Accounting For Derivatives and Hedging Activities

Chapter 13
Accounting for
Derivatives and
Hedging Activities
to accompany
Advanced Accounting, 11th edition
by Beams, Anthony, Bettinghaus, and Smith
Copyright ©2012 Pearson Education,

13-1
Inc. Publishing as Prentice Hall
Accounting for Derivatives and
Hedging Activities: Objectives
1. Understand the definition of a cash flow hedge and the
circumstances in which a derivative is accounted for as a
cash flow hedge.
2. Understand the definition of a fair value hedge and the
circumstances in which a derivative is accounted for as a
fair value hedge.
3. Account for a cash flow hedge situation, and for a fair
value hedge situation, from inception through settlement.
4. Understand the special derivative accounting related to
hedges of foreign currency-denominated receivables and
payables.
5. Comprehend the footnote disclosure requirements for
derivatives.
6. Understand the International Accounting Standards
Board accounting for derivatives.
13-2
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

13-3
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
13-4
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,
13-5
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

13-6
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
13-7
Accounting for Derivatives and Hedging Activities
1: CASH FLOW HEDGE

13-8
Cash Flow Hedge
A Cash Flow Hedge is used

for anticipated or forecasted
transactions where there is
risk of variability in future
cash flows.

13-9
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
13-10
2: FAIR VALUE HEDGE

13-11
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.
13-12
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

13-13
3: HEDGE ACCOUNTING

13-14
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 $1.4007 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 $1.4050.
 On January 31, the spot rate for current
delivery is $1.3995.
Utility settles the contract, accepting delivery of
4,200 gallons of Copyright
oil. ©2012 Pearson Education,
13-15
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:
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
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.
13-16
Sign 12/1 Futures contract 10.00

contract
Cash 10.00
12/31 Futures contract 18.06
Adjust to
fair value OCI 18.06
1/31 OCI 23.10
Settle Futures contract 23.10
contract; 1/31 Cash 4.96
collect
balance on Futures contract 4.96
margin. 1/31 Inventory 5,877.90
Purchase inventory.
Cash 5,877.90
13-17
Record Feb. Cash 8,400.00

the sale
and cost Sales 8,400.00
of sales. Feb. Cost of sales 5,877.90
Inventory 5,877.90
Feb. Cost of sales 5.04
OCI 5.04
The last entry reclassifies the loss on the contract
from OCI into Cost of Sales. The effect is to
increase Cost of Sales to $5,882.94. This is the cost
of the oil based on the futures contract signed on
December 1. Copyright ©2012 Pearson Education,
13-18
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,-840000)
Result: 0.003937
13-19
Forward rates and fair value of contract:
Notional
Amount Contract Discounted
Date Forward rate £500,000 Fair value 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
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
13-20
12/2 no entry for forward contract - no cash exchanged
12/31 Forward contract 4,901
OCI 4,901
Bring forward contract to discounted fair value.
12/31 OCI 3,346
Exchange gain 3,346
Effective interest method amortization of the 10,000
The change
in value for the
discount. 850,000 x .003937
forward contract is an The discount on the
unrealized gain put into contract is amortized
OCI. over the 3 months of
the contract.

13-21
3/
1 Forward contract 15,099
OCI 15,099
Bring forward contract to fair value, $20,000
The final 3/
balance in 1 Cash 20,000
OCI is
$10,000 CR. Forward contract 20,000
This will
reduce the for net settlement of contract: 860,000 current -
equipment's 840,000 contract
depreciation 3/
over its life. 1 Equipment 860,000
Cash 860,000
13-22
Purchase equipment from supplier
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.

13-23
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.
13-24
Fair Value Hedge: Example 3 (cont.)
Loss on Forward
Report at fair 12/31 contract 19,802
value at Forward contract 19,802
reporting date.
12/31 Inventory 20,000
Adjust Gain on Inventory 20,000
inventory to
fair value 1/31 Forward contract 10,000
Forward contract 19,802
Adjust
values prior Gain on Forward
contract 29,802
to final
settlement. Loss on Inventory 30,000
Inventory 30,000
Settle 1/31 Cash 10,000
contract. Forward contract
10,000
13-25
4: ACCOUNTING FOR
HEDGES OF FOREIGN
CURRENCY RECEIVABLES
AND PAYABLES

13-26
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 $0.0095.
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 $0.0098 $1,960

13-27
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.
13-28
12/2: Buy 12/2 Equipment 1,880

equipment
and sign Accounts payable (¥) 1,880
forward 12/2 Contract receivable (¥) 1,900
contract.
Contract payable ($) 1,900
12/31 Accounts payable (¥) 40
12/31:
Adjust Exchange gain 40
foreign 12/31 Exchange loss 40
monetary
accounts Contract receivable (¥) 40
to current
(year-end)
rate. Copyright ©2012 Pearson Education,
13-29
1/30: Pay 1/30 Contract payable ($) 1,900

promised
$1,900 on Cash ($) 1,900
forward 1/30 Cash (¥) 1,960
contract
and Contract receivable (¥) 1,860
receive Exchange gain 100
yen in 1/30 Accounts payable (¥) 1,840
exchange
Exchange loss 120
Cash (¥) 1,960
Use the yen to pay the supplier

13-30
5: FOOTNOTE
DISCLOSURE
REQUIREMENTS FOR
DERIVATIVES

13-31
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
 placement on statements
 types of situations hedged
 expected length of time
 effect of discontinuance of hedge
13-32
6: THE IASB STANDARDS

FOR DERIVATIVES

13-33
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
13-34
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13-35

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Chapter 13

Copyright ©2012 Pearson Education,

Copyright ©2012 Pearson Education,

Copyright ©2012 Pearson Education,

1: CASH FLOW HEDGE

Copyright ©2012 Pearson Education,

A Cash Flow Hedge is used

Copyright ©2012 Pearson Education,

2: FAIR VALUE HEDGE

Copyright ©2012 Pearson Education,

A Fair Value Hedge is used for

Copyright ©2012 Pearson Education,

Copyright ©2012 Pearson Education,

Sign 12/1 Futures contract 10.00

Record Feb. Cash 8,400.00

Copyright ©2012 Pearson Education,

The contract will be settled net.

Copyright ©2012 Pearson Education,

Copyright ©2012 Pearson Education,

12/2: Buy 12/2 Equipment 1,880

1/30: Pay 1/30 Contract payable ($) 1,900

Copyright ©2012 Pearson Education,

Copyright ©2012 Pearson Education,

6: THE IASB STANDARDS

Copyright ©2012 Pearson Education,

IAS 32 – financial instruments

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