OLC SUPPLEMENT – CHAPTER 10
FINANCIAL INSTRUMENTS
A financial instrument can be defined as any contract that gives rise to both a financial asset of
one party (such as cash or a receivable) and a financial liability or an equity instrument of
another party (such as common shares). Primary financial instruments have been introduced
throughout the text. The focus of this supplement is secondary financial instruments, which are
contracts that specify (1) a cost to each party that enters into the contract, (2) the value covered
by the contract, (3) the date at which the contract expires, and (4) the manner in which the parties
will fulfill their obligations at the termination date. These contracts are designed specifically to
spread future financial risks among several willing parties at an agreed upon price that is payable
in the future when the risks have materialized. Action by the contracting parties will be
determined at some future date and will depend on both what actually occurs and what the
contract permits. Nevertheless, the signing of the contract is the transaction that triggers the
requirement to estimate and recognize its value.
The most well known financial instruments are derivatives (defined below). Various types of
derivative contracts are traded in active financial markets.
Derivatives
A derivative is a legal contract between two or more parties. They are called derivatives because
their value is always based on, or derived from the value of some underlying rate (e.g., interest or
foreign currency rate), price (e.g., commodity price such as silver or pork bellies), credit rating,
(e.g., Standard & Poor’s or Moody’s ratings), or credit index (e.g., LIBOR). For a financial
instrument to qualify as a derivative it must require no initial investment; its value must change
in response to some specific underlying item; and it must be settled at a future date.
A derivative provides one way for corporations to hedge or limit their exposure to one
financial risk by taking on an offsetting financial risk. A derivative either transfers or spreads the
risk of the loss of cash from one party to other parties. What follows is a summary of simple
forms of derivative contracts to which a corporation might be a party. More complex forms of
derivatives are covered in finance courses and in advanced financial accounting courses.
Options
An option contract specifies the rights to buy or sell assets, including securities, but imposes
different obligations on the buyer and the seller. The option buyer has the choice to exercise the
option at some future date, although the buyer must pay the cost of purchasing the option.
Corporations can buy options to sell assets (a call) or buy options to purchase assets (a put). In
both cases, the corporation is the buyer of the option. Its only obligation is the payment of cash
for the purchase. The corporation (buyer) can choose what action to take at a future date, but this
is not true for the seller or writer of an option that will have no choice in the future but to fulfill
the terms of the contract if the buyer exercises the option. Financial models, in particular the
Black and Scholes options pricing model, are used to estimate the future value of the liability
associated with the option.
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Corporations may also decide to be writers of options but global legislation requires
exceptional financial strength of the options writers to assure option buyers that the writers will
not default on their liabilities.
Forward Contracts
Forward contracts specify the terms under which the contracting parties undertake an exchange
at a future date. For example, the buyer may purchase a six-month forward contract whereby a
promise is made to deliver $1,000,000 cash in exchange for $1,000,000 face value of fixed-rate
government bonds. Conversely, the writer of the contract promises to deliver $1,000,000 face
value of fixed-rate government bonds in exchange for $1,000,000 cash. At the date of the
exchange if the market price of the bonds exceeds $1,000,000, conditions are favourable to the
buyer that pays only $1,000,000 for a bond of higher value. At the same time, the writer suffers a
loss because $1,000,000 is received in exchange for a bond with a higher value.
Forward contracts differ from other secondary financial instrument contracts because they are
not liquid and do not trade in secondary markets as corporations usually enter into forwards with
well established financial institutions. They are private contracts that are not marked to market
daily, which creates an additional risk that the losing party may default.
Futures contracts
A futures contract is a forward contract that specifies the terms under which assets, such as
barrels of oil or bushels of wheat, will be purchased and sold at a specified future date. The
obligations of parties to a futures contract are symmetrical because there is no choice about the
future purchase or sale by the contracting parties. In other words, if the conditions for the
exchange are favourable to the buyer, they will be unfavourable to the seller, and vice versa. The
price of the future transaction is derived from the value of the underlying asset(s) upon which the
contract is based. Futures contracts are marked to market daily, meaning that every day the
difference between the contract price and the fair market value must be paid by the "losing" party
in the contract. These payments are made into a fund (similar to the idea of a sinking fund for
debt obligations) in order to ensure that the terms of the contract will be fulfilled by the
contracting parties when the contract expires. Both parties must post collateral to prevent credit
default. Both futures contracts and options contracts are traded in secondary markets throughout
the world.
