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Module

Derivatives
and Related
Accounting
Issues

Derivatives, defined
Financial instruments that derive their value
from changes in the value of a related asset
or liability.

Characteristics of Derivatives
Underlyings - the rates or prices that relate to the
asset or liability underlying the derivative instrument
Notional amount - the number of units or quantity
that are specified in the derivative instrument
Minimal initial investment - a derivative requires
little or no initial investment because it is an
investment in a change in value rather than an
investment in the actual asset or liability
No required delivery- generally the parties to the
contract, the counterparties, are not required to actually
deliver an asset that is associated with the underlying

Common Types of Derivatives


Forward Contracts
Futures Contracts
Option Contracts
Interest Rate Swaps

Forward Contracts
A contract to buy or sell a specified amount of
an asset at a specified fixed price with delivery
at a specified future point in time.
The value of the contract at inception is zero and
typically does not require an initial cash outlay.
The total change in the value of the forward
contract is measured as the difference between
the forward rate and the assets spot rate at the
forward date.

Example of a Forward Contract


Writer
of the
Contract

Convey 100,000 euros in 90 days


Pay $85,000 in 90 days

Holder
of the
Contract

Euros at the forward rate in 90 days.. $ 85,000


Assumed spot rate in 90 days
90,000
Gain in value of forward $ 5,000

Measuring Changes in the Value


of a Forward Contract Over Time
The cumulative change in the forward value of a
contract is measured as the difference between the
original forward value and the remaining forward
value.
The net present value of the change in forward
value consists of two components:
the change in the spot rates over time and
the change in the time value of the contract
(spot - forward differences)

Measuring Changes in the Value of a


Forward Contract Over Time, continued

Futures Contracts
Like a forward contract except that futures are:
Traded on an organized exchange
The exchange clearinghouse becomes the intermediary
between the buyer and seller of the contract
Contracts are standardized versus customized
An initial deposit of funds is required to create a
margin account

Futures Contracts, continued


Futures contracts vis a vis forward contracts, continued
Marked to market each day
Represent current versus future dollars therefore
eliminating the need for discounting
The party that writes a contract is said to be short and
the owner of the contract is said to be long

Example of a Futures Contract


Contract to buy oil in May at $45/barrel
Sell oil
The Short

Buy oil

Buy oil
Clearing
House

Sell oil

Futures price/barrel on day 1.. $45


Futures price/barrel on day 2.. 46
Gain in value of contract. $ 1

The
Long

Option Contracts
Represent a right rather than an obligation to
either buy or sell some quantity of a particular
underlying.
The buy or sell price is referred to as the strike
price or exercise price
A call option allows the holder to buy an
underlying whereas a put option allows the
holder to sell an underlying

Option Contracts, continued


The holder of an option must pay an initial
nonrefundable cash outlay known as the option
premium
The value of an option consists of the intrinsic
value and the time value

Example of an Option
Option
Writer

Buy corn at $2.20/bu

Option
Holder

Assume: market price per bushel is $2.22


notional amount is 100,000 bushels
option value is $2,400
Intrinsic Value is the difference between the strike price and
the market price (100,000 bu ($2.20 - $2.22) = $2,000)
Time Value is the value of the option less the intrinsic value
($2,400 - $2,000 = $400)

Option Terms Illustrated


Premium Paid
Exercise (strike) Price
Current Value of underlying
At-the-Money
Out-of-the-Money
In-the-Money
Intrinsic Value
Time Value

Call
Option A
$1,000
30,000
29,500
No
Yes
No
1,000

Call
Option B
$1,000
30,000
30,800
No
No
Yes
800
200

Put
Option C
$1,000
30,000
29,200
No
No
Yes
800
200

Swaps
A type of forward contract represented by a
contractual obligation, arranged by an
intermediary that requires the exchange of cash
flows between two parties.
For example, a company with a loan payable with
a fixed (variable) interest rate exchanges the fixed
rate of interest expense for a variable (fixed) rate
of interest.

Example of an Interest Rate Swap


Bank
CounterParty

Pays a
variable
rate
Receives
8% fixed

Issuer Of
$10 Million
Debt

Pays 8%
fixed

Creditors

If variable rate is 7.5%, Debtor:


Pays to creditors. $ (800,000)
Pays to bank counterparty.. (750,000)
Receives from bank counterparty..
800,000
Net interest expense... $ 750,000

Derivatives Designated as a Hedge


A derivative may be used to avoid the exposure
to the risk that the value of an asset or liability
may change unfavorably over time due to
rate/price changes.
for example, the value of inventory may
decrease due to price changes.
Derivatives designated as a hedge are classified
as either a fair value hedge or a cash flow
hedge.

Fair Value Hedges


The hedged item is either a recognized asset or
liability or a firm commitment.
The prices or rates are fixed and therefore,
subsequent changes in the price or rates affect the
fair value of the recognized asset or liability or firm
commitment.
The derivative instrument can be designated as a
hedge against changes in fair value.

Fair Value Hedges, continued


Fair value hedges receive special accounting
treatment if certain criteria are satisfied.
Qualifying criteria call for formal documentation of
the hedging relationship and ongoing assessment of
hedge effectiveness. Other criteria must also be
satisfied.

Special Accounting Treatment for


Fair Value Hedges
The special accounting treatment results in:
The gain or loss on the derivative instrument is
recognized currently in earnings and
The gain or loss on the hedged item is also recognized
currently in earnings.
For example, the gain in the value of a futures
contract to sell inventory can be used to offset the
decrease in the value of a firm commitment to buy
inventory. Recognizing both changes in value in
current earnings gives recognition to the offsetting
nature of the hedge.

