Financial Statement Analysis

Professor Julian Yeo

Class Notes 06: Fixed Claims

Part I: Investments in Debt Securities
1.1 Classifications
1.2 Other-than-temporary Impairment
1.3 Quality issues and ways to detect manipulations
1.4 Disclosures

Part II: Debt

2.1 Accounting for Bonds
2.2 Quality issues and ways to detect manipulations

Part III: Leases

3.1 Capital Leases vs Operating Leases
3.2 Comparing Capital vs Operating Leases
3.3 Quality issues and ways to detect manipulations
3.4 Disclosures

Part IV: Derivatives

4.1 Accounting for Derivatives
4.2 Quality issues and ways to detect manipulations
4.3 Disclosures

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Part I: Investments in debt securities
A debt security generally represents a creditor relationship with another entity. Examples
of debt securities are municipal securities, corporate bonds, convertible debt, commercial
paper, and collateralized mortgage obligations. A debt security is not an option contract,
financial futures contract, forward contract, or lease.

1.1 Classifications
Investments in debt securities are classified as either
• “Trading securities” - if the securities were purchased with the purpose of
generating profits from short-term price increases,
• “Held to maturity securities” - if the firm has the intent and ability to hold the
securities to maturity, or
• “Available for sale securities” - otherwise.

The accounting treatment for investments in debt securities that are classified as “held to
maturity” is parallel to the accounting for issuance of long-term debt. Of course,
investments in debt securities represent an asset and not a liability and thus generate
interest revenue and not interest expense. But the amounts are calculated in the same
way.

When deciding on classification, do not assign the held-to-maturity classification if there

is uncertainty about the entity's intention to do so, or if it intends to hold the security only
for an indefinite period. Also, do not use the held-to-maturity classification if the entity
believes it will make a security available for sale if there are changes in market interest
rates, a need for liquidity, changes in the yield on alternative investments, changes in
funding sources and terms, or changes in foreign currency risk. However, the held-to-
maturity designation can be considered reasonable when an entity subsequently sells the
security because there is evidence of a significant deterioration in the issuer's
creditworthiness, or a tax law change that reduces the tax-exempt status of the interest on
a debt security, or regulatory changes necessitating the sale or transfer of held-to-maturity
positions. The designation is also reasonable if there is a business combination or
disposition, and the entity is selling held-to-maturity securities in order to maintain its
existing interest rate risk position or credit risk policy.

It is acceptable for an entity to use the held-to-maturity designation if it has sold debt
securities when either the sale occurs near enough to its maturity date that the interest rate
risk is substantially eliminated, or if the sale of the security occurs after the entity has
already collected at least 85% of the principal outstanding on the debt as of the date when
the entity acquired it. These conditions are considered equivalent to holding the security
to maturity.

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The accounting treatment for the other two classifications is similar to that for “held to
maturity” investments. The major difference is that at the end of each year, in addition to
accruing interest revenue, the balance of the investment account is adjusted to reflect the
securities’ market value on the balance sheet date. The unrealized gain/loss is reported
on the income statement if the securities are classified as “trading,” or as a component of
shareholders’ equity if the securities are classified as “available for sale” (part of
“accumulated other comprehensive income”). When market prices are not available,
estimates of fair value are used instead (typically based on discounted cash flow
analysis).

On the balance sheet, all “trading securities,” and “available for sale securities” that the
firm expects to sell within a year are reported combined in current assets under the
caption “marketable securities.” “Held to maturity securities” that mature in the next
year are also included in current assets. Long-term investments in debt securities appear
on the balance sheet as a noncurrent asset (“investment in securities”).

In the cash flow statement, interest receipts are included in cash from operations. Cash
flows from purchasing, selling and maturity of “available for sale” and “held to maturity”
securities are included in cash from investing activities. Cash flows from purchasing and
selling “trading securities” are included in cash from operating activities.

Example 1:
On 1/1/20X7, the firm purchased a bond with par value of $1,000 and coupon rate of
10% for $1,136.16. Interest is paid annually on 12/31. The effective interest rate is 5%.
The bonds’ market value on 12/31/20X7 was $1,120. The bonds were sold on 7/1/20X8
for $1,190.

