Ch.19 Derivatives, Contingencies, Business Segments, and Interim Reports 1. The concepts of derivatives and hedging activities 2. Different types of risk faced by a business 3. The characteristics of swaps, forwards, futures, and options 4. Define hedging and the difference between a fair value hedge and a cash flow hedge 5. Account for derivatives and for hedging 6. The contingent items to the areas of lawsuits and environmental liabilities 7. The supplemental disclosures of financial information by product line and by geographic area 8. The importance and difficulties of interim reports 19-1
1. Understand the business and accounting concepts connected with derivatives and hedging activities Simple Example of a Derivative On October 1, 2013, you purchase 100 shares of stock in Nauvoo Software Solutions (your employer) at the market price of $50 per share. On January 1, 2014, you need to make a college tuition payment of $5,000 on behalf of your daughter. Your employment contract states that any shares you purchase from the company must be held for at least three months before you can sell them. 19-2
Simple Example of a Derivative A downward movement in the stock price between now and January 1 would be disastrous for you. What is the solution to your dilemma? 19-3
Simple Example of a Derivative You can avoid downward movement if you make the following agreement: If the price of the stock is above $50 per share, you agree to pay cash equal to the excess to John Bennett, a local speculator. If the price goes below $50, Bennett will pay you a cash amount equal to the deficit. This agreement is called a derivative. 19-4
Simple Example of a Derivative A derivative is a financial instrument or contract that derives its value from the movement of the price, foreign exchange rate, or interest rate on some other underlying asset or financial instrument. No matter what happens to the price of Nauvoo stock between now and then, you will wind up with $5,000 on January 1. When the agreement is made, no journal entry is required, because it is merely an exchange of promises about some future action; that is, an executory contract. 19-5
2. Identify the different types of risk faced by a business Types of Risk Price risk is the uncertainty about the future price of an asset. Credit risk is the uncertainty that the party on the other side of the agreement will abide by the terms of the agreement. Interest rate risk is the uncertainty about future interest rates an their impact on future cash flows as well as on the fair value of existing assets and liabilities. Exchange rate risk is the uncertainty about the U.S. dollar cash flows arising when assets and liabilities are denominated in a foreign currency. 19-6
3. Describe the characteristics of the following types of derivatives: swaps, forwards, futures, and options Swap A swap is a contract in which two parties agree to exchange payments in the future based on the movement of some agreed-upon price or rate. A common type of swap is an interest rate swap where two parties agree to exchange future interest payments on a given loan amount (one set of interest payments is based on a fixed interest rate and the other is based on a variable interest rate). 19-7
Swap Pratt Company takes advantage of its good working relationship with a bank that issues only variable-rate loans. On January 1, 2013, Pratt receives a 2-year, $100,000 loan with interest payments occurring at the end of each year. The interest rate for the first year is 10%, and the rate in the second year will be equal to the market interest on January 1 of that year. 19-8
Swap Pratt enters into an interest rate swap agreement with another party whereby Pratt agrees to pay a fixed interest rate of 10% on the $100,000 loan to that party in exchange for receiving a variable amount based on the prevailing market rate. Pratt will receive an amount equal to [$100,000 (Jan. 1, 2014 interest rate 10%)] if the interest rate is above 10% and will pay the same amount if the rate is less than 10%. 19-9
Swap To see the impact of this interest rate swap, consider the following table: Pratt will pay $10,000 no matter what the prevailing interest rates in 2014. 19-10
Forwards A forward contract is an agreement 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 of the exchange rate being set now. On November 1, 2013, Clayton Company sold machine parts to Maruta Company for 30,000.00 to be received on January 1, 2014. The current exchange rate is 120 = $1. 19-11
Forwards Clayton enters into a forward contract with a large bank, agreeing that on January 1 Clayton will deliver 30,000,000 to the bank and the bank will give U.S. dollars in exchange at the rate of 120 = $1, or $250,000 ( 30,000,000/ 120 per $1). If on January 1, 2014, 30,000,000 is worth less than $250,000, the bank will pay Clayton the difference in cash (U.S. dollars). (continued) 19-12
Forwards If 30,000,000 is worth more than $250,000 Clayton pays the difference in cash. The impact of the forward exchange is shown in the following table: (continued) 19-13
