FAS 133 IAS 39 CICA 13

1
Accounting for Derivative Financial Instruments
and Hedging Transactions

• FAS 133 IAS 39 CICA 13
• Bob Jensens Free Tutorials, Glossaries,
  and Cases are at http//www.trinity.edu/rjensen
  /caseans/000index.htm

2
ACCOUNTING FOR DERIVATIVES

• Presentation by
• Bob JensenTrinity University San Antonio, TX
  78212rjensen_at_trinity.edu
• http//www.trinity.edu/rjensen/

3
ACCOUNTING FOR DERIVATIVES

• Bob Jensen's threads on Enron are at
  http//www.trinity.edu/rjensen/fraud.htm 
• Bob Jensen's threads on Derivative Financial
  Instruments Fraud are at http//www.trinity.edu/rj
  ensen/FraudRotten.htmDerivativesFrauds 
• Also note http//www.trinity.edu/rjensen/Fraud.htm
  FrankPartnoyTestimony 
• How Enron Used SPEs and Derivatives Jointly is
  Explained at http//www.trinity.edu/rjensen//theor
  y/00overview/speOverview.htm
•  
• Bob Jensens threads on derivatives accounting
  are at  http//www.trinity.edu/rjensen/caseans/000
  index.htm

4
Frank Partnoys Works

• Of all the many documents and books that I have
  read about derivative financial instruments, the
  most important have been the books and documents
  written by Frank Partnoy. Some of his books are
  listed at the bottom of this message.

5
Frank Partnoys Works

• The single most important document is his Senate
  Testimony. More than any other single thing that
  I've ever read about the Enron disaster, this
  testimony explains what happened at Enron and
  what danger lurks in the entire world from
  continued unregulated OTC markets in derivatives.
  I think this document should be required reading
  for every business and economics student in the
  world. Perhaps it should be required reading for
  every student in the world. Among other things it
  says a great deal about human greed and behavior
  that pump up the bubble of excesses in government
  and private enterprise that destroy the
  efficiency and effectiveness of what would
  otherwise be the best economic system ever
  designed.

6
Frank Partnoys Works

• Testimony of Frank Partnoy Professor of Law,
  University of San Diego School of Law Hearings
  before the United States Senate Committee on
  Governmental Affairs, January 24, 2002 ---
  http//www.senate.gov/gov_affairs/012402partnoy.h
  tm

7
Frank Partnoys Works

•  
• FIASCO The Inside Story of a Wall Street Trader
• FIASCO Blood in the Water on Wall Street
• FIASCO  Blut an den weißen Westen der Wall
  Street Broker.
• FIASCO Guns, Booze and Bloodlust the Truth
  About High Finance
• Infectious Greed How Deceit and Risk Corrupted
  the Financial Markets
• Codicia Contagiosa
• His other publications include the following
  highlight
• "The Siskel and Ebert of Financial Matters Two
  Thumbs Down for the Credit Reporting Agencies"
  (Washington University Law Quarterly)

8
REASONS FOR NEW STANDARDS
Undisclosed Assets and LiabilitiesUnbooked
Assets and LiabilitiesMeaningless Measures of
Value Risk Rise in Scandals in the 1980s
1990sComplex Frauds --- Partnoys
Fiasco Explosion of Swap Contracts Evolution
Toward Fair Value Accounting
9
PROBLEMS WITH NEW STANDARDS
Complex Contracts Technical Jargon Complex
Scoping of Coverage --- NPNS Complex Hedge
Accounting RulesMany Derivatives Are Difficult
to Value Difficult to Find Embedded
DerivativesComplex Effectiveness Testing
Rules Continuous Stream --- DIG,
Amendments Implementation Failures --- Freddie
Mac, etc. Held-to-Maturity Interim
DistortionsHedge Acctg. Denied to Most Macro
Hedges
10
Differences Between StandardsFAS 133 vs. IAS 39
vs. CICA 13
Differences are relatively minor IAS 39 Macro
Hedging Amendment Listing of Major
Differences http//www.trinity.edu/rjensen/caseans
/canada.htm .
11
Hedge Accounting Section Objectives

