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Derivative Accounting for Faculty What are we assuming students know before studying derivative accounting in 383? What is the scope of coverage in Accounting 383? What are Derivatives under US GAAP? What is the accounting model for speculative derivative instruments? 1 What are the accounting models for derivatives classified as hedges? Derivative Accounting for Faculty What are we assuming students know before studying derivative accounting in 383? •Students have taken the first two terms of the Intermediate Accounting sequence 381 and 382 and should be familiar with: •Comprehensive Income as a financial statement •Accumulated Other Comprehensive Income as a separate component of Equity. •Basic valuation techniques such as observing market prices and discounted cash flow (NPV) analysis. •Unrealized versus realized gains/losses and the accounting implications of marking assets to market value on the balance sheet. 2 Derivative Accounting for Faculty What is the scope of coverage in Accounting 383? • ASC 815-10 and IAS 39 •What are considered derivative financial instruments under US GAAP and IFRS? •Derivatives classified as hedges are accounted for differently the speculative derivatives •The Accounting Model for Speculative Derivatives •The Accounting Model for Derivatives classified as hedges •Fair Value Hedges •Cash Flow Hedges •Net Investment in Foreign Entity Hedges NOT covered in Accounting 383 3 Derivative Accounting for Faculty What are Derivatives under US GAAP? Three Criteria 1. The instrument has (1) one or more underlyings and (2) an identified payment provision. 2.The instrument requires little or no investment at the inception of the contract. 3.The instrument requires or permits net settlement. How is the IFRS definition of a Derivative different? Net settlement feature isn't required. 4 Derivative Accounting for Faculty What does US GAAP mean by net settlement? •Derivative contracts can call for physical delivery, financial net settlement, or allow for either one. •The technical definition of a net settlement feature under US GAAP is: 1.Its terms implicitly or explicitly require or permit net settlement. For example penalties for none performance may be implied net settlement. 2.It can readily be settled net by a means outside the contract. 3.It provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement. 5 Derivative Accounting for Faculty Help me understand: Do garden variety derivatives usually allow for net settlement? How practical is this difference between US GAAP and IFRS •Options? •Forwards? •Futures always permit net settlement right? •Interest rate swaps? 6 Derivative Accounting for Faculty What US GAAP Scope Exceptions to the definition of a Derivative are considered in Accounting 383? •Normal Purchases and Normal Sales scope exception. Example: A company that uses cotton in the production of it's fabrics for sale may enter into a forward contract to buy cotton at a fixed price to stabilize variability in cotton prices. In buying its own raw materials for the purpose of delivery, they would probably claim the Normal Purchases and Normal Sales scope exception to avoid Derivative accounting. Kieso covers the concept of a forward contract that isn't classified as a derivative in the Inventory chapter, under the heading, “Purchase commitments.” 7 Derivative Accounting for Faculty How is US GAAP and IFRS different with regard to the Normal Purchase and Normal Sales scope exception? •IFRS has a similar exception to derivative classification for “Expected own use,” contracts. •Under US GAAP the exception is elective. •IFRS the exception is mandatory. 8 Derivative Accounting for Faculty What is the accounting model for speculative derivative instruments? •Financial Instruments that are defined as Derivatives, that don't qualify for hedge accounting •Instrument could be an asset or liability •Accounting is the same for US GAAP and IFRS •Valued on the balance sheet at Fair Value •Unrealized gain/loss to “Mark to market,” is recognized in net income. 9 Derivative Accounting for Faculty Example: Your company on January 2, 20XX purchased a call option contract for $500 that allows you to purchase 10,000 shares of XYZ corporation stock at $10 per share. The fair value of XYZ stock on that date is $10 per share. The option can be exercised until it expires on May 15, 20XX (the same year). As of February 28th the value of the stock increased to $15 per share. On that date the value of the option contract is $50,200. (Example adapted and shortened from Tyee's class notes) 10 Derivative Accounting for Faculty What is the exercise price of the option? •$10 per share What is the fair value of the option on January 2nd? •Should be the Option Premium paid by your company to purchase the option, $500. What is the intrinsic value of the option on January 2nd? •$0 •There is no spread between the value of the underlying asset, the stock and the strike price on January 2nd. 11 Derivative Accounting for Faculty How can the option have a fair value on January 2nd if there is no intrinsic value? •The options fair value and thus the premium your company has to pay has two components: •Intrinsic value – in this case $0 AND •Time value – the premium for the potential for profit during exercise period of the option. •Since there is no Intrinsic value the premium you pay of $500 must be entirely for the time value. 