—_____2eniens Chapter 13, Basic Derivatives Relat standards: PERS9 Financial Instruments PAS 32 Finacial nstrumons: Presentation ‘PERS? Financia instruments: Disclosures Tearning Objectives ‘State the characteristics of derivative. Give examples of derivatives. State the purposes of acquiting derivatives, Account for derivatives that are not designated as hedging instruments Introduction A few decades ago, derivatives were considered of-balance sheet items, meaning they were not separately accounted for in the financial statements. However, because of the risks inherent {engaging in derivative transactions and thei potential for abusive ‘use, reporting standards now require proper accounting, dlisdosure of derivatives. Many companies have incurred substantial losses on derivatives, inchding ENRON, Procter & Gamble, Barings PLC, DELL Computer, and so on. Users of financial statement, therefore, need sufficient information on an ‘enliy’s derivative transactions in order for them to. properly assess the associated risks. Purpose of derivatives ‘The purpose of obtaining derivatives is either: a. to speculate (incur rsh; oe 1. tohedge avoid o manage ris). sieeve a ws eee ot ‘The use of derivatives for 5 generally discouraged because ofthe hi ore commonly, financial sks speculation purposes is igh risk associated with it derivatives are used to managers, patclarly risks. Risks the possibilty that an event will occur having an adverse effect om the achievement of an entiys objectives, Rik reasured_ in terms of impact (possible loss) and ldelnad (probability). Financial risk isthe risk ofa possible future change in interest ate, financial instrament price, index price, cet rating, or other variable. PERS 7 requires qualitative and quantitate disclosures fr the following types of financial sks 1. Credit risk ~ is “the risk that one party to a finandal instrament will cause a financial loss for the other party by failing to discharge an obligation.” gts Appens A) Liquidity risk ~ is "he risk that an entity will encounter dlfficlty in meeting obligations associated with fnancal lisbilities that are settled by delivering cash or another financial asset” (852 Append A) Credit risk and liquidity risk are opposites. For example, credit isk includes the possibility that an entity ‘cannot collect on its receivables, wile liquidity risk inchades| the possiblity that an entity cannot pay its payables. AS a guide, recall that liquidity is defined in the Conceptual Framework as the ability of the entity to pay its short-term abilities. ‘Market risk ~ is “the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices.” (RS 7Appensn A) Market risk ‘comprises the following three fypes of risk: ioa a ‘chaper ta 1. Gurency risk is “the isk that the air value or Future cash flows of a financial instrument will fuctuate because of ‘changes in foreign exchange rates." (9S Apendin ‘i, Inert rate rk ~ i “the risk that the far value oF future ‘cashflows ofa financial instrument wil fluctuate because ‘of changes in market interest ates." (VRS.Appendis A) © Other price risk "the risk that the fai vale or fue cash flows ofa financial instrament will ficuate because of changes in market prices (other than those arising from, interest rate risk or currency sk), whether those changes ae caused by factors specific 10 the individual financial instrument or its issuer, ot factors affecting all similar financial nstroments traded in the mathe.” (FRS7Appieay Disclosure of concentration of cre risk is required of ‘most financial instruments. Disclosure of market risk (or price sk) is normally required of financial instruments measured at fair value, Disclosure of interest rate risk is normally required of debt instruments with variable interest rates. Disclosure of currency risk is required of financial instruments measured in foreign currency Derivative accountig is becoming more and more important Some companies even employ accountants whose sole esponsibility is to account for derivative transactions, The audit profession also regards derivative transactions as ik areas, Every year, audit firms and entities with internal audit activity devote ‘more and more resources to audits of derivatives. Accounting for Inthe money the holder should exercise gun in exersing > Out of the money ~ the holder should not exercise les in exercising Mol exercise the option; Example: You purchased a call option from Me. Mi fonkey. The option gives you the right to buy banana for PS (strike pie rice o exercise pric), Caw 1: Atexercise date, banana costs P12 at Seven Eleven. 4 The options the money. You wil ave Eg ke ‘Mr. Monkey. eee CCise 2: At exercise date, banana costs P3 at Seven Eleven. + The option is out of the money. You are bet ‘banana at Seven Eleven than from Mr. Monkey. ter off buying Example 25 You purchased a put option from Ms. Banana, The option gives you the right to sella monkey for P00, (Case 1: At exercise date, monkey is being sold for P80 in the market '® The option isin the money. You wil gain P20 fom sling monkey to Ms. Banana, ‘ase 2: At exercise date, monkey is being sold fr P50 in the market AAots Sapir [ei © The option is out of the mong. You are beter off seling monkey inthe market. Like the other derivatives, options may also be settled through net cash payment. Let's say in Example 2~ Case 1 above, the option is in the money: however, you don't actually have a ‘monkey to sell. To wetle the option, Ms. Banana pays you the net diference of P00 Ifthe option is out of the money. mo cash settlement is required because the option gives you a “right” not an bligation, ‘You will teat the aegulstion cost ofthe option a a loss while Ma, ‘Banana will twat itasa gain. 4. Swap ~ fsa contract in which two partis agree to exchange payments in the future based on the movement of some Sgreed-upon prie oF rate, Common examples include: 1 Taterest rate swap ~is 2 contract between two partis who agree to exchange fature interest payments on a given lan, Amount. Usually, one set of interest payments is based ona fied interest rat an the other i base on a ouriable interest rate + Foreign currency swap ~ is 2 contact between two parties ‘who agre to exchange a sum of money in one currency for ‘another currency. 