session c - financial instruments update

© 2001 Arthur Andersen All rights reserved.

a

Financial Instruments

Financial Executives InternationalCurrent Financial Reporting Issues Conference

New York, New YorkNovember 12, 2001

John E. Stewart

© 2001 Arthur Andersen All rights reserved. 2

Agenda

• FASB Statement 133

• FASB Statement 140

• Financial Instruments Projects– FASB– JWG– AICPA

• EITF Issues

• SEC Hot Topics


FASB Statement 133 - Overview

• Amended twice since June 1998– 137 deferred effective date– 138 amended several areas

• Single, integrated accounting framework

• Statement 133 is effective for all fiscal quarters of all fiscal years beginning after June 15, 2000– January 1 for calendar-year fiscal years

• DIG process

• DIG guidance and open items (200+ issues)


DIG - FASB staff Q&A

• A - Definition of a derivative

• B - Embedded derivatives

• C - Scope exceptions

• D - Recognition and measurement of derivatives

• E - Hedging - general

• F - Fair value hedges

• G - Cash flow hedges

• H - Foreign currency hedges

• I - Disclosures

• J - Transition provisions

• K - Miscellaneous


Scope

Always ask two questions:

• Is the contract a derivative?– Very broad

• If not, is the contract embedded with a derivative?– Foreign currency

– Convertible debt

– Beneficial interests

– Prepaid swaps

– Dual trigger and other insurance contracts

– Indexed debt (equity, commodity, etc.)

– Etc., etc.


Valuation - What needs to be valued?

• Each freestanding derivative

• Each embedded derivative

• Each host contract upon bifurcation

• Each item hedged in a fair value hedge

• Cash flows in a cash flow hedge

• Intrinsic value and time value

Required quarterly for recognition, measurement and assessment of hedge effectiveness


Qualification

• Contemporaneous, formal documentation required at hedge at inception– Objectives and strategy

– Hedged item

– Hedging instrument

– Risk being hedged

– How effectiveness will be assessed

• SEC has required restatement for improper documentation

• All criteria for hedge accounting must be met


• Scope– Equity warrants

– Loan commitments

– Financial guarantees and insurance

– Residual value guarantees

• Normal purchases and sales – Electricity

– CPI

– Forwards plus options

– Cross indexes

• When and how to bifurcate

• Shortcut qualification

Complexities - A sampler!


Complexities - A sampler, continued!

• Hedging the benchmark rate (methods 2 and 3)

• Forward points in forward currency hedges

• Purchased and complex options

• Basis risk for nonfinancial assets

• Aggregating (e.g. commercial paper programs and loans)

• Tracking OCI

• Impairment of long-lived assets


Complexities - A sampler, continued!

• Central treasury

• Assessing effectiveness

• Mortgage servicing rights

• Net investment hedges

• Call monetization

• Prohibitions

• Interaction with other literature (APBs and FASBs)

Be sure to read the DIG issues!


Other considerations

• Disclosures

• Open DIG issues

• Transition for DIG issues

• Impact on EITF guidance

• New EITF issues


FASB Statement 140 - Transfers of financial assets

• Clarify criteria for determining whether a transferred asset has been sold under Statement 125

• Modify requirements for SPE to be a “qualifying” SPE

• Modify the accounting for collateral in financings

• Require extensive disclosures for securitizations


FASB Statement 140 - Transfers of financial assets

• Final statement issued September 2000

• Effective for transactions after 3/31/01

• Disclosures and collateral provisions required for fiscal years ending after 12/15/00

• Supercedes all of Statement 125

• FASB Staff Q&A (123 items)

• Impact on EITF issues

• Many implementation questions


FASB Statement 140 - A sampler of implementation issues

• Isolation (FDIC and other) - Technical Bulletin 01-1

• Constraints, partial sales, calls and puts, ROAPs

• QSPE status– Holdings– Derivative use– Servicing (D-99)– Warehousing– Liability management (commercial paper)

• Disclosures– Scope– Securitizations– Collateral


Measurement of financial instruments - FASB project

• Goal is to provide guidance for measuring and accounting for all financial assets and liabilities at fair value

