19th
Edition
Chapter 19
Derivatives,
Contingencies,
Business Segments,
and Interim Reports
Intermediate
Accounting
James D. Stice
Earl K. Stice
PowerPoint presented by Douglas Cloud
Professor Emeritus of Accounting, Pepperdine University
© 2014 Cengage Learning
19-1
Simple Example of a Derivative
•
•
A derivative is a financial instrument or contract
that derives its value from the movement of the
price, foreign exchange rate, or interest rate on
some other underlying asset or financial
instrument.
When the agreement is made, no journal entry is
required, because it is merely an exchange of
promises about some future action; that is, an
executory contract.
19-2
Types of Risk
•
•
•
Price risk is the uncertainty about the
future price of an asset.
Credit risk is the uncertainty that the
party on the other side of the agreement
will abide by the terms of the agreement.
Interest rate risk is the uncertainty about
future interest rates an their impact on
future cash flows as well as on the fair
value of existing assets and liabilities.
(continued)
19-3
Types of Risk
•
Exchange rate risk is the uncertainty about
the U.S. dollar cash flows arising when
assets and liabilities are denominated in a
foreign currency.
19-4
Swap
•
•
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.
A common type of swap is an interest rate
swap where two parties agree to exchange
future interest payments on a given loan amount
(one set of interest payments is based on a fixed
interest rate and the other is based on a variable
interest rate).
(continued)
19-5
Swap
•
Pratt Company takes advantage of its good
working relationship with a bank that issues
only variable-rate loans.
•
On January 1, 2013, Pratt receives a 2-year,
$100,000 loan with interest payments
occurring at the end of each year.
•
The interest rate for the first year is 10%, and
the rate in the second year will be equal to the
market interest on January 1 of that year.
(continued)
19-6
Swap
•
•
Pratt enters into an interest rate swap
agreement with another party whereby Pratt
agrees to pay a fixed interest rate of 10% on
the $100,000 loan to that party in exchange for
receiving a variable amount based on the
prevailing market rate.
Pratt will receive an amount equal to
[$100,000 × (Jan. 1, 2014 interest rate – 10%)]
if the interest rate is above 10% and will pay the
same amount if the rate is less than 10%.
(continued)
19-7
Swap
To see the impact of this interest rate swap,
consider the following table:
Pratt will pay $10,000 no matter what the
prevailing interest rates in 2014.
19-8
Forwards
•
•
A forward contract is an agreement between
two parties to exchange a specified amount of a
commodity, security or foreign currency at a
specified date in the future with the price of the
exchange rate being set now.
On November 1, 2013, Clayton Company sold
machine parts to Maruta Company for
¥30,000.000 to be received on January 1, 2014.
The current exchange rate is ¥120 = $1.
(continued)
19-9
Forwards
•
•
Clayton enters into a forward contract with a
large bank, agreeing that on January 1 Clayton
will deliver ¥30,000.000 to the bank and the
bank will give U.S. dollars in exchange at the
rate of ¥120 = $1, or $250,000
(¥30,000,000/¥120 per $1).
If on January 1, 2014, ¥30,000,000 is worth less
than $250,000, the bank will pay Clayton the
difference in cash (U.S. dollars).
(continued)
19-10
Forwards
•
•
If ¥30,000,000 is worth more than $250,000
Clayton pays the difference in cash.
The impact of the forward exchange is shown in
the following table:
(continued)
19-11
Futures
•
•
A futures contract is a contract, traded on an
exchange, that allows a company to buy or sell
a specified quantity of a commodity or a
financial security at a specified price on a
specified future date.
It is very similar to a forward contract with the
difference being that a forward contract is a
private contract negotiated between two
parties, whereas a futures contract is a
standardized contract that is sponsored by a
trading exchange.
19-12
Futures
•
Hyrum Bakery uses 1,000 bushels of wheat
every month. On December 1, 2013, Hyrum
decides to protect itself against price
movements. Hyrum buys a futures contract to
purchase 1,000 bushels of wheat on January
1, 2014, at $4 per bushel.
•
This is a standardized exchange-traded
futures contract, so Hyrum has no idea who is
on the other side of the agreement.
(continued)
19-13
Futures
•
As with other derivatives, a wheat futures
contract is usually settled by a cash payment
at the end of the contract instead of the actual
delivery of the wheat.
•
The effect of the futures contract is illustrated
in the following table:
19-14
Option
•
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.
•
A call option gives the owner the right to buy
an asset at a specified price.
