5. Financial Instruments and Derivatives Flashcards
Changes in the values of which type(s) of hedge(s) are reported on the income statement?
- Fair value hedges 2. Net investment hedges 3. The ineffective portion of cash flow hedges
Changes in the values of which type(s) of hedge(s) are reported in OCI?
Unrealized gains and losses on the effective portion of a cash flow hedge is recognized in OCI until net settlement occurs (i.e. the hedged instrument and the hedging instrument are both settled). At net settlement, the net gain or loss is recognized in income.
The fair value of an option contract is equal to what?
The time value plus the intrinsic value (the market price minus the strike price; i.e. how much the option is in-the-money of the underlying security)
A gain or loss on a non-hedging, speculative trade of a derivative is recognized where in the financial statements?
In net income during the period of the gain or loss.
How are unrealized gains and losses on a fair value hedge recognized?
In net income during the period of the gain or loss. An offsetting gain or loss on the hedged risk is recognized in net income during the same period.
How are 1) the value of a derivative and 2) changes in its value reported on financial statements?
A derivative is reported at fair value on every balance sheet date, and unrealized gains and losses are reported in income during the period of the change—unless the derivative is being used as a cash flow hedge, in which case unrealized gains and losses are reported in OCI until the cash flow occurs.
A hedge that is entered into to protect against changes in the value of a recorded asset is what kind of hedge?
A fair value hedge
A hedge that is entered into to protect against changes in the amount of a future payment is what kind of hedge?
A cash flow hedge
When an entity first enters into a derivative contract, at what value should it record the derivative on its books?
Zero. The entity doesn’t pay anything to enter into the contract, and therefore the contract doesn’t have any value yet. A value for the derivative is recorded when a gain or loss on the derivative is recorded.
What are the characteristics of a derivative?
- Settled in net cash or equivalents
- Has one or more underlyings and notional amounts
- Requires no significant net investment
What’s the difference between a fair value hedge and a cash flow hedge?
A fair value hedge uses a financial instrument to protect against changes in the fair value of an asset that is already recognized on the balance sheet (not an asset that will be purchased and recognized in the future). Unrealized gains and losses on the hedging instrument are recognized in income at each period.
A cash flow hedge uses a financial instrument to protect against changes in the amount of a future cash flow (inflow or outflow). Unrealized gains and losses on the hedging instrument are recognized in OCI until the cash flow occurs, at which time the gains and losses are reversed out of OCI, and any ineffective portion of the hedge is recognized in income.
Example: Cash Flow Hedge
A U.S. company intends to buy US$260,000 of equipment in euros in six months. It enters a forward exchange contract to hedge against an increase in the exchange rate.
After three months, the exchange rate goes up, and as a result, the value of the forward exchange contract increases to $10,000. The company makes an entry:
Dr. Current Asset: Forward Exchange Contract $10,000
Cr. OCI $10,000 (the unrealized gain)
After six months, the company buys the equipment at the increased exchange rate for $270,000. It makes an entry:
Dr. Equipment $260,000
Dr. OCI $10,000 (reversing previous entry)
Dr. Cash $10,000 (received from counterparty)
Cr. Forward Exchange Contract $10,000 (reversing previous entry)
Cr. Cash $270,000 (paid to equipment vendor)
What if, three months after entering the forward exchange contract, the exchange rate had decreased, causing the company to assume a $10,000 liability to the counterparty? The company would make an entry:
Dr. OCI $10,000 (the unrealized loss)
Cr. Current Liability: Forward Exchange Contract $10,000
After six months, the company buys the equipment at the decreased exchange rate for $250,000. It makes an entry:
Dr. Equipment $250,000
Dr. Forward Exchange Contract $10,000 (reversing previous entry)
Dr. Loss on Ineffective Portion of Cash Flow Hedge $10,000 (recognized in income)
Cr. OCI $10,000 (reversing previous entry)
Cr. Cash $10,000 (paid to counterparty)
Cr. Cash $250,000 (paid to equipment vendor)