• Implementation guidance– How to determine fair value

– Scope of instruments

– Company’s own creditworthiness

• Presentation issues

• Preliminary views document issued in Q4 1999

• Intermediate objective - more specific guidance on how to determine fair value and improve disclosure

• Coordination with JWG project


Financial instruments - JWG project

• Joint Working Group of standard setters– Australia, Canada, France, Germany, Japan, New Zealand, Nordic countries,

U.K., U.S., and IASC

– Special report issued December 2000

– Comments were due June 30, 2001

– IASB involvement

• All financial instruments at fair value through earnings

• No hedge accounting

• New derecognition standards ( Statement 140)

• New disclosures


Debt versus equity - FASB project

• Better distinguish between debt and equity instruments where classification has become problematic– Examples include preferred stock that at the issuer’s option can be exchanged

for notes payable, convertible debt, and mandatorily redeemable preferred stock

• Deals with classification issues and initial measurement

• Addresses minority interest


Debt versus equity - Important and controversial issues

• Unbundling instruments with debt and equity attributes, like convertible debt

• Determining what instruments need to be split up and how to classify the pieces of such instruments (obligations-based approach)

• Reclassifying of minority interest to equity– Consequences

• Transition -- restate with exceptions


Debt versus equity - Status

• The obligation-based approach would require:

– Obligation components that require settlement by a transfer of assets would be

classified as liabilities

– Components that require or permit settlement by a transfer of a fixed number

of the shares determined at issuance would initially be classified as equity;

otherwise, classified as liabilities

• Implications on several common instruments

• Interaction with EITF issues

• Exposure draft issued in October 2000

– Comments were due April 30, 2001

– Roundtable in October 2001


Other projects - Overview

• FASB Concepts Statement No. 7 - present value measurement

• IAS 39 - financial instruments and implementation guide

• AICPA - loan loss allowances

• AICPA - purchase of high risk receivables

• International activity - leases

• FASB DIG D-1 project

• FASB and SPEs


EITF issues

• Revenue Recognition and Sales Incentives

• Treatment of Other Costs (Capitalize versus Expense)

• Stock Compensation

• Equity Method Investments

Financial Instruments

Real Estate

Equity Transactions

Derivative Related

• Nonmonetary Transaction

• Business Combination

Leases

• Other Issues


EITF issues - Financial instruments

• Residual interests in securitizations (99-20)

• Measuring fair value of equity securities with restrictions in a nonmonetary exchange (00-N)

• Creditor’s accounting for a modification or exchange of debt (01-7)

• When to combine separate instruments (01-G)

• Other items


EITF issues - Equity transactions

• Equity instrument received for providing goods or services (00-8)

• Equity instruments granted to nonemployees (00-18)

• Classification of equity derivatives (00-19)

• Convertible securities with beneficial conversion features (00-27)

• Convertible instrument issued for goods or services (01-1)

• Combining 00-19 instruments (01-F)


EITF issues - Derivative related

• Majority owner's accounting for the minority interest in a subsidiary and a derivative (00-4)

• Derivatives indexed to stock of consolidated subsidiary (00-6)

• Derivative instruments under Issue 96-13 that could require net cash settlement (00-7)

• Gain or loss classification from extinguished hedged debt (00-9)

• Measuring the fair value of energy-related contracts (00-17)

• Determination of whether share settlement is within the control of the issuer (00-19)

• Meaning of “indexed to a company’s own stock” (01-6)


EITF issues - Leases

• Meeting the ownership transfer requirements of FASB Statement 13 for leases of real estate (00-11)

• Accounting for sales of fractional interests in equipment (01-4)

• Determining when an energy-related contract is a lease (01-8)

• Interaction of FASB Statements 13 and 133 on residual value guarantees (01-H)


SEC “Hot Topics” - Financial instruments

• Documentation and disclosures related to derivative instruments and hedging activities

• Valuation

• Allowance for loan losses

• Equity and warrant issues

• SPEs

• Nontemporary impairment

• Statement 140 QSPE treatment and disclosures

• Mezzanine classification (D-98)


www.arm.arthurandersen.com

session c - financial instruments update

Documents

agenda fasb statement

dig issues impact

eitf guidance new eitf

dig fasb staff qa

intrinsic value

time value

hedge accounting

fair value hedge cash