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Derivatives Derivatives A. Derivatives are financial instruments that “derive” their values from some other security or index. (TA-1) B. They are extensively used to hedge against various risks, particularly interest rate risk. C. Hedging means taking a risk position that is opposite to an actual position that is exposed to risk. (TA-2) 1. Interest rate futures are derivative contracts often bought and sold to hedge against risk. They allow a firm to sell (or buy) a financial instrument at a designated future date, but at today’s price. 2. Interest rate swaps hedge risk by exchanging fixed interest payments for floating rate payments, or vice versa, without exchanging the underlying principal amounts. Interest rate swaps are the most frequently used derivatives. (TA-3) 3. A forward contract is similar to a futures contract but (a) calls for delivery on a specific date, (b) is not traded on a market exchange, and (c) doesn’t call for a daily cash settlement for price changes in the commodity underlying the contract. 4. An option on a financial instrument is a derivative that permits its holder either to buy or to sell the instrument at a specified price and within a given time period, without the obligation to exercise the option. D. All derivatives, no exceptions, are carried on the balance sheet as either assets or liabilities at fair value. When the fair value changes, a gain or loss occurs. (TA-4) 1. If the derivative is not designated as a hedging instrument, or doesn’t qualify as one, the gain or loss is recognized immediately in earnings. 2. If the derivative is used to hedge against exposure to risk, the gain or loss is either recognized immediately in earnings along with an offsetting loss or gain on the item being hedged or a. deferred in “comprehensive income” until it can be recognized in earnings at the same time as earnings are affected by a hedged transaction. 3. Which way depends on whether the derivative is designated as a fair value hedge, cash flow hedge, or foreign currency hedge. E. When a derivative designated as a fair value hedge is adjusted to reflect changes in fair value, the resulting gain or loss is 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, of the item being hedged also is included currently in earnings. (TA-5) (TA-8) F. When a derivative designated as a cash flow hedge is adjusted to reflect changes in fair value, the resulting gain or loss is 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. The effect is matching the earnings effect of the derivative with the earnings effect of the item being hedged - the reasoning that supports hedge accounting. The portion of the gain or loss due to “ineffective” hedging is reported in earnings immediately. (TA-6) G. A foreign currency hedge can be a hedge of foreign currency exposure of: (TA-7) 1. a firm commitment – treated as a fair value hedge. 2. an available-for-sale security – treated as a fair value hedge. 3. a forecasted transaction – treated as a cash flow hedge. 4. a company's net investment in a foreign operation - the gain or loss is reported in other comprehensive income as part of the cumulative translation adjustment. H. To qualify as a hedge, the hedging relationship must be “highly effective” in achieving offsetting changes in fair values or cash flows. Hedge accounting must be terminated for hedging relationships that no longer are highly effective. (TA-9) I. The loss (gain) on a hedged item would not exactly offset each other if the hedging arrangement is ineffective. The effect would be a greater (or lesser) amount recognized in earnings for the swap than for the note. Without an exact offset, earnings would be affected caused by hedge ineffectiveness. J. Fair value changes unrelated to the risk being hedged are ignored. PowerPoint Slides A PowerPoint presentation of the Appendix is available at the textbook website. Teaching Transparency Masters The following can be reproduced on transparency film as they appear here, or you can use the disk version of this manual and first modify them to suit your particular needs or preferences. DERIVATIVES Derivatives are financial instruments that “derive” their values or contractually required cash flows from some other security or index. Derivative financial instruments have become the key tools of risk management. The most frequently used derivatives are: o Financial futures o Forward contracts o Options o Interest rate swaps Derivatives can manage or hedge companies’ exposures to risk, including interest rate risk, price risk, and foreign exchange risk. TA-1 DERIVATIVES USED TO HEDGE RISK Hedging means taking a risk position that is opposite to an actual position that is exposed to risk. The effectiveness of a hedge is influenced by the closeness of the match between the item being hedged and the financial instrument chosen as a hedge. A futures contract allows a firm to sell (or buy) a financial instrument at a designated future date, at today’s price. A forward contract is similar to a futures contract but does not call for a daily cash settlement for price changes in the underlying contract. Gains and losses on forward contracts are paid only