DERIVATIVE ADDITIONAL INFORMATION

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1 DERIVATIVE ADDITIONAL INFORMATION I. DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES A. Definitions and Concepts 1. Derivative Instrument A "derivative instrument" is a financial instrument that "derives" its value from the value of some other instrument and has all three of the following characteristics: a. One or more underlyings and one or more notional amounts or payment provisions (or both), and b. It requires no initial net investment or one that is smaller than would be required for other types of similar contracts, and c. Its terms require or permit a net settlement (i.e., it can be settled for cash in lieu of physical delivery), or it can readily be settled net outside the contract (e.g., on an exchange) or by delivery of an asset that gives substantially the same results (e.g., an asset readily convertible to cash). 2. Underlying An "underlying" is a specified price, rate, or other variable (e.g., interest rate, security or commodity price, foreign exchange rate, index of prices or rates, etc.), including a scheduled event (e.g., a payment under contract) that may or may not occur. 3. Notional Amount A "notional amount" is a specified unit of measure (e.g., currency units, shares, bushels, pounds, etc.). 4. Value or Settlement Amount The value or settlement amount of a derivative is the amount determined by the multiplication (or other arithmetical interaction) of the notional amount and the underlying. For example, shares of stock times the price per share. 5. Payment Provision A "payment provision" is a specified (fixed) or determinable settlement that is to be made if the underlying behaves in a specified way. 6. Hedging Hedging is the use of a derivative to offset anticipated losses or to reduce earnings volatility. When a hedge is effective, the change in the value of the derivative offsets the change in value of a hedged item or the cash flows of the hedged item. B. Common Derivatives 1. Option Contract A contract between two parties that gives one party the right, but not the obligation, to buy or sell something to the other party at a specified price (the strike price or exercise price) during a specified period of time. The option buyer, or holder, must pay a premium to the option seller, or writer, to enter into the option contract. A call option gives the holder the right to buy from the option writer at a specified price during a specified period of time. A put option gives the holder the right to sell to the option writer at a specified price during a specified period of time DeVry/Becker Educational Development Corp. All rights reserved. 1

2 EXAMPLE PUT OPTION On January 1, Year 1, Roberts Company purchased a put option on the stock of Buy Big Inc. The option gave Roberts the right to sell 10,000 shares of Buy Big stock at $75/share during the next 30 days. Roberts paid a premium of $2/share to enter into the option. Roberts exercised the option when Buy Big stock was selling for $69/share. Underlying: $75/share Notional amount: 10,000 shares of Buy Big stock Initial net investment: $2/share x 10,000 shares = $20,000 Settlement amount: $75/share x 10,000 shares = $750,000 Derivatives generally have multiple settlement options. This derivative could be settled in the following ways: 1. Roberts could deliver 10,000 shares of Big Buy stock to the option writer in exchange for $750,000. Note that these shares could either be shares already owned by Roberts, or shares purchased by Roberts for $690,000 ($69/share market price x 10,000 shares) and then delivered to the option writer. Either way, Roberts realizes a gain of $60,000 [($75/share exercise price $69/share market price) x 10,000 shares. The option writer realizes a loss of $60,000 because the option writer must pay $75/share for stock with a market value of $69/share. 2. The option writer could pay Roberts $60,000 to settle the contract. This is a net settlement. Because $20,000 was paid to purchase the put option, Roberts will report a net gain of $40,000 ($60,000 gain $20,000 premium). If the stock price had remained above $75/share during the 30 day period, Roberts would not have exercised the option. 2. Futures Contract An agreement between two parties to exchange a commodity or currency at a specified price on a specified future date. One party takes a long position and agrees to buy a particular item while the other party takes a short position and agrees to sell that item. Unlike an option, both parties are obligated to perform according to the terms of the contract. Futures contracts are made through a clearinghouse and have standardized notional amounts and settlement dates. EXAMPLE FUTURES CONTRACT On January 1, Year 1, Jones Company entered into a long position on a futures contract in which it agreed to buy 100,000 for $1.67/ on April 1, Year 1. On April 1, Year 1, the spot rate was $1.74/. Underlying: $1.67/ Notional amount: 100,000 Initial net investment: $0 (no cost to enter into the futures contract) Settlement amount: $1.67/ x 100,000 = $167,000 Derivatives generally have multiple settlement options. This derivative could be settled in the following ways: 3. Jones could pay $167,000 and receive 100,000. Jones could then realize a $7,000 gain by selling the 100,000 at the spot rate of $1.74/ ($174,000 $167,000 = $7,000). 4. The other party to the futures contract could pay $7,000 to Jones. This is a net settlement. Jones could then purchase the 100,000 for $174,000 and still show a net outflow of $167,000 ($174,000 purchase price $7,000 gain). If the spot rate on April 1 had been $1.59/, Jones would have realized loss on the contract because Jones would have paid $167,000 for 100,000 that could have been purchased outside the futures contract for only $159,000 ( 100,000 x $1.59/ ) DeVry/Becker Educational Development Corp. All rights reserved. 2

