Accounting for Derivatives Pertemuan Matakuliah: Akuntansi Keuangan Lanjutan I Tahun: 2010

Bina Nusantara University 3 Derivatives (def.) Derivative is a name given to a broad range of financial securities. The derivative contract's value to the investor is –Directly related to fluctuations in price, rate or some other variable –That underlies it. Typical derivative instruments –Option contracts –Forward contracts –Futures contracts

Bina Nusantara University 4 Types of Derivatives - Types of Derivatives - Forward Contracts Forward contracts –Negotiated contracts between two parties –For the delivery or purchase of A commodity or A foreign currency –At an agreed upon price, quantity, and delivery date. Settlement of the forward contract may be –Physical delivery of the good, or –Net settlement

Bina Nusantara University 5 Types of Derivatives - Types of Derivatives - Futures Contracts Futures contracts are specific type of forward contracts –Characteristics are standardized –Characteristics are set by futures exchanges Rather than by the contracting parties –Exchange guarantees performance Settlement may also be made by entering another futures contract in the opposite direction

Bina Nusantara University 6 Types of Derivatives - Types of Derivatives - Options With options, only one party is obligated to perform The other party has –Ability, –But not obligation to perform

Bina Nusantara University 7 Using Derivatives as Hedges A hedge can –Shift risk of fluctuations in sales prices, costs, interest rates, currency exchange rates –Help manage costs –Reduce risks to improve financial position –Produce tax benefits –Help avoid bankruptcy

Bina Nusantara University 8 Hedge Accounting At inception, document the hedge –Relationship between hedged item and derivative instrument –Risk management objective and strategy for hedge Hedged instrument Hedged item Nature of risk being hedged Means of assessing effectiveness

Bina Nusantara University 9 Hedge Effectiveness To qualify for hedge accounting, the derivative instrument must be –Highly effective in offsetting –Gains or losses –In the item being hedged

Bina Nusantara University 10 Critical Term Analysis Effectiveness considers –Nature of the underlying variable –Notional amount –Item being hedged –Delivery date of derivative –Settlement date of the underlying If critical terms are identical, effectiveness is assumed

Bina Nusantara University 11 Example of Effectiveness Item to be hedged –Accounts payable –Due January 1, 2007 –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, 2007

Bina Nusantara University 12 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

Bina Nusantara University 13 Cash Flow Hedge Hedges –Anticipated or forecasted transactions Hedges exposure to variability in expected future cash flows associated with a risk. Hedged risk –Variability in expected future cash flows

Bina Nusantara University 14 Accounting for Cash Flow Hedge Hedge instrument is recorded at cost Adjust to fair value Change in fair value is recorded as Other Comprehensive Income (OCI) When the forecasted transaction impacts the income statement –Reclassify OCI to the hedged revenue or expense account

Bina Nusantara University 15 Cash Flow Hedge Example: Fuel Utility anticipates purchasing oil for sale to its customers next February. On Dec. 1 Utility enters a futures contract to acquire 4,200 gallons of oil at $ per gallon for delivery on Jan. 31. A margin of $10 is to be paid up front. On Dec. 31, the price for delivery of oil on Jan. 31 is $ On Jan. 31, the spot rate for current delivery is $ Utility settles the contract, accepting delivery of 4,200 gallons of oil.

Bina Nusantara University 16 Hedge: Fuel (cont.) In Feb. Utility sells all the oil to its customers for $8,400 and reclassifies its OCI from the hedge as cost of sales. Pertinent rates: Change in futures contract to Dec. 31 = $18.06 Change in futures contract to Jan. 31 = ($23.10) The loss on the contract is ($5.04) OCI, and this serves to increase the cost of sales. 12/112/311/31 Futures rate, for 1/31$1.4007$1.4050$ Cost of 4,200 barrels$5,882.94$5,901.00$5,877.90

Bina Nusantara University 17 Hedge: Fuel - Entries 12/1Futures contract10.00 Cash /31Futures contract18.06 OCI /31OCI23.10 Futures contract /31Cash4.96 Futures contract /31Inventory5, Cash 5, Adjust to fair value Settle contract; collect balance on margin. Purchase inventory. Sign contract

Bina Nusantara University 18 Hedge: Fuel – Entries cont’d Feb.Cash8, Sales 8, Feb.Cost of sales5, Inventory 5, Feb.Cost of sales5.04 OCI 5.04 Record the sale and cost of sales. 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, This is the cost of the oil based on the futures contract signed on Dec. 1.

Bina Nusantara University 19 Fair Value Hedge Hedges –An existing asset or liability position, or –A firm purchase or sales commitment Hedged risk –Change in the value of the asset, liability, or commitment

Bina Nusantara University 20 Accounting for a Fair Value Hedge Exchange gains and losses are recognized immediately in income –Exchange gain or loss Offset by related losses and gains on the hedged item