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B. Derivative Instruments and Hedging Activities

B. Derivative Instruments and Hedging Activities

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Module 19: Derivative Instruments and Hedging Activities

(c) Both of these terms are important for two reasons:

1] Their existence is a necessary condition for determining whether or not a financial instrument or

other contract is a derivative instrument;

2] They are determining factors in calculating the “settlement amount” of a derivative instrument.

(d) All of these terms are discussed in more detail later in this section, but this basic understanding of

deriva­tive instruments may be helpful in working through the remaining definitions, explanations,

and examples.

2. Foundation Principles for Accounting for Derivatives and Hedging—The basic principles driving the struc­

ture of accounting for derivatives and hedging are

a. Fair value measurement. Derivative instruments meet the definition of assets and liabilities (probable fu­

ture economic benefits or sacrifices of future economic benefits resulting from past transactions or events).

As such they should be reported on an entity’s financial statements. The most relevant measure for reporting

financial instruments is “fair value.”

(1) ASC Topic 820 defines fair value as “the price that would be received to sell an asset or paid to transfer

a lia­bility in an orderly transaction between market participants at the measurement date.”

(2) As a corollary to this principle, gains and losses that result from the change in the fair value of

derivative in­struments are not assets and liabilities. Therefore, gains and losses should not be reported

on the bal­ance sheet but rather should either appear in comprehensive income or be reported in current


(3) The details for reporting gains and losses appear in a subsequent section.


Hedging. Certain derivative instruments will qualify under the definition of hedging instruments. Those that

qualify will be accounted for using hedge accounting, which generally provides for matching the recogni­

tion of gains and losses of the hedging instrument and the hedged asset or liability. (More details about

hedge accounting are provided in a later section.) Three kinds of hedges have been defined in the standard.


Fair value hedge—A hedge of the exposure to changes in the fair value of (a) a recognized asset or

liabil­ity, or (b) an unrecognized firm commitment.


Cash flow hedge—A hedge of the exposure to variability in the cash flows of (a) a recognized asset or

liabil­ity, or (b) a forecasted transaction.


Foreign currency hedge—A hedge of the foreign currency exposure of (a) an unrecognized firm

commit­ment, (b) an available-for-sale security, (c) a forecasted transaction, or (d) a net investment in a

foreign operation.

     If a derivative instrument does not qualify as a hedging instrument under one of the three categories

shown above, then its gains or losses must be reported and recognized in current earnings.


Definition of a Derivative Instrument—Three distinguishing characteristics of a derivative instrument, must

be present for a financial instrument or other contract to be considered a derivative instrument. All three charac­

teristics must be present.

a. The financial instrument or other contract must contain (a) one or more underlyings, and (b) one or more

no­tional amounts (or payment provisions or both).

(1)An underlying is any financial or physical variable that has either observable changes or objectively

verifia­ble changes. Therefore, underlyings would include traditional financial measures such as com­

modity prices, interest rates, exchange rates, or indexes related to any of these items. More broadly,

measures such as an entity’s credit rating, rainfall, or temperature changes would also meet the

definition of an underlying.


Notional amounts are the “number of currency or other units” specified in the financial instrument or

other contract. In the case of options, this could include bushels of wheat, shares of stock, etc.

(3)The settlement amount of a financial instrument or other contract is calculated using the underlying(s)

and notional amount(s) in some combination.

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(a) Computation of the settlement amount may be as simple as multiplying the fair value of a stock

times a specified number of shares.

(b) On the other hand, calculation of the settlement amount may require a very complex calculation,

involv­ing ratios, stepwise variables, and other leveraging techniques.

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Module 19: Derivative Instruments and Hedging Activities


NOTE: The term “notional amount” is sometimes used interchangeably with “settlement amount.” Watch

to determine if the context in which the term is used is calling for a number of units (notional amount), or a

dollar value (settlement amount).

b. The financial instrument or other contract requires no initial net investment or an initial net investment that

is smaller than would be required for other types of contracts that would be expected to have a similar re­

sponse to changes in market factors.