Futures A futures contract is a contract, traded on an exchange, that allows a company to buy or sell a specified quantity of a commodity or a financial security at a specified price on a specified future date. It is very similar to a forward contract with the difference being that a forward contract is a private contract negotiated between two parties, whereas a futures contract is a standardized contract that is sponsored by a trading exchange. 19-14
Futures Hyrum Bakery uses 1,000 bushels of wheat every month. On December 1, 2013, Hyrum decides to protect itself against price movements. Hyrum buys a futures contract to purchase 1,000 bushels of wheat on January 1, 2014, at $4 per bushel. This is a standardized exchange-traded futures contract, so Hyrum has no idea who is on the other side of the agreement. (continued) 19-15
Futures As with other derivatives, a wheat futures contract is usually settled by a cash payment at the end of the contract instead of the actual delivery of the wheat. The effect of the futures contract is illustrated in the following table: 19-16
Option An option is a contract giving the owner the right, but not the obligation, to buy or sell an asset at a specified price any time during a specified period in the future. A call option gives the owner the right to buy an asset at a specified price. A put option gives the owner the right to sell an asset at a specified price in exchange for the rights inherent in the option. The owner of the option pays an amount in advance to the party on the other side of the transaction, who is called the writer of the option. 19-17
Option On October 1, 2013, Woodruff Company decides that it will need to purchase 1,000 ounces of gold for use in its computer chip manufacturing process in January, 2014. Gold is selling for $1,100 per ounce on October 1, 2013. For cash flow reasons, Woodruff plans to delay the purchase of gold until January 1, 2014, and is concerned about potential increases in the market price of gold between October 1, 2013, and January 1, 2014. 19-18
Option Woodruff enters into a call option contract on October 1. The contract gives Woodruff the right, but not the obligation, to purchase 1,000 ouches of gold at a price of $1,100 per ounce. The option period extends to January 1, 2014. Woodruff has to pay $20,000 to buy this option. 19-19
Option The chart below shows the anticipated activity at three possible gold prices. The existence of the option contract means that Woodruff will pay no more than $1,100,000 for gold. 19-20
4. Define hedging, and outline the difference between a fair value hedge and a cash flow hedge Types of Hedging Activities Broadly defined, hedging is the structuring of transactions to reduce risk. A fair value hedge is a derivative that offsets, at least partially, the change in the fair value of an asset or a liability. A cash flow hedge is a derivative that offsets, at least partially, the variability in cash flows from forecasted transactions that are probable. 19-21
5. Account for a variety of different derivatives and for hedging relationships Overview of Accounting for Derivatives and Hedging Activities The accounting difficulty caused by derivatives is illustrated in this simple matrix: The historical cost focus of traditional accounting is misplaced with derivatives because derivatives often have little or no up-front historical cost. 19-22
Overview of Accounting for Derivatives and Hedging Activities 1. Balance sheet. Derivatives should be reported in the balance sheet at their fair value as of the balance sheet date. No other measure of value is relevant for derivatives. 2. Income statement. When a derivative is used to hedge risks, the gains and losses on the derivative should be reported in the same income statement in which the income effects on the hedged items are reported. 19-23
Overview of Accounting for Derivatives and Hedging Activities No hedge. All changes in the fair value of derivatives that are not designated as hedges are recognized as gains or losses in the income statement in the period in which the value changed. Fair value hedge. Changes in the fair value of derivatives designated as fair value hedges are recognized as gains or losses in the period of the value change. 19-24
Overview of Accounting for Derivatives and Hedging Activities Cash flow hedge. Changes in the fair value of derivatives designated as cash flow hedges are recognized as part of the accumulated other comprehensive income account. To account for a derivative as a hedge, a company must define, in advance, how it will determine whether the derivative is functioning as an effective hedge. 19-25
Disclosure Companies are required to provide a description of their risk management strategy and how derivatives fit into that strategy for both fair value and cash flow hedges. Companies must disclose the amount of derivative gains or losses that are included in income because of hedge ineffectiveness. For cash flow hedges, a company must describe the transactions that will cause deferred derivative gain and losses to be recognized in net income. 19-26
Disclosure The notional amount is the total face amount of the asset or liability that underlies a derivative contract. The notional amount of derivative instruments is often reported and is frequently misleading. Notional amounts grossly overstate both the fair value and the potential cash flows of derivatives. 19-27
