StIce | StIce |Skousen
Derivatives, Contingencies,
Business Segments, & Interim
Reports
Chapter 19
Intermediate Accounting
16E
Prepared by: Sarita Sheth | Santa Monica College
COPYRIGHT © 2007
Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are
trademarks used herein under license.
Learning Objectives
1. Understand the business and accounting
concepts connected with derivatives and
hedging activities.
2. Identify the diferent types of risk faced by
a business.
3. Describe the characteristics of the
following types of derivatives: swaps,
forwards, futures, and options.
4. Define hedging, and outline the difference
between a fair value hedge and a cash
flow hedge.
Learning Objectives
5. Account for a variety of different derivatives
and for hedging relationships.
6. Apply the accounting rules for contingent
items to the areas of lawsuits and
environmental liabilities.
7. Prepare the necessary supplemental
disclosures of financial information by
product line and by geographic area.
8. Recognize the importance of interim reports,
and outline the difficulties encountered
when preparing those reports.
Simple Example of a Derivative
You are an employee
of Nauvoo Software
Solutions.
Simple Example of a Derivative
On October 1, 2008, you purchase
100 shares of stock in the company
at the market price of $50 per
share, for a total price of $5,000.
Simple Example of a Derivative
On January 1, 2009, you need to make a
college tuition payment of $5,000 on behalf
of your daughter. You can’t sell the stocks
now because your employment contract
states that the shares must be held for at
least three months before they can be sold.
How can you avoid downward
movement in the stock price between
now and January 1?
Simple Example of a Derivative
If the price of the stock is above $50/share,
you agree to pay cash equal to the excess to
John Bennett, a local speculator. If the
price goes below $50, Bennett will pay you a
cash amount equal to the deficit.
This agreement is called a
derivative.
Definition of Derivative
• Derivative- 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.
• When the agreement is made, no
journal entry is required, because it is
an executory contract.
Types of Risk
• Price Risk
• Credit Risk
• Interest Rate
Risk
• Exchange Rate
Risk
Types of Derivatives
•
•
•
•
Swap
Forward contract
Futures
Options
Types of Derivatives
• Swap- a contract where two parties
agree to exchange payments in the
future based on the movement of
some agreed-upon price or rate.
– Interest rate swap- two parties agree to
exchange future interest payments on a
given loan amount.
Types of Derivatives
Interest Rate Swap
Interest Rate on January 1, 2009
7%
10%
Variable-rate interest
payment in 2009
$ (7,000) $(10,000)
Receipt (payment) for
interest rate swap
(3,000)
0
Net interest
payment in 2009 $(10,000) $(10,000)
13%
$(13,000)
3,000
$(10,000)
Types of Derivatives
• Forward contract- an agreement
between two parties to exchange a
specified amount of a commodity,
security, or foreign exchange at a
specified date in the future with the
price or exchange rate being set now.
Types of Derivatives
On November 1, 2008, Clayton Company
sold machine parts to Maruta Company for
¥30,000,000 to be received on January 1,
2009. The current exchange rate is ¥120 =
$1. Clayton enters into a forward contract
with a large bank that guarantees this
exchange rate.
Types of Derivatives
Exchange Rate on January 1
¥118 = $1 ¥120 = $1 ¥122 = $1
Variable of
¥30,000,000
$254,237 $250,000 $245,902
Clayton receipt
(payment) to settle
forward contract
(4,327)
0
4,098
Net dollar receipt
by Clayton
$250,000 $250,000 $250,000
Stop and Think
What type of credit risk
is associated with a
forward contract?
Types of Derivatives
• Futures contract- 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.
• Futures contracts are similar to
forward, difference is that a forward
contract is private and futures are
traded on an exchange.
Types of Derivatives
Hyrum Bakery uses 1,000 bushels of
wheat every month. On December 1, 2008,
Hyrum decides to protect itself against
fluctuations in prices. Hyrum buys a
futures contract to purchase the wheat at
$4 per bushel.
