Introduction Derivatives are becoming increasingly common but very complicated. Huge losses may be suffered by banks and other financial institutions because of too much exposure in derivative . financial instruments. Trading in derivatives has been likened to a wild frontier where adventure and danger are constant companion. Potential huge gains and losses may arise from their settlement. Purpose of derivatives Entities use derivative financial instruments to manage financial risk. Financial risk may originate from the following sources: a. Change in commodity price b. Change in cash flows c. Foreign currency exposure. The reduction of financial loss stemming from the financial risk is the motivating factor in trading in derivatives. Actually, derivative financial instruments create rights ‘and obligations that have the effect of transferring between the parties to the instrument the financial risks inherent in an underlying primary financial instrument.Types of financial risk pice risk is the uncertainty about the future price of an asset. Entities are exposed to a price risk with respect to existing assets such as investments in trading securities and assets to be acquired in the future such as purchase commitments and equipment to be imported at a future date. Credit risk is the uncertainty over whether a counterparty or the party on the other side of the contract will honor the terms of the contract. Banks and other financial institutions are usually exposed to a credit risk by granting loans to borrowers. There is always the possibility of nonpayment of the loans. Interest rate risk is the uncertainty about future interest rates and their impact on cash flows and the fair value of the financial instruments. For example, a borrower with a variable-rate loan is exposed. to an interest rate risk by reason of the fluctuation of interest rate in the future. Even a borrower with fixed-rate loan is also exposed to an interest rate risk because there is always the possibility that interest rate will decrease in the future. ’ Foreign currency risk is the uncertainty about future Philippine Peso cash flows stemming from assets and liabilities denominated in foreign currency. The peso equivalent of the foreign currency loan on the date of Maturity will differ from the peso equivalent of the foreign ‘Currency loan when it was obtained.What is a derivative? nt that derives its reign exchange A derivative is simply @ financial instrume) + or financial Oe a value from the movement in commode ny rate and interest rate of an underlying instrument. ntract, meaning, it is rivative i: ecutory CO) Actually, a derivative is an ex’ mises about future not a transaction but an exchange of pr action. instruments give one party financial asset or financial nder conditions that are On inception, derivative financial a contractual right to exchange liability with another party w potentially favorable. On the other hand, the other party has a contractual obligation to exchange under potentially unfavorable conditions. Expressed in the simplest terms, parties to the derivative financial instrument are taking bets on what will happen to the "underlying" financial instrument in the future. Characteristics of a derivative A derivative is a financial instrument with the following three characteristics: 1. The value of the derivative changes in response to the change in an "underlying" variable. An underlying is a specified interest rate, commodity price, foreign exchange rate, price index and other variable. Although not mentioned specifically, a derivative must contain a notional which could be an am« number of shares or number of units or BNE wie 2. The derivative requires either no initial i an initial small net investment. ene In other words, there is no payment or there i payment for the derivative on the date of Sa ae 8. The derivative is readi ea eee eae eon as elitesHedging Derivative accounting requires unders t tanding of hed; accounting because most often derivatives are used for Hedi Hedging means designating one or more hedging instrument so that the change in fair value or cash flows is an offset, in whole or in part, to the change in fair value or cash flows of a hedged item. Simply stated, hedging is a means of protecting a financial Joss or the structuring of a transaction to reduce risk. There are three types of hedging relationship, namely fair value hedge, cash flow hedge, hedge of a net investment in a foreign operation. Only cash flow hedge will be discussed and illustrated extensively in this financial accounting book. Hedging is discussed more in detail in an advanced accounting course. A hedge or hedging relationship has two components, namely hedging instrument and hedged item. Hedging instrument A hedging instrument is the derivative whose fair value or cash flows would be expected to offset changes in the fair value or cash