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?
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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.
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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
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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.
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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.
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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?
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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.”
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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.
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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.
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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)
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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.
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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.
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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.
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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
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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.
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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.
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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
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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.
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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.
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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
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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.
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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.
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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.
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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.
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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
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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.
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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
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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.
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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.
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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.
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Derivatives for Faculty
Questions? Comments?
Email:
tyee@tyeereview.com
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