Types of Derivatives
Wheat Price on January 1
$3.80
$4.00
$4.20
Cost to purchase
1,000 bushels
$(3,800 )
Hyrum receipt
(payment) to settle
futures contract
(200 )
Net dollar receipt
by Clayton
$(4,000 )
$(4,000 )
0
$(4,000 )
$(4,200 )
200
$(4,000 )
Types of Derivatives
• Options contract- gives 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.
• Two types of options:
– Call option -gives the owner the right to
buy an asset at a specified price.
– Put option- gives the owner the right to
sell an asset at a specified price.
Types of Derivatives
On October 1, 2008, Woodruff Company decides
that it will need to purchase 1,000 ounces of gold
for its computer chip manufacturing process in
January, 2009. Gold is selling for $300 per ounce
on October 1, 2005. Woodruff enters into a call
option contract on October 1 which gives Woodruff
the right to purchase 1,000 ounces of gold at a
price of $300 per ounce.
Types of Derivatives
Gold Price (per ounce) on January 1
$280
$300
$320
Cost of 1,000 ounces of gold if—
• Buy gold at:
January 1 prices
$280,000 $300,000 $320,000
• Exercise option
$300,000 $300,000 $300,000
Will option be exercised? No
Cost of gold
Same
Yes
$280,000 $300,000 $300,000
Types of Hedging Activities
• Hedging- Structuring of transactions
to reduce risk.
• Fair value hedge- offsets, at least
partially, the change in the fair value
of an asset or liability.
• Cash flow hedge- offsets, at least
partially, the variability in cash flows
from forecasted transactions that are
probable.
Accounting for Derivatives and
for Hedging Activities
Balance sheetDerivatives should be
reported in the balance
sheet at their fair value
as of the balance sheet
date.
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.
Accounting or Derivatives and
Hedging Activities
• Changes in the fair value of derivatives
designated as:
– No hedge are recognized as gains or losses
in the income statement in the period in
which the value changes.
– Fair value hedge are recognized as gains or
losses in the period of the value change.
– Cash flow hedge are recognized as part of
accumulated other comprehensive income.
Accounting or Derivatives and
Hedging Activities
• Companies must provide a description of
their risk management strategy and how
derivatives fit into that strategy.
• Firms must disclose the gains and losses on
derivatives, separated by category:
– Fair value hedges
– Cash flow hedges
– Other
• Notional amount- total face amount of the
asset or liability that underlies a derivative
contract.
Examples of Accounting for
Derivatives
On January 1, 2008, Pratt
Company received a two-year
$100,000 variable-rate loan and
also entered into an interest rate
swap agreement.
Jan. 1 Cash
100,000
Loan Payable
100,000
Examples of Accounting for
Derivatives
The market interest rate on 12/31/ 2008 is 11%.
There is no change in The interest rate swap asset
the underlying items in
is reported at its present
the 2008 balance sheet
value of $901 ($1,000
and income statement.
discounted) in the
12/31/2008 balance sheet.
The 2008 income statement shows a deferred
gain of $901 on the interest rate swap. A gain is
recognized in 2009 to offset increased in interest
expense.
Examples of Accounting for
Derivatives
The December 31, 2005 entry to record Pratt’s 2008
interest payment, along with the adjusting entry, is:
Dec 31 Interest Expense
Cash
($100,000 x .10)
Interest Rate Swap
Other Comprehensive
Income
December 31, 2006
Interest Expense
Cash
($100,000 x .11)
10,000
10,000
901
Asset
901
11,000
11,000
Examples of Accounting for
Derivatives
December 31, 2006
Cash
Interest Rate Swap
Other Comprehensive
Income
Other Comprehensive
Income
Interest Expense
Loan Payable
Cash
1,000
901
99
1,000
$901 x .11;
1,000
rounded
100,000
100,000
Examples of Accounting for
Derivatives
On November 1, 2008, Clayton
Company sold machine parts to
Maruta Company for ¥30,000,000 to
be received on January 1, 2009. On
the same date, Clayton also entered
into a yen forward contract.
Nov. 1 Yen Receivable
Sales
250,000
250,000
¥30,000,000 ÷
¥120 per $1
Examples of Accounting for
Derivatives
The actual exchange rate on December 31,
2008 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].