when they are closed out. An option gives its holder the right either to buy or to sell an instrument, say a Treasury bill, at a specified price and within a given time period. Interest rate swaps exchange fixed interest payments for floating rate payments, or vice versa, without exchanging the underlying notional amounts. Over 70% of derivatives are interest rate swaps. TA-2 INTEREST RATE SWAP Swap of annual payments on $100,000 notional amount; fixed interest rate: 10% ($10,000) Company A fixed 10% Company B floating % Floating rate: 9% at time of first payment ($9,000); Company A pays Company B $1,000 TA-3 ACCOUNTING FOR DERIVATIVES All derivatives, no exceptions, are carried on the balance sheet as either assets or liabilities at fair value. When the fair value changes, a gain or loss occurs. How we account for the gain or loss depends on how the derivative is used. 1. If the derivative is not designated as a hedging instrument, or doesn’t qualify as one, the gain or loss is recognized immediately in earnings. 2. If the derivative is used to hedge against exposure to risk, the gain or loss is either recognized immediately in earnings along with an offsetting loss or gain on the item being hedged or 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. TA-4 FAIR VALUE HEDGES A change in either prices or interest rates can cause a change in the fair value of an asset, a liability, 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, it can be designated as a fair value hedge. 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. o When the derivative is adjusted to reflect changes in fair value, the other side of the entry is recognized as a gain or loss to be included currently in earnings. o At the same time, the loss or gain from changes in the fair value (due to the risk being hedged) of the item being hedged also is included currently in earnings. o So, to the extent the hedge is effective, the gain or loss on the derivative will be offset by the loss or gain on the item being hedged. TA-5 CASH FLOW HEDGES If a derivative is used to hedge against exposure to changes in cash inflows or outflows of an asset or liability or a forecasted transaction, it can be designated as a cash flow hedge. When the derivative is adjusted to reflect changes in fair value, the other side of the entry is recognized as a gain or loss to be deferred as a component of other comprehensive income - included in earnings later, at the same time as earnings are affected by the hedged transaction. Comprehensive income includes net income itself and changes in elements of the balance sheet that the FASB feels don’t (yet) belong in net income: o foreign currency translation adjustments o unrealized gains and losses on available-for-sale securities o minimum pension liability adjustments The portion of the gain or loss due to “ineffective” hedging is reported in earnings immediately. TA-6 FOREIGN CURRENCY HEDGES The possibility that foreign currency exchange rates might change exposes many companies to foreign currency risk. A foreign currency hedge 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 the cumulative translation adjustment. TA-7 ILLUSTRATION INTEREST RATE SWAPS Wintel Semiconductors issued $1 million of 18-month, 10% notes payable to First Bank on January 1, 2013. Wintel is exposed to the risk that general interest rates will decline, causing the fair value of its debt to rise. To hedge against this fair value risk, the firm entered into an 18-month interest rate swap agreement on January 1. 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. Cash settlement of the net interest amount is made semi-annually at June 30 and December 31 of each year with the net interest being the $50,000 fixed interest ($1 million x [10% x ½]) and the difference between the floating interest rate times $1 million at those dates. Illustration A-1 TA-8 Floating settlement rates were 9% at June 30, 2013, 8% at December 31, 2013, and 9% at June 30, 2014, and December 31, 2014. 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. 1/1/2013 6/30/2013 Fixed rate Floating rate 10% 10% 10% 9% 12/31/2013 6/30/2014 10% 8% 10% 9% Fixed payments ($1 million x [10% x ½]) Floating payments ($1 million x ½ floating rate) Net interest receipts $50,000 45,000 $ 5,000 $50,000 40,000 $10,000 $50,000 45,000 $ 5,000 Fair value of interest rate swap $ 9,363 $ 9,615 0 $1M $1,009,363 $1,009,615 $1M Fair value of note payable 0 Illustration A-1 TA-8 (continued) 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 loss on the note. Both are recognized in earnings the same period (June 30, 2013). January 1, 2013 Cash ..................................................................... 1,000,000 Notes payable ......................................................... 1,000,000 To record the issuance of the notes. June 30, 2013 Interest expense (10% x ½ x $1 million) ................... Cash ..................................................................... To record interest. 50,000 50,000 Cash ($50,000 – [9% x ½ x $1 million]) .................. Interest expense ....................................................... To record the net cash settlement. 