Prepared by Gabriela H. Schneider, CMA; Grant MacEwan College INTERMEDIATE ACCOUNTING INTERMEDIATE ACCOUNTING Sixth Canadian Edition KIESO, WEYGANDT, WARFIELD, IRVINE, SILVESTER, YOUNG, WIECEK

C H A P T E R 18 Dilutive Securities and Earnings per Share

Appendix 18B Accounting for Derivatives

Study Objectives 1.Explain who uses derivatives and why they are used 2.Understand the basic guidelines for accounting for derivatives 3.Describe the accounting for derivative financial instruments 4.Describe the disclosure requirements for traditional and derivative financial instruments

Derivatives Derivatives are financial instruments that create rights and obligations, that transfer financial risk from one party to the another party Used to reduce financial risks Price risk Liquidity risk Credit risk Cash flow risk Derivative instruments include Forwards Futures Options

Derivatives Traditional accounting does not reported these instruments Movement is towards recognition and reporting of these instruments, to Provide information on exposed risks Provide information on risk management

Derivatives Used by Producers and Consumers Lock in future revenues or costs Speculators and Arbitrageurs Maintain market liquidity Additional motivations to use derivatives Manage interest rate volatility Manage foreign exchange rate volatility

Derivative Instruments Financial forwards or financial futures Options Call Option Holder has the right, but not the obligation, to purchase at a preset (strike or exercise) price Put Option Holder has the right to sell at a preset price Swaps Interest rate

Basic Principles of Derivative Accounting Currently no GAAP in place for derivative accounting General consensus exists for: a)Measurement at fair value b)Recognition of gains/losses from fair value changes c)Preclusion of special accounting related to hedging d)Increasing disclosure

Derivative Accounting - Example Given: Call option entered into January 2, 2002 Option expires April 30, 2002 Option to purchase 1,000 shares at $100 per share Share market price on January 2, 2002 is $100 per share Option is purchased for $400 (Option Premium) Share price March 31 st $120 per share

Accounting for Derivatives Option Price Formula Option Premium = Intrinsic Value + Time Value Market Price less Strike (Exercise) Price Option Value Less Intrinsic Value Option Premium = ($100 - $100) + ($400 - $0) Journal Entries

Accounting for Derivatives January 2 Temporary Investment (Call Option)400 Cash 400 March 31 Temporary Investment (Call Option) 20,000 Unrealized Holding Gain/Loss 20,000 Intrinsic Value = 1,000 shares ($100 - $120) March 31 Unrealized Holding Gain/Loss300 Temporary Investment (Call Option) 300 Time Value = ($400 - $100)

Accounting for Derivatives April 1 Cash20,000 Loss on Settlement of Call Option 400 Call Option20,100 20,000 20,100 Unrealized Gain or Loss Call Option Temp. Investment , ,100 Reported on March 31 st Balance Sheet, with Call Option balance Unrealized 20,000 Less: Loss 400 Net Income 19,600

Hedging Used to manage interest rate and foreign exchange risk Fair Value Hedge To offset exposure to fair value changes of Recognized asset or liability, or Unrecognized firm commitment Examples are Interest rate swap Put option

Interest Rate Swap Party AParty B Financial Intermediary A pays B at a fixed (or floating) rate B pays A using the opposite rate of A

Interest Rate Swap Given: A enters into a 5-year interest rate swap with B Terms are: A will receive payments at the fixed rate of 8% A will pay at variable rate (6.8% when contract entered into) Principal sum involved is $1,000,000

Interest Rate Swap No entry required when swap entered into Fair value of the swap reported on the Balance Sheet Any gains or losses reported on the Income Statement

Futures Contract Gives the holder the right to purchase at a preset price Unrealized gains or losses are recorded Gain or loss arises when the spot price is different than the forward (contract) price

Disclosure Requirements Include the following: 1)Terms and conditions of instrument 2)Interest rate risk 3)Credit risk, including significant concentrations 4)Fair value of any and all recognized and unrecognized financial instruments 5)Hedges 1)Description of hedge 2)Type of hedge used

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