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ISSUES IN ACCOUNTING EDUCATION Vol. 23, No. 1 February 2008 pp. 103–117

Accounting for Derivatives and Hedging Activities: Comparison of Cash Flow versus Fair Value Hedge Accounting

Pamela A. Smith and Mark J. Kohlbeck

ABSTRACT: Warfield Company is considering hedging the risk associated with (1) an available-for-sale (AFS) security portfolio and (2) an anticipated purchase of oil. Warfield’s Board of Directors has limited experience in this area and has requested that you summarize the accounting and reporting implications if these items are hedged. The hedged risk in these two transactions can be either the risk associated with the cash flow or the risk associated with changes in the fair value. The two risks are discussed in separate parts of the case.

In Part A, you will complete the accounting entries required for both cash flow and fair value hedges of the AFS security portfolio and summarize the financial statement impact to help you understand the mechanics and implications of hedge accounting. In Part B, you will complete the accounting entries required for both cash flow and fair value hedges, based on the structure of the transaction to purchase the oil, and sum- marize the financial statement impact of the accounting entries. You will then use the summary to draft a memo to the Board in which you articulate your understanding of the transaction structures, hedge accounting treatment, the financial statement impact, and documentation requirements for hedge accounting.

CASE INSTRUCTIONS

You have recently been employed by Warfield Company (the Company) and wereapproached by Mr. Clinton, the corporate treasurer, to assist in a project to helpthe Board of Directors understand the accounting and reporting implications of hedge accounting. Clinton is currently evaluating how to designate a put option that was purchased as a hedge of an available-for-sale (AFS) security portfolio. Clinton is also evaluating a hedge of an anticipated purchase of oil. He is evaluating the cash flow and fair value risks associated with each item.

Mr. Young, the Chairman of the Board, has read about the potential devastating effects of derivatives and is wary about the proposed use of derivatives to hedge these items. Therefore, the Board wants an analysis of the proposed hedge structures’ impact on the

Pamela A. Smith is a Professor at Northern Illinois University and Mark J. Kohlbeck is an Assistant Professor at Florida Atlantic University.

Professor Smith is indebted to numerous graduate and undergraduate students enrolled in classes at Northern Illinois University for their contributions to the development of this instructional case. We are indebted to Terry Warfield for helpful insights on earlier drafts and class-testing this case. We also thank Sue Ravenscroft (editor) and two anonymous reviewers for their helpful comments. The fact patterns in this case are based on actual corporate hedging scenarios. The names of the companies and individuals are fictitious. The fact patterns have been modified and simplified for instructional purposes. See the Teaching Notes for access to classroom ready tables. These tables are also available from the authors upon request.

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financial statements to help its members understand the financial reporting implications of hedging.

Mr. Clinton has provided you with the facts for each hedge item. Part A provides the information about hedging the AFS security portfolio, and Part B provides the information related to the anticipated purchase of oil. Read the facts for each part and complete the tasks requested by Mr. Clinton. When completing these tasks, please ignore tax effects.

Part A: Hedge the Cash Flow versus Fair Value of Available-for-Sale Security Portfolio

On October 31, Warfield Company purchased 100,000 shares of Smith Company stock for $40 a share and classified the purchase as an AFS security according to Statement of Financial Accounting Standard No. 115, Accounting for Certain Investments in Debt and Equity Securities (SFAS No. 115, FASB 1993). On November 30, the market price of Smith was $45 a share. On this date, the SFAS No. 115 adjustment to fair market value was recorded. Mr. Clinton believes that the market value of Smith has peaked. He has identified risks associated with the ultimate cash flow and the fair value of the AFS security portfolio and wants to hedge one of these risks. Therefore, the Company purchased a 60-day at-the- money put option for $3 a share to hedge the AFS security on November 30. The put option gives Warfield the right to sell Smith at $45 a share. Because the intrinsic value is zero upon its purchase (the put option is at-the-money), the $3 price represents the time value of the put option. The time value relates to the time to maturity and the likelihood that option will end up being in-the-money.

Mr. Clinton must designate and document which risk is being hedged. He is considering two alternative risks to hedge and has asked you to complete the accounting and summarize the reporting implications related to each of the following hedge designations for this hedging instrument.

Hedged Item: Cash Flows from AFS Security Portfolio Assume Mr. Clinton is interested in hedging the future cash flows generated from the

AFS security portfolio because the cash flows will be used to satisfy a bond sinking fund requirement due on January 31. Therefore, the ultimate cash flows from this securities portfolio are designated as the hedged item. The put option gives Warfield the right to sell Smith at $45 a share, allowing Warfield to lock in the future cash flows from this portfolio.

Hedged Item: Fair Value of AFS Security Portfolio Assume Mr. Clinton is interested in hedging the fair value of this AFS security port-

folio. The fair value of the portfolio is designated as the hedged item because Warfield has to maintain certain asset levels to maintain a current ratio required by a lender. The put option will help accomplish the fair value hedge because the intrinsic value of the put option plus the spot price of the stock equals $45 a share. Therefore, with the put option, Warfield can lock in a minimum $4.5 million fair value of this portfolio.

Required

(1) Using Table 1, complete the journal entries for the AFS securities and the put option, assuming the designated hedge item is the ultimate cash flow from the portfolio.1 The

1 Monthly adjustments are required for the hedge transactions because Warfield closes its books each month. Further, the declining time value of the put option at December 31 is a function of the variability of the stock share price and reduction in the days to maturity.

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boxes in the Tables indicate that an answer is expected. If no entry is necessary, indicate with ‘‘none.’’