• After completing this section, you should be able
  to
• Determine whether a contract is scoped into the
  standards and, if so, whether it is
• Qualified for Hedge Accounting
• Treated as a cash flow, fair value, or FX hedge
• Understand the basic journal entries
• Cry out loud if forced to implement the standards

12
One million lines of journal entries  Just how
expensive is FAS 133?

• "The Potential Crisis at Fannie Mae," Comstock
  Funds, August 11, 2005 --- http//snipurl.com/Fann
  ie133
• We have no proprietary information about Fannie
  Mae, but what is publicly known is scary enough.
  As you may recall, last December the SEC required
  Fannie to restate prior financial statements
  while the Office of Federal Oversight (OFHEO)
  accused the company of widespread accounting
  regularities that resulted in false and
  misleading statements. Significantly, the
  questionable practices included the way Fannie
  accounted for their huge amount of derivatives.
  On Tuesday, a company press release gave some
  alarming hints on how extensive the problem may
  be.
• The press release stated that in order to
  accomplish the restatements, we have to obtain
  and validate market values for a large volume of
  transactions including all of our derivatives,
  commitments and securities at multiple points in
  time over the restatement period. To illustrate
  the breadth of this undertaking, we estimate we
  will need to record over one million lines of
  journal entries, determine hundreds of thousands
  of commitment prices and securities values, and
  verify some 20,000 derivative prices
• This year we expect that over 30 percent of our
  employees will spend over half their time on it,
  and many more are involved. In addition we are
  bringing some 1,500 consultants on board by
  years end to help with the restatementAltogether
  , we project devoting six to eight million labor
  hours to the restatement. We are also investing
  over 100 million in technology projects to
  enhance or create new systems related to
  accounting and reportingwe do not believe the
  restatement will be completed until sometime
  during the second half of 2006
• Bob Jensen's tutorials on accounting for
  derivatives are at http//www.trinity.edu/rjensen/
  caseans/000index.htm

13
FOUR CORNERSTONES

• Derivatives are contracts that create rights and
  obligations that meet the definitions of assets
  and liabilities
• Fair value is the only relevant measure for
  derivatives(Mainly because historical cost is
  zero or near-zero)
• Value risk can be hedged into cash flow risk, and
  cash flow risk can be hedged into value risk, but
  both risks cannot simultaneously be eliminated.
• Hedge effectiveness tests can be varied with the
  type of risk being hedged.

14
Example Futures ContractsFinancial Risk May Be
Unbounded

• May be contracts to buy or sell at contracted
  (future) price that moves along with spot prices
  on an organized exchange linking buyers and
  sellers. Cost Zero!
• Notional standardized quantities per contract
  for a standard product such as a particular type
  of corn.
• Underlying the value per unit such as the price
  of a bushel of corn or a Treasury or Libor
  interest rate.
• Futures are a unique kind of derivative because
  futures gains and losses are posted daily in cash.

15
Example Futures Contracts (Continued)

• Since futures contracts are cleared daily for
  cash, the accounting was relatively simple under
  the now-defunct FAS 80.
• FAS 133 rules are more complicated for hedging
  contracts --- see 000starta.xls file at
  http//www.cs.trinity.edu/rjensen/Calgary/CD/FAS
  133OtherExcelFiles/cases/
• CBOT --- http//www.cbot.com/
• The prices you first see listed are the forward
  prices. To find spot prices, click on the link
  called "Charts." 

