February 2001

Edited by Robert H. Colson, CPA

Editor’s Note: This column is devoted to accounting and auditing issues that arise in the normal course of CPA practice. Some articles cover events and transactions for which there may be alternatives in current practice. Others highlight problems that CPAs have encountered in implementing accounting or auditing standards. Most of the situations presented come from participation in meetings of technical committees of the New York State Society of CPAs.

During a recent Foundation for Accounting Education seminar on accounting for derivatives, Robert Dyson indicated during a lengthy discussion that small clients might be depending on their auditors for significant assistance in a number of areas related to derivatives. A significant problem area will be acquiring—on a timely basis—the knowledge that the client has engaged in derivative activity with the intent of hedging a balance sheet item or firm commitment. The company may not realize that a transaction entered into based on the recommendation of another advisor could have significant accounting implications. The following case study was taken from Dyson’s discussion.

Derivatives and the Small Company: A Case Study

By Robert Dyson, CPA

A company, whose functional currency is the U.S. dollar, purchases olive oil from a vendor in Italy, paying the vendor in lire rather than dollars. On Dec. 31, 2000, the company recognized accounts payable of

12.20 billion lire on these purchases, which it recorded at $6.89 million using the foreign exchange rates as of the dates the transactions took place. If the company restates those payables using the exchange rate as of Dec. 31, 2000, it would have to write up the payables by $181,000.

The financial institution where the company settles its accounts with the Italian vendor suggested during the course of the year that the company purchase forward exchange contracts to lock in the price of lire that would be needed to settle the accounts. The company followed this advice and obtained contracts to purchase 14.28 billion lire for a total of $8 million (based on the exchange rates at the date the contracts were completed). The 14.28 billion lire would have cost $8.279 million, an increase of $279,000, if purchased at the exchange rates in effect on Dec. 31, 2000. These outstanding contracts were not tied to specific purchases, but the company intended to use them to settle the outstanding payables in the ordinary course of business during the first few months of 2001. The company did not formally designate the forward contracts as hedges, nor did it document its intent to use them as hedges.

Two concerns arise from this example:

The auditor may not see any transactions in a company’s books related to the purchase of the forward contracts until they are settled in 2001. In addition to careful inquiries of company management, auditors should be aware of a company’s banking relationships. Inquiries of bankers may provide evidence of derivatives that is not documented in the company’s records.

The new accounting principles for hedge accounting require contemporaneous documentation to designate that the purpose of a derivative is to hedge a balance sheet account or firm commitment. Discovery of the hedge after the fact does not permit the use of hedge accounting if the documentation is not appropriate. If hedge accounting is not utilized, the payable and derivative must be marked to market on the Dec. 31, 2000, balance sheet with the gains and losses going to earnings in that year.

The two most common types of derivatives that auditors of small companies are likely to run into are forward contracts for foreign currencies by importers and exporters and interest rate swaps for real estate developers and construction companies. Dyson recommends that auditors with clients in these industries take special care this year as companies implement Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities. A summary of SFAS 133, effective for all fiscal quarters of fiscal years beginning after June 15, 1999, is available online from the Financial Accounting Standards Board website at www.rutgers.edu/accounting/raw/fasb/public/index.html.

Additional information about the audit impact of SFAS 133 is available in Statement on Auditing Standards No. 92, Auditing Derivative Instruments, Hedging Activities, and Investments in Securities. A summary of SAS 92, effective for fiscal years ending June 31, 2001, is available online from the American Institute of CPAs website at www.aicpa.org/pubs/cpaltr/oct2000/sasno 92.htm.