(1) Many derivative instruments require no net investment or simply a premium as compensation for the

time value of money.

(a) Futures contracts may require the establishment of a margin account with a balance equal to a small

per­centage (2–3%) of the value of the contract.

(b) A call option on a foreign currency contract would again only cost a small fraction of the value of

the con­tract.

(c) These are typical contracts that would meet this definition and would be included in the definition

of de­rivative instruments.

c. The terms of the financial instrument or other contract do one of the following with regard to settlement:

(1) Require or permit net settlement, either within the contract or by a means outside the contract.

(a) Net settlement means that a contract can be settled through the payment of cash rather than the ex­

change of the specific assets referenced in the contract.

(b) This type of settlement typically occurs with a currency swap or an interest rate swap.

(c) This definition may have some unanticipated consequences. For example, a contract with a liquidat­

ing damages clause for nonperformance, the amount of which is determined by an underlying,

would meet this criterion.

(2) Provide for the delivery of an asset that puts the recipient in a position not substantially different from

net settlement.

(a) This might include a futures contract where one party to the contract delivers an asset, but a

“market mechanism” exists (such as an exchange) so that the asset can be readily converted to cash.

1] Convertibility to cash requires an active market and is a determining factor in whether or not a

finan­cial instrument or other contract will be treated as a derivative instrument.


4. Inclusions in and Exclusions from Derivative Instruments

The following table provides a list of those financial instruments and other contracts that meet the definition of

derivative instruments and those that do not meet the definition of derivative instruments or because they are

specifically excluded from treatment.

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• Options to purchase (call) or sell (put) exchange-traded


• Futures contracts

• Interest rate swaps

• Currency swaps

• Swaptions (an option on a swap)

• Credit indexed contracts

• Interest rate caps/floors/collars

• Normal purchases and sales (does not exclude “take or pay”

contracts with little or no initial net investment and products

that are readily convertible to cash)

• Equity securities

• Debt securities

• Regular-way (three-day settlement) security trades

(this exclusion applies to “to be announced” and “when

issued” trades)


• Mortgage-backed securities

• Employee stock options

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Module 19: Derivative Instruments and Hedging Activities

Royalty agreements and other contracts tied to sales volumes

Variable annuity contracts

Adjustable rate loans

Guaranteed investment contracts

Nonexchanged traded contracts tied to physical variables

Derivatives that serve as impediments to sales accounting (e.g.,

guaranteed residual value in a leasing ar­rangement)


Interest rate swaps are one of the most commonly used derivative instruments in business. The following dis­

cussion first describes an interest rate swap and then shows how it meets the definition of a derivative in­strument.

(1) In a common example, two parties may agree to swap interest payments on debt. Usually this occurs when

one party (Company F) has issued fixed-rate debt and believes that interest rates are going to drop, while

a second party (Company V) has issued variable-rate debt and believes that interest rates are going to rise.

In this case, both companies would be interested in exchanging interest payments since both be­lieve that

their interest expense would decrease as a result of the swap. Variable-rate interest may be de­termined

by any number of indices (e.g., Fed Funds Effective Swap Rate (OIS), London Interbank Offered Rate

[LIBOR], S&P 500 index, some fixed relationship to T-bill rates, AAA corporate bonds, etc.).

(a) In this example, the notional amount is defined as the principal portion of the debt, which would

be the same for both the fixed and variable rate debt. The underlying is the index that determines

the varia­ble interest rate, for example, six-month LIBOR. There is no initial net investment

required for this contract since the first payment will not occur until the first interest date arrives,

and net settle­ment can be achieved through the payment of interest and principal at the maturity

date. Therefore, all three of the criteria for a derivative instrument are present, and it is accounted

for as an interest rate swap. Similar examples could be developed for the other financial instruments

listed in the “in­cluded” column below.

