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Derivatives. Chapter 16 Robinson, Munter and Grant. Learning Objectives. Distinguish between financial and derivative instruments Accounting hedges Accounting models Impact on net income and comprehensive income Fair value disclosures. Financial Instruments. Cash - PowerPoint PPT Presentation
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Derivatives
Chapter 16
Robinson, Munter and Grant
Robinson, Munter & Grant
Chapter 16 2
Learning Objectives
• Distinguish between financial and derivative instruments
• Accounting hedges
• Accounting models
• Impact on net income and comprehensive income
• Fair value disclosures
Robinson, Munter & Grant
Chapter 16 3
Financial Instruments
• Cash
• Evidence of an ownership interest in another entity
• Contract that binds two parties– Obligates delivery/exchange of cash or
another financial instrument, and– Conveys right to receive/exchange cash or
another financial instrument
Robinson, Munter & Grant
Chapter 16 4
Derivative Instruments
• At least one underlying (variable)
• One or more provisional amounts or payment provision or both
• No initial net investment or smaller initial net investment than would be required for other types of contracts
• Terms require or permit net settlement
Robinson, Munter & Grant
Chapter 16 5
Common Types of Derivative Instruments
• Swaps: Counterparties change position relative to underlying
• Options: Right to buy or sell underlying asset
• Forwards: Obligation to buy or sell an underlying
Robinson, Munter & Grant
Chapter 16 6
Common Types of Derivative Instruments
• Futures: Exchange-traded forward contract
• Caps, Floors, Collars: Zero dollar-cost options that place limits on movement of the underlying asset
• Combination of the above elements
Robinson, Munter & Grant
Chapter 16 7
Investment Return Example
• Shares of XYZ currently worth $100 each
A: buy 1,000 shares of XYZ for $100,000
B: enter forward contract to acquire 1,000 shares for $100 in 6 months
• In six months, price of XYZ
1) Increases to $150
2) Decreases to $50
Robinson, Munter & Grant
Chapter 16 8
Investment Return Example
Share purchase Forward contract
$150 $50,000 gain
50% ROA
$50,000 gain
Infinite ROA
$50 $50,000 loss
(50%) ROA
$50,000 loss
(Infinite) ROA
Robinson, Munter & Grant
Chapter 16 9
Holding Derivative Instruments
• Speculative investments are not designed to manage market or credit risks.
• Hedging instruments are part of an entity’s process of managing credit or market risk.
Robinson, Munter & Grant
Chapter 16 10
Risk of Accounting Loss
Composed of:1. Credit risk: that other party may not
perform in accordance with the terms of the contract
2. Market risk: that changes in market conditions may make a financial asset less valuable or a liability more burdensome
3. Risk of theft or physical damage
Robinson, Munter & Grant
Chapter 16 11
Risk of Accounting Loss
• Maximum recorded loss the company could reflect in the financial statements
• Not a measure of economic loss– Lost future revenues, for example
• An accounting hedge derivative is used to manage the risk of accounting loss
Robinson, Munter & Grant
Chapter 16 12
Derivatives and Hedging
• Fair value hedges – Against changes in the fair value of hedged
item
• Cash-flow hedges– Variability of future cash flows
• Net investment hedges– Foreign investee
Robinson, Munter & Grant
Chapter 16 13
Fair Value Hedge Accounting
• Against changes in the fair value of an existing asset or liability, or and unrecorded commitment
• Gain or loss is included in income– Perfect hedging would result in no net gain or
loss
• Hedged item must be marked-to-market
Robinson, Munter & Grant
Chapter 16 14
Fair Value Hedge Accounting
• Hedging ineffectiveness is recognized in earnings immediately– For qualifying fair value hedges
• Qualifying fair value hedge: change in derivative is 80-125% of the change in the hedged item
Robinson, Munter & Grant
Chapter 16 15
Fair Value Hedge Accounting• Overhedge: Absolute value of the change
in the derivative is greater than the opposing change in the fair value of the hedged item
• Underhedge: Absolute value of the change in the derivative is less than the opposing change in the fair value of the hedged item
Robinson, Munter & Grant
Chapter 16 16
Fair Value Hedge Derivative Criteria
• Extensive formal documentation of hedge
