Accounting For Derivatives and Hedging Activities PDF

Accounting for Derivatives
and Hedging Activities
Dr. Derek K. Chan

HKU
Accounting for Derivatives 1

Outline
1. Overview
2. Four Common Types of Derivatives
3. Derivatives and Hedging Activities
4. Accounting and Disclosure Requirements for Derivatives
and Hedging Activities
Please refer to Appendix A of the textbook for the accounting for

derivatives and hedging activities.

1. Overview
1.1 Risk Management and Derivatives
Uncertainty about the future value of assets and liabilities or about
future cash flows exposes companies to risk.
Of the many types of risk faced by a firm, four common types are:
Price risk is the uncertainty about the future price of an asset or a
liability An asset could decrease in value; a liability could
increase in value.
Credit risk (also known as counter-party risk or default risk) is the
uncertainty that the party on the other side of a transaction will
abide by the terms of an agreement.
Interest rate risk is the uncertainty about future interest rates and
their impact on future cash flows and fair value of financial
instruments (e.g., bond investment or loan).
Exchange rate risk is the uncertainty about the future domestic
(HK) dollar cash flows stemming from assets and liabilities
denominated in foreign currencies.

Derivatives - General
One way to manage this risk is through the use of
derivatives.
A derivative is financial instrument that derives its value
from the changes in another measure of value (often
referred to as the underlying item).
underlying item

Types of Underlying Items
The underlying items from which derivatives derive their
value are:
Rates Euro .......HK$9.46 (29/3/04)
Indexes Hang Seng, Dow Jones, Standard & Poors 500
Financial instruments
Commodities
Oil
Cotton Corn
Many derivatives are executory contracts, meaning that
they are not a transaction but are an exchange of promises
about future actions (to be executed or performed later by
both parties). No accounting record at the contract
signing date.
A derivative usually (1) requires little or no initial net

investment, and (2) permits or requires net settlement in the
end with a cash payment instead of with actual delivery of
the underlying items.

Derivatives - Valuation and Nature
Valuation:
Derivatives are valued in the balance sheet at each
financial reporting date at market value.
Remark: Valuation is problematic where there is no
market for the derivative Use present value of future
cash flows
Nature:
Derivatives can be characterized as a zero-sum game
because of their what one party gains, the other party
loses nature.

Example 1: Simple Example of a Derivative
Assume that you are an employee of Don Dot-Com.
On October 1, 2014, you purchase 5,000 shares of common stock

in the company at the market price of $4 per share, making the
total purchase price of $20,000.
On January 1, 2015, you need to make a tuition payment of

$20,000 and you must make certain that you have $20,000 on that
date.
Suppose you cannot sell the Don shares now because your
employment contract states that any shares you purchase from the
company must be held for at least three months before you can
sell them.

Example 1: Contd
Your risk management dilemma is this:
you want to hold the Don shares as an asset for the next three
months, but a downward movement in the stock price
between now and January 1, 2015, would be disastrous.
The answer to your problem is the following agreement:
If the price of Don stock is above $4 per share on January 1,

2015, you agree to pay a cash amount equal to that excess
(multiplied by 5,000 shares) to Rick Lee, a local speculator.
If the price of Don stock goes below $4, Rick Lee agrees to
pay you a cash amount equal to the deficit (multiplied by
5,000 shares).
The broad name given toAccounting

agreements such as this is a derivative.
for Derivatives 9
Example 1: Contd
How does this derivative agreement solve your risk management dilemma?
Look at the table below:
Stock price on January 1, 2015
$3.50 $4.00 $4.50
Value of shares $17,500 $20,000 $22,500
Receipt from (payment to) Rick Lee 2,500 -0- (2,500)
Net amount $20,000 $20,000 $20,000
Because of the structure of the agreement, you wind up with $20,000 on

January 1, 2015, no matter what happens to the price of Don stock between
now and then.
After the fact, a derivative contract is sometimes a good deal and sometimes a
bad one. But because of the absolute necessity of having $20,000 on January
1, 2015, you are willing to trade off any stock profits you make for the right to
receive payments that will reimburse your stock losses.

1.2 Hedging Activities
Example 1 is an example for a hedge.
A hedge is a transaction entered into to reduce risk.

A hedge reduces the volatility of a position, but can
potentially cancel out gains.
A derivative can be used as a hedge against a change in the
value of the item being hedged.
In Example 1, how much money will change hands between you

and Rick Lee on October 1, 2014, the day you enter into the
derivative contract?
Do you have to pay Rick Lee anything up front to get him to
sign the agreement?
Or does he have to pay you?
1.2 Hedging Activities
The valuation of derivatives depends on two factors: (1) the
expected return on Don stock over the three-month period and (2)
the difference in the way you and Rick Lee view risk.
Here, we make the following simplest assumptions: (1) you and