Interest Rate Swaps
An interest rate swap is a specific type of futures contract in which the parties agree to make a
series of future exchanges of cash amounts on specific dates. Recall that debt obligations
require the corporation to make future interest payments. The predictability of these payments
depends on the terms of the debt contract. Some debt contracts carry a fixed interest rate on a
specified debt, resulting in fixed interest payment, while other contracts carry a variable interest
rate, making the interest payment somewhat predictable. Since market interest rates do change
over time, a corporation that has a fixed interest rate debt can incur substantial opportunity costs
to service its debt when interest rates fall. Managers can do sensitivity analyses to estimate the
extent to which the corporation can bear this opportunity cost and then establish a threshold
beyond which the corporation is unwilling to bear the opportunity loss. If it seems probable this
threshold will be exceeded, then the managers can enter into a swap contract, thereby hedging
the risk associated with expected future changes in interest rates that may be unfavourable to the
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corporation’s cash flow situation. Usually a financial institution such as a bank acts as an
intermediary between the two parties and receives a fee for its service.
The floating interest expense on a swap is based on a fluctuating interest rate benchmark such
as LIBOR (London InterBank Offered Rate). Each party then agrees to pay the cash value of the
interest payment to the other party at a specific future date. The corporation that agrees to
exchange its fixed interest payments for the variable interest payments of another party faces the
risk that LIBOR may be higher when the contract terminates. In this case, the actual cash
required to fulfill the corporation’s obligation will be higher than what was estimated at the
contracting date, which would be unfavourable to the corporation. On the other hand, if LIBOR
falls relative to the rate when the contract was signed, the variable rate obligation will be lower
than the amount estimated at the contracting date, and the corporation benefits from entering into
the swap contract.1
Foreign Currency Swaps
Corporations may issue debt instruments that are denominated in various foreign currencies (e.g.,
U.S. dollar, euro, Japanese yen). They do so in order to access the capital markets in different
countries and to reduce the risk associated with changing foreign currency exchange rates,
particularly if they have significant operations in foreign countries. Other corporations also enter
into purchase and sales contracts with payments to be made in various foreign currencies. These
corporations become exposed to fluctuations in cash flow because of foreign currency
fluctuations. To mitigate the effects of exchange rate fluctuations, corporations enter into foreign
currency swaps where payments in one currency are exchanged for payments in another currency
at a future date. In essence, these swaps are derivatives that convert fluctuating or floating cash
flows into a fixed amount.
Embedded Derivatives
Financial contracts do not all fall neatly into primary and secondary financial instrument
classifications. Some contracts are hybrids or a mix of primary and secondary financial
instruments, but their economic substance is that cash flow will vary similar to a pure derivative
contract. Hence, the embedded derivative portion of the contract must be recognized and
measured at fair value. For example, some primary debt contracts may specify an interest rate or
principal payment based on changes in an underlying rate, security price, commodity price,
index, or currency. The interest or principal payment is an embedded derivative in the debt
contract and must be separated and accounted for as a derivative. Bonds may include a call
option to acquire common shares of the corporation that issued the bonds. The call option is an
embedded derivative. A second example is when a Canadian company enters into a lease
contract where payments are made in US dollars. Payment in a foreign currency is an embedded
derivative. Another example would be a contract to purchase specific resources from a supplier.
If the price of the resource is dependent on changes in the LIBOR index, then the price is an
embedded derivative. Finally, corporations may agree to swap resources, a non-financial
contract, with the quantities dependent upon their relative values at some future date. If the value
of the resource is tied to an underlying price, rate, or index, then this non-financial contract
1
Interest rate swap agreements can also involve different currencies wherein the fixed and floating rate liabilities are
swapped in different currencies (e.g., fixed interest payments in Canadian dollars are exchanged for floating interest
payments in Euros). In cross-currency interest swaps, the index is usually related to the currency in which the swap
will occur.
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contains an embedded derivative which must be accounted for as a secondary financial
instrument.
The objective of identifying such contracts as embedded derivatives is to ensure that all
derivatives will be recognized at fair value on the balance sheet and all gains and losses appear
on the income statement.
Accounting for Derivatives
Accounting for secondary financial instruments is complex in large part because the cash flows
associated with the execution of these contracts occur in the future and the actual gains or losses
are not known with certainty until the settlement of the contract.
Until recently, Canadian accounting standards for financial instruments failed to include when
a financial instrument should be recognized on the balance sheet and how its value should be
estimated once it has been recognized. The reason was that unlike primary financial instruments,
most derivative contracts cost nothing and yet there is an active trading market in these contracts.
These contracts were then kept off the balance sheet. Yet, derivative contracts can be traded at
their market value at any time.
