Chapter 2-Accounting For Derivatives and Hedging Activities

Chapter 2
Accounting for Derivatives and Hedging

activities
Learning Objectives
1. Understand the definition of a derivative and the types of risks that

derivatives can manage.
2. Understand the structure, benefits and costs of options, futures
contracts, forward contracts, and swaps.
3. Understand the definition of a cash-flow hedge and the circumstances
in which a derivative is accounted for as a cash-flow hedge.
4. Understand the definition of a fair-value hedge and the circumstances
in which a derivative is accounted for as a fair-value hedge.
5. Account for a cash-flow-hedge situation from inception through
settlement and for a fair-value-hedge situation from inception
through settlement.
6. Accounting for foreign currency hedge
Copyright © 2018, 2015, 2012 Pearson Education, Inc. All Rights Reserved
Derivative (definition)
Derivative is the name given to a broad range of financial
securities. Their common characteristic is that the derivative
contract’s value to the investor has a direct relationship to
fluctuations in price, rate, or some other variable that
underlies it.
A derivative can be used to offset (“hedge”) the potential
fluctuation in
❖ Interest rates
❖ Commodity prices
❖ Foreign currency exchange rates
❖ Stock prices
Types of risks
Interest rates, commodity prices, foreign currency exchange

rates, and stock prices are the most common types of price
and rate risks that companies hedge.
For example, Starbucks faces a variety of risks including

interest rate risk, commodity price fluctuation, and foreign
currency fluctuation. Because Starbucks forecasts future cash
flows and earnings based on future rates and prices, it enters
into derivative contracts to manage the risk of those future
outcomes.
By entering into these types of agreements, Starbucks locks in

exchange rates, interest rates, and commodity prices,
reducing the effects of future changes in exchange rates,
interest rates, and commodity prices, on its cash flow and
income.
Using Derivatives as Hedges
A hedge can
– Shift risk of fluctuations in sales prices, costs,
interest rates, or currency exchange rates.
– Help manage costs
– Reduce risks to improve financial position
– Produce tax benefits
– Help avoid bankruptcy
Derivatives
The four basic types of derivatives are:
– Forward Contracts
– Futures Contracts
– Options
– Swaps
Forward Contracts
Forward Contracts are
– Negotiated contracts between two parties for
the delivery or purchase of
● A commodity or
● A foreign currency
– At an agreed upon price, quantity, and
delivery date.
Settlement of the forward contract may be
– Physical delivery of the good, or
– Net settlement
Futures Contracts
Futures contracts are a specific type of forward
contract.
– Characteristics are standardized.
– Characteristics are set by futures exchanges
(Rather than by the contracting parties) so
performance risk is eliminated.
– Exchange guarantees performance.
Settlement may also be made by entering another

futures contract in the opposite direction.
Options
Options are the right (but not the

obligation) to either
❖ Call (buy), or
❖ Put (sell)
With options, only one party is obligated to

perform depending on the election of the
other party to exercise their option.
Swaps
Swaps are contracts to exchange an ongoing

stream of cash flows, commonly swapping interest
rates.
❖ Swap variable- for fixed-rate debt, or.
❖ Swap fixed- for variable-rate debt.
Swaps are commonly negotiated on an individual

basis like forward contracts, but may be
standardized and exchange-traded like futures.
Example: Forward Contract
Sun decides to sell future production by entering into a

forward contract with Irene for delivery of 10,000 items
in one year at a price of $10 per item. Thus, Sun has
determined their selling price regardless of the market,
and Irene has locked in her purchase price.
Sun risks loss of potential revenue if the market price
for the items increases in the next year. Irene risks loss
of potential savings if the market price for the items
decreases in the next year.
Forward Contract Impact
If Sun’s fixed costs are $50,000, and the variable

cost is $3 per unit, Sun will lock in a profit of
$20,000 ($100,000 revenue less $50,000 fixed costs
less $30,000 variable costs).
If the market price for the item increases, Sun can
sell at the higher market price and settle with
Irene by paying her the difference, or simply sell
the items to Irene at the contracted price. Either
way, Sun has profit of $20,000.
Test your knowledge
• What is a characteristic of a forward contract?
– a Traded on an exchange
– b Negotiated with a counterparty
– c Covers a stream of future payments
– d Must be settled daily
• What is a characteristic of a swap?
– a Traded on an exchange
– b Only interest rates can be the underlying
• What is a characteristic of a futures contract?
– a Gives the holder the right but not the obligation to buy or sell
• What is a characteristic of an option?
– a Gives the holder the right but not the obligation to buy or sell
Hedging activities
• Hedge is the term we use to describe a combined

transaction of an existing position and a derivative
contract designed to manage the risks the firm faces
by holding the existing position alone. Most firms
create hedges by using one of a few basic types of
derivatives: forward contracts, futures contracts,
options, or swaps.
Derivatives not designated as a hedge
• A firm might hold a derivative for speculative or investment purposes.

