Financial Instruments & Derivatives Flashcards
Financial Instrument Types
COD
Financial instruments include the following:
Cash
Ownership interest in an entity (i.e. Stocks)
Derivative contracts that create a right and obligation to transfer other financial instruments (i.e. Stock Options)
Amortized Cost - notes, loans receivable or payable
Cost/Valuation such as equity - investments in the equity securities of non public companies
FMV - many financial instruments including investments in certain marektable securites and all derivatives should be recorded at FMV on F/S.
Three reasons for acquiring Derivatives
- Investments - an entity may invest its excess working capital, or amounts set aside in sinking funds, in derivatives such as stock options to increase its return on investments
- Arbitrage - is the ability to take advantage of price differentials in separate markets allowing the entity to enter into transactions that are potentially profitable without significant risk of loss.
- Hedges - is the use of a derivative to reduce or eliminate a risk that the entity is subject to either as a result of an asset or liability recognized on its financial statements or a future transaction.
Derivaties are acquired to increase potential gains when used as investments but may also produce losses. Derivatives are used as hedges to reduce or eliminate the risk of an adverse change in circumstatnces, but also eliminate the opportunity to take advantage of a favorable change.
- derivatives may be assets or liabilities
- derivaties are always reported at their fair values
- unrealized gains and losses are genearlly recognized in income
- unrealized gains/losses on cash flow hedges are temporarily recognized on OCI instead of income
- unrealized gains/losses on fair value hedges are recognized in income along with offsetting losses or gains on the hedged item
- all other unrealized gains/losses on hedges are recognized in income in the period of the increase/decrease in value
Derivatives Characteristics
NUNS
No net investment - to be considered a derivative, there must either be no intial net investment or an initial net investment that is smaller than would normally be required for an instrument that would respond similiarly in the market.
Underlying and a
Notional amount - the notional amount is basically the number of units (units, bushels, pounds) and the underlying is the factor that affects the derivatives value (speciied price,interest rate, exchange rate)
Net Settlment - derivative can be settled in a net amount.
Required to be reported at fair value.
Derivative Examples
- Option Contract - has the right but not obligation to purchase/sell in the future. Put-option, right to sell chares, call-option, right to acquire shares in the future. (Put if you think it drops and a call if you think it will go up)
- Futures Contract - has the right and obligations to deliver/purchase foreign currency or goods in the the future at a price set today. Similar to a Forward contract normally traded on a national exchange
- Forward Contract - has right and oblication to buy/sell a commodity at a future date for an agreed-upon price
- Interest rate or foreign currency swap - a forward based contract or agreement between two counterparties to exchange steams of cash flows over a specified period in the future.
Off-Balance Sheet Risks of Derivatives
Derivatives create an off-balance sheet risk, due to the possible changes in amount owed.
- disclose the credit risk - risk that a loss occurs because another party fails to perform according to the terms of the contract
- required disclosures about each significant concentration
- activity, region, or economic characteristic
- the maximum amount of loss due to credit risk
- the entity’s policy of requiring collateral or other security
- the entity’s policy arrangements to mitigate the creidt risk
- optional to disclose market risk - risk a loss may occur as a result of changes in the market valueof financial instrutments due to economic circumstances.
Fair Value Hedge
If the derivative is hedging against the a recognized asset/liablity on the balance sheet or a firm purchase commitment, then changes in the value of derivative are reported in income from continuing operations.
<strong>An example of a fair value hedge would be against the value of inventories such as gas in the books example.</strong>
Cash Flow Hedge
If the derivative is hedging against a forecasted transaction that is expected to take palce in the future, but which is not yet a legal commitment, then changes in value of the derivative are reported as direct adjustment to stockholder’s equity and included in OCI until the transaction is complete and the cash flows have actually occured.
An example is the purcahse of a futures contract on steel by a company that believes it will need to make large steel purcahsed in the newar future. An increase in the price of steel will cause the value of the futures contract to rise, helpting the company pay the increased cost. Since those costs aren’t yet reflected in the income, the increase in the futures contract is not reflected either.
Embedded Derivatives and BIfurcation
Some instruments are not derivatives but include features that have the characteristics of a derivative. An investment in bonds has two inherent risks:
- There is credit risk because the issuer of bonds may or may not perform, which will affect the interest rate
- there is market risk because the bonds will bear interest at a fixed rate and market interest rates making the bonds more or less desirable and causing increases or decreases in their fair values
Summary of Derivatives
To summarize, when derivatives are used as speculation or fair value hedges, gains and losses are reported in net income (in the case of fair value hedge, there will be offseting amounts onthe asset or commitment being hedged).
