appendix 17a: accounting for investments in derivative financial instruments

Appendix 17A: Accounting for Investments in

Derivative Financial Instruments

Understanding derivatives a. Forward Contract: Gives holder the right and obligation to purchasean asset at a preset price for a specified period oftime.

Example: Dell enters into a contract with a broker for delivery of 10,000 shares of Google stock in three months at its current price of $110 per share. => $1,100,000

Dell has received the right to receive 10,000 shares in three months and incurred an obligation to pay $110 per share at that time.

Understanding derivatives b. Option Contract: Gives the holder the right, but not the obligation, to buyshare at a preset price for a specified period of time. Example: Dell enters into a contract with a broker for an option (right) to purchase 10,000 shares of Google shares at its current price of $110 per share.

The broker charges $3,000 for holding the contract open for two weeks at a set price.

Dell has received the right, but not the obligation to purchase this stock at $110 within the next two weeks.

Concept of Derivative Instruments The forward contract and the option contract both involve a

future delivery of stock. The value of each of these contracts relies on the underlying asset –the Google stock. Therefore, these financial instruments (the FORWARD and the OPTION contracts) are known as derivatives because they derive their value from values of other assets (e.g., Google stocks or other stocks or bonds or commodities).

Or, their value relates to a market –determined indicator (e.g., interest rates or the S&P’s 500 index).

Who uses derivatives?

a. Producers and consumers: HedgersExample:

Heartland –Large producer of potatoesMcDonald –Large consumer of potatoes (French fries)

The objective is not to gamble on the outcome or to profit but to lock in a price at which both of them obtain an acceptable profit.

Both companies, the producer and the consumer, are hedgers.They hedge (protect) their positions to ensure an acceptable

financial outcome.

b. Speculators and arbitrageurs: SpeculatorsThe objective is to gamble on the outcome or to profit based

on the outcome.

Why use derivatives?

-Changes in the price of jet fuel: Delta, Continental, United….

-Changes in interest rates: Citigroup, AIG, BoA…..

-Changes in exchange rates: GE, GM, Cisco …..

Accounting guidelines for derivatives (FAS 133)

a. Recognized as assets and liabilities. b. Reported at fair value. c. UNREALIZED Gains and losses from speculation in derivatives recognized in income immediately. d. UNREALIZED Gains and losses from hedge transactions reported in accordance with the type of hedge either in OCI or income.

Derivative financial investment -Speculation.

Call option: Gives the holder the right, but not the obligation, to buy shares at a preset price (strike price or exercise price).

A company (speculator) can realize a gain from the increase in the value of the underlying share with the use of a Call Option – a derivative.

Example: A company enters into a call option contract on January 2, 2007, with Baird investment Co., which gives it the option to purchase 1,000 shares (referred to as the notional amount) of Laredo stock at $100 per share. On January 2nd, the Laredo shares are trading at $100 per share. The option expires on April 30, 2007. The company purchases the call option for $400.

If the price of Laredo stock increases above $100, the company can exercise this option and purchase the shares for $100 per share. If Laredo’s stock never increases above $100 per share, the call option is worthless.


Accounting entries:(1) To record purchase (option premium) of call option: Call Option 400 Cash 400

The option premium consists of two amounts: Intrinsic Value & Time value

*Option premium = Intrinsic value + Time value;

(a)Intrinsic value = Preset strike price - Market price On January 2, the intrinsic value is ZERO because

the market price equals the preset strike price.

(b)Time value is estimated using an option-pricing model. It reflects the possibility that the option has a fair value

greater than zero. WHY? Because, there is expectation that the price of Laredo shares will increase above the strike price during the option term. On January 2, the time value of the option is $400.


(2) FYE Adjustments: March 31, 2007:a. To record increase in intrinsic value of option:

On March 31, 2007, Laredo shares are trading at $120 per share.

Therefore, the Intrinsic Value of the Call Option is now:$20,000 = $120,000 – $100,000.

This gives the company an unrealized gain of: $20,000 = $20,000 - $0.

The company records the increase in intrinsic value as follows: Call Option 20,000 Unrealized Holding Gain or Loss—Income20,000


(b) To record decrease in time value of the option:

On March 31, 2007, a market appraisal indicates that the time value of the option is $100.

