Derivatives Hedging Translation Flashcards
How are derivatives recorded?
At cost when acquired re-valued to fair value each period on Balance Sheet.
How are unrealized gains/losses on trading securities recorded?
Recorded on income statement
How are gains and losses on Available for Sale (AFS) securities recorded?
They are included in Other Comprehensive Income.
What is a Fair Value Hedge? How is it recorded?
Fair Value Hedge offsets exposure to changes in the value of a recognized asset/liability or of an unrecognized commitment
Initially recorded on Balance Sheet at Fair Value
Gains/Losses recorded on Income Statement
What is a Cash Flow Hedge? How is it recorded?
Cash flow hedges protect from exposure to fluctuations in cash flows.
Initially recorded on Balance Sheet at Fair Value
Gains/Losses going to OCI
Example: A cereal company enters into a futures contract on grain purchases to offset the risk that grain will go up in price.
Where are gains and losses on foreign currency hedges recorded?
In Other Comprehensive Income (OCI)
What disclosures are required for derivative transactions?
Objectives and Strategies
Context to help investor understand the instrument
Risk Management Policies
Complete List of Hedged Instruments
How do transactions denominated in in a currency other than a company’s functional currency affect the income statement?
Fluctuations in that currency cause a gain or loss that must be recognized on the income statement as Income from Continuing Operations
For the balance sheet which date’s translation rate is used to report assets and liabilities?
The current translation rate as of the balance sheet date is used to report assets and liabilities.
Which date’s currency translation rate is used for the reporting of revenue and expense transactions in a foreign currency?
Use the weighted average exchange rate for the current year.
If the functional currency is the reporting currency which exchange rate is used on the foreign currency financial statements?
Foreign Currency Financial Statements are remeasured into the Reporting Currency (Dollar) using the weighted-average exchange rate
Foreign Currency is reporting currency = translation only
Where are re-measurement gains and losses due to foreign currency translation of unaffiliated companies reported?
On the income statement as Other Income.
Discount/Premium on Forward Contract Formula
Spot Rate (TD) - FR Settlement Date x # of units
An agreement with an unrelated party binding on both, usually legally enforceable, specifying all significant terms and including a disincentive for non performance sufficient to make non performance likely
Firm Commitment
Transaction expected to occur for which there is no firm commitment, doesn’t give the entity present rights or obligations, can be hedged applying hedge accounting
Forecasted transaction
Transaction whose terms are denominated in a currency other than the entity’s functional currency
Foreign Currency transaction
Foreign Currency transactions - when an entity:
- buys or sells on credit goods or services whose prices are denominated in foreign currency
- borrows or lends funds and the amounts payable or receivable are denominated in foreign currency
- a party to an unperformed forward exchange contract
- acquires or disposes of assets or incurs or settles liabilities denominated in foreign currency
An agreement to exchange at specified future date CURRENCIES of different countries at specified rate (FR)
Forward exchange contract
A forward based contract to make or take delivery of a designated financial instrument, foreign currency or commodity during a:
* designated period
* at a specified price or yield
traded/less credit risk than forward contracts
Futures contract
In the money
underlying is > strike or exercise price
Out of the money
underlying is < strike or exercise price
At the money
underlying = strike or exercise price
Intrinsic value
larger than 0 or the difference between FV of stock and exercise price
Net settlement can be done by:
- no delivery equal to notional amount required (interest rate swap)
- delivery = notional amount settled by exchange or market mechanism or side contract agreement
- delivery = notional amount; asset is readily marketable to cash or the asset itself is a derivative (swaption or delivery of marketable security)
Notional Amount
of units, bushels, shares of stocks, principal amount, face value, stated value, basis points, barrels etc.