Beginning Interest Decrease in Ending

Year Balance Revenue Coupon Balance Balance
20X7 1,136.16 56.81 100 43.19 1,092.97
20X8 1,092.97 54.65 100 45.35 1,047.62
20X9 1,047.62 52.38 100 47.62 1,000.00

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If the bonds are classified as held to maturity:
1/1/X7: Investment in bonds 1,136.16
Cash 1,136.16

12/31/X7: Cash 100

Interest revenue 56.81
Investment in bonds 43.19

7/1/X8: Cash 1,190

Interest revenue 27.33
Gain on sale of bonds 69.7
Investment in bonds 1,092.97

If the bonds are classified as available for sale:

1/1/X7: Investment in bonds 1,136.16
Cash 1,136.16

12/31/X7: Cash 100

Interest revenue 56.81
Investment in bonds 43.19

Investment in bonds 27.03

Unrealized gain/loss on
Available for sale securities 27.03

7/1/X8: Cash 1,190

Unrealized gain/loss on
Available for sale securities 27.03
Interest revenue 27.33
Gain on sale of bonds 69.7
Investment in bonds 1,120

If the bonds are classified as trading securities:

1/1/X7: Investment in bonds 1,136.16
Cash 1,136.16

12/31/X7: Cash 100

Interest revenue 56.81
Investment in bonds 43.19

Investment in bonds 27.03

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 Unrealized gain on trading securities 27.03

7/1/X8: Cash 1,190

Interest revenue 27.33
Gain on sale of bonds 42.67
Investment in bonds 1,120

How Frequently Should I Reassess Investment Classifications?

Should reassess the classifications at each reporting date, and change their classifications
as appropriate. A company’s classification may be called into question by the SEC. For
example, if there is a pattern of selling securities that had been classified as held-to-
maturity, this is an indicator that the company should not do so again with new
investments. Most reclassifications are permitted only under rare circumstances.
Reclassification out of held to maturity could result in the entire portfolio of held-to-
maturity investments being transferred out of this category.

1.2 Other-than-temporary Impairment

Investment in debt securities are assed for Other-than-temporary impairment (OTTI)
if the fair value is less than amortized cost. Each of the following triggers OTTI
recognition:
(i) Intent to sell the security before recovery of amortized cost
(ii) A great than 50% probability that the entity will be required to sell the
security before recovery of amortized cost
(iii) A greater than 50% probability of not recovering the entire amortized cost

OTTI loss is measured as the entire difference between the amortized cost and fair value.
It is recognized in the income statement when impairment occurs.

However, if the investment is impaired due to (iii) a greater than 50% probability of not
recovering the entire amortized cost, OTTI needs to be separated into two components:
 Component 1: The amount representing the credit loss, and
 Component 2: The remaining amount, which is presumed to be related to all other
factors
Component 1 is to be recognized in its entirety in net income. The non-credit portion of
impairment (component 2) is recognized in other comprehensive income.

Reversals of impairment losses are not allowed.

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1.3 Quality Issues and ways to detect manipulation
Quality Issues:
1. Timing securities sales or “cherry picking”
Sell securities with unrealized gains while keeping securities with unrealized losses.

2. Reclassifying securities from one category to another to manage income or equity

Reclassifying securities with unrealized gains from available-for-sale to trading

3. Failure to recognize “other-than-temporary” impairments

4. Manipulating fair value estimates of non-listed or thinly-traded debt securities or

using noisy measures of fair value

5. Overstated non-credit related OTTI reported in other comprehensive income

Ways to detect manipulation:

1. Beware of reported net realized gains. The gains are discretionary (timing securities
sales) and non-recurring.
2. Large decline in net unrealized gains (losses) that is inconsistent with market returns
on similar instruments. This is an indicator of “cherry picking”
3. Large amounts of unrealized losses, especially if they relate to positions that have
been in continuous loss for 12 months or longer. This potentially indicates the failure
to recognize OTTI.
4. Overstated non-credit related OTTI reported in other comprehensive income.
5. Look at composition of securities holdings (e.g., treasuries vs corporate; long
remaining maturity vs short remaining maturity).
6. Look at the quality of fair value estimates (e.g., level 1 vs level 3).

1.4 Disclosures
Disclosures for Available-for-Sale Securities
 Amortized cost basis
 Aggregate fair value
 Total recognized other-than-temporary impairment
 Total gains separately reported from total losses
 Contractual maturities of the securities

Disclosures for Held-to-Maturity Securities

 Amortized cost basis
 Aggregate fair value
 Total recognized other-than-temporary impairment
 Gross unrecognized holding gains reported separately from gross unrecognized

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 holding losses
 Net carrying amount
 Contractual maturities of the securities

Disclosures for Securities Transferred from the Held-to-Maturity Category

 Net carrying amount of the sold or transferred security
 Net gain or loss in accumulated other comprehensive income related to any
derivative, hedging the forecasted acquisition of held-to-maturity securities
 The related realized or unrealized gain or loss
 The reasons for the decision to sell or transfer the security

