GAAP Review Series - Part 4

This GAAP Review Series is designed for the accountant or practitioner who needs a detailed review of standards that apply to nonspecialized companies. The series provides a comprehensive study of FASB Statements and Interpretations and APB Opinions that apply to all companies and presents implementation guidelines and disclosure illustrations.

GAAP Review Series — Part 4

Objectives: 

• Understand FASB standards that impact derivative instruments, international accounting, long-lived assets, non-monetary exchanges and business combinations
• Apply recent FASB pronouncements for these selected areas
• Prepare disclosures related to these selected areas

Prerequisite:  Experience in financial reporting.

Also available in the GAAP Review Series:

• Part 1
• Part 2
• Part 3

Chapter 1

Accounting for Financial Assets and Derivative Instruments

Learning Objectives

As a result of this chapter you will be able to

• Apply SFAS No. 140 to transactions involving the transfer or servicing of financial assets.
• Understand the provisions of SFAS No. 156, Accounting for Servicing of Financial Assets – an amendment of FASB Statement No. 140.
• Identify derivative financial instruments and prepare the required financial statement disclosures.
• Apply SFAS No. 133 (as amended by SFAS No. 138, SFAS No. 149, and SFAS No. 161) for accounting for derivative instruments and hedging activities.
• Understand the provisions of SFAS No. 155, Accounting for Certain Hybrid Financial Instruments.

Introduction

This chapter describes accounting standards for reporting the use of derivative securities. This chapter also describes the new accounting rules for transactions that are common for financial institutions and may occur for industrial companies, namely, transfers and servicing of financial assets (SFAS No. 140) and the use of derivative securities in hedging activities (SFAS Nos. 133 and 138).

This chapter also provides an overview of SFAS No. 155, Accounting for Certain Hybrid Financial Instruments, issued in February 2006.

SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities – a replacement of FASB Statement No. 125

SFAS No. 140 replaces FASB Statement No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities. It revises the standards for accounting for securitizations and other transfers of financial assets and collateral and requires certain disclosures, but it carries over most of Statement 125's provisions without reconsideration.

SFAS No. 140 provides accounting and reporting standards for transfers and servicing of financial assets and extinguishments of liabilities. Those standards are based on consistent application of a financial-components approach that focuses on control. Under that approach, after a transfer of financial assets, an entity recognizes the financial and servicing assets it controls and the liabilities it has incurred, derecognizes financial assets when control has been surrendered, and derecognizes liabilities when extinguished.

In addition to replacing Statement 125 and rescinding FASB Statement No. 127, Deferral of the Effective Date of Certain Provisions of FASB Statement No. 125, SFAS No. 140 carries forward the actions taken by Statement 125. Statement 125 superseded FASB Statements No. 76, Extinguishment of Debt, and No. 77, Reporting by Transferors for Transfers of Receivables with Recourse. Statement 125 amended FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities, to clarify that a debt security may not be classified as held-to-maturity if it can be prepaid or otherwise settled in such a way that the holder of the security would not recover substantially all of its recorded investment. Statement 125 amended and extended to all servicing assets and liabilities the accounting standards for mortgage servicing rights now in FASB Statement No. 65, Accounting for Certain Mortgage Banking Activities, and superseded FASB Statement No. 122, Accounting for Mortgage Servicing Rights. Statement 125 also superseded FASB Technical Bulletins No. 84-4, In-Substance Defeasance of Debt, and No. 85-2, Accounting for Collateralized Mortgage Obligations (CMOs), and amended FASB Technical Bulletin No. 87-3, Accounting for Mortgage Servicing Fees and Rights.

SFAS No. 156, Accounting for Servicing of Financial Assets – an amendment of FASB Statement No. 140

SFAS No. 156 amends SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, – a replacement of FASB Statement No. 125, with respect to the accounting for separately recognized servicing assets and servicing liabilities. SFAS No. 156

• Requires an entity to recognize a servicing asset or servicing liability each time it undertakes an obligation to service a financial asset by entering into a servicing contract in any of the following situations:
• A transfer of the servicer's financial assets that meets the requirements for sale accounting.
• A transfer of the servicer's financial assets to a qualifying special-purpose entity in a guaranteed mortgage securitization in which the transferor retains all of the resulting securities and classifies them as either available-for-sale securities or trading securities in accordance with FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities.
• An acquisition or assumption of an obligation to service a financial asset that does not relate to financial assets of the servicer or its consolidated affiliates.
• Requires all separately recognized servicing assets and servicing liabilities to be initially measured at fair value, if practicable.

• Amortization method – Amortize servicing assets or servicing liabilities in proportion to and over the period of estimated net servicing income or net servicing loss and assess servicing assets or servicing liabilities for impairment or increased obligation based on fair value at each reporting date.
• Fair value measurement method – Measure servicing assets or servicing liabilities at fair value at each reporting date and report changes in fair value in earnings in the period in which the changes occur.
• At its initial adoption, permits a one-time reclassification of available-for-sale securities to trading securities by entities with recognized servicing rights, without calling into question the treatment of other available-for-sale securities under Statement 115, provided that the available-for-sale securities are identified in some manner as offsetting the entity's exposure to changes in fair value of servicing assets or servicing liabilities that a servicer elects to subsequently measure at fair value.
• Requires separate presentation of servicing assets and servicing liabilities subsequently measured at fair value in the statement of financial position and additional disclosures for all separately recognized servicing assets and servicing liabilities.