5. Embedded Derivative Instruments and Bifurcation

Financial instruments and other contracts may contain features which, if they stood alone, would meet the

definition of a derivative instrument. These financial instruments and other contracts are known as “hybrid

in­struments.” This means that there is a basic contract, known as the “host contract,” that has an embedded

deriva­tive instrument. In these circumstances, the embedded derivative instrument may have to be separated

from the host contract, a process known as bifurcation, and treated as if it were a stand-alone instrument. In

this case, the host contract (excluding the embedded derivative) would be accounted for in the normal manner

(as if it had never contained the embedded derivative), and the now stand-alone derivative instrument would be

accounted for using the rules for derivatives.

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a. Three criteria are used to determine if bifurcation must occur. All criteria must be met.

(1) The embedded derivative meets the definition of a derivative.

(2) The hybrid instrument is not regularly recorded at fair value, with changes reported in current earnings

as they occur under other GAAP. If the hybrid instrument is regularly recorded at fair value, then there

is no need to bifurcate the embedded derivative since the same end result is being accomplished already.

(3) The economic characteristics and risks of the embedded derivative instrument are not “clearly and

closely related” to the economic characteristics and risks of the host contract.

b. Below are listed a number of hybrid instruments that would normally require bifurcation:

(1) A bond payable with an interest rate based on the S&P 500 index.

(2) An equity instrument (stock) with a call option, allowing the issuing company to buy back the stock.

(3) An equity instrument with a put option, requiring the issuing company to buy back the stock at the re­

quest of the holder.

(4) A loan agreement that permits the debtor to pay off the loan prior to its maturity with the loan payoff

pen­alty based on the short-term T-bill rates.

(5) Loans with term-extending options whose values are based on the prime rate at the time of the


(6) Convertible debt (from the investor’s viewpoint)

c. The holder of a hybrid instrument normally requiring bifurcation can make an election not to bifurcate the

in­strument. Instead, the entire instrument is valued at fair value.

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Module 19: Derivative Instruments and Hedging Activities


(1) This election is irrevocable and is made on an instrument-by-instrument basis.

(2) Changes in fair value of the hybrid instruments are recognized each year in earnings.

(3) If a company elects to use fair value measurement on selected hybrid instruments, the balance sheet

disclo­sure may be presented in one of two ways:

(a) As separate line items for the fair value and non–fair value instruments on the balance sheet,

(b) As an aggregate amount of all hybrid instruments with the amount of the hybrid instruments at fair

value shown in parentheses.

d. The fair value option may be applied to host financial instruments resulting from separation of an embedded

nonfinancial derivative instrument from a nonfinancial hybrid instrument. If the fair value option is elected,

the disclosure rules for fair value apply.


6. Hedging Instruments—General Criteria

Two primary criteria must be met in order for a derivative instrument to qualify as a hedging instrument.

a. Sufficient documentation must be provided at the beginning of the process to identify at a minimum (1) the

ob­jective and strategy of the hedge, (2) the hedging instrument and the hedged item, and (3) how the effec­

tiveness (see below) of the hedge will be assessed on an ongoing basis.

b. The hedge must be “highly effective” throughout its life.

(1) Effectiveness is measured by analyzing the hedging instrument’s (the derivative instrument) ability to

gener­ate changes in fair value that offset the changes in value of the hedged item.

(2) At a minimum, its effectiveness will be measured every three months and whenever earnings or

financial statements are reported.

(3) A “highly effective” hedge has been interpreted to mean that “the cumulative change in the value of the

hedging instrument should be between 80 and 125% of the inverse cumulative changes in the fair value

or cash flows of the hedged item.”

(4) The method used to assess effectiveness must be used throughout the hedge period and must be con­

sistent with the approach used for managing risk.

