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 purchase
an asset at a preset price for a specified period of
time.

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 buy
share 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&Ps 500 index).

Who uses derivatives?

a. Producers and consumers: Hedgers

Example:
Heartland Large producer of potatoes
McDonald 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: Speculators
The 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 2
nd
,
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 Laredos 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 LossIncome 20,000


(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 LossIncome 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) 20,000
Loss 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 Option
Example:
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 <=(125100)*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 income
Unrealized 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 500
AFS Securities 500

To record an increase in the value of the put option:
Put Option 500
Unrealized Holding Gain or LossIncome 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 Haywards 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
Assets
Available-for-Sale securities (@ FMV) $12,000
Put Option (@ FMV) 500

Shareholders Equity
Accumulated other comprehensive income:

Balance Sheet:
By using fair value accounting for both financial instruments, the financial
statements reflect the underlying substance of Haywards 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 hedges
Cash 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 potatoes
McDonald 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 2006
No 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, 2006
Allied makes the following entry to record the increase in the
value of the futures contract.

Futures Contract 25,000
Unrealized Holding Gain or LossEquity 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.
December 31, 2006
Current Assets
Futures contract (@ FMV) $25,000

Shareholders Equity


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 2007
On 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 $1,575,000
Less: 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 Transaction
Allied 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.
January 31, 2007

Current Assets
Inventory $1,575,000

Shareholders Equity


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

July 2007
Assume 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 LossEquity 25,000
Cost 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

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