5. Caps floors and collars ~ are essentially options designed to shift the risk of an upward and/or downward movement in variables, such as interest rates, These ate normally linked toa notional amount and a reference rate For example, if an entity wants to transfer the risk of ierest rates going, up, the entity will enter into a cap on 2 notional amourt of say, PIOOM, with the intrest rate of 55% Now, ifthe interest rate increases to 6%, the cap holder will be able to claim a settlement amount from the cap seller for the differential rate of 0.5% on the notional amount. See Deitel ees cet me ‘settlement. ° (On the other hand, fan entity expects the interes ge don ich pls a ako hime caty eee 8 floor, which would allow him to claim a setlement yn interest rate falls below a particular strike rate. = Interest ate collars the ito fh ip and fy, that payment will be triggered if the rate goes above te gy or falls below the floor. . on Caps, floors and collars difer from interest ate sna because under caps, floors and collars, the other yu pat dos no rece have a vara ed inert ae Sseption is an option on asap, The optin provides alder with he ght to enter intos swap st sspeohet eae date at specie tere This dervative fan chratoare ce moptionand raven 7. Weather derivative ~ a contract that requires pa ites payment based ‘on climatic, geological or other physical variables, Measurement of derivatives Adervatves are messi at far alu. The scsunting for he hangin fa value depends on wether he deatne 1 Not designated aa hedging instrument 2 Designated a far value hele or 3 Designated as cash ow hedge, Nohedging designation ivatives that are not designated as hedging instruments are ‘onsidered obtained for speculation on the direction of the movement of prices, rates or other underlying. Non-designated Sevivatives are accounted for as held for trading. securities Maore “Accordingly, changes in avalos are recoprize in prof or og (esFVPO, Tee scope of this chapter Is derivatives that ae wop designated se hedging instruments. Hedging” Wansaclons oe discussed in Adve Accounting? ‘Accounting for non-designated derivatives Llustration 1: Forward contact No hedging designation [ABC-Co. expects the value of the yen to decrease in the next 30 days, Accordingly, on Dec. 15, 2081, ABC Co. enters into a 30-day forward contract to sl! 1,000,000 yens at a forward rate of PO47 “The forward rate on Dec. 3, 20M is POARS, while the spot rate on Jan. 15,2012 is P46, > Dee. 15,20:1 (Contract date) Heigel item Nowe Forward donract (Deion) ic Deas ome ‘os on forward contac. 156 Forward cna iin | capes ae a] ard ake er > Jan 18.202 (Settons Vration #1: Net cash setlement ‘ABC Co, doesnot have 1M yens to sl. Accordingly, contrat insted oma net cash basis 1, the forward | “Theneteash setlement is computed a follows Forward rate at contrac date (Dee. 15,2041) Spot rate on setloment date Jan 1, 252) (Change in underlying favorable ‘Multiply by: Notional amount (No.of yens) Net eash receipt ow 046 ‘or M0000 10.000 Dec 15.201 Noenty (ame ee fe atin of i > Des. 31,201 (Reporting date) ‘The value ofthe derivative is computed as follows: Forward eate at contact date (Dee 18,24) oa Forward rate at rprtng date (Dee 31,22) 0.488 (Change waerving~ unfavorable 015 “Multiply by: Notional amount (No.of yes) :.000000 Loss! Derivative liability (25,000 The movement in the rate {s unfavorable because ABC'S seling price under the forward contact is #047 per yen, while the selling price inthe market is P.485 per yen. ABC will incur a los of 715,000 if it settles the forward contract currently, Accordingly, 8 ‘corresponding deriative ability is recognized [Hedge tem None [Fora conract Dean] Gn 16 Forward ena ii) 1K ‘ain enor cota =25K the forward contract 7 Te gin on Jan. 15 202 simply “qeecedin heey oitan also be computed as follows: z Forward rate a previous reporting date Dee 3, 21) ass Spotrate on setlement date Jan. 15,202) aa (Change in underlying ~ favorable aaa Multiply by: Notional amount (No.of ns) Lon Gain on setlement date ae yssa pt Variation #2: Gross setlement "ABC Co sls IM yens under the forward contact [Wied =Nawe [Foran ont Dera Yimts2m2 00 ane eure oA [aM 047 pet ne) Forward contrat hbity. 15K “Cash foreign cue. ak {Malou a) (Gain on forward contac 25K edhe le a he resid ree +h clu ft Heed ea Man eae teow iis ae “ania ws hdging werner egg taco ced a Add 42 Whether the forward contract i setled. grass oF net, the Bettie Dea 3 Fae beet Dee 31 30) Fa, 20 "0 18 Roo lg ie foster eo nl mp Ao wih ee Shoe scat ss “Dept wi Am Baca? ohh ee | Rae sit sod aes dra eta a ee | ‘Gniract subsequently Increases, the entity may be able wo withiray coh | Gen es dpa whens vo oy wer Geen cao | ‘Sqn py stor ca minnie pad mie ene She depo For crn a dn te bate ec Stet dae he dpe seve w ey cay th oy | ‘omed onthe futures contract. case of los the loss seat apne | post and any renuiting mount return tothe ety. mal [Futures contract (Derivative | amounts of (a) gain or loss and (2) net eash receipt or payment are Rolie am tte Cosh 2x ‘od nd aps dat Net seteent| Gross settenent uct 7 Gavan setement date (0435-| 7 Gain on setlement date (OS 04s) x =25K gue (045)x 1M = 25K gi Net cath recipe (087 046) x | Net cash ep 47K, > Dec.31,20x1 (Reporting date) “Hadged item = None Futures contract Derivative IM =10R at cash eet tale of yene dk setlementdate vale of yer So 10K wees rept ‘© Total et gui onthe contract: | @ Tol net gun om the contact (047-046) x 1M = 10K met gain | (47-046) x IN 1K net gin oF (15K loss on 1291/1 + 28K | oF (15K ls om 12611 + 25K non 1/152 1K net gin non 1552 = 1K net gi) Dec 312001 oon ures cont 10K tures conta (abi). 