They might also hold a derivative for hedging purposes, but choose not
to qualify the derivative for special hedge accounting. Any derivative a
firm holds that does meet all the criteria to qualify for hedge accounting
is accounted for as if it was a stand-alone asset or liability using fair-
value accounting.
• These contracts are recorded at fair value at initial recognition and all
subsequent balance sheet dates. Firms recognize any unrealized changes
in the fair value during each accounting period in earnings. If a firm
intends to use a derivative, or a pool of derivatives for hedging purposes,
and they meet the criteria to qualify as a hedge, then the derivatives are
accounted for in the manner explained in the following sections.
Hedge Accounting (1 of 2)
At inception, document
– The relationship between hedged item and derivative
instrument
– The risk management objective and strategy for the
hedge
● Hedging instrument
● Hedged item
● Nature of risk being hedged
● Means of assessing effectiveness
Hedge Effectiveness
● To qualify for hedge accounting, the derivative instrument must be
highly effective in offsetting gains or losses in the item being
hedged.
● Effectiveness considers
– Nature of the underlying variable
– Notional amount of the derivative and the item being hedged
– Delivery date of derivative
– Settlement date of the underlying
● Two common approaches are critical term analysis and
statistical analysis.
● If critical terms are identical, effectiveness is assumed.
Example of Effectiveness
Item to be hedged
– Accounts payable
– Due January 1, 2017
– For delivery of 10,000 euros
– Variable is the changing value of euros
Hedge instrument
– Forward contract
– To accept delivery of 10,000 euros
– On January 1, 2017
Statistical Analysis
If critical terms of item to be hedged and hedge
instrument do not match, statistical analysis can
determine effectiveness.
– Regression analysis
– Correlation analysis
Example
– Using derivatives based on heating oil or crude
oil to hedge jet fuel costs
Types of Hedge Accounting
• Fair-value hedge accounting. The item being hedged is an existing asset or
liability position or firm purchase or sale commitment. In this case, both
the item being hedged and the derivative are marked to fair value at the
end of the quarter or year-end on the books. The gain or loss on these
items is reflected immediately in earnings. The risk being hedged is the
variability in the fair value of the asset or liability.
• Cash-flow hedge accounting. The derivative hedges the exposure to the
variability in expected future cash flows associated with a risk. The
exposure may be related to a recognized asset or liability (such as a
variable-rate financial instrument) or to a forecasted transaction such as a
forecasted purchase or sale. The derivative is marked to fair value at year-
end and is recorded as an asset or liability. The effective portion of the
related gain or loss’s recognition is deferred until the forecasted
transaction affects income. The gain or loss is included as a component of
Accumulated Other Comprehensive Income (AOCI) in the balance sheet’s
stockholders’ equity section.
Cash-Flow Hedge (2 of 2)
A cash-flow hedge is used for anticipated or

forecasted transactions where there is risk of
variability in future cash flows.
Accounting for a Cash-Flow Hedge
A cash-flow hedge is
● recorded at cost
● adjusted to fair value at each reporting date
● accounted for in Other Comprehensive Income (OCI)
when there are gains or losses
When the forecasted transaction impacts the income
statement
● Reclassify OCI to the hedged revenue or expense
account
Fair-Value Hedge (2 of 2)
A fair-value hedge is used for an asset or

liability position, or firm purchase or sale
commitment, where there is a risk of
variability in the value of the position.
Accounting for a Fair-Value Hedge
Both the item being hedged and the derivative

are:
● adjusted to fair value at each reporting date
● accounted for immediately in income with
offsetting gains or losses
Cash-Flow Hedge: Example 1 (1 of 4)
Utility anticipates purchasing oil for sale to its customers next
February. On December 1, Utility enters into a futures contract
to acquire 4,200 gallons of oil at $1.4007 per gallon for delivery
on January 31. A margin of $10 is to be paid up front.
● On December 31, the price for delivery of oil on January 31 is
$1.4050.
● On January 31, the spot rate for current delivery is $1.3995.
Utility settles the contract, accepting delivery of 4,200 gallons of
oil.
In February, Utility sells all the oil to its customers
for $8,400 and reclassifies its OCI from the hedge as
cost of sales. Pertinent rates:
Blank 12/1 12/31 1/31
Futures rate, for
1/31 $1.4007 $1.4050 $1.3995
$5,901.00
(4200X$1.4050)
Cost of 4,200 $5,882.94 $5,877.90
barrels (4200X$1.4007) (4200X$1.3995)
Change in futures contract to 12/31 = $18.06 ($5,901.00- $5,882.94 )
Change in futures contract to 1/31 = ($23.10) ($5,877.90- $5,901.00)

