19-1

1. The concepts of derivatives and hedging activities

2. Different types of risk faced by a business

3. The characteristics of swaps, forwards, futures, and

options

4. Define hedging and the difference between a fair

value hedge and a cash flow hedge

5. Account for derivatives and for hedging

6. The contingent items to the areas of lawsuits and

environmental liabilities

7. The supplemental disclosures of financial information

by product line and by geographic area

8. The importance and difficulties of interim reports

Ch.19 Derivatives, Contingencies, Business

Segments, and Interim Reports

19-2

Simple Example of a Derivative

• On October 1, 2013, you purchase 100 shares of

stock in Nauvoo Software Solutions (your employer) at

the market price of $50 per share.

• On January 1, 2014, you need to make a college

tuition payment of $5,000 on behalf of your daughter.

• Your employment contract states that any shares you

purchase from the company must be held for at least

three months before you can sell them.

1. Understand the business and accounting

concepts connected with derivatives and

hedging activities

19-3

Simple Example of a Derivative

• A downward movement in the stock price

between now and January 1 would be

disastrous for you.

• What is the solution to your dilemma?

19-4

You can avoid downward movement if you make

the following agreement:

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.

Simple Example of a Derivative

19-5

• 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 or financial

instrument.

• No matter what happens to the price of Nauvoo

stock between now and then, you will wind up with

$5,000 on January 1.

• 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.

Simple Example of a Derivative

19-6

Types of Risk

• Price risk is the uncertainty about the future price of

an asset.

• Credit risk is the uncertainty that the party on the

other side of the agreement will abide by the terms of

the agreement.

• Interest rate risk is the uncertainty about future

interest rates an their impact on future cash flows as

well as on the fair value of existing assets and

liabilities.

• Exchange rate risk is the uncertainty about the U.S.

dollar cash flows arising when assets and liabilities

are denominated in a foreign currency.

2. Identify the different types of risk faced by

a business

19-7

Swap

• A swap is a contract in which two parties agree

to exchange payments in the future based on

the movement of some agreed-upon price or

rate.

• A common type of swap is an interest rate

swap where two parties agree to exchange

future interest payments on a given loan amount

(one set of interest payments is based on a fixed

interest rate and the other is based on a variable

interest rate).

3. Describe the characteristics of the following

types of derivatives: swaps, forwards,

futures, and options

19-8

• Pratt Company takes advantage of its good

working relationship with a bank that issues

only variable-rate loans.

• On January 1, 2013, Pratt receives 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.

Swap

19-9

• 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, 2014 interest rate – 10%)]

if the interest rate is above 10% and will pay the

same amount if the rate is less than 10%.

Swap

19-10

To see the impact of this interest rate swap, consider

the following table:

Pratt will pay $10,000 no matter what the prevailing

interest rates in 2014.

Swap

19-11

Forwards

• A forward contract is an agreement between

two parties to exchange a specified amount of a

commodity, security or foreign currency at a

specified date in the future with the price of the

exchange rate being set now.

• On November 1, 2013, Clayton Company sold

machine parts to Maruta Company for

¥30,000.00 to be received on January 1, 2014.

The current exchange rate is ¥120 = $1.

19-12

Forwards

• Clayton enters into a forward contract with a

large bank, agreeing that on January 1 Clayton

will deliver ¥30,000,000 to the bank and the

bank will give U.S. dollars in exchange at the

rate of ¥120 = $1, or $250,000

(¥30,000,000/¥120 per $1).

• If on January 1, 2014, ¥30,000,000 is worth less

than $250,000, the bank will pay Clayton the

difference in cash (U.S. dollars).

(continued)

19-13

Forwards

• If ¥30,000,000 is worth more than $250,000

Clayton pays the difference in cash.

• The impact of the forward exchange is shown in

the following table:

(continued)

19-14

• A futures contract is a contract, traded on an

exchange, that allows a company to buy or sell

a specified quantity of a commodity or a

financial security at a specified price on a

specified future date.

• It is very similar to a forward contract with the

difference being that a forward contract is a

private contract negotiated between two

parties, whereas a futures contract is a

standardized contract that is sponsored by a

trading exchange.