10K ream: ye eal ea of he dt compl he age eer ‘said ye a Iilustration 2 Futures contract~ No hedging designation (On December 1, 21, ABC Co, enters into a futures contrat to ‘purchase 1,000 ounces of silver on February 1, 20x2 for P200 per ‘unee. The broker requires an initial margin deposit of P20,00, ‘The quoted prices per ounce of silver areas follows: ‘ABC Co, recognizes loss an a Habit because the “fi purchase price of F200 is higher than the current price of P19. This condition is unfavorable to ABC Co. Mhoss Cope apr + Theparty ina futures contrat who agrees to ella commodity {is sai to bein the short positon. The party who agrees purcuse a commodity iin the long position, It prices fl, the entity in the short postion recognizes gain tecause he can sil sll at a higher price. On the ether hen {he entity in the in postion (uch a5 nthe istration sbony recognizes loss because he will be required to purchawe at | higher price, > Feb 1,202 Settlement date) ‘The net ensh settlement is computed a follows: Fotures price a orc date (Dee. 1,201) 200 Current price on stent date (Feb, 1,202) 1s, Change in unrving unfavorable Gs “Multiply by Notional amount (ounces of iver) 4 [Net ash payment om futures contract om) Deposit with Broker noo Net cash cept on setlement date 0 Hegel item = Nowe Futures contract Derivative) Tih.202 Cash 5K Forres contrac iby 108 os on futures contact. 5K Dest wth broke. 20K The loss on settlement date is simply ‘squeezed’ in the entry or it can also be computed a follows: [090 pie al Dee 3,21 18 pie a Feb 1,252) x1 a] = SK lose Alterative journal entries: Simple entries edged item = None Futures contact Derivative) Feb La as on furs contac. SK 90-45) Futures contract (abi) 8K "bree io ecg the had Futures onrac labiliy 15 (Goch ay Cash ween SK epost with cer. ak epanraeteneg itustration 3: Put option — No hedging designation ‘On December 15,2031, ABC Co, purchased a foreign curteny pt option fr 7,500 to el 1,000,000 yens at P.47 on January 15, 2%. Dee. 15 2 Dee 31,20e1 an 15 2h Sporrate Pods. PODS Fairvalue of put option 7500 5000 8000 © Analysis: “+ The put option gives ABC Co, the right to sell 1M yens for 1470000 (IM x 0.47). ABCCo. paid ¥7,500 for this right. 1 the spot rate on Ja 15, Hes lessthan the | Greater than tbe POAT sike Equal othe LAT strike price | price out fhe money) 047 strike paeasats | | ea te ‘ABC evercisesthe | ABC discards the option and) ABC Ca wile ‘option and sellsthe IM yensin the | indilferet on receivesthe | market at thehigher ate. | whether to 470.000 pre- ABCtratsthecanying | ees the agreed sale price. | amount ofthe option 3s os. option rn © Unlike forward and futures contracts, the option holier is ot required to buy of sel Ifthe option sot he mon the holder simply let the instrument expire and West acquisition cost ofthe option as loss ‘The entry on December 15, 20x1 is as follows:chaper'3 at option Dervating ic Deiat = fee Oeietee Variation: Out of the money investment (aca ‘ton promi’) was made, “The entry on December 31 20x is as fllows ‘There isan entry forthe put option because a small iii tem = Now Deis 2 Assume thatthe spot rate on January 15, 2032 is PAB. The en aa en 75K isas follows: v “cam 25K edged item None | Pat option Deriatoey —] Lamon Pst option. 8K utoption SK 258) sk ‘nro Ne eapotion pu ton ch ot ft Hedge tom ~ Nowe Put option Deroatioe) rch 20a as on pul option -25K Putoptn, 5K axes 1 rei ao he dan Scenario 1 Gross setlement “The entry on January 15,2042 sa follows Helge tem = None ‘Put option (Derioatie) | Tis. 2002 {Coto caren APO fame som poe) Ptoption (7K 25K) 5K (Cath foreign cureny. AOR finadeapa)| {Gainon pat opto SK ‘de ef Tiger se po Scenario 2 Net settlement Toe entry on January 15,2002 sas follows: Hedge tem Nove ‘Put option Derivative) Tenis. 2002 {Cash 67-040 AK Pt option (5 = 258) SK. Gairvon put option. SK ‘rate ne tenet Jn case of “out of the money,” the total loss on the put option is equal to the acquisition cost of the option, Thi is analyzed below: Loss = 1281/4 2300 Los 175/52 5.00 Total os Cequa fo ‘option premium’) 7500 1 Concept 7 [PERS 9 permits an entity to separate the intrinsic value and time value of an option contract and designate as the hedging instrament only the change in intrinsic value, The change in ine value is excluded, lustration 4: No hedging designation ~Call option (On April, 20x1, ABC Co, enters into a eal option contract with {an investment banker which gives ABC Co, the option to purchase "000 XYZ, Ine shares of stocks ata strike price of P100 per share. ‘The call option expires on July 1, 201. ABC Co. pays the ‘ewvestment banker P600 forthe call option. The market pice of the XYZ, Ine shares on April 1,201 is P100 per share. § Notes: The call option gives ABC Co. the right to purchase 1,000 shares for P100 per share. ABC Co, paid P60 fo this right ‘The 1,000 shares are referred to asthe notional amount.os chap The FAO payment to the investment banker is referred tas the option prema, which is much les than the cot of” parchasing the shares directly ‘= The option promium indicates the value of thecal option a this point in time. The option prim const ofthe sum of) ins ealue and (b) nee, At this point in time, the intrinsic vale is zero Because the ‘market price ofthe shares is equal to the exercise price (P10) market price ls P100 exercise price ual PO), °F On contract date, the option has fair value greater than zero. ‘Thisis due to the expectation that the market price of the XYZ, Inc. shares will increase above the option Price during the ‘option term (his is often refered to as the time value of the ‘option, The fme value f the option is estimated using option. Pricing models, eg, the Black Scholes model ‘_Atthis pont. the equation above willbe shown as follows: Option premium ‘0, Tntrinsicoalue + 0 . Aikitional information April, 201 June 20x Marke price of YZ, Inc shares —-PIO0/sh. ——PUO6Ish, Time vale of option 600 0 ‘The entry on April 120 is as fellows: _Hedged item = None Call option Derivative) “Apa 20h sll opon “on Gah 00, ese tie 9 ‘The entries on fne 90, 201 are as follows Helge tom - None Call option (Derivateg) Tac. alopton ony a ain oneal option... 