Professional Documents
Culture Documents
Presentation by
Bob Jensen Trinity University One Trinity Place San Antonio, TX 78212
rjensen@trinity.edu
http://www.trinity.edu/rjensen/
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Bob Jensen 190 Sunset Hill Road Sugar Hill, NH 03586 Phone 603-823-8482 rjensen@trinity.edu
http://www.trinity.edu/rjensen/
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http://www.trinity.edu/rjensen/caseans/000index.htm
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Debt securities that the enterprise has the positive intent and ability to hold to maturity are classified as held-to-maturity securities and reported at amortized cost. Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value, with unrealized gains and losses included in earnings. Debt and equity securities not classified as either held-to-maturity securities or trading securities are classified as available-for-sale securities and reported at fair value, with unrealized gains and losses excluded from earnings and reported in a separate component of shareholders' equity.
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classify items of other comprehensive income by their nature in a financial statement and display the accumulated balance of other comprehensive income (AOCI) separately from retained earnings and additional paid-in capital in the equity section of a statement of financial position.
(b)
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Financial Derivatives & Scandals Explode in the Early 1990's Video or Audio clip from CBS Sixty Minutes SIXTY01.avi or SIXTY01.mp3 Audio clip from John Smith of Deloitte & Touche in August 1994 SMITH01.mp3 Examples of derivative contracts that even the professional analysts could not decipher q The derivatives that Merrill Lynch wrote that drive Orange County into bankruptcy q Other derivatives fraud summaries are at http:// www.trinity.edu/rjensen/fraud.htm#DerivativesFraud Video and audio clips of FASB updates on FAS 133 q Audio 1 --- Dennis Beresford in 1994 in New York City BERES01.mp3 q Audio 2 --- Dennis Beresford in 1995 in Orlando BERES02.mp3 Derivative Financial Instrument Frauds --- Off line --- Click Here 1-9
Requires booking of most derivative financial instruments at fair value (with some exceptions for NPNS, regular-way, insurance contracts, weather derivatives, short sales, interest-strips, etc.) Derivatives are to be marked to current fair value at least every 90 days and on reporting dates. Changes in fair value are to be charged or credited to current earnings unless the derivatives qualify for hedge accounting treatment as cash flow, fair value, or FX hedges. Not all economic hedges qualify for hedge accounting relief from current earnings.
Hedge accounting rules under FAS 133 and its amendments are very complex.
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Purchase Commitment | Firm Commitment | Forecasted Transaction | Speculation Stand Alone | Cash Flow Hedge | Fair Value Hedge | FX Hedge Purchased Options | Written Options | Long Forwards | Short Forwards | Swaps | Futures Contracts European versus American versus Asian options Spot Price, Forward Price, Strike Price, Premium, Intrinsic Value, Time Value
Freestanding, Embedded, Structured (tailormade rather than convential financing) OCI versus Firm Commitment | Delta
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Bob Jensen's threads on Enron are at http://www.trinity.edu/rjensen/fraud.htm Bob Jensen's threads on Derivative Financial Instruments Fraud are at http://www.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds Also note http://www.trinity.edu/rjensen/Fraud.htm#FrankPartnoyTestimony How Enron Used SPEs and Derivatives Jointly is Explained at http://www.trinity.edu/rjensen//theory/00overview/speOverview.htm Bob Jensens threads on derivatives accounting are at http://www.trinity.edu/rjensen/caseans/000index.htm
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Frank Partnoys Works Of all the many documents and books that I have read about derivative financial instruments, the most important have been the books and documents written by Frank Partnoy. Some of his books are listed at the bottom of this message.