(2) Using Table 2, complete the journal entries for the AFS securities and the put option, assuming the designated hedge item is the fair value of the portfolio.

(3) Using Table 3, complete the summary of the financial statement impact for the cash flow and fair value hedge. Compare the impact of the two hedging scenarios and be prepared to discuss the following: ! How does the financial statement impact differ between the two hedges of the AFS

security portfolio? ! How is the cash flow ‘‘hedged?’’ ! How is the fair value ‘‘hedged?’’ ! How does the accounting under SFAS No. 133 (FASB 1998) differ from the ac-

counting under SFAS No. 115 once the AFS securities are designated as the hedged item?

Part B: Hedge of Anticipated Purchase of Oil On October 31, Warfield Company is anticipating the purchase of 100,000 barrels of

oil on January 31st of next year. The oil will be resold on March 31 at the spot price. However, recent turmoil in the world’s oil-producing regions has negatively affected the supply of oil. These conditions are expected to continue into the foreseeable future. Mr. Clinton, the corporate treasurer, asked you to assist in the analysis of structuring the antic- ipated oil purchase transaction and the use of a futures contract to hedge this transaction. The Company can structure the transaction with the counterparty as either a forecasted transaction or a firm commitment.

In anticipation of this transaction, the treasurer has determined that Warfield will pur- chase a futures contract at $39 per barrel (bbl) for 100,000 bbls with a maturity of January 31.2 The critical terms of the futures contract will match the anticipated transaction so the hedge is 100 percent effective. The futures contract is at market rates, and the company maintains a margin account with the broker; therefore, no cash will be exchanged at the inception of the contract. The futures contract settles in cash for the difference between the price stated on the contract and the spot price on January 31 (maturity).

If the oil purchase is structured as a forecasted transaction, then Warfield will enter a futures contract for the right to buy oil on January 31 at $39 / bbl. In a forecasted transaction, the price of oil is uncertain because the price will depend on the spot rate for oil on January 31 (this is referred to as a floating price). However, the futures contract provides a specific price ($39) for the oil on January 31 (this is referred to as a fixed price). Hedging the forecasted transaction with a futures contract converts uncertain future cash flows into fixed future cash flows by locking in the future cash flows related to this transaction. Therefore, this hedge converts a floating exposure into a fixed amount (floating to fixed). Under this scenario, cumulative gains or losses on the futures contract (assumed to be a 100 percent effective hedge) will offset the cumulative changes in forecasted cash flows of the purchase of oil.

If the oil purchase is structured as a firm commitment for 100,000 bbls to be delivered on January 31 at a price of $39 / bbl, then Warfield will enter a futures contract for the right

2 The hedge structure is set by the Treasury Department. You are not responsible for determining what derivative to use, whether to buy or sell the derivative, or when to enact the hedge terms. The hedge structure created in this case is purposefully simplified (assumes no time value, no processing cost, etc.) so that the impact of the hedge accounting is clear.

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to sell the oil on January 31 at $39 / bbl. In a firm commitment, the price of oil is a specific price without regard to what happens in the market (a fixed price). The futures contract in this scenario is a commitment to sell the oil for $39. However, in order to settle the futures contract, the oil will be purchased at the spot rate on January 31 (an unknown or floating price). Hedging the firm commitment with the sale of a futures contract converts a fixed firm commitment into an uncertain future value (fixed to floating). Since the hedge is assumed to be 100 percent effective, cumulative gains or losses on the futures contract will offset the cumulative changes in the fair value of the firm commitment.

The Board of Directors is concerned about the robustness of either hedge structure because of the uncertainty of oil prices increasing or decreasing during the hedge period. Therefore, Mr. Clinton created two pricing scenarios (price-increasing and price-decreasing) and asked you to complete the accounting entries and a summary of the financial statement impact for both pricing scenarios. Analysis of the hedge accounting under these different pricing assumptions will help evaluate the robustness of the hedge.

Required

(1) Price-Increasing Assuming a price-increasing scenario, use Tables 4, 5, and 8 to complete the following (clearly label each account, i.e., futures, firm commitment, Gain / Loss—Income State- ment (IS), Gain / Loss—Other Comprehensive Income (OCI)). The boxes in the Tables indicate that an answer is expected. If an entry is not applicable, indicate ‘‘none.’’ ! Journal entries for the hedge if it is structured as a forecasted transaction; ! Journal entries for the hedge if it is structured as a firm commitment; ! Financial statement summaries for each of the above.

(2) Price-Decreasing Assuming a price-decreasing scenario, use Tables 6, 7, and 9 to complete the following (clearly label each account, i.e., futures, firm commitment, Gain / Loss—Income State- ment (IS), Gain / Loss—Other Comprehensive Income (OCI)). ! Journal entries for the hedge if it is structured as a forecasted transaction; ! Journal entries for the hedge if it is structured as a firm commitment; ! Financial statement summaries for each of the above.

(3) Evaluate the two transaction structures and hedging strategies discussed above and prepare a memo to the Board of Directors clearly explaining the following (use Table 10 to compare the two transaction structures): a. The difference between the forecasted transaction and the firm commitment and

pros / cons of structuring the transaction with the supplier as one or the other; b. The concepts behind cash flow and fair value hedging and the accounting treatment

of each as it relates to these transactions; c. The documentation requirements (including the timing of any required documen-

tation) in order to qualify for hedge accounting treatment under SFAS No. 133; d. The overall impact on the financial statements if the hedge is a cash flow hedge

versus a fair value hedge and whether oil prices are increasing or decreasing (use the tables and summaries completed in Requirements 1 and 2 above);

e. The circumstances under which you would recommend one transaction structure versus the other.