6000 ‘rel tn i 1 tet pon te te wee ‘nes ar xc ft share evr eriape “ane a oss al ep 209 (aoa, Cal opin nae "nd ect fa ee foi uw he te * cain is ecoprized fom the changin inne vale tecrse he pin ‘the money. we Tote incase the option sou of the money, the enity née ma ecognize 4 loss from the change i intinsic value because the option erat designated as a hedging instrument. in the ti | ‘The maximum loss that would be resized in | seption is the premium paid which sequal t the time vow oft ‘tion on inal recognition In other words ifthe option is oto the Ply discards the option and treats the scqusition costa loss, The decree in vale reflects both the decreas khan tht he mse 3 ate shew nine inter er ene ‘he shorter time to maturity of the option contrat. “se Deets ‘Chape ses ‘The following are the current market rates: [Net cash settlement Jan 1, 2081 oe Jan 1 202 10% Cal option (Derivative) pe edged item None Titerest rate ap (Derk oe =a ative) {Los on call option. 40 Plena et | Cp [ —______| "wen | vont ‘iat te te Dec 31.2d sume “The nt cash settlement on the swap is determined as follows: The net cash eit cn alo be analyzed slow 20x a , a eeive variable 0.060 Tome Paes FGDs pice ss) enon arn ee Sate shmest roscoe mut pre assay fy fihel 5, nm no Neath stoner esp i Neteshectiomert crept a Thiers rts wed ae the crenata the blag ofthe ere, [Net settlement reduces transaction costs associated with tM 00) (IM 10% = 100200, Seo settlement of derivative contracts ‘There is no cash settlement in 20x1 because the variable 7 ard fived rates at the beginning of the year are the same (ue, 8% Ilustration 5: Interest rate swap (Payment at maturity) —Nobedging and 8%, respectively). [ABC Co, believes that market rates will increase in the future, a “Thus, on January 1, 20x1, ABC Co. enters into an intrest rate | tReceive OOK Py PAIK = Net recep PTR) —J swap on a P1,00,000 loan whereby ABC Co. agrees to receive a = tariable interest and pay fice interest of 8%, The interest rate ‘The net cash settlement in 20x2 i discounted to determine swap wil bested net on Dec. 31,202. i the fair vale ofthe derivative on Dec. 31, 20x: aie —_—_—— oe [Net ash settlement = ecept eon Oe 3,202) 2mno0 nals PV af 1 10% re 050909 En a Te Oy A aa a Fair value of derivative = 12/3131 (aed 15182 > le the current rate falls below 8%, ABC Co, pays the deficiency. > Whether the curent rate increases or decreases, ABC Co. pays fied interest of 8%. Cashsetlementis dueafter2 years. ‘The net cash settlement on Dec. 31, 2042 i discounted at ‘the current rate on Jan, 1, 20:2. An “of 1s used because the net ‘cash settlement is due one period from December 31, 2041 son Dacember 31,20 to Decamber St, 202), An aset is recognized because theme cash settlement isa rit[ _ “The entry on December 3,204 sas follows edged item — None Interest rate swap Derioategy ase erties “ ‘Te net cash settlement is discounted to determine the fie vat ofthe derivative on Dee 31,2041, re {Ganon int ate ag IMlustration 6 Interest rate swap (Periodic payment) ~ No hedging [ABC Co, believes that market rates will increase in the future, ‘Thus-om Jan. 1, 20s, ABC Co, enters into an interes ate swap on 1 F1,00,000 loan whereby ABC Co. agrees to receive variable interest and pay fixed interest of 9%. Swap payments shall be + made every Dec. 31 in the ne three years. The folowing are the Be | cot ap atch poy Ur rai 5 L Gani a pt Medondaunrannatya eo ee sta > pane Fatale of devote 1231 aki oe Net ash settlement eect era ee ee Hedge ten = None Test a nap Deiat) PV of oninary anny is used because sap payments Dean are made atthe end ofeach Yeats Dee 3 mae ee Y av Alay is recognized because the net cash comer ine payment Lsonint tesmap.izacs | bopaerr es * eee ht etic anit poms: He item — None Interest rate sway ivative) fan 302 % (edged ten =X ea ny Ian 3008 1% Bet ep tre can sno > on. 3, 2001 1 ad pt ge tam ~None | ater at nap Dean) ime a ad ar yt iat eae ‘The met coh setiment in 200 is determined 25 2 bss fr > Dee 31201 ating the fai vale fhe interest ate ap on Des 3,203 ‘Theta tment onthe swaps determines s follows: 2033 oT Tecivevarble TD Tm Teco ane wa 800 fyvthed a Pay ed sone $000, Net cahsetomontecpt 500 Net ash stoma =payment : ‘agw) au on cuenta a hep of he ear : __ Alie rates fe “The net cash settlement s discounted to determine the fair v inustation 7: "Receive fixed, pay variable” interest rate swap ofthe dervative on Dec. 31, 202. ‘The current rate on January 1, 20x i 10%, ABC Co, believes that [Net cash receipt dar nD 31203 may at) ‘Ravket rates will decrease inthe future, Accordingly on January {Tapat, ABC Co. enters into an interest rate swap on a 1,000.00, Tair cal of derivative. [2302 (see oan whereby ABC Co. agrees to receive fixed intrest of 10% and pay variable interest. Swap payments shall be made a the end of “The change in the fair value of the interest rate_swa Trick year in the next three years, The following ate the current Seon flows Soa te on 1 at alone at sp De 3, 22- at aie am ta Cryig enter espe 31,282 numa i en Dyce The el sllmant onthe swaps determined allows a io ive OR ed iron Toon Cullowghtere eons) janom 139000 Tacs apd cea stone = pant : aon ‘sa onthe cet tthe lag of pa 125142 payment) 19800 1261h2 (ir valoe adjstmer) _ 34619 ett a. Ast = puto fir ole 26786 > Dec. 31,2013 edged stem = None [Rese 10K Pay OK = Net payment 2) ‘The net cash settlement is discounted to determine the fair value ‘lhe derivative on Dee. 31,20, Netcash payment (ac mma starting De 3. 2082) 0.00) PV of ordinary annuity of 1 12%, n=? 