Intermediate accounting 17e stice skousen cengage chapter 19

Stice | Stice | Skousen Intermediate Accounting,17E Derivatives, Contingencies, Business Segments, and Interim Reports PowerPoint presented by: Douglas Cloud Professor Emeritus of Accounting, Pepperdine University 19-1 © 2010 Cengage Learning Simple Example of a Derivative You You are are an an employee employee of of Nauvoo Nauvoo Software Software Solutions Solutions On October 1, 2011, you purchase 100 shares of stock in the company at the market price of $50 per share, for a total price of $5,000 (continues) 19-2 Simple Example of a Derivative • On January 1, 2012, you need to make a college tuition payment of $5,000 on behalf of your daughter You can’t sell the stocks now because your employment contract states that the shares must be held for at least three months before they can be sold How can you avoid downward movement in the stock price between now and January 1? (continues) 19-3 Simple Example of a Derivative You can avoid downward movement if you make the following agreement: If the price of the stock is above $50 per share, you agree to pay cash equal to the excess to John Bennett, a local speculator If the price goes below $50, Bennett will pay you a cash amount equal to the deficit This agreement is called a derivative (continues) 19-4 Simple Example of a Derivative • A derivative is a financial instrument or contract that derives its value from the movement of the price, foreign exchange rate, or interest rate on some other underlying asset • When the agreement is made, no journal entry is required, because it is merely an exchange of promises about some future action; that is, an executory contract (continues) 19-5 Simple Example of a Derivative How does this derivative agreement solve your risk management dilemma? Look at the following chart: No matter what happens, you will wind up with $5,000 on January 19-6 Types of Risk • Price risk is the uncertainty about the future price of an asset • Credit risk is the uncertainty that the party on the other side of the agreement will abide by the terms of the agreement • Interest rate risk is the uncertainty about future interest rates • Exchange rate risk is the uncertainty about the U.S dollar cash flows arising when assets and liabilities are denominated in a foreign currency 19-7 Types of Derivatives • A swap is an agreement to exchange payments in the future, usually a fixed payment for a variable payment, or vice versa • A forward is an agreement to exchange an item at a set date in the future at a price that is set now (continues) 19-8 Types of Derivatives • A future is quite similar to a forward except that the terms of futures contracts are standardized and these contracts are traded in markets • An option is the right to buy or sell an asset at a specified price in the future 19-9 Swap • Pratt takes advantage of a good working relationship with a bank, receiving a 2-year, $100,000 loan with interest payments occurring at the end of each year • The interest rate for the first year is 10%, and the rate in the second year will be equal to the market interest on January of that year (continues) 19-10 Illustrations of Accounting for Derivatives and Hedging Activities • On December 1, 2011, Hyrum Company decided to hedge against potential fluctuations in the price of wheat for its forecasted January 2012 purchases • The firm bought a futures contract entitling and obligating Hyrum to purchase 1,000 bushels of wheat on January 1, 2012, for $4 per bushel (continues) 19-36 Illustrations of Accounting for Derivatives and Hedging Activities • No entry is made to record the futures contract • The actual price of wheat on December 31, 2011, is $4.40 per bushel Hyrum will receive a $400 payment [1,000 bushels × ($4.40 – $4.00)] on January 1, 2012, to settle the futures contract (continues) 19-37 Illustrations of Accounting for Derivatives and Hedging Activities The impact of the change on the anticipated cost of wheat when purchased in January 2012 is accounted for as follows: (continues) 19-38 Illustrations of Accounting for Derivatives and Hedging Activities The adjusting entry to recognize the change in the fair value of the futures contract is as follows: 2011 Dec 31 Wheat Futures Contract (asset) 400 Other Comprehensive Income The gain from the increase in the value of Hyrum’s futures contract is deferred as a part of other comprehensive income (continues) 400 19-39 Illustrations of Accounting for Derivatives and Hedging Activities The entries to record the purchase of 1,000 bushels of wheat in the open market and the cash settlement of the wheat future contracts are as follows: 2012 Jan Wheat Inventory 4,400 Cash (1,000 bushels × $4.40) 4,400 Cash (futures contract settlement) 400 Wheat Futures Contract (asset) 400 Accumulated Other Comprehensive Income 400 Gain on Futures Contract 400 19-40 Accounting for Contingencies • Contingent losses Circumstances involving potential losses that will not be resolved until some future event occurs • Contingent gains Circumstances involving potential gains that will not be resolved until some future event occurs 19-41 Accounting for Lawsuits FASB Statement No identifies several key factors to consider These include the following: The nature of the lawsuit Progress of the case in court, including progress between date of the financial statements and their issuance date Views of legal counsel as to the probability of loss Prior experience with similar cases Management’s intended response to the lawsuit 19-42 Accounting for Environmental Liabilities • The SEC staff issued Staff Accounting Bulletin No 92, which set forth the SEC’s interpretation of GAAP regarding contingent liabilities, with particular applicability to companies with environmental liabilities • The AICPA issued SOP 96-1 outlining key events that can be used to determine whether an environmental liability is probable (continues) 19-43 Accounting for Environmental Liabilities • The FASB, in Statement No 143, requires that an obligation associated with retiring an asset should be recognized when incurred and be measured using present value techniques The offsetting debit should be an addition to the cost of the associated asset 19-44 Business Segments Information to be disclosed in the financial statement notes under the provisions of FASB Statement No 14 included revenues, operating profit, and identifiable assets for each significant industry segment of a company 19-45 Business Segments FASB Statement No 131 additional disclosure requirements: Total segment operating profit or loss Amounts of certain income statement items such as operating revenues, depreciation, interest revenue, interest expense, tax expense, and significant noncash expenses Total segment assets (continues) 19-46 Business Segments Total capital expenditures Reconciliation of the sum of segment totals to the company total for each of the following items:  Revenues  Operating profits  Assets (continues) 19-47 Business Segments In addition to these five items, companies must also disclose how operating segments are identified Revenue test A segment should be reported if its total revenue is 10% or more of the company’s total revenue (external and internal) (continues) 19-48 Business Segments Profit test A segment should be reported if the absolute value of its operating profit (or loss) is greater than 10% of the total operating profit for all segments that reported profits Asset test A segment should be reported if it contains 10% or more of the combined assets of all operating segments 19-49 Interim Reports • Statements showing financial position and operating results for intervals of less than a year are referred to as interim financial statements • There are two prominent viewpoints about reporting interim results  Each reporting interval is to be recognized as a separate accounting period  The interim period is an integral part of the annual period (accepted by the APB in Opinion No 28) 19-50 ... seen in the table displayed on Slide 19- 20 (continues) 19- 19 Option The option contract means that Woodruff will pay no more than $300 per ounce for the gold 19- 20 Types of Hedging Activities •... this exchange rate (continues) 19- 13 Forwards The impact of the forward exchange is shown in the following table: The prevailing exchange rate is called the spot rate 19- 14 Futures • Hyrum Bakery... cash payment at the end of the contract (continues) 19- 15 Futures The effect of the futures contract is illustrated in the following table: 19- 16 Option • A call option gives the owner the right