Accounting for DerivativeInstruments

Risky BusinessIt has been said that until the early 1970s most financial managers worked in acozy, if unthrilling world. Since then, however, constant change caused byvolatile markets, new technology, and deregulation has increased the risks tobusinesses. For example, in 1971 currencies were allowed to float freely. Afterthat came oil price shocks, high inflation, and wide swings in interest rates. Theresponse from the financial community was to develop products to manage therisks due to changes in market prices. These productsoften referred to as deriv-ativesare useful for risk management because the fair values or cash flows ofthese instruments can be used to offset the changes in fair values or cash flowsof the assets that are at risk. The growth in use of derivatives has been aided bythe development of powerful computing and communication technology, whichprovides new ways to analyze information about markets as well as the powerto process high volumes of payments.

However, derivatives cause problems. The following table shows five companiesthat have experienced substantial losses in the derivatives market.

LEARNING OBJECTIVESAfter studying this chapter,you should be able to:

A Explain the difference invaluation basis between atraditional and derivativefinancial instrument.

B Describe the accounting fortraditional financialinstruments.

C Describe the accounting forderivative financialinstruments.

D Explain how to account for afair value hedge.

E Explain how to account for acash flow hedge.

F Identify special reportingissues related to derivativefinancial instruments thatcause unique accountingproblems.

G Describe the disclosurerequirements for traditionaland derivative financialinstruments.

CHAPTER26

Pretax LossCompany (in millions) Type of Derivative Who Pays

Showa Shell Sekiyu $1,580 Currency derivatives Stockholders(Japan)

Metaligesellschaft $1,340 Oil derivatives Stockholders(Germany)

Codelco (Chile) $200 Metals derivatives TaxpayersProcter & Gamble (U.S.) $157 Leveraged currency swaps StockholdersAir Prod. & Chemicals $113 Leveraged interest rate Stockholders

(U.S.) and currency swapsSource: Fortune, July 25, 1994, p. 107.

26-1

Although these losses are substantial, derivatives do not introduce risks that arefundamentally different from the risks already present in the financial markets.Nonetheless, derivative instruments raise questions about off-balance-sheetfinancing, unjustifiable deferrals of losses, premature recognition of gains, andinadequate disclosure of information in financial statements about risks, fair val-ues, and other attributes of these instruments. Thus, developing accounting anddisclosure standards for these instruments has been a major challenge for theaccounting profession.

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26-2 Chapter 26 Accounting for Derivative Instruments

Preview of Chapter 26As the opening story indicates, the issues related to derivative instruments have result-ed in a number of challenges. In this chapter, we examine the accounting and disclo-sure requirements for derivative instruments, as recently addressed in SFAS No. 133Accounting for Derivative Instruments and Hedging Activities.1 The content andorganization of the chapter are as follows:

FINANCIAL INSTRUMENTSFinancial instruments are defined as cash, an ownership interest in an entity, or a con-tractual right to receive or deliver cash or another financial instrument on favorable orunfavorable terms.2 By this definition, traditional assets and liabilities such as accountsand notes receivable, accounts and notes payable, investments in debt and equity secu-rities, and bonds payable are considered financial instruments. Illustration 26-1 pre-sents examples of traditional financial instruments and their basis for valuation.3

1Accounting for Derivative Instruments and Hedging Activities, Statement of FinancialAccounting Standards No. 133 (Stamford, Conn.: FASB, 1998). All derivative instruments, whetherfinancial or not, are covered under this standard. Our discussion in this chapter focuses on deriv-ative financial instruments because of their widespread use in practice.2According to SFAS No. 133 (Appendix F), financial instruments are defined as cash, ownershipinterest in an entity, or a contract that both: (a) imposes on one entity a contractual obligation todeliver cash or another financial instrument to a second entity or to exchange other financialinstruments on potentially unfavorable terms with the second entity; and (b) conveys to that sec-ond entity a contractual right to receive cash or another financial instrument from the first entityor exchange other financial instruments on potentially favorable terms with the first entity.

Objective A

Explain the difference in valuation basis

between a traditionaland derivative

financial instrument.

