Prepared by: Gabriela H. Schneider, CMA Northern Alberta Institute of Technology INTERMEDIATE ACCOUNTING Seventh Canadian Edition KIESO, WEYGANDT, WARFIELD, YOUNG, WIECEK

Appendix 17A Hedging Hedging

10.Understand how derivatives are used in hedging. 11.Explain what hedge accounting is and identify the qualifying hedge criteria. 12.Explain the difference between a fair value and cash flow hedge. 13.Calculate the impact on net income using hedge accounting for both types of hedges. Learning Objectives

Derivatives Used For Hedging Financial risks faced by organizations:Financial risks faced by organizations: –Price risk Fair value impact on assets and liabilitiesFair value impact on assets and liabilities –Cash flow risk Risk due to variability of cash flowRisk due to variability of cash flow –Liquidity risk Cash flow commitmentsCash flow commitments –Credit risk Cash flow commitmentsCash flow commitments Derivatives used to offset these fair value and cash flow risksDerivatives used to offset these fair value and cash flow risks

Hedging Used to manage interest rate and foreign exchange riskUsed to manage interest rate and foreign exchange risk Two types of hedgesTwo types of hedges 1.Fair Value Hedge 2.Cash Flow Hedge

Hedging Fair Value HedgeFair Value Hedge –To offset exposure to fair value changes of Recognized asset or liabilityRecognized asset or liability –Examples are Put optionPut option Forward contractForward contract Cash Flow HedgeCash Flow Hedge –Offset risks of future transactions –Gains/losses reported as part of Other Comprehensive Income

Optional Hedge Accounting Available as an accounting option when the following are met:Available as an accounting option when the following are met: 1.When the hedge is entered into a.Identify the exposure b.Designate that hedge accounting applied c.Document risk management objectives and strategies 2.Reasonable assurance should exist that the firms’ risk management policy is being maintained a.Hedge effectiveness can be reasonably measured b.Hedge is reassessed as regular intervals c.Other

Forward Contract as Fair Value Hedge Commitment to sell an instrument/investment at a pre-determined priceCommitment to sell an instrument/investment at a pre-determined price Eliminates the risk of a price decreaseEliminates the risk of a price decrease

Fair Value Hedge - Example Investment (intended for sale) purchased at a cost of: $1,000 Journal entry to purchase Investment1,000 Cash1,000Investment (intended for sale) purchased at a cost of: $1,000 Journal entry to purchase Investment1,000 Cash1,000 Forward contract entered intoForward contract entered into

Fair Value Hedge - Example At year end assume investment value is $1,050 Journal entry: Investment50 Gain on Investment50 and Loss on Investment 50 Investment-Derivative 50At year end assume investment value is $1,050 Journal entry: Investment50 Gain on Investment50 and Loss on Investment 50 Investment-Derivative 50 No effect on cash flowsNo effect on cash flows

Fair Value Put Option - Example Under hedge accountingUnder hedge accounting Gain is recorded on the hedged item andGain is recorded on the hedged item and Loss is recorded on the underlying derivativeLoss is recorded on the underlying derivative Applies also to lossesApplies also to losses

Cash Flow Hedge - Examples Interest rate swaps used as hedgesInterest rate swaps used as hedges Similar in nature to forward contractsSimilar in nature to forward contracts Requires two parties to enter intoRequires two parties to enter into Payments are made under a fixed or floating rate of interestPayments are made under a fixed or floating rate of interest Payments then made by the second partyPayments then made by the second party –Terms are the opposite of the original payment terms

Interest Rate Swap Party A Party B FinancialIntermediary A pays B at a fixed (or floating) rate B pays A using the opposite rate of A

Interest Rate Swap Given: Jones enters into a 5-year interest rate swap with B Terms are: Jones will make payments at the fixed rate of 8% Jones will receive payments at variable rate (6.8% when contract entered into) Principal sum involved is $1,000,000

Interest Rate Swap No entry required when swap entered intoNo entry required when swap entered into Fair value of the swap reported on the Balance SheetFair value of the swap reported on the Balance Sheet Any gains or losses reported through other Comprehensive Income until realized through interest expenseAny gains or losses reported through other Comprehensive Income until realized through interest expense

Interest Rate Swap Value of the swap determined at the end of each yearValue of the swap determined at the end of each year Based on the difference between the fixed (contract) rate and the prevailing rate of interestBased on the difference between the fixed (contract) rate and the prevailing rate of interest Value of the swap contract reported on the Balance Sheet at fair market valueValue of the swap contract reported on the Balance Sheet at fair market value Any gain reported as part of Comprehensive IncomeAny gain reported as part of Comprehensive Income Value at the end of the swap contract is zeroValue at the end of the swap contract is zero

Forward Contract as a Cash Flow Hedge Forwarding contracts may be used to hedge anticipated future transactions (and the associated cash flow risks) i.e. a purchase commitmentForwarding contracts may be used to hedge anticipated future transactions (and the associated cash flow risks) i.e. a purchase commitment Gives the holder the right to purchase at a preset priceGives the holder the right to purchase at a preset price Unrealized gains or losses are recorded in Other Comprehensive IncomeUnrealized gains or losses are recorded in Other Comprehensive Income When gains/losses are realized, they are transferred from OCI to NIWhen gains/losses are realized, they are transferred from OCI to NI –Gain or loss arises when the spot price is different than the forward (contract) price

Disclosure Requirements Include the following:Include the following: 1)Terms and conditions of instrument 2)Interest rate risk 3)Credit risk, including significant concentrations 4)Fair value of any and all recognized and unrecognized financial instruments 5)Hedges 1)Description of hedge 2)Type of hedge used

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