1. Accounting for Derivatives and Hedging Activities
Chapter 13
Accounting for Derivatives and Hedging Activities
Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall 1

2. Accounting for Derivatives and Hedging Activities: Objectives
Understand the definition of a cash flow hedge and the circumstances in which a derivative is accounted for as a cash flow hedge.
Understand the definition of a fair value hedge and the circumstances in which a derivative is accounted for as a fair value hedge.
Account for a cash flow hedge situation, and for a fair value hedge situation, from inception through settlement.
Understand the special derivative accounting related to hedges of foreign currency-denominated receivables and payables.
Comprehend the footnote disclosure requirements for derivatives.
Understand the International Accounting Standards Board accounting for derivatives.
Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

3. Using Derivatives as Hedges
A hedge can
Shift risk of fluctuations in sales prices, costs, interest rates, or currency exchange rates
Help manage costs
Reduce risks to improve financial position
Produce tax benefits
Help avoid bankruptcy
Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

4. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall
Hedge Accounting
At inception, document
The relationship between hedged item and derivative instrument
The risk management objective and strategy for the hedge
Hedging instrument
Hedged item
Nature of risk being hedged
Means of assessing effectiveness
Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

5. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall
Hedge Effectiveness
To qualify for hedge accounting, the derivative instrument must be highly effective in offsetting gains or losses in the item being hedged.
Effectiveness considers
Nature of the underlying variable
Notional amount of the derivative
Item being hedged
Delivery date of derivative
Settlement date of the underlying
If critical terms are identical, effectiveness is assumed.
Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

6. Example of Effectiveness
Item to be hedged
Accounts payable
Due January 1, 2012
For delivery of 10,000 euros
Variable is the changing value of euros
Hedge instrument
Forward contract
To accept delivery of 10,000 euros
On January 1, 2012
Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

7. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall
Statistical Analysis
If critical terms of item to be hedged and hedge instrument do not match, statistical analysis can determine effectiveness.
Regression analysis
Correlation analysis
Example
Using derivatives based on heating oil or crude oil to hedge jet fuel costs
Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

8. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall
Accounting for Derivatives and Hedging Activities
1: Cash Flow Hedge
Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

9. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall
Cash Flow Hedge
A Cash Flow Hedge is used for anticipated or forecasted transactions where there is risk of variability in future cash flows.
Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

10. Accounting for Cash Flow Hedge
A Cash Flow Hedge is
recorded at cost
adjusted to fair value at each reporting date
accounted for in Other Comprehensive Income (OCI) when there are gains or losses
When the forecasted transaction impacts the income statement
Reclassify OCI to the hedged revenue or expense account
Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

11. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall
Accounting for Derivatives and Hedging Activities
2: Fair value hedge
Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

12. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall
Fair Value Hedge
A Fair Value Hedge is used for an asset or liability position, or firm purchase or sale commitment, where there is a risk of variability in the value of the position.
Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

13. Accounting for a Fair Value Hedge
Both the item being hedged and the derivative are
adjusted to fair value at each reporting date
accounted for immediately in income with offsetting gains or losses
Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

14. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall
Accounting for Derivatives and Hedging Activities
3: hedge accounting
Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

15. Cash Flow Hedge: Example 1
Utility anticipates purchasing oil for sale to its customers next February. On December 1, Utility enters into a futures contract to acquire 4,200 gallons of oil at $ per gallon for delivery on January 31. A margin of $10 is to be paid up front.
On December 31, the price for delivery of oil on January 31 is $
On January 31, the spot rate for current delivery is $
Utility settles the contract, accepting delivery of 4,200 gallons of oil.
Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

16. Cash Flow Hedge: Example 1 (cont.)
In February, Utility sells all the oil to its customers for $8,400 and reclassifies its OCI from the hedge as cost of sales. Pertinent rates:
Change in futures contract to 12/31 = $18.06
Change in futures contract to 1/31 = ($23.10)
The loss on the contract is ($5.04) OCI, and this serves to increase Cost of Sales.
12/1
12/31
1/31
Futures rate, for 1/31
$1.4007
$1.4050
$1.3995
Cost of 4,200 barrels
$5,882.94
$5,901.00
$5,877.90
Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

17. Cash Flow Hedge: Example 1 (cont.)
Sign contract
12/1
Futures contract
10.00
Cash
12/31
18.06
OCI
1/31
23.10
4.96
Inventory
5,877.90
Adjust to fair value
Settle contract; collect balance on margin.
Purchase inventory.
Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

18. Cash Flow Hedge: Example 1 (cont.)
Record the sale and cost of sales.
Feb.
Cash
8,400.00
Sales
Cost of sales
5,877.90
Inventory
5.04
OCI
The last entry reclassifies the loss on the contract from OCI into Cost of Sales. The effect is to increase Cost of Sales to $5, This is the cost of the oil based on the futures contract signed on December 1.
Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

19. Cash Flow Hedge: Example 2
On 12/2/11, Winkler anticipates purchasing equipment on 3/1/12 with payment on that date of £500,000. On 12/2/11, Winkler signs a 90-day forward contract to buy £500,000 for $1.68 (the spot rate is $1.70).
The $10,000 contract discount will be amortized to Exchange Gain over three months using the effective interest method. Implied interest is:
PV = 1.70(500,000) = $850,000
FV = 1.68(500,000) = $840,000
Period = 3 months
Monthly rate using Excel =rate(nper,pmt,pv,fv)
=rate(3,0,850000, )
Result:
Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

