Module
Derivatives
and Related
Accounting
Issues
Derivatives, defined
• Financial instruments that derive their value
from changes in the value of a related asset
or liability.
Derivatives
2
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
Derivatives
3
Common Types of Derivatives
• Forward Contracts
• Futures Contracts
• Option Contracts
• Interest Rate Swaps
Derivatives
4
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.
Derivatives
5
Example of a Forward Contract
Writer
of the
Contract
Convey 100,000 euros in 90 days
Pay $85,000 in 90 days
Holder
of the
Contract
Euros at the forward rate in 90 days….. $ 85,000
Assumed spot rate in 90 days…………
90,000
Gain in value of forward……………… $ 5,000
Derivatives
6
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)
Derivatives
7
Measuring Changes in the Value of a
Forward Contract Over Time, continued
30 days
Days Prior to Forward Date
30
0
Fair value of forward contract:
Original forward value
Current forward value
Change in value
$
$
50,000
53,000
3,000
$ 50,000
55,000
$ 5,000
Present value of change
$
2,830
$ 5,000
Change in value from prior period
$
2,830
$ 2,170
Change in spot rates
Change in time value
$
$
2,500
330
$ 2,100
$
70
Derivatives
8
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
9
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
Derivatives
10
Example of a Futures Contract
Contract to buy oil in May at $45/barrel
Sell oil
The Short
Buy oil
Buy oil
Clearing
House
Sell oil
The
Long
Futures price/barrel on day 1……………….. $45
Futures price/barrel on day 2……………….. 46
Gain in value of contract……………………. $ 1
Derivatives
11
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
Derivatives
12
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
Derivatives
13
Example of an Option
Option
Writer
Buy corn at $2.20/bu
Option
Holder
Assume: market price per bushel is $2.22
notional amount is 100,000 bushels
option value is $2,400
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)
Derivatives
14
Option Terms Illustrated
Premium Paid
Exercise (strike) Price
Current Value of underlying
At-the-Money
Out-of-the-Money
In-the-Money
Intrinsic Value
Time Value
Derivatives
Call
Option A
$1,000
30,000
29,500
No
Yes
No
1,000
Call
Option B
$1,000
30,000
30,800
No
No
Yes
800
200
Put
Option C
$1,000
30,000
29,200
No
No
Yes
800
200
15
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
16
Example of an Interest Rate Swap
Bank
CounterParty
Pays a
variable
rate
Receives
8% fixed
Issuer Of
$10 Million
Debt
Pays 8%
fixed
Creditors
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
Derivatives
17
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.
Derivatives
18
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.
Derivatives
19
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.
Derivatives
20
Special Accounting Treatment for
Fair Value Hedges
The special accounting treatment results in:
• 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.
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.
Derivatives
21
Special Accounting Treatment for
Fair Value Hedges, continued
Changes in the time value of a derivative are generally
excluded from the assessment of hedge effectiveness
and are always recognized in current earnings.
Derivatives
22
Accounting for a Fair Value
Hedge Illustrated
Assume 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.
Notional amount in units
Spot price per unit
Future price per unit
Fair value of contract
Derivatives
60 days
100,000
1.495
1.490
30 days
100,000
1.482
1.480
$ 1,000
0 days
100,000
1.460
1.460
$ 3,000
23
Accounting for a Fair Value
Hedge Illustrated, continued
Notional amount in units
Spot price per unit
Future price per unit
Fair value of contract
Remaining Term of Contract
60 days
30 days
0 days
100,000
100,000
100,000
1.495
1.482
1.460
1.490
1.480
1.460
$
1,000
$
3,000
Change in fair value of contract
Current period change in spot rates
Current period change in time value
Effect on current earnings:
Gain (Loss) in value of inventory
Gain (Loss) in value of contract
Net measure of effectiveness
Gain (Loss) in value of contract
excluded from hedge effectiveness
Net effect on current earnings
Derivatives
$
$
$
1,000
1,300
(300)
$
$
$
2,000
2,200
(200)
$
$
$
(1,300)
1,300
-
$
$
$
(2,200)
2,200
-
$
$
(300)
(300)
$
$
(200)
(200)
24
Assessing the Effectiveness of a
Fair Value Hedge
Sales price of inventory
Cost of sales
Gross profit
Hedging gain (loss) on contract
Hedging gain (loss) on inventory
Subtotal
Gain (loss) on contract excluded from
assessment of effectiveness
Net effect on earings
Derivatives
Desired
Position
$ 149,500
(120,000)
$ 29,500
$
$
29,500
29,500
Without the
Hedge
$ 146,000
(120,000)
$ 26,000
$
$
26,000
With the
Hedge
$ 146,000
(116,500)
$ 29,500
$
3,500
(3,500)
$ 29,500
26,000
(500)
29,000
$
25
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
26
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
27
Special Accounting Treatment for
Cash Flow Hedges
The special accounting treatment results in:
• 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.
Derivatives
28
Special Accounting Treatment for
Cash Flow Hedges, continued
As with fair value hedges, the change in the
time value of a derivative may be excluded
from the assessment of hedge effectiveness.
Derivatives
29
Accounting for a Cash Flow
Hedge Illustrated
Assume 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.
Notional amount in units
Spot price per unit
Future price per unit
Fair value of contract
Derivatives
Remaining Term of Contract
60 days
30 days
0 days
100,000
100,000
100,000
$
1.49
$ 1.510
$
1.54
$
1.50
$ 1.525
$
1.54
$ 2,500
$ 4,000
30
Accounting for a Cash Flow
Hedge Illustrated, continued
Notional amount in units
Spot price per unit
Future price per unit
Fair value of contract
Change in fair value of contract
Current period change in spot rates
Current period change in time value
Effect on OCI:
Gain (Loss) in value of derivative
Reclassification of OCI into earnings
Net effect on OCI
Effect on current earnings:
Adjustment to cost of sales
Gain (Loss) in value of contract
excluded from hedge effectiveness
Net effect on current earnings
Derivatives
Remaining Term of Contract
60 days
30 days
0 days
100,000
100,000
100,000
$
1.49
$
1.510
$
1.54
$
1.50
$
1.525
$
1.54
$
2,500
$
4,000
$
$
$
2,500
2,000
500
$
$
$
1,500
3,000
(1,500)
$
2,000
$
3,000
$
$
$
2,000
500
500
$
$
$
3,000
(1,500)
(1,500)
Date Inventory
Is Sold
$
$
(5,000)
(5,000)
$
5,000
$
5,000
31
Assessing the Effectiveness of a
Cash Flow Hedge
Sales price of inventory (assumed)
Cost of sales - inventory
Cost of sales - processing (assumed)
Gross profit
Reclassification of OCI
Adjusted gross profit
Gain (loss) on contract excluded from
assessment of effectiveness
Net effect on earings
Derivatives
Desired
Position
$ 225,000
(149,000)
(30,000)
$ 46,000
$ 46,000
Without the
Hedge
$ 225,000
(154,000)
(30,000)
$ 41,000
$
41,000
With the
Hedge
$ 225,000
(154,000)
(30,000)
$ 41,000
5,000
$ 46,000
(1,000)
$ 45,000
32
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.
Derivatives
33
Disclosures Regarding Derivative
Instruments & Hedging Activities
Required 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.
Derivatives
34