12 Derivative Accounting for Faculty How can the option have a fair value on January 2nd if there is no intrinsic value? •The options fair value and thus the premium your company has to pay has two components: •Intrinsic value – in this case $0 AND •Time value – the premium for the potential for profit during exercise period of the option. •Since there is no Intrinsic value the premium you pay of $500 must be entirely for the time value. 13 Derivative Accounting for Faculty What entry is recorded when the option contract is purchased on January 2nd? DR Investment in Call Option CR Cash $500 $500 14 Derivative Accounting for Faculty On February 28th, what is the, “time value,” component of the total $50,200 fair value of the option contract? •The intrinsic value is $50,000. $15 stock price - $10 exercise price = $5 spread. $5 spread multiplied by 10,000 shares is $50,000. •The the additional $200 must be the time value component. What is the valuation of the Call Option Contract on the balance sheet as of February 28th? •Investments in derivatives are valued at fair value. Therefore the balance sheet asset should be reported at $50,200. 15 Derivative Accounting for Faculty What entry needs to be recorded if financial statements are presented as of February 28th? DR Investment in Option Contract $49,700 CR Unrealized holding gain (inc stmt) ($50,200 - $500) $49,700 Note: Kieso, Chapter 17 Appendix, does a similar example where they break the entry into two parts. One to record the difference in intrinsic value and the other to record the difference in time value. 16 Derivative Accounting for Faculty What are the accounting models for derivatives classified as hedges? •The type of hedge you designate a derivative as, depends on what the company is attempting to hedge. •Derivatives designated as hedges continue to be valued at fair value on the balance sheet. •We cover two types of hedges in Accounting 383. The categories are the same for both US GAAP and IFRS. Fair Value Hedges 17 Cash Flow Hedges Derivative Accounting for Faculty What is a Fair Value Hedge? •The derivative instrument is hedging the changes in fair value of an asset or liability owned by the company. •For example the value of equity investments owned the company or the value of the Company's own outstanding debt. •The unrealized gain/loss on the derivative instrument continues to be recognized in Net Income. •However the accounting for the hedges item changes. •The hedged item is valued at fair value on the balance sheet. •Unrealized gain/loss on the hedged item is also recognized in Net Income. •If the derivative is perfectly correlated with the hedged item, the net unrealized gain/loss should have $0 impact on earnings per share. 18 Derivative Accounting for Faculty Example Fair Value Hedge: (Similar to example in Kieso) Thomas Company has Available for Sale Securities with a fair value recorded on the balance sheet as of January 1, 20XX of $100,000. Thomas plans to hold these securities for the entire year and wants to lock in that value for this fiscal year to avoid the risk of losing any of the $100,000. To achieve their risk management objective, Thomas Company invests in a put option that allows them to sell the securities next year for $100,000. Ignoring transaction costs, assume the value of the option was $0 as of January 1, 20XX. The put option expires in two years and Thomas designates the put option as a Fair Value Hedge for GAAP accounting purposes. As of December 31, 20XX the AFS securities have increased in value to $70,000. Assume the put option has increased in value by $30,000 as of December 31, 20XX. Ignore the effect of deferred income taxes. 19 Derivative Accounting for Faculty If the Put Option derivative designated as a Fair Value Hedge didn't exist, what entries would be done to re-value the AFS securities as of December 31, 20XX? DR Unrealized Loss on AFS Securities (OCI) CR AFS Securities Valuation Account $30,000 $30,000 How does the the revaluation of AFS Securities entry change if a derivative instrument as designated as a Fair Value Hedge of the AFS Security item? The unrealized gain/loss and related tax effects go through the income statement. DR Unrealized Loss on AFS Securities (IS ) $30,000 CR AFS Securities Valuation Account $30,000 20 Derivative Accounting for Faculty How is the put option valued on the balance sheet as of December 31, 20XX and what are the related entries? As of December 31, 20XX the put option increased by $30K. Since Derivatives are recorded at fair value on the balance sheet, this is an asset of $30K. DR Investment in Put Option $30,000 CR Unrealized gain on the Put Option (IS) $30,000 What is the Net Income statement impact of AFS Securities and the Derivative instrument when analyzed together? They net to $0 income statement impact. 