INTERMEDIATE

ACCOUNTING
Sixth Canadian Edition
KIESO, WEYGANDT, WARFIELD, IRVINE, SILVESTER, YOUNG, WIECEK

Prepared by
Gabriela H. Schneider, CMA; Grant MacEwan College
 CHAPTER

18
Dilutive Securities and
Earnings per Share
Appendix 18B
Accounting for
Derivatives
 Study Objectives

1. Explain who uses derivatives and why they are

used
2. Understand the basic guidelines for accounting
for derivatives
3. Describe the accounting for derivative financial
instruments
4. Describe the disclosure requirements for
traditional and derivative financial instruments
 Derivatives
• Derivatives are financial instruments that create
rights and obligations, that transfer financial risk
from one party to the another party
• Used to reduce financial risks
• Price risk • Liquidity risk
• Credit risk • Cash flow risk
• Derivative instruments include
• Forwards
• Futures
• Options
 Derivatives

• Traditional accounting does not

reported these instruments
• Movement is towards recognition and
reporting of these instruments, to
• Provide information on exposed risks
• Provide information on risk management
 Derivatives

• Used by
• Producers and Consumers
• Lock in future revenues or costs
• Speculators and Arbitrageurs
• Maintain market liquidity
• Additional motivations to use derivatives
• Manage interest rate volatility
• Manage foreign exchange rate volatility
 Derivative Instruments

• Financial forwards or financial futures

• Options
• Call Option
• Holder has the right, but not the obligation, to
purchase at a preset (strike or exercise) price
• Put Option
• Holder has the right to sell at a preset price
• Swaps
• Interest rate
 Basic Principles of
Derivative Accounting
• Currently no GAAP in place for derivative
accounting
• General consensus exists for:
a) Measurement at fair value
b) Recognition of gains/losses from fair value
changes
c) Preclusion of special accounting related to
hedging
d) Increasing disclosure
 Derivative Accounting -
Example
Given:
• Call option entered into January 2, 2002
• Option expires April 30, 2002
• Option to purchase 1,000 shares at $100 per
share
• Share market price on January 2, 2002 is
$100 per share
• Option is purchased for $400 (Option
Premium)
• Share price March 31st $120 per share
 Accounting for Derivatives
Option Price Formula
Option Intrinsic Time
Premium
= Value
+ Value

Market Price less Option Value

Strike (Exercise) Less
Price Intrinsic Value
Option
Premium
= ($100 - $100) + ($400 - $0)

Journal Entries
 Accounting for Derivatives
January 2
Temporary Investment (Call Option) 400
Cash 400
March 31
Temporary Investment (Call Option) 20,000
Unrealized Holding Gain/Loss 20,000
Intrinsic Value = 1,000 shares ($100 - $120)
March 31
Unrealized Holding Gain/Loss 300
Temporary Investment (Call Option) 300
Time Value = ($400 - $100)
 Accounting for Derivatives
April 1
Cash 20,000
Loss on Settlement of Call Option 400
Call Option 20,100
Unrealized Gain
Temp. Investment Call Option
or Loss
400 300 20,000 20,100
20,000
20,100 Reported on
March 31st Unrealized 20,000
Balance Sheet, with Less: Loss 400
Call Option balance Net Income 19,600
 Hedging
• Used to manage interest rate and
foreign exchange risk
• Fair Value Hedge
• To offset exposure to fair value changes of
• Recognized asset or liability, or
• Unrecognized firm commitment
• Examples are
• Interest rate swap
• Put option
 Interest Rate Swap

A pays B at a fixed (or floating) rate

Financial
Party A Party B
Intermediary

B pays A using the opposite rate of A

 Interest Rate Swap
Given:
A enters into a 5-year interest rate swap with B
Terms are:
A will receive payments at the fixed rate of 8%
A will pay at variable rate (6.8% when contract
entered into)
Principal sum involved is $1,000,000
 Interest Rate Swap

• No entry required when swap entered into

• Fair value of the swap reported on the
Balance Sheet
• Any gains or losses reported on the
Income Statement
 Futures Contract

• Gives the holder the right to purchase

at a preset price
• Unrealized gains or losses are recorded
• Gain or loss arises when the spot price is
different than the forward (contract) price
 Disclosure Requirements
• Include the following:
1) Terms and conditions of instrument
2) Interest rate risk
3) Credit risk, including significant
concentrations
4) Fair value of any and all recognized and
unrecognized financial instruments
5) Hedges
1) Description of hedge
2) Type of hedge used
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