Chapter 13

Accounting for
Derivatives and
Hedging
Activities

Accounting for Derivatives and

Hedging Activities: Objectives
1.
2.
3.
4.
5.
6.

Understand the definition of a cash flow hedge and the

circumstances in which a derivative is accounted for as a cash
flow hedge.
Understand the definition of a fair value hedge and the
circumstances in which a derivative is accounted for as a fair
value hedge.
Account for a cash flow hedge situation, and for a fair value
hedge situation, from inception through settlement.
Understand the special derivative accounting related to hedges
of foreign currency-denominated receivables and payables.
Comprehend the footnote disclosure requirements for
derivatives.
Understand the International Accounting Standards Board
accounting for derivatives.

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13-2

Using Derivatives as Hedges

A hedge can
Shift risk of fluctuations in sales
prices, costs, interest rates, or
currency exchange rates
Help manage costs
Reduce risks to improve financial
position
Produce tax benefits
Help avoid bankruptcy
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13-3

Hedge Accounting
At inception, document
The relationship between hedged item and
derivative instrument
The risk management objective and
strategy for the hedge
Hedging instrument
Hedged item
Nature of risk being hedged
Means of assessing effectiveness
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13-4

Hedge Effectiveness
To qualify for hedge accounting, the derivative
instrument must be highly effective in offsetting gains
or losses in the item being hedged.
Effectiveness considers
Nature of the underlying variable
Notional amount of the derivative and the item being
hedged
Delivery date of derivative
Settlement date of the underlying
If critical terms are identical, effectiveness is assumed.

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13-5

Example of Effectiveness
Item to be hedged

Accounts payable
Due January 1, 2012
For delivery of 10,000 euros
Variable is the changing value of euros

Hedge instrument
Forward contract
To accept delivery of 10,000 euros
On January 1, 2012

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13-6

Statistical Analysis
If critical terms of item to be hedged and
hedge instrument do not match, statistical
analysis can determine effectiveness.
Regression analysis
Correlation analysis
Example
Using derivatives based on heating oil or
crude oil to hedge jet fuel costs

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13-7

Accounting for Derivatives and Hedging Activities

1: CASH FLOW HEDGE

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13-8

Cash Flow Hedge

A Cash Flow Hedge is used for
anticipated or forecasted
transactions where there is risk of
variability in future cash flows.

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13-9

Accounting for Cash Flow Hedge

A Cash Flow Hedge is
recorded at cost
adjusted to fair value at each reporting
date
accounted for in Other Comprehensive
Income (OCI) when there are gains or
losses

When the forecasted transaction

impacts the income statement
Reclassify OCI to the hedged
revenue or expense account
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13-10

Accounting for Derivatives and Hedging Activities

2: FAIR VALUE HEDGE

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13-11

Fair Value Hedge

A Fair Value Hedge is used for an asset
or liability position, or firm purchase or
sale commitment, where there is a risk
of variability in the value of the
position.

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13-12

Accounting for a Fair Value

Hedge
Both the item being hedged and the
derivative are
adjusted to fair value at each
reporting date
accounted for immediately in
income with offsetting gains or
losses

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13-13

Accounting for Derivatives and Hedging Activities

3: HEDGE ACCOUNTING

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13-14

Cash Flow Hedge: Example 1

Utility anticipates purchasing oil for sale to its
customers next February. On December 1, Utility
enters into a futures contract to acquire 4,200
gallons of oil at $1.4007 per gallon for delivery on
January 31. A margin of $10 is to be paid up front.
On December 31, the price for delivery of oil on
January 31 is $1.4050.
On January 31, the spot rate for current delivery
is $1.3995.
Utility settles the contract, accepting delivery of
4,200 gallons of oil.

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13-15

Cash Flow Hedge: Example 1

(cont.)
In February, Utility sells all the oil to its
customers for $8,400 and reclassifies its OCI
from the hedge as cost of sales. Pertinent rates:
12/1

12/31

1/31

Futures rate, for 1/31

$1.4007

$1.4050

$1.3995

Cost of 4,200 barrels

$5,882.94

$5,901.00

$5,877.90

Change in futures contract to 12/31 = $18.06

Change in futures contract to 1/31 = ($23.10)
The loss on the contract is ($5.04) OCI, and this
serves to increase Cost of Sales.