(5) Similar hedges should usually be assessed for effectiveness in a similar manner unless a different

method can be justified. (Even though a hedging instrument may meet the criterion for being highly

effective, it may not eliminate variations in reported earnings, because to the extent that a hedging

instrument is not 100% effective, the difference in net loss or gain in each period must be reported in

current earnings.)


Fair Value Hedges

A fair value hedge is the use of a derivative instrument to hedge the exposure to changes in the fair value of an

asset or a liability.


Specific criteria. The hedged asset/liability must meet certain criteria in order to qualify as a fair value

hedge. The hedged item must be either all or a specific portion (e.g., a percentage, a contractual cash flow)

of a recognized asset/liability or an unrecognized firm commitment.

(1) Both of these situations arise frequently in foreign currency transactions.


A company may enter into a firm commitment with a foreign supplier to purchase a piece of equipment, the price of

which is denominated in a foreign currency and both the delivery date and the payment date are in the future. The

company may decide to hedge the commitment to pay for the equipment in a for­eign currency in order to protect

itself from currency fluctuations between the firm commitment date and the payment date. For the period between

the firm commitment date and the delivery date, the company will be hedging against an unrecognized firm commit­

ment. For the period between the delivery date and the payment date, the company is hedging against a recognized

liability. (See Section 9, Foreign Currency Hedges, below, for the accounting associated with this example.)

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(2) For an unrecognized firm commitment to qualify it must be (1) binding on both parties, (2) specific

with re­spect to all significant terms, and (3) contain a nonperformance clause that makes performance



Accounting for a fair value hedge. Gains and losses on the hedged asset/liability and the hedging instru­

ment will be recognized in current earnings.


On 1/1/Y1, Dover Corp. purchases 200 shares of Porter, Inc. stock at $40. The securities are classified as available-forsale. The market price moves to $45 by the end of the year. Assume Dover does not elect the fair value option to report

its shares of Porter stock. In order to protect itself from a possible decline in the stock value of its available-for-sale

security, Dover purchases an at-the-money put option for $300 on 12/31/Y1. The put option gives Dover the right, but

not the obligation, to sell 200 shares of Porter stock at $45 per share, and the option expires on 12/31/Y3. Dover des­

ignates the hedge as a fair value hedge because it is hedging changes in the security’s fair value. The fair value of an

option is made up of two components, the time value and the intrinsic value. At the time of purchase, the time value is

the purchase price of the options and the intrinsic value is $0 (because the option was purchased at-the-money).

Over the life of the option, the time value will drop to $0. This is due to the fact that time value relates to the

ability to exercise the option over a specified period of time. As the option moves toward the expiration date, the

perceived value of the time value portion of the option will decrease as a function of the time value of money (TVM)

issues and other market forces. The time value will generally decrease over the life of the option, but not necessarily

in a linear fashion. The intrinsic value will vary based on the difference between the current stock price vs. the stock

price on the date the option was purchased. As shown in the table below, the intrinsic value of the option increases

from $0 to $200 between 12/31/Y1 and 12/31/Y2 because the stock price has dropped by $1 (× 200 shares), and the

hedge has been effective for that same amount. As can be seen by analyzing the two components of the put option,

the market is the primary driver of the value that should be assigned to the option. As is often the case, the intrinsic

value of the option is considered to be a “highly effective” hedge against changes in the stock price, while the time

value is ineffective and is reflected in current earnings. Additional information is provided below.


Porter stock price

Put option

Time value

Intrinsic value





$ 45

$ 44

$ 42


$ 0



(200 × $1)

$ 0


(200 × $3)


1.  Available-for-sale securities



Record the purchase of Porter stock (200 × $40).




2.  Available-for-sale securities


Other comprehensive income


Record the unrealized gain on Porter stock (accounting prior to the hedge in accordance with ASC Topic 320.

(200 × $5 valuation in­crease from holding gain to market value)

3.  Put option


Record the purchase of at-the-money put option.




4.  Put option


Gain on hedge activity


Record the increase in the intrinsic value (fair value) of the option.