The new accounting standards related to financial instruments, specifically section 3855 of the
CICA Handbook, no longer permits off balance-sheet treatment of these instruments. Instead,
financial assets and liabilities must be measured at their fair value and reported on the balance
sheet. Derivative liabilities can only be removed when the contracts either expire or are cancelled
or discharged. In addition, gains and losses related to financial instruments must be recognized
on the income statement during the period they arise. Specific details related to the initial
recognition and subsequent measurement of financial instruments are covered in advanced
accounting courses.
Disclosures
The timing of the termination of derivative contracts rarely coincides with the timing of
mandatory financial disclosure. Hence at the date of financial disclosure, the value of the
derivative contract must be marked to market along with disclosure of any related gain or loss on
the income statement even though the gain or loss remains unrealized as at that date. Such gains
or losses are reported as a component of Comprehensive Income.2 When the derivative contract
terminates and the actual gain or loss is subsequently realized, the accountant must adjust the
various accounts that relate to the contract and determine the actual gain or loss on the contract.
In reality, the situation is much more complex because corporations holding derivative contracts
can agree, in some instances, to terminate them and enter into new ones. The disclosures made
by Petro-Canada, the focus company of Chapter 10, in its annual report for 2007 illustrate the
complexity of this topic.
2
See OLC Supplement – Comprehensive Income for more details.
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Note 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
...
q) Financial Instruments
All financial instruments are initially recognized at fair value on the balance sheet. The Company has classified each
financial instrument into one of the following categories: held-for-trading financial assets and liabilities, loans and
receivables, held-to-maturity financial assets and other financial liabilities. Subsequent measurement of financial
instruments is based on their classification.
Held-for-trading financial assets and liabilities are subsequently measured at fair value with changes in those fair
values recognized in net earnings.
Loans and receivables, held-to-maturity financial assets and other financial liabilities are subsequently measured at
amortized cost using the effective interest method.
The Company classifies cash and cash equivalents as held-for-trading financial assets, accounts receivable as loans
and receivables, and accounts payable and accrued liabilities, short-term notes payable and long-term debt as other
financial liabilities.
The Company combines transaction costs and premiums or discounts directly attributable to the issuance of longterm debt with the fair value of the debt and amortizes these amounts to earnings using the effective interest method.
The Company classifies financial instruments that are derivative contracts as held-for-trading financial assets and
liabilities unless designated as effective hedges.
r) Hedging and Derivatives
The Company may use derivative contracts to manage its exposure to market risks resulting from fluctuations in
foreign exchange rates, interest rates and commodity prices. These derivative contracts are not used for speculative
purposes and a system of controls is maintained that includes a policy covering the authorization, reporting and
monitoring of derivative activity.
Derivative contracts that are not designated as hedges for accounting purposes are recorded on the Consolidated
Balance Sheet at fair value with any resulting gain or loss recognized in investment and other income (expense) on
the Consolidated Statement of Earnings.
The Company formally documents all derivative contracts designated as hedges, the risk management objective and
the strategy for undertaking the hedge.
For designated cash flow hedges, the portion of the gain (loss) on the hedging item that is deemed to be effective is
recognized as other comprehensive income (loss), net of tax, in the Consolidated Statement of Comprehensive
Income, and is then reclassified to the Consolidated Statement of Earnings in the same period or periods during
which the hedged item affects net earnings. The portion of the gain (loss) that is deemed to be ineffective is
recognized immediately in net earnings on the Consolidated Statement of Earnings in the period in which it occurs.
For designated fair value hedges, both the hedging item and the underlying hedged item are measured at fair value.
Changes in the fair value of both items are recognized immediately in net earnings on the Consolidated Statement of
Earnings in the period in which they occur.
The Company assesses, both at inception and over the term of the hedging relationship, whether the derivative
contracts used in the hedging transactions are highly effective in offsetting changes in the fair value or cash flows of
hedged items. If a derivative contract ceases to be effective or is terminated, hedge accounting is discontinued. Any
gains (losses) relating to terminated cash flow hedges included in other comprehensive income are typically
reclassified to net earnings on the Consolidated Statement of Earnings in the period in which the cash flow hedge is
terminated.
Note 2. CHANGES IN ACCOUNTING POLICIES
The Company adopted Canadian Institute of Chartered Accountants (CICA) Handbook Section 1506, Accounting
Changes; Section 1530, Comprehensive Income; Section 3855, Financial Instruments – Recognition and
Measurement; Section 3861, Financial Instruments – Presentation and Disclosure; Section 3865, Hedges; and
Emerging Issues Committee (EIC) Abstract 160, Stripping Costs Incurred in the Production Phase of a Mining
Operation, on January 1, 2007.
