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Appendix A: Derivatives

Accounting for Derivatives

A key to accounting for derivatives is knowing the purpose for which a company holds them and whether the company is effective in serving that purpose. Derivatives, for instance, may be held for risk management (hedging activities). The desired effect, and often the real effect, is a reduction in risk. On the other hand, derivatives sometimes are held for speculative position taking, hoping for large profits. The effect of this activity usually is to increase risk. Perhaps more important, derivatives acquired as hedges and intended to reduce risk may, in fact, unintentionally increase risk instead.

   It's important to understand that, serving as investments rather than as hedges, derivatives are extremely speculative. This is due to the high leverage inherent in derivatives. Here's why. The investment outlay usually is negligible, but, the potential gain or loss on the investment usually is quite high. A small change in interest rates or another underlying event can trigger a large change in the fair value of the derivative. Because the initial investment was minimal, the change in value relative to the investment itself represents a huge percentage gain or loss. Their extraordinarily risky nature prompted Warren Buffett, one of the country's most celebrated financiers, to refer to derivatives as “financial weapons of mass destruction.” Accounting for derivatives is designed to treat differently (a) derivatives designated as hedges and those not designated as hedges as well as (b) the effective portion and the ineffective portion of gains and losses from intended hedges.

 

Derivatives not serving as hedges are extremely speculative due to the high leverage inherent in such investments.

   The basic approach to accounting for derivatives is fairly straightforward, although implementation can be quite cumbersome. All derivatives, no exceptions, are carried on the balance sheet as either assets or liabilities at fair (or market) value.6 The reasoning is that (a) derivatives create either rights or obligations that meet the definition of assets or liabilities, and (b) fair value is the most meaningful measurement.

 

Each derivative contract has a “fair value,” which is an amount that one side owes the other at a particular moment.

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   Accounting for the gain or loss on a derivative depends on how it is used. Specifically, if the derivative is not designated as a hedging instrument, or doesn't qualify as one, any gain or loss from fair value changes is recognized immediately in earnings. On the other hand, if a derivative is used to hedge against exposure to risk, any gain or loss from fair value changes is either (a) recognized immediately in earnings along with an offsetting loss or gain on the item being hedged or (b) deferred in comprehensive income until it can be recognized in earnings at the same time as earnings are affected by a hedged transaction. Which way depends on whether the derivative is designated as a (a) fair value hedge, (b) cash flow hedge, or (c) foreign currency hedge. Let's look now at each of the three hedge designations.

Fair Value Hedges

A company can be adversely affected when a change in either prices or interest rates causes a change in the fair value of one of its assets, its liabilities, or a commitment to buy or sell assets or liabilities. If a derivative is used to hedge against the exposure to changes in the fair value of an asset or liability or a firm commitment, it can be designated as a fair value hedge a derivative is used to hedge against the exposure to changes in the fair value of an asset or liability or a firm commitment.. In that case, when the derivative is adjusted to reflect changes in fair value, the other side of the entry recognizes a gain or loss to be included currently in earnings. At the same time, though, the loss or gain from changes in the fair value (due to the risk being hedged)7 of the item being hedged also is included currently in earnings. This means that, to the extent the hedge is effective in serving its purpose, the gain or loss on the derivative will be offset by the loss or gain on the item being hedged. In fact, this is precisely the concept behind the procedure.

 

A gain or loss from a  fair value hedge  is recognized immediately in earnings along with the loss or gain from the item being hedged.

   The reasoning is that as interest rates or other underlying events change, a hedge instrument will produce a gain approximately equal to a loss on the item being hedged (or vice versa). These income effects are interrelated and offsetting, so it would be improper to report the income effects in different periods. More critically, the intent and effect of having the hedge instrument is to lessen risk. And yet, recognizing gains in one period and counterbalancing losses in another period would tend to cause fluctuations in income that convey an increase in risk. However, to the extent that a hedge is ineffective and produces gains or losses different from the losses or gains being hedged, the ineffective portion is recognized in earnings immediately.

   Some of the more common fair value hedges use:

  

 

An interest rate swap to synthetically convert fixed-rate debt (for which interest rate changes could change the fair value of the debt) into floating-rate debt.

  

 

A futures contract to hedge changes in the fair value (due to price changes) of aluminum, sugar, or some other type of inventory.

  

 

A futures contract to hedge the fair value (due to price changes) of a firm commitment to sell natural gas or some other asset.