1.65005 Fair oatue of derivative - 12131 ability) 33500 1 tony ant isl cn mp pays are ah ern 1s dan Be AN) A by pus a he et eh aTart rae Sap Dera es. 2001 somite swap, Interstate peop > Des, 31,2052 “The entry to record the fist cash settlement is as fellows: eiged tem ~ Nowe ‘he adjusting entry is as follows edged item ~ None Interest rate sap (Devowtioe) Dec.i.an aston nt rate ap. 2127 Interest ate oe 227 te men ange Be Leste tric **} > Dec.31, 20:3 Inert rat swap...20009 Cash sownon ne ‘The net cash settlement in 2033 is determined as a b eceive 10 aad Pay variable Mts 8) ‘The net cash settlement is discounted to determine the ofthe derivative on Dec. 31,2012. [Net cash payment toe D3, 203m date) Multiply by: PVT 818% net Fair oalue of derivatce 1213 abit The nein i ve the net at sap ee follows: a Fir value of interest ate swap Dec. 3,202 ily) Carrying amount of interes rte swap ~ Dee 3,202 (43001 hit - 21000 pt ash sete) = aii) in fur eal incre in ity) edged item Nome Taterest ae wap Derivatiog ss.) nee tea 08 Lasn in te wap Con a0 tenn ed cn Additional ilustrations: The succeeding illustrations aim to provide CPA reviewees editional learning moterals onthe accountng for derivatives, Illustration 1: Forward contract (On March 1, 20x1, ABC Co. sold inventory toa foreign company for FC 1,000,000 (FC means foreign currency) when the spat ‘exchange rate was FC40: PL. Payments due on April 1, 20x ABC Co. fs concerned about the possible fluctuation in exchange rates, $0 on this date, ABC Co. entered into a forward contract to sell FC 1,000,000 to a broker for 25,00. According tothe terms of ‘the forward contract, if FC 1,000,000 is worth less than ¥25,00 on ‘Apel 1, 20x1, ABC Co, shall receive from the broker the ditference: ifs worth more than P25,000, ABC Co. shall pay the broker the dlitterence, Case st: the exchange rate on April 1, 0x1 is FC3S: PL, how much is the ‘set cash settlement? Indicate whether itis a receipt or payment, . llot Slaton sed sling price ‘eling price at current spot rate M = 35) Excese~payment broker Case #2: Tithe exchange rote on April 1,201 is FC30: PI, how much, pet ea setement? Indicate whether it isa receipt or paym Sotto aed sling price Salling price a current spt rate (IM +50) Deficiency = receipt fom broker Case #3: Whe exchange rate on March 3, 20x1 is FCAS: PL, how the fair value of the interest rate swap? Indicate whether. derivative asst or lbility. Solution: Fad sling price Sling pice at curent spot rate (1M +45) Fairsalu of forward contract derivative asset Iniystration 2 Forward contract [ABC Co, does printing jobs for varius customers. On J 20x1, ABC Co, forecasted the purchase of 1,000 reams of ‘he neat quarter. The expected purchase date ison April 15, [ABC Co. expects thatthe price of paper will uctuate the upcoming elections. Thus, on January 1, 20x, ABC into a forward contract to purchase 1,000 reams of pa forward rate of P600 per ream. Ifthe market price on Aj 20u1 is more than P60, ABC Co, shall receive the dif the broker, On the other hand, if the market prices less ‘ABC Co. shall pay the difference to the broker. The usc rts , contract willbe settled net on April 15, 20x The discount 10%. 1 the price of paper is P700 per ream on March 31, 20s, how much Is the derivative asset (lability) to be recognized in ABC Cavs frst quarter financial statements? solution: Fined purchase price P00» 1.00) ong Purchase price at cutrent market price F700» 100) 70, Derivative asset = receivable from broker 700000 ‘The derivative need not be discounted because itis to be settled within 15 days, The effect of discounting would be ‘material. IMustration 3: Forward contract ~ Present value [ABC Co. produces feeds for hogs and chickens. In its long-term ‘budget completed on November 1, 201, ABC Co. forecasts a parchase of 10,000 kilos of comm on January 1,20. ‘To protect itself from fluctuation in prices, ABC Co. enters into a foeward contrat on Novernber 1, 201 to purchase 10,00 ils of «orn for P5,00,000 (or P50 pe Kilo. The forward contract will be settled net on January 1,203. Requirement (a): What is the notional value of the forward contract? Answer: 5,000,000 (100k nor iguresPD forwar ie) price of corms P65 pr ilo derivative ase (bil) rd nani statements? Requirement (If the curent market ‘on December 31, 20x, what amount of shall be reported in ABC Cos 20x1 year “The appropriate discount rates 10%.Salton Fixed purchase price (100000 PS) Purchase price at current market price (100.00 x68) Receivable from broker PV of 1 610% nol Ait) 09801. FV 0 810% = LARS Requirement (0 he current matket price of com is P40 ‘0n December 31, 22. what amount of derivative asst (J shall be reported ip ABC Co's 2032 year-end financial state The appropriate discount ates 10%. Solution: Fixed purchase price (10,000 #30 tose potatoes| sos Dope See, Requirement: Compute forthe total net deriva ‘onDecember 3, 20x1, slution: Long atures contrac to purchase soi ‘xed purchase pice (2 10 200000 Purdie pce at current market pie P5008 1) _160.0 Unfavorable ~ Payable to broker 20m “Long” futures contrac o purchase ster: Fixed purchase price F.400 200) 320000, Purchase pice at current markt price (10209) _ 380000 Favorable ~ Receivable from broker am “Shot atures contrac to sl fer beams: Fixed sling price (72501000) 250000 Selig rie at current markt price (P2041) _220,000 Favorable ~ Receivable from broker sm000 “Short” atures contact sl potatoes: Fixed selling price (110) sq00 ‘Selling price 8 curent market price (75431500) _112500_ Unfavorable Payable to broker eso, Netdertoative exset se IMlustation 5: Call option : On May 6, 20x1, ABC Co, entered inte'a firm commitment to purchase equipment from a foreign company for FC 100,000 ‘when the exchange rate was FC 40: PI Payment is due on Jae 1 20x1. ABC Co. is concemed about the possible ucustion in ‘exchange rates, so on this date, ABC Co, acquire acl option fo purchase FC 1000000 for 25000. ABC Co. paid an option ‘premium of P1000, Case 1 If the exchange rate on June 1, 20x FCS: I, how much Aid ABC Ca, save by purchasing the cll option? Am Oy Solution Purchase price using the option Purchase price without the opin (N= 35) ‘cing fr execs he option = gross Less Ct of parca pion Net savings from call option Case 21 the exchange rate on June 1, 201 is FC50: I, how did ABC Co. save by purchasing the cll option? Suto Purchase price using the option Purchace pice without the option (IM +50) Sings om execs he pon ros ABC Co. would have been better off not to purchased the cil option, Itustration 6 Put option ‘On March 31, 2041, ABC Co. acquired for P10,000 2 put which entitles ABC Co. to sell 20,000 units of a commodit 7220 per unit. The option expres an July 1, 20e1. On July 1, the current market price of the commodity is P250 per uit eguironent: How mich is the loss on the put option recognized by ABC Co. in it x financial statements? Satuton: The option i ou ofthe money (220 sale price using the 17250 current market price), Since an option gives the hol ‘right, and not the obligation, to Buy o sel, ABC