5.  Loss on hedge activity


Available-for-sale securities


Record the decrease in the fair value of the securities (accounting after the hedge is established) $200 = 200

shares × $1 holding loss.

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Module 19: Derivative Instruments and Hedging Activities


NOTE: The $200 gain on hedge activity from the put option is balanced effectively against

the $200 loss on hedge activity from the hedged available-for-sale security. The portion of the

unreal­ized holding gain or loss on an available-for-sale security that is designated as a hedged

item in a fair value hedge is recognized in earnings during the period of the hedge. This is why

the $200 holding loss on the available-for-sale securities is recognized in the period’s earnings.

6.  Loss on hedge activity


Put option


Record the loss related to the time value of the option. $140 = $300 – $160


7.  Put option


Gain on hedge activity


Record the increase in the intrinsic value of the put option.

8.  Loss on hedge activity


Available-for-sale securities


To record the decrease in the fair value of the securities (accounting after the hedge is established); $400 = 200

shares × $2 holding loss on available-for-sale securities.

9.  Loss on hedge activity


Put option


Record the loss related to the time value of the option. $140 = $300 – $160

10. Cash


  Put option


Available-for-sale securities


Record the exercise of the put option (sell the 200 shares of stock @ $45) and close out the put option investment.

11.  Other comprehensive income


Gain on Porter stock


To reclassify the unrealized holding gain recognized in entry 2., from other comprehensive income to earnings,

because the securities were sold.


Cash Flow Hedges

Cash flow hedges use derivative instruments to hedge the exposure to variability in expected future cash



Specific criteria. Additional criteria must be met in order to qualify as a cash flow hedge.

(1) The primary criterion is that the hedged asset/liability and the hedging instrument must be “linked.”


Linking is established if the basis (the specified rate or index) for the change in cash flows is the

same for the hedged asset/liability and the hedging instrument.

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(2) Cash flows do not have to be identical, but they must meet the highly effective threshold discussed


(3) In addition, if the hedged asset/liability is a forecasted transaction, it must be considered probable,

based on appropriate facts and circumstances (i.e., past history).

(4) Also, if the forecasted hedged asset/liability is a series of transactions, they must “share the same risk


(a) Purchases of a particular product from the same supplier over a period of time would meet this


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Module 19: Derivative Instruments and Hedging Activities


b. Accounting for a cash flow hedge. For the hedging instrument:

(1) The effective portion is reported in other comprehensive income, and

(2) The ineffective portion and/or excluded components are reported on a cumulative basis to reflect the

lesser of

(a) The cumulative gain/loss on the derivative since the creation of the hedge, or

(b) The cumulative gain/loss from the change in expected cash flows from the hedged instrument since

the creation of the hedge.

1] The above amounts need to be adjusted to reflect any reclassification of other comprehensive

in­come to current earnings. This will occur when the hedged asset/liability affects earnings

(e.g., when hedged inventory is sold and the cost of inventory passes through to cost of goods



A commercial bakery believes that wheat prices may increase over the next few months. To protect itself against

this risk, the bakery purchases call options on wheat futures to hedge the price risk of their forecasted inventory pur­

chases. If wheat prices increase, the profit on the purchased call options will offset the higher price the bakery must

pay for the wheat. If wheat prices decline, the bakery will lose the premium it paid for the call options, but can then

buy the wheat at the lower price. On June 1, year 1, the bakery pays a premium of $350 to purchase a September

30, year 1 call for 1,000 bushels of wheat at the futures price of $16.60 per bushel. The call option is considered a

cash flow hedge be­cause the designated risk that is being hedged is the risk of changes in the cash flows relating to

changes in the purchase price of the wheat. On September 30, the bakery settles its call options and purchases wheat

on the open market. Per­tinent wheat prices are shown below.

Spot price (June 1)

Futures price (as of June 1 for September 30)

Spot price (September 30)




June 1

1.  Call option


Record the purchase of the call option.