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Testimony of Frank Partnoy Professor of Law, University of San Diego School of Law Hearings before the United States Senate Committee on Governmental Affairs, January 24, 2002 --http://www.senate.gov/~gov_affairs/012402par
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FIASCO: The Inside Story of a Wall Street Trader FIASCO: Blood in the Water on Wall Street FIASCO: Blut an den weien Westen der Wall Street Broker. FIASCO: Guns, Booze and Bloodlust: the Truth About High Finance Infectious Greed : How Deceit and Risk Corrupted the Financial Markets Codicia Contagiosa His other publications include the following highlight: "The Siskel and Ebert of Financial Matters: Two Thumbs Down for the Credit Reporting Agencies" (Washington University Law Quarterly)
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Undisclosed Assets and Liabilities Unbooked Assets and Liabilities Meaningless Measures of Value & Risk Rise in Scandals in the 1980s & 1990s Complex Frauds --- Partnoys Fiasco Explosion of Swap Contracts Evolution Toward Fair Value Accounting
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Complex Contracts & Technical Jargon Complex Scoping of Coverage --- NPNS Complex Hedge Accounting Rules Many Derivatives Are Difficult to Value Difficult to Find Embedded Derivatives Complex Effectiveness Testing Rules Continuous Stream --- DIG, Amendments Implementation Failures --- Freddie Mac, etc. Held-to-Maturity Interim Distortions Hedge Acctg. Denied to Most Macro Hedges
Differences are relatively minor IAS 39 Macro Hedging Amendment Listing of Major Differences
http://www.trinity.edu/rjensen/caseans/canada.htm
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Determine whether a contract is scoped into the standards and, if so, whether it is Qualified for Hedge Accounting Treated as a cash flow, fair value, or FX hedge Understand the basic journal entries Cry out loud if forced to implement the standards
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One million lines of journal entries: Just how expensive is FAS 133?
"The Potential Crisis at Fannie Mae," Comstock Funds, August 11, 2005 --- http://snipurl.com/Fannie133 We have no proprietary information about Fannie Mae, but what is publicly known is scary enough. As you may recall, last December the SEC required Fannie to restate prior financial statements while the Office of Federal Oversight (OFHEO) accused the company of widespread accounting regularities that resulted in false and misleading statements. Significantly, the questionable practices included the way Fannie accounted for their huge amount of derivatives. On Tuesday, a company press release gave some alarming hints on how extensive the problem may be. The press release stated that in order to accomplish the restatements, we have to obtain and validate market values for a large volume of transactions including all of our derivatives, commitments and securities at multiple points in time over the restatement period. To illustrate the breadth of this undertaking, we estimate we will need to record over one million lines of journal entries, determine hundreds of thousands of commitment prices and securities values, and verify some 20,000 derivative prices This year we expect that over 30 percent of our employees will spend over half their time on it, and many more are involved. In addition we are bringing some 1,500 consultants on board by years end to help with the restatementAltogether, we project devoting six to eight million labor hours to the restatement. We are also investing over $100 million in technology projects to enhance or create new systems related to accounting and reportingwe do not believe the restatement will be completed until sometime during the second half of 2006 Bob Jensen's tutorials on accounting for derivatives are at http://www.trinity.edu/rjensen/caseans/000index.htm
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FOUR CORNERSTONES
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Derivatives are contracts that create rights and obligations that meet the definitions of assets and liabilities Fair value is the only relevant measure for derivatives (Mainly because historical cost is zero or near-zero) Value risk can be hedged into cash flow risk, and cash flow risk can be hedged into value risk, but both risks cannot simultaneously be eliminated. Hedge effectiveness tests can be varied with the type of risk being hedged.
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May be contracts to buy or sell at contracted (future) price that moves along with spot prices on an organized exchange linking buyers and sellers. Cost = Zero! Notional = standardized quantities per contract for a standard product such as a particular type of corn. Underlying = the value per unit such as the price of a bushel of corn or a Treasury or Libor interest rate. Futures are a unique kind of derivative because futures gains and losses are posted daily in cash.
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Since futures contracts are cleared daily for cash, the accounting was relatively simple under the nowdefunct FAS 80.
FAS 133 rules are more complicated for hedging contracts --- see 000starta.xls file at http://www.cs.trinity.edu/~rjensen/Calgary/CD/FAS133Other CBOT --- http://www.cbot.com/ The prices you first see listed are the forward prices. To find spot prices, click on the link called "Charts."
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May be contracts to buy or sell at contracted (future) price that moves along with spot prices in over-thecounter (OTC) private contracts. Cost = Zero! Notional = unique quantities per contract for a defined product such as a particular type of corn. Underlying = the value per unit such as the price of a bushel of corn or a Treasury or Libor interest rate. Unlike futures contracts, forward contracts are neither standardized nor cleared daily for cash gains and losses.