Illustration

Because interest rate swaps comprise over 65% of derivatives in use, we will use swaps to illustrate accounting for derivatives. Let's look at the example in Illustration A-1 on the next page.

 

The income effects of the hedge instrument and the income effects of the item being hedged should affect earnings at the same time.

   When the floating rate declined from 10% to 9%, the fair values of both the derivative (swap) and the note increased. This created an offsetting gain on the derivative and holding loss on the note. Both are recognized in earnings at the same time (at June 30, 2011).

A-5

ILLUSTRATION A-1

Interest Rate Swap—Shortcut Method

 

Wintel Semiconductors issued $1 million of 18-month, 10% bank notes on January 1, 2011. Wintel is exposed to the risk that general interest rates will decline, causing the fair value of its debt to rise. (If the fair value of Wintel's debt increases, its effective borrowing cost is higher relative to the market.) To hedge against this fair value risk, the firm entered into an 18-month interest rate swap agreement on January 1 and designated the swap as a hedge against changes in the fair value of the note. The swap calls for the company to receive payment based on a 10% fixed interest rate on a notional amount of $1 million and to make payment based on a floating interest rate tied to changes in general rates.8 As the Illustration will show, this effectively converts Wintel's fixed-rate debt to floating-rate debt. Cash settlement of the net interest amount is made semiannually at June 30 and December 31 of each year with the net interest being the difference between the $50,000 fixed interest [$1 million × (10% × ½)] and the floating interest rate times $1 million at those dates.

   Floating (market) settlement rates were 9% at June 30, 2011, 8% at December 31, 2011, and 9% at June 30, 2012. Net interest receipts can be calculated as shown below. Fair values of both the derivative and the note resulting from those market rate changes are assumed to be quotes obtained from securities dealers.

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The interest rate swap is designated as a fair value hedge on this note at issuance.

The swap settlement is the difference between the fixed interest (5%) and variable interest (4.5%).

The fair value of derivatives is recognized in the balance sheet.

The hedged liability (or asset) is adjusted to fair value as well.

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   The net interest settlement on June 30, 2011, is $5,000 because the fixed rate is 5% (half of the 10% annual rate) and the floating rate is 4.5% (half of the 9% annual rate).

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As with any debt, interest expense is the effective rate times the outstanding balance.

The settlement is the difference between the fixed interest (5%) and variable interest (4%).

The derivative is increased by the change in fair value.

The note is increased by the change in fair value.

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   The fair value of the swap increased by $252 (from $9,363 to $9,615). Similarly, we adjust the note's carrying value by the amount necessary to increase it to fair value. This produces a holding loss on the note that exactly offsets the gain on the swap. This result is the hedging effect that motivated Wintel to enter the fair value hedging arrangement in the first place.

   At June 30, 2012, Wintel repeats the process of adjusting to fair value both the derivative investment and the note being hedged.

The net interest received is the difference between the fixed interest (5%) and floating interest (4.5%).

The swap’s fair value now is zero.

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   The net interest received is the difference between the fixed rate (5%) and floating rate (4.5%) times $1 million. The fair value of the swap decreased by $9,615 (from $9,615 to zero).10 That decline represents a holding loss that we recognize in earnings. Similarly, we record an offsetting holding gain on the note for the change in its fair value.

   Now let's see how the carrying values changed for the swap account and the note:

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   The income statement is affected as follows:

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   As this demonstrates, the swap effectively converts fixed-interest debt to floating-interest debt.

  
ADDITIONAL CONSIDERATION

Fair Value of the Swap

The fair value of a derivative typically is based on a quote obtained from a derivatives dealer. That fair value will approximate the present value of the expected net interest settlement receipts for the remaining term of the swap. In fact, we can actually calculate the fair value of the swap that we accepted as given in our illustration.

