University:
California State University, Northridge
Course:
ACCT 350 | Intermediate Financial Accounting I
Academic year:

2024
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456

Pages:

44
Author:

Bulfaro0ql

Derivatives, Contingencies, Business Segments, & Interim Reports Chapter 19 Intermediate Accounting Learning Objectives 1. Understand the business and accounting concepts connected with derivatives and hedging activities. 2. Identify the diferent types of risk faced by a business. 3. Describe the characteristics of the following types of derivatives: swaps, forwards, futures, and options. 4. Define hedging, and outline the difference between a fair value hedge and a cash flow hedge. Learning Objectives 5. Account for a variety of different derivatives and for hedging relationships. 6. Apply the accounting rules for contingent items to the areas of lawsuits and environmental liabilities. 7. Prepare the necessary supplemental disclosures of financial information by product line and by geographic area. 8. Recognize the importance of interim reports, and outline the difficulties encountered when preparing those reports. Simple Example of a Derivative You are an employee of Nauvoo Software Solutions. Simple Example of a Derivative On October 1, 2008, you purchase 100 shares of stock in the company at the market price of $50 per share, for a total price of $5,000. Simple Example of a Derivative On January 1, 2009, you need to make a college tuition payment of $5,000 on behalf of your daughter. You can’t sell the stocks now because your employment contract states that the shares must be held for at least three months before they can be sold. How can you avoid downward movement in the stock price between now and January 1? Simple Example of a Derivative If the price of the stock is above $50/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. Definition of Derivative • Derivative- 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. • When the agreement is made, no journal entry is required, because it is an executory contract. Types of Risk • Price Risk • Credit Risk • Interest Rate Risk • Exchange Rate Risk Types of Derivatives • • • • Swap Forward contract Futures Options Types of Derivatives • Swap- a contract where two parties agree to exchange payments in the future based on the movement of some agreed-upon price or rate. – Interest rate swap- two parties agree to exchange future interest payments on a given loan amount. Types of Derivatives Interest Rate Swap Interest Rate on January 1, 2009 7% 10% Variable-rate interest payment in 2009 $ (7,000) $(10,000) Receipt (payment) for interest rate swap (3,000) 0 Net interest payment in 2009 $(10,000) $(10,000) 13% $(13,000) 3,000 $(10,000) Types of Derivatives • Forward contract- an agreement between two parties to exchange a specified amount of a commodity, security, or foreign exchange at a specified date in the future with the price or exchange rate being set now. Types of Derivatives On November 1, 2008, Clayton Company sold machine parts to Maruta Company for ¥30,000,000 to be received on January 1, 2009. The current exchange rate is ¥120 = $1. Clayton enters into a forward contract with a large bank that guarantees this exchange rate. Types of Derivatives Exchange Rate on January 1 ¥118 = $1 ¥120 = $1 ¥122 = $1 Variable of ¥30,000,000 $254,237 $250,000 $245,902 Clayton receipt (payment) to settle (4,327) 0 4,098 forward contract Net dollar receipt by Clayton $250,000 $250,000 $250,000 Stop and Think What type of credit risk is associated with a forward contract? Types of Derivatives • Futures contract- 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. • Futures contracts are similar to forward, difference is that a forward contract is private and futures are traded on an exchange. Types of Derivatives Hyrum Bakery uses 1,000 bushels of wheat every month. On December 1, 2008, Hyrum decides to protect itself against fluctuations in prices. Hyrum buys a futures contract to purchase the wheat at $4 per bushel. Types of Derivatives Wheat Price on January 1 $3.80 $4.00 $4.20 Cost to purchase 1,000 bushels $(3,800 ) Hyrum receipt (payment) to settle (200 ) futures contract Net dollar receipt by Clayton $(4,000 ) $(4,000 ) 0 $(4,000 ) $(4,200 ) 200 $(4,000 ) Types of Derivatives • Options contract- gives 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. • Two types of options: – Call option -gives the owner the right to buy an asset at a specified price. – Put option- gives the owner the right to sell an asset at a specified price. Types of Derivatives On October 1, 2008, Woodruff Company decides that it will need to purchase 1,000 ounces of gold for its computer chip manufacturing process in January, 2009. Gold is selling for $300 per ounce on October 1, 2005. Woodruff enters into a call option contract on October 1 which gives Woodruff the right to purchase 1,000 ounces of gold at a price of $300 per ounce. Types of Derivatives Gold Price (per ounce) on January 1 $280 $300 $320 Cost of 1,000 ounces of gold if— • Buy gold at: $280,000 $300,000 $320,000 January 1 prices • Exercise option $300,000 $300,000 $300,000 Will option be exercised? No Cost of gold Same Yes $280,000 $300,000 $300,000 Types of Hedging Activities • Hedging- Structuring of transactions to reduce risk. • Fair value hedge- offsets, at least partially, the change in the fair value of an asset or liability. • Cash flow hedge- offsets, at least partially, the variability in cash flows from forecasted transactions that are probable. Accounting for Derivatives and for Hedging Activities Balance sheetDerivatives should be reported in the balance sheet at their fair value as of the balance sheet date. 