September 30

2.  Loss on hedge activity


Call option


Record the expiration (change in time value) of the call option.

3.  Call option


Other comprehensive income


Record the increase in intrinsic value of the call option. $700 = {1,000 bushels × [$17.30 (the spot price per

bushel on September 30) – $16.60 (the futures price as of June 1 for September 30)]}

4. Cash

Call option

Record the cash settlement of the call option.



5. Inventory




Record the purchase of the wheat at the spot price. $17,300 = 1,000 bushels × $17.30


Foreign Currency Hedges

Foreign currency denominated assets/liabilities that arise in the course of normal business are often hedged

with offsetting forward exchange contracts. This process, in effect, creates a natural hedge. Normal accounting

rules apply, and the FASB did not change this accounting treatment in the implementation of hedge accounting.

Hedge accounting is required in four areas related to foreign currency hedges. The four foreign currency

hedges are discussed below.

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Unrecognized firm commitment. Either a derivative instrument or a nonderivative financial instrument

(such as a receivable in a foreign currency) can be designated as a hedge of an unrecognized firm commit­

ment attributable to changes in foreign currency exchange rates. If the requirements for a fair value hedge

are met, then this hedging arrangement can be accounted for as a fair value hedge, discussed above.


Available-for-sale securities. Hedge accounting is not used for trading and held-to-maturity securities.

The use of hedge accounting for transactions for securities designated as available-for-sale may be allowed

in some instances. Derivative instruments can be used to hedge debt or equity available-for-sale securities.

However, equity securities must meet two additional criteria.

(1) They cannot be traded on an exchange denominated in the investor’s functional currency.

(2) Dividends must be denominated in the same foreign currency as is expected to be received on the sale

of the security.

  If the above criteria are met, hedging instruments related to available-for-sale securities can be accounted

for as fair value hedges, discussed above.


Foreign currency denominated forecasted transactions. Only derivative instruments can be designated

as hedges of foreign currency denominated forecasted transactions. A forecasted export sale with the price

denominated in a foreign currency might qualify for this type of hedge treatment.

(1) Forecasted transactions are distinguished from firm commitments (discussed in a. above) because the

tim­ing of the cash flows remains uncertain.

(a) This additional complexity results in hedging instruments related to foreign currency denominated

fore­casted transactions being accounted for as cash flow hedges, discussed above.

(b) Hedge accounting is permissible for transactions between unrelated parties, and under special

circum­stances (not discussed here) for intercompany transactions.

d. Net investments in foreign operations. The accounting for net investments in foreign operations has not

changed from the ASC Topic 830 rules, except that the hedging instrument has to meet the new “effective”

criterion. The change in the fair value of the hedging derivative is recorded in a manner consistent with a

translation adjustment in other comprehensive income which is then closed to the accumulated other com­

prehensive income account in the equity section of the balance sheet.

Hedge Accounting ASC Topic 815 (SFAS 133)

Type of Hedge


Fair Value

Cash Flow

Foreign Currency (FC)

Types of hedging

instru­ments permitted



Derivatives or nonderivatives depending on the

type of hedge

Balance sheet valuation

of hedging instrument

Fair value

Fair value

Fair value

Recognition of gain

or loss on changes

in value of hedging



in earnings

Effective portion currently as a

component of other comprehen­

sive income (OCI) and reclassified

to earnings in future period(s) that

forecasted transaction affects earnings

FC denominated firm commitment

Currently in earnings

Available-for-sale security (AFS)

Currently in earnings

Ineffective portion currently in


Forecasted FC transaction

Same as cash flow hedge

Net investment in a foreign operation

OCI as part of the cumulative translation

adjustment to the extent it is effective as a hedge

Recognition of gain or

loss on changes in the

fair value of the hedged


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in earnings

Not applicable; these hedges are not

associated with recognized assets or


FC denominated firm commitment

Currently in earnings

Available-for-sale security (AFS)

