FAR: Derivatives

Basic Characteristics of Derivatives

1. Derivatives is a contract asset (receivable) or liability (payable) that derives its value from changing prices,
interest rates, and foreign currency exchange rates.
2. The price rates and all other basis for the change is known as the “underlying”.
3. The change is the multiplied to a notional amount to get the full monetary value of the receivable or payable.
4. Derivatives are measured at FV. Therefore, if there is no change, the FV of the derivative is ZERO.

5. Derivatives are used for hedging or speculation.

6. Derivatives require no or a very little investment at the contract date.
7. Cash flow Hedge Derivatives: Changes in FV are deferred in OCI until the “Hedge Item” is settles (reclassified
to P/L)
8. “All Other” Derivatives: Changes in FV are recognized in P/L
9. Cash flow Hedge Simplified: Future cash flows are Variable or Undetermined.
10. Hedging Derivatives: Forwards (Price), Futures (Price), Swaps (Interest Rate), Options (Price)
11. Derivatives are settled at net amounts at a future date.
Identify the following in accounting for derivatives
1. What is the Underlying?
2. What is the Notional Amount?
3. How much is the change?
4. Identify the risk and the corresponding change whether favorable or unfavorable hence the recognition of a
receivable/gain or payable/loss.
5. Once the hedged item is settled the OCI from the Hedging Instrument is reclassified to P/L.

Hedging Controlling, if not eliminating risk, by engaging in a contract that has an opposite risk.
Hedge Forward Contract Entity transacts DIRECTLY transact with the Bank
Instrument Futures Contract Managed/Transact through an exchange or broker

Cash Flow Hedge FV Hedge

Eliminate: Variable or Undetermined CF CF not variable anymore, CF has already been fixed by
the Forward Contract
Hedged: Purchase of Foreign Currency Hedged: Forward Contract
Deferred G/L G/L to be recognized – P/L
 Purchase Hedge Instrument (Derivative Contract / Forward
Contract)
↑₱ Loss ↑₱ Gain/Receivable
Buy
↓₱ Gain/Savings ↓₱ Loss/Payable
↑₱ Gain/Savings ↑₱ Loss/Payable
Sell
↓₱ Loss ↓₱ Gain/Receivable

Identify the risk –

Change is multiplied effect to the primary
FV - when there is
Derivative GR: Beg. Value = 0 to the Notional contract (hedge item)
change
Amount -> opposite effect
with the derivative
 JOURNAL ENTRIES at HEDGE ITEM HEDGE INSTRUMENT
Contract Date No Entry No Entry
- GR: No investment; No change in
FV
- XPN: Options Contract
BS Date (12/31/20xx) No Entry Forward Contract Receivable XXX
UG on FC – OCI XXX

UL on FC – OCI XXX
Forward Contract Payable XXX
Settlement Date Purchases / Inventory XXX 1.) Update the UG/UL
Cash XXX Forward Contract Receivable XXX
UG on FC – OCI XXX

UL on FC – OCI XXX
Forward Contract Payable XXX

2.) Settlement of FCR/FCP

Cash XXX
Forward Contract Receivable XXX

Forward Contract Payable XXX

Cash XXX
 JOURNAL ENTRIES at HEDGE ITEM HEDGE INSTRUMENT
Settlement Date Purchases / Inventory XXX 3.) Close UG/UL-OCI to P/L
Cash XXX Loss on FC or Purchase* XXX
UL on FC – OCI XXX

UG on FC – OCI XXX
Gain on FC or Purchase* XXX

* Purchase Account may be used depending

How much is the cost of goods purchased? on the question of the problem; no definite
Purchases XXX treatment
Gain on FC (XXX)
Loss on FC XXX
Cost of goods purchased XXX
Sit. 1 Call Option ↑Php
JOURNAL ENTRIES at HEDGE ITEM HEDGE INSTRUMENT (Call Option)
Contract Date No Entry Call Option XXX
Cash XXX
BS Date (12/31/20xx) No Entry Call Option XXX
UG – OCI XXX

Settlement Date Purchases / Inventory XXX 1.) Update the UG

Cash XXX Call Option XXX
UG – OCI XXX

2.) Settlement of FCR/FCP

Cash XXX
Call Option XXX

3.) Close UG/UL-OCI to P/L

UG – OCI XXX
How much is the cost of goods purchased? Gain on CO or Purchase* XXX
Purchases XXX * Purchase Account may be used depending
Gain on CO (XXX) on the question of the problem; no definite
treatment
Cost of goods purchased XXX
Sit. 2 Call Option ↓Php Losses on CO are not recognized
JOURNAL ENTRIES at HEDGE ITEM HEDGE INSTRUMENT (Call Option)
Contract Date No Entry Call Option XXX
Cash XXX
BS Date (12/31/20xx) No Entry No Entry
Settlement Date Purchases / Inventory XXX Write off Call Option
Cash XXX Loss XXX
Call Option XXX

Interest Rate Risk (POV of Borrower)

↑% Loss
Interest Rate Swap
↓% Gain/Savings
Cash Flow Variable Interest Loan
Hedge
Underlying ∆% (a) X%
Fair Value Fixed Interest Loan
Hedge Notional Amount (b) XXX
Receivable/Payable XXX
(a x b)
 JOURNAL ENTRIES at HEDGE ITEM HEDGE INSTRUMENT
Contract Date No Entry No Entry
If Long-term – record at PV

BS Date (12/31/20xx) No Entry Interest Rate Swap Receivable XXX

UG – OCI XXX

UL – OCI XXX
Interest Rate Swap Payable XXX
Settlement Date Interest Expense XXX 1.) Update the UG/UL
Cash XXX Interest Rate Swap Receivable XXX
UG – OCI XXX
Notes Payable XXX
Cash XXX UL – OCI XXX
Interest Rate Swap Payable XXX

2.) Settlement of FCR/FCP

Cash XXX
Interest Rate Swap Receivable XXX

Interest Rate Swap Payable XXX

Cash XXX
 JOURNAL ENTRIES at HEDGE ITEM HEDGE INSTRUMENT
Settlement Date Interest Expense XXX 3.) Close UG/UL-OCI to P/L
Cash XXX Loss or Interest Expense* XXX
UL – OCI XXX
Notes Payable XXX
Cash XXX UG – OCI XXX
Gain or Interest Expense* XXX

How much is the Interest Expense?

Interest Expense XXX
Gain (XXX)
offset
Loss XXX
Interest Expense XXX