flows of the hedged item. Hedged item A hedged item is an asset, liability, firm commitment, highly Probable forecast transaction or net investment in a foreign Operation. = To be designated as hedged item, the hedged item should expose the entity to risk of changes in fair value or future cash flows.Measurement of derivatives An entity shall recognize and measure all derivatives as either asset or liability at fair value. Both the fair value and notional shall be fully disclosed. An unrealized gain or loss is recognized when there is change in the fair value. Whether the change in fair value is recognized in profit or loss or in other comprehensive income depends on the following situations: a. The derivative is not designated as a hedging instrument, b. The derivative is designated as a cash flow hedge. c. The derivative is designated as a fair value hedge. No hedging designation Changes in fair value of a derivative that is not designated as a hedging instrument shall be recognized in profit or loss. In this case, the derivative can be thought of as a speculation. Cash flow hedge A cash flow hedge is a derivative that offsets in whole or in part the variability in cash flows from a probable forecast transaction, A probable "iorecast transaction" is an uncommitted but anticipated future transaction. * a. The derivative or hedging instrument is measured at fair value. b. The change in fair value is recognized as component of other comprehensive income to the extent that the hedge is effective. c. The ineffective portion is recognized in profit or loss. d. The hedged item is not adjusted to conform with fair value.Fair value hedge A cat value hedge is a derivative that offsets in whole or in part the change in the fair value of an asset or a liability. a. aa derivative or hedging instrument is measured at fair value. b. The hedged item is also measured at fair value in contrast with a cash flow hedge where the hedged item is not adjusted. c. The changes in fair value are recognized in profit or loss. Examples of derivatives The derivatives that are often designated as hedging instruments are: Interest rate swap Forward conract Futures contract Option Foreign currency forward contract ope sp Note that these derivatives are financial instruments separate from the primary financial instruments, meaning, "stand-alone" derivatives. In fact, these derivative financial instruments would not exist in their own right but have been created solely to hedge against financial risks created by other primary financial instruments or by transactions that have yet to occur but are anticipated. Interest rate swap Interest rate swap is a contract whereby two parties agree to exchange cash flows for future interest payments based on a contract of loan. The contract of loan is the primary financial instrument and the interest rate swap agreement is the derivative financial mstrument,Illustration 1 - Interest rate swaP C ny borrowed P5,000,000 from On January 1, 2017, Easy Compa! 1 bo nee va First Bank at a variable rate 0 ins ee ’ The terms of the loan are: a. The principal loan is payable on December 31, 2018. a b. ‘The interest is payable on December 31 of each year based on the prevailing interest rate at the beginning of the year. The contract of loan is the primary financial instrument, ‘To protect itself from fluctuation in interest rate, on January — | 1, 2017, Easy Company entered into an agreement with Second Bank as the speculator to receive variable interest and to pay a fixed interest based on an "underlying" interest rate of 10% and notional amount of P5,000,000, : This "receive variable, pay fixed interest rate swap" agreement with the Second Bank is the derivative financial instrument. . e 1 peal i 2 hen aaa This derivative contract means that Easy Cormcnnee receive a swap payment from the Second Bank based P5,000,000 if the January 1 interest rate is more than.Net cash settlement The net cash settlement bet; : 2 ween Easy Company and the Soe vous veaien ARE between the ananla interest v pear aan! 6 fixed interest to be paid and would December 31,2017 December 31, 2018 Receive variable 500,000 : } 600,000 Pay 10% fixed (500,000) (600,000) Net cash settlement — ee receipt 5A 100,000 Another computation Variable rate on January 1, 2018 12% Underlying interest rate 10% Variable rate more than underlying rate _2% Net cash settlement—receipt (P5,000,000 x 2%) 100,000 The computation means that under the interest rate swap, Easy Company shall receive P100,000 from Second Bank on December 31, 2018. With respect to the contract of loan with First Bank, observe the following schedule of interest payments: December 31, 2017 December 31, 2018 Variable interest to be paid to First Bank 500,000 600,000 Net cash settlement with 4 , Second Bank - receipt as (100,000) Netinterest expense _ 500,000 500,000 Note that Easy Company incurs a uniform or