FSP FAS 157-3 – Determining the Fair Value of a Financial Asset when the Market for that Asset is Not Active

This FSP was issued in October, 2008 and was effective upon issuance.  Revisions resulting from a change in the valuation technique or its application shall be accounted for as a change in accounting estimate, but the disclosure requirements of FAS 154 are not required.

FSP FAS 157-3 was issued to clarify the application of FAS 157 in a market that is not active and provides an example to illustrate key considerations.  This FSP follows the guidance that given in the letter issued by the SEC and the FASB in September 2008.

There are three key principles of FAS 157 that this FSP emphasizes:

1.  A fair value measurement represents the price that would be received by the holder of the financial asset in an orderly transaction that is not a forced liquidation or distressed sale.  Generally a market price is considered the best estimate of the fair value and an indicator that the sale is not a forced liquidation.  When a market is in turmoil, it is not appropriate to conclude that all market activity represents forced liquidations, nor is it appropriate to assume that a market price is the fair value of the asset. An entity must use judgment to determine if the market price is representative of fair value, especially when the market is in turmoil.

2.  The use of a reporting entity’s own assumptions about future cash flows and appropriately risk-adjusted discount rates is acceptable when relevant observable inputs are not available (such as when a market is in turmoil).  Occasionally observable inputs must be adjusted to be relevant to an entity’s particular asset.  This would cause the input to be lowered to a Level 3 input, but it may be a better indicator of the actual fair value and an appropriate disclosure would be used to explain this to investors.

3.  Broker (or pricing services) quotes may be an acceptable input for fair value, but if the market is not active, the entity would need to determine how the quote was determined.  If the broker is using an internal model to calculate the quote instead of information from actual market transactions, then the entity should place less reliance on the broker quote.

The purpose of FAS 157 was to provide information to investors about how an entity determines the fair value of its assets.  Considering the crash of the credit market and the current financial situation, I would suggest very robust disclosures around the fair value of financial instruments, especially derivative instruments, in your 2008 10Ks.

FSP FAS 140-4 and FIN 46(R)-8, Disclosures by Public Entities (Enterprises) about Transfers of Financial Assets and Interests in Variable Interest Entities.

This FSP was issued December 11, 2008 and is effective for the first reporting period (interim or annual) ending after December 15, 2008 with earlier application encouraged.  It is to be adopted prospectively, but disclosures for past periods is encouraged (but not required).

 This FSP was issued to provide additional disclosures about transfers of financial assets and to provide additional disclosures about their involvement with variable interest entities (VIE).

 FIN 46(R) is amended to require disclosures by a public enterprise that is a sponsor that has a variable interest in a VIE, a non-transferor sponsor of a qualifying SPE (QSPE) and a non-transferor servicer of a QSPE that holds a significant variable interest in the QSPE. 

 The new disclosure requirements are included in Appendices B through D and are rather lengthy.  This blog will include Appendix B disclosures and C and D will be in a later blog.

 Appendix B – Disclosure Requirements of Statement 140 for Public Entities

 The objectives of these disclosures are to provide financial statement users with an understanding of the following:

 1.  A transferor’s continuing involvement with financial assets that it has transferred in a securization or asset-backed financing arrangement.

2.  The nature of any restrictions on assets that relate to a transferred financial asset, including the carrying amounts of such assets.

3.  How servicing assets and liabilities are reported under FAS 140.

4.  For securization or asset-backed financing arrangements accounted for as sales, (a) when a transferor has continuing involvement with the transferred financial assets and (b) transfers of financial assets accounted for as secured borrowings, how the transfer of financial assets affects an entity’s financial position, financial performance, and cash flows.

 In determining whether to aggregate the disclosures for multiple transfers, the reporting entity should consider:  a)  the nature of the transferor’s continuing involvement, b) the types of financial assets transferred, c) risks related to the transferred financial assets to which the transferor continues to be exposed after the transfer and the change in the transferor’s risk profile as a result of the transferor, d) the requirements of FSP SOP 94-6-1.

