Derivatives including hedging

Net Versus Gross Settlement

Note: In the following exercise, you are required to review the Basis for Conclusions (BCs) for the standard(s) that provide the accounting guidance for this topic. As the BCs is generally not included in the codification and thus is not authoritative, it will most likely be necessary for you to research it through review of the pre-codified standards. Appropriate references have been provided to allow you to do so. Pre-codified standards are accessible on the FASB website at www.fasb.org or, in the event that your school participates in the American Accounting Association's Academic Accounting Access program, they may be found there as well.

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One of the requirements in US GAAP to determine that a financial instrument is a derivative is the requirement that there be a net settlement provision. A net settlement is a one-way transfer of an asset, usually cash, from the counterparty in a loss position to the counterparty in a gain position. In a gross settlement, there is a two-way exchange where one party typically delivers cash or a cash equivalent, and the other party delivers an underlying asset. When a contract requires net settlement, neither party is required to deliver the underlying asset equal to the notional amount of the contract to the other party. For example, in an interest rate swap, one counterparty pays a stream of fixed-rate cash flows in exchange for a stream of floating-rate cash flows from the other party. The exchange of cash flows occurs periodically (e.g., monthly or quarterly), and typically one counterparty pays or receives a net cash amount each period based on the difference between the fixed and floating-rate cash flows. The notional amount is generally not exchanged between counterparties, but is used only for calculating the size of cash flows to be exchanged. Read ASC 815-10-15, paragraphs 83(c), 99, 100 and 109A through124 and SFAS No. 133, paragraphs 259 through 266. Also read IAS 39, paragraph 9 and paragraphs B-2 through B-3 (found in the Guidance on Implementation).

How are derivatives contracts required to be settled under US GAAP and IFRS? List the different settlement methods under each standard.

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Why are derivative contracts required to be settled the way you have described in Scene 1 under each standard?

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Will the settlement method difference have an impact on what financial instruments will be classified as derivatives under US GAAP and under IFRS?

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In your opinion, which settlement method do you think makes more economic or business sense relative to helping businesses achieve their objectives in using derivatives?