•
A put option gives the owner the right to sell
an asset at a specified price in exchange for the
rights inherent in the option.
(continued)
19-15
Option
•
The owner of the option pays an amount in
advance to the party on the other side of the
transaction, who is called the writer of the
option.
(continued)
19-16
Option
•
•
•
On October 1, 2013, Woodruff Company
decides that it will need to purchase 1,000
ounces of gold for use in its computer chip
manufacturing process in January, 2014.
Gold is selling for $1,100 per ounce on October
1, 2013.
For cash flow reasons, Woodruff plans to delay
the purchase of gold until January 1, 2014, and
is concerned about potential increases in the
market price of gold between October 1, 2013,
and January 1, 2014.
(continued)
19-17
Option
•
Woodruff enters into a call option contract on
October 1.
•
The contract gives Woodruff the right, but not
the obligation, to purchase 1,000 ouches of
gold at a price of $1,100 per ounce. The
option period extends to January 1, 2014.
•
Woodruff has to pay $20,000 to buy this
option.
(continued)
19-18
Option
•
The chart below shows the anticipated
activity at three possible gold prices.
•
The existence of the option contract means
that Woodruff will pay no more than
$1,100,000 for gold.
19-19
Types of Hedging Activities
•
•
•
Broadly defined, hedging is the structuring of
transactions to reduce risk.
A fair value hedge is a derivative that
offsets, at least partially, the change in the
fair value of an asset or a liability.
A cash flow hedge is a derivative that
offsets, at least partially, the variability in
cash flows from forecasted transactions that
are probable.
19-20
Overview of Accounting for
Derivatives and Hedging Activities
The accounting difficulty caused by derivatives is
illustrated in this simple matrix:
The historical cost focus of traditional accounting
is misplaced with derivatives because derivatives
often have little or no up-front historical cost.
(continued)
19-21
Overview of Accounting for
Derivatives and Hedging Activities
1. Balance sheet. Derivatives should be
reported in the balance sheet at their fair
value as of the balance sheet date. No
other measure of value is relevant for
derivatives.
2. 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.
19-22
Overview of Accounting for
Derivatives and Hedging Activities
•
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 changed.
•
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.
(continued)
19-23
Overview of Accounting for
Derivatives and Hedging Activities
• Cash flow hedge. Changes in the fair value of
derivatives designated as cash flow hedges are
recognized as part of the accumulated other
comprehensive income account.
To account for a derivative as a hedge, a
company must define, in advance, how it
will determine whether the derivative is
functioning as an effective hedge.
19-24
Disclosure
•
•
•
Companies are required to provide a
description of their risk management strategy
and how derivatives fit into that strategy for
both fair value and cash flow hedges.
Companies must disclose the amount of
derivative gains or losses that are included in
income because of hedge ineffectiveness.
For cash flow hedges, a company must
describe the transactions that will cause
deferred derivative gain and losses to be
recognized in net income.
(continued)
19-25
Disclosure
•
•
•
The notional amount is the total face
amount of the asset or liability that underlies
a derivative contract.
The notional amount of derivative
instruments is often reported and is
frequently misleading.
Notional amounts grossly overstate both the
fair value and the potential cash flows of
derivatives.
19-26
Pratt Swap
On January 1, 2013, Pratt Company received a
two-year $100,000 variable-rate loan and also
entered into an interest rate swap agreement.
The journal entry to record this information
follows:
2013
Jan. 1 Cash
Loan Payable
100,000
100,000
No entry is made to record the swap agreement
because the swap has a fair value of $0.
(continued)
19-27
Pratt Swap
•
The actual market interest rate on December
31, 2013 is 11%.
•
With this rate, Pratt will receive a $1,000
payment [$100,000 x (0.11 – 0.10)] at the end
of 2014.
On December 31, 2013, Pratt has a $1,000
receivable under the swap agreement, and the
receivable has a present value of $901
(FV = $1,000, N =1, I = 11%).
•
(continued)
19-28
Pratt Swap
The impact of the change in interest rate on
the interest rate swap and on reported
interest expense is accounted for as follows:
19-29
Pratt Swap
The journal entry to record Pratt’s 2013 interest
payment, along with the adjusting entry to
recognize the change in the fair value, is as
follows:
2013
Dec 31 Interest Expense
Cash ($100,000 × 0.10)
31 Interest Rate Swap (asset)
Other Comprehensive
Income
10,000
10,000
901
901
The journal entries at the end of 2014 are on
Slide 19-43.