 Disclosure requirements for collateral:

 1.  The entities policy for requiring collateral or other security, if the entity has entered into repurchase agreements or securities lending transactions.

 2.  If the entity has pledged any of its assets as collateral, the carrying amount and classification of those assets and associated liabilities (as of the date of the latest statement of financial position presented), including qualitative information about the relationship(s) between those assets and associated liabilities.

 3.  If the entity has accepted collateral that it is permitted to sell or repledge, the fair value (as of the date of each statement of financial position presented) of that collateral and of the portion of that collateral that it has sold or repledged, and information about sources and uses of that collateral.

 Disclosure requirements for in-substance defeasance of debt:

 1.  A general description of the transaction and the amount of debt that is considered extinguished at the end of each period that the debt remains outstanding for debt that was considered to be extinguished by in-substance defeasance under the provisions of FAS 76.

 Disclosure requirements for all servicing assets and liabilities:

 1.  Management’s basis for determining its classes of servicing assets and liabilities

 2. A description of the risks inherent in servicing assets and liabilities and, if applicable, the instruments used to mitigate the income statement effect of changes in fair value of the servicing assets and liabilities.

 3.  The amount of contractually specified servicing fees, late fees, and ancillary fees earned for each period for which results of operations are presented, including a description of where each amount is reported in the statement of income.

 4.  Quantitative and qualitative information about the assumptions used to estimate the fair value.

 Disclosure requirements for servicing assets and liabilities subsequently measured at fair value:

 1. For each class of servicing assets and liabilities, the activity in the balance of servicing assets and liabilities including, but not limited to, the following:  a.) the beginning and ending balances; b.) additions and disposals; c.) changes in fair value during the period resulting from changes in valuation inputs or assumptions used in the valuation model and/or other changes in fair value and a description of those changes; and d.) other changes that affect the balance and a description of those changes.

Disclosure requirements for servicing assets and liabilities subsequently amortized in proportion to and over the period of estimated net servicing income or loss and assessed for impairment or increased obligation:

 1. For each class of servicing assets and liabilities, the activity in the balance of servicing assets and liabilities including, but not limited to, the following: a.) the beginning and ending balances; b.) additions and disposals; c.) amortization; d.) application of valuation allowances to adjust carrying value of servicing assets; e.) other than temporary impairments; and f.) other changes that affect the balance and a description of those changes.

 2.  For each class of servicing assets and liabilities, the fair value of recognized servicing assets and liabilities at the beginning and end of the period.

 3.  The risk characteristics of the underlying financial assets used to stratify recognized servicing assets for purposes of measuring impairment in accordance with paragraph 63 of FAS 140.

 4.  The activity by class in any valuation allowance for impairment of recognized servicing assets, including beginning and ending balances, aggregate additions charged and recoveries credited to operations, and aggregate write-downs charged against the allowance, for each period for which results of operations are presented.

 Disclosure requirements for securization or asset-backed financing arrangements accounted for as sales when the transferor has continuing involvement:

 1.  For each income statement presented:

a.  its accounting policies for initially measuring the interests that continue to be held by the transferor, if any, and servicing assets and liabilities,

b.  the characteristics of the transfer, including a description of the transferor’s continuing involvement with the transferred financial assets and the gain or loss from sale of transferred financial assets,

c.  cash flows between a transferee and the transferor, including proceeds from new transfers, proceeds from collections reinvested in revolving-period transfers, purchases or previously transferred financial assets, servicing fees, and cash flows received on the interests that continue to be held by the transferor.

 2.  For each statement of financial position presented:

a.  qualitative and quantitative information about the transferor’s continuing involvement with transferred financial assets including:

            1.  the nature, purpose, size and activities of SPEs utilized to facilitate a transfer of financial assets, including how the SPEs are financed.

            2.  the total principal amount outstanding, the amount that has been derecognized, and the amount that continues to be recognized in the statement of financial position.

            3.  the terms of any arrangements that could require the transferor to provide financial support to the transferee or its beneficial interest holders, including a description of any events or circumstances that could expose the transferor to loss. 