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There were no accounting rules for forward contracts prior to FAS 133.
FAS 133 rules are complicated for hedging contracts --see 000starta.xls file at http://www.cs.trinity.edu/~rjensen/Calgary/CD/FAS133Other CBOT --- Does not exchange forward contracts Contracts are non-standardized and might be subject to credit risk.
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Swaps are generally portfolios of forward contracts with regularly-spaced payment dates. Cost = Zero! Notional = unique quantities per contract for a defined product such the number of bonds being hedged. Underlying = the value per unit such as the price of a bushel of corn or a Treasury or Libor interest rate. Interest rate swaps were only invented in 1984, but they became the leading form of cash management and now have notionals over $100 trillion dollars..
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There were no accounting rules for swap contracts prior to FAS 133.
FAS 133 rules are complicated for hedging contracts --see 000starta.xls file at http://www.cs.trinity.edu/~rjensen/Calgary/CD/FAS133Other There are a few standardized swaps traded on exchanges Contracts are non-standardized and might be subject to credit risk.
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Contracts to sell or buy at contracted (future) price that moves along with spot prices on an organized exchange linking buyers and sellers. Sale Price > $0=Premium! Example: Selling Puts or Calls. Notional = standardized quantities per contract for a standard product such as a particular type of corn. Underlying = the value per unit such as the price of a bushel of corn or a Treasury or Libor interest rate. Options may also be non-standardized OTC. Use of options dates back to Roman times.
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Contracts to buy or sell at contracted (future) price that moves along with spot prices on an organized exchange linking buyers and sellers. Purchase Price > $0=Premium! Example: Buying Puts or Calls. Notional = standardized quantities per contract for a standard product such as a particular type of corn. Underlying = the value per unit such as the price of a bushel of corn or a Treasury or Libor interest rate. Purchased options are the only derivatives where risk is limited to the premium (purchase) price paid initially.
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The accounting was relatively simple under the nowdefunct FAS 80.
FAS 133 rules are more complicated for hedging contracts --- see 000starta.xls file at http://www.cs.trinity.edu/~rjensen/Calgary/CD/FAS133Other
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Most derivatives are reported at fair value on balance sheet Changes in fair value for derivatives not qualifying in a hedging relationship are recorded in earnings Hedge accounting is provided for the change in value of derivatives designated and qualifying as:
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DIG is made up of FASB staff members, Big 5 members and Industry professionals. Active DIG observers include the SEC and certain regulators. DIGs mandate is to assist the FASB in answering implementation questions by identifying practice issues that arise from applying Statement 133 and to advise the FASB staff on how to resolve the issues. Issues are discussed by DIG, tentatively concluded by the FASB staff and posted on the FASB website (www.fasb.org) for two months before being presented to the Board for negative clearance.
DIG Site http://www.fasb.org/derivatives/
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Flow chart for deciding whether derivative is scoped into FAS 133
Flow chart for deciding how to account for a derivative financial instrument qualified for hedge accounting. Cash Flow Hedge (booked item vs. forecasted transact.) Fair Value Hedge (booked item vs. firm commitment) Foreign Currency (FX) Hedge (fair value vs. cash flow)
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The definition is based on distinguishing characteristics A derivative instrument is a contract with all three of the following characteristics (6):
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Underlying and either a notional amount or a provision or both Relatively small initial net investment (5% Rule in Para A5 of FAS 149)
payment
Net settlement or its equivalent (excludes most short sales & Take-OrPays, but see FAS 133 Paragraph 290)
Definition includes freestanding as well as embedded derivative instruments A number of exclusions exist
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Statement 133 created a new definition of the term derivative Some instruments that are not usually considered derivatives are included (e.g. certain purchase/sales contracts) The definition is based on certain distinguishing characteristics. Certain scope exceptions exist; not everything that meets the definition of a derivative is subject to the requirements of Statement 133.