Rick Lee have the same risk preferences, i.e., no risk premium is
paid or received to induce parties to contract; and (2) the $4 price
of the stock on October 1, 2014, is equal to the expected price on
January 1, 2015, i.e., the expected return on holding the stock is
zero.
Under these two assumptions, the money exchanged at the signing

of the agreement on October 1, 2014, is $0 because the probability
of you being required to make a payment to Lee on January 1,
2015, is equal to the probability that he will have to make a
payment to you.
1.3 Accounting for Hedging Activities
What journal entry would you be required to make to recognize
the signing of the agreement on October 1, 2014?
The answer is that you make no journal entry. No cash changes
hands; you and Lee have merely exchanged promises about
some future action.
This type of contract is called an executory contract and is very
common in business.
The derivative contract is off balance sheet on the day it is
signed (i.e., no asset or liability is recognized).
A derivative instrument like this is said to have off balance
sheet risk because it could fluctuate in value after the initial
agreement date, but these fluctuations historically have not been
required to be reflected in the balance sheet.
The current accounting standards on derivatives bring these
fluctuations onto the balance sheet.
On December 31, 2014, the price of Don stock is $3.75 per
share, making your investment in Don shares worth $18,750.
The payment exchange with Rick Lee is to be made on the
following day.
With the price per share at $3.75, it appears that you will receive
a payment from Lee of $1,250 ($0.25 5,000 shares).
How should this information be reflected in the asset section of

your December 31, 2014, balance sheet?

Two possibilities are outlined below:
#1 #2
Valuation of stock Fair value Fair value
Don stock $18,750 $18,750
Recognition of derivative receivable? NO YES

Derivative payment receivable -0- 1,250
Historically, the accepted accounting treatment was Option #1.

But Option #2 provides the best information because it reports
the fair value of both the stock movement and the derivative
payment receivable.
As will be discussed later, Option #2 is required under the
current accounting standards.
2. Four Common Types of Derivatives
2.1 Forwards
A forward contract is a private agreement between two
parties to exchange a specified amount of a commodity,
security, or foreign currency at a specified date in the
future with the price or exchange rate being set now. fixed the price now
Substance: A non-cancelable sale/purchase order for a

commodity, security, or foreign currency.
Nature: Executory both parties execute at the
settlement (delivery) date.
Forward contracts are usually settled with cash payments
instead of by actual delivery of the underlying asset.

2.1 Forwards
Forwards: Two-sided risk exposure
Each party to a forward contract is viewed as being
BOTH a writer and a holder.
Each party is obligated to deliver a commodity, security,
or foreign currency at a specified date in the future to
the other party.
No walking away.
Each counter-party can have a Gain or a Loss.
One partys gain equals the other partys loss, i.e., a
zero-sum game.
Because it is a private agreement, the party who gains
has a counter-party risk (i.e., non-performance of the
counter-party)
Example 2: Forward Contract
Assume that on November 1, 2014, Merry Company sold toys to
Takashi Company for 10,000,000 to be received on January 1,
2015.
The current exchange rate is 100=HK$6.
In order to be assured of the dollar amount that will be received,

Merry enters into a forward contract with a large bank agreeing
that, on January 1, 2015, Merry will deliver 10,000,000 to the
bank and the bank will give HK dollars in exchange at the rate of
100=HK$6, or HK$600,000.
This forward contract guarantees the HK dollar amount that

Merry will receive from the receivable denominated in Japanese
yen.
Example 2: Contd
Operationally, this forward contract would usually be settled as
follows:
Given the exchange rate on January 1, 2015, if 10,000,000 is

worth less than HK$600,000, the bank will pay Merry the
difference in cash (HK dollars).
If 10,000,000 is worth more than HK$600,000, Merry pays

the difference to the bank in cash.
Therefore, no yen need be delivered as part of the contract;

the contract is settled with HK dollar cash payment.

Example 2: Contd
The impact of the forward contract to Merry is shown in the
following table:hk dollar settle
Exchange rate on January 1, 2015
100=HK$6.3 100=HK$6 100=HK$5.7
Value of 10,000,000 HK$630,000 HK$600,000 HK$570,000
Receipt (payment) to settle forward contract

(30,000) -0- 30,000
Net HK dollar received by Merry HK$600,000 HK$600,000 HK$600,000

2.2 Futures
A futures contract (traded on an exchange) allows a
company to buy or sell a specified quantity of a
commodity, currency, or financial security at a specified
price on a specified future date. forward contract
A futures contract is very similar to a forward contract,
with the difference being that a futures contract is a
standardized instrument that is sponsored by and traded on
an organized exchange.
no counter-party risk; mark-to-market on a daily basis

Example 3: Futures Contract
Assume that Kamei Bakery uses 1,000 bushels of wheat every
month.
On December 1, 2014, Kamei decides to protect itself against

price movements for its January 1, 2015, wheat purchase by
buying a futures contract that obligates Kamei to purchase 1,000
bushels of wheat on January 1, 2015, at a price of $40 per bushel
(which is also the prevailing price of wheat on December 1, 2014).
This is a standardized, exchange-traded futures contract, so Kamei

has no idea who is on the other side of the agreement.
As with other derivatives, a wheat futures contract is usually

settled by a cash payment at the end of the contract instead of
actual delivery of the wheat.
Example 3: Contd
Settlement of Kameis futures contract would be as follows:
If the price of wheat is less than $40 per bushel on January 1,

2015, Kamei will make a cash payment of that difference,
multiplied by 1,000 bushels.
If the price of wheat is greater than $40 per bushel on January

1, 2015, Kamei will receive a cash payment equal to that
difference, multiplied by 1,000 bushels.