Co, simply of te cost ofthe option as toss. Accordingly, ABC. Co. 10,000 loss. ss Deets we tration 7 Call option On Oct 1, 20c1, ABC Co. acquired for P10,000 a cll option on S000 units ofa commodity ata strike price of F220 per unit. The ‘erent market prices are (October 1, 20x 20 December 31, 2081 20 March 31,20 (exercise date) 20 Requirements: Compute forthe following: 4 Derivative asset (ability) on December 31,20. ‘Unrealized gain (loss) on December 31,20. Net eash settlement ~ receipt (payment) ~on March31, 2042, {4 Realized gain loss) onthe call option on March 31, 202. Salutons: Requirement (a: Derivative asset (i sed purchase price (220200) Purchase rie at current market price (20%29000) _4500.000_ Derivative asset-receoable from broker —eas00 Requirement (bs Unrealized gain (os) on December 31, 2011 Fae value of call option - July 1,204 st) 10000 Far value of call option - Dec. 31, 201 (eave) 000 Unrealized gain - increase in fai value 390.000 Requirement (Net cash settlement on March 31,2052 Fixed purchase pric P20 2100) 400.00 Purchase price at curent market price (2502000) _,000000_ [Net ash settlement - receipt 0.00 Requirement (@: Realized gain oss) on March 31,202 ; ‘Mirek Cash (see Requirement '€) ‘00.000 | Call option (ace Requirement) oom Gain calopton sez) 20000 ‘ii tt 220-2IMlustation& Interest rte swap (wap payment at mati (On Jan, 1, 2081, ABC Co. entered into an interest rate soa £1,000000 loan, Under the swap agreement, ABC Co. shall interest at whatever the current market rate of interest is beginning of the year and pay fixed interest at 10% payment shall be made on Des. 3, 202, ke, maturity furrent rates were 10% on Jan, 201 and 8% on Jan. 1,202, Requinment: How much is the net cash receipt (pa maturity date and what amount of derivative asset (lab presented inthe Dec. 31, 20x statement of financial position Salton: Receive variable (as) Pay 10% fed ‘Ne ex pagent duc on Dee. 31,2052 Multiply by: PV of 1 €8%, net Tair value of interest rate soap on Doe 31,20 Wabi station 9 Interest rate swap (periodic swap payments) On Janvary 1, 2x1, ABC Co. cbtaned a five-year, ‘ariable-rate loon with interest payments due at each and the principal ue on December 31,2085. [As protection from posible fluctuations in current market ‘ABC Co. enters inta an interest rate swap forthe whole pr ofthe Joan. Under the agreement, ABC Co, shall receive Inerest and pay fine interest based on a fixed rate of 8%, payments shall be made at each yearend, ‘The ollowing are the current market rates: Jan. 1.2031, ee Jan. 1, 2032 ry Jan. 1,203 12% ae Dvie fae Requirement (a): What isthe “notional” amount of the interes rate swap agreement? “Anse: 100,00 — the principal amount of the loan Requirement (b How much is the fir valve ofthe interest rate ‘swap on December 31, 20x? (Indicate whether its derivative set or Hability.) Solution ecsve variable (M29%) 009 Pay 8% xed sao Tet ak aetlonsit- Rept Gas mesa ovens) TOM _AMuipiy be PV ondinaryaneuity 9% ect az Tar alco interes rate apse sy Alert slain: expt 8% pay) IM PV ore samy 9%, ef eReZaet Requirement (2): How much is the fir value of the interest ate ‘swap on December 31, 202? (indicate whether itis a derivative asset or ibility) Salton: Receive variable (IM x 12%) i000 Pay 8 fied 000 [Net ash settlement = receipt (ue anoualy ort ops) 000 Multiply by PV ordinary annuity 12% 2-3 24018 Fair value of interest rate sap asst 00 Me9%. ac Drie a | Chapter 13: Summary PROBLEMS 1+ A derioatice is Banca instrument or other contract dies is sue from the changes in value of some tunderlying asset or oer instrument The charters of a derivative are: (a) its value chan responce to the change in an underlying: (6) it requ finial net investment or only a very minimal nid inestment and (it is sete at a tare dat, LUnter¥ing—a specified price, rate, or other variable inc aschesuled event that may of may not oscut, Notional amount ~ a specified uit of measure (eg, ‘urreny units, numberof shares, bushels, pounds, etc). Derivatives are obtained either as (a) hedging insta hedge some kind of risk or (b) non-hedging instrument for speculation), Examples of derivatives Forward contract ~ an agreement between two exchange a specified amount of a commodity, secur foreign currency at a specified date in the future at a agreed price. Futures contract ~ similar to forward contact but is anexchange. Option contrac that gives the holder the right, but obligation, to buy (ell option) or sll (put eption an a speed price ay time during a specie. period in ‘Swap ~ a contract in which two partes agree to ex payments in the future based on the movement of see pon pe rat vatives ee measured at fair value, Changes in the value of a derivative that is not designated as a {instrument are recognized in profit or loss. PROBLEM 1: TRUE OR FALSE Team increase in prices would result othe recognition of again fina “short” futures contrac. 2, If the market price exceeds the strike price in @ put option tontract, the option i ai to bein the money 15, The maximum amount of los in an option contrat that is not designated asa hedging instrument s equal tothe acqulstion ‘ost of the option. 44. Dogs Co enters into a futures contract. At the inception, Dogs ‘Co, pays a deposit to the broker. The deposit forms par of the camying amount ofthe derivative instrument. |5, Howl Co, acquies an option. Howl Ca. pays an amount for the option. The payment forms part ofthe carrying amount of the derivative instrument. 6 According to PFRS 9, ll derivatives shall be measured at fair value. 7. Derivatives that are not designated as hedging instruments are accounted for a held fr trading securities. All subsequent changes in the fair value of the derivative is recognized in profit or loss. 8. Entity A enters into a foreign curency swap. Entity A does ‘not designate the swap as a hedging instrument. The gin ot loss on the measurement ofthe swrap at each reporting date shall be recognized in profit or loss 98. Entity X enters into a forward contact to buy 1000 foreign currencies at forward rate of POD At the reporting dat, the forward rate sPL.50. Entity X wll recognize a gain of P00 on the forward contract. 