Disclosures for Impairment of Securities

Apply to all investments for which other than temporary impairments have not been
recognized:
 Aggregate fair value of investments with unrealized losses
 Aggregate amount of unrealized losses
 A description of the information considered by the entity to conclude that the
impairments are not other than temporary (such as industry analyst reports, sector
credit ratings, and current levels of subordination), as well as the nature of the
investments, the causes of impairment, the number of unrealized loss positions,
and the severity and duration of the impairments

If the entity has recognized a credit loss on a debt security, you will find the following
disclosures:
 The methodology and significant inputs used to measure the credit loss. Examples
of significant inputs are credit ratings, current levels of subordination, third-party
guarantees, loan-to-collateral value ratios, and delinquency rates.
 A tabular roll forward of the amount related to credit losses, showing the
beginning balance of credit losses recognized in other comprehensive income,
additions to and reductions from the credit loss amount, and the ending balance.

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Part II: Debt

2.1 Accounting for Bonds

Bond is typically issued at a fixed, or stated coupon rate. If the investor believes that the
rate is too high, then it will only pay a reduced price for the bond (issue price< face
value), thereby reducing the effective interest rate (otherwise known as the market yield
rate or effective yield rate). Bond is issued at a discount, with discount = face value –
issue price. Conversely, if the stated coupon rate is higher than the effective interest rate,
then the investor will be willing to pay more for the bond. The bond is issued at a
premium, with premium= issue price - face value.

Bond is reported on the balance sheet at amortized cost. Amortized cost is historical cost
adjusted for the cumulative amortization of any discount or premium.

There are two main rules underlying accounting for bonds:

1. The interest expense for a period is the market (effective) interest rate times the
book value of the debt at the beginning of the period:
Int t = BV t-1 * r.
2. The book value (carrying value) of the debt at any point in time is the present
value of the future payments, discounted at the effective market interest rate:
BVt = ∑
T
CFi (1+ r)−( i− t )
i= t

From 1 and 2, we can also extrapolate the periodic interest from the coupon and the two
relevant balance sheets:
Int t = Payment t + BV t - BV t-1 .

Prior to 2008, firms could only apply fair value adjustments to debt under strict
conditions (fair value hedges, hybrid financial instruments). Since 2008, firms may elect
the fair value option for debt issues and report the debt at fair value with unrealized
gains/loss included in net income. If fair value option is elected, capitalized issuance
costs are expensed immediately. For firms that use amortized cost, they are still required
to disclose the estimated fair value of most financial instruments including debt.

A convertible bond is a hybrid instrument that its holder can either convert into common
stock or convert into cash–but not both, as is the case with a debt security having a
detachable warrant. The debt issuer includes the convertibility feature in a debt security
in order to obtain a lower cash interest rate, and also may deliberately set a favorable
conversion rate in order to encourage conversion of the debt into equity–thereby
eliminating the need for repayment. The buyer is interested in convertible securities
because of the possibility of earning a profit by converting them to stock if the entity's
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stock price rises. For convertible bonds, the full amount is reported as debt. As a result,
debt is overstated, equity is understated and the effective rate is understated.

2.2 Quality issues and ways to detect manipulations

Quality issues:
1. Excluding from the balance sheet debt owed
2. Recognizing gains/losses from early retirement of debt
3. Unrealized gains/losses from reporting debt at fair value. Note: this is negatively
correlated with economic performance of the firm (decrease in credit worthiness
results in unrealized gains)
4. Manipulating recognized or disclosed fair value estimates
5. Classifying short-term debt as long-term debt
6. Presence of debt instruments with equity characteristics (e.g., convertible bonds)
7. Using off-balance sheet debt
8. Large difference between book and fair values of debt. This occurs when there
are significant changes in interest rates or firm’s credit profile since the debt
issuance. Implications:
 Economic leverage is different from book leverage (book value of debt should
not be used as a proxy for its fair value)
 Interest expense will change significantly when debt is recycled

Ways to detect manipulations on debt:

1. Exclude from reported income, gains/losses related to debt retirement or
revaluation (using fair value option).
2. Reclassify a portion to equity and adjust interest expense for convertible debt
3. Adjust reported book value of debt and interest expense. If effective rate at
issuance has changed, debt will be overstated and recurring interest expense will
be understated.
4. Adjust financial statements to reflect off-balance sheet debt. Increase debt, asset
and (possibly) adjust equity. See example on capitalizing operating lease.
5. Evaluate the quality of debt fair value estimates.
6. Vehicles to mark debt using off-balance sheet transactions. A company may
finance a joint venture or related entity with debt or with a parent company
guarantee for all or a portion of the joint venture debt. This debt amount or debt
guarantee would not appear on the parent company’s balance sheet, but may be a
real obligation and very similar in substance to debt. An analyst would find these
types of debt arrangements or guarantees typically in the MD&A section listed as
an off-balance sheet arrangement.
7. Items excluded from table of contractual obligations. Within the MD&A section,
SEC rules require a table of contractual obligations. The table summarizes
information usually contained in other sections of the 10-K and lists fixed debt
and debt like commitments, such as long-term debt, capital and operating lease
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 payments, purchase obligations, and other long-term contractual liabilities.
However, not all contractual-type fixed payment arrangements are included. If a
contractual arrangement may be cancelled without any material penalties, it
may be excluded.

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Part III: Leases
A lease is a contract between a lessor and a lessee which conveys the right to use,
generally for a specified period of time. The lessor holds the legal title to the asset, and
the lessee uses the asset.

3.1 Capital Leases vs Operating Leases

SFAS 13 (1976) divided leases into two types: Capital leases and Operating leases, and
shifted the focus to economic (and not the legal) substance to determine the appropriate
accounting treatment. Capital leases are leases that transfer substantially all the risks and
benefits of ownership. Essentially, the lessee "owns" the asset; hence, the transaction
should be capitalized. Operating leases are all other leases. IAS 17 is similar. It uses the
term Finance lease instead of capital lease.
SFAS 13 stipulates conditions under which a lease transaction or contract must be
accounted for as a capital lease. From the lessee's (user of the asset) point of view, s/he
must capitalize the lease if any of the following four criteria are met:
1. The lease transfers ownership of the property to the lessee by the end of the lease
term.
2. The lease contains an option to purchase the leased property at a bargain price.
3. The lease term is greater than or equal to 75% of the estimated economic life of the
leased property.
4. The present value of rental and other minimum lease payments equals or exceeds
90% of the fair value of the leased property.

At the inception of a capital lease, a leasehold asset and a leasehold obligation should be
recognized on the balance sheet at the present value of minimum lease payments.

The discount rate to determine the present value of the minimum lease payment is the
incremental borrowing rate
– The rate at inception, the lessee would have incurred to borrow the funds
to purchase the asset using a secured loan with similar payment schedules

But, the lessee should use the implicit interest rate of the leasing party if it is
– Known to the lessee
– The implicit rate is lower than the incremental borrowing rate

Capitalized Lease - Lessee's books

Under a capital lease, the lessee records the acquisition of an asset and the incurrence of
an obligation equal to the present value of the rental and other minimum lease payments.
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The leased property is amortized over the lease term, unless the lease transfers the title or
offers a bargain purchase. The periodic rental payments are treated as payments of the
lease obligation and interest expense.
Example: On December 31, 2013 MBA office leased a copier, promising to pay
$100,000 immediately, and $100,000 each year over the next two years (i.e.,
$300,000 in total). The interest rate implicit in the lease was 10%, compounded
annually. Assume the lease is classified as a capital lease, and straight-line
depreciation is used for three years, with no salvage value.
The present value of the three payments is: _______ .
1. Acquisition of the leased asset (December/31/13) 1
dr. Leasehold asset PV of future lease payments
cr. Lease obligation PV of future lease payments
1a. First payment:
dr. Lease obligation
cr. Cash
2. Amortization of the leased asset (end of the first year, 12/31/14):
dr. Amortization expense to the Income statement
cr. Leasehold asset
3. Make lease payment (end of the first year, 12/31/14):
dr. Interest expense to the Income statement
dr. Lease obligation
cr. Cash
What is the total lease related expense for 2014, when the lease is classified as a capital
lease? What would be the lease related expenses if the lease were classified as an
operating lease? Over the life of the lease, which classification provides for more
expenses?

1 The acquisition of a leased asset is a use of cash. Long-term borrowing is a source of cash. The
acquisition may have no net effect on cash. Under SFAS 95, such "sources" and "uses," should be
disclosed in a footnote to the statement and not in the body of the statement.
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Solution to Capital Lease example:

Total expense over the duration of the lease

Types Capital/Finance Lease Operating Lease
Expenses Depreciation Expense Interest Rental Expense
Expense**
Year 1 91.18 17.36 100*
Year 2 91.18 9.09 100
Year 3 91.18 100
Total 273.55 26.45 300

* Even though pay immediately at acquisition, would treat first payment as Prepaid Rent,
and recognize expense at the end of year 1. Same would apply for subsequent
payments.