            4.  whether the transferor has provided financial or other support during the periods presented that it was not previously contractually required to provide to the transferee or its beneficial interest holders, including if the transferor assisted the transferee or its beneficial interest holders in obtaining support with the type and amount of support and the primary reasons for providing the support.

            5.  information about any liquidity arrangements, guarantees and/or other commitments by third parties related to the transferred financial assets that may affect the fair value or risk of interest that continues to be held by the transferor is encouraged.

 b.  its accounting policies for subsequently measuring assets or liabilities that relate to the continuing involvement with the transferred financial assets, and the key inputs and assumptions used in measuring the fair value of assets or liabilities that relate to the transferor’s continuing involvement,

c.  if it is not practicable to estimate the fair value of certain assets obtained or liabilities incurred in transfers of financial assets during the period, a description of those items and the reasons why it is not practicable to estimate the fair value.

d.  a stress analysis or stress test showing the hypothetical effect on the fair value of those interests, including any servicing assets or liabilities,

e.  information about the asset quality of transferred financial assets and any other financial assets that it manages together with them.

 Disclosure requirements for transfers of financial assets accounted for as secured borrowings:

 1.  the carrying amount and classification of assets and associated liabilities recognized in the transferor’s statement of financial position at the end of each period presented, including qualitative information about the relationship(s) between those assets and associated liabilities.

This is a lot of information to put into your footnotes.  With the high interest in credit markets over the last several months, I wouldn’t skimp on these disclosures.  Follow the spirit of the law, not the letter.

EITF 08-4, Transition Guidance for Conforming Changes to EITF Issues No. 98-5, “Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios”.

EITF 08-4 was ratified by the Board in June of 2008 and was issued to provide transition guidance for conforming changes made to EITF 98-5 that resulted from EITF 00-27 and FAS 150.  These changes are effective for financial statements issued for fiscal years ending after December 15, 2008 and earlier application is permitted.  The effect of these changes is to be applied retrospectively with the cumulative effect of the change being reported in retained earnings.  If a company must make a change in its accounting to implement these changes, then the disclosure requirements in FAS 154 should be followed.

 The major changes are as follows:

 1.  Footnote 1 is changed to further define the commitment date as being the date when an agreement has been reached with an unrelated party, binding on both parties and usually legally enforceable, with the following characteristics: 

 a. The agreement specifies all significant terms,

b. The agreement includes a disincentive for nonperformance that is sufficiently large to make performance probable,

c. The Task Force observed that if an agreement includes subjective provisions that permit either party to rescind its commitment to consummate the transaction, a commitment date should not occur until the provisions expire or the convertible instrument is issued, whichever is earlier.

 2.  If the convertible instrument has a stated redemption date, a discount is to be amortized from the date of issuance to the stated redemption date of the convertible instrument.  If there isn’t any stated redemption date, the discount is to be amortized from the date of issuance to the earliest conversion date.

 3.  If the instrument is converted before the discount is fully amortized, at the date of conversion, the remaining discount should be immediately recognized as interest expense or as a dividend as appropriate.  Any expense should not be classified as extraordinary.

 There are updates to the examples in EITF 98-5, that you should take a look at for further guidance.

 There have been several documents from the FASB and the SEC pertaining to fair value and credit derivatives over the past year.  This will be something that your auditors will be taking a close look at as we go through the 10K audit season.

Proposed FSP on Discontinued Operations

A proposed staff position would require an entity to report fewer activities as discontinued operations.  If adopted the FSP would be effective for fiscal years beginning after December 15, 2009 and would be applied retrospectively.  A final FSP is expected in 2009.

The proposed staff position would define a discontinued operation as an operating segment as defined in FAS 131 that has been disposed of or is classified as held for sale or a business as defined in FAS 141(R) that meets the criteria to be classified as held for sale on acquisition.

A reporting unit, a subsidiary, or an asset group that is not an operating segment would no longer be classified as a discontinued operation unless it qualifies as a business held for sale on acquisition.

The following disclosures would also be required:

1.  A description of the facts and circumstances leading to the expected disposal and the expected manner and timing of the disposal.