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TABLE 1 Cash Flow Hedge of Available-for-Sale Security Portfolio

(in 000s)

October 31 November 30 December 31 January 31

Stock Price $40 $45 $44 $43 Option Value:

Time Value (TV) $3 $1.6 $0 Intrinsic Value (IV) $0 $1.0a $2b

$3 $2.6 $2 ($45 Strike Price)

Entries for AFS Securities

Entries for Put Option—TV

Entries for Put Option—IV

Entries for Settlement

a (IV ! $45 strike " $44 spot) b (IV ! $45 strike " $43 spot)

TABLE 2 Fair Value Hedge of Available-for-Sale Security Portfolio

(in 000s)

October 31 November 30 December 31 January 31

Stock Price $40 $45 $44 $43 Option Value:

Time Value (TV) $3 $1.6 $0 Intrinsic Value (IV) $0 $1.0a $2b

$3 $2.6 $2 ($45 Strike Price)

Entries for AFS Securities

Entries for Put Option—TV

Entries for Put Option—IV

Entries for Settlement

a (IV ! $45 strike " $44 spot) b (IV ! $45 strike " $43 spot)

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TABLE 3 Summary of Financial Statement Impact

October 31 November 30 December 31 January 31

Panel A: Hedge of Cash Flows from Available-for-Sale Security Portfolio (in 000s)

Changes in Balance Sheet:

Assets

Liabilities

Equity—OCI

Equity—NI

Cash flows

Stock Value

Put Option

Total Investment Value

Panel B: Hedge of Fair Value of Available-for-Sale Security Portfolio (in 000s)

Changes in Balance Sheet:

Assets

Liabilities

Equity—OCI

Equity—NI

Cash flows

Stock Value

IV of Put Option

Hedged Fair Value

TV of Put Option

Total Investment Value

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TABLE 4 Price-Increasing Scenario

Cash Flow Hedge of Forecasted Transaction

October 31 Nov 30 Dec 31 Jan 31 March 31

Oil Price $35 $40 $37 $44 $46 Futures Rate $39 $41 $38 $44

Entries for the Futures Contract (Contract to BUY)

Entries for the Forecasted Transaction

TABLE 5 Price-Increasing Scenario

Fair Value Hedge of Firm Commitment

October 31 Nov 30 Dec 31 Jan 31 March 31

Oil Price $35 $40 $37 $44 $46 Futures Rate $39 $41 $38 $44

Entries for the Futures Contract (Contract to SELL)

Entries for the Firm Commitment (Contract to BUY)

TABLE 6 Price-Decreasing Scenario

Cash Flow Hedge of Forecasted Transaction

October 31 Nov 30 Dec 31 Jan 31 March 31

Oil Price $35 $32 $34 $30 $29 Futures Rate $39 $34 $35 $30

Entries for the Futures Contract (Contract to BUY)

Entries for the Forecasted Transaction

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TABLE 7 Price-Decreasing Scenario

Fair Value Hedge of Firm Commitment

October 31 Nov 30 Dec 31 Jan 31 March 31

Oil Price $35 $32 $34 $30 $29 Futures Rate $39 $34 $35 $30

Entries for the Futures Contract (Contract to SELL)

Entries for the Firm Commitment (Contract to BUY)

TABLE 8 Summary of Financial Statement Impact

Price-Increasing Scenarios

Oct 31 Nov 30 Dec 31 Jan 31 Mar 31

Cash Flow Hedge (Converting Floating to Fixed)

Changes in Balance Sheet:

Assets

Liabilities

Equity—OCI

Equity—NI

Cash Flows

Value of Futures Contract

Inventory value

Fair Value Hedge (Converting Fixed to Floating)

Changes in Balance Sheet:

Assets

Liabilities

Equity—OCI

Equity—NI

Cash Flows

Value of Futures Contract

Value of Firm Commitment

Inventory Value

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TABLE 9 Summary of Financial Statement Impact

Price-Decreasing Scenarios

Oct 31 Nov 30 Dec 31 Jan 31 Mar 31

Cash Flow Hedge (Converting Floating to Fixed)

Changes in Balance Sheet:

Assets

Liabilities

Equity—OCI

Equity—NI

Cash Flows

Value of Futures Contract

Inventory Value

Fair Value Hedge (Converting Fixed to Floating)

Changes in Balance Sheet:

Assets

Liabilities

Equity—OCI

Equity—NI

Cash Flows

Value of Futures Contract

Value of Firm Commitment

Inventory Value

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TABLE 10 Summary of All Hedging Scenarios

Cash Flow Hedge: Floating to Fixed

Balance Sheet Volatility?

(Yes or No) Cash Flow

(Fixed)

Inventory Value

(Floating)

Cost of Goods Sold

(Fixed) Profit (Loss)

Prices Increasing

Prices Decreasing

Fair Value Hedge: Fixed to Floating

Balance Sheet Volatility?

(Yes or No) Cash Flow (Floating)

Inventory Value

(Floating)

Cost of Goods Sold (Floating)

Profit (Loss)

Prices Increasing

Prices Decreasing

REFERENCES Financial Accounting Standards Board (FASB). 1993. Accounting for Certain Investments in Debt

and Equity Securities. Statement No. 115. Norwalk, CT: FASB. ———. 1998. Accounting for Derivative Instruments and Hedging Activities. Statement No. 133.

Norwalk, CT: FASB.

