4. The portion of gains and losses on derivative instruments designated and qualifying in cash flow hedges and net investment hedges representing (a) the amount of the hedges' ineffectiveness, and (b) the amount, if any, excluded from the assessment of hedge effectiveness.
      5. Derivative instruments not designated or qualifying as hedging instruments under this Statement.

      The above information should be presented separately by type of derivative contract, for example, interest rate contracts, foreign exchange contracts, equity contracts, commodity contracts, credit contracts, other contracts, and so forth. The disclosure should identify the line item(s) in the statement of financial performance in which the gains and losses for these categories of derivative instruments are included. The quantitative disclosures should be presented in tabular format except for the information required for hedged items in item (1).

   3. For derivative instruments that are not designated or qualifying as hedging instruments, if an entity's policy is to include those derivative instruments in its trading activities (for example, as part of its trading portfolio that includes both derivative and nonderivative or cash instruments), the entity can elect not to separately disclose gains and losses as required above provided that the entity discloses all of the following:
      1. The gains and losses on its trading activities (including both derivative and nonderivative instruments) recognized in the statement of financial performance, separately by major types of items (such as fixed income/interest rates, foreign exchange, equity, commodity, and credit);
      2. The line items in the statement of financial performance in which trading activities' gains and losses are included;
      3. A description of the nature of its trading activities and related risks, and how the entity manages those risks.
4. An entity that holds or issues derivative instruments (or nonderivative instruments that are designated and qualify as hedging instruments relating to an unrecognized firm commitment related to a foreign currency fair value hedge or a hedge of the foreign currency exposure of a net investment in a foreign operation) should disclose for every annual and interim reporting period for which a statement of financial position is presented:
   1. The existence and nature of credit-risk-related contingent features and the circumstances in which the features could be triggered in derivative instruments that are in a net liability position at the end of the reporting period.
   2. The aggregate fair value amounts of derivative instruments that contain credit-risk-related contingent features that are in a net liability position at the end of the reporting period.
   3. The aggregate fair value of assets that are already posted as collateral at the end of the reporting period, and (1) the aggregate fair value of additional assets that would be required to be posted as collateral, and/or (2) the aggregate fair value of assets needed to settle the instrument immediately, if the credit-risk-related contingent features were triggered at the end of the reporting period.
5. An entity's disclosures for every annual and interim reporting period for which a statement of financial position and a statement of activities are presented also should include the following:

   Fair value hedges

   1. For derivative instruments, as well as nonderivative instruments that may give rise to foreign currency transaction gains or losses, that have been designated and have qualified as fair value hedging instruments and for the related hedged items:
      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.

   Cash flow hedges (not used by not-for-profit organizations)

   1. For derivative instruments that have been designated and have qualified as cash flow hedging instruments and for the related hedged transactions:
      1. The net gain or loss recognized in earnings during the reporting period representing (a) the amount of the hedges' ineffectiveness, and (b) the assessment of hedge effectiveness, and a description of where the net gain or loss is reported in the statement of income or other statement of financial performance.
      2. 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, and 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 twelve months. (This disclosure would not apply to not-for-profit organizations.)
      3. 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.
      4. 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. (This disclosure also would not apply to not-for-profit organizations.)

Concentration of Credit Risk

FASB ASC 825 includes disclosure requirements regarding concentration of credit risk. Disclosure of information about significant concentrations of credit risk for all financial instruments is also required. Both individual and group concentrations of credit risk are to be disclosed. The following should be disclosed about each significant concentration:

1. Information about the (shared) activity, region, or economic characteristic that identifies the concentration;
2. The amount of accounting loss the entity would incur if any party to the financial instrument failed to completely perform and if any collateral proved worthless;
3. The entity's policy for requiring collateral on financial instruments subject to credit risks, information about access to the collateral, and the nature and a brief description of collateral supporting financial instruments;
4. The entity's policy of entering into master netting agreements to mitigate the credit risk of financial instruments, information about the arrangements for which the entity is a party, and a brief description of the terms of those arrangements, including the extent to which they would reduce the entity's maximum amount of loss due to credit risk.