2. The gain or loss recognized.

3. The carrying amount of major classes of assets and liabilities.

4. The profit or loss, major income and expense items constituting that profit or loss, and whether the profit or loss is presented in continuing or discontinued operations.

5. Major classes of cash flows.

6. A reconciliation of amounts disclosed in the notes with amounts presented separately on the face of the financial statements as held for sale and as discontinued operations.

7. The segment in which the component is reported under Statement 131.

This FSP would cause a lot of changes and since it is applied retrospectively, it could also involve a lot of work to restate previous years.  Stay tuned to see if this one gets approved.

FSP FAS 133-1 and FIN 45-4 “Disclosures about Credit Derivatives and Certain Guarantees: An Amendment of FASB Statement No. 133 and FASB Interpretations No. 45; and Clarification of the effective date of FASB Statement No. 161”

This new FSP is effective for financial periods ending after November 15, 2008.  This would be for the 2008 10K for calendar year companies.

The FSP clarifies that FAS 161 is effective for any reporting period, annual or interim, beginning after November 15, 2008.  There was some controversy over whether FAS 161 was to be applied in the interim periods. 

This FSP applies to credit derivatives within the scope of FAS 133, hybrid instruments with embedded credit derivatives and guarantees within the scope of FIN 45.  Examples would be credit default swaps, credit spread options, and credit index products.

The disclosures on the credit derivatives would apply to the seller of the contract (the party that assumes the credit risk, the guarantor or the party that provides the credit protection). 

The disclosures would include:

 The nature of the credit derivatives including the approximate term of the credit derivative, the reasons for entering into the credit derivative, the circumstances that would require the seller to perform under the credit derivative, and the current status of the payment/performance risk based on either external or internal ratings.

The maximum potential amount of future payments the seller could be required to make under the credit derivative.  This amount is not to be netted against any collateral.

The fair value of the credit derivative as of the date of the balance sheet.

The nature of any recourse provisions that would enable the seller to recover from third parties and any assets either held as collateral that the seller can obtain and liquidate to recover all or a portion of the amounts paid under the credit derivative.  This disclosure would include any purchased credit protection with identical underlying(s).

For any embedded credit derivatives, the seller of the embedded credit derivative shall disclose the required information for the entire hybrid instrument, not just the embedded credit derivatives.

FIN 45 is amended to include disclosure of the current status of the payment/performance risk of the guarantee.  This would require the same disclosures for credit derivatives and guarantees.

Recent Happenings

I know it has been a long time since the last update, but here are the highlights.

FASB ratified three EITF consensuses at its November 24^th meeting.     

EITF 08-6 – “Equity Method Investment Accounting Considerations

EITF 08-7 – “Accounting for Defensive Intangible Assets

EITF 08-8 – “Accounting for an Instrument (or Embedded Feature) with a Settlement Amount That is Based on the Stock of an Entity’s Consolidated Subsidiary”

All three of these EITFs are effective for reporting periods beginning after December 15, 2008 and have to do with FAS 141(R) “Business Combinations” and FAS 160 “Minority Issues”.  I will write up a summary of each of these soon.

FIN 48 for Nonpublic Companies

The FASB has decided that nonpublic entities with pass through status at the parent company level will have to follow the guidance in FIN 48 “Income Tax Uncertainties” beginning in fiscal years beginning after December 15, 2008.  All other nonpublic companies will have to apply the provisions of FIN 48 as of fiscal years beginning after December 15, 2207 or this year.  However, nonpublic entities will be allowed to provide fewer disclosures.  They will not be required to disclose a tabular reconciliation of unrecognized tax benefits and the effect those unrecognized tax benefits would have on the effect tax rate if they were recognized.  The FASB will provide more guidance on how pass through entities would apply FIN 48 in situations where tax positions are created by subsidiaries or related to nonfederal jurisdictions. 