Example 3: Contd
The impact of the futures contract to Kamei is shown in the
following table:
Wheat price on January 1, 2015
$38 $40 $42
Cost to purchase 1,000 bushels ($38,000) ($40,000) ($42,000)
Receipt (payment) to settle futures (2,000) -0- 2,000

contract
Net cost of January wheat ($40,000) ($40,000) ($40,000)

2.3 Swaps
A swap is a contract in which two parties agree to

exchange payments in the future based on the
movement of some agreed-upon price or rate.
A good example is the exchange of a stream of
variable interest payments for a stream of fixed
payments.
A swap can transform the stream of future cash flows
that you have into cash flow stream that you want.

Example 4: Interest Rate Swap
An interest rate swap is a contract where two parties agree to
exchange future interest payments on a given loan amount; one
set of payments is based on a fixed interest rate and the other is
based on a variable interest rate.
In effect, an interest rate swap is a series of forward contracts
based on interest rates (net payment must be made at specified
intervals).
Assume that Patell Company has a good relationship with a bank
that issues only variable interest rate loans.
Patell takes advantage of its connections at the bank and, on
January 1, 2014, receives a two-year, $1,000,000 loan, with
interest payments occurring at the end of each year.
The interest rate for the first year is the prevailing market rate of
10%, and the rate in the second year will be equal to the market
interest rate on January 1 of that year.
Example 4: Contd
Patell is reluctant to bear the risk associated with the uncertainty
about what the interest payment in the second year will be.
So Patell enters into an interest rate swap agreement whereby

Patell
will receive an amount equal to $1,000,000 (Jan. 1, 2015
interest rate 10%) if the January 1, 2015, interest rate is
greater than 10%; and
will pay the same amount if the rate is less than 10%.
The interest swap payment will be made at the end of the year
2015.

Example 4: Contd
To see the impact of this interest rate swap, consider the following
table:
Interest rate on January 1, 2015
7% 10% 13%
Variable interest payment ($70,000) ($100,000) ($130,000)
Receipt (payment) for interest rate swap (30,000) -0- 30,000
Net interest payment in 2015 ($100,000) ($100,000) ($100,000)
The interest rate swap agreement has changed Patells uncertain

future interest payment into a payment of $100,000 no matter
what the prevailing interest rates are in 2015.
An interest rate swap can effectively change the loan that you got
into the loan that you want.
2.4 Options
An option contract gives the holder the right, but not the
obligation, to buy or sell an asset at a specified exercise
price during a specified future period
A call option gives the holder the right to buy an asset
A put option gives the holder the right to sell an asset
The holder of an option must pay cash in advance (a
premium) for the option (at the inception of the
contract); in exchange, the holder is protected against
unfavourable price or rate movements but can still
benefit from favourable movements
The premium compensates the option writer for the
risk the writer will incur
The premium is the cost of buying insurance
2.4 Options
Options: One-sided risk exposure
The holder can always walk away (holder has right but
not obligation)
The writer can never walk away (writer has obligation)
The holder can ONLY GAIN (less premium paid)
The writer can ONLY LOSE (less premium earned)
The holders gain always equals the writers loss (again, a
zero-sum game)

Example 5: Option
Assume that on October 1, 2014, Wong Company entered into a
firm commitment to purchase a piece of specialized sewing
equipment from a British company.
A firm commitment is not a purchase, but is a firm agreement

to purchase an asset in the future at a price that is set now.
The agreed-upon price of the equipment is 100,000, and the

purchase date is January 1, 2015.
The exchange rate on October 1, 2014, is 1=HK$12.

Example 5: Contd
To reduce the exchange rate risk that could increase the HK dollar
cost of the equipment, Wong enters into a call option contract on
October 1, 2014.
The contract gives Wong the right, but not the obligation, to
purchase 100,000 at an exchange rate of 1=HK$12.
The option period extends to January 1, 2015, and Wong had to pay
HK$5,000 to buy this option.
A detailed treatment of option valuation is beyond the scope of this
course. Briefly, the price that must be paid to purchase an option is
higher
when the option exercise price is lower,
when the length of the option is longer, and
when the movement of the price of the underlying asset
(British pounds in this example) is more volatile.