16
Example Forward ContractsFinancial Risk May Be
Unbounded

• May be contracts to buy or sell at contracted
  (future) price that moves along with spot prices
  in over-the-counter (OTC) private contracts.
  Cost Zero!
• Notional unique quantities per contract for a
  defined product such as a particular type of
  corn.
• Underlying the value per unit such as the price
  of a bushel of corn or a Treasury or Libor
  interest rate.
• Unlike futures contracts, forward contracts are
  neither standardized nor cleared daily for cash
  gains and losses.

17
Example Forward Contracts (Continued)

• There were no accounting rules for forward
  contracts prior to FAS 133.
• FAS 133 rules are complicated for hedging
  contracts --- see 000starta.xls file at
  http//www.cs.trinity.edu/rjensen/Calgary/CD/FAS
  133OtherExcelFiles/cases/
• CBOT --- Does not exchange forward contracts
• Contracts are non-standardized and might be
  subject to credit risk. 

18
Example Swap Contracts Financial Risk May Be
Unbounded

• Swaps are generally portfolios of forward
  contracts with regularly-spaced payment dates.
  Cost Zero!
• Notional unique quantities per contract for a
  defined product such the number of bonds being
  hedged.
• Underlying the value per unit such as the price
  of a bushel of corn or a Treasury or Libor
  interest rate.
• Interest rate swaps were only invented in 1984,
  but they became the leading form of cash
  management and now have notionals over 100
  trillion dollars..

19
Example Swap Contracts (Continued)

• There were no accounting rules for swap contracts
  prior to FAS 133.
• FAS 133 rules are complicated for hedging
  contracts --- see 000starta.xls file at
  http//www.cs.trinity.edu/rjensen/Calgary/CD/FAS
  133OtherExcelFiles/cases/
• There are a few standardized swaps traded on
  exchanges
• Contracts are non-standardized and might be
  subject to credit risk. 

20
Example Written Option ContractsFinancial Risk
May Be Unbounded

• Contracts to sell or buy at contracted (future)
  price that moves along with spot prices on an
  organized exchange linking buyers and sellers.
  Sale Price gt 0Premium! Example Selling Puts
  or Calls.
• Notional standardized quantities per contract
  for a standard product such as a particular type
  of corn.
• Underlying the value per unit such as the price
  of a bushel of corn or a Treasury or Libor
  interest rate.
• Options may also be non-standardized OTC. Use of
  options dates back to Roman times.

21
Example Purchased Option ContractsFinancial
Risk Is Bounded by Premium Paid

• Contracts to buy or sell at contracted (future)
  price that moves along with spot prices on an
  organized exchange linking buyers and sellers.
  Purchase Price gt 0Premium! Example Buying
  Puts or Calls.
• Notional standardized quantities per contract
  for a standard product such as a particular type
  of corn.
• Underlying the value per unit such as the price
  of a bushel of corn or a Treasury or Libor
  interest rate.
• Purchased options are the only derivatives where
  risk is limited to the premium (purchase) price
  paid initially.

22
Example Purchased Options (Continued)

• The accounting was relatively simple under the
  now-defunct FAS 80.
• FAS 133 rules are more complicated for hedging
  contracts --- see 000starta.xls file at
  http//www.cs.trinity.edu/rjensen/Calgary/CD/FAS
  133OtherExcelFiles/cases/
• CME --- http//www.cme.com/trading/dta/del/delayed
  _quotes3520.html
• Value of Option Intrinsic Value Time Value 

23
KEY ASPECTS OF THE 133/39 STANDARDS

• Most derivatives are reported at fair value on
  balance sheet
• Changes in fair value for derivatives not
  qualifying in a hedging relationship are recorded
  in earnings
• Hedge accounting is provided for the change in
  value of derivatives designated and qualifying
  as
• Fair value hedges
• Cash flow hedges
• Foreign currency hedges
• Hedge effectiveness tests may be tough hurdles
  over time