The loss on the contract is ($5.04) ($23.10) + $18.06
Other Comprehensive Income (OCI), and this serves to increase Cost of Sales.
C
o
p
y Cash-Flow Hedge: Example 1 (3 of 4)
r
i
g • Sign 12/1 Futures contract
blank Cash
10.00
blank
blank
10.00
h contract 12/31 Futures contract 18.06 blank
t Adjust to blank OCI blank 18.06
fair value 1/31 OCI 23.10 blank

© blank Futures contract blank 23.10
Settle contract; 1/31 Cash 4.96
2 collect balance blank Futures contract 4.96
on margin 1/31 Inventory 5,877.90 blank
0
blank Cash blank 5,877.90
1
3
Purchase inventory
b
y
Record the
Feb. Cash 8,400.00 blank
sale and cost
blank Sales blank 8,400.00
of sales
Feb. Cost of sales 5,877.90 blank
blank Inventory blank 5,877.90

Feb. Cost of sales 5.04 blank
blank OCI blank 5.04
The last entry reclassifies the loss on the contract from OCI into Cost
of Sales. The effect is to increase Cost of Sales to $5,882.94. This is
the cost of the oil based on the futures contract signed on December
1.
Fair-Value Hedge: Example 2 (1 of 3)
Utility has accumulated 10,000 barrels of oil in inventory

that it will not sell until the later winter months. Utility
wants to maintain the value of the inventory, which is
recorded at cost of $85 per barrel, in the event that the
price of oil falls before they are able to sell it. On
November 1, Utility enters into a futures contract to sell
the oil for $90 a barrel in three months.
The contract will be settled net.
● The market price of the oil is $92 per barrel at December
31.
● The estimated value of the forward contract on
December 31 is a liability of the $2 per barrel difference
between our contracted price and the market price.
● The liability is measured as $20,000 / (1.01), or $19,802,
assuming a 1% per month interest rate.
● On January 31, the spot price is $89 and Utility settles the
contract by receiving $10,000, or ($90-$89) x 10,000
barrels.
Report at fair
value at
12/31 Loss on Forward contract 19,802 blank
reporting date
blank Forward contract blank 19,802
12/31 Inventory 20,000 blank
Adjust blank Gain on Inventory blank 20,000
inventory to 1/31 Forward contract 10,000 blank
fair value blank Forward contract 19,802 blank
Adjust values blank Gain on Forward contract blank 29,802

prior to final blank Loss on Inventory 30,000
settlement
blank Inventory 30,000
1/31 Cash 10,000 blank
Settle
blank Forward contract blank 10,000
contract
Accounting for Derivatives and Hedging Activities
ACCOUNTING FOR HEDGES OF

FOREIGN CURRENCY
RECEIVABLES AND PAYABLES
Foreign Exchange Rates
Spot Rate
 The exchange rate that is available today.
Forward Rate
 The exchange rate that can be locked in today for
an expected future exchange transaction.
 The actual spot rate at the future date may differ
from today’s forward rate.
 A forward contract requires the purchase (or sale)
of currency units at a future date at the contracted
exchange rate.
C
o Foreign Exchange –
p
y
Option Contracts
r
i
An options contract gives the holder the option of
g buying (or selling) currency units at a future date at
h the contracted “strike” price.
t
 A “put” option allows for the sale of foreign
© currency by the option holder.
 A “call” option allows for the purchase of foreign
2 currency by the option holder.
0
 An option gives the holder “the right but not the
1
3 obligation” to trade the foreign currency in the
future.
b
y
Transaction Exposure
Export sale:
Exposure exists when the exporter allows buyer to pay in a foreign
currency sometime after the sale has been made. The exporter is
exposed to the risk that the foreign currency might depreciate
between the date of sale and the date payment is received,
decreasing the U.S. dollars collected.
Import purchase:
Exposure exists when the importer is required to pay in foreign
currency sometime after the purchase has been made. The importer
is exposed to the risk that the foreign currency might appreciate
between the date of purchase and the date of payment, increasing the
U.S. dollars that have to be paid for the imported goods.
C
o
p Foreign Currency Transactions
y
r There are two methods of accounting for changes in the
i value of a foreign currency transaction, the one-
g transaction perspective and the two-transaction
h perspective.
t
©
The one-transaction perspective assumes:
1. the export sale is not complete until the foreign
2 currency receivable has been collected .
0
2. Changes in the U.S. dollar value of the foreign
1
3 currency is accounted for as an adjustment to
Accounts Receivable and Sales.
b
y
C
o
p Foreign Currency Transactions
y
r
i GAAP requires the two-transaction approach and
g treats the sale and collection of cash as two separate
h transactions.
t
1. Account for the original sale in US Dollars at
© date of sale. No subsequent adjustments are
required.
2
0
2. Changes in the U.S. dollar value of the foreign
1 currency are accounted for as gains/losses from
3 exchange rate fluctuations reported separately
from sales in the income statement.
b
y
Foreign Exchange Transaction -
Example
Summary of the relationship between fluctuations in
exchange rates and foreign exchange gains and losses:
 Foreign currency receivables from an export sale