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13-16

Cash Flow Hedge: Example 1

(cont.)
Sign
contract

12/1 Futures contract

Cash
12/31 Futures contract

Adjust to
fair value

10.00
10.00
18.06

OCI
1/31 OCI

18.06
23.10

Futures contract

Settle
contract;
collect
balance on
margin.

1/31 Cash

23.10
4.96

Futures contract
1/31 Inventory
Cash

4.96
5,877.90
5,877.90

Purchase inventory.
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13-17

Cash Flow Hedge: Example 1

(cont.)
Record
the
sale
and
cost of
sales.

Feb. Cash

8,400.00

Sales
Feb. Cost of sales

8,400.00
5,877.90

Inventory
Feb. Cost of sales
OCI

5,877.90
5.04
5.04

The last entry reclassifies the loss on the contract from

OCI into Cost of Sales. The effect is to increase Cost of
Sales to $5,882.94. This is the cost of the oil based on
the futures contract signed on December 1.

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13-18

Cash Flow Hedge: Example 2

On 12/2/11, Winkler anticipates purchasing equipment on 3/1/12
with payment on that date of 500,000. On 12/2/11, Winkler
signs a 90-day forward contract to buy 500,000 for $1.68 (the
spot rate is $1.70).
The $10,000 contract discount will be amortized to Exchange
Gain over three months using the effective interest method.
Implied interest is:

PV = 1.70(500,000) = $850,000
FV = 1.68(500,000) = $840,000
Period = 3 months
Monthly rate using Excel =rate(nper,pmt,pv,fv)
=rate(3,0,850000,-840000)
Result: 0.003937

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13-19

Cash Flow Hedge: Example 2

(cont.)
Forward rates and fair value of contract:
Date

Forward rate

Notional
Amount
500,000

12/2

$1.68

840,000

12/31

$1.69

845,000

5,000

4,901

3/1

$1.72

860,000

20,000

15,099

Contract
Fair value

Discounted
Fair value

The contract will be adjusted to its discounted fair

value. Use the incremental borrowing rate (12%, or
1% monthly), discounting for the remaining contract
life.
12/31: 5,000 / (1.01)2
3/1 (end of contract): 15,000
Note: 1/31 would be equal to fair value / (1.01)1
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13-20

Cash Flow Hedge: Example 2

(cont.)
12/2

no entry for forward contract - no cash exchanged

12/31 Forward contract

4,901

OCI

4,901

Bring forward contract to discounted fair value.

12/31 OCI

3,346
Exchange gain

3,346

Effective interest method amortization of the 10,000

discount. 850,000 x .003937

The change in value

for the forward
contract is an
unrealized gain put
into OCI.
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The discount on
the contract is
amortized over
the 3 months of
the contract.
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Cash Flow Hedge: Example 2

(cont.)
3/1 Forward contract

15,099

OCI

15,099

Bring forward contract to fair value, $20,000

3/1 Cash

The final
balance in
OCI is
$10,000 CR.
This will
reduce the
equipment's
depreciation
over its life.

20,000

Forward contract

20,000

for net settlement of contract: 860,000 current - 840,000

contract
3/1 Equipment

860,000

Cash

860,000

Purchase equipment from supplier

3/1 OCI

6,654
Exchange gain

6,654

remaining amortization: 10,000 - 3,346

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13-22

Fair Value Hedge: Example 3

Utility has accumulated 10,000 barrels of oil in
inventory that it will not sell until the later winter
months. Utility wants to maintain the value of the
inventory which is recorded at cost of $85 per barrel,
in the event that the price of oil falls before they are
able to sell it. On November 1, Utility enters into a
futures contract to sell the oil for $90 a barrel in three
months.
The contract will be settled net.