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CASE LEARNING OBJECTIVES AND IMPLEMENTATION GUIDANCE Introduction

This case provides a comprehensive, yet simplistic, application of Statement of Finan- cial Accounting Standard No. 133, Accounting for Derivatives and Hedging Activities (SFAS No. 133, FASB 1998). SFAS No. 133 is perhaps the most technically complex set of accounting standards to date, and most accounting faculty have very little, if any, prac- tical experience with derivatives and hedging. Gaining an understanding of this topic can be challenging; teaching this topic is even more challenging. Since few instructors can teach this topic using first-hand experiences, this case allows for faculty to use a holistic approach for teaching the complexities of hedging. The fact patterns reflect economic risks and the hedging alternatives available to hedge these risks.

A primary benefit of this case is the flexibility with which it can be used (see ‘‘Imple- mentation Guidance’’ section below). Another benefit is the comprehensive nature of the case. The scenarios in Part A and Part B are designed so students can see the overall differences in cash flow versus fair value hedging. This is a benefit over most textbook exercises that display only component parts of a hedge transaction. The piecemeal approach of textbook problems is beneficial to learning the component parts but does not aid in the understanding of the overall impact of, or motivation for, hedge transactions. An underlying benefit is demonstrating that the hedge structure precedes the hedge accounting.

Learning Objectives The case asks students to evaluate the accounting and reporting that follows an eco-

nomic business decision. That is, the case provides an opportunity to emphasize that ac- counting and reporting should not lead economic decisions, but instead that accounting follows and reports economic outcomes.

The case encourages students to learn how and why companies hedge the exposure of a particular risk. To this end, the case focuses on the financial statement reporting of each alternative, as students learn how to account for the derivatives and hedging activities. Further, the case challenges students to think about hedging risk from a ‘‘big picture’’ perspective by requiring students to compare cash flow versus fair value hedge structures and the resiliency of the hedges under the alternative pricing scenarios.

Often students complete an assignment and do not think about alternative solutions or the implications if circumstances change. Completion of the financial statement summaries provides students with an opportunity to compare and contrast the impact of the hedge structures and the pricing scenarios. The financial statement summaries can be used in class to focus attention on the overall reasons for the hedge instead of on the detailed mechanics of the entries.

By completely this case successfully, students should be able to:

1. Understand the difference between fair value and cash flow hedge accounting; 2. Understand the financial statement impact of fair value and cash flow hedge accounting; 3. Understand that economic risk should be the motivating force behind the hedge

structure; 4. Understand the difference between a forecasted transaction and a firm commitment; 5. Understand the documentation requirements to qualify for hedge accounting; and 6. Understand the impact of price changes on the hedge structure.

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Implementation Guidance This case can be used in intermediate, advanced, or special topics accounting courses.

The case provides flexibility as to how it can be used, depending on the background material available to the students, the class time dedicated to the topic, and the instructor’s learning objective. Because of the complexity of the topic and the magnitude of entries and scenar- ios, the authors have found that using an approach called ‘‘scaffolding’’ helps provide an infrastructure to students as they learn the mechanics of the hedge entries (Chang et al. 2002; Hartman 2002; McKenzie 2000). Scaffolding is discussed further in the ‘‘Use in Intermediate Accounting’’ section.

The tables included in the case provide an infrastructure and visual depiction of the simultaneous transactions that occur in a hedge. Completion of the journal entries using these tables gives structure to the assignment and provides students an opportunity to point out the different accounting treatment for each hedge. The instructor can use these tables to walk students through the entries for one or more of the hedging transactions and to communicate key points for each transaction. The transaction walk-through is important in implementing scaffolding and is discussed in the following section.

Part A of the case is best suited for an intermediate class, and Parts A and B together are best suited for an advanced accounting class.

Use in Intermediate Accounting Part A can be used as an in-class or out-of-class exercise to demonstrate cash flow and

fair value hedge accounting for a recognized asset. The instructor can use Part A as an in- class exercise to walk students through the entries after the students have read assigned material in the textbook or other readings on the topic.

The following demonstrates the scaffolding technique for Part A. The instructor starts with entries for the available-for-sale (AFS) security on October 31, asking students for input as to what that entry should be. The instructor writes the entry in the appropriate boxes in Table 1 using information from the Teaching Notes and then moves on to the next required entry. As each entry is completed, instructors should also solicit the rationale or reasoning for each entry from the students. This approach provides the students an oppor- tunity to learn by following along in class.

The entries for the put option are separated into its two value components: time value (TV) and intrinsic value (IV). Walking through the entries for the put option in this manner presents instructors with an opportunity to explain these two components. This also provides an opportunity for instructors to point out that it is the changes in the stock price and the put option that represent the hedge. By separating the value of the put into time value and intrinsic value, it is easier for students to see that the changes in the intrinsic value offset the changes in the stock price and are the effective part of the hedge. It is also easier for students to see the accounting differences between the cash flow and fair value hedge.

After all the entries are completed, the students can complete the financial statement summaries as an out-of-class assignment or in-class in teams. Completing the financial statement summaries helps students see the impact of the accounting on the financial state- ments and provides a basis for a class discussion on the differences between a cash flow and fair value hedge.

Use in Advanced Accounting or Special Topics If this topic is covered in an advanced accounting course, then Part A and Part B can

be assigned in stages. One of the authors had success using this case in an advanced

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accounting class over a two-week (four classes) period. While textbook reading gives stu- dents the background and terminology needed for the case, the students learn the mechanics and concepts of hedging through the case materials.3 The entries for Part A can be com- pleted by the students out of class, walked through in class (as described above), or handed out to the students already completed. Regardless of which way the students are assigned the entries, the financial statement summaries should be discussed in class to make sure everyone understands the difference between a cash flow and fair value hedge.