Financial Statement Presentation

The FASB and the IASB have issued a discussion paper on financial statement presentation.  The new format would look more like the cash flow statement and be separated into a business section (that would include operating and investing sections,  a financing section, income taxes, discontinued operations and equity.  All the statements would relate to each other as the assets and liabilities in the operating section would correspond to the cash flows and income from the operating sections of those statements.  There would also be a reconciliation between the cash flow statement and the statement of comprehensive income.  The information would also be further disaggregated by function, nature or both (in which case nature would be reported as a subset of function).  The function of an item would be the primary activities in which an entity is engaged (selling goods, advertising, business development)  The nature of an item is the characteristics that distinguish financial statement items that are not equally affected by similar economic events  (separating revenue into wholesale and retail).  For the cash flow statement, the indirect method would no longer be allowed.  A final statement is expected in 2011.

Subsequent Events and Going Concern

The FASB issued two exposure drafts that incorporate the AICPA guidelines into the FASB codification.  The new exposure drafts on subsequent events and going concerns basically are the same as the AICPA version.  I will do a summary on these soon also.

I hope this catches you up for year end.  I will have more soon.

Fair Value – My Opinion

With all the talk about fair value accounting during the current credit crisis, I feel the need to make some clarifications about FAS 157 and fair value accounting.

Bob Hertz, the Chairman of the FASB, gave an excellent speech last week. You can read it at the following link: http://www.fasb.org/news/09-18-08/herz_speech.pdf  

Also, the SEC has provided some additional guidance at: http://www.sec.gov/news/press/2008/2008-234.htm

A fair value measurement is meant to be what an asset/liability would sell for between willing and knowledgeable market participants. Fire sale prices are not indicative of fair value nor does the fact that you had to sell some assets at fire sale prices mean that all your other assets need to be marked down. In the financial markets, an active market for mortgage securities has disappeared. There are no willing participants and nobody has any knowledge about what these instruments are worth. Therefore, market prices should not be used to fair value these securities because they are not indicative of the securities real value.

When a active market does not exist, other valuation techniques should be used.

Paragraph 19 of FAS 157 states: “Valuation techniques that are appropriate in the circumstances and for which sufficient data are available shall be used to measure fair value. In some cases, a single valuation technique will be appropriate (for example, when valuing an asset or liability using quoted prices in an active market for identical assets or liabilities). In other cases, multiple valuation techniques will be appropriate (for example, as might be the case when valuing a reporting unit). If multiple valuation techniques are used to measure fair value, the results (respective indications of fair value) shall be evaluated and weighted, as appropriate, considering the reasonableness of the range indicated by those results. A fair value measurement is the point within that range that is most representative of fair value in the circumstances.”

As stated in the SEC guidance, in the absence of an active market for the mortgage securites, a discounted cash flow method may be a more appropriate measure of fair value.

There isn’t anything wrong with fair value accounting. It did its job in disclosing to investors that certain investments were a lot riskier than orginally thought. Proper application of the FAS 157 rules is necessary to fairly value the mortgage backed securites and to put some realism back in the market.

Just my opinion. Please leave your opinion and maybe together we can figure this mess out.

Proposed Amendment to FAS 128 – Earnings per Share

This proposed Statement is being issued as part of a joint project with the IASB to eliminate differences between FAS 128 – Earnings per Share and IAS 33 – Earnings per Share.  If adopted the denominator for the earnings per share (EPS) calculation would be the same under both US GAAP and IFRS.  The numerator would still be different as the components of net income are different under US GAAP and IFRS.

 This project was started in 2002 and previous exposure drafts were issued in 2003 and 2005.  A final statement is expected in the second half of 2009.  If adopted this standard would be applied retrospectively.

1.  Basic Earnings per Share

 Instruments included in basic EPS

 Paragraph 9(a) has been added to FAS 128 and paragraph 10 has been re-written.  These paragraphs have been amended to include “instruments for which the holder has (or is deemed to have) the present right as of the end of period to share in current-period earnings with common shareholders.  Examples of those instruments include the following:

 1. An instrument that is currently exercisable for little or no cost to the holder

2. Shares that are currently issuable for little or no cost to the holder

3. A participating security that is not measured at fair value each period with changes in fair value recognized in current-period earnings

4. A class of common stock with different dividend rates from those of another class of common stock but without prior or senior rights.”