creates an asset exposure to foreign exchange risk.
 Foreign currency payables from an import purchase
creates a liability exposure to foreign exchange risk.
Accounting for Unrealized Gains and Losses
Under the two-transaction perspective, a foreign

exchange gain or loss arises at the balance sheet date
that has not yet been realized in cash.
Two approaches exist to account for unrealized
foreign exchange gains and losses:
1. Deferral approach:
Gains and losses are deferred on the balance sheet
until cash is paid or received and a realized foreign
exchange gain or loss is included in income when paid.
Accounting for Unrealized Gains and Losses
2. Accrual approach (required by U.S. GAAP):

Unrealized foreign exchange gains and losses are
reported in net income in the period in which the
exchange rate changes.
Change in the exchange rate from the balance sheet
date to date of payment results in a second foreign
exchange gain or loss that is reported in the second
accounting period.
Example 1
Gaw Produce Company purchased inventory from a Japanese

company on December 18, 2013. Payment of 4,000,000 yen (¥) was
due on January 18, 2014. Exchange rates between the dollar and
the yen were as follows:
Exchange
Date Rate
December 18, 2013 ¥1 = $.0080
December 31, 2013 ¥1 = $.0082
January 18, 2014 ¥1 = $.0083
Required:
Prepare all journal entries for Gaw Produce Co. in connection with
the purchase and payment.
Answer
2013
Dec.18 Purchases (¥4,000,000 x .0080) 32,000
Accounts payable 32,000

31 Foreign exchange loss 800
Accounts payable 800
(¥4,000,000 x .0080) - (¥4,000,000 x .0082)

2014
Jan.18 Foreign exchange loss 400
Accounts payable 400
(¥4,000,000 x .0082) - (¥4,000,000 x .0083)

18 Accounts payable 33,200
Cash (¥4,000,000 x .0083) 33,200
Example 2
Old Colonial Corp. (a U.S. company) made a sale to a foreign customer on
September 15, 2013, for 100,000 stickles. Payment was received on October 15,
2013. The following exchange rates applied:
Exchange
Date Rate
September 15, 2013 §1 = $.48
September 30, 2013 §1 = $.50
October 15, 2013 §1 = $.44
Required:
Prepare all journal entries for Old Colonial Corp. in connection with this sale
assuming that the company closes its books on September 30 to prepare
interim financial statements.
Answer
2013
Sept. 15 Accounts receivable (§100,000 x $.48) 48,000
Sales 48,000

30 Accounts receivable 2,000
Foreign exchange gain 2,000
[§100,000 x ($.50 - $.48)]

Oct. 15 Foreign exchange loss 6,000
Accounts Receivable 6,000
[§100,000 x ($.50 - $.44)]

Oct. 15 Cash [§100,000 x ($.50 - $.44)] 44,000
Accounts receivable 44,000
Hedging Foreign Exchange Risk
Companies will avoid uncertainty associated with

the effect of unfavorable changes in the value of
foreign currencies using foreign currency
derivatives.
The two most common derivatives used to hedge
foreign exchange risk are foreign currency forward
contracts and foreign currency options.
Hedging Foreign Exchange Risk
Two foreign currency derivatives often used :

 Foreign currency forward contracts lock in the price
for which the currency will sell at contract’s
maturity.
 Foreign currency options establish a price for which
the currency can be sold, but is not required to be
sold at maturity.
Fair-Value Hedge Example: Liability
Ruby purchases equipment costing 200,000 yen on 12/2/16 with
payment due on 1/30/17.
On 12/2/16 Ruby enters a forward contract to purchase 200,000 yen
on 1/30/17 at the forward contract rate of $0.0095.
Accounts Forward Contract