When derivatives are used as cash flow hedges, gains and losses are reported in OCI (they are transferred to net income when the expected events occur and offsetting amounts are reported in net income.
Alternating Accounting Approach for Nonpublic Entities
(Interest Rate Swaps)
The Private Company Council (PCC) of the FASB established an alternative accounting approach that is available to nonpublic entities when accounting for certain interest rate swaps, oftwen referred to as “plain vanilla” interest rate swaps, and which have become very common among large and small entities.
This Simplified Hedge Accounting Approach gives nonpublic companies the option to use this simpiler approach to account for certain types of interest rate swaps that are entered into for the purpose of economically converting variable-rate interest payments to fixed-rate payments.
In order to use the simplified approach circumstances must:
- the entity has an obligation that bears interest at a variable rate
- the entity enters into a derivative contract known as an interest rate swap under which:
- the entity will receive payments from other party at a variable rate
- the entity will make payments to the other party at a fixed rate.
- as a result of the swap, the net interest paid by the entity is equivalent to what would have been paidif the obligation had interest at a fixed rate.
In order to qualify for the alternative treatment, the variable rate in the swap must vary according to changes in the same index that caused changes in the rate on the related obligation. In addition:
- terms must be virtually identical such that they mirror the terms of the underlying obligation.
- the settlement date on which payments are exchanged for the swap are very close to the dates on which payments are made on the underlying obligation.
- the initial fair value of the swap is zero, indicating that the interest rates are comparable on the date it is entered into and that the parties have different views on anticipated future changes in the index rate
- the notional amount of the swap, the amount on which the swapped interest rates are calculated, must be equal to, or lower than the principal balance of the hedged instrument
- all interest payments must be designated as hedged, in proportion to the ratio of the notional amount of the hedge and the principal blance of the underlying obligation
Convertible Bonds
have an added feature in that they can be converted into common stock. As a result, increases in the stock price mitigate market risk as the bondholders can covert their bons into shares of stock if the value of the stock exceeds that of the bonds. As a result, the value of bonds will fluctuate as interest rates fluctuation and as the value of the stock fluctuates.
- the convertible bond would be considered a compound or hybrid instrument
- the bond is the host instrument
- the conversion feature would be considered an embedded derivative
Hybrid Instruments treatment
Since all derivatives are required to be reported at fiar value, the entity will account for a hybrid instrument in one of two manners:
- if the host instrument is reported at fair value, the derivative is also reported at fair value
- if the host instrument is not reported at fair value, the derivative will be separated or bifurcated from the host instrument and accounted for separately
- this would only be appropriate if the features have the charactersitcs of a derivative (NUNS)
- the derivative should have characteristics that respond to market influences differently from the host instrument
Transfer and Servicing of Financial Assets
- a transfer of financial assets in which the transferor retains either the right or the obligation to reacquire the instrument, prior to its maturity, for an amount determined at the transfer date, is accounted for as a financing transaction, rather than a sale.
- in order to recognize a gain/loss on disposal, three conditions must be satisfied:
- the asset must be beyond the reach of the transferor and its creditors
- the transferor cannot place any restrictions on what the transferee can do with the asset
- there is no repurchase or redemption agreement that might allow the transferor to force a return of the asset
Fair Value per ASC 820
FASB ASC 820 defines fair value as the price that would be received to sell and asset or paid to transfer a liability in an orderly transaction between marekt participants at the measurement date (at exit price).
An orderly transaction is a transaction that allows for normal marketing activities that are usual and customary, so they are NOT a forced transaction or sale.
Required Fair Value Measurements
Fair value measurements are required in very few circumstances:
- derivatives are always reported at fair value
- identifiable assets acquired and liabilities assumed in a business combination are originally measured at fair value.
- investments in marketable securities other than debt securitites accounted for as held to maturity are reported at market value on each balance sheet date
- impaired assets are written down due to their fair values
- nonmonetary transactions are measured at the fair value of the consideration exchanged
Embedded Dervatives and Bifurcation under IFRS
- Compound financial interests are non-derivative financial instruments that have both laiblity and equity components (i.e convertible bonds)
- They are split into debt, equity and if applicable, derivative components, whereas under GAAP, they are only split if certain requirements are met.
- Some contracts that include debt and equity components also have a component that causes the cash flows from the combined instrument to occur in a manner that is similar to a derivative, indicating an embedded dervative.
- when the host contract is a financial asset, it is reported as a single instrument and is accounted for under the amortized cost method or at FVTPL, as appropriate.
- when the host contract is not an asset, the embedded dervative is separated or bifurcated from the host instrument and accounted for separately.