24
DERIVATIVES IMPLEMENTATIONGROUP (DIG)

• DIG is made up of FASB staff members, Big 5
  members and Industry professionals. Active DIG
  observers include the SEC and certain regulators.
• DIGs mandate is to assist the FASB in answering
  implementation questions by identifying practice
  issues that arise from applying Statement 133 and
  to advise the FASB staff on how to resolve the
  issues.
• Issues are discussed by DIG, tentatively
  concluded by the FASB staff and posted on the
  FASB website (www.fasb.org) for two months before
  being presented to the Board for negative
  clearance.
• DIG Site http//www.fasb.org/derivatives/

25
Bob Jensens Flow Charthttp//www.trinity.edu/rje
nsen/acct5341/speakers/133flow.htm

• Flow chart for deciding whether derivative is
  scoped into FAS 133
• Flow chart for deciding how to account for a
  derivative financial instrument qualified for
  hedge accounting.Cash Flow Hedge (booked item
  vs. forecasted transact.)Fair Value Hedge
  (booked item vs. firm commitment)Foreign
  Currency (FX) Hedge (fair value vs. cash flow)

26
DERIVATIVE DEFINITION 616

• The definition is based on distinguishing
  characteristics
• A derivative instrument is a contract with all
  three of the following characteristics (6)
• Underlying and either a notional amount or a
  payment provision or both
• Relatively small initial net investment
• Net settlement or its equivalent (excludes most
  short sales Take-Or-Pays, but see FAS 133
  Paragraph 290)
• Definition includes freestanding as well as
  embedded derivative instruments
• A number of exclusions exist

27
FREESTANDING DERIVATIVESOverview

• Statement 133 created a new definition of the
  term derivative
• Some instruments that are not usually considered
  derivatives are included (e.g. certain
  purchase/sales contracts)
• The definition is based on certain distinguishing
  characteristics.
• Certain scope exceptions exist not everything
  that meets the definition of a derivative is
  subject to the requirements of Statement 133.

28
FREESTANDING DERIVATIVES Three Characteristics
69 and 57

• A derivative instrument is a contract with all
  three of the following characteristics
• 1. Underlying and either a notional amount or a
  payment provision or both
• 2. No initial net investment or smaller initial
  net investment than contracts with similar
  responses to changes in market factors
• 3. Net settlement or its equivalent

29
FREESTANDING DERIVATIVES Characteristic
1Underlying 7 and 57(a)

• An underlying is a variable, such as
• An interest rate (e.g., LIBOR)
• The price of a security or commodity (e.g., price
  of a share of ABC stock or a bushel of wheat)
• A foreign exchange rate (e.g., Euro/U.S. spot
  rate)
• A measure of creditworthiness (e.g., Moodys)
• An index on any of above or other (e.g., SP 500,
  CPI)
• Other specific items

30
FREESTANDING DERIVATIVES Characteristic
1Notional Amount 7

• A notional amount is a number of
• Currency units
• Shares
• Bushels
• Pounds
• Other units
• Notional amount is used to determine the
  settlement amount (for example, a price x a
  number of shares)

31
FREESTANDING DERIVATIVES Characteristic
1Examples of Underlyings and Notional Amounts

• Derivative Underlying Notional
  Amount
• - Stock option - Stock price - Number
  of shares
• - Currency forward - Exchange rate - Number of
  currency units
• - Commodity future - Commodity price - Number
  of commodity units
• - Interest rate swap - Interest index - Dollar
  amount

32
FREESTANDING DERIVATIVES Characteristic
1Payment Provision 7

• A payment provision specifies a fixed or
  determinable settlement if the underlying behaves
  in a specified way.
• For example
• if interest rates increase by say 300
  basis points then payment of an
  applicable amount would be required

33
FREESTANDING DERIVATIVES Characteristic
2Initial Net Investment 8 and 57(b)

• A derivative requires either
• No initial net investment
• A smaller initial net investment than other types
  of contracts that have a similar response to
  changes in market factors
• A derivative does not require an initial net
  investment of
• the notional amount
• An exchange of currencies is not a net investment