ACCOUNTING FOR DERIVATIVEINSTRUMENTS

Other Reporting Issues

Embedded derivativesQualifying hedge criteriaDisclosure provisionsSummary of SFAS No.133

DerivativesUsed forHedging

Fair value hedgeCash flow hedge

FinancialInstruments

Traditional financialinstrumentsDerivative financialinstruments

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ILLUSTRATION 26-1Traditional FinancialInstruments

Financial Instruments 26-3

ILLUSTRATION 26-2Derivative FinancialInstruments and RelatedUnderlyings

Derivative Financial Instrument

Interest rate swaps and optionsStock index futures and stock optionsCommodity futures and optionsCurrency futures and optionsCaps, floors, and collarsSwaptions and leaps

Underlyings

Interest ratesStock pricesCommodity pricesExchange ratesStock prices, interest ratesInterest rates, stock prices

Valuation Basis

Fair value

3The reporting for many of these traditional financial instruments is addressed elsewhere in the text-book: Cash and notes receivable in Chapter 7; accounts and notes payable in Chapter 13; bonds payablein Chapter 14; convertible bonds in Chapter 17; bond and equity investments in Chapter 18.4The Boards long-term objective is to require fair value measurement and recognition for allfinancial instruments (SFAS No. 133, para. 216).5Fair value is defined as the amount at which an asset (or liability) could be bought (incurred) orsold (settled) between two willing parties (i.e., not forced or in liquidation). Quoted market pricesin active markets are the best evidence of fair value and should be used if available. In the absenceof market prices, the prices of similar assets or liabilities or accepted present value techniques can be used. Disclosures About Fair Value of Financial Instruments Statement of FinancialAccounting Standards No. 107 (Stanford, Conn.: FASB, 1991) paras. 56, 11.

Traditional Financial Instrument

CashAccounts and notes receivableInvestments in debt securities

Investments in equity securitiesAccounts and notes payableBonds payable

Valuation Basis

Fair valueFair valueFair value or amortized cost, depending on classificationof securitiesFair valueCost or amortized costCost or amortized cost

As indicated, many traditional financial instruments are reported at fair value. TheFASB is now examining whether all traditional financial instruments should be report-ed at fair value.4 The definition of financial instruments also includes many innovativeand complex financial instruments such as futures, options, forwards, swaps, and caps.These innovative financial instruments are referred to as derivative financial instru-ments (or simply derivatives), because their value is derived from values of other assets(e.g., stocks, bonds, or commodities) or is related to a market-determined indicator (e.g.,interest rates or the Standard and Poors 500 Stock Composite Index).

As indicated in the opening story, when the values of these underlying assets (orsimply, underlyings) change, firms that hold derivatives on them can experience signif-icant losses or gains. Illustration 26-2 summarizes common derivatives, their relatedunderlyings, and their basis for valuation.

In SFAS No. 133 the Financial Accounting Standards Board concluded that deriva-tives meet the definitions of assets or liabilities and should be recognized in finan-cial statements. The Board also mandated that all derivatives should be reported atfair value, stating that fair value accounting will provide statement users the best infor-mation about derivative financial instruments in the balance sheet and income state-ment.5 Relying on some other basis of valuation for derivatives, such as historical cost,does not make sense because many derivatives have a historical cost of zero.Furthermore, given the well-developed markets for derivatives and for the assets fromwhich derivatives derive their value, the Board believed that reliable fair value amountscould be determined for derivative financial instruments.

UNDERLYING CONCEPTSItems which meet the defini-tions of assets or liabilitiesand which are reliably mea-surable should be recognizedin the financial statements.

c INTERNATIONALPERSPECTIVEThe International AccountingStandards Committee (IASC)has also adopted comprehen-sive accounting standards forfinancial instruments, includ-ing derivatives.

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Illustration of Traditional Financial InstrumentTo illustrate the accounting for a traditional financial instrument, assume that HaleCompany purchases 1,000 shares of Laredo Inc. common stock for $100,000 on January2, 2000. These securities are classified as trading securities because they are held withthe intent of selling them after a short period of time. The entry to record the investmenton January 2