Advanced Accounting

Thirteenth Edition, Global Edition

Chapter 13
Accounting for
Derivatives and
Hedging Activities

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

Accounting for Derivatives and
Hedging Activities: Objectives
13.1 Account for derivative instruments that are not
designated as a hedge.
13.2 Understand the definition of a cash-flow hedge and
the circumstances in which a derivative is
accounted for as a cash-flow hedge.
13.3 Understand the definition of a fair-value hedge and
the circumstances in which a derivative is
accounted for as a fair-value hedge.
13.4 Account for a cash-flow-hedge situation from
inception through settlement and for a fair-value-
hedge situation from inception through settlement.

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

Accounting for Derivatives and
Hedging Activities: Objectives (continued)
13.5 Understand the special derivative accounting
related to hedges of existing foreign currency-
denominated receivables and payables.
13.6 Comprehend the footnote disclosure requirements
for derivatives.
13.7 Understand the International Accounting Standards
Board accounting for derivatives.

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

13.1: Derivative Instruments Not
Designated as a Hedge
Accounting for Derivatives and Hedging Activities

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

Using Derivatives as Hedges
A hedge can
– Shift risk of fluctuations in sales prices, costs,
interest rates, or currency exchange rates
– Help manage costs
– Reduce risks to improve financial position
– Produce tax benefits
– Help avoid bankruptcy

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

Hedge Accounting
At inception, document
– The relationship between hedged item and
derivative instrument
– The risk management objective and strategy for
the hedge
● Hedging instrument
● Hedged item
● Nature of risk being hedged
● Means of assessing effectiveness

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

Hedge Effectiveness
● To qualify for hedge accounting, the derivative
instrument must be highly effective in offsetting
gains or losses in the item being hedged.
● Effectiveness considers
– Nature of the underlying variable
– Notional amount of the derivative and the item
being hedged
– Delivery date of derivative
– Settlement date of the underlying
● If critical terms are identical, effectiveness is
assumed.
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Example of Effectiveness
Item to be hedged
– Accounts payable
– Due January 1, 2017
– For delivery of 10,000 euros
– Variable is the changing value of euros
Hedge instrument
– Forward contract
– To accept delivery of 10,000 euros
– On January 1, 2017

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

Statistical Analysis
If critical terms of item to be hedged and hedge
instrument do not match, statistical analysis can
determine effectiveness.
– Regression analysis
– Correlation analysis
Example
– Using derivatives based on heating oil or crude
oil to hedge jet fuel costs

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

13.2: Cash-Flow Hedge
Accounting for Derivatives and Hedging Activities

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

Cash-Flow Hedge
A cash-flow hedge is used for anticipated or
forecasted transactions where there is risk of
variability in future cash flows.

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

Accounting for a Cash-Flow Hedge
A cash-flow hedge is
● recorded at cost
● adjusted to fair value at each reporting date
● accounted for in Other Comprehensive Income
(OCI) when there are gains or losses
When the forecasted transaction impacts the income
statement
● Reclassify OCI to the hedged revenue or
expense account

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

13.3: Fair-Value Hedge
Accounting for Derivatives and Hedging Activities

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

Fair-Value Hedge
A fair-value hedge is used for an asset or liability
position, or firm purchase or sale commitment,
where there is a risk of variability in the value of the
position.

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

Accounting for a Fair-Value Hedge
Both the item being hedged and the derivative are
● adjusted to fair value at each reporting date
● accounted for immediately in income with
offsetting gains or losses

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

13.4: Hedge Accounting
Accounting for Derivatives and Hedging Activities

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

Cash-Flow Hedge: Example 1 (1 of 4)
Utility anticipates purchasing oil for sale to its
customers next February. On December 1, Utility
enters into a futures contract to acquire 4,200
gallons of oil at $1.4007 per gallon for delivery on
January 31. A margin of $10 is to be paid up front.
● On December 31, the price for delivery of oil on
January 31 is $1.4050.
● On January 31, the spot rate for current delivery is
$1.3995.
Utility settles the contract, accepting delivery of
4,200 gallons of oil.
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Cash-Flow Hedge: Example 1 (2 of 4)
In February, Utility sells all the oil to its customers
for $8,400 and reclassifies its OCI from the hedge as
cost of sales. Pertinent rates:

 Blank 12/1 12/31 1/31

Futures rate, for 1/31 $1.4007 $1.4050 $1.3995
Cost of 4,200 barrels $5,882.94 $5,901.00 $5,877.90

Change in futures contract to 12/31 = $18.06

Change in futures contract to 1/31 = ($23.10)
The loss on the contract is ($5.04) OCI, and this
serves to increase Cost of Sales.

