Accounting for Derivatives on Financial Statements

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  • 0:03 Why Derivatives?
  • 0:53 Fair Value Hedges
  • 2:21 Accounting for Fair…
  • 3:09 Cash Flow Hedges
  • 4:41 Lesson Summary
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Lesson Transcript
Instructor: James Walsh

M.B.A. Veteran Business and Economics teacher at a number of community colleges and in the for profit sector.

Let's look at the journal entries and financial 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 financial instruments that get their value from fluctuations 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 flow 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)

If the market value of the crop falls to $10,000, the food company owes Brown the $2,000 difference 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 fluctuate 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 crop $2,000 Loss on decline in value is recognized
Grain inventory $2000 The credit reduces the value of the grain asset to fair market value
Futures contract on grain $2,000 This sets up the futures contract as a contra asset to the 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.

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