Transcript Current Accounting and Auditing Developments

March 2011
Christina K. Catalina, CPA
Phone: 631-414-4414
Email: [email protected]

The Financial Accounting Standards Board (FASB)
sought to address the concerns about transparency in
the disclosures of derivative activities by issuing
Statement No. 161 (“SFAS 161”), Disclosures About
Derivative Instruments and Hedging Activities (codified
in ASC 815). SFAS 161 follows SFAS 157 (codified in ASC
820), which revised financial reporting requirements
for the alternative investment community in 2008, and
included increased disclosures relating to the fair value
measurements of securities and derivatives.
Why Issued
◦ Expands existing disclosure requirements to improve
transparency of financial reporting and provide users of
financial statements with an enhanced understanding of:
 How and why derivatives are used
 How derivatives and related hedged items are accounted for
 How derivative instruments affect an entity’s financial position,
results of operations and its cash flows

Qualitative disclosures include:
◦ Objectives for holding or issuing derivative instruments, the
context needed to understand those objectives, associated
risk exposures, and strategies for achieving those objectives
 Disclose information in the context of each instrument’s primary
underlying risk exposure
 e.g., interest rate risk, credit, foreign exchange rate, equity price,
commodity price risks
◦ Information to understand the volume of entity’s derivative
activity (e.g., notional amounts, Number of contracts)

Significant disclosure requirements (continued):
◦ Quantitative disclosures in tabular format, presented by major
type of instrument
 Location and fair value amounts of derivative instruments in the
statement of assets and liabilities
 Fair value amounts must be presented gross in tabular disclosure,
even if qualify for net balance sheet presentation or are subject to
master netting arrangements with their counterparties
 Collateral amounts should be excluded
 May need rational allocation methodology for portfolio-level valuation
adjustments (i.e. nonperformance risk)
 Location and amounts of gains and losses from derivative
instruments in the statement of operations

Significant disclosure requirements (continued):
◦ Present as separate asset and liability values
◦ Segregate between derivatives designated and qualifying as
hedging instruments and those that are not
 By type of contract (ie: interest rate, foreign currency, commodity,
equity, credit, etc)
◦ Further separate derivatives qualified as hedges by the
following:
 Fair value hedges
 Cash flow hedges
 Net Investment hedges



Significant disclosures include the “balance sheet” and
“income statement” disclosures, both of which are
required to be presented in a tabular format.
Most of ASC 815’s other required disclosures are
qualitative and are usually in the footnotes to the
financial statements. These disclosures address
trading activities and related risks.
ASC 815 also requires that any disclosure within the
notes be cross-referenced to other relevant disclosures
of the derivative activity of the entity.
Futures
contracts
◦The Fund uses futures contracts to gain exposure to, or hedge against, changes in the value of equities and
commodities, interest rates or foreign currencies. A futures contract is a firm commitment to buy or sell a
specified quantity of currency or securities, or a standardized amount of a deliverable grade commodity, at a
specified price and specified future date, unless the contract is closed before the delivery date. Upon entering
into a futures contract, the Fund is required to pledge to the broker an amount of cash, U.S. government
securities, or other assets, equal to a certain percentage of the contract amount (initial margin deposit).
Subsequent payments, known as “variation margin”, are made or received by the Fund each day, depending on
the daily fluctuations in the fair value of the underlying security. The Fund records an unrealized gain or loss
equal to the daily variation margin. When the contract is closed, the Fund records a realized gain or loss equal
to the difference between the value of the contract at the time it was opened and the value at the time it was
closed.
◦The purchase and sale of futures contracts requires margin deposits with a Futures Commission Merchant
(“FCM”). Subsequent payments (variation margin) are made or received by the Fund each day, depending on
the daily fluctuations in the value of the contract, and are recorded for financial statement purposes as
unrealized gains or losses by the Fund. Futures contracts provide reduced counterparty risk to the Fund since
futures are exchange-traded; and the exchange’s clearinghouse, as the counterparty to all exchange-traded
futures, guarantees the futures against default.
◦The Commodity Exchange Act requires an FCM to segregate all customer transactions and assets from the
FCM's proprietary activities. A customer's cash and other equity deposited with an FCM are considered
commingled with all other customer funds subject to the FCM’s segregation requirements. In the event of an
FCM’s insolvency, recovery may be limited to the Fund’s pro rata share of segregated customer funds available.
It is possible that the recovery amount could be less than the total of cash and other equity deposited.