 The phrase “exercisable or issuable for little or no cost” refers to the amount required to be paid by the holder, whether in cash, assets or services rendered.  The amount required to be paid (exercise price) should be compared to the end-of-period market price to determine if the instrument is “exercisable or issuable for little or no cost”.  For example an option with a $1 exercise price while the end-of-period market price is $100 would be considered exercisable for little or not cost.  For share-based awards all service has to be rendered before the instrument would be considered issuable for little or no cost. 

 FSP EITF 03-6-1 (see previous blog) clarified that a share-based compensation award that has non-forfeitable dividends is considered a participating security and should be included in the calculation of basic EPS using the two-class method. 

 Two-class method

 Paragraph 60(a) is added to require participating securities to be added to basic EPS using the two-class method.  The participating security must be either not measured at fair value with changes in fair value being recognized in earnings or a share-based award that is recognized as equity.  The two-class method is to be used regardless whether the participating security can be converted in a class of common stock or not; the if-converted method is no longer allowed.

 2.  Diluted Earnings per Share

 Instrument measured at fair value

 Paragraph 11(a) has been added to clarify that an instrument that is measured at fair value with the changes in fair value being recognized in current earnings should not be included in the calculation for diluted EPS.  These instruments should not be included in the diluted EPS calculation because their effect on shareholders is already recognized in the numerator through net income.

 Treasury stock method

 Paragraph 17 has been amended to change the treasury stock method.  Under the proposed amendment, options and warrants will be assumed to be outstanding at the beginning of the period and exercised at the end of the period instead of being outstanding and exercised at the beginning of the period. 

 To determine the proceeds from the assumed exercise and to evaluate if the instruments are dilutive, the end-of-period market price is to be used instead of the average-market-price during the period.

 Paragraph 46 has been amended to change calculation of the number of incremental shares to be included in diluted EPS.  The number of incremental shares will be calculated using the end-of-period market price for both the quarter and year-to-date calculation.  Under current guidance, the average-market-price is used for the quarter-to-date calculation and a weighted average of the quarterly calculations is used for the year-to-date calculation. 

 If an instrument classified as a liability is settled in common shares, the end-of-period carrying value of the liability is included in diluted EPS as assumed proceeds.  Settling a liability with shares has the same effect on an entity’s net assets as issuing shares for cash, therefore, the incremental shares from settling the liability are included in diluted EPS.

 Two-class method

 Paragraphs 61(a) – 61(e) have been added to clarify the use of the two-class method for diluted EPS.  Current guidance requires all potential commons shares assumed to be issued to be included in the computation of diluted EPS. 

 Under the two-class method, an entity allocates undistributed earnings (what is left after dividends are declared) to all potential common share or participating securities that are assumed to be outstanding.  The numerator is adjusted for the undistributed earnings associated with the potential common shares or participating securities that are assumed to be outstanding, but the numerator is not adjusted for any dividends that would have been issued to those shares or participating securities.

 Paragraph 61(c) states in part “1) For a participating security that is not measured at fair value each period with changes in fair value recognized in earnings that also is a potential common share, 2) for a second class of common stock that also is a potential common share, or 3) for a participating share-based-payment award that is recognized as equity, diluted EPS shall reflect the more dilutive effect of applying either:

 a. The two-class method assuming that the participating security or second class of common stock is not exercised or converted; or

b. The treasury stock method, reverse treasury stock method, if-converted method, or contingently issuable share method for the participating security or second class of common stock.”

 The Appendix updates the examples in FAS 128 to incorporate the new rules.  Since this is the third exposure draft, we will just have to wait and see if this one actually gets adopted.  Stay tuned!

Proposed Statement: Accounting for Hedging Activities, an amendment of FASB 133

   Scope

 The proposed Statement would amend FAS 133 to a) simplify accounting for hedging activities, b) make the accounting model and disclosures more useful and easier to understand, c) resolve practice issues related to current hedging rules, and d) address differences between recognition and measurement of the derivative instrument and the hedged item.

 The scope of the proposed Statement is the same as FAS 133 and it does not change the types of items or transactions that are eligible for hedge accounting.