This gives the company an unrealized loss of $300:$300 = $400 - $100

The company records this change in time value as follows: Unrealized Holding Gain or Loss—Income 300 Call Option 300


(4) To record the settlement of the call option contract with Baird on April 1, 2007:

On April 1, 2007, the company exercises the call option (simultaneously buys and sells) and records the settlement of the call option with Baird as follows: Cash (120,000 – 100,000 = net cash) 20,000Loss on Settlement of Call Option 100

Call Option 20,100


Effects of the call option on net income: Date Transaction Income (Loss) Effect

March 31, 2007 Net increase in value of call option $19,700

April 1, 2007 Settle call option (100) Total net income $19,600


Financial statement reporting:

(1)Call option is reported as an asset at fair value.

(2) Any gains or losses (unrealized or realized) are reported in income.

Three basic characteristics of Derivative Instruments(FAS 133)

1. The instrument has one or more underlyings and an identified payment provision. 2. The instrument requires little or no investment at the inception of the contract. 3. The instrument requires or permits net settlement.


1. The instrument has one or more underlyings and an identified payment provision.

An underlying is a specified stock price, interest rate, commodity price, index of prices or rates, or other market-related variable.

The interaction of the underlying, with the face amount or the number of units specified in the derivative contract (the notional amounts), determines payment.

Example: The underlying is the stock price of Laredo stocks. The value of the call option increased in value when the value of the Laredo stock increased.

Payment Provision = Change in the stock price x Number of Shares


2. The instrument requires little or no investment at the inception of the contract.Example: The company paid a small premium to purchase the call option –an amount much less than if purchasing the Laredo shares as a direct investment.

3. The instrument requires or permits net settlement.Example: The Laredo stock Call Option allows the company to realize a profit on the call option without taking possession of the shares.This Net Settlement feature reduces the transaction costs associated with derivatives.

Derivatives Used for Hedging

Hedging is the use of derivatives to reduce Price risk, interest rate risk and exchange rate risk.

(1) Interest rate risk is risk that changes in interest rates will negatively affect the fair-values or cash flow of interest sensitive assets and liabilities.

(2) Exchange rate risk is the risk of foreign exchange rates negatively affecting profits. SFAS 133 (ASC 815) establishes accounting and reporting standards for derivative financial Instruments used in hedging activities.

The FASB allows two types of hedges: a. Fair Value Hedges;b. Cash Flow Hedges.

Derivatives Used for Hedging –FV Hedge

a. Fair value hedge:

A derivative used to hedge (offset) the exposure to changes in the fair value of a recognized asset or liability, or of an unrecognized commitment. In a perfectly hedged position, the gain or loss on the fair value of the derivative equals and offsets that of the hedged asset or liability.

(1) Interest rate swaps: Used to hedge the risk that changes in interest rates will have a negative impact on fair value of debt obligations.

(2) Put options: Used to hedge the risk that an equity investment will decline in value.


Put Option

An option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price (STRIKE PRICE) within a specified time.

A put becomes more valuable as the price of the underlying stock depreciates (falls) relative to the strike price.

This is the opposite of a call option.


Put OptionExample:On March 1, 2007, you purchased a March 08 Taser 10 put. That means, you have the right to sell 100 shares of Taser at $10 until March 2008 (usually the third Friday of the month).

If shares of Taser fall to $5 and you exercise the option, you can purchase 100 shares of Taser for $5 in the market and sell the shares to the option's writer for $10 each, which means you make $500 = (100 x ($10-$5)) on the put option.

Note that the maximum amount of potential profit in this example ignores the premium paid to obtain the put option.


Accounting for a Fair Value Hedge -Put option:

Example: On April 1, 2006, Hayward Co. purchases 100 shares of Sonoma stock at a market price of $100 per share.

Hayward does not intend to actively trade this investment. It consequently classifies the Sonoma investments as available-for-sale (AFS).

On December 31, 2006, Sonoma shares are trading at $125 per share.


(a) Hayward records this AFS investment as follows on 4/1/2006:AFS Securities 10,000

Cash 10,000

(b) On December 31, 2006, Sonoma shares are trading at $125 per share.Following the rules of FAS 115, Hayward records AFS securities at FMV on the Balance sheet and reports unrealized gains and losses in equity as part of Other Comprehensive Income: AFS Securities 2,500 <=(125–100)*100

Unrealized Holding Gain (loss) –Equity 2,500


(c) Balance Sheet presentation of the Sonoma Investment on 12/31/2006: Assets

Available-for-securities (at FMV) $12,500 Shareholders’ Equity

Accumulated other comprehensive incomeUnrealized Holding Gain (loss) $2,500


(d) Hedge Derivative: Hayward is exposed to the risk that the price of the Sonoma stock will decline. To hedge this risk, Hayward locks in its gain on Sonoma investment by purchasing a put option on 100 shares of Sonoma stock.