Currently in earnings

Forecasted FC transaction

Not applicable; same as cash flow hedge

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10. Forward Exchange Contracts

It was stated previously that foreign currency transaction gains and losses on assets and liabilities which are

denominated in a currency other than the functional currency can be hedged if a US company enters into a for­

ward exchange contract.

a. The following example shows how a forward exchange contract can be used as a hedge, first against a firm

com­mitment and then, following delivery date, as a hedge against a recognized liability.

b. The general rule for estimating the fair value of forward exchange contracts is to use the forward exchange

rate for the remaining term of the contract.


Baker Simon, Inc. enters into a firm commitment with Dempsey Ing., Inc. of Germany, on October 1, year 1, to

pur­chase a computerized robotic system for €6,000,000. The system will be delivered on March 1, year 2, with pay­

ment due sixty days after delivery (April 30, year 2). Baker Simon, Inc. decides to hedge this foreign currency firm

commit­ment and enters into a forward exchange contract on the firm commitment date to receive €6,000,000 on the

payment date. The applicable exchange rates are shown in the table below.


Spot rates

Forward rates for

April 30, year 2

October 1, year 1

€1 = $.90

€1 = $.91

December 31, year 1

€1 = $.92

€1 = $.94

March 1, year 2

€1 = $.92

€1 = $.935

April 30, year 2

€1 = $.96

c. The following example separately presents both the forward contract receivable and the dollars payable

liabil­ity in order to show all aspects of the forward contract.

(1) For financial reporting purposes, most companies present just the net fair value of the forward contract,

which would be the difference between the current value of the forward contract receivable and the dol­

lars payable accounts.

(2) The transactions which reflect the forward exchange contract, the firm commitment and the acquisition

of the asset and retirement of the related liability appear as follows:

Forward contract entries

(1) 10/1/Y1 (forward rate for 4/30/Y2

€1 = $.91)

Forward contract receivable (€)

Dollars payable

Hedge against firm commitment entries



This entry recognizes the existence of the forward exchange contract

using the gross method. Under the net method, this entry would

not appear at all, since the fair value of the forward contract is zero

when the contract is initiated. The amount is calculated using the

10/1/Y1 for­ward rate for 4/30/Y2 (€6,000,000 × $.91 = $5,460,000).

Note that the net fair value of the forward exchange contact on 10/1/

Y1 is zero be­cause there is an exact amount offset of the forward

contract receivable with the dollars payable liability.

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Module 19: Derivative Instruments and Hedging Activities

Forward contract entries

(2) 12/31/Y1 (forward rate for 4/30/Y2

€1 = $.94)

Forward contract receivable (€)


Hedge against firm commitment entries

(3) 12/31/Y1

Loss on hedge activity


Gain on hedge activity



Firm commitment


€6,000,000 × ($.94 – $.91) = $180,000. The dollar values for this

entry reflect, among other things, the change in the forward rate

from 10/1/Y1 to 12/31/Y1. However, the actual amount recorded

as gain or loss (gain in this case) will be determined by all market


The dollar values for this entry are identical to entry (2),

reflecting the fact that the hedge is highly effective (100%)

and also the fact that the market recognizes the same factors

in this transaction as for entry (2). This entry reflects the first

use of the firm commitment account, a temporary liability

account pending the receipt of the asset against which the

firm commitment has been hedged.

(4) 3/1/Y2 (forward rate for 4/30/Y2 €1

= $.935)

Loss on hedge activity

(5) 3/1/Y2


Forward contract receivable (€)

Firm commitment



Gain on hedge activity


€6,000,000 × ($.935 – $.94) = $30,000. These entries again will be driven by market factors, and they are calculated the same way as

entries (2) and (3) above. Notice that the decline in the forward rate from 12/31/Y1 to 3/1/Y2 resulted in a loss against the forward

contract receivable and a gain against the firm commitment.

