1. Module Derivatives and Related Accounting Issues

2. Derivatives2 Derivatives, defined Financial instruments that derive their value from changes in the value of a related asset or liability.

3. Derivatives3 Characteristics of Derivatives Underlyings - the rates or prices that relate to the asset or liability underlying the derivative instrument Notional amount - the number of units or quantity that are specified in the derivative instrument Minimal initial investment - a derivative requires little or no initial investment because it is an investment in a change in value rather than an investment in the actual asset or liability No required delivery- generally the parties to the contract, the counterparties, are not required to actually deliver an asset that is associated with the underlying

4. Derivatives4 Common Types of Derivatives Forward Contracts Futures Contracts Option Contracts Interest Rate Swaps

5. Derivatives5 Forward Contracts A contract to buy or sell a specified amount of an asset at a specified fixed price with delivery at a specified future point in time. The value of the contract at inception is zero and typically does not require an initial cash outlay. The total change in the value of the forward contract is measured as the difference between the forward rate and the asset’s spot rate at the forward date.

6. Derivatives6 Example of a Forward Contract Writer of the Contract Holder of the Contract Convey 100,000 euros in 90 days Pay $85,000 in 90 days Euros at the forward rate in 90 days….. $ 85,000 Assumed spot rate in 90 days………… 90,000 Gain in value of forward……………… $ 5,000

7. Derivatives7 Measuring Changes in the Value of a Forward Contract Over Time The cumulative change in the forward value of a contract is measured as the difference between the original forward value and the remaining forward value. The net present value of the change in forward value consists of two components: –the change in the spot rates over time and –the change in the time value of the contract (spot - forward differences)

8. Derivatives8 Measuring Changes in the Value of a Forward Contract Over Time, continued

9. Derivatives9 Futures Contracts Like a forward contract except that futures are: Traded on an organized exchange The exchange clearinghouse becomes the intermediary between the buyer and seller of the contract Contracts are standardized versus customized An initial deposit of funds is required to create a margin account

10. Derivatives10 Futures Contracts, continued Futures contracts vis a vis forward contracts, continued Marked to market each day Represent current versus future dollars therefore eliminating the need for discounting The party that writes a contract is said to be short and the owner of the contract is said to be long

11. Derivatives11 Example of a Futures Contract The Short Clearing House The Long Sell oil Buy oil Sell oil Futures price/barrel on day 1……………….. $45 Futures price/barrel on day 2……………….. 46 Gain in value of contract……………………. $ 1 Contract to buy oil in May at $45/barrel

12. Derivatives12 Option Contracts Represent a right rather than an obligation to either buy or sell some quantity of a particular underlying. The buy or sell price is referred to as the strike price or exercise price A call option allows the holder to buy an underlying whereas a put option allows the holder to sell an underlying

13. Derivatives13 Option Contracts, continued The holder of an option must pay an initial nonrefundable cash outlay known as the option premium The value of an option consists of the intrinsic value and the time value

14. Derivatives14 Example of an Option Option Writer Option Holder Buy corn at $2.20/bu Intrinsic Value is the difference between the strike price and the market price (100,000 bu  ($2.20 - $2.22) = $2,000) Time Value is the value of the option less the intrinsic value ($2,400 - $2,000 = $400) Assume:market price per bushel is $2.22 notional amount is 100,000 bushels option value is $2,400

15. Derivatives15 Option Terms Illustrated

16. Derivatives16 Swaps A type of forward contract represented by a contractual obligation, arranged by an intermediary that requires the exchange of cash flows between two parties. For example, a company with a loan payable with a fixed (variable) interest rate exchanges the fixed rate of interest expense for a variable (fixed) rate of interest.

17. Derivatives17 Example of an Interest Rate Swap Issuer Of $10 Million Debt Bank Counter- Party Pays 8% fixed Pays a variable rate Receives 8% fixed If variable rate is 7.5%, Debtor: Pays to creditors…………………….$ (800,000) Pays to bank counterparty…………..(750,000) Receives from bank counterparty…..800,000 Net interest expense………………...$ 750,000 Creditors

18. Derivatives18 Derivatives Designated as a Hedge A derivative may be used to avoid the exposure to the risk that the value of an asset or liability may change unfavorably over time due to rate/price changes. –for example, the value of inventory may decrease due to price changes. Derivatives designated as a hedge are classified as either a fair value hedge or a cash flow hedge.