3 3. Forward Contract Forward contracts are similar to futures contracts, except that they are privately negotiated between two parties with the assistance of an intermediary, rather than through a clearinghouse. Forward contracts do not have standardized notional amounts or settlement dates. The terms of a forward contract are established by the parties to the contract. 4. Swap Contract A private agreement between two parties, generally assisted by an intermediary, to exchange future cash payments. Common swaps include interest rate swaps, currency swaps, equity swaps, and commodity swaps. A swap agreement is equivalent to a series of forward contracts. EXAMPLE SWAP CONTRACT On January 1, Year 1, East Company and West Company entered into an interest rate swap in which East Company agreed to make to West Company a series of future payments equal to a fixed interest rate of 8% on a principal amount of $1,000,000. In exchange, West Company agreed to make to East Company a series of future payments equal to a floating interest rate of LIBOR + 1% on the principal amount of $1,000,000. Underlying: East Company 8% and West Company LIBOR + 1% Notional amount: $1,000,000 Initial net investment: $0 (no cost to enter into the swap contract) Settlement amount: East Company 8% x $1,000,000 = $80,000 and West Company (LIBOR + 1%) x $1,000,000 On the first settlement date, LIBOR was 8.5% and the following amounts were exchanged: $80,000 East Company West Company $95,000 = $1,000,000 x 9.5% Derivatives generally have multiple settlement options. This derivative could be settled in the following ways: 5. East Company could pay $80,000 to West Company and West Company could pay $95,000 to East Company. 6. West Company could pay $15,000 ($95,000 $80,000) to East Company. This is a net settlement and is the most likely form of settlement in this example. C. Derivative Risks Market risk and credit risk are the inherent risks of all derivative instruments. 1. Market Risk Market risk is the risk that the entity will incur a loss on the derivative contract. As demonstrated in the examples above, derivatives are a "zero sum game." Every derivative has a "winner" and a "loser." 2. Credit Risk Credit risk is the risk that the other party to the derivative contract will not perform according to the terms of the contract. For example, in the interest rate swap example above, East Company faces the risk that West Company will refuse to pay the net settlement of $15, DeVry/Becker Educational Development Corp. All rights reserved. 3

