derivatives, contingencies, business segments, and interim reports

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Derivatives, Derivatives, Contingencies, Contingencies,

Business Business Segments, and Segments, and Interim ReportsInterim Reports

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Understand the business and accounting concepts connected with derivatives and hedging activities.

Identify the different types of risk faced by a business.

Describe the characteristics of the following types of derivatives: swaps, forwards, futures, and options.

Learning Objectives

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Define hedging, and outline the difference between a fair value hedge and a cash flow hedge.

Account for a variety of different derivatives and for hedging relationships.

Learning Objectives

CONTINGENCIES Apply the accounting rules for contingent

items to the areas of lawsuits and environmental liabilities.

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Learning Objectives

SEGMENT REPORTING Prepare the necessary supplemental disclosures of

financial information by product line and by geographic areas.

INTERIM REPORTING Recognize the importance of interim reports, and

outline the difficulties encountered when preparing those reports.

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Types of Risk

• Price risk

• Credit risk

• Interest rate risk

• Exchange rate risk

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Types of Derivatives

• Swap

• Forward contract

• Futures contract

• Option

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A swap is a contract in which two parties agree to exchange payments in the

future based on the movement of some agreed-

upon price or rate.

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A forward contract is an agreement

between two parties to exchange a

specified amount of a commodity, security, or foreign exchange at a specified date in the future with the price or exchange rate being set now.

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A futures contract is a contract, traded on an exchange, that allows a company to

buy a specified quantity of a

commodity or a financial security at a specified price on a

specified future date.

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An option is a contract giving the owner the right, but not the obligation, to buy or sell an asset at a specified price any

time during a specified period in

the future.

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Call Option: Contract giving the owner the right, but not the obligation, to buy an

asset at a specified price.

Put Option: Contract giving the owner the right, but not the obligation, to sell an asset at a

specified price.

An option differs from other derivative instruments because it protects the owner against unfavorable

movements in prices or rates while allowing the owner to benefit from favorable movements.


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Types of Hedging Activities

Hedging: Structuring of transactions to reduce risk.

• Fair value hedge: A derivative that offsets, at least partially, the change in the fair value of an asset or liability.

• Cash flow hedge: A derivative that offsets, at least partially, the variability in cash flows from forecasted transactions that are probable.

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Accounting for Derivatives

Balance sheet: Derivatives should be reported in the balance sheet at their fair value as of the balance sheet date.

Income statement: When a derivative is used to hedge risks, the gains and losses on the derivative should be reported in the same income statement in which the income effects on the hedged items are reported.

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• No hedge: All changes in the fair value of derivatives that are not designated as hedges are recognized as gains or losses in the income statement in the period in which the value changes.

• Fair value hedge: Changes in the fair value of derivatives designated as fair value hedges are recognized as gains or losses in the period of the value change.

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• Cash flow hedge: Changes in the fair value of derivatives designated as cash flow hedges are recognized as part of accumulated other comprehensive income.

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Firms must disclose the gains and losses on derivatives, separated by category:

– Fair value hedges

– Cash flow hedges

– Other• Notional amount: Total face

amount of the asset or liability that underlies a derivative contract.


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On January 1, 2002, Pratt Company received a two-year $100,000

variable-rate loan and also entered into an interest rate swap agreement.

On January 1, 2002, Pratt Company received a two-year $100,000

variable-rate loan and also entered into an interest rate swap agreement.

Jan. 1 Cash 100,000Loan Payable 100,000

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The actual market interest rate on December 31, 2002 is 11%.

The actual market interest rate on December 31, 2002 is 11%.

There is no change in the underlying items in the 2002 balance sheet and

income statement.

There is no change in the underlying items in the 2002 balance sheet and

income statement.The interest rate swap asset is

reported at its present value of $901 ($1,000 discounted) in the December

31, 2002 balance sheet.

The interest rate swap asset is reported at its present value of $901 ($1,000 discounted) in the December

31, 2002 balance sheet.The 2002 income statement shows a deferred gain of $901 on the interest rate swap. A gain is recognized in 2003 to

offset increased in interest expense.

The 2002 income statement shows a deferred gain of $901 on the interest rate swap. A gain is recognized in 2003 to

offset increased in interest expense.

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The December 31, 2002 entry to record Pratt’s 2002 interest payment,

along with the adjusting entry, is:

The December 31, 2002 entry to record Pratt’s 2002 interest payment,

along with the adjusting entry, is:

Dec 31 Interest Expense 10,000Cash 10,000

($100,000 x .10)

31 Interest Rate Swap 901Other Comprehensive

Income 901

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December 31, 2003 December 31, 2003

Dec 31 Interest Expense 11,000Cash 11,000

($100,000 x .11)

31 Cash 1,000Interest Rate Swap 901

Other Comprehensive Income 99

ContinuedContinuedContinuedContinued $901 x .11; rounded

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December 31, 2003 December 31, 2003

Dec 31Other Comprehensive Income 1,000

Interest Expense 1,000

31 Loan Payable 100,000Cash 100,000

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Contingencies

FASB Statement No. 5:

“. . . an existing condition, situation, or set of circumstances involving uncertainty as to possible gain . . . or loss . . . to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur.”

