Derivatives and Hedge Accounting Flashcards
What is a derivative instrument?
a derivative instrument is a financial instrument that derives its value from the value of some other instrument and has all 3 of the following characteristics:
one or more underlyings and one or more notional amounts or payment provisions (or both)
it requires no initial net investment or one that is smaller than would be required for other types of similar contracts
its terms require or permit a net settlement (it can be settled for cash in lieu of physical delivery) or it can readily be settled net outside the contract (on an exchange) or by delivery of an asset that gives substantially the same results (an asset readily convertible to cash)
derivatives can be either freestanding (independent) or embedded; a freestanding derivative is bought or sold on its own, whereas an embedded derivative is contained within a financial instrument that holds a nonderivative host contract; a hybrid instrument contains both the nonderivative host contract and the embedded derivative
an example of a hybrid instrument is a convertible bond; the bond itself pays interest and principal to the investor, but it also gives the holder of the bond the right to convert the bond into shares of common stock of the issuer; this right of conversion is considered the embedded derivative
What is an underlying?
it is a specified price, rate, or other variable (interest rate, security or commodity price, foreign exchange rate, index of prices or rates, etc.), including a scheduled event (a payment under contract) that may or may not occur
What is a notional amount?
it is a specified unit of measure (currency units, shares, bushels, pounds, etc.)
What is a value/settlement amount?
the value or settlement amount of a derivative is the amount determined by the multiplication (or other arithmetical interaction) of the notional amount and the underlying; for example, shares of stock times the price per share
What is payment provision?
it is a specified (fixed) or determinable settlement that is to be made if the underlying behaves in a specified way
What is hedging?
it is the use of a derivative to offset anticipated losses or to reduce earnings volatility; when a hedge is effective, the change in the value of the derivative offsets the change in value of a hedged item or the cash flows of the hedged item
What is an option contract?
a contract between two parties that gives one party the right, but not the obligation, to buy or sell something to the other party at a specified period of time; the option buyer, or holder, must pay a premium to the option seller, or writer, to enter into the option contract
a call option gives the holder the right to buy from the option writer at a specified price during a specified period of time
a put option gives the holder the right to sell to the option writer at a specified price during a specified period of time
the holder of a call or put option has the choice to either exercise the option or let it lapse after the specific period of time if the option terms are not favorable
What is a futures contract?
an agreement between two parties to exchange a commodity, currency, or other asset at a specified price on a specified future date; one party takes a long position, meaning it agrees to buy a particular item, while the other party takes a short position, meaning it agrees to sell that item
unlike an option, which is used at the discretion of the option holder, both parties are obligated to perform according to the terms of the futures contract; futures contracts are made through a clearinghouse and have standardized notional amounts and settlement dates
What is a forward contract?
it is similar to a futures contract, except that is is privately negotiated between two parties with the assistance of an intermediary, rather than through a clearinghouse; forward contracts do not have standardized notional amounts or settlement dates; the terms of a contract are established by the parties to the contract
What is a swap contract?
a private agreement between two parties, generally assisted by an intermediary, to exchange future cash payments; common swaps include interest rate swaps, currency swaps, equity swaps, and commodity swaps; a swap agreement is equivalent to a series of forward contracts; a “plain vanilla” interest rate swap is a swap of fixed and floating interest rate payments
What are derivative risks?
market risk and credit risk are the inherent risks of all derivative instruments
market risk - it is the risk that the entity will incur a loss on the derivative contract; derivatives are a “zero sum game;” every derivative has a winner and a loser
credit risk - it is the risk that the other party to the derivative contract will not perform according to the terms of the contract; for example, in an interest rate swap, an entity faces the risk that the other party will refuse to pay the net settlement amount
Accounting for derivative instruments including hedges
balance sheet - all derivative instruments are measured at fair value and recognized in the balance sheet as either assets or liabilities, depending on the rights or obligations under the contracts; accounting for changes in the fair value of a derivative is dependent on whether the derivative has been designated as (and whether it qualifies as) a hedge, combined with the reason for holding the instrument
reporting gains and losses - gains or losses on a derivative instrument not designated as a hedging instrument are recognized currently in earnings (on the income statement)
fair value hedge - it is an instrument designated as a hedge of the exposure to changes in fair value of a recognized asset or liability, or of an unrecognized firm commitment, that are attributable to a particular risk; gains/losses on such instruments as well as the offsetting gain/loss on the hedged item are recognized in earnings in the same accounting period; the derivative must be expected to be highly effective in offsetting the fair value change of the hedged item
cash flow hedge - it is an instrument designated as hedging the exposure to variability in expected future cash flows attributed to a particular risk; gains/losses on such instruments included in the assessment of hedge effectiveness are reported as a component of other comprehensive income until the hedged transaction impacts earnings; the amounts that are reclassified into earnings from accumulated other comprehensive income should be presented in the same income statement line as the earnings effect of the hedged item
foreign currency hedge - it is an instrument designated as hedging the exposure to variability in foreign currency in a variety of foreign currency transactions
foreign currency fair value hedge - gains/losses are accounted for in the same manner as gains/losses on other fair value hedges - in earnings
foreign currency cash flow hedge - gains/losses are accounted for in the same manner as gains/losses on cash flow hedges - in other comprehensive income until the hedged items affect earnings
foreign currency net investment hedge - gains/losses are reported in other comprehensive income as part of the cumulative translation adjustment
reporting cash flows can be done one of two ways - no hedging designation or hedging designation
no hedging designation (speculation) - cash flows from a derivative with no hedging designation should be accounted for in investing activities unless the derivative is held for trading purposes; if held for trading purposes, the cash flows should be accounted for in operating activities
hedging designation - cash flows from a derivative with a hedging designation may be accounted for in the same category as the item being hedged; if the derivative contains an other-than-insignificant financing element at inception (often a matter of judgment), all cash flows associated with that derivative should be reported as cash flows from financing activities, not just those related to the financing element
