1. ACC 424 Financial Reporting II Lecture 13 Accounting for Derivative financial instruments

2. 2 Agenda Derivative financial instruments FASB 133 Examples of accounting for –Futures contracts –Options –Financial swaps –Currency swaps –Interest rate swaps Disclosure requirements

3. 3 A financial instrument Derivatives are financial instruments A financial instrument (FASB 105) is cash, evidence of an ownership interest in an entity, or a contract that both: a) imposes on one entity a contractual obligation (1) to deliver cash or another financial instrument to a second entity or (2) to exchange financial instruments on potentially unfavorable terms with the second entity; b) conveys to that second entity a contractual right (1) to receive cash or another financial instrument from the first entity or (2) to exchange other financial instruments on potentially favorable terms with the first entity.

4. 4 A derivative financial instrument SFAS 119 defined a derivative financial instrument by example –a futures contract, forward contract, swap, option, or other financial instrument with similar characteristics FASB 133 uses 4 characteristics of of derivatives to delineate them: –Underlying(s) Derivative’s value is tied to or derived from the value of an underlying asset, financial instrument or other reference item Can be an interest rate, a per share price, commodity price,foreign exchange rate, index etc that is subject to change –Based on contractual, face or notional amount Face value of debt, number of shares, quantity of currency, number of bushels etc. stated in contract –No or relatively little initial investment Payment not equal to contracted per number of bushels or ounces of silver multiplied by per unit price (underlyings) –Net cash or cash-equivalent settlement based on the interaction between the change in the underlying and the notional amount Purchase contract for 100,000 units at $14.20 sold when price is $14 leads to settlement of (14.20-14.00)  100,000=$20,000 & no delivery Market mechanism for net settlement (e.g., offsetting sale contract)

5. 5 Standards affecting derivative disclosure & reporting SFAS 105 & SFAS 107 deal with disclosures about financial instruments and SFAS 119 deals with disclosures about derivative financial instruments specifically –SFAS 105 is concerned with off-balance-sheet risk or concentrations of credit risk –Off-balance-sheet risk is the risk of accounting loss that exceeds the amount currently recognized as an asset or liability in the balance sheet (e.g., a speculative forward exchange contract) FASB 130 prescribes comprehensive income reporting to include net income & changes in owners’ equity other than those resulting from transactions with owners. Latter changes include: –FASB 52 translation adjustments (current rate method) –FASB 115 available-for-sale securities’ gains & losses –FASB 133 derivatives gains & losses in hedging situations

6. 6 Standards affecting derivative accounting SFAS 52 addresses accounting for foreign currency forward contracts (see last week) and foreign currency futures contracts. –Amended by FASB 133 for fiscal quarters beginning after June 15, 2000 FASB 133 specifies accounting for derivatives except for foreign currency derivatives still subject to FASB 52 –Applies to fiscal quarters beginning after June 15, 2000

7. 7 Principles underlying FASB 133 Derivatives are assets & liabilities –Should be recognized in financial statements Only fair value relevant for derivatives Only assets, liabilities & residual equity should be reported in the balance sheet Special accounting for hedge instruments & hedged items restricted to qualifying transactions –Qualification based primarily on assessment of offsetting fair value changes or cash flows changes for the hedged risk

8. 8 Fair value change reporting Two conditions for hedge treatment –Designation as a hedge –Qualification as a hedge Derivatives not meeting conditions –Value changes reported in earnings Derivatives meeting conditions –Depends on exposure being hedged. Value changes for the derivative reported in earnings or other comprehensive income –Types of exposures hedged Fair value hedges Cash flow hedges Foreign currency hedges

9. 9 Derivatives meeting hedge treatment conditions Fair value hedges of existing assets liabilities & firm commitments not otherwise recognized under GAAP –Derivative value changes reported in earnings concurrent with offsetting change in value of hedged item –Changes in value of hedge item that are not offset by derivative value changes reported in earnings when they occur Cash flow hedges. Hedges of cash flows expected from forecasted or probably anticipated transactions –Portion of derivative change effective in hedging risk initially reported in other comprehensive income & reclassified to earnings during the period in which the forecasted transaction affects earnings –Portion of change not effective in hedging risk reported to earnings directly Foreign currency hedges. Hedges of foreign currency denominated firm commitments and forecasted transactions, available-for-sale (AFS) securities & net investments in foreign operations –Commitments & AFS value changes reported in earnings –Forecasted transactions & investment in foreign operations value changes reported in other comprehensive income