Part B is more advanced and requires students to complete the cash flow and fair value hedge accounting entries when prices are increasing and then again assuming that prices are decreasing. Completing the entries for a different pricing scenario provides opportunity to practice the entries and provides an opportunity to evaluate the robustness of the hedging strategy. Again, the instructor can walk through the entries in class for the price-increasing scenario and let the students complete the price-decreasing scenario. Care should be taken that the students have the entries for the hedges completed correctly before they write their memos. Because the memo is such a strong learning tool, we do not want the students to spend time learning the wrong things. Therefore, instructors should provide students with check figures for the scenarios completed out-of-class if the memo is assigned.

The memo requires students to explain that the transaction can be structured as a forecasted transaction or a firm commitment, and that the hedge accounting requirements that follow the transaction structure. In their memos, students must also explain the docu- mentation requirements, and the overall impact on the financial statements of each hedge strategy under each pricing scenario. Students who have completed this case have found that writing a memo that compares the hedges under the price-increasing and -decreasing scenarios yielded increased understanding and enhanced their ability to articulate that understanding.

Certain simplifications have been made in Part B to reduce the case complexity. There is no time value assigned to the futures contract, making the hedges 100 percent effective. In practice there may be some time value, but in most cases, it would be a minimal amount and is therefore ignored here. If there were an ineffective portion to the hedges in Part B, then it would not make a difference in the financial statement summaries used to compare the two hedge structures. The ineffective part of a hedge is reflected in earnings for both a cash flow and fair value hedge. Therefore, for comparison purposes, there is no incre- mental issue to analyze. However, the following questions generate great discussion in class: What if there was an ineffective part of this hedge? How would it be reflected in the cash flow hedge? How would it be reflected in the fair value hedge?

No additional material or labor costs are added to the oil (the inventory) purposefully, so the raw cost of the inventory can be traced to the sales date. The case is intended to display a component part of the raw material inventory. The inventory is not transformed, so the difference in the selling price and cost of goods sold is easily traceable. In practice, the inventory may have had material and labor costs added during the manufacturing process.

Student Reactions to the Case This case has been used in undergraduate and graduate classes. It has been used as the

primary instructional resource for teaching derivatives and hedging, and it has been used

3 The primer included in the Teaching Notes can be used to provide background reading if derivatives are not covered in the textbook.

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as an outside class assignment, where teams of students were assigned part of the case and were required to present their part to the rest of the class.

Despite the complexity of the material, the overall response to the case was positive. The biggest issue brought up by the students was overcoming the terminology and the desire to spend more time on the topic. Many students felt that they were barely grasping the concepts, which is understandable if this is the first time they were exposed to the topic.

Exhibit 1 summarizes the results of the survey administered to 150 students who com- pleted the case. This exhibit also presents sample student responses from the two open- ended questions included in the survey.

EXHIBIT 1 Student Survey Results

(1 ! Strongly disagree, 5 ! Strongly agree)

Mean Response 1. The case helped me understand the difference between fair value and cash

flow hedge accounting. 4.09 2. The case helped me understand the financial statement impact of fair value and

cash flow hedge accounting. 3.96 3. The case helped me understand that economic risk should be the motivating

force behind the hedge structure. 3.63 4. The case helped me understand the documentation requirements for hedge

accounting. 3.81 5. The case familiarized me with the impact of different pricing scenarios on

hedge strategies. 3.89

Open-Ended Questions

Did you find anything in the case unclear or unrealistic? If so, what specific part(s) of the case were unclear or unrealistic?

! ‘‘I think the 100% effectiveness of the hedge was unrealistic, but it made the hedge accounting and objectives more clear.’’

! ‘‘I think the case is a good learning tool. It really helps when trying to tackle the effects and treatment of hedges.’’

! ‘‘Extremely simplified—however, this is more instructive than a realistic scenario.’’ ! ‘‘The case was straightforward.’’ ! ‘‘If it wasn’t oversimplified, I would have never gotten it.’’ ! ‘‘It was difficult to find guidance on firm commitments and forecasted transactions.’’ ! ‘‘This is hard concept to understand. More background and guidance needs to be given.’’

Would you recommend that instructors at other universities use this case? Why or why not?

! ‘‘Yes, definitely ... it was very interesting and educational. It made a hard concept easier to grasp.’’

! ‘‘Yes, it helps bring all the hedge accounting issues together and helps us learn how to communicate the information to management with good writing skills.’’

! ‘‘Yes, it forces you to work with a fair value and cash flow hedge. It also forces you to explain the transactions in your own words, which is a huge learning tool.’’

! ‘‘I would recommend the case because it forced me to understand and explain the principles and conceptual knowledge behind the journal entries.’’

! ‘‘Before writing the memo it was not clear at all. But after writing the memo I had some sort of idea.’’

(continued on next page)

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EXHIBIT 1 (continued)

! ‘‘It was hard, but a good tool.’’ !‘‘Yes, but there should be more explanations.’’

! ‘‘Yes, I recommend other instructors to use it. Derivative and hedging are difficult concepts. But after I read the textbook and other materials and write a memo ... everything gets clearer.’’

! ‘‘Yes, it is a good case to understanding, but should be preceded with more guidance if being used in a similar context.’’

! ‘‘Yes, it was a very clear comparison and portrayed the difference between the two hedges very well.’’

! ‘‘It was a good idea, but it was definitely a hard case.’’ ! ‘‘I would recommend it. It was tough, but a good review of hedging. It is a nice challenge.’’ ! ‘‘No. Why bother torturing students with something that nobody could possibly have been

confident about and that many didn’t get correct.’’