Credit Default Swaps
◦ The Fund enters into credit default swaps to manage its exposure to the market or certain sectors of the
market, to reduce its risk exposure to defaults of corporate and sovereign issuers, or to create exposure to
corporate or sovereign issuers to which it is not otherwise exposed. Credit default swap contracts involve an
arrangement between the Fund and a counterparty which allow the Fund to protect against losses incurred as
a result of default by a specified reference entity. The Fund pays a premium and the counterparty agrees to
make a payment to compensate the Fund for losses upon the occurrence of a specified credit event.
Generally, the Fund pays a premium upfront and the counterparty agrees to make a payment to compensate
the Fund for losses upon the occurrence of a specified credit event. The payment flows are usually netted
against each other, with the difference being paid by one party to the other. During the term of the contracts,
changes in value are recognized as unrealized gains or losses by marking the contracts to fair value.
Additionally, the Fund records a realized gain (loss) when a contract is terminated and when periodic
payments are received or made at the end of each measurement period, but prior to termination. The Fund’s
credit default swap contracts are scheduled to terminate from 20XX through 20XX.
◦ The fair value of open swaps may differ from that which would be realized in the event the Fund terminated
its position in the contract. Risks may arise as a result of the failure of the counterparty to the swap contract
to comply with the terms of the swap contract. The loss incurred by the failure of a counterparty is generally
limited to the aggregate fair value of swap contracts in an unrealized gain position as well as any collateral
posted with the counterparty. The risk is mitigated by having a master netting arrangement between the Fund
and the counterparty and by the posting of collateral by the counterparty to the Fund to cover the Fund’s
exposure to the counterparty. Therefore, the Fund considers the creditworthiness of each counterparty to a
swap contract in evaluating potential credit risk. Additionally, risks may arise from unanticipated movements
in the fair value of the underlying investments.
◦ A Fund could be exposed to credit or market risk due to unfavorable changes in the fluctuation of interest
rates or if the counterparty defaults on its obligation to perform. Risk of loss may exceed amounts recognized
on the statement of assets and liabilities. Such risks involve the possibility that there will be no liquid market
for these agreements, that the counterparty to the agreement may default on its obligation to perform and
that there may be unfavorable changes in the fluctuation of interest rates. In connection with swap
agreements, securities/cash may be set aside as collateral by a Fund’s custodian. A Fund may enter into swap
agreements in order to, among other things, change the maturity or duration of the investment portfolio;
protect a Fund’s value from changes in interest rates; or expose a Fund to a different security or market.
The following table identifies the fair value amounts of derivative instruments included in the statement of financial condition
as derivative contracts, categorized by primary underlying risk, at December 31, 2010. Balances are presented on a gross basis,
prior to the application of the impact of counterparty and collateral netting. Total derivative assets and liabilities are adjusted
on an aggregate basis to take into consideration the effects of master netting arrangements and have been reduced by the
application of cash collateral receivables and payables with its counterparties. The Fund does not designate any derivative
instruments as hedging instruments under ASC 815.
(in thousands)
Primary underlying risk
Interest rate
Interest rate swaps
Derivative
assets
Derivative
liabilities
Location
$
100
100
Investments in derivatives
800
800
1,250
1,250
Investments in derivatives
3,500
1,000
4,500
6,000
2,000
8,000
Investments in derivatives
Investments in securities
2,100
2,100
500
500
Investments in derivatives
Credit
Purchased protection:
Credit default swaps
Gross derivative assets and liabilities
Investments in derivatives
7,650
1,800
11,650
Less: Master netting arrangements
Less: Cash collateral applied
Total derivative assets and liabilities
(2,500)
5,150
$
Foreign currency exchange rate
Forward contracts
Equity price
Total return swaps
Options
Commodity price
Futures contracts
$
250
250
$
(2,500)
(1,000)
8,150
The following table identifies the net gain and loss amounts included in the statement of
operations as net gain (loss) from derivative contracts, categorized by primary underlying
risk, for the year ended December 31, 2010.
(in thousands)
Primary underlying risk
Interest rate
Interest rate swaps
Realized
gain (loss)
$
Foreign currency exchange rate
Forward contracts
$
(900)
(900)
Equity price
Total return swaps
Options
Commodity price
Futures contracts
Credit
Purchased protection:
Credit default swaps
Total gain (loss)
125
125
Unrealized
gain (loss)
$
(200)
(200)
1,000
1,000
1,500
500
2,000
3,000
1,800
4,800
1,400
1,400
(2,000)
(2,000)
2,500
5,000
5,125
$
8,600