Special Accounting Treatment for


Fair Value Hedges, continued
Changes in the time value of a derivative are generally
excluded from the assessment of hedge effectiveness
and are always recognized in current earnings.

Accounting for a Fair Value


Hedge Illustrated
Assume that a company has 100,000 units of
commodity A, with a cost of $120,000, that will be sold
in 60 days. In order to hedge against possible market
declines in the value of commodity A, the company
acquires a futures contract to sell commodity A in 60
days at $1.49 per unit.

Accounting for a Fair Value


Hedge Illustrated, continued
Notional amount in units
Spot price per unit
Future price per unit
Fair value of contract

Remaining Term of Contract


60 days
30 days
0 days
100,000
100,000
100,000
1.495
1.482
1.460
1.490
1.480
1.460
$
1,000
$
3,000

Change in fair value of contract


Current period change in spot rates
Current period change in time value
Effect on current earnings:
Gain (Loss) in value of inventory
Gain (Loss) in value of contract
Net measure of effectiveness
Gain (Loss) in value of contract
excluded from hedge effectiveness
Net effect on current earnings

$
$
$

1,000
1,300
(300)

$
$
$

2,000
2,200
(200)

$
$
$

(1,300)
1,300
-

$
$
$

(2,200)
2,200
-

$
$

(300)
(300)

$
$

(200)
(200)

Assessing the Effectiveness of a


Fair Value Hedge
Sales price of inventory
Cost of sales
Gross profit
Hedging gain (loss) on contract
Hedging gain (loss) on inventory
Subtotal
Gain (loss) on contract excluded from
assessment of effectiveness
Net effect on earings

Desired
Position
$ 149,500
(120,000)
$ 29,500

29,500

29,500

Without the
Hedge
$ 146,000
(120,000)
$ 26,000

26,000

With the
Hedge
$ 146,000
(116,500)
$ 29,500
$
3,500
(3,500)
$ 29,500

26,000

(500)
29,000

Cash Flow Hedges


The hedged item is either an existing asset or
liability with variable future cash flows or a
forecasted transaction.
The prices or rates are not fixed and therefore, an
entity is exposed to the risk that future cash
flows may vary due to changes in prices/rates.
The derivative instrument can be designated as a
hedge and allow the entity to fix the price or rate
and reduce the variability of cash flows.

Cash Flow Hedges, continued


Cash flow hedges receive special accounting
treatment if certain criteria are satisfied.
Qualifying criteria call for formal documentation
of the hedging relationship and ongoing
assessment of hedge effectiveness. Other criteria
must also be satisfied.

Special Accounting Treatment for


Cash Flow Hedges
The special accounting treatment results in:
The gain or loss on the derivative instrument initially
being reported in other comprehensive income (OCI)
The gain or loss is initially reported in OCI rather
than current earnings because the hedged forecasted
cash flows have not yet occurred.
Once the forecasted cash flows have occurred, the
OCI gain or loss will be reclassified into earnings in
the same period or periods in which the forecasted
transaction affects earnings.

Special Accounting Treatment for


Cash Flow Hedges, continued
As with fair value hedges, the change in the
time value of a derivative may be excluded
from the assessment of hedge effectiveness.

Accounting for a Cash Flow


Hedge Illustrated
Assume that a company is forecasting the purchase of
100,000 units of commodity A in 60 days. The
commodity will be processed and sold within 30 days
of receipt.
Notional amount in units
Spot price per unit
Future price per unit
Fair value of contract

Remaining Term of Contract


60 days
30 days
0 days
100,000
100,000
100,000
$
1.49
$ 1.510
$
1.54
$
1.50
$ 1.525
$
1.54
$ 2,500
$ 4,000

Accounting for a Cash Flow


Hedge Illustrated, continued
Notional amount in units
Spot price per unit
Future price per unit
Fair value of contract

Remaining Term of Contract


60 days
30 days
0 days
100,000
100,000
100,000
$
1.49
$
1.510
$
1.54
$
1.50
$
1.525
$
1.54
$
2,500
$
4,000

Change in fair value of contract


Current period change in spot rates
Current period change in time value
Effect on OCI:
Gain (Loss) in value of derivative
Reclassification of OCI into earnings
Net effect on OCI
Effect on current earnings:
Adjustment to cost of sales
Gain (Loss) in value of contract
excluded from hedge effectiveness
Net effect on current earnings

$
$
$

2,500
2,000
500

$
$
$

1,500
3,000
(1,500)

2,000

3,000

$
$

2,000

500
500

$
$

3,000

(1,500)
(1,500)

Date Inventory
Is Sold

$
$

(5,000)
(5,000)

5,000

5,000

Assessing the Effectiveness of a


Cash Flow Hedge
Sales price of inventory (assumed)
Cost of sales - inventory
Cost of sales - processing (assumed)
Gross profit
Reclassification of OCI
Adjusted gross profit
Gain (loss) on contract excluded from
assessment of effectiveness
Net effect on earings

Desired
Position
$ 225,000
(149,000)
(30,000)
$ 46,000

$ 46,000

Without the
Hedge
$ 225,000
(154,000)
(30,000)
$ 41,000

41,000

With the
Hedge
$ 225,000
(154,000)
(30,000)
$ 41,000
5,000
$ 46,000
(1,000)
$ 45,000

Disclosures Regarding Derivative


Instruments & Hedging Activities
Objective of using hedging instruments and
strategies for achieving objectives.
Description of various types of fair value and cash
flow hedges.
Description of the entitys risk management policy
for hedging types and description of hedged
transactions.

Disclosures Regarding Derivative


Instruments & Hedging Activities
Required disclosures (continued)
Specific disclosures regarding fair value hedges
including effect on earnings.
Specific disclosures regarding cash flow hedges
including effect on earnings and reclassifications of
OCI.