   Since the June 30, 2011, floating rate of 9% caused the cash settlement on that date to be $5,000, it's reasonable to look at 9% as the best estimate of future floating rates and therefore assume the remaining two cash settlements also will be $5,000 each. We can then calculate at June 30, 2011, the present value of those expected net interest settlement receipts for the remaining term of the swap:

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*Present value of an ordinary annuity of $1: n = 2, i = 4.5% (½ of 9%) (from Table 4)

Fair Value of the Notes

The fair value of the note payable will be the present value of principal and remaining interest payments discounted at the market rate. The market rate will vary with the designated floating rate but might differ due to changes in default (credit) risk and the term structure of interest rates. Assuming it's 9% at June 30, 2011, we can calculate the fair value (present value) of the notes:

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*½ of 10% × $1,000,000

Present value of an ordinary annuity of $1: n = 2, i = 4.5% (from Table 4)

Present value of $1: n = 2, i = 4.5% (from Table 2)

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Note: Often the cash settlement rate is “reset” as of each cash settlement date (thus the floating rate actually used at the end of each period to determine the payment is the floating market rate as of the beginning of the same period). In our illustration, for instance, there would have been no cash settlement at June 30, 2011, since we would use the beginning floating rate of 10% to determine payment. Similarly, we would have used the 9% floating rate at June 30, 2011, to determine the cash settlement six months later at December 31. In effect, each cash settlement would be delayed six months. Had this arrangement been in effect in the current illustration, there would have been one fewer cash settlement payments (two rather than three), but would not have affected the fair value calculations above because, either way, our expectation would be cash receipts of $5,000 for both Dec. 31, 2011, and June 30, 2012.

  

Cash Flow Hedges

The risk in some transactions or events is the risk of a change in cash flows, rather than a change in fair values. We noted earlier, for instance, that fixed-rate debt subjects a company to the risk that interest rate changes could change the fair value of the debt. On the other hand, if the obligation is floating-rate debt, the fair value of the debt will not change when interest rates do, but cash flows will. If a derivative is used to hedge against the exposure to changes in cash inflows or cash outflows of an asset or liability or a forecasted transaction (like a future purchase or sale), it can be designated as a cash flow hedge a derivative used to hedge against the exposure to changes in cash inflows or cash outflows of an asset or liability or a forecasted transaction (like a future purchase or sale).. In that case, when the derivative is adjusted to reflect changes in fair value, the other side of the entry is a gain or loss to be deferred as a component of other comprehensive income and included in earnings later, at the same time as earnings are affected by the hedged transaction. Once again, the effect is matching the earnings effect of the derivative with the earnings effect of the item being hedged, precisely the concept behind hedge accounting.

   To understand the deferral of the gain or loss, we need to revisit the concept of comprehensive income. Comprehensive income, as you may recall from Chapters 4, 12, 17, and 18, is a more expansive view of the change in shareholders' equity than traditional net income. In fact, it encompasses all changes in equity other than from transactions with owners.11 So, in addition to net income itself, comprehensive income includes up to four other changes in equity that don't (yet) belong in net income, namely, net holding gains (losses) on investments (Chapter 12), gains (losses) from and amendments to postretirement benefit plans (Chapter 17), gains (losses) from foreign currency translation, and deferred gains (losses) from derivatives designated as cash flow hedges.12

 

A gain or loss from a cash flow hedge is deferred as other comprehensive income until it can be recognized in earnings along with the earnings effect of the item being hedged.

   Some of the more commonly used cash flow hedges are:

 

 

An interest rate swap to synthetically convert floating rate debt (for which interest rate changes could change the cash interest payments) into fixed rate debt.

 

 

A futures contract to hedge a forecasted sale (for which price changes could change the cash receipts) of natural gas, crude oil, or some other asset.

Foreign Currency Hedges

Today's economy is increasingly a global one. The majority of large “U.S.” companies are, in truth, multinational companies that may receive only a fraction of their revenues from U.S. operations. Many operations of those companies are located abroad. Foreign operations often are denominated in the currency of the foreign country (the Euro, Japanese yen, Russian rubles, and so on). Even companies without foreign operations sometimes hold investments, issue debt, or conduct other transactions denominated in foreign currencies. As exchange rates change, the dollar equivalent of the foreign currency changes. The possibility of currency rate changes exposes these companies to the risk that some transactions require settlement in a currency other than the entities' functional currency or that foreign operations will require translation adjustments to reported amounts.

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   A foreign currency hedgeif a derivative is used to hedge the risk that some transactions require settlement in a currency other than the entities' functional currency or that foreign operations will require translation adjustments to reported amounts. can be a hedge of foreign currency exposure of:

  

 

A firm commitment—treated as a fair value hedge.

  

 

An available-for-sale security—treated as a fair value hedge.

  

 

A forecasted transaction—treated as a cash flow hedge.

  

 

A company's net investment in a foreign operation—the gain or loss is reported in other comprehensive income as part of unrealized gains and losses from foreign currency translation.13

 

The possibility that foreign currency exchange rates might change exposes many companies to foreign currency risk.