(continued)
19-30
Pratt Swap
2014
Dec. 31 Interest Expense
11,000
Cash ($100,000 × 0.11)
11,000
31 Cash (from swap agreement) 1,000
Interest Rate Swap (asset)
901
Other Comprehensive
Income ($901 × 0.11)
99
31 Accumulated Other
Comprehensive Income
1,000
Interest Expense
1,000
31 Loan Payable
100,000
Cash
100,000
19-31
Clayton Forward
On November 1, 2013, Clayton Company sold
machine parts to Maruta Company for
¥30,000,000 to be received on January 1, 2014.
On the same date, Clayton also entered into a
yen forward contract. The required entry is as
follows:
2013
Nov. 1 Yen Receivable
Sales
250,000
250,000
¥30,000,000/
¥120 per $1
(continued)
19-32
Clayton Forward
The actual exchange rate on December 31,
2013 is ¥119 = $1. Clayton will have a loss on
the forward contract and will be required to
make a $2,101 payment [(¥30,000,000/¥119
per $1) – $250,000]. The impact of the change
in the yen exchange rate is as follows:
(continued)
19-33
Clayton Forward
The adjusting entries to recognize the change in
the fair value of the forward contract and in the
U. S. dollar value of the yen receivable are as
follows:
2013
Dec. 31 Loss on Forward Contract
2,101
Forward Contract
31 Yen Receivable
2,101
Gain on Foreign Currency
2,101
2,101
(continued)
19-34
Clayton Forward
The journal entries necessary in Clayton’s books
on January 1, 2014, to record receipt of the yen
payment and settlement of the yen forward
contract are as follows:
2014
Jan. 1 Cash (¥30,0000,000/¥119
per $1)
252,101
Yen Receivable
252,101
1 Forward Contract (liability)
2,101
Cash (forward contract
settlement)
2,101
(continued)
19-35
Clayton Forward
•
•
It should be noted that the Clayton
forward contract does not qualify for
hedge accounting under FASB ASC
Topic 815.
Derivatives that serve as economic
hedges of foreign currency assets and
liabilities are accounted for as
speculations, with all gains and losses
recognized as part of income immediately.
(continued)
19-36
Hyrum Future
•
On December 1, 2013, Hyrum Company
decided to hedge against potential
fluctuations in the price of wheat for its
forecasted January 2014 purchases.
•
The firm bought a futures contract entitling
and obligating Hyrum to purchase 1,000
bushels of wheat on January 1, 2014, for
$4.00 per bushel.
(continued)
19-37
Hyrum Future
•
No entry is made to record the futures
contract because, as of December 31,
2013, the future has a fair value of $0.
•
The actual price of wheat on December 31,
2013, is $4.40 per bushel. Hyrum will
receive a $400 payment [1,000 bushels ×
($4.40 – $4.00)] on January 1, 2014, to
settle the futures contract.
(continued)
19-38
Hyrum Future
The impact of the change on the anticipated
cost of wheat when purchased in January
2014 is accounted for as follows:
(continued)
19-39
Hyrum Future
The adjusting entry to recognize the change
in the fair value of the futures contract is as
follows:
2013
Dec. 31 Wheat Futures Contract (asset)
400
Other Comprehensive Income
400
The gain from the increase in the
value of Hyrum’s futures contract
is deferred as a part of other
comprehensive income.
(continued)
19-40
Hyrum Future
The journal entries necessary to record the
purchase of 1,000 bushels of wheat in the open
market and the cash settlement of the wheat
futures contracts are as follows:
2014
Jan. 1 Wheat Inventory
Cash
4,400
4,400
1,000 bushels x $4.40
1 Cash (future contract settlement) 400
Wheat Futures Contract (asset)
1 Accumulated Other
Comprehensive Income
400
Gain on Futures Contract
400
400
19-41
Woodruff Option
•
On October 1, 2013, Woodruff Company paid
$20,000 to purchase a call option to buy 1,000
ounces of gold at a price of $1,100 per ounce
some time before January 1, 2014.
•
Because Woodruff paid cash for the gold
option, the following journal entry is made on
October 1:
2013
Oct. 1 Gold Call Option (asset)
Cash
20,000
20,000
(continued)
19-42
Woodruff Option
•
The actual price of gold on December 31,
2013, is $1,128 per ounce. Woodruff will
receive a $28,00 payment [($1,128 x 1,000
ounces) – ($1,100 x 1,000 ounces)] on
January 1, 2014, to settle the call option.
