Professional Documents
Culture Documents
Accounting for
Investments in
Derivative Financial
Instruments
Understanding
derivatives
a. Forward Contract:
Understanding
derivatives
b. Option Contract:
Example:
Dell enters into a contract with a broker
for an option (right) to purchase 10,000
shares of Google shares at its current price
of $110 per share.
The broker charges $3,000 for holding the
contract open for two weeks at a set price.
Dell has received the right, but not the
Concept of Derivative
Instruments
The forward contract and
the option contract
Example:
Heartland Large producer of potatoes
McDonald Large consumer of potatoes (French
fries)
The objective is not to gamble on the
outcome or to profit
but to lock in a price at which both of
them obtain an acceptable profit.
c. UNREALIZED Gains
and losses from
speculation in
derivatives recognized in income
immediately.
Accounting entries:
(1) To record purchase (option premium) of
call option:
Call Option
Cash
400
400
Date
(Loss) Effect
Transaction
Income
April 1, 2007
(100)
$19,600
Example:
The underlying is the stock price of Laredo
stocks.
The value of the call option increased in value
AFS Securities
2,500
<=(125100)*100
Assets
Available-for-securities (at FMV)
$12,500
Shareholders Equity
Accumulated other comprehensive income
Unrealized Holding Gain (loss)
$2,500
500
500
HAYWARD CO.
Balance Sheet (Partial)
December 31, 2007
Assets
Available-for-Sale securities (@ FMV) $12,000
Put Option (@ FMV)
500
Shareholders Equity
Accumulated other comprehensive income:
Unrealized Holding Gain (loss)
$2,500
Balance Sheet:
By using fair value accounting for both financial instruments,
the financial statements reflect the underlying substance
HAYWARD CO.
Income Statement (Partial)
FYE December 31, 2007
Other Income
Unrealized holding gain (loss) Put Option
$ 500
Income Statement:
The income statement indicates that the gain on the put
option offsets
the loss on the AFS securities.
Spot price:
Price of an asset today, that will be delivered
sometime in the future.
Example:
September 2006
No entry is necessary!
A memorandum indicates the signing of the
futures contract and its designation as a cash
flow hedge for future purchase of aluminum
inventory.
Futures Contract
25,000
Unrealized Holding Gain or LossEquity
25,000*
*25,000 = ($1,575 $1,550) x 1,000 tons
Shareholders Equity
Accumulated other comprehensive income:
Unrealized Holding Gain (loss)
$25,000
Inventory -Aluminum
1,575,000
Cash ($1,575 x 1,000 tons = $1,575,000)
1,575,000
Note:
There are no income effects at this point!!!
<=Anticipated Transaction
$1,575,000
Shareholders Equity
Accumulated other comprehensive income:
Unrealized Holding Gain (loss)
$25,000
July 2007
Assume that Allied processes the aluminum into finished
goods (cans).
The total cost of the manufactured cans (including the
aluminum purchases
of $1,575,000 in January 2007) is $1,700,000.
Sales Revenue
$2,000,000
*Cost of Inventory
$1,700,000
Less: Futures contract adjustment
25,000
Cost of goods sold
$1,675,000
NOT COVERED!!