Appendix 17A:

Accounting for
Investments in
Derivative Financial
Instruments

Understanding
derivatives

a. Forward Contract:

Gives holder the right and obligation to

purchase
an asset at a preset price for a specified
period of
time.
Example:
Dell enters into a contract with a
broker for delivery of 10,000
shares of Google stock in three
months at its
current price of $110 per share.
=> $1,100,000
Dell has received the right to receive

Understanding
derivatives

b. Option Contract:

Gives the holder the right, but not the

obligation, to buy
share at a preset price for a specified period
of time.

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

both involve a future delivery of stock.

The value of each of these contracts relies on

the underlying
asset the Google stock.

Therefore, these financial instruments (the

FORWARD and
the OPTION contracts) are known as
derivatives because
they derive their value from values of other
assets
(e.g., Google stocks or other stocks or bonds
or commodities).

Who uses derivatives?

a. Producers and consumers: Hedgers

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.

Both companies, the producer and the

consumer, are hedgers.
They hedge (protect) their positions to
ensure an acceptable financial
outcome.

Why use derivatives?

-Changes in the price of jet
fuel:
Delta,
Continental,
United.
-Changes in interest rates:
Citigroup, AIG, BoA..
-Changes in exchange rates:
GE, GM, Cisco ..

Accounting guidelines for

derivatives (FAS 133)
a. Recognized as assets and liabilities.

b. Reported at fair value.

c. UNREALIZED Gains
and losses from
speculation in
derivatives recognized in income
immediately.

d. UNREALIZED Gains and losses from

hedge transactions
reported in accordance with the type
of hedge

Derivative financial investment

-Speculation.

Call option:Gives the holder the right, but not

the obligation, to buy shares at a preset price
(strike price or exercise price).

A company (speculator) can realize a gain

from the increase
in the value of the underlying share with the
use of a Call Option a derivative.

Example: A company enters

into a call option
contract on January 2, 2007, with Baird investment
Co., which gives it the option to purchase 1,000
shares (referred to as the notional amount)
of Laredo stock at $100 per share. On January
2nd, the Laredo shares are trading at $100 per
share. The option expires on April 30, 2007. The
company purchases the call option for $400.
If the price of Laredo stock increases above
$100, the company can exercise this option

Derivative financial investment

-Speculation.

Accounting entries:
(1) To record purchase (option premium) of
call option:

Call Option
Cash

400
400

The option premium consists of two

amounts:

Intrinsic Value & Time value

*Option premium = Intrinsic value + Time value;

(a)Intrinsic value = Preset strike price - Market

price
On January 2, the intrinsic value is ZERO
because
the market price equals the preset strike price.
(b)Time value is estimated using an optionpricing model.

Derivative financial investment

-Speculation.
(2) FYE Adjustments: March 31, 2007:
a. To record increase in intrinsic value of option:
On March 31, 2007, Laredo shares are trading at
$120 per share.
Therefore, the Intrinsic Value of the Call Option
is now:
$20,000 = $120,000 $100,000.

This gives the company an unrealized gain of:

$20,000 = $20,000 - $0.
The company records the increase in intrinsic
value as follows:
Call Option
20,000

Derivative financial investment

-Speculation.
(b) To record decrease in time value of the
option:
On March 31, 2007, a market appraisal
indicates that
the time value of the option is $100.

This gives the company an unrealized loss of

$300:
$300 = $400 - $100
The company records this change in time
value as follows:
Unrealized Holding Gain or LossIncome
300

Derivative financial investment

-Speculation.
(4) To record the settlement of the call option
contract with
Baird on April 1, 2007:
On April 1, 2007, the company exercises the
call option
(simultaneously buys and sells) and records
the settlement
of the call option with Baird as follows:

Cash (120,000 100,000 = net cash)

20,000
Loss on Settlement of Call Option
100
Call Option
20,100

Derivative financial investment

-Speculation.
Effects of the call option on net income:

Date
(Loss) Effect

Transaction

Income

March 31, 2007

$19,700

Net increase in value of call option

April 1, 2007
(100)

Settle call option

Total net income

$19,600

Derivative financial investment

-Speculation.
Financial statement
reporting:
(1)Call option is reported as an asset at
fair value.

