Accounting issues of Derivative financial instruments

Accounting for Derivative Instruments

Introduction

In recent times the derivatives securities has grown very rapidly. This is because of its usefulness in hedging against risks post by the market. In addition due to the computer technology to process high volume of information and it increased the ways and sophistication of market enables the growth of these derivative securities.

Financial Instruments

Financial instruments are defined as cash, ownership interest in an entity, contractual right to receive or deliver cash or another financial instrument on favorable or unfavorable terms. In this context, accounts and notes receivable, accounts of notes payable, investments in debt and equity securities and bonds payable ar considered financial instruments. Most of them are valued on the basis of fair value, however some are valued at cost or amortized cost. The basis of valuation of these securities are as follows:

Cash is valued on the basis of fair value.

Accounts and notes receivable is valued on the basis of fair value.

In vestment in debt securities is based on fair value or cost or amortized cost depending on their classification.

Investments in equity is valued based on fair value.

Accounts and notes payable is valued on the basis of cost or amortized cost.

Bonds payable is valued on the basis of cost or amortized cost.

As defined above the financial derivatives such as options, futures, swaps, caps are also fianacial instruments called derivatives. That means their values depend on some other assets sucha s stocks or interest rates etc called underlying. As underlying values change the derivatives may undergo substantial gains or losses. The illustration below will show the underlying and the basis of valuation of common derivatives.

Interest rate swaps and options underlying is interest rate and the basis of valuation is fair value.

Stock Index futures and stock option underlying is stock price and the basis of valuation is fair value.

Currency futures and option underlying is exchange rates and the basis of valuation is fair value..

Caps, floors and collars underlying is stock prices interest rates and the basis of valuation is fair value.

Swaptions and leaps underlying is interest rates, stock prices and the basis of valuation is fair value.

In SFAS 133, Financial Accounting Standard board concluded that derivatives meet the definition of assets and liabilities and should be recognized in financial statements. It also mandated that all derivatives must be valued at fair value, as fair value accounting will provide statements users the best information regarding financial derivatives in the balance sheet and income statement. In addition, in boars point of view historical cost is not feasible as most derivatives has zero historical cost. In addition, as in the context of well developed derivative markets the board thinks it is tenable to reliably estimate the fair value of derivatives.

Example for accounting for traditional financial instrument

To illustrate the accounting of traditional securities assume Company “A” has purchased 1000 shares of Company “B”. The cost of purchase of these shares is 100000 on January 2nd 2000. On March 31st the share price has increased by 20 per share. On 1st of April 2000 the Company “A” sold the Company”b” shares for 120000. The double entry accounting for these transactions are as follows:

January 2, 2000

Dr Cr

Trading securities 100000

Cash 100000

March 31, 2000

Dr Cr

Securities Fair Value 20000

Adjustment (Trading) 20000

April 1, 2000

Dr Cr

Cash 120000

Trading Securities 100000

Gain on Sale of Securities 20000

June 30, 2000 (Balance Sheet Date)

Dr Cr

Unrealized Holding gain 20000

Securities Fair Value

Adjustment (Trading) 20000

It can be seen from the above double-entry, in the 1st quarter January 1st-March 200 income is shown when the stock prices increase in value. However, in the 2nd quarter no income is shown when the security is sold as the unrealized gains are off set against the gain on sale. In addition, one can see the investment in securities applying fair value accounting shows the value at appropriate dates balance sheet dates.

Example of Accounting for a normal Financial Derivative

To illustrate accounting for derivative financial securities, say in the previous example Company “A” instead of purchasing the shares of Company “B”, it can enter in to a call option with an investment company “C”. This can give the company “A”, the option to purchase 100 per share of company “B”. If the share price increases above 100 per share company “A” can exercise the right to purchase the call option. If the share price decreases company “A” will not exercise the right and the call option becomes worthless. In that case, company “A” will experience a loss.

