What Was FAS 133? Derivative & Hedge Accounting Rules

Statement of Financial Accounting Standards No. 133 (FAS 133) established accounting and reporting rules for derivative instruments and hedging activities. Issued in 1998, it mandated that entities recognize all derivatives as assets or liabilities on their balance sheet and measure them at fair value. This marked a substantial shift in financial reporting, aiming to increase transparency for investors. FAS 133 is no longer the active standard, as its principles were incorporated into the Financial Accounting Standards Board’s (FASB) Accounting Standards Codification (ASC) as Topic 815, “Derivatives and Hedging.” While the name “FAS 133” is historical, the rules it established form the core of current U.S. GAAP for derivatives, though subsequent updates have simplified certain aspects.

Defining a Derivative Instrument

A contract is considered a derivative if it meets three criteria. First, the contract must contain one or more underlyings and one or more notional amounts. An underlying is a variable, such as an interest rate or security price, that causes the derivative’s value to change. The notional amount is a specified unit of measure, like a number of shares or currency units, used to calculate the settlement amount.

Second, the contract requires no initial net investment or one that is smaller than what would be required for other contracts with a similar response to market factors. This feature provides derivatives with significant leverage. For example, the cost of an option to buy 100 shares of stock is substantially less than the cost of purchasing the shares outright, yet the option holder benefits from favorable price movements.

Third, the contract’s terms must require or permit net settlement. This means the contract can be settled by a net payment of cash or another asset, without either party having to deliver the asset associated with the underlying. Net settlement can be explicitly stated in the contract, occur through a market mechanism like an exchange, or be met if the contract requires delivery of an asset that is readily convertible to cash, like a publicly traded stock.

Hedge Accounting Fundamentals

The default accounting for derivatives requires marking them to fair value each period, with value changes affecting the income statement. This can create earnings volatility that may not reflect the economic purpose of using a derivative to manage risk. To address this, ASC 815 provides for optional “hedge accounting,” which aligns the timing of the derivative’s gains and losses with those of the hedged item, mitigating income statement volatility.

To qualify, a company needs formal documentation at the start of the hedging relationship. This documentation must identify the specific hedging instrument, the hedged item or transaction, the nature of the risk being hedged, and the company’s risk management objective and strategy. It must also specify how the company will assess the hedge’s effectiveness both at the start and on an ongoing basis. This formal designation is a prerequisite; a company cannot retroactively decide a derivative was a hedge.

A hedge is considered effective if the changes in the derivative’s value or cash flows highly correlate with changes in the hedged item’s value or cash flows. This assessment must be performed at least quarterly to ensure the relationship continues to qualify for special accounting treatment.

Types of Hedging Relationships

Fair Value Hedge

A fair value hedge protects against changes in the fair value of a recognized asset, liability, or an unrecognized firm commitment. Companies use this to manage exposures from items like fixed-rate debt or inventory. The risk being hedged is that the item’s fair value could fluctuate due to changes in interest rates, foreign currency rates, or commodity prices. For example, a company with fixed-rate debt can use an interest rate swap to hedge against the risk of falling interest rates increasing the debt’s fair value. Under fair value hedge accounting, the gain or loss on the swap is recognized in earnings, and the change in the hedged debt’s value attributable to the risk is also recognized in earnings, creating an offset.

Cash Flow Hedge

A cash flow hedge protects against the variability of future cash flows related to a forecasted transaction or a variable-rate asset or liability. The goal is to lock in a future cash payment or receipt. For example, a company expecting to purchase raw materials in the future can use a forward contract to fix the price. The effective portion of the gain or loss on the forward contract is initially recorded in Other Comprehensive Income (OCI). This amount is then moved from Accumulated Other Comprehensive Income (AOCI) into earnings in the same period the hedged transaction affects earnings.

Hedge of a Net Investment in a Foreign Operation

This hedge is for companies with investments in foreign operations. When a parent company translates a foreign subsidiary’s financial statements, it creates translation gains or losses recorded in OCI as part of the cumulative translation adjustment (CTA). A net investment hedge uses a derivative or a nonderivative liability to offset this foreign currency risk. The gain or loss on the effective portion of the hedging instrument is also recorded in the CTA section of OCI. This directly offsets the translation gain or loss, and the amounts remain in AOCI until the investment is sold or liquidated.

Embedded Derivatives

A derivative-like feature can exist within a larger, non-derivative contract, which is known as an embedded derivative. The overall contract is called a “hybrid instrument,” containing a “host contract” (the non-derivative part) and the embedded feature. An example is a corporate bond whose redemption value is linked to a stock index.

ASC 815 requires companies to determine if an embedded derivative must be separated, or “bifurcated,” from the host contract and accounted for as a standalone derivative. Bifurcation is required only if three specific criteria are met.

Not Clearly and Closely Related

The first criterion is that the economic characteristics and risks of the embedded derivative are not “clearly and closely related” to those of the host contract. For instance, an interest rate cap in a variable-rate loan is considered clearly and closely related. However, a lease payment adjusted by the price of gold would not be, as real estate economics are distinct from the gold market.

Not Measured at Fair Value

The second criterion is that the hybrid instrument itself is not already being measured at fair value with changes reported in earnings. If the entire contract is already accounted for this way, separation is unnecessary as the accounting objective is already met.

Qualifies as a Derivative

The final condition is that a separate, standalone instrument with the same terms as the embedded feature would meet the definition of a derivative. If all three criteria are met, the company must bifurcate the embedded derivative. It is then recorded on the balance sheet at fair value, with value changes recognized in earnings, separate from the host contract.