10. Entity Y enters into a forward contact to buy 1000 foreign currencies ata forward rate of P200. At settlement date the spot rate increases to PROD. On the net settlement of the forward contract, Entity Y receives a net cash payment of aePROBLEM 2: MULTIPLE CHOICE -THEORY 1. Which ofthe flowing isnot a characteristic ofa derivative fa. tis sete ata future date Bb. It derives its value from the changes in value of other national amount. <&Terequies noni net investment or only a very mi {nil net investment 4. Allo these are valid characteristics ofa derivative 2. Which ofthe following can be an underlying fora deriva temperature orclimate interest or exchange . specified price all ofthese Entity X enters int a forward contact to sel 1,000,000 f currency units at forward rate of P.O. At the reporting tnd on settlement date the curent rates are P48 and. respectively. Identify the notional amount and the under inthe contrac. [Notional amount Underying a. P50 1,000.00 . con 00 Foreign currency © 1.00900 Forward rates 44. P050,P048and P05? 1,000,000 4. tis an agreement between two parties to exchange a amount of 3 commodity, security, oF foreign currency «specified date inthe fture at 9 re-agreed pric, It Tkely an overthe-counter transaction rather standardized and traded instrument 2 Forward contrat «Backward contract bs Fates contact, 4. Pass contract 5. Which ofthe following derivatives is most likely tobe ‘oma net cash bass? r Forward contact Call option 1 Fotunes contrat 4. Put option ete os a te 6 am ely sures utes coat for 190 ats of a Say. The tars pe a ota net Spr ste aren peo steer ates PO. Wich Towing statement comet? ft entity the. te entity will recgrize Shor position Gain, Long postion Gain, Long position Loss. Wrong positon None: Classic Co, enters into a “short” futurescontract during the period. The futures contract willbe settled net in the fllowing Period. At the reporting date, lasic Co. recognizes a gion the futures contract, Which of the following statements is cone? 2, Classic Co’ curent period statement of financial position will include a derivative Habiity fr the futures contact. Prices have increased, ‘cPries have deceased. 4 aande |S If he strike price ina all option contract exceeds the current price, the option is considered 2 Inthemoney. b. Outofthe money. Atte money. <4. No money, no honey. 9. In which ofthe following instances would the holder ofthe Instrument recognizes los when the market rate oF pice decreases? 4. Futures contract where the holders in the long position. ', Forward contract to purchase a specified quantity of 2 commodity. Call option 4. Patoption10 in which of the following instances would the holder of instrument recognizes gain when the market rate or increases? a Futures contract where the holder is inthe short posi {Forward contract to sel foreign currency units "Receive fined, pay variable” interest rate swap, ‘1 *Reeeve variable, pay xed” intrest rate swap PROBLEM 3: EXERCISES 4. On December 1, 20x, Stir Box Co. enters into a forward contract to buy 1,000 kilograms of coffee beans forward price of P250 per kilogram. The market prices subsequent periods are as follows ‘December 31, 20. vo AS January 15,202. AS Reguinents: Provide the joural entries under each following. scenarios: (a) the contract is settled by the purchase ofthe commodity, Le, dcentory and (b) the cont Settled through net cash payment. 2. On December 15, 201, Star Gass Co. entered into a forward contzat to buy 10000 yens at the forward 150. On December 31, 20s, the forward rate was PL by January 15,20, the spot rate moved to P16, Reprenents: Provide the joumal ents under each following, scenarios: a) the contact is sted by the purchase of yen an (the contac i sted through payment j 3. On December 1, 2041, View Co. enters into a futures to sll 100,000 foreign currency units on January 31, 100 per unit. The broker requires an intial margin 10,000. The curren ots ate as fellows ates st Bsc eats pected Dee. 3,301 32 —o %8 18 eyrement: Provide the journal entries, 44 Brook Co. purchased 2 put option contract on March 1, Dini when Back Yard Co. shares were trading at PIRO per Share. Brook paid #720 for the option. The option contact fives Brook the right to sell 1,000 shares of Back Yard Co. at 1180 per sare, The option expires on July 1.2031 ‘May. 1, 20:1 June 30,2081 Spot prices P1680 PI) Time value af option 7 180 Reyuinenerts: Provide the journal entries. Assume net settlement of he contrac 5 Kalley Co. purchased a put option on Flynn common shares on July 7, 2004, for $170. The put option is for 200 shares and the strike price is $5. The option expires on January 31,2005. ‘The following, data are available with respect to the put option: Date Market Priceof Flynn Shares, ‘Time Value of ut Option September 20,2004 $54 per share cy December 31,2004 $52 per share 8 Jaowary 31, 2005 $55 per share ° Rauroments Prepare he our ents © On January 1, 202, Eden Ventures, Inc, abtained a three-year, 1 million loan with interest payments due at the end ofeach Year and the principal tobe repaid on December 31, 2008. The literest rate forthe frst year isthe prevailing market rate of 9 Percent and the rate each succeeding year will be equal othe a if’erty pes ime er er area ae maine a eee ree ore a ce ee ae Serene en oral mate epuenn Mae e journal ete forthe intrest rte swap on tron the as on a te ee nt ot designated av hedging instrument ignore PUES! itas ne ton For purposss of estimating fate Rac sume tat he crent intrest te the Bt Fear urine ate (round all ers 6 the neat dn 1) Brn 122 3} Deeb 31,2002 3) December 31,2003 4) December 31,2008. gee 7. Hay Co, enters into a “receive fined, pay variable” interes rate sap on July 1, 2 for a notional amount of 3,000,000. The set rate is 12%, equal tothe curent rte on July 1, 20x. Cash setlement is due on July 1,253. Information on market rates fatlows aly 1.200 12% Ialy 1.209%, aly 12083, oqienents Renner i the derivative eset laity) tobe presented Ty's June 30,2082 statement of firancl postion? tb. Provide the entry on setlement date. [PROBLEM 4: MULTIPLE CHOICE ~ COMPUTATIONAL 1 On Jan. 1, 0x1, Lights Co, forecasted the purchase of 1000 ‘units of raw material. The expected date of purchase ison [April 15, 20s Lights Co. expects the prices to fluctuate. Thus fon Jan, 1, 20x, Lights Co. enters into a forward contact to ‘purchase 1000 units ofthe raw material at» forward rate of oO per unit I the market peice on April 15, 20k is more than P600, Lights Co. shall receive the difference fom the broker, whereas if the market price isles than PAOD, Lights Co. shall pay the difference, The forward contract will be settled net on April 15, 0x1. The discount rate i 10% If the price of the raw material is PS50 per unit on Ma. 31, 20x, how much is the derivative aset (ability o be recognized in Lights Co’s frst quarter financial statement? a. 50,000, B00) 45485. (45455) sete following information for the next gestions (On Nov. 2, 20c, Binbin Co. enters into a D-day forward contrat witha bank to purchase $100,000 ata st-price of P50 per dole ‘The forward rate on Dec. 31, 20x is #52, while the spt exchange rateon Jan. 31,2082, settlement date is P49, 2 What amount of derivative asset (Uabilty) Is reported in Binbin’s Dec, 31, 20x1 statement of financial poston? a. 200000 (200000) «109000 4. (100000) 3, How much isthe gain (los) recognized on Ja. 3, 20027 10000. (1aq000) «30000 4.200000)joa ee omen ace «ne es sl 200 wi rca eon AP. A Te refer PES per unit on March 31,2081 and Pp market pri ‘nt, What amount of gain (los) i 4.109000) ee eee see = crn ca ea occ re clearer pert e Pes Ce Ean cee ett ten hai edn «100.00 a ) Papa « 400m; 2000 dom; anom) 4. 0} an.000) 6 On December 15, 204, Sealfoling Co. enters into a 30-day forward contrat t sell 100,000 yens atthe forward rate of 7120. On December 31, 20s, the forward rate was PLS and by January 15,22, the spot ate moved to P27. How much isthe total gain os) recogrzed onthe forward contrac? 2 Tow” —b.¢70000) «39000. (30000) 7. Biter Cotte Co expects the value ofthe euro to decrease in the next 30 days. Accordingly, on December 15, xt, Biter ‘enters into a 30-day forward contract to sell 100,000 euros at the forward rate of P4000, On December 31, 20xt, Biter reporied a derivative lability ofP20,000, The forward rate on December 31,2081 must have been 8 5800. b.PA7O. c P5200. PBA. Rome Co. enters into a futures contract to sell 1000 units of 2 foreign currency for P100 per unt, The broker requires an iio 9 et ee ee initiat margin deposit of P20,000. The quoted prices per unit “on settlement date, how much cash did Rome Co, receive frm or pad tothe broker? 330000 recep 50,000 receipt 3000 payment 44.50,000 payment z é ‘Mavam El Co, acquired the following futures contracts for a iccommodity on Jan. 1, 20: ‘Notional Futures price Market price sist -1natst Lang’ fares contact 2800 209 180 ‘Shor futurescontract 1300280, 20 How much is the net derivative aset (liability) on Dec. 31, 20x17 a. 43,000 b.(43,000)c.68,000 4. 69.000) 10, Mingming Co. paid a premium of 25,000 fora all option on 00 units of foreign currency a a strike price of P50) per unit. The subsequent market prices were P99 atthe reporting date and 498 at exercise date. On expiration date, Mingming Co. recognizes a. 20000 gain. «10,000 gain b. 5,000 loss 410,00 oss. ing Company for ¥80,000,000 on August 0, The “xchange rate on June 18 is 100 = $1, To reduce the exchange ‘ate risk that could increase the cost ofthe equipment in US, dollars, Edwards pays $12,000 for a call option contract. This ontrat gives Edwards the option to purchase ¥8 000,000 at ‘n-exchange rate of ¥100 = $1 on August 20.On August 2, theerg 56, Comper Sper ‘xchange rate 89 = $1. How much did Edwards save by purchasing the call option? 3. $1200 b s48215, © $0215, 4 Edwards would have been better off not to ast the ealloption bi fate on March 1 is VI00 = 1. To reduce the exchange rate that could increase the cost of the equipment in US ‘Chow pays $20000 for a call option contrat. This ives Chow the option to purchase ¥B000000 at an exchange ‘ate of ¥100~$1 on June 1. On une I, the exchange ate IIS “$1. How much did Chow save by purchasing the call pon (answers rounded tothe nearest dalle)? a. $2000 b. S761 © SH7619 4. Chow would have been beter aff not to have purchased the ell option, (ipa) Use the flowing information for tenet tre question: (On January 1, 2002, Cougar Company received 9 two-year ‘$500.0 loan. The lan calls for payments tobe made a the end of ‘2ch year based on the prevailing market rate at January 1 of each Year. The interest ate at January 1, 2002, was 10 percent. Aggie Company’ also has a two-year $500,000 loan, but Aggie’ loan ‘arses a fixed interest rate of 10 percent, Cougar Company dacs ‘ot want to bear the risk that interest rales may increase in year ‘bro of the oan. Aggie Company believes tha ates may decreane nd it would prefer to havea variable debt, So the two companies “a Tate swap agreement whereby Arie arses 7 se Cougs intrest payment in 2003 and Cougar ikewise so male Cots gies intrest payment in 203. The two se ne make stent payment for he diference Seon December 31, 208. interest rate on January 12008 8 percent, what will be th ? Cougars temet payment lo AB? 2.5100 payment ¢ $1000 payment $500 rept 4.510000 ecipt sre 1M. the interest rate on January 1,200, is 12 percent, what wil ‘be Cougar’ settlement payment to/from Aggie? 2.$5000 payment €-$10,000 payment $5000 receipt 44.$10000 receipt si) 15, the intrest rate on December 31, 2002 is 12 percent, what snotnt wil Cougar eeport as the fair vale ofthe interest rate ‘ap at December 31, 20027, 2 0 $899 $1000 — d.ssonom0 ou PROBLEM 5: FOR CLASSROOM DISCUSSION Forward contact 1. Me Co. expects the value ofthe won to increase in the next 30| days. Accordingly, on December 15, 20x1, Mc Co enters into 30-day forward contract to buy 10000 wons at the forwa Tate of P24. On Deoember 31, 20x, the forward rate was 'FL.27 and by January 15,2012 the spot ate moved to P10. Requirements: Provide the joural entries under each of the folowing scenarios: (a) the contract is setled by the actual prrchase ofthe foreign currency; and (b) the contact is settled ‘hough net cash payment