Derivative Accounting Principles and Rules

1
Derivative AccountingPrinciples and Rules

• Derivative Instrument -- Fair Value
• Gain or Loss -- Recognized in Income Statement

2
E14-20

• 1/1/01 Cash 3,000,000
• Note Payable 3,000,000
• 12/31/01 Interest Expense 210,000
• Cash 210,000
• Cash 12,000
• Interest Expense 12,000
• Note Interest expense is 198,000 (3,000,000 X
  6.6).
• 12/31/01 Gain or loss 53,497
• Liability under derivative 53,497
• Note Payable 53,497
• Gain or loss 53,497
• Note P.V. of Difference of interest rate 1 of
  3,000,000 for 2 years
• 30,000 X 1.783263 53,497

3
P14-20

• 1/1/00 Cash 5,000,000
• Note Payable 5,000,000
• 12/31/00 Interest Expense (5M X 8.6) 430,000
• Cash (From Bradford) 20,000
• Cash (To Local Bank) 450,000
• 12/31/00 Gain or loss 124,342
• Liability under derivative 124,342
• Note Payable 124,342
• Gain or loss 124,342
• 12/31/01 Interest Expense (5M X 9.5) 475,000
• Cash (To Local Bank) 450,000
• Cash (To Bradford) 25,000
• 12/31/01 Liability under derivative 124,342
• Investment in derivative 89,164
• Gain or loss 213,506
• Gain or loss 213.506
• Note Payable 213,506

4
Fair Value Hedge

• Example Swap from Fixed Rate Mortgage to
  Variable Rate Mortgage
• Accounting Rules
• Derivative Instrument
• Valuation Fair Value
• Gain or Loss Recognized in Income
  Statement

5
Fair Value Hedge

• Derivative Instrument
• Valuation Fair Value
• Gain or Loss Recognized in I/S
• Underlying Financial Instrument
• Valuation From Modified Cost
• To Fair Value
• Gain or Loss Recognized in I/S

6
Fair Value Hedge

• Effective Hedge No Gain or Loss
• Ineffective Hedge Gain or Loss Recognized
• in Income Statement
• Partial Hedge Effective Vs Ineffective

7
STOCK OPTION PLANS

• Classification - Based on Intention
• Compensatory Stock Option Plan
• Stock Option
• Stock Appreciation Rights
• Non-compensatory Stock Option Plan
• With separable (detachable) stock warrants
• Without separable (detachable) stock warrants

8
STOCK OPTION PLANS

• Classification - Based on Tax Law
• Qualified Stock Option
• Not taxable to employees at the date of grant
• Not taxable to employees when exercised and held
  the stock
• Would be taxed at capital gain tax rate when the
  stock was sold
• Non-qualified Stock Option
• May be taxable to employees at the date of grant
• Taxable to employees when options were exercised
  Employer would be able claim deduction for tax
  purpose for the amount taxable to employees
• Taxable to employees at ordinary tax rate when
  options were exercised

9
Compensatory Stock Option Accounting Rules

• The Intrinsic Value at the Date of Grant
• No compensation expense recognized if exercise
  price is equal or more than the market price of
  the stock at the date of grant
• Fair Value at the Date of Grant
• Discounted Cash Flow Method (Present Value
  Concept)
• Black-Scholes Model
• Fair Market Value determined by market
• Fair Value at Balance Sheet Date
• Adjustment of compensation expense each year