Accounting for investments in derivative financial instruments

Appendix 17A:  Accounting for Investments in Derivative Financial Instruments ASC 815 (FAS 133) 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 10,000 shares in three months and incurred an obligation to pay $110 per share at that time 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 obligation to purchase this stock at $110 within the next two weeks 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) Or, their value relates to a market –determined indicator (e.g., interest rates or the S&P’s 500 index) 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 b Speculators and arbitrageurs: Speculators The objective is to gamble on the outcome or to profit based on the 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 (ASC 815) 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 either in OCI or income 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   (referred to as the notional option to purchase 1,000 shares 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 and purchase the shares for $100 per share If Laredo’s stock never increases above $100 per share, the call option is worthless 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 option-pricing model It reflects the possibility that the option has a fair value greater than zero WHY? Because, there is expectation that the price of Laredo shares will increase above the strike price during the option term On January 2, the time value of the option is $400 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 Unrealized Holding Gain or Loss—Income 20,000 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 value of the futures contract to Allied increases Because, Allied will be able to purchase the aluminum inventory at the lower price of $1,550 per ton 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 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   sells the income until the period in which it inventory, thereby effecting earnings 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 Unrealized Holding Gain or Loss—Equity 25,000 25,000* *25,000 = ($1,575 – $1,550) x 1,000 tons Allied reports the future contract in the balance sheet as current asset and the gain on the futures contract as part of other comprehensive income 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 (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 Cash ($1,575 x 1,000 tons = $1,575,000) 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) 25,000 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 Less: Cash received on settlement of future contract Net cash outflow   $1,575,000 (25,000) $1,550,000 Note: There are no income effects at this point!!! [...]... statement indicates that the gain on the put option offsets the loss on the AFS securities The reporting for these financial instruments, even when they reflect a hedging relationship, illustrates why the FASB argued that fair value accounting provides the most relevant information about financial instruments, including derivatives Problem 18 Derivatives Used for Hedging –CF Hedge Cash flow hedges... Available -for- Sale securities (@ FMV) Put Option (@ FMV) $12,000 500 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 of Hayward’s net exposure to the risks of holding Sonoma stock Derivatives Used for Hedging –FV Hedge... memorandum indicates the signing of the put option contract its designation as a fair value hedge for the Sonoma investment *At inception: Exercise price equals the current market price 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. .. 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 activities The FASB allows two types of hedges: a Fair Value Hedges; b Cash Flow Hedges Derivatives Used for Hedging –FV Hedge a Fair value hedge:   A derivative used to hedge (offset) the exposure to changes in the fair... 20,100 Derivative financial investment -Speculation Effects of the call option on net income: Date Transaction Income (Loss) Effect March 31, 2007 Net increase in value of call option April 1, 2007 Settle call option Total net income   $19,700 (100) $19,600 Derivative financial investment -Speculation Financial statement reporting: (1)Call option is reported as an asset at fair value   (2) Any gains or... 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... 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 To record an increase in the value of the put option: Put Option 500 Unrealized Holding Gain or Loss—Income 500... Holding Gain or Loss—Income 500 500 Note: The decline in the price of Sonoma shares results in an increase in the fair value of the put option The increase in fair value on the option offsets or hedges (protects) the decline in value on Hayward’s AFS security Derivatives Used for Hedging –FV Hedge (f) Financial statement disclosure: (i) Balance sheet: Both the investment security and the put option are reported... 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... (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 ... accounting for both financial instruments, the financial statements reflect the underlying substance of Hayward’s net exposure to the risks of holding Sonoma stock Derivatives Used for Hedging... FASB argued that fair value accounting provides the most relevant information about financial instruments, including derivatives Problem 18 Derivatives Used for Hedging –CF Hedge Cash flow hedges... records the increase in intrinsic value as follows: Call Option 20,000 Unrealized Holding Gain or Loss—Income 20,000 Derivative financial investment -Speculation (b) To record decrease in time value