4 II. ACCOUNTING FOR DERIVATIVE INSTRUMENTS INCLUDING HEDGES A. Balance Sheet All derivative instruments are recognized in the balance sheet as either assets or liabilities, depending on the rights or obligations under the contracts. All derivative instruments are measured at fair value. Accounting for changes in the fair value of a derivative is dependent on whether the derivative has been designated as (and whether it qualifies as) a hedge, combined with the reason for holding the instrument. B. Reporting Gains and Losses 1. No Hedging Designation Gains/losses on a derivative instrument not designated as a hedging instrument are recognized currently in earnings, similar to the accounting for trading securities. 2. Fair Value Hedge (see example below) A fair value hedge is an instrument designated as a hedge of the exposure to changes in fair value of a recognized asset or liability, or of an unrecognized firm commitment, that are attributable to a particular risk. Gains/losses on such instruments as well as the offsetting gain/loss on the hedged item are recognized in earnings in the same accounting period. The derivative must be expected to be highly effective in offsetting the fair value change (that could affect income) of the hedged item. 3. Cash Flow Hedge (see example below) A cash flow hedge is an instrument designated as hedging the exposure to variability in expected future cash flows attributed to a particular risk. Gains/losses on the ineffective portion of a cash flow hedge are reported in current income. Gains/losses on the effective portion of a cash flow hedge are deferred and are reported as a component of other comprehensive income until the hedged transaction impacts earnings, as follows: a. If a forecasted sale or expense is hedged, the gain/loss in AOCI is reclassified to earnings when the sale or expense is recognized in earnings. b. If a forecasted inventory purchase is hedged, the gain/loss in AOCI is reclassified to earnings when the inventory is sold to customers. c. If a forecasted fixed asset purchase is hedged, the gain/loss in AOCI is reclassified to earnings as the fixed asset is depreciated. d. If an existing asset or liability is hedged, the gain/loss in AOCI is reclassified to earnings when the asset or liability impact earnings. 4. Foreign Currency Hedge A foreign currency hedge is an instrument designated as hedging the exposure to variability in foreign currency in a variety of foreign currency transactions. a. Foreign Currency Fair Value Hedge Gains and losses from changes in the fair value of foreign currency transaction hedges classified as fair value hedges are accounted for in the same manner as gains/losses on other fair value hedges in earnings DeVry/Becker Educational Development Corp. All rights reserved. 4

5 b. Foreign Currency Cash Flow Hedge Gains and losses from changes in the fair value of foreign currency transaction hedges classified as cash flow hedges are accounted for in the same manner as gains/losses on cash flow hedges in other comprehensive income for the effective portion and current income for the ineffective portion. c. Foreign Currency Net Investment Hedge Gains and losses from changes in the fair value of foreign currency transaction hedges entered into to hedge a net investment in a foreign operation are reported in other comprehensive income as part of the cumulative translation adjustment (discussed in F-2) for the effective portion and current income for the ineffective portion. Type of Hedge Instrument Accounting for Changes in Fair Value No hedge designation Included in current earnings Fair value hedge Included in current earnings as an offset to the gain/loss from the change in fair value of the hedged item Cash flow hedge: Effective portion Ineffective portion Foreign exchange hedge: Fair value hedge Cash flow hedge Net investment hedge Included in other comprehensive income until the hedged transaction impacts earnings Included in current earnings Included in current earnings as an offset to the gain/loss from the change in fair value of the hedged item Effective portion Included in other comprehensive income until the hedged transaction impacts earnings Ineffective portion Included in current earnings Included in other comprehensive income, as cumulative translation adjustment C. Reporting Cash Flows Cash flows from a derivative with no hedging designation should be accounted for in investing activities, unless the derivative is held for trading purposes. If a derivative with no hedging designation is held for trading purposes, the cash flows should be accounted for in operating activities. The cash flows from a derivative held as a hedge may be accounted for in the same category as the item being hedged. If the derivative contains an other-thaninsignificant financing element at inception (which is often a matter of judgment), all cash flows associated with that derivative should be reported as cash flows from financing activities, not just those related to the financing element DeVry/Becker Educational Development Corp. All rights reserved. 5