Fair Value Disclosures

Entities are required to disclose the fair value of all (recognized and unrecognized) financial instruments that it is practicable to estimate, including liabilities. Pertinent descriptive information as to the fair value of the instrument is to be disclosed if an estimate of fair value cannot be made without incurring excessive costs as well as the reason it is not practical to estimate fair value.

Fair value information should be presented along with the related carrying value so that it is clear whether the values represent assets or liabilities and how the carrying amounts relate to what is reported in the statement of financial position. If disclosed in more than one note, a summary table containing the above data is required in one of these notes, with a cross-reference to the location of the other FASB ASC 825 notes. “Traded” financial instruments are to be distinguished from those that are categorized as “other than traded.” In disclosing fair value of a financial instrument, that fair value should not be aggregated, netted, or combined with either the fair value of a nonderivative financial instrument or other financial instruments except to the extent that offsetting carrying amounts in the statement of financial position is permitted under general principles.

FASB ASC 825-10-50 contains examples of procedures for estimating fair value.

If the carrying amount for trade receivables and payables approximates fair value, no disclosure is required.

If an estimate of fair value cannot be made without incurring excessive costs, disclose the following:

1. Information pertinent to estimating fair value such as carrying amount, effective interest rate, and maturity;
2. Reasons why estimating fair values is not practicable.

FASB ASC 825 does not change any other requirements of GAAP in regard to financial instruments. It applies to all entities and to all financial instruments except those listed in paragraph 8. In paragraph 8, the statement excludes certain types of financial instruments including pensions, postretirement benefits, deferred compensation, defeased debt, insurance contracts, lease contracts, warranty obligations, and others. Despite possible variations in definitions, amounts computed under GAAP requirements satisfy the requirements of FASB ASC 825.

Disclosures are required for each year included for comparative purposes and may be in the body of the financial statements or in the notes. Methods and significant assumptions used should be disclosed.

The FASB issued ASU 2013-03 Financial Instruments (Topic 825) Clarifying the Scope and Applicability of a Particular Disclosure to Nonpublic Entities (ASU 2013-03) to clarify that the requirement to disclose the level of the fair value hierarchy within which the fair value measurements are categorized in their entirety (Level 1, 2, or 3) does not apply to nonpublic entities for items that are not measured at fair value in the statement of financial position but for which fair value is disclosed. The fair value disclosure requirements of FASB ASC 825 only apply to entities with total assets of $100 million or more. If these disclosure requirements apply for amounts not recorded in the financial statements at fair value, categorization into the fair value hierarchy is not required.

ASU 2013-03 was effective upon issuance (February 2013).

Fair Value Measurement Option

FASB ASC 825-10 provides reporting entities, including not-for-profit organizations, with the option to report many financial assets and liabilities at their fair value. Note that what is provided is an option to expand the use of fair value reporting to certain financial assets and liabilities—there is no requirement to do so. The FASB expects to expand the use of fair value measurement, which is consistent with its long-term measurement objectives for accounting for financial instruments.

Fair value option. FASB ASC 825-10 permits organizations to choose, at specified election dates, to measure eligible items at fair value (the “fair value option”). The decision about whether to elect the fair value option:

• Is applied instrument by instrument, except as discussed in FASB ASC 825-10-25;
• Is irrevocable (unless a new election date occurs);
• Is applied only to an entire instrument and not to only specified risks, specific cash flows, or portions of that instrument.

Organizations may elect the fair value option for the following items (which are referred to throughout the statement as eligible items):

• A recognized financial asset and financial liability, except any specifically excluded, as described later.
• A firm commitment that would otherwise not be recognized at inception and that involves only financial instruments.
• A written loan commitment.
• The rights and obligations under an insurance contract that is not a financial instrument (because it requires or permits the insurer to provide goods or services rather than a cash settlement) but whose terms permit the insurer to settle by paying a third party to provide those goods or services.
• The rights and obligations under a warranty that is not a financial instrument (because it requires or permits the warrantor to provide goods or services rather than a cash settlement) but whose terms permit the warrantor to settle by paying a third party to provide those goods or services.
• A host financial instrument resulting from the separation of an embedded nonfinancial derivative instrument from a nonfinancial hybrid instrument, subject to the exclusions referred to above.