21 Derivative Accounting for Faculty What is a Cash Flow Hedge? •The derivative instrument is hedging the a future transaction that will effect cash flows. •For example, a forward contract to fix the price of inventory for future delivery, where the contract meets the definition of a derivative and the Normal Purchases exception is not elected. OR variable rate interest payments scheduled for the future, hedged by an interest rate swap. •The unrealized gain/loss on a derivative instrument classified as a Cash Flow Hedge is recognized in Other Comprehensive Income. 22 Derivative Accounting for Faculty Example Cash Flow Hedge: Suppose your company has outstanding debt with a principle balance of $1,000,000 and a variable interest rate equal to LIBOR plus 1%. Let's say that happens to be 8% as of January 1, 20XX. The debt contract is similar to a bond because the company makes interest only payments annually and then pays the entire principle at the end of three years. Management is concerned about volatility in the cash interest that it pays over the three year period and would like to fix the 8% rate. The company enters into an interest rate swap with a Counter-party. The Company is obligated to make annual payments of 8% on $1,000,000 to the Counter-party. The Counter-party will pay the Company a rate of LIBOR plus 1%. Suppose the variable rate changes to 6.8% (LIBOR + 1% = 6.8%) by December 31, 20XX. 23 Derivative Accounting for Faculty What are the related entries effecting cash flows on December 31, 20XX? DR Interest Expense $68,000 CR Cash $68,000 To record cash paid on $1mill debt instrument. DR Interest Expense $80,000 CR Cash $80,000 DR Cash $68,000 CR Interest Expense $68,000 To record cash flow on Interest Rate Swap Instrument. Note the resulting net cash flow is $80,000 as if they had an 8% fixed rate. 24 Derivative Accounting for Faculty How is the Interest Rate Swap accounted for on the balance sheet and what are the related entries? A valuation of the expected future cash flows provides that the Interest Rate Swap is a liability because it requires the Company to pay cash at a rate of 8% that is higher than the market rate of 6.8%. Assume this liability has a fair value of $40K. DR Unrealized loss on Interest Rate Swap (OCI) CR Interest Rate Swap Instrument $40K $40K 25 Derivative Accounting for Faculty Can similar instruments be designated as either Fair Value or Cash Flow Hedges? i.e. Could and interest rate swap be either one? •The designation depends on the hedging objective. If the facts were reversed an interest rate swap could be used as a Fair Value Hedge instead of a Cash Flow Hedge. Example: Consider the same debt contract as the previous example except the company pays a fixed interest rate of 8%. The company's credit rating would cause the fair value of this outstanding debt to vary over time. The company could attempt to hedge the volatility in the value of its debt by entering into an interest rate swap to exchange the fixed rate for a variable rate. The interest rate swap derivative instrument in this case could be designated as a Fair Value Hedge. 26 Derivative Accounting for Faculty What kind of financial instrument is a convertible bond? Convertible debt is considered a hybrid financial instrument – Part debt instrument – Part derivative instrument for the option to convert to equity Do you account for the embedded derivative? •Issuer ignores the embedded derivative. Note that detachable warrants are different •Investor has to bifurcate the value into two instruments, the debt and the derivative and account for each separately 27 Derivative Accounting for Faculty How does a company qualify a derivative for hedge accounting? •Extensive documentation is required. – The company has to designate the derivative as a hedge – Identify what is being hedge – Document the risk management object that the hedge addresses. •The hedge has to be highly effective. – The correlation of cash flows or values between the derivative and the hedged item is close to 1.0, or within .10. – Many exceptions. – Evaluation of correlation is beyond the scope of Accounting 383. 28 Derivative Accounting for Faculty When does correlation have to measured? •Under US GAAP correlation has to be proven at least every three months. – Even if the reporting entity doesn't issue quarterly financial statements. •Under IFRS correlation can be proven only once a year. 29 Derivative Accounting for Faculty Why would a derivative instrument purchased to hedge the value of a trading security never qualify as a Hedge for GAAP accounting? • To be a Hedge, the derivative has to offset an item which the changes in fair value would either effect future earnings or future cash flows. • If both the change in fair value of the hedged item as well as the derivative would be recorded in the income statement without qualifying the derivative as a Hedge, then no Hedge treatment is used. • i.e. A derivative for trading securities doesn't need specialized hedge accounting. 30 Derivatives for Faculty Questions? 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