** See below for the working of interest expense

Beginning Ending Interest Payment Net Addition
Balance Balance Expense to Principal
Year 1 173.55*** 90.91 17.36 100 -82.64
Year 2 90.91 0.00 9.09 100 -90.91
Total 26.45

*** Don’t forget the immediate 100 payment at acquisition.

Journal entries:

At the inception of the lease

Dr Leased Asset 273.55
Cr Lased Obligation 273.55

First immediate payment

Dr Leased Obligation 100.00
Cr Cash 100.00

At the end of 2004 (year 1)

Dr Depreciation Expense 91.18
Cr Leased Asset 91.18
(note: I am bypassing accumulated depreciation to illustrate the concept – technically
you should do it through accumulated depreciation)
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Dr Interest Expense 17.36
Dr Leased Obligation 82.64
Cr Cash 100.00

3.2 Comparing Capital vs Operating Leases

If lessees were given a choice between a capital or operating lease, lessees normally
would prefer to treat a lease as an operating lease for the following reasons:
• to avoid the recognition of the lease liability (and hence have better leverage ratios)
• to defer the recognition of expenses (and hence have higher retained earnings)
• to avoid the recognition of the leased asset (and hence have higher return on asset)

Some Key Relationships

 The initial carrying value of leased assets acquired is equal to the present value of
lease obligations assumed at the initiation of the new lease.
 The carrying value of Long Term Lease Obligations (in aggregate) equals the present
value of the minimum scheduled lease payments at the balance sheet date
 For income tax purposes, the amount of the rental payment is tax deductible by the
lessee under a capitalized or an operating lease.
 If the lease is accounted for using the operating lease method, the only expense is the
rent expense, which equals the periodic lease payments. That is,

Expense OL = periodic lease payment

 If the lease is accounted for using the capital lease method, there are two expenses:
interest expense and depreciation expense. That is,

Expense CL = interest expense + depreciation expense

 Under the capital lease method, the periodic lease payments equal the interest
expense plus the reduction in the lease obligation during the period. That is,

Periodic lease payment = interest expense + periodic reduction in lease obligation 2

2 Beg Bal Lease Obligation + interest expense – Periodic Lease Payment = End Bal Lease Obligation
Periodic Lease Payment = Interest Expense + (BB Lease Obligation – EB Lease Obligation)
Periodic Lease Payment = Interest Expense + periodic reduction in lease obligation

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From the above three equations it follows that the difference in a period’s expense under
the capital lease method versus the operating lease method is:

Depreciation Periodic reductions in

(1) Expense CL - Expense OL = -
expense lease obligation

Since the balance of the lease obligation decreases over time, interest expense decreases
over time, and thus the periodic reduction in the lease obligation increases over time.

The depreciation expense, on the other hand, is either constant (straight-line method) or
decreases over time (accelerated method).

Because total depreciation and total reductions in the lease obligation over the lease term
are equal, expression (1) is positive during the early lease years and negative during the
late years.

That is, using the operating lease method defer the recognition of expenses relative to the
capital lease method. Since most managers are “myopic,” they prefer the operating lease
method. (Note the choice of accounting method for financial reporting does not affect
tax reporting.)

• Many analysts attempt to adjust the financial statements from one lease method to the
other (typically from the operating lease method to the capital lease method). They
have two motivations:
• To make the financial statements of different companies comparable
• To make the financial statements more informative. (Many people argue that
the capital lease method is more informative and that it should be used for
essentially all leases.)

The following equations are used to adjust the financial statements form one method to
the other.

To adjust the income statement:

Depreciation Periodic reductions in

(1) Expense CL - Expense OL = -
expense lease obligation

To adjust the balance sheet:

(2) Book value of lease obligation = Present value of (remaining) minimum lease payments

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 Cumulative Cumulative Accumulated Cumulative reductions
(3) - = -
expense CL expense OL depreciation in lease obligation

Since the original balance of the lease obligation equals the gross book value of the
leased property, it follows from (3) that

Cumulative Cumulative Book value of Net book value of

(4) - = -
expense CL expense OL lease obligations leased assets

3.3 Quality issues and ways to detect manipulations

Quality issues:
1. Manipulate terms of lease transactions or relevant estimates to qualify for the
operating lease method (e.g., overstate the “incremental borrowing rate” used in
calculating the present value of minimum lease payments; increase contingent
rentals to reduce minimum payments, etc)
2. When “capital” leases are disguised as “operating” leases
- Debt is omitted
- Overstated equity
- Overstated earnings for growth firms

Ways to detect manipulations in leases

1. Converting operating leases to capital leases
Typical approach:
(i) Recognize the Present Value of minimum lease payment as additional
debt*
(ii) Increase fixed assets to reflect leased operating capacity*
(iii) Reduce equity to balance the reformulated balance sheet*
(iv) Increase operating income by rent expense
(v) Reduce operating income by depreciation
(vi) Increase net financial expense by interest expense
(vii) Adjust for income tax accordingly

* While the adjustments are appropriate for liabilities, the assets and equity is likely to be
overstated. This is because under an alternative capital lease, the leased assets would
have been recorded as equal the liability only on the date of inception. For more detailed
multi-year approach, see steps outlined in Class Exercise 6.3.