The following definitions of financial assets and financial liabilities should be used:

• Financial asset—Cash, evidence of an ownership interest in an entity, or a contract that conveys to one entity a right (1) to receive cash or another financial instrument from a second entity, or (2) to exchange other financial instruments on potentially favorable terms with the second entity.
• Financial liability—A contract that imposes on one entity an obligation (1) to deliver cash or another financial instrument to a second entity, or (2) to exchange other financial instruments on potentially unfavorable terms with the second entity.

As mentioned above, certain financial assets and financial liabilities are not subject to the fair value option. The items specifically cited in FASB ASC 825-10 are the following:

• An investment in a subsidiary that the entity is required to consolidate.
• An interest in a variable interest entity that the entity is required to consolidate.
• Employers' and plans' obligations (or assets representing net overfunded positions) for pension benefits, other postretirement benefits (including health care and life insurance benefits), postemployment benefits, employee stock option and stock purchase plans, and other forms of deferred compensation arrangements.
• Financial assets and financial liabilities recognized under leases (This exception does not apply to a guarantee of a third-party lease obligation or a contingent obligation arising from a canceled lease.)
• Deposit liabilities, withdrawable on demand, of banks, savings and loan associations, credit unions, and other similar depository institutions.
• Financial instruments that are, in whole or in part, classified by the issuer as a component of shareholders' equity (including “temporary equity”).

Election dates. FASB ASC 825-10 provides that an organization may decide whether to elect the fair value option for each eligible item on its election date. Alternatively, an organization may elect the fair value option according to a preexisting policy for specified types of eligible items. An organization may choose to elect the fair value option for an eligible item only on the date that one of the following occurs:

• The entity first recognizes the eligible item.
• The entity enters into an eligible firm commitment.
• Financial assets that have been reported at fair value with unrealized gains and losses included in earnings because of specialized accounting principles cease to qualify for that specialized accounting.
• The accounting treatment for an investment in another entity changes because:
  • The investment becomes subject to the equity method of accounting.
  • The investor ceases to consolidate a subsidiary or variable interest entity but retains an interest (for example, because the investor no longer holds a majority voting interest but continues to hold some common stock).
• An event that requires an eligible item to be measured at fair value at the time of the event but does not require fair value measurement at each reporting date after that, excluding the recognition of impairment under lower-of-cost-or-market accounting or other-than-temporary impairment.

Reporting changes in fair value. All unrealized gains and losses on items for which the fair value option has been elected should be reported by not-for-profit organizations in the statement of activities. These unrealized gains and losses may be reported within or outside of other intermediate measures of operations unless they are part of discontinued operations. Health care organizations subject to the AICPA Audit and Accounting Guide, Health Care Organizations, should report unrealized gains and losses on items for which the fair value option has been elected within the performance indicator (or as part of discontinued operations, if applicable).

In considering whether to exercise the option to report an eligible financial asset or liability at fair value, not-for-profit organizations should carefully consider the implications of the preceding paragraph. Essentially, changes in the fair value of elected financial assets and financial liabilities are reported in the statement of activities. Not-for-profit organizations are sometimes sensitive to having items affect their statement of activities over which they have no control—such as changes in fair value. Experience tells us that the fair value option is not very widely used by not-for-profit organizations.

The authors expect that the assets and liabilities for which the fair value option will most likely be elected are pledges and loans receivable and payable. The practical effect of the election for pledges will be to “unfreeze” the interest rate used to discount long-term pledges. Rather than continue to use the interest rate in effect at inception of the pledge, the current rate will be used to recalculate the discount each period.