10. 10 Assessing hedge effectiveness Management must: –Document its risk management strategy –Identify the risks being hedged –Designate the the hedging instruments –Assess the effectiveness of the hedging instrument Must identify how effectiveness is assessed Assess the hedging instrument as highly effective (initially and every 3 months) High effectiveness –Derivative neutralizes or offsets the fair value or cash flow changes that are being hedged –A range of 80%-125% effectiveness may be sufficient for high effectiveness –Common effectiveness measure Negative hedge effectiveness quotient = hedging instrument’s fair value change/change in fair value or cash flows of the hedge item Effectiveness of the hedging instrument affects –Its qualification as a hedging instrument –Treatment of value change on the instrument Ineffective portion goes to earnings –In a fair value hedge, the reported change on the hedged item

11. 11 Futures contracts FASB definition of a futures contract: A legal agreement between a buyer or a seller and the clearinghouse of a futures exchange... in the United States and... in other countries... that (a) Obligates the purchaser (seller) to accept (make) delivery of a standardized quantity of a commodity or financial instrument at a specified date or during a specified period, or provides for cash settlement rather than delivery, (b) Effectively can be canceled before delivery date by entering into an offsetting contract for the same commodity or financial instrument, & (c) Has all changes in value of open contracts settled on a regular basis, usually daily. Foreign currency futures contract/forward exchange purchase contract comparison: 1. Futures contract requires deposit at purchase & additional payments if the futures price declines. Forward exchange contract has settlement at end at original price. 2. Delivery is typically not taken on futures contract but, is on forward contract. 3. Futures are purchased on an exchange. Forward contracts are made with dealers.

12. 12 Fair value hedge of exposed asset position using futures Example A firm has 50,000 bushels of grain in inventory carried at LCM of $4.20 per bushel Transactions: November 1, 1991 Sold 10 contracts of 5,000 bushels each for March 1, 1992 delivery at a price of $5.75 per bushel. Margin deposit $10,000 December 31, 1991 Futures quoted at $5.95. Spot price increases from $5.70 to 5.88. March 1, 1992 Sold inventory at $5.10 and futures position closed Required: Record the events related to the futures contract, assuming the futures contract is a highly effective hedge

13. 13 Fair value hedge of exposed asset position Nov 1 Investment in futures$10,000 Cash$10,000 To record the initial margin deposit on the sale of $287,500 in commodity futures Dec 31 Unrealized loss on futures (earnings) 10,000 Cash 10,000 To record the loss on futures contract hedging an exposed asset (5.95-5.75)  50,000 Inventory 9,000 Unrealized gain (earnings) 9,000 To record unrealized gain on inventory of.18  50,000 Both the gain on inventory and the futures loss go to the income statement. Note that they do not completely offset each other.

14. 14 Fair value hedge of exposed asset position March 1Investment in futures$42,500 Gain on futures contract$42,500 To recognize the gain on futures contract when closed out (5.95-5.10)  50,000 Cash 52,500 Investment in futures 52,500 To record receipt from broker including $10,000 deposit when futures contract is closed out Unrealized loss (earnings) 39,500 Inventory 39,500 To adjust the inventory carrying value for the loss on inventory ($5.88-5.10)  50,000

15. 15 Fair value hedge of exposed asset position example Profit on sale of the inventory is $75,500 Sales are $255,000 ($5.10  50,000) Inventory (CGS) is $210,000 + 9,000 - 39,500 = $179,500 Profit on sale would have been $30,500 less without the futures contract. Profit would have been $255,000- $210,000 (4.20  50,000) =$45,000. $30,500 gain is the avoidance(via the futures contract) of the loss in the inventory’s sales value. Gain is realized when the inventory is sold If the futures position were closed on March 1, but the sale made later the $30,500 gain would be realized at the time of the later sale The total profit on all the transactions is $77,500 The $2,000 is the excess profit from the futures. The futures net profit is $32,500 (42,500-10,000), $2,000 more than the loss in inventory sales value $30,500 ($39,500-9,000). This $2,000 gain is realized over the life of the futures contract Futures contract effectively locks in the $5.75 price and a total profit on the sale of ($5.75-4.20)  50,000 = $77,500.