6 EXAMPLE FAIR VALUE HEDGE On September 30, Year 1, Smith Company signed a contract to purchase 100,000 lbs. of copper wire on December 31, Year 1 for $1.55/lb. Risk: When it enters into this firm purchase commitment, Smith faces the risk that the price of the copper wire could fall below $1.55/lb. A loss must be recognized on a firm purchase commitment when the contract price exceeds the market price (discussed in F 4). Hedge: To hedge the risk of loss on the firm purchase commitment, Smith takes a short position in a forward contract in which Smith agrees to sell 100,000 lbs. of copper for $0.92/lb on December 31, Year 1. If the price of copper goes down, Smith will record a gain on the hedge because Smith has "locked in" a higher selling price. This hedge is classified as a fair value hedge because Smith is hedging the change in the value of the firm purchase commitment. Smith expects this hedge to be highly effective because the price of copper wire is directly related to the price of copper. The prices of copper wire and of the copper forward contract are as follows: Copper Wire/lb. Copper Forward/lb. September 30, Year 1 $1.550 $0.920 December 31, Year 1 $1.480 $0.851 No journal entries are recorded on September 30, Year 1. The following journal entries must be recorded on December 31, Year 1. Journal Entry: To record the loss on the firm purchase commitment [($1.480/lb. $1.550/lb.) x 100,000 lbs. = $7,000]. Loss on firm purchase commitment 7,000 Firm purchase commitment liability 7,000 Journal Entry: To record the gain on the forward contract hedge [($0.851/lb. $0.920/lb.) x 100,000 lbs. = $6,900]. Fair value hedge 6,900 Gain on fair value hedge 6,900 Earnings impact of purchase commitment (no hedge) = $7,000 loss Earnings impact of purchase commitment (with hedge) = $100 loss ($7,000 loss $6,900 gain) Journal Entry: To record the net settlement of the forward contract. Smith will receive $6,900 because the forward contract allows Smith to sell copper for $0.92/lb. when the price of copper is $0.851/lb (the forward price is equal to the spot price of copper on the settlement date). Cash 6,900 Fair value hedge 6,900 Journal Entry: To record the purchase of 100,000 lbs. of copper wire for $1.55/lb. under the firm purchase commitment. Firm purchase commitment liability 7,000 Inventory 148,000 Cash 155,000 Note that the inventory is reported at its fair value on March 31, Year 2: 100,000 lbs. x $1.480/lb. = $148,000. Because the company entered into the fair value hedge, the cash paid for the inventory totals $148,100 ($155,000 paid under firm purchase commitment $6,900 net settlement from fair value hedge), which is approximately fair value. This is not a perfect hedge, but it is highly effective DeVry/Becker Educational Development Corp. All rights reserved. 6

7 EXAMPLE CASH FLOW HEDGE On September 30, Year 1, Smith Company determined that it will need to purchase 100,000 lbs. of copper wire on March 31, Year 2. The current price of copper wire is $1.55/lb. Risk: Smith faces the risk that the price of the copper wire will increase before the purchase is made on March 31, Year 2. Hedge: To hedge the risk that the price of the copper wire will increase, Smith takes a long position in a forward contract in which Smith agrees to buy 100,000 lbs. of copper for $0.92/lb on March 31, Year 2. If the price of copper goes up, Smith will record a gain on the hedge because Smith has "locked in" a lower purchase price. This hedge is classified as a cash flow hedge because Smith is hedging the cash outflow that will be required to purchase the copper wire on March 31, Year 2. Smith expects this hedge to be highly effective because the price of copper wire is directly related to the price of copper. The prices of copper wire and of the copper forward contract are as follows: Copper Wire/lb. Copper Forward/lb. September 30, Year 1 $1.550 $0.920 December 31, Year 1 $1.480 $0.851 March 31, Year 2 $1.620 $0.988 September 30, Year 1: No journal entries are recorded. December 31, Year 1: Journal Entry: To record the gain on the forward contract hedge [($0.960/lb. $0.920/lb.) x 100,000 lbs. = $4,000]. Cash flow hedge 4,000 OCI Effective portion of hedge* 4,000 * The entire gain is considered effective because it does not exceed the $4,100 loss on the copper wire during the period [($1.591/lb. $1.550/lb.) x 100,000 lbs. = $4,100]. March 31, Year 2: Journal Entry: To record the gain on the forward contract hedge [($0.988/lb. $0.960/lb.) x 100,000 lbs. = $2,800]. Cash flow hedge 2,800 OCI Effective portion of hedge 2,800 Journal Entry: To record the net settlement of the forward contract. Smith will receive $6,800 because the forward contract allows Smith to purchase copper for $0.92/lb. when the price of copper is $0.988/lb (the forward price is equal to the spot price of copper on the settlement date). Cash 6,800 Cash flow hedge 6,800 Journal Entry: To record the purchase of 100,000 lbs. of copper wire for $1.62/lb. Inventory 162,000 Cash 162,000 Because the company entered into the cash flow hedge, the net cash paid for the inventory totals $155,200 ($162,000 paid $6,800 net settlement from the cash flow hedge), only slightly more than the $155,000 that would have been paid if the wire had been purchased on September 30, Year 1. This is not a perfect hedge, but it is highly effective. The $6,800 gain in AOCI will be recognized in earnings when the copper wire is sold to customers DeVry/Becker Educational Development Corp. All rights reserved. 7

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