(continued)
19-43
Woodruff Option
•
The impact on the change in price of gold
is accounted for as follows:
(continued)
19-44
Woodruff Option
The gold call option is reported at its fair
value of $28,000 in the December 31, 2013,
balance sheet. The adjusting entry to
recognize the change in the fair value of the
option is as follows:
2013
Dec. 31 Gold Call Option ($28,000 –
$20,000)
Other Comprehensive
Income
8,000
8,000
(continued)
19-45
Woodruff Option
The journal entry necessary in Woodruff’s book
on January 1, 2014, to record the purchase of
1,000 ounces of gold and the cash settlement of
the option contract are as follows:
2014
Jan. 1 Gold Inventory
1,128,000
Cash
x $1,128
1 Cash1,000
(goldounces
call option
settlement)
28,000
Gold Call Option (asset)
1 Accumulated Other
Comprehensive Income
8,000
Gain on Gold Call Option
1,128,000
28,000
8,000
19-46
Accounting for 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.
19-47
Accounting for Lawsuits
In ASC Topic 450, the FASB identifies several key
factors to consider in making the decision. These
include the following:
1. The nature of the lawsuit
2. Progress of the case
3. Views of legal counsel as to the probability of
loss
4. Prior experience with similar cases
5. Management’s intended response to the
lawsuit
19-48
Disclosure
•
Some companies do not disclose any
information regarding potential liabilities from
lawsuits.
•
Others provide a brief, general description of
pending lawsuits.
•
Sometimes companies provide fairly specific
information about pending actions and
claims.
•
They generally do not disclose dollar
amounts of potential losses.
19-49
Accounting for
Environmental Liabilities
•
•
The SEC staff issued Staff Accounting
Bulletin No. 92, which set forth the SEC’s
interpretation of GAAP regarding contingent
liabilities, with particular applicability to
companies with environmental liabilities.
The AICPA issued SOP 96-1 outlining key
events that can be used to determine
whether an environmental liability is
probable.
19-50
Business Segments
•
•
Information to be disclosed in the financial
statement notes under the provisions of PreCodification FASB Statement No. 14
included revenues, operating profit, and
identifiable assets for each significant
industry segment of a company.
Other provisions of the statement required
disclosure of revenues from major customers
and information about foreign operations and
export sales.
(continued)
19-51
Business Segments
According to the provisions of FASB ASC Topic
280, companies are required to disclose the
following information concerning business
segments:
1. Total segment operating profit or loss
2. Amounts of certain income statement items
such as operating revenues, depreciation,
interest revenue, interest expense, tax
expense, and significant noncash expenses
3. Total segment assets
(continued)
19-52
Business Segments
4. Total capital expenditures
5. Reconciliation of the sum of segment totals
to the company total for each of the following
items:
 Revenues
 Operating profits
 Assets
(continued)
19-53
Business Segments
Separate segment disclosure is required if a
segment meets any one of the following three
criteria:
• Revenue test. A segment should be
reported if its total revenue is 10% or more
of the company’s total revenue (external
and internal).
(continued)
19-54
Business Segments
•
Profit test. A segment should be reported
if the absolute value of its operating profit
(or loss) is more than 10% of the total of
the operating profit for all segments that
report profits (or the total of the losses for
all segments that reported losses).
•
Asset test. A segment should be reported
if it contains 10% or more of the combined
assets of all operating segments.
(continued)
19-55
Business Segments
The FASB also decided that segments can
be combined for reporting purposes, even if
they are treated as separate segments
internally, if the segments have similar
products or services, similar processes,
similar customers, similar distribution
methods, and are subject to similar
regulations.
19-56
Interim Reports
•
•
Statements showing financial position and
operating results for intervals of less than a
year are referred to as interim financial
statements.
Under the integral part of annual period
concept, the same general accounting
principles and reporting practices employed for
annual reports are to be utilized for interim
statements, but modifications may be required
so the interim results will better relate to the
total results of operations for the annual period.
(continued)
19-57
Interim Reports
Example of a Modification
•
Assume a company uses the LIFO method of
inventory valuation and encounters a situation
where liquidation of the base period inventory
occurs at an interim date but the inventory is
expected to be replaced by the end of the
annual period.
•
The inventory should not reflect the LIFO
liquidation by including the cost of replacing the
liquidated LIFO base.
19-58
Chapter 19
₵
The End
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19-59
19-60