Futures

19-15

• Hyrum Bakery uses 1,000 bushels of wheat

every month. On December 1, 2013, Hyrum

decides to protect itself against price

movements. Hyrum buys a futures contract to

purchase 1,000 bushels of wheat on January

1, 2014, at $4 per bushel.

• This is a standardized exchange-traded

futures contract, so Hyrum has no idea who is

on the other side of the agreement.

(continued)

Futures

19-16

Futures

• As with other derivatives, a wheat futures

contract is usually settled by a cash payment

at the end of the contract instead of the actual

delivery of the wheat.

• The effect of the futures contract is illustrated

in the following table:

19-17

• An option is a contract giving the owner the right,

but not the obligation, to buy or sell an asset at a

specified price any time during a specified period in

the future.

• 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 in exchange for the rights

inherent in the option.

• 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.

Option

19-18

• On October 1, 2013, Woodruff Company

decides that it will need to purchase 1,000

ounces of gold for use in its computer chip

manufacturing process in January, 2014.

• Gold is selling for $1,100 per ounce on October

1, 2013.

• For cash flow reasons, Woodruff plans to delay

the purchase of gold until January 1, 2014, and

is concerned about potential increases in the

market price of gold between October 1, 2013,

and January 1, 2014.

Option

19-19

• Woodruff enters into a call option contract on

October 1.

• The contract gives Woodruff the right, but not

the obligation, to purchase 1,000 ouches of

gold at a price of $1,100 per ounce. The

option period extends to January 1, 2014.

• Woodruff has to pay $20,000 to buy this

option.

Option

19-20

Option

• The chart below shows the anticipated

activity at three possible gold prices.

• The existence of the option contract means

that Woodruff will pay no more than

$1,100,000 for gold.

19-21

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.

4. Define hedging, and outline the difference

between a fair value hedge and a cash flow

hedge

19-22

Overview of Accounting for Derivatives and

Hedging Activities

The accounting difficulty caused by derivatives is

illustrated in this simple matrix:

The historical cost focus of traditional accounting

is misplaced with derivatives because derivatives

often have little or no up-front historical cost.

5. Account for a variety of different derivatives

and for hedging relationships

19-23

1. Balance sheet. Derivatives should be

reported in the balance sheet at their fair value

as of the balance sheet date. No other

measure of value is relevant for derivatives.

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

19-24

• 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.

Overview of Accounting for Derivatives and

Hedging Activities

19-25

• 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.

Overview of Accounting for Derivatives and

Hedging Activities

19-26

• Companies are required to provide a

description of their risk management strategy

and how derivatives fit into that strategy for

both fair value and cash flow hedges.

• Companies must disclose the amount of

derivative gains or losses that are included in

income because of hedge ineffectiveness.

• For cash flow hedges, a company must

describe the transactions that will cause

deferred derivative gain and losses to be

recognized in net income.

Disclosure

19-27

• The notional amount is the total face

amount of the asset or liability that underlies

a derivative contract.

• The notional amount of derivative

instruments is often reported and is

frequently misleading.

• Notional amounts grossly overstate both the

fair value and the potential cash flows of

derivatives.

Disclosure

19-28

On January 1, 2013, Pratt Company received a

two-year $100,000 variable-rate loan and also

entered into an interest rate swap agreement.

The journal entry to record this information

follows:

Jan. 1 Cash 100,000

Loan Payable 100,000

2013

No entry is made to record the swap agreement

because the swap has a fair value of $0.

Pratt Swap

19-29

• The actual market interest rate on December

31, 2013 is 11%.

• With this rate, Pratt will receive a $1,000

payment [$100,000 x (0.11 – 0.10)] at the end

of 2014.

• On December 31, 2013, Pratt has a $1,000

receivable under the swap agreement, and the

receivable has a present value of $901

(FV = $1,000, N =1, I = 11%).

Pratt Swap

19-30

The impact of the change in interest rate on the

interest rate swap and on reported interest

expense is accounted for as follows:

Pratt Swap

19-31

The journal entry to record Pratt’s 2013 interest

payment, along with the adjusting entry to

recognize the change in the fair value, is as

follows:

31 Interest Rate Swap (asset) 901

Other Comprehensive

Income 901

Dec 31 Interest Expense 10,000

Cash ($100,000 × 0.10) 10,000

2013

The journal entries at the end of 2014 are on

Slide 19-32.