(2) Any gains or losses (unrealized or

realized) are
reported in income.

Three basic characteristics of Derivative

Instruments(FAS 133)
1.

The instrument has one or more

underlyings and an
identified payment provision.

2. The instrument requires little or no

investment at the
inception of the contract.

3. The instrument requires or permits net

settlement.

Three basic characteristics of Derivative

Instruments(FAS 133)
1.

The instrument has one or more underlyings

and an identified
payment provision.

An underlying is a specified stock price, interest

rate, commodity price, index of prices or rates,
or other market-related variable.

The interaction of the underlying, with the face

amount or the number of units specified in the
derivative contract (the notional amounts),
determines payment.

Example:
The underlying is the stock price of Laredo
stocks.
The value of the call option increased in value

Three basic characteristics of Derivative

Instruments(FAS 133)
2. The instrument requires little or no
investment at the
inception of the contract.
Example:
The company paid a small premium to
purchase the call option an amount much less
than if purchasing the Laredo shares as a
direct investment.

3. The instrument requires or permits net

settlement.
Example:
The Laredo stock Call Option allows the
company to realize a profit on the call option
without taking possession of the shares.

Derivatives Used for Hedging

Hedging is the use of derivatives to reduce
Price risk, interest rate risk and exchange
rate risk.

(1) Interest rate risk is risk that changes in

interest rates will
negatively affect the fair-values or cash flow
of interest
sensitive assets and liabilities.

(2) Exchange rate risk is the risk of foreign

exchange rates
negatively affecting profits.

SFAS 133 (ASC 815) establishes accounting

and reporting standards for derivative
financial Instruments used in hedging

Derivatives Used for Hedging FV

Hedge
a. Fair value hedge:

A derivative used to hedge (offset) the

exposure to
changes in the fair value of a recognized
asset or liability,
or of an unrecognized commitment.

In a perfectly hedged position, the gain or

loss on the
fair value of the derivative equals and
offsets that of the
hedged asset or liability.

(1) Interest rate swaps:Used to hedge the risk

that changes
in interest rates will have a negative impact

Derivatives Used for Hedging FV

Hedge
Put Option
An option contract giving the
owner the right, but not the
obligation, to sell a specified
amount of an underlying security
(STRIKE PRICE)
at a specified price
within a specified time.
A put becomes more valuable as
the price of the underlying stock
depreciates (falls) relative to the
strike price.

Derivatives Used for Hedging FV

Hedge
Put Option
Example:
On March 1, 2007, you purchased a March 08
Taser 10 put.
That means, you have the right to sell 100
shares of Taser at
$10 until March 2008 (usually the third Friday
of the month).

If shares of Taser fall to $5 and you exercise

the option, you
can purchase 100 shares of Taser for $5 in
the market and sell the shares to the option's
writer for $10 each, which means
you make $500 = (100 x ($10-$5)) on the put

Derivatives Used for Hedging FV

Hedge
Accounting for a Fair Value Hedge
-Put option:
Example:
On April 1, 2006, Hayward Co.
purchases 100 shares of Sonoma stock
at a market price of $100 per share.

Hayward does not intend to actively

trade this investment. It consequently

classifies the Sonoma investments as
available-for-sale (AFS).
On December 31, 2006, Sonoma shares
are trading at $125 per share.

Derivatives Used for Hedging FV

Hedge
(a) Hayward records this AFS investment as
follows on 4/1/2006:
AFS Securities
10,000
Cash
10,000
(b) On December 31, 2006, Sonoma shares are
trading at $125 per
share.
Following the rules of FAS 115, Hayward records
AFS securities at FMV on the Balance sheet and
reports unrealized gains and losses in equity as
part of Other Comprehensive Income:

AFS Securities
2,500

<=(125100)*100

Derivatives Used for Hedging FV

Hedge
(c) Balance Sheet presentation of the
Sonoma Investment
on 12/31/2006:

Assets
Available-for-securities (at FMV)
$12,500

Shareholders Equity
Accumulated other comprehensive income
Unrealized Holding Gain (loss)
$2,500

Derivatives Used for Hedging FV

Hedge

(d) Hedge Derivative:

Hayward is exposed to the risk that the price of

the Sonoma stock will decline. To hedge this risk,
Hayward locks in its gain on Sonoma investment
by purchasing a put option on 100 shares of
Sonoma stock.