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An interest rate (e.g., LIBOR) The price of a security or commodity (e.g., price of a share of ABC stock or a bushel of wheat) A foreign exchange rate (e.g., Euro/U.S. $ spot rate) A measure of creditworthiness (e.g., Moodys) An index on any of above or other (e.g., S&P 500, CPI) Other specific items
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Notional amount is used to determine the settlement amount (for example, a price x a number of shares)
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Notional Amount
- Number of shares - Number of
- Commodity future - Commodity price - Number of commodity units - Interest rate swap - Interest index - Dollar amount
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No initial net investment A smaller initial net investment than other types of contracts that have a similar response to changes in market factors
A derivative does not require an initial net investment of the notional amount An exchange of currencies is not a net investment
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FREESTANDING DERIVATIVES Characteristic 3Readily Convertible to Known Amounts of Cash 9 and 57(c)
Readily convertible assets have:
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Interchangeable (fungible) units Quoted prices available in an active market that can rapidly absorb the quantity held by the entity without significantly affecting the price Public securities, commodities, and foreign currencies
For example:
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Regular-way security trades Normal purchases and normal sales Traditional insurance contracts Most financial guarantee contracts OTC contracts with certain underlyings Derivatives that are an impediment to sales accounting
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Contracts that permit net settlement (9a) Contracts that have a market mechanism to facilitate net settlement (but note FAS 138) FAS 149 Electric Power Bookout Exception
As long as it is probable contracts will not settle net and will result in physical delivery (but note FAS 138 and FAS 149)
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(1 )
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FREESTANDING DERIVATIVES Exceptions OTC Contracts with Certain Underlyings 10(e) and 58(c)
Climatic variables:
q q q
Temperature Rain or snowfall totals Wind speed Earthquake severity (Richter scale)
Geological variables:
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FREESTANDING DERIVATIVES ExceptionsOTC Contracts with Certain Underlyings 10(e) and 58(c)
The price or value of nonfinancial assets of one of the parties that is not readily convertible to cash or the price or value of nonfinancial liabilities of one of the parties that does not require delivery of readily convertible assets
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Option to purchase or sell real estate owned by one party (even if it can be net settled) Firm commitment to sell machinery (if unique) owned by one party (even if it can be net settled)
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FREESTANDING DERIVATIVES Exceptions OTC Contracts with Certain Underlyings 10(e) and 58(c)
Exceptions include specified volumes of sales or service revenues of one of the parties. For example:
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FREESTANDING DERIVATIVES Contracts Not Considered Derivatives for Purposes of Statement 133, 11
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Instruments indexed to an entitys own stock and classified in stockholders equity Stock-based compensation covered by Statement 123 (issuer only) Contingent consideration in a business combination covered by Opinion 16 (purchaser only)
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Embedded derivatives are implicit or explicit terms that affect the cash flows or value of other exchanges required by a contract in a manner similar to a derivative The combination of a host contract and an embedded derivative is referred to as a hybrid contract Examples of hybrid contracts are: q Structured notes q Convertible securities q Securities with caps, floors, or collars
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EMBEDDED DERIVATIVES When Does a Contract Have an Embedded Derivative Subject to This Statement? 12
No
Yes
No
No
Factors to consider:
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Equity
Lease
Inflation Interest
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Hedged item is exposed to price risk For a highly effective hedge, there must be offsetting fair value changes for hedged item and hedging instrument Changes in fair value of hedged item and hedging instrument are recorded in earnings Basis of hedged item is adjusted by the change in value
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In qualified hedge accounting, the offset to changes in the hedging derivative is OCI for cash flow hedges but not for fair value hedges. For a qualified fair value hedge, the offset is = Firm Commitment for a purchase contract with a contracted price = Hedged Item carrying value if the hedged item such as inventory is already on the books at historical cost = P&L current earnings if the hedged item such as inventory is already on the books at fair value
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FAIR VALUE HEDGE ACCOUNTING For Hedged Item Booked at Historical Cost
Measurement of Derivative
Accounting Model
Measurement of Hedged Item Offsetting Gain or Loss Attributable to Risk Being Hedged
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Hedged item may be a forecasted transaction with no contracted future price (i.e., not a firm commit.) Effective portion of derivatives gain or loss reported in OCI Earnings recognition matches hedged transaction Ineffective gain or loss recorded in earnings
Derivative instrument recorded at fair value, effective portion through OCI, ineffective through earnings Amounts in OCI recognized in earnings when hedged transaction impacts earnings under FAS 133 but not under IAS 39. In other words, IAS 39 requires basis adjustment when the derivative expires whereas FAS 133 carries OCI forward until hedged item is disposed of in a transaction.