Example 5: Contd
In exchange for this HK$5,000 payment, the option arrangement
protects Wong from unfavorable movements in the exchange rate,
but also allows Wong to benefit from favorable movements.
This can be seen from the table below:

Exchange rate on January 1, 2015
1=HK$12.2 1=HK$12 1=HK$11.8
HK dollar cost of equipment if: $1,220,000 $1,200,000 $1,180,000

- Buy at January 1, 2015, rate
- Exercise option $1,200,000 $1,200,000 $1,200,000
Will option be exercised? Yes Indifferent No
HK dollar cost of equipment $1,200,000 $1,200,000 $1,180,000

Example 5: Contd
The existence of the option contract means that Wong will pay no
more than HK$1,200,000 for the equipment.
And, since the option is a right and not an obligation, Wong can
ignore it, as in the case above in which the exchange rate is
1=HK$11.8, and just buy British pounds at the rate prevailing on
January 1, 2015.
Remember that this ability to enjoy protection from unfavorable

rate changes but to the benefit from favorable rate changes did not
come for free it costs Wong HK$5,000 at the beginning of the
option period.

A hedge is a transaction entered into to reduce risk.
A hedge is a zero-sum game.
A hedge reduces the volatility of a position, but can
potentially cancel out gains.

The Technique of Hedging: A Way to Eliminate Risk
Creating a counterbalancing position to a risk exposure.
A loss on the exposed item will be offset by a gain on the

counterbalancing position.

Much hedging occurs naturally in business.
natural hedging
Examples:
Increases in costs or in the value of liabilities are
offset by related increases in revenues or in the value
of assets. sometimes pass this to customers
Choosing a capital structure that includes financing

in a foreign currency may reduce the exchange rate
risk resulting from income denominated in that
currency.

A derivative can also be used as a hedge against a change in the
value of the item being hedged:
Example 2: Merry Forward. The forward currency contract was

entered into to offset changes in the HK dollar value of the
receivable denominated in Japanese yen.
Example 3: Kamei Future. The wheat futures contract was acquired
to offset movements in the expected purchase price of the following
months supply of wheat.
Example 4: Patell Swap. The interest rate swap was structured to
offset changes in the variable-rate interest payments.
Example 5: Wong Option. The British pound call option was
purchased to offset the negative impact on the cost of equipment of
changes in market exchange rate of British pound.

4. Accounting and Disclosure Requirements
for Derivatives and Hedging Activities
In 1998, the Financial Accounting Standards Board (FASB) in the U.S. issued
Financial Accounting Standard 133 (FAS 133) on Accounting for Derivative
Financial Instruments and Hedging Activities.
In 2000, FASB released FAS 138, Accounting for Certain Derivative
Instruments and Certain Hedging Activities, an amendment of FAS 133.
In 1999, the International Accounting Standards Committee (IASC, now IASB)
issued International Accounting Standard 39 (IAS 39) on Financial
Instruments: Recognition, Measurement, and Hedging Activities. Although
less detailed and complex than FAS 133, IAS 39 accounting rules are virtually
in accordance with FAS 133.
In May 2004, the Hong Kong Society of Accountants (HKSA, now HKICPA)
issued HKAS 39: Financial Instruments: Recognition and Measurement, which
is actually based on IAS 39. HKAS 39 is revised in April 2010.
FASB, IAS, HKAS reporting requirements (FAS 133 & 138, IAS
39, HKAS 39):
Balance Sheet Treatment:
Derivatives should be reported on the balance sheet (as assets or
liabilities) at their fair value (use market quotes or PV of future cash
flows).
Income Statement Treatment:
For derivatives not used to hedge risk (speculative), changes in value
(i.e., gains and losses) should be recognized in the income statement in
the period of the change. hedge risk,speculation/gamble, should recognize the change
For derivatives used to hedge risk, gains and losses on derivatives
should be reported in the same year in which the income effects on the
hedged item are reported (matching principle).
couple, gain/loss happen together
Implication: Gains and losses on derivatives will be deferred if the
income effects of the hedged item are not reported yet.
Accounting for Derivativesforecast transaction.occur, i/s
40
4.1 Two Types of Hedges
FASB, IASB and HKICPA have identified two basic types of hedges
for which derivatives can be used:
Fair value hedge counterparty recognizeoption
Cash flow hedge

Remarks:
FASB, IASB and HKICPA have also identified a third category of
hedges, Foreign Currency Hedge (or Hedge of a Net Investment in a
Foreign Operation), which is a hedge of the foreign currency
exposure of an anticipated foreign currency-denominated
transaction or the net investment in foreign subsidiaries.
While a foreign currency hedge is always accounted for as a cash
flow hedge under IAS 39 and HKAS 39, it is sometimes accounted
for as a fair value hedge and sometimes as a cash flow hedge under
FAS 133. We follow IAS 39 and HKAS 39 in this course.
MV of loan

