Note: This post has been updated. See updated post here.

ASC 815 (FAS133) is filled with complexities and idiosyncrasies about the accounting for derivatives. Ditto for Dodd-Frank. As a facilitator, I love helping people understand and uncover the unusual relationships between these changing regulations and complex accounting activities — but a recent question had me stumped!

I was teaching a course when a participant wanted to know more about Dodd-Frank’s requirement to clear certain derivative contracts through a central counterparty (CCP). Specifically, they asked if the accounting for derivatives would change as a result of variation margining. This scenario has so many moving parts and potential variables that a simple, straightforward answer is impossible.

So I put my response in the “Parking Lot” and told them I would get back to them. Well, after researching the question a bit more, I realized there wasn’t an easy answer.

Background: Dodd-Frank and Derivatives

The Dodd-Frank Wall Street Reform and Consumer Protection Act significantly changed derivative regulation. One of the biggest updates was its requirement that many over-the-counter (OTC) derivative contracts must clear through a CCP, in order to increase derivatives’ transparency and standardization. Ultimately, this rule intends to limit the operational and systematic risks, particularly the counterparty credit risk, that significantly contributed to the 2008 financial crisis.

With this change, many derivative contracts now require variation margining, or periodic payments made to the CCP based on changes in the underlying derivative’s fair value. These payments, usually made daily or even intra-day, may be cash, securities or other liquid assets. As the derivative’s fair value changes, each of the counterparties must make margin payments to “protect” the other from exposure related to collectability.

Impact of Variation Margining on the Accounting for Derivatives

So, what we need to determine is: Are these payments settlement of an entity’s obligation under the derivative contract? Or do they simply represent posting collateral?

If they’re a settlement, then the payments will reduce the fair value of the derivative back to zero (or something close to zero). But if they’re collateral, then the payments will not affect the derivative’s value.

Let’s walk through an example to highlight the issue and (hopefully) provide some clarity.

ASC 815 (FAS 133) and Dodd-Frank Practical Example

Paulson enters into a 5-year interest rate swap (IRS) with Geithner Financial. Under the swap’s terms, the instrument will clear through a CCP, requiring daily cash variation margin payments as calculated and determined by the clearing house. After Day 1 of the trade, the fair value of the IRS decreases, requiring Paulson to make a $50 variation margin payment. How should Paulson reflect this cash payment in its financial statements?

Discussion:

Unfortunately, very little authoritative guidance is available that addresses this issue, although some of the larger accounting firms have provided a bit of insight. Therefore, to determine how to account for this variation margin payment, you need to consider existing principles within U.S. GAAP, as well as a variety of other factors.

You can view the transaction in one of two ways:

1. Settlement view: The payment of $50 by Paulson represents a legal settlement and extinguishment of the liability related to the IRS obligation with Geithner Financial. The IRS obligation would be partially settled or extinguished on a daily basis as cash variation margins are paid, resulting in an open position only on amounts yet to be settled through the variation margining.

1. Collateral view: The payment of $50 by Paulson to the clearing organization is simply a posting of collateral on the open derivative position with Geithner Financial. This assessment would result in a similar outcome as accounted for prior to Dodd-Frank, where the entity would consider guidance within ASC 815 and ASC Topic 210 Balance Sheet, including related footnote disclosures. Paulson would initially record the cash collateral as a separate financial asset (“Collateral due from clearing organization”). Paulson must then determine whether to present the financial asset (from the clearing organization) and the IRS obligation (to Geithner Financial) net in the balance sheet.

So, how should Paulson account for its payment?

As previously noted, there’s very little specific guidance on this topic, so I can’t provide a definitive answer to the practical example presented above. This really means companies must use judgment to determine the proper accounting and consider the following factors:

• Legal assessment of the collateral transferred: The transaction’s legal jurisdiction and terms and conditions can provide the clearest answers of whether a payment is the transfer of collateral or settlement of a legal obligation.

• Form of collateral transferred: The transaction’s accounting may be different if the collateral is cash versus securities or other financial assets.

• Amount of variation margin: The amount of variation margin paid often differs among different clearing organizations, as well as from changes in the fair value of the derivative itself.

• Terms of collateral transferred: The terms associated with the collateral paid to a clearing organization may indicate whether collateral transfer represents settlement of an obligation or just the posting of collateral.

I wish there were a simple way to determine how variation margining changes the accounting for derivatives. But, while none of the factors listed above provide cut and dry answers, they should help companies determine how to account for and present these types of transactions within their financial statements. And if you have your own questions about this challenge or want a second opinion on how to proceed, shoot me an email and I’d be happy to talk.