Pratt Swap

19-32

31 Cash (from swap agreement) 1,000

Interest Rate Swap (asset) 901

Other Comprehensive

Income ($901 × 0.11) 99

31 Accumulated Other

Comprehensive Income 1,000

Interest Expense 1,000

31 Loan Payable 100,000

Cash 100,000

Dec. 31 Interest Expense 11,000

Cash ($100,000 × 0.11) 11,000

2014

Pratt Swap

19-33

On November 1, 2013, Clayton Company sold

machine parts to Maruta Company for

¥30,000,000 to be received on January 1, 2014.

On the same date, Clayton also entered into a

yen forward contract. The required entry is as

follows:

¥30,000,000/

¥120 per $1

Nov. 1 Yen Receivable 250,000

Sales 250,000

2013

Clayton Forward

19-34

The actual exchange rate on December 31,

2013 is ¥119 = $1. Clayton will have a loss on

the forward contract and will be required to make

a $2,101 payment [(¥30,000,000/¥119 per $1) –

$250,000]. The impact of the change in the yen

exchange rate is as follows:

Clayton Forward

19-35

The adjusting entries to recognize the change in

the fair value of the forward contract and in the

U. S. dollar value of the yen receivable are as

follows:

Dec. 31 Loss on Forward Contract 2,101

Forward Contract 2,101

31 Yen Receivable 2,101

Gain on Foreign Currency 2,101

2013

Clayton Forward

19-36

Jan. 1 Cash (¥30,0000,000/¥119

per $1) 252,101

Yen Receivable 252,101

1 Forward Contract (liability) 2,101

Cash (forward contract

settlement) 2,101

2014

The journal entries necessary in Clayton’s books

on January 1, 2014, to record receipt of the yen

payment and settlement of the yen forward

contract are as follows:

Clayton Forward

19-37

• It should be noted that the Clayton forward

contract does not qualify for hedge

accounting under FASB ASC Topic 815.

• 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.

Clayton Forward

19-38

Hyrum Future

• On December 1, 2013, Hyrum Company

decided to hedge against potential

fluctuations in the price of wheat for its

forecasted January 2014 purchases.

• The firm bought a futures contract entitling

and obligating Hyrum to purchase 1,000

bushels of wheat on January 1, 2014, for

$4.00 per bushel.

19-39

• No entry is made to record the futures

contract because, as of December 31, 2013,

the future has a fair value of $0.

• The actual price of wheat on December 31,

2013, is $4.40 per bushel. Hyrum will receive

a $400 payment [1,000 bushels × ($4.40 –

$4.00)] on January 1, 2014, to settle the

futures contract.

Hyrum Future

19-40

The impact of the change on the anticipated cost

of wheat when purchased in January 2014 is

accounted for as follows:

Hyrum Future

19-41

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

2013

Hyrum Future

The gain from the increase in the

value of Hyrum’s futures contract

is deferred as a part of other

comprehensive income.

19-42

Jan. 1 Wheat Inventory 4,400

Cash 4,400

2014

The journal entries necessary to record the

purchase of 1,000 bushels of wheat in the open

market and the cash settlement of the wheat

futures contracts are as follows:

Hyrum Future

1 Cash (future contract settlement) 400

Wheat Futures Contract (asset) 400

1,000 bushels x $4.40

1 Accumulated Other

Comprehensive Income 400

Gain on Futures Contract 400

19-43

Woodruff Option

• On October 1, 2013, Woodruff Company paid

$20,000 to purchase a call option to buy 1,000

ounces of gold at a price of $1,100 per ounce

some time before January 1, 2014.

• Because Woodruff paid cash for the gold

option, the following journal entry is made on

October 1:

Oct. 1 Gold Call Option (asset) 20,000

Cash 20,000

2013

19-44

Woodruff Option

• The impact on the change in price of gold is

accounted for as follows:

• The actual price of gold on December 31, 2013, is

$1,128 per ounce. Woodruff will receive a $28,00

payment [($1,128 x 1,000 ounces) – ($1,100 x

1,000 ounces)] on January 1, 2014, to settle the

call option.