Fair Value Hedge:
A hedge of an exposure to changes in the fair value of (1)
an asset and a liability that is already recognized in the
balance sheet (such as a hedge of exposures to changes in
the fair value of a fixed rate debt as a result of changes in
interest rates) or (2) an unrecognized firm commitment
(such as a non-cancelable fixed price purchase order).
Examples:
variable interest rate MV of loan
Fixed rate debt held or issued swapped to floating rate

debt fair value of the hedged item is fixed (but future
interest payments are variable).
Purchased put option to hedge equity price risk on
trading security.Accounting for Derivatives 42
Cash Flow Hedge:
A hedge of an exposure to variability in cash flows that is
attributable to a particular risk. That exposure may be
associated with (1) an existing recognized asset or liability
(such as all or some future interest payments on variable rate
debt) or (2) a forecasted transaction (such as an anticipated
purchase or sale)
Examples:
Swapping floating rate debt to fixed rate debt future cash
flows are fixed (but fair value of the debt is variable).
Hedging commodity risk in future inventory purchase with
futures.

Fair Value Hedge
Example 2: Merry Forward. The forward currency contract was entered
into to offset changes in the HK dollar value of the receivable denominated
in Japanese yen.
Example 5: Wong Option. The British pound call option was purchased to
offset the negative impact on the cost of equipment of changes in market
exchange rate of British pound associated with an unrecognized firm
commitment.
Cash Flow Hedge
Example 3: Kamei Future. The wheat futures contract was acquired to
offset movements in the expected purchase price of the following months
supply of wheat.
Example 4: Patell Swap. The interest rate swap was structured to offset
changes in the variable-rate interest payments.
Remark: Types of hedges do not depend on the types of derivatives being used,
but on the types of risk of the hedged item that the company wants to manage.

4.2 Accounting for Hedges Income Effects
Derivative is not a hedge. It is a speculation. Changes in fair value
(of the derivative) are reported as gains or losses in the income
statement.
Derivative is a fair value hedge. Changes in fair value are reported
as gains or losses in the income statement and are offset by gains
or losses on changes in the fair value of the asset or liability being
hedged.
Note that accountants historically have not revalued bonds for
changes in market value. However, the FASB, IASB and
HKICPA require firms to revalue bonds when the firm hedges
them with a fair value hedge (i.e., accounting basis for the
hedged item should follow that for the derivative).
Derivative is a cash flow hedge. Changes in fair value are deferred
and reported in comprehensive income (an equity adjustment).
These deferred gains and losses are recognized in income on the
forecasted date of the cash flows being hedged.
Accounting for Fair Value Hedges
Measurement of Derivative
Change in Fair Value*
Measurement of Hedged Item

Earnings
Gain or Loss Attributable to
Risk Being Hedged
* Report gains and losses from change in fair value of the derivative
currently in earnings as they arise. Simultaneously, recognize in earnings a
gain or loss of the hedged item. The effect of that accounting is to reflect in
earnings in the extent to which the hedge is not effective in achieving
offsetting changes in fair value. If the hedge is effective, the net effect on
earnings is zero. Accounting for Derivatives 46
Accounting for Cash Flow Hedges
Measurement of Derivative
Change in Fair Value* 1 Equity

2
Measurement of Hedged Item
Earnings Effects
2 Earnings
(e.g., interest, cost of sales, etc)
* Report all gains and losses from change in fair value of the derivative currently
in Other Comprehensive Income (OCI) as they arise. When the hedged item is
recorded in earnings, transfer the OCI item to earnings. The effect of that
accounting is to delay earnings effect when the hedge is effective. Hedge
ineffectiveness always is reported currently in earnings.
If(forecasted) transaction is no longer probable, recognize the OCI item
immediately in earnings.
4.2 Accounting for Hedges - Criteria
If derivatives are used for a fair value hedge or a cash flow
hedge, they must be identified as hedges of specific items at
the beginning of the hedging relationship. The designation of
a derivative as a hedge should be supported with formal
documentation.
Moreover, required disclosure includes the cumulative gains
or losses included in the reported amounts of hedged assets
and liabilities (for fair value hedges), and the cumulative
gains or losses deferred as part of comprehensive income
(for cash flow hedges).

4.2 Accounting for Hedges - Criteria
Another item that is also sometimes disclosed is the notional
amount of the derivative instrument.
The notional amount is the total face amount of the asset
or liability that underlies the derivative contract.
For example, with an interest rate swap, the notional
amount is the total principal amount of the loan on which
interest payments are being swapped.

Example 6: Accounting for a Fair Value Hedge
Continued with Example 2. On November 1, 2014, Merry
Company sold toys to Takashi Company for 10,000,000 to be
received on January 1, 2015.
The exchange rate on November 1, 2014, was 100=HK$6.
On the same date, Merry also entered into a yen forward contract
and specifically designated it as a hedge.
The journal entry to record this information is:
Nov. 1, Yen Receivable $600,000

2014 Sales $600,000

No entry is made to record the forward contract because, as of
November 1, 2014, the forward has a fair value of HK$0.
The value is zero because settlement payments are made under the
contract only if the exchange rate on January 1, 2015, differs from
100=HK$6.
If the current exchange rate of 100=HK$6 is assumed to be the
best forecast of the future rate, it is expected that, on average, no
payments will be exchanged under the forward contract.