Pratt Swap On January 1, 2013, Pratt Company received a two-year $100,000 variable-rate loan and also entered into an interest rate swap agreement. The journal entry to record this information follows: 2013 Jan. 1 Cash 100,000 Loan Payable 100,000 No entry is made to record the swap agreement because the swap has a fair value of $0. 19-28
Pratt Swap The actual market interest rate on December 31, 2013 is 11%. With this rate, Pratt will receive a $1,000 payment [$100,000 x (0.11 0.10)] at the end of 2014. On December 31, 2013, Pratt has a $1,000 receivable under the swap agreement, and the receivable has a present value of $901 (FV = $1,000, N =1, I = 11%). 19-29
Pratt Swap The impact of the change in interest rate on the interest rate swap and on reported interest expense is accounted for as follows: 19-30
Pratt Swap The journal entry to record Pratt s 2013 interest payment, along with the adjusting entry to recognize the change in the fair value, is as follows: 2013 Dec 31 Interest Expense 10,000 Cash ($100,000 0.10) 10,000 31 Interest Rate Swap (asset) 901 Other Comprehensive Income 901 The journal entries at the end of 2014 are on Slide 19-32. 19-31
2014 Pratt Swap Dec. 31 Interest Expense 11,000 Cash ($100,000 0.11) 11,000 31 Cash (from swap agreement) 1,000 Interest Rate Swap (asset) 901 Other Comprehensive Income ($901 0.11) 99 31 Accumulated Other Comprehensive Income 1,000 Interest Expense 1,000 31 Loan Payable 100,000 Cash 100,000 19-32
Clayton Forward On November 1, 2013, Clayton Company sold machine parts to Maruta Company for 30,000,000 to be received on January 1, 2014. On the same date, Clayton also entered into a yen forward contract. The required entry is as follows: 2013 Nov. 1 Yen Receivable 250,000 Sales 250,000 30,000,000/ 120 per $1 19-33
Clayton Forward The actual exchange rate on December 31, 2013 is 119 = $1. Clayton will have a loss on the forward contract and will be required to make a $2,101 payment [( 30,000,000/ 119 per $1) $250,000]. The impact of the change in the yen exchange rate is as follows: 19-34
Clayton Forward The adjusting entries to recognize the change in the fair value of the forward contract and in the U. S. dollar value of the yen receivable are as follows: 2013 Dec. 31 Loss on Forward Contract 2,101 Forward Contract 2,101 31 Yen Receivable 2,101 Gain on Foreign Currency 2,101 19-35
Clayton Forward The journal entries necessary in Clayton s books on January 1, 2014, to record receipt of the yen payment and settlement of the yen forward contract are as follows: 2014 Jan. 1 Cash ( 30,0000,000/ 119 per $1) 252,101 Yen Receivable 252,101 1 Forward Contract (liability) 2,101 Cash (forward contract settlement) 2,101 19-36
Clayton Forward It should be noted that the Clayton forward contract does not qualify for hedge accounting under FASB ASC Topic 815. Derivatives that serve as economic hedges of foreign currency assets and liabilities are accounted for as speculations, with all gains and losses recognized as part of income immediately. 19-37
Hyrum Future On December 1, 2013, Hyrum Company decided to hedge against potential fluctuations in the price of wheat for its forecasted January 2014 purchases. The firm bought a futures contract entitling and obligating Hyrum to purchase 1,000 bushels of wheat on January 1, 2014, for $4.00 per bushel. 19-38
Hyrum Future No entry is made to record the futures contract because, as of December 31, 2013, the future has a fair value of $0. The actual price of wheat on December 31, 2013, is $4.40 per bushel. Hyrum will receive a $400 payment [1,000 bushels ($4.40 $4.00)] on January 1, 2014, to settle the futures contract. 19-39
Hyrum Future The impact of the change on the anticipated cost of wheat when purchased in January 2014 is accounted for as follows: 19-40
The adjusting entry to recognize the change in the fair value of the futures contract is as follows: 2013 Hyrum Future Dec. 31 Wheat Futures Contract (asset) 400 Other Comprehensive Income 400 The gain from the increase in the value of Hyrum s futures contract is deferred as a part of other comprehensive income. 19-41
The journal entries necessary to record the purchase of 1,000 bushels of wheat in the open market and the cash settlement of the wheat futures contracts are as follows: 2014 Hyrum Future Jan. 1 Wheat Inventory 4,400 Cash 4,400 1,000 bushels x $4.40 1 Cash (future contract settlement) 400 Wheat Futures Contract (asset) 400 1 Accumulated Other Comprehensive Income 400 Gain on Futures Contract 400 19-42
Woodruff Option On October 1, 2013, Woodruff Company paid $20,000 to purchase a call option to buy 1,000 ounces of gold at a price of $1,100 per ounce some time before January 1, 2014. Because Woodruff paid cash for the gold option, the following journal entry is made on October 1: 2013 Oct. 1 Gold Call Option (asset) 20,000 Cash 20,000 19-43
Woodruff Option The actual price of gold on December 31, 2013, is $1,128 per ounce. Woodruff will receive a $28,00 payment [($1,128 x 1,000 ounces) ($1,100 x 1,000 ounces)] on January 1, 2014, to settle the call option. The impact on the change in price of gold is accounted for as follows: 19-44
Woodruff Option The gold call option is reported at its fair value of $28,000 in the December 31, 2013, balance sheet. The adjusting entry to recognize the change in the fair value of the option is as follows: 2013 Dec. 31 Gold Call Option ($28,000 $20,000) 8,000 Other Comprehensive Income 8,000 19-45