TEACHING NOTES Teaching Notes are available only to full-member subscribers to Issues in Accounting

Education through the American Accounting Association’s electronic publications system at http: / / www.atypon-link.com / action / showPublisherJournals?code!AAA. Full-member subscribers should use their personalized usernames and passwords for entry into the system where the Teaching Notes can be reviewed and printed.

If you are a full member of AAA with a subscription to Issues in Accounting Education and have any trouble accessing this material, then please contact the AAA headquarters office at [email protected] or (941) 921-7747.

REFERENCES Chang, K., I. Chen, and Y. Sung. 2002. The effect of concept mapping to enhance text comprehension

and summarization. The Journal of Experimental Education 71 (1): 5–23. Financial Accounting Standards Board (FASB). 1998. Accounting for Derivative Instruments and

Hedging Activities. Statement No. 133. Norwalk, CT: FASB. Hartman, H. 2002. Scaffolding and cooperative learning. In Human Learning and Instruction, 23–69.

New York, NY: City College–CUNY. McKenzie, J. 2000. Scaffolding for success. Electronic version. Beyond Technology, Questioning,

Research and the Information Literate School Community. Available at: http: / / fno.org / dec99 / scaffold.html.

mad Derivatives and Hedging: Accounting vs. Taxation Ballast for stormy financial seas by Robert Bloom and William J. Cenker

Aderivative is a financial instrument that derives its value basedon its relationship to another financial instrument such as astock or bond, to an index or to an exchange rate. With derivatives, mutual funds manage risk in their portfolios. Banks use them to guard against losses. Oil companies use them to hedge against or counteract the prospect of future price changes. Airlines use them to iry to lock in more favorable

fuel prices. And above all on our shrink- ing planet, cross-border transactions de- pend upon them to ameliorate the risk of currency exchange rate fluctuations. Be- cause derivatives used in hedging are more likely than ever to crop up in companies'

financial statements, CPAs need to be con- versant in the accounting requirements for them and especially how to rnanage the temporary differences between financial accounting and tax reporting.

This article focuses on two types of derivatives—options and forward con- tracts. Options are rights to engage in futures contracts, which are contracts to exchange goods of a particular quantity at a designated price and date. Forward con- tracts are the same as future contracts but are not regulated by organized exchanges. Whereas in accounting, derivatives are marked to market, that is not ihe case in income taxation. CPAs should be familiar not only with the accounting require- ments of derivatives but also the income tax regulations governing them, since the differing treatments produce deferred tax consequences. This article contrasts gains and losses using those derivatives and in so doing reconciles the accounting and tax differences in deferred tax accounts.

ACCOUNTING TREATMENT Financial accounting for derivatives takes a fair value approach- The gain or loss on

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the derivative generally offsets the loss or gain on the risk exposure. The accounting treatment depends on whether it qualifies as a hedging inslrument and, if so, on the designated reason for holding it (FASB Statement no. 133, Accounting for Deriva- tive instruments and Hedging Activities, para- graph 18)-

a. No hedging désignai ion. The gain or loss on a derivaiive instrument not designated a hedging instru- ment appears In current income.

b. Fair value ficdge. This is a hedge of the fair value of an asset or ¡iabili- ty in a purchase, sale transaction or firm commitment at a definite price. The gain or loss on a fair value derivative as weW as the off- setting loss or gain on the hedged item appear in current earnings in the same period.

c. Cash/low/ledge. This hedge is con- cerned with variable cash flows stemming from forecasted transac- tions or cash flows from assets and liabilities already incurred.

Effectiveness in hedging is the degree to which the value change in a hedge off- sets the value change in what is being hedged—such as using a forward con- tract to offset exchange rate iluctuations in the euro on a sale of inventory in that currency to a foreign buyer. The effective portion of the gain or loss on a cash flow derivative is a component of other com- prehensive income and reclassified to in- come in [he same period or periods in which the hedged forecasted transaction

affects income. Any remaining gain or loss on the derivative appears in current income.

The types and uses of derivatives are as varied as the number of financial instru- ments in which a company may invest. While the accounting for all derivatives fol- lows the above general rules, this discussion considers derivatives used to manage the risk of currency fluctuations on transactions denominated in a foreign currency

Certain Hed^ng Activities—an amendment of FASB Statement No. J33).

An entity may account for assets and liabilities hedges as well as hedges of for- eign ctirrency firm commitments either as fair value hedges or as cash flow hedges. Hedges of forecasts of foreign currency transactions may only be accounted for as cash flow hedges (FASB Statement no. 138). An entity reports hedges of net in- vestmenls in foreign operations in the

Hedge documentation is imperative for financial accounting as well as income taxation.

Foreign currency hedging transactions involve risk management associated with assets and liabilities denominated in a for- eign cuiTtincy In such events a corporaiion buys or sells goods with a foreign corpo- ration, and the transaction is to be settled in a foreign currency With foreign cur- rency firm commitments, a contract agree- ment to engage in a future foreign currency purchase or sale has occurred—such as a purchase order. With forecasts of foreign currency transactions, predictions of for- eign currency transactions are made, but contractual obligations are not incurred. Net investments in foreign operations in- volve purchases of shares of stock in a foreign corporation. Hence, the "net in- vestment" reflects the equity in this loreign entity (FASB Statement no. 138, Account- ing for Certain Demative Instruments and

same way that the hedged tran.slation ad- justments are reported (FASB Statement no. 133).

For financial accounting purposes, an entity must use a two-transaction per- spective to account for foreign currency lran.sactions: the export sale itself and the extension of credit denominated in a for- eign currency (FASB Statement no. '52, Foreign Currency Translation^. The dollar equivalent of the sale is recorded at the time of sale, and any unrealized foreign ex- change gains and losses are accrued in net income in the period in which the ex- change rate changes (FASB Statement no, 52, paragraph 124).