Example 6: Contd
Assume now that the actual exchange rate on December 31, 2014,
is 100=HK$5.7.
At this exchange rate, Merry will receive a $30,000 on January 1,
2015 under the forward contract.
Accordingly, on December 31, 2014, Merry has a $30,000
receivable under the forward contract.
Since the forward contract is a fair value hedge, the adjusting
entries to recognize the change in the fair value of the forward and
in the HK dollar value of the Yen Receivable are as follows:
Dec. 31, Loss on Foreign Currency (I/S) $30,000
2014 Yen Receivable $30,000
Forward Contract (asset) $30,000
Gain on Forward Contract (I/S) $30,000

Example 6: Contd
The decrease in the Yen Receivable reflects the HK$30,000
decreased dollar value of the receivable after the change in the
exchange rate to 100=HK$5.7.
This loss is offset by the gain from the change in value of the
forward contract.
The forward contract is a fair value hedge of the value of the
receivable, so both changes in value are recognized in 2014
earnings.
The journal entries necessary in Merrys books on January 1,
2015, to record receipt of the yen payment and settlement of the
yen forward contract are as follows:
Jan. 1, Cash $570,000
2015 Yen Receivable $570,000
Cash (forward contract settlement) $30,000
Forward Contract (asset) $30,000
Example 6: Contd
Disclosure. Below is the information that Merry should disclose
in relation to the forward contract as of December 31, 2014:
Merry Company
Disclosure About Fair Value Hedges
December 31, 2014
Notional Fair Value
Amount
Forward Contract to deliver yen asset HK$600,000 HK$30,000
A gain (and offsetting loss on the hedged item) of HK$30,000 was

recognized in 2014 in connection with this forward contract. The cumulative
loss recognized on the hedged yen receivable is HK$30,000.

Example 7: Accounting for a Cash Flow Hedge
Continued with Example 3. On December 1, 2014, Kamei Bakery
decided to hedge against potential fluctuations in the price of
wheat for its forecasted January 2015 purchases.
To do so, Kamei bought a future contract that entitles and
obligates it to purchase 1,000 bushels of wheat on January 1, 2015,
for $40 per bushel.
No entry is made to record the futures contract because, as of
December 1, 2014, the future has a fair value of zero.
The value is zero because settlement payments are made under the
contract only if the price of wheat on January 1, 2015, differs
from $40 per bushel.
If the current price of $40 per bushel is assumed to be the best
forecast of the future price, it is expected that, on average, no
payments will be exchanged under the futures contract.

Example 7: Contd
Assume that the actual price of wheat on January 1, 2015, is $38 per
bushel. At this price, Kamei will make a $2,000 payment on January 1,
2015, to settle the futures contract.
Accordingly, on December 31, 2014, Kamei has a $2,000 payable under
the futures contract.
Since the futures contract is a cash flow hedge, the adjusting entry to
recognize the change in the fair value of the futures contract is as follows:
Dec. 31, Other Comprehensive Income (B/S) $2,000
2014 Wheat Futures Contract (liability) $2,000
The loss from the decrease in the value of Kameis futures contract is
deferred as part of comprehensive income.
The wheat futures contract is a cash flow hedge, with the futures contract
payment intended to offset the decreased amount that Kamei will have to
pay to make its forecasted purchase of 1,000 bushels of wheat on
January 1, 2015.
Example 7: Contd
The journal entries necessary in Kameis books on January 1,
2015, to record receipt of the purchase of 1,000 bushels of wheat
in the open market and cash settlement of the wheat futures
contract are as follows:
Jan. 1, Wheat Inventory $38,000
2015 Cash $38,000
Wheat Futures Contract (liability) $2,000

Cash (futures contract settlement) $2,000
Loss on Futures Contract (I/S) $2,000

Other Comprehensive Income $2,000

Example 7: Contd
The loss on the futures contract is recognized in earnings on
January 1, 2015, the forecasted date of the transaction (i.e., wheat
purchase) that was hedged.
To the extent that the wheat inventory is used to make bread, and
the bread is sold in 2015, the loss on the futures contract will
offset the decreased cost of goods sold arising from the decrease
in the price of wheat to $38 per bushel.

Example 7: Contd
Disclosure. Below is the information that Kamei should disclose
in relation to the futures contract as of December 31, 2014:
Kamei Bakery
Disclosure About Cash Flow Hedges
December 31, 2014
Notional Fair Value

Amount
Futures Contract to purchase wheat $40,000 $2,000
liability
A deferred loss of $2,000 has been recognized in 2014 in relation to this
wheat futures contract. This $2,000 will be recognized as a loss in earnings in
2015.