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

Cash-Flow Hedge: Example 1 (3 of 4)
Sign
12/1 Futures contract 10.00  blank
contract
 blank Cash  blank 10.00
12/31 Futures contract 18.06  blank
Adjust to  blank OCI  blank 18.06
fair value
1/31 OCI 23.10  blank

Settle  blank Futures contract  blank 23.10

contract; 1/31 Cash 4.96  blank
collect
 blank Futures contract  blank 4.96
balance on
margin 1/31 Inventory 5,877.90  blank
 blank Cash  blank 5,877.90

Purchase inventory

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

Cash-Flow Hedge: Example 1 (4 of 4)
Feb. Cash 8,400.00  blank
Record the
sale and  blank Sales  blank 8,400.00
cost of sales Feb. Cost of sales 5,877.90  blank
 blank Inventory  blank 5,877.90
Feb. Cost of sales 5.04  blank
 blank OCI  blank 5.04

The last entry reclassifies the loss on the contract

from OCI into Cost of Sales. The effect is to
increase Cost of Sales to $5,882.94. This is the
cost of the oil based on the futures contract
signed on December 1.
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Cash-Flow Hedge: Example 2 (1 of 4)
On 12/2/16, Win Corp. anticipates purchasing equipment on
3/1/17 with payment on that date of £500,000. On 12/2/16,
Santana signs a 90-day forward contract to buy £500,000 for
$1.68 (the spot rate is $1.70).

The $10,000 contract discount will be amortized to Exchange

Gain over three months using the effective interest method.
Implied interest is:
• PV = 1.70(500,000) = $850,000
• FV = 1.68(500,000) = $840,000
• Period = 3 months
• Monthly rate using Excel =rate(nper,pmt,pv,fv)
=rate(3,0,850000,-840000)

Result: 0.003937

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

Cash-Flow Hedge: Example 2 (2 of 4)
Forward rates and fair value of contract:

Notional Amount Contract Discounted

 Date Forward rate £500,000 Fair value Fair value
12/2 $1.68 840,000 blank   blank
12/31 $1.69 845,000 5,000 4,901
3/1 $1.72 860,000 20,000 15,099

The contract will be adjusted to its discounted fair

value. Use the incremental borrowing rate (12%, or
1% monthly), discounting for the remaining contract
life.
12/31: 5,000 / (1.01)2
3/1 (end of contract): 15,000
Note: 1/31 would be equal to fair value / (1.01)1
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.
Cash-Flow Hedge: Example 2 (3 of 4)
no entry for forward contract - no cash
12/2 exchanged  blank  blank
12/31 Forward contract 4,901  blank

 blank OCI  blank 4,901

 blank Bring forward contract to discounted fair
value.  blank  blank
12/31 OCI 3,346  

 blank Exchange gain  blank 3,346

Effective interest method amortization of the
 blank 10,000 discount. 850,000 x .003937  blank  blank

The change in
value for the The discount on
forward the contract is
contract is an amortized over
unrealized gain the 3 months of
put into OCI. the contract.

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

Cash-Flow Hedge: Example 2 (4 of 4)
3/1 Forward contract 15,099  blank
 blank OCI  blank 15,099
Bring forward contract to fair value,
The final  blank $20,000  blank  blank
balance in 3/1 Cash 20,000  
OCI is  blank Forward contract  blank 20,000
$10,000 CR. for net settlement of contract:
This will  blank 860,000 current - 840,000 contract  blank  blank
reduce the 3/1 Equipment 860,000  
equipment's  blank Cash  blank 860,000
depreciation  blank Purchase equipment from supplier  blank  blank
over its life. 3/1 OCI 6,654  blank
 blank Exchange gain  blank 6,654
remaining amortization:
 blank 10,000 - 3,346  blank  blank

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

Fair-Value Hedge: Example 3 (1 of 3)
Utility has accumulated 10,000 barrels of oil in
inventory that it will not sell until the later winter
months. Utility wants to maintain the value of the
inventory, which is recorded at cost of $85 per
barrel, in the event that the price of oil falls before
they are able to sell it. On November 1, Utility enters
into a futures contract to sell the oil for $90 a barrel
in three months.