Hayward enters into a put option on January 2, 2007, and designates the option as a fair value hedge of the Sonoma investment. This put option (which expires in two years) gives Hayward the option to sell 100 Sonoma shares at a price of $125.

To record a purchase, assuming no premium paid: January 2, 2007:

No entry required.A memorandum indicates the signing of the put option contract

and its designation as a fair value hedge for the Sonoma investment.*At inception: Exercise price equals the current market price.


SPECIAL ACCOUNTING FOR THE HEDGED ITEM (FAS 133):Once the hedge is designated, accounting for any unrealized gain or loss on available for-sale securities is recorded in income, NOT in equity.

(e) On December 31, 2007, Sonoma shares are trading at $120 per share:Following the rules of FAS 115, Hayward records AFS securities at FMV on the Balance sheet and following the rules of Special Accounting of FAS 133,reports unrealized gains and losses in Income:

Unrealized Holding Gain (loss) -Income 500AFS Securities 500

To record an increase in the value of the put option:Put Option 500

Unrealized Holding Gain or Loss—Income 500 Note: The decline in the price of Sonoma shares results in an increase in the fair value of the put option. The increase in fair value on the option offsets or hedges (protects) the decline in value on Hayward’s AFS security.


(f) Financial statement disclosure:

(i) Balance sheet: Both the investment security and the put option are reported at fair value.

HAYWARD CO. Balance Sheet (Partial) December 31, 2007

AssetsAvailable-for-Sale securities (@ FMV) $12,000

Put Option (@ FMV) 500

Shareholders’ EquityAccumulated other comprehensive income:

Unrealized Holding Gain (loss) $2,500

Balance Sheet:By using fair value accounting for both financial instruments, the financial statements reflect the underlying substance of Hayward’s net exposure to the risks of holding Sonoma stock.


(f) Financial statement disclosure:

(ii) Income statement: any unrealized gain or loss on the investment security and the put option is reported under “Other Income” or “Other Expense.” HAYWARD CO.

Income Statement (Partial) FYE December 31, 2007 Other Income

Unrealized holding gain (loss) –Put Option $ 500 Unrealized holding gain (loss) –AFS Securities (500) Income Statement:The income statement indicates that the gain on the put option offsets the loss on the AFS securities.

The reporting for these financial instruments, even when they reflect a hedging relationship, illustrates why the FASB argued that fair value accounting provides the most relevant information about financial instruments, including derivatives.

Derivatives Used for Hedging –CF Hedge

Cash flow hedgesCash flow hedges are used to hedge exposure to cash flow risk.Cash Flow risk arises from the variability in cash flows.

Who uses Cash Flow hedge?Producers and consumers.

Example: Heartland –Large producer of potatoesMcDonald –Large consumer of potatoes (French fries)

The objective is not to gamble on the outcome or to profit but to lock in a price at which both of them obtain an acceptable profit.


Example: In September 2006 Allied Can Co. anticipates purchasing 1,000 tons of Aluminum in January 2007.

Concerned that price for aluminum will increase in the next few months, Allied wants to hedge the risk that it might have to pay higher prices for aluminum in January 2007.

As a result, Allied enters into an aluminum futures contract (forward contract).


Futures contract: Gives holder the right and obligation to purchase an asset at a preset (strike) price for a specified period of time.

Spot price: Price of an asset today, that will be delivered sometime in the future.

Example: The September 2006 aluminum future contract gives Allied the right and the obligation to purchase 1,000 tons of aluminum for a strike price of $1,550 per ton. The contract expires in January 2007.

The underlying for this derivative is the price of aluminum.If the price of aluminum rises above $1,550, the value of the futures contract to Allied increases. Because, Allied will be able to purchase the aluminum inventory at the lower price of $1,550 per ton.


Accounting Entries:

(1)Assume that in September 2006, the spot price equals the strike price. With the two prices equal, the futures contract has no value.

September 2006No entry is necessary!A memorandum indicates the signing of the futures contract and its designation as a cash flow hedge for future purchase of aluminum inventory.


SPECIAL ACCOUNTING:

The FASB allows special accounting for cash flow hedges.

Generally, FAS 133 requires companies to measure and report derivatives at fair value on the balance sheet and report gains and losses directly in net income.