5,000 Interest rate swap ($9,363 - 0) .................................... Holding gain - interest rate swap ........................... To record change in fair value of the derivative. 9,363 5,000 Holding loss - hedged note.......................................... 9,363 Notes payable ($1,009,363 – 1,000,000) ................ To record change in fair value of the notes due to interest. 9,363 9,363 The net interest settlement on June 30, 2013, 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). Illustration A-1 TA-8 (continued) December 31, 2013 Interest expense .................................................... Cash (10% x ½ x $1,000,000) ........................................ To record interest. 50,000 50,000 Cash ($50,000 – [8% x ½ x $1 million]) ........................... Interest expense .................................................... To record the net cash settlement. 10,000 Interest rate swap ($9,615 - 9,363) ...................................... Holding gain - interest rate swap ..................................... To record the change in fair value of the derivative 252 Holding loss - hedged note .................................................. Notes payable ($1,009,615 – 1, 009,363) ....................... To record the change in fair value of the notes due to interest 252 10,000 252 252 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 cash flow hedging arrangement in the first place. Illustration A-1 TA-8 (continued) At June 30, 2014, Wintel repeats the process of adjusting to fair value both the derivative investment and the notes being hedged. June 30, 2014 Interest expense .......................................................... Cash (10% x ½ x $1,000,000)................................ To record interest. 50,000 50,000 Cash ($50,000 – [9% x ½ x $1 million]) .................. Interest expense ....................................................... To record the net cash settlement. 5,000 Holding loss - interest rate swap ................................ Interest rate swap ($0 – 9,615)................................ To record the change in fair value of the derivative 9,615 Notes payable ($1,000,000 – 1,009,615) .................... Holding gain–hedged note ...................................... To record the change in fair value of the notes 9,615 Note payable .......................................................... Cash .......................................................... To repay the loan 1,000,000 5,000 9,615 9,615 1,000,000 Illustration A-1 TA-8 (continued) EFFECTS ON BALANCES Swap Jan. 1, 2013 June 30, 2013 Dec. 31, 2013 June 30, 2014 Notes 1,000,000 9,363 252 9,363 252 9,615 _______________ 0 9,615 1,000,000 _______________ 0 Income Statement () June 30, 2013 (50,000) 5,000 9,363 (9,363) (45,000) Interest expense – fixed payment Interest expense – net cash settlement Holding gain – interest rate swap Holding loss – hedged note Net effect – same as floating interest payment Dec. 31, 2013 (50,000) 10,000 252 (252) (40,000) Interest expense – fixed payment Interest expense – net cash settlement Holding gain - interest rate swap Holding loss – hedged note Net effect – same as floating interest payment June 30, 2014 (50,000) 5,000 9,615 (9,615) (45,000) Interest expense – fixed payment Interest expense – net cash settlement Holding loss - interest rate swap Holding gain – hedged note Net effect – same as floating interest payment Illustration A-1 TA-8 (continued) HEDGE EFFECTIVENESS To qualify as a hedge, the hedging relationship must be highly effective in achieving offsetting changes in fair values or cash flows. An assessment of this effectiveness (generally means a high correlation) must be made at least every three months and whenever financial statements are issued. Hedge accounting must be terminated for hedging relationships that no longer are highly effective. HEDGE INEFFECTIVENESS The loss and gain will not exactly offset each other if the hedging arrangement is ineffective. Because there would not be an exact offset, earnings would be affected, an effect resulting from hedge ineffectiveness. Even if a hedge is highly effective, all ineffectiveness is recognized currently in earnings. FAIR VALUE CHANGES UNRELATED TO RISK BEING HEDGED Fair value changes unrelated to the risk being hedged are ignored. TA-9 Suggestions for Class Activities Professional Skills Development Activities The following are suggested assignments from the end-of-chapter material that will help your students develop their communication, research, analysis, and judgment skills. Communication Skills. Communication Cases A-2 requires group interaction. Real World Cases A-1 and A-3 are suitable for student presentation(s). Questions A-6 and A-7 create good class discussions. Research Skills. In their professional lives, our graduates will be required to locate and extract relevant information from available resource material to determine the correct accounting practice, perhaps identifying the appropriate authoritative literature to support a decision. Research Case A-3 and A-4 provide an excellent opportunity to help students develop this skill. Analysis Skills. Communication Case A-2 and Real World Case A-3 provide opportunities to develop analysis skills.