The contract will be settled net.

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

Fair-Value Hedge: Example 3 (2 of 3)
● The market price of the oil is $92 per barrel at
December 31.
● The estimated value of the forward contract on
December 31 is a liability of the $2 per barrel
difference between our contracted price and the
market price.
● The liability is measured as $20,000 / (1.01), or
$19,802, assuming a 1% per month interest rate.
● On January 31, the spot price is $89 and Utility
settles the contract by receiving $10,000, or ($90-
$89) x 10,000 barrels.

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

Fair-Value Hedge: Example 3 (3 of 3)
Report at fair Loss on Forward
value at 12/31 contract 19,802 blank
reporting date blank Forward contract blank 19,802
12/31 Inventory 20,000 blank
Adjust blank Gain on Inventory blank 20,000
inventory to 1/31 Forward contract 10,000 blank
fair value blank Forward contract 19,802 blank
Gain on Forward
Adjust values blank contract blank 29,802
prior to final blank Loss on Inventory 30,000 blank
settlement blank Inventory blank 30,000
1/31 Cash 10,000 blank
Settle blank Forward contract blank 10,000
contract

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

13.5: Accounting for Hedges of Foreign
Currency Receivables and Payables
Accounting for Derivatives and Hedging Activities

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

Fair-Value Hedge Example: Liability
Ruby purchases equipment costing 200,000 yen on
12/2/16 with payment due on 1/30/17.
On 12/2/16 Ruby enters a forward contract to
purchase 200,000 yen on 1/30/17 at the forward
contract rate of $0.0095.

Date Spot rate Acct Pay Forward rate Cont Rec

12/2 $0.0094 $1,880 $0.0095 $1,900
12/31 $0.0092 $1,840 $0.0093 $1,860
1/30 $0.0098 $1,960 $0.0098 $1,960

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

Fair-Value Hedge: Liability (1 of 3)
Accounts payable:
● Gain of $40 for December
● Loss of $120 for January
Contract receivable:
● Loss of $40 for December
● Gain of $100 for January
Total exchange loss on the transaction = ($20)
- The net gain/loss for December = $0.
- The net loss for January = ($20)

Spread between the spot and forward rate on 12/2

determines the total loss, e.g., the cost of hedging.

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

Fair-Value Hedge: Liability (2 of 3)

12/2: Buy 12/2 Equipment 1,880 blank

equipment
and sign blank Accounts payable (¥) blank 1,880
forward 12/2 Contract receivable (¥) 1,900 blank
contract
blank Contract payable ($) blank 1,900
12/31:
12/31 Accounts payable (¥) 40 blank
Adjust
foreign blank Exchange gain blank 40
monetary
accounts to 12/31 Exchange loss 40 blank
current blank Contract receivable (¥) blank 40
(year-end)
rate

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

Fair-Value Hedge: Liability (3 of 3)

1/30: Pay 1/30 Contract payable ($) 1,900 blank

promised
blank Cash ($) blank 1,900
$1,900 on
forward 1/30 Cash (¥) 1,960  
contract and blank Contract receivable (¥) blank 1,860
receive yen
in exchange blank Exchange gain blank 100
1/30 Accounts payable (¥) 1,840 blank
blank Exchange loss 120 blank
blank Cash (¥) blank 1,960

Use the yen to pay the supplier

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

13.6: Footnote Disclosure
Requirements for Derivatives
Accounting for Derivatives and Hedging Activities

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

Footnote Disclosures
Risk management objectives and strategies must be
disclosed in the footnotes.
Fair-value hedges
● net gain or loss in earnings
● placement on statements
● effectiveness and ineffectiveness
Cash-flow hedges
● hedge ineffectiveness gain or loss
● placement on statements
● types of situations hedged
● expected length of time
● effect of discontinuance of hedge

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

13.7: The IASB Standards for
Derivatives
Accounting for Derivatives and Hedging Activities

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

International Accounting Standards
IAS are similar to U.S. Standards in most respects:

IAS 32 – financial instruments

● Debt and equity instruments
IAS 39 – derivatives and hedges
● Cash-flow and fair-value hedges
● Difference: Hedges of firm commitments can be
accounted for as either a cash-flow or fair-value
hedge.

Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.