For example company “A” decides to purchase a call option of company “B”. Say Company “A” purchase call option on January 2, 2000, when the company “B” shares are trading at 100 per shares. In this contract company “A” purchases call option of 1000 shares at a strike price of 100 per shares. The expiry of the call option is April 30, 2000. Company “A” pays for this c purchase of call option 400 as a premium. The double-entry for these derivative securities transaction under SFAS 133 are as follows:

January 2, 2000

Dr Cr

Call option 400

Cash 400

Say at March 31, 2000 company “B” shares is trading 120 per shares. There fore the 1000 shares will have an intrinsic value of 20000. This is recorded as follows:

March 30, 2000

Dr Cr

Call option 20000

Unrealized

holding gain 20000

Say the time value of the call option at March 3, 2000 is 100 as a fair value. That is, it has lost value of 300. This loss is recorded as follows:

March 30, 2000

Dr Cr

Unrealized holding

loss 300

Call option 300

When the call option is settled on April 1, 2000, The call option value of 20100 and the cash received of 20000 and a loss of 100. This recorded as follows:

April 1, 2000

Dr Cr

Cash 20000

Loss on settlement

of call option 100

Call option 20100

Differences between Traditional securities and derivatives

The traditional securities and derivatives have three fundamental differences. These differences are as follows.

As discussed above, a derivative has underlying as opposed to traditional securities. As well, they have payment provision. This can be based on the number of securities or other units of measurement and the difference between the underlying and the strike price at expiry of the derivative.

As opposed to the direct purchase of shares the initial investment is comparatively is minimal or zero for a derivative than a traditional financial security.

As shown above, the investor in a derivative may earn a profit without taking possession of the security in question.

Accounting for derivative used for hedging

Flexibility in use and the low-cost features of derivatives relative to traditional financial

instruments explain why derivatives have become so popular in recent years. An additional

use for derivatives is in risk management. For example, companies such as Coca-

Cola, Exxon, and General Electric, which borrow and lend substantial amounts in credit

markets are exposed to significant interest rate risk. That is, they face substantial risk

that the fair values or cash flows of interest-sensitive assets or liabilities will change if

interest rates increase or decrease. These same companies also have significant international

operations and are exposed to exchange rate risk—the risk that changes in foreign

currency exchange rates will negatively impact the profitability of their international

businesses.

Because the value and/or cash flows of derivative financial instruments can vary

according to changes in interest rates or foreign currency exchange rates, derivatives

can be used to offset the risks that a firm’s fair values or cash flows will be negatively

impacted by these market forces. This use of derivatives is referred to as hedging.

SFAS No. 133 established accounting and reporting standards for derivative financial

instruments used in hedging activities.14 Special accounting is allowed for two

types of hedges—fair value and cash flow hedges.

In a fair value hedge, a derivative is used to hedge or offset the exposure to changes in

the fair value of a recognized asset or liability or of an unrecognized firm commitment.

In a perfectly hedged position, the gain or loss on the fair value of the derivative and

that of the hedged asset or liability should be equal and offsetting. A common type of

fair value hedge is the use of interest rate swaps (discussed below) to hedge the risk that

fair value hedge is the use of put options to hedge the risk that an equity investment

will decline in value.

To illustrate the accounting for a fair value hedge, assume that Jones Company issues

$1,000,000 of 5-year 8% fixed-rate bonds on January 2, 2001. The entry to record this

transaction is as follows:

January 2, 2001

Cash Dr 1,000,000

Bonds Payable Cr 1,000,000

A fixed interest rate was offered to appeal to investors, but Jones is concerned that

if market interest rates decline, the fair value of the liability will increase and the company

will suffer an economic loss. To protect against the risk of loss, Jones decides to

hedge the risk of a decline in interest rates by entering into a 5-year interest rate swap

contract. The terms of the swap contract to Jones are:

Jones will receive fixed payments at 8% (based on the $1,000,000 amount). Jones will pay variable rates, based on the market rate in effect throughout the life of the swap contract. The variable rate at the inception of the contract is 6.8%.

The settlement dates for the swap correspond to the interest payment dates on the

debt (December 31). On each interest payment (settlement date), Jones and the counterparty

will compute the difference between current market interest rates and the fixed

rate of 8% and determine the value of the swap.17 As a result, if interest rates decline,

the value of the swap contract to Jones increases (Jones has a gain), while at the same

time Jones’s fixed-rate debt obligation increases (Jones has an economic loss). The swap

is an effective risk management tool in this setting because its value is related to the

same underlying (interest rates) that will affect the value of the fixed-rate bond payable.

