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FINANCIAL ACCOUNTING AND REPORTING

DERIVATIVES

Definitions

1. A derivative derives its value from the movements in prices, interest rates, or exchange rates
associated with other financial instruments, assets, or liabilities. In addition, derivative contracts are
often entered into without any exchange of cash at the contract date. The derivative can have zero
value on the contract date, but its value changes subsequently (up or down), depending on the
movement of the relevant price or rate associated with the underlying item.

2. A derivative contract is often an executory contract because it doesn’t involve a transaction but is
merely an exchange of promises about future actions. Other examples of an executory contract are
operating leases and a salary agreement for the coming year between employer and employee: The
employer agrees to pay a certain amount if the employee works, and the employee agrees to work if
the employer pays that certain amount.

3. The four types of risk are as follows:

 Price risk — uncertainty about the future price of an asset.

 Credit risk — uncertainty over whether the party on the other side of a transaction will abide by the
terms of the agreement.
 Interest rate risk — uncertainty about future interest rates and their impact on cash flows and the
fair value of financial instruments.
 Exchange rate risk — uncertainty about the future U.S. dollar cash flows stemming from assets
and liabilities denominated in foreign currencies.

4. Interest payments come in two general varieties — fixed payments and variable payments. Sometimes
it is easier for a firm to negotiate a fixed-rate loan; sometimes it is easier to negotiate a variable-rate
loan. If a firm is obligated to pay one type of interest payment but would prefer to be paying the other,
an interest rate swap can be used to transform the unwanted payment stream into the one that is
desired.

5. A forward contract is an agreement negotiated between two parties to exchange a specified amount
of a commodity, security, or foreign currency at a specified date in the future with the price or exchange
rate being set now.

6. A futures contract is the same thing except that instead of being negotiated between two parties, the
contract is a standard one that is sponsored by an organized exchange. With a futures contract, the
exchange handles the cash settlements between the two parties to the contract. Accordingly, with a
futures contract, the two parties to the agreement almost never directly contact one another. This is not
true with forward contracts because they are directly negotiated between the two parties.

7. Swaps, forwards, and futures provide two-sided protection. If these derivative instruments are
used in a hedging relationship, they hedge against both increases and decreases in prices or rates.

An option provides one-sided hedging: protection against unfavorable movements in prices or rates
without taking away the ability of the firm to profit from a favorable movement in prices or rates.
Because of the one-sided nature of an option, an option has value at the agreement date and the buyer
of the option must pay this amount at the beginning of the contract period.

8. A cash flow hedge is a derivative that offsets, at least partially, the variability in cash flows from a
forecasted transaction that is probable. One example of a cash flow hedge is an interest rate swap that
hedges the fluctuation in variable-rate interest payments. Another example is a futures contract used
to lock in the price of purchases to be made in a future period.

9. Traditional historical cost accounting is inappropriate when accounting for derivative contracts because
the historical cost of a derivative is usually very small, sometimes zero. With derivatives, the
subsequent changes in prices or rates are critical to determining the value of the derivative, yet these
changes are frequently ignored in traditional accounting.

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10. Partial hedge ineffectiveness occurs when the terms of a derivative have not been constructed to
exactly match the amount and timing of the underlying hedged item. Partial hedge ineffectiveness
would occur if, for example, the derivative maturity date did not exactly match the date of a forecasted
purchase.

11. The appropriate financial statement treatment of unrealized gains and losses on derivatives depends
on whether the derivative serves as a hedge and, if so, the type of hedge.

 No hedge. All changes in fair value are recognized as gains or losses in the income statement in
the period in which the value changes.

 Fair value hedge. Changes in fair value are recognized as gains or losses and are offset (either in
whole or in part) by the recognition of gains or losses on the change in fair value of the item being
hedged.

 Cash flow hedge. Changes in fair value are recognized as part of comprehensive income. These
deferred derivative gains and losses are recognized in net income in the period in which the hedged
cash flow transaction was forecasted to occur.

12. The notional amount is the total face amount of the asset or liability that underlies the derivative
contract. The notional amount can be misleading because the value of a derivative is a function of
changes in prices or interest rates and is normally equal to just a small fraction of the notional amount
of the underlying asset.

PROBLEMS

1. Jamil Bakeries specializes in making cakes, cookies, and other pastries out of rice flour which they grind
themselves. Jamil anticipates purchasing 40,000 pounds of rice in January 2018. On November 1, 2017,
Jamil entered into a futures contract with Sagara Growers to purchase 40,000 pounds of rice on January
1, 2018, at P0.50 per pound. On December 31, 2017, and January 1, 2018, the prevailing market price
for rice is P0.55 per pound. Jamil purchases the rice and settles the futures contract on January 1, 2018.

Make the necessary entries on Jamil's books at

(a) November 1, 2017

(b) December 31, 2017
(c) January 1, 2018

(a) No entry is made to record the futures contract on November 1, 2017. As of this date, the rice
futures contract has a fair value of P0.

(b)

Futures Contract (asset) .................... 2,000

Other Comprehensive Income ................ 2,000

The gain from the increase in the value of Jamil's futures contract is deferred as part of
comprehensive income. The futures contract is a cash flow hedge, with the futures contract payment
intended to offset the increased amount that the company will have to pay to make its forecasted
purchase of 40,000 pounds of rice on January 1, 2018.