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Accounting Model
OCI Equity
(1) Earnings
Fair value hedge accounting does not use OCI like in cash flow and FX hedges. The reason is that changes in fair value of hedged items do not change earnings in the same manner as changes in cash flows and FX hedged items. Fair value hedge of a historical cost hedged item requires shifting from historical cost accounting to fair value accounting for the hedged item (but only during the hedging period). Fair value hedge of a firm commitment requires use of a fair value hedge accounting account the FASB invented that is called Firm Commitment but should be named something else.
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Allows entities to voluntarily choose to measure eligible financial instruments at fair value (the fair value option) (Exceptions for items covered by some other standards such as consolidated entities, pensions, post-employment contracts, leases, and financial insurance contracts) Changes in fair value recognized in earnings. (no OCI) Election made on an instrument-by-instrument basis Irrevocable
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Provide an opportunity to mitigate volatility in earnings caused by a mixed attribute accounting model Reduce the need for applying complex hedge accounting provisions Expand the use of fair value measurements International convergence
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Scope:
Recognized financial assets and liabilities (but not forecasted transactions under FAS 133) Firm commitments that would otherwise not be recognized at inception and that involve only financial instruments Written loan commitments Certain rights and obligations under insurance contracts or warranty obligations A financial host contract in a nonfinancial hybrid instrument Certain nonfinancial assets and liabilities
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Hedging Instruments
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For a fair value hedge of foreign exchange risk related to AFS securities or a recognized foreign-currency-denominated debt instrument, an entity can only use a derivative instrument For a fair value hedge of foreign exchange risk related to a firm commitment, an entity can use either a derivative or a nonderivative instrument For a cash flow hedge of a forecasted foreign currency denominated transaction (including forecasted intercompany transactions, recognized foreign-currency-denominated debt instruments and firm commitments accounted for as forecasted transactions), an entity can only use a derivative instrument For a hedge of a net investment in a foreign operation, an entity can use either a derivative or a non-derivative instrument
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2
(1)
$(20) -0$(20)
(2)
(a) those interests in subsidiaries, associates, and joint ventures that are accounted for under IAS 27, Consolidated Financial Statements and Accounting for Investments in Subsidiaries; IAS 28, Accounting for Investments in Associates; and IAS 31, Financial Reporting of Interests in Joint Ventures;
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CASE 1
Cash Flow Hedge of Forecasted Inventory Sale
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ABC is hedging the risk of changes in cash flows related to a forecasted sale of 100,000 bushels of Commodity A to be sold at the end of period 1. The inventory carrying value is $1 million, and current market value is $1.1 million On the first day of period 1, ABC enters into Derivative Z to sell 100,000 bushels at $1.1 million at the end of period At hedge inception, the derivative is at-the-money (fair value is 0) All terms of the commodity and the derivative match (i.e., no expected ineffectiveness) On last day of Period 1, fair value of Derivative Z increased by $25,000 and expected sales price of 100,000 bushels of Commodity A decreased $25,000 From Example 4, Appendix B of Standard
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The variability of cash flows related to the forecasted inventory sale is offset by change in value of derivative.
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ABC has 1,000 bushels of a Commodity with a fair value of $1.1 million and a carrying value of $1.0 million ABC wants to hedge overall fair value of the Commodity On 1/1/X1, ABC enters into an at-the-money matching derivative to hedge the changes in fair value of the 1,000 bushels of the Commodity
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Effectiveness will be assessed by comparing entire change in fair value of derivative to change in market price of inventory (time value will be ignored for illustration purposes only) On 1/31/X1, the fair value of the derivative has increased by $25,000 and the fair value of the inventory has decreased by $25,000
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25,000 25,000
25,000 25,000