Energy companies worldwide use financial derivatives to divide business risk into smaller components, which are bought or sold, in order to diversify risk and manage strategic objectives. A new US government business accounting requirement will change the way those derivatives are represented on quarterly financial reports to creditors, investors, and stockholders.
Beginning with the fiscal year that starts June 15, 2000, or calendar year Jan.1, 2001, many energy companies must change derivative accounting systems to conform to the Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities.
This rule requires that derivative financial instruments such as option, forward, future, and swap contracts be reflected in published quarterly reports unless tied to specific hedge instruments. The standard also requires specific accounting, reporting, and testing methods for the recognition and fair value measurement of such derivatives.
Key concepts
The goal of FAS 133 is the measurement of financial instruments at current fair value, and it is aligned with three key concepts.
- Derivative instruments create assets or liabilities, representing rights or obligations via legal contracts, and should therefore be represented in financial statements in a transparent manner.
- Fair market value is the most relevant measure for financial instruments and the only relevant measure for derivatives and thus should be recorded as they occur, including instances prior to realized gains or losses.
- Where fair-value accounting of derivative financial instruments may cause volatility of company income statements, special accounting rules allow a postponement of such statements through a qualifying hedge, provided such a hedge is tied precisely to the specified derivative.
Types of hedges
FASB 133 qualifies three types of hedges:
- A fair value hedge is defined as being in effect when the change in fair value of the derivative is recognized in net income in the same period as the offsetting changed value of the hedged item.
- A cash flow hedge is recognized on the balance sheet as an offset to variable cash flow of a forecasted transaction and is reflected in equity as "accumulated other comprehensive income."
- A foreign currency hedge offsets the variability or risk associated with income or net investment as a result of changes in foreign currency values.
FASB 133 requires compliance of several criteria to facilitate tying specific derivatives to their designated hedges: 1) identify derivative and corresponding hedge item, 2) identify the determined risk, 3) document risk-management strategies and objectives, and 4) document effective tests of risk by quantitative or qualitative method.
The method chosen must be used consistently during the unrealized hedge's duration, or a statement of accounting change will be required.
Finally, continuous documentation of fair-value calculations and effective testing methods are required for compliance.
Affected energy companies should seek further information regarding US accounting requirements governing hedge and derivative accounting options. FASB 133 will not necessarily assist firms in risk-management techniques or decision-management, and some restatement of earnings may be necessary. In some cases, administration of documentation and transaction costs may be prohibitive.