• Expected to be highly effective– Assessed at least every 3 months
• Written option to hedge an asset or liability must provide at least as much potential for gain as exposure to loss
Robinson, Munter & Grant
Chapter 16 17
Fair Value Hedge Hedged Item
• Must be specifically identified– All or part of an asset, liability or commitment– Single item or portfolio or similar items
• Risk of accounting loss exists– Credit or market risk
Robinson, Munter & Grant
Chapter 16 18
Fair Value Hedge Accounting treatment
• Gain/losses related to both derivative and hedged item are recorded income– Ideally, they would offset each other– Placement within income statement varies– Company must disclose where reported
• Carrying amount of hedged item is marked-to-market
Robinson, Munter & Grant
Chapter 16 19
Fair Value Hedge Discontinue when…
• Hedging criteria no longer met
• Derivative expires, is sold, terminated or exercised
• Entity removes the designation of the fair value hedge
Robinson, Munter & Grant
Chapter 16 20
Cash-Flow Hedge Accounting
• Mitigate against variability of future cash flows
• Classify gains and losses as related to– Effective (offsetting movement in hedged
transaction) hedging, or
– Ineffective hedging• Over- or under-hedge
Robinson, Munter & Grant
Chapter 16 21
Cash-Flow HedgeHedging Criteria
• Extensive formal documentation of hedge– Including plans to assess effectiveness
• Expected to be highly effective– Assessed at least every 3 months
• Written option to hedge an asset or liability must provide at least as much potential for gain as exposure to loss
• Regarding interest receipts, hedging instrument must link existing asset and liability
Robinson, Munter & Grant
Chapter 16 22
Cash-Flow HedgeHedged Transaction
• Must be specifically identified– Single item or group of items with same risk
exposure
• Occurrence of forecasted transaction is probable
• Transaction must be with external party• Risk of accounting loss exists
– Credit or market risk
Robinson, Munter & Grant
Chapter 16 23
Cash-Flow HedgeAccounting treatment
• Effective portion– Other comprehensive income
– Recognized in income when related transaction affects earnings
• Ineffective portion– Overhedge is in earnings
– Underhedge is deferred in other comprehensive income
• Anticipated losses on hedged transaction are recognized in income immediately
Robinson, Munter & Grant
Chapter 16 24
Cash-Flow Hedge AccountingExample
Derivative Increase $100 Increase $90
Hedged item
Decrease $95 Decrease $95
Recognize $5 gain now, defer $95 gain in other comprehensive income
Defer $90 gain
Underhedge is not immediately recognized
Robinson, Munter & Grant
Chapter 16 25
Cash-Flow Hedge Discontinue when…
• Hedging criteria no longer met• Derivative expires, is sold, terminated or
exercised• Entity removes the designation of the cash-
flow hedgeAnd move accumulated gains/losses from
balance sheet to income statement
Robinson, Munter & Grant
Chapter 16 26
Net Investment Hedge Accounting
• Hedge against the changes in the exchange rate impacts on the net investment of a foreign investee
• Gain/loss is included in other comprehensive income
– Part of cumulative translation adjustment– A component of Equity
Robinson, Munter & Grant
Chapter 16 27
Disclosure of Fair Value for Financial Instruments
• Companies must disclose fair value of financial instruments in statements
– Or approximation thereof
• Values come from a variety of financial markets• Absent a financial market, fair values may be
calculated
Robinson, Munter & Grant
Chapter 16 28
Fair Value for Financial InstrumentsMarkets
• Exchange market– Information readily available– Closing prices commonly used
• Dealer market– Dealers trade for their own accounts– Bid and ask prices are more readily available than
closing prices
Robinson, Munter & Grant
Chapter 16 29
Fair Value for Financial InstrumentsMarkets and Other measures
• Brokered market– Brokers do not trade for their own account– Match buyers and sellers
• Principal-to-principal market– Little, if any, public information – Must use best estimate of fair value
• Other measures include discounted cash flows and pricing models
Robinson, Munter & Grant
Chapter 16 30
Summary
• Financial and derivative instruments
• Fair value hedge
• Cash-flow hedge
• Net investment hedge
• Income statement and balance sheet impact
• Value of financial instruments