11/7/2019 Accounting for Derivatives on Financial Statements - Video & Lesson Transcript | Study.

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Accounting for Derivatives on Financial Statements

Lesson Transcript

Let's look at the journal entries and nancial impacts for two types of derivatives designed to take some of the
risk out of business. One is a futures contract and the other is an interest rate swap.

Why Derivatives?
You've probably heard the expression 'risky businesses.' Well if you ask anyone in business they
would agree, business is risky! Businesses make use of derivatives to lessen the risk. Derivatives
are nancial instruments that get their value from uctuations in the value of something else. A
stock option for example, is a derivative that gains or loses value because the stock itself gains or
loses value. Derivatives are often used to hedge risk. A hedge cuts risk because its value moves in
the opposite direction of the risky asset or cash ow that it is being linked with. So, when the price
for an asset goes down, a good hedge has a price that goes up and reduces the money lost from
declining value.

Let's look at two types of derivatives that are used as hedges

Fair Value Hedges

Fair value hedges are derivatives that reduce the risk of an assets value declining by its value
moving in the opposite direction of the underlying asset. A good example is futures contracts,
which are widely used in agriculture.

For example, Farmer Brown has $12,000 worth of grain at today's prices planted and growing. He
worries about the weather, pests that want to eat his crop and grain prices in the global markets
going down. He reduces his worries about grain prices going down by entering into a futures
contract with a major food processor. The food processor makes breakfast cereal, and is just as
worried as Brown is about the price of grain. So on April 1, Farmer Brown and the food company
agree that on Oct 1, Brown will deliver his crop to the local grain elevator and sign ownership over
to the food company. In return, Brown will receive $12,000 from the food company. Here is how
the deal looks to Farmer Brown:

Market value of Grain $10,000 $12,000 $14,000

Cash received or paid by Farmer Brown $2,000 $0 ($2,000)

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If the market value of the crop falls to $10,000, the food company owes Brown the $2,000
di erence to make it $12,000. But if the market value rises to $14,000, Brown will owe the food
company $2,000 to bring the transaction price down to $12,000. The value of the futures contract
on Brown's books is equal to the amount of cash that will change hands.

Accounting for Fair Value Hedges

Since no cash changes hands when the futures contract is signed, no journal entries are made and
the value of the contract is zero. But an important accounting issue arises when the market price of
grain changes. Fair value hedges uctuate in value along with the underlying asset, in this case, the
grain. The gain or loss in value for both must be recognized in the same period's income
statement. When the price of the grain falls, and his crop is only worth $10,000 on June 30, Brown
will make two journal entries that look like this:

Item debit credit Explanation

Loss from decline in value of

$2,000 Loss on decline in value is recognized
crop

The credit reduces the value of the grain asset to fair market
Grain inventory $2000
value

This sets up the futures contract as a contra asset to the

Futures contract on grain $2,000
grain

Gain on futures contract $2,000 This recognizes the gain in value of the futures contract.

Overall, Brown has no net decline in income thanks to the futures contract! Similar entries will be
made on Oct 1 when the contract is executed.

Cash Flow Hedges

A cash ow hedge is an arrangement to mitigate the risk from uneven cash ows arising from an
underlying asset or liability. Our next example will be a derivative that smooth's the cash ows
from a variable rate loan payable.

The new Chief Financial O cer at Foodco was surprised to nd a $20,000 variable rate loan on the
books during his initial review. He knows that investors like a smooth earnings ow from a food
company so he would like to x the interest payments at 10%. To get this done, he enters into an
interest rate swap, a type of derivative with a local hedge fund manager. When rates rise above
10% the hedge fund will compensate Foodco for the di erence. If they fall below 10%, Foodco owes
the hedge fund the di erence. The swap looks like this:

Interest rates 8% 10% 12%

Cash owed to or payable by Foodco ($400) $0 $400

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11/7/2019 Accounting for Derivatives on Financial Statements - Video & Lesson Transcript | Study.com

Again, no journal entries are required at inception if market interest rates are 10%. A di erence
between fair value and cash ow hedges is that gains and losses on cash ow hedges are parked in
'Other Comprehensive Income' on the nancial statements until the contract is settled. In the swap
contract situation, that will be when the loan matures. If market interest rates are 12% at the end
of year 1, journal entries related to the swap look like this:

Item debit credit Explanation

Swap contract $400 Sets up the swap contract asset at a value of $20,000 * (12% - 10%)

Other Comprehensive The value increase from $0 to $400 is parked in other

$400
Income comprehensive income.

When the loan matures, the swap contract will be closed and the other comprehensive income
amounts from the swap will be closed to income since the loan matured.

Lesson Summary
Derivatives are nancial instruments that get their value from uctuations in the value of
something else. There are two types of derivatives that businesses use to reduce risk. One is a fair
value hedge that reduces risk of an assets value declining by its own value moving in the opposite
direction of the underlying asset. The two instruments are paired on the balance sheet with the fair
value hedge as a contra asset. Fluctuations in the derivatives value must be recognized
immediately on the income statement.

The other type of derivative is the cash ow hedge, which mitigates the risk from uneven cash
ows arising from an underlying asset or liability. Fluctuations in the value of the cash ow hedge
are parked in other comprehensive income on the nancial statements until the asset is sold or the
liability matures.

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