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Contingencies

• Contingent losses: Circumstances involving potential losses that will not be resolved until some future event occurs.

• Contingent gains: Circumstances involving potential gains that will not be resolved until some future event occurs.

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Probable Recognize a probable liability if the amount can be reasonable estimated. If not estimable, disclose facts in a note.

Accounting for Contingencies

Likelihood Accounting Action

Reasonably Disclose a possibility liability Possible in a note.

Contingent Losses

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Remote No recognition or disclosure unless contingency represents a guarantee. Then, note disclosure is required.



Contingent Losses

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Probable Recognize a probably asset if the amount can be reasonably estimated. If not estimable, disclose facts in a note.



Reasonably Disclose a possible asset in Possible a note, but be careful to avoid

misleading implications.

Contingent Gains

Remote No recognition or disclosure.

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Accounting for Lawsuits

For uninsured risks, a firm must decide when the liability for litigation becomes probable, and thus, a recorded loss. FASB Statement No. 5 identifies several key factors to consider:

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The nature of the lawsuit. Progress of the case in court, including

progress between date of the financial statements and their issuance date.

Views of legal counsel as to the possibility of loss.

Prior experience with similar cases. Management’s intended response to the

lawsuit.

Accounting for Lawsuits

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Environmental Liabilities

• FASB Statement No. 5 does not give specific guidance on disclosure required when a loss contingency cannot be estimated.

• Recently, accounting standard setters have issued several statements and Exposure Drafts designed to improve the environmental liability information reported in the financial statements and notes.

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• The SEC issued Staff Accounting Bulletin No. 92, its interpretation of GAAP regarding contingent liabilities, with particular applicability to companies with environmental liabilities.

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• 1996, AICPA issued Statement of Position 96-1, “Environmental Remediation Liabilities (Including Auditing Guidance).”

• In February 1996, FASB issued a Proposed Statement of Financial Accounting Standards, “Accounting for Certain Liabilities Related to Closure or Removal of Long-Lived Assets.”

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Segment Reporting

• FASB Statement No. 14 disclosure requirements:–Revenues, operating profit, and identifiable assets

for each significant industry segment.

• A segment is significant if its sales, profits, or assets are 10% or more of total company amounts.

• A practical limit of 10 segments is suggested, and at least 75% of total company sales must be included in the reported segments.

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Segment Reporting

• FASB Statement No. 14 disclosure requirements:–Revenues from major customers and information

about foreign operations and export sales.

34FASB Statement No. 131 Disclosure Requirements

Total segment operating profit or lossAmounts of certain income statement items

such as operating revenues, depreciation, interest revenue, interest expense, tax expense, and significant noncash expenses.

Total segment assets.Total capital expenditures.


Reconciliation of the sum of segment totals to the company total for each of the following items:

- Revenues- Operating profit

- Assets


In addition to these five items, companies must also disclose how operating segments are identified.

In addition to these five items, companies must also disclose how operating segments are identified.

How large must a segment be for

separate disclosure to be required?

How large must a segment be for

separate disclosure to be required?


• Revenue test: A segment should be reported if its total revenue is 10% or more of the company’s total revenue.

• Profit test: A segment should be reported if the absolute value of its operating profit (or loss) is greater than 10% of the total operating profit for all segments that reported profits

• Asset test: A segment should be reported if it contains 10% or more of the combined assets of all operating segments.

A segment is reportable if it meets any one of the three criteria as follows:

A segment is reportable if it meets any one of the three criteria as follows:

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Interim Reporting

Difficulties with Difficulties with Seasonal Seasonal

Interim ReportsInterim Reports

Difficulties with Difficulties with Seasonal Seasonal

Interim ReportsInterim Reports

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Interim Reporting

– Seasonal factors– Revenue fluctuations among

periods– Fixed costs– Matching of revenues– Adjustments for accrued items– Expense estimates (increased

subjectivity)– Extraordinary items– Segment disposal

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APB Opinion No. 28

• The interim period is an integral part of the annual period.

Revenues and expenses for the total period are allocated among

interim periods on some reasonable basis (time, sales volume, productive activity).

Revenues and expenses for the total period are allocated among

interim periods on some reasonable basis (time, sales volume, productive activity).

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APB Opinion No. 28

• The interim period is an integral part of the annual period.

The same GAAP and reporting practices employed for annual reports are to be

used for interim statements, but modification may be necessary for

interim reports to better relate to the total results of operations for the period.

The same GAAP and reporting practices employed for annual reports are to be

used for interim statements, but modification may be necessary for

interim reports to better relate to the total results of operations for the period.

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The EndThe End