(c)

Rice Inventory (40,000 lbs x P0.55) ......... 22,000

Cash ...................................... 22,000

Cash (futures contract settlement) .......... 2,000

Futures Contract (asset) .................. 2,000

Other Comprehensive Income .................. 2,000

Gain on Futures Contract .................. 2,000
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2. Wiggins Fitness Enterprises uses soybeans to make one of their nutritional supplement products.
Wiggins anticipates a need of 500,000 pounds of soybeans in January of 2018. On November 1, 2017,
Wiggins purchased a call option for 500,000 pounds of soybeans on January 1, 2018, at a price of
P0.40 per pound, which is the market price on November 1. Wiggins paid P1,200 for the call option and
designated this option as a hedge against price fluctuations for their January purchase of soybeans. On
December 31, 2017, and January 1, 2018, the prevailing market price for soybeans is P0.45 per pound.
On January 1, 2018, Wiggins purchased 500,000 pounds of soybeans.

Make the necessary entries on Wiggins's books at

(a) November 1, 2017

(b) December 31, 2017
(c) January 1, 2018

(a)

Soybean Call Option (asset) ................. 1,200

Cash ...................................... 1,200

No entry is made on November 1 to record the forecasted purchase of soybeans to occur in January
2018.

(b)

Soybean Call Option (asset) ................ 23,800

Other Comprehensive Income ............... 23,800

With the prevailing market price of P0.45 per pound on December 31, 2017, Wiggins can expect to
receive a payment of P25,000 [(P.45 - P.40) x 500,000 lbs.] on January 1, 2018, to settle the option.
Accordingly, the option is worth P25,000 on December 31, 2017.

(c)

Soybean Inventory ........................... 225,000

Cash (500,000 lbs x P0.45) ................ 225,000

Cash ........................................ 25,000

Soybean Call Option ....................... 25,000

Other Comprehensive Income .................. 23,800

Gain on Soybean Call Option ............... 23,800

The soybean call option is exercised. The gain deferred in Other Comprehensive Income in 2017 is
recognized in the earnings on January 1, 2018, the date of the forecasted transaction (soybean
purchase) that was hedged using the soybean call option.

3. On January 1, 2017, Eden Ventures, Inc., received a three-year, P1 million loan with interest payments
due at the end of each year and the principal to be repaid on December 31, 2007. The interest rate for
the first year is the prevailing market rate of 9 percent, and the rate each succeeding year will be equal
to the prevailing market rate on January 1 of that year. Eden also entered into an interest rate swap
agreement related to this loan. Under the terms of the swap agreement, in the years 2018 and 2007,
Eden will receive a swap payment based on the principal amount of P1 million. If the January 1 interest
rate is greater than 9 percent, Eden will receive a swap payment for the difference; and if the January 1
interest rate is less than 9 percent, Eden will make a swap payment for the difference. The swap
payments are made on December 31 of each year. On January 1, 2018, the interest rate is 8 percent,
and on January 1, 2007, the interest rate is 12 percent.

Make all the journal entries necessary on Eden's books at the dates shown below. For purposes of
estimating future swap payments, assume that the current interest rate is the best forecast of the future
interest rate.

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(1) January 1, 2017
(2) December 31, 2017
(3) December 31, 2018
(4) December 31, 2019

(1)

Cash ........................................ 1,000,000

Loan Payable .............................. 1,000,000

No entry is made to record the swap agreement because, as of January 1, 2017, the swap has a fair
value of P0.

(2)

Interest Expense ............................ 90,000

Cash (P1,000,000 x .09) ................... 90,000

Other Comprehensive Income .................. 17,833

Interest Rate Swap ........................ 17,833

Eden will make a swap payment on December 31, 2018, of P10,000 (9 percent - 8 percent x
P1,000,000). At current market rates, Eden also expects to make a P10,000 swap payment on
December 31, 2019. The present value of these payments is equal to P17,833 (10,000 x 1.7833
[present value of annuity for 2 periods at 8 percent]).

(3)

Interest Expense ............................ 90,000

Cash (P1,000,000 .09) ................... 90,000

Interest Rate Swap .......................... 10,000

Cash (P1,000,000 [.09 - .08]) ........... 10,000

This entry records the swap payment Eden was obligated to make based on the
interest rate (8 percent) at January 1, 2018.

Interest Expense ............................ 10,000

Other Comprehensive Income ................ 10,000

This entry adjusts other comprehensive income for amounts previously accrued at
December 31, 2017.

Interest Rate Swap .......................... 34,620

Other Comprehensive Income ................ 34,620

Based on the current market rate of 12 percent at December 31, 2018, Eden can expect to receive a
swap payment of P30,000 (12 percent - 9 percent x P1,000,000) at December 31, 2007. This payment
has a present value of P26,787 (P30,000 x 0.8929 [present value factor for one period at 12 percent]).
This entry adjusts the interest rate swap account to a balance of P26,787 (debit) and also adjusts the
other comprehensive income account to a balance of P26,787 (credit).

(4)

Interest Expense ............................ 90,000

Cash (P1,000,000 x .09) ................... 90,000

Cash (from Interest Rate Swap) .............. 30,000

Interest Rate Swap ........................ 26,787
Other Comprehensive Income ................ 3,213

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This entry records the swap payment Eden is entitled to receive based on the interest rate (12 percent)
at January 1, 2007. It reduces the value of the interest rate swap account to zero, reflecting the
expiration of the contract, and it increases the balance of the other comprehensive income account to
P30,000, the value of the swap payment received.

Other Comprehensive Income .................. 30,000

Interest Expense .......................... 30,000

This entry uses amounts previously recognized in Other Comprehensive Income to adjust earnings by
offsetting interest expense.

Loan Payable ................................ 1,000,000

Cash ...................................... 1,000,000

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