2. Both methods result in understated capex

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 - Assets “acquired” under a capital lease are not reported within the statement
of cash flows.
- Increase capital expenditures (investing) and borrowing (financing) to reflect
operating capacity acquired and obligations incurred in lease transactions

3. Switching from operating to capital leases boost cash flow

- Changing the mix of capital and operating leases
- Under capital lease, only the interest portion of the rental payment is deducted
from operating cash flow while the remaining portion is capital lease payment
classified as a financing cash outflow

3.4 Disclosures

Capital lease
 The gross amount of assets recorded under capital leases. A detailed list that
includes the assets' cost and the accumulated depreciation appears either on the
balance sheet or in the footnotes.
 Future minimum lease payments in the aggregate and for each of the five
succeeding fiscal years (excluding executory costs including a guaranteed
residual value).

Operating Lease
 Leases which do not qualify as capital leases are accounted for as operating
leases. The lessee recognizes only rent expenses for the periods benefiting from
the use of the asset and ignores, in the accounting, any commitment to make
future payments. The lessor maintains the asset on his/her accounts, subject to
normal depreciation charges, and recognizes rental revenues. The treatment is
like cash based accounting rather than accrual based accounting.
 The fact that the entity has noncancelable lease in excess of one year, including
the future minimum rental payments in the aggregate and for each of the five
succeeding fiscal years.
 Rental expenses for each period for which an income statement is presented.

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Part IV: Derivatives

4.1 Accounting for Derivatives

A derivative is a financial instrument that exhibits the following characteristics:
1) Has one or more underlyings and one or more notional amounts (for example, for
stock option, the underlying is stock price and the notional amount is number of
shares);
2) No initial net investment or a smaller net investment than required for contracts
expected to have a similar response to market changes; and
3) Terms that require or permit
a. Net settlement
b. Net settlement by means outside the contract
c. Delivery of an asset that results in a position substantially the same as net
settlement.

Typical derivative financial instruments include: Option contracts, Forward contracts,

Interest rate caps, Forward interest rate agreements, Interest rate floors, Fixed-rate loan
commitments, Futures, Swaps, Letters of credit.

Why Use derivatives?

Hedge risks (interest rate risk, foreign exchange risk, equity market risks, commodity
risks), generate profits from fees and spreads, speculate (obtain significant exposure with
small or no investment). General Accounting rules for derivatives:
 Recognize derivatives on the balance sheet
 Derivatives should be recognized at fair value
 Gains and losses from speculation should be recognized immediately
 Gains and losses on hedging derivatives should be recognized differently
depending on the hedge

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Example: Speculation
A firm purchases a call option on January 1, 2010. The option gives the right to purchase
one share currently traded at $50. The exercise price is $60. The firm pays $5 for the
option. The option expires on March 1, 2011

On date of purchase:
Option $5 (Assets )
cash $5 (Assets )

On December 31, 2010 the option was valued at $15 as a result of an increase in stock
price

Option $10 (Assets )

Unrealized holding gain (income statement) $10 (Equity )

The unrealized gains and losses will be adjusted for in the operating section of the
statement of cash flows

On January 1, 2011, the firm settles the option (prior to expiration) at $14.

Cash $14
Loss on settlement of option $1*
Option $15
*Loss of time value of the option

Hedging derivatives are classified into:

 Fair value hedge: hedge the exposure in change of fair value of assets/liabilities or an
unrecognized commitment
o Note that the asset/liability being hedged will now be recorded at fair value as
well so that no profit or loss is recorded overall
 Cash flow hedge: hedge exposure to cash flow risk (future cash flows)

To qualify for hedge accounting, the hedge has to be “highly effective”. When testing
hedge effectiveness
 Both prospective and retrospective tests are required
 Examples of tests
1. Dollar offset ratio
 Changes in the hedging derivative should offset between 80%
to 125% of the changes in the fair value or cash flows of the
hedged item
2. Regression analysis
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  Regression of changes in the hedged item on changes in the
derivative should have an adjusted R-squared of at least 80%

Embedded derivatives are terms of a contract or instrument that behave like a

derivative. For example, debt instruments that contain call/prepayment options,
conversion options, interest rate floor/cap/collars, contingent early redemption rights.
Derivatives embedded in host contracts should be accounted for separately if they are
“clearly and closely related to the host contract”. Most embedded derivatives are
considered clearly and closely related to the host contract and are effectively ignored.

