Chapter 13

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

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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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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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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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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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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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 Accounting for Derivatives and Hedging Activities

1: CASH FLOW HEDGE

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 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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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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 Accounting for Derivatives and Hedging Activities

2: FAIR VALUE HEDGE

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 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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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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 Accounting for Derivatives and Hedging Activities

3: HEDGE ACCOUNTING

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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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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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Cash Flow Hedge: Example 1
(cont.)

Sign 12/1 Futures contract 10.00  

contract
  Cash   10.00
12/31 Futures contract 18.06  
Adjust to   OCI   18.06
fair 1/31 OCI 23.10  
value
  Futures contract   23.10

Settle 1/31 Cash 4.96  

contract;   Futures contract   4.96
collect 1/31 Inventory 5,877.90  
balance on
margin.   Cash   5,877.90

Purchase inventory.

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Cash Flow Hedge: Example 1
(cont.)

Record Feb. Cash 8,400.00  

the   Sales   8,400.00
sale Feb. Cost of sales 5,877.90  
and
cost of   Inventory   5,877.90
sales. Feb. Cost of sales 5.04  
  OCI   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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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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Cash Flow Hedge: Example 2
(cont.)
Forward rates and fair value of contract:
Notional
Amount Contract Discounted
 Date Forward rate £500,000 Fair value Fair value
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

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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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 The discount on
contract is an the contract is
unrealized gain put amortized over
into OCI. 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 20,000  
  Forward contract   20,000
The final
balance in for net settlement of contract: 860,000 current - 840,000
OCI is   contract
$10,000 CR.
This will 3/1 Equipment 860,000  
reduce the   Cash   860,000
equipment's
depreciation   Purchase equipment from supplier
over its life. 3/1 OCI 6,654  
  Exchange gain   6,654
  remaining amortization: 10,000 - 3,346

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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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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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 Fair Value Hedge:
Example 3 (cont.)
Loss on Forward
12/31 contract 19,802
Report at fair
value at Forward contract 19,802
reporting date. 12/31 Inventory 20,000
Gain on Inventory 20,000
Adjust 1/31 Forward contract 10,000
inventory to Forward contract 19,802
fair value
Gain on Forward
contract 29,802
Adjust Loss on Inventory 30,000
values prior Inventory 30,000
to final
settlement. 1/31 Cash 10,000
Forward contract 10,000
Settle
contract.

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 Accounting for Derivatives and Hedging Activities

4: ACCOUNTING FOR
HEDGES OF FOREIGN
CURRENCY RECEIVABLES
AND PAYABLES

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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 Forward rate Cont Rec

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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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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 Fair Value Hedge: Liability
(cont.)

12/2: Buy
equipment 12/2 Equipment 1,880  
and sign
forward   Accounts payable (¥)   1,880
contract.
12/2 Contract receivable (¥) 1,900  

  Contract payable ($)   1,900

12/31: 12/31 Accounts payable (¥) 40  

Adjust
foreign   Exchange gain   40
monetary
accounts to 12/31 Exchange loss 40  
current
(year-end)   Contract receivable (¥)   40
rate.

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 Fair Value Hedge: Liability
(cont.)

1/30: Pay
promised 1/30 Contract payable ($) 1,900  
$1,900 on   Cash ($)   1,900
forward
contract 1/30 Cash (¥) 1,960  
and receive   Contract receivable (¥)   1,860
yen in
exchange   Exchange gain   100
1/30 Accounts payable (¥) 1,840  
  Exchange loss 120  
  Cash (¥)   1,960

Use the yen to pay the supplier

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 Accounting for Derivatives and Hedging Activities

5: FOOTNOTE DISCLOSURE
REQUIREMENTS FOR
DERIVATIVES

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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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 Accounting for Derivatives and Hedging Activities

6: THE IASB STANDARDS

FOR DERIVATIVES

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

IAS 32 – financial instruments

• Debt and equity instruments
IAS 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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