20. Cash Flow Hedge: Example 2 (cont.)
Forward rates and fair value of contract:
The contract will be adjusted to its discounted fair value. Use the incremental borrowing rate (12%, or 1% monthly), discounting for the remaining contract life.
12/31: 5,000 / (1.01)2
3/1 (end of contract): 15,000
Note: 1/31 would be equal to fair value / (1.01)1
 Date
Forward rate
Notional Amount
£500,000
Contract
Fair value
Discounted Fair value
12/2
$1.68
840,000
12/31
$1.69
845,000
5,000
4,901
3/1
$1.72
860,000
20,000
15,099
Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

21. Cash Flow Hedge: Example 2 (cont.)
12/2
no entry for forward contract - no cash exchanged
12/31
Forward contract
4,901
OCI
Bring forward contract to discounted fair value.
3,346
Exchange gain
Effective interest method amortization of the 10,000 discount. 850,000 x
The change in value for the forward contract is an unrealized gain put into OCI.
The discount on the contract is amortized over the 3 months of the contract.
Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

22. Cash Flow Hedge: Example 2 (cont.)
3/1
Forward contract
15,099
OCI
Bring forward contract to fair value, $20,000
Cash
20,000
for net settlement of contract: 860,000 current - 840,000 contract
Equipment
860,000
Purchase equipment from supplier
6,654
Exchange gain
remaining amortization: 10, ,346
The final balance in OCI is $10,000 CR.
This will reduce the equipment's depreciation over its life.
Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

23. Fair Value Hedge: Example 3
Utility has accumulated 10,000 barrels of oil in inventory that it will not sell until the later winter months. Utility wants to maintain the value of the inventory which is recorded at cost of $85 per barrel, in the event that the price of oil falls before they are able to sell it. On November 1, Utility enters into a futures contract to sell the oil for $90 a barrel in three months.
The contract will be settled net.
Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

24. Fair Value Hedge: Example 3 (cont.)
The market price of the oil is $92 per barrel at December 31.
The estimated value of the forward contract on December 31 is a liability of the $2 per barrel difference between our contracted price and the market price. The liability is measured as $20,000 / (1.01), or $19,802, assuming a 1% per month interest rate.
On January 31, the spot price is $89 and Utility settles the contract by receiving $10,000, or ($90-$89) x 10,000 barrels.
Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

25. Fair Value Hedge: Example 3 (cont.)
12/31
Loss on Forward contract
19,802
Forward contract
Inventory
20,000
Gain on Inventory
1/31
10,000
Gain on Forward contract
29,802
Loss on Inventory
30,000
Cash
Report at fair value at reporting date.
Adjust inventory to fair value
Adjust values prior to final settlement.
Settle contract.
Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

26. 4: Accounting for hedges of foreign currency receivables and payables
Accounting for Derivatives and Hedging Activities
4: Accounting for hedges of foreign currency receivables and payables
Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

27. Fair Value Hedge Example: Liability
Cary purchases equipment costing 200,000 yen on 12/2/11 with payment due on 1/30/12.
On 12/2/11 Cary enters a forward contract to purchase 200,000 yen on 1/30/12 at the forward contract rate of $
Date
Spot rate
Acct Pay
Forward rate
Cont Rec
12/2
$0.0094
$1,880
$0.0095
$1,900
12/31
$0.0092
$1,840
$0.0093
$1,860
1/30
$0.0098
$1,960
Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

28. Fair Value Hedge: Liability (cont.)
Accounts payable:
Gain of $40 for December
Loss of $120 for January
Contract receivable:
Loss of $40 for December
Gain of $100 for January
Total exchange loss on the transaction = ($20)
The net gain/loss for December = $0.
The net loss for January = ($20)
Spread between the spot and forward rate on 12/2 determines the total loss, e.g., the cost of hedging.
Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

29. Fair Value Hedge: Liability (cont.)
12/2: Buy equipment and sign forward contract.
12/2
Equipment
1,880
Accounts payable (¥)
Contract receivable (¥)
1,900
Contract payable ($)
12/31 40
Exchange gain
Exchange loss
12/31: Adjust foreign monetary accounts to current (year-end) rate.
Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

30. Fair Value Hedge: Liability (cont.)
1/30: Pay promised $1,900 on forward contract and receive yen in exchange
1/30
Contract payable ($)
1,900
Cash ($)
Cash (¥)
1,960
Contract receivable (¥)
1,860
Exchange gain
100
Accounts payable (¥)
1,840
Exchange loss
120
Use the yen to pay the supplier
Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

31. 5: Footnote disclosure requirements for derivatives
Accounting for Derivatives and Hedging Activities
5: Footnote disclosure requirements for derivatives
Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

32. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall
Footnote Disclosures
Risk management objectives and strategies must be disclosed in the footnotes.
Fair value hedges
net gain or loss in earnings
placement on statements
effectiveness and ineffectiveness
Cash flow hedges
hedge ineffectiveness gain or loss
types of situations hedged
expected length of time
effect of discontinuance of hedge
Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

33. 6: the IASB Standards for derivatives
Accounting for Derivatives and Hedging Activities
6: the IASB Standards for derivatives
Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

34. International Accounting Standards
IAS are similar to U.S. Standards in most respects:
IAS 32 – financial instruments
Debt and equity instruments
IAS 39 – derivatives and hedges
Cash flow and fair value hedges
Difference: hedges of firm commitments can be accounted for as either a cash flow or fair value hedge
Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall

35. Copyright ©2012 Pearson Education, Inc. Publishing as Prentice Hall