 Hedge Effectiveness Requirements

 At the beginning of the hedging relationship, an entity should document that the hedging relationship is reasonably effective by performing a qualitative assessment that demonstrates “1) an economic relationship exists between the hedging instrument and the hedged item or hedged forecasted transaction and 2) changes in the fair value of the hedging instrument would be reasonably effective in offsetting changes in the hedged item’s fair value or the variability in the hedged cash flows.”  A quantitative assessment may be necessary under certain situations.  (Examples are given in the appendix to the proposed Standard.)  This assessment will need to be re-evaluated if circumstances suggest that the hedging relationship may no longer be reasonably effective.  This is different from current practice that requires a quantitative assessment that the relationship is highly effective and requires the assessment to be re-evaluated each reporting period.

 The documentation of the qualitative assessment should include “the risk management objective expected to be achieved by the hedging relationship and how the hedging instrument is expected to manage the risk or risks inherent in the hedged item or forecasted transaction”.  Also the basis for expecting that the hedging instrument would be reasonably effective in offsetting changes in the hedged item’s fair value and the sources of volatility for the hedged risk should be documented.  The counter-parties’ credit risk should be taken under consideration.  These documentation requirements are basically the same under FAS 133.

If the risk being hedged is the variability in cash flows related to a group of forecasted transactions within a specific time period, an entity may assess effectiveness using a method that would include a derivative that settles within a reasonable period of time related to the forecasted transaction.  This is different than current practice, which requires the timing of the hedged instrument and hedged item to match exactly.

De-designation of Hedging Relationship

 A hedging relationship can not be de-designated unless the criterion in paragraphs 20 and 21 (for fair value hedges) and paragraphs 28 and 29 (for cash flow hedges) is no longer met or the hedging instrument expires, is sold, terminated or exercised.  Entering into an offsetting derivative instrument would effectively terminate a hedging relationship if the appropriate and concurrent documentation is prepared.  These hedging instruments can not be designated as part of a hedging relationship in a future transaction.  This is different from current practice where the entity can de-designate and re-designate hedging relationships at any time.

 If a cash flow hedge is terminated by entering into an offsetting transaction, any gains or losses in Other Comprehensive Income (OCI) would remain in OCI until the original forecasted transaction affects earnings or is no longer probable of occurring.

 Hedged Risk – Fair Value Hedge

The designated risk in a fair value hedge must be the risk of changes in the overall fair value of the hedged item or changes in the fair value attributable to only foreign currency exchange rates.  This differs from current practice, in that an entity could choose which risks were being hedged.  (For example, interest rate risk, price risk, or credit risk.) 

An exception is the designation of an entity’s own debt (at the inception of the debt) as the hedged item.  In this case, the interest rate risk or the foreign exchange rate risk or a combination of both can be designated as the hedged risk. 

 If the hedged item is a held-to-maturity debt instrument then only the foreign exchange risk may be designated as the hedged risk.

 When measuring fair value, the measurement of the hedged item is to be independent of the measurement of the hedging instrument.

 Hedged Risk – Cash Flow Hedge

 The designated risk in a cash flow hedge must be the risk of overall changes in the hedged cash flows or the risk of changes in functional-currency-equivalent cash flows attributable to foreign currency exchange rates.  As above, this is different than current practice where the individual risks could be designated as the hedged risk.

 Hedge ineffectiveness is to be measured as the difference between the change in fair value of the hedging instrument and the present value of the cumulative change in expected future cash flows on the hedged forecasted transaction.  The amount of the gain or loss recognized in Accumulated Other Comprehensive Income (AOCI) is to equal the present value of the cumulative change in expected future cash flows less any amount previously reclassified to earnings.  The credit risk used to estimate the fair value of the hedging instrument can be used in the estimation of the fair value of the forecasted transaction.  The measurement of hedge ineffectiveness under the proposed Statement differs from current practice in that the change in the cumulative fair value of the hedging instrument is compared to the change of the cumulative fair value of the hedged item.

