Intermediate accounting 17e stice skousen cengage chapter 19

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.. Chang

Intermediate Accounting,17E

Stice | Stice | Skousen

PowerPoint presented by: Douglas Cloud Professor Emeritus of Accounting, Pepperdine

University

Derivatives, Contingencies, Business Segments, and

Interim Reports

Simple Example of a Derivative

You are an employee

On October 1, 2011, you purchase

100 shares of stock in the company

at the market price of $50 per

share, for a total price of $5,000.

Simple Example of a Derivative

• On January 1, 2012, you need to make a

college tuition payment of $5,000 on

behalf of your daughter You can’t sell the stocks now because your employment

contract states that the shares must be

held for at least three months before they can be sold

(continues)

How can you avoid downward movement in the

stock price between now and January 1?

Simple Example of a Derivative

You can avoid downward movement 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

• 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.

• 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.

(continues)

Simple Example of a Derivative

Simple Example of a Derivative

How does this derivative agreement

solve your risk management dilemma? Look at the following chart:

No matter what happens, you will

Types of Risk

an asset.

side of the agreement will abide by the terms of the

agreement.

interest rates.

dollar cash flows arising when assets and liabilities are denominated in a foreign currency.

Types of Derivatives

• A swap is an agreement to exchange payments

in the future, usually a fixed payment for a

variable payment, or vice versa.

• A forward is an agreement to exchange an

item at a set date in the future at a price that is set now.

• An option is the right to buy or sell an asset at

a specified price in the future.

• Pratt takes advantage of a good

working relationship with a bank,

receiving 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

• 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, 2012 interest rate – 10%)] if the interest rate is above 10%.

(continues)

To see the impact of this interest rate swap, consider the following table:

Pratt will pay $10,000 no matter

what the prevailing interest rate.

• Hyrum Bakery uses 1,000 bushels of

wheat every month On December 1,

2011, Hyrum decides to protect itself

against price movements Hyrum buys a futures contract to purchase 1,000

bushels of wheat on January 1, 2012, at

$4 per bushel

• As with other derivatives, a wheat

futures contract is usually settled by a

cash payment at the end of the

contract (continues)

Futures

The effect of the futures contract is

illustrated in the following table:

Option

• 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.

• 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.

On October 1, 2011, Woodruff Company decides that it will need to purchase

1,000 ounces of gold for use in its

computer chip manufacturing process in January, 2012 Gold is selling for $300 per ounce on October 1, 2011 Woodruff

enters into a call option contract on

October 1 which gives Woodruff the right, but not the obligation, to purchase 1,000 ounces of gold at a price of $300 per

Option

The option period extends to January 1,

2012, and Woodruff has to pay $8,000 to buy this option In exchange for this

payment, the option arrangement

protects Woodruff from unfavorable

movements in the price of gold but also

allows Woodruff to benefit from favorable movements This can be seen in the table displayed on Slide 19-20

(continues)

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.

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

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

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

(continues)

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.

• Companies must provide a description of their

risk management strategy and how derivatives fit into that strategy.

• Firms must disclose the gains and losses on

derivatives, separated by category:

 Fair value hedges

 Cash flow hedges

 Other

Overview of Accounting for Derivatives and Hedging Activities

Overview of Accounting for Derivatives and Hedging Activities

• The notional amount is the t otal

face amount of the asset or liability that underlies a derivative contract.

overstate both the fair value and the potential cash flows of derivatives.

Illustrations of Accounting for Derivatives and Hedging Activities

On January 1, 2011, Pratt Company

received a two-year $100,000 variable-rate loan and also entered into an interest rate swap agreement

• The market interest rate on December 31,

2011 is 11%.

• The interest rate swap asset is reported at its present value of $901 ($1,000 discounted) in the December 31, 2011 balance sheet.

