Changes in the ineffective and excluded portions are always recognized imme-
diately in earnings, regardless of the type of hedging relationship.- If the hedge is an FV hedge, the “effective portion” is also recognized currently
in earnings. However, the hedged item is also fair valued on the balance sheet,
with the change in fair value also going into earnings, where it will be offset by
the change in the effective portion of the derivative. - If the hedge is a CF hedge, then the effective portion is recognized in Other
Comprehensive Income (OCI) and then recorded on an after-taxbasis in Accu-
mulated Other Comprehensive Income (AOCI), a retained earnings account, in
accordance with FAS 130. The AOCI is reclassed into earnings when the un-
derlying hedged item impacts earnings. - If the hedge is an NI hedge, the effective portion is also recognized in OCI and
then recorded in AOCI on an after-tax basis, again in accordance with FAS 130.
However, the AOCI is reclassed into earnings only when the subsidiary is sub-
sequently sold or liquidated. - Hedge relationships can be voluntarily or involuntarily terminated. The latter
occurs when the hedge relationship fails the highly effectiveness test or when
the underlying hedged forecast is no longer probable or the hedged firm com-
mitment is no longer firm.
Anyone trying to understand FAS 133 must have a copy of the 800-page Green
Book, which is a clear statement of FAS 133 as amended as of December 10, 2001.
In it, 133 various paragraphs are annotated with references to specific DIG issues,
which are also included in the bound volume. In addition, FAS 130, “Reporting Com-
prehensive Income,” should also be obtained, due to interactions between FAS 130
and FAS 133 regarding the accounting for cash flow and net investment hedges in the
statement of comprehensive income.
The best way to first read FAS 133 is to start with the initial Summary before the
Statement and then skip to Appendix C: Background Information and Basis for Con-
clusions. This will help provide a useful context for reading the Statement itself. In
addition, these DIG Issues are particularly useful in understanding how the Statement
should be applied (in alphabetical order): C10–11, E1–10, E17–19, F2, F5, G2–3,
G7, G9, G15–16, G20, G22–23, H6–11, H15, and K1.
The biggest cause for confusion in understanding FAS 133 is its use of the term
fair value.At times, fair value means fair market value, as in how an economist or
bank trader would mark-to-market a derivative or financial instrument, and is always
used in this sense for fair valuing a derivative on the balance sheet. However, in the
effectiveness testing, fair value is best understood as a technical accounting term
whose definition can vary considerably depending on the actual hedge documenta-
tion.
Depending on the type of hedging relationship and the derivatives used, there are
at least 64 different definitions of fair value that can be used in the effectiveness tests.
In addition, there are some exceptions, for example, the shortcut method and the hy-
pothetical derivative method, that extend the number of permutations beyond 64.
However, many of these permutations are clearly unsuitable, and the number of rel-
evant permutations is in the teens. Selecting the appropriate effectiveness test re-
quires an understanding of the likely distribution of that particular effectiveness test,
and managing the trade-offs between:
19 • 4 FAS 133: ACCOUNTING FOR DERIVATIVE PRODUCTS