(6)  3/1/Y2 (spot rate €1 = $.92)


Firm commitment



Accounts payable (€)


This entry records the receipt of the equipment (recorded at fair

value determined on a discounted net present value basis), the

elimination of the temporary liability account (firm commitment),

and the recogni­tion of the payable, calculated using the spot rate

on the date of receipt (€6,000,000 × $.92 = $5,520,000).

(7)  4/30/Y2 (spot rate €1 = $.96)

Forward contract receivable (€)

(8) 4/30/Y2


Gain on forward contract

Transaction loss



The gain or loss (gain in this case) on the forward contract is

calculated using the change in the forward to the spot rate from 3/1/

Y2 to 4/30/Y2 [€6,000,000 × ($..96 – $.935) = $150,000]

The transaction loss related to the accounts payable reflects

only the change in the spot rates and ignores the accrual of

interest. [€6,000,000 × ($.96 – $.92) = $180,000]

(9) 4/30/Y2

(10)  Accounts payable (€)

Dollars payable



Foreign currency units (€)

Forward contract receivable (€)

Foreign currency units






This entry reflects the settlement of the forward contract at the

10/1/Y1 contracted forward rate (€6,000,000 × $.91 = $5,460,000)

and the re­ceipt of foreign currency units valued at the spot rate

(€6,000,000 × $.96 = $5,760,000).


Accounts payable (€)

This entry reflects the use of the foreign currency units to

settle the account payable.

d. In the case of using a forward exchange contract to speculate in a specific foreign currency, the general rule

to es­timate the fair value of the forward contract is to use the forward exchange rate for the remainder of the

term of the forward contract.



Disclosures related to financial instruments, both derivative and nonderivative, that are used as hedging in­

struments must include the following information:

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a. Objectives and the strategies for achieving them,

b. Context to understand the instrument,

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Module 19: Derivative Instruments and Hedging Activities


c. Risk management policies, and

d. A list of hedged instruments.

(1) These disclosures have to be separated by type of hedge and reported every time a complete set of

finan­cial statements is issued.

(2) In addition, disclosure requirements exist for derivative instruments that are not designated as hedging


e. For instruments and transactions eligible for offset, the following information must be disclosed:






The gross amount of recognized assets and liabilities.

The amounts offset per ASC 210-20-45 or ASC 815-10-45

The net amounts appearing in the statement of financial position.

The amounts subject to master netting arrangements not included in the offset.

The net amount considering items (3) and (4).


12. Fair Value and Concentration of Credit Risk Disclosures of Financial Instruments other than Derivatives

Disclosure of fair values of financial instruments is required if it is practicable to estimate fair value. This re­

quirement pertains to both asset and liability financial instruments, whether recognized in the balance sheet or

not. Disclosure of concentrations of credit risk is required.

a. Credit risk is the risk that a loss will occur because parties to the instrument do not perform as expected.

(1) Such concentrations exist when a number of an entity’s financial instruments are associated with similar

ac­tivities and economic characteristics that could be affected by changes in similar conditions (e.g., an

en­tity whose principal activity is to supply parts to one type of industry).

Lenaburg, Inc.

Notes to Financial Statements


OTHER THAN TRADING (in thousands) December 31, year 2


Cash and cash equivalents

Long-term investments


Short-term debt

Long-term debt

Carrying amount

Fair value










(in thousands) December 31, year 2

Carrying amount


Short-term investments


Fair value


Cash and cash equivalents—The carrying amount of cash and cash equivalents approximates fair value due to

their short-term maturities.

Long-term investments—The fair value is estimated based on quoted market prices for these or similar


Short-term investments—The Company holds US Treasury notes and highly liquid investments for trading

purposes. The carrying value of these instruments approximates fair value.

Short- and long-term debt—The fair value of short- and long-term debt is estimated using quoted market

prices for the same or similar instruments or on the current rates offered to the Company for debt of equivalent

remaining maturities.

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