Hayward enters into a put option on January 2,

2007, and designates the option as a fair value
hedge of the Sonoma investment. This put option
(which expires in two years) gives Hayward the
option to sell 100 Sonoma shares at a price of
$125.

To record a purchase, assuming no premium paid:

January 2, 2007:
No entry required.
A memorandum indicates the signing of the put

Derivatives Used for Hedging FV Hedge

SPECIAL ACCOUNTING FOR THE HEDGED ITEM
(FAS 133):
Once the hedge is designated, accounting for any
unrealized gain or loss
on available for-sale securities is recorded in income,
NOT in equity.

(e) On December 31, 2007, Sonoma shares are trading

at $120 per share:
Following the rules of FAS 115, Hayward records AFS
securities at FMV on
the Balance sheet and following the rules of Special
Accounting of FAS 133,
reports unrealized gains and losses in Income:

Unrealized Holding Gain (loss) -Income

AFS Securities

500
500

To record an increase in the value of the put option:

Put Option
500

Derivatives Used for Hedging FV Hedge

(f) Financial statement disclosure:
(i) Balance sheet:Both the investment security and the
put option are
reported at fair value.

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

Derivatives Used for Hedging FV Hedge

(f) Financial statement disclosure:
(ii) Income statement:any unrealized gain or loss on
the investment
security and the put option is reported under Other
Income or
Other Expense.

HAYWARD CO.
Income Statement (Partial)
FYE December 31, 2007

Other Income
Unrealized holding gain (loss) Put Option
$ 500

Unrealized holding gain (loss) AFS Securities

(500)

Income Statement:
The income statement indicates that the gain on the put
option offsets
the loss on the AFS securities.

Derivatives Used for Hedging CF Hedge

Cash flow hedges
Cash flow hedges are used to hedge exposure
to cash flow risk.
Cash Flow risk arises from the variability in
cash flows.

Who uses Cash Flow hedge?

Producers and consumers.
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

Derivatives Used for Hedging CF Hedge

Example:
In September 2006 Allied Can Co. anticipates
purchasing
1,000 tons of Aluminum in January 2007.
Concerned that price for aluminum will
increase in the
next few months, Allied wants to hedge the
risk that it
might have to pay higher prices for aluminum
in January 2007.

As a result, Allied enters into an aluminum

futures contract (forward contract).

Derivatives Used for Hedging CF Hedge

Futures contract:
Gives holder the right and obligation to purchase
an asset at a preset (strike) price for a
specified period of time.

Spot price:
Price of an asset today, that will be delivered
sometime in the future.

Example:

The September 2006 aluminum future contract

gives Allied the right and the obligation to
purchase 1,000 tons of aluminum for a strike price
of $1,550 per ton. The contract expires in January
2007.
The underlying for this derivative is the price of
aluminum.
If the price of aluminum rises above $1,550, the

Derivatives Used for Hedging CF Hedge

Accounting Entries:
(1)Assume that in September 2006, the spot
price equals the strike price. With the two
prices equal, the futures contract has no value.

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.

Derivatives Used for Hedging CF Hedge

SPECIAL ACCOUNTING:
The FASB allows special accounting for
cash flow hedges.
Generally, FAS 133 requires companies to
measure and report derivatives at fair
value on the balance sheet and report
gains and losses directly in net income.

However, FAS 133 allows companies to

account for derivatives used in cash flow
hedges at fair value on the balance sheet,
but record gains and losses in equity, as
part of other comprehensive income.

Derivatives Used for Hedging CF Hedge

(2) To record increase in value of futures
contract due to
increase in spot price:
At December 31, 2006, the price for January
delivery of aluminum increases to $1,575 per
ton.

December 31, 2006

Allied makes the following entry to record the
increase in the value of the futures contract.