Underlying
specified price, rate, interest rate, currency rate, commodity price, related index; includes physical variables and financial variables - rainfall, credit rating, temperature changes
Hedging Criteria
- sufficient documentation - objective, identification, assessment of the hedge
- must be highly effective throughout its life - measured every 3 months or whenever FS is reported
Remeasurement
Spot rates only
SR TD - SR BSD = FX Gain/Loss - IS
Account: Foreign transaction gain/loss
Remeasurement Disclosures
- Aggregate transaction gain/loss included in net income
2. Significant rate changes subsequent to FS date including its effects to unsettled foreign transactions
Relationship of foreign transactions gain/loss vs
fx purchase or sale
FX Purchase transaction - if rates go high = loss
- if rates go low = gain because liability is settled at lower rates
FX Gain transaction - rates low = loss
rates high = gain
Derivatives Hedging
Imposes a CONTRACTUAL obligation to:
- deliver cash or another financial instrument to a second party
- to exchange financial instruments on potentially unfavorable terms with the second party
Conveys a CONTRACTUAL right to:
- receive cash
- exchange financial instruments on favorable terms
Fair Value Hedge
Use SPOT RATE and FORWARD RATE
Hedge on exposure to change in fair value of a recognized asset or liability or unrecognized firm commitment
Gain on Forward Contracts - IS
Transaction date:
Inventory (SRTD)
A/P
British Pounds Receivable(FRSD)
US $ Payable
Balance Sheet Date:
Foreign Exchange Gain/Loss-IS (SRTD - SRBD)
A/P
British Pounds Receivable (FRSD-FRBD)
Gain on Forward Contracts - IS
Speculation to Exchange Foreign Currency
Use FORWARD RATES only
Gain on Forward Contracts - IS
Transaction date:
British Pounds Receivable (SD FR)
A/P US $
Balance Sheet Date:
British Pounds Receivable (SDFR - BSD FR)
Gain on Forward Contracts - IS
Cash Flow hedge
Same as speculation
Foreign Currency Transaction Gain - OCI
Use forward rates only
Transaction date:
British Pounds Receivable (SD FR)
US $ Payable
BS Date:
British Pounds Receivable (FR BSD - FR SD)
Foreign Currency Transaction Gain - OCI
Foreign Currency Operating Transactions
Use SPOT RATES only
Transaction date:
A/R (SR TD)
Sales
Balance Sheet date:
A/R (SRTD-SRBSD)
Foreign Currency Gain/Loss - IS
Derivative instruments inclusions
call or put options (sell or purchase)exchange traded securities
futures contracts interest rate swaps currency swaps swaptions ( option on a swap) credit indexed contracts interest rate caps/floors/collars
Derivative instruments exclusions
normal purchases/sales equity securities debt securities tba and when issued trades regular way 3 day settlement security trades leases mortgage backed securities employee stock options royalty agreements contracts tied to sales volumes variable annuity contracts adjustable rate loans guaranteed investment contracts non exchanged traded contracts tied to variables derivatives that serve as impediments to sales accounting ( GRV on leases)
Criteria for bifurcation
- embedded derivative meets the definition of derivative
- the hybrid instrument is not regularly recorded a FV with earnings recorded in current earnings (In this case, there is no need to bifurcate)
- the economic characteristics and risks of the embedded derivative instrument are not clearly and closely related to the economic characteristics and risks of the host contract
Hybrid instruments that would normally REQUIRE BIFURCATION:
- bond payable with an interest rate based on the S&P 500 index
- equity instrument(stocks) with a call option, allowing the issuing company to buy back the stock
- equity instrument with put option requiring the issuing company to buy back the stock at the request of the holder
- loan agreement that permits the debtor to pay off the loan prior to its maturity with the loan payoff penalty based on the short term Tbill rates
- loans with term extending options whose values are based on the prime rate at the time of the extension
- convertible debt (from investor’s viewpoint)
THE HOLDER OF THE HYBRID INSTRUMENT CAN ELECT NOT TO BIFURCATE. IN THIS CASE, THE ENTIRE INSTRUMENT IS VALUED AT FAIR VALUE.
ELECTION NOT TO BIFURCATE - what happens?
means an election to use FV measurement
- the election is irrevocable and is made on an instrument by instrument basis
- changes inn FV - to current earnings
- balance sheet disclosures:
as separate line items for the fair value and non fair value instruments on the balance sheet
OR
as an aggregate amount of all hybrid instruments with the amount of the hybrid instruments at fair value shown in parenthesis
The following disclosures are required about credit risk for financial instruments with off-balance-sheet credit risk:
- The amount of accounting loss the entity would incur should any party to the financial instrument fail to perform according to the terms of the contract and the collateral, if any, is of no value.
- The class of financial instruments held
- Categorization between instruments held for trading purposes and purposes other than trading.
Hedging disclosures
Disclosures related to financial instruments, both derivative and nonderivative, that are used as hedging instruments must include the following information:
(1) objectives and the strategies for achieving them,
(2) context to understand the instrument, (3) risk management policies, and
(4) a list of hedged instruments.
These disclosures have to be separated by type of hedge and
reported every time a complete set of financial statements is issued.
In addition, disclosure requirements exist for derivative instruments that are not designated as hedging instruments.
TRANSLATION/REMEASUREMENT TIP - for affiliated companies
ST. NSR
ST. - same translation
NSR - not same remeasurement