Illustrations of Accounting for Derivatives and Hedging Activities

The journal entry to record Pratt’s 2011

interest payment, along with the adjusting entry, is:

Interest Rate Swap (asset) 901 Other Comprehensive

Cash (from swap agreement) 1,000 Interest Rate Swap (asset) 901 Other Comprehensive

Income ($901 × 0.11) 99 Accumulated Other

Comprehensive Income 1,000 Interest Expense 1,000

Illustrations of Accounting for Derivatives and Hedging Activities

Dec 31 Interest Expense 11,000

Cash ($100,000 × 0.11) 11,000

2012

On November 1, 2011, Clayton Company sold machine parts to Maruta Company

for ¥30,000,000 to be received on January

1, 2012 On the same date, Clayton also

entered into a yen forward contract

Nov 1 Yen Receivable 250,000

Illustrations of Accounting for Derivatives and Hedging Activities

The impact of the change in the yen exchange rate on both the yen

receivable and the value of the

forward contract is accounted for as follows:

The actual exchange rate on December 31,

2011 is ¥119 = $1 Clayton will have a loss

on the forward contract and will be required

Gain on Foreign Currency 2,101

2011

(continues)

Illustrations of Accounting for Derivatives and Hedging Activities

Jan 1 Cash (¥30,0000,000/¥119

Yen Receivable 252,101 Forward Contracts (liability) 2,101

Cash (forward contract

• It should be noted that the Clayton forward

contract does not qualify for hedge accounting under FASB Statement No 133

• 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.

Illustrations of Accounting for Derivatives and Hedging Activities

Illustrations of Accounting for Derivatives and Hedging Activities

• On December 1, 2011, Hyrum

Company decided to hedge against

potential fluctuations in the price of

wheat for its forecasted January 2012 purchases.

• The firm bought a futures contract

entitling and obligating Hyrum to

purchase 1,000 bushels of wheat on January 1, 2012, for $4 per bushel

Illustrations of Accounting for Derivatives and Hedging Activities

• No entry is made to record the

(continues)

Illustrations of Accounting for Derivatives and Hedging Activities

The impact of the change on the anticipated cost of wheat when purchased in January

2012 is accounted for as follows:

Illustrations of Accounting for Derivatives and Hedging Activities

The adjusting entry to recognize the change in the fair value of the

futures contract is as follows:

Dec 31 Wheat Futures Contract (asset) 400

Other Comprehensive Income 400

2011

The gain from the increase in the value of Hyrum’s futures contract is deferred as a part

of other comprehensive income

Illustrations of Accounting for Derivatives and Hedging Activities

Jan 1 Wheat Inventory 4,400

Cash (1,000 bushels × $4.40) 4,400 Cash (futures contract settlement) 400

Wheat Futures Contract (asset) 400 Accumulated Other Comprehensive

2012

The entries to record the purchase of 1,000 bushels of wheat in the open market and

the cash settlement of the wheat future

contracts are as follows:

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.

Accounting for Lawsuits

1 The nature of the lawsuit

2 Progress of the case in court, including

progress between date of the financial

statements and their issuance date

3 Views of legal counsel as to the probability

of loss

4 Prior experience with similar cases

5 Management’s intended response to the

FASB Statement No 5 identifies several key factors to consider These include the

following:

• 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.

Accounting for Environmental Liabilities

Accounting for Environmental Liabilities

• The FASB, in Statement No 143 , requires that

an obligation associated with retiring an asset

should be recognized when incurred and be

measured using present value techniques The

offsetting debit should be an addition to the cost

of the associated asset.

Business Segments

Information to be disclosed in the financial

statement notes under the provisions of FASB

Statement No 14 included revenues, operating

profit, and identifiable assets for each significant industry segment of a company.

FASB Statement No 131 additional

disclosure requirements:

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

4 Total capital expenditures

5 Reconciliation of the sum of segment

totals to the company total for each of

the following items:

In addition to these five items,

companies must also disclose how

operating segments are identified.

reported if its total revenue is 10% or more of the company’s total revenue (external and internal).

Business Segments

Profit test. A segment should be

reported if the absolute value of its

operating profit (or loss) is greater

than 10% of the total operating profit for all segments that reported profits

reported if it contains 10% or more

of the combined assets of all

operating segments.

Business Segments

Interim Reports

• Statements showing financial position and operating

results for intervals of less than a year are referred to as

interim financial statements.

• There are two prominent viewpoints about reporting

interim results.

 Each reporting interval is to be recognized

as a separate accounting period.

 The interim period is an integral part of the

annual period (accepted by the APB in Opinion No 28).