Futures Contract
25,000
Unrealized Holding Gain or LossEquity
25,000*
*25,000 = ($1,575 $1,550) x 1,000 tons

Allied reports the future contract in the balance

Derivatives Used for Hedging CF

Hedge
Financial statement disclosure:
Balance sheet:

Allied Can CO.

Balance Sheet (Partial)
December 31, 2006
Current Assets
Futures contract (@ FMV)
$25,000

Shareholders Equity
Accumulated other comprehensive income:
Unrealized Holding Gain (loss)
$25,000

Derivatives Used for Hedging CF Hedge

Since Allied has not yet purchased and

sold the inventory, this gain is an
Anticipated Transaction.
In this type transaction,
a company accumulates in equity
gains and losses on the futures
contract as part of other
comprehensive income until the period
in which it sells the inventory, thereby
effecting earnings.

Derivatives Used for Hedging CF Hedge

(3) To record settlement of futures contract
(assuming spot price
exceeded contract price):
January 2007
On January 31, 2007, Allied purchases 1,000 tons of
aluminum for $1,575 and makes the following entry:

Inventory -Aluminum
1,575,000
Cash ($1,575 x 1,000 tons = $1,575,000)
1,575,000

On the same date, Allied makes final settlement on

the futures contract and records the following entry:
Cash
25,000
Futures Contract ($1,575,000 - $1,550,000)

Derivatives Used for Hedging CF Hedge

Through the use of the futures contract derivative,
Allied has effectively hedged the cash flow for the
purchase of inventory protected itself against the
rising cost of its inventory.
The $25,000 futures contract settlement offsets the
amount paid to purchase the inventory at the
prevailing market price of $1,575,000.

The result: Net cash outflow of $1,550 per ton.

Actual Cash Flows:
Actual cash paid
$1,575,000
Less: Cash received on settlement of future
contract
(25,000)
Net cash outflow
$1,550,000

Note:
There are no income effects at this point!!!
<=Anticipated Transaction

Derivatives Used for Hedging CF

Hedge

Financial statement disclosure:

Balance sheet:

Allied Can CO.

Balance Sheet (Partial)
January 31, 2007
Current Assets
Inventory

$1,575,000

Shareholders Equity
Accumulated other comprehensive income:
Unrealized Holding Gain (loss)

$25,000

Derivatives Used for Hedging CF Hedge

(4) To record disposition of unrealized loss when
goods are sold:

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.

Allied sells the cans in July 2007 for $2,000,000, and

records this sale as follows:
Cash
2,000,000
Sales Revenue
2,000,000

Cost of Goods Sold

1,700,000
Inventory Cans
1,700,000

Since the effect of the anticipated transaction has now

affected earnings, Allied makes the following entry

Derivatives Used for Hedging CV Hedge

Income statement:

Allied Can Co.

Income Statement (Partial)
FYE July 31, 2007

Sales Revenue
$2,000,000

Cost of Goods Sold

1,675,000*
Gross Profit
_ 325,000

*Cost of Inventory
$1,700,000
Less: Futures contract adjustment
25,000
Cost of goods sold
$1,675,000

Derivatives Used for Hedging CF Hedge

The gain on the future contract, which
Allied reported as part of other
comprehensive income, now reduces cost
of goods sold.

As a result, the cost of aluminum

included in the overall cost of goods sold
is $1,550,000.

The futures contract has worked as

planned!!!

Allied has managed the cash paid for

aluminum inventory and the amount of
cost of goods sold.

Learning Objective (LO) 13:

Other reporting issues

NOT COVERED!!

LO 14: Disclosure provisions

Primary disclosure requirements:
Financial instruments are to be disclosed at their
fair value and related carrying value in a note or a
summary table form.
For derivative financial instruments, a firm should
disclose its objectives for holding or issuing those
instruments (speculation or hedging), the hedging
context (fair value or cash flow), and its strategies
for achieving risk management objectives.

A company should not combine, aggregate, or net

the fair value of separate financial instruments.
The net gain or loss on derivative instruments
designated in cash flow hedges should be reported