Trading exemption to required tabular disclosure
◦ For derivatives not designated or qualifying as hedging
instruments, where they are included as part of an entity’s
trading activities, an entity can elect not to separately disclose
gains and losses if:
 Quantitative gains/losses of the trading activities (including both
derivative and non-derivative instruments) are disclosed
separately by major category
 The line items in the income statement in which the trading
activity gains and losses are included
 A description of the nature of the trading activities and related
risks, and how an entity manages that risk is included in
qualitative disclosures
The Effect of Trading Activities on the Statement of Operations for the Year Ended December 31, 2010
Type of Instrument
Fixed income/Interest
rate
Foreign exchange
Equity
Commodity
Credit
Other
Total
Line Item on Statement of
Trading
Operations
Income (Loss)
Net realized gain (loss) and change in unrealized gain
(loss) on investments and swap transactions
Net realized gain (loss) on foreign currency
transactions and translation of assets and liabilities in
foreign currencies
$400
250
Net realized gain (loss) and change in unrealized gain
(loss) on investments and options
(5,200)
Net realized gain (loss) and change in unrealized gain
(loss) on swap and futures contracts
4,800
Net realized gain (loss) and change in unrealized gain
(loss) on investments, options and swap transactions
4,400
Net realized gain (loss) and change in unrealized gain
(loss) on investments
(3,600)
$1,050
The trading income (loss) related to each category includes realized and unrealized gains and losses
on both derivative instruments and non derivative instruments.
At December 31, 2010, the volume of the Fund’s derivative activities based on their notional amounts (a)
and number of contracts, categorized by primary underlying risk, are as follows:
(notional amounts in thousands)
Prim ary underlying risk
Interest rate
Interest rate sw aps
Long exposure
Notional
Num ber
am ounts
of contracts
$
Foreign currency exchange rate
Forw ard contracts
Equity price
Total return sw aps
Futures contracts
Options
Warrants
Com m odity price
Futures contracts
Credit
Credit default sw aps
Other risks
$
50,000
250
5,000
Short exposure
Notional
Num ber
am ounts
of contracts
20,000
100
800
6,000
1,250
30,000
10,000
4,000
3,000
47,000
3,500
700
1,000
1,000
6,200
60,000
4,000
5,000
3,000
72,000
6,000
400
2,000
2,000
10,400
8,000
2,100
3,000
500
50,000
600
15,000
1,800
1,000
4,500
161,000
$
14,450
$
$
116,000
$
14,050

Significant disclosure requirements (continued)
◦ Credit-risk-related contingent features:
 Existence and nature of credit-risk-related contingent features and
the circumstances in which those features could be triggered
 Aggregate fair value amounts of derivative instruments in a net
liability position that contain credit-risk-related contingent
features
 Aggregate fair value of assets posted as collateral
 Adequate cross-referencing if required disclosures presented in
multiple footnotes
The Fund’s derivative contracts are subject to International Swaps and Derivatives Association
(“ISDA”) Master Agreements which contain certain covenants and other provisions that may
require the Fund to post collateral on derivatives if the Fund is in a net liability position with its
counterparties exceeding certain amounts. The aggregate fair value of all derivative instruments
with credit-risk-related contingent features that are in a net liability position at December 31,
2010 is $16,000,000 for which the Fund has posted $12,000,000 as collateral in the normal
course of business. If the credit-risk-related contingent features underlying these agreements
were triggered as of December 31, 2010, the Fund would have been required to post additional
collateral of $6,000,000 to its counterparties. Additionally, counterparties may immediately
terminate these agreements and the related derivative contracts if the Fund fails to maintain
sufficient asset coverage for its contracts or its net assets decline by stated percentages or
amounts. As of December 31, 2010, the termination values of these derivative contracts were
approximately $3,000,000 less than their fair values.

