Chapter 19
Chapter 19 covers four discrete accounting topics and we'll cover all four topics as part of this course.
I. A derivative is a financial instrument or other contract that derives its value from the movement of the price, foreign exchange rate, or interest rate on some other underlying asset or financial instrument. Derivatives are extensively used to manage risk. Though defined in terms of an underlying item, they are often settled by a simple payment of cash; there is no need to take delivery or make delivery of the underlying asset or financial instrument. When no cash changes hands at the time of signing of the contract, the derivative is an executory contract and no journal entry is required to recognize the agreement at that time. At the date of the next financial statement, the fair value of the derivative should be recognized as an asset. Historically, derivatives were treated as off-balance-sheet items with perhaps some disclosure in the notes. Accounting for derivatives was changed by FASB Statement No. 133, issued in 1998, as a result of the accounting scandals involving Enron and other companies.
Because use of derivatives aids a company in managing its risks, we need to have some discussion of risks. The principal types types of risk that derivatives are used to hedge against are:
- Price risk: uncertainty about the future price of an asset
- Credit risk: uncertainty that the party on the other side of an agreement will abide by the terms of the agreement
- Interest rate risk: uncertainty about future interest rates, impacting cash flows as well as fair values of assets and liabilities
- Exchange rate risk: uncertainty about future U.S. dollar cash flows from assets and liabilities denominated in foreign currencies.
Hedging is the structuring of transactions to reduce risk. Derivatives can be used in hedging through the acquisition of a derivative with the characteristic that changes in the value of the derivative are expected to offset changes in the value of the asset being hedged. See pages 1127 through 1135 for examples of the use of derivatives as hedges and the accounting related to them. The FASB has identified three categories of hedging activities:
- Fair value hedges as derivatives offsetting, at least in part, changes in the fair value of an asset or liability
- Cash flow hedges are derivatives offsetting, at least in part, variations in cash flows from forecasted transactions that are probable
- Foreign currency hedges, which are covered in more advanced accounting courses
- On the balance sheet, derivatives shout be reported at their fair value only.
- On the income statement, gains and losses on derivatives used to hedge risk are to be reported in the same income statement in which the income effects of the hedged asset are reported. This may require temporary deferral of unrealized gains or losses in an accumulated other comprehensive income account which is reported as part of equity.
Notice that the derivative must be designated as a hedge of a specific item at the beginning of the hedging relationship, or not at all. The designation should be supported with formal documentation. This must include a definition in advance of how the effectiveness of the hedge is to be determined. If a hedge is only partly effective, the gains and losses associated with hedge ineffectiveness are recognized in income immediately in the period in which they occur. Disclosure requirements include a description of the company’s risk management strategy and how derivatives are used therein. Also, for both fair-value and cash-flow hedges, the transactions must be described that will cause deferred derivative gains and losses to be recognized in net income, and the amount of deferred gains or losses expected to be recognized in net income in the next twelve months must be disclosed. Carefully study Pages 1130 – 1135 for illustrations of derivative accounting.
II. Accounting for contingencies is the subject of FASB Statement No. 5 whose provisions are summarized as follows:
Contingent Losses:
Likelihood / Accounting Action
Probable / Recognize as a probable liability is the amount can be reasonably estimated. Otherwise disclose facts in a note.
Reasonably possible / Disclose a possible liability in a note.
Remote / Make no recognition or disclosure unless contingency represents a guarantee: then disclose in a note.
Contingent Gains:
Likelihood / Accounting Action
Probable / Recognize a probable asset if the amount can be reasonably estimated. Otherwise disclose facts in a note.
Reasonably possible / Disclose a possible asset in a note, but take care to avoid misleading implications. In practice, contingent gains are often not disclosed.
Remote / Make no recognition or disclosure.
FASB Statement No. 5 gives no numerical definitions of the probability judgments to be employed, but in the case of a decision as to whether a liability for a lawsuit exists (where the risk is uninsured), it identifies several key factors to consider:
- The nature of the lawsuit
- Progress of the case in court (including progress between date of financial statements and their issuance date)
- Views of legal counsel as to probability of loss
- Prior experience with similar cases
- Management’s intended response to the lawsuit
III. With regard to business segment reporting the pertinent FASB Statements are #14, issued in 1976, and #131, issued in June 1997. The latter agrees closely with Canadian and in international standards for business segment reporting. FASB Statement No. 131 requires disclosure of the following information concerning business segments:
- Total segment reporting profit or loss
- Amounts of certain income statement items:
- Operating revenues
- Depreciation
- Interest revenue
- Interest expense
- Tax expense
- Significant non-cash expenses
- Total segment assets
- Total capital expenditures
- Reconciliation of the sum of segment totals to the company total for:
- Revenues
- Operating profit
- Assets
- Total segment revenue not less than 10% of total company revenue
- Absolute value of segment profit or loss exceeds 10% of absolute value of total operating profit for all segments reporting a profit, or of total of losses for all segments reporting losses
- Segment assets not less than 10% of combined assets of all operating segments
Pages 1143-4)..
IV. The Security and Exchange Commission requires publicly traded companies to file quarterly financial statements in a 10-Q filing within 45 days of the end of the quarter. These interim financial statements result in significant accounting problems: seasonal factors may raise difficulties in matching expenses with revenues; adjustments for accrual items may involve more reliance on estimation and consequent increased subjectivity; extraordinary items or disposal of a segment may have a disproportionate impact on an interim period’s earnings.
Current U.S. GAAP follows the principle of the integral part of annual period. The interim period is to be treated not as a separate stand-alone accounting period but as a part of the annual accounting period. The same judgments, estimations, accruals, and deferrals should be recognized at the end of each interim period as for the annual period. See pages 1146-7 for further details. Quarterly reports filed with the SEC need not be audited but they are to be prepared in accordance with GAAP.