fixed interest of P500,000 on a variable-rate loan.Journal entries 2017 Jan. 1 Dec. 31 31 2018 Dec. 31 31 31 31 Gash 5,000,000 Loan payable 000 x 10% 500,000 Interest expense (P5,000,000 x 10%) 500,000 5,000,000 Interest rate swap receivable 89,300 Unrealized gain—interest rate swap A derivative is recognized at fair value. The fair value is equal to the present value of P100,000 to be received on December 31, 2018. The present value of 1 for one period at 12% is .893. Thus, P100,000 times .893 equals P89,300. The "unrealized gain" on the interest rate swap is a component of other comprehensive income because the derivative agreement is designated as a cash flow hedge. Such unrealized gain is recognized in profit or loss in the period when the cash flow occurs. 89,300 Interest expense (P5,000,000x 12%) 600,000 Cash 600,000 Cash 100,000 Interest rate swap receivable 89,300 Unrealized gain— interest rate swap 10,700 This is the swap payment from Second Bank as a result of higher interest rate. i The unrealized gain of P10,700 represents the increase in the fair value of the interest rate swap receivable due to passage of time. Loan payable 5,000,000 Cash i 5,000,000 Unrealized gain—interestrateswap 100,000 Interest expense 2 100,000 Notice that the net interest expense for 2018 is P500,000 because of the hedging effect’ of the interest rate swap.Illustration 2— Interest rate swap Assume the same da: : ta i beet ‘ the interest rate on in the Preceding illustration except that January 1, 2018 is 7%. Variable interest rate on J. Ae anuary 1, 2 Underlying interest rate ma fee Variable rate less than underlying rate 3% _3% Net cash settlement with Second Bank (P5,000,000%3%) 150,000 The computation means that under the interest rate swap agreement, Easy Company shall pay Second Bank P150,000 on December 31, 2018 by reason of a lower interest rate. With respect to the contract of loan with First Bank, observe the following schedule of interest payments: December 31,2017 December 31, 2018 Variable interest to be paid to First Bank 500,000 350,000 Net cash settlement with : Second Bank ms 150,000 Net interest expense 500,000 500,000Journal entries 2017 Jan. 1 Dee. 31 31 2018 Dec. 31 31 31 31 5,000,000 Cash 5,000, Loan payable 5,000,000 estexpense (P5,000,000 x 10%) 500,000 oe xpense (1 6b Unrealized loss — interest rate swap 140,250 Interest rate swap payable 140,250 The present value of 1 for one period at 7% is .935. Thus, P150,000 times .935 equals P140,250. The “unrealized loss" on the interest rate swap is a component of other comprehensive income because the derivative is designated as a cash flow hedge. Interest expense (P5,000,000x7%) 350,000 Cash 350,000 Loan payable 5,000,000 Cash 5,000,000 Interest rate swap payable 140,250 Unrealized loss — interest rate swap 9,750 Cash 4 150,000 This is the swap payment to Second Bank as a result of a reduced interest rate. The unrealized loss of P9,750 Pepreeenta the increase in the fair value of the interest rate swap payable due to passage of time. Interest expense ; 150,000 Unrealized loss —interest rate swap 150,000 Notice again that the net interest expense for 2018 is P500,000,Journal entries 2017 Jan. 1 Dec. 31 31 2018 Dec. 31 31 81 5,000,000 es 5,000,000 Im 000,000) 500,000 Interest expense (10% x P5. )) itn Interest rate swap reccivable 155,000 Unrealized gain—interest rate swap 155,000 Simple Company will receive P50,000 at the end.of 2018 by reason of the increase in interest rate by 1% and can expect to receive P50,000 at the end of 2019, 2020 and 2021. The present value of the four annual payments of P50,000 is recognized on December 31, 2017 as interest rate swap receivable, or P50,000 times 3.10 equals P 155,000. The present value of an ordinary annuity of 1 at 11% for 4 periods is 3.10, , Interest expense (11% x 5,000,000) 550,000 Cash 550,000 Cash 50,000 Interest rate swap receivable 50,000 Collection of the interest swap payment from the bank speculator. Unrealized gain — interest rate swap 60,000 Interest expense 50,000 Offset of the unrealized gain against the interest _ expense. Observe that the net interest expense for 2018 _ is P600,000 which is the hedged cash flow for interest. —2018 Dec. 31 31 2019 Dec. 31 31 31 Unrealized gain—intorest rate swap 105,000 Interest rate Swap receivable 105,000 Cancelation of the balance of the interest swap receivable and the related unrealized gain because of the reduced interest rate on January 1, 2019. Thus, P155,000 minus P50,000 equals P105,000. Unrealized loss—interest rate swap 258,000 Interestrate swap payable 258,000 Simple Company will make a payment of P100,000 at the end of 2019 by reason of the reduced interest rate of 8% or a difference of 2% and can expect to make payment of P100,000 at the end of 2020 and 2021. The present value of the three annual payments of P100,000 is recognized on December 31, 2018 as the interest