Thus, if the value of the swap goes up, it offsets the loss related to the debt obligation.

Assuming that the swap was entered into on January 2, 2001 (the same date as the

issuance of the debt), the swap at this time has no value; therefore no entry is necessary:

January 2, 2001

No entry required—Memorandum to note that the swap contract is signed.

At the end of 2001, the interest payment on the bonds is made. The journal entry to

record this transaction is as follows:

December 31, 2001

Interest Expense Dr 80,000

Cash (8% 3 $1,000,000) Cr 80,000

At the end of 2001, market interest rates have declined substantially and therefore

the value of the swap contract has increased. Recall (see Illustration 26-6) that in the

swap, Jones is to receive a fixed rate of 8% or $80,000 ($1,000,000 3 8%) and pay a variable

rate (which in this case is 6.8%) or $68,000. Jones therefore receives $12,000

($80,000 2 $68,000) as a settlement payment on the swap contract on the first interest

payment date. The entry to record this transaction is as follows:

December 31, 2001

Cash Dr12,000

Interest Expense Cr 12,000

In addition, a market appraisal indicates that the value of the interest rate swap has

increased $40,000. This increase in value is recorded as follows:18

December 31, 2001

Swap Contract Dr 40,000

Unrealized Holding Gain or Loss—Income Cr 40,000

This swap contract is reported in the balance sheet, and the gain on the hedging

transaction is reported in the income statement. Because interest rates have declined,

the company records a loss and a related increase in its liability as follows:

December 31, 2001

Unrealized Holding Gain or Loss—Income Dr 40,000

Bonds Payable Cr 40,000.

Cash flow hedges are used to hedge exposures to cash flow risk, which is exposure to

the variability in cash flows. Special accounting is allowed for cash flow hedges.

To illustrate the accounting for cash flow hedges, assume that in September 2000,

Allied Can Co. anticipates purchasing 1,000 metric tons of aluminum in January 2001.

Allied is concerned that prices for aluminum will increase in the next few months. To

control its costs in producing cans, Allied wants to protect against possible price

increases for aluminum inventory. To hedge the risk that it might have to pay higher

prices for inventory in January 2001, Allied enters into an aluminum futures contract.

A futures contract gives the holder the right to purchase an asset at a preset price

for a specified period of time. In this case, the aluminum futures contract gives Allied

the right to purchase 1,000 metric tons of aluminum for $1,550 per ton. This price is

good until the contract expires in January 2001. 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 at the

lower price of $1,550 per ton.20

Assuming that the futures contract was entered into on September 1, 2000, and that

the price to be paid today for inventory to be delivered in January—the spot price—was

equal to the option price, the futures contract has no value. Therefore no entry is necessary:

September, 2000

No entry required. Memorandum entry to indicate that the futures contract is signed.

At December 31, 2000, the price for January delivery of aluminum has increased to

$1,575 per metric ton. Allied would make the following entry to record the increase in

the value of the futures contract:

December 31, 2000

Futures Contract Dr 25,000

Unrealized Holding Gain or Loss—Equity Cr 25,000

([$1,575 2 $1,550] 3 1,000 tons)

The futures contract is reported in the balance sheet as a current asset. The gain on

the futures contract is reported as part of other comprehensive income. Since Allied has

not yet purchased and sold the inventory, this is an anticipated transaction, and gains

or losses on the futures contract are accumulated in equity as part of other comprehensive

income until the period in which the inventory is sold and earnings is affected.

In January 2001, Allied purchases 1,000 metric tons of aluminum for $1,575 and

makes the following entry:21

January, 2001

Aluminum Inventory Dr 1,575,000

Cash ($1,575 3 1,000 tons) Cr 1,575,000

At the same time, Allied makes final settlement on the futures contract and makes

the following entry:

January, 2001

Cash Dr 25,000

Futures Contract Cr ($1,575,000 2 $1,550,000) 25,000