 Disclosures

 For annual and interim reporting periods a disclosure for assets and liabilities reported within a single line item in the balance sheet that includes fair value adjustments, the following items should be disclosed: 

• 1. The carrying amount of the assets or liabilities included within the line item
• 2. Cumulative fair value adjustments related to FAS 133 fair value hedging relationships
• 3. Cumulate fair value adjustments other than those related to FAS 133 fair value hedging relationships
• 4. The carrying amount of the assets or liability excluding any fair value adjustments.

 If an entity designates interest rate risk in a hedging relationship of its own issued debt or other borrowings, the entity needs to add to its debt disclosure the following items: 

• 1. Its use of derivative contracts to convert a portion of its fixed-rate debts to variable-rate debt or vice-versa
• 2. The relationship of the maturity structure of the derivatives to the maturity structure of the debt being hedged
• 3. The overall weighted-average interest rate both including and excluding the effects of derivatives designated as a hedge of its debt or the related interest payments.

 Transition

If adopted this proposed Statement would be effective for fiscal years beginning after June 15, 2009 or for the first quarter 10Q in 2010.

 At the date of initial application, all hedging relationships are to be de-designated, unless the hedged risk is permitted under both FAS 133 and the proposed Statement.  The hedging relationships are to then be re-designated using the hedging criteria in the proposed Statement. 

 For cash flow hedges, the gains or losses in AOCI need to be adjusted to equal the difference, if any, between the fair values of a derivative that would provide cash flows that would exactly offset the hedged cash flows and the amount in AOCI related to the hedge just prior to initial application.  Any adjustment is made to retained earnings.

 At the date of initial application, an entity may transfer any held-to-maturity security for which it intends to manage certain risks inherent in the instrument into the available-for-sale category or the trading category.  The securities transferred to available-for-sale can then be designated as the hedged item in a fair value hedge.  The carrying value of the securities transferred is to be adjusted to fair value with the adjustment being recognized in retained earnings.

 At the date of initial application, an entity may elect to account for any servicing assets or servicing liabilities that were designed as a hedged item immediately preceding initial application at fair value under FAS 156 – Accounting for Servicing of Financial Assets.  The adjustment to fair value should be recognized in retained earnings.

 At the date of initial application, an entity may elect to account for any financial instrument designated as a hedged item on the date immediately preceding initial application at fair value under FAS 159 – The Fair Value Option for Financial Assets and Financial Liabilities.  The adjustment to fair value should be recognized in retained earnings. 

Convergence with IFRS:

 This proposed Statement would diverge from the guidance currently provided by IAS 39 – Financial Instruments: Recognition and Measurement.  However, the IASB is considering two proposed amendments to IAS 39, one of which would bring it in line with this proposed Statement.

 We probably won’t hear about this one until after the first of the year.  As always, stay tuned.

EITF 08-03 – Accounting by Lessees for Maintenance Deposits

EITF 08-03 is effective for fiscal years beginning after December 15, 2008 and any changes are to be reflected as an adjustment to opening retained earnings.

 Under certain equipment lease agreements, a lessee is responsible for the repair and maintenance of the leased asset.  The lease agreement may stipulate that the lessee is to make deposits with the lessor to protect the lessor if the lessee does not properly maintain the asset.  The lessor then reimburses the lessee for any repairs or maintenance performed on the asset up to the amount of the deposit.  At the end of the lease term, any deposit left may or may not be returned to the lessee depending on the contract terms. 

 This EITF applies to arrangements accounted for as a lease that has maintenance deposits that are refunded only if the lessee performs specified maintenance activities.  Payments to a lessor that are not substantively and contractually related to maintenance of the leased asset are not within the scope of EITF 08-03.

 Per paragraph 8 of EITF 08-03, maintenance deposits should be recognized as deposit assets and periodically evaluated as to whether it is probable that the deposit will be returned either through maintenance activities or at the end of the lease term.  If it is less than probable that a part or all of the deposit will be returned, then the asset (or a part thereof) should be written off to expense.  Any reimbursements of maintenance costs are to be recorded as maintenance expense or capitalized in accordance with the lessee’s accounting policy.

 This one was short and sweet, which is how I like them.