…
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Note 5. INVESTMENT AND OTHER INCOME (EXPENSE)
Investment and other income (expense) includes net losses related to the Buzzard derivative contracts (Note 23) of
$535 million (2006 - $259 million’ 2005 - $889 million) and …
Note 23. FINANCIAL INSTRUMENTS AND DERIVATIVES
The Company is exposed to market risks resulting from fluctuations in commodity prices, foreign exchange rates and
interest rates in the course of its normal business operations. The Company monitors its exposure to market
fluctuations and may use derivative instruments to manage these risks, as it considers appropriate. The Company
does not use derivative contracts for speculative purposes.
Crude Oil and Products
During 2004, the Company entered into a series of derivative contracts for the future sale of Dated Brent crude oil in
connection with its acquisition of an interest in the Buzzard field in the U.K. sector of the North Sea. some derivative
contracts matured from July 1, 2007 to December 31, 2007. All remaining outstanding derivative contracts were
settled. This resulted in the following:
2007
Unrealized losses at beginning of year
Net losses during current year (Note 5)
Maturities1
Settlement2
1
2
$ (1,481)
(535)
291
1,725
$
-
Derivative contracts that matured from July 1, 2007 to December 31, 2007 resulted in realized losses of $291
million ($193 million after-tax).
All remaining outstanding derivative contracts were settled, which resulted in realized losses of $1,725 million
($1,145 million after-tax).
The Company enters into forward contracts and options to reduce exposure to Downstream margin fluctuations,
including margins on fixed-price product sales, and short-term price fluctuations on the purchase of foreign and
domestic crude oil and refined petroleum products.
The Company’s outstanding derivative contracts and their related fair values at December 31, 2007 were as follows:
Crude Oil and Products (millions of barrels)
Crude oil purchase
Crude oil sales
Quantity
(MMbbls)
Maturity
Average Price
US$/bbl
0.8
0.8
2008
2008
$ 95.43
$ 95.72
Fair Value
$ (1)
$2
$1
The fair value positions of outstanding derivative contracts were included on the Consolidated Balance Sheet as
follows:
December 31,
December 31
2007
2006
Accounts receivable
$ 1
$
Accounts payable and accrued liabilities
233
Other liabilities
1,252
The fair value these derivative contracts is based on quotes provided by brokers, which represents an approximation
of amounts that would be received or paid to counterparties to settle these instruments prior to maturity. The
Company plans to hold all derivative contracts outstanding at December 31, 2007 to maturity.
Derivative contracts and financial instruments involve a degree of credit risk. The company manages this risk through
the establishment of credit policies and limits, which are applied in the selection of counterparties. Market risk relating
to changes in value or settlement cost of the Company’s derivative contracts is essentially offset by gains or losses
on the underlying transaction.
In addition to the derivative contracts described above, the Consolidated Balance Sheet includes other items
considered to be financial instruments, such as cash and cash equivalents, accounts receivable, accounts payable
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and accrued liabilities, the Fort Hills purchase obligation and long-term debt. The fair values of these other financial
instruments included on the Consolidated Balance Sheet are as follows:
2007
Carrying
Amount
Held-for-trading financial assets
Cash and cash equivalents
Loans and receivables:
Accounts receivable1
Other long-term assets
Other financial liabilities (not held-for-trading)
Accounts payable and accrued liabilities
Short-term notes payable
Long-term debt
Fort Hills purchase obligation
1
$
231
2006
Fair Value
$
231
Carrying
Amount
$
499
Fair Value
$
499
1,931
197
1,931
197
1,566
131
1,566
131
(3,512)
(109)
(3,341)
(329)
$ (4,932)
(3,512)
(109)
(3,495)
(329)
$ (5,086)
(3,319)
(2,894)
(170)
$ (4,187)
(3,319)
(2,959)
(170)
$ (4,252)
Accounts receivable on the Consolidated Balance Sheet as at December 31, 2007 include $42 million (December
31, 2006 - $34 million) of prepaid expenses.
Excluding long-term debt, the fair value of financial instruments approximates their carrying amount due to their short
maturity. The fair value of long-term debt is based on publicly quoted market values.
Although there is no global convergence on a single correct standard for financial instruments,
the Canadian standards are based on, but not identical to International Financial Reporting
Standard 39 issued by the International Accounting Standards Board. The new section on
financial instruments has necessitated changes to many other sections of the CICA Handbook.