Module

Derivatives and Related Accounting

Issues

Derivatives 2

Derivatives, defined

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

Derivatives 3

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

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Common Types of Derivatives

• Forward Contracts

• Futures Contracts

• Option Contracts

• Interest Rate Swaps

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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 asset’s spot rate at the forward date.

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Example of a Forward Contract

Writerof the

Contract

Holderof the

Contract

Convey 100,000 euros in 90 days

Pay $85,000 in 90 days

Euros at the forward rate in 90 days….. $ 85,000Assumed spot rate in 90 days………… 90,000Gain in value of forward……………… $ 5,000

Derivatives 7

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)

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Measuring Changes in the Value of a Forward Contract Over Time, continued

30 0

Fair value of forward contract:Original forward value 50,000$ 50,000$ Current forward value 53,000 55,000 Change in value 3,000$ 5,000$

Present value of change 2,830$ 5,000$

Change in value from prior period 2,830$ 2,170$ Change in spot rates 2,500$ 2,100$ Change in time value 330$ 70$

30 daysDays Prior to Forward Date

Derivatives 9

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

Derivatives 10

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

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Example of a Futures Contract

The ShortClearingHouse

TheLong

Sell oil

Buy oil

Buy oil

Sell oil

Futures price/barrel on day 1……………….. $45Futures price/barrel on day 2……………….. 46Gain in value of contract……………………. $ 1

Contract to buy oil in May at $45/barrel

Derivatives 12

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

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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

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Example of an Option

OptionWriter

OptionHolder

Buy corn at $2.20/bu

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)

Assume: market price per bushel is $2.22notional amount is 100,000 bushelsoption value is $2,400

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Option Terms Illustrated

Call Call PutOption A Option B Option C

Premium Paid $1,000 $1,000 $1,000Exercise (strike) Price 30,000 30,000 30,000Current Value of underlying 29,500 30,800 29,200At-the-Money No No NoOut-of-the-Money Yes No NoIn-the-Money No Yes YesIntrinsic Value - 800 800Time Value 1,000 200 200

Derivatives 16

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.

Derivatives 17

Example of an Interest Rate Swap

Issuer Of$10 Million

Debt

BankCounter-

Party

Pays 8% fixed

Pays a variable

rate

Receives 8% fixed

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

Creditors

Derivatives 18

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.

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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.

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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.

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Special Accounting Treatment for Fair Value Hedges

• 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.

The special accounting treatment results in:

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.

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Special Accounting Treatment for Fair Value Hedges, continuedChanges in the time value of a derivative are generally excluded from the assessment of hedge effectiveness and are always recognized in current earnings.

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Accounting for a Fair Value Hedge IllustratedAssume 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.

60 days 30 days 0 daysNotional amount in units 100,000 100,000 100,000 Spot price per unit 1.495 1.482 1.460 Future price per unit 1.490 1.480 1.460 Fair value of contract 1,000$ 3,000$

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Accounting for a Fair Value Hedge Illustrated, continued

60 days 30 days 0 daysNotional amount in units 100,000 100,000 100,000 Spot price per unit 1.495 1.482 1.460 Future price per unit 1.490 1.480 1.460 Fair value of contract 1,000$ 3,000$

Change in fair value of contract 1,000$ 2,000$ Current period change in spot rates 1,300$ 2,200$ Current period change in time value (300)$ (200)$

Effect on current earnings:Gain (Loss) in value of inventory (1,300)$ (2,200)$ Gain (Loss) in value of contract 1,300$ 2,200$ Net measure of effectiveness -$ -$ Gain (Loss) in value of contract

excluded from hedge effectiveness (300)$ (200)$ Net effect on current earnings (300)$ (200)$

Remaining Term of Contract

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Assessing the Effectiveness of a Fair Value Hedge

Desired Without the With the Position Hedge Hedge

Sales price of inventory 149,500$ 146,000$ 146,000$ Cost of sales (120,000) (120,000) (116,500) Gross profit 29,500$ 26,000$ 29,500$ Hedging gain (loss) on contract 3,500$ Hedging gain (loss) on inventory (3,500)Subtotal 29,500$ 26,000$ 29,500$ Gain (loss) on contract excluded from

assessment of effectiveness (500)Net effect on earings 29,500$ 26,000$ 29,000$

Derivatives 26

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.

Derivatives 27

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.

Derivatives 28

Special Accounting Treatment for Cash Flow Hedges

• 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.

The special accounting treatment results in:

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

Special Accounting Treatment for Cash Flow Hedges, continued

Derivatives 30

Accounting for a Cash Flow Hedge IllustratedAssume 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.

60 days 30 days 0 daysNotional amount in units 100,000 100,000 100,000 Spot price per unit 1.49$ 1.510$ 1.54$ Future price per unit 1.50$ 1.525$ 1.54$ Fair value of contract 2,500$ 4,000$

Remaining Term of Contract

Derivatives 31

Accounting for a Cash Flow Hedge Illustrated, continued

Date Inventory60 days 30 days 0 days Is Sold

Notional amount in units 100,000 100,000 100,000 Spot price per unit 1.49$ 1.510$ 1.54$ Future price per unit 1.50$ 1.525$ 1.54$ Fair value of contract 2,500$ 4,000$

Change in fair value of contract 2,500$ 1,500$ Current period change in spot rates 2,000$ 3,000$ Current period change in time value 500$ (1,500)$

Effect on OCI: Gain (Loss) in value of derivative 2,000$ 3,000$ Reclassification of OCI into earnings (5,000)$ Net effect on OCI 2,000$ 3,000$ (5,000)$

Effect on current earnings: Adjustment to cost of sales 5,000$ Gain (Loss) in value of contract excluded from hedge effectiveness 500$ (1,500)$ - Net effect on current earnings 500$ (1,500)$ 5,000$

Remaining Term of Contract

Derivatives 32

Assessing the Effectiveness of a Cash Flow Hedge

Desired Without the With the Position Hedge Hedge

Sales price of inventory (assumed) 225,000$ 225,000$ 225,000$ Cost of sales - inventory (149,000) (154,000) (154,000) Cost of sales - processing (assumed) (30,000) (30,000) (30,000) Gross profit 46,000$ 41,000$ 41,000$ Reclassification of OCI 5,000 Adjusted gross profit 46,000$ Gain (loss) on contract excluded from assessment of effectiveness (1,000) Net effect on earings 46,000$ 41,000$ 45,000$

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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 entity’s risk management policy for hedging types and description of hedged transactions.

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Disclosures Regarding Derivative Instruments & Hedging ActivitiesRequired 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.