19-45

Woodruff Option

The gold call option is reported at its fair value of

$28,000 in the December 31, 2013, balance

sheet. The adjusting entry to recognize the

change in the fair value of the option is as

follows:

Dec. 31 Gold Call Option ($28,000 –

$20,000) 8,000

Other Comprehensive

Income 8,000

2013

19-46

Woodruff Option

The journal entry necessary in Woodruff’s book

on January 1, 2014, to record the purchase of

1,000 ounces of gold and the cash settlement of

the option contract are as follows:

Jan. 1 Gold Inventory 1,128,000

Cash 1,128,000

2014

1 Cash (gold call option

settlement) 28,000

Gold Call Option (asset) 28,000

1 Accumulated Other

Comprehensive Income 8,000

Gain on Gold Call Option 8,000

1,000 ounces x $1,128

19-47

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.

6. Apply the accounting rules for contingent

items to the areas of lawsuits and

environmental liabilities

19-4819-48

19-4919-49

19-50

Accounting for Lawsuits

In ASC Topic 450, the FASB identifies several key

factors to consider in making the decision. These

include the following:

1. The nature of the lawsuit

2. Progress of the case

3. Views of legal counsel as to the probability of

loss

4. Prior experience with similar cases

5. Management’s intended response to the

lawsuit

19-5119-51

19-5219-52

19-5319-53

19-54

Disclosure

• Some companies do not disclose any

information regarding potential liabilities from

lawsuits.

• Others provide a brief, general description of

pending lawsuits.

• Sometimes companies provide fairly specific

information about pending actions and

claims.

• They generally do not disclose dollar

amounts of potential losses.

19-55

• 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

19-56

Business Segments

• Information to be disclosed in the financial

statement notes under the provisions of Pre-

Codification FASB Statement No. 14 included

revenues, operating profit, and identifiable

assets for each significant industry segment of a

company.

• Other provisions of the statement required

disclosure of revenues from major customers

and information about foreign operations and

export sales.

7. Prepare the necessary supplemental

disclosures of financial information by

product line and by geographic area

19-57

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

According to the provisions of FASB ASC Topic

280, companies are required to disclose the

following information concerning business

segments:

Business Segments

19-58

4. Total capital expenditures

5. Reconciliation of the sum of segment totals

to the company total for each of the following

items:

Revenues

Operating profits

Assets

Business Segments

19-59

• Revenue test. A segment should be reported

if its total revenue is 10% or more of the

company’s total revenue (external and

internal).

Business Segments

Separate segment disclosure is required if a

segment meets any one of the following three

criteria:

19-60

• Profit test. A segment should be reported if

the absolute value of its operating profit (or

loss) is more than 10% of the total of the

operating profit for all segments that report

profits (or the total of the losses for all

segments that reported losses).

• Asset test. A segment should be reported if it

contains 10% or more of the combined assets

of all operating segments.

Business Segments

19-61

The FASB also decided that segments can be

combined for reporting purposes, even if they

are treated as separate segments internally, if

the segments have similar products or services,

similar processes, similar customers, similar

distribution methods, and are subject to similar

regulations.

Business Segments

19-6219-62

19-63

Interim Reports

• Statements showing financial position and

operating results for intervals of less than a year

are referred to as interim financial statements.

• Under the integral part of annual period

concept, the same general accounting principles

and reporting practices employed for annual

reports are to be utilized for interim statements,

but modifications may be required so the interim

results will better relate to the total results of

operations for the annual period.

8. Recognize the importance of interim reports,

and outline the difficulties encountered when

preparing those reports

19-64

Interim Reports

Example of a Modification

• Assume a company uses the LIFO method of

inventory valuation and encounters a situation

where liquidation of the base period inventory

occurs at an interim date but the inventory is

expected to be replaced by the end of the

annual period.

• The inventory should not reflect the LIFO

liquidation by including the cost of replacing the

liquidated LIFO base.

19-6519-65