Continued with Example 4. On January 1, 2014, Patell Company
received a two-year, $1,000,000 variable interest rate loan and also
entered into an interest rate swap agreement. The journal entry to record
this information is
Jan. 1, Cash $1,000,000

2014 Loan Payable $1,000,000
No entry is made to record the swap agreement because, as of January 1,

2014, the swap has a fair value of $0.
The value is zero because the interest rate on January 1, 2014, is 10%
and if it is assumed that the best forecast of the future interest rate is the
current rate of 10%, it is expected that, on average, no payments will be
exchanged under the swap agreement.

Example 8: Contd
Assume now that the actual market interest rate on December 31, 2014,
is 11%.
With the rate at 11%, Patell will receive a $10,000 payment at the end of
2015 under the swap agreement.
Accordingly, on December 31, 2014, Patell has a $10,000 receivable
under the swap agreement and the receivable has a present value of
$9,009 (10,000/1.11).
The journal entry to record Patells 2014 interest payment, along with the
adjusting entry to recognize the change in the fair value of the swap, is
as follows:
Dec. 31, Interest expense $100,000
2014 Cash $100,000
Interest Rate Swap (asset) $9,009


Example 8: Contd
The credit in the entry to record the change in the fair value of the
swap is to Other Comprehensive Income, a non-earnings equity
account.
This treatment is appropriate because the interest rate swap is a
cash flow hedge, with the swap payment receivable intended to
offset the increased cash interest payment at the end of 2015.

Example 8: Contd
The journal entries necessary in Patells books at the end of 2015 are as
follows:
Dec. 31, Interest Expense $110,000
2015 Cash $110,000
Cash (from swap agreement) $10,000
cr expensegain
Other Comprehensive Income $991
Interest Expense $10,000
Loan Payable $1,000,000
Cash $1,000,000
The $991 credited to Other Comprehensive Income represents the
increase in the value of the swap payment receivable stemming from the
passage of time (i.e., accrued interest revenue).
Example 8: Contd
An important thing to notice in these journal entries is that net
interest expense is $100,000 (110,000 - 10,000) because of the
hedging effect of the swap.
Also, the value changes in a derivative designated as a cash flow
hedge are deferred in comprehensive income and then reflected in
earnings (via the reduction in interest expense) in the period when
the hedged cash flow occurs.

Example 8: Contd
Disclosure. Below is the information that Patell should disclose in
relation to the interest rate swap as of December 31, 2014:
Patell Company
Disclosure About Cash Flow Hedges
December 31, 2014
Notional Fair Value

Amount
Interest Rate Swap asset $1,000,000 $9,009
In relation to this interest rate swap, a $9,009 credit has been recognized as
other comprehensive income. This $9,009 will be used to offset interest
expense in the year 2015.

Continued with Example 8, except that we now assume that Patell will
receive or make a swap payment based on the principal of $2,000,000.
The interest rate swap agreement of $2,000,000 principal amount
exceeds the principal amount of the loan and thus the interest rate swap
agreement related to the extra $1,000,000 principal amount should be
accounted for as a speculative investment.
On December 31, 2014, with the rate at 11%, Patell will receive a
$20,000 payment at the end of 2015 under the swap agreement.
Accordingly, on December 31, 2014, Patell has a $20,000 receivable
under the swap agreement and the receivable has a present value of
$18,018 (20,000/1.11).
While one-half of the gain from the increase in the value of Patells
interest rate swap agreement (which reflects the effective portion of the
hedge) is deferred as part of comprehensive income because the swap is
a cash flow hedge, the other half (which reflects over-hedge
ineffectiveness) is reported currently in earnings.
Example 8: Contd
The journal entry to record Patells 2014 interest payment, along with the
adjusting entry to recognize the change in the fair value of the swap, is
as follows:
Dec. 31, Interest expense $100,000
2014 Cash $100,000

Gain on Interest Rate Swap $9,009

Example 8: Contd
The journal entries necessary in Patells books at the end of 2015 are as
follows:
Dec. 31, Interest Expense $110,000
2015 Cash $110,000
Cash (from swap agreement) $20,000
Other Comprehensive Income $991
Gain on Interest Rate Swap $991
Interest Expense $10,000
Loan Payable $1,000,000
Cash $1,000,000
The $991 credited to OCI and Gain on Interest Rate Swap represent the
increase in the value of the swap payment receivable stemming from the
passage of time (i.e., accrued interest revenue).
Continued with Example 5. On October 1, 2014, Wong Company
entered into a firm commitment to purchase a piece of specialized
sewing equipment from a British company on January 1, 2015, at price
of 100,000.
To protect against unfavorable exchange rate changes, Wong also
purchased a call option contract allowing Wong to purchase 100,000 on
January 1, 2015, at an exchange rate of 1=HK$12, which was also the
exchange rate on October 1, 2014.
The British pound call option costs Wong HK$5,000.
No entry is made to record the firm commitment since it is not a
purchase, but is just an agreement to purchase.
Because Wong paid cash for the British pound call option, the following
journal entry is made on October 1, 2014:
Oct. 1, Call Option (asset) $5,000