Example: Fair value hedge

On December 1, 2008, a US firm sells and delivers merchandise to a foreign customer for
5,000 units of foreign currency X, to be received on March 1, 2009. The cost of the
merchandise is $6,000. To hedge its exposure to fluctuations in the exchange rate, the
firm enters into a forward contract to sell 5,000 X on March 1, 2009. On December 1,
2008, the spot price of X is $1.8 and the forward price (for March 1, 2009) is $2. On
December 31, 2008, the spot price is $1.75 and the fair value of the forward contract is
$300. On March 1, 2009, the receivable is collected and the forward contract is settled.

Assets Liabilities Equity

12/1/08 Accounts receivable ↑ 9,000 Sales ↑ 9,000
Inventory ↓ 6,000 (Cost of sales ↑ 6,000) ↓
12/31/08 Accounts receivables ↓ 250 Other income (expense) ↑ 50
Derivatives ↑ 300
3/1/09 Cash ↑ 10,000 Other income (expense) ↑ 950
Accounts receivables ↓ 8,750
Derivatives ↓ 300

Summary of Fair Value Hedge

 Hedge asset/liability at fair value
 Hedge date: if no cash is received or paid, nothing is recorded
 End of period – derivative at fair value
 End of period – hedged asset/liability at fair value
 The hedged item and derivative are reported separately and not netted against
each other

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Example: Cash flow hedge
A US firm expects to purchase merchandise from a foreign supplier for 5,000 units of
foreign currency X. The transaction is forecasted to occur on March 1, 2009. To hedge its
exposure to fluctuations in the exchange rate, on December 1, 2008, the firm enters into a
forward contract to buy 5,000 X on March 1, 2009 at a forward price of $2 per unit of X.
On December 31, 2008, the fair value of the forward contract is $(300). On March 1, the
firm settles the forward contract and buys the merchandise. The spot price of X is $1.95.
On June 1, 2009, the firm sells and deliver the merchandise for $15,000 cash.

Assets Liabilities Equity

12/31/08 Derivatives ↑ 300 AOCI ↓ 300

3/1/09 Cash ↓ 10,000 Derivatives ↓ 300 AOCI ↑ 50

Inventory ↑ 9,750
6/1/09 Cash ↑ 15,000 Sales ↑ 15,000
Inventory ↓ 9,750 (Cost of sales ↑
10,000) ↓
AOCI ↑ 250

Summary of Cash Flow Hedge

 The recognition of the hedged item is unaffected
 The derivative is measured at fair value – changes in value are recognized in OCI
 The firm recognizes the changes in value in its net income when the hedged item
affects the net income

4.2 Quality Issues and ways to detect manipulation

Quality Issues:
1. Improperly qualify for hedging method.
2. Recognized amounts do not capture risk similar to securities or market risks
depend on notional amount. Note: the book value of derivatives is typically a
fraction of the notional amount being hedged.
3. Imprecise fair value estimates: Market prices for most derivatives are not
available. Leverage and option characteristics increase the potential for large
valuation errors
4. Gains/losses from revaluing derivatives due to changes in company’s own credit.
5. Hedged items reported at amounts other than fair value
a. Economic hedges that do not qualify for hedge accounting
b. Artificial volatility in earnings and book value
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 c. “fair value option” has mitigated (but not eliminated) this distortion
6. Classification: The same derivative position can be classified as either a fair value
hedge of cash flow hedge.
7. Embedding derivatives in non-derivative instruments to avoid derivative
accounting.