Woodruff Option The journal entry necessary in Woodruff s book on January 1, 2014, to record the purchase of 1,000 ounces of gold and the cash settlement of the option contract are as follows: 2014 Jan. 1 Gold Inventory 1,128,000 Cash 1,128,000 1 Cash 1,000 (gold ounces call option x $1,128 settlement) 28,000 Gold Call Option (asset) 28,000 1 Accumulated Other Comprehensive Income 8,000 Gain on Gold Call Option 8,000 19-46
6. Apply the accounting rules for contingent items to the areas of lawsuits and environmental liabilities Accounting for Contingencies Contingent losses. Circumstances involving potential losses that will not be resolved until some future event occurs. Contingent gains. Circumstances involving potential gains that will not be resolved until some future event occurs. 19-47
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Accounting for Lawsuits In ASC Topic 450, the FASB identifies several key factors to consider in making the decision. These include the following: 1. The nature of the lawsuit 2. Progress of the case 3. Views of legal counsel as to the probability of loss 4. Prior experience with similar cases 5. Management s intended response to the lawsuit 19-50
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Disclosure Some companies do not disclose any information regarding potential liabilities from lawsuits. Others provide a brief, general description of pending lawsuits. Sometimes companies provide fairly specific information about pending actions and claims. They generally do not disclose dollar amounts of potential losses. 19-54
Accounting for Environmental Liabilities The SEC staff issued Staff Accounting Bulletin No. 92, which set forth the SEC s interpretation of GAAP regarding contingent liabilities, with particular applicability to companies with environmental liabilities. The AICPA issued SOP 96-1 outlining key events that can be used to determine whether an environmental liability is probable. 19-55
7. Prepare the necessary supplemental disclosures of financial information by product line and by geographic area Business Segments Information to be disclosed in the financial statement notes under the provisions of Pre- Codification FASB Statement No. 14 included revenues, operating profit, and identifiable assets for each significant industry segment of a company. Other provisions of the statement required disclosure of revenues from major customers and information about foreign operations and export sales. 19-56
1. Total segment operating profit or loss 2. Amounts of certain income statement items such as operating revenues, depreciation, interest revenue, interest expense, tax expense, and significant noncash expenses 3. Total segment assets Business Segments According to the provisions of FASB ASC Topic 280, companies are required to disclose the following information concerning business segments: 19-57
Business Segments 4. Total capital expenditures 5. Reconciliation of the sum of segment totals to the company total for each of the following items: Revenues Operating profits Assets 19-58
Business Segments Separate segment disclosure is required if a segment meets any one of the following three criteria: Revenue test. A segment should be reported if its total revenue is 10% or more of the company s total revenue (external and internal). 19-59
Business Segments Profit test. A segment should be reported if the absolute value of its operating profit (or loss) is more than 10% of the total of the operating profit for all segments that report profits (or the total of the losses for all segments that reported losses). Asset test. A segment should be reported if it contains 10% or more of the combined assets of all operating segments. 19-60
Business Segments The FASB also decided that segments can be combined for reporting purposes, even if they are treated as separate segments internally, if the segments have similar products or services, similar processes, similar customers, similar distribution methods, and are subject to similar regulations. 19-61
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8. Recognize the importance of interim reports, and outline the difficulties encountered when preparing those reports Interim Reports Statements showing financial position and operating results for intervals of less than a year are referred to as interim financial statements. Under the integral part of annual period concept, the same general accounting principles and reporting practices employed for annual reports are to be utilized for interim statements, but modifications may be required so the interim results will better relate to the total results of operations for the annual period. 19-63
Interim Reports Example of a Modification Assume a company uses the LIFO method of inventory valuation and encounters a situation where liquidation of the base period inventory occurs at an interim date but the inventory is expected to be replaced by the end of the annual period. The inventory should not reflect the LIFO liquidation by including the cost of replacing the liquidated LIFO base. 19-64
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