34
FREESTANDING DERIVATIVES Characteristic 3Net
Settlement 9 and 57(c)

• There are 3 ways to meet the net settlement
  requirement
• 1. Net settlement explicitly required or
  permitted by the contract (transfer of cash or
  other assets)
• 2. Net settlement by a market mechanism outside
  the contract (e.g., futures exchange)
• 3. Delivery of a derivative or an asset that is
  readily convertible to cash

35
FREESTANDING DERIVATIVES Characteristic
3Readily Convertible to Known Amounts of Cash
9 and 57(c)

• Readily convertible assets have
• Interchangeable (fungible) units
• Quoted prices available in an active market that
  can rapidly absorb the quantity held by the
  entity without significantly affecting the price
• For example
• Public securities, commodities, and foreign
  currencies

36
FREESTANDING DERIVATIVES Exceptions 10 and 58

• The following are not subject to Statement 133
• Regular-way security trades
• Normal purchases and normal sales
• Traditional insurance contracts
• Most financial guarantee contracts
• OTC contracts with certain underlyings
• Derivatives that are an impediment to sales
  accounting

37
FAS 138Scope-Excluded Contracts

• Normal purchase/sale exception expanded to
  include
• Contracts that permit net settlement (9a)
• Contracts that have a market mechanism to
  facilitate net settlement (but note FAS 138)

• As long as it is probable contracts will not
  settle net and will result in physical delivery
  (but note FAS 138 and FAS 149)

38
FAS 138 Scope-Excluded Contracts (Contd)
Net settlement of similar contracts should be
rare Excluded from exception Contracts that
require cash settlement or otherwise settle
periodically Contracts that have price based
on underlying unrelated to asset sold or
purchased(1) Contracts denominated in foreign
currency not meeting embedded derivative
separation exception rules of paragraphs 15(a)
and 15(b) (1)


(1) May be considered compound derivatives
39
FREESTANDING DERIVATIVES Exceptions OTC
Contracts with Certain Underlyings 10(e) and
58(c)

• Climatic variables
• Temperature
• Rain or snowfall totals
• Wind speed
• Geological variables
• Earthquake severity (Richter scale)
• Other physical variables

40
FREESTANDING DERIVATIVES ExceptionsOTC
Contracts with Certain Underlyings 10(e) and
58(c)

• The price or value of nonfinancial assets of one
  of the parties that is not readily convertible to
  cash or the price or value of nonfinancial
  liabilities of one of the parties that does not
  require delivery of readily convertible assets
• Option to purchase or sell real estate owned by
  one party (even if it can be net settled)
• Firm commitment to sell machinery (if
  unique)owned by one party (even if it can be net
  settled)

41
FREESTANDING DERIVATIVES Exceptions OTC
Contracts with Certain Underlyings 10(e) and
58(c)

• Exceptions include specified volumes of sales or
  service revenues of one of the parties.
• For example
• Leases based on sales of the lessee
• Royalty agreements

42
FREESTANDING DERIVATIVES Contracts Not
Considered Derivativesfor Purposes of Statement
133, 11

• Instruments indexed to an entitys own stock and
  classified in stockholders equity
• Stock-based compensation covered by Statement 123
  (issuer only)
• Contingent consideration in a business
  combination covered by Opinion 16 (purchaser
  only)

43
EMBEDDED DERIVATIVES Definition 12

• Embedded derivatives are implicit or explicit
  terms that affect the cash flows or value of
  other exchanges required by a contract in a
  manner similar to a derivative
• The combination of a host contract and an
  embedded derivative is referred to as a hybrid
  contract
• Examples of hybrid contracts are
• Structured notes
• Convertible securities
• Securities with caps, floors, or collars