19. Derivatives19 Fair Value Hedges The hedged item is either a recognized asset or liability or a firm commitment. The prices or rates are fixed and therefore, subsequent changes in the price or rates affect the fair value of the recognized asset or liability or firm commitment. The derivative instrument can be designated as a hedge against changes in fair value.

20. Derivatives20 Fair Value Hedges, continued Fair value hedges receive special accounting treatment if certain criteria are satisfied. Qualifying criteria call for formal documentation of the hedging relationship and ongoing assessment of hedge effectiveness. Other criteria must also be satisfied.

21. Derivatives21 Special Accounting Treatment for Fair Value Hedges The gain or loss on the derivative instrument is recognized currently in earnings and The gain or loss on the hedged item is also recognized currently in earnings. The special accounting treatment results in: For example, the gain in the value of a futures contract to sell inventory can be used to offset the decrease in the value of a firm commitment to buy inventory. Recognizing both changes in value in current earnings gives recognition to the offsetting nature of the hedge.

22. Derivatives22 Special Accounting Treatment for Fair Value Hedges, continued Changes in the time value of a derivative are generally excluded from the assessment of hedge effectiveness and are always recognized in current earnings.

23. Derivatives23 Accounting for a Fair Value Hedge Illustrated Assume that a company has 100,000 units of commodity A, with a cost of $120,000, that will be sold in 60 days. In order to hedge against possible market declines in the value of commodity A, the company acquires a futures contract to sell commodity A in 60 days at $1.49 per unit.

24. Derivatives24 Accounting for a Fair Value Hedge Illustrated, continued

25. Derivatives25 Assessing the Effectiveness of a Fair Value Hedge

26. Derivatives26 Cash Flow Hedges The hedged item is either an existing asset or liability with variable future cash flows or a forecasted transaction. The prices or rates are not fixed and therefore, an entity is exposed to the risk that future cash flows may vary due to changes in prices/rates. The derivative instrument can be designated as a hedge and allow the entity to fix the price or rate and reduce the variability of cash flows.

27. Derivatives27 Cash Flow Hedges, continued Cash flow hedges receive special accounting treatment if certain criteria are satisfied. Qualifying criteria call for formal documentation of the hedging relationship and ongoing assessment of hedge effectiveness. Other criteria must also be satisfied.

28. Derivatives28 Special Accounting Treatment for Cash Flow Hedges The gain or loss on the derivative instrument initially being reported in other comprehensive income (OCI) The gain or loss is initially reported in OCI rather than current earnings because the hedged forecasted cash flows have not yet occurred. Once the forecasted cash flows have occurred, the OCI gain or loss will be reclassified into earnings in the same period or periods in which the forecasted transaction affects earnings. The special accounting treatment results in:

29. Derivatives29 As with fair value hedges, the change in the time value of a derivative may be excluded from the assessment of hedge effectiveness. Special Accounting Treatment for Cash Flow Hedges, continued

30. Derivatives30 Accounting for a Cash Flow Hedge Illustrated Assume that a company is forecasting the purchase of 100,000 units of commodity A in 60 days. The commodity will be processed and sold within 30 days of receipt.

31. Derivatives31 Accounting for a Cash Flow Hedge Illustrated, continued

32. Derivatives32 Assessing the Effectiveness of a Cash Flow Hedge

33. Derivatives33 Disclosures Regarding Derivative Instruments & Hedging Activities Objective of using hedging instruments and strategies for achieving objectives. Description of various types of fair value and cash flow hedges. Description of the entity’s risk management policy for hedging types and description of hedged transactions.

34. Derivatives34 Disclosures Regarding Derivative Instruments & Hedging Activities Required disclosures (continued) Specific disclosures regarding fair value hedges including effect on earnings. Specific disclosures regarding cash flow hedges including effect on earnings and reclassifications of OCI.