Hedge documentation is imperative for financial accounting as well as income tax- ation. For financial accounting purposes, on the date of the hedge, an entity must

E X E C U T I V E S U M M A R Y • Hedge documentation is Important in both financial reporting and income taxation. For financial accounting purpos- es, on the date ol the hedge, an entity must identify the hedged item, the instrument used, the type of risk hedged, the means of assessing hedge effectiveness, and the risk management objec- tive and strategy. • Gains and losses of different types of derivatives for fair

value hedges are reflected in the income statement, offset- ting losses and gains on transac- tions being hedged. • Gains and losses on cash flow hedges are "parked" in accumulated other compre- hensive income until the trans- actions occur and then trans- ferred to the income statement to offset the losses and gains on these transactions.

• Foreign currency transac- tions record the dollar equiva- lent of the sale at the time of sale. Any unrealized foreign exchange gains or losses are accrued in net income during the period in which the exchange rate changes. • Mark-to-market rules do not apply to hedging transactions for tax purposes. An entity must treat an investment in regulated futures or foreign currency contracts that

is not a hedging event as though it were sold on the last day of the year for tax purposes.

Robert Bloom. Ph.D.. is a professor of accountancy al John Carroll Uni- versity in University Heights, Ohio. His e-mail address is rbloom® ¡cti.edu. William J!Cenker CPA, Ph.D.. was also a professor of accountancy al John Carroll Univer- sity. He died in March.

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identify the hedged item, the instrument used, the type of risk hedged, the means of assessing hedge effectiveness, and the risk management objective and strategy (FASB Statement no. 133).

INCOME TAX TREATMENT For income taxation, [here is an excep- tion 10 the general requirement for a sale or other disposition to occur prior to gain or loss recognition. An entity treats an in- vestment in regulated futures (that is, fu- ture contracts for the exchange of goods, which in contrast to forward contracts are exchange traded) that is not a hedging transaction as if it were sold ai its fair mar- ket value on the last business day of the taxable year (IRC § 1256(a)(l)). Forty percent of any such gain or loss is treat- ed as short term, 60% as long term (IRC §§ 1256(a)(3)(A)and(B)).

The mark-to-market rules do not, however, apply to hedging transactions, so gains and losses are not recognized on such events (IRC § 1256(e)). In taxation, an entity must clearly identify the hedg- ing transaction as such on the day entered (Treas. Reg. § 1.1221-2(0(1)). The item hedged must be similarly incurred (Treas. Reg. § 1,1221-2(0(2)). The time oí identification is defined as "contem- poraneous," or within 35 days (see Treas. Reg, § 1.1221-2(0(2)(ii)). Further, for tax purposes such identification must be un- ambiguous. Identification for financial accounting or regulatory purposes is not sufficient unless the books and records indicate that the identification is also

being made for income tax purposes (Treas. Reg. § 1.1221-2(0(4)(ii)).

A corporation will normally enter into such contracts to hedge a future purchase commitment or to lock in a sales price de- nominated in a foreign currency The gain or loss is then ordinary, serving to offset any gain or loss in the underlying con- tract. Sometimes, a corporation will need to generate a capital gain or loss, so the above hedging rules conceivably may be important for tax planning purposes.

CASE STUDY Suppose that BC Corp. sells goods with a value of €2 million to Dugas Corp. in France. BC delivers the goods on 11-01- XI. The terms of the agreement require Dugas to pay the euros on 2-01-X2. BC in- vestigates four alternatives with respect to hedging the euro-denominated receivable:

a. Purchase a put option to sell €2 mil- lion on 2-01-X2, designating the transaction as a fair value (asset ex- posure) hedge.

b. Purchase a put option to sell €2 mil- lion on 2-01-X2, designating the transaction as a cash flow hedge, or hedge of variable cash flows. As this example will show, a cash flow hedge generates less variable income effects.

c. Enter into a foreign currency for- ward exchange contract, designat- ing the transaction as a fair value (asset exposure) hedge.

d. Enter into a foreign currency for- ward exchange contract, désignât-

Exhibit 1 Hedging Alternatives Date

11-01-X1 12-31-X1 2-01-X2

Spot Rate' $1,32

1.35 1.29

Receivable Fair Value

$2,640,000 2,700,000 2,580,000

Option Price or Premium^

$0,012 0.010 0,030

Option Fair Value $24,000 20,000 60,000

Forward Rate- Si.30

1.33 1.29

Forward Fair Value

$ 0.00 (59,701)=

2o,ooœ 1. The exchange rate hetween $ and € tor ¡mmediale currency conversion. 2. The exchange rate for currency conversion as of a designated future date. 3. € 2,000,000 X ($1.33 - 1,30) = $60,000: $60,000 x 1 ̂ 1.005 = $59.701 (discounted at an assumed annuai rate of 6% for one month untii payment on 2-01-X2). 1 .€2 , 0 O 0 , O O 0 x ( S r 3 O - 1 2 9 ) . 5. Assumed to have been determined by fliack-Scholes option pricing model. An option price or premium is an initial amount to purchase the option.

ing the transaction as a cash flow hedge.

Fxhibit 1 summarizes financial infor- mation with respect to ihe 82 million re- ceivable and the various alternatives. See the spreadsheet with the online version of this anicle at www.joumalofaccountancy. com for illustrations of necessary journal entries.