Date Spot rate Payable rate Receivable
12/2 $0.0094 $1,880 $0.0095 $1,900
12/31 $0.0092 $1,840 $0.0093 $1,860
1/30 $0.0098 $1,960 $0.0098 $1,960
Fair-Value Hedge: Liability (1 of 3)
Accounts payable:
● Gain of $40 for December ($1,880 - $1,840)
● Loss of $120 for January ($1,840 - $1,960)
Contract receivable:
● Loss of $40 for December ($1,900 - $1,860)
● Gain of $100 for January ($1,860- $1,960)
Total exchange loss on the transaction = ($20)
- The net gain/loss for December = $0.
- The net loss for January = ($20)
Spread between the spot and forward rate on 12/2 determines

the total loss, e.g., the cost of hedging.
C
o
p
y Fair-Value Hedge: Liability (2 of 3)
r
• 12/2: Buy
i
equipment 12/2 Equipment 1,880 blank
g and sign
h forward blank Accounts payable (¥) blank 1,880
contract
t
12/2 Contract receivable (¥) 1,900 blank
© blank Contract payable ($) blank 1,900

12/31:
Adjust 12/31 Accounts payable (¥) 40 blank
2 foreign
blank Exchange gain blank 40
monetary
0 accounts to
12/31 Exchange loss 40 blank
1 current
(year-end)
3 rate blank Contract receivable (¥) blank 40
b
y
Fair-Value Hedge: Liability (3 of 3)
1/30: Pay promised 1/30 Contract payable ($) 1,900 blank

$1,900 on forward blank Cash ($) blank 1,900
contract and
receive yen in 1/30 Cash (¥) 1,960
exchange
blank Contract receivable (¥) blank 1,860
blank Exchange gain blank 100
1/30 Accounts payable (¥) 1,840 blank
blank Exchange loss 120 blank
blank Cash (¥) blank 1,960
Use the yen to pay the supplier
Footnote Disclosures
Risk management objectives and strategies must be

disclosed in the footnotes.
Fair-value hedges
● net gain or loss in earnings
● placement on statements
● effectiveness and ineffectiveness
Cash-flow hedges
● hedge ineffectiveness gain or loss
● placement on statements
● types of situations hedged
● expected length of time
● effect of discontinuance of hedge
C
o The discount rate is the interest rate used to determine the
p present value of future cash flows in a discounted cash flow
y (DCF) analysis. This helps determine if the future cash flows
r from a project or investment will be worth more than the capital
i outlay needed to fund the project or investment in the present.
g
h
t Discount Factor = 1 / (1 * (1 + Discount Rate) Period Number
)
for example: if we have 1% discount for 9 months
©=1/1* (1+ 1%)9
=1/1* (1+ 0.01) 9=
2=1/1*(1.01) 9=
0=1/1* (
1.093685) =1/ 1.093685= 0.91434 X 200000= 182868
1
3
b
y

Chapter 2-Accounting For Derivatives and Hedging Activities

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Chapter 2-Accounting For Derivatives and Hedging Activities

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Chapter 2

Accounting for Derivatives and Hedging

1. Understand the definition of a derivative and the types of risks that

Interest rates, commodity prices, foreign currency exchange

For example, Starbucks faces a variety of risks including

By entering into these types of agreements, Starbucks locks in

Settlement may also be made by entering another

Options are the right (but not the

With options, only one party is obligated to

Swaps are contracts to exchange an ongoing

Swaps are commonly negotiated on an individual

Sun decides to sell future production by entering into a

If Sun’s fixed costs are $50,000, and the variable

• Hedge is the term we use to describe a combined

• A firm might hold a derivative for speculative or investment purposes.

A cash-flow hedge is used for anticipated or

A fair-value hedge is used for an asset or

Both the item being hedged and the derivative

Change in futures contract to 12/31 = $18.06 ($5,901.00- $5,882.94 )

Change in futures contract to 1/31 = ($23.10) ($5,877.90- $5,901.00)

fair value 1/31 OCI 23.10 blank

blank Inventory blank 5,877.90

Utility has accumulated 10,000 barrels of oil in inventory

The contract will be settled net.

Adjust values blank Gain on Forward contract blank 29,802

ACCOUNTING FOR HEDGES OF

 Foreign currency receivables from an export sale

Under the two-transaction perspective, a foreign

2. Accrual approach (required by U.S. GAAP):

Gaw Produce Company purchased inventory from a Japanese

Dec.18 Purchases (¥4,000,000 x .0080) 32,000

Accounts payable 32,000

Companies will avoid uncertainty associated with

Two foreign currency derivatives often used :

Accounts Forward Contract

Spread between the spot and forward rate on 12/2 determines

© blank Contract payable ($) blank 1,900

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

Risk management objectives and strategies must be

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