However, FAS 133 allows companies to account for derivatives used in cash flow hedges at fair value on the balance sheet, but record gains and losses in equity, as part of other comprehensive income.


(2) To record increase in value of futures contract due to increase in spot price:

At December 31, 2006, the price for January delivery of aluminum increases to $1,575 per ton. December 31, 2006Allied makes the following entry to record the increase in the value of the futures contract.

Futures Contract 25,000 Unrealized Holding Gain or Loss—Equity 25,000*

*25,000 = ($1,575 – $1,550) x 1,000 tons

Allied reports the future contract in the balance sheet as current asset and the gain on the futures contract as part of other comprehensive income.


Financial statement disclosure:

Balance sheet:

Allied Can CO. Balance Sheet (Partial) December 31, 2006

Current AssetsFutures contract (@ FMV) $25,000




Since Allied has not yet purchased and sold the inventory, this gain is an Anticipated Transaction.

In this type transaction, a company accumulates in equity gains and losses on the futures contract as part of other comprehensive income until the period in which it sells the inventory, thereby effecting earnings.


(3) To record settlement of futures contract (assuming spot price exceeded contract price):

January 2007On January 31, 2007, Allied purchases 1,000 tons of aluminum for $1,575 and makes the following entry:

Inventory -Aluminum 1,575,000 Cash ($1,575 x 1,000 tons = $1,575,000) 1,575,000

On the same date, Allied makes final settlement on the futures contract and records the following entry:

Cash 25,000 Futures Contract ($1,575,000 - $1,550,000) 25,000


Through the use of the futures contract derivative, Allied has effectively hedged the cash flow for the purchase of inventory –protected itself against the rising cost of its inventory.

The $25,000 futures contract settlement offsets the amount paid to purchase the inventory at the prevailing market price of $1,575,000.

The result: Net cash outflow of $1,550 per ton.Actual Cash Flows:Actual cash paid $1,575,000Less: Cash received on settlement of future contract (25,000)

Net cash outflow $1,550,000

Note: There are no income effects at this point!!! <=Anticipated TransactionAllied accumulates in equity the gain on the futures contract as part of other comprehensive income until the period when it sells the inventory, affecting earnings through cost of goods sold.


Financial statement disclosure:

Balance sheet:

Allied Can CO. Balance Sheet (Partial) January 31, 2007

Current AssetsInventory $1,575,000




(4) To record disposition of unrealized loss when goods are sold:

July 2007Assume that Allied processes the aluminum into finished goods (cans). The total cost of the manufactured cans (including the aluminum purchases of $1,575,000 in January 2007) is $1,700,000. Allied sells the cans in July 2007 for $2,000,000, and records this sale as follows:Cash 2,000,000 Sales Revenue 2,000,000

Cost of Goods Sold 1,700,000 Inventory –Cans 1,700,000 Since the effect of the anticipated transaction has now affected earnings, Allied makes the following entry related to the hedging transaction to affect earnings:

Unrealized Holding Gain or Loss—Equity 25,000Cost of Goods Sold 25,000

Derivatives Used for Hedging –CV Hedge

Income statement:

Allied Can Co. Income Statement (Partial)

FYE July 31, 2007

Sales Revenue $2,000,000 Cost of Goods Sold 1,675,000*

Gross Profit _ 325,000

*Cost of Inventory $1,700,000 Less: Futures contract adjustment 25,000 Cost of goods sold $1,675,000


The gain on the future contract, which Allied reported as part of other comprehensive income, now reduces cost of goods sold. As a result, the cost of aluminum included in the overall cost of goods sold is $1,550,000.

The futures contract has worked as planned!!! Allied has managed the cash paid for aluminum inventory and the amount of cost of goods sold.

Learning Objective (LO) 13:

Other reporting issues

NOT COVERED!!

LO 14: Disclosure provisions

Primary disclosure requirements:

Financial instruments are to be disclosed at their fair value and related carrying value in a note or a summary table form.

For derivative financial instruments, a firm should disclose its objectives for holding or issuing those instruments (speculation or hedging), the hedging context (fair value or cash flow), and its strategies for achieving risk management objectives.

A company should not combine, aggregate, or net the fair value of separate financial instruments.

The net gain or loss on derivative instruments designated in cash flow hedges should be reported as a separate classification of other comprehensive income.

appendix 17a: accounting for investments in derivative financial instruments

Documents

option right

preset price strike

current price

forward contract

exercise price

shares of google shares

option contracts

shares of google stock