Dec. 31 Loss on Forward
Contract
Forward Contract
Yen Receivable
Gain on Foreign
Currency
2,101
2,101
2,101
2,101
Examples of Accounting for
Derivatives
The journal entries necessary in Clayton’s
books on January 1, 2009, to record receipt
of the yen payment and settlement of the
yen forward contract are:
Jan. 1 Cash
Yen Receivable
Forward Contract
Cash
252,101
252,101
¥30,000,000 ÷
2,101
¥119 per $1
2,101
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.
Accounting for Contingencies
Contingent Losses
Likelihood
Probable
Accounting Action
Recognize a probable liability if the
amount can be reasonable
estimated. If not estimable,
disclose facts in a note.
Reasonably
Possible
Disclose a possibility liability
in a note.
Remote
No recognition or disclosure unless
contingency represents a guarantee.
Then, note disclosure is required.
Accounting for Contingencies
Contingent Gains
Likelihood
Probable
Accounting Action
Recognize a probable asset if the
amount can be reasonable
estimated. If not estimable,
disclose facts in a note.
Reasonably
Possible
Disclose a possibility asset
in a note, but be careful to
avoid misleading implication.
Remote
No recognition or disclosure.
Accounting for Lawsuits
•
FASB Statement No. 5 identifies several key
factors to consider:
1. The nature of the lawsuit.
2. Progress of the case in court, including
progress between date of the financial
statements and their issuance date.
3. Views of legal counsel as to the possibility of
loss.
4. Prior experience with similar cases.
5. Management’s intended response to the
lawsuit.
•
No specific guidance on the disclosure
required when a loss contingency cannot
be estimated.
Regulating Authorities Ideas on
Environmental Liabilities
• SEC: Staff Accounting Bulletin No. 92interprets GAAP regarding contingent
liabilities, with particular applicability to
companies with environmental liabilities.
• AICPA: Statement of Position 96-1- outlines
the key events that can used to determine
whether an environmental liability is
probable.
• FASB: SFAS No. 143- states an obligation
associated with retiring an asset should be
recognized when incurred using present value
techniques. The offsetting debit should be an
addition to the cost of the associated asset.
Business Segments
• FASB Statement No. 14 disclosure
requirements:
– Revenues, operating profit, and identifiable
assets for each significant industry segment.
• A segment is significant if its sales, profits, or
assets are 10% or more of total company
amounts.
• A practical limit of 10 segments is suggested,
and at least 75% of total company sales must
be included in the reported segments.
– Revenues from major customers and
information about foreign operations and
export sales.
Business Segments
FASB Statement No. 131 Disclosure Requirements
1.
2.
3.
4.
5.
Total segment operating profit or loss.
Amounts of certain income statement items
such as operating revenues, depreciation,
interest revenue, interest expense, tax
expense, and significant noncash expenses.
Total segment assets.
Total capital expenditures.
Reconciliation of the sum of segment totals to
the company total for each of the following
items:
•
•
•
Revenues
Operating profit
Assets
Business Segments
In addition to these five items, companies
must also disclose how operating segments
are identified.
Revenue test- A segment should be reported if its total
revenue is 10% or more of the company’s total revenue.
Profit test- A segment should be reported if the
absolute value of its operating profit (or loss) is greater
than 10% of the total operating profit for all segments
that reported profits
Asset test- A segment should be reported if it contains
10% or more of the combined assets of all operating
segments.
Stop and Think
How could The Coca-Cola
Company use PepsiCo’s
reported segment
information to aid it in
formulating its
competitive strategy?
Interim Reporting
•Seasonal factors
•Revenue fluctuations among periods
Difficulties
Seasonal
•Matching ofwith
revenues
•Adjustments forInterim
accrued items
Reports
•Expense estimates (increased
•Fixed costs
subjectivity)
•Extraordinary items
•Segment disposal
Interim Reporting
• APB Opinion NO. 28- the interim period is
an integral part of the annual period.
• Revenues and expenses for the total period
are allocated among interim periods on
some reasonable basis (time, sales volume,
productive activity).
• The same GAAP and reporting practices
employed for annual reports are to be
used for interim statements.
• Modification may be necessary for interim
reports to better relate to the total results
of operations for the period.