Ways to detect manipulations:

Always examine the notional amounts and composition of derivatives
o Information about the notional amounts and the types of derivatives is
required for evaluating exposure to market risks
o The risks associated with a given amount of notional exposure vary
significantly across derivatives
 For example, the fair value volatility of a swap is significantly
larger than that of a forward contract with the same notional
amount
o Fair value reflects ex-post realization of risk and generally has little
implications for ex-ante risk
 For example, at inception, the fair value of most derivatives is zero
and yet they expose the parties to significant risks
o On versus off balance sheet risk
 Purchased options are paid for at the time of the purchase and
present no off-balance sheet risk (the risk is limited to the book
value of the investment)
 Other derivatives typically involve no cash payment at the time of
origination and present off balance sheet risk
o Exchange-traded (futures and some options) vs OTC (swaps, forward
contracts and options)
 Exchange-traded options have available market prices and trivial
credit risk
 OTC derivatives usually have non-trivial credit risk, and
estimating their fair value involves significant discretion

4.3 Disclosures
You will find the following disclosures related to derivatives:
 How and why the entity uses derivatives (including the objectives and strategies
associated with the derivatives program)
 How derivatives and hedged items are accounted for
 How derivatives and hedged items affect the entity's financial position, financial
performance, and cash flows
 The volume of activity in the entity's derivatives program
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The preceding information should be disclosed separately for fair value hedging
instruments, cash flow hedging instruments, foreign currency hedging instruments, and
all other derivatives.

Quantitative information by contract type:

 The fair value amounts of derivatives in the balance sheet, and in which line items
they are located
 The amounts of any gains and losses on derivatives and related hedged items,
reported separately for fair value hedges, cash flow hedges, and all other hedges

Fair Value Hedge

 The net gain or loss recognized in earnings for hedge ineffectiveness, and any
component of a derivative instrument's gain or loss excluded from the assessment
of hedge effectiveness
 The net gain or loss recognized in earnings when a hedged firm commitment no
longer can qualify as a fair value hedge

Cash Flow Hedges

 Display within a separate classification in the statement of comprehensive income
an entity's net gain or loss on derivative instruments designated as cash flow
hedges.
 In footnotes: The transactions resulting in the reclassification of gains or losses
from other comprehensive income to earnings
 The estimated amount of gains or losses in other comprehensive income that you
expect will be reclassified into earnings within the next 12 months.
 The maximum time period over which the entity is hedging its exposure to future
cash flows for forecasted transactions
 The amount of gains or losses that were reclassified into earnings because of the
discontinuance of cash flow hedges because it is probable that the originally
forecasted transactions will not occur during the specified time period
 The beginning and ending accumulated derivative instrument
gain or loss, net changes caused by current period hedging activities, and the net
amount of any reclassification into earnings

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Appendix A: More on leases (Optional)
Lessor’s accounting
From the lessor's perspective, a lease is classified as a sales-type, direct financing,
leveraged, or operating lease. For a lease to be classified as a sales-type, direct financing,
or leveraged lease, it must meet one of the four classification criteria specified above (for
lessee’s accounting) and both of the following two further criteria:
a. Collectibility of the minimum lease payments is reasonably predictable, and
b. No important uncertainties surround the amount of unreimbursable costs yet to be
incurred by the lessor under the lease.

A lease that meets one of the first four criteria and both of the last criteria is classified as
a sales-type lease if the fair value of the leased property is different from its carrying
amount. Otherwise, unless the lease meets certain additional criteria for leveraged leases,
a lease that meets one of the first four criteria and both of the last two is classified as a
direct financing lease. Leases that fail to meet the foregoing criteria are classified as
operating leases.

For sales-type leases, the present value of the minimum lease payments is reported as
sales and the carrying amount of the leased property plus any initial direct costs, less the
present value of any unguaranteed residual value, is charged as cost of sales. On the
balance sheet, the lessor reports the net investment in the lease as the present value of the
minimum lease payments and the unguaranteed residual value. The net investment is the
difference between the gross investment (the sum of the minimum lease payments and
the unguaranteed residual value) and unearned interest income. Unearned interest
income is amortized (i.e., recognized) over the lease term so as to produce a constant
periodic rate of return on the net investment.

For a lease classified as a direct financing lease, the lessor reports as an asset on the
balance sheet the net investment in a lease consisting of gross investment less unearned
interest income and plus the unamortized initial direct costs. The gross investment is
calculated by adding the minimum lease payments and the unguaranteed residual value.
Unearned interest income is determined by subtracting the carrying amount of the leased
property from the gross investment. Unearned interest income and the initial direct costs
are amortized over the lease term so as to produce a constant periodic rate of return on
the net investment.

A leveraged lease is a direct financing lease that involves at least three parties (a lessee,
a long-term creditor, and a lessor) and has a few additional characteristics. Accounting
for leveraged leases is somewhat complicated and thus is not discussed here.

A lessor accounts for leases not meeting the criteria for classification as sales-type, direct
financing, or leveraged leases as operating leases. Leased property under operating
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leases is recorded in the same way as other property, plant, and equipment; rent is
reported as income over the lease term in a systematic manner, which is usually straight-
line; and the leased property is depreciated like other productive assets.

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