2014 Cash $5,000
Example 9: Contd
Assume that the actual exchange rate on December 31, 2014, is
1=HK$12.2.
At this exchange rate, Wong will receive HK$20,000 payment on
January 1, 2015, to settle the call option.
Accordingly, on December 31, 2014, the call option is worth HK$20,000.
Because the call option hedged for a firm commitment is considered a
fair value hedge, the adjusting entries to recognize the change in the fair
value of the call option and the change in the fair value of the firm
commitment are as follows:
Dec. 31, Call Option (20,000 5,000) $15,000

2014
Gain on Call Option $15,000
Loss on Firm Commitment $15,000

Firm Commitment (liability) $15,000
Example 9: Contd
The full cost of change in the firm commitment is $20,000. However, the
change in the value of the hedged item is recognized to the extent to
offset the change in the value of the hedge.
The journal entries necessary in Wongs books on January 1, 2015, to
record the purchase of the equipment and the cash settlement of the
option contract are as follows:
Jan. 1, Cash $20,000
2015 Call Option $20,000
Equipment* $1,205,000
Firm Commitment 15,000
Cash $1,220,000
* The treatment effectively includes the HK$5,000 cost of the call option
as part of the hedged purchase price of the equipment.

Example 9: Contd
Disclosure. Below is the information that Wong should disclose in
relation to the call option contract as of December 31, 2014:
Wong Company
Disclosure About Fair Value Hedges
December 31, 2014
Notional Fair Value

Amount
Call Option for British Pounds asset HK$1,200,000 HK$20,000
A gain (and offsetting loss on the hedged item) of HK$15,000 has been
recognized in 2014 in relation to this call option. This cumulative loss
recognized on the hedged firm commitment is HK$15,000.

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Accounting for Derivatives

and Hedging Activities

Dr. Derek K. Chan

Accounting for Derivatives 1

Please refer to Appendix A of the textbook for the accounting for

Accounting for Derivatives 2

Accounting for Derivatives 3

Accounting for Derivatives 4

A derivative usually (1) requires little or no initial net

Accounting for Derivatives 6

Accounting for Derivatives 7

On October 1, 2014, you purchase 5,000 shares of common stock

On January 1, 2015, you need to make a tuition payment of

Accounting for Derivatives 8

The answer to your problem is the following agreement:

If the price of Don stock is above $4 per share on January 1,

The broad name given toAccounting

Because of the structure of the agreement, you wind up with $20,000 on

Accounting for Derivatives 10

A hedge is a transaction entered into to reduce risk.

In Example 1, how much money will change hands between you

Here, we make the following simplest assumptions: (1) you and

Under these two assumptions, the money exchanged at the signing

How should this information be reflected in the asset section of

Accounting for Derivatives 14

Recognition of derivative receivable? NO YES

Historically, the accepted accounting treatment was Option #1.

Substance: A non-cancelable sale/purchase order for a

Accounting for Derivatives 16

The current exchange rate is 100=HK$6.

In order to be assured of the dollar amount that will be received,

This forward contract guarantees the HK dollar amount that

Given the exchange rate on January 1, 2015, if 10,000,000 is

If 10,000,000 is worth more than HK$600,000, Merry pays

Therefore, no yen need be delivered as part of the contract;

Accounting for Derivatives 19

Value of 10,000,000 HK$630,000 HK$600,000 HK$570,000

Receipt (payment) to settle forward contract

Accounting for Derivatives 20

Accounting for Derivatives 21

On December 1, 2014, Kamei decides to protect itself against

This is a standardized, exchange-traded futures contract, so Kamei

As with other derivatives, a wheat futures contract is usually

If the price of wheat is less than $40 per bushel on January 1,

If the price of wheat is greater than $40 per bushel on January

Accounting for Derivatives 23

$38 $40 $42

Cost to purchase 1,000 bushels ($38,000) ($40,000) ($42,000)

Receipt (payment) to settle futures (2,000) -0- 2,000

Accounting for Derivatives 24

A swap is a contract in which two parties agree to

Accounting for Derivatives 25

So Patell enters into an interest rate swap agreement whereby

Accounting for Derivatives 27

Variable interest payment ($70,000) ($100,000) ($130,000)

Receipt (payment) for interest rate swap (30,000) -0- 30,000

Net interest payment in 2015 ($100,000) ($100,000) ($100,000)

The interest rate swap agreement has changed Patells uncertain

Accounting for Derivatives 30

A firm commitment is not a purchase, but is a firm agreement

The agreed-upon price of the equipment is 100,000, and the

The exchange rate on October 1, 2014, is 1=HK$12.