Challenges in ASC 815 disclosures:
◦
◦
◦
◦
Magnitude of derivative activities
Complexity of derivative activities
Sufficiency of information systems resources to manage data
Determining meaningful measurement of volume of
derivative activities
◦ Evaluating and tracking credit-risk-related contingent features
Description
Level 1
Interest rate contracts
Foreign exchange
contracts
Commodity futures
contracts
Total
Level 2
Level 3 Counterparty
and Cash
collateral
netting
Amount reported in
the Statement of
financial condition
$--
$--
$150
$--
$150
100
--
100
(50)
150
50
--
200
--
250
$150
$--
$450
$(50)
$550
NOTE: This is an excerpt from Fair value measurements table. Determine “class” on the basis of the nature and
risks of the investments - consider, for example activity or business sector, vintage, geographic concentration,
credit quality, and economic characteristic In addition to nature and risks, also consider placement in fair value
hierarchy (i.e., Levels 1, 2, or 3)—e.g., greater number of classes may be necessary for fair value measurements
with significant unobservable inputs (Level 3) due to increased uncertainty and subjectivity.
Level 3 roll forward
Interest rate
contracts
Foreign exchange Commodity
contracts
futures contracts
Total
Beginning balance
$250
$675
$--
$925
Total gains (losses)
10
(500)
(30)
(520)
Transfers
--
--
--
--
Purchases
--
--
230
230
Sales (1)
--
--
--
--
Issuances
--
(150)
--
(150)
Settlements (2)
(110)
75
--
(35)
Ending Balance
$150
$100
$200
$450
(1) Assigned derivative assets should be presented in sales line. Assignment of a derivative liability should be
disclosed as a settlement.
(2) All ongoing contractual cash payments (or other consideration) made under the derivative contract should
be disclosed in the settlements line item.

VALUATION TECHNIQUES
◦ Derivative Instruments
 Listed derivatives that are actively traded are valued based on quoted prices from the
exchange and are categorized in level 1 of the fair value hierarchy. Over the counter
(OTC) derivative contracts include [forward, future, swap, warrant and option
contracts related to interest rates, foreign currencies, credit standing of reference
entities, equity prices, or commodity prices]. Depending on the underlying security
and the terms of the transaction, the fair value of certain OTC derivatives may be able
to be modeled using a series of techniques, including closed-form analytic formula
(such as the Black-Scholes option-pricing model), simulation models, or a combination
thereof. Pricing models take into account the contract terms (including maturity) as
well as multiple inputs, including, where applicable, time value, implied volatility,
equity prices, interest rate yield curves, prepayment speeds, interest rates, loss
severities, credit risks, credit curves, default rates and currency rates. Certain pricing
models do not entail material subjectivity as the methodologies employed include
pricing inputs that are observed from actively quoted markets. In the case of more
established derivative contracts, the pricing models used by the Fund are widely
accepted by marketplace participants. OTC derivatives contracts are generally
categorized in Levels 2 or 3 of the fair value hierarchy. The Fund considers the effects
of credit risk and counterparty risk when determining the fair value of its derivatives.

Credit Default Swaps — Credit default swaps are
valued by independent pricing services using pricing
models that take into account, among other factors,
information received from market makers and brokerdealers, default probabilities from index specific credit
spread curves, recovery rates, and cash flows. To the
extent that these inputs are observable, the values of
credit default swaps are categorized as Level 2. To the
extent that these inputs are unobservable the values
are categorized as Level 3.
Questions?
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