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13-23

Fair Value Hedge: Example 3

(cont.)
The market price of the oil is $92 per barrel
at December 31.
The estimated value of the forward contract
on December 31 is a liability of the $2 per
barrel difference between our contracted
price and the market price. The liability is
measured as $20,000 / (1.01), or $19,802,
assuming a 1% per month interest rate.
On January 31, the spot price is $89 and
Utility settles the contract by receiving
$10,000, or ($90-$89) x 10,000 barrels.
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13-24

Fair Value Hedge:

Example 3 (cont.)
Report at fair
value at
reporting date.

Loss on Forward
12/31 contract
Forward contract
12/31 Inventory

Adjust
inventory to
fair value
Adjust
values prior
to final
settlement.
Settle
contract.

19,802
19,802
20,000

Gain on Inventory

20,000

1/31 Forward contract

10,000

Forward contract

19,802

Gain on Forward
contract
Loss on Inventory

29,802
30,000

Inventory
1/31 Cash
Forward contract

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30,000
10,000
10,000
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Accounting for Derivatives and Hedging Activities

4: ACCOUNTING FOR
HEDGES OF FOREIGN
CURRENCY RECEIVABLES
AND PAYABLES

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13-26

Fair Value Hedge Example:

Liability
Cary purchases equipment costing 200,000 yen on
12/2/11 with payment due on 1/30/12.
On 12/2/11 Cary enters a forward contract to
purchase 200,000 yen on 1/30/12 at the forward
contract rate of $0.0095.

Date

Spot rate

Acct Pay

12/2

$0.0094

$1,880

$0.0095

$1,900

12/31

$0.0092

$1,840

$0.0093

$1,860

1/30

$0.0098

$1,960

$0.0098

$1,960

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Forward rate

Cont Rec

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Fair Value Hedge: Liability

(cont.)
Accounts payable:
Gain of $40 for December
Loss of $120 for January
Contract receivable:
Loss of $40 for December
Gain of $100 for January
Total exchange loss on the transaction = ($20)
- The net gain/loss for December = $0.
- The net loss for January = ($20)
Spread between the spot and forward rate on 12/2
determines the total loss, e.g., the cost of hedging.
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13-28

Fair Value Hedge: Liability

(cont.)
12/2: Buy
equipment
and sign
forward
contract.

12/2 Equipment

1,880

Accounts payable ()
12/2 Contract receivable ()

1,880
1,900

Contract payable ($)

12/31:
Adjust
foreign
monetary
accounts to
current
(year-end)
rate.

12/31 Accounts payable ()

1,900
40

Exchange gain
12/31 Exchange loss
Contract receivable ()

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40
40
40

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Fair Value Hedge: Liability

(cont.)
1/30: Pay
promised
$1,900 on
forward
contract
and receive
yen in
exchange

1/30 Contract payable ($)

1,900

Cash ($)
1/30 Cash ()

1,900
1,960

Contract receivable ()

1,860

Exchange gain
1/30 Accounts payable ()
Exchange loss
Cash ()

100
1,840
120
1,960

Use the yen to pay the supplier

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13-30

Accounting for Derivatives and Hedging Activities

5: FOOTNOTE DISCLOSURE
REQUIREMENTS FOR
DERIVATIVES

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13-31

Footnote Disclosures
Risk management objectives and strategies
must be disclosed in the footnotes.
Fair value hedges
net gain or loss in earnings
placement on statements
effectiveness and ineffectiveness
Cash flow hedges
hedge ineffectiveness gain or loss
placement on statements
types of situations hedged
expected length of time
effect of discontinuance of hedge
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13-32

Accounting for Derivatives and Hedging Activities

6: THE IASB STANDARDS

FOR DERIVATIVES

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13-33

International Accounting
Standards
IAS are similar to U.S. Standards in most
respects:
IAS

IAS

32 financial instruments
Debt and equity instruments
39 derivatives and hedges
Cash flow and fair value hedges
Difference: hedges of firm
commitments can be accounted for as
either a cash flow or fair value hedge

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13-34