44
EMBEDDED DERIVATIVES When Does a Contract Have
an Embedded Derivative Subject to This Statement?
12
Would it be a derivative if it was freestanding?
Is the contract carried at fair value
through earnings?
Is it clearly and closely related to the
host contract?
No
Yes
No
Apply This Statement
Yes
No
Yes
Do Not Apply This Statement
45
EMBEDDED DERIVATIVES Clearly and Closely
RelatedGeneral 12 and 6061

• Clearly and closely related refers to
• Economic characteristics
• Risks
• Factors to consider
• The type of host
• The underlying
• See Flow Chart http//www.trinity.edu/rjensen/acc
  t5341/speakers/133flow.htm

46
EMBEDDED DERIVATIVES Clearly and Closely
RelatedUnderlyings

• Type of Host Underlying
• Debt Interest
• Inflation
• Creditworthiness
• Equity Price of share in entity
• Lease Inflation
• Interest

47
EMBEDDED DERIVATIVESClearly and Closely Related

• Paragraph 61 provides guidance for determining
  whether the economic characteristics and risks of
  the embedded derivative are clearly and closely
  related to the economic characteristics and risks
  of the host contract.

48
FAIR VALUE HEDGE 2022

• A fair value hedge is a hedge of the exposure to
  a change in fair value of a recognized asset or
  liability or of an unrecognized firm commitment
  attributable to a particular risk. Key aspects
• Hedged item is exposed to price risk
• For a highly effective hedge, there must be
  offsetting fair value changes for hedged item and
  hedging instrument
• Changes in fair value of hedged item and hedging
  instrument are recorded in earnings
• Basis of hedged item is adjusted by the change in
  value

49
FAIR VALUE HEDGE ACCOUNTING

• Key concepts
• Derivatives are always adjusted on the balance
  sheet at fair value (i.e., marked-to-market)
  (17)
• In qualified hedge accounting, the offset to
  changes in the hedging derivative is OCI for cash
  flow hedges but not for fair value hedges.
• For a qualified fair value hedge, the offset is
  Firm Commitment for a purchase contract
  with a contracted price
  Hedged Item carrying value if the hedged item
  such as inventory is already on the
  books at historical cost PL current
  earnings if the hedged item such as
  inventory is already on the books at fair value

50
FAIR VALUE HEDGE ACCOUNTINGFor Hedged Item
Booked at Historical Cost

• Measurement of Derivative

Change in Fair Value
EarningsChangesOffset(1)
Accounting Model
Measurement of Hedged Item
Offsetting Gain or Loss Attributable to Risk
Being Hedged
(1) Ineffectiveness affects net earnings
51
CASH FLOW HEDGE 2931

• A cash flow hedge is a hedging relationship where
  the variability of the hedged items cash flows
  is offset by the cash flows of the hedging
  instrument. Key aspects
• Hedged item may be a forecasted transaction with
  no contracted future price (i.e., not a firm
  commit.)
• Effective portion of derivatives gain or loss
  reported in OCI
• Earnings recognition matches hedged transaction
• Ineffective gain or loss recorded in earnings

52
CASH FLOW HEDGE ACCOUNTING

• Derivative instrument recorded at fair value,
  effective portion through OCI, ineffective
  through earnings
• Amounts in OCI recognized in earnings when hedged
  transaction impacts earnings under FAS 133 but
  not under IAS 39. In other words, IAS 39
  requires basis adjustment when the derivative
  expires whereas FAS 133 carries OCI forward until
  hedged item is disposed of in a transaction.