Pul option—fair value hedge. On the date of sale, BC Corp, prepares the jour- nal entry for the foreign-currency de- nominated sale, assuming a periodic inventory system and the purchase of the option. If BC Corp, were to satisfy the criteria for hedge accounting and ac- count for the purchase of the put option as a fair value hedge, it would adjust the carrying value ol the receivable and put option to fair values at the balance sheet dates and recognize such adjustments to income. Assummg the option is a hedge for tax purposes, BC would not recognize as income (loss) the adjustment to the fair value of the option or the receivable at 12-31-Xl. Accordingly, a temporary difference between accounting and in- come taxation occurs, having deferred tax consequences, at an assumed tax rate of 35%.

At 2-01-X2, BC adjusts the receivable and option to their current values, col- lects ihe receivable, and exercises the op- tion. For financial accounting purposes, BC recognized income of $56,000 in XI and a net loss of $80,000 in X2 with re- spect to its foreign currency transactions. The difference of $24,000 represents the cost of the option. For income lax pur- poses, BC recognizes the entire option cost of $24,000 as a deduction in X2. The balance in the asset and liability ac- counts is now zero, and, assuming no further hedging transactions at 12-31- X2, BC reverses the 12-31-Xl deferred tax adjustment.

Put option—cashßow hedge. BC Corp. prepares the same journal entries for the sale and option purchase as those for the fair value hedge. Since BC has an exposed asset position that will lead to a future cash Ilow. BC may account for the transaction either as a fair value or cash flow hedge.

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If BC accounts for the transaction as a cash flow hedge, ihe company reports fair value adjustments in other cotrtprehensive in- come, not in the income statement. The balance ol the accounting is similar to that accorded the fair value hedge. BC would adjust the receivable and option to fair value at balance sheet dates. As with the fair value hedge, a temporary difference between accounting and income taxation occurs, having deferred tax conse- quences, at an assumed tax rate of 35%.

The net effect of the above entries is to recognize $4,000 of option expense, which represents the decline in value of the option caused by the passage of time, starting at 12-31-Xl, when the option has no intrinsic value. BC does not recognize a deduction for tax purposes, and hence the net temporary difference is $4,000,

Ai 2-01-X2, BC adjusts the receivable

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OTHER RESOURCES

Accounting standards • FASB Statement no, 52, Foreign Currency Translation • FASB Statement no, 133, Accounting for Derivative Instruments and Hedging Activities • FASB Statement no, 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities-an amendment of FASB Statement No. Ï 33, www.fasb.org

and option to their current values, ad- justs accumulated other comprehensive income (AOCl) to reflect the decline in time value of the options, collects the receivable, and exercises the option. By 2-01-X2, the balance in AOCl is zero, BC recognized a $4,000 expense m XI and a $20,000 expense in X2. The fair value option previously produced far more variable results—$56.000 of income in XI and $80,000 ofloss in X2. Assuming

ferred tax corisequences, at an assumed tax rate of 35%.

In X2, the accounts receivable and the forward contract are adjusted to fair value, the euros are received and delivered to the purchaser and, ai year-end, the above de- ferred tax entry is reversed.

Forward contract—cash ßow hedge. In XI, BC records the sale, but again makes no entry for the fully executory, for- ward currency exchange contract, in-

Ill taxation, an entity must clearly identify the hedging transaction as such on the day entered, and

the item hedged must be similarly incurred.

no further hedging activities at the end ofX2,BCreversesthe 12-31-Xl deferred tax accrual.

Forward contract—fair \alue hedge. Unlike the purchase of a put option, there is no value recorded for a forward contract at the time of execution since this is a fully executory contract, involving no exchange of assets or other action between the par- ties. Accordingly, no asset is recorded at that time. BC records the sale at the cur- rent spot rate.

BC Corp. knov/s the cost of extending credit to Dugas at the outset. This cost or discount equals the difference between the spot rate of $1.32 and the forward rate of $1,30 times €2 million Kl.32 - 1.30) X €2 million = $40,000], The change in the forward rate from the time of the contract is entered until the balance sheet date is a reflection of the value or liability associated with the contract. The value is discounted or given a present value and recorded on the balance sheet along with the adjustment to the fair value of the asset. In this case, since the forward rate has increased to an amount above the forward rate at the time the contract was entered, the contract repre- sents a liability to BC, With fair value hedges, the fair value adjustments appear in income rather than other comprehen- sive income. As was true with options, a temporary difference between accounting and income taxation occurs, with de-

volving no exchange of cash, and having a value of zero. At 12-31-Xl, BC adjusts the value of the receivable using the new spot rate and offsets the resulting gain with an adjustment lo AOCl. The forward contract is recorded, BC amortizes the cost of the forward contract, and recognizes deferred taxes on the difTerence between the accounting and taxable base in the bal- ance sheet accounts. While the effective interest method is preferred for purposes of amortizing the discount, FASB's Deriv- atives Implementation Group permits straight-line amortization of premiums and discounts.

At 2-01-X2, BC again adjusts the re- ceivable and forward contracts to fair value, offsetting gains and losses against AOCl. The foreign currency received is ex- changed for cash at the initial contracted forward rate. DuringX2, BC recognizes the $40,000 cost of the contract for tax pur- poses and, assuming no further hedging transactions, reverses the 12-31-Xl de- ferred tax accrual.

Again notice the appeal of cash flow hedge accounting versus fair value hedge accounting. Fair value accounting re- ported a $299 gain in XI and a $40,299 loss in X2. Cash flow hedge accounting recognized $26,667 (two months amor- tization) in XI and $13,333 in X2, In- come effects, especially for hedges involving forward contracts, are deter- minable at the outset. •̂

58 Journal of Accountancy October 2008