rate swap payable, or P100,000 times 2.58 equals P258,000. The present value of an ordinary annuity of 1 at 8% for 3 periods is 2.58. Interest expense (8% x 5,000,000) 400,000 Cash 400,000 Interest rate swap payable 100,000 : Cach ees 100,000 This is the interest swap payment to the bank speculator. Interest expense 100,000 Unrealized loss—interest rate swap 100,000 Note that the total interest expense is P500,000 for 2019 which is the hedged cash flow for interest.2019 Dec.31 Unrealized loss—interestrateswap 208,000 Interest rate swap payable 208,000 Variable rate on January 1, 2020 6% Underlying fixed rate 10% Variable rate less than underlying rate _% Net cash to be paid to bank speculator (6,000,000 x 4%) 200,000 This means that Simple Company will make a payment of P200,000 to the bank speculator on December 31, 2020 and can expect to make payment of P200,000 on December 31, 2021. The present value of the two annual payments of P200,000 is recognized as interest rate swap payable on December 31, 2019. The present value of an ordinary annuity of 1 at 6% for two periods is 1.83. Unrealized loss—12/31/2019 (200,000x 1.83) 366,000 Unrealized loss per book (258,000— 100,000) 158,000 Increase in unrealized loss 208,000 2020 Dec. 31 Interestexpense (6% x 5,000,000) 300,000 Cash 300,000 31 Interest rate swap payable 200,000 Cash 200,000 This is the interest swap payment to the bank speculator. 31 Interest expense 200,000 Unrealized loss —interest rate swap 200,000Journal entries 2017 Jan. 1 Dee, 31 31 Dec. 31 Cash 5,000,000 Note payable 5,000,000 Interest expense (5,000,000x 10%) 500,000 Cash 500,000 Note payable 169,000 Gain on note payable : 169,000 At every year-end, the note payable is measured at fair value. The fair value ‘s equal to the present value of the principal plus the present value of the interest payments at the "market rate of interest". The PV of 1 at 12% for two periods is .7972 and the present value of an ordinary anruity of 1 at 12% for two periods is 1.69. PV ofprincipal (5,000,000 x .7972) “ 3,986,000 PV of fixed annualinterest (500,000 x 1.69) 845,000 Fair value of note payable — 12/31/2017 4,831,000 Carrying amount of note payable —1/ 1/2017 5,000,000 Decrease in liability - gain F 169,000 Loss on interest rate swap 169.000 Interest rate swap payable 169,000 There is an interest rate swap payable because the market rate is higher than the fixed rate of 10%. The interest rate swap payable is also measured at fair value. Net cash to be paid to speculator (5,000,000x 2%) 100,000 Multiply by the PV of an ordinary annuity of 1 at 12% for two periods 1.69 Interest rate swap payable—December 81,2017 169,000 The gain on note payable and the loss on interest rate swap are recognized immediately in profit or loss because the interest rate swap is designated as a fair value hedge.2018 Dee. 31 Dee. 31 Dec. 31 31 inte reehatpecee 579,720 40,000 Cash. Note payable Me yable is lower than ‘on the note payable. he interest method. Since the fair value of the note pa the face value, there is a discount Such discount is amortized using t Interest expense (4,831,000 x 12%) 579,720 Interestpaid (5,000,000 x 10%) 500,000 Amortization of discount — increase in note 19,720 Note payable 86,120 Gain on note payable 86,120 The PV of 1 at 14% for one period is .8772. PV of principal (5,000,000 x .8772) 4,386,000 PV of annual interest ( 500,000 x 8772) 438,600 Fair value of note payable December 31, 2018 4,824,600 Carrying amount of note payable (4,831,000 + 79,720) 4,910,720 Decrease in note payable— gain 86,120 Interest rate swap payable - 100,000 Cash 100,000 This is the cash payment to the speculator. Loss on interest rate swap 106,440 Interest rate swap payable 106,440 Net cash to be paid to speculator (5,000,000 x 4%) 200,000 Multiply by PV of 1 at 14% for one period 8772 Interest rate swap payable - December 81, 2018 175,440 Carrying amount of interest swap payable 4 (169,000 — 100,000) 69,000 Increase in interest rate swap payable - loss 106,4402019 Dee, 31 Dec. 31 Dec. 31 31 Interest expense 675,400 Cash 500,000 Note payable 175,400 Interest expense 675,400* Interest paid (5,000,000 x 10%) 500,000 Amortization of discount * P4,824,600 times 14% equals P675,444. The amount is rounded to P675,400 to make up for the rounding of present value factors and to bring the carrying amount of the note payable equal to P5,000,000 on the date of maturity. Interest rate swap payable 200,000 Cash 200,000 This is the cash payment to the speculator because the market rate of interest of 14% is higher than the 10% fixed interest rate. Loss on interest rate swap 24,560 Interest rate swap payable 24,560 Final cash payment to speculator 200,000 Carrying amount of interest rate swap payable 175,440 Loss on interest rate swap ~ 24,560 Note payable 5,000,000 Cash. 5,000,000 This is the full repayment of the loan to the bank on the date of maturity.