53
CASH FLOW HEDGE ACCOUNTING
Measurement of Derivative
OCI Equity
Effective
Change in Fair Value
Accounting Model
(1)
Ineffective
Earnings
(1) Based on Timing of Earnings Impact of
Hedged Item (interest, cost of sales,
depreciation)
54
FOREIGN CURRENCY HEDGE 3642 (as amended by FAS
138)

• The Board intended to increase the consistency of
  hedge accounting guidance by broadening the scope
  of eligible foreign currency hedges. At the same
  time, the Board chose to continue certain prior
  practices. Key aspects
• Includes hedges of cash flow, fair value, and net
  investments in foreign operations
• Carries forward the functional currency concept
  from Statement 52
• Permits limited use of nonderivative instruments
• Expands hedge accounting, particularly for
  forecasted transactions and tandem currency hedges

55
Hedging Instruments

• For a fair value hedge of foreign exchange risk
  related to AFS securities or a recognized
  foreign-currency-denominated debt instrument, an
  entity can only use a derivative instrument
• For a fair value hedge of foreign exchange risk
  related to a firm commitment, an entity can use
  either a derivative or a non-derivative
  instrument
• For a cash flow hedge of a forecasted foreign
  currency denominated transaction (including
  forecasted intercompany transactions, recognized
  foreign-currency-denominated debt instruments and
  firm commitments accounted for as forecasted
  transactions), an entity can only use a
  derivative instrument
• For a hedge of a net investment in a foreign
  operation, an entity can use either a derivative
  or a non-derivative instrument

56
OBJECTIVE OF HEDGE ACCOUNTING

• Timing of gain/loss recognition on hedging
  instrument and
• hedged item
• Hedged Item -0- (1) (20) (20)
• Derivative 20 (2) -0- 20
• 20 (20) -0-

Periods 1 2 Total
57
IAS 39 should be applied by all enterprises to
all financial instruments except

•  (a) those interests in subsidiaries,
  associates, and joint ventures that are accounted
  for under IAS 27, Consolidated Financial
  Statements and Accounting for Investments in
  Subsidiaries IAS 28, Accounting for
  Investments in Associates and IAS 31, Financial
  Reporting of Interests in Joint Ventures 

58
IAS 39 should be applied by all enterprises to
all financial instruments except

•  (b) rights and obligations under leases, to
  which IAS 17, Leases, applies however, (i)
  lease receivables recognized on a lessor's
  balance sheet are subject to the derecognition
  provisions of this Standard (paragraphs 35-65 and
  170(d)) and (ii) this Standard does apply to
  derivatives that are embedded in leases (see
  paragraphs 22-26)

59
IAS 39 should be applied by all enterprises to
all financial instruments except

•  c) employers' assets and liabilities under
  employee benefit plans, to which IAS 19, Employee
  Benefits, applies 
• (d) rights and obligations under insurance
  contracts as defined in paragraph 3 of IAS 32,
  Financial Instruments Disclosure and
  Presentation, but this Standard does apply to
  derivatives that are embedded in insurance
  contracts (see paragraphs 22-26)
• (e) equity instruments issued by the reporting
  enterprise including options, warrants, and other
  financial instruments that are classified as
  shareholders' equity of the reporting enterprise
  (however, the holder of such instruments is
  required to apply this Standard to those
  instruments) 

60
IAS 39 should be applied by all enterprises to
all financial instruments except

•  (f) financial guarantee contracts, including
  letters of credit, that provide for payments to
  be made if the debtor fails to make payment when
  due (IAS 37, Provisions, Contingent Liabilities
  and Contingent Assets, provides guidance for
  recognizing and measuring financial guarantees,
  warranty obligations, and other similar
  instruments). In contrast, financial guarantee
  contracts are subject to this Standard if they
  provide for payments to be made in response to
  changes in a specified interest rate, security
  price, commodity price, credit rating, foreign
  exchange rate, index of prices or rates, or other
  variable (sometimes called the 'underlying').
  Also, this Standard does require recognition of
  financial guarantees incurred or retained as a
  result of the derecognition standards set out in
  paragraphs 35-65

61
IAS 39 should be applied by all enterprises to
all financial instruments except

•  (g) contracts for contingent consideration in a
  business combination (see paragraphs 65-76 of IAS
  22 (Revised 1998), Business Combinations) 
• (h) contracts that require a payment based on
  climatic, geological, or other physical variables
  (see paragraph 2), but this Standard does apply
  to other types of derivatives that are embedded
  in such contracts (see paragraphs 22-26). 