Hedge Effectiveness

When a company elects to apply hedge accounting, it must establish at the inception of the hedge the method it will use to assess the effectiveness of the hedging derivative as well as the measurement approach it will use to determine the ineffective portion of the hedge.14 The key criterion for qualifying as a hedge is that the hedging relationship must be “highly effective” in achieving offsetting changes in fair values or cash flows based on the hedging company's specified risk management objective and strategy.

   An assessment of this effectiveness must be made at least every three months and whenever financial statements are issued. There are no precise guidelines for assessing effectiveness, but it generally means a high correlation between changes in the fair value or cash flows of the derivative and of the item being hedged, not necessarily a specific reduction in risk. Hedge accounting must be terminated for hedging relationships that no longer are highly effective.

Hedge Ineffectiveness

 

To qualify as a hedge, the hedging relationship must be highly effective in achieving offsetting changes in fair values or cash flows.

In Illustration A-1, the loss on the hedged note exactly offset the gain on the swap. This is because the swap in this instance was highly effective in hedging the risk due to interest rate changes. However, the loss and gain would not have exactly offset each other if the hedging arrangement had been ineffective. For instance, suppose the swap's term had been different from that of the note (say a three-year swap term compared with the 18-month term of the note) or if the notional amount of the swap differed from that of the note (say $500,000 rather than $1 million). In that case, changes in the fair value of the swap and changes in the fair value of the note would not be the same. The result would be a greater (or lesser) amount recognized in earnings for the swap than for the note. Because there would not be an exact offset, earnings would be affected, an effect resulting from hedge ineffectiveness. That is a desired effect of hedge accounting; to the extent that a hedge is effective, the earnings effect of a derivative cancels out the earnings effect of the item being hedged. However, even if a hedge is highly effective, all ineffectiveness is recognized currently in earnings.

 

Imperfect hedges result in part of the derivative gain or loss being included in current earnings.

Fair Value Changes Unrelated to the Risk Being Hedged

In Illustration A-1, the fair value of the hedged note and the fair value of the swap changed by the same amounts each year because we assumed the fair values changed only due to interest rate changes. It's also possible, though, that the note's fair value would change by an amount different from that of the swap for reasons unrelated to interest rates. Remember from our earlier discussion that the market's perception of a company's creditworthiness, and thus its ability to pay interest and principal when due, also can affect the value of debt, whether interest rates change or not. In hedge accounting, we ignore those changes. We recognize only the fair value changes in the hedged item that we can attribute to the risk being hedged (interest rate risk in this case). For example, if a changing perception of default risk had caused the note's fair value to increase by an additional, say $5,000, our journal entries in Illustration A-1 would have been unaffected. Notice, then, that although we always mark a derivative to fair value, the reported amount of the item being hedged may not be its fair value. We mark a hedged item to fair value only to the extent that its fair value changed due to the risk being hedged.

 

Fair value changes unrelated to the risk being hedged are ignored.




6FASB ASC 815–10: Derivatives and Hedging–Overall (previously “Accounting for Derivative Instruments and Hedging Activities,” Statement of Financial Accounting Standards No. 133 (Norwalk, Conn.: FASB, 1998)).

7The fair value of a hedged item might also change for reasons other than from effects of the risk being hedged. For instance, the hedged risk may be that a change in interest rates will cause the fair value of a bond to change. The bond price might also change, though, if the market perceives that the bond's default risk has changed.

8A common measure for benchmarking variable interest rates is LIBOR, the London Interbank Offered Rate, a base rate at which large international banks lend funds to each other.

9This would be a liability rather than an investment (asset) if the fair value had declined.

10Because there are no future cash receipts from the swap arrangement at this point, the fair value of the swap is zero.

11Transactions with owners primarily include dividends and the sale or purchase of shares of the company's stock.

12FASB ASC 220–10–55–2: Comprehensive Income–Overall–Implementation Guidance and Illustrations (previously “Reporting Comprehensive Income,” Statement of Financial Accounting Standards No. 130 (Norwalk, Conn.: FASB, 1997)).

13This is the same treatment previously prescribed for these translation adjustments by Statement of Financial Accounting Standards No. 52 [FASB ASC 830: Foreign Currency Matters].

14Remember, if a derivative is not designated as a hedge, any gains or losses from changes in its fair value are recognized immediately in earnings.

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