The FASB added this project to its agenda because constituents asked the Board to reconsider Statement 140's requirements for accounting for mortgage servicing assets and servicing liabilities. The FASB decided to broaden the scope of the project to include all servicing assets and servicing liabilities. Servicing assets and servicing liabilities may be subject to significant interest rate and prepayment risks, and many entities use financial instruments to mitigate those risks. Currently, servicing assets and servicing liabilities are amortized over the expected period of estimated net servicing income or loss and assessed for impairment or increased obligation at each reporting date. The FASB acknowledged that the application of the lower of carrying amount or fair value measurement attribute to servicing assets results in asymmetrical recognition of economic events, because it requires recognition of all decreases in fair value but limits recognition of increases in fair value to the original carrying amount.

An entity may use derivative instruments to mitigate the risks inherent in its servicing assets and servicing liabilities. An entity that does not apply hedge accounting to these derivative instruments is exposed to income statement volatility that arises from the use of different measurement attributes for the servicing assets and servicing liabilities and the related derivative instruments. For example, in rising interest rate environments, decreases in the fair value of derivatives are reflected in the income statement, but increases in the fair value of related servicing assets are not reflected in the income statement to the extent that fair value exceeds the amortized carrying amount. Some constituents believe that meeting current hedge accounting criteria is burdensome and unduly restrictive and that the asymmetrical accounting for mortgage servicing assets and servicing liabilities and the related financial instruments used to mitigate the related risks does not appropriately reflect the economics of the hedging techniques employed.

When adding this project to its agenda, the Board also considered the complexity of application of the amortization method, such as the timing and characterization of impairment allowances versus write-downs, as well as the desire to simplify the accounting requirements for servicing assets and servicing liabilities.

SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities

SFAS No. 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, (collectively referred to as derivatives) and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statement of financial position and measure those instruments at fair value. If certain conditions are met, a derivative may be specifically designated as (1) a hedge of the exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment, (2) a hedge of the exposure to variable cash flows of a forecasted transaction, or (3) a hedge of the foreign currency exposure of a net investment in a foreign operation, an unrecognized firm commitment, an available-for-sale security, or a foreign-currencydenominated forecasted transaction.

The accounting for changes in the fair value of a derivative (that is, gains and losses) depends on the intended use of the derivative and the resulting designation.

For a derivative designated as hedging the exposure to changes in the fair value of a recognized asset or liability or a firm commitment (referred to as a fair value hedge), the gain or loss is recognized in earnings in the period of change together with the offsetting loss or gain on the hedged item attributable to the risk being hedged. The effect of that accounting is to reflect in earnings the extent to which the hedge is not effective in achieving offsetting changes in fair value.

For a derivative designated as hedging the exposure to variable cash flows of a forecasted transaction (referred to as a cash flow hedge), the effective portion of the derivative's gain or loss is initially reported as a component of other comprehensive income (outside earnings) and subsequently reclassified into earnings when the forecasted transaction affects earnings. The ineffective portion of the gain or loss is reported in earnings immediately.

For a derivative designated as hedging the foreign currency exposure of a net investment in a foreign operation, the gain or loss is reported in other comprehensive income (outside earnings) as part of the cumulative translation adjustment. The accounting for a fair value hedge described above applies to a derivative designated as a hedge of the foreign currency exposure of an unrecognized firm commitment or an available-for-sale security. Similarly, the accounting for a cash flow hedge described above applies to a derivative designated as a hedge of the foreign currency exposure of a foreign-currency-denominated forecasted transaction.

For a derivative not designated as a hedging instrument, the gain or loss is recognized in earnings in the period of change.

Under SFAS No. 133 an entity that elects to apply hedge accounting is required to establish at the inception of the hedge the method it will use for assessing the effectiveness of the hedging derivative and the measurement approach for determining the ineffective aspect of the hedge. Those methods must be consistent with the entity's approach to managing risk.

SFAS No. 133 precludes designating a nonderivative financial instrument as a hedge of an asset, liability, unrecognized firm commitment, or forecasted transaction except that a nonderivative instrument denominated in a foreign currency may be designated as a hedge of the foreign currency exposure of an unrecognized firm commitment denominated in a foreign currency or a net investment in a foreign operation.

SFAS No. 133 amends SFAS No. 52, Foreign Currency Translation, to permit special accounting for a hedge of a foreign currency forecasted transaction with a derivative. It supersedes SFAS No. 80, Accounting for Futures Contracts, No. 105, Disclosure of Information about Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk, and No. 119, Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments. It amends SFAS No. 107, Disclosures about Fair Value of Financial Instruments, to include in Statement 107 the disclosure provisions about concentrations of credit risk from Statement 105. SFAS No. 133 also nullifies or modifies the consensuses reached in a number of issues addressed by the Emerging Issues Task Force.

SFAS No. 133 is effective for all fiscal quarters of fiscal years beginning after June 15, 2000. Initial application of SFAS No. 133 should be as of the beginning of an entity's fiscal quarter; on that date hedging relationships must be designated anew and documented pursuant to the provisions of SFAS No. 133. Earlier application of all of the provisions of SFAS No. 133 is encouraged, but it is permitted only as of the beginning of any fiscal quarter that begins after June 1998. SFAS No. 133 should not be applied retroactively to financial statements of prior periods.

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