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. Accounting or Derivatives and Hedging Activities • Changes in the fair value of derivatives designated as: – No hedge are recognized as gains or losses in the income statement in the period in which the value changes. – Fair value hedge are recognized as gains or losses in the period of the value change. – Cash flow hedge are recognized as part of accumulated other comprehensive income. Accounting or Derivatives and Hedging Activities • Companies must provide a description of their risk management strategy and how derivatives fit into that strategy. • Firms must disclose the gains and losses on derivatives, separated by category: – Fair value hedges – Cash flow hedges – Other • Notional amount- total face amount of the asset or liability that underlies a derivative contract. Examples of Accounting for Derivatives On January 1, 2008, Pratt Company received a two-year $100,000 variable-rate loan and also entered into an interest rate swap agreement. Jan. 1 Cash 100,000 Loan Payable 100,000 Examples of Accounting for Derivatives The market interest rate on 12/31/ 2008 is 11%. There is no change in The interest rate swap asset the underlying items in is reported at its present the 2008 balance sheet value of $901 ($1,000 and income statement. discounted) in the 12/31/2008 balance sheet. The 2008 income statement shows a deferred gain of $901 on the interest rate swap. A gain is recognized in 2009 to offset increased in interest expense. Examples of Accounting for Derivatives The December 31, 2005 entry to record Pratt’s 2008 interest payment, along with the adjusting entry, is: Dec 31 Interest Expense Cash ($100,000 x .10) Interest Rate Swap Other Comprehensive Income December 31, 2006 Interest Expense Cash ($100,000 x .11) 10,000 10,000 901 Asset 11,000 901 11,000 Examples of Accounting for Derivatives December 31, 2006 Cash Interest Rate Swap Other Comprehensive Income Other Comprehensive Income Interest Expense Loan Payable Cash 1,000 901 99 1,000 100,000 $901 x .11; 1,000 rounded 100,000 Examples of Accounting for Derivatives On November 1, 2008, Clayton Company sold machine parts to Maruta Company for ¥30,000,000 to be received on January 1, 2009. On the same date, Clayton also entered into a yen forward contract. Nov. 1 Yen Receivable Sales 250,000 250,000 ¥30,000,000 ÷ ¥120 per $1 Examples of Accounting for Derivatives The actual exchange rate on December 31, 2008 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]. Dec. 31 Loss on Forward Contract Forward Contract Yen Receivable Gain on Foreign Currency 2,101 2,101 2,101 2,101 Examples of Accounting for Derivatives The journal entries necessary in Clayton’s books on January 1, 2009, to record receipt of the yen payment and settlement of the yen forward contract are: Jan. 1 Cash Yen Receivable Forward Contract Cash 252,101 252,101 ¥30,000,000 ÷ 2,101 ¥119 per $1 2,101 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. Accounting for Contingencies Contingent Losses Likelihood Probable Accounting Action Recognize a probable liability if the amount can be reasonable estimated. If not estimable, disclose facts in a note. Reasonably Possible Disclose a possibility liability in a note. Remote No recognition or disclosure unless contingency represents a guarantee. Then, note disclosure is required. Accounting for Contingencies Contingent Gains Likelihood Probable Accounting Action Recognize a probable asset if the amount can be reasonable estimated. If not estimable, disclose facts in a note. Reasonably Possible Disclose a possibility asset in a note, but be careful to avoid misleading implication. Remote No recognition or disclosure. Accounting for Lawsuits • • FASB Statement No. 5 identifies several key factors to consider: 1. The nature of the lawsuit. 2. Progress of the case in court, including progress between date of the financial statements and their issuance date. 3. Views of legal counsel as to the possibility of loss. 4. Prior experience with similar cases. 5. Management’s intended response to the lawsuit. No specific guidance on the disclosure required when a loss contingency cannot be estimated. Regulating Authorities Ideas on Environmental Liabilities • SEC: Staff Accounting Bulletin No. 92interprets GAAP regarding contingent liabilities, with particular applicability to companies with environmental liabilities. • AICPA: Statement of Position 96-1- outlines the key events that can used to determine whether an environmental liability is probable. • FASB: SFAS No. 143- states an obligation associated with retiring an asset should be recognized when incurred using present value techniques. The offsetting debit should be an addition to the cost of the associated asset. Business Segments • FASB Statement No. 14 disclosure requirements: – Revenues, operating profit, and identifiable assets for each significant industry segment. • A segment is significant if its sales, profits, or assets are 10% or more of total company amounts. • A practical limit of 10 segments is suggested, and at least 75% of total company sales must be included in the reported segments. – Revenues from major customers and information about foreign operations and export sales. Business Segments FASB Statement No. 131 Disclosure Requirements 1. 2. 3. 4. 5. Total segment operating profit or loss. Amounts of certain income statement items such as operating revenues, depreciation, interest revenue, interest expense, tax expense, and significant noncash expenses. Total segment assets. Total capital expenditures. Reconciliation of the sum of segment totals to the company total for each of the following items: • • • Revenues Operating profit Assets Business Segments In addition to these five items, companies must also disclose how operating segments are identified. Revenue test- A segment should be reported if its total revenue is 10% or more of the company’s total revenue. Profit test- A segment should be reported if the absolute value of its operating profit (or loss) is greater than 10% of the total operating profit for all segments that reported profits Asset test- A segment should be reported if it contains 10% or more of the combined assets of all operating segments. Stop and Think How could The Coca-Cola Company use PepsiCo’s reported segment information to aid it in formulating its competitive strategy? Interim Reporting •Seasonal factors •Revenue fluctuations among periods Difficulties Seasonal •Matching ofwith revenues •Adjustments forInterim accrued items Reports •Expense estimates (increased •Fixed costs subjectivity) •Extraordinary items •Segment disposal Interim Reporting • APB Opinion NO. 28- the interim period is an integral part of the annual period. • Revenues and expenses for the total period are allocated among interim periods on some reasonable basis (time, sales volume, productive activity). • The same GAAP and reporting practices employed for annual reports are to be used for interim statements. • Modification may be necessary for interim reports to better relate to the total results of operations for the period.

Derivatives, Contingencies, Business Segments, & Interim Reports

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