62
IAS 39 should be applied by all enterprises to
all financial instruments except

• 3. IAS 39 does not change the requirements
  relating to(a) accounting by a parent for
  investments in subsidiaries in the parent's
  separate financial statements as set out in
  paragraphs 29-31 of IAS 27(b) accounting by an
  investor for investments in associates in the
  investor's separate financial statements as set
  out in paragraphs 12-15 of IAS 28(c) accounting
  by a joint venturer for investments in joint
  ventures in the venturer's or investor's separate
  financial statements as set out in paragraphs 35
  and 42 of IAS 31 or(d) employee benefit plans
  that comply with IAS 26, Accounting and Reporting
  by Retirement Benefit Plans.

63
IAS 39 may apply to insurance companiesbut not
insurance contracts

• 5. IAS 39 applies to the financial assets and
  liabilities of insurance companies other than
  rights and obligations arising under insurance
  contracts, which are excluded by paragraph 1(d).

64
CASE 1 Cash Flow Hedge of Forecasted Inventory
Sale

• ABC is hedging the risk of changes in cash flows
  related to a forecasted sale of 100,000 bushels
  of Commodity A to be sold at the end of period 1.
  The inventory carrying value is 1 million, and
  current market value is 1.1 million
• On the first day of period 1, ABC enters into
  Derivative Z to sell 100,000 bushels at 1.1
  million at the end of period
• At hedge inception, the derivative is
  at-the-money (fair value is 0)
• All terms of the commodity and the derivative
  match (i.e., no expected ineffectiveness)
• On last day of Period 1, fair value of Derivative
  Z increased by 25,000 and expected sales price
  of 100,000 bushels of Commodity A decreased
  25,000
• From Example 4, Appendix B of Standard

65
CASE 1 Cash Flow Hedge of Forecasted Inventory
Sale

• Journal entries at end of period 1
• Derivative Z 25,000
• OCI 25,000
• To record Derivative Z at fair value
• Cash 25,000
• Derivative Z 25,000
• To record settlement of Derivative Z

66
CASE 1 Cash Flow Hedge of Forecasted Inventory
Sale

• Journal entries at end of period 1
• Cash 1,075,000
• CGS 1,000,000
• Revenue 1,075,000
• Inventory 1,000,000
• To record inventory sale
• OCI 25,000
• Earnings 25,000
• To reclassify amount in OCI to earnings upon
  inventory sale

67
CASE 1 Cash Flow Hedge of Forecasted Inventory
Sale

• Forecasted cash flows 1,100,000
• Actual cash flows
• Derivative 25,000
• Sale of inventory 1,075,000
• Total 1,100,000
• The variability of cash flows related to the
  forecasted inventory sale is offset by change in
  value of derivative.

68
CASE 2Fair Value Hedge of Inventory

• ABC has 1,000 bushels of a Commodity with a fair
  value of 1.1 million and a carrying value of
  1.0 million
• ABC wants to hedge overall fair value of the
  Commodity
• On 1/1/X1, ABC enters into an at-the-money
  matching derivative to hedge the changes in
  fair value of the 1,000 bushels of the Commodity

69
CASE 2 (Contd)Fair Value Hedge of Inventory

• Effectiveness will be assessed by comparing
  entire change in fair value of derivative to
  change in market price of inventory (time value
  will be ignored for illustration purposes only)
• On 1/31/X1, the fair value of the derivative has
  increased by 25,000 and the fair value of the
  inventory has decreased by 25,000

70
CASE 2Fair Value Hedge of Inventory

• Journal entries at end of period
• Derivative 25,000
• Earnings 25,000
• To record derivative at fair value
• Earnings 25,000
• Inventory 25,000
• To record loss on hedged inventory